RBS May Buy Back Preferreds

According to Reuters:

Royal Bank of Scotland is considering a liability management exercise that could see it buy back or convert part of a 14 billion pound pile of preference shares and innovative securities to boost its core capital.

Analysts have said the move could help part-nationalised RBS take advantage of discounted prices in the secondary market to generate a bumper equity gain and boost its core Tier 1 ratio, a key measure of capital strength.

As a simplified example of how this works, we can look at simplified bank balance sheets:

Bank Balance Sheet
Before Preferred Buy-Back
Assets Liabilities
Cash $10 Deposits $80
Loans $90 Preferreds $10
  Equity $10

Assume the preferreds are bought back for half of face value. Then:

Bank Balance Sheet
After Preferred Buy-Back
Assets Liabilities
Cash $5 Deposits $80
Loans $90  
  Equity $15

If we further assume that the “Loans” have a Risk-Weight of 1, then:
a) The Tangible Common Equity Ratio has increased from 11% to 17%
b) The Tier 1 Ratio has declined from 22% to 17%
c) The bank has booked a profit of $5

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