The idea that bank capital regulations will be a ‘game changer’ for the sector is gathering momentum.
Last week, we heard that Barclays might need to find an extra £17bn under Basel III and that Lloyds Banking Group and HSBC might see their equity Tier 1 capital reduced to 4.4 per cent and 6 per cent respectively.
Continuing that theme, the new banking team at Barclays Capital have been crunching the numbers on Lloyds and their conclusion is that Basell III could reduce 2013 Tier 1 capital by £18bn.
But that’s not all. Even ignoring a number of the new capital and liquidity proposals it finds Lloyds could still be facing a capital deficit of £3.6bn by 2013.
Here are the workings of BarCap’s Tom Rayner:
(Note: BarCap are working from the assumption that the Basel III regime will be based on a Core Tier 1 ratio of 8 per cent and not the frequently discussed 10 per cent).
As you can see from the above, it is Lloyds’ life business — Scottish Widows — that is most vulnerable to the proposed regulatory changes. This is due to the double counting of capital Lloyds has in its financial subsidiaries, on the bank’s balance sheet.
Now, Rayner makes couple of observations here.
He says that Lloyds’ CoCo bonds, or Contingent Convertibles, won’t be able to plug the gap:
Although conversion of LBG’s £7.5bn recently issued Enhanced Capital Notes (ECNs) would be more than sufficient to eliminate our estimated £3.6bn base case deficit, we believe that this is unlikely for two reasons. Firstly, the Exchange Offer documentation4 defines core Tier 1 capital as communicated to the industry by the FSA on 1st May 20095 and as a result does not appear subject to future regulatory change, although any modification to the calculation of RWAs would affect the ratio.Secondly, while there is a risk that a weaker than anticipated operating environment further depletes capital, our more conservative estimate of Basel III impacts leaves LBG with a 5.6% core Tier 1 ratio, above the 5% trigger level
And that Lloyds should consider the sale Scottish Widows:
With UK life assurers currently trading at a 25% discount to embedded value, we estimate selling the life assurance business would result in a c£2bn loss. Figure 30 [table below] shows that notwithstanding this loss, selling the life assurance business would benefit the capital position by 230bp on our estimates, which appears sufficient to close the deficit. However, it is unclear to us at this stage what price might be achievable, particularly given the reduced attractiveness of these assets to other banks. With very few potential buyers, LBG could either be forced to sell at a lower price or only sell the more attractive parts of the business.
As Rayner notes, selling Widows will be easier said than done, but it is something Lloyds boss Eric Daniels will have to consider, especially if the economic recovery falters.
Overall, Rayner reckons Lloyds will struggle to deliver more than a 14 per cent return on equity over the cycle, which is pretty much where the shares are priced at the moment. And this drives his ‘underweight’ rating and 12-month target price of 53p.
In early trading on Monday, shares in Lloyds were slightly higher — although lagging most of its peers.