Darling & Kroes: Our banks’ future in their hands

The Chancellor and the fearsome European business ‘referee’ lay down the banking law.

Alistair Darling discovered last week the cost of reducing his investment in Britain’s troubled banks. It means the Chancellor must increase his investment first.

Northern Rock received the go-ahead to divide itself into a “good bank” and a “bad bank” – the first step to its privatisation – but only after Mr Darling injects another £3bn of working capital, and lends it another £8bn. This week, Lloyds Banking Group will announce a rights issue to raise around £13bn, but, as its biggest shareholder, the Treasury will subscribe almost £6bn of that.

Also this week, the Treasury will raise its stake in Royal Bank of Scotland in return for insuring its bad debts. It will increase its holding from 70 to 84 per cent by subscribing for £6bn of new shares, though it has agreed to limit its interest to a nominal 75 per cent until enough of the new shares are eventually sold.

Royal will also disclose the businesses it must sell because it is getting this state aid. It will seek a buyer for the 312 branches in England and Wales that trade as RBS, plus six Scottish NatWest branches. And back on the auction block could be the First Direct and Churchill insurance arms RBS tried to sell last year for £3bn, plus its Citizens banking business in America. Negotiations are still taking place with Neelie Kroes, the European Competition Commissioner who last week came close to scuppering Lloyds’ capital raising with fears she would impose draconian conditions on UK banks rescued by the Government.

She shocked investors by ordering ING to sell its insurance business, worth more than £10bn and halving the size of the Dutch group, because it accepted state loans and guarantees after the credit crunch, even though its government is not a shareholder. Mrs Kroes, who is Dutch, is known for tough penalties. “My job is about acting as referee,” she says. “If we think of the European economy as a football match, I set and enforce the rules of the game. We make sure it is a fair match and that there is punishment for people and companies that break the rules and spoil the game for others.”

She has already forced Commerzbank, now 25 per cent owned by the German government, to halve its balance sheet, and has demanded disposals by Fortis, the state-rescued Belgian bank. ING’s shares tumbled on last week’s decision and the UK banks’ followed. Lloyds’ shares fell by a sixth, cutting estimates of its rights-issue price and so increasing the number of shares it must offer. Some thought raising 60 per cent of its existing value impossible, but the shares recovered partly when it emerged Mrs Kroes is seeking only limited disposals and restraints from Lloyds. It will sell its Cheltenham & Gloucester chain, plus about 200 Scottish branches and the online Intelligent Finance bank. Its share of the current-account market, which rose to 30 per cent when Lloyds took over HBoS a year ago, must be cut to 25 per cent.

More radical cuts would have destroyed the raison d’être for the merger, leaving Lloyds with HBoS’s bad loans but denying it gains from creating a bank that will still have a third of the market for mortgages and small-business banking. Lloyds believes it can still generate £1.5bn of synergies.

The bad debts inherited from HBoS are forcing Lloyds to raise the new capital. It agreed in March to insure £260bn of loans with the Government’s asset-protection scheme, but the premium was £16bn, to be paid by issuing new shares that would lift the Treasury’s stake from 43 to 62 per cent. Chief executive Eric Daniels has battled to avoid joining RBS as a government subsidiary, but, to satisfy regulators, he must inject up to £25bn into his balance sheet. Besides the rights issue, £7bn will be created by turning debt into equity.

Royal Bank faces only a £6.5bn fee for joining the asset-protection scheme but it, too, has been renegotiating its deal. This week it is expected to say the original £325bn of loans to be covered will be cut by about £50bn, but the Treasury will still increase its stake in the bank. Instead of a lower fee, Royal may regain some of the £10bn of tax reliefs against past losses it previously agreed to forfeit. Third-quarter trading figures due next week are expected to show further losses, but when Royal returns to profit it will pay less tax.

Mr Darling is expected to give his formal approval for Lloyds’ rights issue this week but he is aware the offer affects his own plans to sell Lloyds shares. This will be Lloyds’ fourth capital raising since the summer of last year, including the offer following the HBoS deal that resulted in the Government becoming its major shareholder.

For UKFI, the agency holding the state’s £60bn bank investment, Lloyds’ massive offer adds shares to a market that will be flooded by sales in coming years.

UKFI also owns the loan book of Bradford & Bingley – awaiting a ruling from Mrs Kroes too – but has been unable to sell it because of tight credit markets and its poor quality. So, short-term, it will concentrate on realising its investment in Rock, a sale made easier by Mrs Kroes last week. She agreed the creation of a new Northern Rock that will hold the branches, £20bn of retail deposits and £10bn of safer mortgages while the existing firm retains £55bn of the riskier loans, including unsecured lending, and accepts no new business.

She calls them “good bank” and “bad bank”, but Rock’s chief executive, Gary Hoffman, who will run both, objects because 90 per cent of mortgages are not in arrears. “So this company would not be accurately described as a ‘bad’ bank,” he protests.The existing Rock will be wound down while the new firm should be ready for privatisation next year, but probably not before the general election.

However, the ongoing Rock will be shackled by Mrs Kroes. She has ordered it to limit lending to £4bn this year, £9bn next year and £8bn in 2011 – half its past annual business. The Rock, which once had assets exceeding £100bn, must also limit retail savings to £20bn until 2012 and its mortgage rates cannot be among the market’s top three. Nor can Mr Hoffman promote the government guarantee that makes Rock savings safer than those at its rivals.

UKFI will ignore calls to remutualise the former building society because that recovers no cash. So who will buy Rock and the bits Lloyds and RBS are forced to sell? Although Tesco and Virgin Money are often mooted, the supermarket group does not need a branch network and Virgin will not overpay for one. ING Direct showed how a big British bank can be built from scratch without branches. And buying existing loan books requires a bidder with deep pockets and capital backing.

Few foreign banks have the resources or inclination to become a small player in a market that, despite Mrs Kroes, will still be dominated by the Big Four.