By Iain Withers and Lawrence White
LONDON (Reuters) - Royal Bank of Scotland (L:RBS) on Friday said deteriorating economic conditions before Brexit were likely to derail next year's profitability and cost targets after it reported strong first-half results, including a 1.7 billion pound dividend.
The results show how the bank's outgoing CEO Ross McEwan has put RBS on a surer financial footing, but his successor will now face major challenges, including steering RBS through any Brexit fallout and returning the lender to private hands.
RBS warned that in the first half of the year some of its consumers and businesses were struggling as the chances rise of a disorderly departure from the European Union.
The state-controlled bank said a tough outlook would make it "very unlikely" it would meet its target of achieving a 12% plus return on tangible equity - a measure of profitability.
RBS, which has undergone a major turnaround since a 45 billion pound bailout in the financial crisis a decade ago, said it would struggle to reduce its cost to income ratio to below 50% by 2020, although this remained its medium term goal.
The bank's shares fell more than 5%, against a 2.8 % drop in the STOXX European banks index (SX7P).
Chairman Howard Davies said the bank faced another period of economic and political uncertainty.
"The subdued outlook for interest rates is affecting all banks, global economic growth prospects are less favourable, trade tensions between China and the U.S. continue to be strained ... and that's also affecting market confidence."
RBS announced the 1.7 billion pound windfall for investors after the sale of a stake in Saudi bank Alawwal helped to support a 48% increase in first-half pretax profits to 2.7 billion pounds.
The British government - which still owns 62% of the RBS - will receive 1 billion pounds.
RBS said its overall lending business remained healthy, but it reported an increase in bad loans of 182 million pounds for the first half compared with the previous year.
RBS also said there was a modest increase in default rates among personal banking customers, a decline in property valuations in the retail sector and large companies delaying financing due to Brexit uncertainty.
"There are some small signs of strain but at this point nothing we're particularly concerned about," CFO Katie Murray said.
The bank also warned of pressure on margins due to intense pricing competition in mortgages, after similar warnings from Barclays (L:BARC), Lloyds (L:LLOY) and CYBG (L:CYBGC).
"This is overall another set of disappointing of results from RBS, which is now facing an extremely demanding operating environment," analyst Edward Firth at broker KBW said.
CEO SEARCH
RBS gave no update on its search for a new CEO to replace McEwan.
New Zealander McEwan, 62, said in April he planned to retire within the next year, but the hunt to replace him has intensified after National Australia Bank (AX:NAB) said last month that he would become its next CEO.
Davies said the board was making good progress on the search and McEwan's successor would be appointed by next April.
"I can assure you I'm keeping his feet to the fire," Davies said.
Excluding a 700 million pound boost from the sale of RBS's Alawwal stake, RBS pretax profits of 2 billion pounds only narrowly beat forecasts of 1.9 billion pounds, according to a company-compiled average of analyst estimates.
The bank followed up on its first full-year dividend in a decade with an interim dividend of 2 pence per share and a special dividend of 12 pence.
