U.K. Asset Protection: Are Barclays, Lloyds Getting a Great Deal or Getting Squeezed?

Includes: LYG, RBS
by: TradingHelpDesk

Background to the Asset Protection Scheme

The Asset Protection Scheme (APS) was announced in January to remove uncertainty about the value of UK banks' past investments and bad debt exposure. The APS was also designed to allow banks to rebuild and restructure their operations to increase lending in the economy to both businesses and consumers.

At the time, the world's financial system was facing a worsening crisis of confidence about the underlying value of bank assets not just in the UK, but globally. This was undermining financial stability and preventing the UK banking system from providing loans and mortgages as the banks continued to hoard cash to protect their balance sheets.

All major UK banks were eligible to apply for APS insurance though some banks like Barclays (NYSE:BCS) and HSBC (HBC) didn’t apply due to their stronger balance sheets, lower bad debt exposure and a reluctance to give the UK government equity, fearing increased intervention thereafter.

However, Royal Bank of Scotland (NYSE:RBS) and Lloyds Group (NYSE:LYG) agreed in principle in February and March, respectively, to participate in the APS and in return to pay a fee to the taxpayer. They also entered into legally binding commitments to increase lending in the economy.

At the time the APS was announced, both RBS and Lloyds had insufficient capital to withstand the downside risks to their balance sheets. They were unable to raise this capital through the private sector, and needed to call on the capital protection afforded by the APS.

These agreements have given both banks implicit protection for their balance sheets, allowing them to begin the process of rebuilding and restructuring the healthier core of their businesses and to increase lending.

Current Overview

Since the APS was initially announced, investor risk appetite and market conditions have improved significantly. The globally coordinated fiscal and monetary stimulus has contributed to the improvement in the macroeconomic situation and a degree of confidence in the banking system has now been restored. But it is clear following the week’s announcements that more intervention in the UK banking sector is required.

Investors exposed to Lloyds Group and Royal Bank of Scotland in particular were forced to re-examine their strategies and expectations this week on news the UK government is to increase its stake in both banks. Equity investors also have to consider the implications of European Commission demands which require both LYG and RBS to divest branches and business units to ensure the UK banking landscape remains competitive.

Royal Bank of Scotland

RBS has agreed to issue £25.5bn of new capital to the UK government in the form of B Shares which may be convertible, subject to conditions, into ordinary shares. The cash injection will give RBS the shameful title of the most bailed-out bank in the world, following the 2008/09 credit crunch. RBS is also to sell 318 UK branches, almost 15% of its network.

RBS has also agreed new terms for its APS participation. It will now insure £282 billion of assets down from £325bn agreed back in February.

As a result the Government's economic interest in RBS will rise to 84%, consistent with the agreement in February, but the Government's ordinary shareholding will not exceed 75%.

To protect against a future worst-case scenario, the Government will provide a contingent capital commitment of up to £8 billion.

Under the new APS framework, RBS is now liable for the first £60 billion of losses, up from £42.2bn, with the taxpayer liable for 90% of losses thereafter up to the new £282bn ceiling.

RBS still retains an exit opportunity if the £60bn loss has not been exceeded and it pays an exit fee of either £3.5 billion or 10% of the actual regulatory capital relief received by RBS while it was in the APS.

In return for the agreement amendments, RBS will pay an annual fee to the UK government of £0.7bn for the first three years followed by a £0.5bn fee each year for the duration of the scheme.

Following pressure by the European Commission, Royal Bank of Scotland is also to divest the RBS branch network in England and Wales, the NatWest branches in Scotland and Direct Small, Medium Enterprise customers across the UK.

It is also to sell-off RBS Insurance, Global Merchant Services and its interest in RBS Sempra Commodities. Divestments can take place over 4 years to maximize value and may be effected through initial public offerings, agreed sales or a combination of these. In particular, RBS Insurance is seen as a potential IPO in the later years of RBS's Strategic Plan.

This will reduce RBS's UK market share by 2% in Retail banking, 5% in SME banking and 5% in the mid-corporate market.

Lloyds Group

Lloyds Group is to receive another £5.7 billion of tax-payer’s support and will have to sell more than 600 branches, accounting for around 4.5% of the total market share of UK current accounts, £30 billion of customer deposits and £70 billion of lending.

Lloyds has 4 years to execute the divestments creating an opportunity for the failed bank to secure a fair price for the assets.

The bank also announced plans to raise £21 billion via a £13.5 billion rights issue and a £7.5 billion debt swap.

Lloyds will have to suffer a £2.5 billion fee to exit the APS scheme after initially agreeing to insure £260 billion worth of assets in March. The Government will take up its rights as a shareholder in Lloyds to participate in the planned capital raising, investing £5.7bn net of an underwriting fee.

Lloyds is seeking to exit the government scheme as it is likely the one-off cost for leaving the APS will be less of a burden on the balance sheet than the ongoing cost of the insurance for some years hence. It also appears that despite the weak UIK economy, the bank is not going to suffer a ‘doomsday’ volume of bad debts.

This will see the Government's shareholding in Lloyds remain at 43% and therefore maintain the return for the taxpayer when the Government's shares are eventually sold.

Lloyds Group disposals to meet the European Commission requirements would consist of the TSB, Cheltenham & Gloucester, Lloyds TSB Scotland, Intelligent Finance and a large number of branches in England.

Bonuses Squashed

In return for the additional taxpayer support, both LYG and RBS have committed not to pay discretionary cash bonuses in relation to 2009 performance to any staff earning above £39,000.

Executive members of both boards have also agreed to defer all bonuses payments due for 2009 until 2012, to ensure that their remuneration is better aligned with the long-term performance of their banks.

RBS and LYG Lending Commitments

Both banks will maintain their existing commitments to increase lending to businesses and homeowners by £39bn.

The Government’s View

The government’s official line on the latest intervention focuses on the tax-payers’ reduced APS exposure going forward rather than the immediate additional cost of injecting further cash into the sector.

Government suggestions that the tax-payer will enjoy “improved value for money” can only be proved retrospectively some years hence when the full extent of bad losses are known and booked against profits.

Due to the agreement’s complexity and the unknown extent of the bank’s possible losses in the years ahead, it is impossible to know if the banks are getting a great deal or if the government is purely squeezing them further to ensure the sector is viable, competitive and managed with better risk controls.

Despite the uncertainties ahead, the government has clearly conducted extensive due diligence on the banks since the original APS announcement and considering the imminence of the 2010 election, it is easy to imagine they have attempted to force a deal on LYG and RBS that will reflect positively on them in the weeks and months ahead as the press and tax-payers digest the consequences of the revised terms.

It also appears that the banks have had a weak negotiating position with pressure coming from the European Commission as well as domestically. Any efforts by RBS management to improve the terms would have been further undermined as the bank was already 70% owned by the tax-payer prior to the changes.

Impact on the Taxpayer

The Government estimated in the Budget that the impact of the financial sector interventions would be between £20-50bn and budgeted £50bn in the public finance projections. The Treasury expects, subject to wider factors, to revise these figures downwards in the Pre-Budget report, alongside the Government's fiscal and economic forecasts.

However, the purchase of shares would, all other factors being held constant, increase the central government net cash requirement (CGNCR) for 2009-10 by around £13 billion relative to that announced at Budget 2009.


Sir Winfried Bischoff, Chairman of Lloyds Banking Group, said: "These Proposals provide a significantly more attractive, market-based alternative to participating in GAPS and offer superior economic value to shareholders. We believe that this represents a significant step towards meeting our, and the Government's, objective that the Group operates as a wholly privately-owned, self supporting commercial enterprise."

RBS Chief Executive Stephen Hester says: "We are now more confident that we will be able to navigate the years ahead without recourse to claims under APS but the decision to participate is necessary to meet the FSA framework and will give us the stability we need to deliver our strategic plan."

City Minister Lord Myners said that RBS was "the worst managed major bank this country has ever seen” and that "RBS was not brought to its knees by bad regulation, but by bad management and bad governance.”

Vicky Redwood of Capital Economics says: "The latest round of public support for the banks highlights that the banking system is still a long way from standing on its own two feet. And until it starts to operate normally again, it is wishful thinking to expect the banks to start lending at decent growth rates."

"The amount of capital that the government has directly injected into RBS, Lloyds and Northern Rock (NHRKF.PK) now adds up to more than £70 billion. And we would not be surprised if the government has to inject even more capital into the banks over the next couple of years. As the IMF recently calculated, UK banks have still absorbed only 40% of their likely losses," Redwood added.


HM Treasury, Royal Bank of Scotland and Lloyds Group

Extracts have been taken from the HM Treasury, RBS and LLOY press releases of the 3rd November