Lloyds’ great escape still a stretch

October 8, 2009

Lloyds Banking Group has adopted the motto of Robert the Bruce. Having not at first succeeded to escape from the British government’s insurance scheme for bad assets, it is trying again. To achieve its goal, the British bank would probably need to raise in the region of 25 billion pounds through share issues and asset sales. Given the complexities involved, that looks a stretch.

Nobody can blame Lloyds for trying. Raising the cash would allow it to opt out of a deal to inject 260 billion pounds — a quarter of its balance sheet — into the government’s asset protection scheme (GAPS). This would strengthen its hand with the European Commission, which is demanding under state aid rules that in return for its participation in GAPS, Lloyds should sell large chunks of its retail bank.

If Lloyds can escape more or less intact, it will keep keep a greater share of the benefits of its merger with HBOS, which will create a superbank with more than 30 percent of Britain’s current accounts and mortgages. Reduced government involvement would also bring down its funding costs. Analysts at Execution reckon this alone could boost Lloyds’ profits by as much as 64 percent by 2011.

However, raising the cash would not be straightforward. A 15 billion pound rights issue would represent more than half Lloyds’ current market value, and would be the largest ever offering attempted in the United Kingdom. It would probably also require the government, which owns 43.5 percent of Lloyds, to inject an additional 6.5 billion pounds into the bank. This might be a reasonable trade for taxpayers, as they would no longer be required to finance losses on Lloyds’ bad loans. But it would require the government to come up with the cash now, rather than after the next election. Stuffing yet more cash into the banking sector would be a tough sell politically.

Even if these hurdles can be overcome, Lloyds would still need to find another 10 billion pounds. One option would be to sell Scottish Widows, its life insurance business, but the price would have to be sufficiently high to provide a boost the bank’s capital. Even then, there would still be a gap. Lloyds could experiment by issuing contingent capital: preference shares that convert into ordinary equity if the bank runs into trouble. But these instruments currently only exist in theory so it is hard to see Lloyds issuing them in large quantities.

Ultimately, Lloyds needs to be prepared for the possibility that the economy slips back into recession. It is hard to see how it can do that without relying on the GAPS to some extent. This may not be particularly good news for shareholders — or, indeed, for taxpayers. But minimising risks to the financial system should be the first priority.

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