QE Lend Long-Term 3

BUILDING TOMORROW™ The State of Banking: Macro Credit Research Still Unstable Bloomberg FI14 Forum, June 2014 Alberto Gallo, CFA Head of European Macro Credit Research +44 (0) 20 7085 5736 [email protected] Lee Tyrrell-Hendry Macro Credit Analyst +44 (0) 20 7085 9462 [email protected] Shikhar Sethi Macro Credit Analyst +44 (0) 20 7085 6479 [email protected] Tao Pan Macro Credit Analyst +44 (0) 20 7678 3122 [email protected] Rajarshi Malaviya Gaurav Chhapia Chanchal Beriwal Produced by The Royal Bank of Scotland plc. In the UK, the Royal Bank of Scotland plc is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct rbs.com/mib Authority and the Prudential Regulation Authority. Why do banks exist? 1. To optimally allocate resources in the economy 2. To borrow short-term andQE lend long-term 3. To promote new businesses and growth 4. To provide safe savings for depositors 5. To generate sustainable profits for shareholders 2 The original sin of European banking Frequency of the words “debt” and “sin” in English language books QE Tulip-mania 1929 crisis 2008 crisis Source: Google Books, Ngram Viewer 3 Of that seventh circle, where the mournful tribe Were seated. At the eyes forth gush’d their pangs, Against the vapors and the torrid soil Alternately their shifting hands they plied. Thus use the dogs in summer still to ply Their jaws and feet by turns, when bitten sore By gnats, or flies, or gadflies swarming round. Noting the visages of some, who lay Beneath the pelting of that dolorous fire, One of them all I knew not; but perceived, That pendent from his neck each bore a pouch With colours and with emblems various mark’d, On which it seem’d as if their eye did feed. The Divine Comedy, Inferno XVII Source: RBS Credit Strategy, Wikipedia 4 Banking: a for-profit business or a social and political activity? Charging interest was sinful for the Catholic Church since Pope Leo the Great The Lombards started loans on collateral, which was not forbidden. Lombard credit spread throughout Europe Italians became famous bankers: the Medici Bank (1397-1494) was the largest banking institution in Europe To fight lending at high interest rates and usury, the Franciscans created the mount of piety, a charity institution to lend at modest rates. They also spread throughout Europe Germany’s landesbanken and sparkassen, Italy’s popolari and cooperative, Britain’s building societies and Spain’s cajas all have ties to local authorities and a high percentage of public ownership and/or non-negotiable control Source: RBS Credit Strategy, Wikipedia 5 Half a century of credit supercycle $tn US GDP 70 US credit market debt European credit market debt Financial crisis 60 Competition & credit control Big Bang (UK) Glass-Steagall Act repealed Quantitative introduced / Bretton Woods easing breaks down 50 40 ? 30 You are here 20 10 0 52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09 12 Source: RBS Credit Strategy, ECB, FRED, Bloomberg 6 Bank capital is at a record low Book value of equity / total assets for US banks 70% 60% 50% 40% 30% 20% 10% 0% 1834 1844 1854 1864 1874 1884 1894 1904 1914 1924 1934 1944 1954 1964 1974 1984 1994 2004 Source: RBS Credit Strategy, FDIC, Historical Statistics of America 7 1. Restarting Europe’s credit engine 2. Fixing the banks (TLTRO, AQR, stress test) QE 3. Boosting non-bank lending (Credit Easing with ABS) 4. The exit show: QE, asset bubbles, macro-pru for the US and UK Source: Google. No animals were harmed during the making of this slide 8 1. Restarting Europe’s credit engine QE Source: Google. No animals were harmed during the making of this slide 9 The credit cycle: Europe stabilising, US re-leveraging, EM crunch A cycle of four phases Bubble Crunch 1. Crunch GDP↓↓, π↓↓, D↑↑, M&A↓↓ 2. Stabilisation GDP↓, π↓, D ↓↓, M&A ↓ 3. Re-leveraging GDP↑, π ↑, D ~, M&A ↑ 4. Bubble GDP↑↑, π ↑↑, D ~, M&A ↑↑ GDP = real growth π = inflation D = default rates M&A = M&A activity Re-leveraging Stabilisation Source: RBS Credit Strategy, Bloomberg Europe is stabilising, the US re-leveraging, EM are in an early crunch 10 Still thelargestbanks in theworld Source: ECB Source: 100% 200% 300% 400% 500% 600% 700% 0% Ireland Cyprus Switzerland UK France Euro Area Spain Bank % assets GDP Sweden Denmark 11 GIIPS Austria Germany ago 10-years Finland Italy Canada Norway Australia Japan Slovenia US Banking systems: Euro area vs US Euro area US 6,790 - Number of banks - 5,783 3.1x - Bank assets/GDP - 0.8x 37 - Number of branches - 35 per 100,000 adults 22% - Bonds/total debt - 52% 16% - Mkt share of top 5 banks - 33% €1,041bn -NPLs-$200bn 10.9% -NPLs/GDP -1.2% Source: RBS Credit Strategy, Bank of Italy, ECB, IMF, World Bank, FRED 12 The good news: Bank deleveraging is stabilising Deleveraging has stabilised: monthly total asset deleveraging in the eurozone, €tn 0. 0 -0.5 -1.0 -0 .6 +0.3-0 .3 -0.2 -1.5 +0 .1 +0. 2 -0 .6 0.0 -2.0 +0.1 -0.1 -2.5 -0.6 -0 .4 -3.0 -0.5 -3.5 -0 .3 -0.2 -0.1 -0.02 +0.4 +0.2 -4.0 -0.03 -0.1 -4.5 -0.2 -4.1 -0.9 -5.0 Jun-12 Dec-12 Jun-13 Dec-13 Total Source: RBS Credit Strategy, ECB 13 The problem: Financial fragmentation is still high Unemployment rate and growth gap between core and periphery continues to widen The funding gap The employment gap The solvency gap SME average loan rates, % Unemployment rate, % Non-performing loans, % 8% Periphery 20% 20% Periphery Core Periphery Core Core 16% 15% 6% 12% 10% 5% 8% 5% 3% 4% 0% 07 08 09 10 11 12 13 14 07 08 09 10 11 12 13 14 07 08 09 10 11 12 13 14 Source: RBS Credit Strategy, Bloomberg Source: RBS Credit Strategy, Bloomberg Source: RBS Credit Strategy, Bloomberg Financial fragmentation impairs the transmission mechanism of monetary policy 14 The bank job: Fixing Europe’s banks Source: Google. No banks were harmed during the making of this slide 15 Lessons fromthecrisis Source: RBS Credit Strategy, ECB, Bloomberg 10% 15% 20% 0% 5% AIB Anglo NBG Bankia loans initial % as Losses Amag Monte HBOS 16 ML Losses as assets % initial BoI WaMu B&B Wach Nrock SNS UBS Dexia Lessons fromthecrisis Source: RBS Credit Strategy, ECB, Bloomberg 10% 15% 20% 0% 5% BBVA Intesa KBC Rabobank Unicredit Santander Lloyds Nordea Credit Ag Group 17 UBS ING Bank BNP CS Soc Gen average loss for bad banks bad for loss average ABN Danske 3% requirement CMZB DB Barclays Capitalism without capital The inverse relationship between RWA % (Y) and bank size, €bn (X) 100% 90% 80% 70% 60% BBVA 50% UniCredit Intesa S ant ander HSBC 40% Rabo ING Lloyds BPCE BNP 30% LBBW ABN Danske CS 20% SEB Nordea Soc G en Barclays Credit Ag Deka Nwide SHB DZ Natixis UBS 10% Poholja DB 0% 0 200 400 600 800 1,000 1, 200 1,400 1, 600 1,800 2, 000 Source: RBS Credit Strategy, Bloomberg, company filings 18 Bank assets%GDP Too bigtofailhasnot gone away Source: RBS Credit Strategy, Bloomberg Strategy, Credit RBS Source: 100% 120% 140% 160% 180% 200% 20% 40% 60% 80% 0% D anske UBS CS ING Bank Santander Rabobank HSBC Credit Ag BNP Barclays 19 SEB DB KBC SocGen Unicredit BES RZB JPM BAC Citi GS MS Interconnectedness: Cross-holdings in Europe’s banking system Italy 4.5% 8.2% 100% Qatar Iberdrola JP Morgan Toro Generali 1.3% 1.4% Abu Dhabi Libya Veolia 2.5% 12.5% 6.5% 2.6% Intesa 3.7% Monte 5.16% BlackRock 4.9% Gr oupama Mediobanca UniCredit 8.7% 0.15% 2.45% Germany 2.4% France 3.5% 2.5% Credit Agricole SocGen Mediolanum 17% Allianz 1.0% 1.4% 10.8% AXA 1.0% 0.06% BES 4.1% 0.03% 10.1% Portugal Telecom 6.0% Natixis AM POP 6.9% Deutsche Bank Commerzbank 0.16% BBVA 1.3% 1.7% Caixa Geral 4.5% 0.12% 4.76% 1.3% 3.9% 5.75% 1.7% 0.5% Credit BNP 2.8% Santander UBS CRH Suisse Caixa Telefonica Holdings 4.0% 6.4% 5.6% 3.2% 1.6% 0.41% 35% Caixabank 12.21% Norway Singapore Gas Natural Repsol Bankinter State Street Source: RBS Credit Strategy, Bloomberg, company filings. Red = bank, Grey = sovereign, Blue = other 20 Costs are still high Number per 100,000 population, in Italy 80 70 60 50 40 30 20 10 0 Museums High schools Secondary Primary Pharmacies K indergart ens H otels B ank schools schools branches Source: OECD, Bloomberg 21 A two-tier banking system Return on equity vs credit rating (bubble size indicates amount of total assets) RoE PLC Investment banks Cooperatives/Savings banks 20% 15% 10% 5% 0% -5% -10% -15% AA A BBBBB B CCC Source: RBS Credit Strategy, Bloomberg 22 Bank CT1 ratio after estimated NPL shocks, and widening ofso shocks,and widening Bank CT1ratioafterestimatedNPL 10% 12% 14% 16% 18% 20% 22% 24% 26% 0% 2% 4% 6% 8% for this. The EBA will use 8% and 5.5% capital threshold forits threshold capital 5.5% 8%and use will EBA for this. The standard for theLandesbanks German Solvency 2, 2.5or the Basel income pre-provision 80%of average PPIis 3y positions.

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