Geoff Cutmore - Morning Thoughts

Right Issues Throwing Good Money after Bad?

Nobody should be surprised by the talk about a cash-raising exercise at RBS. The real question is why it is taking so long for the banks to acknowledge the continued deterioration in the quality of the assets they own.

A Royal Bank of Scotland logo is seen outside the company's offices in central London, Tuesday May 29, 2007. A consortium led by Royal Bank of Scotland PLC said Tuesday it will launch a hostile bid of euro71.1 billion (US$95.5 billion) for ABN Amro, topping a friendly offer from Barclays PLC and pressing Bank of America Corp. for control of the Dutch bank's U.S. arm. (AP Photo/Matt Dunham)
Matt Dunham

Market guesstimates suggest RBS will be looking for something around 10 billion pounds ($20 billion). Very much less than that would invite concerns that a further cash call might be needed. So how should current shareholders respond?

Raising cash from shareholders is always painful. They either pay up or see their holdings diluted. Either way the shareholders suffer. Given RBS' share price has halved in the last year, the owners of this business have already been financially damaged. But we are where we are.

Any decision to take up a rights issue should be based on a fresh examination of the business opportunity for RBS. Treat this decision like any other argument for investing in one asset class over another or one stock in preference for another.

The rub is what the banks' business model will look like from here? The credit crisis is challenging the idea that banks will be able to get back to the business of lending at pre-crunch levels. RBS' share price has to rise 100 percent to return to its pre-crisis levels (and the level some investors would have bought). Does that appear feasible in an environment of slower economic growth where consumers are likely to reign in spending habits?

RBS is not an investment bank, and has therefore missed the worst excesses of the CDO and asset-backed debt market problems. However, Sir Fred Goodwin and his team have been aggressively acquiring companies, with ABN just the latest, albeit one of the largest. New funds will be used to work through that acquisition and bolster existing wholesale and retail commitments.

Some argue shareholders who have enjoyed the profits in the good years should be prepared to add capital in the bad. Well fortunately it doesn't work like that. If this is a business with a bright future, shareholders with a diluted holding will still benefit. If it is not, then putting more money into the business is folly.

This is a far-from-clear-cut story about investing in growth and shareholders should think carefully about their next move. Any bank asking shareholders for money in this environment must be prepared to sweeten the deal with a deep discount to the current price. But even then, investors must ask basic questions about where the growth is going to come from.

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