RBS sell-off skeptics ought to take stock

23 Jun 15

Critics of the government’s decision to begin selling off RBS shares at a loss are prone to some well-established investment fallacies

The decision to begin selling RBS at a £7bn loss has left a large segment of the population either outside itself with disbelief, or confirmed in its suspicions about the social allegiances and regressive-redistribution motives of the recently reinstalled public school boys’ government. To much of the public, this RBS sale appears at face value to be yet another brazen socialisation of costs and privatisation of benefits.

The apparent nonchalance with which £7 billion is being written off – or crystallised as a subvention – stands in stark contrast to Whitehall’s unyielding programme of social and public-sector expenditure cuts.

Why the insistence on rushing the sale through now?  Every 50p rise in RBS shares increases the amount recovered by about £4.5 billion. Would it not be in the public interest to wait for the RBS share price to rise?

Thanks are due to Mr Osborne for this gift to sensationalist, self-serving click-bait. Shrill and combative tone aside, the broad outlines of this interpretation nevertheless resonate among members of the public – and not only among committed opposition activists.

Deeper reasonsBehavioural finance recognises that individual investors are particularly susceptible to the disposition effect, whereby loss-making (price-depreciated) shares are held too long and winners (price-appreciated) shares are sold too soon. It is most commonly explained by the combination of a narrow focus on particular revenue or expenditure categories (mental accounting) and the tendency for losses to loom subjectively larger than gains (loss aversion). The initial entry price takes on special importance, forming a reference point against which gains or losses are gauged. Once the stock falls below its original purchase price, a behavioural investor is predisposed to keep holding on to the stock, in the hope that the paper loss will be reversed, thereby avoiding incurring a cash loss in nominal terms.

Relatedly, normative finance theory has long admonished against committing the sunk cost fallacy. Once funds have been committed to a project, and this commitment is of an irreversible nature, then the principal originally committed should be disregarded in current and future decisions. Only incremental cashflows should be considered. Furthermore, modern finance recognises that the original commitment may have also created an option, the value of which is increasing in the amount of underlying uncertainty. Therefore not only incremental cashflows but the existence and value of this option should be considered in current and future decisions.

RBS LSE share price 2000 to 2015 (Source: Yahoo! Finance)

RBS LSE share price 2000 to 2015 (Source: Yahoo! Finance)

The UK government purchased RBS at 502p per share, while currently it is fluctuating in the vicinity of 350p per share. The initial 502p forms the natural reference point within an RBS-specific mental account, and loss aversion induces a reluctance to crystallise losses with respect to this reference point. Public discomfort with Mr. Osborne’s narrowly framed sell-off is consistent with the disposition effect.

On the other hand, from the public-purse standpoint, intuition might suggest that the government should wait for the RBS share price to rise before selling up. Since RBS fell into Public ownership, however, its stock has been depressed, flat, and attenuated in volatility (see Figure). Consequently, option value is low. And there is little current evidence in the stock price to suggest that gambling on resurrection might be a viable long-shot. RBS’ stock-price history suggests that its management has struggled – and failed – to resolve the underlying problems during 6 years of Public ownership. Indeed RBS’ payments-processing outages – which are exceptional in magnitude within the wider industry – are a further indication of its conflicted existence under Public ownership.

But there are suggestions that RBS may soon return to independent viability. The bank’s management aims to resume returning cash to shareholders via dividends and share buybacks in 2016. To do so, RBS must complete the terms for extinguishing the government’s golden share, called a Dividend Access Share. This involves paying Government the £1.2 billion remaining balance (of the £1.5 billion total) by the end of 2015.

The Rothschild report recommends beginning with an initial small disposal of RBS shares. It is this initial small disposal that is likely to be completed at the current share price, and which is intended to support and speed RBS on the road to independent viability. If all goes to plan, sale of subsequent tranches will take place at higher share prices – and the widely cited £7 billion loss will prove to be an over-estimate. But if RBS shares continue to languish at 350p for years, then to continue holding on to RBS shares – and to doggedly keep paying the interest charge on the financing of the Government’s remaining RBS investment – would be to succumb to the sunk cost fallacy.

The purpose of Government’s crisis intervention in Lloyds, RBS, Bradford & Bingley, and Northern Rock was not to nationalise these businesses for the foreseeable future. The aims of stabilising these institutions and preventing acute systemic failure within the UK financial sector have been achieved. Government is meant to be in the regulation and enforcement business, not in the business of banking.

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