Are banks diluting us by stealth?

Ian Gordon

07-Dec-2012

The banking sector has offered a mixed bag to investors over the last few years. Long suffering shareholders have held on to hopes of a turnaround, underpinned by support from the government and possibly even general improvement in economic conditions.

However as time goes by, we wonder if loyal investors are being fed stories of hope along with a quiet and steady stream of new share issues resulting in dilution. While recapitalization was required for regulatory reasons, we wonder, how much value has actually been eroded as a result of repeated issue of equity by banks.

During 2008/9, following the onset of the current credit crisis from which the UK banking sector has yet to fully re-emerge, investors suffered unprecedented levels of dilution as banks were “recapitalised”.

Banks issued new shares to new and existing shareholders - in part to absorb heavy losses primarily on property-related assets and to meet new regulatory requirements. This was required in order to materially raise the capital cushions held by banks to withstand the impact of potential future economic turbulence.

While this is understandable to a certain extent, calls by Mervyn King, Governor of the Bank of England, for UK banks to raise fresh capital has prompted speculation that Lloyds, and others, may yet be subject to a further round of equity dilution.

No doubt investors have reasons to worry – especially those with vivid of the 973% dilution imposed on RBS shareholders during 2008/09, and the 1106% increase in the share count experienced by Lloyds’ investors between 2008 and 2010.

And with the HSBC share count already up by 3% year-to-date, we argue that “dilution by stealth” continues.

RBS – 973% dilution in two years

The following chart illustrates the scale of recapitalisation which RBS undertook in 2008/9, with a 973% increase in its share count largely reflecting the UK Government’s £45.8bn “investment” at an average in-price of 505.3p (equivalent).

Simplistically, this took RBS’ core tier 1 capital ratio from c.4% to c.10% on a like-for-like basis.

After absorbing the impact of fresh regulatory requirements (e.g Basel 3), RBS’ effective capital strength will, we believe, be more than three times the level deemed adequate by the FSA when it sanctioned RBS’ acquisition of ABN AMRO in 2007.

Figure 1: RBS sharecount - ordinary and “B” shares (million) 2007-2014e

Source: Investec Securities estimates / Company accounts

Lloyds – a weak position gets weaker

The following chart illustrates a somewhat similar story for Lloyds, where the heavy dilution continued for slightly longer – increasing the share count by 1106% between 2007 and 2010.

Lloyds entered the crisis with arguably the weakest capital position of any UK bank. Existing investors were massively diluted by share issuance to pay for the HBOS acquisition, to “replace” capital used to absorb heavy balance sheet repair and to meet enhanced regulatory requirements.

The UK Government invested £20.3bn at an average in-price of 73.6p and has, so far, been diluted down from c.43% to c.39% by further share issuance.

Figure 2: Lloyds share count – ordinary shares (million) 2007-2014e

Source: Investec Securities estimates / Company accounts

Increasing Share counts – a comparison across banks

The following chart illustrates the extent of “dilution by stealth” during 2012 YTD, with the HSBC share count up 3%, RBS and Lloyds both up 2.5%, while the Standard Chartered and Barclays share count has risen by just 0.4% and 0.3% respectively.

Figure 3: UK banks: Increase in ordinary share count (%) in H1 2012 and H2 2012 (so far)

Source: Investec Securities estimates / Company accounts

HSBC’s equity issuance primarily relates to SCRIP take-up, and its decision to satisfy equity-based compensation with new issuance (rather than by purchasing shares in the market).

Lloyds and RBS shareholders have no cash or paper dividends to worry about. Their dilution stems from the FSA-mandated capital neutralisation of Lloyds/RBS’ decision to recommence coupon payments earlier this year following expiry of the European Commission’s 2- year prohibition, as well as issuance for equity-based compensation.

Barclays and Standard Chartered have notably adopted a somewhat different approach – maintaining purchases of shares in the market to meet equity compensation commitments, thereby avoiding unnecessary dilution.

This clearly makes sense in the case of Standard Chartered, given the surplus capital it is already carrying, and for Barclays, in view of the discount to book value at which its shares currently trade.

Barclays being Barclays even managed to be clever regarding the timing of its share purchases, leading to the crystallisation of a one-time gain of c.£200m in H1 2012 when it closed out its hedge of employee share awards.

Lloyds and RBS investors were less fortunate, being diluted by fresh issuance at below the current market price. Lloyds issued 479m new shares at c.35p in March, while RBS issued 53m shares at c.228p in August/September.

The Regulatory Viewpoint

The FSA has sought to make a virtue of “restricting” dividend payments, and “forcing” (some) UK banks to issue new shares for equity-based compensation payments.

Whereas we are not privy to the one-on-one discussions held between banks and their regulators, the evidence might suggest that Lloyds, RBS and HSBC have borne the brunt of such scrutiny. Meanwhile, the Bank of England’s Financial Policy Committee (FPC) has maintained its uncompromising rhetoric – still calling for banks to raise fresh capital.

Although precise definitions of the key regulatory measures continue to evolve, the most useful measure of capital strength is a bank’s core tier 1 ratio. This closely equates to shareholders equity less a reduction for intangible assets (goodwill) on the balance sheet.

Following its exit from the Asset Protection Scheme, RBS has the lowest core tier 1 ratio at 10.3% 30 June pro forma, while Lloyds stands out as being the most exposed to the UK economy, but with “only” £100bn RWAs allocated against £347bn UK Retail customer loans, (inc. £23bn unsecured). At 31 December 2011, HSBC had the lowest core tier 1 ratio of just 10.1%.

Going forward, Barclays has “maintained flexibility” with a block listing ahead of potential new issuance to meet equity-based compensation in 2013 and beyond. It has yet to take a decision over whether to continue to purchase shares in the market.

As for Standard Chartered, as anticipated, it had an unusually high level of SCRIP take-up (c.60%) for its 2012 interim dividend given the temporary disruption to its share price in early August – but aside from that, minimal new equity issuance.

Risks Ahead?

To be clear, it is not our view that any UK bank should be required to issue further fresh equity.

For the two banks with the “weakest” capital position – RBS and Lloyds – we expect planned ongoing balance sheet shrinkage to prove (more than) sufficient to maintain adequate capital ratios throughout the Basel 3 transition.

Moreover, we do not anticipate that any Lloyds dividend will be declared before February 2014, and even then we are only looking for a nominal 1p per share. For RBS, any resumption of dividend payments will, we believe, come later.

One consequence of the “dilution by stealth”, caused by issuance since the UK Government’s final investment on 31 December 2009, has been to reduce the Government’s stake from 84% to 80%.

Without any additional capital injection, and without any sell-down of the Government’s holding at a loss, we expect this to continue to decline at c.1% per annum.

Rhetoric from the Bank of England and the FSA?

We give credit to the Bank of England and Financial Services Authority for belatedly owning up to a number of their key policy mistakes during the crisis.

Specifically, we welcome the recent reversal of their position on the (excessive) liquidity reserves which were being stockpiled by the banks at their behest with negative consequences for banks’ profitability, the rebuilding of confidence in financial markets, and the supply of credit to the real economy.

A combination of the easing of such reserve requirements and the launch of the Finance for Lending Scheme should both improve both the pricing and availability of credit.

However, on the issue of bank capital, we do not regard the rhetoric coming from either the Financial Services Authority or the Bank of England’s Financial Policy Committee (FPC) as remotely helpful.

The latest FPC minutes again called for banks to “supplement internal capital generation by seeking opportunities to raise capital externally”. We can only conclude this is a comment made for a politically motivated agenda, rather than with any genuine reference to the true capital requirements of the UK banks.

In contrast to a number of European peers, every UK bank has now outlined capital plans that are consistent with migration through the Basel 3 transition while maintaining minimum core tier 1 capital ratios at 10% or more.

Expect to see more ‘stealth by dilution’

Ultimately, our expectation is that Lloyds, RBS (and others) will resist regulatory/political pressure for any material fresh capital raisings. The UK Government’s own stake in these banks may serve to mitigate against allowing some of the worst excesses of additional regulatory-inspired value destruction to be implemented.

However, at the margin, in a similar manner and scale to 2012, we expect to see ongoing dilution by stealth. Investors should, we believe, be able to differentiate between the affected banks and those (e.g. Standard Chartered) which remain in a position to “stand above the fray”.

As HSBC’s widely admired Group Finance Director, Iain Mackay, caustically remarked last August (in reference to the FPC) “They believe banks are capable of reinforcing their capital by cutting the variable compensation of their employees, by restricting dividends to their shareholders, and by raising capital in the marketplace. Funnily enough, generating profits doesn’t seem to figure in their calculations.”

This article is for general guidance only and should not be relied up as constituting advice suitable to your particular circumstances. You should seek your own independent advice from a suitable professional before taking any action following this article.