How can bank sales pay dividends for us?

Interest is hotting up in how to sell the Government's stakes in Britain's banks. A disposal of some of the Treasury's holdings in Royal Bank of Scotland, Lloyds Banking Group or Northern Rock next year would be a good piece of mid-term news for the Coalition Government. Not only could it raise extra cash but it would also help draw a line under the controversy over bankers' pay.

What has looked unlikely has been a 1980s-style mass float to individual shareholders in the mould of the "tell Sid" campaign for British Gas.

UK Financial Investments, which manages the Government's stakes in the banks, has made it clear it favours selling the £66bn total in RBS and Lloyds a few billion pounds at a time to big financial institutions.

In evidence to the Treasury Select Committee, Robin Budenberg, UKFI's chief executive, said that for Lloyds and RBS "the most likely outcome, in terms of our disposal, is a disposal on the market to other private-sector investors".

The most imminent candidate looks to be RBS. The stricken giant has been slipping in and out of profit, depending on what measure you take, and its first-quarter results showed signs of continuing recovery after two years of radical surgery by Stephen Hester, the chief executive.

Lloyds, on the other hand, has only just got a new chief executive who is conducting a major strategic review that could result in sell-offs of Scottish Widows and other businesses. The bank was also the main casualty of the Independent Commission on Banking's (ICB) preliminary report and could be unsettled by a forced branch sell-off.

The first half of next year is a logical time for sales to start. By then, the Chancellor will probably have made a decision on the ICB proposals that investors will have had a chance to digest.

The Government could in theory hang in for the long haul – the Swedish government still owns a stake in Nordea after bailing out the bank in the early 1990s.

But the longer the state is a shareholder, the less enthusiasm there will be for the banks' shares among private investors. And a sale could generate money for the Treasury and take the sting out of the issue of bankers' bonuses by plotting a path back to private ownership.

That preference also tells against a sale to a trade buyer, which would face serious competition questions.

The big obstacle to the Government selling its shares is the "overhang" created by its huge holdings. Potential buyers of the shares know that the Government's average buying prices were 50.2p and 73.6p for RBS and Lloyds respectively.

There is, in theory, no reason for potential investors to pay more than those prices because they know the shares will fall when the Government starts unloading its stake.

Shares of RBS and Lloyds have occasionally bobbed up above the state's buy-in price since the Government bailout of late-2008 but never for long enough to prompt a partial sale. They closed yesterday at 42.2p for RBS and 54.6p for Lloyds, leaving the Government about £10bn out of pocket.

However, the free-market Centre for Policy Studies (CPS) think-tank has weighed in with an innovative option that combines 1980s popular capitalism with a way round the overhang problem.

Under the proposal, each taxpayer would be given shares. If those shares are sold, a fixed amount – say the Treasury's average buy-in price – goes back to the Government with the individual taxpayer taking any profit, subject to capital gains tax, giving the Government a share in any increase in the share price.

CPS says its plan would reverse the overhang by placing a "floor" under the share price because millions of people would hold the shares with no incentive to sell them for less than a given price.

Taxpayers would benefit both individually and collectively through the state getting its money back and potentially reaping a profit.

James Conway of Portman Capital, one of the paper's authors, says: "A sale to institutions would have to be done at a discount and we don't think that any upside should go to anybody but the taxpayer who bore the risk.

"I think the chances [of adoption] are pretty reasonable. There are concerns over implementation but technology has made huge leaps and bounds. There was a volition to make a universal distribution for the 1980s privatisations but the technology didn't exist."

However, though the proposal is attractive for policy reasons – spreading the shares among the public – some doubt that the overhang problem would be solved by having millions of small shareholders prepared to sell at a certain price.

For now, UKFI is biding its time in the expectation that the fundamental value of the banks will become attractive – both RBS and Lloyds trade at no premium to their book values.

UKFI has resisted the temptation to sell shares when prices went above buy-in levels because it wants to reassure the market that it will not act in an unpredictable way to dump the stock.

With only one shareholder, the Government, Northern Rock is, in some ways, a simpler transaction.

UKFI has gone as far as to appoint Deutsche Bank to advise on options for returning Northern Rock to the private sector. These include a flotation back to institutional investors, a trade sale and remutualisation.

On paper, there is no shortage of potential buyers for Northern Rock: Lord Levene's NBNK acquisition vehicle would be interested, as would Virgin Money, which tried to buy the bank before it was nationalised.

Remutualisation has also gone up the agenda.

Options for returning Northern Rock to the mutual sector include setting it up as a standalone society or selling to an existing one. A cross-party group of 100 MPs has called for remutualisation and both the Coventry and Yorkshire societies have expressed interest in buying it.

Remutualising Northern Rock would not promise a quick payday for the Treasury but the consultancy Landman Economics has argued that a float or trade sale would not recoup the Government's £50bn injection into the bank. Instead, Landman advocates the Treasury taking an income stream through financial instruments called "profit participating deferred shares".

The sticking point for any kind of disposal of Northern Rock at the moment is that the bank is loss-making to the tune of £232m and faces a buffeting from low interest rates, which reduce returns on deposits, and a moribund housing market.

Ron Sandler, the bank's executive chairman, has said a return to profit is not essential for a sale and its foray back into 90 per cent mortgages and packaging up loans for sale as bonds shows the bank trying to beef up returns to get itself in shape.

UKFI and the banks' bosses will no doubt keep stressing that no sales are imminent but by 2012 the political pressure to produce results will steadily ratchet up.