Credible tests dig a deeper hole for RBS

The Bank of England’s stress tests may not have proved much, but they did show that RBS shares could still crater more, even after losing more than 30% for the year by Tuesday night.

Of Britain’s other lenders, only Lloyds could be said to have passed with something like flying colours, but only Royal Bank of Scotland flunked across the board.

RBS’s battered stock fell as much as 5% on Wednesday morning, before halving the amount later.

The move probably tells us as much about price momentum as it shines a light on sentiment among the public-owned group’s private investors.

Still, although it is unlikely that many of them will have many illusions left about RBS’s ability to strengthen returns sustainably anytime soon, its inability to meet this year’s stressed 7.3% core capital target whilst StanChart, Barclays, HSBC and Lloyds were, is an eye opener for investors.

The 71.5% state-owned group was not even able to match the government’s buffer after triggering an emergency conversion of contingent convertible (CoCos) bonds into equity, the very purpose for which the paper was made eligible as regulatory capital.

The outcome should also, unfortunately, prick the illusion that reported capital ratios offer reliable insight into a bank’s ability to withstand economic or financial shocks. RBS notably posted the highest core capital amongst its rivals in 2015 at 15.5%.

Admittedly, the BoE went to town with its stress scenario this time, demanding a minimum T1 capital ratio of 4.5%, envisaging a property price rout and global economic collapse, replete with $20/bbl. oil. Bank-specific risks tightened conditions further, case-by-case.

Barclays and particularly commodities-dependent StanChart only got over the wall after dividend freezes and CoCo conversions.

HSBC and Lloyds limped, seeing core equity compressed to 7.6% and 9.7% from 11.9% and 12.8% respectively, but would not have imploded.

After RBS’s capital cushion only reached 5.5%, it last night rushed out a statement pledging to raise about £2bn in a new agreed capital plan with the BoE. It requires deeper cost cuts, more balance sheet lightening and non-core asset liquidations.

Raising credible bank capital in a world of collapsed bank capital values is not going to be smooth, but at least the prospect of state embarrassment from another government cash injection looks to have been avoided.

However, expectations for RBS were already dire and logically, there is now room for forecast downgrades. Thomson Reuters data shows investors see its return on equity at 2.7% this fiscal year, a positive figure compared with negative returns at the end of 2015 albeit well below expectations of 10.4% for Lloyds and 10.9% at upstart rival Virgin Money. One failed stress test later, any hope that the RBS’s stock and financial strength had reached a floor needs to be dropped.

On a more positive note, Britain’s bank testing regime itself was on trial as much as its lenders.

The weakest bank was indeed ‘busted’ and market views of which UK-facing banks were stronger were corroborated. Compare those outcomes with ECB stress tests during the summer, which had no clear pass and fail.

Investors in Barclays, Lloyds and HSBC still need to tread carefully through a hazard strewn outlook.  But now, there are fewer reasons to look in RBS’s direction.