Royal Bank of Scotland (RBS), formerly a dominant U.K. bank, was undone by its global ambitions, in our opinion. RBS destroyed its narrow economic moat with its reckless acquisition of ABN AMRO at the peak of the market bubble in 2007. The bank was bailed out to the tune of £45 billion by the U.K. government, but has since lost it all, and then some, on dodgy assets and misconduct.
RBS has made considerable progress in its transformation, but still has quite a ways to go. RBS's bad-bank assets, just £11 billion at the end of 2014, are down 95% from their peak, but the group is left with aging computer systems, overly complex product offerings, and a well-deserved reputation for poor customer service. We think that the additional clean-up costs, estimated at £2 billion through 2017, along with £4 billion of misconduct provisions, will eat up much of the bank's operating profits through 2016. Income on asset sales will be used to prop up the group's capital ratios – shareholders shouldn't expect to see material capital return until 2016 at the earliest, in our opinion.
We think that the risk of interference from RBS's largest shareholder, the U.K. government, has largely played out – it's clear now that the government is firmly in control and has dictated much of RBS's strategy. RBS set its new strategy in place in early 2014 – it will be a U.K.-focused bank, earning the bulk of its income from retail and corporate banking, with only a small investment bank aimed at meeting the needs of its corporate clients.
RBS will renew its focus on SME lending and further sell down its stake in Citizens, its lacklustre U.S. bank. While management resisted this strategy for some time citing the benefits of diversification, (and we think that the accelerated restructuring destroyed shareholder value) that's in the past. Looking forward, we think RBS's renewed focus on U.K. banking, a profitable business in a concentrated market, will serve shareholders well, as will its reduced emphasis on investment banking, which offers limited returns to shareholders under new capital rules.
Moreover, we're happy to bid adieu to Citizens, which has had subpar performance for years.
We're reducing our fair value estimate for RBS to £3.70 from £4 as we incorporate higher near-term regulatory and restructuring costs, partially offset by an update in our cost of equity methodology which reflects our lower long-term inflation expectations. Our fair value estimate is 1.0 times tangible book value and 0.8 times book value as of March 31.
