UK banks told to boost capital, shield taxpayers

LONDON (Reuters) - Britain's top banks should shield their retail operations from riskier investment banking activities and hold more capital to protect taxpayers from any future financial crisis, a government-commissioned report said.

Proposals outlined on Monday appear harshest for Lloyds Banking Group , which may be forced to sell hundreds more branches in addition to the 600 already on the block in order to improve competition on the high street.

For the others, ring-fencing their retail arms could force HSBC , Barclays and peers to hold billions of pounds more capital and increase funding costs, potentially squeezing their profits.

Overall, however, the recommendations in the commission's 208-page interim report were not as severe as many had feared, as banks already hold close to the recommended core Tier 1 capital level of 10 percent in anticipation of new global rules.

The panel's decision to steer clear of recommending a full break-up will also give the banks more flexibility to manage their cash and means the changes will be cheaper to implement.

"They've got away with it, apart from Lloyds which might have to sell off more assets, but it could have been harsher and it wasn't," said John Smith, senior fund manager at Brown Shipley.

"There's relief that it's been in line with expectations."

British finance minister George Osborne said he welcomed the "excellent analysis" and findings of the commission led by former Bank of England interest rate setter John Vickers.

Speaking at a news conference in London Vickers said he "absolutely rejects" criticism that his report had been soft on the banks, adding the proposals could be transformative.

The aim had been to make banks less risky and better able to absorb losses, thus ensuring that vital operations like payments systems and cash for ATMs are kept running if a lender nears collapse as RBS did three years ago.

Barclays had been seen as most at risk if the panel proposed more formal separation of businesses, due to its reliance on investment banking. Along with HSBC it had threatened to quit London for New York or Hong Kong if regulation was too onerous.

But by 0948 GMT its shares were up 3.3 percent, while Royal Bank of Scotland rose 2.5 percent and the other UK banks were broadly flat.

Big banks in Britain and elsewhere have already boosted their capital levels in preparation for new rules. Global watchdogs have signaled that extra safeguards for big banks are likely to include a capital buffer of about 3 percent on top of the new global minimum of 7 percent for all banks from 2013.

The commission said it did not expect the City of London would become a less attractive place to do business as a result of its proposed reforms and said continued prosperity was not dependent on British banks.

"Most of the historical evidence suggests that the City's growth was not driven by UK-headquartered banks' success but by its openness to foreign firms and their success in entering the market," it said, adding its reforms should have a broadly neutral effect.

However the ICB took a hard line by requiring the extra 3 percent of capital to be in the form of pure equity as it doubts the effectiveness of hybrid debt known as contingent capital which is also being considered by global regulators.

Underscoring the need for reform, the commission noted the balance sheets of Britain's banks are more than four times the country's annual gross domestic product -- way ahead of the United States where the economy and its banks are roughly the same size.

The UK is also ahead of other countries heavily reliant on the financial services sector such as Switzerland and the Netherlands.

Vickers declined to say what the overall cost to the banks would be or to specify what substantially enhancing disposals by Lloyds might entail.

The banks are expected to lobby heavily before the commission's final report is handed to Osborne and Business Secretary Vince Cable in September.

BRANCHES SALE?

The panel said more needed to be done to combat a lack of competition on the high street as Lloyds' takeover of HBOS -- a rescue deal engineered by the government -- left it with a 30 percent share of the current account market.

Signaling hundreds more branches need to go, its report said Lloyds' sale of 600 branches would "have a limited impact on competition unless it is substantially enhanced."

Deutsche Bank analysts estimated that a 50 percent increase in the size of the disposals previously asked of Lloyds could shave around 6 percent off group earnings.

Vickers and his team stopped short of the nuclear option of unwinding Lloyds' takeover of HBOS, but said: "There is cause for regret that the government in 2008 amended competition law to facilitate the Lloyds TSB/HBOS merger ."

"Enhancing the divestiture would be more economically efficient than reversing the Lloyds TSB/HBOS merger," it added.

Lloyds said it was assessing the full implications of the report and would update the market once it had reviewed it in detail.

(Additional reporting by Paul Hoskins, Huw Jones and Sarah White; editing by Sophie Walker)

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