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Banks face costly refinancing

Big domestic banks in Greta Britain need to raise as much as Ł750 billion in the next three years to support balance sheets and liquidity as the government prepares to wind down support for the sector, analysts said.

The banks have shown they can stand on their own feet in the bond markets over the past year, raising billions of euros without any government backing.

Lloyds, for example, has just done its first covered bond, a key bank funding tool, which attracted more than €2.5 billion in orders from investors.

But the sheer size of the banks long-term funding needs raises questions about whether they can do it unaided.

“It's presumptuous to assume that the support used 12 to 18 months ago is not needed now when there is a lot of refinancing that needs to happen,” said one financial institutions banker at a European investment bank. Bankers and analysts have said it is unlikely the government will want to extend the Special Liquidity Scheme (SLS) and Credit Guarantee Scheme (CGS) used to support banks through the credit crisis, given the United Kingdom's already massive budget deficit.

Lloyds and Royal Bank of Scotland (RBS), owned 41 and 84% respectively by the government, have said they would shrink their balance sheets to cut funding demands.

“Shrinking a balance sheet will obviously reduce the funding needs. Market skepticism is around how quickly this can be achieved,” said Mike Harrison, banks analyst at Barclays.

Credit Suisse analysts have estimated UK domestic banks -- Lloyds, RBS and Barclays -- would have to issue Ł420 billion to Ł750 billion in wholesale long-term funding over the next three years to maintain existing balance sheets and meet new liquidity regulations.

“We don't think the banks can raise this much money over three years (equivalent to Ł45 billion - Ł80 billion per bank per year) unless they are prepared to pay very considerable spreads,” the Credit Suisse analysts said in a research note.

“Of course, the BOE (Bank of England) might extend its funding schemes, but this seems unlikely to us.”

On Monday, the UK's Financial Services Authority (FSA) said it would not demand that banks comply with the UK's new liquidity rules, which require them to hold cash or highly liquid assets like government bonds to withstand market shocks, until the economy was recovering properly.

“The FSA's move was quite telling,” said one financial sector banker at a European bank. “It's the first sign of regulators being more pragmatic.”

However, the FSA said on Wednesday financial firms would have to close their funding gap by the end of 2012 as special liquidity and credit guarantee schemes are withdrawn. The programs will end in two to four years.

Credit rating agency Moody's Investors Service highlighted the dilemma facing the UK government in a report this week, which warned that some banks could face ratings downgrades as support is phased out.

Analysts pointed to how much more it already costs Lloyds and RBS to raise money from the markets.

“For example, Lloyds and RBS have issued seven- to 10-year senior debt this year at around 190 basis points over mid-swaps,” said Harrison at Barclays. “For HSBC, it would be closer to 60 basis points.” Lloyds' covered bond has priced at a spread of 95 basis points over mid-swaps, which compares with an HSBC covered bond in January done at a spread of 40 basis points.

Lloyds has said it has Ł157 billion of government-backed support, with a “significant proportion" that matures over the next two years from the government's SLS and CGS.”

The bank said it planned to avoid having to refinance much of this funding by “balance sheet reduction.”

“The only way you can do what it (Lloyds) says is to make the assumption they will be able to get people to pay back the loans,” said another bank analyst, who asked not to be named.

“But people aren't going to pay back mortgages early and nor will borrowers on commercial real estate.” (Reuters)