Merging on the ridiculous

Royal Bank of Scotland (RBS) recently announced that it is dramatically downsizing its investment banking business. This largely marks the end of its ill-fated acquisition of ABN Amro (ABN). The unwinding show the tough time commercial banks have when they try to break into investment banking through an expensive acquisition.

There are a few reasons why RBS' acquisition came to grief. First, there is no doubt that the bank overpaid for this asset. In 2007, ABN was the subject of an intense bidding war between Barclays and a consortium comprising RBS, Fortis and Banco Santander. The RBS consortium won and RBS took over the investment banking business and Asian network. Fortis and Banco Santander took over the Dutch and Brazilian retail operations.

The former chairman of ABN, Rijkman Groenink, was accused of obstructing the RBS-led deal. But he did a magnificent job of playing one bidder against the other, although he was only paid a few million euros to retire for his effort.

His strategy resulted in the consortium agreeing to pay US$98 billion for the bank at the peak of the market, at a huge premium over the bank's book value. It did not help that the 2008 credit crisis - a catastrophe for the banking business - hit just as the deal closed.

But ABN was not the right bank for RBS to fulfil its investment banking dreams. It was mainly a commercial bank with a relatively small investment banking business - as was RBS. ABN's investment banking business was built largely on using its commercial bank's balance sheet to give cheap loans to clients to win mandates.

Before the acquisition in 2006, despite its investment banking revenues being boosted by the buoyant markets, operating expenses and loan losses were ballooning. Its trading books were also filled with high-risk assets.