Government intervention

During the recession, many big companies were heavily affected and some even failed. One of which would have failed without government intervention is the Royal Bank of Scotland which will be covered within this report. The purpose of this report is, firstly, to give the most important facts from its history and to provide background information about the entity. Secondly, to state the role of RBS within the financial system. Finally, to report the efficiency during the recession to the present date, by referring to different sources such as journals, newspapers and other internet sources.

History and background

RBS Group is a large and powerful entity that is the parent company of RBS Bank and many other subsidiary companies in specialist retail areas such as loans and insurance, credit card companies, mortgage firms, internet/ telephone banking and private banking. Names under RBS’s corporate umbrella include NatWest, Churchill insurance, MINT, the one account and Adam & Co and Coutts private banking (RBS, 2009a).

RBS was founded in 1727 and traded primarily in the capital of Scotland, Edinburgh for just over half a century with a total staff count of 8, until in 1783 a branch in Glasgow was established, this branch accumulated more than half of the banks entire revenue confirming that the banks development to Glasgow was a strategic success (RBS, 2009b).

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1874 marked the opening of RBS’s first branch in London during the rise of the Rothschild Empire and shortly before Britain purchased a share of the Suez Canal in Egypt, a canal which transformed the world trade in the late 1800’s which later benefitted RBS. As London now saw an increase in trade from the Middle East so did it see an increase in London banking of which RBS was now a part (Lee, 2005).

In the twentieth century RBS expanded rapidly acquiring several English banks including William Deacon’s Bank Ltd & Glyn, Mills & Co and Drummonds Bank. They then travelled across the Atlantic Ocean to establish their first branch in New York, USA, in 1960.

Nine years later RBS merged with the National Commercial bank of Scotland due to the economic turbulence of the time. At this point they introduced their brand mark the daisy wheel, which now signifies their corporate identity, due to the increasing use of marketing and advertising within England the demand for a clear and unique branding emblem was stronger than ever.

In the 1980’s they went on and launched Direct Line motor Insurance and also brought the Citizens Financial Group in the USA. By the 1990s they were at the forefront of telephone and internet banking (RBS, 2009b).

In 2000 RBS took over NatWest in the biggest banking takeover that had ever taken place in Britain whereby RBS consequently inheriting more than 200 branches nationwide and a rich heritage that dated back to 1650. After this takeover, in 2002, they had become the second largest bank in Europe and the fifth largest in the world by market capitalisation. Carrying on from this big takeover and the success of it, they then went on to perform the biggest takeover in banking history in 2007. They led a unique consortium to acquire the Dutch bank ABN AMRO by taking over one of its divisions after the company was shredded and claimed by various other banks (RBS, 2009b).

According to RBS Group (2008), its structure consists of 7 divisions, they are:

1. Global banking & Markets
2. Global Transaction Services
3. UK Retail & Commercial Banking
4. US Retail & Commercial Banking
5. Europe & Middle East Retail & Commercial Banking
6. Asia Retail & Commercial Banking
7. RBS Insurance

At the present, according to RBS (2009c), the Royal Bank of Scotland Group is an award winning company and has over 40 million customers around the world, 25 million of which are from the UK. Furthermore, after 280 years of experience in financial sector it has 2278 branches in over 50 countries.

Role of RBS in financial system

It is apparent that RBS’s major area of operations is banking, but what are the roles of banks in financial system and economy? The simplest explanation would be bringing together lenders and borrowers, hence, implicating its role as a financial intermediary. However, banks are more than that as they are involved in numerous financial activities such as commercial banking, retail banking, investment banking, private banking, wholesale banking, corporate banking, insurance, financial advice and other. According to (RBS Group, 2009d), the Royal Bank of Scotland is involved in all types of financial activities mentioned previously, whereas some areas, in particular Private Banking services, which are executed through Coutts & Company, is considered to be the number 1 private bank (RBS Group, 2009d).

Lending and Borrowing

The main function of financial intermediary is bringing lenders and borrowers together, in other words, bank borrows money from lenders and lending them to borrowers. The importance of their role can be illustrated by giving a simple example. Suppose your neighbour decided to buy a plane costing £200,000, on terms that it will be repaid in 23 years and with appropriate interest rate. Firstly, it is unlikely that person would be able to find anyone, who would be glad to lend this amount of money for 23 years to a stranger. Secondly, if it would, due to high exposure to risk, lender would set unaffordable interest (Howells and Bain, 2007). Therefore it is in both parties interest to use a financial intermediary such as RBS.

Maturity transformation

However, banks do not just find lenders willing to lend exact amount in order to match with exact amount borrowers wish to borrow, what they do is called maturity transformation. In other words they are converting short-term funds lent to a bank into long-term loans or mortgages. Nevertheless, it is bank’s duty to meet all the repayments to lenders; thus ability to participate in maturity transformation highly depends on size. If there are a lot of deposits (inflows) and withdrawals are pretty much the same, they cancel each other; the larger the number of depositors the less exposure to unexpected withdrawals, which allows them to maintain lower level of liquidity and transform them into interest-earning assets (Howells and Bain, 2007).

Risk transformation

Risk reduction can be achieved in two ways, by diversification of lending and by screening of borrowers. Exists saying “do not put all eggs in one basket”, which is perfectly relate to financial risk reduction by employing portfolio diversification. By definition, diversification means “the holding of many (rather than a few) assets” (Howells and Bain, 2007, p12). Thus, banks gather the small income from a large number of savers and converting them from short-term deposits into long-term loans for lending to big companies or investing in well-diversified portfolio of assets (Howells and Bain, 2007). Secondly, banks, as a financial intermediary, decrease information asymmetry and disinformation of lenders by monitoring borrowers, in other words, whether they use funds effectively and for the purposes stated when requesting a loan (FIC, 2010).

Transaction costs

Since banks facilitate lenders and borrowers by meeting requirements for both, it is therefore reducing transaction costs. Whereas transaction cost can be regarded as time spent searching for lender or borrower, as well as cost of borrowing is highly reduced with intermediary presence as a result of reduction of risk. Moreover, if lender would try to diversify its rather small savings directly through financial markets, it would face huge transaction costs (Howells and Bain, 2007).

Turning to the Royal Bank of Scotland, it can be stated that apart from all these roles in financial system it is also important to the UK economy in terms of social matter, owing to the fact that it is one of the biggest bank in the United Kingdom (RBS, 2009c).

How effective is the Royal Bank of Scotland?

Effectiveness during recession and results

It is obvious that most financial institutions are struggling with global financial crisis, whereas some are affected less or more than the others. Royal Bank of Scotland Group is one of those falling into the category which were affected the most during financial turmoil (Telegraph 2009a).

A chain of events can be established in order to investigate performance of RBS and reasons for bailout and therefore outcome for shareholders and company as a whole.

Firstly, during the boom in economy, all banks gain more confidence in economic environment and were optimistic to expand, by acquiring more businesses. Thus, 9th of October, 2007, RBS have won the battle for control of ABN AMRO, after shareholders, totalling 86% of bank’s shares, accepted a takeover bid, amounting £48bn (FT, 2007). Despite the fact that group chief executive, at that time, Sir Fred Goodwin was optimistic about the acquisition (FT, 2007), some investors doubt it in spite of credit crunch in August 2007 (The Guardian, 2009). It can be evidenced from Figure 1 (Yahoo! Finance UK. RBS.L), where prices of RBS shares tumbled from 558p at the day of acquisition down to 402.75p a month later. In addition a lot of press releases predicted the disaster in this takeover; most of them referred their concerns to RBS’ interest in this battle, as journalists and analysts have suggested that bid was too expensive (The Guardian, 2009).

Despite the obvious reduction in share price of RBS Group, it can be argued that it should be referred to an acquisition of ABN AMRO, as at that point in time there was turmoil in whole economy (The Guardian, 2008). Apparently, figure 2 (Yahoo! Finance UK. Barclays), 3 (Yahoo! Finance UK. LLOY.L) and 4 (Yahoo! Finance UK. HSBA.L), suggests that not only RBS had a downward trend, but other financial institutions as well, such as Barclays, Lloyds Group and HSBC, the biggest banks in the UK.

On 7th October 2008, RBS stock dropped by 40% down to 90p on fears that bailout will result in partial nationalisation and dilution of existing shareholders’ wealth, as there was rumours which suggested that RBS asked Government for a capital Injection (Times Online, 2008). In response RBS disclaim this rumour by saying that it has not sought any help from the Government (Times Online, 2008). Nevertheless, 13th October 2008, RBS received its first financial aid from the Government amounting £20bn. It was followed, by actual RBS report of record corporate loss in UK history of £24.1bn and the Government stated that it will inject £13bn more into the company (BBC, 2009) and RBS stock slumped to 10.30p.

It was suggested that RBS failed to manage risk appropriately, and these problems were “obvious to all even before financial crisis” (Scotsman, 2009). One of the mistakes identified was trading of sub-prime mortgages, where according to Telegraph (2009c), in early 2007 it was buying about £34bn of sub-prime assets, despite the fact that Sir Fred Goodwin at least three times since 2006 said that they are not involved in sub-prime lending and sound control of risk is fundamental to the Group’s business (Telegraph, 2009d). Thus, questioning their adequacy in matter of appropriate risk management. Another reason for their failure, according to Market Watch (2008), was acquisition of ABN AMRO. According to Figure 5 (RBS Group, 2008), the major part of Group’s losses made of Write-down of goodwill and other intangible assets accounting nearly 32,6 billion, whereas in 2006 and 2007 there was no write-down’s. Therefore, the reason RBS losses are usually referred to acquisition of ABN AMRO is because the biggest part of these write-down’s occurred from it, as well as 50% of credit and market loses pertained to ABN AMRO (RBS Group, 2008). However, it can be argued, as write-down of goodwill can be seen as a reaction of financial sector on economic downturn and hence reconsideration of value of assets. It can be seen from Figure 6 (RBS Group, 2008), that RBS’ financial results on a pro forma basis in 2007 are nearly the same as statutory, implying that they were right in their estimations. However, if we compare pro forma for 2008 and statutory results for the same year, loss before tax makes a huge difference, nevertheless it can be explained by referring to Figure 7 (RBS Group, 2008), which is “notes”. According to them, pro forma excludes write-down of goodwill and other intangible assets, which amount is the difference between pro forma and statutory loss before tax, thus confirming their accuracy in estimations.

The results for RBS were dreary, as 84% at present is owned by taxpayers, as a result of Governments injection of £45.5bn. On top of that, European Union competition authorities demanded RBS to “sell its insurance businesses, some retail branches, its global payment service and its interest in a commodities-trading operation” (WSJ, 2009).

Effectiveness at present

Given the order by European Commission to sell part of its businesses, the Royal Bank of Scotland “have identified what went wrong, acted to fix the immediate problems and have set in place a sweeping restructuring and new strategic plan to regain standalone strength” (RBS, 2009c). However, how effective they are given the second chance to rebuild its business?

According to RBS Group (2009) it has managed to generate £45.5 billion worth of new lending to UK companies; although they have reported an operating loss of £1,525 million in the third quarter (before tax, purchased intangibles amortization, integration and restructuring costs, gain on redemption of own debt, strategic disposals and write-down of goodwill and other intangible assets), it is a considerable improvement, in comparison to second quarter, which amounted to £3,533 million. Some other encouraging progress has been outlined, such as customer deposits, excluding repos grew up 2%. Furthermore, they have issued £4.8 billion of unguaranteed term debt during the third quarter, and they assert that the liquidity situation is improving at a fast pace (RBS Group, 2009).

Conclusion

This report has, firstly, given the background and history of the Royal Bank of Scotland Group, secondly, its role in financial system, where it was established that its main role is as a financial intermediary, and finally, the effectiveness in its role was examined by referring to different sources relevant to the issue. Thus, RBS Group was affected the most during the recession, providing that it made the biggest corporate loss in UK history. However, it was established that reason for its failure was inappropriate risk management and to some extent – greed, as it is evidenced from the fact of buying and trading huge amount of toxic debt, implying their inefficiency before and during recession. By gingerly examining the latest data available, which is Interim Management Statement for Q309, it was acknowledged that RBS Group has made progress and is improving, which can be also regarded as an increase in their effectiveness.

APPENDIX I

• University of BrightonEC162 Economics of Financial MarketsAssignmentMaterialCharts, tables, graphsBARCLAYS. Oct 2008, 3m chart.jpgC:University of BrightonEC162 Economics of Financial MarketsAssignmentMaterialCharts, tables, graphsUntitled-5.jpg
• University of BrightonEC162 Economics of Financial MarketsAssignmentMaterialCharts, tables, graphsHSBC. Oct 2008, 3m chart.jpgC:University of BrightonEC162 Economics of Financial MarketsAssignmentMaterialCharts, tables, graphsLLOYDS TSB. Oct 2008, 3m chart.jpg
• University of BrightonEC162 Economics of Financial MarketsAssignmentMaterialCharts, tables, graphsRBS Income statement for 2008.jpg
• University of BrightonEC162 Economics of Financial MarketsAssignmentMaterialCharts, tables, graphsRBS. Key financials.jpg
• University of BrightonEC162 Economics of Financial MarketsAssignmentMaterialCharts, tables, graphsNotes.jpg

APPENDIX II – AUDIT

Date: 01.12.2009 (Tuesday)

Place: University of Brighton, Mithras House, Canteen.

The purpose of meeting: Talk through and to make some plans

Decisions: It was decided firstly to go onto the Royal Bank of Scotland’s website and to get as much information as we could, in order to understand the way it operates. It was also decided, that our main focus would be on the presentation as its deadline fell due first.

Date: 07.12.2009 (Monday)

Place: University of Brighton, Mithras House, Canteen.

The purpose of meeting: To decide how we are going to structure our presentation.

Decisions: After deciding to cover the history, structure and the functions of RBS, it was decided that we will split the presentation into 3 pieces, each of us will inherit and prepare a segment separately, and the final results will be merged to create the report. It was divided in the following way: Kelly Walker – History and Background, Josh Reynolds – Structure of RBS and Dmitrijs Seladjins – Reasons for bailout and some positive facts about RBS (In order to give a full picture of RBS, as sometimes it is forgotten in light of recent events).

Date: 04.01.2010 (Monday)

Place: University of Brighton, Mithras house annexe, Pool room.

The purpose of meeting: To talk through, who done what and whether we are ready to merge the presentation.

Decisions: Not everybody done their parts, so it was not possible to merge it. For this reason we went through our plan again, who is doing what and then we discussed if anybody was faced with problems associated with finding appropriate information or making it concise and informative.

Date: 14.01.2010 (Thursday)

Place: University of Brighton, Mithras house Annexe, Pool room.

The purpose of meeting: To merge individual group members work and to practice a verbal run through of the group presentation.

Decisions: The main decision made involved the organisation of how we would present our work, for example, who would stand where and how we would rotate between the person presenting, the person controlling the slides and the idle person, to form a smooth flowing presentation.

Presentation conducted 14.01.2010 between 16-17:00pm

Date: 16.01.2010 (Saturday)

Place: Home (internet session)

The purpose of meeting: To decide the structure of the Report and things to include.

Decisions: It was decided that Kelly and Josh would work on History and Background, and Dmitrijs will write about the role of RBS within the financial system. It was decided that the analysis will be undertaken by the whole group and merged at the end. However, a considerable part of the analysis was conducted by Dmitrijs.

Date: 21.01.2010 (Thursday)

Place: University of Brighton, Mithras House, Canteen.

The purpose of meeting: To merge all the parts together.

Decisions: It was decided so that each of us will read through and highlight some areas which should be amended or improved.

Date: 29.01.2010 (Friday)

Place: University of Brighton, Mithras House Annexe.

The purpose of meeting: Last corrections and final check

Decisions: No decisions were made, as everything was done.

The report is complete.

Kelly Walker, Josh Reynolds and Dmitrijs Seladjins agreed that everybody in the group will receive equal marks for the group report.

References

BBC (2008), [Online] [accessed 24 January 2010]

FIC (2010), [Online] [accessed 24 January 2010]

FT (2007), [Online] [accessed 24 January 2010]

Howells, P. and Bain, K. (2007) Financial Markets and Institutions. 5th ed, England: Pearson Education Limited

Lee, S., J. (2005) Gladstone and Disraeli. Oxon: Routledge

RBS Group (2008), Annual Review and Summary Financial Statement 2008.London: The Royal Bank of Scotland plc

RBS Group (2009), [Online] [accessed 26 January 2010]

RBS Group (2009c), [Online] “What we do” [accessed 24 January 2010]

RBS Group (2009d), [Online] “Group Structure” [accessed 24 January 2010]

RBS, (2009a). ‘Our global network’ RBS homepage [Online]. [Accessed 12/01/2010]

RBS, (2009b). ‘Heritage’, RBS home page [Online]. [ Accessed 13/01/2010]

Scotsman (2008), [Online] [accessed 24 January 2010]

Telegraph (2009a), [Online] [accessed 24 January 2010]

Telegraph (2009b), [Online] [accessed 24 January 2010]

Telegraph (2009c), [Online] [accessed 24 January 2010]

Telegraph (2009d), [Online] [accessed 25 January 2010]

The Guardian (2008), [Online] [accessed 24 January 2010]

The Guardian (2009), [Online] [accessed 24 January 2010]

Times Online (2008), [Online] [accessed 24 January 2010]

WSJ (2009), [Online] [accessed 25 January 2010]

Yahoo! Finance UK. Barclays (2010), [Online] [accessed 24 January 2010]

Yahoo! Finance UK. HSBA.L (2010), [Online] [accessed 24 January 2010]

Yahoo! Finance UK. LLOY.L (2010), [Online] [accessed 24 January 2010]

Yahoo! Finance UK. RBS.L (2010), [Online] [accessed 24 January 2010]