David Duffy, the new chief executive of Yorkshire Bank, will be familiar with the claim among locals that Yorkshire is “God’s own country”. For investors and bankers in its parent National Australia Bank, however, recent years in the northern UK heartlands of Yorkshire and Scotland (home of Clydesdale Bank) have been far from heavenly.
During a period when the Australian economy was booming, NAB’s UK banking business was a heavy drag on group profits. The nadir came in 2012, when Clydesdale – whose licence encompasses the Yorkshire brand since NAB merged the two banks in 2005 – recorded a £139 million cash earnings loss. That year, Clydesdale transferred £5.6 billion of underperforming UK commercial real estate assets to NAB, after a botched attempt to build up in business banking in the UK’s more affluent southern regions.
The losses have made NAB’s UK ties particularly frustrating, not least because the business in Australia enjoyed especially strong revenue growth in 2012 and 2013. Clydesdale managed to post a positive cash earnings profit in 2013, but losses from the UK commercial real estate run-off then more than wiped out any benefit to NAB. Meanwhile, reconciled earnings figures show Clydesdale continued to lose money in 2013 and 2014, largely due to the UK’s consumer-redress scheme for mis-sold payment protection insurance.
Perhaps ironically, now that the UK’s economic recovery is gathering pace and the country’s regulator may be easing pressures on banks’ profits, NAB finally looks set to rid itself of Clydesdale – just as Australian economic growth slows due to weaker mineral demand from China. As Euromoney went to press, Duffy and his bosses at NAB were preparing to set Clydesdale free as an independent entity for the first time since the 1920s (NAB bought Clydesdale in 1987 and Yorkshire in 1990. Clydesdale was previously part of Midland Bank). In October, NAB said it hoped to complete a demerger of Clydesdale to existing shareholders, before an IPO of between 20% and 30% of the bank in London and Sydney in February 2016.
“I think the markets are good,” says Duffy, pointing to the £5 billion IPO of Worldpay in October. He estimates the value of Clydesdale at the IPO at £2 billion to £2.5 billion, or about 0.7 times book value.
For Duffy, the return to profitability of Allied Irish Banks in 2014 presented an opportune time to leave after a “very tiring, demanding” three-year tenure at the bank. He would otherwise have been getting stuck into what he says would have been at least another five years of managing the Irish state’s gradual exit, starting with an IPO. “It was the only time I could reasonably do it, in a stable way, with good relationships with everyone around,” he explains, meaning in particular relations with the finance ministry.
He thought about taking a year off, and took calls from bigger banks of the kind he used to work for. Duffy started his career at Goldman Sachs, before eventually becoming head of wholesale banking at ING, then spearheading Standard Bank International in London (the markets unit of the latter was sold last year to China’s ICBC). “Going back into a big bowling lane in some giant organisation didn’t really attract me – it’s just processing,” Duffy says.
The lure of Clydesdale, which he joined in June, was that he thinks it, of all the UK’s so-called challenger banks, has the best chance of closing the gap on the country’s handful of dominant banks.
“This is an opportunity to change the face of UK banking,” says Duffy. He admits that sounds grandiose; Clydesdale is only a quarter of the size by assets of Nationwide, the smallest of the six biggest UK lenders. It is 18 times smaller than HSBC’s UK business, the smallest of the big four UK franchises.
Yet Clydesdale is already the biggest of the next tier of banks, by revenues and assets. The branch network is clustered in Scotland and Yorkshire, but in mortgages, which make up around two thirds of its balance sheet, more than half of its book is in London and the southeast, much originated via brokers. Duffy deems his bank to have better odds of gaining on the incumbents than more specialised challengers: those with more than 90% of their loans in areas like mortgages (Virgin Money), consumer finance (Tesco Bank) or SMEs (Shawbrook).
Although it still needs to set up its own treasury function, Duffy claims Clydesdale, which is headquartered in Glasgow and named after the river that runs through the city, has the further advantage of already operating largely independently, so needing less investment in areas like IT systems than banks carved out of big UK banks as part of competition requirements, such as TSB from Lloyds Banking Group or Williams & Glyn from RBS.
He readily admits there has been a lack of investment in the Clydesdale and Yorkshire brands. But Duffy is already succeeding in one of his first priorities, before a shareholder vote on the demerger in January, which is overcoming a “negative bias” against Clydesdale among NAB’s Australian investors, while mustering interest in the IPO among potential new investors, including in the US, UK and Asia.
The investment banks coordinating the transaction – Bank of America Merrill Lynch, Macquarie Capital and Morgan Stanley – had “very positive feedback” from a non-deal roadshow earlier this year to Sydney, Melbourne, Hong Kong, New York, London and Edinburgh. The Australians liked the idea of getting exposure to the UK story as the Chinese and Australian economies slow, says Duffy. “They looked at this as diversification with good timing.”
Crucially, the chief executive and his team can point to a £1.7 billion indemnity from NAB against past conduct charges (principally the mis-selling of PPI) that the UK regulator asked for as a condition of the demerger. NAB raised A$5.5 billion ($4 billion) in a rights issue in May, mostly to fund the indemnity. Despite news in October of £390 million in additional PPI provisions, which will be deducted from the indemnity, Duffy reckons there is only a “very low risk” that future charges for PPI will exceed the remaining indemnity.
“The calculations we had done on what might be the most extreme outcome, you can imagine, are significantly lower than the amount the regulator finally settled on [for the indemnity],” he says. “They’re the ones on the hook for whether you’re sufficiently capitalized for the future, so they added another layer of conservatism.”
In addition, according to Duffy, asset quality risks are “historically low” after NAB’s transfer of commercial real estate loans. The non-performing loans ratio, in fact, fell to 1.6% in the first half of 2015, while the bank has a 13% common equity tier-1 ratio and is 86% funded by retail deposits. So selling at a discount to book value allows plenty of upside, in his opinion.
Challenger bank listings hardly offer rarity value in the UK today. There have already been two such IPOs this year – Aldermore and Shawbrook. One Savings Bank, TSB and Virgin Money listed last year. Metro Bank appointed BAML, Goldman and Royal Bank of Canada for an IPO, it was reported in October. Williams & Glyn aims to have an IPO before the end of 2016. Still, they have generally performed strongly in the secondary market; Virgin Money was up 44% from its listing, for example.
|Clydesdale face other challenger banks such as Aldermore and Shawbrook, Metro Bank, Williams & Glyn, One Savings Bank, TSB and Virgin Money|
Buying into Clydesdale at 0.7 times book value would offer an “attractive entry point,” says Brian Johnson, Sydney-based banking analyst at CLSA. He says asset manager Henderson’s split from insurer AMP is a well-known precedent for a demerger of a UK subsidiary that has brought good returns for Australian investors who held onto it, although there are also tax disadvantages to owning non-Australian stocks.
The possible impact of M&A activity on Clydesdale’s share price could bring in other investors. Johnson points to Spanish bank Sabadell’s takeover of TSB, less than a year after its IPO, at a 29% premium to the share price immediately before the takeover was announced. “There’s a fair chance that [Clydesdale] will be merged or taken over in the medium term,” says Johnson. “A lot of the players [in the UK challenger market] are sub-scale, so it’s inevitable they will get together and merge, or be taken over.”
With market share in loans at Clydesdale and TSB both under 2%, one senior FIG banker in London thinks Sabadell could acquire Clydesdale, while Virgin Money, Shawbrook and Bank of Ireland – or even AIB, after its IPO – could also acquire or merge with Clydesdale. “Sabadell has to buy more in the UK. It needs to get to at least 7% or 8% market share, minimum,” says the banker. “You only really start to make money after 10%.”
Duffy, likewise, expects mergers between challenger banks. “In a few years’ time I doubt the market will look as it does today,” he says. He is open to the idea of being bought out. “If somebody comes along, the board has to make a decision in the shareholders’ best interests, and if they’re paying a very expensive premium, then it’s right for shareholders.”
He adds: “There are other Asian, US and European players who might consider the UK market attractive for different reasons, and they might come in and look at establishing a beachhead with a challenger bank today.”
In time, Duffy hopes Clydesdale itself could be in a position to make an acquisition to strengthen the franchise, either geographically or in terms of its product offering. Scale alone would not be enough. “There are parts of northern England, which we’re not in, which we would see as logical and as an extension of our footprint,” he says, discussing a potential acquisition.
“There are parts in the south, where, if it was a complementary product profile and if you’re extending […] the number of customers that you are accessing, then [an acquisition] could make sense.”
In the latter case, he points to SMEs in particular. “Mortgages would be less attractive because [the bank] already has that capability nationally.”
Clydesdale will have to gain greater credibility in the stock market first. “The only path to consolidation is if we’ve earned the right to the conversation with investors,” Duffy says. “We have to deliver on this franchise.” Duffy has the advantage, at least, of his experience at AIB – Ireland’s second biggest bank, with similar franchise strengths to Clydesdale in mortgages and, before his arrival, similar deficiencies in areas like costs and digital banking.
After the bailout, Duffy took the job at AIB in late 2011 in a “politically intense environment” in which the country was pretty much being run by the troika of the IMF, European Commission and the European Central Bank, and the bank itself was heavily reliant on ECB funding. “The media were caught up in the emotional events of the day, with the banks being particularly important in that media discussion,” he remembers. He was given the job, he says, thanks to being “untarnished by events” and, unlike many of the people previously at the top of the bank, being Irish.
“There was no way to address the situation without being in the field and taking it full-on. I had to do constant media, so go on the radio, TV, as well as bank enquiries, troika meetings, regulator meetings… I used to travel round the entire country, meeting the customers and taking the heat, the stress, the anger,” he says. “From the staff, to pay, benefits, pensions, to the structure of the bank, to the leadership team, to the board, it all had to change at the same time.”
Duffy built a 2,000-strong division to restructure non-performing loans, mainly residential real estate, but had to lay off many thousands more. He cut his own pay, despite the state already effectively capping bankers’ pay at €500,000 (less than half, incidentally, what his predecessor at Clydesdale earned). “It was about the optics of being willing to take a sacrifice as well,” says Duffy.
Fixing AIB was crucial to Ireland’s economy and its relations with the multilaterals. Ultimately, AIB was able to convince the local and international authorities that it could bring down levels of arrears and provide credit to the economy. Duffy says he started to gain “grudging acceptance” from customers that he was solving the bank’s problems.
That record at AIB is an assurance for potential investors in the Clydesdale IPO, says Johnson. In turning around Clydesdale, Duffy can enjoy a less politically charged environment, given that it has not been bailed out by the taxpayer, and possibly a more benign economic and regulatory environment too.
The dangers of the UK leaving the EU – and possible Scottish independence prompted by that – are both “wonderful imponderables”, according to Duffy. Clydesdale would be likely to register outside Scotland in the event of independence. “The reality is you protect your funding; access to the Bank of England would dictate your actions,” he says. But he feels it is best to focus more on what the bank’s management can control. Now is a good time for UK banks, he says, even one concentrated outside London and the southeast.
“You’ve got a stable, growing economy, with a stable political environment and a single party that has reasonable tenure to run in its election window and a regulatory environment that seems to have started to see the light at the end of the tunnel,” he says.
There has been an “inflexion point” in the SME segment in the north of the England, in his view, with deleveraging ending and net loan growth returning. “You’re seeing growth occurring now in the north of England,” he says. “There’s a lag factor in Scotland and in northern England, where house prices are growing again, faster than in London.”
|'This is an opportunity to change the face of UK banking' – David Duffy|
Duffy remains confident that this is a good time for challenger banks, including Clydesdale. The big banks are more distracted by lawsuits, legacy conduct charges and managing new regulations, he says, particularly around their investment banking divisions. “The big banks are obviously capable and competitive in scale, but they are going through immense amounts of complexity and will do for some period of time.”
Up to now, Clydesdale has been a “poorly managed, poorly served business” – partly a result of being run by a parent bank “many thousands of miles away, almost on global lines”. Coupled with uncertainty over the ownership of the bank, he says it “led to lack of management focus and lack of investment”. An example is the weak digital banking platform, or the reliance on human cashiers at branches. Now Clydesdale’s management “can make decisions […] for the value of the franchise”. Investment in digital banking is “a top priority”.
Spending money on the franchise apparently does not mean getting out of its regional heartlands – repeating the mistake of venturing into businesses it understands less well, like commercial real estate – and seeking higher returns in riskier assets. The bank’s average loan-to-value in mortgages is already relatively high, around 58%, compared with a national average of around 50%, according to Standard & Poor’s. Duffy says Clydesdale has spent time restructuring its risk management division, tightening its concentration and operational risk appetite by sector and product.
Clydesdale’s strategy under Duffy “expressly decides not to charge off down south and start building in other places where we don’t have history,” he insists. “That’s what we did before.” Instead, the approach is to “take what you already have that’s really strong and do it a hell of a lot better.”
Rather than expanding in southern England, Duffy thinks Clydesdale should be doing more in Edinburgh, while the Yorkshire Bank brand should become more active in Manchester and Birmingham: cities where it has operated since its creation. “We see natural potential and competitive ability in those markets,” he says.
Among the bank’s best assets in Duffy’s mind are its customer relationships passed down generations, sometimes with bank managers who have worked with families and their businesses for decades. Yorkshire Bank clients sometimes talk of a “systemic bank in Yorkshire,” he says. “There is a tremendous opportunity to play into that loyalty.” It was the same at AIB. “These are community-based brands,” he says.
Meanwhile, when it comes to digital banking – which could also see Clydesdale pick up clients outside its traditional heartlands – investors will also gain some confidence from Duffy’s record at AIB.
John Cronin, research analyst at Investec, says heavy investment in this area under Duffy has brought AIB a larger market share in Ireland’s unusually large under-40s demographic. “First mover advantage [in digital banking] is something AIB will benefit from in the years to come,” says Cronin. “It’s now up to the other Irish banks to follow suit.”
Investment in technology at AIB was a central element of the difficult, rather paradoxical effort to reposition the bank for an economic recovery at the same time as drastically cutting costs (he says branches had never been closed in the history of the state). “When I started [at AIB] there was no app, no digital, no branch transformation,” he says. By the time of his departure the bank could claim existing customers could go online and get approval for a mortgage in principle within a minute.
Duffy draws a parallel to the situation at Clydesdale, even if the strategy is even less radical today. “I’m not in any way going to pretend that this is lifetime-advantage territory; this is interim-advantage territory,” he says. “I think digital across all the banks will revert to the mean over time. Every now and again you have an advantage, or you have to catch up, but digital is not the differentiator anymore.”
But investments in mobile banking, for example, could help Clydesdale improve its efficiency. Cost-to-income at the bank is high, around 70%. Duffy thinks it will help take out “the hoops, the bureaucracy” of serving customers.
The bank will open new branches as economic activity shifts to new districts. In busy urban areas, it is launching what Duffy calls “flagship branches” with state-of-the-art technology for retail and SMEs that will be open evenings and on Sundays so small businesses can drop off their day’s takings via self-service machines.
Duffy maintains that when it comes to taking out a big loan, people still want to speak to bankers face-to-face in a branch, even if they take some initial steps online. Yet the aim is for “a fully transformed distribution network”.
“The model of the branch is going to change dramatically,” he says.