Can the Rock challenge big banks?

BBC business editor Robert Peston on ways to stimulate competition

Northern Rock is back in profit - to the tune of about £200m - though that's slightly disguised by the break-up of the bank into two separate entities.

The swing from loss to profit over the past six months looks pretty impressive: stripping out one-offs, the Rock made a loss in the second half of last year of more than £100m.

But there's a paradox. It's Northern Rock Asset Management, the so-called bad bank - the bit that holds £50bn of mortgages and isn't going to be privatised - that made a healthy profit of £350m.

It is the new bank, Northern Rock plc, the one that's to be privatised, which suffered losses of £143m - because it is not lending enough to cover the interest it pays out on deposits and other finance.

What do these results tell us?

First, that mortgage loans are going bad at a slower rate, although it is striking that there hasn't yet been a fall in the number of mortgage borrowers who are in arrears: the number of residential mortgages accounts where the borrower is more than three months behind with the payments increased slightly, to 22,837, up from 22,564 at the end of 2009.

As for the loss on so-called impaired loans, that was £278bn at Asset Management and an insignificant £0.4m at Rock plc, compared with £1bn for the whole of 2009.

Second, there's an excellent chance that the taxpayer will make a profit when all those Rock mortgages are finally repaid over the coming decade or more.

And this liquidation process will be quite something, after just under £50bn of buy-to-let and other loans made by Bradford & Bingley - the other nationalised mortgage bank - are crunched into Asset Management in the autumn.

In case you hadn't notice, the government has become quite a player in the distressed debt market, with a loan book in run-off of about £100bn, financed by loans from the taxpayer of around £50bn (although, of course, the majority of loans made by B&B and the Rock would not count as poor quality or distressed).

Finally, Rock plc is a very immature bank, with £17.6bn of deposits financing just £11.2bn of mortgage loans.

As it stands, with limited products and 76 branches, it's more a bothersome flea than a ferocious tiger in the competitive struggle against elephantine Lloyds, Barclays, RBS, HSBC and Santander.

If the government wants to promote competition in the retail banking market, which is what it claims, it is going to have to think creatively about how it privatises the Rock.

It certainly can't be floated on the stock market in its current under-developed shape. And it's not obvious that a conventional auction over the coming few months would maximise the return to taxpayers - in that the competition authorities would probably block bids from all the big players, and bids from smaller players would be derisory.

That said, the twin aims of providing a fat profit for the state and stimulating competition in banking can be achieved if Rock plc can somehow be put into an arranged marriage with the 600 branches - which have 4.6% share of the retail banking market - that are being sold (under duress) by Lloyds.

If the Northern and Clydesdale businesses owned by National Australia Bank could also be included in the enlarged Rock, then a potentially significant new bank would be born.

To be clear, mergers of banks are ferociously complicated, because their IT systems and cultures are typically incompatible. But if George Osborne, the chancellor, wants to be true to his ambition of creating genuine choice in banking for British consumers, he is going to have to be imaginative in how he sells the Rock - and ignore the tantalising allure of the fast buck.

You can keep up with the latest from business editor Robert Peston by visiting his blog on the BBC News website.