NAB plays its lonely card

A sympathetic reaction to NAB's costly restructure of its UK arm reflects the fact it was the bank's only real option. After wearing the hit, the bank will eventually be able to move decisively on its British operations.

From the moment Cameron Clyne announced a strategic review of National Australia Bank’s troubled UK operations in February the outcome was pretty much a foregone conclusion.

With the depressed UK economy falling back into recession – Clyne said today the UK recovery was slower than in the 1930s – and dragging its commercial property market back with it, it was obvious that it would be impossible to exit the UK market without incurring horrendous losses against the book value of the business.

While there were some in the market who still advocated an exit, selling at a time when there are few buyers of UK banking assets and those few are looking for absolute steals and vendor funding wasn’t a palatable option, particularly when the pound is at decades-long lows against the Australian dollar.

Given the deterioration in the already weak UK economy and the likelihood of minimal economic growth for some years, however, there wasn’t a ‘’do nothing’’ option either and, while Clyne has always kept open the possibility that NAB would use the distressed state of the UK banking market to expand by acquisition, doubling up in the UK in the current circumstances wasn’t a realistic option and would, in any event, have triggered a shareholder revolt.

So Clyne has played the only realistic card that he held and, as expected, announced a major and costly restructuring of the UK business that in essence is a retreat to its roots.

NAB’s business in the UK was created through its acquisitions of the Clydesdale and Yorkshire banks in Scotland and northern England. Those banks were predominantly retail and small and medium-sized enterprise focused.

NAB, however, always harboured ambitions to expand into the more prosperous southern parts of England, originally envisaging that it would be via an acquisition. After failing (after several attempts) to land a target, NAB opted for organic expansion, opening 73 ‘’financial solutions centres", 31 of them in southern England.

Unhappily, during the UK property boom in the lead-up to the global financial crisis, those centres appear to have focused on lending for investment properties, which took a big hit during the crisis and are now trending down again. It is that portfolio of nearly $10 billion of commercial loans that is at the heart of the problems within NAB’s UK banks.

Under the restructuring unveiled today NAB is going to transfer that portfolio out of the UK business and onto its own balance sheet, improving Clydesdale’s balance sheet, profitability and funding requirements. The portfolio, which pushed the UK business into loss in the March half, will be quarantined and will be in run-off mode – NAB has created a ‘’bad bank".

Inevitably the restructuring has triggered a flood of red ink. There will be more than $300 million of restructuring costs, although NAB says that will deliver annual cost savings of about $115 million by 2015. NAB has increased the provisioning against the portfolio by $230 million and written off about $220 million of Clydesdale goodwill. Separately it has expensed another provision of about $190 million due to payment protection insurance claims in the UK.

The UK business lost about $39 million in the March half and forced the NAB group result down 15.6 per cent to $2 billion on a statutory basis, although it was up 5.7 per cent on a cash basis thanks to a rebound in the performance of its wholesale banking division.

By excising the commercial real estate portfolio (and 1400 people) NAB believes it will return Clydesdale to profitability – on a pro forma basis it would have generated cash earnings of about $155 million without those exposures. It would also reduce the Clydesdale's wholesale funding requirement leaving it effectively self-funding through its customer deposits.

The news was unpleasant but largely anticipated, which explains why the sharemarket absorbed it so easily today.

In a perverse fashion the fact that the market essentially regarded the UK banks as worthless made the decision to extract the commercial property loans from the UK business, and take the associated hits within the parent’s P&L and balance sheet, somewhat easier than it might conventionally have appeared.

Historically, the NAB’s core UK operations, while positioned within poorer parts of the UK, have been fairly solid and stable (albeit unspectacular) profit generators. NAB is hoping that returning them to their roots and re-focusing them on retail and SME lending will end the destructive cycle that has seen it continuously transferring capital from its relatively high-returning Australasian businesses to shore up the UK balance sheet.

If the clean-up can be executed effectively – it won’t be easy to run down the property portfolio quickly in an already deteriorating market without further damaging the market and exaggerating the losses – the decision about what to do with the residual UK business will be deferred to another day. And now it will be easier to hold onto, or to sell.