Lloyds' HBOS losses highlight flaws in FSA capital measures

In a trading statement earlier this month, Lloyds warned its total 2008 losses could reach £10 billion, of which £7 billion originates from the corporate lending book of Halifax Bank of Scotland (HBOS), which it acquired in January.

The news raised concern over Lloyds' capital position, as the group may need to raise extra capital this year to absorb losses. Such a move would be at odds with the FSA, which has called for banks to reduce capital levels in an effort to avert procyclicality.

The regulator announced on January 19 that it expects banks to hold minimum core tier one capital of just 4% of their assets, while advocating they build up a capital cushion when economic conditions ease. But implementing such a policy in the middle of the current crisis may have come too late to help banks in the current crisis. Critics of the move believe shareholders are unlikely to support lower capital levels in a period when bank losses, already substantial, could deteriorate further.

Lloyds estimates its core tier 1 capital ratio at 31 December 2008 to be 6-6.5%, a level it is unlikely to reduce in the immediate future, given the pressure on its portfolios. "It seems counter-productive that at a time when everyone is worried about capital not being enough, the FSA is allowing banks to lower their capital," says Olivia Frieser, a senior credit analyst at BNP Paribas in London. "I think the problem is that investors will not feel comfortable with Lloyds lowering its capital."

The initial loss warning prompted ratings agency Moody's to downgrade Lloyds' long-held Aaa rating to Aa3 on February 16. According to the agency, lowering capital would be the wrong move at this time, despite the FSA's guidance.

"Changing capital requirements in itself doesn't change the financial position of an institution," says Elisabeth Rudman, senior credit officer at Moody's in London. "For us, the weakening of capital is a sign of the weakening of the financial strength of the bank and that would be reflected in the ratings."

"There is a gap between what the regulators are thinking in terms of capital requirements and what the market is thinking," says Simon Adamson, senior analyst at CreditSights in London. "The market thinks tier 1 ratios should be 10% or higher and I don't think regulators really see that."

The FSA declined to comment on Lloyds' capital position or the timing of its new capital requirements. Lloyds is due to announce its full 2008 results on Friday February 27.

See also: Trading book capital must be "several times" higher, FSA says