No cause for alarm – but the banks still have a political game to play

FIRST, the credit ratings agencies have a lot to answer for, missing the tremors in the mortgage sector that erupted in 2007 which raised questions about their value. No wonder they’re being ultra-cautious this time around.

Yesterday’s downgrading by Moody’s of European banks, including Royal Bank of Scotland and Lloyds Banking Group, pushed the UK pair to the bottom of the FTSE-100 index, though traders also had their heads turned on the latest US jobs data and on reports that taxpayers may be asked to put more money into the banks.

The prospect of recapitalising the banks divided market watchers, some believing it would be no bad thing as it would beef up balance sheets and give them more scope to withstand any volcanic blasts in the eurozone. If the price of injecting a little more cash is to keep the eurozone intact and stable, then it may be worth paying. It would also give the banks more room for lending to the wider economy.

But Moody’s was less concerned with putting more money into the banks and said its downgrade did not reflect a deterioration in their financial strength. It was bothered more by the likelihood of the UK government loosening the implicit guarantee to prop them up, viewed by some analysts as a reasonable argument, as there must come a time when the banks are free to operate outwith the constraints of the Treasury.

The banks have been on review for some time, most notably since the government-appointed Independent Commission on Banking recommended changes that would add to bank costs by forcing a number of structural changes to the way they operate.

In the end, the downgrade was not as bad as had been expected and the likelihood is that the banks will be more concerned that they’ll need to commit more capital to reserves if they fail the next round of stress tests.

The first round, in July, drew derision, as the tests failed to take account of the emerging crisis in the eurozone and the prospect of nations defaulting on their debts. We now know that such an outcome cannot be discounted and that bank exposure to default will have serious consequences.

Privately, RBS is confident it has done enough to merit another pass mark, even if the capital threshold is raised a notch or two from last time’s 5 per cent. No-one knows yet what it will be, but several analysts were prepared to state that it had no need to raise more capital and one even described the prospect as “comical”.

The new tests are thought less likely to draw on the legacy issues surrounding the ABN Amro businesses that left RBS with a mountain of toxic debt. It has also severely reduced its risk-grade assets.

In addition, the government already has something called contingent capital, an £8 billion pot that it can inject and which counts towards capital reserves.

While some of those European banks with greater exposure to Greece are in for a nervous wait in the recap waiting room, RBS and Lloyds appear to be included only because of the need for a continent-wide approach to the banking issue.

That’s a political game, but one that they’ll have to continue playing for some time.

l Terry Murden is Business Editor of The Scotsman.