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Bond Markets: A Banking Perspective

Bond Markets: A Banking Perspective. John Cummins, Group Treasurer, RBS 5 October 2012. CISI -Chartered Institute for Securities and Investment EFFAS- The European Federation of Financial Analysts Societies.

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Bond Markets: A Banking Perspective

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  1. Bond Markets: A Banking Perspective John Cummins, Group Treasurer, RBS 5 October 2012 CISI -Chartered Institute for Securities and Investment EFFAS- The European Federation of Financial Analysts Societies The views expressed in these slides are an expression of the presenter’s personal views only and do not necessarily reflect the views or policies of The Royal Bank of Scotland Group plc, its subsidiaries or affiliated companies, or its Board of Directors. RBS does not guarantee the accuracy of the data included in this presentation and accepts no responsibility for any consequence of their use. This presentation does not constitute an offer or a solicitation of an offer with respect to any particular investment.

  2. Agenda • The RBS Journey • Current State of the Inter Bank Market • Uncertainty for Investors • Regulatory Changes • Rating Agency Methodology Changes • Low Interest Rates • Eurozone Crisis • Summary

  3. The RBS Journey

  4. Progress against plan Group – Key performance indicators Worst point H112 Medium-term Target Balance sheet & risk (Group): 154%1 104% c100% Loan : deposit ratio (net of provisions) £297bn3 <10% TPAs £62bn Short-term wholesale funding2 £90bn3 £156bn >1.5x STWF Liquidity portfolio4 28.7x6 15.6x <18x Leverage ratio5 4%7 11.1% >10% Core Tier 1 Capital ratio Value drivers (Core): (31%)8 10.2% >12% Return on Equity (RoE)9 97%10 61% <55% Cost : income ratio11 • Strong capital, liquidity and funding metrics • Prioritising: • Safety and soundness of the Group • Ongoing reduction in wholesale funding • An appropriate liquidity buffer 1 As at October 2008 2Amount of unsecured wholesale funding under 1 year including bank deposits <1 year excluding derivatives collateral. 3 As of December 2008 4 Eligible assets held for contingent liquidity purposes including cash, government issued securities and other securities eligible with central banks. 5 Funded tangible assets divided by Tier 1 Capital. 6 As of June 2008 7 As of 1 January 2008. 8 Group return on tangible equity for 2008 9 Indicative: Core attributable profit taxed at 28% on attributable core average tangible equity (c75% of Group tangible equity based on RWAs). 10 2008. 11 Adjusted cost:income ratio net of insurance claims.

  5. Significant progress on funding and liquidity measures • Further improvement in LDR; Group 104%, Core 92% • STWF down £18bn q-o-q to £62bn, now only 7% of funded assets • Liquidity buffer strengthened, now ~2.5x STWF • Negligible impacts from Moody’s rating action 1 Worst point taken as at FY08 except Loan:Deposit Ratio (October 08) and customer deposits (Dec 09). 2 RBS pro-forma. 3 Liquidity buffer reserves comprise cash at central banks and eligible unencumbered government and other debt securities. 4 Short-term Wholesale Funding comprises the sum of all the Group’s outstanding debt securities, subordinated liabilities and wholesale bank deposits with a residual maturity of less than one year. Wholesale bank deposits excludes cash collateral received under derivatives contracts. 5 Including deposits in disposal groups (£22.3bn Q112 and £22.5bn Q212). 6 Total Wholesale Funding.

  6. Improved Funding Composition …driving much improved funding1 mix Loan : deposit ratio continues to improve… £bn Group Core Wholesale Funding2 Deposits3 151% 135% 118% 108% 104% 52% 49% 42% 37% 33% 48% 63% 67% 58% 51% 2008 2009 2010 2011 H1’12 2008 2009 2010 2011 H1’12 • Non-Core & Markets deleveraging, coupled with strong deposit gathering franchises have driven continued improvements in loan : deposit ratio • UK Retail had a solid half, increasing deposits across both savings and current accounts by 11% (£2.4bn). UK Corporate increased deposits by £3bn in Q2. • Group deposits are up £7bn vs H1’11 1 Primary funding sources, excluding repurchase agreements and equity. 2 Wholesale funding including derivative collateral. 3 Total customer deposits, including deposits of disposal groups.

  7. Response: Target further reduction in wholesale funding Wholesale funding1 usage run-down 2008 2009 2010 2011 H1’12 2013 2014 • H112 net issuance of £2.1bn • £1.8bn public issuance of secured funding in Q1, no public issuance in Q2 • No public senior debt issuance expected in H2’12 with the exception of some modest refinancing in the Group’s holding company • Total wholesale funding1 down £45bn (17%) in H1’12, £21bn (9%) in Q2 1 Wholesale funding includes unsecured debt securities, subordinated liabilities and bank deposits. Excludes derivative collateral.

  8. Confidence in the Inter Bank Market Remains Low

  9. Selected European Sovereign CDS Performance Since 2009 Selected European Sovereign CDS performance (mid 5 Year on-the-run spreads) Jun-12: Pro bailout party ND wins the Greek parliamentary elections Feb-12: Eurozone agrees on €130bn Greek bailout Jan-12: S&P downgrades ratings of nine sovereigns including France, Italy and Spain 584 Dec-11: EU countries attempt a new treaty to achieve fiscal consolidation May-10: EU and IMF agrees on €110bn rescue package for Greece and EFSF is created 538 Dec-10/Jan-11: ESM is set up worth €500bn Nov-11: Greek PM announces referendum on EU debt deal, while Italian PM resigns Mar-10: Greek PM warns that deficit reduction will be difficult due to high borrowing costs Nov-10: Ireland starts talks with EU, €85bn bailout package is agreed on May-12: Greece fails to form a coalition government Jun-11: Talks begin over soft restructuring of Greece Mar-12: 95.6% participation in Greece PSI unlocks second bailout Jan-10: Concerns start to build around Portugal, Ireland, Greece and Spain Dec-09: Rating agencies downgrade Greek ratings to A1/BBB+ 191 97 70 Sep/Oct-11: Italy is downgraded to A and Spain to AA Source: J.P. Morgan Data Query as of June 27th 2012

  10. Selected European Banks CDS Performance Since 2009 15-Jun-11:George Osborne’s speech at Mansion House. The Chancellor endorsed the plan that “big” banks should “ring-fence” their essential operations 24-May-11: Moody’s put 14 UK financial institutions on review for a possible downgrade 21/22-Nov-10: Economic / political turmoil in Ireland as it accepts controversial bailout package and general elections called 07-May-10: Hung parliament in UK. Investors meet ECB for another bailout fund Selected European Banks CDS performance (mid 5-year on-the-run spreads) 15-Jun-12: ICB White Paper 12-Sep-11: Final ICB report published 546 29-Feb-12:2nd LTRO 19-Jan-09:£50bn bank rescue package announced 447 05-Aug-11: US downgraded 302 301 271 238 197 15-Sep-11:US$ funding line 21-Dec-11:1st LTRO 11-Apr-11: Interim ICB report published Source: J.P. Morgan Data Query as of June 27th 2012

  11. UK Banks CDS Underperforming Vs. Cash

  12. Correlation between the Cash & CDS August 2011 through to mid-Nov 2011, CDS and cash highly correlated at c. 1 for RBS and Lloyds, and 0.80 Barclays. Correlation between CDS and Cash decreases from Dec 2011 to Jan 2011. Rapid decrease in correlation from March 2012 where it was c. 0.80 for RBS and Lloyds, to present correlation of c.-0.2 i.e. negative correlation

  13. Global Financial Institution Issuance • Senior unsecured remains the main source of funding for Financials. • Covered bonds has seen increase as Financials look to optimise cost of funding and access to market. • Securitisation has also increased its share from 2009-2011. • Government guaranteed trades issued in 2012 after none seen in2011 2009 2010 2011 2012 YTD Source: Dealogic as of June 227th 2012, Financial Institution Public Issuance in OECD

  14. During heightened period of volatility, European banks have extensively used their respective GG Schemes to access the market 2008-2012YTD Government Guaranteed issuance by European banks ($mm equivalent) 2008 2009 2010 2011 2012 Source: Dealogic as of June 27th 2012. Amounts in $mm equivalent based on exchange rates at time of issue

  15. Whilst the environment makes investing in banks an uncertain activity

  16. Changes in Regulation (1) • Basel 3/CRD 4 – Quality of Bank Capital – Banks will be required to hold significantly more Core Equity

  17. Regulation: Higher Capital Requirements including UK Finish Total Capital (inc T2) Total Capital (inc T2) Total Capital (inc T2) Core Equity Tier 1 Conservation Buffer Total Capital (inc T2) Total Capital (inc T2) Total Capital (inc T2) Core Equity Tier 1 Conservation Buffer Core Equity Tier 1 Core Equity Tier 1 Core Equity Tier 1 Core Equity Tier 1 Core Equity Tier 1 Core Equity Tier 1 Core Equity Tier 1 * *(Primary Loss Absorbing Capital)

  18. Changes in Regulation (2) • For Banks • Basel 3/CRD 4 • Quality of Bank Capital – Banks will be required to hold significantly more Core Equity • New liquidity rules will include need for liquidity buffers of “high quality liquid” assets. What counts will impact the bond markets • Recovery and Resolution Regimes • What will be “Bail-inable”? New form of instrument or all liabilities including deposits? • Independent Banking Commission • In which bank are you investing? • Trading Book Review • V@R replaced by expected shortfall under stress, market liquidity risk via liquidity horizons, consistent and granular models, Banking/trading book boundary review, interest rate risk in banking book to be pillar 1 subject to separate review • Derivatives OTC and via CCPs – Absorbs high quality liquid assets as more collateral is required • More to come? • Banking Union in Eurozone • Common deposit guarantee schemes across Europe • For Investors • Investors also have new regulation (Solvency II, Money Market Fund – SEC cannot agree - etc) which will alter demand for bank paper

  19. Changes in Regulation (3) It still keeps coming:Examples of Regulatory Papers Since Mar 2012 BIS: Fundamental Review of the Trading Book (May 2012) BIS: Principles for effective risk data aggregation and risk reporting (June 2012) BIS: A framework for dealing with domestic systemically important banks (June 2012) BIS: Monitoring indicators for intraday liquidity management(June 2012) BIS/IOSCO: Margining for OTC derivatives (July 2012) BIS: Management of risk in foreign exchange transactions (Aug 2012) BIS: Core principles for Effective Banking Supervision (Revised) (Sep 2012) Crown Dependencies: DP on Basel 3 in Channel Islands and Isle of Man (Sep 2012) EBA: Technical standards for Reporting Leverage Ratio and Liquidity (June 2012) EU: Crisis Management – Bail in (June 2012) EU: Banking Union (Sep 2012) FSA: CP12/23 Implications of non-EEA national depositor preference regimes (Sep 2012) FSA: CP12/24 Regulatory Reform (PRA/FCA Rule books) (Sep 2012) FSB: Shadow Banking April 2012; EU Green paper Shadow Banking (Mar 2012) FSB: Report on Securities Lending and Repos (Apr 2012) HMT: Independent Banking Commission – Sept 2011 – White paper (June 2012) HMT: New Regulatory Regimes in UK (FSA/HMT) 2011– White paper (June 2012) HMT: Wheatley Review on LIBOR (Aug 2012) HMT: Setting the Strategy for UK Payments (July2012) HMT: Financial Sector Resolution: Broadening the Game (Aug 2012)

  20. Credit Rating Agencies: Changed Perception of the Banking Industry • In the wake of the global financial crisis Credit Rating Agencies (CRAs) have come under increased scrutiny; the crisis highlighted that ratings were previously overstated • The value of government support to financial institutions became very apparent throughout the crisis and support was extended in ratings, for example systemic support extended to five notches of ratings benefit for some UK banks • More recently, CRAs have made concerted efforts to be more cautious in their ratings. They have recalibrated bank ratings and their perception of the banking industry is now more negative than at the onset of the crisis • Investment banking activities in particular are viewed as being credit negative due to volatility of earnings, opaqueness and vulnerabilities relating to confidence sensitivity • This changed perception has been reflected in the downward revision of multiple bank ratings; bank ratings criteria have been amended accordingly with the main losers being large universal banks • Additionally, moves to address the “too big to fail” problem, through overhaul of bank regulations and support frameworks, further places systemic support assumptions under pressure 19

  21. Recent Areas of CRA Focus Multiple negative rating actions have been undertaken since the start of 2011 including: Fitch October 11 Moody’s Mar-Jun 12 • Updated ratings methodology to restrict qualitative ratings benefit for firms that undertake significant capital market activities • Consider global capital market firms to be inherently vulnerable to: • confidence sensitivity; • interconnectedness; • opacity of risk • Moody’s believe these firms have diminished longer term profitability and growth prospects • Downgraded long term ratings of 17 universal banks by one to three notches, includes firms such as RBS, Barclays, UBS, Citi, BoA, Goldmans • Lowered systemic support assumptions included in some UK bank ratings (Lloyds and RBS downgraded two notches) • Fitch state “ …there is more advanced political will to reduce the implicit support for the country’s banks…” S&P November 11 • Revised bank ratings criteria to enhance comparability of bank ratings with other sectors and improve ratings transparency • Large universal banks main losers, many being downgraded by one notch 20

  22. The Link between Bank and Sovereign Ratings Additionally: • CRAs consider sovereign ratings and bank ratings to be inextricably linked. This is evidenced, for example, by: • Sovereigns extending banks capital support, liquidity support, asset insurance and guarantees in times of stress • Significant levels of sovereign debt held by banks • The link between a sovereign’s monetary system to its economy and the impact of a poor economic environment on bank performance • Currently the ongoing Eurozone crisis is placing further pressure on bank ratings due to the difficult operating environment and weakening sovereign strength Multiple banks are currently assigned Negative rating outlooks indicating further downgrades are likely 21

  23. Low interest rates impact bank returns UK Base Rate

  24. Eurozone Crisis: ECB in the context of other Central Banks • At end 2011 central bank balance sheets were back in focus following the ECB’s 3-yr LTRO which boosted the ECB’s total balance sheet by around 5% of GDP. The ECB had expanded its balance sheet more than any other in the closing months of 2011 – 5% of GDP over the last three months compared to 3% in the UK, 0.6% in the US and 0.4% in Switzerland. The ECB had the largest balance sheet of the G4, equivalent to 30% of GDP compared to 20% for the Fed and the BoE. No central bank comes close to the SNB, however, whose balance sheet stands at 70% of GDP. • In 2012 the ECB continued to grow its balance sheet with the 3-yr LTRO on February 29 adding another c5% of GDP to the central bank’s assets and monetary base. The Fed’s announcement in September could add $1.5trn to its balance sheet. The ECB’s balance sheet has grown faster than others in recent months, aggravated by the 3-year LTRO. The ECB’s balance sheet is now the largest of the G4 (30% of GDP). The Fed is at 20% Expansion in the ECB’s monetary base is less pronounced that the growth in its balance sheet. It nonetheless contrasts clearly with the US monetary base which has stagnated over the past half year The ECB expanded its balance sheet more than any other in closing months of 2011

  25. Eurozone Crisis: Target 2 data & graph (Source: IIF)

  26. Summary • Banks will have a continued need to issue term debt • To manage their maturity transformation • To meet “Bail-In” objectives • Secured Debt is an effective way of managing cost but there are limits to encumbrance for unsecured debtors • Banks will also have continuing and increasing demand for high quality collateral for managing liquidity and to manage credit risk • Investors meanwhile see many challenges to investing in banks • The Euro crisis continues to put strain on the system

  27. Questions?

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