Lloyds walking a fine line to hold on to what it has

Published on 19/09/2009 13:46

IT MUST have been an agonising moment for Eric Daniels. For months the chief executive of Lloyds Banking Group had said nothing about the frenzied behind-the-scenes discussions with the Treasury on how he could stop the government taking an even bigger stake in the bank.

On Friday, amid more speculation that the City regulator, the Financial Services Authority, was playing hardball with Lloyds, the bank finally cracked and confessed: yes, it is "considering possible alternatives" to submitting to the government's asset protection scheme (APS).

Until then, rumours about what was going on had swept the City. Terms of the negotiations and Lloyds' plans for raising cash had for weeks been in the papers and the talk of the Square Mile's bars.

Lloyds' communications staff had been directed to release the same bland statements – over and over again – confirming nothing.

"You can collect them like baseball cards," joked one insider.

Initial terms of the deal had been struck with the Treasury in March, but since then it became clear that Daniels was scheming alternatives.

His objective is to retain control of the bank by keeping the government's stake to less than 50 per cent. Currently the taxpayer owns 43 per cent.

If he could whittle down the 260 billion of dodgy assets, he could bring down the stiff charges – 15.6bn – paying up the full fee would mean the government owning 65 per cent of the bank.

Cutting the size of the pot would also reduce its reliance on the scheme, which is essentially a form of state aid.

If he didn't, then Europe would force him to sell off parts of his hard won prize, the bank's lion's share of the UK retail banking market.

The prize was a result of Lloyds takeover of HBOS a year ago last week. Deemed a disaster by investors but waived through by prime minister Gordon Brown, Daniels has doggedly maintained the deal will come good, gritting his teeth through an estimated 20bn worth of write-downs on HBOS assets alone.

But if Lloyds joins the APS, Daniels' vision of "building the UK's leading financial services company" goes dark.

Neelie Kroes, the European Competition Commissioner, had been rattling sabres all summer. Both of the UK banks that were in talks to join the APS – Lloyds and the Royal Bank of Scotland – would have to be cut down to size, she said.

It would be unfair to the banks that hadn't needed billions to bail them out if, through state aid, the ones that did ended up with a dominant market share. That could be considered a moral hazard.

Kroes said RBS would need to look at its share of the corporate banking market while Lloyds' one third of the UK retail market in mortgages and savings would have to be reduced.

In one proposal to Kroes' commission, the bank desperately offered up its Cheltenham & Gloucester branches, plus a few hundred bank branches in Scotland.

It was a fudge, which meant the bank had to do an embarrassing about-face on an earlier decision to shut C&G – much to the fury of the unions. But it is understood this did not mollify Kroes.

Last week reports emerged that the European Competition Commission would force Lloyds to sell some or all of its 1,000 Halifax branches. But this was just one of many proposals that were on the table. Sir Win Bischoff, the new chairman of Lloyds, last Thursday flew to Brussels to meet Kroes' deputies. He is said to have presented plans for a huge shake-up of the group in a bid to retain Halifax.

In another blow for Lloyds last week, the City watchdog cast serious doubts on Daniels' plan for escaping the APS. Following a stringent stress test, the FSA told Lloyds that if it didn't go into the scheme, it would have to significantly boost its capital. Analysts estimate it would have to raise anywhere from 15bn to 20bn – some have estimated 25bn – to meet the FSA's new capital requirements.

Most think Lloyds will have to do both – raise money to reduce the amount of assets in the APS – but not exit it altogether.

"The idea of Lloyds exiting the APS is unlikely primarily because raising 15bn to 20bn isn't a viable option," said Exane BNP Paribas analyst Ian Gordon.

How would Lloyds go about raising such a sum? Possibilities include a 10bn cash call on investors – a persistent rumour that again the bank has neither confirmed nor denied.

Or it could sell parts of the group such as Scottish Widows or Clerical Medical – either wholesale or through flotations.

But some – including the Bank of England and the FSA – consider getting enough money together as "unfeasible".

Yet Daniels, an unlikely optimist, believes improving economic conditions and expected performance improvement in its loan portfolio means things are looking up for the bank. If the UK property market continues its shaky recovery, several billions of the group's assets won't need the insurance promised by APS and investors might start crawling down from their defensive positions in the hills and look more favourably at yet another rights issue.

While Daniels is looking on the bright side, the FSA is walking on the dark side of the street. Recognising the UK's economic recovery is fragile, the regulator has insisted the bank pump up its capital cushion through upping its core tier one ratio. How much core tier one is enough? The truth is, no one knows. It depends on the stringency of the stress tests applied as to how much capital a bank needs.

Basel II, the international banking standards body, currently says banks only need four per cent tier one capital.

But Lloyds says it has 6.3 per cent.

Going into the APS would boost the cushion up to 14.5 per cent. Is that enough, or too much?

The British Bankers Association believes that the UK is taking a harder line on capital requirements than other governments.

Although it admits banks need to have bigger cushions under them, they argue too much capital requirements would "hamstring" UK banks as they would fail to attract investment and thus be unable to finance new loans.

Said one industry insider: "It is a delicate balancing act."