Lloyds Banking Group plc (LLOY) Earnings Call Transcript & Summary

Good afternoon, everybody. Thank you very much for joining us for the discussion with Lloyds. [Operator Instructions] So with that, I'm very pleased to welcome William Chalmers, CFO of Lloyds Banking Group. Afternoon, William. Thank you very much for joining us.

My pleasure, Rohith, thank you very much for inviting me.

If we can just, I guess, dive into strategy. You talked about the ROT rebuilding to above the cost of equity in perhaps 2 to 3 years' time, even in the current rate environment. I'm just wondering if you could talk through the building blocks to get there and also what you consider to be an appropriate cost of equity?

Sure. Yes, happy to, Rohith, and thank you for the question. It's obviously an important driver of our business. As a business we aspire to the ROE, the ROT being higher than the cost of equity. And indeed, we have a track record, as you know, of achieving that. We're not, at the moment, giving guidance beyond year-end. So I'll be a bit careful in terms of what I say, but I'm happy to give you a few sense, if you like, of key influencers around that and what we see going on in the business looking forward. It's perhaps worth starting off with 2020, which, as you know, has been a pretty tough year. We've had macro, we've had rates, we've had income developments. We've had impairments. Which have pretty much all moved against us during that time. But I think it is still true to say that the business, from a fundamentals point of view, remains very strong and is very well positioned, whether that's market share in our core businesses, whether it's a scale that we enjoy, whether it's our cost focus, all of those pieces remain in place despite the current turbulence. What it means is that over the course of the coming year, I think we'd expect to see the pressures start to stabilize in the income area. We see activity that drives ROI, for example, start to recover from the 2020 pressures that we've seen. And that goes in line with our continued focus on costs that will remain a hallmark really of our approach. The impairment picture, needless to say, is going to very much depend upon the macro. But having said that, you know our IFRS 9 assumptions from a macro perspective and indeed, you know how IFRS 9 works instead, I'll give you a sense as to what we expect to see from an impairments point of view. That will drive return. Cost of equity is obviously a subject of a great deal of discussion. Based upon market measures, you could come out with some really, very high numbers for cost of equity right now. But I guess we would look through that and use a longer-term cost of equity. I won't put a precise number on it, but typically, the kind of 9%, 10% or thereabouts is generally considered appropriate. So based upon all of that, we would aspire to build the returns in line with or in excess of the cost of equity over the medium term, just as I said before, with those ingredients.

And as you just alluded to, and I guess you've been clear in the past that the sort of an update of the strategy or the next stage of the strategy, we'll need to wait until the next CEO has been appointed and is in place. But I was wondering where you might see the opportunities to improve profitability. For example, Lloyds is uniquely positioned amongst U.K. banks in terms of its bancassurance footprint and capability, potentially, there's more areas of cost efficiency that you can go for. So where do you see the opportunities?

Good question. And you're right to start off with the arrival of the new Chairman and the arrival of the new CEO. We would expect them, obviously, to own the new strategy. And so we'll be timing our strategy announcements in a way aligns with their arrival and give them opportunity to consider the bank and its strengths and the challenges and opportunities that it faces. Now having said that, we are, as a Board, very focused on the continuation of the current strategy and indeed building towards the new one as we go into 2021. We're working hard on that next evolution of the strategic piece, and that work continues, irrespective of the considerations, if you like, of the Chairman and CEO, who will, I have no doubt, build into the considerations that we already work on. Today, and also looking forward, there's a range of opportunities that we see to improve the profitability of the business. I would highlight a number really across the business. You brought out there the bancassurance point, which I think is absolutely right. That's a business that enjoys some secular tailwinds in terms of demographics, in terms of wealth accumulation and we'd look to build upon that going forward. That is also an area where I think we can benefit from the interaction with the banking division as we better understand our customer needs and as we better bring products to bear to address those needs from the kind of combined bank and insurance operations that we have. I would expect that will focus on areas like financial planning and retirement as we go forward. Perhaps protection, which is obviously more relevant in today's market than it's really ever been. But it will take time. Those are important secular tailwinds, as I mentioned earlier on, but building our customer proposition and indeed building the scale of our operations, it will take time to get to a successful outcome there. I'd also highlight some other business areas. SME will be one of them. And there, we spent a lot of time building in the GTB, the transaction banking area. Which, again, is an area where we've seen significant growth, a little bit abated by the development of COVID-19, but nonetheless an important area for growth going forward. And then I think finally, in retail, we really should be able to bring the benefits of our scale to bear that also goes for costs within the business. And that obviously is a very important contributor to profitability. In that area, I think scale matters. I think technology is a further area where, again, scale matters. And being a leading bank in the U.K., we really should be able to capitalize on our strength in that respect. And together with the revenue drivers that I just mentioned, drive further profitability looking forward.

So moving on to capital. How do you balance the need to invest in sustainable profitability versus distributions to shareholders?

Yes. It's a very important and obviously topical question. I think the place where I would start in that respect is just to reiterate something which I hope is broadly known already, which is that our core financial objective is the delivery of a sustainable return to shareholders. That obviously requires both capital return in any given year and also the development of sustainable profitability around the business. So to take a step back in that respect, the way we look at it is every year, we go through an investment process. In fact, we're in the middle of it right now. We have a planning process, which includes investment decisions or discussions and decisions around core, what is it that is necessary to keep the bank running and safe and around discretionary. What is it that we choose to invest in, as a matter of product proposition and return-seeking investments. We apply some pretty challenging return requirements to the latter bucket, obviously, in particular, the discretionary investments and those are both in terms of quantum and also in terms of timing of that return. And they do take into account the macroeconomic conditions that we find ourselves in at any one moment. So for example, right now, we're taking into account the effect of COVID-19 on some of our markets. So through those, I think, generally speaking, we have a decent track record of getting decent value. And whether they're organic or inorganic, we apply, broadly speaking, the same sort of targets, again, from a timing and a quantum perspective. If those are met, then we'll invest. We then -- once we move beyond that, have a strongly returning business. We have done historically. We'd expect to continue going forward. And off the back of that, we'd look to make sustainable capital distributions to shareholders based upon our target capital levels, which you obviously know about. As you know, with that, we make the investment decisions that we do. We're committed to a capital return to shareholders. We're very focused, therefore, on both an attractive and, importantly, a sustainable return over time, again, including both capital and sustainable earnings.

And then nearer term, once the limitations on capital distributions are lifted, how do you think about the mix between ordinary dividends and specials or share buybacks? Should we -- do you think there's a different environment going forward in terms of the mix between ordinaries and additional distributions? Or will it go back to something that we've become used to over recent years?

It's a good question. In the past, as you know, we've done dividends and we've done special share repurchases. As we look forward, our primary objective is to ensure, again, the attractive and sustainable capital return. I think the business is well positioned to do that. There's no doubt that as we look forward, the returns over the next couple of years at least are going to be lower than the returns that we've seen before the coronavirus situation came along. And I'm sure the Board will take that into account in terms of its dividend and buyback or for that matter special dividend mix. It is -- having said all of that, the mix consideration is very much a debate for the Board at year-end. I'd expect it to be based on a range of factors, outlook, share prices and so forth. We don't have any particular religion about exactly what form that takes other than we do think that a ordinary dividend at route, if you like, the core of it is an important factor. So I won't preempt that debate. But hopefully, that gives you a bit of a sense of insight as to considerations that we have.

And then if we move on to income. Interest rates look set to remain near 0 over the coming years. There was a big step down in the margin in Q2, as you'd anticipated, partly rates, partly mix, partly customer support. How do you see the next couple of years from an interest margin perspective?

It's an important debate. And obviously, I'm slightly constrained in the sense that I won't give guidance beyond 2020 for all the reasons that I mentioned before, not least of which new Chair and CEO, obviously, have to come in and take a look at the business. And we'll give guidance for the 2021 year, the year-end results next year. And so flesh it out more fully then. I think having said that, a couple of comments on H2. As you know, we had developments in the quarter preceding that, i.e., Q2 and also some commentary that I gave for the looking ahead period going into Q3 and Q4, which essentially had 2 positives and 2 negatives to them. The positive developments in the margin being the stopping of the overdraft, the free overdraft pricing and that working its way back into the margin. The deposit repricing playing out in full throughout the book, particularly in the commercial business. And then some benefits, which we're currently seeing actually from mortgages being repriced at a higher rate versus those mortgages that were rolling off. So those are the positive influences upon the margin. The negative, the flip side, the structural hedge is obviously rolling over, and we've hedged out most of the maturities for, in fact, all of the maturities for this year and have now started work on next. But nonetheless, the structural hedge rolls over clearly into a lower rate environment. And then we've got the full year impact of the lower rates environment playing itself out over the course of the remainder of this year. So those are factors which led me to comment at the half year that we expect margin stability around the 240 level for Q3 and Q4, leading to around 250 on average for the year as a whole. There are variables within that, that are worth highlighting. The unsecured volumes is one. That's very activity dependent. In fact, it's unusual, actually, how activity dependent margin is right now. But broadly speaking, we're seeing them a little bit better than we thought we would do at the half year. But not much. So I called out unsecured balances being down 5% to 10% at the half year over the course of the remainder of 2020. It's probably more like 0% to 5% based on what we're seeing right now. But adding all of that up, I don't think that we moved from the margin guidance that we gave at the half year. Looking forward, over the next couple of years, to your question, again, we're not giving precise guidance, but the factors that I mentioned around deposit repricing around the overdraft free periods coming to an end. And then the challenging factors around the structural hedge around the rates, the low rates impact, those are going to be similar factors to drive the margin outlook over the next couple of years, and I expect us to take those into account when we give the market '21 guidance at the beginning of next year.

And then in terms of the volume piece of net interest income and lending priorities, Lloyds is focused on the consumer credit and SME and mid-market corporates as the drivers of growth over recent years and has been more cautious in terms of mortgage lending. You mentioned just now the improvement in pricing that we've seen in the mortgage market. Does that change your view on the mix going forward? And as you said, unsecured activity dependent. So interested in how you're thinking about the mix going forward? And then particularly on the commercial side, once the government schemes expire and to what degree do you think that's front-loaded some of the demand in commercial banking?

Yes. It's a good question. That point around the mix change in lending is one that's subject to fairly frequent debate, actually, including a session that I was in this morning. There's no doubt, if you step back, Rohith, to your point, we have traditionally been very focused on shareholder value in our lending strategy. Indeed, its shareholder value principles that have led to the lending strategy as a whole. And that, in turn, has typically led us to focus a little bit more on pricing and quality of what we write versus necessarily volumes. Having said that, just a couple of comments on what's going on in the book right now. The mortgage market volumes are in excess of where we expected them to be at the half year. I think that's a function of, to a degree, pent-up demand, to a degree, a less of a deterioration perhaps in the macro than people had thought at this time. And maybe it's even a substantially better economic outcome, although it's very, very early to make a call of that type. But those mortgage market volumes are higher than we expected, and indeed, the pricing at which we are writing is very attractive right now. So volumes are outperforming, pricing in excess of where we expected to be. The consumer credit side, I just made a rough comment as to where we think we're ending up. I think our view on consumer credit remains, but through the cycle return on consumer credit is very, very attractive and that continues to be the case. We will be cautious, obviously, in the current market about where we write and how we write. Volumes are performing a little bit better than we had expected on the consumer credit side versus what we expected at the half year. But again, it's on a through the cycle basis, we see that as an attractive market. Consistent with our principles, therefore, if you track back to the opening comment on shareholder value, we are at the moment, able to balance growth, value and risk aspirations in a -- from our perspective, in a sensible way and that allows us to take our share, and effecting some products more than our share, in the mortgage product, for example, and indeed, benefit from our scale. So that's good. I think consumer credit will be a function of activity levels, as said. The consumer -- the commercial side -- I think the commercial side is a difficult one to call. I mean what we've seen is an awful lot of that demand on the assets be taken out and then stored as deposits effectively. So it seems to be quite a lot of precautionary demand that's driving much of the BBL volume, possibly from the CBIL volume. And so we see pretty high deposit balances across the commercial business, which is essentially people depositing their BBLs on the liability side of our balance sheet. Therefore, what happens when those BBLs are paid back, I think it really depends upon the timing. It depends obviously upon macro developments. But at the moment, at least, this is not conventional lending demand. This is more precautionary demand that, again, leads to deposits. And therefore, when the BBLs are paid back, it is not necessarily replaced by lending.

And then -- so given that outlook, what levers are available to you to pull to support revenues from what looks like a continuing challenging environment in terms of balance sheet management, product mix, product pricing? And you also talked earlier, or you mentioned earlier, an expectation of recovery in other operating income next year. That's been an area that's been quite tough in recent years. And what's the driver for that?

Yes. It's -- your question is around the various aspects of income there. Rohith, I'll address each in turn. I think when we look at the repricing on the net interest income line, as you know, there's 2 sides to that, clearly, asset side and the liability side. Dealing with the liability first, there's limited room on the liability side for continued repricing. We have done a fair bit. There is further liability repricing, as I mentioned earlier, playing through in H2 and there's some further scope in certain product areas beyond that, but it's typically within pretty small balances. And so we're at a point now where much of the liability repricing has played out. There's a little bit more to come, but not an awful lot. The asset side, as I mentioned before, we are seeing some attractive mortgage pricing in excess of that, which is -- of the mortgages that is which are rolling off. And therefore, there's some improvement in the overall margin balance in mortgages there. And again, I made the point about consumer finance activity and the volume dependencies. I think what that means is on the retail side, we continue to manage margin. It's somewhat augmented by the commercial side, where the margin in, for example, Bounce Back Loans is generally -- it's pretty much on our average margin a little bit better, perhaps, so there's some limited margin enhancement there. But it is impacted by low rates. It is impacted by customer support, and it is impacted, obviously, by the structural hedge. And so these are balancing factors. Overall, I think we have some scope to continue to manage the margin, but we are in a low interest rate environment, and that obviously exerts a degree of pressure, which we have to manage as best we can. I think the other income point, other income continues to be pretty challenging in H2. It's the same picture as I portrayed at the half 1 results. It's a function of a variety of different things. Commercial markets activity continues to be relatively limited. We've seen some improvement in transaction banking. But again, somewhat constrained by the environment. In retail, we see payments volumes actually improving, which is helpful. There's still further to go, we think, but we see payments volumes improving. And then insurance, I mentioned before, insurance is an important secular driver for us, but it is going to take time to build that business. And for the time being at least, the activity levels that we see, whether it's in branch sales, whether it's annuity sales because of low interest rates, whether it's other forms of activity, including some weather effects from the August plugs that we had. Insurance is currently quite subdued, and I would expect that to play out through the Q3 period. And then potentially start to improve perhaps a little bit in the back end of this year, but we'll see how this latest news on lockdown actually plays into that. But it overall creates a picture of other income in the second half that is a little lower than we would like. I think beyond that, we see 2 things really. We see a pickup in activity levels across the business generally. Each of those 3 business areas that I mentioned earlier on and we see that some of the effects of the investments that we've made start to play out, whether that's in transaction banking, whether that's in financial planning and retirement or protection. And that will improve the picture over time. But we are committed to diversifying the business to building the other income line and that's something that will take a bit of time to play through, but we believe we're making the right moves.