Does Battered Royal Bank of Scotland Group Plc or Healthy Lloyds Banking Group Plc Have a Brighter Future?

Seven years after the financial crisis the UK government is close to exiting its stake in one bailed-out bank, Lloyds Banking Group Plc (LSE:LLOY), but still owns 73% of the struggling Royal Bank of Scotland Group Plc (LSE:RBS). As both of these banks see their future as UK-focused retail and business lenders, which represents a more appealing investment?

Work in progress

RBS is seemingly years behind its competitors in recovering from the global financial crisis as it’s still in the process of shedding non-core assets, winding down an oversized investment banking arm and raising the necessary capital to comply with higher regulatory requirements. This isn’t the only concern for the bank as it continues to face huge fines from regulators, with the next being a possible $13bn fine from US regulators over the sale of mortgage-backed securities before the financial crisis.

The good news for RBS going forward is that year-on-year profits have increased in the future core of the business – the personal and commercial banking divisions. However, the bank slipped back into losses for the third quarter of this year, compared to a £1.1bn profit for the same period in 2014, after heavy restructuring costs continued to take their toll on the balance sheet.

Despite the attraction of buying-in while shares trade at less than book value I would steer clear of RBS for a while yet. Why? First the need for further restructuring and the company itself not foreseeing a return to dividend payments until at least 2017. And the fact that the litigation risks section of its third quarter results still ran over two pages also suggests that 2016 isn’t going to be the year when investors see real growth in the share prices.

An end to PPI payouts?

With the return of dividend payments this year and an estimated 5% yield next year, Lloyds has made itself the subject of much investor attention ahead of next March’s much-ballyhooed offering of the remaining government stake. Despite the attractive dividends, share prices have been knocked down nearly 8% this year due to concerns over revenue growth and the possibility of rising interest rates affecting Lloyd’s significant mortgage portfolio by increasing rates of default.

One potential tailwind for the bank is the possibility of the end of payouts related to the Payment Protection Insurance scheme after seeing nearly £14bn go out the window in recent years. If PPI claims do indeed expire some time in 2018 as has been mooted, Lloyds would be able to free up significant capital it has continually been forced to set aside for payments to claimants.

Lloyds’ refocusing since the financial crisis makes it a viable play on the health of the UK economy for investors through its reliance on mortgages and other retail and commercial lending. While this will preclude astronomical growth levels, it does make Lloyds a very appealing safe bet with a hefty dividend yield as long as one sees the economy continuing to grow steadily. For me, RBS really is years behind Lloyds in cleaning up its balance sheet and still facing the prospect of large fines, making it a much less compelling investment than Lloyds at this time.

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Ian Pierce has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.