When Royal Bank of Scotland (RBS) unexpectedly released its preliminary earnings report on Friday, the biggest news wasn't the £230 million it earned for shareholders during the quarter, a mere 3% return on equity, but rather the negative £93 million in loan losses taken. Full results will be released on August 1. Markets were impressed by the results – shares were up about 15% at one point – but we're less so. We're pleased with the signal that management is sending, that the bank's turnaround is on track and that its provisions for losses in its bad bank won't need further buttressing, but it does little to change our long-term view on the company. By 2017, as RBS further stabilizes, we expect loan losses to normalize around 0.4% of loans and for returns on equity to be near 12%. We plan to maintain our fair value estimate of GBX 400 and our no-moat rating for the largely government-owned bank.
Investors should look at RBS' negative loan losses of £93 million in the context of the £5.1 billion of provisions taken in the fourth quarter of 2013 – that that kitchen-sink charge bought the bank a lot of breathing room, and this quarter's negative provision is only 2% of it. While negative loan losses are clearly unsustainable, we do think that near-term provisioning is likely to remain light with the bank benefiting from the possibility of further right backs, rising property values in the U.K. and Ireland, and the benign economic environment. We think losses are likely to increase to more normal levels as interest rates begin to rise and loan repayments become more cumbersome.
RBS' bottom line was held back by £250 million of litigation and conduct charges, £130 million of goodwill write downs, and £80 million of write downs of deferred tax assets. Last quarter, we had noted that RBS' PPI provisions looked light to us, so we weren't surprised to see that the conduct charges included £150 million of additional PPI charges. We'll be interested to see how RBS' stockpile of PPI provisions compares with competitors when full earnings are released next week. The £130 million goodwill write down was related to investment banking assets transferred during the reorganization, and the deferred tax asset write down was related to RBS' downsizing in its U.S. markets business. Looking forward, we expect RBS to continue to face material legal and conduct charges, which will mean lumpy results. In particular, we think that allegations that investment banks manipulated foreign exchange market rates could lead to significant fines. With only 6% market share, we don't expect the bulk of fines to fall on RBS' shoulders. Still, the final outcome will also be driven by each bank's individual conduct, which may not bode well for RBS, given its cowboy culture under Fred the Shred.
