FINANCIAL INSTITUTIONS

ISSUER IN-DEPTH22 March 2017

Contacts

Alessandro Roccati 44-20-7772-1603Senior Vice Presidentalessandro.roccati@moodys.com

Daniel Forssen,CFA 44-20-7772-1553Associate Analystdaniel.forssen@moodys.com

Michael Eberhardt,CFA

44-20-7772-8611

VP-Sr Credit Officermichael.eberhardt@moodys.com

Laurie Mayers 44-20-7772-5582Associate ManagingDirectorlaurie.mayers@moodys.com

Robert Young 212-553-4122MD-FinancialInstitutionsrobert.young@moodys.com

The Royal Bank of Scotland Group plcNew Cost Measures To Improve Weak Efficiency andProfitability

SummaryOn February 24, 2017, Royal Bank of Scotland Group plc (RBS, LT senior unsecured Ba1positive) announced a £7.0 billion loss for 2016, driven by £10 billion of restructuring costsand litigation and conduct charges. Excluding these costs, RBS would have made an adjusted1

net income of £3 billion2, with an adjusted return on Assets (ROA) of around 0.4% andan adjusted Return on Equity (ROE) of around 2%. Management announced £2 billion ofnew cost cuts and other measures to improve efficiency, which would result in a statutoryreturn on tangible equity (ROTE) of above 12% by 2020 (compared with the previous targetof 2019). These measures, if achieved, would be positive for bondholders as the bank’sprofitability would improve, and its ability to absorb shocks would increase.

» Recurring profitability remains subdued as restructuring progresses. Since itreceived a government bail-out in 2008, RBS has reported cumulative losses in excessof £50 billion due to substantial credit losses, restructuring costs, as well as litigationand conduct provisions. The bank’s latest cost cuts come in response to a low level ofefficiency of the recurring business.

» RBS’s cost cut plan would enhance RBS’s efficiency. The additional £2 billion costcuts planned by 2020 are designed to reduce RBS’s cost income ratio to below 50%from 66% in 2016, in line with its domestic and international peers. The latest plannedsavings, which come on top of £3 billion achieved in the last three years, account foraround 24% of the adjusted cost base in 2016. Management has identified specific areasfor further cost reduction which should make achievement of these targets feasiblewithout eroding revenues.

» RBS will likely remain loss-making in 2017, but may return to profitabilityin 2018. RBS’s core franchises, plus Williams and Glynn (W&G, not rated), therestructuring division and central operations, reported adjusted pre-tax profits of £3.7billion in 2016. We expect a similar outcome at the adjusted operating level in 2017.However, the ongoing high level of restructuring costs, as well as litigation and conductcharges, will likely result in RBS reporting a loss once again in 2017. In 2018, RBS shouldreturn to profitability at the statutory level, assuming large litigations are settled.

Our positive outlook on RBS’s senior ratings reflects the bank’s material progress towardscompleting its restructuring plan, and its lower asset risk, as well as its reduced but still-sizeable capital market operations.

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Recurring profitability remains subdued as restructuring progressesOur assessment of RBS’s profitability is one of the main constraints on its standalone credit profile, as reflected in its Baseline CreditAssessment (BCA) of ba1. Since the UK government bailout in 2008, RBS has generated cumulative losses in excess of £50 billion(Exhibit 1), putting the bank lowest among its Global Investment Bank (GIB) peers in terms of profitability.

Exhibit 1

RBS has reported £27 billion of losses in the last five years, and more than £50 billion since 2008RBS: Net income loss trend

Source: RBS's Annual Reports and Data Supplements.

In the last five years, substantial negative items– mostly restructuring costs and litigation and conduct charges - have resulted in heavylosses for RBS, although profits before these items have improved since 2013, supported by a decrease in the cost of risk (see Exhibit 2).

Exhibit 2

Recurring business profitability has improved, mostly due to reduced loan impairmentsRBS: Recurring business pre-tax income and negative items

Note: negative items mostly relate to litigation and conduct charges and restructuring costs, own credit adjustments and, to a lesser extent, goodwill write-off.Source: RBS's Annual Reports and Data Supplements.

However, despite this moderate improvement, the profitability of RBS’s recurring business remains weak. The group reported £3.7billion of adjusted operating profit in 2016, with an adjusted ROA of just around 0.4%. Profitability from the recurring businessremained subdued during the year, characterised by low revenues and a high cost base. This translated into low efficiency levels and ahigh cost-income ratio of 66%, well-above peers (see Exhibit 3).

This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page onwww.moodys.com for the most updated credit rating action information and rating history.

2 22 March 2017 The Royal Bank of Scotland Group plc: New Cost Measures To Improve Weak Efficiency and Profitability

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Exhibit 3

RBS’s recurring business has low efficiencyGroup recurring business revenues, operating costs and cost to income ratio

65%72% 69% 72%

66%

50%

0%

20%

40%

60%

80%

100%

0

5

10

15

20

25

2012 2013 2014 2015 2016 2020 target

Revenues Operating costs C/I ratio

Note: operating costs exclude litigation and conduct charges and restructuring costs.Source: RBS's Annual Reports and Data Supplements.

RBS’s cost cut plan would enhance efficiencyIn February 2017, RBS management announced strategic actions designed to increase efficiency and ultimately profitability. The bankaims to reduce its cost to income ratio to below 50%, and increase its unadjusted ROTE to 12% by 2020, by cutting operating costswhile maintaining revenues broadly unchanged: RBS plans to increase lending volumes in order to offset an expected reduction inlending margins (see Exhibit 4).

Exhibit 4

Costs and revenue initiatives to address weak efficiencyOperating cost and Revenue Initiatives

Notes: PBB = Personal and Business Banking; CPB = Commercial and Private Banking. Lending growth target includes the impact of balance sheet/ risk-weighted assets (RWA) reductions.Cost saving target and progress in 2017 calculated using operating expenses excluding restructuring costs, litigation and conduct costs, write down of goodwill 2016 VAT release.Source: RBS investor presentations

In the current environment, operating cost cuts are RBS’s main lever to boost profit. The bank aims to reduce costs by £750 million in2017, rising to £2 billion by 2020. We view the 2017 target as achievable. The bank exceeded its targets in each of the last three years,achieving cost reductions of £1.1 billion in 2014, and £1 billion in both 2015 and 2016. Beyond 2017, cost cuts will more challenging, asthey will mostly affect the core divisions; however, management has identified specific areas for further cost reduction which should beachievable without eroding revenues.

We believe that RBS’s target of preserving net interest income (NII) at its current level is subject to elevated risk. This is because (1)current low interest rates weigh on the bank’s net interest margin and (2) its £123 billion structural hedge (end-2016), which generateda benefit of £1.3 billion through net interest income in 2016, will progressively roll-off over the coming years. In addition, revenues andprofitability may be pressured by reduced demand for credit and an increase in the cost of risk during the period the UK renegotiates itsfuture relationship with the EU.

RBS will likely remain loss-making in 2017, but may return to profitability in 2018We expect RBS’s recurring profitability will remain broadly stable in 2017, supported by its strong franchise in the UK, and its large shareof the UK retail and commercial banking markets. These provide stable and predictable earnings, despite some revenue pressures, most

3 22 March 2017 The Royal Bank of Scotland Group plc: New Cost Measures To Improve Weak Efficiency and Profitability

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of which are related to current low interest rates. RBS also plans to improve returns on risk-weighted assets (RWAs) by reducing RWAsin its core operations by £20 billion by end-2018, in order to boost recurring profitability and to improve its stressed capital resilienceunder future internal and regulatory stress tests.

However, substantial additional costs remain. RBS faces complex operational challenges related to the restructuring of its core retailand commercial banking operations, as well as the reintegration of W&G, and the government-mandated separation of its retail andinvestment banking divisions (“ring-fencing”) by the deadline of January 2019.

» Restructuring costs (excluding W&G) will amount to around £2 billion between 2017 and 2019 (of which around £1 billion in 2017).We view that additional investment costs, mostly related to IT infrastructures and digitalisation could be required.

» Further costs related to W&G are likely. In February 2017, RBS said the European Commission was considering an alternative to thedisposal of W&G, originally mandated as a condition of state aid the bank received in 2009. So far, RBS has spent around £2 billionpreparing W&G for sale, and has provisioned an additional £750 million relating to the alternative plan.

» RBS intends to reduce Capital Resolution’s risk-weighted assets (RWAs) to £15-20 billion3 from £35 billion at end-2016 and windup the division at end-2017, with residual costs of £800 million, mostly expected in 2017.

A settlement of the bank’s US RMBS litigation could generate additional costs, pushing it into a loss in 2017. RBS’s biggest outstandinglegal disputes relate to US Residential Mortgage Backed Securities (RMBS)4. The bank had set aside £6.7 billion ($8.3 billion) for thispurpose as of 31 December 2016, mostly related to litigation with the US Department of Justice and the Federal Housing FinanceAgency. We estimate the cost for the bank of settling major RMBS-related cases to be between $6.7 billion (median settlement) and$13.1 billion (high-end settlement), based on RBS’s RMBS market share of 9.8% during 2004-07, and on the median and high-endsettlement cost per basis point of market share for selected banks. We estimate RBS would be able to fully-cover the median scenariosettlement from existing reserves. However, we estimate the high-end scenario would decrease the bank’s CET1 by around 160 basispoints.

RBS could potentially return to profitability in 2018, assuming its large outstanding lawsuits are settled in 2017. This would draw theline under ten year of losses, following the UK government’s bail-out of the bank in 2008.

4 22 March 2017 The Royal Bank of Scotland Group plc: New Cost Measures To Improve Weak Efficiency and Profitability

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Moody's Related ResearchCREDIT OPINIONS:

» The Royal Bank of Scotland Group plc, March 2017

» Royal Bank of Scotland N.V., October 2016

» Ulster Bank Ireland DAC, March 2017

ISSUER COMMENTS:

» Q4 2016 Results: High litigation provisioning and restructuring costs, while core performance continues to improve

» The Royal Bank of Scotland Group plc: Removal of Royal Bank of Scotland’s obligation to separate and divest Williams & Glynwould be credit positive, February 2017

» Royal Bank of Scotland's Provision for US RMBS Settlements Is Credit Negative, January 2017

» RBS Settlement Related to 2008 Rights Issue Is Credit Positive, December 2016

» UK Concludes Investigation into RBS' Treatment of SME Customers, a Credit Positive, November 2016

» RBS' US Mortgage Settlement Is Credit Positive, October 2016

CREDIT FOCUS:

» RBS: Substantial Restructuring Progress Underpins Our Positive Outlook, Jan 2016 (1011844)

» Global Investment Banks - Europe: Wind-down of Legacy Assets Has Reduced but Not Eliminated Tail Risk, October 2015(1008546)

» Successful Execution of Group Restructuring Could Ease Credit Constraints, August 2015 (1007224)

» Restructuring Progresses but Still Weighs on Credit Profile, November 2014 (1000061)

SECTOR COMMENT

» UK Stress Test Highlights Weaknesses at RBS, Barclays and Standard Chartered, November 2016

BANKING SYSTEM OUTLOOK:

» United Kingdom, July 2016 (1029597)

COMPANY PROFILES:

» Ulster Bank Limited, January 2016

» Ulster Bank Ireland DAC, June 2016

To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of thisreport and that more recent reports may be available. All research may not be available to all clients.

5 22 March 2017 The Royal Bank of Scotland Group plc: New Cost Measures To Improve Weak Efficiency and Profitability

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Endnotes1 All adjusted figures exclude one-off costs (mostly litigation and conduct charges and restructuring costs)

2 Adjusted net income of £3 billion in 2016 is calculated as RBS' statutory loss of £7.0 billion excluding £5.9 billion of litigation and conduct costs, £2.1 billionof restructuring costs, £0.8 billion of Capital Resolution disposal losses, a £0.3 billion deferred tax asset impairment and a payment of £1.2 billion to retirethe UK government's dividend access share (DAS).

3 excluding Alawwal Bank (LT deposits A3 stable, baa2 BCA) stake. BCA: Baseline Credit Assessment

4 Other major outstanding lawsuits were settled in 2016. In December, RBS settled the majority of claims by value related to its £12 billion rights issuein 2008 (already provisioned). In November, the UK Financial Conduct Authority (FCA) concluded its investigation into RBS’s treatment of small andmedium-sized enterprise (SME) customers transferred to the company’s Global Restructuring Group (GRG) during 2008-13. RBS set aside £400 millionto refund fees paid by the affected customers. In October, RBS reached a final $ 1.1 billion (£846 million) settlement with the US National Credit UnionAdministration (NCUA), resolving two outstanding civil lawsuits over allegations of mortgage mis-selling.

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Contacts

Alessandro Roccati 44-20-7772-1603Senior Vice Presidentalessandro.roccati@moodys.com

CLIENT SERVICES

Americas 1-212-553-1653

Asia Pacific 852-3551-3077

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