Bankers rush to raise capital

Merrill Lynch is the latest American bank to go to the sovereign wealth funds of the Far East for finance. Will the UK banks be forced to follow suit?

This week's $5bn (2.5bn) injection into Merrill Lynch from Temasek Holdings was just the latest bail-out by Asian and Middle East investors as the credit crunch forces the giants of Wall Street to replenish their capital positions.

Including Switzerland's UBS, stakes taken by state investment funds in investment banks in the past month have hit nearly $30bn and still fears persist. Goldman Sachs analysts said on Wednesday that Citigroup might have to cut its dividend even after its $7.5bn capital injection from Abu Dhabi.

The capital infusions into names such as Merrill Lynch and Morgan Stanley demonstrate the parlous state some of the world's most prestigious banks have got themselves into after feasting on a debt boom that blew up in their faces. The injections also highlight the huge wall of money estimated at more than $2trn waiting in Asia and the Middle East to be invested in Western companies.

So far, Britain's banks have remained aloof from the capital-raising binge, but some investors and analysts are concerned that a combination of further write-downs and reduced profit generation could leave some UK lenders' capital reserves depleted.

Banks hold capital as a buffer to protect depositors against losing their savings if bad debts rise. Under international rules, lenders are required to hold a certain percentage of their risk-weighted assets (loans) as cash or items that can be readily turned into cash. Capital is divided into tier one (which is mostly shareholders' equity) and tier two (which is mainly long-term debt).

The Bank of England has reassured the markets that the high profits of recent years have left the UK's banks well capitalised with diversified businesses that set them up to withstand the fallout from the credit crunch. Banks such as Bradford & Bingley, Alliance & Leicester and, to a lesser extent, HBOS could face funding strain but are considered well capitalised. HSBC, LloydsTSB and Standard Chartered are widely seen as secure. The main concerns are Royal Bank of Scotland and Barclays, the two UK banks with the biggest relative exposure to sub-prime mortgages, leveraged finance and other activities hit by the crisis. The fears centre on write-downs caused by plunging values of debt products; potential obligations to support their conduit funds and investment vehicles set up for clients; and a severe slowdown in income growth, which would hamper their ability to rebuild capital.

RBS has borne the brunt of capital concerns. Britain's second-biggest bank's shares languished throughout the autumn as rumours spread about its exposure to US sub-prime mortgages and massive write-downs.

There is no doubt that RBS's capital position is tight following its acquisition of ABN Amro's wholesale and Asian operations: Citi analysts estimate that the bank's ratio of tangible equity to assets is the lowest in Europe.

This is not new territory for RBS, which has regularly stretched its capital ratios after acquisitions. When its core tier one ratio dipped below four per cent after the acquisition of NatWest in 2000 negative analysts pointed to the bank's precarious capital position. But RBS used its massive cash generation to rebuild its ratios quickly. The difference this time is that RBS is trying to rebuild its ratios in the most difficult and unpredictable markets most bankers can remember.

The bank responded to fears with a strong trading statement on 6 December that announced a net 1.25bn of credit-crunch write-downs far less than the market had feared. RBS's chief executive, Sir Fred Goodwin, said he expected the bank to be comfortably within its target ranges for tier one and total capital. He added that the dividend, which could be threatened by a capital shortfall, was "business as usual".

But concerns have remained. Some analysts expect further write-downs as the credit crunch continues to play out over the first half of next year. They also point out that the end of the debt boom will hamper growth at RBS's global markets business, which has been one of the main drivers of the bank's profits in recent years.

Citigroup analysts said. "We believe that the highly leveraged balance sheet of RBS is a key factor in preventing a sustained re-rating of the stock."

Analysts at Cazenove went further two weeks ago, suggesting that RBS could need a 5.8bn rights issue in the new year. They added that RBS has "little room for manoeuvre if activity levels in capital markets fall below its own expectations in 2008".

But others say something on this scale would be unthinkable because Sir Fred would know that he would be forced to resign if he sprang a massive rights issue on investors after reassuring them the capital position was fine.

Barclays also faced concerns before it gave estimates for its write-downs in a November trading statement. Britain's third-biggest bank is exposed to the credit crunch through Barclays Capital, its debt-focused investment bank, which has added assets at a rapid pace in recent years and was heavily involved in creating exotic structured investment vehicles.

"Our ratios are comfortable ... we are strong," said Mr Varley, when asked about the bank's capital position in November.

Barclays already has a sovereign wealth investor in the shape of Temasek, which bought a 2.1 per cent stake to support Barclays' attempt to buy ABN. It could easily get a further boost from China Development Bank, which bought a stake at the same time.

Opinions differ over the two banks' capital positions over the next year. While Cazenove predicts a career-threatening rights issue from Sir Fred, others believe RBS's cash generation will hold up. If RBS and Barclays face further write-downs, they will try to take the losses through their income statements. This would reduce profitability but avoid the disruption and possible embarrassment of a big capital raising. Other options include selling off non-core assets and investments. RBS has flagged up about 1.3bn of sales for 2007, including Thames Water, which more than offset its write-downs so far. Other disposals are on the cards such as Angel Trains, the train-leasing company that could fetch 4bn.

An advantage Britain's banks have over the banks that have sought injections so far is their greater diversity of earnings. The Wall Street investment banks are heavily dependent on the capital markets. UBS had to act to protect its core private banking business from a credit rating downgrade. RBS and Barclays have other businesses such as fund management, retail banking and insurance that give them a steady earnings stream that could be looked on favourably by ratings agencies and regulators.

Still, one analyst puts the chances of a UK bank getting a capital-boosting sovereign wealth injection at about 50:50. If things get rough, that wall of money could prove very tempting.