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NatWest Group Credit Research

Jeroen Julius
Team: Credit
BI Senior Credit Analyst

1. NatWest Bonds May Converge With Lloyds Post-2Q: Credit Outlook

(Bloomberg Intelligence) -- THESIS: Table of Contents

NatWest's bonds may tighten vs. Credit Considerations Key Topics

Lloyds as earnings metrics of the Credit Checklist Brexit Impact on U.K. Economy
NEW

two banks (net interest margin, Credit Drivers: Fundamentals

return on equity) have been Credit Drivers: Asset Quality
Valuation
converging, judging by 1H results.
But effiency and loan-book differences (NatWest is geared to wholesale lending, Lloyds more to
residential mortgages) could keep NatWest's curve just wide. NatWest's MDA buffer may drop to 3-4%
in 2023 from 5.6% in 2Q. Asset quality has stayed healthy but inflation could force Stage 3 loans
higher. Moody's has a positive outlook. (07/29/22)

Credit Considerations

Credit Checklist

2. NatWest Credit Profile Dictated by Balance Sheet, UK Focus

NatWest's capital and liquidity are sound and asset quality is healthy. However, its large exposure to
SMEs presents a risk given high inflation. And its UK-centric business model means that weak growth
in the domestic economy is a key risk. Profitability has recovered, helped by loan loss write-backs,
and the margin outlook is improving due to higher rates and despite intense competition in U.K.
mortgage lending. Litigation risk has diminished and political risk is receding as the state has cut its
equity stake.

Stock performance remains subdued, limiting financial flexibility. NatWest's bond-supply outlook is
benign, reflecting its smaller balance sheet, market-leading retail-deposit franchise and limited
growth options. (06/16/22)

NatWest Group - Interactive Credit Checklist

Source: Bloomberg Intelligence

Credit Drivers: Fundamentals

NatWest Capital Guidance Implies $7 Billion Buffer Shrinkage

NatWest's capital buffer -- once the sector's highest -- will decline further, given guidance, but should
remain healthy. The bank's profitability has been helped by reserve releases, though it's still trailing

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Lloyds' due to lower margins and high costs. Its MREL issuance needs are low and liquidity metrics
have remained sound. (03/30/22)

3. NatWest Capital Buffer Down, May Settle At 3.5%

NatWest's capital position is sound, with a 15.9% pro forma CET1 ratio as of 1st January, well above its
9% requirement (rising in 4Q on reintroduction of 1% U.K. counter-cyclical buffer) and higher than
most U.K. and European peers. But it targets 13-14% by 2023, so this ratio should come down further
and its MDA buffer may settle around 3.5%. The bank's share buyback in March cut its CET1 ratio by
69 bps. Further shrinkage could be achieved through loan growth. Also, RWAs may increase due to
the indirect effect of inflation on borrowers. NatWest is no longer on the list of G-SIBs, and its 1%
systemic-risk-buffer requirement has dropped out at the group level, though the ring-fenced bank
now faces a 1.5% requirement.

NatWest's leverage ratio was 5.8% as of 4Q, well above the BOE's 3.25% minimum requirement.
(03/28/22)

NatWest CET1 Ratio vs. Requirements

Source: Bloomberg Intelligence

4. Earnings Recovery Helped by Reserve Releases

NatWest's profitability has recovered from Covid-19's temporary blip. The bank reported a 3 billion-
pound attributable net profit for 2021 (9.4% return on tangible equity), helped by a 1.3 billion
impairment release. For 2022, it expects to report a cost of risk below the through-the-cycle average
of 20-30 bps. Its net-interest margin is under pressure (1.50% in 2021 vs. 1.60% in 2020, our
calculation) due to low rates, intense competition in U.K. mortgages and excess liquidity. Its
cost/income ratio (70-75%) is worse than Lloyds'. As a result, NatWest's profitability is lower than its
U.K. peer.

Subsidiary NatWest Markets -- which is being shrunk -- remained unprofitable in 2021, as did the
Ulster Bank unit. NatWest has decided to withdraw from the Republic of Ireland in the coming years.
(03/28/22)

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NatWest Group - Quarterly Reported ROE (%)

Source: Bloomberg Intelligence

5. MREL Needs Are Fulfilled; Liquidity Is Sound

NatWest's MREL position is healthy, with an MREL ratio of 39.8% at end-4Q -- well above its estimated
MREL requirement of 25.7% of RWAs. It has about 23 billion pounds of holdco senior MREL bonds in
issue, slightly above its long-term (steady-state) requirements. Its MREL-eligible bonds are issued out
of NatWest Group Plc, which is the resolution entity. NatWest's reduced geographic footprint and
simplified business model mean that it dropped off the list of Global Systemically Important Banks (G-
SIBs) in November 2018, so it's not subject to TLAC requirements.

NatWest's wholesale funding reliance is low, with an 75% loan-deposit ratio at end-4Q, reflecting its
market-leading deposit franchise in the U.K. Its liquidity coverage ratio (172%) is close to the average
for our coverage universe and could help absorb most shocks. (03/28/22)

NatWest Group -- Liquidity Coverage Ratio (%)

Source: Bloomberg Intelligence

6. Positive Rating Actions In June-July

In July, Moody's upgraded NatWest Group's senior unsecured debt ratings to Baa1 from Baa2
(keeping the positive outlook) mirroring the upgrade of its notional Baseline Credit Assessment to
baa1 from baa2. The latter reflected the rater's view that "the group's capital and allowance for loan
losses are sufficient to withstand the more benign but still challenging operating environment." S&P
and Fitch moved to a stable outlook (from negative) in June-July, as part of sector-wide changes.

NatWest's CET1 ratio target (13-14% by 2023) could lead to downward rating pressure at some point,
arguably, depending on the macroeconomic context and the bank's profitability. The U.K.
government's stake in NatWest (cut by 4.9 percentage points to about 48.1% in March) doesn't
appear to be a major ratings factor. (03/28/22)

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NatWest Group - Interactive Credit Rating Overview

Source: Bloomberg Intelligence

7. Ring-Fence Structure and Issuing Entities

The ring-fencing rules for U.K. banks (to ensure continuity of vital banking functions in case of group
failure) took effect in 2019. NatWest's ring-fenced bank (NatWest Holdings comprising NatWest Bank
Plc and The Royal Bank of Scotland Plc) accounts for the majority of assets (60-65%) and RWAs (75-
80%), whereas its capital ratios are somewhat lower than those of the non-ring-fenced bank
(comprising NatWest Markets and RBS International which provides offshore services to investment
funds). Both sit below the holding company (NatWest Group), which is the group's resolution entity.

NatWest Group, NatWest Bank and NatWest Markets all issue debt externally, though only issuance
out of NatWest Group is MREL-eligible. The other two entities issue senior secured and senior
unsecured bonds. (03/28/22)

NatWest Issuing Entity Structure

Source: Bloomberg Intelligence

Credit Drivers: Asset Quality

NatWest $134 Billion U.K. Corporate, Property Loans Still a Risk

NatWest Group's asset quality has been resilient to Covid-19 and Brexit impacts but will be sensitive
to the effect of higher inflation on U.K. households and corporate borrowers, given the bank's large
mortgage and corporate loan books and domestic focus -- the U.K. accounts for 90% of lending.
Asset-quality metrics were healthy as of 4Q. (03/31/22)

8. Corporate Risks vs. Mortgage Safety

NatWest's market-leading position in U.K. corporate lending (70 billion pounds, 19% of loan book as of
4Q) leaves the bank's asset quality sensitive to inflationary effects on the U.K. economy. Commercial
real-estate exposure (9% of the book) is exposed to reduced occupancy rates following Covid-19 (it is
mostly related to investment properties as opposed to development lending). Mortgages are 52% of

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total loans, with a healthy 54% average loan-to-value ratio. Unsecured retail lending (credit cards,
etc.) is lower than for Barclays and Lloyds. The government furlough program ended in September
but the U.K. unemployment rate is near all-time lows.

Asset quality metrics were still healthy as of 4Q -- the Stage-3-loans ratio was 1.3%, similar to U.K.
peers, with 40% coverage. (03/29/22)

NatWest Loan Book Mix (363 Billion Pounds, End-4Q)

Source: Bloomberg Intelligence

Valuation

NatWest May Issue T2 Bonds in 2022 to Refinance Maturing Bonds

NatWest will likely be a frequent issuer of Tier 2 bonds in 2022-23 to replace maturing T2 bonds. Its
dollar senior holdco curve trades wide of Lloyds and on top of Barclays, despite business-model
differences. The bank's AT1s trade broadly in line with its U.K. peers, partly reflecting the
convergence of its hitherto sector-leading MDA buffer. (04/01/22)

9. NatWest T2 Refinancing in 2022-23 Likely

NatWest Group's T2 bonds have a BBB composite rating. Six of its nine Tier 2 bonds are in dollars.
They trade wide to the T2 bonds of Lloyds and HSBC but inside StanChart's. NatWest's T2 stack was
3% of RWAs as of 1 January, above its 2.9% minimum requirement. This shows that NatWest's T2 net
issuance need is low (depending on RWA trend). However, most of its T2 bullets will mature in 2022-
23 and will need to be replaced. It still has some legacy T2 bonds spread across the group (with
remnants at NatWest Markets NV, NatWest Markets Plc and NatWest Bank). The process of replacing
these bonds with T2 issuance via Natwest Group will continue.

The 750 million-euro 1.043% T2 issued in 3Q is trading below par value. Earlier in 2021, it issued a 1
billion-pound 2.105% bond (also below par). (03/30/22)

NatWest Group $T2 Bullets vs. U.K. Peers (bps)

Source: Bloomberg Intelligence

10. NatWest Dollar Senior Holdco on Top of Barclays

NatWest Group's holdco senior curve in dollars is wide of Lloyds' curve -- Lloyds' bonds are rated
higher (A2/BBB+/A) than those of NatWest (Baa1/BBB/A). But NatWest's curve is close to Barclays --
the latter's bonds carry broadly the same ratings as NatWest's. S&P and Fitch changed their outlook

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on NatWest's ratings to stable (from negative) in June-July, as part of sector-wide reassessments of

U.K. bank ratings.

NatWest has been a frequent issuer of holdco senior bonds in dollars, mostly in benchmark size. For
2022, it plans to issue the equivalent of 3-5 billion pounds in MREL senior, partially offsetting about 7
billion loss of senior MREL eligibility through 2022. To date, it has issued four bonds under its Green,
Social & Sustainability framework, raising about 2.8 billion pound-equivalent. (03/30/22)

NatWest Dollar Holdco Senior Bonds vs. UK Peers

Source: Bloomberg Intelligence

11. NatWest AT1s In Line With Peers, MDA Buffer May Follow

NatWest Group's 8% and 6% dollar AT1s trade close to Lloyds' 7.5% bond. Both banks have a similar
U.K.-centric business model. They also trade close to those of HSBC which is less exposed to the U.K.
but sensitive to Chinese real estate and Hong Kong political risks. They also trade broadly in line with
Barclays' AT1s. Barclays has a larger capital markets unit and potentially more volatile revenue.
NatWest's MDA buffer exceeds that of its U.K. peers -- 6.9% as of 1 January vs. Barclays (3.2%), Lloyds
(3.2%) and HSBC (4.2%). But the bank's 13-14% CET1 target for 2023 suggests that its MDA buffer will
move closer to peers.

NatWest and Barclays AT1s are high yield-rated (Moody's, S&P) whereas Lloyds and HSBC AT1s are
high-grade (Moody's, Fitch). In June 2021, NatWest issued the 4.6% bond which has slumped.
(03/30/22)

NatWest Dollar AT1s vs. U.K. Peers

Source: Bloomberg Intelligence

12. Holdco Senior CDS Close To Opco Senior CDS

NatWest's two five-year sub/senior CDS pairs (one for the operating company, one for the holding
company) show that holdco senior CDS has been trading close to opco senior CDS. This suggests that
the market is giving more weight to payment rank and less to structural subordination when pricing
NatWest risk. The ring-fencing of The Royal Bank of Scotland Plc and NatWest Bank Plc has moved a
large part of the operating companies' asset base into a bankruptcy-remote sphere. NatWest's opco
CDS references NatWest Markets Plc, which has been left outside of the ring-fence.

As NatWest keeps migrating its Tier 2 issuance to the holdco, deliverables for opco CDS could drop
further over time. The last T2 bond issued out of NatWest Markets dates from before the financial
crisis. (03/30/22)

This report may not be modified or altered in any way. The BLOOMBERG PROFESSIONAL service and BLOOMBERG Data are owned and
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marketing and operational support and service for the Services and distributes the Services either directly or through a non-BFLP
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NatWest's Holdco vs. Opco CDS (bps)

Source: Bloomberg Intelligence

Key Topics

Brexit Impact on U.K. Economy

13. BE Primer: UK Recession Risk High As BOE Fights Double-Digit CPI

Contributing Analysts
Dan Hanson
(Economics)

Not a lot is going right for the UK at present. Consumer spending power is being hammered by
soaring inflation and growth has slowed to a crawl. At the same time, the global economy is losing
speed and the Bank of England is embarking on a rapid tightening cycle. Recession is a real
possibility but our base case is it's avoided by a slim margin.

The Bank of England is likely to continue tightening policy, having raised rates at each of its last five
meetings. Our baseline expectation is that the central bank lifts rates to 2.5% by year end, taking
them into restrictive territory. The big risk is that inflation proves tougher to tame and a hard landing
becomes unavoidable. (07/28/22)

To contact the analyst for this research:

Jeroen Julius at jjulius8@bloomberg.net

This report may not be modified or altered in any way. The BLOOMBERG PROFESSIONAL service and BLOOMBERG Data are owned and
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