LONDON (Reuters) - Royal Bank of Scotland (RBS.L) could create an internal "bad bank" to house more of its problem loans, even if Britain decides not to enforce a breakup of the part-nationalized lender, banking industry and political sources say.
Britain's finance ministry, aided by investment bank Rothschild, is close to concluding a review into whether RBS, 81 percent owned by taxpayers, should be made to hive off its soured assets into a separate legal entity. It is expected to make its recommendations known in early October, sources said.
Analysts expect the Treasury to decide against recommending a breakup. They argue it is not needed since RBS has already wound down or sold off the vast majority of its bad loans and that European state aid rules and the need for approval from RBS's minority investors would make the plan unworkable.
Advocates of a breakup, including former Bank of England Governor Mervyn King and ex-UK finance minister Nigel Lawson, say it will leave the bank, rescued through a 45.5 billion pounds ($72.7 billion) 2008 government bailout, better placed to lend and support the UK economy.
If the idea is rejected, RBS, which is intensely scrutinized by lawmakers and regulators, could try to appease critics by forming an internal bad bank without government intervention.
The bank is coming to the end of a five-year recovery plan overseen by Chief Executive Stephen Hester who will leave in October. At the start of 2009, Hester and restructuring chief Rory Cullinan identified 258 billion pounds of RBS's most risky loans that would be sold off or wound down. Only between 36 billion and 38 billion pounds worth of those loans are expected to remain by the end of the year, RBS said in August.
New CEO Ross McEwan may decide to enlarge and revamp the non-core portfolio when he takes over in October, sources say, putting assets from the group's Irish business, Ulster Bank, and more UK commercial real estate loans inside it.
When the good bank/bad bank split was first mooted, RBS harbored hopes of reducing its Irish exposure by swapping some of Ulster Bank's assets for the UK assets of an Irish bank. But the prospect of such a deal is fading.
A source with knowledge of RBS's efforts told Reuters the bank had learned that the two most obvious candidates (Ireland's National Asset Management Agency and state-owned Allied Irish Banks (ALBK.I)) would not take part in an asset swap.
Finance Minister George Osborne commissioned a review of RBS in June responding to a demand by the Parliamentary Commission on Banking Standards, which he had set up to examine ethics within the industry.
The Treasury and Rothschild have reviewed different sizes of "bad bank" ranging from the "low 10s of billions" to as high as 120 billion of assets when more of Ulster Bank is included, sources familiar with the matter said.
But Sanford Bernstein analyst Chirantan Barua said new state aid rules would be a major barrier.
European Union regulators said in August that executives at "any bank in receipt of state aid in the form of recapitalization or impaired assets measures" should have their total pay capped at 15 times the national average or 10 times the average salary of employees in the bank.
If applied to RBS that would limit the salary of its chief executive and other senior managers to 431,000 pounds. McEwan was appointed on a salary of 1 million pounds a year.
"If the Treasury is a rational investor, we expect them to call off the bad bank good-bank idea," said Barua.
The government would also need to convince RBS's minority investors to back it because UK Financial Investments, which manages the UK's stake, cannot vote on a proposal it has put forward under Stock Exchange rules.
"In the event of a split both sides of this new bank could require recapitalization which would be expensive both for shareholders and for the taxpayer," said one of RBS's biggest 10 private investors.
Osborne in June laid out criteria to determine whether the government proceeds with a breakup including a commitment for taxpayers not to put any more taxpayer funds into the bank.
An internal "bad bank" would house only assets which are being sold or wound down. As the assets are offloaded, the amount of capital the bank needs to hold is reduced, freeing up capital to lend to other customers. Osborne said a breakup would need to support the British economy, be in the interest of taxpayers, and speed up the bank's return to private ownership.
RBS and the Treasury declined to comment.
($1 = 0.6226 British pounds)
(Additional reporting by Laura Noonan; editing by David Evans)