The UK government plans to sell its 80% stake in the Royal Bank of Scotland the chancellor, George Osborne, announced at his annual Mansion House speech to financiers in the City of London. Based on the current value of RBS shares, selling now would constitute more than a £7 billion loss. But, ultimately, RBS is better off out of government hands and the decision to sell is the best option available to it.
When the government bought the bulk of RBS in 2008, it invested £45 billion to stave off bankruptcy and recapitalise the bank. Shareholders took substantial losses, but were fortunate that it did not default or they would have lost everything. This was important as it prevented other potential cases and systemic risk was averted. But the cost was a large commitment and loss on the holding as the RBS share price fell further.
This was due to further bad news from subprime mis-selling and the market fixing that followed – the losses and fines from these made it even harder for the share price recovery that was necessary to recoup the government’s investment. The losses and fines imposed by regulators are now quantifiable but have been counterproductive to recovery since they reduced the RBS equity base at a time when its need for capital had increased – further punishing the main shareholder, the government itself.
It’s important to note that the loss the government currently faces is currently unrealised, though the announcement of plans to sell will start to crystallise it. RBS shares may rise on this news but after the sale commences future rises will not benefit the taxpayer.
So why sell?
Bank profits are derived from deals and lending transactions that entail considerable managerial effort and corporate risk. Unfortunately both require significant incentives for managerial teams and without bonuses or remuneration that are tied to transactions, the flow of deals will dry up along with profits.
The coalition government could not stomach paying these bonuses but the bank’s profit and valuation cannot increase without a change in incentives. Stephen Hester, CEO of RBS from 2008 to 2013, struggled with the politics of this policy during his years. In this sense, banks and their profits are more controlled by their workers than shareholders who bear the risk. As such, the government is better off not trying to control the day-to-day running and consequent value of the bank.
The government could have wound RBS up without default, but this was also deemed unacceptable. After downscaling it has regained some value, even if not enough to return the initial investment. Another alternative would be to break the bank up and sell its different units off or transfer ownership to local stakeholders.
This raises the question of what objective the government should set itself – private value or maximising public welfare. Framed narrowly, a focus on the RBS-specific loss ignores the fact that it is part of a wider bailout programme. When considered as part of the government’s return from bank bailouts as a whole, the RBS sale can be seen to crystallise a net gain of £14 billion.
The banking sector is undergoing many other changes. If the government maintained its RBS holding, it might be less able to encourage other forms of lending (such as peer-to-peer). So the future shape of RBS will be left to the mergers and acquisitions market, even though these are the activities that made RBS vulnerable in the first place. Nonetheless, free-market forces are still the best means to determine its future structure and therefore its worth. And few are arguing for relinquishing controls on this activity in the future – only on increasing future scrutiny.
Aiming to recoup the bail-out money in full was the pre-election position of both Labour and the Conservatives, but only because it was unlikely to be achieved in either parliament. The same is true of this term, but ironically starting to remove the bind over its control is a key step in creating more RBS value.
The government’s decision to sell its stake in RBS will level the playing field against banks that were not bailed out. It will also free up the processes of reforming banking regulation and issues such as where banks should locate their capital base, for example HSBC. Selling such a large stake always had the potential for a negative price impact.
Still too big to fail?
The final issue that will remain after sale is, what are the chances of ending up here again? Can the government credibly commit to letting it default in the future, or are banks still “too big to fail”?
In this respect things are changing in the US and the governor of the Bank of England spoke last night about making investment banking culture more accountable for its mistakes. We will have to hope that after the sale is completed – when RBS is back under risk-taking management – its chances of survival for future years remain high or that provision for another bail-out is credibly withdrawn. Either way, this sell-off is for professional, not private investors.
Now read this: RBS sell off is a missed opportunity