The Royal treatment

Small, lean, Royal Bank of Scotland prospered by maximizing its options.

Small, lean, Royal Bank of Scotland prospered by maximizing its options.

By Jane Adams
November 2000
Institutional Investor Magazine

Small, lean, Royal Bank of Scotland prospered by maximizing its options. Can it stay nimble
and innovative after its bruising takeover of the far bigger National Westminster Bank?

n 1995 Tesco decided to try peddling credit and debit cards along with its eggs and butter. Not wanting to get bogged down in back-office minutiae, the U.K. supermarket giant struck a deal with National Westminster Bank to administer its stores’ Clubcard customer loyalty program and enhance it with a few basic banking services.

Tesco officials loved the results, but the NatWest relationship didn’t last. Within a year Tesco had proposed broadening its financial offerings to compete more aggressively against banks. But NatWest demurred, afraid of aiding an assault on its own vast retail branch network. Frustrated, Tesco turned to Royal Bank of Scotland.

Their partnership, a 50-50 joint venture called Tesco Personal Finance, in June reported its first profit. And the NatWest that spurned Tesco is gone, victim of a bitter takeover by the nimble, more forward-looking RBS.

Royal Bank of Scotland’s £20 billion ($30 billion) purchase of NatWest in March, after a bruising six-month battle, stunned British banking. Deftly outmaneuvering a London-based giant twice its size, the 58th-largest bank in the world vaulted into the ranks of the top 20. But in a real sense, the shocking outcome was prefigured in the aisles and at the checkout counters of Tesco.

“NatWest was living in the dark ages,” scoffs RBS executive deputy chairman Sir George Mathewson, who as group chief executive directed the war against NatWest before handing over the reins of power in March to Frederick Goodwin, former deputy group chief executive. “They felt that they couldn’t offer Tesco a full range of product because it would compete with their own.”

Easy enough for Mathewson to say, of course. His midsize Edinburgh-based bank had far fewer branches in England than NatWest, and thus less to lose. But that, he insists, is an overly narrow view of business strategy. The point, he and other RBS officials say, is that in a world where technology and customer preferences are constantly changing, it makes sense to keep open as many options as possible and to be eager to compete with yourself. “We got over internal competition ages ago,” he says. “For every customer our joint venture takes from us, it takes 15 from someone else.”

Good bankers diversify their risks. RBS diversifies just about everything. Under the Mathewson model, there is no one Royal Bank of Scotland, no one approach to its marketplaces and, to the banking and investing public, no single RBS corporate logo or image. The NatWest name still coexists with Royal Bank of Scotland, and there are subsidiaries still named Greenwich NatWest, NatWest Offshore and NatWest Stockbrokers. RBS and NatWest maintain separate Web sites, as does the Direct Line insurance subsidiary, which also offers lending and investment services. Most of these compete, to at least some extent, with Tesco Personal Finance, which also does joint marketing with Tesco’s own online supermarket site.

Such a strategy would be anathema to London-based rivals HSBC Holdings and Lloyds TSB, not to mention the many other financial institutions that were products of mergers and have gone to great lengths to unify their brand identities, product lines and distribution networks. The contrarian RBS method is to maintain multiple brands, ramp up distribution channels, push as many products as possible through them all and keep repeating whatever works.

“One of the things about mergers is that there’s been a lot of damage caused by people who started messing about with brands before they understood what they were,” says Mathewson. “It’s difficult to understand what makes people attach themselves to one brand rather than another. You mess about with customers at your peril in that regard.”

Of course, it’s easy to be nimble as a regional bank focused on Scotland turning to a variety of ventures to reach customers outside of its limited home base. And owning NatWest does open up an array of new options in such areas as corporate and small-business banking, where RBS is now No. 1 in U.K. market share.

But the combination brings with it the potential for enormous headaches. Goodwin, Mathewson and their colleagues face a huge test in applying an aggressive strategy that worked well for a smallish operation to an enterprise that has tripled in size, almost overnight. They must find a way to capitalize on NatWest’s reach and marketing potential -- combined, RBS and NatWest are No. 2 in U.K. retail banking behind Barclays Bank, for example, and No. 1 in private banking -- while quickly disposing of the very things that made the London bank vulnerable to takeover: its historically high costs and the deadweight of its legacy systems.

And NatWest was some dinosaur. Though strong in wholesale banking and syndicated lending, it struggled with a bloated and bureaucratic consumer business that was losing market share. Through the second half of the 1990s, revenues grew at a weak 4 percent annually (RBS logged a 16 percent growth rate), and the bank projected a decline in 2000. NatWest’s efficiency rating -- the ratio of costs to revenues -- approached 70 percent at a time when RBS and other cost-conscious banks were aiming for and hitting 50 percent or lower. Too late to repel unsolicited offers from RBS and its crosstown rival, Bank of Scotland, NatWest decided to restructure its retail bank, complete with layoffs and branch closings.

Compounding these problems, NatWest made a series of strategic blunders. It gave up on an attempt to build a U.S. retail bank in 1996, when it sold Jersey City, New Jerseybased Natwest Bancorp to Fleet Financial Group. Desperate to stay independent, NatWest tried to buy U.K. insurer Legal & General Group last year, outraging investors; eventually, it decided to unload Gartmore Investment Management and its $85 billion of assets under management. (It sold in June to Nationwide Mutual Insurance Co. of Columbus, Ohio, for $1.6 billion.)

“Their culture was stodgy, and their attitude was not sales-oriented,” says Mark Thomas, head of banking analysis at Fox-Pitt, Kelton in London.

As praised for their managerial abilities as NatWest was vilified for a lack of vision and poor execution, RBS executives dived straight into running their new acquisition, taking over NatWest’s technology and back-office operations, reducing the workforce, eliminating redundancies. They sacked most of its top officers, electing to stick with members of the homegrown echelon that enabled RBS to post an eye-catching 49 percent efficiency ratio. (Lloyds TSB is the U.K.'s large-bank leader, at 42.5 percent.)

RBS’s acquisition turns the classic bank-consolidation scenario on its head: A relative minnow of a financial institution, with 33,000 workers and $150 billion in assets, had suddenly become a leviathan, with 99,000 employees and $450 billion in assets. Though it’s still in its early stages, the results have been encouraging.

In August RBS dampened lingering market skepticism by beating all expectations for first-half earnings. Revenues grew 10 percent, to $9 billion, and pretax profits were up 11 percent, to $2.2 billion. Through midyear the bank had cut 7,500 of the 9,000 employees scheduled to depart in 2000. It also said it had achieved $541 million of a projected $827 million in annualized cost savings and $69 million of $180 million in revenue improvements anticipated by December 31. “The biggest element of surprise was that income is broadly in line with previous performance, and there is not much disruption to business,” says Fox-Pitt, Kelton’s Thomas. The RBS share price jumped 11 percent on that news, to £11.70. A month later it was at £12.83, and by mid-October it was higher still, at £14.

And RBS did not just score a financial coup. It won a public relations bump by keeping open branches that NatWest had previously said it would close and by eliminating fees for overdrafts and automated teller withdrawals. Goodwin wants the markets to anticipate more merger dividends. “We only took the reins at the NatWest on March 6,” he said at the time of the earnings announcement. “So in terms of expecting things to come through and start happening, particularly in relationship to revenue, there’s very little impact on the P&L in the first period.”

The big bounce will come as the bank uses NatWest to further maximize its options, “whether they be in delivery channels, corporate versus personal banking, or brand values,” says Mathewson. “It is this philosophy that has put us in a unique position today, with more opportunities to grow income and cut costs than our competitors. The Royal Bank has built its strategy around the creation of future options leading to choices and growth opportunities. We have declined to bet the bank on a single view of the future.”

ROYAL BANK OF SCOTLAND’S PURCHASE OF NatWest is by far the biggest ever attempted by a bank whose history extends from the Industrial Revolution to the Internet. Founded in 1727, RBS claims a number of banking firsts, including overdraft coverage in 1728, multicolored bank notes in 1777 and branch banking in the 19th century. Today’s more diversified RBS took shape through a series of decisions that accelerated in the 13 years since Mathewson joined the bank as director of strategic planning and development and began widening RBS’s options.

Consider the Tesco deal: NatWest, with 2,000 branches heavily concentrated in England, was clearly spooked by Tesco’s 845 stores and by what the chain might do with its vast consumer database. Defending the decision to bail out, a former NatWest executive says: “Tesco was in our markets and wanted to become much more like us as a retail bank. The Royal Bank was coming in de novo. They had no reason not to do it this way.”

RBS, which has at least a half dozen similar joint ventures, gives Tesco Personal Finance back-office and product support, but otherwise lets the affiliate set its own course. The Tesco venture tries to open accounts for, and broaden relationships with, 10 million Tesco Clubcard holders. (To put that in perspective, after the NatWest acquisition RBS has 15 million customers in the U.K. and Ireland.)

More than 1.6 million shoppers have signed up with Tesco Personal Finance, and the unit posted a profit of £1 million in the first half. One indication that the strategy is working: Tesco Personal Finance has become one of the U.K.'s fastest-growing credit card marketers. Tesco disclosed that in January 2000 it received 250,000 card applications, one fifth of the total for the entire country. Earnings will likely continue to be held down by spending on such technology as customer relationship management systems to aid in the cross-selling of bank products to Tesco shoppers.

“You need to be aware of how strong the Tesco brand is,” says David Edwards, finance director of Tesco Personal Finance. “There is a great loyalty to Tesco, and you shouldn’t underestimate the benefit of that loyalty for a financial services customer. It’s the proposition of being able to offer a financial product like a can of beans. You can just go in, pick it up and buy it.”

The Tesco deal paved the way for another 50-50 arrangement with Richard Branson’s Virgin Group transportation and entertainment empire. The venture, Virgin One, started in 1998, but only after Virgin, which has been putting its name on everything from cell phones to soda pop, had vetted several proposals, including one from the similarly ambitious Bank of Scotland (see box).

“A number of people expressed concern about how they would have to change back-end legacy systems in order to accommodate this sort of account,” says Jayne-Anne Gadhia, who heads Virgin One. “Royal Bank didn’t see that as a problem.” RBS was also keen to build new Virgin-branded products, rather than just put a private label on existing bank offerings. “They’re not out to stiflingly control everything,” Gadhia says. “Any good idea will be supported, and they make sure it’s safe.”

Gadhia says that Virgin One turned a profit -- she doesn’t say how big -- in August and should at least break even in 2001. With 40,000 customers, it is considerably smaller than Tesco Personal Finance. But that number had doubled from the previous year, and the business revolves around a big-ticket item: consumer mortgages. Virgin One is originating nearly 4 percent of new mortgages in the U.K. With loans totaling £2.5 billion, Virgin One has increased its share of the mortgage market, to 1.05 percent from less than 0.5 percent last year.

As with Tesco, cross-selling is critical in terms of both building on the Virgin brand’s allure and getting loan applicants to consolidate their financial business in an all-in-one package called a current account mortgage. The borrower gets an incentive to link the mortgage to the current, or checking, account, from which installment payments are deducted automatically. The concept originated in Australia, where 20 to 30 percent of mortgages are tied to this type of account. Virgin One introduced the current account mortgage in the U.K., and bigger lenders such as Woolwich, which is being acquired by Barclays Bank, and Halifax Group’s Intelligent Finance unit have followed.

Among other major joint ventures engineered under Mathewson are RBS Advanta, a credit card partnership with Advanta Corp. of the U.S., and IBOS, a consortium of European banks that jointly sell corporate cash management and other operational services. In July RBS effectively created an insurance joint venture, selling a 50 percent interest in two subsidiaries, Royal Scottish Assurance and National Westminster Life Assurance, to CGNU, the U.K.'s biggest insurer, for $900 million.

Direct Line Insurance -- an RBS subsidiary and a precursor of today’s virtual banks (it was one of the first financial service providers in the world to do business primarily by telephone) -- predated Mathewson’s arrival by two years. But last year, on his watch, it went on the Internet with and acquired the U.K. roadside repair firm Green Line from troubled Cendant Corp. of the U.S. for $330 million. It also formed a joint venture with Spain’s BankInter called Línea Directa.

Mathewson, 60, has a scientific background, including a Ph.D. in electrical engineering from St. Andrews University in Scotland and five years of research and development work for Bell Aerospace Corp. in the U.S. “An engineering-analysis and mathematical background are extremely useful in banking,” he says. “It gives you a huge appreciation for systems of all types. And systems, in my mind, is what business is all about.”

Mathewson joined the bank in 1987 after serving as chief executive of the Scottish Development Agency. He became deputy group chief executive in June 1990 and rose to the top job a year and a half later. In March he effectively kicked himself upstairs into the “more strategic” executive deputy chairman role, he says, because eight years as CEO was enough, and Goodwin, who came in as his No. 2 in 1998, had impressively cut expenses and boosted profits while running Clydesdale Bank, the Scottish subsidiary of National Australia Bank Group.

For his cost-cutting zeal the 42-year-old Goodwin earned the nickname “Fred the Shred,” which got prominent play in the tabloid coverage of the NatWest takeover battle. But Goodwin has softened his image by keeping branches open and attending to the morale of employees while implementing the plan to cut 9,000 of them by year-end and that many more by 2003. “It looks like the front line has been given a great deal of confidence that it will have products it can deliver and that it’s got a management that is focused on it,” says Jon Kirk, a Fox-Pitt, Kelton banking analyst.

To be sure, Goodwin has been hacking away. Analysts from Crédit Lyonnais Securities Europe estimate that underlying costs have declined 2.3 percent so far. Almost all of the former NatWest managers are gone. Goodwin’s closest colleagues now include corporate banking chief Iain Robertson, who joined RBS in 1992 from, coincidentally, NatWest; Norman McLuskie, an 18-year RBS veteran who is chief executive of “retail direct” activities, including credit cards and the Tesco and Virgin ventures; Cameron McPhail, chief executive of wealth management, who managed an extensive RBS retail reengineering effort during the 1990s; and Direct Line chief executive Ian Chippendale, who has run the insurance unit since 1997.

The one former NatWest officer at that level is retail banking chief Gordon Pell, but he joined in February from Lloyds TSB, as other high-ranking NatWest people were beginning to exit. The only other prominent NatWest holdover is Mark Fisher, the 39-year-old head of the “manufacturing division.” The unit provides the technology and back-office functions on which Goodwin will lean heavily to hit his targets.

One of those goals is to whittle the cost-to-income ratio down to 40 percent, which would be the efficiency equivalent of breaking the sound barrier. Two U.S. banks renowned for cost controls, Fifth Third Bancorp of Cincinnati and Firstar Corp. of Milwaukee, have gotten their ratios down to the low 40s, but they are regional institutions far smaller and less complicated than RBS and its megabank peers. Goodwin has a long way to go. RBS was at 49 percent, but that rose to 57 percent, because NatWest was an outlier at 68 percent.

leader in technology. But it may also have been underrated. Technology has been a key to making Direct Line and other nontraditional delivery innovations work, including Tesco and Virgin. And an aggressive Internet strategy is taking shape, with multiple brands and channels paralleling what the company is doing in the physical world.

In January, for example, RBS formed a joint venture with the utility Scottish Power to offer Internet and e-commerce services beginning with a small-business portal called Work24. RBS sees it as a vehicle for packaging power, telephony and Internet access with banking and insurance accounts. Elsewhere, Royal Bank of Scotland International, which serves the offshore finance industry, started an e-banking service in 1999 for its financial intermediary customers.

Analysts have been slow to see the wisdom in the scattered Internet approach. “They have had other things on their mind, but they have not communicated as coherent an e-strategy as some of their competitors,” says Fox-Pitt, Kelton’s Thomas.

RBS certainly acted decisively in dealing with NatWest’s technology, even though some experts rated it as superior to that of the Scots. NatWest’s credit card division, the biggest MasterCard issuer in Europe and second among U.K. card players to Barclays Bank, was a font of invention in the early 1990s, beginning with Mondex, a system for automating cash using smart cards. MasterCard International acquired control of Mondex in 1997; NatWest more than recouped its $100 million-plus development cost, and the high-tech R&D shop that built Mondex was a source of pride. But the tightfisted RBS management canceled all development work because it saw no revenues on the horizon. RBS sold the remnants of the R&D unit, Platform-7, in March to plastic card producer DataCard Group for $7.5 million, and the RBS back office will stand or fall on its own merits -- albeit with NatWest alumnus Fisher in charge.

“Both banks had legacy systems,” says Mathewson. “Royal Bank had done more to its platform than had NatWest, and
the Royal platform was much cheaper to maintain.” Those decisions may have contributed to an accolade in August by London-based consulting firm Compass Group. It rated RBS’s data centers the most efficient in the worldwide banking industry, with unit costs 22 percent below the mean.

RBS was more favorably disposed toward another NatWest R&D by-product, Magex, which handles online payments for music, videos and other digital content. Music companies, perturbed by the unrestricted copying of recordings over the Internet using Napster and similar software, are looking for a way to assure that artists and publishers get paid, and Magex could be it. In April RBS participated in an $80 million financing for Magex led by Goldman, Sachs & Co. and the Capital Z and George Soros private equity funds. Also in April RBS made a $6 million strategic investment to control 39 percent of TrustMarque, a U.K. start-up that specializes in security systems for online commerce.

Mathewson concedes that NatWest was superior in Internet payments technology, which is being incorporated in online projects that RBS is doing with Tesco and Virgin and with its own banking Web site, Despite its understated marketing, the RBS site in April earned a “best buy” rating from Which, a British consumer organization. And even though there are so many dot-com addresses in RBS’s extended family, Mathewson says there is one element of consistency: The bank does not segregate its Internet platforms from brick and mortar the way that Bank One Corp. in the U.S. did with, or Prudential Banking in the U.K. did with Egg. “We don’t see what additional value it brings,” he says. “If you use our site, you can treat it as a separate Internet bank, but you also have access to our branches and to our telephone support.”

For all of the options RBS has kept open, it has many holes to fill if it really wants to lay claim to being a global financial powerhouse. Its U.S. branch bank, Citizens Financial Group of Providence, Rhode Island, is confined to the New England region. Though RBS wants to grow in Asia, it starts on a relatively small base of corporate finance and treasury management business inherited mostly from NatWest. Much of what RBS does in continental Europe is tied to a cross-border alliance with Banco Santander Central His-
pano, which owns 6.5 percent of RBS, and with several of its correspondent banks. Compared to the few truly global financial companies, such as Citigroup and HSBC, RBS still looks like a niche player, and its multiple branding makes comparisons with those companies problematic.

Mathewson can boast that RBS’s market valuation, the currency it can use to seize opportunities and diversify, has climbed from $1.5 billion to $55 billion since he became chief executive. RBS may not be in the same league as Citigroup with its $260 billion valuation or HSBC with its $230 billion, but it has some weight to throw around. Before it bagged NatWest it had considered going after Barclays Bank (market cap: $38 billion), which would have been at least as groundbreaking. “At the time, I thought Bar-
clays probably had a stronger franchise,”
says Mathewson, “but I have to say that NatWest is proving to be an excellent fit and is giving us a wide variety of businesses to move forward with.”

If he has already lined up his next target, he isn’t saying. The NatWest integration may be on schedule, but it is also a handful that could limit RBS’s deal-making capacity for some time. “The field is still being surveyed,” he says. “We are aware that there could be opportunities, and as we move forward things will change.”


The bank that lost the NatWest fight

Royal Bank of Scotland Group won the biggest takeover battle in U.K. banking history. Its Edinburgh-based rival, Bank of Scotland, started it.

Although National Westminster Bank was regarded as vulnerable to an acquisition and had been in the sights of several sizable institutions, Bank of Scotland made the first formal offer in September 1999. Had it succeeded, it would have been a $100 billion-in-assets David humbling a $300 billion-in-assets Goliath.

RBS, with about $50 billion more in assets than Bank of Scotland, topped the initial bid in November, triggering a frenzied courtship of institutional investors even as NatWest management tried vainly to assert its independence. RBS had secured the necessary board and shareholder support by February, and its $30 billion transaction closed on March 6.

BoS group chief executive Peter Burt says he looks back on that as a “uniquely challenging” period -- and not just because the takeover bid went for naught. Also in 1999, BoS entered an agreement with American televangelist and right-wing political activist Pat Robertson to organize an Internet and telephone banking service. Robertson’s ministry and television network would supply the customers, and BoS would operate the bank.

This deal came a cropper after Robertson in midnegotiation described Scotland as a “dark land” because of its tolerance of homosexuality. In response to the ensuing public protest, BoS ended the dalliance. Burt, 56, says there has been no lasting damage, financial or otherwise. “At a personal level my senior colleagues and I remain puzzled at why we didn’t foresee the storm blowing up,” he admits.

The failures overshadowed the fact that Bank of Scotland has been at least as much in the forefront of banking and technology innovation as RBS. BoS pioneered British online banking in 1985. In 1997 it started Sainsbury’s Bank, a joint venture with supermarket chain J. Sainsbury. The broad menu of banking services it provides its 1.1 million customers spurred supermarket rival Tesco to terminate its deal with NatWest and link up with RBS instead.

Not to be outdone by RBS’s alliance with Virgin Group, BoS is exploring an Internet banking joint venture with Easy Group, parent of cut-price airline Easyjet. The bank also owns an online mortgages site in the Netherlands called Eubos and an Internet service provider called BOS Internet.

Bank of Scotland announced record pre-tax profits for the first half of this year of
£965 million ($1.45 billion), up 14 percent, but that was before costs of £54 million related to the NatWest bid. Some critics thought that NatWest was too much of a stretch for Bank of Scotland. BoS’s mid-October stock price of 616 pence was off from its 12-month zhigh, almost a year earlier, of 790.51 pence, though the recent trend has been up.

Burt doesn’t categorically foreclose other acquisition attempts, though he doubts he’ll get hostile again. “A year ago I would have said that I saw no opportunities on the horizon, and then NatWest emerged,” he says. First up is a new U.S. alliance expected to result from a number of discussions Bank of Scotland has held with organizations that presumably offer affinity-marketing propositions better than Pat Robertson’s. “You have to kiss a lot of frogs to meet a prince,” Burt says. -- J.A.