A Raid On The Staid

Bank of Scotland's run at NatWest could transform British banking

Rarely in recent memory has an event so excited the City of London as Bank of Scotland's $35 billion raid on National Westminster PLC on Sept. 24. The audacious and unwelcome assault on a major if somewhat tarnished London bank by a Scottish player less than half its size has stoked up hope among investors that the long-awaited shakeout in British banking has at last arrived. With other bids rumored, share prices of a wide range of banks and insurers, from Barclays to Halifax to Abbey National, have turned frothy.

There's a lot here to put the City in a tizzy. It's by far the biggest takeover ever attempted in Britain. And whether it succeeds or not, the Edinburgh-based bank's raid is likely to have sweeping consequences for the sleepy but profitable world of British banking. Everyone knew consolidation made sense. But since the mid-1990s, the pecking order in British banking has been virtually frozen as the four biggest institutions--NatWest, Barclays, HSBC, and Lloyds TSB--warily circled each other without ever pouncing. Hefty market capitalizations and concerns that regulators would block combinations of the big banks discouraged strategic moves.

Now, credit goes to Bank of Scotland, a smaller, more innovative player, for trying a new avenue of attack that could crack open the market. Mediocre performers are now on notice that they are vulnerable, and foreigners may soon eye takeovers in Britain.

Credit goes especially to Peter A. Burt, Bank of Scotland's 55-year-old chairman and a former executive at Hewlett-Packard Co., for stalking big prey. Once, when courted by Barclays Bank to take over the chief executive spot, he said he would--provided Bank of Scotland could take over Barclays. That didn't happen, but Burt kept looking south for a deal. Now, the City is applauding his audacity. Combining Bank of Scotland's focused management with NatWest's retail and corporate banking franchise could produce a winner, analysts say.

HUGE THREAT. NatWest is often dismissed as a weak sister compared with its stronger domestic competitors, but it still has 16% of the British retail market and a quarter of the corporate market. It made a return on equity of 19% last year, about double the return for German stalwart Deutsche Bank. And NatWest had operating profits of $3.8 billion in the 12 months ended on June 30, 1999. "If Bank of Scotland's team starts to run NatWest, it will be a huge threat to HSBC, Barclays, and Lloyds TSB," says Jonathan Gollins, British bank analyst at Donaldson, Lufkin & Jenrette International in London.

But first, Burt has to bag his prey. Bank of Scotland originally considered making its bid in combination with Edinburgh-based Royal Bank of Scotland Group PLC. Now, Royal Bank is contemplating a rival offer that would have the support of Spain's Banco Santander Central Hispano, which owns a 10% stake in Royal Bank. Other potential bidders include British mortgage specialists Abbey National and Halifax. Outsiders, such as Deutsche Bank or even Citigroup, could be tempted by a rare opportunity to gain a huge piece of the British market. But Dutch heavyweights ING Group and ABN Amro Holding say they aren't interested because Britain is outside the euro zone.

The question is whether an outsider would want to pay more than $35 billion for a bricks-and-mortar bank. Most observers think branch banking is going to become less attractive as startups and established players offer electronic alternatives. But the decline will be slow and profitable if well managed, and Bank of Scotland knows how to wring costs out of a bank network.

What is certainly true is that every bank with aspirations in Britain is now reassessing its position, as the NatWest deal rearranges the game board. Barclays, for instance, has a dynamic new chief executive, Matthew Barrett, who formerly headed Bank of Montreal. It may become an acquirer--but also could be a target, since its returns lag those of the domestic leader, Lloyds TSB, which are in the 30% range.

IN JEOPARDY. And if one or both of the Scottish banks fail to bag NatWest, they themselves could also be up for grabs. They are probably too small to be viable on their own, and their aggressiveness may have cost them their previous protections from takeovers. The more fragmented insurance and fund management area, which has seen most of the recent deals, will also likely see further activity. Insurer Legal & General Group PLC, which NatWest tried to acquire, is in play. Norwich Union, another insurer, is a frequently rumored target, while giant Prudential Corp. has courted Barclays and NatWest in the past.

Before all this unfolds, NatWest's fate will have to be decided. The bank, headed by CEO Derek Wanless since 1992, put its independence in grave jeopardy by disappointing investors. It has been slow to cut costs, for example. In the key banking measure of cost-to-income ratio, NatWest's number in the first half of 1999 was 68%, while Bank of Scotland's runs just below 50%. NatWest has also made huge blunders, such as its troubled foray into the U.S. in the late 1980s, which led to a $1.1 billion loss in 1996, and its failed move into investment banking. That resulted in $730 million in write-offs in 1997. "The seven dwarfs probably could have done better," says a British fund manager.

The final straw was the bank's Sept. 3 announcement that it had agreed to buy Legal & General for $17 billion. Investors considered the price too high and the strategic plan, which envisaged L&G CEO David Prosser running NatWest's 1,700 retail branches, flawed. They pounded the bank's share price down 19%, exposing it to hostile suitors.

The City finds Bank of Scotland's Burt and his chief executive, 57-year-old Gavin G. Masterton, a welcome contrast to NatWest's top brass. They have largely avoided mistakes. One possible exception was the planned U.S. direct-banking venture with evangelist Pat Robertson earlier this year. That plan got scuttled by the uproar that followed Robertson's scathing remarks about Scotland. But Burt and Masterton get credit for having juiced up performance through an energized sales effort and for streamlining operations. For the year ended in February, 1999, the bank earned $1.6 billion in pretax income. Bank of Scotland helped its bid by reporting pretax earnings up 12%, to $777 million, in the six months ended Aug. 31.

MAKING A SLOW START. Bank of Scotland plans to dispose of NatWest's noncore assets, including marginally profitable U.S. bond boutique Greenwich NatWest Ltd. and its Gartmore fund management subsidiary. The bank hasn't put figures on these disposals, but analysts reckon they could bring $4.1 billion. Bank of Scotland would also cut roughly $500 million in costs per year, largely by combining processing operations and information systems. And it would continue its push into computer banking, where NatWest has made a slow start.

Investors will now have to decide whether the Scots have the proper credentials to run one of Britain's biggest financial institutions. Bank of Scotland's bid may not be the winning move, but it has certainly changed the game.