The Royal Bank of Scotland Commits Error in Stress Test
On Friday, The Royal Bank of Scotland Group plc (RBS), which is largely owned by the U.K. government, announced that it committed an error in the calculation of tier one common equity capital (CET1) during the 2014 European Banking Authority (:EBA) stress test.
The Error
CET1, a key measure of financial strength, is calculated during the stress test conducted by the EBA to determine a financial institution’s ability to endure a financial crisis. The Royal Bank of Scotland had reported a full year 2016 CET1 of 6.7% under the modeled Adverse Scenario in the stress test results published in October 2014.
However, the bank recently realized that it overstated its ability to withstand an economic downturn through inaccurate computation of CET1. After accounting for its mistakes, the revised figure comes down to 5.7%, just 20 basis points above the minimum ratio requirement.
The bank specified that the mistake had an impact on the EBA stress test results only and its current capital ratios remain unaffected. Further, it restated its targeted CET1 ratio of around 11% by the end of 2015 and 12% by the end of 2016.
What Led to the Blunder?
According to the EBA calculations, tax credit in the form of deferred tax assets (DTAs) are to be excluded from the estimated capital available. However, The Royal Bank of Scotland made a slip-up by incorrectly adding this tax credits on theoretical losses resulting in €4.2 billion inflation in the projected equity capital.
Overall Impact
When the European stress test results were announced in Oct 2014, among the major UK banks, Lloyds Banking Group plc (LYG) had reported the lowest core capital ratio of 6.2% with Barclays PLC (BCS) and HSBC Holdings plc (HSBC) reporting stronger figures at 7.1% and 9.3%, respectively.
However, the error made by The Royal Bank of Scotland pushed it down to the weakest position in terms of financial strength. The bank tried to lighten the impact of its error by highlighting its consistent efforts to improve its equity ratios. Further, the bank stated that the CET1 ratio would rise at least by 2.2%, if it was calculated on the basis of its third-quarter financials.
However, the bank’s failure to regain investors’ confidence is evident from the drop in the stock price at the end of Friday’s trading session.
Currently, The Royal Bank of Scotland holds a Zacks Rank #1 (Strong Buy).
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