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 (NWG 0.04%) (NWG -0.14%), Lloyds (LLOY 0.86%) (LYG -0.78%), and Barclays (BARC -0.57%), 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.

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