By Sinead Cruise and Iain Withers
LONDON (Reuters) - Just over a decade after fending off insolvency, taxpayer-backed Royal Bank of Scotland <RBS.L> is struggling with an unfamiliar dilemma: how to effectively deploy billions of pounds of excess capital on its balance sheet.
Years of cost cuts and asset sales have left the lender with jam-packed coffers, which management had hoped could help buy back the government's 62% stake in the quickest time possible.
A few months ago, analysts and bank insiders believed the government was poised to begin selling RBS's stock back to the bank, a key step in a sales process aimed at reducing concerns about potential political interference in its lending activities.
RBS rushed through a shareholder motion in February to use its excess capital in this way but five months on, its haste has proven futile.
The government now appears to be dragging its feet on disposals, frustrating some private shareholders and knocking the bank's privatisation ambitions off-course.
Some investors and analysts are now speculating that a new Chancellor, expected to be appointed by the new leader of the ruling Conservative Party later this month, could review the government's stance on fresh RBS sales.
This could include waiting to see the bank's share price rise much higher to avoid any public backlash on perceived loss of value for the taxpayer.
That raises the bigger question of whether the government - whose two rounds of RBS share sales so far crystallised around 3 billion pounds of cumulative losses - can meet its target to exit RBS by 2024.
"The business is in better shape but our share price is much lower. But that is because our shares are in the Brexit bucket and the political bucket. I can't control that," one senior RBS executive told Reuters.
"We are continually growing capital so by the end of the year will be in an even better or even worse position, depending on how you look at it. So figuring out how we get that capital back to taxpayers is for us, a really big focus."
While the bank sits on cash it would ideally like to give back to the government, investors face accepting lower returns on their equity.
RBS shares have shed 14% since Chancellor Philip Hammond last sold shares in the bank in June 2018 and despite a 5% rally this year, Britain's Brexit impasse has weighed on their price.
Trading at 225 pence each, they are less than half the 501 pence-a-share bailout price, making further losses on future sales all but inevitable.
RBS, however, has long argued that the bailout price is the wrong yardstick to use for taxpayer profit or loss, given the bank has been so dramatically restructured.
"We haven't built the bank back to that bank. So we're not going to be that valuation again," the RBS executive said.
"We sold Worldpay, we sold Direct Line and exited lots of other things. So we're now this bank, which is a really good, well capitalised bank, but it's not going to be that value."
RBS's accumulation of surplus capital is the result of many years of belt-tightening, restructuring and effort to put a litany of financial crisis misdeeds behind it.
The largest fine – an eye-watering $4.9 billion U.S. penalty in May 2018 for mis-selling toxic mortgage-backed securities in the run-up to the subprime mortgage crunch – came in well below analyst estimates.
This left RBS with a comfortable cushion of around 4 billion pounds over its capital requirements.
The recent sale of a 40% stake in Saudi bank Alawwal boosted RBS's core capital ratio by 60 basis points to 16.8%, compared with a target of 14%.
But unlike most blue chip companies, returning excess capital through hiked dividends or share buybacks is not a straightforward matter for RBS while it remains majority government owned.
The bank's overriding priority is to return itself to full private ownership so it can attract fresh institutional investment and neutralise worries of meddling in its operations if Britain's opposition socialist Labour party came to power.
Labour previously outlined plans to break up the bank into regional lenders, and while the party has played down such radical moves in recent months, it has said it would halt any further privatisation if this meant a loss to taxpayers.
The RBS executive told Reuters the bank was exploring options for special dividends but it also wanted to reserve capital to buy government stock when it eventually returned to market.
Bumper dividends might benefit the taxpayer but will not reduce the government stake.
A traditional buyback will also have the adverse effect of increasing the government's relative ownership - assuming RBS can find willing buyers among investors who have waited years to see it in rude financial health.
"Irrespective of what they may or may not have said to RBS, they didn't opt to sell at 263 pence two months ago so to me it doesn't feel likely that they would choose to sell today," Ian Gordon, bank analyst at Investec, told Reuters.
"RBS is reluctant to conduct buybacks in the open market ... I argue that they should. Such buybacks would be strongly value-accretive at this level but I'm not sure I'm winning the argument."
A source familiar with thinking at UK Government Investments, which manages the state's RBS holding, said it would only act when a sale represented value for money, noting the current low share price.
The source added that the 501 pence bail-out price was not a relevant factor in assessing taxpayer value.
Private investors nonetheless expect some reward for their patience soon.
"They are very mindful that the more they keep piling up equity, the harder it is to deliver the 12% ROE (return on equity) they have promised, so I suspect they will have to crack on at interims and either do a normal buyback or pay a big special dividend," one of the bank's top 10 investors said.
(Editing by Susan Fenton)