􀀗 With the immediate nationalisation
threat removed, the risk/reward ratio
looks significantly better
􀀗 We have reduced our target prices for
Barclays to 110p (from 170p) and Lloyds
to 90p (from 130p) and raised RBS to
35p (from 15p)
􀀗 Most importantly, we upgrade RBS to
Overweight (V) from Neutral (V);
Barclays and Lloyds remain Neutral (V)
Measures announced recently by HM Treasury and the FSA
confirm that the government does not want to fully nationalise
UK banks. In these circumstances, the only situations where
nationalisation could occur would be if there is a run on the
banks or they run out of regulatory capital.
How likely is the latter scenario? Here a critical element is
the FSA’s decision to view recent recapitalisations not as a
shift to permanently higher capital adequacy, but as a buffer
that can be allowed to erode through recession.
We estimate that provided equity tier 1 is allowed to decline
to 5% over the next three years, then even with impairments
at 300bp, Lloyds and RBS should still be able to afford high
single-digit WRA growth.
There is, of course, additional risk to this outcome from
continued write-downs on credit assets, but the proposed
Asset Protection scheme could put a cap on the downside.
The decline in industry profitability is cyclical rather than
structural. Pre-impairments, the industry generates operating
returns on risk assets of 200-250bp. Impairments will be
unpredictable over the next few years but mean reversion
should eventually take them back to 50bp, leaving the
industry with 20% plus returns on our estimates.

Summary
􀀗 Measures announced by HM Treasury and the FSA confirm that
the government does not want to fully nationalise UK banks
􀀗 In past recessions the industry has controlled its capital position
by unwinding lending. Now the authorities have blocked this
mechanism but the quid pro quo is the Asset Protection scheme,
which will transfer credit risk to HM Treasury
􀀗 The decline in industry profitability is cyclical rather than structural.
Pre-impairments, the industry generates operating returns on risk
assets of 200-250bp. Impairments will be totally unpredictable
over the next few years but should eventually mean revert, leaving
the industry with 20% plus returns

Nationalisation risk
Under what circumstances could the remaining
UK banks be nationalised? We identify three
scenarios:
􀀗 A run on deposits involving either retail or
wholesale depositors
􀀗 Fulfilling the banks’ public policy objective
(carry on lending) is only possible if the
institutions are in state ownership.
􀀗 Write-offs and impairments cause institutions
to run out of regulatory capital.
The good news is that we do not have to worry
too much about the first scenario. Personal
deposits are protected by the government up to
GBP50,000. CDS spreads point to an easing of
funding problems. As far as credit markets are
concerned, if RBS is nationalised it becomes a
better risk.
The second issue is currently the subject of
intense political debate. As it stands, banks that
have accepted government capital or will
participate in the new Asset Protection scheme
have given verifiable quantitative commitments to
HM Treasury to support creditworthy borrowers
in a commercial manner. Therefore it is difficult,
in our view, to see what could be achieved with
the banks in full public ownership in addition to
the current situation.
This consideration, plus the damage from adding
bank balance sheets to public finances, may
explain recent government pronouncements
“the capacity for soundly managed banks and
markets to support the generation of wealth in the
economy could never be matched by the public

sector. British Banks are best managed and owned
commercially” Paul Myners, Financial Services
Secretary (Financial Times, 21 January 2009).
The political judgment that semi-autonomous banks
are better than instruments of the state could change,
but as the situation currently stands, we do not
believe scenario two is the most likely outcome.
This leaves scenario three. Our effort to answer
this question is the motivation for this document.
Decapitalisation risk
Will write-offs, impairments and the public policy
objective of keeping the lending tap open cause
UK banks to run out of regulatory capital?
Clearly, answering this question requires a lot of
assumptions, about impairments, credit market
write-downs, WRA growth and core profitability.
Our starting point is the assumptions the
authorities made when they determined the UK
industry had a shortfall of some GBP50bn of
equity capital last autumn. These assumptions
included impairments at 150bp, 10% pa WRA
growth and the absence of tax relief.
But investor expectations are for something very
much worse. This downturn is perceived to be
much more serious than the last recession of the
early 1990s and therefore impairments are
expected to be orders of magnitude higher.
Although there are a lot of imponderables, today’s
borrowers have some advantages over their early
1990s counterparts. First, interest rates are not in
double digits and second, although there are
currently question marks over the supply of credit,
it seems likely that government intervention will
ultimately prevent the deliberate contraction of
bank credit that exacerbated the 1990s downturn.
Trade-off
We highlight a trade-off between impairments and
WRA growth. In a recession, impairments could
be 100bp higher (as a percentage of risk assets),
than in a normal year. The reduction in group
capital (net of tax) would be 72bp x WRAs. But
for a bank with a 6% equity tier 1 target, this
would equate to the capital released from
shrinking WRAs by 12%.
The difference between this recession and the
early 1990s is that the government will not allow
lending to contract, at least for domestic
mortgagees and small and medium-sized
businesses borrowers. However, these
constituencies account for only 20-30% of bank
risk assets, so the re-allocation of capital away
from market and international activities could still

enable the banks to meet their public policy
objectives even if total WRAs growth has to be
heavily constrained.
Here a critical element is the FSA’s decision to
view recent recapitalisations not as a shift to
permanently higher capital adequacy but as a
buffer that can be allowed to erode through
recession. We estimate that provided equity tier 1
is allowed to decline to 5% over the next three
years, then with impairments at c.200bp (of
WRAs), Lloyds and RBS would be capable of
funding organic WRA growth of 13-14% pa and
Barclays could manage 9-10%. With impairments
at 300bp, we believe Lloyds and RBS should still
be able to afford high single digits, albeit Barclays
would have problems.
Of course, impairments are not the only factor
putting pressure on the capital position. There is
also the risk of write-downs on credit market
instruments. But attempting to mark portfolios to
market at year-end and then netting off Q4
charge-offs (and fair value acquisition
adjustments in the case of Lloyds) reveals that this
factor will not make too much difference to the
organically fundable growth rate over a three-year
period (exhibit 2) .
Lending and funding
Although the government is determined to keep
the lending tap open, demand invariably falls
during a recession. The personal sector does not
want to buy houses when prices are falling, whilst
businesses will not invest when there is no
consumer demand. This shortfall in lending
should be reasonably positive as regards banks’
capital and would not necessarily put the banks at
loggerheads with the government since the banks’
commitments are about keeping open the supply
of lending, not the end-demand.
But the supply of lending will still be limited by
wholesale funding. True, it is expected that
implementing the recommendations of the Crosby
report for government guarantees on triple-A
rated asset-backed securities could raise
GBP100bn pa but UK banks’ domestic lending is
GBP1.6tr.
Limited lending and a shortage of wholesale
funding would be a necessary first step towards
de-leveraging. The Bank of England has identified
a funding gap (customer lending funded by
wholesale deposits) of GBP740bn, or 58% of UK
GDP, which is expected to fall materially as banks
reshape their business models away from
wholesale funding.
Exhibit 3. A collapse in bank lending is a feature of all
recessions
Exhibit 4. The funding gap relates primarily to foreign
currency lending to non-UK residents
-10
-5
0
5
10
15
20
25
30
-5 -4 -3 -3 -2 -1 0 1 2 2 3 4 5
Time pre and post recession
Annual growth rate
Japan 1997 Norway 1991 Sweden 1992 UK 1992
0
100
200
300
400
500
600
700
07 Mar May Jul Sep Nov 08 mar May Jul Sep Nov
GBPbn
0%
100%
200%
300%
400%
500%
600%
700%
Loans/deposits
Net funding gap Sterling (LHS)
Net funding gap Foreign Currency(LHS)
Sterling loans/deposits (RHS)
Foreign currency loans/deposits(RHS)
Source: Bank of England Financial Stability Review Source: Bank of England