Britain's spring sows the seeds for NAB's exit

Could this finally be the year? An unexpected burst of late-year optimism in the United Kingdom has raised the prospect that Michael Chaney and Cameron Clyne might face a quite positive dilemma sometime in 2014.

Ever since the financial crisis erupted at the outset of Clyne’s term as National Australia Bank’s chief executive he, and the bank’s performance, has been lumbered with the loss-laden baggage left over from the group’s ill-timed expansion into property lending in the south of the UK.

Clyne’s restructuring of the UK business into a ‘good’ and continuing retail bank and ‘bad’ bank which still has $6.8 billion of commercial property in run-off mode has been gaining traction. The good bank is now solidly profitable and its earnings have been growing solidly, while the run-off of the bad bank has been accelerating.

Despite the improvement, however, the UK operations remain a major drag on NAB’s performance and disguise the very significant lift Clyne has achieved within the core domestic banking businesses.

If NAB could somehow shed its UK operations, there are estimates that its return on equity would rise from the current level of about 14.5 per cent to something close to 17.5 per cent.

At NAB’s annual general meeting this month Chaney told shareholders that the UK economy’s return to growth had been a key driver in reduced loan losses and, with the restructuring and recapitalisation of the UK bank, the legacy issues were receding.

The NAB chairman said that while disposal of the UK business had not been possible “to date” the restructuring was beginning to bear fruit. He also said that NAB had been talking to people about a sale of the businesses over the year but hadn’t received an acceptable offer.

The UK economy has been one of the surprise stories of 2014. Despite the UK government’s controversial austerity program, the nation has surprised on the upside within a larger Europe still struggling to generate any growth.

Last week the UK Office of National Statistics said UK GDP was 0.8 per cent higher in the September quarter than the June quarter, and revised its annual growth rate up from 1.5 per cent to 1.9 per cent. A survey of 25 economists also published last week produced an average forecast of GDP growth in 2014 of 2.5 per cent.

Given the still-brittle shape of mainland Europe – and the still-uncomfortable levels of UK public debt – there ought to be a lot of caveats around the outlook, but the UK economy has surprised on the upside this year, continually outperforming official expectations.

If that trend were to continue it would have two broad impacts on NAB. The group’s good bank would be more profitable, while it would be able to wind down the non-core portfolio even faster. The UK operations would be far less of a drag on its core performance.

NAB would then face a dilemma – albeit a better one than it has had to deal with over the past five years.

When he first became chief executive, Clyne was open-minded about how to deal with the UK legacy he inherited: whether to try to exit the UK, or instead to exploit the distressed conditions and bulk up in the south of England via acquisition, pursuing the ambition that has driven NAB ever since it first entered the UK with the purchase of Clydesdale Bank in 1987.

As the UK economy deteriorated post-crisis and the losses mounted (and NAB was, like all the UK banks, hit by a torrent of ‘conduct’ issues like insurance mis-selling) the expansion option was abandoned, and one suspects that even with conditions and the value of the ongoing UK business improving, it isn’t one the bank would contemplate again or indeed be allowed to contemplate by the market.

An improving UK economy, however, does create options in relation to the timing of a sale, with Clyne having to weigh up whether he should exit the UK as quickly as possible or, if the UK recovery appears entrenched, to allow it some time to run in order to maximise value.

However a complication for any aspiring vendor of bank assets in the UK is that the UK government is actively exploring its options for exiting its own positions in UK banks.

UK taxpayers owned nearly 40 per cent of Lloyds before the government sold 6 per cent of the group’s capital into the market. The government, despite losing about $425 million on that sale, is now looking at how best to sell the rest.

Taxpayers still own 81 per cent of the Royal Bank of Scotland, although its condition means there is little likelihood of any sell-down until after the next UK election in mid-2015 at the earliest.

The overhang of bank assets – as a result of the government’s desire to quit its exposures, but also because the harsh regulatory regime the UK is introducing will inevitably force the sale of some bank assets – may make it difficult for NAB to maximise its own exit terms.

When Clyne, early in his term, pondered aloud about the prospects of exploiting the difficult UK conditions to bulk up NAB’s presence he wasn’t ruling out the sale of the UK operations. The thesis was that adding the right operations at the right price could help produce a better eventual sale price.

While that remains a rational approach, it is unlikely that either the NAB board and management or the market-at-large has any stomach for expansion in the UK, even if it were part of an exit strategy.

Whether or not NAB does relinquish the ambition it held for a quarter of a century by selling out of that market in 2014, if the UK economy continues to hold up and the NAB portfolios continue to perform in line with last year’s improving trends, 2014 would be the year in which an exit finally became a realistic option.