LONDON (Reuters) - Royal Bank of Scotland will face pressure to further shrink its investment bank should an investigation into interest rate rigging show cultural failings persist in the business, political and industry sources have said.
The part-nationalised bank is expected to be fined between 400 million and 500 million pounds for its role in the manipulation of the London interbank offered rate (Libor) and other global benchmark rates.
John Hourican, head of RBS's investment bank, and Peter Nielsen, head of markets, may be asked to leave the bank when the settlement is announced, possibly as early as next week, two sources have told Reuters.
Negotiations over the settlement may roll into the week beginning January 28, however, sources have said.
Chief Executive Stephen Hester has warned of a "miserable day" for RBS when the punishments are meted out, and the bank is braced for the publication of embarrassing emails exposing the extent of collusion between traders.
The revelations will put the future of RBS's investment bank under fresh scrutiny and are likely to re-ignite calls from political factions who want the 81-percent state-owned lender to focus on its domestic market.
Switzerland's UBS, which was fined a record $1.5 billion (942.5 million pounds) last month for its role in the rate-rigging scandal, is winding down its fixed-income business and returning to its private banking roots.
One of the political sources with knowledge of government thinking told Reuters that if the findings by U.S. and British regulators are particularly lurid, RBS will come under immediate pressure to make further cuts to its investment banking operations.
"If the culture is rancid, the only way I can think of changing the business is to make it a lot smaller," said the source, who declined to be named.
Sources close to RBS are confident that Hester will survive, unlike Bob Diamond, who lost his job as chief executive of rival Barclays after it was fined $450 million over the rate-rigging scandal.
Although the investigation is expected to expose wrongdoing up to two years into his tenure, the sources are hopeful that MPs and regulators will accept that Hester was occupied with restoring the bank to health during that period.
The veteran banker was parachuted in to RBS after a 45.5 billion pound state bailout in 2008 saved it from collapse.
The Financial Services Authority declined to comment on the outcome of the Libor investigation or the implications for RBS. The Treasury and RBS also declined to comment.
Stricter banking regulations and low profitability across the industry had already prompted Hester to take a knife to the investment bank, which now accounts for only about 20 percent of operating profit, compared with around half in 2007.
A strong proponent of universal banking, Hestor is reluctant to make any more cuts, having argued that RBS needs investment banking activities to serve its corporate clients properly, but he could find his hand forced.
Britain's financial regulator is keen for RBS to bolster its capital position, either through selling its U.S. business, Citizens, or further shrinking its investment bank.
There is growing political support within Britain for banks to separate their retail operations from riskier investment banking activities.
Another political source told Reuters that MPs would seize on any sign that the culture within the investment bank was still rotten and look for severe remedies.
RBS's private investors, however, will resist further cuts.
They fear making the investment bank a sort of sacrificial lamb could make the state's stakes in RBS far tougher to sell.
"We are extremely sensitive to political interference in the sector, and it's getting worse. Shrinking the investment bank further at RBS is pointless - it's been de-risked - and may hurt the corporate bank," one of RBS's biggest 10 investors said.
RBS's Chairman Philip Hampton said last year that the bank was preparing for the British government to start selling its shares in the bank in the next two years, but some investors believe that could be scuppered by regulatory interference.
"There is a big political drive to get these stakes sold at some point soon but, set against this, there is a faction on the FPC (Bank of England's Financial Policy Committee) which wants the UK banking sector to be as domestic as possible and to run with more capital, which could be painful for share prices," the top 10 investor said.
The big bonuses paid out at the investment bank also sit badly with taxpayers. Hourican received a pay package worth almost 7.5 million pounds in 2011, far ahead of Hester, who waved his bonus and took home a salary of 1.2 million pounds.
At its peak, RBS's global banking and markets business (GBM) had a balance sheet exceeding 1 trillion pounds.
The division has since been chopped down to less than half that and renamed markets and international. RBS has sold off or shut down much of its equities operations but retains significant fixed income and foreign exchange businesses.
However, it has still produced more than 10 billion pounds of profits since the financial crisis. In the first half of last year, it made an operating profit of 1.1 billion pounds and produced a return on equity of 14 percent.
Additional reporting by Sinead Cruise; Editing by Carmel Crimmins and Will Waterman