Cloud lifts from UK banks as review ends Damp squib or analytical pragmatism? That was the verdict being weighed up by observers on Wednesday, as Britain's two part-nationalised banks - Royal Bank of Scotland and Lloyds Banking Group - told the market they would not need to raise fresh capital to meet regulatory requirements, ending six months of doom-mongering and supervisory scrutiny. The sigh of relief from management was echoed in investor sentiment, too, with both lenders" share prices up more than 2 per cent by the end of the day. Plugging the gap Estimated capital shortfall of UK banks A cloud had hung over the whole UK banking sector, particularly RBS and Lloyds, ever since the Bank of England's Financial Policy Committee suggested last November that banks might be £50bn short of capital. The FPC toned down its aggregate estimate in March, when the committee acknowledged that the real sector-wide deficit - once capital buffers and pre-planned capital generating strategies were factored in - was probably closer to £12bn or £13bn. But it has taken until now for the top-down theory on capital shortfalls to flow through to detailed bank-by-bank analysis by the Prudential Regulation Authority, the BoE's new banking regulator. RBS and Lloyds were the first to be told of the PRA's conclusions, details of which were not disclosed, though the banks" respective capital deficits are understood together to account for about two-thirds of the aggregate shortfall. Over the next six weeks, the remaining half-dozen of Britain's eight biggest lenders - Barclays, HSBC, Standard Chartered, Santander UK, Co-op Bank and Nationwide - should all receive the PRA's conclusions on how short of capital each of them is and what measures need to be undertaken to close the gap. On the basis of preliminary estimates, only the Co-op and Barclays have deficits of any note. The Co-op's much-publicised problems, including a capital shortfall of up to £1bn, have led to the collapse of a planned acquisition of more than 600 branches from Lloyds, the exit of the chief executive and a six-notch credit rating downgrade from rating agency Moody's. The broader Co-op group is now engaged in a sweeping strategic review as it seeks to shore up its banking operations. Sales of the group's life and non-life insurance operations are already under way. Barclays is also expected to have a shortfall, initially estimated at £1bn-£2bn, though that should be relatively easily addressed through some tweaks to businesses plus a potential issue of contingent convertible capital, or cocos. IMF urges "fix" for banking system The International Monetary Fund on Wednesday urged the UK government to do more to fix the banking system and said that there should be a "clear strategy" for how to return Royal Bank of Scotland and Lloyds Banking Group into private hands, writes Sarah O'Connor in London. The IMF said the poor health of the banks, particularly of the two part-nationalised lenders, was hampering the Bank of England's attempts to restore growth to the economy. While quantitative easing has boosted money growth in the economy, this has not fed through into credit growth, in part because banks" balance sheets are still impaired. "Any strategy should seek to return the banks to private hands in a way that maximises the value for taxpayers, strengthens confidence and competition in the sector, and minimises outward spillovers," the IMF report on the UK economy said. In this context, if a sovereign backstop is required to meet a capital shortfall, it should be provided. George Osborne, the UK chancellor, said he agreed with the IMF. "Having refocused their business, now is the time for a clear strategy on how to return RBS and Lloyds to the private sector in a way that protects value for the taxpayer," he told a press conference. The Parliamentary Banking Commission I established is completing its work, and we will then set out the way ahead. The IMF also said the government should try to increase competition in the banking sector to "better serve the needs of UK companies and households, especially given few alternative sources of funds for start-ups and smaller enterprises." However, officials were unwilling to make specific recommendations on how the government should do this. The IMF weighed in on bank regulation too, saying the Bank of England's financial policy committee should have powers to limit loan-to-value ratios, something the FPC has been unwilling to take on, and warned of the risk of "significant activity migration" to more lightly regulated shadow banks and non-banks. But it was always RBS and Lloyds that were going to account for the majority of the issues, given the hits to profitability and therefore to capital generation that both have taken as they have dealt with legacy loan losses from the financial crisis. Even after the PRA's communication with the banks, there are no published numbers regarding the precise deficits. According to people involved, the numbers are in any case fluid because of the imprecise nature of some capital generating measures already in train. On balance, though, both banks are expected to have to close a deficit of between £3bn and £4bn. For RBS, there are two key ways of addressing the shortfall, both of which have been announced - the bank will shrink its investment banking business by a further 20 per cent; and it will float its US subsidiary, Citizens. The PRA seems to have accepted RBS's argument that it should be allowed to extend its capital remedies beyond the end of 2013, but it will come under pressure to launch the Citizens float earlier than its original end-2014 target. RBS executives believe the removal of uncertainty over the bank's capital position will help silence calls from reformist voices, such as former chancellor Lord Lawson and Sir Mervyn King, outgoing BoE governor, that the group should be broken up into a bad bank and good bank. Lloyds" measures are more piecemeal. Aside from continuing the gradual sell-down of its ownership of insurer-cum-fund manager St James's Place, the bank aims to see through a sale of Scottish Widows Investment Partnership, cut a further £20bn from its "non-core" loan portfolio and exit seven or eight more countries of the 18 in which it is present. The bank wasted no time in beginning implementation of its plan, announcing on Wednesday afternoon after the markets closed that it would sell another 15 per cent tranche in St James's Place, reducing its shareholding to 21 per cent. The bank said it expected to make a £40m gain on the deal, boosting its core tier one capital ratio 0.16 percentage points. Lloyds generated nearly £400m from the sale of a stake of about 20 per cent in March. That transaction carried a year-long lock-up on the remaining shareholding but that has been waived by underwriters. Lloyds said it was taking the chance to "maximise value for shareholders," pointing out that St James's Place shares are now trading at about 640p compared with the 510p level at which the bank sold the March tranche. The bank said its remaining stake was subject to a lock-up that could not be waived for six months. Some scepticism will continue to hang over RBS and Lloyds until their capital measures are fully implemented. But at least the banks have a clear sense now of what regulators want - and that can only boost investor sentiment, further improving the government's prospects for reprivatisation.