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Litigation Charges to Weigh on RBS Q4 Results

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Recently, Royal Bank of Scotland (RBS - Free Report) announced that it would set aside nearly £3 billion ($4.97 billion) for impending litigation claims related to mortgage-backed securities and other legal costs in the U.S., which were sold before the financial crisis.

The latest charge adds to £4 billion of charges that it announced in November 2013. We expect these to incur a significant loss for the bank when it reports final quarter and full-year 2013 results next month.

Royal Bank of Scotland was once the shining example of the banking system in Britain. However, when the banking crisis erupted, the British government was forced to bail out the bank with nearly £45 billion ($70 billion) – which was the biggest bailout in history. Six years down the line, the bank is 81% owned by U.K. taxpayers and still struggling to surmount all troubles.

Notably, Royal Bank of Scotland is one of the 18 banks being investigated by the Department of Justice in the U.S. over faulty mortgage sold to Fannie Mae and Freddie Mac .

The bank also declared that it set aside an amount of £465 million ($766 million) in provision to cover claims related to the faulty sale of Payment Protection Insurance. The cumulative provision is £3.1 billion, of which £2.2 billion has been utilized as of 31 Dec 2013. The remaining provision of £0.9 billion covers the redress and administrative expenses of a year.

Additionally, Royal Bank of Scotland will keep £500 million to cover claims related to so-called interest rate hedging products sold to small businesses. The cumulative provision, including expenses, was £1.25 billion as of Dec 31, 2013.

In the fourth quarter of 2013, the company expects to incur additional impairment and asset valuation adjustments in the range of £4.0–£4.5 billion. This will result from the strategic creation of an internal bad bank, known as R.B.S. Capital Resolution – which was established on Jan 1, 2014.

Additionally, as of Dec 31, 2013, Third Party Assets were below the previous guidance of £35 billion, primarily due to increased level of non-core asset reduction.

In addition to all the above charges, core operating expenses in the fourth quarter will include £200 million of additional provisions for various conduct-related and legal expenses.

From the capital perspective, Royal Bank of Scotland continues to target a fully loaded Basel III Core Tier 1 ratio of 11% by the end of 2015 and 12% or more by the end of 2016. Additionally, the bank expects to report a Core Tier 1 ratio of around 11% as of Dec 31, 2013. On a fully loaded Basel III basis, the Group's equivalent Core Tier 1 ratio is expected to be between 8.1% and 8.5%.

Even though Royal Bank of Scotland is in troubled waters now, we are encouraged by its efforts to restructure its business. With the divestment of its non-profitable units, we believe that the bank will be able to overcome the challenges bracing it and regain its former glory.

Royal Bank of Scotland currently carries a Zacks Rank #3 (Hold). A better-ranked foreign bank is HDFC Bank Ltd. (HDB - Free Report) with a Zacks Rank #2 (Buy).

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