Do Britain's banks have ub-prime skeletons hidden in the closet?

Britain's banks have not yet made the disastrous write-offs of sub-prime assets announced by their US rivals, but they can't delay disclosure of any losses much longer
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The Independent Online

HSBC will today kick off the most keenly awaited round of bank trading statements in years as investors seek reassurance that contagion from the US has not spelt disaster for Britain's biggest lenders.

HSBC was one of the first to alert the market to the looming crisis in the US sub-prime credit market when it issued its first ever profit warning last December. The bank's once-profitable foray into loans to risky customers had blown up as rocketing defaults caused bad debts to jump.

HSBC is expected to flag further write-downs from the sub-prime fallout today, but, unless there is a massive shock, investors will probably take the news in their stride. HSBC has stopped selling and trading US mortgage-backed securities and its shares have performed well through the credit crunch.

The main concerns for investors in recent weeks have been Barclays and Royal Bank of Scotland. These are the two British lenders whose corporate and investment banking arms have grown most strongly on the back of the debt boom of recent years.

Investors were already nervous about the exposure of Barclays and RBS to the crash in the debt markets before the recent wave of statements from US banks upping their credit-crunch write-downs. The huge increases forced the departures of two of the most powerful men on Wall Street – Citigroup chief executive Chuck Prince and his counterpart at Merrill Lynch, Stan O'Neal.

Things came to a head for Barclays at the end of last week as rumours swirled of a rights issue, a $10bn write-down, emergency Bank of England funding, and the resignations of John Varley, chief executive, and Bob Diamond, the head of investment banking.

Barclays said publicly on Friday there was "no substance" to any of the rumours. This would once have been an unusual step, but Barclays has been forced to reassure the market before during the credit crunch, notably when it was rumoured to have borrowed from the Bank of England in September.

Investors' fears have mounted, partly because of lack of information. Whereas US and European rivals such as Citigroup and UBS report their full results quarterly, Britain's financial giants publish theirs only twice a year, with the next results season not starting until February.

The market will have to make do with UK banks' trading statements, which will appear over the next month. Barclays is due to issue its trading statement on 27 November, with RBS following on 6 December. Despite demands from worried investors, neither bank shows any sign of bringing the statements forward.

Given the record of US banks that had to add massively to their early estimates, it may make sense for both Barclays and RBS to take their time and get the best possible information out to investors. Both are said to be aware of investors' desire for detailed information on top of the usual coded language of trading statements.

Concerns centre on three areas: the banks' capital positions, the scale of potential write-downs, and loss of revenue.

Sceptical analysts say that UK banks' capital positions are tighter than those of many lenders in the US and Europe because they have used their own cash to pay for acquisitions and have piled on assets in investment banking that have consumed capital. With less of a buffer to absorb shocks, pessimists say write-downs in the low billions might force the banks to raise capital.

Barclays is thought to be more exposed to write-downs on complex credit products such as structured investment vehicles (SIVs) and collateralised debt obligations (CDOs), both of which are at the heart of the market's fears about banks. SIVs issue short-term, cheap debt to invest in assets such as mortgage-backed securities and CDOs invest in different grades of debt. The bank's obligations to SIVs it set up for clients helped prompt rumours of a lack of liquidity, which Barclays has been forced to counter.

RBS's exposure to the US credit markets is mainly through RBS Greenwich Capital, a major player in the packaging and distribution of mortgage backed securities. At the bank's interim results in August, Johnny Cameron, the head of corporate and investment banking, flagged a 23 per cent drop in volumes from asset-backed securities (ABS) in the first half. This will no doubt hit revenue, but Mr Cameron also pointed out that ABS only account for 1.6 per cent of group income.

But RBS's capital position appears tight. Its core tier one capital ratio is 4.7 per cent but will drop to 4.25 per cent by the end of this year after paying its share of the ¿71bn price of ABN Amro of the Netherlands. That gets RBS close to the 4 per cent that is generally accepted as a minimum.

RBS has proved to be extremely cash generative in the past and could be expected to add a percentage point of internally generated capital to its ratio over the course of a year as it did after buying NatWest in 2000. But with so many uncertainties in terms of asset values and the outlook for revenue, the market has been scared.

There is further uncertainty surrounding RBS because, with its consortium partners, it has just bought ABN. RBS's main share of the acquisition is ABN's wholesale banking business. Investors are worried about ABN's exposure to credit markets and lack of recent disclosure about this risk.

RBS beat Barclays to buy ABN after a six-month battle. A big rights issue to shore up capital would put either bank's chief executive under pressure but would be particularly perilous for RBS's Sir Fred Goodwin after he drove through the ABN deal during the credit crunch.

While Barclays has been quite vocal in its own defence, RBS has remained typically tight-lipped since its August results about its exposure the credit crunch. Sir Fred refused to discuss current trading on a call last month to discuss the ABN deal.

Other analysts believe the market's fear is overdone. Antony Broadbent, an analyst at Bernstein, said last week that Barclays' likely write-down was £1.6bn and RBS's was £500m.

The credit crunch is not just about US sub-prime loans. The freezing of almost all credit markets on 9 August has left banks with leveraged loan assets on their balance sheets that they would previously have packaged up and sold off to investors. The drying up of these markets will significantly hit revenues at RBS and Barclays. Mr Broadbent calculated that the main threat of value reduction to both banks came from reduced profits as revenue drops at once buoyant businesses. RBS's likely profit hit this year is £3.5bn, while Barclays' is £3bn, he calculated.

After each losing almost one third of their value this year by the end of last week, both banks' shares performed well yesterday. Barclays' rose 2.7 per cent, adding to its 8.1 per cent gain the day before; RBS rose 4.1 per cent. Someone must think the sell-off is overdone. The news flow starts today, and in less than a month, we should know.

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