The Bank of England (BOE) announced the results of what can be called U.K.’s version of the Fed’s stress tests aimed at understanding the capital situation as it exists for U.K.’s banking system this Wednesday [News Release – Financial Policy Committee statement from its policy meeting, 19 March 2013, Bank of England Press Releases, Mar 27 2013]. The primary finding was that the country’s largest banking institutions were overstating regulatory capital by as much as £52 billion ($79 billion), as the reserves for loan losses and other fines/charges were grossly insufficient. Taking this shortfall into account, the country’s biggest banks will need to increase capital by around £25 billion ($38 billion) by the end of the year. As the banks already have plans in place to retain earnings, sell assets and also cut costs, this translates to them raising between £12-13 billion ($18-20 billion) in fresh capital over coming months.
The Royal Bank of Scotland Group (NYSE:RBS) has the largest capital gap to bridge this year – of around £6 billion ($9 billion) – followed by Lloyds Banking Group (NYSE:LYG) with £3 billion ($4.5 billion) [RBS and Lloyds must raise extra £9bn, Financial Times, Mar 27 2013]. Barclays (NYSE:BCS) comes third in the list with the need to raise £2 billion ($3 billion) by the end of 2013.
We maintain a $11 price estimate for RBS’s stock, which is at a premium of nearly 30% to current market prices. A large part of this difference can be attributed to the weak sentiments towards European banks in the wake of Cyprus’s contentious bailout plan and the continuing economic weakness in the region. But a move by RBS to raise additional capital could result in a marked reduction in this estimate.
The economic situation in Europe has been precarious since the downturn of 2008, with the outlook for the region seen as negative over the next few quarters at least. This has forced U.K. financial regulatory bodies to take stronger action towards making sure that the country’s banking system does not collapse the way it did a few years ago. After all, RBS and Lloyds are still partly held by the U.K. government as a result of their bailouts, and the other banking giants Barclays and HSBC barely escaped the need to be propped up by making drastic changes to their business model.
The weak outlook for the region puts substantial pressure on the outstanding loan portfolio of these banks – so much so that the BOE believes the banks may be forced to write-off high-risk loans worth about £30 billion ($45 billion) more than the provisions they have currently set aside. BOE also believes that the banks are underestimating their legal liabilities from mis-selling products like interest-rate derivatives and payment protection insurances (PPIs) to the tune of £10 billion ($15 billion).
Keeping a three-year horizon in mind, the BOE estimates that banks in the U.K. will need to raise between £12-13 billion ($18-20 billion) in fresh capital to ensure a Basel III capital ratio of 7% at the end of 2013 after adjusting for the over-statements. And about half of this figure has to be raised by RBS. This does not bode well for RBS, which has been struggling over the years to take back the 82% stake the U.K. government owns in it, as the decade-long roadmap it laid out for going public again is bound to be delayed by a couple of more years at least.
Disclosure: No positions