Who can boss the banks?

Over the past few weeks and months, Andrew Bailey of the Financial Services Authority - and soon-to-be boss of one of the FSA's successor bodies, the Prudential Regulatory Authority - has been ambling around the City, agreeing how much additional capital the big banks need to raise, to protect themselves from losses on loans to customers barely keeping their heads above water, and as insulation against fines and compensation for past misdeeds.

You may have noticed the results. For instance, the bank 80% owned by taxpayers, Royal Bank of Scotland, has announced it is floating some of its US business, Citizens, on the stock market and selling a further stake in the insurer Direct Line.

Those actions will boost the numerator in its capital ratio. And at the same time, it will be shrinking its investment bank, thus cutting the denominator in the ratio, its loans and investments.

The net result is that its capital ratio becomes bigger, and the bank - all other things being equal (that ghastly qualification again) - becomes stronger.

It is all pretty technical stuff, not the kind of news to set the pulse racing. And similarly useful and dull capital-enhancing plans have been agreed with RBS's rivals.

The issue, which is a little bit more substantial, is whether all this diligent chivvying by Mr Bailey will be deemed by the Bank of England's Financial Policy Committee to be adequately filling the hole in bank's balance sheets - a hole described by Sir Mervyn King in late November as "material" (see my previous pieces here and here).

Sir Mervyn, the outgoing governor of the Bank of England and inaugural chairman of the FPC, rather upped the stakes last week when he signalled - in evidence to MPs and Lords on the Banking Standards Commission - that he fears RBS remains too weakened and poisoned by its stocks of poor loans and investments to provide the credit essential for economic recovery in the UK.

So the explosive question is this one: will the FPC order the banks to improve their capital ratios over and above the plans they've agreed with Mr Bailey, such that RBS and Lloyds would need to ask taxpayers (us) for yet more financial support?

Now the chancellor is hoping and wishing that the answer is no, because his backbenchers would be incandescent with rage if yet more public money were to go into these bruised banks.

As it happens, I think it is likely his wish will be granted. But that's not 100% certain.

Here are some of the relevant considerations for the FPC.

Probably the most important one is that banks have not been providing what Sir Mervyn would regard as adequate volumes of loans to small businesses and households.

As you will recall, in the last three months of 2012, banks benefiting from the Bank of England's cheap finance, from the Funding for Lending Scheme, actually contracted the loans they provide to individuals and non-financial businesses by £2.4bn.

And, as I mentioned yesterday, one possible remedy would be to force the banks to raise so much additional capital that they would feel under enormous pressure to create new credit, so that they could earn an adequate return on this capital.

Which is nice in theory, but it turns out this is not a remedy readily available to the FPC.

That powerful new body, whose mandate is to preserve financial stability subject to not imperilling the government's growth and employment ambitions, could instruct the banks to increase their capital ratios.

But as I explained above, boosting capital ratios can be achieved either by elevating the numerator - the acquisition of new capital - or by diminishing the denominator, through cutting the provision of loans.

To elucidate, an instruction to increase capital ratios yet more could have the opposite consequence desired by Sir Mervyn: it could encourage the banks to lend even less.

Why, you may ask, can't the FPC therefore instruct the banks to leave the denominator alone and simply increase the numerator, by going to their shareholders for more equity capital?

Well, I am told that would run into all sorts of legal obstacles, both in the UK and in respect of EU law, because it would be seen as a significant infringement of their commercial freedom.

It would be a bit like instructing all FTSE 100 companies to build new factories in Britain - not an instruction that would carry much force with private companies.

Or to put it another way: the FPC's toolkit can't stray too far from the globally agreed Basel capital adequacy tools; and they are about ensuring that capital ratios are above agreed minima, but not about the precise level of the numerator or denominator.

And it is even more complicated for the FPC. Let's just say that in an ideal world, it wanted all the banks to increase their capital ratios beyond levels agreed with Mr Bailey. Well, that could be seen as discriminatory, in that there is an important split between banks that are boosting credit provision and those that are not.

For example, Santander, Lloyds and RBS collectively cut by £7.6bn what the Bank of England calls their certified lending to households and businesses in the fourth quarter of last year. But Barclays and HSBC both increased their lending.

Or to put it another way, ordering all banks to increase their capital ratios could be seen as unfair to Barclays and HSBC.

In fact, there is a perfectly credible theoretical argument that at this stage of the cycle, the FPC should be encouraging the banks to actually reduce their capital ratios by inflating the denominator, the value of their lending.

All of which, I think, leads to two conclusions.

There is no magic bullet available to the FPC to simultaneously strengthen banks and increase credit creation. Probably the best it can aim for is to make sure banks have the capital they need to withstand realistic shocks without impeding the growth of credit.

And if George Osborne agrees with Sir Mervyn that RBS and Lloyds aren't lending enough, then the remedy remains the one it has always been and the one he loathes: he could exercise his rights as their biggest shareholder and order them to increase their appetite for risk.