This article has been adapted from our sister site across the pond,  Fool U.K.

So far I have steered clear of the two major banks bailed out by the U.K. taxpayer, Lloyds Banking Group (NYSE: LYG) and Royal Bank of Scotland (NYSE: RBS). I have missed out on some gains -- this year they have outperformed the FTSE 100 by around 20% and 12%, respectively.

But it has been a volatile ride, and too full of uncertainly for my taste. The fundamental difficulty I have is that these banks' balance sheets cannot be trusted. Too often the bad news has been drip-fed.

And this continues. As late as Nov. 24, Lloyds CEO Eric Daniels told the Financial Times that the bank's Irish exposure "was not something to be particularly worried about" and that the market's reaction was overdone. 

About three weeks later, as my colleague Owain Benallack reported, the bank issued a statement indicating losses in Ireland some 1.2 billion pounds higher than analysts expected.

But as I am fortunate in having no history with these shares, dispassionately, do they now look like a recovery play? And if so, which is the better bet?

Lloyds looks closer to returning to normality, with its share price just 7% shy of the average cost of the government's 41% stake. RBS's shares are 20% below the cost of the government's 84% stake. And Lloyds seems to have more definitely moved into profitability.

But there are plenty of obstacles along the way, for both banks. These include:

  • Eurozone exposure. Both have high exposures to Ireland, which hopefully are now adequately provisioned, but with weak balance sheets both would be hit by further crises.
  • The housing market. Deterioration in confidence in the housing market would hit both banks' large mortgage businesses, and the Bank of England warned recently of the pressure on households of increased interest rates and the effect of fixed-rate deals ending in 2011.
  • Commercial property. Half of Lloyds' 60 billion pound commercial property loan book is in its work-out unit, with about one-third of that 30 billion pounds written off. The bank hopes to reduce exposure by 4 billion pounds this year. RBS has similar exposure and is seeking to sell a 3 billion pound portfolio of property loans. At that rate, it will take seven to eight years to deal with the impaired loans. Undoubtedly much greater write-downs would be needed to accelerate this program, demonstrating how vulnerable the valuations are.
  • Funding rollover. The Bank of England has been encouraging all the banks to repay its emergency funding early, before the January 2012 deadline, as it fears a credit crunch in the market as banks seek to refinance these and other wholesale loans.
  • Capital calls. The National Audit Office (NAO) has warned that both banks may need new equity to be injected between now and 2019 to meet the proposed Basel III rules, despite the banks shedding non-core assets.
  • Government share sale. The NAO has also pointed out that the state's holding in the two banks is six times larger than the biggest-ever European share sale -- a 10 billion pound placing of Deutsche Telekom stock during the dot-com bubble. To put much of a dent in such a large holding would require selling at fire-sale prices (which puts a cap on the share price) or waiting until the banks have good profit records, are well-capitalized, and have clean balance sheets.

And then there is the question of a break-up. Former City minister Lord Myners has called for the government's Commission on Banking to consider carving up both banks to stimulate competition. This would make it easier for new entrants such as TescoVirgin, or Metro Bank to change the competitive landscape in retail banking.

A break-up of RBS looks remote, as does the possibility of this government splitting retail and investment banking. But one member of the Commission, former gas regulator Clare Spottiswoode, has warned that breaking up the Lloyds/HBOS merger is a serious possibility.

Shareholders would receive value from the split, but Lloyds' dominant market share in retail banking would be diluted. Its outgoing CEO is making much of the previous government's promise to waive competition considerations as an inducement for Lloyds to take over the failing HBOS, but to my mind, with the NAO highlighting the problem of selling such large tranches of shares, the better argument for a break-up may be to facilitate the privatization.

The Commission will publish interim findings in the spring and a final report in September, following which the structure of the banking sector will be clearer. The funding situation, Eurozone, interest rates, and housing market may look different then, too.

For me, that will be the time to consider investing. At present, Lloyds vs. RBS is a no-score draw.

More from Fool U.K.'s Tony Reading:

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