OSB Group Plc (OSB) Earnings Call Transcript & Summary

Good morning, and welcome to the OSB Group Plc 2023 Interim Results. My name is Gwen and I'll be the operator for today's call. [Operator Instructions] I would now like to turn the conference call over to our host, Andy Golding, CEO of OSB Group. Please go ahead.

Thank you. Good morning, everybody, and thank you for attending the OSB Group's 2023 half year results. It's good to get back to an in-person meeting and good to see a number of familiar faces in the room. Firstly, I am truly sorry that this reporting period is impacted by the recent announcement we made regarding the impact of changing customer behavior in our Precise Mortgages book on the EIR accounting and consequently, the adverse adjustment we had to book in the first 6 months. This has, of course, reduced our financial KPIs in the period. And whilst we are here to provide any further color that analysts and shareholders may require, I cannot emphasize enough that the business remains in a fundamentally strong position and I hope that sharing some of our key operational successes with you through this presentation, we'll only seek to remind you of a number of the positives that make the group a strong and long-term proposition for both customers and owners alike. I'm going to start by giving a brief summary of the key highlights in terms of performance for the first half. April will then take you through some more detail in terms of the numbers. You'll then hear a little bit more from me on how our lending and savings franchises have performed followed by the outlook before we open up to Q&A. Just checking if it changed. So gross organic lending increased by 2% in half 1 to GBP 2.3 billion despite a clear softening of the wider market, driven by the increased living and borrowing costs, denting purchaser confidence. The net loan book grew in the first half by 4%, 5% before the impact of the adverse EIR adjustment, demonstrating the strength of our lending franchise. We are now the fourth largest buy-to-let lender in the U.K. according to the U.K. finance data and we've continued to increase our market share of new business flow during half 1 without compromising our underwriting standards. We have focused Precise Mortgages on growth in the residential sector and Kent Reliance on really serving the professional landlords, who still are making purchasing decisions as well, of course, as having more complex refinancing needs, which play well to the Kent Reliance strength. Our InterBay brand has seen more than a twofold increase in lending during the period and retention performance across the board has been strong with now 75% of borrowers in Kent taking a new product with the group within 3 months of their deal maturing and an already very encouraging 59% in Precise Mortgages as our Choices program there gains traction, enabling us to lock in long-term income generation for the future. We remain committed to doing the right thing for our customers. I'm pleased to confirm that we're embedding the new consumer duty rules into our business and have signed up to the government's mortgage charter. So turning to our strong credit and risk management. ECL provisions have increased during the first half, driven by moderation in house prices, a continued worsening, sorry, of the macroeconomic outlook, modeled IFRS 9 staging migration and a handful of specific provisions. However, importantly, 3-month plus arrears have remained broadly stable at 1.2%. The group remains well-capitalized and highly liquid, a position that we feel is very important when facing into macro headwinds. We've enjoyed strong growth in retail savings at attractive post swap costs and customer Net Promoter Scores remain excellent. Our capital position is strong with CET1 of 15.7%. And in April, the group issued GBP 250 million of MREL qualifying Tier 2, making further progress on optimizing our capital stack. We have declared an interim dividend of 10.2p per share, in line with our stated policy and we continue to target a medium-term CET1 ratio of 14% once the capital stack has been fully optimized. The Board remains committed to returning excess capital to shareholders. However, this, of course, is contingent on us being able to issue senior [ holdco ] debt to meet our interim and end-state MREL requirements. I'll cover more about the outlook and our guidance later on, but we remain excited by the opportunities in our core markets. And I hope that my introduction has provided a useful reminder of the simple fundamentals that provide the backdrop for us to continue to deliver attractive and sustainable returns across the cycle. These 2 slides show our strategy and our underlying financial highlights. On the underlying slide, we've shown our KPIs, excluding the EIR adjustment. I think it's important to understand the underlying strong shape of the business. For example, excluding the EIR adjustment, the ROE would have been 22%. April will cover each of these for you in her review, but I hope this snapshot reiterates my points regarding the fundamentals of the group under normalized trading. I'll now hand you over to April to talk you through the numbers in more depth.

Thank you, Andy, and good morning, everybody. Before I start, I would like to add my own apology for the EIR adjustment we announced in our trading update on the 6th of July and the impact it's clearly had on our financial performance in the first half. Today, we are confirming a total underlying EIR adjustment for the group of GBP 180.7 million, which is GBP 208.5 million on a statutory basis based on behavioral assumptions consistent with those outlined in the trading update and also consistent with an additional month of behavioral observations since then. I'll talk more about the EIR adjustment later and I'm sure we'll cover it in Q&A as well. So turning to the slide. We've presented the performance in the first half on an underlying basis before and after the EIR adjustment. This slide explains the key drivers of the first half ROE of 8% or as Andy mentioned, 22%, excluding the impact of the adjustment. The group delivered an underlying pretax profit of GBP 117 million for the first 6 months of the year, down 60% from GBP 294 million in the prior period, with the benefit of net loan book growth and improved margins more than offset by the adverse EIR adjustment and a higher impairment charge. Excluding the EIR adjustment, underlying PBT would have been GBP 297 million. Again, excluding this adjustment, underlying net interest income grew by 25% to GBP 461 million due primarily to growth in the net loan book and the strength of net interest margin, which was up 31 basis points to 333 basis points on an underlying basis, marginally exceeding expectation and reflecting the beneficial impact of rising base rates. More on that later. We continue to maintain our strong focus on cost discipline and efficiency with administrative expenses coming in slightly below our expectation in the first half. The underlying management expense ratio of 78 basis points was 6 basis points higher than the prior period, reflecting the anticipated impact of inflation and planned investment in people and operations. The underlying cost-to-income ratio increased to 40% in the first half due to the lower income following the EIR adjustment. Excluding this adjustment, it increased marginally by 1 percentage point to 24%. Looking ahead, we expect an underlying cost-to-income ratio of around 29% in the second half due to planned further investment in the business as we make further progress on the next phase of our technology investment, focusing on improving efficiency in our business operations. Taking that second half guidance would result in a full year ratio of circa 33%. We recognized an underlying loan loss equivalent to a ratio of 37 basis points in the first half of the year, due primarily to moderation in house prices and a worsening of the economic outlook as well as modeled IFRS 9 stage migration. I'll provide more detail on the key drivers a bit later. So turning to the income statement. You'll see that we recognized a net underlying fair value loss on financial instruments of GBP 12.1 million compared to a gain of GBP 11.1 million in the previous period. The key driver behind this change was a loss in respect of the ineffective portion of hedges that arose from recent swap volatility and will unwind over the remaining life of the hedged fixed-rate retail saving bonds and mortgages. And this was partially offset by further gains on pipeline mortgage swaps, which will also reverse over the life of the swaps. Underlying earnings per share of 19.5p in the first half reduced by 60% versus the prior period commensurate with the reduction in profit. Underlying EPS would have increased to 51.3p excluding the EIR adjustment. Turning to the next slide, which summarizes our strong secure balance sheet. Thank you, Andy. Our net loan book increased by 4% or 5% excluding the EIR adjustment in the first half to GBP 24.6 billion, supported by GBP 2.3 billion of gross new lending, which was up 2% versus the first half of 2022. Retail deposits grew by 5% to GBP 20.7 billion as at the 30th of June as the group continued to attract new savers. We remain predominantly retail funded with the diversification provided by Bank of England funding schemes and securitizations. We repaid GBP 301 million of funding under the index long-term repo scheme during the first half and drawings under the TFSME scheme remained unchanged at GBP 4.2 billion. As Andy mentioned, in June, we completed a GBP 330 million FTF securitization of owner-occupied prime mortgages originated by Precise Mortgages under the CMF program, which really demonstrated investor demand for group issuance. The credit quality of our loan book remains strong with 3-month plus arrears broadly stable for the group at 1.2% and that includes OSB at 1.3% and CCFS at 1%. Andy will talk to the interest coverage ratios for buy-to-let originations a bit later. Our loan book is secured at sensible loan to values. The weighted average book LTV for the group increased marginally to 63% in the first half from 60% at 2022 year-end, reflecting a moderation in house prices in the period. The new lending LTV improved marginally to 68% from 71% in the first half of last year, demonstrating our continued focus on the risk assessment of new lending. Turning to the next slide, more about the EIR adjustment as promised. The EIR adjustment, of it, GBP 178 million related to the Precise Mortgage book and the estimated time that borrowers would spend on the reversion rate at the end of their fixed rate terms. The Precise Mortgage products were designed to move to revert rate, which was similar to both the initial fixed rate and open market rates. And you can see that on the red line of the graph. In contrast, our Kent Reliance brand has historically had a high step-up in reversion, providing a clear incentive to refinance. In light of this, Kent Reliance has a long and well-established broker-led Choices program to encourage borrowers to switch to a new product with us quickly. And we assume that, on average, they spend circa 1 month in reversion. The graph on this slide demonstrates this difference in how each band stepped up or down in reversion using 5-year fixed Buy-to-Let through time. And you can see that sharp acceleration in step-up, especially from late '22 and through the first half of this year due to the unexpected rapid rise in bank base rate. These rate rises and the volatile rate outlook led to customer behavioral changes to the Precise borrowers. And over the course of the first half, we observed a step change in how long customers were spending on the reversion rate before selecting a new product with us or refinancing, in particular, the attrition rate of borrowers who stay on the reversion rate for several months. This moved our expectation of the number of months spent on reversion rate down by 12 months to 5 months as at the end of June, giving rise to the EIR adjustment. Following this adjustment, the potential impact of any future behavioral changes is much reduced. The impact on net interest income of plus or minus 3 months spent on reversion is plus or minus GBP 70 million. We've also disclosed the impact on the group's net interest margin for new origination, assuming 12 months less spent in reversion for the Precise customers. Keeping all other assumptions unchanged, including pricing, swap spreads, cost of funds and product mix would lead to a reduction of just 11 basis points based on group applications in June. This will obviously take time to come through in the overall group net interest margin due to the size of the back book. The next slide shows our NIM waterfall, where you can see the high-level drivers behind the NIM in the period. Underlying NIM reduced to 203 basis points from 303 basis points in the second half of last year, with the benefit of base rate rises more than offset by the adverse EIR adjustment, which accounted for 130 basis points. But moving from left to right on this waterfall, the retail funding spread benefited from delays in the market passing base rate rises on to savers in full. The cost of new retail funding also benefited from widening swap spreads, particularly at the 1 and 2-year points where we raised retail funds. There were also delays though in mortgage pricing reflecting the rate rises in full and volatile swap spreads, slightly lower impact, you can see in the amber bar. Other funding primarily relates to the benefit of increased average funding from Bank of England and equity as well as favorable swap margin calls. The underlying net interest margin for the second half of 2023 is expected to be broadly flat to 2022 after the expected impact of further planned MREL qualifying debt issuance subject to market conditions, resulting in a full year NIM of circa 2.6%. The next slide provides a waterfall of the movement in the statutory impairment provision in the first half. As you can see from the chart and again moving left to right, we adopted more adverse forward-looking macroeconomic scenarios in our IFRS 9 models, which together with house price moderation in the period, accounted for a GBP 12.6 million increase in provisions. Enhancements to models and updates to post-model adjustments reflect the potential impact of the rising cost of borrowing on customer affordability led to an increase of GBP 8.4 million. A GBP 4.5 million increase in provisions related to accounts with arrears of 3 months or more and a further GBP 15.8 million related to changes in the credit profile of borrowers as they transitioned through modeled IFRS 9 impairment stages. This transition was primarily movements from Stage 1 to Stage 2. Individually assessed provision increases net of write-offs and other items totaled GBP 0.8 million. You can see that our total coverage ratio has increased by 15 basis points in the first 6 months and remains more than twice the level it was pre-pandemic at the end of 2019 as geopolitical, inflationary and cost of living concerns have replaced pandemic-related concerns. We will continue to proactively review our forward-looking economic scenarios and coverage ratios as the outlook evolves. Okay. Let's take a look at capital. You can see that the group's CET1 ratio remained strong at 15.7% at the end of June. Again, going from left to right in the waterfall, which explains the movement in the CET1 ratio in the period. You can see our very strong capital generation from profitability of 2% prior to the EIR adjustment. We utilize 0.8% to support the 4% growth in the loan book during the period. The impact of the declared interim ordinary dividend was 0.4% and the full effect of the GBP 150 million share repurchase program announced in March was immediately deducted from capital with an impact of 1.4%. We also had noncash transitional and other items of 0.8%. Finally, the impact of the statutory EIR adjustment on capital and RWAs was 1.2%. The next slide provides an overview of the components of the group's minimum capital requirements, its capital resources at the end of June and our interim MREL requirement from July next year. Total capital resources as at the end of June of 19.2% include the benefit of our successful GBP 250 million MREL qualifying Tier 2 issuance in April. As Andy said, this marks further progress on our journey to optimizing our capital stack. The group continues to target a CET1 ratio of 14%, whilst the capital structure has been optimized fully. And we intend to come to the market with a program of further MREL qualifying debt issuance ahead of our July 2024 interim MREL requirement, likely in 2 separate benchmark-sized issues. We expect to operate above the 14% target in the meanwhile and as we wait for clarity on the implementation of Basel 3.1 later this year and its timing versus the group's IRB accreditation. The group continues to actively engage with the PRA and the timing of our IRB application relating to rating systems covering our core Buy-to-Let and residential first charge mortgages. The Group is ready to submit module 1 when regulatory consent is provided. In line with our stated dividend policy, we've announced an interim dividend of 10.2p per share. As with previous years, the Board will make its full year dividend recommendation with the full year results, taking account of amongst other factors, the economic outlook at that time and continuing progress against the group's MREL eligible debt issuance program. The Board is confident that the group's strategy and proven capital generation capability can support both strong net loan book growth and further capital returns to shareholders, supported by further planned issuance of MREL qualifying that in advance of the group's interim MREL requirement in July, subject to market conditions. I'll now pass back to Andy, who will give an update on our lending and funding franchises.

Thank you, April. I feel obliged to check the slide is on the right one for you. Our award-winning lending franchises continue to drive retention and deliver growth whilst maintaining our position at the forefront of the market. Originations in both Buy-to-Let and residential have been encouraging despite that more subdued overall market, both in terms of volume and quality. Our carefully selected commercial lending has performed well too, reporting in the doubling of originations following our renewed focus in that subsegment through our InterBay brand. Average interest coverage ratios for new originations have reduced as expected given the significant increase in underlying mortgage rates, but clearly demonstrate that landlords have been able to balance raising rents with their costs. In H1, they were healthy at 178% and 154% for OSB and CCFS respectively. And despite house price moderation, our LTVs remain sensible across the group. Professional landlords accounted for 91% of OSB's Buy-to-Let completions in the period and limited company mortgages represented 86% of Kent Reliance and 65% of Precise completions, an increasing trajectory that continues to play to our strengths. Our funding platform continues to deliver to our savings strategy of attract, retain and satisfy. We opened circa 86,000 new savings accounts in the period despite increasing competition for deposits and we retained through reinvestment into new fixed rate products, 90% and 87% of maturing deposits in OSB and CCFS respectively. Net Promoter Score stayed high at over 60 plus in Charter Savings Bank and 71 plus in Kent Reliance. We've been working hard on our technology development during the first half and expect to be able to launch a new customer-facing savings platform in H1 '24, which will enhance the journey for our savers whilst delivering operational efficiency within the business. Our Bank of England funding through TFSME remained unchanged at GBP 4.2 billion. And in June, we completed that GBP 330 million securitization transaction of prime residential mortgages. So in summary, a strong operational performance and the fundamental is still good. Clearly, I'm disappointed that the period has been impacted by the adverse EIR adjustment. We remain cognizant of uncertain macroeconomic outlook and the impact of the higher cost of living and borrowing on the mortgage market and specifically customer affordability. However, we have a healthy pipeline of new business and have a proven track record of retaining and attracting new customers and working with high-quality borrowers. Based on current pipeline and application volumes, we continue to target underlying net loan book growth of circa 7% for 2023, supported by that widely reported demand mismatch in rental property supply. As we look at current pricing and funding costs, we expect underlying NIM for half 2 '23 to be broadly flat to the full year '22 resulting in a full underlying net interest margin of circa 2.6% after the expected impact of further planned MREL qualifying debt issuance subject to market conditions. We expect the underlying cost-to-income ratio to be circa 29% for H2 and therefore, 33% for the full year as we continue to invest in improving customer experience and upgrading some of our core systems. The group does have a track record of delivering strong results. And whilst the adverse EIR adjustment has had a disappointing impact on H1, I hope that you will agree that our underlying strengths of our business model are not in doubt and that despite some macroeconomic uncertainty and headwinds, we look forward to the future with cautious optimism. Thank you for listening, and we will now open up to Q&A. We're going to do Q&A from the room first and then we'll ask if we've got questions. First hand I saw was Gary say...

It's Gary Greenwood from Shore Capital. I just wanted to ask about the impairment charge, which I think came in the first half was higher than most on Sales for the full year. I was just wondering to what extent are you being -- to what extent you should have taken a prudent view there because it looks like it's been provision build rather their natural underlying losses. Obviously, the IR assumption changes were a surprise to most. Is this just management trying to be very cautious? And then how should we think about impairment charges coming through in the second half of the year? Should they be lower?

April?

I mean a lot of this was a worsening in the economic outlook. And obviously, the knock-on impact that has on our post-model adjustments from an affordability assessment perspective and really is because of the worsening outlook through to June when it came to both inflation and interest rates. You're right, the underlying performance of the book remains very strong. I suppose as we sit here today, I think everything looks a little bit better. But it clearly has been quite a volatile ride, hasn't it, from a macroeconomic outlook over the last year or so. So I think we're suitably positioned. I mean I think we've always been a little bit more conservative perhaps than the pack when it comes to our assumptions for HPI. I think the main change in our scenarios other than a higher peak for base rates with the HPI would be just like a little bit steeper peak to trough, but also more prolonged trough. And that's really what's been driving it. And clearly, the expectation of higher sort of end peak rate for base rate has had an impact on our post-model adjustments as well for affordability. But as I said, I think, whether it's credit performance, economic outlook, the SONIA curve, everything is looking a little bit better now. So if that continued, then one would expect a more benign second half.

Okay. We'll go ahead next.

It's Perlie from KBW. Can I ask you about margins? So first of all, I think the second half guidance is effectively 303, right, flat to full year '22. So it's quite a large step down 30 basis points. Obviously, some of that would be MREL issuance cost. But I guess, the cost of fund and passing on, on the lending side, probably broadly balance each other out a bit. So is it all because of the MREL because that sounds quite a lot? So just what else is in that assumption? So yes, that's number one. And the second question is, what are your assumptions with regards to the unwind of the forward-looking part of the EIR adjustment that you've taken? And whether that 303 half 2 guidance includes that? And I guess, more broadly, how does that unwind interact with an 11 basis point impact on the sort of front end that impact that you're seeing on the front end?

You hit me with a technical EIR accounting question. I'll try and be succinct. I think those are both for me, aren't they? So drive the second half NIM. Well, clearly, you're absolutely right, part of the impact, but only part is due to the coupons on both the Tier 2 we issued in April, but also a few months of coupons on our planned further issuance program of senior holdco debt. But the other item is, look, we've got mortgages, which are maturing on to lower prevailing rates. As we honored our application pipeline, I think we've spoken about this in the past, we honored the application pipeline and offered retention pricing through a period of swap spread volatility and periods of time, when these swap spreads widened. And we're also -- and I suppose that was a very deliberate stance and it's stood at some very good stead when it comes to our broker Net Promoter Score and also our ability to grow our market share during the first half, but it has had some impact on margins in the second half. And we're also assuming that the cost of retail funds settles at closer to SONIA through the bulk of the year. Over the last 18 months, we've had opportunities to raise retail funds at significantly below SONIA. And you'll also if you think about the more longer-term view for NIM, clearly, as the 18 months' worth of funds that significantly sub-SONIA comes to refinance. And if I'm right, that will sort of settle close to the SONIA mark. Clearly, that's going to provide a drag, unfortunately, on margins going forward. I think you've probably heard much the same from other banks through the reporting season as well. Technical EIR, let me try and be succinct because of the mechanisms of EIR, the impact of the unwind of the liability we've created is really balance sheet. And it's a balance sheet reversal because the cash we'll receive over the life of the mortgages will be less in the interest accrual we continue to make because you don't change your EIR percentage and your interest accrual for behavioral changes.

Ben [indiscernible]. I'll answer about the market then not about EIR. [indiscernible].

You mentioned about your new savings platform coming online next year. I just -- you obviously don't have a current account offering currently. I was wondering whether you could give any color on whether you intend to fill that gap either organically or organically? And then secondly, on Slide 17, you talked about the Precise EIR asset reflecting time spent on reversion and early repayment charges. I'm just interested in any assumptions you're making around early repayment charges. We've recently seen more holders making overpayments in the resi market. And I was wondering if there's any upside there if you've modeled repayments for EIR in a similar way to the reversionary duration, i.e., using actual experience rather than future expectations? And if I can squeeze in a third one, just in relation to your reversionary assumption of 5 months and using the actual experience, you'd be aware that other U.K. banks take a slightly different approach. I know you won't want to comment on peers. So my question is a bit more specific. If you had conversations with your accountants around OSB's accounting this area and why it's different to peers? And if yes, what was the outcome of those conversations?

I mean I'll talk about the savings development work and current accounts. We're not building a platform to launch a new current account. We're currently building a much slicker much more self-service-orientated, app-based, et cetera, savings platform. So it makes it very easy for savers to pick a new product, which from one product to another renew when their product comes to maturity, just a much smoother customer journey and we think that's really important as a fairly big provider now into that retail savings mark. But no, we're not planning to build a current account franchise. You kind of always toy with the benefit of effectively 0 rate funding via the systems. You've got a lot of infrastructure costs that go with running a current account franchise. Are there offerings out there which are for sale and potentially achievable? I don't know. We always do market evaluations. [ Klemens ] printed his article about [ Shore Brook ] and on one current account provider. We will continue to look at the market and see opportunities. And if something presents which we think adds long-term value for shareholders, we'll come back and talk about it. But nothing that we can talk about further at this point.

I think you are part, I mean, I can't comment on what other competitors may be saying about their EIR accounting. We certainly do take a forward view as well, but based on the data we have available to us. So it's not rigidly sticking to a run rate of behavior, but we have to pin it on something. Yes, we've had conversations with the accountants. Their support -- continue to support our accounting methodology as being appropriate for our circumstances. Circumstances are different across the different banks, both from a product design perspective and from perhaps their availability of data through the cycle. But there's no question in their mind that our accounting was appropriate. You asked about ERC assumptions. We do make some assumptions, but it's just not material for any of our books. And we're very conscious that we've seen quite a bit of volatility and behavior. We saw, for example, when there was a fear of rapidly rising rates post the mini budget, we saw a real acceleration of people paying the 1% early redemption charge in the last year of their mortgage in order to fix again. We're not expecting that's going to happen again. But yes, we would have -- if it was in any way material, we would have disclosed sensitivities in the accounts. And obviously, that's valid across our books, you know Kent Reliance and InterBay and the Precise books. I think that was -- it wasn't. Yes.

Yes. I mean just adding on some of that customer behavior on mortgages, I mean, interestingly, 2-year fixed rate mortgages haven't been in the flavor for a really long time. And actually, we're seeing some savvy borrowers that are saying we're going to shorten the product term because rates are higher because they're taking a forward-look view and even some that are just saying, we're going to stick on variable for a bit because we think the long-term or medium-term prognosis is a better direction of travel on swap rates and therefore fixed pricing. So in part, that's the beauty of dealing with some professional landlords as they are taking a portfolio-based financial decision rather than Mr. or Mrs. Smith worrying about whether the mortgage is going to go up a couple of hundred quid. And that's interesting behavior that we haven't seen for a long time in the low-risk rate environment.

Yes. Grace Dargan from Barclays. So maybe just coming back on impairments. I appreciate a good chunk of the impairment was model-driven. Guess another good chunk was Stage 1 to 2 increase. So I guess, what in particular were the increase in credit risk indicators that you saw change as a result of that? And I guess, how are you expecting those to evolve from here? Are you expecting a similar run rate? And I guess noticing you're saying actually underlying is still quite strong. So be interested to hear thoughts on that. And then maybe I will ask one on capital. I appreciate it's difficult to talk about full year '23, but maybe looking more medium term, you've got, I would say, a bit more visibility now on kind of your thinking around optimizing the capital stack. And it'd be really good to get your kind of latest thoughts on balancing distributions and loan growth. And also kind of how you're thinking over the next maybe 2 or 3 years around timing of distributions? Or put another way, how much above 14%, if you're fully optimized, you're kind of comfortable operating at, given the changes that are coming through with Basel?

Got all good questions. You're absolutely right. There was an impact of GBP 15.8 million from staging that was predominantly Stage 1 to Stage 2. I suppose it's the only part of the IFRS 9 framework where you really don't use perfect foresight because if it's Stage 1, then you take a 12-month view of your potential losses and when it goes into stage to its lifetime. And some of it was arrears-based, but a lot of it wasn't. And I suppose it's the usual factors of a worsening credit score, perhaps higher personal indebtedness and other factors we look at, which give us those sort of early warning indicators. Of course, once you've entered into a stage, it takes a time before you can cure out of it, particularly Stage 3 to Stage 1, but also Stage 2 to Stage 1 as well. So you could find yourself broadly flat when it comes to portfolio arrears, but still see a growth because of that difference between people going in and people coming out, that makes sense. Does that answer your question or...

I guess into H2 in particular, are you concerned that you'll see a similar charge?

Well, I mean we've obviously got the benefit of 1.5 months or so since then. I mean, as I mentioned earlier, everywhere you look at it, things look a little bit better. I mean, really, it's the -- it's the expectation of where rates will go, in particular and it's the HPI performance which really makes the difference. And we don't wait to see arrears before we put people through the stages based on those early warning indicators. But we've got a little ways to go this year, but what we see today is looking mildly positive. On capital, I guess you're asking more medium term rather than the dividend for this year. I mean I don't think there's really any change to our policy. As we optimize that stack, we can free up more CET1 to distribute to shareholders. And so it's quite linked to the timing of that, some optimization of the stack and the debt issuance. And we -- I personally and the Board think of the capital we generate every period through profitability of kind of fueling growth and a progressive dividend and the size of the back the capital generation capability of it can do both. And then I think about the excess of CET1 above our minimum requirement and our target of 14%, once you've optimized the stack as being available for distribution back to shareholders through share repurchases. Of course, we've got that uncertainty to some extent on what will happen with Basel 3.1, but we should know by the end of the year and be able to give a lot more clarity. And I would say there's been a lot of lobbying from industry, industry bodies, government against some of the platinum plating, also the lack of transitional relief for standardized firms despite Basel bending over backwards to give relief to IRB firms. And I think it's broadly helpful perhaps as to how the U.S. have come out in the last few weeks with their consultation paper. It's a slightly later implementation date. It's a much higher threshold, GBP 100 billion before you have to adopt it. But more importantly, they have stated quite clearly that they don't necessarily feel that the risk weights are always appropriate for their market. And I think hopefully, that just gives the PRA a little bit more wiggle room to listen to the feedback. But I'm, of course, just speculating, we'll find that as we go to the end of the year. But really, no change from anything we've said in the past when it comes to our philosophy on capital. And this is a business that generates considerable capital through profit. We do have a strong position. We've got a good access, which means we are in a good position, whichever way you look at it. And over the medium term, that should allow us to return further capital to our shareholders.

Okay. I think we will now open up to the phones, please.

Thank you. We have our first question comes from John Cronin from Goodbody.

Just a few from me, please. Okay, following up on some of the previous questions on net interest margin. Look, appreciate you've outlined, April, the trends we should expect to see in the second half and contributing to a downdraft half-on-half in underlying NIM. And first, the -- just trying to take beyond '23, how should we think about new evolution given the kind of profile of mortgages rolling off and further issuance plans and maybe broad-based kind of pressure on asset yields and deposit costs perhaps? Just trying to get a sense of where you think we should be moving our NIM forecast to beyond '23? And secondly, just to follow-up as well on costs. I guess 2 kind of questions on cost. One is, you've also got costs growing at a pretty strong run rate as guided. The planned investment in the business will continue to see that come through. I mean are you confirmed in any way, I guess, around potential further investments beyond what you were initially expecting perhaps as a result of this EIR adjustment and the kind of influence that that might have in terms of required cost spend for the IRB program, but they're trying to overdraw the links between the 2? And then secondly, look, just in terms of kind of percentage uplift, how should we think about cost growth trajectory beyond '23? And finally, just one on product fees. So thanks for the updated H1 ICR disclosures. And if you were to adjust for those to account with the kind of uptick that there has been in product fees in average terms, I mean, what kind of impact does that roughly have on -- I mean, how much would that reduce the interest coverage ratio by if you were to overlay that differential between where products [ speeds ] were say 18 months ago and where they are today?

Let's do the number reverse order and I'll take the ICR point and touch on costs and then April can add on cost and talk about the NIM sort of bridge and journey. I mean the ICR piece, we do our ICRs at stress rate. And if that's a 5-year fixed, it's the pay rate. And of course, you do in higher interest rate environments and you'll see it not just in our product availability, but our competitors. We will offer customers an opportunity to pay a higher fee and therefore, a lower fixed, but we are talking about a 5-year fixed casting forward over a significant amount of time when rents will undoubtedly rise during that period. And actually, the prognosis is that the exit on to another 5-year fixed rate in 5 years' time will be lower. So that's just kind of engineering products really to suit market taste. No different from what we were doing when back in sort of 2013 when we were writing Buy-to-Let mortgages in the mid-5s. And then we started to push them down to the falls, but up the fee so that landlords that have the capability wanted to do that. I mean, we've disclosed the flow ICRs in terms of the half year. I think they're still very strong, particularly given that interest rates versus what we were looking at 12 months ago for an underlying mortgage costs are higher. And many of our Buy-to-Let loans are in the 6s, particularly in the OSB and the InterBay brands and yet we're still delivering 178% ICR coverage, which I think is very strong spot rates come down and we hope the overarching price mortgages comes down and rents continue to go up because of that demand/supply mismatch. I think that position will only improve. And of course, book ICRs on existing loans are higher because typically, we've been originating around that sort of 198, 202% ICR mark. So I can't answer the question exactly the way you asked it. But if it isn't a 5-year fixed, it's a stress rate and that's a fairly significant stress rate over and above and that's how we calculate the ICR. So there's no funny business, I guess, is the word in the way that we calculate and disclose them.

I suppose the one point is actually, if you think about the first half, a lot of it, we still thought base rate was going to peak around 4% and therefore, we weren't loading fees on. I think it's only at the point where you suddenly see a real widening of the swap spread and things have come back a bit since then, that we might have put a bit more fee on the product.

Yes, I think that's right. I mean in terms of cost, John, I mean, you know we're always a sort of a cost control animal. We try to make sure that the management expenses ratio kind of is in line with the growth in the balance sheet. Clearly, we've had to absorb, like every other business, a fair chunk of inflation, both in terms of our sort of our own cost for energy and other bits and pieces, but also obviously trying to do the right thing by our staff, which I think is pretty important in a high inflationary environment. I think the cost base is in good shape. We have invested a fair chunk during the course of the first half of this year in terms of development, that new savings platform that I talked about. We try and balance carefully the difference between capital expenditure and revenue expenditure. And if my IT CIO or my COO want to spend money on enhancing a system, they need to show me the benefits case that says, well, am I going to get it back then in terms of operational efficiency. So we're quite balanced in the way that we look at that. I mean, I don't think the EIR adjustment has a bearing on cost. I don't think it changes. I mean IRB is about credit risk modeling and the way in which we manage credit and operational risk in the business, it's not of our accounting. So I don't think it has any bearing on that. Clearly, April will touch on NIM, some of the costs that we face are around coupons on elements that come through the net interest margin. But we will continue to grow the cost base in line with the balance sheet if we need to. We'll try and continue to keep that management expenses ratio right. And our cost-to-income ratio, as you know, John, is always wildly moved by either income and upward or in this case, on the EIR adjustment downward, which has an impact, but costs are generally pretty well controlled.

Yes. I mean if we get to a stage where we want to invest a bit more beyond the growth in the balance sheet, of course, that's the point we'll come back and we'll talk to the market about it with a good business case for synergies just like our colleagues have to come to us if they want to spend some money. So I think going back to NIM, you're asking me great question as always, more of the medium-term drivers. But you're absolutely right, Andy. We do have further issuance requirements. You only have to look at the capital stacks for our MREL requirement to know and have a good estimate of the amount we're looking to raise. And I mentioned a couple of benchmark-size trades on top of that Tier 2 trade before we get to July and some more after that. So that clearly is a drag. I think I mentioned earlier that over the last sort of 18 years, we've been raising retail deposits that's significantly sub-SONIA, SONIA minus 40, SONIA minus 50. That's more weighted towards 1 year than 2 year because that's been what investors have been looking for, retail depositors we've been looking for through this period of rate volatility and that will start to mature from next year really on to whatever the prevailing rate is and I'm calling that closer to SONIA. And that is going to be a drag. I think you'll see that across the industry. We have an awful lot of borrowings across the industry from Bank of England onto the TFSME scheme. As long as wholesale markets are liquid, I would expect a lot of that to be refinanced through covered bonds, securitization. That is more expensive than retail savings at the moment. We will probably do some of that through securitization ourselves. And it could, of course, have a knock-on impact to the savings market if the wholesale markets are not liquid. So certainly, the whole -- that amount of funding happened to be refinancing. I'm calling that that's going to have an impact on everybody's cost of funds. When it was given to us, we were told we had to drop mortgage pricing. We'll have to wait and see what the competitive dynamic is on mortgage pricing to see whether that increased cost gets passed on to borrowers and that is also obviously impacted by the affordability constraints of higher rates. And I guess I mentioned earlier, in the short term and it is obviously a factor for the medium term as well. On the lending side, where perhaps business the industry wrote 5 years ago was on high yields to what we're facing today and that's because of the mortgage market hasn't passed on all of that widening of swap spreads and rate rises on to borrowers either. And I mentioned earlier, the sort of short-term impact is just the way we honored our application pipeline. We hedge some of our application pipeline, but not all of it. And therefore, we have had some ups and downs when it comes to what the actual NIM is of that front book between the application point and when we actually completed. But of course, there are ups as well as down there. I should finish with some upside, which is that we've obviously been very cautious in our lending appetite really since the pandemic. And we're not doing so much of the high-yielding business that we're very good at. As soon as that outlook stabilizes, you should expect us to start doing more of those high-yielding businesses, development finance, bridging, commercial, asset finance, et cetera. And that, I hope, is a real potential upside to our net interest margin as well.

Guys, can I just come -- can I come back on one more, the costs point? I'm modeling cost growth about 14% in '24, 9% in '25. I mean, let's -- not looking for specific guidance on it obviously, but look, we hear from a lot of banks around the intensive costs involved in the IRB programs and kind of directionally would you be guiding to double-digit growth over the next 5?

Well, I mean, we're not going to give guidance for 2024. I think there's clearly some inflationary impacts on wage inflation. We did the right thing by our staff in this sort of challenging environment. But it's all about how much investment we want to do in the business and whether we can do that within the sort of, the economies of scale we naturally generate plus any further inflationary pressures, but I think inflation thankfully is starting to come down.

I think most we've done a pretty good job in the first half of this year of absorbing what was fairly chunky inflation on staff costs and other business pieces because of growth in the balance sheet and therefore, management of the management expenses ratio. And that's the denominator, John, we always come back to is, if you're going to grow your cost base, you've got to grow your balance sheet to pay for it. And you won't always do that in exact harmony. But if you're doing cost more than growth, you need to have a pretty good business case to make it so.

And we're not shy about coming back to the market and saying we want to invest a bit more money, but we're going to generate the following synergies. We've just not had to do that so far given the sort of the growth in our business and we've been able to fund things we want to do through economies of scale as we can sort of continue to really modernize our technology stack, which I think is like every other bank, we've just been, I think, quite lucky with our ability to do it within the economies of scale we've generated.

Conscious of time, I'll ask if there's a couple more on the phone that are waiting to ask. Sorry, operator, do we have any further questions on the phone?

Yes. We have our next question comes from Portia Patel from Canaccord.

And I'm afraid my questions are on EIR again. And just 2, please. The sensitivity you provided to the reversion period is very useful for that. But I was wondering if we should expect one-off impacts like we've seen in this period in the future if reversion period move either way? Or should we expect it to be reassessed on a more frequent basis going forward, such as the impact can be smoothed? Perhaps this is a function of the accounting treatment. If you could just explain that would be really helpful. And secondly, I just wondered if there had been any changes or if you're intending to make any changes to the design of the Precise Mortgage product to encourage behavioral trends more akin to what we see in the Kent book or you believe that the Precise products are fit as is?

I mean, will we expect any more? I mean it really depends on what happens to interest rates and the interest rate outlook because that's really what's driven this. And perhaps after this adjustment, there's more chance of people spending a bit longer if rates start to fall, portfolio landlords, as Andy mentioned, there are reasons why they might stick on the revert rate despite it looking like a very high step up as they assess their overall cost of funds across the portfolio and they'll have their own view about what's going to happen to rates and whether it's worth a little bit of short-term pain in order to sort of lock in at a rate as it starts to fall. And we have a lot of anecdotal evidence that residential customers are actually thinking the same way as well. So it's very much driven by the absolute level of rates, but also by the outlook. And so I suppose there's always a chance of people spending longer or less. I mean, we look at this frequently anyway. I mean the very formal process involving our auditors from a challenge perspective of 6 monthly, but this is something where we're collecting data every month and we'll continue to do so. I mean, the size of this adjustment really was a result of such a rapid increase in rates over such a short period of time, which meant that the entire back book was suddenly facing a material step-up and an incentive to refinance, whereas previously, it had reverted to a rate slightly above or very slightly below the fixed rate. So it's the speed of the rate changes which really caused this. So clearly heightened sense, I'm sure, across the organization and the Board on looking at this even more frequently than we did previously. But it wasn't that we were asleep at the wheel. We were looking at this. It was just a sudden change. And I don't think there's anything wrong with the design of that product. In fact, designing a product that has a relatively modest step-up in reversion, there's nothing wrong with it. It's just vulnerable to 12 consecutive base rate rises in a very short period, I suppose.

Yes. I mean, Portia, I would say, I mean products that we're writing today have a different step-up than those that were written 5 years ago as in it's not quite so high a margin over base. So that has a sort of forward impact in terms of behavior. But I think going forward for us, it is important that we continue to build the Choices program in Precise Mortgage, which does over time mean you will try and get more people on to a new product when their product matures. And of course, that locks them in for a further period in terms of a new fixed rate, new product fee, et cetera, et cetera. But a couple of sort of city people have said to me, well, why would anyone stay on a revert rate for anything at all? I wouldn't. But the average borrower, particularly residential through Precise Mortgage is not that kind of individual. And by the time they realize that their payment's gone up, then there's a 3-month kind of window to get refinanced done and that takes a while and we all know solicitors are a bit slow and whatever. So there's always some time. And that's why, for us, it's important that we keep pushing the Choices program message. But it amazes me if some people you're rightly say, look, here's another deal and it's a good deal and they still think about it for quite some time. But we will -- over the years, we will work hard to change that behavior. But I mean, you talked about it being one-offs. We'll monitor the thing, we've taken EIR adjustments all the way through in the past. There are typically normal course adjustments that are absorbed within our ability to grow the bank and make profit. And that's the way I think we're trying to think about it going forward.

But we have applied the same assumption to parts of the back book that were originated more recently that are likely to reach reversion in what we expect to be a falling rate environment. So perhaps there's some elements of prudency there. But we've been wrong on what's going to happen with the rate outlook over the last 18 months. So I'm not going to call it. We're certainly just looking at what the SONIA curve is implying at the moment.

Okay. I'm conscious of time, but we will just take one more from the phone because I know we have -- if there is one, operator, is there further question on the phone?

There are no further questions over the phone.

Okay. Thank you. If any final questions or points from the room here?

We've got 1 minute.

Okay. We'll give you the minute back. Thank you very much, everybody, for attending and have a good day and a good weekend as we're nearing that point. Cheers.