ISSUER COMMENT 30 APRIL Royal Bank of Scotland Group plc - United Kingdom. Summary Opinion

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1 ISSUER COMMENT ANALYST CONTACTS Andrea Usai VP-Sr Credit Officer Maxwell Price Associate Analyst Royal Bank of Scotland Group plc - United Kingdom Q Results: Litigation, Conduct and Restructuring Charges Keep Results in the Red But further good progress on group restructuring was achieved in the quarter Summary Opinion Bank of Scotland Group (RBS, Baa2 review for downgrade)1 to report a net loss of 446 million (versus a profit of 1.2 billion in Q1 2014). These quarterly results are credit negative but have no direct impact on the bank s ratings, as they are broadly in line with our expectation of high earnings volatility during the group s multi-year restructuring. Alessandro Roccati Senior Vice President alessandro.roccati@moodys.com Laurie Mayers Associate Managing Director laurie.mayers@moodys.com Robert Young MD-Financial Institutions robert.young@moodys.com In Q1 2015, 1.3 billion of litigation, conduct and restructuring charges led Royal Large charges related to pending litigations, conduct and the ongoing restructuring have continued to erode operating profits from the core retail and commercial banking operations. On an underlying basis, helped by favourable credit conditions in the UK (Aa1 stable), Ireland (Baa1 stable), and cost-reduction initiatives, the performance of RBS s UK Personal & Business Banking and Commercial & Private Banking divisions continued to improve. However, the heavy restructuring also continued to take its toll on the results of the Corporate & Institutional Banking division, adding further pressure on the group s profits. As we expected, RBS made further progress on its complex restructuring plan. In Q1, RBS sold an additional shares in Citizens (Citizens Bank NA, A3 review for upgrade, A3 review for downgrade, a3; and Citizens Bank of Pennsylvania, A3 review for upgrade, a3), reducing its stake down to 40.8%. Investors appetite and favourable market conditions have also helped RBS to achieve further reductions in the legacy asset portfolio RBS Capital Resolution (RCR) and aided the disposal of other assets and businesses that management no longer considers as strategic. The reduction in poorquality RCR loans led to a further strong improvement in the group s overall asset quality metrics.

2 In Q1, lower RWAs resulting from ongoing de-risking strengthened the regulatory capital position.the group s fully loaded Basel III Common Equity Tier 1 (CET1) ratio increased by 30 basis points to 11.5% at quarter-end and led to a marginal improvement in the leverage ratio to 4.3%. RBS has a target CET1 ratio of 13% for 2016 and risk-weighted assets (RWAs) are targeted to fall below 300 billion by the end of We consider these targets as achievable if the restructuring is implemented as management has planned, and if no major headwinds materialise. Detailed Considerations All figures in this report relate to Q and comparisons are made to Q1 2014, unless otherwise indicated. Litigation/conduct costs and restructuring charges led to a large quarterly loss RBS s net loss of 446 million resulted from a number of notable items, which included (1) total litigation and conduct provisions of 856 million ( 100 million were in respect of Payment Protection Insurance, 257 million for packaged current accounts and 334 million in respect of foreign exchange litigations); (2) 453 million restructuring costs (of which 277 million related to US property write downs); and (3) a loss of 320 million due to the fall in market price of Citizens shares, against an increase in their tangible net asset value over the quarter. Whilst we consider the latter as being exceptional, we consider litigation and conduct costs as recurring and we expect them to continue to weigh on the profitability of RBS and the other large UK and global banks, as regulatory authorities continue to heavily scrutinise their (current and past) conduct of business practices. Results by business line were mixed in Q1 Exhibit 1 summarises RBS s quarterly performance by division on a reported basis and Exhibit 2 shows the impact from conduct, litigation and restructuring charges on the underlying divisional performance. Exhibit 1 Operating Profits Show Relatively Good Performance for the UK Retail and Commercial Operations RBS: quarterly operating profits by business line Source: RBS s Q1 Results 2015 and Excel data supplement. This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on for the most updated credit rating action information and rating history. 2

3 Exhibit 2 Large Conduct, Litigation and Restructuring Charges Eroded Underlying Core Profits in Q1 RBS: Underlying operating profits by core business line for Q Source: RBS s Q1 Results 2015 and Excel data supplement. The Personal & Business Banking (PBB) division, which comprises RBS s retail and business banking in the UK, as well as its Irish operations, reported an operating profit of 399 million, from a profit of 519 million in the same period a year earlier. RBS s UK domestic operations represent one of RBS s key credit strengths because they generate stable and predictable (underlying) earnings and continue to grow in a competitive market. Excluding conduct and litigation costs of 354 million, which continued to erode profits, lower credit costs meant that the quarterly performance improved. Compression of mortgage margins meant that income was broadly flat at 1.1 billion. In addition, operating expenses reduced by 15% to 746 million and lower defaults prompted a net 26 million provision reversal. Ulster Bank Ireland Limited (Baa3 review for downgrade/baa3 review for downgrade, b3), generated an operating profit of 51 million, from a profit of 9 million in This large improvement was driven by the strengthening of the sterling versus the euro and corresponds to an increase of 3% on a constant currency basis with zero net credit costs. We positively note that the improving credit conditions in Ireland are aiding the recovery of Ulster Bank s performance. Although RBS has confirmed its commitment to its Irish operations, earlier this year it indicated it will workout the low-yielding tracker mortgage book, which, if disposed of with limited financial losses would be a positive development and a key step in the positive evolution of Ulster Bank s franchise and long-term performance. RBS s Commercial Banking division reported an operating profit of 412 million versus 321 million in the same period a year earlier. Adjusted for the effect of the transfer of the Private Banking (RBSI) business to Commercial Banking from 1 January 2015, total income was 822 million and benefited from the wider interest margin on deposits. These operations are also a key business for RBS, which has a strong market share in the UK domestic market, and net lending was 1.3 billion in the quarter, increasing the loan book to 88.8 billion. The Corporate & Institutional Banking (CIB) division reported an operating loss of 741 million, compared with a profit of 333 million a year earlier, driven by lower income because of the heavy ongoing restructuring of this business and a total of 500 million of litigation and conduct costs. Income by product line was lower than in the same period in 2014 across the board with the larger declines reported in Credit (down 49% to 235 million), Rates (down 40% to 217 million) and Currencies (down 25% to 143 million). As a result of the ongoing restructuring, and excluding litigation, conduct costs and restructuring charges, operating expenses fell 18%. The quarterly reduction in capital markets operations, which we view as credit positive because these activities carry earnings volatility and tail risk, resulted in a 4.3 billion decline in RWAs. 3

4 Earlier this year, RBS identified certain capital markets activities that are not generating an adequate risk return or consume too much capital, and as such it intends to dispose of them. This will result in a reduction of between billion of RWAs by 2019, from 103 billion at end of March Of this reduction, c. 25 billion is expected to be achieved during The group expects to downsize the investment banking franchise to reduce the number of countries in which it operates to around 13 by 2019 from 38 currently, which would in turn further focus its activities toward its core UK market. A reduction in these activities could be positive for the ratings because they are inherently riskier than more traditional retail and commercial banking and will most likely support further improvements in the group s capital and leverage metrics. Despite this reduction, however, the group remains fully committed to certain product lines FX, Rates, DCM, Structured Finance and Loans that it deems important to support its corporate client base4. Further good progress on asset disposals continued to help de-risk the business and improve regulatory capitalisation In Q1, RBS made good progress on a number of its ongoing restructuring initiatives: RCR s funded assets reduced by 4 billion to 11.1 billion. The corresponding reduction in (equivalent) RWAs was 57% to 24.3 billion. We positively note that the asset disposals thus far have kept broadly unchanged the proportion of non-performing loans that remain. The disposal of poor-quality assets, particularly some Irish loans that were heavily provisioned, contributed to a large decline in the group s overall non-performing ratio5 to 5.4% at the end of March 2015 from 6.8% at end Management has announced that it is on target to divest the vast majority of the RCR assets by the end of 2015, a year earlier than originally planned, which we consider as achievable. It has also indicated that the then residual RCR assets (circa 15% of its original size) will be returned to the CIB division; RBS sold a further tranche of Citizens in the quarter, reducing its stake to around 40.8%2. Management has indicated that it expects the deconsolidation of this business to take place once it reduces the residual stake to below 35%, expected later this year. This will allow RBS to recognise the benefits from this large disposal in its regulatory capital ratio; and, RBS announced the sale of a portfolio of North American loan commitments worth $36.5 billion to Mizuho Bank Ltd (unrated), with a correspondent reduction of RWAs of around $8 billion3. In addition, earlier this month, RBS announced it had reached an agreement to sell an additional $5.6 billion tranche of the same portfolio. Finally, RBS has sold its international private banking operations and wealth business to Union Bancaire Privée SA, with assets totalling c.chf32 billion at the end of 2014, corresponding to CHF2 billion of RWAs. Exhibit 3 RCR: Asset Breakdown and RWAs Show Improving Trend Source: RBS s Q1 Results 2015 and Excel data supplement. 4

5 De-risking has led to a higher regulatory capital ratio, but it could still experience some volatility in the coming quarters RBS s capital position is currently one of the highest amongst large UK banks and it is well placed in relation to its global peers (Exhibit 4).Whilst we consider that the group's overall restructuring is realistic, we continue to believe that RBS's capital ratios could experience some volatility in the coming quarters as the restructuring plan is executed and other expenses, such as litigation, restructuring costs and other regulatory fines, continue to be incurred. Ongoing deleveraging meant that RBS s capital position improved during Q1. RBS s fully-loaded Basel III CET1 ratio was 11.5% at the end of Q1, up 30 basis points in the quarter. Furthermore, the ongoing reduction in the RCR and capital markets activity meant that the group s total RWAs (on a fully loaded Basel III basis) reduced by 2.1% to 349 billion, over the same period. Exhibit 4 CET1 ratios for Global Investment Banks, as at end-march 2015 (*): figures as at 31 December Source: Banks investor presentations. RBS has a target CET1 ratio of >11% for end-2015, and the additional actions that it intends to implement mean it has increased the target capital ratio to 13% for end We consider these targets as achievable and take comfort from the proven track record of the group s restructuring, which continues as planned in the absence of major headwinds (such as possible increases in RWAs from certain ongoing regulatory policy initiatives). Last quarter, management also indicated that it will request regulatory approval to return any excess capital to shareholders, once it achieves the 13% capital target. We believe that RBS s ongoing de-risking will help the group to meet additional leverage ratio requirements, following the recommendations from the UK Financial Policy Committee published on 31 October RBS s leverage ratio was 4.3% at end-q1, well above the current 3% minimum level that the UK Prudential Regulatory Authority (PRA) currently requires. Robust funding and liquidity were broadly unchanged in Q1 RBS s liquidity and funding positions have remained sound. The group s liquid asset portfolio was up 6 billion to 157 billion during the quarter, substantially in excess of the firm s short-term wholesale funding stock of 27 billion. Deposits were at 349 billion, broadly in line with the end of the previous quarter. Furthermore, as new lending broadly offset asset-reduction activity, RBS s loan-todeposit ratio was unchanged in the quarter at 95%. Earlier this year, management announced that the large issuance of loss-absorbing capital in the coming years will increase the loan-todeposit ratio, which it currently targets to be between 105% and 110% by Confirming the bank s sound liquidity and funding position, RBS reported an estimated Basel III liquidity coverage ratio of 112% at end Q1 and a net stable funding ratio of 110%. 5

6 Ratings Considerations On 17 March 2015, we placed RBS Group's Baa2 senior unsecured long-term debt and its Prime-2 short-term ratings on review for downgrade. The ratings for the junior instruments of RBSG were placed on review for upgrade. At the same time, we placed RBS's Baa1 long-term debt and deposit ratings on review for upgrade. RBS's Prime-2 short-term ratings and those of its junior subordinated debt instruments were unaffected by this rating action. RBS's ba1 standalone BCA reflects (1) the challenges the group continues to face in implementing its complex restructuring, despite substantial progress achieved thus far, (2) the group's still-sizeable global capital markets business, despite downsizing achieved over the last several quarters, whose earnings are inherently volatile and riskier than those from retail and commercial banking activities; (3) its still-weak (albeit improving at a rapid pace) asset-quality profile driven by its exposures in Ireland, the commercial real-estate (CRE) sector and other non-performing assets; (4) weak profitability; and (5) past risk-management failings. These factors are somewhat mitigated by (1) strong underlying earnings from non-investment banking activities which are, however, currently being eroded by high conduct-related cost and litigation charges; (2) the group's strong de-risking and restructuring track record; (3) adequate and improving capitalisation, which in our view could still experience some volatility in the run-up to the completion of the group's overall restructuring plan; and (4) sound liquidity and funding positions. The review for upgrade on the long-term deposit and debt ratings for RBS, the review for downgrade on the long-term debt ratings for RBSG and the review for upgrade on the ratings for RBSG's junior instruments, were underpinned by the bank's standalone credit strength but also take into account the introduction of our new methodology, and specifically our Advanced Loss Given Failure (LGF) analysis. 6

7 Endnotes 1 The ratings shown in this report are: (1) the senior unsecured debt rating and relevant outlook for the holding company RBS Group; and, (2) the deposit ratings, senior unsecured debt ratings, relevant outlook and baseline credit assessments for RBS plc, Ulster Bank and Citizens. 2 Please see our Issuer Comment: RBS Sale of Additional Shares in Citizens Financial Is Credit Positive, published on 30 March Please see our Issuer Comment: RBS Announced Further Restructuring of its Operations, a Credit Positive published on 2 March Please see our Issuer Comment: RBS Announced Further Restructuring of its Operations, a Credit Positive published on 2 March Risk Element In Lending (REIL) as a percentage of gross loans. 7

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9 AUTHORS Andrea Usai Maxwell Price EDITOR Greg Davies 9