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

[Audio Gap] Now in fact, when the energy regulator put out the numbers before the Truss intervention, they recommended a rise of GBP 3,500 for the average household. And what the Truss intervention did was to bring that back to GBP 2,500 for the household. So actually a level below what we've been assuming at the half, which is clearly a benign development now. Second point, consumer spend, I think most likely, the Truss intervention boosts confidence, potentially boosts spend levels versus what they would have otherwise have been and in turn, is overall supportive to economic activities in general. And then we look at interest rates. It's interesting how the Truss support measure is going to have quite a significant effect upon inflationary expectations. So it will take somewhere between 4% to 5% off of inflation measures. That, in turn, I think, may reduce a little bit of the wage pressure in the economy, which may have a bearing on the overall course of interest rates. Of course, medium-term interest rates may be what they will be, but on the other hand, perhaps a little pressure taken off the near-term interest rates. And then finally, unemployment. I think versus where we might have been, there's no doubt that the Truss intervention is going to reduce unemployment. And in that context, you add all that together, and it's a more supportive macro outlook. It's a more supportive impairment outlook from our perspective and so overall, a positive development.

Yes. I guess, a really remarkable feature of results. But every time you speak to a bank or a company at the moment and very much in keeping with the messaging so far is a really quite relaxed stance on the asset quality outlook, which is remarkable given the degree of macro uncertainty out there. I guess when you're looking at the risk in your book, are there specific areas that you're most closely monitoring?

Well, I mean, I think the concern is understandable in terms of the macro developments. But I think when we look at the customer base, it's pretty resilient. So we see a buildup of deposits during the course of the pandemic, as you know, almost GBP 70 billion, and that gives significant cushions to customers. We've also seen interest in deleveraging. As you know, our cards book is now still 20% below where it was pre-pandemic. And that's across all risk classes. It's not just the better off paying down unsecured balances. It's really across the better off and the worse off paying down balances. So a delevered, unsecured portfolio. Unemployment remains low. We forecast about 4.2%, 4.3% at the half. I think now with the Truss intervention, we're not going to be 1 million miles from that when we look at it again in Q3. And then government support, as said, supports confidence, supports ability to pay, and that's supported by the customer behavior that I mentioned earlier on. To answer your question, where do we look across the book. Well, we look at kind of all areas, clearly, but we feel relatively comfortable as we look at them. So mortgages, for example, average LTV of 40%. Customer income in the average in mortgages, GBP 75,000. We look at CRE, for example, average security there around 63x -- 63% rather. We look at SME, 90% secured. We look at large corporate, 70% investment grade. So overall, we look across the book, and we feel very comfortable with the risk that we've taken on. And I think it's primarily because as I said, we apply stresses at the point of origination, consider ourselves to be a through-the-cycle lender. So far, at least, that has been borne out by a remarkably consistent and benign credit experience. Inevitably, things may get tougher as we go forward, but we feel pretty well positioned for that.

Yes. Is it possible to close that door at the back? I think there's a bit of sound coming in. So everyone in the room as well, we do have audience response survey questions that I think we will do. The remote that's on your table, you can use them to reply to the number that comes up on the screen. If it's all right, I might start with the first question. We can kind of pepper them throughout the session. Are you able to bring up question one? Okay, cool. So what would cause you to become more positive on Lloyds' shares? Number one, positive revenue surprises; two, greater cost savings; three, better asset quality; four, stronger capital, higher dividends; five, clarity on U.K. macro. Yes, if you just take a moment to reply using the remote. [Voting]

Okay. That's a really emphatic response there.

Yes. Well, maybe not too surprising.

I mean kind of speaks for itself. I don't know if you've got a particular comment.

Yes. It is very interesting. I think it endorses some of the questions that you've just been going through actually, Aman, and perhaps -- well, hopefully, some of the responses that we've given. It has been a somewhat unclear backdrop. Political uncertainty has been higher than it normally is. I think that perhaps with the developments of last week, the outlook has some clarity lent to it. I think we have to see how it plays out. But nonetheless, hopefully, we're heading in a better direction.

Okay. Let's take a more positive tone. Turning to the income outlook, interest rates. You're enjoying a very significant tailwind from rising interest rates. It's allowed you to significantly lift your earnings expectations for the year but driven by a better income outlook. But actually, what's interesting since the Q2 update that you've given, the interest rate outlook has actually improved meaningfully. U.K. base rate is expected to be probably 150 basis points higher than what the market was looking for. And I know your guidance was cast at a lower interest rate assumption. I mean how -- can you talk us through the income outlook? And I guess, really what I'm interested in is is there any upside potential [ I'm sure ] that you could flag?

Yes. Yes. It is -- the rate developments have been pretty profound as everybody in the audience would have seen, and you've clearly commented on that. It is causing a very significant impact in terms of our P&L, and we think that will persist not just in 2022 but indeed in the years beyond. So at the half year, as you say, we pointed to greater than 280 in terms of the net interest margin, and we upped our RoTE target to circa 13%. Since then, as you point out, the base rate expectations for year-end have measurably increased. We thought it's going to be 2% at the half year. Likelihood is now that it's significantly above that. So have yield curves. So we thought the yield curve was based off of around 2.35% as of the half year. It's now sitting about 3.5%. And so that's a 5-year swap basis. So again, significant movements in base and in yield curve. When we look at that from a revenue point of view, 4 main drivers contribute to that income effect. So the base rate changes, pass on, volume effect upon the deposit base and then finally, the structural hedge. Now just talking through each of those, the base rate changes have allowed us to restore the liability margin back to something that is much more normal versus what it was in a 0 rate environment. As said, the base rate assumption that we had at the half year was 2%. It's going to be above that most likely. The pass on. It's an area which has received much attention and perhaps we'll talk more about it. But so far, at least, we've been passing on between 20% to 30% of the base rate changes. That is measurably below our planning assumptions, which are in excess of 50%. So again, that's a source of further upside. And if we see more base rate changes where we continue to pass on less than our planning assumptions, to your point, Aman, that's a source of upside, if you like. Volumes, deposit flows in the first half continue to be robust. We had about GBP 1.9 billion increases in deposits in the first half of the back of circa just shy of GBP 70 billion since the end of 2019. So that's the deposit base against we can leverage the base rate and the pass on is increasing. And then finally, hedge. The hedge is being deployed at clearly much more attractive rates as we go into the current environment. And there are significant sums to do so. So the maturities in the second half of this year, for example, circa GBP 13 billion; maturities next year, circa GBP 35 billion; and then it increases in the years thereafter. And we're actively deploying the hedge into those more attractive yields as we look forward. Now there are some developments that are not entirely in our favor. So for example, the movement in swap curve compresses mortgage spreads. And that's been a factor, and everybody will be familiar with the fact there's been quite a lot of volatility in mortgage spreads this year. But having said that, you step back and you take all of that and around, and this is a very clear and a very material upwards impact to our earnings assumptions, and in turn, it's one that will persist beyond '22 and into '23 and '24.

Yes. Yes. I guess, I mean, you've touched on a lot of points there. If I were to just drill into deposit pass-through, deposit betas as we like to refer to them, it's dramatically increasing your deposit income. You'd argue a normalization in the condition. That obviously reflects a benign deposit environment, in part because of excess liquidity in the system, but the strength of your deposit franchise, we're seeing it in real time. But the deposit betas are lower than what you planned for and they look to be nudging higher. I guess, what's your take on deposit betas? Can they remain relatively low? Can they remain a material tailwind for the NIM?

Yes, it's an important area, and it receives a lot of discussion internally as well as, I know, a lot of attention externally. When we look at the pass on, we determine what we're going to do based upon 3 main inputs really. One is customer value, clearly. At the end of the day, the success of the business rests upon the strength of the franchise. Price is an important determinant of that, but clearly, it's not the only determinant and other factors like service and so forth are important. But delivering customer value is clearly very important. Secondly, what are the competitors doing? How do we position ourselves versus the competitors? And the remarkable point there, I think, is just how bunched up this has been over the course of 2022. And so the competition has typically passed on 20% to 30% of base rate changes. We're well in that pack. But it is quite striking how the competition has basically stayed in that vein. And then finally, funding. As you'll be aware, the loan-to-deposit ratio of the business right now is about 95%. That indicates a very liquid balance sheet off the back of various different factors over the last few years. And so of the 3 constraints, funding is probably the least constraining of them. What all of that has meant is that of the 165 basis points or so of base rate changes, as I said, we passed on between 20% to 30% so far. Now clearly, as rates rise, we are more attuned, if you like, to ensure that we offer customer value as we seek to and as we achieve the restoration of the liability margin. And so therefore, I would expect that as rates rise, we will steadily pass on more than we have seen so far. If you look at the most recent base rate rise in August of 50 basis points, we passed on 20 of those basis points to customers, which is about 40%. So you can see it's starting to tick up. And I think as we see base rate rises for the remainder of this year, we'll be actually around those types of levels, which is a bit of an increase from where we were in the first half, but on the other hand, is still significantly below our planning assumptions of, as said, in excess of 50%. So all of that adds up to the pass-on decisions delivering against those 3 constraints, but again, achieving favorable outcomes from an income perspective for the business on the basis of the planning assumptions being higher than the pass on. One final point. If you would like to get a metric that is kind of a indicative insight to this, you've seen our sensitivities at the half year, I'm sure, which is basically saying for every 10 percentage points below our planning assumptions, we're seeing about GBP 50 million increase in income for a given 25 basis point rise in the yield curve based rate.

10% lower deposit beta.

Yes.

Yes. I mean you did also mention -- you referred to this, maybe I'll combine these 2 points together, but the structural hedge, something that we really like to analyze on the sell side because, I guess, you can.

Why not?

That balance is -- the books are yielding about 1%, not far off, being reinvested some 200 to 300 basis points higher based on where it is. I mean, it does look like it's a pretty meaningful, compounding tailwind to net interest income going forward. I mean is there anything you can add to your expectations in terms of the quantum path?

Yes. Yes. No, it's an important part of our P&L. It's an important part of the way in which we manage the business for value and also earnings stability as well. That's the other factor that's worth bearing in mind. The structural hedge right now is circa GBP 250 billion. We have increased it by about GBP 65 billion since the beginning of the pandemic, since the end of 2019. That's been funded partly by the inflow of deposits that I mentioned earlier on. It's also being funded by better management of existing deposits that we had on the balance sheet. And in addition, it's been funded by the evolution and maturity of some of the buffers that we had at the back end of 2019 as they have shown their persistency over time. As you say, Aman, that structural hedge is deployed on various terms through the yield curve, but on average, it's yielding about 1%, which means that as we redeploy it, we are, as you say, redeploying it at much more favorable rates based on the yield curve right now. And we're doing so in size. So I mentioned earlier on, maturities of GBP 13 billion in the second half, GBP 35 billion and going up in years thereafter. So these are quite sizable deployments. You add all of that together, and we're looking at about a GBP 400 million tailwind in '22 versus '21 from the structural hedge. We're looking about a GBP 500 million tailwind in '23 versus '22 from the structural hedge. Now all of that is based upon existing forward curves and assumptions around that clearly. But one of the objectives that we have is to steadily derisk that earnings profile as we deploy the structural hedge into the curve as it stands today. Just a word on guidance there is that our guidance of greater than 280 at H1 on the net interest margin was predicated upon curves at that time. And I think as you indicated earlier on, we've since seen the 5-year swap curve increase by about 100 basis points since that half year intervention. So we're hopeful that over time, the structural hedge will build into that more favorable curve environment and deliver it further upside.

I mean the income environment does seem to be a constructive one, and we can see the drivers. The one potential offset, the one that you referred to was mortgage margins. I guess swap rates have been moving around a lot. That's what -- that's the reference rate that we referred to when we're thinking about mortgage margins. Swap rates have been very volatile, but it does look like the system has increased mortgage pricing quite a lot over the last few weeks and months. We like to track your mortgage pricing quite closely. When we look, we think you're probably operating ahead of your 75 to 100 basis points guidance range. Please do tell us if you disagree with that.

Sure. I'd be happy to comment on that.

I mean that is remarkable given that we were some way below that probably at the end of Q1. I guess, is this sustainable, this operating environment for mortgage margins? Is this a reintroduction of the risk premium and asset pricing? Or can we expect competition just to reemerge and [ wait ]?

Yes. It's a good question. I'll make one more comment actually on other facets of the income strength before coming to the mortgage margin, if I could. We talked a lot about rates, quite rightly because that has been the singular development in the first half that's made the most different. There are 1 or 2 other streams to the income development. Other income, for example, is pretty much steady as she goes. You've seen some patterns that we saw in Q1 and then again in Q2. It is playing out more or less in the ways that we would expect. We've also seen, I think, beneficially some compression in operating lease depreciation off the back of a stronger car market. That is an important part of our financing business. And indeed, it's been another favorable factor in the overall income performance. So I just mentioned those 2 for the sake of completeness, clearly lesser factors but nonetheless relevant. Mortgage pricing is, as you say, been a subject of great interest and significant volatility over the course of the year. In fact, maybe to express it more precisely, mortgage pricing has been an upward trajectory through the course of the first half. But mortgage spreads have been very volatile within that, and that is clearly a distinguishing feature. We put forward in February a strategic plan that was predicated upon a mortgage spread assumption of 75 to 100 basis points. We then saw, principally because of swap curve moves, a completion and application margin environment that was more like 60 basis points during the course of the first half. And so when we then gave our guidance at the end of the first half, we adjusted down to those levels, and we based that guidance of greater than 280 on that 60 basis points that we had achieved during the first half, better to mark-to-market, if you like. Now then what happened during the course of July and August is that actually spreads went up significantly more than we had expected. So they ended up, to your point, Aman, operating in the kind of 80 to 100 basis point spread environment, better than our assumptions in fact. And then, of course, as a further twist, we had a sharp rally in swaps at the end of August, beginning of September, which then brought spreads down again to quite compressed levels. Now what's important is where are we today and what happens looking forward. It's very interesting to see the significant price moves of all of our competition and us in the mortgage market right now. And when we look back -- or rather when we consider where that might end up, we look back at the experience over the course of the summer as a reference point. And so over the course of the summer, as I said, we got into the sort of 75 to 100 planning range that we had previously seen, it may be that, that is indeed where we end up as a result of price changes now. But I think we must -- we have to wait for a period of swap stability to see where that actually lands, with the expectation that it's not unrealistic to expect a return to the 75 to 100 basis points because that's what we saw during the summer. Now it might be that lower volumes start to cause a bit more competition, which, in turn, erodes spreads from there maybe. But equally, it's just as likely that I think concerns about the macro environment and risk-based pricing starts to support spreads. So I think you could see it going either way. But again, we look back at the summer as a data point, a relevant data point about where the market feels comfortable with sustainable mortgage spreads. So that's kind of hopefully a bit of helpful insight, Aman.

Yes. No, absolutely. I'm going to insert a couple of more ARS questions here, if we may. Can we go to question 2? What do you expect to be the biggest influence on Lloyds' revenues in the coming 12 months? One, loan growth; two, pricing; three, policy rates; four, fees and commissions. [Voting]

I've got a feeling [ where it might come out ], Aman, but let's see.

[indiscernible]

[indiscernible] if that's what I guessed or not, but...

I think again, that speaks for itself, doesn't it? No, I think it does.

I mean I think it's fair to say that interest rates are a very significant exogenous impact upon our revenues. But I think it's also fair to say that there are some levers under our control that we hope to augment that with.

Can we do question 3? If we can take question 3 and 4, that would be great. How do you think about Lloyds' cost development versus expectations? Likely to beat expectations thanks to cost savings; likely to meet; likely to miss expectations due to cost inflation; four, not sure, but I want to see more cost savings. [Voting]

I think that's interesting.

Well, I think to comment briefly on that, as we look at 2022, we committed to GBP 8.8 billion, and that is what we'll deliver.

Yes. I mean you guys have got a strong track record on costs. Perhaps it reflects just the inflationary environment, which feels pretty uncertain. Can we go to the next question? Okay. How do you see Lloyds' position on capital and dividends? One, upside risk from better earnings; two, upside risk from falling requirements; three, downside risk from weaker earnings; four, downside risk from rising regulatory requirements. [Voting]

Upside risk from earnings. I mean actually, before I maybe let you comment on that, I think I had a question on capital that I thought I'd like to run by you. Perhaps you can address the results of that as part of it. Another notable feature of your Q2 results is your strong capital position, pro forma CET1 ratio of 14.8%, well ahead of your target level of around 13.5%. You've lifted your capital generation guidance for 2022 to greater than 200 basis points, emphasis on greater than. There does seem to be pretty scope for substantial distribution potential perhaps with full year '22 results. I mean can you fill us in there? And could we see you repeat or even exceed the GBP 2 billion buyback that you announced in February?

Yes, it's a good question. And I'll, in a sense, start with where I intend to finish, which is that we do expect the capital position to be strong, and we do remain very committed to distribution of excess capital. But to your point, Aman, at the half year, 14.8% CET1 ratio after dividend [ accruals to that date ] is a strong position. As you know, we also increased the dividend at the half by 20%, which is a fair signal of where we expect to be at the end of the year for the dividend components at least. The half 1 capital generation was 139 basis points, which is a strong delivery by any measure. When we look at half 2, we mentioned for the full year, greater than 200 basis points. You rightly said, Aman, the greater than is an important part of that statement. I mentioned that at the half, and it's still true as we sit here today. It will be significantly greater than. Underneath that, second half underlying banking contribution will be strong. We'll see potentially a little bit less boost from RWAs that we saw during the course of the first half. We won't have the Embark consolidation. And the insurance component of the dividend will be interesting because it is clearly partly interest rate dependent. So we'll see how we get on with the insurance [ dividend ]. We expect some question mark will be whether it's as high as what we saw in the first half for that component of it. But overall, as said, significant capital performance during the year as a whole, and that continues into H2. It's important to make a couple of comments here. One is that that performance, that capital strength is not at the expense of future years. So when we look at the average 150 that we talked about back in February, that was before some of the income developments that we've been talking about this morning. So bear that in mind, this is a strong performance, which we expect to persist, with puts and takes, clearly, but nonetheless, persist as a generic theme during the course of future years ahead. Our target is also the same, the second point that is worth making, which is to say that if we do have regulatory change, as indicated in the Q&A just there, the target is significantly ahead of current regulatory requirements. So to put some numbers on that, the target is at 13.5%. Current regulatory requirements are 11%. That's a gap that allows us to absorb things like the countercyclical buffer, for example, which is expected to increase during the course of this year. So there's a bit of room within the target to address these things. Ultimately, Aman, to your question, the capital distribution, as ever, is going to be a question for the Board at the end of the year. They'll take a look at the outlook. They'll take a look clearly at the capital position. They'll take a look at the regulatory outlook as part of that. But overall, again, to kind of finish where I started, I guess, we do expect the capital position to be strong. We do remain very committed to repatriating any excess capital that we don't need in the business. And that will lead, I'm sure, to announcements around the dividend, announcements about surplus capital distribution at the right time.

Okay. Great. I'm also going to open the floor up at some point. If anyone would like to ask a question, we do have some microphones that are dotted around the room. We actually do have a question there. Could we pass the mic?

I'm just curious about something regarding the European energy crisis. Have you seen any activity from clients stopping their lines more because of the prices in Europe?

No, in short, not so far. When we look at the commercial business, the areas where we might see that are around things like overdraft facilities or alternatively revolving credit facilities, drawdowns in liquidity in its various product forms. So far, that has remained remarkably stable. We look at data over the course of the last year, we look at it over the course of the last 3 months, there's no particularly discernible pattern. We put out some numbers just to testify to that at the half year in one of the slides, and the update on that really during July and August is much the same now as it was then. Having said that, you'll be aware that our strategy is very much focused on the U.K., and we basically serve U.K. clients right away from retail up to large corporate. And so when I make these comments, it's really for the U.K. customer base that we are serving. There is clearly some international European and U.S. exposure within that business, but it is predominantly U.K. focus. And as I said, at the moment, it appears very stable.

While we let people think of more questions, we might do the final couple of ARS, and then we'll come back to a question here. What are you most concerned about at Lloyds in the current macro environment? One, weaker revenue; two, cost inflation; three, deteriorating asset quality; four, capital; five, none of the above, expect Lloyds to be resilient. [Voting]

It's a pretty darn big question. Deteriorating asset quality. I think that's pretty consistent with our conversations.

Yes. I mean as I said on that, we -- when we look at it, we look at current behavior, we look at early warning indicators, we look at the resilience of the underlying asset. And I've made comments on each of those points earlier on in the conversation, so I won't repeat them, but we feel very comfortable.

I think that's the end of the ARS questions. I think there was a question on the row there.

Just 2 questions. Does the movement in the mortgage margins, the volatility of it create any effect on actual mortgage demand, or mortgage originations on top of the macro factors you just discussed? And then two, just more broadly on the commercial side again. Outside of drawing down on liquidity for energy crisis-related events, is there good organic momentum in the commercial loan originations?

Yes. Thank you for those questions. In terms of spread developments, I think there's less spread developments that are driving mortgage demand and more rate developments really, allied to, to a degree at least, the overall trend in rates being upwards in turn is exerting some pressure on volume. So if we -- just pulling that apart slightly, what we see within spreads is that spreads can go up and down at any given moment, but it doesn't terribly much change the overall customer demand picture. But on the other hand, if you put that in the context of a rising rate environment, then what you see is essentially 2 things going on. One is customers tend to rush to fixing rates at that point. And we're certainly seeing some evidence of that, in particular, August was an especially heavy month from that perspective. And the duration of those fixes tend to go longer. So we've seen a significant rebalancing away from 2-year fixed into 5-year fixes, which I think is in common with the sector, but that's certainly a trend. So then, I think, a factor which we have yet to see play out, but I think we're beginning to see the start of it, which is to say, as rates get higher, it starts to reduce or put pressure on the overall home moving and indeed new buyer market. And so the overall volumes of mortgages in that context starts to go down a little bit, which means that you get a gross versus net distinction within the mortgage market. Very strong gross volumes, slightly more muted net volumes. And I would expect that to be the pattern that we'll see over the course of the second half of this year. On commercial, there it's an interesting pattern actually. I think the overall point that I would make is that corporates and SME are currently and are likely to remain for the near term pretty liquid. That is to say, the liquidity that was secured during the pandemic, the storage of deposits, which were part of that almost GBP 70 billion that I mentioned earlier on in my comments, that has contributed to a very liquid and kind of cash-rich balance sheets across the SME and large corporate world. So the degree of new loan origination reflects that, I think. Having said that, we do see pockets of activity within that. And those pockets, I think, are probably generic in the sense that they're market-wide, maybe some of them are affecting some of the particular initiatives that we embark upon. And so we've been trying to grow in certain areas of the large corporate business, which SPG is one example, which has tended to lend itself to periods of activity and loan demand in the context of those particular activities. And as a result, you see that coming through in terms of the large corporate balances that we report. But as I said, those are particular in their nature and allied to areas of activity that we see. The overall picture, as I said, I think, is of corporate demand reflecting the liquid state of their balance sheets.

Okay. Perfect. We are just about on time. So thank you, everyone, for joining us. Thank you very much, William, for having us -- well, having our questions. Thank you very much, everyone. We'll bring this session to a close. We shortly have HSBC next. Thank you.

Thank you very much.