At dawn, the banks were back from the brink

The newspaper headlines were all about the nationalisation of Britain's banks. But during the all-night talks to finalise last week's £500bn bailout, the idea of the state owning a stake in a swathe of banks was quietly dropped.

Instead of buying ordinary shares, the Treasury proposed to recapitalise troubled lenders by subscribing for preference shares. "Prefs" count as capital, but are more akin to loans. They will pay a flat interest rate to the Government but there are no votes, no seat in the boardroom and, under the plan thrashed out early on Wednesday, there will be no gain for the taxpayer when the valuations of the banks recover.

Related articles

• Council salaries hit by bank collapses
• Carnage: Seven days that shook the world
• Is Gordon Brown cashing in on the markets crisis?
• Goodwin offers to resign to enable RBS to attract £10bn
• A £516 trillion derivatives 'time-bomb'
• Welcome to Iceland: Despite the crunch, it's still worth a visit
• Tim Lott: Don't blame all this on the greedy City types
• John Rentoul: The week Gordon met his ERM
• Nicholas Foulkes: The names have changed, but it feels like Britain in the Seventies all over again
• Alan Watkins: Brown's control of the crisis is illusory
• A 'Green New Deal' can save the world's economy, says UN
• Treasury: we are ready to take majority stakes in failing banks
• Which over-inflated market will be hit next?
• Walker drops Woolworths to buys bits of Iceland
• Lawyers head to Iceland to get cash back
• £1bn of private-equity deals put back as debt market freezes over
• Economic View: What will it take for the markets to see we have the weapons to resist disaster?
• Margareta Pagano: These bankers don't deserve to keep their jobs
• Credit insurance claims surge as companies suffer
• Friends Provident waits in wings for HBOS stake in St James's
• Rugby Estates reveals £100m equity plans to shareholders
• If we don't get our house in order, the bailout will backfire
• How much lower can we sink? Fund managers see a glimmer of hope
• Peston finds his voice and now the City's ears are burning
• Are customers now off the danger list if a UK bank goes to the wall?
• When credit is a dirty word, the debt must go
• It's back to the future as savers become the chosen ones
• Crunch point in charges saga
• The homes that the credit crunch can't blow down
• Julian Knight: Our watchdog can’t see straight for looking two ways at once
• Up is down: The credit crunch quiz
• Search the news archive for more stories

Despite the speculation, no mention was made of warrants or convertible stock that would have given the state an equity interest.

Although the Treasury has stated that it is "willing to assist in the raising of ordinary equity if requested to do so" – possibly through underwriting rights issues – even the banks involved regard that as a last resort which they hope never to use.

The chief executive of the British Bankers' Association (BBA), Angela Knight, admits: "This is not a nationalisation policy."

The Treasury meeting, attended by new City minister Paul Myners and Cabinet Office minister Baroness Vadera with veteran Cazenove adviser David Mayhew, was the second held on consecutive nights between Chancellor Alistair Darling and leaders of Britain's big banks. But almost immediately after it concluded, three of the eight banks involved – Abbey, Standard Chartered and HSBC – said they would have no call on the government package. Others will try to raise capital from the private sector before turning to the Government for help.

One reason for the Treasury's decision to turn to preference shares rather than equity was to avoid a row over pre-emption – the convention that requires new shares to be offered to existing investors first.

The Government could not risk the conflict in demanding that the banks raise capital, and then subscribing for the new shares at below-market value. Nor did it want to be accused of buying at low prices when it was the leak of its recapitalisation plan that caused prices to crash last week.

Further, one condition of a bank accepting new capital from the Government is that dividends must be cut or constrained, and that would affect the yield received by the state if it bought ordinary shares. The income the Treasury received would be less than the cost of the money it injected.

So instead, while existing investors will see their dividends reduced, the Treasury will receive a coupon – possibly more than 10 per cent – on any preference shares it buys, thus avoiding leaving taxpayers with a loss.

Also, if a bank collapses, prefs rank ahead of ordinary shares, which would almost certainly be worthless. Thomas Huertas, banking sector director at City regulator the Financial Services Authority (FSA), says: "With prefs, the risk to the taxpayer is much lower."

As a building society, Nationwide – another of the eight included in the bailout plan – cannot offer ordinary shares and would thus issue permanent interest-bearing shares (Pibs), which are the equivalent of prefs.

The preference shares would boost banks' capital, but as the lenders rebuild their reserves – through profits or a subsequent recapitalisation – they could be redeemed, so ending the banks' obligations to the Government. Although nothing was said at the meeting that started on Tuesday evening and lasted until 5am on Wednesday – with the participants fortified by takeaway curries – the Government could seek redemption terms that allow it to benefit from the banks' recovery.

"The Government envisages the terms of the prefs will be that they would return a considerable benefit to the taxpayer," says Mr Huertas. "When they are redeemed, there would be a good return to the taxpayer."

But the terms will be negotiated with individual banks – and banks will weigh up whether it will be easier to raise capital elsewhere.

Capital is still available from City investors for some banks. Last month Lloyds TSB raised £767m by selling new shares, while Barclays, which sold £4.5bn of equity to investors from China and Qatar this summer, sold another £701m of shares last month. HSBC refinanced its British subsidiary after last week's Treasury announcement by injecting £750m of capital from the parent.

However, banks are unlikely to try a conventional rights issue to existing investors. Three have done so this year, but Bradford & Bingley's £400m issue had to be restructured twice and was still shunned by almost all shareholders. After its shares continued to fall, the mortgage bank was nationalised last month.

More than 90 per cent of July's £4bn rights issue from HBOS, the Halifax and Bank of Scotland group, was also left with underwriters, who were forced to buy shares at 275p; these were trading as low as 93p last week.

Royal Bank of Scotland (RBS) successfully raised £12bn in a rights issue, but the shares sold at 200p were trading at the same 90p level prior to the Treasury bailout.

Despite the Government's offer to assist in raising ordinary equity, ministers could not risk such losses.

Nor could the banks risk attempting a new equity rights issue, say City analysts, even though the eight lenders told the Government they will raise £25bn of capital by the end of the year.

The deadline was set so the extra capital covers the substantial writedowns the banks will have to make on their 31 December balance sheets. The targets for individual banks will be agreed with the FSA this week, but the Government is ready to provide an extra £25bn capital if necessary.

Stockbrokers estimate that HBOS alone needs to raise in excess of £5bn – more than its stock market value prior to the bailout agreement. If the state had subscribed that amount in ordinary shares, it would have gained majority control of the bank.

RBS is estimated to need more than £7bn of new capital – equivalent to half its market value at last week's lowest point. Barclays requires a similar sum. Lloyds TSB, which is planning a rescue takeover of HBOS, needs to raise more than £5bn too and must decide whether to leave HBOS to find its own capital prior to a bid, or use its stronger balance sheet to effect a combined recapitalisation.

Lloyds can probably find further funding without resort to the government scheme, but if HBOS seeks state help, it will have to make pledges to the Treasury over dividends and executive pay as well as on lending – commitments that might therefore apply to its new owner.

Ms Knight at the BBA says banks have reluctantly accepted the constraints on pay and other matters that the Government will impose. "There is a minimum quid pro quo if you are offered a government package of this sort. We would not want to be in this position in the first place, but there has to be a bargain struck."

The Treasury is expected to allow banks to pay dividends in shares rather than cash because it affects neither their capital nor their liquidity. Mr Huertas defends the constraint on conventional payments, saying: "It cannot be in the interests of an investor to provide a large amount of capital and see it paid out in dividends to prior shareholders.

"They [ministers] are not only assessing the political terms but ensuring a sound basis in commercial terms."

Labour MPs cheered Gordon Brown's defence of the package in Parliament last week, but in truth the Treasury is not expecting to become a major equity owner of Britain's banks. Holding preference shares is little different from the loan facilities made available except that the cash counts as capital for the banks but, despite the headlines, without nationalising them.