RBS and Lloyds re-made by Europe

I am still away sorting out my family stuff. But I could not let the most significant ever forced reconstruction of the British banking industry go by (one of the most important ordained reconstructions of any UK industry) without sticking my oar in.

So here are a few thoughts.

There are three main elements to what will be announced tomorrow: divestments of banking operations by the Royal Bank of Scotland and Lloyds to stimulate competition; divestments by the Royal Bank of Scotland to punish it for taking so much state aid; measures to strengthen both Royal Bank and Lloyds.

First, Royal Bank and Lloyds will be obliged to create two new banks out of their existing sprawling networks which they will commit to sell within four years to promote competition.

One important thing to note is that the British government can take none of the credit (or the blame, if that were how you felt about it) for this attempt to provide a bit more choice to consumers and small businesses.

This forced fragmentation of our banks is being ordered by the European Commission - and more specifically by its competition bit under Neelie Kroes.

It will be fascinating to see if either the Treasury or the Tories give her credit for actions which - they both claim - are consistent their own ambitions.

In the case of RBS, it will create a new small-business bank - which it will endow with the historic "Williams & Glyn" brand name - by hiving off more than 300 branches, many of them in the north-west of England.

This will reduce RBS's market share in small-business banking by around five percentage points, from about 30%.

And there will be an analogous disposal of a retail bank, under the brand Cheltenham & Gloucester, by Lloyds.

Then there'll be the smack for RBS.

Ms Kroes has decided that RBS has to be made an example of for taking so many foolish risks during the boom years that it now needs a mind-boggling amount of support from taxpayers.

RBS only learned the horrid truth in the past week.

So, to discourage banks in future from being so reckless, she is insisting that RBS flog off all its insurance operations (which go under the Churchill and Direct Line brands), plus a bit of investment banking, plus a bit of retail services.

But RBS shouldn't be too badly damaged by the break-up, because it will have four to five years to flog these assets - which means they should fetch a decent price, not a knockdown, fire-sale price.

Finally there are the measures to strengthen what's left of RBS and Lloyds from the harm of potential future losses.

Both are being forced by the City watchdog, the Financial Services Authority, to increase their respective stocks of core "tier one" capital - largely pure equity - to comfortably over 8% of risk-weighted assets (10% or so).

This is four times the minimum they were obliged to hold before the crunch - which shows, arguably, that the FSA and overseas regulators were absurdly lax during the boom years.

RBS will again turn to taxpayers to help reinforce its buffer against future losses on loans and future losses.

It will raise some £25bn of new capital, most of it from the Treasury - which will lift the state's shareholding in RBS from 70% to a maximum of 84%.

But to maintain a fig leaf of commercial independence, the Treasury will promise it will never exercise voting rights exceeding 75% of all voting shares (which will allow RBS to keep its stock-market listing).

It's not all bad news for private-sector shareholders in RBS. Although this is a weak bank, it's less weak than it expected to be at this stage of the recession.

So it needs less insurance from the Treasury against future losses on loans and investments - in the form of the so-called Government Asset Protection Scheme (Gaps) - than it originally negotiated.

Under the revised Gaps, it'll pay an annual fee of around £1bn a year for the equivalent of catastrophe insurance - which will be cancellable at any time. This will cover it for future losses on loans that exceed £40bn (up from £20bn - ignoring losses already incurred - under the original deal).

The terms are better for shareholders in a second sense: RBS will be able to use its recent losses to reduce future tax bills.

As for Lloyds, it will probably escape Gaps altogether by raising comfortably more than £20bn of extra equity capital from shareholders and from financial institutions that have already provided it with other, less desirable forms of capital.

In other words, some of this additional equity capital will be genuinely new money, whereas some will be a conversion of existing capital that doesn't provide the desired degree of protection.

In steering clear of Gaps, Lloyds' dependence on the state will stay as it is (that is a 43% stake for taxpayers plus assorted taxpayer-backed loans and guarantees - so still very substantial).

But the chancellor has extracted a huge price for the implicit support Lloyds has received from the promise of Gaps over the past few months.

In return for underwriting the bank's survival since the beginning of this year, Lloyds will give a £2.5bn discount to taxpayers on the subscription of new capital.

This represents another massive transfer of wealth from Lloyds' private-sector shareholders to the state.

I guess those shareholders will think the price is worth paying to stem the creeping nationalisation of Lloyds. But it is quite a price.