Can Britain's banks afford to be rescued?

Can Britain's banks afford to be rescued?
Government plans to address the toxic assets on lenders balance sheets is going to lead to punitive costs, writes Katherine Griffiths.

Last Updated: 7:29PM GMT 17 Feb 2009

Rumours circulated at the weekend that politicians were fed up of the flow of bad news coming from banks. The chancellor, Alistair Darling, was said to be considering nationalising those in the worst state, in a bid to take control of the dire situation.

If Mr Darling was thinking of pressing the nationalisation button, the temptation passed. While it cannot be ruled out that Royal Bank of Scotland and Lloyds Banking Group might end up in public ownership, the Government again seems determined to stick to its course and to keep at least part of those banks in the private sector.

The rationale is that the banks will recover more quickly if they are still run as commercial operations, even if over the next few years the Government, as a major stakeholder, will make demands over issues including lending levels, repossessions, and bonuses.

Yet it is becoming clear that trying to preserve partial privatisation of the banks will be very difficult. Banking sources have said that Treasury officials and their advisers have become increasingly worried about how to balance dealing with the enormity of UK banks' losses with the need to strike a decent deal for the taxpayer.

At the heart of the action plan is the insurance scheme the Government will offer to banks so that they can cap their losses from toxic assets. However, due to the pace and scale of deterioration of assets, there is an view that the Government will also have to launch a separate bad bank for the most noxious investments.

Neil Dwane, chief investment officer for Europe at RCM, part of insurer Allianz, said: "History shows that almost every banking crisis has had a good bank/bad bank as part of the solution, such as Japan and Sweden in the 1990s, or the Savings & Loans crisis in the USA. This solution works because the toxic assets are placed in a vehicle, underwritten by the state, which can cope with the toxicity over time."

The Treasury left the door open for a bad bank when it announced its latest rescue package for the banks last month, but there has been reluctance among ministers to embrace the idea because it would mean crystalising huge losses and putting them onto the public balance sheet.

However, analysts believe the Government must take the hit. Mr Dwane said the Government should "produce full and clear results for all banks, highlighting the toxic assets".

If a bad bank is launched, it is likely to sit alongside the insurance plan, which has been branded the asset protection scheme. But in a further complication, the Treasury and its advisers at Credit Suisse and Citibank have realised that the scale of the banks' problems mean that it will be very difficult to make the insurance scheme work while keeping part of the banks in the private sector.

Many believe RBS, which has a balance sheet of £2,000bn, may have to put as much as £200bn of toxic assets into the insurance scheme. If the Government follows the US example and charges 4pc for providing insurance to cover losses on these assets after a first loss to the bank, RBS would have to pay a fee of £8bn to the Government.

RBS would be unable to pay the fee in cash without destroying its capital ratio, and so would have to issue some form of capital instruments as payment. However, the bank is in a difficult position because if the capital instruments carry a 10pc coupon - compared to the 12pc the Government charged for injecting equity in the form of preference shares in October - RBS is still looking at a swingeing £800m annual payment.

Alternatively, RBS could pay the Government for the insurance using a different instrument, such as a warrant. While this might not carry a hefty annual fee, the major drawback is that warrants convert into ordinary equity. As RBS is already 70pc owned by the Government, issuing new stock to the state which would further dilute private shareholders could cause its battered share price to plunge to a new low.

Stephen Hester, chief executive of RBS, has said the bank is the "guinea pig" in thrashing out the details of the asset protection scheme with the Government. But Lloyds - which is 43pc state owned - will also have to make heavy use of the insurance scheme.

This will leave Barclays in difficult situation. The bank, which has avoided taking Government money, said last month it was likely to use the insurance scheme. The bank said it would pay in cash, as to pay in certain types of capital instruments would trigger an anti-dilution clause with the Middle Eastern investors who came on board last year. If this clause is triggered, it could give the Middle Eastern group majority ownership of Barclays.

Barclays must now decide whether it can afford to pay in cash. If it cannot, it may have to stay out of the scheme, which could put it at a disadvantage to rivals.

http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/4681836/Can-Britains-banks-afford-to-be-rescued.html