Will the bad be taken out of RBS?

Will RBS be split into two banks?

A draft report from the Parliamentary Commission on Banking Standards calls for the split of Royal Bank of Scotland into a good bank and a bad bank, I have learned.

The MPs and Lords on the Commission have till next Monday to read the report and formulate their views.

Then the haggling will start, with the aim of nailing down the whole thing in the subsequent few days.

But would George Osborne and David Cameron reject a recommendation from the Commission which they set up?

There is a chance, but not a cast-iron certainty, that the chancellor will know the Commission's will on how to clean up the banks, before he delivers his own take on all this in his set-piece annual address to the City at the Mansion House on 19 June.

Officials at the Treasury won't be stunned and surprised that the Commission looks set to opt for a break-up of RBS. They have done a good deal of technical work on the practicalities.

This represents contingency planning. As I understand it, they don't believe there is a strong technical case for or against dismantling RBS, and the question of whether it happens will therefore be a political one.

RBS's fate depends on whether the chancellor and prime minister would wish to slap down their own Commission - on the assumption, which isn't guaranteed, that the Commission doesn't back down before the report's publication.

To date, the chancellor has made it clear he is not keen on re-engineering RBS. I am told that David Cameron is even less supportive of a break-up.

They fear it would delay privatisation of the bank, which they would like to see begun before the election in 2015. And they are not persuaded that such a reconstruction of the bank would deliver benefits to taxpayers, which own 81% of RBS, or to the economy.

They also fear that it might be seen as a politically controversial second state bailout of the giant bank - which their own MPs would detest.

But the view of some members of the Commission - strongly influenced by Sir Mervyn King, the soon-to-retire governor of the Bank of England - is that RBS would feel liberated and emboldened if its residual toxic assets and operations were hived off.

This would, they believe, make RBS less reluctant to provide the precious credit needed by the UK to cure its economic anaemia.

They also argue that investors would have more confidence in a cleaned-up RBS, boosting its share price and improving its access to finance,

Privatising "good" RBS would therefore be easier and better for taxpayers' wealth than privatising the whole thing. Or at least that's what some Commission members say.

As for the bad loans to be removed from RBS, they would be held on the government's balance sheet till they had been repaid, without the need for a fire sale. And, as the example of the break-up of Northern Rock in this way shows, there is a reasonable chance that if held to maturity, a decent return would be earnable for taxpayers from these allegedly poisonous assets.

As of the end of the March, RBS still had £54.6bn of what it calls non-core assets, or the stuff that would be hived off into this bad bank - although that is on course to fall by a fifth or so by the end of the year.

On a so-called risk-weighted basis, that presents just over a ninth of all its assets.

However there is another, more radical option also being assessed by the Treasury. Which would be to simultaneously take out of RBS the most troubled of its global operations, Ulster Bank, with its substantial lossmaking business in the Republic of Ireland and Northern Ireland.

Ulster has £37bn of assets (loans and investments) on a risk-adjusted basis.

One idea would be to transfer Ulster Bank into the arms and ownership of the Irish government, by swapping all or part of Ulster Bank for low quality British loans and investments currently owned by Ireland's National Asset Management Agency: NAMA inherited these stinky British assets when it acquired the problem loans of Ireland's reckless banks.

There is a certain logic to Ireland taking control of Ulster Bank while the Treasury runs off the loans made in Britain by over-excited Irish banks.

That said, the chancellor may conclude that the complexities of valuing all the relevant loans and the legal difficulties in transferring ownership may be too daunting.

Even so, if the Parliamentary Commission says some kind of break-up of RBS is the sine qua non of restoring the important bank to robust health, George Osborne will not find it easy to defy the revealed will of parliament (or at least a high-powered cross-section of parliament) without providing a pretty compelling argument about why such radical surgery would be bad for Britain.

Update 1400:

A couple of members of the Parliamentary Commission on Banking Standards have rung me to say they are not thrilled by the first draft of Commission's final report - which they received recently and which I wrote about this morning.

More precisely, they say the proposal in the draft, to break up RBS into a good bank and a bad bank, hasn't yet been fully and properly debated by the Commission.

"Some Commission members are massively in favour of breaking up RBS, but we haven't discussed it collectively", said one. "I am not sure we took enough evidence on it. That is not to say I am against the idea, but I would have to be persuaded".

Another parliamentarian on the Commission pointed to potentially big costs involved in extracting RBS's low quality loans, and the risk that such a reconstruction could take many months, even years.

"It is true that Mervyn King was massively in favour of breaking up RBS", he said. "But we really didn't hear the views of others on this".

He would be arguing, he said, for more work to be done on the practicalities of splitting RBS.

Or to put it another way, the prime minister and chancellor, who are sceptical about breaking up this huge semi-nationalised bank, have allies on the Commission.

That said, one influential member of the Commission told me he regarded the break-up of RBS as of fundamental importance to securing sustainable economic recovery in Britain.