Group Finance Director's Review
During the first half of 2010, the Group delivered a strong trading performance against the backdrop of a stabilising economy. The Group delivered good revenue growth, lower costs, and a significant reduction in impairment. Impairment, particularly in the Wholesale division, has fallen faster than originally expected and as a result the Group has returned to profitability on a combined businesses basis in the first half of 2010. Importantly for the future of the enlarged entity, the Group has continued to make excellent progress in the integration of HBOS. On a combined businesses basis, the Group reported a profit before tax of £1,603 million in the first half of 2010, compared to a loss before tax of £3,957 million in the first half of 2009.
Statutory profit before tax in the first half of 2010 was £1,296 million, compared to £5,950 million in the first half of 2009 which benefited from the impact of an £11,173 million credit from the gain arising on the HBOS acquisition (negative goodwill). Profit attributable to equity shareholders was £596 million and earnings per share totalled 0.9 pence.
In line with the full year 2009 announcement and to enable meaningful comparisons to be made with prior periods, the income statement commentaries below are on a combined businesses basis (see ‘basis of presentation’). Certain commentaries also exclude the unwind of fair value adjustments.
The Group delivered a good revenue performance in the first half of 2010. Total income, net of insurance claims, was 5 per cent higher at £12,481 million which included a gain of £423 million as a result of the Group's liability management exercises (first half of 2009: £745 million). Excluding the impact of liability management transactions income was 8 per cent higher.
Group income was primarily driven by a strong performance in Retail, which recorded a 24 per cent increase in net interest income as a result of continued migration of mortgage business onto standard variable rate products and higher new business margins as assets are priced to more appropriately reflect risk, particularly in the mortgage portfolio. Whilst lending markets have remained generally subdued throughout the industry, the Group has maintained a 23 per cent share of gross mortgage lending. Unsecured lending balances were lower, principally reflecting lower customer demand. During the first half of the year, we have continued to build our current account and savings customer franchises in what remains a competitive market for customer deposits.
In Wholesale, total income decreased by 6 per cent driven by a decrease in net interest income reflecting lower interest-earning asset balances following the disposal of debt securities and available-for-sale assets and reduced interest earnings in Treasury and Trading. This was partially offset by an increase in the banking net interest margin as lending business continues to be re-priced to reflect customer risk profiles.
In Wealth and International, total income increased by 4 per cent reflecting the positive impact in the Wealth businesses of higher global stock markets and, in International, favourable foreign exchange movements. This was partly offset by lower net interest margins which reflected the impact of higher impaired loan balances and lower deposit margins. There was also a small benefit from the gains on completion of the sales of Employee Equity Solutions and Bank of Scotland Portfolio Management Service.
New business sales in our life, pensions and investments businesses decreased by 14 per cent, largely reflecting the withdrawal of certain HBOS legacy products with lower returns, partially offset by higher sales of OEICs and higher margin protection products.
However, as a result of the continuing repositioning of the product set, integration activities, and higher returns from retirement income products in the first half of 2010, UK new business profit increased by £53 million to £132 million. The Insurance division’s EEV new business margin increased to 3.4 per cent in the first half of 2010, compared to 2.4 per cent in the first half of 2009.
Within Central items total income increased by £48 million to £544 million. This reflects a £192 million increase in the fair value of the embedded derivatives within the Group’s Enhanced Capital Notes and a £185 million increase in the fair value of other derivatives which can not be mitigated through hedge accounting, partially offset by a decrease of £322 million in gains on liability management transactions.
Group net interest income increased by £469 million, or 7 per cent, to £6,911 million. The net interest margin from our banking businesses was 36 basis points higher at 2.08 per cent, as higher asset pricing and compression of the spread between base rate and LIBOR more than offset the impact of lower deposit margins, due to continued low base rate and ongoing competition for customer balances. We had previously outlined that we expected the net interest margin to increase to circa 2 per cent for 2010, and have achieved this margin improvement in the first half. We expect the margin to see further modest improvement in the second half. We previously guided that we expect further margin improvements in subsequent years reflecting the impact of continued improvements in asset pricing, moderate base rate rises and greater stability in wholesale funding markets. We now believe that the margin is likely to return to more than 2.5 per cent in the medium-term (circa 2014). This margin outlook reflects our core economic assumptions for the medium term and includes the impact of the Group’s asset reduction programme and the assumed costs of refinancing as wholesale funding matures.
Other income, net of insurance claims, increased by £73 million, or 1 per cent, to £5,570 million, largely reflecting higher income from Wholesale, driven by gains on asset sales and recoveries in the values of private equity portfolios, and a favourable movement in mark-to-market values on derivatives that can not be mitigated through hedge accounting (within Central items) partially offset by lower gains on liability management transactions and by lower income in Retail driven by lower gross lending volumes and overdraft fee income. The Insurance results include a charge to income of £70 million due to the decision to withdraw from writing new PPI business.
Over time, income from our core businesses is expected to grow at 6–7 per cent per year. In 2009 approximately 80 per cent of underlying income, excluding gains on liability management transactions, came from core relationship businesses. Such income growth will be partially offset by the impact of the rundown of non-relationship assets and the effect of the retail business disposal.
Total Group banking assets decreased to £704 billion from £727 billion at 31 December 2009, with a £15 billion decrease in loans and advances to customers primarily driven by reductions in non-relationship lending portfolios across the three banking divisions. Our balance sheet reduction plans are on track and we are pleased with the progress made in the period as market conditions were more difficult than the latter part of 2009, and we continued to achieve asset sales within our provision levels. Customer deposits have increased by 3 per cent since 31 December 2009 to £420 billion with growth being seen across all three deposit taking divisions.
The Group has an excellent track record in managing its cost base, and has continued to deliver a strong cost performance. During the first half of 2010, operating expenses decreased by 5 per cent to £5,435 million, as substantial integration related savings were captured, together with lower levels of operating lease depreciation. After investment, ongoing business as usual expenses were held within inflationary levels. Our cost:income ratio also saw further improvement to 43.5 per cent (45.1 per cent excluding gains from liability management transactions).
We have already made significant progress in capturing savings from the integration programme with £650 million of cost synergy savings being realised in the first half of 2010, and the annual run-rate savings totalled £1,084 million as at 30 June 2010. The Group expects to end 2010 with annual run-rate savings of circa £1,300 million and is on track to deliver a run-rate of £2 billion per annum of cost synergies and other operating efficiencies by the end of 2011. The Group expects the cost:income ratio to reduce to approximately 40 per cent in the medium term.
During the first half of 2010, the Group achieved a significant reduction in impairment charges. Impairment losses of £6,554 million are 51 per cent lower than the £13,399 million charge in the first half of 2009 and 38 per cent lower than the £10,589 million charge in the second half of 2009, significantly ahead of previous guidance. Although the reductions are largely driven by Wholesale, all divisions (and, importantly, within the Wealth and International division, our Irish business) are showing improving trends in 2010.
In Retail, impairment losses decreased by £857 million, or 39 per cent, to £1,335 million, particularly reflecting prudent risk management, stabilising house prices and the benefit of continued low interest rates. Impairment losses as a percentage of average loans and advances to customers improved to 0.72 per cent in the first half of 2010 compared to 1.15 per cent in the first half of 2009. Secured impairment losses reduced to £53 million while unsecured impairment losses reduced to £1,282 million. As house prices have recovered the proportion of the mortgage portfolio with an indexed loan-to-value of greater than 100 per cent has decreased and now accounts for 9.5 per cent (31 December 2009: 13.0 per cent). More importantly the value of the portfolio with an indexed loan-to-value greater than 100 per cent and more than three months in arrears has fallen nearly £1.5 billion and is now £2.5 billion, representing 0.7 per cent of the portfolio, down from 1.1 per cent in the first half of 2009. The number of mortgage customers new to arrears has also stabilised in the last twelve months, and is now well below the peak experienced in the second half of 2008. We expect to see modest reductions in Retail impairment charges in the second half of 2010. During 2011 as the UK economic environment improves and house prices continue to stabilise further impairment improvements will be delivered, but this improvement is expected to be at a significantly slower rate than the last year.
The Wholesale charge for impairment losses also fell significantly from £9,738 million in the first half of 2009 to £2,991 million in the first half of 2010. Impairment losses as a percentage of average loans and advances to customers improved to 2.85 per cent in 2010 compared to 6.87 per cent in the first half of 2009. The decrease in this period generally reflects action taken in 2009, the stabilising economic environment and continuing low interest rates. We continue to expect the volume of underlying impairment losses from traditional trading and manufacturing businesses to increase during 2010, as the full impact of economic conditions filters into business insolvencies and asset values. This is a typical lag effect, observed in previous recessions, as the economy passes through, and out of, a recession. However the effects of this are expected to be significantly less than the benefit of lower absolute impairments from the HBOS Corporate Real Estate and HBOS (UK and US) Corporate portfolios. Depending upon UK economic conditions, notably future commercial real estate price stability and the continuation of low interest rates, and the performance of individually large exposures, we would expect to see a modest reduction in second half impairment, compared to the first half of 2010, with further reductions in 2011. We remain vigilant in monitoring changes in economic conditions and to individual lending positions and continue to invest heavily in expert resource to work with customers to restructure their businesses on to sustainable bases, thus protecting employment where possible.
In Wealth and International, impairment charges totalled £2,228 million, up 52 per cent on £1,469 million in the first half of last year but down 15 per cent on the £2,609 million charge in the second half of last year. The level of losses continues to be dominated by the economic environment in Ireland. We expect to see further reductions in the Wealth and International impairment charge in the second half of 2010, although economic conditions continue to be monitored closely, particularly in Ireland.
Overall at a Group level we believe that, based on our current economic assumptions, impairment losses will fall moderately in the second half of 2010 with further meaningful reductions in 2011 and beyond. As economic conditions improve we expect the overall Group impairment charge as a percentage of average loans and advances to customers will improve towards an expected 50-60 basis points by around 2014.
At 30 June 2010, the Group’s capital ratios had increased significantly with a total capital ratio of 13.4 per cent, a tier 1 ratio of 10.3 per cent and a core tier 1 ratio of 9.0 per cent.
The improvement in the capital ratios reflects balance sheet liability management transactions, lower risk-weighted assets and the improved underlying performance. A number of balance sheet liability management transactions were undertaken in spring 2010 which resulted in holders of certain securities swapping these for common equity. A profit of £423 million was recognised as a result (compared to £745 million for similar transactions in the first half of 2009).
Risk-weighted assets have reduced by 6 per cent to £463 billion as a consequence of balance sheet reductions, tighter risk criteria for new business and the improved credit outlook. Over the medium term, we continue to expect to see further reductions in the Group’s risk-weighted assets as a result of both balance sheet asset reductions and a positive procyclical impact from the expected improvement in the UK economic environment.
Through the implementation of capital management and restructuring initiatives implemented during the first half of 2010, we have repatriated £2 billion of core tier 1 capital from the insurance companies to the banking companies. Whilst this has no overall impact on the Group’s core tier 1 capital under current Basel regulations, the initiatives deliver a material reduction in the impacts of the potential capital reforms announced by the Basel Committee on Banking Supervision in December 2009, and updated in July 2010.
We note the various recently issued regulatory capital consultation papers and impact studies and will continue to work to ensure that robust levels of capital are maintained as the ongoing capital requirements for banks continue to change.
In the Group’s interim results announcement last year, we set out our strategy to reduce non-relationship assets, including business which is outside our current risk appetite, by some £200 billion by the end of 2014 from the non-relationship asset pool of £300 billion. It continues to be our intention to manage these assets for value and, given the current economic climate, our primary focus remains on running these assets down over time. During 2009, reductions of £60 billion were achieved. In the first half of 2010 we achieved additional reductions of £23 billion.
We continue to expect to achieve a further reduction in non-relationship assets of approximately £117 billion over the next few years. The running down of these portfolios is not expected to have a significant impact on the Group’s financial performance over the medium term. In addition, we continue to progress plans to execute the divestment of retail assets and liabilities in line with our state aid obligations.
As we have guided previously, the balance sheet reduction over time will provide the Group with increased optionality and flexibility from the resultant releases in both funding and capital. These benefits continue to be incorporated into the Group’s overall business plans. Together with initiatives to increase customer deposits in line with market growth, we will reduce the proportion of the Group’s funding that is derived from wholesale markets and eliminate our use of public and central bank facilities by the end of 2012. This will provide capacity for core business growth in line with our relationship strategy.
The Group has made good progress against its funding objectives and further enhanced its liquidity position which is supported by our robust and stable customer deposit base.
The Group has continued to reduce its reliance on short-term wholesale funding. During the first half of the year the absolute level of Group wholesale funding fell to £311 billion, from £326 billion at the end of 2009, reflecting a combination of good retail customer deposit growth and a reduction in non-relationship balance sheet assets. Over the next four years, we expect the combination of customer deposit growth and balance sheet reduction to significantly reduce the Group’s wholesale funding requirement.
The tenor of the Group’s wholesale funding base has also proved to be resilient with the Group maintaining its maturity profile of wholesale funding, such that at 30 June 2010 approximately 49 per cent of wholesale funding had a maturity date greater than one year. Over time, and as we see improvements in the capacity of wholesale funding markets, we expect to maintain the amount of the Group’s wholesale borrowings with a maturity date greater than one year in excess of 40 per cent. We note continuing regulatory consultations relating to liquidity requirements which could require banks to manage their liquidity risk differently and we continue to respond to evolving requirements.
As previously guided, over the next couple of years the Group expects its public capital and senior funding issuance to be £20 billion to £25 billion per annum. We have made good progress on our 2010 term funding issuance plans, having already completed some £18 billion of our planned term issuance for the year. In addition, during the first half of the year, the Group completed a further £8 billion of term funding via a series of privately placed funding transactions. The Group continues to benefit from a diversity of funding sources, which have been enhanced by the establishment of a US Medium Term Note programme and a second regulated covered bond programme, and the first public US$ tranche of RMBS by a UK issuer since 2008.
The Group’s overall liquidity support from public and central bank sources reduced by £25 billion to £132 billion during the first half of 2010. A significant proportion of the remaining balance, including all the Special Liquidity Scheme and Credit Guarantee Scheme facilities, matures over the course of the next couple of years although the Group’s balance sheet reduction plans and deposit strategy will avoid the necessity to refinance much of this. Overall, based on expected spreads and balance sheet mix, we continue to believe that the increased cost of wholesale funding over the next few years will negatively impact the Group’s net interest margin by less than 10 basis points, and this cost is expected to be more than offset by the impact of improved product pricing.
Increases in customer deposits and the reduction in assets set out above mean that we expect to see a steady improvement in the Group’s loan to deposit ratio. The Group does not set a target for this ratio, which we believe does not reflect either the quality of lending or the term of deposits held, but would expect to see it return to legacy Lloyds TSB levels of approximately 140 per cent or lower over the next few years. During the first half of 2010 the ratio, excluding repos, improved to 163 per cent, from 169 per cent at the 2009 year end.
The Group continues to actively support the UK economy by lending to UK households and businesses. In the first half of 2010, we have extended £14.9 billion of gross new mortgage lending and £23.7 billion of committed gross lending to businesses, of which £5.7 billion was for SMEs.
Under the terms of our lending commitments to the UK Government, we agreed to make available gross new lending of £67 billion in the 12 months to March 2011, of which £23 billion would be extended to homeowners and £44 billion to UK businesses. In the four months from 1 March to 30 June 2010, we have extended lending that qualifies under the programme totalling £8.4 billion to UK homeowners and £17 billion to UK businesses, of which £4.1 billion has been extended to SMEs.
Profit before tax includes the unwind of £1,323 million of acquisition related fair value adjustments. In the second half of 2010, we currently expect a further benefit of some £1.2 billion broadly in line with previous guidance. Thereafter, over the medium term, declining annual benefits are expected to accrue.
A large proportion of the funds held by the Group’s insurance businesses are invested in assets which are expected to be held on a long-term basis and which are inherently subject to short-term investment market fluctuations. Whilst it is expected that these investments will provide enhanced returns over the longer term, the short-term impact of investment market volatility can be significant. In the first half of 2010, lower equity market returns compared to our long-term assumptions have contributed to negative insurance and policyholder volatility totalling £199 million.
The UK Government’s June 2010 Budget included a number of tax changes that will impact the Group including legislation to reduce the rate of corporation tax over time and the proposed introduction of a bank levy from 1 January 2011. Further detail on these changes is included in note 25 on page 123.
The tax charge for the half-year to 30 June 2010 was £630 million, representing an effective tax rate of 48.6 per cent. The effective tax rate is higher than the UK statutory rate primarily due to losses in Ireland taxed at lower rates and the non-recognition of the related deferred tax asset.
The Group implemented changes to the terms of its principal UK defined benefit pension schemes in the first half of 2010. As a result of these changes, the amount of any future salary increases that will be deemed pensionable will be capped each year at the lower of:Retail Prices Index inflation;each employee’s actual percentage increase in pay; and 2 per cent of pensionable pay. The effect of this change was to reduce the Group's retirement benefit obligations recognised on the balance sheet by £1,019 million with a corresponding curtailment gain recognised in the income statement.
We have continued to make strong progress in the first half of 2010 with the result that the Group is now profitable on a combined businesses basis, capital ratios are stronger and funding is well placed. Overall, therefore, based on our current projection of a slow but steady UK economic recovery and current regulatory context, we believe the Group has strong medium-term prospects.
Tim Tookey
Group Finance Director
Lloyds TSB Bank plc, Lloyds TSB Scotland plc and Bank of Scotland plc (members of Lloyds Banking Group), are authorised and regulated by the Financial Services Authority. FSA authorisation can be checked on the FSA’s Register at: www.fsa.gov.uk/register/home.do. Lloyds TSB Bank plc, Lloyds TSB Scotland plc and Bank of Scotland plc are members of the Financial Services Compensation Scheme and the Financial Ombudsman Service.
