RBS to bolster capital after flunking UK stress test

By Steve Slater and Huw Jones

LONDON, Nov 30 (IFR) - Royal Bank of Scotland (LSE: RBS.L - news) must bolster its capital after failing this year's stress test of British lenders as the state-backed lender faces a big US fine for misconduct and continues to struggle with its turnaround.

RBS, 73%-owned by the UK taxpayer, said it would take a range of actions, including selling off bad loans and cutting costs to make up the capital shortfall of about £2bn identified by the test.

Barclays (LSE: BARC.L - news) and Standard Chartered (HKSE: 2888.HK - news) also came up short in the Prudential Regulation Authority's annual health check of seven lenders, although their turnaround and capital raising plans already in place will be enough to address their problems, the regulator said.

RBS shares fell 4% after the results, as analysts said it showed the big hit from potential litigation it faces and its ongoing struggles to improve its business.

"The bank continues to be a work-in-progress restructuring story," said Chirantan Barua, analyst at Bernstein.

RBS said it had agreed a plan of action that the regulator had accepted. This involved "an array of capital management actions", including cutting costs, reducing risk-weighted assets, running down or selling non-core loans, and "the proactive management of undrawn facilities", such as reducing overdraft facilities.

The bank said this should address the shortfall, but said "additional management actions may be required until RBS's balance sheet is sufficiently resilient to stressed scenarios".

£30BN MISCONDUCT

This year's test was the third annual healthcheck by the Bank of England's PRA and was more severe than in 2014 and 2015. It was the first based on the central bank's new approach to stress testing, which includes potential misconduct costs.

The PRA estimated the banks could incur £30bn of misconduct costs by the end of 2017, although it did not give a breakdown by bank. It said, by design, the estimate was much larger than provisioned by the banks.

RBS faces a fine from US authorities for mis-selling mortgage-backed securities, which analysts estimate could be as much as £12bn.

This year's healthcheck also included material traded risk losses, which the PRA said reduced capital by £20bn by 2017 across all the banks.

The banks had to withstand valuation adjustments, counterparty credit risk, a fall in investment banking revenues and volatile markets, with the VIX volatility index averaging 37 for a year.

They were tested against a sharp rise in credit spreads on corporate bonds. Investment-grade US corporate bond spreads widen to about 500bp from around 170bp in the scenario, for example, while high-yield US corporate bond spreads widen to 1,690bp from 640bp in the scenario.

Other scenarios in the test include global GDP contracting by 1.9% in the first year, oil prices dropping to US$20 per barrel, a 50% crash in Hong Kong property prices and a 42% drop in UK commercial real estate prices.

The PRA did not set a standard pass/fail for its test, but set a "hurdle level" for each bank's common equity Tier 1 (CET1) ratio based on their existing capital requirements. It also set a "systemic reference point", which adds a capital buffer based on their global, systemic importance.

For the five main listed banks, CET1 hurdle levels ranged from 6.1% for Standard Chartered to 6.8% for Barclays. The systemic reference points ranged from 6.6% for StanChart (HKSE: 2888-OL.HK - news) to 7.8% for Barclays, and was 7.1% for RBS.

Banks also had to keep their leverage ratio above 3%.

Banks were able to use additional Tier 1 capital - bonds that convert into equity if their CET1 ratio falls below 7% - in the stress test for the first time. The seven firms had issued £23bn of AT1s by the end of 2015.

RBS's CET1 ratio fell to 5.5% under a stressed scenario and was 6.7% even after mitigating action and the conversion of AT1s, still 40bp short of its systemic reference point.

Barclays' CET1 fell to 5.9% under a stressed scenario, but improved to 8.3% after mitigating action and the conversion of AT1 bonds, above the required level. Standard Chartered's capital fell to 5.5% under stress, but was 9.9% after mitigating action and AT1 conversion.

HSBC, Lloyds Banking Group, Nationwide and Santander UK (LSE: 44RS.L - news) did not suffer any capital inadequacies in the test, the BoE said.

In aggregate, the banks fared worse than analysts and investors had expected.

"Today's performance is worse than predicted, this is the highest average fall in CET1 and leverage ratios we've seen in the history of a UK concurrent stress test," said Steven Hall, banking partner at KPMG.

The BoE said the overall level of capital in the UK banking system was satisfactory, equivalent to 13.5% of risk-weighted assets, and in aggregate could support the economy in a severe, broad and synchronised stress scenario.

The BoE will next year introduce a second stress test to run alongside its annual check. It will be more of a test of banks' business models and strategies.

The UK's annual stress test process is shifting closer towards the US system, whereby banks are not only told to raise capital if necessary but can also be to told to cut or stop dividends or be prevented from buying back shares. (Reporting by Steve Slater and Huw Jones; Editing by Ian Edmondson)