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