Financial Economy and Royal Bank of Scotland - Term Paper Example

INTRODUCTION Commercial banks and financial services providers are greatly affected by the financial economy in the countries where they operate, inparticular, the home country. Because of the fact that the activities, profit margin and reported earnings of such companies are directly involved with the factors prevailing in financial economy, any changes in these factors can cause great financial shocks. Changes in inflation and interest rates are all likely to result in either expand or contract the lending capacity and profit margins of banks. Changes in exchange rates imply fluctuations in the reported earning of companies having subsidiaries in international countries. RBS is engaged in international banking and financial services business and thus confronts with the challenges posed by any changes taking place in financial economic conditions only in the United Kingdom but throughout the world. This paper provides an insightful study on the effects of financial economic factors on the activities, operations, profits and reported earnings of the Royal Bank of Scotland. The paper starts from discussing the prime banking and financial services activities of the bank and its international operations. It then moves towards the company's debt/ gearing level and analyzes the impact of changes in interest rates, inflation and exchange rates in the activities and earnings of the company. The paper also sheds light on the extent of the RBS' involvement with the Financial Services Authority (FSA). ROYAL BANK OF SCOTLAND- INFLUENCE OF FINANCIAL ECONOMY The Royal Bank of Scotland is one of the largest companies in the UK as well as the world. The company is ranked as the greatest company in Scotland, second largest in the United Kingdom and sixth largest in the world. The company is involved with provision of financial services to a variety of customers ranging from large corporations to small businesses and individuals (Scotland PLC: The financial industry in Edinburgh, 13.04.07). RBS has its banking operations in various parts of the world. Being a banking and financial services company, the Royal Bank of Scotland is greatly influenced by changes in financial economic conditions. RBS- Operations The Royal Bank of Scotland has a wide range of operations in various areas of banking i.e. corporate markets (investment and risk management services in both the UK and global large businesses and financial institutions), retail markets (including retail operations and wealth management), Ulser bank providing products and services to retail and corporate customers in Ireland, Citizens commercial banking organisation, RBS insurance and manufacturing (RBS annual report, 2006). The major business segments of RBS are personal banking, private banking, business banking and corporate banking (Royal Bank of Scotland, 13.04.07). Overseas Operations The Royal Bank of Scotland has its operations in different parts of the world including UK the home market, the United States, Europe and Asia Pacific. The company's operations in UK include dealing in the areas of corporate markets, retail markets, insurance and manufacturing. In the United States, RBS has its operations in the areas of corporate and retail banking. The company is engaged in the same operations as in UK all over the Europe, whereas in Asia Pacific the RBS is involved with corporate market, retail market and manufacturing operations (RBS Annual Report, 2006). Retail Operations The company operates in a vast range of financial services including retail operations. The Royal Bank of Scotland's retail banking operations includes services to personal and small business customers. In this regard, the company provides its services in the areas of consumer banking, business banking, cards and direct finance in the United Kingdom. The Royal Bank of Scotland's has its international wealth management operations in continental Europe and Asia Pacific region, as well as in the UK home market. RBS- Debt/Gearing: The Royal Bank of Scotland's total debt is 825,942, whereas the company's total equity finance is 45,490. This suggests that the RBS has a total gearing level at about 94% i.e. the proportion of total debt funds in the company's total capital structure (RBS annual report, 2006). Hence, the company relies heavily on debt funds as compared to the equity finance which constitutes only about 4% of the company's total capital. RBS- Effect of Changes in Interest Rate, Inflation and Exchange Rate: Financial economic conditions in the countries where RBS operates, primarily in the UK, have a great impact on the company's performance. Changes in factors like interest rate, inflation and exchange rate considerably affect the company's earnings and cash flows. Not only that, the company is also affected by changes in exchange rate because of its operations in different parts of the world especially in the United States and the Europe. Changes in exchange rate between UK sterling and these currencies cause great fluctuation in the company's earnings. Business activities of commercial banks are heavily reliant on interest rates and the margin or spread between borrowing and lending costs form a major part of their profits. Any changes in prevailing interest rates in the economy seriously affect the profit margins and stock price performance of RBS. Flannery and James propound that "commercial banks stock returns are very sensitive to interest rate changes" (1984, p1146) The Royal Bank of Scotland is not only affected by interest rate changes in the UK's economy, but also the changes in global markets because of the company's international operations. Oertmann, Rendu and Zimmermann illuminate that "internationally operating banks in the UK are clearly more affected by global interest rate shifts rather than by domestic ones." (2000, p447) The Royal Bank of Scotland's business is seriously affected by changes in interest rates and spreads. Changes in these factors are likely to cause fluctuation in the company's interest rate margin gained between lending and borrowing costs (RBS annual report, 2006). The rate of inflation prevailing in the economy is also a very important factor that affects the RBS' position. According to Greenwood and Smith (1997) there is a strong relationship between development of financial markets and rate of inflation in the economy. As the inflation rate moves upwards or downwards, it greatly affects bank lending capacity. An increase in inflation rate forces banks to restrict their lending operations and vice versa. Bank lending capacity and liquidity squeeze in response to rising inflation. Similarly, the Royal Bank of Scotland confronts with the risk of high inflation because it causes the central banks and authorities to contract the bank's lending capacity in the form of monetary policy. Changes in inflation are also likely to result in changes in interest rates and reserve requirements of commercial banks. Thus, changes in inflation have a great impact on the activities and performance of RBS. The economy of United Kingdom is highly influenced by changes in exchange rates. As the exchange rate fluctuates, the UK needs to confront changes in other economic indicators like GDP, inflation etc. Gagnon (2006) illustrates, with the help of exchange rate movements during 90s, that fluctuations in exchange rate in UK had a great influence on the rate of inflation, GDP and other economic variables in the country such as labour wages and production level etc. Changes in exchange rate greatly affect the activities, operations and earnings of commercial banks. The Royal Bank of Scotland is influenced by the changes in exchange rate of UK sterling- US dollar and UK sterling- Euro exchange rate changes have a significant effect on the company. These fluctuations not only affect the values of company's assets and liabilities denominated in foreign currencies but also influence the reported earnings of the company's segments in non-UK countries. The general conditions prevailing in financial markets are of crucial importance to the bank's trading portfolio and investment performance (RBS annual report, 2006). The company is severely influenced by non-bank financial institutions as they give tough competition to RBS in its operations around the world. In the United Kingdom, the Royal Bank of Scotland is affected by large financial institutions as they offer competition in corporate and institutional customers. The company needs to compete with specialised asset finance providers in the asset finance market. In the UK credit card and personal banking market, the company is influenced by nonblank financial institutions such as building societies, large retailers and life assurance companies etc. Not only in the UK, in other regions of the world like the United States, Europe and Asia Pacific, different non-bank financial institutions influence the activities of RBS. Because of the fact that these institutions are large players in the markets where the RBS operates, they greatly affect the company's competitive strategies (RBS annual report, 2006). RBS- The FSA Involvement: The company has been preparing its financial statements in accordance with the International Financial Reporting Standards (IFRS) since 1 January 2004 (RBS annual report, 2006). The Royal Bank of Scotland is regulated by the Financial Services Authority (FSA). FSA puts forwards various rules and regulations with respect to financial reporting which are followed by the Royal Bank of Scotland. The Royal Bank of Scotland was fined 750,000 by FSA after it was accused to be breaching the regulations concerning money laundering. The fine penalty was followed by investigation on the part of FSA authorities where RBS could not provide sufficient documentation concerning customer identification for some accounts (Scotland PLC: The financial industry in Edinburgh, 13.04.07). CONCLUSION This paper discusses the ways and the extent to which changes in financial economic conditions in the United Kingdom as well as in the world affect the Royal Bank of Scotland. It illuminates that banks are greatly affected by changes in financial economic conditions of the domestic country as well as in other parts of the world where they operate. The Royal Bank of Scotland is a provider of banking and financial services in a variety of areas such as retail banking, corporate banking and personal banking etc. The company has its banking and operations in different parts of the world apart from the United Kingdom which is its home market, such as the United States, Europe and Asia Pacific. The Royal Bank of Scotland has a high debt/ gearing level and its total capital comprises about 94% of debt finance and 4% of equity funds. The activities and performance of Royal Bank of Scotland are greatly affected by changes in interest rates and inflation as these factors bring about changes in bank's lending capacity and interest spreads. Changes in exchange rate affect the reported earnings of RBS' subsidiaries outside the United Kingdom, especially in the United States and Europe. The Royal Bank of Scotland is regulated by Financial Services Authority (FSA) that fined the bank for charges concerning money laundering issues. Hence, the financial economic factors play a very important role in the smooth growth of RBS' earnings and international operations. References .Flannery, M.J. and James, C.M. (1984), "The Effect of Interest Rate on the Common Stock Returns of Financial Institutions," The Journal of Finance, 39(4), pp. 1141-1153 Gagnon, J.E. (2006), "The Effect of Exchange Rates on Prices, Wages, and Profits: A Case Study of the United Kingdom in the 1990s," International Economic Journal, 20(2), pp. 149-160 Greenwood, J. and Smith, B. (1997), "Financial Markets in Development, and the Development of Financial Markets," Journal of Economic Dynamics and Control, 21, pp. 145-181 Oertmann, P., Rendu, C. and Zimmermann, H. (2000), "Interest Rate Risk of European Financial Corporations," European Financial Management, 6(4), pp. 459-478 Royal Bank of Scotland. Products. Accessed 13 April 2007 from http://www.rbs.co.uk/default.htm Scotland PLC: The financial industry in Edinburgh. Corporate Watch. Accessed 13 April 2007 from http://www.corporatewatch.org.uk/lid=1356 . Read More