Banks' Capital: Now We Know the Worst

LONDON -- The threat of being forced to raise more capital has weighed on banks since last November, when the Financial Policy Committee pronounced that U.K. banks in aggregate could be 50 billion pounds undercapitalized.

The Committee last week halved its estimate to 25 billion pounds. Banks have to raise that by the year-end, but around half is covered by initiatives already in train. So the real shortfall is a much lower 12 billion pounds.

It's no surprise, then, that the report was greeted with a jump in the share prices of the three banks most affected, RBS  (LSE: RBS  ) (NYSE: RBS  ) , Lloyds  (LSE: LLOY  ) (NYSE: LYG  ) , and Barclays  (LSE: BARC  ) , though the turmoil in Cyprus left them overall down on the day.

The FPC has not revealed how the 12 billion-pound capital shortfall is split between individual banks, but the Financial Times says it includes 6 billion pounds for RBS, 3 billion pounds for Lloyds, and around 1 billion pounds for Barclays.

Fudge
There's some political expediency at play. Judging how much capital a bank needs is a subjective process, and the FPC chairman, Bank of England Governor Mervyn King, is a capital hawk. But the government said it wouldn't put more equity into RBS and Lloyds, so if the FPC had been too harsh, then both banks could have found themselves between a rock and a hard place.

Higher capital ratios also reduce banks' ability to lend, with knock-on effects on the economy. With Mervyn King on his way out, policy is shifting toward the perceived greater emphasis on growth of his successor Mark Carney. Conveniently, the FPC lowered its yardstick for minimum capital Tier 1 ratios (after its judgemental adjustments) from 9% to 7%.

Some of the under-provided risks might remain, but the threat of banks being forced to raise dilutive equity has diminished.

Capital raising
Fundamentally there are three options to cover the shortfall: raise new capital, shed assets, or conserve cash.

Barclays is expected to make another issue of contingent capital bonds after its $3bn issue last year was five-times oversubscribed. The bonds pay a 7.6% coupon but get wiped out if the bank's Tier 1 ratio drops below 7%. RBS and Lloyds might follow suit.

RBS and Lloyds are still shedding assets, but those initiatives are presumably included in the FPC's assessment. RBS plans to make even bigger cuts in its investment bank to help meet the FPC's shortfall.

RBS is also planning to partially float its U.S. retail bank Citizens. With the U.S. economy and its banks healthier than the U.K., a successful IPO could put some fire under RBS's shares.

LLoyds
Announcing last year's results, Lloyds boasted that it was ahead of its transformation plan. Costs had been reduced by 5% and it had sold 40 billion pounds of distressed assets against a plan of 25 billion pounds. That might give it less headroom to shed more assets, but then, Lloyds is probably better placed than RBS to launch a contingent bond issue. It has a similar convertible issue on its books already.

The third way of raising capital is to conserve cash. Doing that quickly means things like cutting bonuses and dividends -- or in the case of RBS and Lloyds, delaying starting paying dividends. But given the political impetus behind privatization, both banks will do all they can to avoid that.

Recovery
Recovery in the banks' shares requires past bad assets to be disposed of, the end of regulatory and legal costs such as PPI and LIBOR, and a positive economic environment.

The muted demands of the FPC are some encouragement that the first item is well on the way to being dealt with. Former shareholders' legal action against RBS over its 2008 rights issue show that the second item is still alive and kicking, though I doubt that action has great prospects. Economic recovery looks distant, but it is bound to come.

So banks shares have a reasonable upside. But it could be a long haul, and the eurozone hangs over the sector as an ever-present threat.

Boring
If you invest in bank shares, it's worth having some money in more boring stocks -- ones that you can tuck away and forget about, that will pay good dividends and grow in value over the long term. The Motley Fool has picked five FTSE 100 stocks that should fit that description. You can read more about them in this brand-new report: "Five Shares to Retire On."

You don't have to be saving for retirement to benefit from some boring stocks in your portfolio. You can download the report straight to your inbox by clicking here -- it's free.


Read/Post Comments (0) | Recommend This Article (0)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2341486, ~/Articles/ArticleHandler.aspx, 11/28/2014 12:29:16 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement