LONDON -- Are the banks uninvestable? That's what the Association of British Insurers (ABI) -- the body that represents most institutional investors in the U.K. -- has suggested. In evidence last month to the Parliamentary Commission on Banking Standards, it said institutions were reluctant to invest because of increasing risks and shrinking returns.

Then last week, the British Bankers' Association's CEO repeated the charge on Radio 4's Today program. What's this, the banks' own lobby group drawing attention to the undesirability of its equity? Something strange is going on, especially when set against the positive performance of bank shares this year.

War of words
It's part of the war of words with the Bank of England and its hawkish governor Sir Mervyn King. The banks, and institutional investors, see undue meddling by the regulators and think the sector should be left to get on with the job of repairing balance sheets and resuming normal commercial operations.


But what really gets their goat is Sir Mervyn King's agenda to force banks to raise more capital. That could dilute existing investors and reduce returns on equity.

Stability
For its part, the Bank of England is concerned about financial stability. First and foremost, it doesn't trust banks' balance sheets:

  • It thinks banks have under-provided against potential bad debts, recording the full value of loans to "zombie" companies, individual mortgage-holders, and commercial property landlords that they know are unlikely to be repaid in full.
  • It dislikes that International Accounting Standards preclude banks from making general provisions against possible future bad debts.
  • It distrusts banks' assessment of the capital required to support risk-weighted assets, which larger banks are allowed to measure using their own models.
  • It is suspicious that U.K. banks have provided less against periphery eurozone loans than domestic lenders have.
  • It thinks banks have underestimated the costs of PPI mis-selling and other scandals.

The bank estimated that the sector may have to raise 20 billion pounds to 50 billion pounds of new capital, and set itself the task of assessing individual bank's requirements by next March.

George Osborne to the rescue
Help for the banks has come from an unlikely quarter. George Osborne's surprise appointment of Mark Carney as Governor of the Bank of England from next July has given the City hope that it will be overseen by someone who puts more emphasis on stimulating economic growth than the current incumbent.

More immediately, the Treasury has made it clear that it will not subscribe new equity for Royal Bank of Scotland or Lloyds Banking . That saves equity investors from the threat of dilution.

Instead, the Bank of England now expects banks to shrink assets and/or raise capital other than equity. However, either would still reduce returns to shareholders.

Bonds
Barclays
has already responded with an innovative 3 billion-pound bond issue enthusiastically taken up by Asian and U.S. investors. It pays a coupon of 7.6%, but gets wiped out if the bank's tier 1 capital ratio falls below 7%. Thus it counts as tier 1 capital.

If the banks do anything well, it's imitating each other. So with the issue four times oversubscribed, it is likely we will see similar issues from other banks.

RBS and Lloyds continue to shrink their balance sheets. RBS is fighting pressure to sell its U.S. retail bank and is likely to cut back capital intensive parts of its investment bank instead. Lloyds is pressing ahead with the sale of 632 branches to Co-op Bank, hopefully more successfully than RBS' aborted sale to Santander.

Performance
Lloyds has been the leader in the banks' performance table this year. It shares are up 78%, followed by RBS at 46% and Barclays at 39%.

Bank shares have done well as concerns over the eurozone ease, and as their operating performance on an underlying basis has improved. Though one-off charges obscure the accounts, it looks as if they may have turned the corner.

If the institutions and banks are successful in their lobbying, then they may also succeed in making the sector "investable" in their own terms. But the dangers in the eurozone and potential contagion in the banking system makes this still a high-risk sector.

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The article Are the Banks Uninvestable? originally appeared on Fool.com.

Tony does not own any shares mentioned in this article. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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