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

Well, good morning, everybody, and thank you for joining us. And this is the first slot of the first day of the UBS European Conference in our new venue, and it's wonderful to see so many people in real life despite the various strikes that afflict the economy at the moment. So thank you so much for joining us. I'm Jason Napier. I run the European Banks, research team for the firm. And we're delighted to have William Chalmers, the CFO of Group Finance Director of Lloyds Banking Group with us today. William, thank you so much for joining us.

Pleasure. Thank you very much.

So the format for this is half an hour of fireside chat. I would greatly prefer to have your questions be asked rather than mine, but I do have a roster of things that I am interested in finding out about. So we'll come to you in a few moments to see what is on your mind. But William, if we might begin, the U.K. has had a tough time in the last little while. What we used to finally, refer to as the risk-free rate has been all over the place. And although gilt squeezes are back where they were before the mini budget, I think there's a lot of reticence on the part of international investors to look at the U.K. as a macroeconomically stable place. You're the biggest bank in the land. What are you seeing from your customers at the moment in terms of behavior?

Well, as you say, Jason, it's been a challenging couple of months, and I think that's felt by everybody to a great or lesser extent. And indeed, if you look at our macro forecast, which we put out in Q3, I mean, we're expecting things to get a little tougher going into 2023. Having said that, I think the consumers and the companies that we serve are generally proven to be pretty resilient actually and adapting quite well to the circumstances. Consumer spend as an example of that is up Q3 versus 2019. Debit cards up about 29%. Credit cards expenditures are up about 17%. And that's including in some fairly discretionary categories, so retail, restaurants, travel, that sort of stuff, which ultimately, if people are really squeezed, they can always pull back on. We've seen some decent early warning indicators within the business. I mean we track early warning indicators across the retail, commercial and insurance segments. And so far, at least they're very stable. So take a couple of examples credit card minimum payers, for example, very stable. Savings top-up stable. You saw some encouraging deposit flow during the course of Q3. And in commercial, invoice factor financing debtor days, again, very stable overdraft usage, RCF usage, that sort of thing, very stable, not indicating signs of stress amongst the customers. And the same could be said for insurance policy contributions, that sort of thing. So the Type 2 indicators that we monitor to show signs of stress if there are any are proving pretty resilient to the times that we're in. Now we've seen the observed credit charge for Q3 also be relatively modest in the context of overall history. So it's low and below pre-pandemic charges, at around GBP 250 million for the observed part of the credit charge. And so that, again, looks relatively stable and in line with kind of expectations from our perspective. Within that, we see some retail trends that are modest. So if you look at the observed credit charge for Q3 and compare that to Q2 or Q1, you'll see a tick up within there. And there's a little bit of unsecured arrears developing there. But actually, you will also see a tick-up that is somewhat overstated because Q1 and Q2 were enhanced by or benefited from debt sales and CRD IV releases. So actually, the uptick in Q3 is more modest than it might first appear. You look at the commercial charge and the commercial charge in Q3 is basically nothing. I think it was GBP 8 million. So negligible already. I think that is skewed by our customer base, and we have a customer base that is in the sort of probably slightly better off part of the demographic. We typically lend to customers in that demographic. And so our experience is a function of our customer base for sure. As we look forward, I think overall, therefore, it will get tougher for sure. But at the moment, at least, the consumers and companies that we're serving are resilient and adapting, Jason.

One of the things that, I guess, people might say in response to things like the acceleration in unsecured growth might be that the people who are borrowing and not the people with the cash surpluses and so on. You presumably have better insights than we do about income deciles and indebtedness levels. Is there a shaft difference in behavior amongst different groups by indebtedness or income level?

Yes. We look at that. When we look at the early warning indicators that I referred to earlier on, we segment them according to the customer base. We're not seeing terribly much differentiation between the upper end of the customer base and lower end of the customer base. Again, it's worth just reiterating the fact that as a general customer base is skewed to a slightly better off segments. We have a pretty broad demographic on the liability side of the balance sheet. We have a somewhat more skewed demographic on the asset side of the balance sheet. Simply because our approach to lending is kind of through the cycle, we tend to stress customers, that's true and a secured and also on the unsecured side. And so again, we're seeing probably a better quality of customer versus the economy average. But to answer to your question, Jason, are we seeing different behaviors amongst different segments within that customer base. Not so much, no. I mean you might look at subscription cancellations, for example, is a sign of customer stress. If you look at those for the lower income segments that we serve, they're not performing terribly differently to the upper income segments that we serve. Overall, I think your point is also right that the customers that are spending most, for example, those credit card and debit card statistics that I mentioned those generally are the better off customers. And so the credit card expenditures, for example, you can testify to that by the volume of repayments that you're getting within the credit card expenditures. So high spend levels, but equally high repayments from those customers, which means that the balances within credit cards are growing relatively modestly as a result. But the people who are spending money and also the people who are borrowing from us right now, not always, but typically within the slightly better off segments.

And having spent GBP 50 on a hamburger last night, I can certainly talk to inflation and so on.

Yes.

Barclays mentioned in their results that they are seeing similar prepayment rates ahead of normal across all income deciles, which is consistent with what you're saying. Notwithstanding that sort of defend behavior to date, you put aside quite a lot of loan loss reserving in Q3, on a more somber macro outlook. Could you talk about the assumptions that you incorporated and whether those are cautious enough? How you sort of calibrate that sort of thing.

Sure. Yes. The -- I mean, I guess the start point is that we feel that we are well provisioned, and we're pretty comfortable on asset quality. The approach that we took at Q3, we think is basically the approach that is mandated by IFRS 9. So we didn't try to necessarily do anything that was beyond the regular course of business from our perspective. The Q3 provision, as you know, was GBP 668 million in total. That was composed basically 3 components. One is the observed credit charge of GBP 250 million. I'll come back to that in a second. Two is what we call the multiple economic scenario charge, which is the charge for the forward-looking outlook within the economy, GBP 618 million. And then that was offset against GBP 200 million of COVID-related releases. Now the base case within that multiple economic charge, i.e., as we look forward, the outlook, if you like, the base case, we believe, is a pretty prudent base case. So we've got recession forecast in for 2023, last about a year, we've got about 5.5% unemployment. We've got about a 10% HPI peak to trough fall within that base case. So overall, we think some pretty prudent assumptions. But then the ECL, expected credit loss is actually built up not just on the base case, but also a 30% weighting to the downside case, and a 10% weight into the severe down type case. That's the methodology. And the severe downside case for which we take a 10% weighting is really pretty severe. So there, we're looking at a GDP contraction of 4.5%. We're looking at HPI reduction peak to trough of over 45% over the forecast period. And we're looking at about 10.5% unemployment. So really pretty severe downside from which we take 10% weighting. What all of that means is the expected credit loss on the balance sheet right now, in fact, the provision that is taken against the top-up loans is now running at about GBP 5 billion, just over GBP 5 billion. Our base case expected credit loss, i.e., the provisions that we would expect to take for that top-up loans if our base case plays out is more like GBP 4.3 billion. So there's a GBP 700 million buffer between what we expect to need in the context of our base case versus what we've got provisioned on the balance sheet right now by virtue of our methodology. So we think we're pretty well provisioned, and that's leading to decent coverage levels and so forth. Now all of that, as you know, Jason, is on what we would describe as a low-risk book. So our mortgage LTV on average, for example, is 40.3%. And again, testimony to that low risk is the performance and the observed credit charge that we're seeing to date. If things get worse, we believe that we're pretty adequately provisioned against them. One could take a look at the downside case that we have within our ECL. It's in the back of our Q3 disclosures. If that were to materialize, it would result in about a GBP 5.5 billion ECL. That's about GBP 500 million on top of where we are today. But again, it's a pretty tough downside. You're looking there at about 2.3% GDP contraction, you're looking there at unemployment of about 7.5%. You're looking there at HPI, peak to trough of about 30%. So it's quite a tough downside. And again, gives us a sense of confidence in our overall provisioning position.

No, no. In my imaginings anyway, the modeling appears probably a lot more straightforward in retail. Collateral coverage in resi, small but very many exposures in cards. How do you get your mind around risk managing the corporate component of that reserve build?

Yes, yes. It's, the corporate component is a combination of modeled outputs and also judgment outputs, if you like. And so you'll see those again disclosed typically at the full year and half year. We take a very granular look at the overall corporate portfolio to make sure that we are adequately provisioned. And overall, the performance over the last 2 or 3 years has been really very benign, and that's gone right way through to Q3, where, as I said before, we've got about an GBP 8 million corporate charge, which is de minimis. But that is -- one shouldn't mistake that the modesty of that corporate charge, if you like, for a lack of granularity of the analysis. It's simply that we're not seeing corporates behavior, if you like, reflecting the tougher times, that as I said, we, to an extent, forecast going forward. But so far, it's a very strongly performing book. Now that is after a number of years of de-risking across the book. As you know, the size of the Lloyds' commercial book has gone down significantly over the last 10 years. And as it stands today, 70% of our large corporate exposure, for example, is investment grade. It's a very highly secured book. On average, we've got about 39% loan-to-value ratio within the commercial real estate book and so forth. So it's very highly secured. It's typically to investment-grade large corporates. The performance has been very benign to the extent we think that's going to deteriorate in line with our base case and the methodology around the ECL, we've got that embedded in our provisions. But to date, at least, it's been very solid.

So we've spent quite a lot of time talking about reasons why people might not own banks right now, notwithstanding the provisioning levels. The principal reason for being involved aside from valuation is revenue momentum, right. The guidance for net interest margin for this year implies a fourth quarter exit -- well, fourth quarter average was 14 basis points above what used to be consensus for next year. I wonder whether you could talk to the extent to which the trends we observe in history are almost locked in given what's happened to rates markets, and we'll talk a little bit about the hedge in a second.

Sure. Sure. Yes, maybe just to give a bit of history and cost on that, Jason. I think first of all, we are positively geared to rates, and you've seen that, obviously, over the course of this year. We saw our Q3 net interest margin of 2.98%. That was significantly up on Q2, as you know, which was 2.87%. That combination gave us confidence to increase guidance for full year to greater than 2.90%. So that's where the guidance is. And as your question suggests, really, Jason, if you work out the arithmetic of that, it kind of suggests that Q4 margin is likely to be ahead of the Q3 margin. So that's the trajectory as we go into the back end of this year. What's going on behind that, it's a bunch of different things. So number one, it's obviously the base rate changes themselves. Number two, the pass on decisions associated with those base rate changes and the effect that they have, and then the redeployment of the hedge into a more favorable interest rate environment. And we're seeing that as it reprices, it benefits the interest margin. So those are the factors that are going on as tailwinds. And together, they more than outweigh the headwinds, predominantly from mortgage margins, right? So that's the overall guidance for remainder of this year, greater than GBP 290 million, which again implies a decent run rate going into Q4. And that is after having taken account of the writing of quite a bit of mortgage volume pretty compressed spreads at the back end of September when we had the gilt squeeze. And that will play through into completion margins for Q4 for our mortgage margins. But at that point, notwithstanding greater than 2.90% is the guidance for the margin. I think as we look forward, we continue to expect the margin to be solid looking forward. Now what does that mean? When we look for as a bunch of headwinds and tailwinds that I've just described, which kind of evolved. So looking at each of those, for example, we see the full year effect of the bank base rate coming into play next year. But on the other hand, don't forget that probably by that time, most of the bank base rate changes that we will have seen will be in the rearview mirror as such. When we look forward, we see the hedge getting redeployed into more favorable interest rate environments. But I said, mentioned the other day that the hedge balance overall is slightly back-end loaded during the course of 2023. So a factor that take into account. And then finally, pass on, we'll be moving, I suspect, as rates get higher into pass-on environment that gets closer to the 50% that we've used in our illustrative assumptions. So those are the kind of factors and how they might evolve. And then against that, you've also got the mortgage margin coming in greater volume as the mortgage asset starts to refinance into those lower margin environment. And added to that, a bit more quantum in a slightly more costly environment for wholesale funding within the balance sheet. So these are the kind of factors that will affect the margin. As I said, I expect it to be pretty solid over the course of 2023 and beyond. We'll give guidance on that at the year-end as we normally do. And today, we're not giving guidance as such, but hopefully just giving some helpful illustrations. What does it depend upon? Again, the bank base rate changes, the pass-on environment the development of curbs and, of course, mortgage margins. All of these things are going to affect how we evolved into '24, '23.

Now the sector as a whole has now built a hedge that's 6/7 of the size of the mortgage book in the industry. And so if the mortgage book has 150 basis points of spread over swaps and the hedge is being rolled at 300 basis points more than the existing rate, it would appear that there is a lot of potential for mortgage yields perhaps to come down a little bit as swaps have come down and as liabilities reprice, certainly think there'll be some in the audience who might prefer that to be the case when the mortgages come to reset. But it does feel like the NIM picture is quite well defended even if rates fall as is in your central scenario. And I wonder whether -- can we be categorical and say that the NIM doesn't retrace as quickly as it went up in the event that rates start to fall as you forecast?

Yes. I mean, as you say, the structural hedge will be at a component of that. When we look at the structural hedge, we've got about GBP 250 billion size of hedge, as you know. We've also got a GBP 31 billion buffer against that hedge. We'll look closely at how deposits behave going forward, but it may be that there's room to deploy a bit more of that buffer into the hedge as we look forward, which will be helpful. The effect of that hedge as it rolls over from the current yield, which is a shade over 1% into the yields that we have today, which, of course, are significantly ahead of that will be quite a tailwind for the overall net interest margin within the book. And that will be helpful. We'll be looking to get that locked into the hedge over the course of the future years. But the extent to which we're able to lock it in at current rates will obviously depend on the maturity profile. Got a weighted average life of 3.5 years. We clearly have chunks. I think I talked about GBP 35 billion or so going into next year. That's on top of about GBP 3 billion of maturities a tailwind of this year, so GBP 38 billion in total. But as I said, next year's profile is a bit back-end loaded in terms of the redeployment of that piece. Overall, I think, Jason, when you step back, we would expect the margin to be pretty resilient over the course of '23 and potentially beyond. And a lot of that has to do with, as you say, redeployment of the hedge into the environment that we expect to see. I just don't want people to lose sight of I guess the mortgage refinancing issue, which is coming down the pipes. I mentioned the other day that we've got about GBP 60 billion over the course of the next 12 months within mortgage refinancing. It's coming off at typically around 1.7% thereabouts. It's going on at around 60 basis points in the current market thereabouts. So how that mortgage margin evolves going into '23 is going to be an important determinant of the margin going forward. And then there are one or two other things going on, which I don't want to kind of overdramatize but they're there. So for example, wholesale funding cost is going up a little bit. We and the rest of the market have to refinance things like TFSME going into '25, '26, and we'll be looking to forward or front-load some of that. And so slightly higher wholesale volumes, slightly higher cost to refinance into. But again, the underlying point is I'd expect the NIM to be pretty resilient off the back of that.

Okay. Are there any questions in the audience? Okay. Well, another one for me.

Sure.

At the end of the third quarter, you had a 15% CET1 ratio, which is about 11% of market cap above what you say you need, you provisioned on a more cautious set of assumptions than some of the peer group perhaps. Without prejudging what the Board may or may not want to do at the fourth quarter, you've paid down to 14% before. Would there be any reason to suggest that the macro conditions make that impossible to do?

Well, I guess just to start off where you started as such, Jason, it's a strong capital position for sure. We've generated about 191 basis points of capital so far this year. That led us to increase our guidance at Q3, as you saw the full year, 225 to 250 basis points of capital. And I expect in that context, Q4 to continue to be pretty productive from a capital point of view, just as Q3 was, which is around a 52 basis point margin. So that will carry on more or less inspired by the same things in Q4. What's going on there? I think a couple of things. One is, it's a strong business model in a time of rising rates. So I think it's a testimony to the strength of the business model, and we're obviously helped by the rising rate environment. There's also a few one-off bits and pieces going on. So the insurance contribution, I think I've mentioned before, has been a big contributor in the context of rising rates this year. That's been helpful. The ECL provision that we took at Q3, the MES part, the outlook part at least, was underpinned by IFRS 9 transitional adjustments. And so the capital impact of that outlook charge was not as great as it might otherwise be. And then finally, we've had a slightly lower effective tax rate than we would normally have, but nonetheless, put all that to one side, it's through a very robust and strong capital performance during the year. That's led us to a Q3 cap ratio of 15%, as you say, that's about 1.5% above what our targets would be. And I think that will lend itself to a cushion around excess capital at the end of the year. It's worth saying that it's on top of, as you know, Jason, 20% growth in our dividend, which is all accrued into the numbers. And that 15%, if you like, is after that, those accruals at least up until the third quarter. And that's in line with our progressive and sustainable dividend policy. So in addition to that 20% dividend growth, I would still expect there to be a decent discussion around excess capital at the end of the year with the Board. You raised the question rightly, Jason, about where might we have the confidence to take the capital level down to. It's an uncertain environment out there, for sure. Geopolitics, macro regulatory to an extent. We still have the ACS to play out in the remainder of this year. But I think we faced into quite a lot of those uncertainties. At the year-end of 2021, not identical, but nonetheless, it was not a particularly certain environment at that point that led us to a conclusion to distribute down to 14% at that point and to leave a cushion of 50 basis points between 14% and our target of 13.5%. Now you might say, well, since then, the macro has deteriorated and indeed, our Q3 forecast would support that. But on the other hand, we've provisioned against it. That's what the charge of Q3 was taken for, at least on a base basis. And so when we look forward, as ever, it's going to be a question for the Board at the end of the year, it always is and it should be. And they'll take into account the macro, the regulatory, the business outlook and all of these sort of things. But I think we start from a strong capital position, Jason, and that is a good start point.

Yes. And certainly on guidance, you should add 2% or 3% of market cap in fourth quarter capital generation to the third quarter position. Will the Board know what's going on with pension deficit resolution, the triennial review at that point? That should be in better shape than it was last year.

It should be, yes. And largely, the question, the answer to your question is yes. The deficit position, we've taken some big steps forward, I think, in terms of sorting out the deficit over the last 2 or 3 years. As you remember, we had at the end of 2019 a deficit of GBP 7.3 billion. Now since then, we paid GBP 1 billion in 2020 and contributions GBP 1 billion in 2021 in contributions, GBP 2 billion in fixed and variable contributions in '22. So that's kind of GBP 4 billion right there off of that GBP 7.3 billion deficit. On top of that, we've had decent asset performance in the last 3 years. We have benefited from the rising rate environments that we've seen. Now we're a little bit exposed to inflation. But on the other hand, we have caps in terms of how much we pay pension is in an inflation environment. So that kind of mitigates that issue. And then I think on the back of the recent gilts volatility, it's affected both the asset and the liability side as it has with all pension funds, but we've emerged as a, I would say, a modest beneficiary from that period of volatility. So when we call it now, Jason, we're working on the numbers. My expectation at the moment, based on what we can see is that deficit will have fallen to around GBP 2 million to GBP 2.5 billion in that zone. Now that number is to be determined to be clear, is being worked on right now. But that would be my, where my expectation is. That will be known and understood by the Board. And I think it should give us confidence to go into a good discussion with the trustees at the end of the year and together figure out what the future contribution schedule should look like. So a lot of progress, I think, in that area.

Thank you. And that neatly brings us to time. So William, thank you so much for joining us today.

Pleasure.

Thank you, everyone, for coming.

Pleasure, thank you.