What if RBS and Lloyds get ING medicine?

October 28, 2009

(Corrects paragraph 9 to add words “aggressively” and “that are less capital intensive”, following company clarification of its position)

Steely Neelie is living up to her reputation. If the EU Competition Commissioner’s approach to bailed out banks in the Netherlands and Germany is any guide, the banks still negotiating should be bracing themselves.

In July, the Commission outlined its three guiding principles: that the banks be viable; that the costs of restructuring be borne by owners, not just taxpayers, and that competition not be distorted.

In practice, Kroes has imposed a swingeing 45 percent balance sheet reduction on ING, Commerzbank, and WestLB. Despite the consistent approach, shareholders have been shocked by the scale of the remedies demanded of ING on Monday. In addition to a demerger that analysts had long called for, ING has to sell the US arm of ING Direct and a big chunk of its domestic Dutch operations. It also has to pay a further 1.3 billion euros to the government to underwrite impaired American mortgage securities. The shares have plummeted by more than a fifth.A similar approach could have far-reaching consequences for those banks still awaiting approval, which include RBS and Lloyds Banking Group.

The two big British state-supported banks have adopted different approaches to their negotiations. RBS insists that it has already embarked on a “radical” restructuring that will see its balance sheet shrink by around 500 billion pounds from a peak of 1.2 trillion pounds, or almost 40 percent. By the end of the first half, it had already achieved more than half of this reduction.

Chief executive Stephen Hester has further acknowledged that the EU will want “its pound of flesh”. In particular, executives are bracing themselves for Kroes to insist that they reduce their operations in Britain’s notoriously uncompetitive small and medium-sized enterprise (SME) banking market.

As with ING, Kroes might also look at the government guarantee scheme. Analysts at Credit Suisse have speculated that she may want RBS to take more than the current first loss of 19.5 billion pounds.

With Lloyds, however, an ING-style remedy would spark an existential crisis.

Lloyds has not commented on the EU negotiations. But unlike RBS, it does not intend to shrink its balance sheet aggressively. While it plans to get out of certain business lines, it wants to replace them with others that are less capital intensive.

If Kroes does impose a 45 percent cut in assets, virtually the only way to achieve this would be to unwind last year’s takeover of HBOS, the failing mortgage bank, which created the UK’s biggest retail bank by some distance: the old Lloyds TSB business accounted for just under 40 percent of assets at the end of last year. Reversing the deal is almost unthinkable for Lloyds’ management and its shareholders, who are counting on annual cost savings of 1.5 billion pounds to boost profits. It is also hard to contemplate for the British government, which is a 43.5 percent shareholder in the bank and waived competition rules to allow the deal.

Lloyds is attempting to reduce its participation in the government guarantee scheme, which may allow it to argue for more lenient treatment.

Kroes is expected to retire once the term of the current Commission, which may be extended until the year-end, expires. It may be that Lloyds is trying to stall until “steely Neelie” is gone. However, the competition directorate has a history of playing hard-ball. And as the Dutch commissioner has shown in her handling of the government’s sale of ABN Amro’s Dutch
business to Deutsche Bank, Neelie can be especially tough if she thinks the banks are trying to game the system.

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