Will Royal Bank of Scotland Group plc Overstretch Itself Again?

rbsWhen the UK’s banks were hit by liquidity problems, Royal Bank of Scotland (LSE: RBS) (NYSE: RBS.US) led the way in spectacular fashion.

Retail banking consists of taking in deposits and lending money out, which is easy enough to grasp — but the quality of the loans a bank makes and the capital it has to back them up is key.


And that’s what was woefully lacking when the crunch hit. Too many banks had made too many bad loans, bringing the phrase “toxic assets” into everyday usage, and RBS had paid too much money for expansion — for example, for its part in the acquisition of Dutch Bank ABN AMRO.

Since then, liquidity requirements on banks have been tightened, and the quantity and quality of a bank’s capital has come under close scrutiny — you’ll have heard talk of Tier 1 ratios and the like (with the word “Core” bandied around), so what’s that all about?

Capital vs risk

Well, Tier 1 capital represents the money a bank has to back up the risks it takes when it lends money, and the ratios measure that capital against the quantity and risk of a bank’s assets — assets like mortgages and business loans are risk-weighted by reducing their actual book value to compensate for the probability of some loans becoming unrecoverable. The exact definitions are controlled by the Basel Committee on Banking Supervision, and its Basel III rules.

So a bank’s Tier 1 ratio compares its Tier 1 capital with the risk-weighted value of its assets — with a Core Tier 1 ratio only including the best of the best of its capital, essentially just equity and retained profits.

Before the crisis, a Tier 1 ratio of only 4% minimum was required by banking regulations, with a Core Tier 1 minimum of only 2% needed.

But by 2018, banks will be required to show a Core Tier 1 ratio (or Common Equity Tier 1 ratio) of a minimum 7%, so how is RBS doing against that?

Getting stronger

Well, when the bank reported its results for the year ended December 2013, RBS reported Core Tier 1 capital of £42bn, with a Core ratio of 10.9%. In absolute terms, that’s a fall in capital from £47bn a year previously, but with progress made on non-performing assets, the ratio itself is up from 10.3%.

That doesn’t quite mean RBS is out of the woods yet, as definitions are being tightened and we should expect to see risk-weighting of assets becoming stricter.  But on an estimate for Basel III capital requirements, RBS reckons it has managed a tougher fully-loaded Common Equity Tier 1 ratio of 8.6%, which is up from 7.7% at the end of 2012.

Safe now?

Whether that means RBS is safe from future liquidity crunches, or whether the banking sector will just take longer and find different ways to overstretch itself, remains to be seen.

Finally, our top experts at The Motley Fool have produced their Guide To Investing In Banks, so if you're thinking of putting some of your own money into RBS or any of our other banks, it could be essential reading.

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Alan does not own any shares in RBS.