UK Banks - JP Morgan Cazenove

Europe Equity Research
02 June 2010
RBS.L, RBS LN
Underweight
47p
UK Banks Price Target: 42p
Government Exit Strategies - Looking at the Options LLOY.L, LLOY LN

Underweight
57p
Price Target: 50p
• At the crux of this debate is the conflict of interest of owning large Banks
stakes in the banks whilst trying to implement significant regulatory Carla Antunes da Silva
AC
changes in a global forum and balancing this with influencing banks' (44-20) 7325-8215
lending behaviour. We see 3 main costs to the UK; carla.antunes-silva@jpmorgan.com
• 1 – During the temporary ownership period the stakes account for c.4% Amit Goel, CFA
(44-20) 7325-6924
of net debt to GDP under the Maastricht definition. Whilst we do not amit.x.goel@jpmorgan.com
see the stakes as long-term holdings, if fully consolidated, UK net debt J.P. Morgan Securities Ltd.
to GDP would go from 64% (2009) to 165%;
For Specialist Sales advice, please
• 2 – Indirectly, there is a cost to the sovereign from providing guarantees contact:
to the sector (both implicit and explicit) – for every 10bps of additional Oliver Doeltl
financing costs, we estimate annual costs of c.£1bn for the government; (44-20) 7779-2187
oliver.doeltl@jpmorgan.com
• 3 – Last but not least, we estimate a financing cost of c.£3.2bn annually
Nick Gough
of holding these stakes, equivalent to a meaningful 8% of 2010E UK
(44-20) 7325-9459
budget interest expense. nick.c.gough@jpmorgan.com
• Despite comment that disposals of the stakes are not imminent, with the Justine Shih
(44-20) 7779 2149
change of government we believe the breakeven prices are less relevant, justine.shih@jpmorgan.com
esp if the government were to structure a transaction similar to the
British Gas & BT privatisations, where there could be a focus on retail Price Performance
investors, not least because this would ‘democratise’ any potential future 100
share upside. News flow around the exit strategies will be a drawn out p
70
process, providing trading opportunities, and may remain unclear.
40
• While stocks have come off their highs on the back of sovereign May-09 Aug-09 Nov-09 Feb-10 May-10
LLOY.L share price (p)

concerns and both Lloyds and RBS are now trading on 0.9x 11E P/NAV, MSCI-Eu (rebased)
we remain UW on both. Fundamentally, we see NAV per share as a YTD 1m 3m 12m
ceiling rather than as a floor as we currently struggle to see returns Abs 8.3% -15.7% 12.7% -12.9%
exceeding CoE. TP for Lloyds remains unch at 50p with modest Rel 12.4% -10.2% 14.6% -29.5%
earnings changes (-1.1% 2012E) and unch at 42p for RBS, where we Price Performance
raise 12E EPS by 6.7% on reduced loss estimates for non core activities. 55
p 40
• Given the strain on public finances we believe the likelihood of a specific
tax charge along the lines of a wholesale liability tax is high and could 25
May-09 Aug-09 Nov-09 Feb-10 May-10
remove c.10-20% of sector earnings, raising a much needed £5-10bn.
RBS.L share price (p)
Beyond that, further regulatory changes will likely have to be pushed MSCI-Eu (rebased)
back, as we believe regulation goes hand in hand with economic YTD 1m 3m 12m
stability. Abs 45.6% -15.0% 27.4% 24.9%
Rel 49.7% -9.5% 29.3% 8.3%
Equity Ratings and Price Targets
Mkt Cap Rating Price Target
Company Symbol (£ mn) Price(p) Cur Prev Cur Prev
Royal Bank of Scotland Group P RBS.L 50,172.13 47 UW n/c 42 n/c
Lloyds Banking Group Plc LLOY.L 36,109.41 57 UW n/c 50 n/c
Source: Company data, Bloomberg, J.P. Morgan estimates. n/c = no change. All prices as of 28 May 10.
See page 44 for analyst certification and important disclosures, including non-US analyst disclosures.
J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may
have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their
investment decision.
Carla Antunes da Silva Europe Equity Research
(44-20) 7325-8215 02 June 2010
carla.antunes-silva@jpmorgan.com
Amit Goel, CFA
(44-20) 7325-6924
amit.x.goel@jpmorgan.com
Table of Contents
Why should the government reduce the stakes? ..................4
What has been the history of government stakes? .......................................................4
Conclusion for the UK .................................................................................................5
UK fiscal position and the impact on the government bank
stakes ........................................................................................8
Exit price has some bearing but is not critical to the fiscal position ............................9
The potential impact on bank taxes and special levies...............................................12
What are the potential mechanisms and associated impact?
.................................................................................................18
Share sale ...................................................................................................................19
Convertible bonds ......................................................................................................22
Buyback .....................................................................................................................22
An asset swap.............................................................................................................24
Index implications ..................................................................25
Tracker demand .........................................................................................................25
Timing of Index re-weighting ....................................................................................27
Stock implications..................................................................28
Lloyds Banking Group ...........................................................29
Royal Bank of Scotland .........................................................36
Valuation Methodology and Risks ........................................41
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With the UK general election now over, and a new coalition government in place, we
turn our thoughts to the potential implications for the government’s holdings in RBS
and Lloyds Banking Group. This is especially relevant in light of the upcoming
budget announcement due on 22nd June.
We note that with the Conservative Party working with the Liberal Democrats there
could be greater uncertainty, as the Liberals have been keen on retaining the stakes,
whereas the Conservatives have been more in favor of rapid disposals. Nevertheless,
we also note that the current government may be less price sensitive compared to the
previous Labour government, as they are less associated with the average entry
prices for either of the banks.
One factor that may complicate proceedings is the commitment to establishing an

independent commission to investigate the separation of retail and investment
banking. This commission is being given one year to report, and some market
participants question whether this would prohibit any significant exit strategies,
especially in the case of RBS where the outcome could significantly impact the
profitability of the group.
Whilst this could be an issue, we still think that it is important to look at the options
available to the UK government in terms of strategies as this is one of the main areas
of consideration in terms of investor uncertainty.
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Why should the government reduce the

stakes?
At this stage, we avoid the intellectual debate on whether banks are better managed
in state or public hands, but instead focus on three main themes which we think are
crucial discussion points – international precedent, the potential bearing on the UK's
fiscal position and the potential conflict of interest the holdings create, in particular
when the government is looking at proposals to reform the banking system.
What has been the history of government stakes?

In the recent crisis several governments supported their banks by injecting capital
both at the equity and preference share levels, in addition to providing liquidity
facilities and asset insurance schemes.
Already we have seen governments reduce and exit holdings in several countries, and
the UK appears to be on this track. Table 1 on page 6 highlights the main
transactions we have seen so far, and we below we discuss some of the precedents.
The Swedish crisis

The recent credit crisis has been compared several times to the Swedish financial
crisis of the 1990s. In 1992 during the Swedish crisis Nordbanken was nationalized
and then subsequently Listed in 1995. In the IPO, 34.5% of the company was listed
with shareholders split along the following lines:
Figure 1: Nordbanken Offering: Investor Split

Other International Sw edish Institutions
30% 22%
Nordic Institutions
5%
Sw edish Public
US Institutions
28%
15%
Source: J.P. Morgan, Company data.
Swedish retail investors were offered a 7.6% discount to the other investors for 90%
of the shares offered to them. The Swedish government’s 65.5% remaining stake
was reduced via a series of M&A transactions down to 19.9% in the descendant bank
Nordea.
The US banks
The largest US banks have generally repaid TARP funds relatively quickly. Only in
the case of Citigroup were TARP preferred shares converted into equity giving the
US government ownership.
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This stake is now being sold, with a first tranche of 19.5% of the holding having
been placed. This was done by selling shares into the market over a period of time,
with Morgan Stanley mandated to execute a pre arranged trading plan. Further,
unconfirmed press reports (FT 25/05/10) have suggested that the Qatar Investment
Authority has expressed interest in buying part of the remaining stake.
Note in the case of Citigroup the US government has been able to sell part of its
holding at a profit – the purchase price was $3.25 per share, and on the shares sold so
far the average sale price was $4.13 giving $1.3bn profit excluding financing costs.
The Swiss banks

The Swiss government attained a 9.3% stake in UBS as part of a balance sheet
restructuring exercise announced in October 2008, where it injected SF6bn in
exchange for mandatory convertible notes (MCNs) that converted into equity at min.
SF18.21 and carried a 12.5% coupon.
In September 2009 the government sold its 332.2mn shares via an accelerated book
build (ABB), at CHF 16.50, leading to a loss on the stock but more than offset by
coupons received SF1.8bn.
French banks
Credit Lyonnais was nationalized in 1945 after WW2, and was eventually privatized
in 1999. In the IPO the French government sold 89.1% of the bank, retaining 10.9%
that was sold in 2002.
In the IPO 33% of the equity was allocated to strategic investors who paid a premium
depending upon the size of their investment. (The premium was 3.5% if more than
4% of the share capital was purchased, 1.9% if less). Credit Agricole took the largest
stake at 10% of the offering. The rest of the IPO was allocated to three types of
investor, (i) the French public, (ii) Employees (10%) and (iii) Institutions. The
French public offering was at a 2.7% discount, and if shares were held for more than
18months additional (free) shares were awarded.
The remaining 10.9% was sold to BNP via a rapid auction on 24 Nov 2002, who
subsequently sold the holding to Credit Agricole.
Conclusion for the UK

So far, most countries have had an exit strategy, although in some cases the exit has
taken several years (in the case of Sweden it is still not complete, having started in
the 1990s) and the methods of exit have varied significantly. In public offerings it
appears that local retail investors have been given disproportionate allocations and
discounted prices. This could be a means to avoid criticism of ‘selling too early’ as
the retail public benefits if the share price appreciates after sale.
We believe that if the holdings in RBS and Lloyds were expected to become semi
permanent then the EU would have applied tougher penalties for state aid than the
ones announced last autumn. We also note that although we have focused on RBS
and Lloyds Banking Group in this report, the conclusions are equally valid for the
UK government's holdings in Northern Rock and Bradford & Bingley.
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Furthermore whilst there may be limited pressure to sell when the sovereign's fiscal
position is sound, if there is uncertainty it may be beneficial to sell earlier rather than
later. We explore this topic in the next section. There could be significant funding
costs, and if stakes are considered permanent, given the magnitude of bank balance
sheets in relation to national balance sheets, they could lead to significant distortions
in national accounts.
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(44-20) 7325-6924
Table 1: Global Banks - Summary of Equity Injections since 2007

Capital Injection Exit
RBS Oct 08 £15.0bn initial recapitalisation
Mar-09 £5.0bn preference share conversion
Nov-09 £25.5bn worth B-shares
Lloyds Oct 08 £13.0bn initial recapitalisation
May-09 £1.5bn 12% preference share conversion
Nov-09 £5.9bn (43% share of 13.5bn rights offer) Nov 09 Lloyds exited the APS for a £2.5bn fee
UBS Oct-08 CHF6bn mandatory convertible notes, 9.3% stake if converted
Aug-09 Swiss Confederation placed all shares with institutional investors (CHF5.5bn) and received FV
of coupons(CHF1.8bn) from UBS
CASA Dec-08 €3bn perpetual super subordinated
Oct-09 Redeemed €3bn notes (using capital from issuance of highly subordinated notes)
BNP May-09 €5.1bn Preferred shares
Oct-09 Paid back €5.1bn
Soc Gen Dec 08 €1.7bn Subordinated debt
May 09 €1.7bn Preferred shares
Oct 09 €3.4bn capital redeemed
Commerzbank Nov-08 €8.2bn silent participation(preference shares)
Jan-09 €8.2bn silent participation(preference shares)
Jan-09 €1.8bn for 25% stake
Morgan Stanley Oct-08 $10bn preferred shares (TARP) and warrants
Jun-09 MS paid back $10bn
Aug-09 Warrant repurchased for $.95bn
Goldman Oct-08 $10bn preferred shares and warrants
Sachs
Jun-09 GS bought back $10bn preferred shares
Jul-09 Repurchased TARP Warrant for $1.1bn
Citigroup Oct-08 $25bn perpetuity preferred stock and a warrant to purchase common stock (partially
converted to common shares (27% stake) in 2009)
Dec-08 $20bn perpetuity preferred stocks and a warrant to purchase common stock
Jan-09 $5bn capital benefit from asset guarantee
Dec-09 Citi repaid $20bn (generated capital by selling $17bn common shares and $3.5bn convertible
notes)
May-10 US Treasury planning to sell its 27% stake in Citigroup over the course of 2010
Bank of Oct-08 $15bn preferred shares and warrants
America
Jan-09 $10bn preferred shares and warrants
Jan-09 $20bn preferred shares and warrants
Dec-09 Repurchased all preferred stocks for $45bn and paid outstanding dividend
ING Oct-08 €10bn 8.5% preferred shares
Dec-09 ING Repurchased €5bn preferred shares(capital generated using rights issue)
Source: J.P. Morgan estimates, Company data.
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(44-20) 7325-6924
UK fiscal position and the impact on the

government bank stakes
Given the concerns over the fiscal positions of UK and European governments, in
this section we review the impact of the government stakes on the UK’s fiscal
position, and whether any impact could encourage a sale earlier rather than later.
Note we do not think that the UK’s fiscal deficit means that the stakes have to be
sold, but nevertheless it is an interesting debate.
There are several measures of the debt position, and so we first summarise each
For more information please see
metric and the associated impact from the government bank holdings. The three
JP Morgan’s ‘Global Data Watch
30 Apr 2010’, referring to pages main measures we have focused on are (i) the ‘Public Sector Net Debt’ (PSND), (ii)
52-53 and JPM UK Economics the PSND ex temporary effects of financial interventions (PSND ex) and (iii)
team: ‘General Government Gross Debt’ (GGGD). For more details on the specifics of UK
Malcolm Barr economics we refer the reader to Malcolm Barr and Alan Monks:
(44-20) 777-1080
malcolm.barr@jpmorgan.com • Public Sector Net Debt (PSND) - This is the most commonly cited measure of
Allan Monks debt in the UK, taking the consolidated liabilities of the entire public sector, and
(44-20) 777-1188 netting out only liquid assets (such as official reserves, deposits, and other short-
allan.j.monks@jpmorgan.com term instruments). This measure includes the liabilities of the banks that have
government stakes, net of their liquid assets. Currently, the reported numbers
include the Northern Rock and Bradford & Bingley exposures, and this summer
the Office of National Statistics (ONS) will incorporate Lloyds Banking Group
and RBS, which will significantly increase debt levels.
• Public Sector Net Debt excluding financial interventions (PSND ex) – This
adjusted measure of PSND removes the impact of the financial interventions that
is deemed to be temporary, i.e. the balance sheet impact, but retains the aspects
that are potentially more permanent such as the potential losses on holdings
(based on a mark to market approach). This measure was introduced by the
previous administration to the current coalition.
• General Government Gross Debt (GGGD) – This is a European Union
standard that is used in accordance with the Excessive Deficit Procedure of the
Note the incoming government is Maastricht Treaty. Under this measure the balance sheets of the state owned
setting up an Office for Budget banks are not included, only the funding requirements for the stakes, i.e. £66bn
Responsibility (OBR) to make an for RBS and Lloyds Banking Group in total. There are other differences from the
independent assessment of the PSND, primarily that the gross liabilities are used, there is no netting for liquid
public finances and may present
assets, and only the general government is included, not public corporations
the data in a different way.
(although this is small). Note the Maastricht Treaty’s deficit and debt target
limits are 3% and 60% respectively.
Table 2 shows an estimate of each of these measures based on the March 2010 UK
Budget projections and our estimates of the impact from consolidating the RBS and
Lloyds liabilities in the PSND.
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(44-20) 7325-6924
Table 2: UK - National Debt Based on March Budget Estimates

£ billion
2008 2009 2010E 2011E 2012E 2013E 2014E
PSND %GDP 52.7% 63.6% 165.1% 161.6% 155.9% 149.7% 145.9%

PSND ex % GDP 43.8% 54.1% 63.6% 69.5% 73.0% 74.5% 74.9%
GGGD % GDP 55.5% 71.4% 80.5% 86.0% 88.7% 89.2% 88.7%
PSNB %GDP 6.0% 11.0% 10.7% 8.2% 6.6% 5.0% 3.8%

PSNB ex % GDP 6.7% 11.8% 11.1% 8.5% 6.8% 5.2% 4.0%
Deficit % GDP 6.7% 12.2% 11.2% 8.6% 6.9% 5.3% 4.2%
PSND 742 913 1,081 1,216 1,339 1,441 1,527

PSND ex 617 777 952 1,095 1,218 1,320 1,406
PSND inc RBS, Lloyds 2,471 2,546 2,601 2,653 2,739
Source: J.P. Morgan estimates, HMT. Note the figures are based on an end March year end, i.e. 2010E represents the period end Mar 2009 to end Mar 2010.
As can be seen the PSND will potentially balloon this year when the RBS and Lloyds
Banking Group liabilities net of liquid assets are included. Interestingly, the public
sector net borrowings (PSNB) excluding the temporary effects of financial
interventions is greater than that including, this is due to the potential losses on the
stakes and the exclusion of potential gains from the SLS and asset purchase facility.
If the holdings in RBS and Lloyds become more permanent then clearly the PSND
ex figure becomes less relevant, and the public finances will look highly leveraged.
Note that we do not think this will have a meaningful impact on sovereign funding
costs, as the more important measure in this regard being the GGGD. On this
measure the contribution from the stakes is c.4.5% 2010E declining inline with
nominal GDP growth. If the stakes are sold the measure would reduce debt level by
the consideration received. The table below shows the benefit to 2012E GGGD
depending on different exit prices for the government stakes in RBS and Lloyds.
Table 3: UK - Sensitivity of GGGD to exit prices relative to average entry price 2012E
Lloyds Exit Gain / Loss
-30%/51.5p -20%/58.9p -10%/66.2p 0%/73.6p 10%/81.0p 20%/88.3p 30%/95.7p
-30%/35.1p 2.9% 3.0% 3.1% 3.3% 3.4% 3.5% 3.6%
-20%/40.1p 3.2% 3.3% 3.4% 3.5% 3.7% 3.8% 3.9%
RBS -10%/45.2p 3.4% 3.6% 3.7% 3.8% 4.0% 4.1% 4.2%
Exit 0%/50.2p 3.7% 3.9% 4.0% 4.1% 4.2% 4.4% 4.5%
Gain / Loss 10%55.2p 4.0% 4.1% 4.3% 4.4% 4.5% 4.7% 4.8%
20%/60.2p 4.3% 4.4% 4.6% 4.7% 4.8% 4.9% 5.1%
30%/65.3p 4.6% 4.7% 4.8% 5.0% 5.1% 5.2% 5.3%
Source: J.P. Morgan estimates, UKFI
Exit price has some bearing but is not critical to the fiscal
position
From this exercise it would appear that whilst the exit prices do have some bearing, it
is not critical, and largely symbolic. What is more relevant is that the stake is
sold, as the funding requirement still has a noticeable bearing on public
finances. This could be especially important when we consider the commentary
from Standard & Poor’s credit research. S&P reiterated its negative outlook for UK
sovereign debt in Mar 2010 and said that it expects GGGD to continue to trend
towards 100% of GDP, a level which if sustained over the medium term would be
incompatible with a 'AAA' rating.
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(44-20) 7325-6924
Table 4 below illustrates expectations for GGGD from several sources.
Table 4: UK - GGGD and Deficit Estimates

2008 2009 2010E 2011E 2012E 2013E 2014E 2015E
GGGD %GDP
S&P 52.0% 68.4% 77.1% 83.3% 88.6% n.a. 100.0%* n.a.
HMT 55.5% 71.4% 80.5% 86.0% 88.7% 89.2% 88.7% n.a.
IMF 52.0% 68.2% 78.2% 84.9% 88.6% 90.2% 90.7% 90.6%
OECD n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a.
Fiscal Deficit %GDP

S&P -5.0% -11.5% -10.9% -9.3% -8.3% n.a. -6.0%* n.a.
HMT -6.7% -12.2% -11.2% -8.6% -6.9% -5.3% -4.2% n.a.
IMF -4.8% -10.9% -11.4% -9.4% -7.6% -6.2% -5.2% -4.3%
OECD -5.3% -11.3% -11.5% -10.3% n.a. n.a. n.a. n.a.
Real GDP Growth

S&P 0.5% -5.0% 1.2% 2.2% 1.8% n.a. n.a. n.a.
HMT 0.5% -5.0% 1.3% 3.3% 3.5% n.a. n.a. n.a.
IMF 0.5% -4.9% 1.3% 2.5% 2.9% 2.8% 2.7% 2.5%
OECD 0.6% -4.9% 1.3% 2.5% n.a. n.a. n.a. n.a.
Source: J.P. Morgan estimates, S&P, HMT, IMF, OECD. S&P 2014E is based on the text of the statement.
Given how close to 100% we may be, the benefit from a sale may be significant.
Perhaps the question is, what is the benefit that the government can derive from
having more direct control of credit to the economy versus the benefit from a sale?
The risk to other stakeholders in RBS and Lloyds being that the government’s
interests may not be aligned to theirs and more directed lending could be negative for
profitability.
Further, we note that whilst we have discounted including RBS and Lloyds liabilities
from the sums, one could make the argument that they will have significant funding
requirements over the next few years, and as such may be competing with the
governments for credit. This would add relevance to the PSND measure, and hence
be a reason for the government to sell sooner rather than later.
When we look at Moody’s comments the key metrics are slightly different but the
conclusions are broadly similar. Moody's states;
“Moody’s defines an Aaa government as a government that has sufficient balance

sheet flexibility to keep its debt highly affordable through cycles and crises. In this
context, debt affordability is best captured by the ratio of debt interest payments to
government revenues, and debt is deemed highly affordable when this ratio remains
in single-digit territory. Based on current projections, this affordability ratio is
expected to move close to the 10% threshold that delineates the Aaa-Aa boundary.”
Moody’s Investors Service: UK General Election: Hung Parliament No Direct

Threat to UK’s Aaa Rating – May 2010
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Figure 2 below illustrates the interest expense to revenue ratio as projected in the
March 2010 budget:
Figure 2: Ratio of Interest Expense to Revenues

11.0%
10.0%
9.0%
8.0%
7.0%
6.0%
5.0%
2008 2009 2010E 2011E 2012E 2013E 2014E
Source: J.P. Morgan estimates, HMT Budget projections
So, as can be seen, the current projection is for the ratio to be above this level in
2013E. The impact from the bank stakes is potentially twofold:
• Direct funding requirements for the holdings – i.e. the cost of borrowing the
£66bn invested in the stakes;
• Impact of the ownership on sovereign funding costs – the impact on sovereign
borrowing costs from the 'implicit guarantees' enjoyed by the banks.
Table 5 below we attempt to quantify these impacts.
Table 5: Interest Expense to Revenue – Impact from bank stakes

£ billion
2008 2009 2010E 2011E 2012E 2013E 2014E
Interest Expense 31 31 42 50 60 66 74
Revenue 534 508 541 582 621 660 699
Interest / Revenue 5.7% 6.1% 7.7% 8.6% 9.6% 10.1% 10.6%
PSND ex 617 777 952 1,095 1,218 1,320 1,406
Average Debt 697 864 1,024 1,157 1,269 1,363
Interest Rate 4.4% 4.8% 4.9% 5.2% 5.2% 5.4%
Gross Issuance 147 228 187 187 159 141 117

Redemptions -21 -17 -39 -49 -48 -47 -43
Net Issuance 126 211 148 138 111 94 74
Stake Funding
Stake 65.8 65.8 65.8 65.8 65.8 65.8
Interest Expense 2.9 3.2 3.2 3.4 3.4 3.6
Interest/ Revenue ex stakes 5.5% 7.1% 8.0% 9.1% 9.5% 10.0%
Difference -0.6% -0.6% -0.6% -0.5% -0.5% -0.5%
Sovereign Funding Costs

5bps spread impact 0.3 0.4 0.5 0.6 0.6 0.7
% Revenue 0.07% 0.08% 0.09% 0.09% 0.10% 0.10%
From the analysis we see that a sale of the stakes could make a material
difference to the interest expense to revenue ratio, especially whilst the banks
are not paying dividends. Note if the stakes were to become more permanent it
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may be fair to include the income of the banks in revenues along with the
financing costs of their debt.
Figure 3 below illustrates the movement in sovereign CDS spreads for the UK over
the past 12 months where we have seen more limited widening compared to other
G20 economies as expectations remain that the UK will be able to address its fiscal
deficit.
Figure 3: UK Sovereign CDS spreads (5Yr Senior)

bps
200
150
100
50
0
08/08/2008 08/11/2008 08/02/2009 08/05/2009 08/08/2009 08/11/2009 08/02/2010 08/05/2010
Source: Bloomberg.
The potential impact on bank taxes and special levies

A secondary consequence of the UK's fiscal deficit and other national fiscal deficits
is on the risk of additional taxes on banking profits and possibly bonus payments.
Additional taxation is one of the items that the coalition government has highlighted
in its agreement document:
“'…We will introduce a banking levy and seek a detailed agreement on

implementation…”
Conservative Liberal Democrats Coalition Agreement, May 2010
This was a discussion point at the G20 Finance ministers meeting in April, and we
expect detailed proposals to be presented at the summit at the end of June. Clearly
on top of the direct impact on profitability additional taxation will slow the process
of banks rebuilding their balance sheets, and hence will have further consequences
on the availability of credit and on economic growth, but this is an area where we
believe regulatory change is very likely, not least because it is an additional source of
much needed government revenue.
In the tables below we estimate the potential direct revenues that such a tax could
generate in the UK assuming a 15bps fee on UK wholesale liabilities, and relate that
to (i) the impact on bank profitability, (ii) total tax receipts in the UK and the fiscal
position.
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Table 6: UK Banks - Potential Revenues from a Bank Fee (based on UK liabilities)

£ million
UK Liabilities UK Deposits UK Derivatives UK Wholesale Charge Annual Cost/ Rev
Barclays 1,320,449 322,455 403,416 594,578 0.15% 892
HSBC 751,160 351,387 134,977 264,796 0.15% 397
RBS 1,276,784 453,302 424,544 398,938 0.15% 598
Lloyds 983,148 406,741 40,485 535,922 0.15% 804
Santander UK 278,069 143,893 18,963 115,213 0.15% 173
Total 4,609,610 1,677,778 1,022,385 1,909,447 0.15% 2,864
Source: J.P. Morgan estimates.
Based on these assumptions such a fee could generate c. £2.9bn per annum in the UK
from these banks alone. Note that we have not included possible receipts from
building societies and other international banks present in the UK. We note that so
far £2bn (net receipts) were raised from the UK banks bonus tax for the fiscal year of
2009, but a final figure is yet to be reached. Please refer to Table 13 for more details.
Table 7: UK Banks - Impact of Fee on Profitability (based on UK liabilities)

£ million
2010E 2011E 2012E 2010E Chg 2011E Chg 2012E Chg
Barclays 4,389 5,326 5,577 -20% -17% -16%
HSBC 8,583 13,004 17,077 -5% -3% -2%
RBS -1,077 536 3,726 56% -112% -16%
Lloyds 547 2,474 4,939 -147% -32% -16%
Santander UK 1,673 1,802 1,976 -10% -10% -9%
Total 14,115 23,142 33,294 -20% -12% -9%
Reducing profitability by c.10% 12E, concentrated at those banks with more significant
wholesale funded structures, i.e. Barclays, RBS and Lloyds. Clearly the impact on the
banks would be significantly greater if the fees are adopted globally, as has also been
suggested. Note there has been some discussion about a reduction in the corporate tax
rate from 28% to 25%, as this was an item in the Conservative party election manifesto,
nevertheless it was not in the coalition agreement. Whilst we think this is an unlikely
change, in the tables below we show the potential impact in isolation on our estimates
and in combination with a 15bps wholesale liability levy applied at a local level.
Table 8: UK Banks: Potential Impact of Lower Corporation Tax in UK

£ million
2010E 2011E 2012E 2010E Chg 2011E Chg 2012E Chg
Barclays 249 298 312 6% 6% 6%
HSBC 0 270 348 0% 2% 2%
RBS 0 24 169 0% 5% 5%
Lloyds 33 127 248 6% 5% 5%
Santander UK 54 58 64 3% 3% 3%
Total 336 778 1,141 2% 3% 3%
Table 9: UK Banks: Potential Overall Impact from Tax Changes

£ million
Overall 2010E 2011E 2012E 2010E Chg 2011E Chg 2012E Chg
Barclays 3,747 4,732 4,997 -15% -11% -10%
HSBC 8,186 12,877 17,028 -5% -1% 0%
RBS -1,676 -38 3,296 56% -107% -12%
Lloyds -224 1,798 4,383 -141% -27% -11%
Santander UK 1,555 1,687 1,867 -7% -6% -6%
Total 11,587 21,056 31,571 -18% -9% -5%
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Note, in looking at the banking levy we have focussed on the UK entity liabilities. It is unclear whether a levy will be structured
in this way, it could be based on the consolidated balance sheets of the UK banks, or the UK entities of all banks operating in the
UK. In Table 10 below we illustrate the potential cost if the levy is applied to the consolidated liabilities of the UK banks.
Table 10: Global Banks: Potential Impact of Global Liability Tax 2011E
$ million
BoA Citi GS MS CS UBS DB Barc HSBC Lloyds RBS STAN BNP SocGen SAN UCG Avg Total
Assets 2,396,643 1,733,955 849,000 773,420 962,692 1,154,149 2,259,167 2,084,235 2,696,520 1,515,727 2,408,440 566,086 2,846,731 1,439,001 1,626,854 1,365,672 1,667,393 26,678,291
Adjustments to US GAAP 0 0 0 0 0 -468,345 -949,681 -636,275 -248,637 -65,564 -770,069 -36,658 -915,189 -267,583 -73,277 -13,390 -277,792 -4,444-,667
Adjusted Assets 2,396,643 1,733,955 849,000 773,420 962,692 685,803 1,309,486 1,447,960 2,447,883 1,450,163 1,638,371 529,428 1,931,541 1,171,419 1,553,577 1,352,283 1,389,601 22,233,623
deduct Tier 1 Capital -166,802 -150,460 -86,391 -57,545 -43,402 -40,159 -55,872 -93,325 -142,207 -70,758 -90,173 -28,702 -96,968 -55,023 -90,470 -64,319 -83,286 -1,332,576
deduct Insured Retail Deposits -657,034 -193,430 -4,667 -6,866 -94,484 -125,466 -139,142 -219,174 -420,386 -258,232 -236,614 -120,136 -257,362 -109,568 -427,013 -346,945 -226,032 -3,616,520
Covered Liabilities 1,549,572 1,383,995 749,943 702,415 815,443 514,072 1,096,244 1,120,869 1,869,259 1,097,806 1,276,296 378,841 1,552,495 988,426 1,034,479 933,110 1,066,454 17,063,265
Levy 0.15% 0.15% 0.15% 0.15% 0.15% 0.15% 0.15% 0.15% 0.15% 0.15% 0.15% 0.15% 0.15% 0.15% 0.15% 0.15% 0.15% 0.15%
Total Potential Fee 2,324 2,076 1,125 1,054 1,223 771 1,644 1,681 2,804 1,647 1,914 568 2,329 1,483 1,552 1,400 1,600 25,595
Liability reduction from other 0 0 0 0 -119,062 -20,521 -13,712 0 0 -32,212 0 0 -29,405 -25,019 0 0 -14,996 -239,931
areas
Adj Covered Liabilities 1,549,572 1,383,995 749,943 702,415 696,381 493,551 1,082,531 1,120,869 1,869,259 1,065,594 1,276,296 378,841 1,523,090 963,407 1,034,479 933,110 1,051,458 16,823,333
Fee Paid -2,324 -2,076 -1,125 -1,054 -1,045 -740 -1,624 -1,681 -2,804 -1,598 -1,914 -568 -2,285 -1,445 -1,552 -1,400 -1,577 -25,235
Net impact -1,511 -1,349 -731 -685 -836 -592 -1,137 -1,202 -2,159 -1,143 -1,369 -438 -1,599 -1,040 -1,086 -980 -1,116 -17,857
% 2011E net income -8% -10% -7% -10% -11% -8% -17% -14% -12% -18% -23% -11% -15% -16% -8% -13% -12% -12%
Source: J.P. Morgan estimates. Note this exercise does not show our anticipated charges from the Obama proposal as we are applying the idea in a slightly different way. E.g. for BoA and Citi, the US proposal deducts all assessed deposits – c.$900bn for BOA and $327bn
for Citi. The French banks have insurance subsidiaries that potentially inflate the size of their balance sheets.
In this case the impact would be much greater, with the UK government collecting c.£6.0bn per annum gross from the group of 5
banks included in this exercise. The press has reported (Independent 23/05/10) that the government is seeking to raise c.£8bn per
annum from the levy.
Note further the coalition statement is:
“…We will reform the corporate tax system by simplifying reliefs and allowances, and tackling avoidance, in order to reduce
headline rates. Our aim is to create the most competitive corporate tax regime in the G20, while protecting manufacturing
industries…”
Among many other challenges, one of the big difficulties for governments is to make sure they avoid taxation arbitrage and so
global coordination will be crucial to underpin any of these measures discussed. Furthermore, potentially changes could be
negative for banks that have structured their businesses to minimise their tax burden, or those that profit from the structuring of
such business for corporates.
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In the following tables we highlight the potential impact on the fiscal position,
looking in more detail at government revenues and expenditure.
Table 11: UK - Breakdown of government revenue and net borrowing

£ billion
2009 2010E 2011E
HM Revenue and Customs
Income tax (gross of tax credits) 153.4 144.4 146.4
Income tax credits -5.6 -5.6 -5.9
National insurance contributions 96.9 94.9 97.0
Value added tax 78.4 70.0 78.0
Corporation tax1 43.7 36.0 42.1
Corporation tax credits2 -0.6 -0.7 -0.8
Petroleum revenue tax 2.6 0.8 1.6
Fuel duties 24.6 26.2 27.5
Capital gains tax 7.8 2.5 2.7
Inheritance tax 2.8 2.4 2.3
Stamp duties 8.0 7.7 9.8
Tobacco duties 8.2 8.8 8.8
Spirits duties 2.4 2.6 2.6
Wine duties 2.7 3.0 3.1
Beer and cider duties 3.4 3.5 3.6
Betting and gaming duties 1.5 1.4 1.4
Air passenger duty 1.9 1.9 2.4
Insurance premium tax 2.3 2.3 2.3
Landfill tax 1.0 0.8 1.1
Climate change levy 0.7 0.7 0.7
Aggregates levy 0.3 0.3 0.3
Customs duties and levies 2.7 2.6 2.6
Temporary bank payroll tax3 0.0 0.0 2.0
Total HMRC 439.1 406.5 431.8
Vehicle excise duties 5.6 5.7 6.0
Business rates 22.9 23.7 24.7
Council tax4 24.4 24.8 25.8
Other taxes and royalties5 16.0 15.7 18.7
Net taxes and NICs6 507.9 476.4 507.0
Accruals adjustments on taxes -4.2 1.4 4.0
Less own resources contribution to -5.1 -3.8 -4.6
Less PC corporation tax payments -0.2 -0.2 -0.2
Tax credits adjustment7 0.7 0.7 0.8
Interest and dividends 7.7 4.2 4.4
Other receipts8 26.8 28.7 29.5
Current receipts 533.5 507.5 540.8
Expenditure 563.7 604.6 644
Depreciation 18.7 19.5 20
Surplus -48.9 -116.6 -123.2
Net Investment 47.2 50 40
Net Borrowing (PSNB ex) -96.1 -166.6 -163.2
Source: J.P. Morgan estimates, HMT
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Table 12: UK Banks: Potential Impact on public finances from additional taxation
£ billion
2009 2010E 2011E 2012E
Current receipts 534 508 541 582
Expenditure 564 605 644 662
Depreciation 19 20 20 21
Surplus -49 -117 -123 -102
Net Investment 47 50 40 29
Net Borrowing (PSNB ex) -96 -167 -163 -131
Liabilities Tax n.a. 2.9 2.9 2.9

Lower Corporation Tax n.a. -0.3 -0.8 -1.1
Total Taxation n.a. 2.5 2.1 1.7
Cumulative Impact
Liabilities Tax n.a. 2.9 5.7 8.6
Lower Corporation Tax n.a. -0.3 -1.1 -2.2
Total Taxation n.a. 2.5 4.6 6.3
% Net Borrowing
Liabilities Tax n.a. -1.7% -1.8% -2.2%
Lower Corporation Tax n.a. 0.2% 0.5% 0.9%
Total Taxation n.a. -1.5% -1.3% -1.3%
Source: J.P. Morgan estimates, HMT
From this data just looking at the impact on five UK banks, the impact of additional
taxation could be significant. Furthermore, there is also the discussion surrounding
whether the payroll tax is extended in duration. In 2009/10 this is anticipated to have
raised £2bn according to the Treasury, with some estimates at closer to £2.5bn.
When we sum the reserves the banks have taken for this charge we derive £2.1bn
excluding the contributions from Morgan Stanley and J.P. Morgan.
Table 13: UK Bonus Tax

£ million
Cost (lcl) Cost (GBP) Impact on 2012E
RBS £368 £368 -4.8%
Lloyds £20 £20 -0.3%
HSBC $355 £234 -1.1%
Barclays £225 £225 -2.9%
Standard Chartered $58 £38 -0.9%
Bank of America $465 £306

Citigroup $400 £263
Goldman Sachs $600 £395
Deutsche Bank €225 £200
Total £2,050
Note one area of potential contention is whether the revenues collected from a bank
levy are maintained in a fund to pay for future potential bailouts of the banking
sector or are treated as general revenue for the government. The key difference
depends on whether a payment to general revenues leads to changes to other taxes or
spending, as illustrated in the following example provided by the IMF in its interim
report for the G-20 (16/04/2010):
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It makes no substantive difference to the public sector’s financial position

whether a levy accrues to general revenues or to a fund that invests in
government securities. Payment to general revenue leads, in the absence of changes
to other taxes or spending, to less need for the government to sell debt on the open
market. Payment to a fund which then purchases government debt has the same
effect. The only difference is that payment to general revenues reduces the gross
amount of debt issued, whereas payment into a fund leaves gross debt unchanged,
but with part of debt now held by a public entity—the fund. In both cases, net public
debt—the net amount owed to the private sector by the government and the fund
combined, which determines the interest burden—is lower, and by the same amount.
The table below illustrates, for a levy of 100.
Flow of Payments Government Debt

Private sector Fund Government Revenues Gross Debt Net Debt
No fund -100 0 +100 -100 -100
Fund -100 +100 0 0 -100
When failure occurs and cash is needed, the impact is again the same: with no fund,
financing needs can be met by the government selling new debt on the open market;
with a fund, financing needs are met by selling its own holdings of government debt
or passing them to institutions which may sell them.
In that report the IMF proposed two new taxes:
• (i) Financial Stability Contribution (FSC) – It is unclear whether a charge

should be kept in a fund or should feed into general government revenues, but the
idea is that there are levies to build a provision for future losses. Regarding the
size of the charges, the document states that past experiences suggest that for
many countries provisioning for c.2-4% of GDP should be sufficient, although
for countries where the financial sector is particularly large relative to GDP this
provision should be correspondingly higher – this could lead to a higher charge in
the UK. Note UK GDP is c.£1.4trn, so the potential annual impact could be very
significant for the UK banks.
• (ii) Financial Activities Tax (FAT) – Two approaches are reviewed, a tax on
financial transactions (a Tobin tax), which the report says does not appear to be
well suited to the specific purposes set out in the mandate from the G-20 leaders,
and a financial activities tax. The proposal for a financial activities tax is on the
sum of profits and renumeration of financial institutions, but could be tiered
above threshold rates of return.
We think the analysis is not quite as simple as the example suggests, as it is unclear
for multinational organizations who collects the levies and hence which
government's securities the funds are invested in (the proportional split).
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What are the potential mechanisms and

associated impact?
In this section we review possible ways for the government to reduce its holdings in
RBS and Lloyds Banking Group if it decides to exit. This is by no means an
exhaustive list but we have highlighted four main methods of potential exit:
• Share sales;
• Issuance of convertible bonds;
• Buy back;
• An asset swap.
The table below shows the current holdings of RBS and Lloyds Banking Group and
the average government entry prices.
Table 14: Lloyds Banking Group: Average Government Entry Price

£ million
Shares Total Investment Per Share
m £m p
Initial Recapitalisation 7,277 12,957 182.5
Preference Share Conversion* 4,521 1,508 38.43
Rights Issue 15,810 5,850 37.0
Total Investment 27,609 20,315 73.6
Return on Investment
Fees Received** -376
Dividends received
Profit/Loss on disposals
APS fee (Gross) -2,500
Total Investment less APS fee 27,609 17,439 63.2
% stake held by Government 41%
Source: J.P. Morgan estimates, Company data, UKFI data. Pre Dec 2009 rights price based on UKFI data, adjusted for accrued divs
and redemption premiums of £230mn. APS fee taken gross at £2.5bn, was £1.8bn after tax.
Table 15: RBS: Average Entry Price for the UK Government

Shares Total Investment Per Share
m £m p
Initial Recapitalisation 22,854 14,969 65.5
Preference Share Conversion* 16,791 5,058 31.8
APS B Shares 51,000 25,500 50.0
Return on Investment
Fees Received** -305
Dividends received
Profit/Loss on disposals
% stake held by Government 82%
Source: UKFI. Notes *Total investment adjusted to take account of accrued dividends and redemption premiums received of around
£270 million, **Underwriting fees on transactions paid to HM Treasury, including the recapitalisation and preference share conversion
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Share sale
There are several ways that a share sale could be executed, the most common being:
• A public offering – in the UK there have been several privatizations, and the
Conservative party has discussed this possibility for the bank stakes. Potentially
stock could be offered to institutional and retail investors at different pricing
points and depending on previous ownership;
• A 'drip feed' – similar to the strategy that the US government is employing for
the sale of its Citigroup holding. Clearly, this can be executed in combination
with occasional accelerated book builds;
• An additional listing – the government could potentially list the B-shares in the
case of RBS;
• Private placing – potentially the government could sell shares to a closed group
of investors without a broader public offering, or a strategic investor such as a
sovereign wealth fund.
Below we review each of these methods in greater detail. Note there have been some
questions whether the government could sell the RBS shares whilst there is a
commission looking at the separation of retail and investment banking activities. We
think that this makes a placing more difficult, but with the right disclosures should
not be prohibitive and would be reflected in the pricing achieved.
Public offering
The stakes could be sold in a similar manner to previous privatizations of
government assets. The two most notable transactions are the privatisations of
British Telecom and British Gas, we review both below.
British Telecom privatisation

BT was the first major privatisation of the 1980s and potential shareholders were
split into four categories: institutions, the general public, BT employees and
pensioners, and buyers in the US, Canada and Japan. Initially 51% of the company
was offered, and then there were two follow-on offerings in 1991 and 1993 spanning
a period of 9 years. The charts below show the allocations and the relative size of the
offerings.
Figure 4: British Telecom IPO (November 1984)

Internatio
Employ e nal 3rd issue
es/Pensi 14% 22%

Institutio
oners s 1st issue
5% 47% 51%
2nd
Public issue
34% 27%
First Issue Allocations Percentage shares issued
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British Gas privatisation

British Gas was the second privatisation and broadly followed the British Telecom
model. Initially UK retail investors were to be allocated 40% of the shares, but due
to over subscription they ultimately received 65%. 96% of the company was offered
with the government retaining only 4%.
Figure 5: British Gas IPO (November 1986)

Internatio UK Internatio
nal Retail nal
20% 40% 11%
UK UK
UK
Institution Institution
Retail
al al
65%
40% 24%
Planned Allocations Ultimate Allocations

From both of these transactions there is a heavy bias towards UK retail investors,
who were typically offered a discount to institutional investors, and UK institutions
were also given preferential allocations. Shares were offered to retail investors at c2-
5% discounts. Currently the shareholder structures of RBS and Lloyds Banking
Group are split as illustrated below.
Figure 6: RBS and Lloyds YE09 Shareholder Profiles

UK
Other UK
Retail
13% Retail
19%
17%
Foreign
UK
Institution
UK Foreign Institution
al
Institution Institution al
29%
al al 49%
41% 32%
RBS Investor Base YE09 Lloyds Investor Base YE09

Source: J.P. Morgan estimates, Company Reports
We note that both Lloyds Banking Group and RBS have substantial institutional
investor bases and high weightings of UK investors. If the mix were to become more
skewed towards retail investors then this could increase the focus on dividends and
payout ratios. Managements may be under greater pressure to resume dividend
payments as soon as EU restrictions are lifted, i.e. from Apr 2012 for both RBS and
Lloyds Banking Group.
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Slow drip feed

The government could sell the stakes into the market slowly over time, in a similar
way to the US government's approach with its Citigroup stake. This could be
effective, the main issue being the amount of time that this would take. Clearly, as
the government sells the free float increases, potentially increasing the turnover, but
based on current average trading volumes it would take c. 9.4 years for RBS and 1.9
years for Lloyds if sales were limited to 15% of average daily volume.
Table 16: UK Banks: Time to Sell RBS and Lloyds at 15% of the volume
RBS Lloyds
Gov Shares 90,645 27,609
Average Daily Volume 176 259
15% ADV 26 39
Implied Days 3,434 711
Years 9.4 1.9
Source: J.P. Morgan estimates, Bloomberg
This method would have limited impact on the strategies of the groups and their
earnings potential in our view.
Additional listing
According to the terms of the RBS Accession Agreement:
‘The B Shares will not initially be listed on any stock exchange. HM Treasury is
entitled to require RBS to seek a listing of the B Shares. The Dividend Access Share
will not be listed on any stock exchange.’
So potentially the government could require RBS to list the B-shares separately to
the common equity. If it is possible for the preferential dividend rights to be
maintained this could be a way for the government to extract more value from its
holding.
Private placement
It may be possible for the government to sell part of its holding to a strategic buyer,
such as a foreign bank or sovereign wealth fund.
There have been unconfirmed reports in the press recently (FT 25 May 2010) that
Qatar Investment Authority (QIA) has expressed interest in buying part of the US
Treasury’s stake in Citigroup; we could possibly see such a transaction for the UK
banks. QIA currently has a 12% stake in Barclays (including 2% from Challenger, a
related entity).
Summary of impact from a share sale

Overall we believe a share sale would have a neutral impact on valuation, but the
increased liquidity could have a positive impact in terms of where the shares trade in
relation to fundamental valuation. Further there would be index implications which
we discuss later in pages 25-27.
An increase in the retail investor base could shift the focus more towards dividend
distributions, at the expense of reinvestment in the businesses, and a strategic buyer
may add value to other stakeholders. Further as the UKFI does not currently 'loan'
shares in its holdings, a sale would add incrementally more liquidity, however this
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benefit would be partially offset if shares are mainly acquired by retail investors
(who also loan limited amounts of stock).
We think a share sale with possibly a combination of the measures outlined above is
the most likely exit route.
Convertible bonds
It may be possible for the government to issue mandatory convertible notes (MCNs)
that convert into RBS or Lloyds shares. These could be similar to the instruments
issued by Barclays in October 2008 to Middle Eastern investors and institutions.
The attraction for investors could be the ability to earn a yield during the period
when RBS and Lloyds cannot distribute earnings, and for the government the
attraction could be a conversion price at a premium to current share prices (although
this should be neutral from a deficit point of view as the additional yield expense is
reflected in government expenditure, offsetting the additional gain).
The difficulty of this approach is the volume of issuance required, and given some
investor mandates, some may not be able to participate. We think that this approach
could be used but in limited size, and may be executed alongside another exit method
such as an equity placing.
Buyback
In the Acquisition and Contingent Capital Agreement between HM Treasury and
RBS it says:
‘that in relevant circumstances, and acknowledging the conversion feature

applicable to the B Shares set out in the B Share terms, the Company will repurchase
the B Shares if it is prudent and practicable. Such repurchase would be subject to
FSA approval and take account of the Regulatory Group’s capital position at the
time of the proposed repurchase and prevailing market conditions’
Furthermore, HM Treasury has agreed with the European Commission:
1. That without the prior approval of the European Commission, it will not agree to
sell to the Company any B Shares issued to and held by HM Treasury below the
following minimum purchase prices: (a) for purchases before 31 December 2012,
50p; (b) for purchases between 31 December 2012 and 30 December 2013, 55p;
(c) for purchases between 31 December 2013 and 30 December 2014, 60p; and
(d) for purchases from 31 December 2014, 65p.
In each of these cases, if the price of the Ordinary Shares is higher than the above
agreed price when the sale is agreed, the price of the Ordinary Shares will be the
minimum price.
2. That without the prior approval of the European Commission, it will not convert
any B Shares issued to and held by it into Ordinary Shares unless the market
price of Ordinary Shares is at least 50p on the date on which HM Treasury
delivers its Conversion Notice. This price is subject to adjustment in line with
adjustments to the Conversion Price.
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3. If the capital position of the Company allows this and subject to any consent
required from the FSA, it will request the Company to purchase from it an
appropriate number of B Shares (within the above-mentioned price parameters)
or to retire an appropriate amount of the Contingent Subscription.
So under the agreement it appears possible for RBS to buy back the B shares, and in
fact if the capital position allows it, it is possibly an EC requirement.
We do not think that the opportunity will arise however in the short term, given the
capital impact and the regulatory uncertainty surrounding the potential changes to
capital requirements and business models. It would be very risky for the FSA to
permit such a move in the absence of a further capital raise, which would offset any
potential positive impact for common equity holders. In Table 17 below we illustrate
the group's capital ratios if there was a buyback without additional capital raise.
Table 17: RBS: Capital ratios if the B shares were redeemed

£ million
2009 2010E 2011E 2012E 2013E
Core Tier 1 Capital 48,151 49,108 50,460 55,607 63,447

ow APS deduction -5,106 -4,460 -3,643 -2,223 -435
CT1 ex deduction 53,257 53,568 54,104 57,829 63,882
RWAs 438 483 545 503 471

ow APS deduction -128 -111 -91 -56 -11
RWAs ex deduction 566 595 637 558 482
Core Tier 1 Ratio 11.0% 10.2% 9.3% 11.1% 13.5%

Core Tier 1 Ratio ex APS 9.4% 9.0% 8.5% 10.4% 13.3%
B share capital 25,500 25,500 25,500 25,500 25,500

Net Yield 1.5% 1.5% 1.5% 1.5% 1.5%
Earnings on B shares 383 383 383 383
Cumulative Earnings 0 383 765 1,148 1,530
CT1 post buyback 23,225 24,195 28,959 36,417

CT1 post buyback ex APS 27,685 27,839 31,182 36,852
CT1 ratio post buyback 4.8% 4.4% 5.8% 7.7%

CT1 ratio post buyback ex APS 4.7% 4.4% 5.6% 7.7%
Whilst in 2013E from the table above the capital ratio looks better, the calculations
above do not incorporate the potential Basel III changes which could further reduce
capital ratios by c. 200-300bps.
In an environment where there is still significant macro uncertainty we expect that

whilst some regulation may be pushed back, regulators will still limit the amount of
capital distribution to investors.
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(44-20) 7325-6924
Terms and Impact of exiting the contingent capital facility

Whilst we think it is unlikely that the B shares are bought back, we think that RBS
could seek to terminate the contingent capital facility early.
Currently the facility is triggered if the core tier 1 ratio for the group falls below 5%,
and is £8.0bn in size. It is triggered in tranches (provisionally set as £6bn and £2bn)
and is scheduled to last for 5 years. The company can terminate the facility if it has
the FSA’s consent at any time.
The fee for the facility is 4% of the total size, i.e. £320mn per annum at the
origination, and if RBS exits or reduces their participation the fee is reduced
proportionately.
At the YE09 the fair value of the consideration payable was £1,458mn, and the
company set aside £1,208mn towards a contingent capital reserve, so if there is early
termination part of this reserve could be released. The potential benefit is small
however in the context of the group – if 100% of the reserve was released it would
benefit NAV by c. 1p, i.e. 2%.
An asset swap
The fourth method that the government could use to maximise the value of its
holding could be to restructure the businesses and swap the holdings for various
assets.
This seems unlikely to us, and it is not clear whether it is legally possible, but it
could transfer value from other stakeholders to the taxpayer, and could be similar to
the restructuring of Northern Rock. Further, it could be a means to break up the
banks to create more competition in the market place.
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Index implications
Currently several of the key indices tracked by investors base their weighting
methodology on the free floats of stocks. As such, if the UK government does
reduce its stakes in the banks, there will be some significant index implications.
For further details please refer
Whilst the overall supply would dwarf the potential demand, potential timing
to;
differences could lead to trading opportunities.
JPM: 2010 Global Index
Handbook, Jan 2010
In the section below we review the potential impact.
We would like to thank Trista
Rose for her collaboration in this
section. For more details on
Tracker demand
Index implications please For the UK banks the main indices are the FTSE, MSCI and DJ Stoxx. Figure 7
contact: below illustrates the amount of passive money benchmarked to each.
Equity Derivatives & Delta One
Strategy Figure 7: Estimated Passive Indexed Assets $bn
Trista J Rose
(44-20) 7325 4402
trista.j.rose@jpmorgan.com
Source: J.P. Morgan Derivatives and Delta One Strategy. Data as of Dec 2009.
The tables below show the potential demand in three cases: (i) a sale of 100% of the
government holding in Lloyds Banking Group, (ii) a sale of 100% of the
government's common equity holding in RBS, and (iii) a sale of the government’s
common equity holdings and B share holdings in RBS.
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Table 18: Simulated Demand – Lloyds free float increased to 100%

Old weight New weight Demand - shares Demand - USD xADV
FTSE
FTSE 100 1.539% 2.609% 466.40 372.17 1.80
FTSE ALL SHARE 1.307% 2.215% 2,743.52 2,189.26 10.60
FTSE AW 0.137% 0.233% 274.35 218.93 1.06
MSCI
MSCI EAFE 0.322% 0.536% 838.97 669.47 3.24
MSCI EUROPE 0.500% 0.833% 127.12 101.44 0.49
MSCI KOKUSAI 0.157% 0.261% 38.14 30.43 0.15
STOXX
Stoxx 600 0.483% 0.822% 78.66 62.77 0.30
TOTAL 4,567.16 3,644.46 17.64
Source: J.P. Morgan Derivatives and Delta One Strategy, FTSE, MSCI Barra, Stoxx Ltd, Bloomberg
Table 19: Simulated Demand – RBSs free float increased to 100% no B share sale
Old weight New weight Demand - shares Demand - US xADV
FTSE
FTSE 100 0.555% 1.849% 674.59 448.26 3.83
FTSE ALL SHARE 0.471% 1.570% 3,968.20 2,636.85 22.55
FTSE AW 0.049% 0.164% 396.82 263.68 2.25
MSCI
MSCI EAFE 0.119% 0.396% 1,302.05 865.20 7.40
MSCI EUROPE 0.185% 0.615% 197.28 131.09 1.12
MSCI KOKUSAI 0.058% 0.193% 59.18 39.33 0.34
STOXX
Stoxx 600 0.180% 0.607% 118.93 79.03 0.68
TOTAL 6,717.05 4,463.44 38.17
Source: J.P. Morgan Derivatives and Delta One Strategy, FTSE, MSCI Barra, Stoxx Ltd, Bloomberg
Table 20: Simulated Demand –RBS free float increased to 100% and B shares listed
Old weight New weight Demand - shares Demand - US xADV
FTSE
FTSE 100 0.555% 3.512% 1,541.59 1,024.38 8.76
FTSE ALL SHARE 0.471% 2.983% 9,068.20 6,025.77 51.53
FTSE AW 0.049% 0.312% 906.82 602.58 5.15
MSCI
MSCI EAFE 0.119% 0.754% 2,985.05 1,983.55 16.96
MSCI EUROPE 0.185% 1.172% 452.28 300.54 2.57
MSCI KOKUSAI 0.058% 0.367% 135.68 90.16 0.77
STOXX
Stoxx 600 0.180% 1.156% 271.93 180.69 1.55
TOTAL 15,361.55 10,207.66 87.29
Source: J.P. Morgan Derivatives and Delta One Strategy, FTSE, MSCI Barra, Stoxx Ltd, Bloomberg.
Overall the passive demand from index trackers is c.17% of the supply based on
our estimates.
Further if the free float was increased to 100% for both banks they could re-enter the
Stoxx 50 Index, further increasing demand. Note additions can only be made to this
index during the annual review (every September).
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(44-20) 7325-6924
Timing of Index re-weighting

In the event of a rights issue (not our base case scenario) the FTSE, MSCI and Stoxx
rebalance occurs at the close on the last day that the stock is cum rights. If there is a
placing the treatment is slightly different:
• FTSE – if the impact is more than 10% then the rebalance is done within 2-4 days
typically
• MSCI – if the placing is expected to have significant market impact the
reweighting can be delayed to the next quarterly review
• Stoxx – for the Stoxx if the impact is greater than 5% then the rebalance is
usually executed within 2-4 days
Note whilst these are the times that the rebalancing occurs, passive funds do not have
to execute at the exact same time, there can be some flexibility build into their
mandates to reduce the potential for their trading to minimise price impact.
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(44-20) 7325-6924
Stock implications
Despite the stocks having corrected in the wake of sovereign concerns, both RBS and
Lloyds Banking Group have outperformed the European banks index by 71.7% and
23.8% respectively YTD and are currently trading at 0.92x NAV and 0.93x NAV
2011E respectively. Fundamentally, we believe that returns are capped for both
these banks until they address certain issues. We go through each stock in turn as we
try to explain why we struggle to see RoEs exceeding 11-12% over the next three
years or so.
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Lloyds Banking Group

Lloyds Banking Group Plc (LLOY.L;LLOY LN)
Company Data FYE Dec 2008A 2009A 2010E 2011E
Price (p) 57 Adj. EPS FY (p) -0.46 -0.19 -0.01 0.04
Date Of Price 28 May 10 Headline EPS FY (p) 0.05 0.04 0.01 0.04
Price Target (p) 50 NAV/Sh FY (p) 164.3 58.3 58.0 61.7
Price Target End Date 31 Dec 10 P/NAV FY 0.3 1.0 1.0 0.9
52-week Range (p) 76 - 40 Pretax Profit Adjusted FY (£ mn) (5,761) (11,633) (941) 3,837
Mkt Cap (£ bn) 36.11 Net Attributable Income FY (£ 772 2,827 547 2,474
Shares O/S (mn) 63,775 mn)
Adj P/E FY NM NM NM 1,463.9
Core Tier One Ratio FY 6.2% 8.1% 8.3% 9.4%
Source: Company data, Bloomberg, J.P. Morgan estimates.
Over the last few months on the back of management guidance, expectations have
moved towards the group earning an operating profit on a combined business basis in
2010E. In fact in the Q1 IMS the management stated that due to lower wholesale
impairments this goal had already been achieved in Q1. The next question that
investors have been asking is, what would it take for the group to earn a 15%
RoNAV, and hence justify multiple expansion?
Based on our estimates the group will earn an 11.2% RoNAV in 2012E, and to
generate a 15% RoNAV the net attributable profit would need to be 36% higher at
£6,733mn as illustrated below (note we are referring to return on tangible equity, to
achieve a 15% return on total equity attributable profit would need to be significantly
greater but also the book value is that much higher).
Table 21: Lloyds Banking Group: 2012E 15% RoNAV Net Attributable Profit Calculation
£ million
Current Estimates
NAVps 2011E (p) 61.7
NAVps 2012E (p) 69.3
Average NAVps 2012E (p) 65.5
No. of Shares (mn) 67,666
2012E Net Attrib 4,939
2012E RoNAV 11.1%
Required Estimates
2011E NAV 41,725
Implied 2012E Net Attrib 6,766
% change in estimate 37%
Implied 2012E EPS (p) 10.0
Implied 2012E NAV 48,492
Implied 2012E NAVps (p) 71.7
Implied 2012E RoNAV 15.0%
To drive such an outperformance in earnings there are potentially three key levers: (i)
an increase in net interest margins, (ii) a reduction in costs, and (iii) a further
reduction in provisioning requirements. We go through each in turn.
(i) Sensitivity to increasing banking NIM

The first area that we explore is the potential for greater NIM expansion than
currently estimated. In H209 banking NIM expanded to 1.83% from 1.72% in H109,
after declining from 2.01% in 2008. Management guidance at the FY 2009 results
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for 2010E is c2.0%, with an upward trajectory beyond then. In our base case we
expect 2.1% in 2010E, increasing to 2.4% in 2012E.
Table 22: Lloyds Banking Group: Banking NIM Progression

£ million
H108 H208 H109 H209 2008 2009 2010E 2011E 2012E
Banking NII 6,415 6,768 5,724 6229 13,183 11,953 12,944 13,355 13,924
AIEA 644,889 666,969 671,944 676548 655,989 674,246 618,453 601,771 588,642
Banking NIM 1.99% 2.03% 1.70% 1.84% 2.01% 1.77% 2.09% 2.22% 2.37%
Group NII 7,042 7,861 6,442 6,284 14,903 12,726 12,944 13,355 13,924
Source: J.P. Morgan estimates, Company data. Group net interest income is historically greater than banking net interest income, but in H209 it was broadly the same. We have assumed that they
are equal going forwards.
Note that whilst the NIM may be increasing, the size of the balance sheet is
shrinking. Management has guided to a further £140bn reduction by end 2014E, of
which £100bn is in customer loans and £40bn in Treasury assets. This will put
pressure on the absolute level of net interest income despite the margin expansion.
In the analysis below to illustrate the combined effect, in the 15% RoE scenario we
have assumed that this 'right sizing' has taken place.
Table 23: Lloyds Banking Group: Potential for NIM expansion

£ million
% Change % Change % Change
2009A 2012E 15% RoNAV 12E/09A 15% RoNAV/09A 15% RoNAV/12E
Net Interest Income 12,726 13,924 18,396 9.4% 44.6% 32.1%
Non Interest Income 9,740 10,378 10,378 6.5% 6.5% 0.0%
Total Income 22,466 24,301 28,773 8.2% 28.1% 18.4%
Operating Costs -11,609 -11,315 -13,397 -2.5% 15.4% 18.4%
Pre Provision Operating Profit 10,857 12,986 15,376 19.6% 41.6% 18.4%
Provisions -23,988 -6,002 -5,736 -75.0% -76.1% -4.4%
Underlying PBT -13,131 6,984 9,640 -153.2% -173.4% 38.0%
Restructuring Charges -1,096 -400 0 -63.5% -100.0% -100.0%
Fair Value Unwind 6,100 500 0 -91.8% -100.0% -100.0%
Other Exceptionals 9,169 0 0 -100.0% -100.0% na
Profit Before Tax 1,042 7,084 9,640 579.8% 825.1% 36.1%
Tax 1,911 -2,019 -2,747 -205.6% -243.8% 36.1%
Profit After Tax 2,953 5,065 6,892 71.5% 133.4% 36.1%
Minorities -126 -126 -126 0.0% 0.0% 0.0%
Net Attributable Profit 2,827 4,939 6,766 74.7% 139.3% 37.0%
NIM 1.77% 2.37% 3.44% 33.4% 94.2% 45.6%

Cost Income Ratio 51.7% 46.6% 46.6% -9.9% -9.9% 0.0%
Impairment Charge 3.25% 0.98% 0.98% -69.9% -69.9% 0.0%
Banking Net Interest Income 11,953 13,924 18,396 16.5% 53.9% 32.1%
Average Customer Loans 686,462 613,642 586,462 -10.6% -14.6% -4.4%
AIEA 674,246 588,642 534,246 -12.7% -20.8% -9.2%
Based on the table above, it appears that the net interest margin would need to
increase by 167bps from 2009 levels, and a further 107bps from JPMe 2012E to
achieve a 15% RoNAV. What we are seeing in the market however is that asset
pricing has started to stabilize and in some markets actually contract slightly. For the
UK mortgage market, data from the Council of Mortgage Lenders (CML) suggests
that the back book of existing business has largely re-priced, as illustrated in the
charts below.
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(44-20) 7325-6924
Figure 8: Yield on mortgages Figure 9: Spread between new business and outstanding balances
6.50% 1.00%
6.00% 0.80%
5.50% 0.60%
0.40%
5.00%
0.20%
4.50%
0.00%
4.00% -0.20%
3.50% -0.40%
3.00% -0.60%
Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
Outstanding Balances New Business Spread
Source: CML / BOE Source: CML / BOE
Clearly new business prices can pick up again from these levels but that is largely in
our forecasts.
Further, on the liability side we have several concerns:
Whilst deposit spreads have been compressed and are likely to improve we expect
greater amounts of competition than what we have seen in previous cycles, and hence
more limited benefit. Further, with regards to wholesale funding we expect investors
to require higher margins to compensate for the increased risk that is associated with
less valuable sovereign protection.
There is also potentially an issue with the sheer volume of paper that needs to be
issued by sovereigns, banks and corporates over the coming 18-24 months, pushing
up yield requirements. In fact there is a risk that banks are forced to resort to central
bank facilities as they are effectively ‘crowded out’ from term debt issuance. For
further details on this topic please see JP Morgan's 'European Banks H2'10 Outlook
- The Big Squeeze' 27 May 2010 by Roberto Henriques. This may result in the
duration of liabilities shortening in the near term, helping earnings, but is negative in
the medium term.
As observed in the report, if sovereign concerns were to diminish this would be less
of an issue, however we think this would likely be on the back of effective austerity
plans, which would have their own impact on economic growth and hence bank
earnings. Our UK economists estimate a 0.5x multiplier between fiscal tightening
and GDP growth (please see JP Morgan's 'UK fiscal policy: the coming tightening
and its impact' 21 May 2010 by Malcolm Barr).
(ii) Sensitivity to reducing costs

At the time of the HBOS acquisition, management guided to £1.5bn of cost
synergies, c.28% of the HBOS cost base. Since then this figure has been revised
upwards to £2.0bn, c37% of the HBOS cost base. Given £766mn has already been
achieved, this leaves £1.25bn to be done by end 2011E. Over this period integration
costs are estimated to total 155% of the annual benefit.
Overall management guidance is for c.2% reductions in the cost income ratio per
annum for the next few years (note in 2009 the ratio of 48.4% benefited from £1.5bn
gains on exchange and tender offers, excluding this item the ‘clean’ cost income ratio
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(44-20) 7325-6924
was 51.7%). We model the cost income ratio declining to 46.6% 2012E. Table 24
below illustrates the reductions in costs to achieve a 15% RoNAV.
Table 24: Lloyds Banking Group: Potential for Cost Reduction

£ million
Total Income 22,466 24,301 24,301 8.2% 8.2% 0.0%
Operating Costs -11,609 -11,315 -8,925 -2.5% -23.1% -21.1%
Provisions -23,988 -6,002 -5,736 -75.0% -76.1% -4.4%
Underlying PBT -13,131 6,984 9,640 -153.2% -173.4% 38.0%
Tax 1,911 -2,019 -2,747 -205.6% -243.8% 36.1%
Profit After Tax 2,953 5,065 6,892 71.5% 133.4% 36.1%
Minorities -126 -126 -126 0.0% 0.0% 0.0%
NIM 1.77% 2.37% 2.61% 33.4% 47.0% 10.2%

Cost Income Ratio 51.7% 46.6% 36.7% -9.9% -28.9% -21.1%
Impairment Charge 3.25% 0.98% 0.98% -69.9% -69.9% 0.0%
AIEA 674,246 588,642 534,246 -12.7% -20.8% -9.2%
Based on this analysis the cost income ratio would need to decline to 37% to achieve
a 15% RoNAV. We note that this would imply a further absolute cost reduction of
£2.6bn, i.e. in total savings of 64% of the HBOS cost base or 28% of the combined
2008 cost base.
(iii) Sensitivity to reducing provisions

The biggest delta in 2010 results compared to 2009 will be the level of provisioning.
We have assumed a significant improvement, continuing in 2011E and 2012E, in line
with management guidance.
Table 25: Lloyds Banking Group: Provisioning Guidance & Expectations

%
2010 Guidance FY08 FY09 FY10E FY11E FY12E
Group Significantly lower than 2009 1.81% 3.25% 1.90% 1.33% 0.98%
Retail Lower than 2009 0.97% 1.11% 0.93% 0.83% 0.74%
Wholesale Significantly lower than 2009 3.32% 5.92% 3.11% 2.04% 1.51%
Wealth & International Peaked but risk in Ireland 1.05% 6.04% 4.58% 2.42% 1.04%
Table 26 shows how we would have to further reduce our provisioning estimates to
achieve a 15% RoNAV in 2012E.
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Table 26: Lloyds Banking Group: Potential for Further Provisioning Reduction
£ million
Total Income 22,466 24,301 24,301 8.2% 8.2% 0.0%
Operating Costs -11,609 -11,315 -11,315 -2.5% -2.5% 0.0%
Provisions -23,988 -6,002 -3,346 -75.0% -86.0% -44.2%
Underlying PBT -13,131 6,984 9,640 -153.2% -173.4% 38.0%
Tax 1,911 -2,019 -2,747 -205.6% -243.8% 36.1%
Profit After Tax 2,953 5,065 6,892 71.5% 133.4% 36.1%
Minorities -126 -126 -126 0.0% 0.0% 0.0%
NIM 1.77% 2.37% 2.61% 33.4% 47.0% 10.2%

Cost Income Ratio 51.7% 46.6% 46.6% -9.9% -9.9% 0.0%
Impairment Charge 3.25% 0.98% 0.57% -69.9% -82.4% -41.7%
AIEA 674,246 588,642 534,246 -12.7% -20.8% -9.2%
Based on this analysis the group would need to report a provisioning rate of 57bps on
a normalized basis. In Table 27 below we show our normalized provisioning
estimates;
For details on changes to Table 27: Lloyds Banking Group: Normalised Provisioning Rate
provisioning methodology please %
refer to;
Normalised 2012E H109 H209
JP Morgan ‘European Banks: Retail 0.68% 1.16% 1.09%
Asset Quality – Assessing the Secured 0.12% 0.34% 0.11%
impact of regulatory changes’ Unsecured 7.00% 9.09% 11.16%
Wholesale 1.48% 6.87% 5.83%
17 May ‘10 Corporate Markets 1.50% 9.01% 5.83%
Treasury and Trading 0.00% 0.00% 0.00%
Asset Finance 1.50% 6.34% 7.16%
Wealth & International 0.87% 4.77% 8.55%
Wealth 0.05% 0.52% 0.96%
International 1.00% 5.59% 9.93%
Total 0.91% 4.11% 3.25%
Whilst at the start of this year impairments have tracked better than our expectations,
and we do not expect to need to downgrade our provisioning estimates, if global (and
particularly UK) growth assumptions are reduced the pace of improvement could be
slowed. Note that at FY09 the company based its 2010E guidance on a UK GDP
growth rate of 1.8% in 2010E which appears high relative to current consensus
expectations of c.1.3%.
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Summary of potential for 15% RoNAV

So to achieve a 15% RoNAV would be a stretch, even without the impact of
additional taxation that we have discussed earlier in this report or other regulatory
changes. Furthermore, as discussed below, there are sanctions that have been applied
by the EU which we expect will act as a further headwind.
EU sanctions
As a consequence of the state aid that the group has received, the European Council
has imposed several requirements on the business. In the analysis above we have
included the impact of balance sheet reduction, but in addition the group is required
to dispose of a retail banking business with at least 600 branches, 4.6% share of the
UK personal current account market and c.19% of the group’s mortgage assets,
within 4 years. This was slightly more substantial than our original estimates. The
company has said that at YE08 this business consumed £18bn of RWAs, had £70bn
of loans, £30bn of deposits, and generated c.£500mn of PBT. Below we illustrate its
potential contribution.
Table 28: Lloyds Banking Group: UK Retail Disposal Assets

£ million
UK Retail Divestment Contribution 2008 2009E 2010E 2011E 2012E
Income 1,400 1,186 1,263 1,351 1,467

Expenses -600 -593 -631 -648 -675
PPOP 800 593 631 702 792
Provisions -300 -354 -334 -294 -263
PBT 500 239 298 408 529
Loans 70.0 71.2 71.4 71.9 72.5

Deposits 30.0 30.6 31.5 32.5 33.4
RWAs 18.0 21.6 22.1 20.3 19.0
Cost Income 43% 50% 50% 48% 46%

Asset Margin 2.0% 1.7% 1.8% 1.9% 2.0%
Risk Weight 26% 30.3% 30.9% 28.2% 26.2%
LDR 233% 233% 226% 221% 217%
Provisions/ Loans 0.43% 0.50% 0.47% 0.41% 0.36%
Table 29 below shows the historic earnings of Lloyds TSB and HBOS adjusted for
the unsustainability of its revenue base. We refer the reader to J.P. Morgan Lloyds
Banking Group – With or Without APS, 11th August 2009 for more details on how
we reached the underlying earnings potential. The combined profits in 2007 are 13%
short of the 2012E requirement for a 15% RoNAV or 22% short, if we include a UK
liability tax impact.
Table 29: Lloyds + HBOS Historic Earnings

£ million
2003 2004 2005 2006 2007
LLOY 3,254 2,392 2,493 2,803 3,289
HBOS 2,452 3,118 3,230 3,879 4,045
HBOS Adj 1,618 2,058 2,132 2,560 2,670
Total 4,872 4,450 4,625 5,363 5,959
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(44-20) 7325-6924
Overall Lloyds Banking Group valuation

We have revised our estimates to reflect the recent exchange offer announcement.
For more details please see J.P. Morgan’s ‘Lloyds Banking Group: Exchange Offer
of Upper Tier 2 Securities' 01/06/10. Our new estimates are shown in Table 30
below. Our SoP based TP of 50p remains unchanged.
Table 30: LBG: Changes to Estimates

2010E 2011E 2012E
New basic EPS (p) 0.8 3.7 7.3
EPS growth (%) -81.8% 352.1% 99.6%
Old basic EPS (p) 0.5 3.7 7.4
% difference 56.9% -1.1% -1.1%
New JPM adjusted NAV (p) 30.9 43.7 51.9

JPM adj, NAV growth (%) 66.1% 41.4% 18.9%
Old JPM adjusted NAV (p) 30.9 43.9 52.2
% difference -0.1% -0.4% -0.5%
New reported NAV (p) 58.0 61.7 69.3

Reported NAV growth (%) -0.5% 6.3% 12.4%
Old reported NAV (p) 58.4 62.1 69.8
% difference -0.6% -0.6% -0.7%
New DPS (p) 0.0 0.0 0.0

DPS growth (%) 0.0% 0.0% 0.0%
Old DPS (p) 0.0 0.0 0.0
% difference 0.0% 0.0% 0.0%
PE -64.4x 14.7x 7.9x

Stated P/NAV 1.0x 0.9x 0.8x
Stated RoNAV(%) 1.4% 6.1% 11.1%
Table 31: Lloyds Banking Group: 2010E Based SoP

£ million
Earnings Value Valuation Basis Value per share (p) P/E (x) P/BV (x)
Retail Banking 2,193 14,684 RoE - g/CoE - g 22 6.7 1.5
Wholesale Banking 832 17,942 RoE - g/CoE - g 26 21.6 1.1
Insurance 781 9,460 14 12.1 1.7
Wealth & International -534 4,558 RoE - g/CoE - g 7 -8.5 1.0
Underlying Core Earnings 3,272 46,643 69 14.3 1.3
Corporate Center -529 -3,704 -5
Capital Excess/ Shortfall -269 -8,826 BV/ P/E -13
ow Pillar 2 5,578
Lloyds Banking Group 2,474 34,113 50 13.8 1.0
Price Target 50
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Amit Goel, CFA
(44-20) 7325-6924
Royal Bank of Scotland

Royal Bank of Scotland Group Plc (RBS.L;RBS LN)
Company Data FYE Dec 2008A 2009A 2010E 2011E 2012E 2011E
Price (p) 47 (New) (Old)
Date Of Price 28 May 10 Adj. EPS FY (p) -45.75 -1.34 0.29 1.59 3.78 0.89
Price Target (p) 42 Adj P/E FY NM NM 160.1 29.5 12.4 52.7
Price Target End Date 31 Dec 10 Headline EPS FY (p) -60.99 -4.44 -0.98 0.49 3.38 0.04
52-week Range (p) 59 - 28 NAV/Sh FY (p) 73.9 51.9 52.8 53.3 51.1
Mkt Cap (£ bn) 50.17 P/NAV FY 0.6 0.9 0.9 0.9 0.9
Shares O/S (mn) 107,366 Net Attributable Income (24,051) (3,607) (1,077) 536 3,726 49
FY (£ mn)
Operating profit FY (£ (8,127) (5,718) (1,700) 811 5,637 1,137
mn)
Tier One Ratio FY 9.9% 14.4% 12.4% 11.2% 12.7%
Source: Company data, Bloomberg, J.P. Morgan estimates.
As we have discussed for Lloyds Banking Group market expectations have improved
substantially over the past six months, and so for RBS we have asked the same
question – can the group earn a 15% RoNAV? Note this is management's target for
the core business in 2013E. Based on our estimates the group would fall
significantly short where in 2013E we expect the group to earn a 9.6% RoNAV. In
the section below we illustrate the change in our estimates required to get there.
Flexing a 15% RoE

To achieve a 15% RoNAV in 2013E net attributable income would need to be 61%
greater than our current forecast at £9.8bn.
Table 32: RBS: Net Attributable Profit Requirement to Achieve a 15% RoNAV
£ million
Current Estimates
NAVps 2012E (p) 54.7
NAVps 2013E (p) 60.2
Average NAVps 2013E (p) 57.5
No. of Shares (mn) 110,160
2013E Net Attrib 6,052
2013E RoNAV 9.6%
Required Estimates for a 5% RoNAV

2012E NAV 60,276
Implied 2013E Net Attrib 9,775
% change in estimate 61%
Implied 2013E EPS (p) 8.9
Implied 2013E NAV 70,051
Implied 2013E NAVps (p) 63.6
Implied 2013E RoNAV 15.0%
Source: J.P. Morgan estimates. Note we are referring to tangible equity.
This is despite the regulatory and taxation concerns that we have discussed
previously and EU sanctions that are more stringent than those imposed on Lloyds
Banking Group. Potentially the EU sanctions reduce core PBT by 14%.
EU sanctions
The asset disposals mandated by the EU could reduce the core group's earnings
capacity by c.13-14% going forwards, whilst also reducing the capital requirements.
For further details please refer to ‘UK Banks: Upgrading Barclays to Neutral and
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Amit Goel, CFA
(44-20) 7325-6924
Revisiting RBS which remains UW’ 04 Dec 2009. Note the level of capital gains
that could be generated is unclear.
Table 33: RBS: Potential impact on core and group PBT from disposals
£ million
PBT Impact 2008 2009 2010E 2011E 2012E
Sempra -209 -52 -163 -147 -151

GMS -267 -249 -261 -269 -277
Insurance -584 -58 -413 -558 -597
UK -347 146 -36 -71 -171
Total -1,407 -213 -873 -1,044 -1,196
Core 4,413 8,325 7,018 7,266 8,798

Core ex Assets 3,006 8,112 6,146 6,222 7,603
% Change -31.9% -2.6% -12.4% -14.4% -13.6%
Group -6,938 -6,232 801 2,511 6,287

Group ex Assets -8,345 -6,445 -72 1,467 5,091
% Change nm nm nm -42% -19%
RWA Impact 2008 2009 2010E 2011E 2013E

Sempra -10.7 -10.2 -10.2 -15.3 -15.3
GMS -1.5 -1.6 -1.5 -1.5 -1.5
UK -14.5 -18.2 -18.5 -18.8 -19.2
Total -26.7 -30.0 -30.2 -35.6 -36.0
Group 578 438 483 545 503

Group ex Assets 551 408 453 510 467
% Change -4.6% -6.8% -6.2% -6.5% -7.2%
Source: J.P. Morgan estimates, Company data. PBT shown before items such as integration costs, APS fees and liability management
gains.
In Table 34 below we illustrate the historic peak earnings of RBS in relation to the
£9.8bn 15% RoNAV scenario, 2007 earnings are still 17% short and a much more
significant 61% compared to our estimates.
Table 34: RBS + ABN historic earnings

£ million
2003 2004 2005 2006 2007
RBS Net Attrib 3,978 5,112 5,392 6,202 7,549
ABN Contribution* 800 800 800 800 800
Total 4,778 5,912 6,192 7,002 8,349
Changes to earnings estimates and valuation

The tables below show our revised divisional forecasts and the changes to our
estimates.
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Amit Goel, CFA
(44-20) 7325-6924
Table 35: RBS: Revised Divisional Estimates

£ million
2009 2009 2010 2008 2009 2010E 2011E 2012E 2013E
Q3 Q4 Q1 FY FY FY FY FY FY
UK Retail 64 128 140 723 229 733 1,140 1,569 1,829

UK Corporate 379 340 318 1,781 1,125 1,355 1,610 1,798 2,035
Wealth 119 89 62 348 420 419 485 548 587
Global Banking & Markets 321 871 1,466 -1,796 5,709 3,568 2,892 2,879 3,293
Global Transaction Services 253 224 233 1,002 973 983 1,067 1,182 1,249
Ulster Bank -85 -275 -137 218 -368 -580 -576 -296 59
US Retail & Commercial -43 -19 40 528 -113 158 240 530 711
RBS Insurance 11 -170 -50 584 58 182 408 588 664
Central Items 120 -5 200 1025 292 200 0 0 0
Total Core 1,139 1,183 2,272 4,413 8,325 7,018 7,266 8,798 10,428
Non Core -2,664 -2,536 -1,559 -11,351 -14,557 -6,218 -4,755 -2,511 -908
Operating Profit -1,525 -1,353 713 -6,938 -6,232 801 2,511 6,287 9,520
Table 36: RBS: Changes to estimates

2010E 2011E 2012E 2013E
New Net Attributable -1,077 536 3,726 6,052
Growth (%) -70% -150% 595% 62%
Old Net Attributable -1,536 49 3,497 5,845
% Difference -30% 988% 7% 4%
New basic EPS -1.0 0.5 3.4 5.5

EPS growth (%) -77.8% -149.4% 595.1% 62.5%
Old basic EPS -1.4 0.0 3.2 5.3
% difference -29.8% 989.0% 6.7% 3.7%
New diluted underlying EPS 0.3 1.6 3.8 5.7

EPS growth (%) -121.8% 443.2% 138.2% 52.1%
Old diluted underlying EPS -0.7 0.9 3.6 5.6
% difference -142.8% 78.7% 5.2% 2.2%
New NAVps 51 51 55 60
NAV growth (%) -0.9% 1.0% 6.6% 10.0%
Old NAVps 49 49 53 58
% difference 4.1% 4.4% 4.0% 3.6%
New JPM NAVps 45 44 47 52

JPM NAVps growth (%) -7.1% -1.6% 5.7% 11.5%
Old JPM NAVps 43 43 45 51
% difference 3.6% 3.5% 2.8% 2.3%
PE -47.5 96.1 13.8 8.5

RoNAV -1.9% 1.0% 6.4% 9.6%
JPM Adj RoNAV 0.6% 3.6% 8.8% 12.1%
RWAs (bn) 483 545 503 471
Core Tier 1 Ratio 10.2% 9.3% 11.1% 13.5%
No. of Shares 110,160 110,160 110,160 110,160
Tier 1 Ratio 12.4% 11.2% 13.2% 15.8%
Our SoP based price target remains unchanged at 42p despite the slight increase to
estimates as the upgrade is primarily in the non core division, partially offset by
slightly lower estimates for the core businesses.
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Amit Goel, CFA
(44-20) 7325-6924
Table 37: RBS: 2010E Based SoP

£ million
Division Net Profit Value Per Share PE P/BV
2011E Valuation Basis (£m) (£) (x) (x)
GLOBAL BANKING & MARKETS 2,082 RoE - g/CoE - g 25,388 0.23 12.2 1.1
GLOBAL TRANSACTION SERVICES 768 PE 9,218 0.08 12.0 0.0
UK RETAIL 821 RoE - g/CoE - g 5,493 0.05 6.7 1.4
UK CORPORATE 1,159 RoE - g/CoE - g 8,829 0.08 7.6 1.2
WEALTH 349 RoE - g/CoE - g 1,552 0.01 4.4 1.7
ULSTER -415 RoE - g/CoE - g 2,238 0.02 -5.4 1.2
US RETAIL & COMMERCIAL 173 RoE - g/CoE - g 5,412 0.05 31.3 1.3
RBS INSURANCE 294 RoE - g/CoE - g 4,800 0.04 16.3 1.6
CORE GROUP POST TAX CORE EARNINGS 5,231 62,930 0.57 12.0 1.4
NON CORE -3,423 DCF -7,357 -0.07
APS IMPACT -715 0 0 0.00
CAPITAL EXCESS/(SHORTFALL) vs 2011E EC Capital -557 1.0 x BV -9,711 -0.09
Total RBS Group 536 45,862 0.42 85.6 0.9
Adjusted discount factor 1.0
Fair Value 45,862 0.42
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Amit Goel, CFA
(44-20) 7325-6924
40
(44-20) 7325-8215 02 June 2010
Amit Goel, CFA
(44-20) 7325-6924
Valuation Methodology and Risks

Lloyds Banking Group (Underweight; Price Target 50p)
Valuation Methodology
Our Dec-10 price target is 50p, based on our sum-of-the-parts analysis. We base this
on a peer multiple rating as well as incorporating adjustments to our net asset value
for the Group's capital position. We have increased our price target to reflect
improved provisioning guidance and lower costs.
Risks to Our View

Post the HBOS acquisition, the quality of the Lloyds Banking Group loan portfolio
deteriorated significantly. We believe that without the Asset Protection Scheme the
company is now more exposed to a possible double dip in the economy. Being one of
the more geared plays into UK retail banking and the UK economy it is also exposed
to a faster recovery.
Royal Bank of Scotland (Underweight; Price Target 42p)
Valuation Methodology
Our Dec-10 target price is 42p, based on our sum-of-the-parts analysis.
Risks to Our View

Several risks could prevent the stock from achieving our target price and rating.
Through Corporate Markets, the bank is highly exposed to corporate credit quality
and to some extent the market conditions in fixed income. RBS is also exposed to the
UK general insurance cycle and currency risks, more specifically the US dollar both
through Corporate Markets and Citizens, and also the euro, which present risks to the
upside and downside, in our view.
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(44-20) 7325-8215 02 June 2010
Amit Goel, CFA
(44-20) 7325-6924
Royal Bank of Scotland: Summary of Financials

Profit and Loss Statement Ratio Analysis
£ in millions, year end Dec FY08A FY09A FY10E FY11E FY12E £ in millions, year end Dec FY08A FY09A FY10E FY11E FY12E
Per Share Data
Net interest income 15,939 13,567 13,799 13,596 13,703 EPS Reported -60.99 -4.44 -0.98 0.49 3.38
% Change Y/Y 28.7% (14.9%) 1.7% (1.5%) 0.8% EPSAdjusted -45.75 -1.34 0.29 1.59 3.78
Non-interest income 5,227 10,592 13,215 12,712 12,963 % Change Y/Y (157.6%) (97.1%) (121.8%) 443.2% 138.2%
Fees & commissions -437 5,296 7,929 8,899 9,074 DPS 23 0 0 0 0
% change Y/Y (103.6%) (1,311.9%) 49.7% 12.2% 2.0% % Change Y/Y (27.6%) (100.0%) - - -
Trading revenues -437 5,296 5,286 3,814 3,889 Dividend yield 145.7% 0.0% 0.0% 0.0% -
% change Y/Y (114.4%) (1,311.9%) (0.2%) (27.9%) 2.0% Payout ratio -38.2% -0.0% -0.0% 0.0% 0.0%
Other Income - - - - - BV per share 101.46 56.09 56.95 57.45 -
Total operating revenues 16,682 25,068 28,139 27,638 28,120 NAV per share 73.89 51.90 52.75 53.26 -
% change Y/Y (42.5%) 50.3% 12.3% (1.8%) 1.7% Shares outstanding 39,434.2 106,182.3 106,182.3 106,182.3 -
Admin expenses -15,916 -17,401 -17,058 -16,650 -16,078
% change Y/Y (4.2%) 9.3% (2.0%) (2.4%) (3.4%) Return ratios
Other expenses - - - - - RoRWA - (0.7%) (0.2%) 0.1% -
Pre-provision operating profit 7,042 7,667 11,081 10,988 12,042 Pre-tax ROE (51.0%) (7.4%) (1.9%) 1.0% -
% change Y/Y (43.3%) 8.9% 44.5% (0.8%) 9.6% ROE (43.0%) (5.3%) (1.4%) 0.7% -
Loan loss provisions 7,428 13,899 10,281 8,477 5,755 RoNAV (104.1%) (8.6%) (1.9%) 1.0% -
Other provisions 0 0 0 0 1
Earnings before tax -8,127 -5,718 -1,700 811 5,637 Revenues
% change Y/Y (190.7%) (29.6%) (70.3%) (147.7%) 594.9% NIM (NII / RWA) 1.1% 1.5% 1.6% 1.7% -
Tax (charge) (1,280) (339) (425) 227 1,578 Non-IR / average assets (0.0%) 0.6% 0.9% 0.9% -
% Tax rate 15.7% 5.9% 25.0% 28.0% 28.0% Total rev / average assets 0.9% 1.3% 1.9% 2.0% -
Minorities 412 648 48 48 48 NII / Total revenues 94.5% 54.1% 49.0% 49.2% -
Net Income (Reported) (24,051) (3,607) (1,077) 536 3,726 Fees / Total revenues (2.6%) 21.1% 28.2% 32.2% -
Trading / Total revenues (2.6%) 21.1% 18.8% 13.8% -
Balance sheet
ASSETS Cost ratios

Net customer loans 691,876 554,654 522,479 491,622 451,734 Cost / income 59.2% 59.1% 52.8% 52.9% -
% change Y/Y 24.0% (19.8%) (5.8%) (5.9%) (8.1%) Cost / assets 0.0% 0.8% 1.0% 1.0% -
Loan loss reserves 9,324 14,988 10,195 6,598 2,278 Staff numbers 199,500 189,525 180,049 171,046 -
Investments 335,565 349,420 671,856 641,996 624,690
Other interest earning assets 1,111,647 530,296 510,019 490,736 479,559 Balance Sheet Gearing
% change Y/Y 74.1% (52.3%) (3.8%) (3.8%) (2.3%) Loan / deposit 150.3% 133.9% 124.2% 114.2% -
Average interest earnings assets 1,447,212 879,716 843,839 809,719 789,944 Investments / assets 15.1% 23.0% 23.0% 23.1% -
Goodwill 16,386 14,786 14,786 14,786 14,786 Loan / assets 31.2% 36.4% 36.0% 35.5% -
Other assets - - - - - Customer deposits / liabilities 20.7% 27.2% 29.0% 31.1% -
Total assets 2,218,693 1,522,481 1,451,154 1,383,065 1,321,597 LT Debt / liabilities 12.1% 16.2% 15.5% 14.8% -
LIABILITIES Asset Quality / Capital

Customer deposits 460,318 414,251 420,753 430,458 436,382 Loan loss reserves / loans 1.4% 2.8% 2.0% 1.4% -
% change Y/Y 5.3% (10.0%) 1.6% 2.3% 1.4% NPLs / loans 2.2% 8.3% 10.1% 10.2% -
Long term funding 269,188 246,329 225,290 204,361 185,358 LLP / RWA (1.29%) (3.17%) (2.13%) (1.55%) -
Interbank funding 178,268 115,642 105,765 95,940 87,019 Loan loss reserves / NPLs 62.6% 32.5% 19.2% 13.1% -
Average interest bearing liabs 907,774 776,222 751,808 730,758 708,759 Growth in NPLs 251.9% 145.3% 15.0% (5.0%) -
Other liabilities - - - - - RWAs 577,800 438,200 483,474 545,484 -
Retirement benefit liabilities 1,547 2,715 2,483 2,252 2,043 % YoY change 18.9% (24.2%) 10.3% 12.8% -
Shareholders' equity - - - - - Core Tier 1 6.0% 11.0% 10.2% 9.3% -
Minorities 5,436 2,227 2,227 2,227 2,227 Total Tier 1 9.9% 14.4% 12.4% 11.2% -
Total liabilities & Shareholders Equity - - - - -
Source: Company reports and J.P. Morgan estimates.
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Amit Goel, CFA
(44-20) 7325-6924
Lloyds Banking Group: Summary of Financials

Profit and Loss Statement Ratio Analysis
Per Share Data
Net interest income 14,903 12,726 12,944 13,355 13,924 EPS Reported 0.05 0.04 0.01 0.04 0.07
% Change Y/Y 144.4% (14.6%) 1.7% 3.2% 4.3% EPSAdjusted -0.46 -0.19 -0.01 0.04 0.07
Non-interest income 6,933 11,875 10,373 10,702 11,015 % Change Y/Y (100.9%) (58.0%) (95.4%) (538.6%) 86.0%
Fees & commissions - - - - - DPS 11 - - - -
% change Y/Y - - - - - % Change Y/Y (68.2%) - - - -
Trading revenues - - - - - Dividend yield - 0.0% 0.0% 0.0% 0.0%
% change Y/Y - - - - - Payout ratio 24103.9% - - - -
Other Income -481 -637 -637 -637 -637 BV per share 208.59 67.86 67.03 70.68 78.31
Total operating revenues 21,355 23,964 22,680 23,421 24,301 NAV per share 164.30 58.29 58.01 61.66 69.29
% change Y/Y 95.4% 12.2% (5.4%) 3.3% 3.8% Shares outstanding 16,323.0 63,775.0 67,665.7 67,665.7 67,665.7
Admin expenses -12,236 -11,609 -11,389 -11,320 -11,315
% change Y/Y 119.8% (5.1%) (1.9%) (0.6%) (0.0%) Return ratios
Other expenses - - - - - RoRWA 0.2% 0.6% 0.1% 0.5% 1.1%
Pre-provision operating profit 9,119 12,355 11,291 12,101 12,986 Pre-tax ROE 3.3% 2.7% 2.1% 7.8% 14.1%
% change Y/Y 70.1% 35.5% (8.6%) 7.2% 7.3% ROE 0.0% 7.3% 1.2% 5.3% 9.8%
Loan loss provisions -14,880 -23,988 -12,232 -8,264 -6,002 RoNAV 0.0% 8.8% 1.4% 6.1% 11.1%
Other provisions - - - - -
Earnings before tax 760 1,042 942 3,637 7,084 Revenues
% change Y/Y (81.0%) 37.1% (9.6%) 286.2% 94.8% NIM (NII / RWA) 5.3% 2.0% 2.1% 2.3% 2.4%
Tax (charge) (38) (1,911) 268 1,036 2,019 Non-IR / average assets 0.9% 1.1% 1.0% 1.1% 1.2%
% Tax rate (5.0%) (183.4%) 28.5% 28.5% 28.5% Total rev / average assets 2.9% 2.2% 2.2% 2.4% 2.6%
Minorities (26) (126) (126) (126) (126) NII / Total revenues 69.8% 53.1% 57.1% 57.0% 57.3%
Net Income (Reported) 772 2,827 547 2,474 4,939 Fees / Total revenues 0.0% 0.0% 0.0% 0.0% 0.0%
Trading / Total revenues 0.0% 0.0% 0.0% 0.0% 0.0%
Balance sheet
ASSETS Cost ratios

Net customer loans 677,246 626,969 590,207 583,396 584,360 Cost / income 57.3% 50.6% 50.2% 48.3% 46.6%
% change Y/Y 222.8% (7.4%) (5.9%) (1.2%) 0.2% Cost / assets 1.7% 1.1% 1.1% 1.2% 1.2%
Loan loss reserves 14,152 20,700 20,700 20,700 20,700 Staff numbers - - - - -
Investments - 150,011 150,249 137,288 121,897
Other interest earning assets - - - - - Balance Sheet Gearing
% change Y/Y - - - - - Loan / deposit 173.2% 168.9% 165.4% 171.1% 179.9%
Average interest earnings assets - - - - - Investments / assets 6.8% 4.5% 4.7% 4.5% 4.1%
Goodwill 7,230 6,103 6,103 6,103 6,103 Loan / assets 60.1% 61.0% 59.5% 61.3% 64.0%
Other assets - - - - - Customer deposits / liabilities 34.7% 36.1% 36.0% 35.8% 35.5%
Total assets 1,127,725 1,027,255 991,301 951,649 913,583 LT Debt / liabilities 22.1% 22.8% 22.7% 22.6% 22.5%
LIABILITIES Asset Quality / Capital

Customer deposits 391,062 371,241 356,881 340,974 324,735 Loan loss reserves / loans 2.0% 3.2% 3.4% 3.4% 3.4%
% change Y/Y 149.8% (5.1%) (3.9%) (4.5%) (4.8%) NPLs / loans 4.6% 9.4% 7.3% 5.2% 4.2%
Long term funding 249,665 234,483 225,413 215,366 205,109 LLP / RWA 2.98% 4.86% 2.53% 1.83% 1.38%
Interbank funding 155,074 82,452 79,263 75,730 72,123 Loan loss reserves / NPLs 45.2% 35.2% 47.8% 67.9% 85.3%
Average interest bearing liabs - - - - - Growth in NPLs 89.7% 87.9% (26.4%) (29.6%) (20.4%)
Other liabilities - - - - - RWAs 498,500 493,307 482,815 450,935 436,480
Retirement benefit liabilities 2,479 780 750 716 682 % YoY change 249.6% (1.0%) (2.1%) (6.6%) (3.2%)
Shareholders' equity - - - - - Core Tier 1 6.2% 8.1% 8.3% 9.4% 9.4%
Minorities 1,605 829 829 829 829 Total Tier 1 9.5% 9.6% 9.9% 11.1% 11.2%
Total liabilities & Shareholders Equity - - - - -
Source: Company reports and J.P. Morgan estimates.
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(44-20) 7325-6924
Analyst Certification:
The research analyst(s) denoted by an “AC” on the cover of this report certifies (or, where multiple research analysts are primarily
responsible for this report, the research analyst denoted by an “AC” on the cover or within the document individually certifies, with
respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views expressed in this report
accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research
analyst’s compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the
research analyst(s) in this report.
Important Disclosures
• Market Maker/ Liquidity Provider: JPMSL and/or an affiliate is a market maker and/or liquidity provider in Lloyds Banking
Group, Royal Bank of Scotland.
• Lead or Co-manager: JPMSI or its affiliates acted as lead or co-manager in a public offering of equity and/or debt securities for
Lloyds Banking Group, Royal Bank of Scotland within the past 12 months.
• Analyst Position: The following analysts (and/or their associates or household members) own a long position in the shares of Lloyds
Banking Group: Amit Goel.
• Beneficial Ownership (1% or more): JPMSI or its affiliates beneficially own 1% or more of a class of common equity securities of
Lloyds Banking Group, Royal Bank of Scotland.
• Client of the Firm: Lloyds Banking Group is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI
provided to the company investment banking services, non-investment banking securities-related services and non-securities-related
services. Royal Bank of Scotland is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to
the company investment banking services, non-investment banking securities-related services and non-securities-related services.
• Investment Banking (past 12 months): JPMSI or its affiliates received in the past 12 months compensation for investment banking
services from Lloyds Banking Group, Royal Bank of Scotland.
• Investment Banking (next 3 months): JPMSI or its affiliates expect to receive, or intend to seek, compensation for investment
banking services in the next three months from Lloyds Banking Group, Royal Bank of Scotland.
• Non-Investment Banking Compensation: JPMSI has received compensation in the past 12 months for products or services other
than investment banking from Lloyds Banking Group, Royal Bank of Scotland. An affiliate of JPMSI has received compensation in
the past 12 months for products or services other than investment banking from Lloyds Banking Group, Royal Bank of Scotland.
Lloyds Banking Group (LLOY.L) Price Chart
810 Date Rating Share Price Price Target

N 550p UW 67p (p) (p)
675 18-Dec-06 UW 421 530
UW 580p N 610p UW 150p UW 50p 24-Feb-07 UW 441 580
540 05-Jun-07 N 429 600
UW 530p N 600p N 480p UW 180p UW 14p UW 40p UW 44p
31-Jul-07 N 398 610
Price(p) 405 25-Sep-07 N 398 550
18-Jan-08 N 302 480
270 22-Sep-08 UW 213 180
19-Nov-08 UW 98 150
18-Feb-09 UW 38 67
135
31-Mar-09 UW 48 14
11-Aug-09 UW 98 40
0
Sep Jun Mar Dec Sep
18-Dec-09 UW 51 44
06 07 08 08 09 22-Mar-10 UW 60 50
Source: Bloomberg and J.P. Morgan; price data adjusted for stock splits and dividends.
Break in coverage Jan 31, 2006 - Feb 07, 2006. This chart shows J.P. Morgan's continuing coverage of this stock; the
current analyst may or may not have covered it over the entire period.
J.P. Morgan ratings: OW = Overweight, N = Neutral, UW = Underweight.
44
(44-20) 7325-8215 02 June 2010
Amit Goel, CFA
(44-20) 7325-6924
Royal Bank of Scotland (RBS.L) Price Chart
Date Rating Share Price Price Target

N 730p N 320p UW 25p (p) (p)
910 18-Dec-06 OW 558 2270
OW 2,400p OW 730p N 420p UW 50p UW 38p 21-Dec-06 OW 552 2400
728 21-May-07 OW 547 800
OW 2,270p OW 800p N 470p UW 120p UW 17p UW 26p UW 42p 07-Aug-07 OW 477 730
Price(p) 546 08-Aug-07 N 494 730
18-Jan-08 N 323 470
364 29-Feb-08 N 337 420
22-Apr-08 N 312 320
182 22-Sep-08 UW 214 120
19-Nov-08 UW 42 50
18-Feb-09 UW 21 25
0
Sep Jun Mar Dec Sep
31-Mar-09 UW 23 17
06 07 08 08 09 21-Jul-09 UW 40 26
21-Sep-09 UW 56 38
Source: Bloomberg and J.P. Morgan; price data adjusted for stock splits and dividends.
Break in coverage Jan 31, 2006 - Feb 07, 2006. This chart shows J.P. Morgan's continuing coverage of this stock; the 30-Mar-10 UW 45 42
current analyst may or may not have covered it over the entire period.
J.P. Morgan ratings: OW = Overweight, N = Neutral, UW = Underweight.
Explanation of Equity Research Ratings and Analyst(s) Coverage Universe:

J.P. Morgan uses the following rating system: Overweight [Over the next six to twelve months, we expect this stock will outperform the
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months, we expect this stock will perform in line with the average total return of the stocks in the analyst’s (or the analyst’s team’s)
coverage universe.] Underweight [Over the next six to twelve months, we expect this stock will underperform the average total return of
the stocks in the analyst’s (or the analyst’s team’s) coverage universe.] J.P. Morgan Cazenove’s UK Small/Mid-Cap dedicated research
analysts use the same rating categories; however, each stock’s expected total return is compared to the expected total return of the FTSE
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Coverage Universe: Carla Antunes da Silva: Barclays (BARC.L), HSBC Holdings plc (HSBA.L), Lloyds Banking Group
(LLOY.L), Royal Bank of Scotland (RBS.L)
J.P. Morgan Equity Research Ratings Distribution, as of March 31, 2010

Overweight Neutral Underweight
(buy) (hold) (sell)
JPM Global Equity Research Coverage 45% 42% 13%
IB clients* 48% 46% 32%
JPMSI Equity Research Coverage 42% 49% 10%
IB clients* 70% 58% 48%
*Percentage of investment banking clients in each rating category.
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45
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(44-20) 7325-6924
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(44-20) 7325-6924
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Government Exit Strategies - Looking at the Options LLOY.L, LLOY LN

LLOY.L share price (p)

One factor that may complicate proceedings is the commitment to establishing an

Why should the government reduce the

What has been the history of government stakes?

The Swedish crisis

Figure 1: Nordbanken Offering: Investor Split

The Swiss banks

Conclusion for the UK

Amit Goel, CFA

Table 1: Global Banks - Summary of Equity Injections since 2007

UK fiscal position and the impact on the

Table 2: UK - National Debt Based on March Budget Estimates

PSND %GDP 52.7% 63.6% 165.1% 161.6% 155.9% 149.7% 145.9%

PSNB %GDP 6.0% 11.0% 10.7% 8.2% 6.6% 5.0% 3.8%

PSND 742 913 1,081 1,216 1,339 1,441 1,527

Table 4 below illustrates expectations for GGGD from several sources.

Table 4: UK - GGGD and Deficit Estimates

Fiscal Deficit %GDP

Real GDP Growth

“Moody’s defines an Aaa government as a government that has sufficient balance

Moody’s Investors Service: UK General Election: Hung Parliament No Direct

Figure 2: Ratio of Interest Expense to Revenues

Table 5 below we attempt to quantify these impacts.

Table 5: Interest Expense to Revenue – Impact from bank stakes

Gross Issuance 147 228 187 187 159 141 117

Sovereign Funding Costs

Figure 3: UK Sovereign CDS spreads (5Yr Senior)

The potential impact on bank taxes and special levies

“'…We will introduce a banking levy and seek a detailed agreement on

Conservative Liberal Democrats Coalition Agreement, May 2010

Table 6: UK Banks - Potential Revenues from a Bank Fee (based on UK liabilities)

Table 7: UK Banks - Impact of Fee on Profitability (based on UK liabilities)

Table 8: UK Banks: Potential Impact of Lower Corporation Tax in UK

Table 9: UK Banks: Potential Overall Impact from Tax Changes

Amit Goel, CFA

Note further the coalition statement is:

Table 11: UK - Breakdown of government revenue and net borrowing

Liabilities Tax n.a. 2.9 2.9 2.9

Table 13: UK Bonus Tax

Bank of America $465 £306

It makes no substantive difference to the public sector’s financial position

Flow of Payments Government Debt

In that report the IMF proposed two new taxes:

• (i) Financial Stability Contribution (FSC) – It is unclear whether a charge

What are the potential mechanisms and

Table 14: Lloyds Banking Group: Average Government Entry Price

Table 15: RBS: Average Entry Price for the UK Government

British Telecom privatisation

Figure 4: British Telecom IPO (November 1984)

es/Pensi 14% 22%

British Gas privatisation

Figure 5: British Gas IPO (November 1986)

Planned Allocations Ultimate Allocations

Figure 6: RBS and Lloyds YE09 Shareholder Profiles

RBS Investor Base YE09 Lloyds Investor Base YE09

Slow drip feed

Summary of impact from a share sale

‘that in relevant circumstances, and acknowledging the conversion feature

Furthermore, HM Treasury has agreed with the European Commission:

Table 17: RBS: Capital ratios if the B shares were redeemed

Core Tier 1 Capital 48,151 49,108 50,460 55,607 63,447