RBS - A tale of two banks

Today’s results for RBS were very much a tale of two banks.   Operating profit up from £1.8bn in 2011 to £3.5bn, but net profit showed a huge loss of  £ 5.2bn which was in excess of the expected £3.5bn loss that analysts had been predicting.  CEO Steven Hester will be hoping people will focus on the good news – that under his guidance ‘new RBS’ is improving and moving towards a better future.  But early signs suggest the markets have focused on the losses of ‘old RBS’ – losses created by adjustments to loan values, mis-selling compensation and fines that are the legacy of the pre-crisis world of finance.  In immediate trading after the announcement, their share price fell by more than 3% to some £3.35.

So, what are the issues behind these figures?

Beyond what you could call the technical mists that surround loan valuations, provisions and capital ratios, the key questions are:

·      what is the proper role for banks in a modern economy and

·      what policies and structures of governance are needed to ensure they do and continue to do the right thing?

On the first point we can now see that the way banks operated before the crisis was in a quite false context that made it sensible to innovate and sell the products they did, to create the profits they did and to pay themselves the bonuses that they did. Their emphasis was on ‘product’ and who they could sell and maximize revenues to rather than their customers - what were their needs and how could they support them?  On that basis the test of successful banking is whether they are creating the right products, developing the right relationships with customers and lending to support and finance business activity in what we can call the ‘real economy’.

On this particular count there is still much a long way to go. While banks such as RBS have been successful in clearing much of the bad debt from their balance sheets and while they have been rebuilding their capital and liquidity positions they have not yet created a culture and internal innovative systems to drive the right kind of relationships and culture that are fundamentally customer focused.

On the second point we can see a variety of policy approaches emerging to remedy the control and governance systems of banks. In the UK the approach is largely that the market will regulate itself: that regulators need to impose constraints and financial requirements but it is the banks themselves who will restructure and reorganize themselves so that they are consistently selling the right products to the right people at the right price. In the rest of the EU there is a much greater willingness to intervene directly to change that behaviour and to change that culture. Currently there are proposals to introduce, for example, a one-year salary cap on bankers bonuses. This may or may not be successful in its execution. In order to fulfill these obligations, financial institutions may well switch remuneration from bonuses into core pay or some other method of flexible pay. But the message is clear that the policy is an explicit signal to force change on an industry that is actually slow to change in response to the new realities of this decade. A third approach can be seen in Switzerland where, so devastated by the actions and behaviours of their banking system, the electorate are likely to bestow much greater powers on shareholders to influence directly remuneration and the day-to-day management decisions of banks.

These debates will rage. And they are fuelled by the annual review of the financial performance of the banks that are published at this time of year. My guess is that as the markets digests the full detail of RBS profits, they might well soften their attitude and see some of the positive developments that the results suggest. Its share price may well ease back up over the course of the next few hours or days.

What is clear is that there is still much work to be done.  But how we manage and regulate banks is still under discussion.  If left largely to market forces, the changes needed will take a long time.  In my view we should be willing to put more assertive actions in places to change the behaviour of banks through stronger representation of share-holders,  incentives to lend more actively to the business community and potentially make structural changes to support and drive investment in innovation, technology, infrastructure and growth.  In that way we might see an end to this prolonged slow recovery rather sooner.