Jeremy Warner: De-risking of RBS is the major challenge for the new CEO

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The Independent Online

Outlook Few new brooms face as much of a clean-up challenge as Stephen Hester at Royal Bank of Scotland. Yet it is not so much of a long hard slog that the former British Land boss has to look forward to as a gruelling regime of extreme weight loss. Like Lloyds TSB, RBS hopes to achieve early repayment of the Government's preference capital, so that it can resume dividend payments some time in 2010.

There are only two ways to do this. Either RBS must find private investors prepared to refinance the preference stock, or it must "de-risk" its balance sheet in a way that persuades the Financial Services Authority that it is safe for RBS to redeem the Government's preference capital.

As Barclays has discovered to its cost, in these markets it is proving virtually impossible to find outside investors to provide capital on reasonable terms. Assuming the banking crisis eases, it may be easier in a year or two, but Mr Hester cannot bank on it.

A potentially better way of achieving the same result is simply to shrink the balance sheet so that it requires less capital. This can be engineered either by selling assets, or putting them into run-off, but in any case is easier said than done. RBS already faces a huge deleveraging process regardless of the ambition to shrink the capital base.

Mr Hester doesn't yet know quite how big – that judgement must await the outcome of the strategic review – but he concedes that RBS's ratio of assets to capital is going to have to fall to somewhere close to US standards, and then some depending on what is agreed internationally as the new benchmark. Whatever it is, it will be considerably lower than the extreme multiples the RBS balance sheet swelled to after the acquisition of ABN Amro.

The only assets so far earmarked for disposal are the insurance interests, and there is in any case quite limited scope for "deleveraging" in the UK retail bank, as RBS has agreed with the Government as part of the recapitalisation programme to keep small business and mortgage lending at pre-bust levels. That leaves the global markets business, Citizens in the US, and the stake in Bank of China. All these businesses look ripe either for severe downsizing or outright sale.

In the meantime, rising bad debt experience in the real economy, coming on top of the roughly £8bn of writedowns RBS is likely to incur as a result of the meltdown in financial markets, will almost certainly push the bank into overall loss for the year as a whole. Not even in the early 1990s, when RBS was also virtually bust, did it face humiliation as deep as this.

Next year, the losses from asset-backed securities will presumably fall significantly or even disappear entirely, but in their place will come plain vanilla recessionary writedowns to match. Whichever way you cut it, Mr Hester faces a grim couple of years. Undoing all the expansionary handiwork of his predecessor, Sir Fred Goodwin, will be expensive and it will take time.

As for the Government, which is likely to end up as a near-60 per cent shareholder in RBS, you have to wonder whether it has fully thought through the politics of these gigantic recapitalisations. Both the affected banks and ministers insist the Government will act as no more than an ordinary commercial shareholder beyond the relatively loose conditions and credit allocation already announced.

To underpin the assertion of an arms-length arrangement, a separate company has been set up under Sir Philip Hampton and John Kingman to hold the share stakes. Ministers are no doubt sincere in what they say, but it remains to be seen how they will behave once the recession really begins to bite, and complaints from MPs and constituents flood in about supposedly unfair lending decisions. What is the point in having a controlling stake in a bank, some politicians will ask, if you cannot get it to do what you want.

Mr Hester therefore faces a double challenge. He is required both to shrink the bank so as to resume dividends and to expand it at the same time so as to meet the Government's reflationary objectives. It will be interesting to see how he manages to square the circle between these self-evidently conflicting priorities.