If LLOY and RBS manage to drag out their “detailed discussions” with HM Treasury over the exact workings of the Asset Protection Scheme then with luck the UK economy will have recovered to a sufficient extent such that LLOY in particular will be able to avoid ever actually formally signing the documentation and entering the scheme.  LLOY stated in their H1 2009 results that they are ” working with HM Treasury to finalise the detailed terms and conditions and operational mechanics of the Group’s intended participation in the Government’s Asset Protection Scheme. The operation of the scheme and the impact on our business (and the consequential impact on our lending and the wider economy) is complex.  The Group expects to conclude these discussions and agree terms and conditions which are in the interests of shareholders”.

In their recent results LLOY were much more optimistic in their outlook than RBS.  LLOY currently have a Core Tier 1 capital ratio of 6.3% and if the economy recovers they could well generate enough operating earnings to cover future impairments (LLOY commented “impairments in the second half of 2009 are expected to be significantly lower than the first half with progressive reductions thereafter”) and thus survive the FSA’s stress test that Core Tier 1 capital may not fall below 4% over the cycle.  Formally entering the APS would effectively cap LLOY shares at 150 pence for the next few years.

RBS reported a Core Tier 1 capital ratio of 6.4% in their H1 2009 results but look unlikely to escape entering into the APS no matter how V-shaped an economic recovery anyone predicts (RBS commented the “APS is key to RBS’s short-term ability to withstand stressed scenarios, though important issues remain to be confirmed”).  Entering the APS would effectively cap RBS shares at 65 pence for the next few years.

From HMT’s viewpoint, not having to take on the liability of insuring 90% of £235 bln of LLOY future write-offs as well as £305.5 bln of RBS future write-offs is clearly a very desirable outcome so its suits HMT as well to allow the current “detailed APS negotiations” to drag on as long as the economy looks to be recovering.

Never formally enacting the APS would remove very large contingent liabilities from the Government’s balance sheet and the APS would have served its purpose by shoring up confidence in the UK banking sector when it was most needed at zero cost to the tax payer.  Such an outcome would be in the best interests of LLOY’s shareholders (with the Government being the largest shareholder) and would also cause a large jump in the LLOY share price which would present a window of opportunity for the Government to be able to sell some shares in LLOY at a profit for the taxpayer.  One way to play this is via a long LLOY/short RBS money-for-money pairs trade as RBS is not strong enough to get by without the APS.  If the banks give back part of their gains since March then LLOY and RBS should broadly track each other; but if LLOY do wriggle free of the APS then they will substantially outperfom RBS.  In the meantime do not expect an early end to the APS negotiations.