Lloyds warns investors of risk from EU state aid rules

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Lloyds Banking Group's £4bn capital-raising started yesterday, with a warning to investors that European state aid rules could forcibly break up the company.

The bank hopes to use the Government's Asset Protection Scheme (APS) to insure itself against unmanageable losses. But the plan must be signed off in Brussels, and could force divestments.

A "Forward Plan" detailing how Lloyds will free itself of government investment and continue as a stable business is to be submitted, in partnership with the Treasury, to the European Commission in July. A ruling is expected in early 2010.

The expectation is that no radical re-shaping will be required. But it is possible, Lloyds acknowledged in yesterday's investor prospectus. It says: "The terms are likely to include the obligation to reduce significantly the size of the group's balance sheet... The group expects such reduction to be achieved through making divestments of or exiting non-core businesses. However, a reduction could require the group to divest or exit core businesses."

The capital raising now under way aims to raise £4bn to buy back preference shares issued as part of the Government bailout in January. If fully successful, the taxpayers' stake in the institution will remain at 43.4 per cent. In the worst case scenario, it will rise to 65 per cent.

The most obvious benefit of buying out the preference shares is to avoid the £480m annual interest bill. But the plan would also avoid the shares being converted, which is what the Government wants as part of the negotiations under the APS. If all goes according to plan, the money will not only represent the first major repayment of the taxpayer bailout, but will also improve Lloyds' tier one capital ratio by 80 basis points to about 6.7 per cent.