uk banks - jp morgan cazenove

8/8/2019 UK Banks - JP Morgan Cazenove

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Europe Equity Research02 June 2010

UK Banks

RBS.L, RBS LNUnderweight47p

Price Target: 42p

Government Exit Strategies - Looking at the Options LLOY.L, LLOY LNUnderweight57p

Price Target: 50p

Banks

Carla Antunes da SilvaAC

(44-20) 7325-8215

[email protected]

Amit Goel, CFA

(44-20) 7325-6924

[email protected]

J.P. Morgan Securities Ltd.

For Specialist Sales advice, pleascontact:

Oliver Doeltl

(44-20) 7779-2187

[email protected]

Nick Gough

(44-20) 7325-9459

[email protected]

Justine Shih

(44-20) 7779 2149

[email protected]

Equity Ratings and Price TargetsMkt Cap Rating Price Target

Company Symbol ( mn) Price(p) Cur Prev Cur Pr

Royal Bank of Scotland Group P RBS.L 50,172.13 47 UW n/c 42 nLloyds Banking Group Plc LLOY.L 36,109.41 57 UW n/c 50 nSource: Company data, Bloomberg, J.P. Morgan estimates. n/c = no change. All prices as of 28 May 10.

See page 44 for analyst certification and important disc losures, including non-US analyst d isclosures.J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm mhave a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making thinvestment decision.

40

70

100

p

May-09 Aug-09 Nov-09 Feb-10 May-10

Price Performance

LLOY.L share price (p)

MSCI-Eu (rebased)

YTD 1m 3m 1

Abs 8.3% -15.7% 12.7% -12.

Rel 12.4% -10.2% 14.6% -29.

25

40

55

p

May-09 Aug-09 Nov-09 Feb-10 May-10

Price Performance

RBS.L share price (p)

MSCI-Eu (rebased)

YTD 1m 3m 1

Abs 45.6% -15.0% 27.4% 24.

Rel 49.7% -9.5% 29.3% 8.

At the crux of this debate is the conflict of interest of owning largestakes in the banks whilst trying to implement significant regulatorychanges in a global forum and balancing this with influencing banks'lending behaviour. We see 3 main costs to the UK;

1 During the temporary ownership period the stakes account for c.4%of net debt to GDP under the Maastricht definition. Whilst we do notsee the stakes as long-term holdings, if fully consolidated, UK net debtto GDP would go from 64% (2009) to 165%;

2 Indirectly, there is a cost to the sovereign from providing guaranteesto the sector (both implicit and explicit) for every 10bps of additional

financing costs, we estimate annual costs of c.1bn for the government;

3 Last but not least, we estimate a financing cost of c.3.2bn annuallyof holding these stakes, equivalent to a meaningful 8% of 2010E UKbudget interest expense.

Despite comment that disposals of the stakes are not imminent, with thechange of government we believe the breakeven prices are less relevant,esp if the government were to structure a transaction similar to theBritish Gas & BT privatisations, where there could be a focus on retailinvestors, not least because this would democratise any potential futureshare upside. News flow around the exit strategies will be a drawn outprocess, providing trading opportunities, and may remain unclear.

While stocks have come off their highs on the back of sovereignconcerns and both Lloyds and RBS are now trading on 0.9x 11E P/NAV,we remain UW on both. Fundamentally, we see NAV per share as aceiling rather than as a floor as we currently struggle to see returnsexceeding CoE. TP for Lloyds remains unch at 50p with modestearnings changes (-1.1% 2012E) and unch at 42p for RBS, where weraise 12E EPS by 6.7% on reduced loss estimates for non core activities.

Given the strain on public finances we believe the likelihood of a specifictax charge along the lines of a wholesale liability tax is high and couldremove c.10-20% of sector earnings, raising a much needed 5-10bn.

Beyond that, further regulatory changes will likely have to be pushedback, as we believe regulation goes hand in hand with economicstability.


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Carla Antunes da Silva(44-20) [email protected]

Amit Goel, CFA(44-20) [email protected]

Table of Contents

Why should the government reduce the stakes?..................4What has been the history of government stakes? .......... .......... ........... ........... .......... ...4Conclusion for the UK.................................................................................................5

UK fiscal position and the impact on the government bankstakes ........................................................................................8

Exit price has some bearing but is not critical to the fiscal position ........... ........... ......9The potential impact on bank taxes and special levies...............................................12

What are the potential mechanisms and associated impact?.................................................................................................18

Share sale...................................................................................................................19

Convertible bonds......................................................................................................22Buyback .....................................................................................................................22An asset swap.............................................................................................................24

Index implications ..................................................................25

Tracker demand .........................................................................................................25Timing of Index re-weighting....................................................................................27

Stock implications..................................................................28

Lloyds Banking Group...........................................................29

Royal Bank of Scotland .........................................................36

Valuation Methodology and Risks ........................................41


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With the UK general election now over, and a new coalition government in place, we

turn our thoughts to the potential implications for the governments holdings in RBS

and Lloyds Banking Group. This is especially relevant in light of the upcomingbudget announcement due on 22nd June.

We note that with the Conservative Party working with the Liberal Democrats there

could be greater uncertainty, as the Liberals have been keen on retaining the stakes,

whereas the Conservatives have been more in favor of rapid disposals. Nevertheless,

we also note that the current government may be less price sensitive compared to the

previous Labour government, as they are less associated with the average entry

prices for either of the banks.

One factor that may complicate proceedings is the commitment to establishing an

independent commission to investigate the separation of retail and investment

banking. This commission is being given one year to report, and some market

participants question whether this would prohibit any significant exit strategies,especially in the case of RBS where the outcome could significantly impact the

profitability of the group.

Whilst this could be an issue, we still think that it is important to look at the options

available to the UK government in terms of strategies as this is one of the main areas

of consideration in terms of investor uncertainty.


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Why should the government reduce the

stakes?At this stage, we avoid the intellectual debate on whether banks are better managed

in state or public hands, but instead focus on three main themes which we think are

crucial discussion points international precedent, the potential bearing on the UK's

fiscal position and the potential conflict of interest the holdings create, in particular

when the government is looking at proposals to reform the banking system.

What has been the history of government stakes?

In the recent crisis several governments supported their banks by injecting capital

both at the equity and preference share levels, in addition to providing liquidity

facilities and asset insurance schemes.

Already we have seen governments reduce and exit holdings in several countries, and

the UK appears to be on this track. Table 1 on page 6 highlights the main

transactions we have seen so far, and we below we discuss some of the precedents.

The Swedish crisis

The recent credit crisis has been compared several times to the Swedish financial

crisis of the 1990s. In 1992 during the Swedish crisis Nordbanken was nationalized

and then subsequently Listed in 1995. In the IPO, 34.5% of the company was listed

with shareholders split along the following lines:

Figure 1: Nordbanken Offering: Investor Split

Swedish Public

28%

Other International

30%

Swedish Institutions

22%

Nordic Institutions

5%

US Institutions

15% Source: J.P. Morgan, Company data.

Swedish retail investors were offered a 7.6% discount to the other investors for 90%

of the shares offered to them. The Swedish governments 65.5% remaining stake

was reduced via a series of M&A transactions down to 19.9% in the descendant bankNordea.

The US banks

The largest US banks have generally repaid TARP funds relatively quickly. Only in

the case of Citigroup were TARP preferred shares converted into equity giving the

US government ownership.


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This stake is now being sold, with a first tranche of 19.5% of the holding having

been placed. This was done by selling shares into the market over a period of time,

with Morgan Stanley mandated to execute a pre arranged trading plan. Further,unconfirmed press reports (FT 25/05/10) have suggested that the Qatar Investment

Authority has expressed interest in buying part of the remaining stake.

Note in the case of Citigroup the US government has been able to sell part of its

holding at a profit the purchase price was $3.25 per share, and on the shares sold so

far the average sale price was $4.13 giving $1.3bn profit excluding financing costs.

The Swiss banks

The Swiss government attained a 9.3% stake in UBS as part of a balance sheet

restructuring exercise announced in October 2008, where it injected SF6bn in

exchange for mandatory convertible notes (MCNs) that converted into equity at min.

SF18.21 and carried a 12.5% coupon.

In September 2009 the government sold its 332.2mn shares via an accelerated book

build (ABB), at CHF 16.50, leading to a loss on the stock but more than offset by

coupons received SF1.8bn.

French banks

Credit Lyonnais was nationalized in 1945 after WW2, and was eventually privatized

in 1999. In the IPO the French government sold 89.1% of the bank, retaining 10.9%

that was sold in 2002.

In the IPO 33% of the equity was allocated to strategic investors who paid a premium

depending upon the size of their investment. (The premium was 3.5% if more than

4% of the share capital was purchased, 1.9% if less). Credit Agricole took the largest

stake at 10% of the offering. The rest of the IPO was allocated to three types ofinvestor, (i) the French public, (ii) Employees (10%) and (iii) Institutions. The

French public offering was at a 2.7% discount, and if shares were held for more than

18months additional (free) shares were awarded.

The remaining 10.9% was sold to BNP via a rapid auction on 24 Nov 2002, who

subsequently sold the holding to Credit Agricole.

Conclusion for the UK

So far, most countries have had an exit strategy, although in some cases the exit has

taken several years (in the case of Sweden it is still not complete, having started in

the 1990s) and the methods of exit have varied significantly. In public offerings it

appears that local retail investors have been given disproportionate allocations anddiscounted prices. This could be a means to avoid criticism of selling too early as

the retail public benefits if the share price appreciates after sale.

We believe that if the holdings in RBS and Lloyds were expected to become semi

permanent then the EU would have applied tougher penalties for state aid than the

ones announced last autumn. We also note that although we have focused on RBS

and Lloyds Banking Group in this report, the conclusions are equally valid for the

UK government's holdings in Northern Rock and Bradford & Bingley.


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Furthermore whilst there may be limited pressure to sell when the sovereign's fiscal

position is sound, if there is uncertainty it may be beneficial to sell earlier rather than

later. We explore this topic in the next section. There could be significant fundingcosts, and if stakes are considered permanent, given the magnitude of bank balance

sheets in relation to national balance sheets, they could lead to significant distortions

in national accounts.


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Table 1: Global Banks - Summary of Equi ty Injection s since 2007

Capital Injection Exit

RBS Oct 08 15.0bn initial recapitalisationMar-09 5.0bn preference share conversionNov-09 25.5bn worth B-shares

Lloyds Oct 08 13.0bn initial recapitalisationMay-09 1.5bn 12% preference share conversionNov-09 5.9bn (43% share of 13.5bn rights offer) Nov 09 Lloyds exited the APS for a 2.5bn f

UBS Oct-08 CHF6bn mandatory convertible notes, 9.3% stake if convertedAug-09 Swiss Confederation placed all shar

of coupons(CHF1.8bn) from UBSCASA Dec-08 3bn perpetual super subordinated

Oct-09 Redeemed 3bn notes (using capitaBNP May-09 5.1bn Preferred shares

Oct-09 Paid back 5.1bnSoc Gen Dec 08 1.7bn Subordinated debt

May 09 1.7bn Preferred sharesOct 09 3.4bn capital redeemed

Commerzbank Nov-08 8.2bn silent participation(preference shares)

Jan-09 8.2bn silent participation(preference shares)Jan-09 1.8bn for 25% stake

Morgan Stanley Oct-08 $10bn preferred shares (TARP) and warrantsJun-09 MS paid back $10bnAug-09 Warrant repurchased for $.95bn

GoldmanSachs

Oct-08 $10bn preferred shares and warrants

Jun-09 GS bought back $10bn preferred shJul-09 Repurchased TARP Warrant for $1.

Citigroup Oct-08 $25bn perpetuity preferred stock and a warrant to purchase common stock (partiallyconverted to common shares (27% stake) in 2009)

Dec-08 $20bn perpetuity preferred stocks and a warrant to purchase common stockJan-09 $5bn capital benefit from asset guarantee

Dec-09 Citi repaid $20bn (generated capitalnotes)

May-10 US Treasury planning to sell its 27%Bank of

AmericaOct-08 $15bn preferred shares and warrants

Jan-09 $10bn preferred shares and warrantsJan-09 $20bn preferred shares and warrants

Dec-09 Repurchased all preferred stocks foING Oct-08 10bn 8.5% preferred shares

Dec-09 ING Repurchased 5bn preferred sh

Source: J.P. Morgan estimates, Company data.


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UK fiscal position and the impact on the

government bank stakesGiven the concerns over the fiscal positions of UK and European governments, in

this section we review the impact of the government stakes on the UKs fiscal

position, and whether any impact could encourage a sale earlier rather than later.

Note we do not think that the UKs fiscal deficit means that the stakes have to be

sold, but nevertheless it is an interesting debate.

There are several measures of the debt position, and so we first summarise each

metric and the associated impact from the government bank holdings. The three

main measures we have focused on are (i) the Public Sector Net Debt (PSND), (ii)

the PSND ex temporary effects of financial interventions (PSND ex) and (iii)

General Government Gross Debt (GGGD). For more details on the specifics of UK

economics we refer the reader to Malcolm Barr and Alan Monks:

Public Sector Net Debt (PSND) - This is the most commonly cited measure of

debt in the UK, taking the consolidated liabilities of the entire public sector, and

netting out only liquid assets (such as official reserves, deposits, and other short-

term instruments). This measure includes the liabilities of the banks that have

government stakes, net of their liquid assets. Currently, the reported numbers

include the Northern Rock and Bradford & Bingley exposures, and this summer

the Office of National Statistics (ONS) will incorporate Lloyds Banking Group

and RBS, which will significantly increase debt levels.

Public Sector Net Debt excluding financial interventions (PSND ex) This

adjusted measure of PSND removes the impact of the financial interventions that

is deemed to be temporary, i.e. the balance sheet impact, but retains the aspectsthat are potentially more permanent such as the potential losses on holdings

(based on a mark to market approach). This measure was introduced by the

previous administration to the current coalition.

General Government Gross Debt (GGGD) This is a European Union

standard that is used in accordance with the Excessive Deficit Procedure of the

Maastricht Treaty. Under this measure the balance sheets of the state owned

banks are not included, only the funding requirements for the stakes, i.e. 66bn

for RBS and Lloyds Banking Group in total. There are other differences from the

PSND, primarily that the gross liabilities are used, there is no netting for liquid

assets, and only the general government is included, not public corporations

(although this is small). Note the Maastricht Treatys deficit and debt target

limits are 3% and 60% respectively.

Table 2 shows an estimate of each of these measures based on the March 2010 UK

Budget projections and our estimates of the impact from consolidating the RBS and

Lloyds liabilities in the PSND.

For more information please see

JP Morgans Global Data Watch

30 Apr 2010, referring to pages

52-53 and JPM UK Economics

team:

Malcolm Barr

(44-20) 777-1080

[email protected]

Allan Monks

(44-20) 777-1188

[email protected]

Note the incoming government is

setting up an Office for Budget

Responsibility (OBR) to make an

independent assessment of the

public finances and may present

the data in a different way.
https://mm.jpmorgan.com/servlet/UserDocsHelperServlet?action=openpdf&docId=GPS-407478-0https://mm.jpmorgan.com/servlet/UserDocsHelperServlet?action=openpdf&docId=GPS-407478-0https://mm.jpmorgan.com/servlet/UserDocsHelperServlet?action=openpdf&docId=GPS-407478-0https://mm.jpmorgan.com/servlet/UserDocsHelperServlet?action=openpdf&docId=GPS-407478-0https://mm.jpmorgan.com/servlet/UserDocsHelperServlet?action=openpdf&docId=GPS-407478-0


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Table 2: UK - National Debt Based on March Bu dget Estimates

billion

2008 2009 2010E 2011E 2012E 2013E 2014E

PSND %GDP 52.7% 63.6% 165.1% 161.6% 155.9% 149.7% 145.9%PSND ex % GDP 43.8% 54.1% 63.6% 69.5% 73.0% 74.5% 74.9%GGGD % GDP 55.5% 71.4% 80.5% 86.0% 88.7% 89.2% 88.7%

PSNB %GDP 6.0% 11.0% 10.7% 8.2% 6.6% 5.0% 3.8%PSNB ex % GDP 6.7% 11.8% 11.1% 8.5% 6.8% 5.2% 4.0%Deficit % GDP 6.7% 12.2% 11.2% 8.6% 6.9% 5.3% 4.2%

PSND 742 913 1,081 1,216 1,339 1,441 1,527PSND ex 617 777 952 1,095 1,218 1,320 1,406PSND inc RBS, Lloyds 2,471 2,546 2,601 2,653 2,739

Source: J.P. Morgan estimates, HMT. Note the figures are based on an end March year end, i.e. 2010E represents the period end Mar 2009 to end Mar 2010.

As can be seen the PSND will potentially balloon this year when the RBS and Lloyds

Banking Group liabilities net of liquid assets are included. Interestingly, the publicsector net borrowings (PSNB) excluding the temporary effects of financial

interventions is greater than that including, this is due to the potential losses on the

stakes and the exclusion of potential gains from the SLS and asset purchase facility.

If the holdings in RBS and Lloyds become more permanent then clearly the PSND

ex figure becomes less relevant, and the public finances will look highly leveraged.

Note that we do not think this will have a meaningful impact on sovereign funding

costs, as the more important measure in this regard being the GGGD. On this

measure the contribution from the stakes is c.4.5% 2010E declining inline with

nominal GDP growth. If the stakes are sold the measure would reduce debt level by

the consideration received. The table below shows the benefit to 2012E GGGD

depending on different exit prices for the government stakes in RBS and Lloyds.

Table 3: UK - Sensitivit y of GGGD to exit pric es relative to average entry pric e 2012E

Lloyds Exit Gain / Loss

-30%/51.5p -20%/58.9p -10%/66.2p 0%/73.6p 10%/81.0p 20%/88.3p 30%/95.7p-30%/35.1p 2.9% 3.0% 3.1% 3.3% 3.4% 3.5% 3.6%-20%/40.1p 3.2% 3.3% 3.4% 3.5% 3.7% 3.8% 3.9%

RBS -10%/45.2p 3.4% 3.6% 3.7% 3.8% 4.0% 4.1% 4.2%Exit 0%/50.2p 3.7% 3.9% 4.0% 4.1% 4.2% 4.4% 4.5%

Gain / Loss 10%55.2p 4.0% 4.1% 4.3% 4.4% 4.5% 4.7% 4.8%20%/60.2p 4.3% 4.4% 4.6% 4.7% 4.8% 4.9% 5.1%30%/65.3p 4.6% 4.7% 4.8% 5.0% 5.1% 5.2% 5.3%

Source: J.P. Morgan estimates, UKFI

Exit price has some bearing but is not critical to the fiscal

positionFrom this exercise it would appear that whilst the exit prices do have some bearing, it

is not critical, and largely symbolic. What is more relevant is that the stake is

sold, as the funding requirement still has a noticeable bearing on public

finances. This could be especially important when we consider the commentary

from Standard & Poors credit research. S&P reiterated its negative outlook for UK

sovereign debt in Mar 2010 and said that it expects GGGD to continue to trend

towards 100% of GDP, a level which if sustained over the medium term would be

incompatible with a 'AAA' rating.


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Table 4 below illustrates expectations for GGGD from several sources.

Table 4: UK - GGGD and Deficit Esti mates2008 2009 2010E 2011E 2012E 2013E 2014E 2015E

GGGD %GDPS&P 52.0% 68.4% 77.1% 83.3% 88.6% n.a. 100.0%* n.a.HMT 55.5% 71.4% 80.5% 86.0% 88.7% 89.2% 88.7% n.a.IMF 52.0% 68.2% 78.2% 84.9% 88.6% 90.2% 90.7% 90.6%OECD n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a.

Fiscal Deficit %GDPS&P -5.0% -11.5% -10.9% -9.3% -8.3% n.a. -6.0%* n.a.HMT -6.7% -12.2% -11.2% -8.6% -6.9% -5.3% -4.2% n.a.IMF -4.8% -10.9% -11.4% -9.4% -7.6% -6.2% -5.2% -4.3%OECD -5.3% -11.3% -11.5% -10.3% n.a. n.a. n.a. n.a.

Real GDP GrowthS&P 0.5% -5.0% 1.2% 2.2% 1.8% n.a. n.a. n.a.

HMT 0.5% -5.0% 1.3% 3.3% 3.5% n.a. n.a. n.a.IMF 0.5% -4.9% 1.3% 2.5% 2.9% 2.8% 2.7% 2.5%OECD 0.6% -4.9% 1.3% 2.5% n.a. n.a. n.a. n.a.

Source: J.P. Morgan estimates, S&P, HMT, IMF, OECD. S&P 2014E is based on the text of the statement.

Given how close to 100% we may be, the benefit from a sale may be significant.

Perhaps the question is, what is the benefit that the government can derive from

having more direct control of credit to the economy versus the benefit from a sale?

The risk to other stakeholders in RBS and Lloyds being that the governments

interests may not be aligned to theirs and more directed lending could be negative for

profitability.

Further, we note that whilst we have discounted including RBS and Lloyds liabilities

from the sums, one could make the argument that they will have significant funding

requirements over the next few years, and as such may be competing with the

governments for credit. This would add relevance to the PSND measure, and hence

be a reason for the government to sell sooner rather than later.

When we look at Moodys comments the key metrics are slightly different but the

conclusions are broadly similar. Moody's states;

Moodys defines an Aaa government as a government that has sufficient balance

sheet flexibility to keep its debt highly affordable through cycles and crises. In this

context, debt affordability is best captured by the ratio of debt interest payments to

government revenues, and debt is deemed highly affordable when this ratio remains

in single-digit territory. Based on current projections, this affordability ratio is

expected to move close to the 10% threshold that delineates the Aaa-Aa boundary.

Moodys Investors Service: UK General Election: Hung Parliament No Direct

Threat to UKs Aaa Rating May 2010


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Figure 2 below illustrates the interest expense to revenue ratio as projected in the

March 2010 budget:

Figure 2: Ratio of Interest Expense to Revenues

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

11.0%

2008 2009 2010E 2011E 2012E 2013E 2014E Source: J.P. Morgan estimates, HMT Budget projections

So, as can be seen, the current projection is for the ratio to be above this level in

2013E. The impact from the bank stakes is potentially twofold:

Direct funding requirements for the holdings i.e. the cost of borrowing the

66bn invested in the stakes;

Impact of the ownership on sovereign funding costs the impact on sovereign

borrowing costs from the 'implicit guarantees' enjoyed by the banks.

Table 5 below we attempt to quantify these impacts.

Table 5: Interest Expense to Revenue Impact from bank s takes

billion2008 2009 2010E 2011E 2012E 2013E 2014E

Interest Expense 31 31 42 50 60 66 74Revenue 534 508 541 582 621 660 699Interest / Revenu e 5.7% 6.1% 7.7% 8.6% 9.6% 10.1% 10.6%PSND ex 617 777 952 1,095 1,218 1,320 1,406Average Debt 697 864 1,024 1,157 1,269 1,363Interest Rate 4.4% 4.8% 4.9% 5.2% 5.2% 5.4%

Gross Issuance 147 228 187 187 159 141 117Redemptions -21 -17 -39 -49 -48 -47 -43Net Issuance 126 211 148 138 111 94 74

Stake FundingStake 65.8 65.8 65.8 65.8 65.8 65.8

Interest Expense 2.9 3.2 3.2 3.4 3.4 3.6Interest/ Revenue ex stakes 5.5% 7.1% 8.0% 9.1% 9.5% 10.0%Difference -0.6% -0.6% -0.6% -0.5% -0.5% -0.5%

Sovereign Funding Costs5bps spread impact 0.3 0.4 0.5 0.6 0.6 0.7% Revenue 0.07% 0.08% 0.09% 0.09% 0.10% 0.10%


From the analysis we see that a sale of the stakes could make a material

difference to the interest expense to revenue ratio, especially whilst the banks

are not paying dividends. Note if the stakes were to become more permanent it


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may be fair to include the income of the banks in revenues along with the

financing costs of their debt.

Figure 3 below illustrates the movement in sovereign CDS spreads for the UK over

the past 12 months where we have seen more limited widening compared to other

G20 economies as expectations remain that the UK will be able to address its fiscal

deficit.

Figure 3: UK Sovereign CDS spreads (5Yr Senior)

bps

0

50

100

150

200

08/08/2008 08/11/2008 08/02/2009 08/05/2009 08/08/2009 08/11/2009 08/02/2010 08/05/2010 Source: Bloomberg.

The potential impact on bank taxes and special levies

A secondary consequence of the UK's fiscal deficit and other national fiscal deficits

is on the risk of additional taxes on banking profits and possibly bonus payments.

Additional taxation is one of the items that the coalition government has highlighted

in its agreement document:

'We will introduce a banking levy and seek a detailed agreement on

implementation

Conservative Liberal Democrats Coalition Agreement, May 2010

This was a discussion point at the G20 Finance ministers meeting in April, and we

expect detailed proposals to be presented at the summit at the end of June. Clearly

on top of the direct impact on profitability additional taxation will slow the process

of banks rebuilding their balance sheets, and hence will have further consequences

on the availability of credit and on economic growth, but this is an area where we

believe regulatory change is very likely, not least because it is an additional source of

much needed government revenue.

In the tables below we estimate the potential direct revenues that such a tax could

generate in the UK assuming a 15bps fee on UK wholesale liabilities, and relate that

to (i) the impact on bank profitability, (ii) total tax receipts in the UK and the fiscal

position.


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Table 6: UK Banks - Potential Revenues from a Bank Fee (based on UK liabiliti es)

million

UK Liabilities UK Deposits UK Derivatives UK Wholesale Charge Annual Cost/ RevBarclays 1,320,449 322,455 403,416 594,578 0.15% 892HSBC 751,160 351,387 134,977 264,796 0.15% 397RBS 1,276,784 453,302 424,544 398,938 0.15% 598Lloyds 983,148 406,741 40,485 535,922 0.15% 804Santander UK 278,069 143,893 18,963 115,213 0.15% 173

Total 4,609,610 1,677,778 1,022,385 1,909,447 0.15% 2,864

Source: J.P. Morgan estimates.

Based on these assumptions such a fee could generate c. 2.9bn per annum in the UK

from these banks alone. Note that we have not included possible receipts from

building societies and other international banks present in the UK. We note that so

far 2bn (net receipts) were raised from the UK banks bonus tax for the fiscal year of

2009, but a final figure is yet to be reached. Please refer to Table 13 for more details.

Table 7: UK Banks - Impact of Fee on Profitability (based on UK liabi lities) million

2010E 2011E 2012E 2010E Chg 2011E Chg 2012E ChgBarclays 4,389 5,326 5,577 -20% -17% -16%HSBC 8,583 13,004 17,077 -5% -3% -2%RBS -1,077 536 3,726 56% -112% -16%Lloyds 547 2,474 4,939 -147% -32% -16%Santander UK 1,673 1,802 1,976 -10% -10% -9%Total 14,115 23,142 33,294 -20% -12% -9%


Reducing profitability by c.10% 12E, concentrated at those banks with more significant

wholesale funded structures, i.e. Barclays, RBS and Lloyds. Clearly the impact on the

banks would be significantly greater if the fees are adopted globally, as has also been

suggested. Note there has been some discussion about a reduction in the corporate taxrate from 28% to 25%, as this was an item in the Conservative party election manifesto,

nevertheless it was not in the coalition agreement. Whilst we think this is an unlikely

change, in the tables below we show the potential impact in isolation on our estimates

and in combination with a 15bps wholesale liability levy applied at a local level.

Table 8: UK Banks: Potenti al Impact of Lower Corpor ation Tax in UK

million

2010E 2011E 2012E 2010E Chg 2011E Chg 2012E ChgBarclays 249 298 312 6% 6% 6%HSBC 0 270 348 0% 2% 2%RBS 0 24 169 0% 5% 5%Lloyds 33 127 248 6% 5% 5%Santander UK 54 58 64 3% 3% 3%

Total 336 778 1,141 2% 3% 3%Source: J.P. Morgan estimates.

Table 9: UK Banks: Potential Overall Impact fr om Tax Changes

million

Overall 2010E 2011E 2012E 2010E Chg 2011E Chg 2012E ChgBarclays 3,747 4,732 4,997 -15% -11% -10%HSBC 8,186 12,877 17,028 -5% -1% 0%RBS -1,676 -38 3,296 56% -107% -12%Lloyds -224 1,798 4,383 -141% -27% -11%Santander UK 1,555 1,687 1,867 -7% -6% -6%Total 11,587 21,056 31,571 -18% -9% -5%



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In the following tables we highlight the potential impact on the fiscal position,

looking in more detail at government revenues and expenditure.

Table 11: UK - Breakdown o f governm ent revenue and net borrowi ng

billion

2009 2010E 2011EHM Revenue and CustomsIncome tax (gross of tax credits) 153.4 144.4 146.4Income tax credits -5.6 -5.6 -5.9National insurance contributions 96.9 94.9 97.0Value added tax 78.4 70.0 78.0Corporation tax1 43.7 36.0 42.1Corporation tax credits2 -0.6 -0.7 -0.8Petroleum revenue tax 2.6 0.8 1.6Fuel duties 24.6 26.2 27.5Capital gains tax 7.8 2.5 2.7Inheritance tax 2.8 2.4 2.3Stamp duties 8.0 7.7 9.8

Tobacco duties 8.2 8.8 8.8Spirits duties 2.4 2.6 2.6Wine duties 2.7 3.0 3.1Beer and cider duties 3.4 3.5 3.6Betting and gaming duties 1.5 1.4 1.4Air passenger duty 1.9 1.9 2.4Insurance premium tax 2.3 2.3 2.3Landfill tax 1.0 0.8 1.1Climate change levy 0.7 0.7 0.7Aggregates levy 0.3 0.3 0.3Customs duties and levies 2.7 2.6 2.6Temporary bank payroll tax3 0.0 0.0 2.0Total HMRC 439.1 406.5 431.8Vehicle excise duties 5.6 5.7 6.0Business rates 22.9 23.7 24.7Council tax4 24.4 24.8 25.8Other taxes and royalties5 16.0 15.7 18.7Net taxes and NICs6 507.9 476.4 507.0Accruals adjustments on taxes -4.2 1.4 4.0Less own resources contribution to -5.1 -3.8 -4.6Less PC corporation tax payments -0.2 -0.2 -0.2Tax credits adjustment7 0.7 0.7 0.8Interest and dividends 7.7 4.2 4.4Other receipts8 26.8 28.7 29.5Current receipts 533.5 507.5 540.8Expendi ture 563.7 604.6 644Depreciation 18.7 19.5 20Surplu s -48.9 -116.6 -123.2Net Investment 47.2 50 40Net Borr owin g (PSNB ex) -96.1 -166.6 -163.2

Source: J.P. Morgan estimates, HMT


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Table 12: UK Banks: Potential Impact on public finances from additional taxation

billion

2009 2010E 2011E 2012ECurrent receipt s 534 508 541 582Expenditure 564 605 644 662Depreciation 19 20 20 21Surplu s -49 -117 -123 -102Net Investment 47 50 40 29Net Borr owin g (PSNB ex) -96 -167 -163 -131

Liabilities Tax n.a. 2.9 2.9 2.9Lower Corporation Tax n.a. -0.3 -0.8 -1.1Total Taxation n.a. 2.5 2.1 1.7

Cumulative ImpactLiabilities Tax n.a. 2.9 5.7 8.6Lower Corporation Tax n.a. -0.3 -1.1 -2.2Total Taxation n.a. 2.5 4.6 6.3

% Net BorrowingLiabilities Tax n.a. -1.7% -1.8% -2.2%Lower Corporation Tax n.a. 0.2% 0.5% 0.9%Total Taxation n.a. -1.5% -1.3% -1.3%

Source: J.P. Morgan estimates, HMT

From this data just looking at the impact on five UK banks, the impact of additional

taxation could be significant. Furthermore, there is also the discussion surrounding

whether the payroll tax is extended in duration. In 2009/10 this is anticipated to have

raised 2bn according to the Treasury, with some estimates at closer to 2.5bn.

When we sum the reserves the banks have taken for this charge we derive 2.1bn

excluding the contributions from Morgan Stanley and J.P. Morgan.

Table 13: UK Bon us Tax

million

Cost (lcl) Cost (GBP) Impact on 2012E

RBS 368 368 -4.8%Lloyds 20 20 -0.3%HSBC $355 234 -1.1%Barclays 225 225 -2.9%Standard Chartered $58 38 -0.9%

Bank of America $465 306Citigroup $400 263Goldman Sachs $600 395Deutsche Bank 225 200Total 2,050


Note one area of potential contention is whether the revenues collected from a banklevy are maintained in a fund to pay for future potential bailouts of the banking

sector or are treated as general revenue for the government. The key difference

depends on whether a payment to general revenues leads to changes to other taxes or

spending, as illustrated in the following example provided by the IMF in its interim

report for the G-20 (16/04/2010):


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It makes no substantive difference to the public sectors financial position

whether a levy accrues to general revenues or to a fund that invests in

government securities. Payment to general revenue leads, in the absence of changesto other taxes or spending, to less need for the government to sell debt on the open

market. Payment to a fund which then purchases government debt has the same

effect. The only difference is that payment to general revenues reduces the gross

amount of debt issued, whereas payment into a fund leaves gross debt unchanged,

but with part of debt now held by a public entitythe fund. In both cases, netpublic

debtthe net amount owed to the private sector by the government and the fund

combined, which determines the interest burdenis lower, and by the same amount.

The table below illustrates, for a levy of 100.

Flow of Payments Government Debt

Private sector Fund Government Revenues Gross Debt Net DebtNo fund -100 0 +100 -100 -100Fund -100 +100 0 0 -100

When failure occurs and cash is needed, the impact is again the same: with no fund,

financing needs can be met by the government selling new debt on the open market;

with a fund, financing needs are met by selling its own holdings of government debt

or passing them to institutions which may sell them.

In that report the IMF proposed two new taxes:

(i) Financial Stability Contribution (FSC) It is unclear whether a chargeshould be kept in a fund or should feed into general government revenues, but the

idea is that there are levies to build a provision for future losses. Regarding the

size of the charges, the document states that past experiences suggest that for

many countries provisioning for c.2-4% of GDP should be sufficient, althoughfor countries where the financial sector is particularly large relative to GDP this

provision should be correspondingly higher this could lead to a higher charge in

the UK. Note UK GDP is c.1.4trn, so the potential annual impact could be very

significant for the UK banks.

(ii) Financial Activities Tax (FAT) Two approaches are reviewed, a tax on

financial transactions (a Tobin tax), which the report says does not appear to be

well suited to the specific purposes set out in the mandate from the G-20 leaders,

and a financial activities tax. The proposal for a financial activities tax is on the

sum of profits and renumeration of financial institutions, but could be tiered

above threshold rates of return.

We think the analysis is not quite as simple as the example suggests, as it is unclear

for multinational organizations who collects the levies and hence which

government's securities the funds are invested in (the proportional split).


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What are the potential mechanisms and

associated impact?In this section we review possible ways for the government to reduce its holdings in

RBS and Lloyds Banking Group if it decides to exit. This is by no means an

exhaustive list but we have highlighted four main methods of potential exit:

Share sales;

Issuance of convertible bonds;

Buy back;

An asset swap.

The table below shows the current holdings of RBS and Lloyds Banking Group andthe average government entry prices.

Table 14: Lloyds Banking Group: Average Government Entry Price

million

Shares Total Investmen t Per Sharem m p

Initial Recapitalisation 7,277 12,957 182.5Preference Share Conversion* 4,521 1,508 38.43Rights Issue 15,810 5,850 37.0Total Investment 27,609 20,315 73.6Return on InvestmentFees Received** -376Dividends receivedProfit/Loss on disposals

Total Investment 27,609 19,939 72.2APS fee (Gross) -2,500Total Investment less APS fee 27,609 17,439 63.2% stake held by Government 41%

Source: J.P. Morgan estimates, Company data, UKFI data. Pre Dec 2009 rights price based on UKFI data, adjusted for accrued divs

and redemption premiums of 230mn. APS fee taken gross at 2.5bn, was 1.8bn after tax.

Table 15: RBS: Average Entry Price fo r the UK Government

Shares Total Investmen t Per Sharem m p

Initial Recapitalisation 22,854 14,969 65.5Preference Share Conversion* 16,791 5,058 31.8APS B Shares 51,000 25,500 50.0Total Investment 90,645 45,527 50.2Return on Investment

Fees Received** -305Dividends receivedProfit/Loss on disposals

Total Investment 90,645 45,222 49.9% stake held by Government 82%

Source: UKFI. Notes *Total investment adjusted to take account of accrued dividends and redemption premiums received of around

270 million, **Underwriting fees on transactions paid to HM Treasury, including the recapitalisation and preference share conversion


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Share sale

There are several ways that a share sale could be executed, the most common being:

A public offering in the UK there have been several privatizations, and the

Conservative party has discussed this possibility for the bank stakes. Potentially

stock could be offered to institutional and retail investors at different pricing

points and depending on previous ownership;

A 'drip feed' similar to the strategy that the US government is employing for

the sale of its Citigroup holding. Clearly, this can be executed in combination

with occasional accelerated book builds;

An additional listing the government could potentially list the B-shares in the

case of RBS;

Private placing potentially the government could sell shares to a closed group

of investors without a broader public offering, or a strategic investor such as asovereign wealth fund.

Below we review each of these methods in greater detail. Note there have been some

questions whether the government could sell the RBS shares whilst there is a

commission looking at the separation of retail and investment banking activities. We

think that this makes a placing more difficult, but with the right disclosures should

not be prohibitive and would be reflected in the pricing achieved.

Public offering

The stakes could be sold in a similar manner to previous privatizations of

government assets. The two most notable transactions are the privatisations of

British Telecom and British Gas, we review both below.

British Telecom privatisation

BT was the first major privatisation of the 1980s and potential shareholders were

split into four categories: institutions, the general public, BT employees and

pensioners, and buyers in the US, Canada and Japan. Initially 51% of the company

was offered, and then there were two follow-on offerings in 1991 and 1993 spanning

a period of 9 years. The charts below show the allocations and the relative size of the

offerings.

Figure 4: Bri tish Telecom IPO (November 1984)

Institutios

47%

Employe

es/Pensi

oners

5%

Public

34%

Internatio

nal

14%

2nd

issue

27%

3rd issue

22%

1st issue

51%

First Issue Allocations Percentage shares issued



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British Gas privatisation

British Gas was the second privatisation and broadly followed the British Telecom

model. Initially UK retail investors were to be allocated 40% of the shares, but dueto over subscription they ultimately received 65%. 96% of the company was offered

with the government retaining only 4%.

Figure 5: B ritish Gas IPO (November 1986)

UK

Retail

40%

Internatio

nal

20%

UK

Institutional

40%

UK

Retail65%

UK

Institution

al

24%

Internatio

nal

11%

Planned Allocations Ultimate Allocations


From both of these transactions there is a heavy bias towards UK retail investors,

who were typically offered a discount to institutional investors, and UK institutions

were also given preferential allocations. Shares were offered to retail investors at c2-

5% discounts. Currently the shareholder structures of RBS and Lloyds Banking

Group are split as illustrated below.

Figure 6: RBS and Lloyds YE09 Shareholder Profil es

Foreign

Institution

al

29%

UK

Institution

al

41%

Other

13%

UK

Retail

17%

UK

Retail

19%

UK

Institution

al

49%

Foreign

Institution

al

32%

RBS Investor Base YE09 Lloyds Investor Base YE09Source: J.P. Morgan estimates, Company Reports

We note that both Lloyds Banking Group and RBS have substantial institutional

investor bases and high weightings of UK investors. If the mix were to become more

skewed towards retail investors then this could increase the focus on dividends and

payout ratios. Managements may be under greater pressure to resume dividend

payments as soon as EU restrictions are lifted, i.e. from Apr 2012 for both RBS and

Lloyds Banking Group.


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Slow drip feed

The government could sell the stakes into the market slowly over time, in a similar

way to the US government's approach with its Citigroup stake. This could beeffective, the main issue being the amount of time that this would take. Clearly, as

the government sells the free float increases, potentially increasing the turnover, but

based on current average trading volumes it would take c. 9.4 years for RBS and 1.9

years for Lloyds if sales were limited to 15% of average daily volume.

Table 16: UK Banks: Tim e to Sell RBS and Lloyds at 15% of the vo lume

RBS LloydsGov Shares 90,645 27,609Average Daily Volume 176 25915% ADV 26 39Implied Days 3,434 711Years 9.4 1.9

Source: J.P. Morgan estimates, Bloomberg

This method would have limited impact on the strategies of the groups and their

earnings potential in our view.

Additional listing

According to the terms of the RBS Accession Agreement:

The B Shares will not initially be listed on any stock exchange. HM Treasury is

entitled to require RBS to seek a listing of the B Shares. The Dividend Access Share

will not be listed on any stock exchange.

So potentially the government could require RBS to list the B-shares separately to

the common equity. If it is possible for the preferential dividend rights to be

maintained this could be a way for the government to extract more value from itsholding.

Private placement

It may be possible for the government to sell part of its holding to a strategic buyer,

such as a foreign bank or sovereign wealth fund.

There have been unconfirmed reports in the press recently (FT 25 May 2010) that

Qatar Investment Authority (QIA) has expressed interest in buying part of the US

Treasurys stake in Citigroup; we could possibly see such a transaction for the UK

banks. QIA currently has a 12% stake in Barclays (including 2% from Challenger, a

related entity).

Summary of impact from a share sale

Overall we believe a share sale would have a neutral impact on valuation, but the

increased liquidity could have a positive impact in terms of where the shares trade in

relation to fundamental valuation. Further there would be index implications which

we discuss later in pages 25-27.

An increase in the retail investor base could shift the focus more towards dividend

distributions, at the expense of reinvestment in the businesses, and a strategic buyer

may add value to other stakeholders. Further as the UKFI does not currently 'loan'

shares in its holdings, a sale would add incrementally more liquidity, however this


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benefit would be partially offset if shares are mainly acquired by retail investors

(who also loan limited amounts of stock).

We think a share sale with possibly a combination of the measures outlined above is

the most likely exit route.

Convertible bonds

It may be possible for the government to issue mandatory convertible notes (MCNs)

that convert into RBS or Lloyds shares. These could be similar to the instruments

issued by Barclays in October 2008 to Middle Eastern investors and institutions.

The attraction for investors could be the ability to earn a yield during the period

when RBS and Lloyds cannot distribute earnings, and for the government the

attraction could be a conversion price at a premium to current share prices (although

this should be neutral from a deficit point of view as the additional yield expense is

reflected in government expenditure, offsetting the additional gain).

The difficulty of this approach is the volume of issuance required, and given some

investor mandates, some may not be able to participate. We think that this approach

could be used but in limited size, and may be executed alongside another exit method

such as an equity placing.

Buyback

In the Acquisition and Contingent Capital Agreement between HM Treasury and

RBS it says:

that in relevant circumstances, and acknowledging the conversion feature

applicable to the B Shares set out in the B Share terms, the Company will repurchase

the B Shares if it is prudent and practicable. Such repurchase would be subject to

FSA approval and take account of the Regulatory Groups capital position at the

time of the proposed repurchase and prevailing market conditions

Furthermore, HM Treasury has agreed with the European Commission:

1. That without the prior approval of the European Commission, it will not agree tosell to the Company any B Shares issued to and held by HM Treasury below the

following minimum purchase prices: (a) for purchases before 31 December 2012,

50p; (b) for purchases between 31 December 2012 and 30 December 2013, 55p;

(c) for purchases between 31 December 2013 and 30 December 2014, 60p; and

(d) for purchases from 31 December 2014, 65p.In each of these cases, if the price of the Ordinary Shares is higher than the above

agreed price when the sale is agreed, the price of the Ordinary Shares will be the

minimum price.

2. That without the prior approval of the European Commission, it will not convertany B Shares issued to and held by it into Ordinary Shares unless the market

price of Ordinary Shares is at least 50p on the date on which HM Treasury

delivers its Conversion Notice. This price is subject to adjustment in line with

adjustments to the Conversion Price.


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3. If the capital position of the Company allows this and subject to any consentrequired from the FSA, it will request the Company to purchase from it an

appropriate number of B Shares (within the above-mentioned price parameters)or to retire an appropriate amount of the Contingent Subscription.

So under the agreement it appears possible for RBS to buy back the B shares, and in

fact if the capital position allows it, it is possibly an EC requirement.

We do not think that the opportunity will arise however in the short term, given the

capital impact and the regulatory uncertainty surrounding the potential changes to

capital requirements and business models. It would be very risky for the FSA to

permit such a move in the absence of a further capital raise, which would offset any

potential positive impact for common equity holders. In Table 17 below we illustrate

the group's capital ratios if there was a buyback without additional capital raise.

Table 17: RBS: Capital ratio s if t he B sh ares were redeemed million

2009 2010E 2011E 2012E 2013E

Core Tier 1 Capital 48,151 49,108 50,460 55,607 63,447ow APS deduction -5,106 -4,460 -3,643 -2,223 -435CT1 ex deduction 53,257 53,568 54,104 57,829 63,882

RWAs 438 483 545 503 471ow APS deduction -128 -111 -91 -56 -11RWAs ex deduction 566 595 637 558 482

Core Tier 1 Ratio 11.0% 10.2% 9.3% 11.1% 13.5%Core Tier 1 Ratio ex APS 9.4% 9.0% 8.5% 10.4% 13.3%

B share capital 25,500 25,500 25,500 25,500 25,500

Net Yield 1.5% 1.5% 1.5% 1.5% 1.5%Earnings on B shares 383 383 383 383Cumulative Earnings 0 383 765 1,148 1,530

CT1 post buyback 23,225 24,195 28,959 36,417CT1 post buyback ex APS 27,685 27,839 31,182 36,852

CT1 ratio post buyb ack 4.8% 4.4% 5.8% 7.7%CT1 ratio post buyb ack ex APS 4.7% 4.4% 5.6% 7.7%


Whilst in 2013E from the table above the capital ratio looks better, the calculations

above do not incorporate the potential Basel III changes which could further reduce

capital ratios by c. 200-300bps.

In an environment where there is still significant macro uncertainty we expect thatwhilst some regulation may be pushed back, regulators will still limit the amount of

capital distribution to investors.


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Terms and Impact of exiting the contingent capital facility

Whilst we think it is unlikely that the B shares are bought back, we think that RBS

could seek to terminate the contingent capital facility early.

Currently the facility is triggered if the core tier 1 ratio for the group falls below 5%,

and is 8.0bn in size. It is triggered in tranches (provisionally set as 6bn and 2bn)

and is scheduled to last for 5 years. The company can terminate the facility if it has

the FSAs consent at any time.

The fee for the facility is 4% of the total size, i.e. 320mn per annum at the

origination, and if RBS exits or reduces their participation the fee is reduced

proportionately.

At the YE09 the fair value of the consideration payable was 1,458mn, and the

company set aside 1,208mn towards a contingent capital reserve, so if there is early

termination part of this reserve could be released. The potential benefit is smallhowever in the context of the group if 100% of the reserve was released it would

benefit NAV by c. 1p, i.e. 2%.

An asset swap

The fourth method that the government could use to maximise the value of its

holding could be to restructure the businesses and swap the holdings for various

assets.

This seems unlikely to us, and it is not clear whether it is legally possible, but it

could transfer value from other stakeholders to the taxpayer, and could be similar to

the restructuring of Northern Rock. Further, it could be a means to break up the

banks to create more competition in the market place.


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Index implications

Currently several of the key indices tracked by investors base their weighting

methodology on the free floats of stocks. As such, if the UK government does

reduce its stakes in the banks, there will be some significant index implications.

Whilst the overall supply would dwarf the potential demand, potential timing

differences could lead to trading opportunities.

In the section below we review the potential impact.

Tracker demand

For the UK banks the main indices are the FTSE, MSCI and DJ Stoxx. Figure 7

below illustrates the amount of passive money benchmarked to each.

Figure 7: Estimated Passive Indexed Assets $bn

Source: J.P. Morgan Derivatives and Delta One Strategy. Data as of Dec 2009.

The tables below show the potential demand in three cases: (i) a sale of 100% of the

government holding in Lloyds Banking Group, (ii) a sale of 100% of the

government's common equity holding in RBS, and (iii) a sale of the governments

common equity holdings and B share holdings in RBS.

For further details please refer

to;

JPM: 2010 Global Index

Handbook, Jan 2010

We would like to thank Trista

Rose for her collaboration in this

section. For more details on

Index implications please

contact:

Equity Derivatives & Delta One

Strategy

Trista J Rose(44-20) 7325 4402

[email protected]


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Table 18: Simulated Demand Lloyd s free float inc reased to 100%

Old weight New weight Demand - shares Demand - USD xADV

FTSEFTSE 100 1.539% 2.609% 466.40 372.17 1.80FTSE ALL SHARE 1.307% 2.215% 2,743.52 2,189.26 10.60FTSE AW 0.137% 0.233% 274.35 218.93 1.06MSCIMSCI EAFE 0.322% 0.536% 838.97 669.47 3.24MSCI EUROPE 0.500% 0.833% 127.12 101.44 0.49MSCI KOKUSAI 0.157% 0.261% 38.14 30.43 0.15STOXXStoxx 600 0.483% 0.822% 78.66 62.77 0.30TOTAL 4,567.16 3,644.46 17.64

Source: J.P. Morgan Derivatives and Delta One Strategy, FTSE, MSCI Barra, Stoxx Ltd, Bloomberg

Table 19: Simulated Demand RBSs free float inc reased to 100% no B share s ale

Old weight New weight Demand - shares Demand - US xADVFTSEFTSE 100 0.555% 1.849% 674.59 448.26 3.83FTSE ALL SHARE 0.471% 1.570% 3,968.20 2,636.85 22.55FTSE AW 0.049% 0.164% 396.82 263.68 2.25MSCIMSCI EAFE 0.119% 0.396% 1,302.05 865.20 7.40MSCI EUROPE 0.185% 0.615% 197.28 131.09 1.12MSCI KOKUSAI 0.058% 0.193% 59.18 39.33 0.34STOXXStoxx 600 0.180% 0.607% 118.93 79.03 0.68TOTAL 6,717.05 4,463.44 38.17

Source: J.P. Morgan Derivatives and Delta One Strategy, FTSE, MSCI Barra, Stoxx Ltd, Bloomberg

Table 20: Simulated Demand RBS free float increased to 100% and B shares lis ted

Old weight New weight Demand - shares Demand - US xADVFTSE

FTSE 100 0.555% 3.512% 1,541.59 1,024.38 8.76FTSE ALL SHARE 0.471% 2.983% 9,068.20 6,025.77 51.53FTSE AW 0.049% 0.312% 906.82 602.58 5.15MSCIMSCI EAFE 0.119% 0.754% 2,985.05 1,983.55 16.96MSCI EUROPE 0.185% 1.172% 452.28 300.54 2.57MSCI KOKUSAI 0.058% 0.367% 135.68 90.16 0.77STOXXStoxx 600 0.180% 1.156% 271.93 180.69 1.55TOTAL 15,361.55 10,207.66 87.29

Source: J.P. Morgan Derivatives and Delta One Strategy, FTSE, MSCI Barra, Stoxx Ltd, Bloomberg.

Overall the passive demand from index trackers is c.17% of the supply based on

our estimates.

Further if the free float was increased to 100% for both banks they could re-enter theStoxx 50 Index, further increasing demand. Note additions can only be made to this

index during the annual review (every September).


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Timing of Index re-weighting

In the event of a rights issue (not our base case scenario) the FTSE, MSCI and Stoxx

rebalance occurs at the close on the last day that the stock is cum rights. If there is aplacing the treatment is slightly different:

FTSE if the impact is more than 10% then the rebalance is done within 2-4 days

typically

MSCI if the placing is expected to have significant market impact the

reweighting can be delayed to the next quarterly review

Stoxx for the Stoxx if the impact is greater than 5% then the rebalance isusually executed within 2-4 days

Note whilst these are the times that the rebalancing occurs, passive funds do not have

to execute at the exact same time, there can be some flexibility build into theirmandates to reduce the potential for their trading to minimise price impact.


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Stock implications

Despite the stocks having corrected in the wake of sovereign concerns, both RBS and

Lloyds Banking Group have outperformed the European banks index by 71.7% and

23.8% respectively YTD and are currently trading at 0.92x NAV and 0.93x NAV

2011E respectively. Fundamentally, we believe that returns are capped for both

these banks until they address certain issues. We go through each stock in turn as we

try to explain why we struggle to see RoEs exceeding 11-12% over the next three

years or so.


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Lloyds Banking Group

Company Data

Price (p) 57Date Of Price 28 May 10Price Target (p) 50Price Target End Date 31 Dec 1052-week Range (p) 76 - 40Mkt Cap ( bn) 36.11Shares O/S (mn) 63,775

Lloyds Banking Group Plc (LLOY.L;LLOY LN)

FYE Dec 2008A 2009A 2010E 2011E

Adj. EPS FY (p) -0.46 -0.19 -0.01 0.04Headline EPS FY (p) 0.05 0.04 0.01 0.04NAV/Sh FY (p) 164.3 58.3 58.0 61.7P/NAV FY 0.3 1.0 1.0 0.9Pretax Profit Adjusted FY ( mn) (5,761) (11,633) (941) 3,837Net Attributable Income FY (mn)

772 2,827 547 2,474

Adj P/E FY NM NM NM 1,463.9Core Tier One Ratio FY 6.2% 8.1% 8.3% 9.4%Source: Company data, Bloomberg, J.P. Morgan estimates.

Over the last few months on the back of management guidance, expectations have

moved towards the group earning an operating profit on a combined business basis in2010E. In fact in the Q1 IMS the management stated that due to lower wholesale

impairments this goal had already been achieved in Q1. The next question that

investors have been asking is, what would it take for the group to earn a 15%

RoNAV, and hence justify multiple expansion?

Based on our estimates the group will earn an 11.2% RoNAV in 2012E, and to

generate a 15% RoNAV the net attributable profit would need to be 36% higher at

6,733mn as illustrated below (note we are referring to return on tangible equity, to

achieve a 15% return on total equity attributable profit would need to be significantly

greater but also the book value is that much higher).

Table 21: Lloy ds Banki ng Group : 2012E 15% RoNAV Net Attribut able Profit Calculatio n

million

Current EstimatesNAVps 2011E (p) 61.7NAVps 2012E (p) 69.3Average NAVps 2012E (p) 65.5No. of Shares (mn) 67,6662012E Net Attrib 4,9392012E RoNAV 11.1%

Required Estimates2011E NAV 41,725Implied 2012E Net Attrib 6,766% change in estimate 37%Implied 2012E EPS (p) 10.0Implied 2012E NAV 48,492Implied 2012E NAVps (p) 71.7

Implied 2012E RoNAV 15.0%


To drive such an outperformance in earnings there are potentially three key levers: (i)

an increase in net interest margins, (ii) a reduction in costs, and (iii) a further

reduction in provisioning requirements. We go through each in turn.

(i) Sensitivity to increasing banking NIM

The first area that we explore is the potential for greater NIM expansion than

currently estimated. In H209 banking NIM expanded to 1.83% from 1.72% in H109,

after declining from 2.01% in 2008. Management guidance at the FY 2009 results


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for 2010E is c2.0%, with an upward trajectory beyond then. In our base case we

expect 2.1% in 2010E, increasing to 2.4% in 2012E.

Table 22: Lloyds Banking Group: Banking NIM Progression

million

H108 H208 H109 H209 2008 2009 2010E 2011E 2012EBanking NII 6,415 6,768 5,724 6229 13,183 11,953 12,944 13,355 13,924AIEA 644,889 666,969 671,944 676548 655,989 674,246 618,453 601,771 588,642Banking NIM 1.99% 2.03% 1.70% 1.84% 2.01% 1.77% 2.09% 2.22% 2.37%

Group NII 7,042 7,861 6,442 6,284 14,903 12,726 12,944 13,355 13,924

Source: J.P. Morgan estimates, Company data. Group net interest income is historically greater than banking net interest income, but in H209 it was broadly the same. We have assumed that they

are equal going forwards.

Note that whilst the NIM may be increasing, the size of the balance sheet is

shrinking. Management has guided to a further 140bn reduction by end 2014E, of

which 100bn is in customer loans and 40bn in Treasury assets. This will put

pressure on the absolute level of net interest income despite the margin expansion.

In the analysis below to illustrate the combined effect, in the 15% RoE scenario we

have assumed that this 'right sizing' has taken place.

Table 23: Lloyds Banking Group: Potential for NIM expansion

million

% Change % Change % Change2009A 2012E 15% RoNAV 12E/09A 15% RoNAV/09A 15% RoNAV/12E

Net Interest Inco me 12,726 13,924 18,396 9.4% 44.6% 32.1%Non Interest Income 9,740 10,378 10,378 6.5% 6.5% 0.0%Total Inco me 22,466 24,301 28,773 8.2% 28.1% 18.4%Operating Costs -11,609 -11,315 -13,397 -2.5% 15.4% 18.4%Pre Provision Operating Profit 10,857 12,986 15,376 19.6% 41.6% 18.4%Provisions -23,988 -6,002 -5,736 -75.0% -76.1% -4.4%

Under ly ing PBT -13,131 6,984 9,640 -153.2% -173.4% 38.0%Restructuring Charges -1,096 -400 0 -63.5% -100.0% -100.0%Fair Value Unwind 6,100 500 0 -91.8% -100.0% -100.0%Other Exceptionals 9,169 0 0 -100.0% -100.0% naProfit Before Tax 1,042 7,084 9,640 579.8% 825.1% 36.1%Tax 1,911 -2,019 -2,747 -205.6% -243.8% 36.1%Profit After Tax 2,953 5,065 6,892 71.5% 133.4% 36.1%Minorities -126 -126 -126 0.0% 0.0% 0.0%Net Attr ibutab le Profi t 2,827 4,939 6,766 74.7% 139.3% 37.0%

NIM 1.77% 2.37% 3.44% 33.4% 94.2% 45.6%Cost Income Ratio 51.7% 46.6% 46.6% -9.9% -9.9% 0.0%Impairment Charge 3.25% 0.98% 0.98% -69.9% -69.9% 0.0%

Banking Net Interest Income 11,953 13,924 18,396 16.5% 53.9% 32.1%Average Customer Loans 686,462 613,642 586,462 -10.6% -14.6% -4.4%

AIEA 674,246 588,642 534,246 -12.7% -20.8% -9.2%


Based on the table above, it appears that the net interest margin would need to

increase by 167bps from 2009 levels, and a further 107bps from JPMe 2012E to

achieve a 15% RoNAV. What we are seeing in the market however is that asset

pricing has started to stabilize and in some markets actually contract slightly. For the

UK mortgage market, data from the Council of Mortgage Lenders (CML) suggests

that the back book of existing business has largely re-priced, as illustrated in the

charts below.


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Figure 8: Yield on mortgages

3.00%

3.50%

4.00%

4.50%

5.00%

5.50%6.00%

6.50%

Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10

Outstanding Balances New Business

Source: CML / BOE

Figure 9: Spread between new business and outstanding balances

-0.60%

-0.40%

-0.20%

0.00%

0.20%

0.40%

0.60%0.80%

1.00%

Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10

Spread

Source: CML / BOE

Clearly new business prices can pick up again from these levels but that is largely inour forecasts.

Further, on the liability side we have several concerns:

Whilst deposit spreads have been compressed and are likely to improve we expect

greater amounts of competition than what we have seen in previous cycles, and hence

more limited benefit. Further, with regards to wholesale funding we expect investors

to require higher margins to compensate for the increased risk that is associated with

less valuable sovereign protection.

There is also potentially an issue with the sheer volume of paper that needs to be

issued by sovereigns, banks and corporates over the coming 18-24 months, pushing

up yield requirements. In fact there is a risk that banks are forced to resort to centralbank facilities as they are effectively crowded out from term debt issuance. For

further details on this topic please see JP Morgan's 'European Banks H2'10 Outlook

- The Big Squeeze'27 May 2010 by Roberto Henriques. This may result in the

duration of liabilities shortening in the near term, helping earnings, but is negative in

the medium term.

As observed in the report, if sovereign concerns were to diminish this would be less

of an issue, however we think this would likely be on the back of effective austerity

plans, which would have their own impact on economic growth and hence bank

earnings. Our UK economists estimate a 0.5x multiplier between fiscal tightening

and GDP growth (please see JP Morgan's 'UK fiscal policy: the coming tightening

and its impact'21 May 2010 by Malcolm Barr).

(ii) Sensitivity to reducing costs

At the time of the HBOS acquisition, management guided to 1.5bn of cost

synergies, c.28% of the HBOS cost base. Since then this figure has been revised

upwards to 2.0bn, c37% of the HBOS cost base. Given 766mn has already been

achieved, this leaves 1.25bn to be done by end 2011E. Over this period integration

costs are estimated to total 155% of the annual benefit.

Overall management guidance is for c.2% reductions in the cost income ratio per

annum for the next few years (note in 2009 the ratio of 48.4% benefited from 1.5bn

gains on exchange and tender offers, excluding this item the clean cost income ratio
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was 51.7%). We model the cost income ratio declining to 46.6% 2012E. Table 24

below illustrates the reductions in costs to achieve a 15% RoNAV.

Table 24: Lloyds Banking Group: Potential for Cost Reduction

million

% Change % Change % Change2009A 2012E 15% RoNAV 12E/09A 15% RoNAV/09A 15% RoNAV/12E

Net Interest Inco me 12,726 13,924 13,924 9.4% 9.4% 0.0%Non Interest Income 9,740 10,378 10,378 6.5% 6.5% 0.0%Total Inco me 22,466 24,301 24,301 8.2% 8.2% 0.0%Operating Costs -11,609 -11,315 -8,925 -2.5% -23.1% -21.1%Pre Provision Operating Profit 10,857 12,986 15,376 19.6% 41.6% 18.4%Provisions -23,988 -6,002 -5,736 -75.0% -76.1% -4.4%Under ly ing PBT -13,131 6,984 9,640 -153.2% -173.4% 38.0%Restructuring Charges -1,096 -400 0 -63.5% -100.0% -100.0%Fair Value Unwind 6,100 500 0 -91.8% -100.0% -100.0%Other Exceptionals 9,169 0 0 -100.0% -100.0% naProfit Before Tax 1,042 7,084 9,640 579.8% 825.1% 36.1%

Tax 1,911 -2,019 -2,747 -205.6% -243.8% 36.1%Profit After Tax 2,953 5,065 6,892 71.5% 133.4% 36.1%Minorities -126 -126 -126 0.0% 0.0% 0.0%Net Attr ibutab le Profi t 2,827 4,939 6,766 74.7% 139.3% 37.0%

NIM 1.77% 2.37% 2.61% 33.4% 47.0% 10.2%Cost Inco me Ratio 51.7% 46.6% 36.7% -9.9% -28.9% -21.1%Impairment Charge 3.25% 0.98% 0.98% -69.9% -69.9% 0.0%

Banking Net Interest Income 11,953 13,924 13,924 16.5% 16.5% 0.0%Average Customer Loans 686,462 613,642 586,462 -10.6% -14.6% -4.4%AIEA 674,246 588,642 534,246 -12.7% -20.8% -9.2%


Based on this analysis the cost income ratio would need to decline to 37% to achieve

a 15% RoNAV. We note that this would imply a further absolute cost reduction of2.6bn, i.e. in total savings of 64% of the HBOS cost base or 28% of the combined

2008 cost base.

(iii) Sensitivity to reducing provisions

The biggest delta in 2010 results compared to 2009 will be the level of provisioning.

We have assumed a significant improvement, continuing in 2011E and 2012E, in line

with management guidance.

Table 25: Lloyds Banking Group: Provisioning Guidance & Expectations

%

2010 Guid ance FY08 FY09 FY10E FY11E FY12EGroup Significantly lower than 2009 1.81% 3.25% 1.90% 1.33% 0.98%

Retail Lower than 2009 0.97% 1.11% 0.93% 0.83% 0.74%Wholesale Significantly lower than 2009 3.32% 5.92% 3.11% 2.04% 1.51%Wealth & International Peaked but risk in Ireland 1.05% 6.04% 4.58% 2.42% 1.04%


Table 26 shows how we would have to further reduce our provisioning estimates to

achieve a 15% RoNAV in 2012E.


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Table 26: Lloyds Banking Group: Potential for Further Provisioning Reduction

million

% Change % Change % Change2009A 2012E 15% RoNAV 12E/09A 15% RoNAV/09A 15% RoNAV/12ENet Interest Inco me 12,726 13,924 13,924 9.4% 9.4% 0.0%Non Interest Income 9,740 10,378 10,378 6.5% 6.5% 0.0%Total Inco me 22,466 24,301 24,301 8.2% 8.2% 0.0%Operating Costs -11,609 -11,315 -11,315 -2.5% -2.5% 0.0%Pre Provision Operating Profit 10,857 12,986 12,986 19.6% 19.6% 0.0%Provisions -23,988 -6,002 -3,346 -75.0% -86.0% -44.2%Under ly ing PBT -13,131 6,984 9,640 -153.2% -173.4% 38.0%Restructuring Charges -1,096 -400 0 -63.5% -100.0% -100.0%Fair Value Unwind 6,100 500 0 -91.8% -100.0% -100.0%Other Exceptionals 9,169 0 0 -100.0% -100.0% naProfit Before Tax 1,042 7,084 9,640 579.8% 825.1% 36.1%Tax 1,911 -2,019 -2,747 -205.6% -243.8% 36.1%Profit After Tax 2,953 5,065 6,892 71.5% 133.4% 36.1%Minorities -126 -126 -126 0.0% 0.0% 0.0%Net Attr ibutab le Profi t 2,827 4,939 6,766 74.7% 139.3% 37.0%

NIM 1.77% 2.37% 2.61% 33.4% 47.0% 10.2%Cost Income Ratio 51.7% 46.6% 46.6% -9.9% -9.9% 0.0%Impai rmen t Charg e 3.25% 0.98% 0.57% -69.9% -82.4% -41.7%

Banking Net Interest Income 11,953 13,924 13,924 16.5% 16.5% 0.0%Average Customer Loans 686,462 613,642 586,462 -10.6% -14.6% -4.4%AIEA 674,246 588,642 534,246 -12.7% -20.8% -9.2%


Based on this analysis the group would need to report a provisioning rate of 57bps on

a normalized basis. In Table 27 below we show our normalized provisioning

estimates;

Table 27: Lloyds Banking Group: Normalised Provisioning Rate%

Normalised 2012E H109 H209Retail 0.68% 1.16% 1.09%Secured 0.12% 0.34% 0.11%Unsecured 7.00% 9.09% 11.16%Whol esale 1.48% 6.87% 5.83%Corporate Markets 1.50% 9.01% 5.83%Treasury and Trading 0.00% 0.00% 0.00%Asset Finance 1.50% 6.34% 7.16%Wealth & Internatio nal 0.87% 4.77% 8.55%Wealth 0.05% 0.52% 0.96%International 1.00% 5.59% 9.93%Total 0.91% 4.11% 3.25%


Whilst at the start of this year impairments have tracked better than our expectations,

and we do not expect to need to downgrade our provisioning estimates, if global (and

particularly UK) growth assumptions are reduced the pace of improvement could be

slowed. Note that at FY09 the company based its 2010E guidance on a UK GDP

growth rate of 1.8% in 2010E which appears high relative to current consensus

expectations of c.1.3%.

For details on changes toprovisioning methodology please

refer to;

JP Morgan European Banks:

Asset Quality Assessing the

impact of regulatory changes

17 May 10
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Summary of potential for 15% RoNAV

So to achieve a 15% RoNAV would be a stretch, even without the impact of

additional taxation that we have discussed earlier in this report or other regulatorychanges. Furthermore, as discussed below, there are sanctions that have been applied

by the EU which we expect will act as a further headwind.

EU sanctions

As a consequence of the state aid that the group has received, the European Council

has imposed several requirements on the business. In the analysis above we have

included the impact of balance sheet reduction, but in addition the group is required

to dispose of a retail banking business with at least 600 branches, 4.6% share of the

UK personal current account market and c.19% of the groups mortgage assets,

within 4 years. This was slightly more substantial than our original estimates. The

company has said that at YE08 this business consumed 18bn of RWAs, had 70bn

of loans, 30bn of deposits, and generated c.500mn of PBT. Below we illustrate its

potential contribution.

Table 28: Lloyds Banking Group: UK Retail Disposal Assets

million

UK Retail Divestmen t Contri buti on 2008 2009E 2010E 2011E 2012E

Inco me 1,400 1,186 1,263 1,351 1,467Expenses -600 -593 -631 -648 -675PPOP 800 593 631 702 792Provisions -300 -354 -334 -294 -263PBT 500 239 298 408 529

Loans 70.0 71.2 71.4 71.9 72.5Deposits 30.0 30.6 31.5 32.5 33.4RWAs 18.0 21.6 22.1 20.3 19.0

Cost Income 43% 50% 50% 48% 46%Asset Margin 2.0% 1.7% 1.8% 1.9% 2.0%Risk Weight 26% 30.3% 30.9% 28.2% 26.2%LDR 233% 233% 226% 221% 217%Provisions/ Loans 0.43% 0.50% 0.47% 0.41% 0.36%


Table 29 below shows the historic earnings of Lloyds TSB and HBOS adjusted for

the unsustainability of its revenue base. We refer the reader toJ.P. MorganLloyds

Banking Group With or Without APS, 11th August 2009 for more details on how

we reached the underlying earnings potential. The combined profits in 2007 are 13%

short of the 2012E requirement for a 15% RoNAV or 22% short, if we include a UK

liability tax impact.

Table 29: Lloy ds + HBOS Historic Earning s

million

2003 2004 2005 2006 2007LLOY 3,254 2,392 2,493 2,803 3,289HBOS 2,452 3,118 3,230 3,879 4,045HBOS Adj 1,618 2,058 2,132 2,560 2,670

Total 4,872 4,450 4,625 5,363 5,959



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Overall Lloyds Banking Group valuation

We have revised our estimates to reflect the recent exchange offer announcement.

For more details please seeJ.P. Morgans Lloyds Banking Group: Exchange Offerof Upper Tier 2 Securities'01/06/10. Our new estimates are shown in Table 30

below. Our SoP based TP of 50p remains unchanged.

Table 30: LBG: Changes to Estim ates

2010E 2011E 2012ENew basic EPS (p) 0.8 3.7 7.3EPS growth (%) -81.8% 352.1% 99.6%Old basic EPS (p) 0.5 3.7 7.4% difference 56.9% -1.1% -1.1%

New JPM adjust ed NAV (p) 30.9 43.7 51.9JPM adj, NAV grow th (%) 66.1% 41.4% 18.9%Old JPM adjusted NAV (p) 30.9 43.9 52.2% differ ence -0.1% -0.4% -0.5%

New reported NAV (p) 58.0 61.7 69.3Reported NAV growth (%) -0.5% 6.3% 12.4%Old reported NAV (p) 58.4 62.1 69.8% difference -0.6% -0.6% -0.7%

New DPS (p) 0.0 0.0 0.0DPS growth (%) 0.0% 0.0% 0.0%Old DPS (p) 0.0 0.0 0.0% difference 0.0% 0.0% 0.0%

PE -64.4x 14.7x 7.9xStated P/NAV 1.0x 0.9x 0.8xStated RoNAV(%) 1.4% 6.1% 11.1%


Table 31: Lloy ds Banki ng Group: 2010E Based SoP million

Earning s Value Valuation Basis Value per share (p) P/E (x) P/BV (x)Retail Banking 2,193 14,684 RoE - g/CoE - g 22 6.7 1.5Wholesale Banking 832 17,942 RoE - g/CoE - g 26 21.6 1.1Insurance 781 9,460 14 12.1 1.7Wealth & International -534 4,558 RoE - g/CoE - g 7 -8.5 1.0Underly ing Core Earning s 3,272 46,643 69 14.3 1.3Corporate Center -529 -3,704 -5Capital Excess/ Shortfall -269 -8,826 BV/ P/E -13ow Pillar 2 5,578Lloyds Banki ng Group 2,474 34,113 50 13.8 1.0

Price Target 50



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Royal Bank of Scotland

Company Data

Price (p) 47Date Of Price 28 May 10Price Target (p) 42Price Target End Date 31 Dec 1052-week Range (p) 59 - 28Mkt Cap ( bn) 50.17Shares O/S (mn) 107,366

Royal Bank of Scotland Group Plc (RBS.L;RBS LN)

uk banks - jp morgan cazenove

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