RBS gets upgrade from RBC though 'significant' risks linger

The Royal Bank of Scotland has exceeded expectations so far this year, said RBC Capital Markets as it upgraded the bank's shares to a 'sector perform' rating.

RBC upped its price target to 240p from 210p as it felt capital risks and margin headwinds are shrinking for RBS but sees upside for the shares only if the bank is able to generate excess capital, "which seems unlikely in the near term".

Significant risks to excess capital come from an expected additional £1bn in provisions due to the US Department of Justice fine on residential mortgage-backed securities (RMBS) -- "but if fines are as high as some US banks, the additional provision could be an additional £4bn" -- plus a 45 basis point benefit to capital from deconsolidation of partly-owned Saudi bank Alawwal which is "uncertain".

On the upside, however, the threat to excess capital has been curtailed by the settlements with the Federal Housing Finance Agency and with the European Commission on Williams & Glyn both with minimal additional provisions.

Furthermore, Alawwal is in merger negotiations which could lead to regulatory deconsolidation of the stake; RBS expects the impact from IFRS 9 to be positive to capital; the run-down of non core is progressing at the upper end of expectations; and that RBS looks in a better position for this year's stress tests after litigation settlement, further build-up of loss absorbing capacity and its low exposure to consumer credit.

RBC analysts forecast underlying 2017 return on tangible equity of 9.5% and rising to 12% by 2020 in line with the company's "floor" target.

"Despite reported spread pressure on mortgages, the bank lending survey suggests expansion in spreads. Pressure on margins has been offset by market share gains in the current account market," they wrote in a note to clients on Monday, though still expecting margins to fall by 9 basis points by 2019 due to the funding structure of the bank.

A possible pre-dividend excess capital of 92p per share by 2020 could increase the RBS valuation to 350p - but the analysts "do not expect the valuation to get the benefit for this capital position until more capital headwinds are dealt with and the dividend is restarted".