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

There will be a presentation by William Chalmers following by a question-and-answer session. [Operator Instructions] Please note this call is scheduled for 1 hour. I must advise you that this call is being recorded today. I will now hand over to William Chalmers. Please go ahead, sir.

Thank you, operator, and good morning, everybody. Thanks for joining our Q1 interim management call. As usual, I'll run through the group's financial performance in the first quarter of 2022 before we then open the line for Q&A. It is only 9 weeks since Charlie and I outlined the group's new strategy alongside the full year results, so I do not intend to go through our strategic plans again today. I will nonetheless provide comments on this at the half year. Suffice to say, the group has embarked upon implementation of the plans we set out in February. Indeed, you may have seen the recent announcement on our new management structure, which is aligned with the new strategy and positions the group for delivery. Now let me turn to the results presentation, starting with an overview of the financials on Slide 2. The group had a solid financial performance in Q1. Net income of GBP 4.1 billion is up 12% from the prior year, supported by a stronger net interest margin of 268 basis points, other income of GBP 1.3 billion and our continued low operating lease depreciation charge. We remain committed to efficiency in retaining our market-leading cost position. Operating costs of GBP 2.1 billion are up 3% year-on-year, reflecting stable BAU costs and planned higher investment. We remain on track for a circa GBP 8.8 billion operating cost guidance for the full year. Asset quality remained strong. GBP 177 million net impairment charge reflects a low incurred charge with new to arrears remaining very benign and below pre-pandemic levels. It also reflects our updated economic outlook, which I'll talk more about later on in the presentation. Given this solid performance, statutory profit after tax is GBP 1.2 billion. Return on tangible equity is 10.8%. Underlying this outcome, we've seen continued franchise and balance sheet growth. Capital build of 50 basis points in the quarter after the 230 basis points of regulatory headwinds on the 1st of January was strong. And this has enabled the group to make significant accelerated contributions to the defined benefit pension schemes. As of Q1, we made the full GBP 800 million annual fixed deficit contribution, plus around half of the expected variable contributions relating to our year-end planned distributions. Finally, risk-weighted assets closed the quarter at GBP 210 billion following the regulatory inflation of GBP 16 billion, which we outlined at the full year. Moving on to Slide 3 and the continued recovery in customer activity and franchise growth seen in Q1. We continue to see good levels of activity in the U.K. mortgage market Balances were up GBP 1.2 billion in the quarter given continued open mortgage book growth of GBP 1.7 billion. Credit card balances were flat in the quarter. That is a reasonable performance given the normal seasonal repayments that we see in Q1. And added to this, we're seeing improving travel spend given lifting restrictions, which is an important component, as you know, of overall card spend. Elsewhere in Consumer Finance, motor finance is up GBP 0.1 billion in the context of supply chain issues across the motor industry. Commercial Banking balances meanwhile were up GBP 2.6 billion, led by the growth of GBP 2.9 billion in Corporate & Institutional, particularly higher financial institutions balances. Taken together, average interest earning assets of GBP 448 billion are up GBP 8.6 billion on the prior year. AIEAs are down GBP 1.4 billion on Q4 driven by lower trade and average term lending balances in Commercial Banking. However, for 2022 as a whole, we continue to expect low single-digit percentage growth in AIEAs. Now looking briefly at the other side of the balance sheet. We continue to see deposit growth in Q1. Retail deposits are up GBP 2.5 billion, reflecting resilient customer inflows across current accounts and relationship savings products. This further highlights the strength of our customer franchise. Commercial deposits were up GBP 2.8 billion driven by higher balances from SMEs and corporate and institutional clients. I'll now look at the group's strong revenue performance on Slide 4. Net interest income of GBP 2.9 billion is up 10% year-on-year and up 2% in the quarter. This was significantly driven by the stronger net interest margin of 268 basis points on average interest earning assets of GBP 448 billion. Q1 margin is up 19 basis points from Q1 2021 and up 11 basis points on Q4. This is a result of base rate changes, increased deposit volumes and benefits from the structural hedge more than offsetting the dilutive impact of mortgage margins. As mentioned, we continue to see a competitive mortgage market with average completion margins in Q1 around 85 basis points. Application margins are below this level in the context of both pricing and swaps continuing to move upwards. We'll continue to monitor closely how this develops, recognizing that we probably need to see a period of swap stability to see where margins ultimately settle. Turning to the hedge. Structural hedge now has a nominal balance of GBP 245 billion. We have approved capacity of GBP 250 billion, up GBP 10 billion in the quarter including a little more of the substantial deposit growth that we've experienced through the pandemic. We continue to be cautious on hedge eligibility with buffers of roughly 3x pre-pandemic levels. And in this context, gross income from hedge balances was GBP 0.6 billion in the quarter. Given rising swap rates, we continue to expect 2022 hedge income to be higher than 2021 and then to increase modestly again in 2023 and '24. We remain positively exposed to rising interest rates. We currently expect a 25 basis point parallel shift in the yield curve and the associated base rate rise to benefit interest income by around GBP 175 million in year 1. As you know, this is illustrative and based on the same assumptions as we have outlined previously, including the 50% pass-through, clearly, in practice, the pass-through could differ from this assumption as indeed we saw in Q1. The group's interest rate sensitivity is lower than reported in the full year given the increase in the size of the hedge, higher rates over the last few weeks, and a larger hedge means that we've locked in more interest income through the P&L rather than reporting a theoretical sensitivity. It's also worth noting that sensitivity, as always, does not consider potential asset spread compression particularly in mortgages as a result of swap movements, again, as we've seen here in the first quarter. In practice, what we're seeing is base rate changes benefit income today, and this is expected to persist through 2022, providing a net tailwind to the margin. The impact of mortgage repricing, if spreads remain low, will continue to build into the margin in the second half and indeed over the longer term. For 2022, the base rate changes we have seen so far this year and the very significant interest rate moves in the market in recent weeks, combined with our new year-end base rate assumptions, are resulting in an improved interest income outlook. We therefore now expect the group margin to be above 270 basis points for 2022. Now looking briefly at other income. OI continues to show signs of recovery. GBP 1.26 billion in the quarter is up 11% on prior year and in line with the last 3 quarters. As mentioned, we're seeing improving activity levels in retail and insurance, while market performance has also improved in Q1 over Q4. We saw an adverse impact of around GBP 30 million in the quarter relating to the winter storms, although this was offset by a positive insurance methodology change. If you remove both of these items, the underlying run rate for the quarter was just over GBP 1.2 million. Operating lease depreciation of GBP 94 million in the quarter remains low in the context of the reduced Lex fleet size and continuing strength in used car prices. Now let me turn to Slide 5 and the group's continued focus on efficiency. Operating costs of GBP 2.1 billion were up 3% from prior year. As mentioned, this includes stable BAU costs combined with planned higher investments. We outlined the group's new cost reporting basis at the full year. Restructuring costs and fraud charges that are now included within BAU operating costs are broadly in line with the prior year charges. Our cost-income ratio of 52.3% remains market-leading. As you can see on the slide, the cost-income ratio excluding remediation is 51%, consistent with previous quarters. Remediation charge of GBP 52 million in Q1 reflects a continuation of existing programs and no further charge in respect of HBOS Reading. Q1 charge is in line with our expectation of an ongoing cost of GBP 200 million to GBP 300 million per year. In sum, we're maintaining our focus on efficiency and our market-leading cost position even after increased investment. We remain on track for the circa GBP 8.8 billion operating cost guidance for 2022. Turning to Slide 6 and the group's asset quality. Asset quality remains strong and new to arrears remain very benign with underlying charges below pre-pandemic levels. The net impairment charge of GBP 177 million for the first quarter reflects an underlying charge of GBP 150 million plus GBP 27 million in respect of our updated economic scenarios. We revised our base case economic assumptions at the quarter end and now include a slightly weaker GDP forecast. But given performance in the year-to-date, slightly stronger house price and unemployment outturns. Alongside this, we now also expect higher inflation. For 2022, we forecast CPI inflation of 7.5% peaking in Q4 with 4.3% thereafter in 2023. We focus on the potential impact of higher inflation on our customers and the potential risks to asset quality. Our low-risk model means that we have limited direct exposure to customer segments, which are most likely to experience near-term payment difficulties from cost of living pressures. However, we are proactively contacting customers where we feel they may need assistance and we'll continue to help with financial health checks and other support measures. While discussing asset quality, it's worth noting that we have no direct exposure to Russia or Ukraine. We are actively investigating and monitoring any indirect exposures and have not yet found anything of significant concern. Our clear U.K.-focused business model is helpful in this regard. Overall, absent the material change, the main effects on us with the current Ukraine crisis and attended inflationary impact are likely to be second and third order, for example, on overall levels of economic activity. We expect those to be captured by our macroeconomic forecasts. But of course, we remain vigilant. Based on this outlook, the stock of ECLs remained stable at GBP 4.5 billion at the end of Q1. This remains GBP 0.3 billion higher than at the end of 2019 before the onset of the pandemic. And within that ECL, we continue to hold just under GBP 800 million COVID-related management judgments including the central adjustment. We have also now added a further judgmental ECL provision of about GBP 100 million to reflect potential affordability risks for our lower-income customers. Touching briefly on our IFRS 9 strategy. As we've discussed before, in Q1, we updated our models to reflect CRD IV regulatory requirements. Notably, this includes a change in the definition of default for mortgages from 180 to 90 days and updating our approach to past term interest-only mortgages. Together, this has resulted in an increase in mortgage assets in Stage 2 and Stage 3. This change is presentational. It does not change the economics and has an immaterial impact on the ECLs. And indeed, excluding this regulatory change, the underlying movement in mortgage assets staging in the quarter has actually seen further improvements. In summary and looking forward, given our performance to date and macroeconomic scenarios, we continue to expect the net asset quality ratio to be around 20 basis points in 2022. Moving on to below the line on Slide 7. Following the change in cost reporting that we outlined at the full year, there's now very little difference between underlying and statutory profits. As you can see, restructuring costs of GBP 24 million reflect only the remaining M&A and integration-related costs. The volatility line shows a charge of GBP 138 million and includes negative insurance and banking volatility in addition to the usual fair value unwind and amortization of purchased intangibles. And after these items, statutory profit before tax of GBP 1.6 billion and profit after tax of GBP 1.2 billion both represent a solid financial performance. The return on tangible equity of 10.8% in the quarter above our cost of capital reflects this performance. Based largely on the stronger income outlook that I outlined earlier, we now expect the ROTE for 2022 will be greater than 11%. Total net assets per share were 56.5p for Q1, up 4.1p from the prior year but down 1p on Q4. The quarter-on-quarter movement largely reflects strength in income contribution offset by movements in the cash flow hedge reserve given how rates moved during the quarter. Looking forward, you should remember that the 2021 final dividend will come out of TNAV in Q2, while the buyback impacts as the program is conducted through the year. I'll now turn to Slide 8 and consider the group's capital position. Risk-weighted assets of GBP 210 billion are up GBP 14 billion in the quarter but down GBP 2 billion excluding the regulatory inflation of the 1st of January that we set out in the full year results. Lending growth has been offset by optimization, and we've seen limited impact from credit migration given our strong portfolio. Strong business-led contributions augmented by effective RWA management supported strong capital build of 50 basis points in the quarter and a closing CET1 ratio of 14.2%, both after the headwinds on the 1st of January. Importantly and as previously mentioned, the healthy capital build has enabled the group to make significant accelerated pension contributions. We've already made the full annual GBP 800 million fixed contribution, and this is included in the 50 basis points build. In addition, we've made around half of the variable contributions relating to our planned year-end 2021 distributions equivalent to GBP 500 million. This is reflected in our 14.2% CET1 quarter end position. It's an efficient use of capital, and it means the group will have greater free capital through the rest of 2022. In line with the guidance previously, we continue to expect 2022 closing RWAs to be around GBP 210 billion. This is driven by the expected balance sheet growth offset by optimization activity through the rest of 2022. And so based on our performance to date, our business model and the outlook, we expect capital build to continue to be strong through the rest of this year. Finally, turning to Slide 9. In summary, the group has delivered a solid financial performance in Q1 with strong revenue growth, supported by an increased margin and continued recovery in customer activity. At the same time, we've maintained our focus on costs while asset quality remains robust. Capital build of 50 basis points in the quarter supports the group's strong capital position and has enabled significant pension contributions. As mentioned, uncertainties persist in the current environment, most notably concerning the potential impact of inflation on our customers and in context we will provide effective support for our customers wherever we can. The group's business model is resilient, together with our new strategy positions the organization well. This confidence is reflected in our updated guidance of 2022. As you've heard, we now expect the net interest margin to be greater than 270 basis points and the return on tangible equity to be greater than 11%. All our guidance statements, including those for 2022 and the longer term are reaffirmed. Outside of the financials, and as mentioned at the start of the call, the group has recently implemented a new management structure. This is fully aligned with our new strategy, and it helps position the group to deliver higher, more sustainable returns and capital generation. That concludes my remarks this morning. Thank you very much for listening. Let me now turn the call back to the operator for Q&A. Operator, over to you.

[Operator Instructions] And we take our first question from Omar Keenan with Credit Suisse.

I had just some questions on net interest income, please, and I wanted to ask on the revised NIM guidance, which is now above 270 basis points. I understand that's a floor rather than a target, but I wanted to understand what the minimum assumption changes that were there that we can make our judgment of how far above 270 bps it will be. Presumably at least it's the deposit beta experience from the December hike and maybe including an extra Bank of England rate hike, but if you can clarify what those minimum conditions are, that will be very helpful. And then just secondly, on the structural hedge, I can see the duration has shortened a bit from 3.5 years to between 3 and 3.5. And I guess the shape of the yield curve lets you do that without giving up any yield. What are the various debates that you're having at the moment in terms of how to position the structural hedge given what's going on in the fixed income markets? It looks like you think it's worth shortening a bit and say increasing a year 2 to 4 rate sensitivity if you think the buyer yield is ultimately higher.

Yes, thank you for the questions, Omar. And I'll try to deal with each of them sequentially. In terms of the guidance on net interest margin, as you say, we have increased it from greater than 260 to greater than 270 in the context of significantly increasing rates and, of course, the effect of bank base rate changes to date applied to substantially increased deposit volumes over the course of the pandemic, including some of the growth that we've seen in the last quarter. Now as you pointed out, the language is greater than 270, and so in that sense, it's a floor. But what are we looking for in terms of the basis in which we have undertaken those judgments. I think, first of all, I draw your attention to our slightly revised economic forecasts, so we have one more base rate rise in the context of that. That's a base rate rise that is expected to take place before the end of this year, one in May and one in the later part of the year to take the base rate to 1.25%. We then see one further base rate rise before flattening out thereafter. The second is the rise in interest rates generally that we have seen over the course of this quarter. So since 24th of February, spots on year is up around 50% or so. Term rates are up around 35% or so. And so that has been a factor, too. And then finally, a third area that you might look at there is around the deposit beta assumptions that we've made, which are very much in line with the guidance that we've given you before, which is as we progress into rising interest rate environment, the rising base rates associated with that, then I think we'll see the part and assumption start to converge towards this 50% that we model on, on a continuing basis. And so those are the types of judgments that we put into our expectations around the interest rate. I think they're around the margin, I should say. There are clearly some moving pieces in there. What will happen to interest rates, for example, or how will the bank base rate environment play out, for example, and indeed, ultimately, what will the deposit B2B, for example, a 3 points in question. But that's the basis on which we performed the interest margin guidance. Structural hedge. The structural hedge, as you know, is managed both for continuity and stability in earnings and also for shareholder value. We managed to hedge dynamically. We are very much aware of and debating interest rate movements as we see them on an ongoing basis. Now underneath that, as I said, this is about hedging interest rate risk and therefore contributing earnings stability to the P&L. And that is the objective. And that is why we generally manage around the weighted average life that we manage to. We don't tend to deviate too much from it. As we look forward, Omar, we will debate where rates are today. We'll look at, obviously, the inflationary outlook and how we expect both the Bank of England and the markets to adjust that over time, and we'll deploy their hedge accordingly. But that will all be within pretty tight risk management standards that in the end are about ensuring earnings stability in the context of shareholder value.

That's wonderful. Can I just ask a quick follow-up question on the deposit betas? So at what point are you assuming that they converge to the 50%, I guess, the deposit beta experienced from the December, February and maybe March rate hike you factored?

Yes. Omar, we won't disclose precise details on that for obvious commercial reasons. But generally speaking, I think it is fair to say that in the context of the initial base rate rises, the liability margin has recovered somewhat. And therefore, the deposit beta has been lower than the 50% that we would typically describe it as. Looking forward, I suspect it will gradually converge to that level as interest rates increase, but we're not disclosing more than that in terms of [indiscernible].

And we take our next question from Rohith Chandra-Rajan with Bank of America.

Sorry, I'm going to boringly stay on the margin. Thank you for the comments on the liability side. That's certainly very helpful. You mentioned earlier, William, that application spreads on mortgages were below the 85 basis points completion spread that you saw in Q1. I mean, I guess, when we look across the market, you've seen lenders continuing to raise mortgage rates but really not keeping pace with the move in swap rates. I'm just wondering how far below the 85 basis points current application spreads are. And do you still think the 75 to 100 basis points mortgage spread guidance or expectation that you gave at the full year results is reasonable particularly for this year and then also over the sort of period of the plan? That will be one question. And then just picking on margin, just on the consumer credit side of the business, are you still confident in the recovery in demand for consumer credit given the concerns around inflation that you flagged? And then I have another one on capital, please.

Yes. Sure. Thank you, Rohith. On your first question on mortgage pricing, which is obviously a factor in the overall net interest margin as well, as you pointed out. A couple of points there. First of all, completion margins, as said, 85 basis points during the quarter, consistent, I think, with what we said at the February 24. But also, as you say, application margins, as per my script earlier on, have been below that over the course of the quarter. And that, of course, will feed through into our completion margins that we talked about in Q2. In terms of your question around how do we feel about the planning assumption of 75 to 100 basis points, we don't generally mark our plans -- our 3-year, 5-year plans to market every quarter, but I suppose you've seen 2 divergences over the course of this quarter. One is interest rates clearly significantly above our plans, which is a net positive from an earnings point of view. And the other is application margins, which have probably been a touch below our plans of 75 to 100 actually in the course of the quarter, which is a net negative. Now you add those 2 together, and it is a net positive to our expectations versus where they were on February 24. So the net effect of interest rates versus mortgage margins both today and also as we project forward into '23 and '24 is a net positive versus where we were on 24th. It's also worth saying that even if mortgage completion margins ultimately flip to the lower levels of our planning assumptions, even a touch below, it's a pretty attractive business from an economic return point of view, Rohith. So we consider that and we bear that in mind as we move forward. Consumer credit. We have seen increases in expenditure within consumer credit over the course of the quarter. So if you look at Q1 credit card retail spend now versus what it was in Q1 of 2019, it is up 7%. And that trajectory has been gradually improving through the 3 months. So for example, March '22 credit card spend is up 13% versus where it was in March 2019. Aligned to that, Rohith, we also see travel spend recovering quite fast. I think I mentioned it in my comments. And as you know, that's responsible for around 1/3 of our overall credit card expenditures. Now to be clear, there's a balance in there which is typically more weighted towards transactors today versus revolvers, and that needs to be accounted for in terms of the pace of which balances might expand within consumer credit. But those spending patterns are broadly supportive of consumer credit gradually, and I would make the point gradually expanding more or less in line with our expectations not hugely different to where we were on February 24.

And just -- sorry, just on the mortgage spreads, would you be able to comment on where the application spreads are currently?

No, Rohith, I don't typically comment on the application margins. They vary quite a lot in any period of time. What I would say, Rohith, around the margin question in mortgages in general is that we've seen a period of rapidly rising swap rates. And as you pointed out in your question, we've also seen alongside that rising pricing. Now a lot of people pre-hedge, and therefore, pricing generally will lag to operate. And that, I think, is what we've seen in Q1. I think what we have to see is get a good impression of what the overall margin is going to be on a stable look-forward basis, Rohith, is a period of swap stability. And at that point, pricing can catch up with a period of swap stability. And at that point, you'll get a sense as to what the true mortgage margin is. And indeed, in the context of our 75 to 100 basis points of planning assumption for '24, I think we feel comfortable with that. But let's wait for that period of swap stability and see how prices react and let's see where ultimately the mortgage margins settle as a consequence of that.

Okay. And then I just had a quick one on capital, please, particularly around the pension contribution. So you mentioned that you've taken all of the fixed contribution and half of the variable. So in terms of how we think about the phasing of the variable contribution, I mean, is the sort of the Q4 and the Q2 distributions, the contributions related to those, should we think that they're evenly split over the subsequent 2 quarters?

Yes. Thanks, Rohith. First of all, in terms of the fixed contribution, as you know, the fixed contribution is around GBP 800 million per year. We've taken all of that in the context of our Q1 capital numbers. In total, that's about 31 basis points of capital consumed by that, which is before you get to the 50 basis points capital generation. The accelerated component of that is obviously 3/4, so around 23 basis points of capital is consumed by that accelerated proportion of the fixed capital -- of the fixed pension contributions, which gives you some idea around the underlying capital generation of the business. And since [ pensions ] are variable, there's no predetermined schedule for that, Rohith. It is reasonable to think about it as spread through the course of the year. We've taken a view that we had, frankly, strong capital generation in Q1, and therefore, we felt it appropriate to accelerate variable contributions ahead of what we might otherwise do. And that's what we've done. We'll see how capital generation fares for the remainder of the year, which as I said we expect to be strong. But in that context, we'll look to get the variable contributions behind us probably reasonably promptly. So I think overall, Rohith, no particular schedule for that variable contribution, but we'll deal with it probably relatively rapidly, I suspect.

And we take our next question from Raul Sinha with JPMorgan.

Maybe just one follow-up on the discussion previously. I was just wondering at a high level, what do you think is the utility of purely focusing on the mortgage margin when swap rates and rates in general are moving up rapidly just given the timing differences you've talked about? Because there's a lot of focus, I think, from investors and analysts on just your mortgage spread and using the mortgage spread as a proxy for the Lloyds overall margin, but clearly it appears that tailwind on the deposit side are obviously much stronger and realize much more quicker than the feed-through on the mortgage pressure side. So just interested in sort of your broader thoughts on the utility you're focusing on the application and the completion margin on a quarterly basis. That's the first question. . The second question is around -- just a follow-up to what Omar was asking in terms of deposit pass-through. What have you actually realized so far in terms of deposit pass-through rates? It looks very low from the outside. And my question really is it appears that the large banks aren't really passing on very material rate hikes so far, but there are clearly some very high interest rates in the market on savings products. Are you starting to see -- and obviously, you had very strong deposit outflow -- inflows in Q1 as well. So are you starting to expect this pricing environment to change on the deposit side just given the amount of surplus capital -- or surplus deposits the industry seems to be sitting on?

Yes. Thank you. Thanks for the question, Raul. On the first question, I think you're absolutely right to point out the right way to look at the overall interest rate and mortgage margin environment is holistically. And I think we've described that certainly, I've tried to put forward that argument in the context of various calls in the past where you need to look at interest rate movements and mortgage pricing movements in the same bucket, if you like, look at them at the same time because, as we have seen, where we see swap rate movements, that is advantageous from an earnings point of view particularly if the base rate rises come about shortly thereafter. That's advantageous to net interest income. Of course, some element of that is likely to be offset in the context of narrowing mortgage spreads as those same swap rate movements take place. But there's a give and a take here. And as I said, the business -- our business, both now and looking forward, is a net beneficiary from that overall move. It has been so far. We expect it to be going forward. So that's one point. The second point per your comments, Raul, is from a timing perspective, the bank base rate changes and the associated liability margin widening that comes with that alongside the reinvestment of the structural hedge as maturities become available and as we consider the size of the structural hedge in the context of deposit increases. Those benefits start to accrue pretty much from day 1, particularly the bank base rate changes and then gradually the build into the hedge. The mortgage margin plays through as the mortgage book matures. And so you will see the mortgage margin plays a role in the context of the NIM in quarter 1 for sure. It will play a little bit more of a role in the context of the NIM in the second half of this year as the mortgage book rolls over, and it will play a stronger role in '23 and '24. But again, coming back to this point around looking at the whole, we are a net beneficiary of those interest rate changes, the swap moves, the base rate changes and the mortgage margin compression. That is a net benefit and net positive for our P&L for our interest income line. The -- moving on to the second of your question, the deposit pass-through question. The way that we look at deposit pass-through is a function of 3 main parameters. One is about offering, frankly, value and service to our customers. That's very important to us. Our customers come first. At the end of the day, they are what the business is. And we're building a strategy based upon our customers, so we are very observant of that, and it's an absolute priority for us. The second is the overall balance sheet need of the business or what the funding needs of the business look like. At the moment, as you know, we have a loan-to-deposit ratio of 94%, which is a very liquid balance sheet. We've seen deposit inflows now of GBP 70 billion since the start of the pandemic, which is what sponsored that loan-to-deposit ratio. And so that's a factor in determining how do we look at the deposit environment going forward against asset growth needs that we have. And then thirdly, we have to look at what the competition does, as your comments indicated, Raul, and we keep a close eye on that. We aim to remain competitive in the customer services and products that we offer, and we believe we do. I think you will see headline rates from time to time, and you will see increases on certain products from time to time. But it's always worth looking behind the headline, if you like, as to how broad that pricing change might be and, therefore, what the overall competitive implications of it might be. As we look forward and we adjust deposit pricing, I think it's inevitable, and history would suggest that at very low interest rates that tends to be relatively modest parcel of interest or base rate changes simply because what you're doing is essentially allowing the liability margin to recover to something more like what it looked like before we came into this very, very low interest rate environment. It is also inevitable that as the bank base rate changes and go up, that institutions like us are likely to respond to that in terms of passing a little bit more on over time. Precisely how fast that development happens depends upon those 3 factors that I mentioned just a second ago.

That's really helpful. I guess just one unrelated follow-up. Is there any kind of capital headwind that we should be thinking about for the remaining quarters of the year apart from the pension contribution just in context of the fact that the capital generation target was not updated given your strong performance in Q1?

Yes, sure. A couple of points on capital generation. First of all, Raul, as you know, we don't offer guidance so much on capital generation. I think we talked about an average of 150 basis points over the course of '22 to '24 in our 24th February results presentation. But that was an average over a period of time with the net of the year is differing in the makeup in that respect. But having said that, what we have seen is, as I said, strong capital generation in the first quarter of this year. And looking forward, looking at the components of that, I expect to continue to see strong core capital -- sorry, core banking build within that capital build for the remaining quarters. We'll get some tailwinds and some headwinds within that role. So headwinds will be -- we had RWA benefits in the first quarter, likely to be less in quarters going forward. Tailwinds, we are likely to see reduced pension contributions clearly in the context of us having accelerated into Q1. Also in Q1, we didn't have an insurance component to the overall capital build. And so adding all of those together, 2 comments, really. One is, I think we'll continue to see pretty strong capital build through the course of the year. I don't think you're necessarily missing any big items, none that I would call out as such. And overall, I think we're likely to be well ahead of that 150 that was mentioned on the 24th of February.

And we take the next question from Jonathan Pierce with Numis.

I've got 2 questions, and actually, they're on exactly the same topic as the last set of questions, so sorry about that. But coming at it slightly differently. I do wonder, William, whether you're still being slightly cautious on this mortgage margin point by lumping together the benefits of the managed margin and the hedge income and saying that will more than offset the mortgage margin decline in recent months. Because if I just think about the hedge alone, we've seen a 100 basis point increase in the reinvestment rates on the hedge since the start of the year, whereas maybe mortgage spreads are down, I don't know, 20, 30 basis points. So even though you put a lot more mortgages through the pipes every quarter than the structural hedge reinvestment, it feels to me like the hedge is providing a pretty much complete offset incrementally versus the extra pressure that's coming through on new business mortgage margins. And therefore, what you are seeing is really just a pure flow-through of the benefits of the managed margin. Am I missing something there? Because I really can't get too worried about the movement in mortgage margins that we've seen since the start of the year for that very reason.

Thanks for the question, Jon. I'm not sure you're necessarily missing anything. No, I mean, I guess a couple of points. One is, as I said, in the context of the rising rates, we see benefits from that in the hedge, as you pointed out. We see benefits from that in the context of bank base rate changes that should follow. We're forecasting 2 more bank base rate changes this year, 1 more than we expected on February 24 to bring it to 1.25 at the end of the year. And we also see benefits from the overall volumes that we have in deposits, as mentioned. So those are the benefits that we see. I don't think you're missing anything in that respect. I think on the mortgage side, we are seeing, as I said, application margins that are below completion margins of 85. And I mentioned in answer to Rohith's question earlier on that actually application margins in Q1 have been outside of our 75 to 100 basis points, too. And we'll see that flow through. As you know, Jonathan, we have about GBP 90 billion of mortgages maturing in any given year on a roughly GBP 300 billion book. And so the rates at which we had written those mortgages in the course of recent years, particularly high rates in '20 and '21, that provides quite a significant step down for those mortgage maturities as they mature in remainder of '22 but particularly going into '23 and '24. So there is a step down from that, and we've given some indication of that previously. That element ought not to be underestimated, Jonathan, in the context of the rising rate and spread compression market that we're seeing. But as I said, I would call out that we are a net beneficiary versus where we were on February 24.

Yes. I mean I absolutely expect the mortgage refinancing headwind is coming later this year and next year on those sort of mid-pandemic 2-year fixes. But I was really just talking about the separate issue of the movement in mortgage margins that we've seen on new business since the start of the year, but that's helpful. Can I ask a second one on deposit beta?

Yes.

The -- we can sort of back out from your slides showing that 10 basis points of the margin improvement was from base rate in the course that probably each 25 basis point rate hike so far has helped the managed margin by, I don't know, probably GBP 350 million, whereas I think your guidance at the end of the year on 50% pass-through assumption was 200, including the hedge to maybe 150 managed margin. Am I in the right ballpark there because I'm thinking about how we roll through the full period benefit into Q2 because the sort of base rate average in Q2 versus Q1, about 30 basis points, which is not dissimilar actually to what Q1 was versus Q4. In other words, are we looking at the moment at about GBP 350 million per 25 basis point hike? And should we see, even absent any further base rate increases in Q2, another high single-digit improvement in the margin from the flow-through of the February and the March rate hike into Q2?

Yes. Thanks, Jonathan. A couple of comments to make for you. One is just to reiterate the point around the base rate changes that we have put into the economic forecast for the remainder of this year, which you'll have noted. Second is, as your comment really alludes to, Jonathan, we have seen relatively modest pass-ons in the course of the late part of last year and beginning of this year. And indeed, we've seen these relatively accelerated base rate changes certainly versus our expectations from December onwards. So that combination has led to some of the outperformance that you've seen in Q1. And then that leads to the third point, which is to say these base rate changes and the effects of them on the liability margin, they stay with us for this year, and they stay with us for next year and beyond. So it's not transitional. It stays in the interest income, provided, of course, if we don't kind of compete it away in so far as that margin has been widened to date, that stays with us. Third point is -- sorry, fourth point is our sensitivity that we've given is 175 rather than the numbers that you've given, Jonathan. But as you say, your numbers were based off of slightly different assumptions. But 175, as you know, is based on the 50% pass-on assumption and indeed a full asset side pass-on in the context of mortgage balances and spreads. What I would say, and perhaps this is helpful, is it's roughly linear. So that is to say when we look at the overall component of our sensitivity, that component which relates to liability margin management is roughly linear in terms of the relationship that it has 50% versus 0 versus 100%.

And we take our next question from Joseph Dickerson with Jefferies.

Most of my questions have been answered. But could you just discuss on the GBP 800 million COVID overlay that's sitting on the balance sheet? What are the hurdles that need to be met before you look to release that? Or do you just plan to bleed it out as credit starts to normalize on an underlying basis?

Thanks, Joe. It's an important question. As you say, we have COVID-related judgments within our overall ECL now just shy of GBP 800 million. That's composed of 2 main blocks. One is the GBP 400 million group overlay that is essentially a insurance, if you like, against changes in the conditioning assumptions on which our economic forecasts have built. The second is a further amount just shy of GBP 400 million, which is essentially saying that we would have experienced higher levels of default but for various forms of government support programs that are in place. That second block is in order to compensate temporarily lower default ratios. The commenting on each of those, Joe, which will go to inform how we look at them going forward, for the GBP 400 million release, what we would need to see in order to reconsider that is low and sustained low levels of infections, number one; and number two, a period of no new emergence of vaccine-resistant viruses. It's worth remembering today that it's only a matter of weeks ago, let's say 8 weeks ago or thereabouts, that we were at the height of the Omicron-induced virus and nobody quite knew where that was going to go. So although it seems like a long time ago, in fact, it wasn't. There's no doubt, Joe, that as we go through this year, we will take a look at that environment and see whether or not we indeed have a sustained low level of infections and indeed whether or not there is an emergence of any new viruses and whether they are vaccine resistant. And off the back of that, be able to reexamine the GBP 400 million, that is the group central judgment. On the second piece, Joe, it's a question of how asset quality performs off the back of the withdrawal of government support programs. And so far, Joe, the performance has been very benign, as I mentioned in my comments. The underlying performance of our portfolios, retail and commercial, has been very strong, which gives you confidence that actually, of that amount of slightly less than GBP 400 million that is there for the potential increase in default as these support programs withdraw, it so far has not been much used up, let's say. We just have to see how asset quality performs in the context of the weeks ahead of us before taking another look at that. But hopefully, that gives you some idea as to how we're looking at it.

And we take the next question from Chris Cant with Autonomous.

If I could just come back on the deposit beta point, and then we can do the same math on your slides with the 10 basis point improvement in the quarter. You talked about it being fairly linear in terms of how the deposit feature assumption materializes into the actual NII movement we're seeing. But what we've seen in the first quarter is about double your disclosed full year sensitivity. So implicitly, the pass-through wasn't kind of very limited. It's virtually nothing. Is that a fair inference? Or is there also a variance in the first quarter in terms of the quantum of managed margin deposits that you thought you had versus what you now actually think you have? That will be the first question, please. And second, on the cost of living point. I thought your comments around the GBP 100 million sort of add-on within the mix of your macroeconomic variable change was quite interesting. What do you expect to see here in terms of customer behavior? So there's a few data points kicking around. I think there was a data point from Centrica recently about the number of customers now in arrears on their gas bills has gone up by some multiple versus where they were a year ago. Is your take that it's just about your customer profile and you don't overlap in the Venn diagram, which I sort of struggle with given your size in the U.K. market? Or is it that you think the people who are going to get into real difficulty as a consequence of that cost of living are not part of your cohort and where others are maybe struggling, they go into arrears on their gas bill first, but they're not going to stop paying that credit card. Is that how you're thinking about it? I'm just curious if you could add a little bit more color on that cost of living comment, please.

Sure. Thanks, Chris. In terms of the performance in the first quarter on net interest income, the relationship of that sensitivity, as I said before, I think it is fair to say that the bank base rate changes have made more of a difference than the sensitivity would suggest. And a lot of that comes down to the extent to which the liability margin is being restored in the context of slightly higher interest rates versus the near 0 interest rates that we've experienced over the last few years. So there is -- that is certainly a factor. I mentioned the linearity, and perhaps I should have been more precise in the answer to the question for Jon. But if you look at our overall 175 sensitivity in year 1, around half of that is related to effectively the 50% pass-on assumption. So that's where the linearity comes in for that half, which is related to the pass-on assumption is around half of the overall 175. And that's where the linearity kicks in, which hopefully helps you with your numbers as we look forward. So literally, what does that mean half of 175, therefore, is related to pass-on assumptions. I think it is -- as we look forward, as I said, it is likely that as rates go higher, we will seek to pass on more in the context of, as I said, making sure that we deliver customer value as well as service and interest in making sure that we remain competitive and at the forefront. And off the back of that, we would see part on assumptions that converge towards our 50% sensitivity that we show you in the illustrations that we've been giving. I would say that the underlying performance of the business in the deposit area has been very strong. And so when we look at the quality of the business on the liability side, we've seen further GBP 4 billion or so of deposit inflows over the course of the first quarter. And that fields, as I say, very strong from a franchise point of view. Cost of living point. Chris, just to give you some thoughts on that, really. We do, obviously, see quite a lot of data in terms of how our customers are responding to tougher conditions from a cost of living point of view and the inflationary environment. And so to give you 1 or 2 data points that we think are interesting, we think we've seen around 1.2 million subscription payments that have been stopped by our customers since summer of 2021. Those relate significantly to things like television streaming services. They also relate to more discretionary items of expenditures such as gym subscriptions and that sort of thing. So we've seen signs of customers somewhat tightening their belts with respect to discretionary expenditures, and we keep a close eye on those because they are also the data points that inform us as to whether or not we need to proactively reach out to customers and offer them support and financial planning health and so forth. In terms of our approach, a couple of points, Chris, about how we see the economic environment feeding through. One is that if you look at our economic assumptions, we still maintain GDP growth in 2022. Now admittedly, we don't see much occurring in the remaining 3 quarters of this year because most of it is already banked as of Q1 as it were. But nonetheless, it's a positive GDP environment, albeit lesser than it was on February 24, when we talked about our Q4 assumptions. Likewise and very importantly, we see unemployment remaining low, 4.1% for 2022, only gradually rising thereafter in 2023. So those are very low levels of unemployment. And as you know, Chris, unemployment has always been the leading indicator for asset quality default. So as long as unemployment levels remain low, then I think the consequences of that for our portfolios will be measured by those unemployment levels and, therefore, be manageable. Further point, we've seen over the pandemic savings cushions. I mentioned we've seen deposits increase by GBP 70 billion since December '19, significant buildup in savings cushions. But then perhaps more importantly, when we look at the portfolios, we are careful about the extension of credit. And we make -- we try to make sure that we only extend credit where we believe the customer can afford to pay it back predominantly for their interests. We also stress our portfolios, so we stress secured portfolios, for example, to now well over 7% for affordability. Unsecured book, which is obviously most likely to be at risk potentially in this context, it's a prime on secured book. And you can see that testified too by some of the public securitization data, and credit scores are available. It's not to say that we won't necessarily see some uptick in impairments if inflationary conditions persist and economic conditions worsen, but, on the other hand, is mitigated by these factors. And then moving on to commercial again, affordability checks, affordability criteria are key, stressing likewise, we lend on cash flows, so 80% of the SME book is secured. We're very careful about early warning triggers to try to make sure that where defaults do occur, we offer customer assistance where we can, again, both in their interest and ultimately in the interest of lowering losses. So I think, Chris, the data that we see in sum gives us some indications as to how customers are responding. Our view is that the economics are looking tougher. Cost of living is a big part of that. But overall, we see the unemployment rate staying low, which is an important data point. And then finally that we see the portfolios both retail and commercial as being well positioned, if you like, despite more adverse economic circumstances.

And we take our next question from Andrew Coombs with the Citi.

I have one follow-up. Can you hear me?

We can hear you now, Andrew. Yes, it's better.

So I was just saying I have one follow-up question, following on from Joseph and Chris' questions and then one on capital. On the follow-up. I'm interested in the point on the overlay because we've been talking about when you might release this for some time. And I remember the discussion a year ago was really when you had more resilient data post CGRS, and we now have that resilient data. I am interested that you're still attaching that overlay to very much COVID-based measures. So you're talking about prolonged periods of lower levels of infection, vaccine success. But is it a case now that, that overlay becomes fungible. So even if we were to see lower levels of infection and success of the vaccines that now you might rather wait and see how the cost of living crisis proceeds, how the Russia-Ukraine conflict proceeds from here before releasing that overlay. So any comments around that? And then the second question on capital. In your earlier commentary, you said you felt that you're going to surpass the 150 basis point guidance for this year. I see no reason why that couldn't be the case for the future years as well given the step-up in your interest margins even with the cost of risk normalization. So as that 150 was baked into your plan and you now expect to exceed that, what do you plan to do with the extra organic capital generation? Would you accelerate the pension contributions even further? Would you look at more RWA growth? Or is there a potential for even larger buybacks than you currently have plugged into your plan?

Yes. Yes. Thank you. Thanks for that, Andrew. On the first of the questions as to the overlay, it's worth saying that the provisioning assumptions as to COVID and the provisioning assumptions as to cost of living are not fungible. They're very much built up in and of their own justifications, separate pillars as it were. When we look at the coronavirus-related provisions there, as I said, we have 2 blocks, the GBP 400 million and the just shy of GBP 400 million blocks. And hopefully, the comments that I gave earlier on around the conditions to release the first of those are clear. In the great scheme of things, when you've only had an outbreak of coronavirus circa 8 weeks ago, looking at it in the context of the second quarter doesn't seem to be all be different to looking at it in the context of the first quarter. So we'll look at it as the year goes on. And as I say, in the great scheme of things, I'm not sure the timing difference is going to make a lot of difference to our capital ratios, to the business, to our stakeholders and so forth. But we will get to it and we'll look at it over the course of Q2, I'm sure. Secondly, on the cost of living adjustment, the inflation adjustments, what we've done there is to look closely at potential probability of defaults in some of the lower income segments in unsecured, number one; and number two, to look at some of the segments within our commercial book that are more affected by inflationary pressure, particularly input pressures. And so we've looked at those sectors that we lend to. And in each case, we've taken a view on how that might affect probability of default and then collected up provision as an inflation compensation, if you like, to compensate for that. Now that is based upon our economic forecast right now. And clearly, if inflation takes off in a bigger way than we currently forecast, if the economy deteriorates more than the current forecast, then we'll have to relook at those. But that overlay of circa GBP 100 million is consistent with the economic forecast that we have in place right now. It's also worth saying, Andrew, that it comes on top of an examination of the stress -- the extreme stress -- severe stress scenario at the end of last year, which was also conducted with an inflationary watch, if you like. And that contributed a GBP 60 million overlay for the severe ECL case or the severe scenario built into our ECL. So the total inflationary adjustments, therefore, are more like GBP 150 million or thereabouts as, again, [indiscernible] adjustments for the inflationary scenario. But again, to return to the point, they're not fungible versus the COVID. So if COVID runs off because of low level of infections and no new virus, then we'll look at that, and we'll consider whether or not we need to effectively release those provisions. Quite separately to that, we'll look at the economic environment including the potential asset quality repercussions of higher inflation, and we'll determine how much ECL we need to set aside for those conditions. For the second of your questions on capital generation, Andrew, I've made comments around the strength of capital generation in Q1. And as I said, we expect that to remain pretty strong for the remainder of this year. I think as we look beyond this year, there's clearly a long way to go, number one; there's clearly many uncertainties that are out there, number two. But the business remains relatively well positioned. And so we feel comfortable with the overall development and progress that is being seen in the business. Therefore, I wouldn't really want to go into too much speculation about what we might do with capital in the period thereafter. Safe to say that we feel comfortable with where the business is today, and I've given you an outlook for 2022.

Thank you. And ladies and gentlemen, as you know, this call is scheduled for 1 hour, and we have now reached the end of the allotted time. So this was the last question we have had time to take this morning. If you have any further questions, please contact the Lloyds Investor Relations team. And Mr. Chalmers, back to you for any closing remarks. Thank you.

Thank you, operator. Just to say thank you very much indeed to everybody for taking the time to listen. So thanks very much indeed, and have a good day.

This concludes the Lloyds Banking Group's 2022 Q1 Interim Management Statement Call. For those of you wishing to review this event information for the replay is available on the Lloyds Banking Group website. Thank you for participating.