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Last week, The Royal Bank of Scotland Group plc (RBS - Snapshot Report) reported net operating income of £1,047 million ($1,654 million) for third quarter 2012 (ended September 30, 2012). This reflects a substantial increase of 61% from net operating income of £650 million ($1,029 million) reported in the prior quarter.

Core operating income stood at £1,633 million ($ 2,579 million), up 8% sequentially. Further, non-core operating loss as reported was £586 million ($926 million), down 32.5% sequentially. Improvements in asset prices and tightening of credit spreads led by favorable market conditions in the quarter drove the non-core results.

Results reflected a stable development in the core bank’s operating results, along with a further reduction in operating losses from the Non-Core division. Moreover, decline in operating expenses depicts better expense management.

Furthermore, division-wise, on a sequential basis, Retail & Commercial reported a 3.4% fall in operating profit and Direct Line Group recorded 19.3% dip. However, Market division reported rise of 7.0%. Further, Central items reported operating profit compared with loss reported in the prior quarter.

Performance in Detail

Net Interest income fell 3.4% on a sequential basis to £2,873 million ($4,538 million) from £2,973 million ($4,707 million). The decline was driven by lower levels of interest earning assets. Net interest margin was 1.94%, down 1 basis point from 1.95% in the prior quarter. The slight decrease was led by continued margin pressure in Retail &
Commercial which more than offset the dip in liquidity and funding costs.

Non-interest income came in at £3,585 million ($5,663 million), up 3.5% sequentially from £3,465 million ($5,485 million). An increase in realized bond gains due to repositioning of the liquidity portfolio, which was partially offset by a fall in Retail & Commercial, led to positive results.

Operating expenses for the quarter totaled £3,639 million ($5,748 million), down 6.1% from the prior quarter. The fall in expenses were mainly driven by the continued run-down of non-core and lower staff expenses in Markets and International Banking. Moreover, core cost to income ratio improved from 62% in the prior quarter to 59%, as cost-management in all businesses was constantly monitored.

Loan impairment losses were £1,183 million ($1,869 million), down 18% sequentially. The decline was led by a dip in loan impairments in the non-core portfolio by 40%, partially offset by 4.5% rise in core loan impairments.

Balance Sheet

As of September 30, 2012, funded balance sheet was £909 billion ($1,436 billion), down £20 billion ($32 billion) sequentially. The fall was driven by £7 billion ($11 billion) reduction in non-core funded assets and reduced International Banking and Ulster Bank balances. Total assets stood at £1,377 billion ($2,175 billion), down 2.7% sequentially.

Loans and advances to customers dipped 3% sequentially to £443 billion ($700 billion), driven by non-core run-down and contractions in the International Banking portfolio. Loan to deposit ratio improved from 104% to 102% in the quarter.

Capital ratios

As of September 30, 2012, core tier 1 ratio stood at 11.1%, in line with the prior quarter. Gross risk weighted assets came in at £481 billion ($760 billion), down 1.4% sequentially from £488 billion ($773 billion). The decline reflects a reduction in market risk along with balance sheet contraction.

Outlook

Management expects persistent economic and regulatory challenges to continue for the rest of 2012 and into 2013.  RBS aims to focus on maintaining a strong balance sheet and capital position along with prudent expense management.

The bank expects trends in Core Retail & Commercial businesses to be consistent with the third quarter, although Markets business is likely to show normal seasonal variations in the fourth quarter.  Moreover, net interest margin over the second half is expected to be generally stable compared with the first half of 2012.

Continuing with the strong progress on restructuring, RBS aims to substantially complete most of the restructuring actions from its 2009 strategic plan in the next 15-18 months.

Recent Developments

In October 2012, RBS completed the successful initial public offering of Direct Line Group as part of its restructuring plan.

RBS sold 520.8 million ordinary shares in Direct Line Group, representing 34.7% of the total share capital, generating gross proceeds of £911 million ($1,458 million). The disposals of Global Merchant Services and RBS Sempra Commodities JV businesses have already been concluded.

Peer Performance

Among peers, Deutsche Bank AG’s (DB - Analyst Report) net income attributable to its shareholders came in at €747 million ($935 million) in third quarter 2012, up 3% from €725 million in the prior-year quarter. On a per share basis, the company reported earnings per share of €0.78 in the reported quarter, ahead of €0.74 reported in the year-ago period.

The quarterly results reflect enhanced revenues. Particularly, the performance in its Corporate Banking and Securities segment improved significantly as market conditions bettered and client activity increased. However, the positives were mostly offset by costs related to restructuring efforts and litigation issues and this almost neutralized the year-over-year increase.

Our Viewpoint

Going forward, we expect RBS’ diversified business model and sound financial position to keep contributing to its overall growth in the future.  However, we are concerned about the increasing competition, volatility in the global economy and the effects of the deepening Euro-Zone crisis.

Shares of RBS currently retain a Zacks #3 Rank, which translates into a short-term Hold rating.

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