March 27 (Bloomberg) -- Royal Bank of Scotland Group Plc, Britain’s biggest state-owned lender, faces a tougher challenge selling its U.S. subsidiary after the unit failed the Federal Reserve’s stress test.
RBS Citizens Financial Group Inc., based in Providence, Rhode Island, was one of three U.S. units of foreign banks whose capital plan was rejected by the Fed in its annual test, regulators said yesterday. The Fed also failed subsidiaries of Spain’s Banco Santander SA and London-based HSBC Holdings Plc, citing flaws in the quality of their capital planning.
RBS, based in Edinburgh, has said it would be open to takeover offers for its U.S. unit even as it prepares the division for an initial public offering this year. The bank’s options may be limited now that the Fed has found flaws in its internal processes, something that has held up other U.S. bank deals. M&T Bank Corp.’s takeover of Hudson City Bancorp Inc., the biggest pending U.S. bank merger, has been stalled twice because regulators found flaws with M&T’s money-laundering controls.
“The Fed has been very cautious in terms of permitting larger acquisitions among the bigger banks,” Jennifer Thompson, an analyst at Portales Partners LLC, said in a phone interview. “The fact that you now have some internal control issues would probably make a potential acquirer think twice about doing a deal.”
The British government, which owns 80 percent of RBS, has been pushing the lender to focus on U.K. consumer and corporate banking as it tries to recoup some of the 45.5 billion pounds ($75.4 billion) spent bailing out the company five years ago. The shares fell 1.6 percent to 301.10 pence by noon in London trading. The firm’s stock jumped as much as 2.5 percent after the Wall Street Journal reported on March 24 that Sumitomo Mitsui Financial Group Inc. may bid for its U.S. unit.
Citizens is “one of the best-capitalized banks in the industry and we’re pleased to be able to continue normalizing our capital structure,” Chief Executive Officer Bruce Van Saun said in a statement. “We clearly have more work to do to meet the Fed’s standards, and we’re fully committed to doing that.”
Regulators seeking to prevent a repeat of the 2008 financial crisis run annual tests on the largest U.S. banks to see how they would fare in a recession or economic shock. The Fed expanded the test this year to include 12 new lenders, including six U.S. units of foreign banks.
The Fed objected to RBS Citizens’ capital plan because they had concerns about its practices for estimating revenue and losses under economic stress. The Fed objected to HSBC for similar reasons.
Regulators rejected Santander due to “widespread and significant deficiencies” in its governance, internal controls, risk-management and information systems, the Fed said.
The banks said in statements that the test actually showed their strength, noting that their capital levels were above the minimum and saying they’ll rework their plans to address the Fed’s concerns. Jim Hughes, a spokesman for RBS Citizens, declined to comment on the IPO plans.
Flunking the test means that the banks won’t be able to increase dividends they send to their parent company, according to a Fed official. It also could harm their parent firms’ reputation, according to Walter J. Mix III, head of Berkeley Research Group’s financial services practice and a former commissioner of the California Department of Financial Institutions.
“If a firm has capital adequacy risks that are made public, it affects the reputation of the institution,” Mix said in a phone interview. “And that can impact the overall franchise value of the company.”
The Fed also objected to capital plans submitted by New York-based Citigroup Inc. and Zions Bancorporation, a lender based in Salt Lake City. The central bank approved plans for 25 banks, including the U.S. units of Toronto-based Bank of Montreal, Spain’s Banco Bilbao Vizcaya Argentaria SA and Japan’s Mitsubishi UFJ Financial Group Inc.
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