Should Darling back Lloyds' rights issue?

I'm not quite sure why there has been another great flurry of speculation overnight about how Lloyds intends to raise additional capital.

Nothing very significant has changed since the last couple of times I wrote about this (in my notes Lloyds: Mind the GAPS and Lloyds to cut use of taxpayer insurance).

As I said back then, Lloyds is desperate to make zero use of the Governments' Asset Protection Scheme (or GAPS).

But its ability to steer clear of GAPS depends on whether it can raise sufficient capital from commercial sources to satisfy the regulator, the Financial Services Authority, that it doesn't need new insurance from taxpayers against potential losses on loans (under GAPS, taxpayers would insure £260bn of Lloyds' poorer quality loans and investments in return for a fee in so-called 'B' shares of £15.6bn).

The amount of new capital it would need is between £24bn and £25bn - or so the FSA ordained last month.

To put this into context, Lloyds' total market value is only £26bn.

So it would need to raise capital equivalent to its own current size, which is not the easiest thing to pull off.

However, it believes that's do-able (as I've said before).

Its plan would be to raise a record-breaking £15bn or so in an issue of new shares and finance the rest through disposals of businesses such as the life insurer and investor, Scottish Widows.

We'll know in a fortnight or so whether this will happen.

There are a number of outstanding imponderables.

One of those is Neelie Kroes - or rather what agreement will eventually be reached by Lloyds with the EU competition commissioner on branches and assets it must sell such that, in Neelie Kroes' view, it doesn't reap unfair competitive advantage from all the state support it has received.

I am told a deal with Kroes may be announced simultaneous with the announcement of how Lloyds intends to raise capital (which makes sense, since there are implications for Lloyds' future cash flow from the forced disposals).

Then there are the other obvious questions.

Will private-sector investors wish to provide the additional capital? Probably, would be my judgement (which in itself tells you something about how the confidence of investors has improved).

Will the scheme satisfy the regulator? Again, probably.

And what will be the attitude of the largest shareholder, the government - as represented by UK Financial Investments - which has a power of veto, as owner of 43% of Lloyds.

The buck will, in the end, stop with the chancellor.

It won't be an easy decision for Alistair Darling to take. Because it is by no means clear that what the board of Lloyds perceives to be in the bank's interest is actually in the interest of taxpayers and the economy.

Now Lloyds motivation for trying to raise capital and avoid the GAPS is straightforward: it doesn't want to increase its financial dependence on the state or defer the day when it can claim to be a freestanding commercial organisation.

But there are other considerations for Alistair Darling.

One is whether Lloyds will be less likely to provide the vital credit needed by businesses and householders if it opts to raise capital from commercial sources rather than the GAPS.

Well, as I understand it, Lloyds projections for growth in what are known as risk-weighted assets (loans and investments adjusted for their riskiness) would be broadly similar were it to go down either route.

Which implies that Lloyds won't lend less to vital parts of the economy if it's a little less tied to the state.

Of course, the chancellor has to decide whether he's comfortable diluting his leverage over Lloyds, just in case the economy recovers less strongly than he would hope and it would be useful to boss Lloyds around to force it to lend more.

But probably the most important judgement for him is about what will provide the greatest certainty for taxpayers of the greatest return for them on their existing investment in Lloyds over the shortest timescale.

Arguably it will be easier and quicker for the government to flog its 43% stake over the coming years if Lloyds remains an ostensibly "clean" bank, viz a bank that doesn't contain a "bad" part insured by GAPS.

All that said, there is one final and difficult judgement for Darling.

The great problem for him of Lloyds going for an issue of new shares is that the Treasury would have to invest up to £6.5bn of additional and precious cash, to prevent dilution of taxpayers' stake.

From an investment point of view, it would be insane for the Treasury not to put the money up. That will be the advice the chancellor will be given by UK Financial Investments.

But - as I think we all know now - Darling doesn't have £6.5bn (or even six shillings) simply lying around at the Treasury, available for any emergency.

If he wants to invest the £6.5bn, he'll have to borrow it.

It will add to the government's already ballooning public-sector deficit.

And even in the context of the £203bn net of gilt-edged government debt being sold this year, £6.5bn is not a rounding error.

By contrast, the great advantage of going for GAPS is that there are no upfront costs for taxpayers. All the cash costs would come later, as and when the insured assets would deteriorate in value.

Finally, there would be a very tricky task of managing public expectations if he puts an additional £6.5bn into Lloyds.

Which is that most taxpayers would assume that if he puts in all that extra money it would give him the right - and indeed the obligation - to boss Lloyds around even more than he has been doing. Which, of course, is precisely the opposite of what Lloyds board both wants and assumes.

There is a painful paradox here for Lloyds' directors, which I am not sure they have grasped.

A so-called private sector solution to its capital shortage would involve a huge additional injection of taxpayers' money. And as far as taxpayers are concerned that should oblige the bank to become more of a servant to their needs and interests, not less.