The biggest insurance policy in history

The £500bn scheme to insure banks' toxic assets sets another bailout record. Sean Farrell reports

Tomorrow will see the announcement of the most important part yet of the Government's patchwork of bank support measures: a £500bn insurance scheme against future losses.

Bankers, Treasury officials and their advisers are working furiously to agree rough terms for taking part in the new scheme. The announcement is set to coincide with Royal Bank of Scotland's results, with Lloyds Banking Group to follow on Friday.

The asset protection scheme (APS) was announced last month in the Government's second banking bailout and was greeted as the biggest step yet in the authorities' attempts to restore confidence to the banking system. It will take the guarantees, investments and other support announced to prop up the banks to more than £1 trillion.

But uncertainty about the plan's details and the Government's intentions, heightened by fears this week over US bank nationalisations, have sparked concerns for investors.

Under the plan, the Government will guarantee banks against losses from existing loans and toxic investments on their balance sheets, providing the banks with a limit on the losses they will suffer as the economy worsens.

But even though the banks are keen on the idea, there are several major sticking points that will probably keep all sides working until the early hours of Friday.

The first bone of contention is how much risk they will be left with. The Government wants the banks to keep responsibility for all of the first 10 per cent of any losses and then a portion of the next 10 per cent to encourage them to keep losses to a minimum. The banks naturally want the Government to take on more of the risk.

Though the APS would theoretically leave the Government on the hook for massive potential losses, the likelihood of defaults cutting into the state-guaranteed chunk is small. Many bank assets are "toxic" because there is no price for them in shattered markets rather than because they are racking up big defaults. The Government, which is charging a fee, could even make a profit.

Like all the Government's support measures, the APS does not come for free. The Government's fee is expected to be between 3 per cent and 4 per cent of the value of the assets that are insured. So if RBS puts £200bn of assets into the scheme at 4 per cent, it would have to pay £8bn.

Bank shares have been volatile recently on concerns about whether the details of the APS would threaten nationalisation of any of the banks. In particular, there were fears that the Government's fee could reduce capital ratios and weaken the banks. But that fee is likely to be spread over up to five years – the expected life of the guarantees – limiting the short-term cost. Analysts say the most important point for the banks is that, by taking on some of the risk of loss, the Government's plan will immediately reduce the risk-weighted assets on their balance sheets, strengthening their capital ratios (capital as a percentage of risk-weighted assets).

"We continue to believe that the details of the asset protection scheme will be instrumental in determining whether the sector stays in the private sector," Credit Suisse analysts say. They add that a higher fee should be a good thing because it means a bigger reduction in risk-weighted assets, boosting banks' strength at the bottom of the cycle. A further bone of contention is how the fee is paid. On the day of the announcement, the Government said it expected to be paid in "alternative capital instruments" rather than ordinary shares. The securities are expected to be similar to preference shares, paying a rate of interest but not giving the Government extra voting rights. RBS is already set to be 70 per cent owned by the Government and would not want to dilute its shareholders' interests further. Lloyds is desperate not to allow the state's stake – already 43 per cent – to become a majority holding.

Even without voting rights, the new securities issued to the Government could disadvantage existing investors. The analysts at Credit Suisse say it is essential that the terms of the new shares are clarified as soon as possible. The scheme is aimed mainly at getting the banks lending to support the economy. With the conditions worsening sharply, banks expect big losses on loans and potentially even further writedowns on illiquid securities on their balance sheets. They have therefore tended to hoard capital against future losses rather than lend it to struggling British businesses and consumers. The APS has replaced the Government's earlier intention to form a "bad bank", which would have let lenders get the loans and toxic assets off their balance sheets completely by selling them to the Government. That plan found-ered because it was too difficult to put a value on the assets but some observers argue the APS faces similar problems.

"I think it is going to be a fudge; it's hard for the numbers to stack up. If you want to make it market-based you are going to bankrupt the banks," an investment banker not involved in the scheme said. "But they are not going to do that so [the APS] will be a fudge."

The APS comes with strings attached, including a requirement for the banks to open up their books to the Government and come clean about the risk on their balance sheets. Participating banks will also have to pledge extra lending to UK mortgage holders and small and medium businesses, and could be required to make concessions on how their bankers are paid. RBS became the guinea pig for the APS when it predicted a £28bn loss for 2008 but Lloyds has since shocked the market with bigger-than-expected forecast losses, increasing the urgency for it to reassure the markets.

Though they are protesting over details, RBS and Lloyds have little choice but to take part. The big question hangs over Barclays, which turned down Government capital in October to keep control over lending and pay. The bank has also treated some assets differently from rivals, particularly leveraged loans which it is holding to maturity instead of marking to the market price.

Barclays had indicated that it intended to pay cash if it took part in the APS to avoid the Government holding a stake in the bank but investment bankers are increasingly doubtful that Barclays will take part in the scheme at all.

This week's announcements will clear up a lot of uncertainty but no one should expect the scheme to start quickly. The Government and its advisers will still have to pore over the banks' books and agree which assets are going to go in. If it does not work and losses batter the banks, then nationalisation could prove to be the only option.