UK faces dilemma over bank support

A man speaks on his mobile phone near the Bank of England in London March 5, 2010.

LONDON (Reuters) - Britain faces a difficult balancing act in deciding how and when to reduce support for the banking sector, Moody's Investors Service said on Tuesday.

"The growth in the UK's public debt burden means the government cannot afford further substantial bank bailouts without further weakening its credit profile and/or burdening taxpayers," Moody's said in a report.

"However, at the same time, maintaining confidence in the financial system is vital for the underlying economy."

The government and the Bank of England have helped the country's banks through the credit crisis in a number of ways, including a Credit Guarantee Scheme, a Special Liquidity Scheme and an Asset Protection Scheme.

Moody's said it expected this "extraordinary" support to be gradually withdrawn, but the government would have to be cautious before taking action.

"The government will need to be certain of the full standalone viability of the larger banks before it can hope to be confident in reducing the availability of extraordinary support," Moody's said.

The agency said it did not expect Britain's Special Liquidity Scheme and Credit Guarantee Scheme to be extended beyond their current terms.

But it also said the credit crisis had showed that governments are determined not to let banks fail as a result of liquidity shortfalls, so that liquidity measures could be swiftly reinstated if needed.

The financial services regulator, for example, has just given banks more time before demanding they meet the new higher liquidity levels that it had proposed, to help them withstand market shocks.

Moody's itself will start to phase out "extraordinary" support assumptions it incorporated into its senior debt and deposit ratings of a number of financial institutions.

The agency introduced these assumptions of increased government support to help provide stability for the senior debt and deposit ratings of some banks during the crisis.

Moody's said once these were withdrawn, this could mean senior debt and deposit rating downgrades for some financial institutions if they have not improved their standalone strength to offset the phasing out of government support.

"How and when we reduce the support assumptions incorporated into the senior debt and deposit ratings of the banks will depend upon a number of factors, including the importance of the bank and the pace of the recovery of the UK economy."

The agency said its senior debt and deposit ratings would migrate gradually rather than in one large move.

"In general, we expect the government to take longer to phase out extraordinary support for the largest banks than for smaller institutions - and this slower pace will be reflected in our ratings adjustments."

Small institutions could see government support withdrawn more quickly, driven more by the degree of overall market confidence rather than their "intrinsic" recovery, Moody's said.

"As government support is reduced we may also consider reintroducing sector support assumptions for some institutions," it said.

(Editing by Greg Mahlich)