Paragon Banking Group PLC (PAG) Earnings Call Transcript & Summary

So good morning, everyone, and welcome to our interim results. As you would expect, today we'll follow a different format from those of previous years. What we will give you, though, will be a lot of detail on the performance during this period. You'll get a lot of detail and analysis on the crucial area of the impairments and also a lot of color around current [ trading and what customers are telling us at this time. There's a lot to go through, and we want to ensure there's plenty of time for your questions at the end. ] So if we turn into the slide deck itself, first of all, let's just talk about our priorities. At the outset, very quickly and very clearly, we set 4 key priorities which establish the framework for the way we manage the business through this crisis. These priorities, as you can see set out on the slide, were to support our customers and suppliers, to protect our people, safeguard our capital base and preserve the long-term value and franchise of the business. As you go through the presentation, you will see how these -- this specific strategy and these priorities have actually been employed in the actions we've taken and the decisions we've followed. So moving on now to the next slide, Slide 3. One thing that has helped going into this crisis is the business was in very good shape. Coming out of the global financial crisis, that was some 10, 12 years ago, we, as you know, we set the strategy. We set up the bank. We commenced the diversification strategy on our funding. We have broadened our lending activities, increased focus on specialist lending. But this has all been done by creating a defensive balance sheet. 98% of our assets are secured. That's supported by strong capital ratios and extensive liquidity. And the business has and continues to be managed by highly experienced teams who have operated across many different credit and economic cycles. So turning to the actual response, our response to the crisis. As I said, there was a quick reaction. It was swift, and it was effective. And this, I think, reflects on the strong existing operational resilience and the high levels of agility and capability that already existed in the organization. One week before lockdown, significant numbers of our employees were working from home. Four days after lockdown, 90% of our staff were working from home, including all the call centers and all the customer-facing teams. We have also reallocated resources to where demand was needed. Alongside this, the technology that we have already -- had already established and developed during this period has been quite outstanding. The platforms have been stable despite significant new technology deliveries during this period. We've introduced portals across the customer side of our business to support them with payment holidays. We've also introduced new portals to support CBILS and bounce back loans. These we're all done very effectively, very efficiently and very quickly. We've also had given further support to our customers through attractively priced funding due to the access in the TFSME program. We will now turn to the next slide. We can look very briefly at the actual high levels of the financial results themselves. Let me say at the outset, pre-COVID, the business was trading in line with our and your expectations. We were delivering everything that we had expected, and the business has made good progress on the delivery of its strategy and the plans for the future. However, the uncertainty of the environment and the outlook has impacted these results through the IFRS 9 overlay. The impairment and the impact on the income line has totaled around GBP 28 million, leading to a 28% reduction in the operating profits and their consequential impact on other key measures of profitability. Richard will go through this in quite some detail with you. However, let me state at the outset: we have undertaken a deliberate, cautious approach in this unprecedented situation and given the range of uncertainties. Additionally, these provisions are not reflected in the prima facie evidence, at least so far, on any sign of increasing defaults. In terms of new lending, there was some impact in March, but clearly, it's not for the whole period. However, the new lending during this period reflects the strategy of increasing diversification, greater specialization and with better customer retention had led to a 6% underlying growth in the net loan book and a NIM growth of 5 basis points to our NIM now of 229 basis points. On the funding side, that proved a real standout performance. Retail savings balances were 8.1% since September, and a significant further increase has taken place since the period end. This has all been achieved whilst also driving down the cost of deposits, particularly on the marginal side, although the stock cost will fall in due course. Additionally, we enhanced our funding through a retained securitization, which alongside the TFSME I've already mentioned, has added to the breadth and cost effectiveness of our funding options. As you know, we took the decision not to pay a dividend at the interims. And this, alongside the profitability within the business, has resulted in continued increase in the strong capital ratio, and the CET1 now stands at 14.4%. And finally, I can confirm that we have submitted our IRB module 1 application to the PRA. There's a long way to go, but this is a pleasing first step, [ and we'll continue to report back in due course. At this point, I'll hand over to Richard, who will take you through the results. And I will pick back up a little later on. ]

Thank you, Nigel. Before running through our normal analysis of the income and capital positions, I'll start by looking at the accounting approach we've taken to COVID-19. So this all appears on Page 7 of the deck. You'll see that we've made 2 categories of adjustment. The first one is on income recognition, and the second is on impairments. You'll be familiar with our purchase portfolios through Idem Capital, where effectively, our interest recognition or income recognition is done on a discounting basis. We take the expected cash flows from the portfolios, discount them at an effective interest rate that we set at the purchase date, and that determines the carrying value. So any adjustments through -- to our expected cash flows, therefore, wash through to our carrying values and income recognition. So as a consequence of the changes we've made, where we've looked to reduce cash flow for a 6-month period and then see a partial recovery for the 18 months after that, we can see a GBP 3.7 million adjustment. Of the slide notes in April and May, the performance that we've seen from the cash -- from those portfolios support this assumption. On impairments, we've made a GBP 24 million adjustment. For -- as Nigel mentioned, the portfolio is largely secured. The main impact that we have on our assessment of impairments are GDP, unemployment and property or asset prices. We've gone through an analysis of our economics. We've created a number of different scenarios, the most harsh of which is materially more harsh than the PRA scenario that was announced on the 7th of December. But if we had decided that we'd weighted the entirety of our provisions to that harsh scenario, we would have seen an additional GBP 33 million of provision going through in this period. We've put additional overlays in from nonmodeled portfolios or also where the model approach doesn't fully reflect the short-term evidence of COVID-19, and I'll talk about those in a moment. The weighting that we have applied to our scenarios is there to reflect the potential impacts of all of the different initiatives and regulatory interventions that we've seen. However, we're at a very, very early stage of the -- seeing what the real economic effects are from COVID-19. And until people start coming off furloughs and the self-employed income support schemes, it's going to be very difficult to see exactly how the market pans out. So our judgment scenarios and weightings are all likely to change over the coming periods. If you can move to Page 8 on the deck, you can see the approach that we've taken on the economics. So as I said, we've created 4 different scenarios. The 3 key outputs, so unemployment, GDP and house prices, are shown on the charts here. For the first scenario, this represents a fairly swift snapback in performance, a fairly immediate and positive impact from the protection and stimulus measures. We would then see a central scenario, which has got a slightly longer recovery. Unemployment peaks around 8%, GDP falls by 7%, and house prices are down by about 4%. We've created a downside scenario, which has got higher unemployment, higher reductions in GDP and lower house prices. The harshest scenario, you'll see from the chart, we have a second dip in GDP. Unemployment goes to 9%. GDP drops 11%. But importantly, it takes 2 years to recover. And that's a very material impact on the financial modeling. It also sees house prices dropping by 20%. The severe scenario was benchmarked against the Bank of England's scenario, as I mentioned earlier. There, we were -- the Bank of England forecast showed GDP would be recovered within 5 quarters of the onset of COVID-19. Our scenario shows that to take just over 2 years. So the embedded effect on our economics on lost output and, therefore, in turn, provisions is more material. When we're looking at the different scenarios, we see the upside scenario as being the least likely. So we've given that a 10% weighting. The most severe scenario, we've given a 15% weighting. The central and downside cases are weighted at 40% and 35%, respectively. Now these are entirely judgmental. But the overall weighting is broadly aligned to the less severe of our 2 downside cases. As I mentioned earlier, if we had weighted everything at 100% to the severe case, we'd have seen an additional GBP 33 million of charges. I'll now look at the income statement in a little more detail on Slide 9. So prior to the COVID overlay that I talked about in terms of Idem, net interest income would have been up 5% on the same period last year. The overlay clearly reduces this figure but would still have seen a 2.4% increase year-on-year. Other operating income is lower. This maintains the trend that we talked about at the year-end, where we've seen generally lower account charges but also more fee-free products being offered to our customers. Operating costs in the period were lower than both our initial expectations for the period but also the 2019 level. We've delayed some recruitment. We've delayed some investment. We've also seen lower share-based accruals largely as a result of the movements in the share price over the period. Our GBP 24 million impairment, though, related to the bad debt charge, to GBP 30 million for the period and takes operating profits down to GBP 57.2 million, which is 28.3% below the figures that we reported last year. You'll also see those fair value charges were broadly neutral in the period. This compared to the GBP 7.8 million charge that we saw in the first half last year. But I would note that with this, we're seeing a lot of intramonth volatility because swap curves have moved very materially and very swiftly over the last 2 or 3 months. Moving on to Slide 10, we can see our segmental performance. Within Mortgages, our profits fell by GBP 7.7 million compared to the first half last year. But without the COVID overlay, that would have been a 4% increase or a GBP 3.4 million addition. It's also worth pointing out that, if you recall, we did a sale of almost GBP 0.7 billion of assets through a residual sale in the second half of last year. So those loans would have been there in the comparable period. For Commercial Lending, we saw profits down GBP 4.4 million. But it would have been up GBP 7.2 million but for the COVID overlay. The Commercial Lending book has increased by 16-and-a-bit percent since 2019 and ended the period just below GBP 1.5 billion. For Idem, the COVID adjustments that we've made have exacerbated the underlying runoff of the Idem portfolio. And so that has, overall, seen a GBP 13.2 million reduction in profits year-on-year. For the central costs, overheads and central funding costs were a little favorable, given rates and that position on operating expenses that I mentioned and below their 2019 level. If I can move on to net interest margins. Despite the Idem adjustment, NIM increased to 229 basis points. If it hadn't been for the impact of that adjustment on Idem, the reported figure would have been 235 basis points. The lower of the 2 charts on the screen shows the position of the group net interest margin, excluding Idem. The runoff of Idem has a disproportionate impact on the -- if you like, the group profile. But the underlying one shows the impact of our ongoing and growing businesses on net interest margin. 2019 saw quite a big influence following the acquisition of Titlestone in 2018, but we've done no acquisitions in the period since then. So the movement from 2019 to 2020 is a very clean comparable. We're seeing a steady improvement in NIM in the mortgage segment. And this comes back to the fairly unique back-book, front-book dynamics that we've talked about in the past. But the overall level in terms of group NIM is essentially driven by the relative growth of Commercial Lending, compared to the relative runoff of the Idem business. Net interest margin will also be influenced by the lower rates we now see. We will be earning less money on our net assets, but we are benefiting from lower funding costs. Nigel will talk a lot more about the progress on our deposit business in a few moments. We -- the normal chart that we'd include showing divisional rate margin -- sorry, rate and volume variances is now included in the appendices. So if you want to have a look there, there's a little bit more detail on some of those NIM drivers. Moving on to Slide 12. There's a little bit more detail here on cost-to-income ratio. As I mentioned earlier, our costs were lower because of share-based remuneration accruals, investment largely delayed. So for some of those, those costs that would have occurred in H1, we would now assume they're going to be coming through in H2 or even spilling over into 2021. But with the increase in total income and the reduction in costs, we've seen the cost/income ratio fall from 42.8% last year to 41.8% this year. And had it not been for the COVID overlay on Idem, we would have been back to the 2017 level of 40.7%. Slide 13 looks at impairments. When you look at the actual announcement that we made this morning, there's a lot more disclosure there pointing to the -- from about Page 35 onwards in terms of the front part of the accounts, but also, note 11 is now a very extensive piece of analysis around all of the different portfolios and the IFRS 9 staging. So I would suggest you have a look at those for a lot more granular detail. I've already summarized the approach we've taken to the economic forecasting. And what we believe is a cautious approach to looking at risks in what's substantially a secured portfolio. In percentage terms, these overlays have fallen primarily on the commercial and Mortgages segments, where the balance sheet provision on Mortgages is up 42% and 92% on commercial as a consequence. If we look at the value of our Stage 1 and Stage 2 provisions, again for those 2 books, they've increased just under 8 basis points at September to 22 basis points now. I'd also point out that the overlays that we have made on particularly the commercial books have tended to fall in the -- in Stage 1 as they've not been ascribed to individual loans but have very much been seen as an overlay. So you really want to look at Stage 1 and 2 together if you're looking at coverage ratios. And for Idem, the bulk of the COVID adjustment arose on the income line rather than impairments, as I mentioned earlier. In terms of capital, on Slide 14, as Nigel mentioned, the capital position is strong. CET1 increased to 14.4%; total capital ratio to 16.7%; the reduction in the countercyclical buffer to 0%; increase to surplus, we hold; added around GBP 70 billion of capacity. And so our overall surplus over regulatory requirements is just over 2 -- GBP 0.2 billion at the end of March. We've continued to take advantage of transitional relief following the introduction of IFRS 9. Clearly, we have lost some of the value of the transitional relief we had last year as we gradually move through the 5-year process. But we'll be -- we have taken advantage in this period, and the net effect is shown on the capital bridge that I'll come to in a moment. But on a fully loaded basis, our CET1 level would still be strong at 14%. Our capital continues to be based on the standardized approach. We announced at the end of 2019 that our module 1 application for IRB had been delayed just to check compliance with CP21/19. This is a consultation paper and -- embedding a range of enhancements, largely from the EBA, on people using internal models. Now we've completed our reviews, submitted the module 1 at the end of March, and now we're moving through the subsequent modular elements of the buy-to-let rating system. And we'll be taking a broader rollout plan for our other rating systems for the other main portfolios over the coming years. From what we've seen from other applicants -- applicant firms, this is likely to be a long process. And we can't speculate at this stage on either the timing or likely implications of that accreditation. But as we get more and more detail over the coming months and years, we'll give the market the updates when we can. Page 15, as I mentioned, cover the capital bridge from the position at the year-end. We saw the net effect of retained earnings and the transitional adjustments being accretive by 0.7% in terms of our capital figures. Net lending growth has used 0.2% of CET1. And our other movements, the most notable of which is a movement on -- a positive movement on the deficit on our defined pension scheme, would take our overall CET1 level to 14.4%. Plus the 2.3% for Tier 2 gives us around 16.7% ending total capital ratio. I mentioned the additional slides that we normally have for NIM. They're now in the appendix. But there are a number of others that will be there if you want to use those as a reference. So nothing is missing compared to the normal financial presentation. But we do think it's more worthwhile to focus more heavily on the COVID adjustments at this stage. So on that, I'll hand you back to Nigel.

Okay. Thank you, Richard. So let me turn to providing some more information on how the business has been managed through this situation, and what we are seeing in terms of current trading and engagement with our customers. So if you turn to Page 17, this shows the nature of the dynamic response to the COVID-19 crisis. We've spoken already about the strategy and the priorities and the actions that we've taken. We've now moved on from that, and we have moved into a stage which we have called modified BAU. This is where governance has been normalized. All the normal controls and operations and procedures around that are happening as they did pre-COVID-19. The Phase 2 forbearance engagement has commenced. The full surveying function is now happening. There are full internal inspections taking place. The key projects that we had halted whilst we were focused on the immediacy of the crisis a couple of months ago will have now been reinstated. The CBILS and bounce back loans lending is underway. And we have a higher and more enhanced customer engagement and insight program in place as a consequence of the whole event rather than just the specifics around the impairment requirements. And we have also commenced planning for a return to the workplace, but that will only be done when it's safe and when it's appropriate to do so. So if we turn now to looking at the divisional performances and some of the more recent aspects of trading. So Page 18 shows the buy-to-let lending performance, highlighting the performance in the first half against comparable periods. The strategy of increased specialization, better customer retention and improving margins is evidenced across all 3 of these charts. Whilst the pipeline was up on the period end, originations came to an abrupt halt in March, leaving volumes marginally down. However, actual completed business shows further progress in specialist lending, a further move away from the more commoditized amateur landlord, leaving specialist lending seeing year-on-year growth and representing 92% of all new business. Better customer engagement combined with a change in portfolio mix to professional and longer-dated fixes have seen the redemption rate fall from 10.5% to 7.8% over the last 3 years. Excluding the asset sale last year of -- through PM12, the underlying net loan book growth stood at 6% alongside the NIM improvements mentioned earlier. Turning to Slide 19. As you'll be very familiar, our buy-to-let portfolio has consistently outperformed the industry averages in terms of arrears and delinquencies compared to the sector and the wider mortgage market. This, you can see very clearly on the slide on the left-hand side. In addition to that, we have strong asset backing for the portfolio. Average LTVs stand at 67.7%. And the chart in the middle also shows how the average LTVs have fallen by 13% since 2008. And LTVs greater than 90%, now stands at just 2% and compared to 31% in 2008. The fundamental driver for our landlords' investment is tenant demand, which has been consistently strong for many years. This, perhaps not surprisingly, dropped sharply in lockdown as social distancing measures were introduced. But as the chart on the right shows, which is from Zoopla, with the use of -- and with the use of video technology and subsequent lockdown easing, not only has demand been restored but now exceeds the level seen pre COVID-19. Demand has now stabilized and look still above the COVID-19 levels, but I would -- and I would expect this demand to remain strong going forward. We should now look at the buy-to-let payment holidays on the next slide. So Slide 20 highlights the levels of payment holidays granted through the buy-to-let book. As you can see with the chart, they are at around 21% of the book. However, only 2.8% of the payment holidays are on loans with LTVs in excess of 90%. And our view is that the vast majority of all buy-to-let holidays were taken on a precautionary basis by the landlords. Indeed, we've undertaken extensive engagement with these customers and more recently commenced discussions about the ending of their arrangements. To date, 73% have said they will be returning to a full payment, and a separate analysis suggests that there is no other identifiers of stress in their financial affairs. The balance of 27% have yet to make a decision. However, none have specifically requested an extension yet, although I suspect some will. But to date, none have requested any. Furthermore, through survey analysis, only 2% have indicated that they would expect a severe impact on their portfolio which will result in losses to them. Turning to Slide 21, we can look at current trading. The declining trend of new lending is a product of the closure of the housing market as well as our own actions on lending criteria and product repricing. A particular impact for us is due to the insistence, our insistence, on physical internal inspections particularly on complex properties or ones where we do not have a high confidence level in automated valuations. This typically accounts for 25% of all new business flows. With the reopening of the housing market and reduced competition from new nonbank lenders, we expect volumes to recover in the coming months. Indeed, application flows so far this month are 20% up compared to April. Turning to Slide 22, we can look at the position on development finance. Originally, this was the -- a business that we started up organically some time ago, but that activity was rolled into the Titlestone business following its acquisition in 2018. Its performance in the first half of the period continued the excellent progress of recent years. New lending growth was up 23% to nearly GBP 200 million, increasing the portfolio to over GBP 500 million. Again, like the buy-to-let portfolio, the starting point is strong, with average loan-to-GDV standing at 65.9% with an average facility size of only GBP 4.3 million. Only GBP 25.7 million or 5% of the portfolio sits above 80% loan to GDV. And where appropriate, these are already well provided. The next stage -- the next page shows the position with regards to the development finance payment holidays. The -- at the top of Page 23, what you can see is the fact that a number of the sites that we were financing closed. A total of 32 out of 145, some 22% of the portfolio, was shut. This was due to typically supply chain disruption, and it meant that, in effect, April was trading at around 60% of normal levels, but this has now increased further to 73% in May. There has been a gradual reopening of the site, and now only one site remains closed, which we expect to reopen shortly. With supply chain improvements coming through, and we should expect to see improvements in further activity, although social distances will still mean it will not run at full operational capacity than before. Forbearance in development finance is different to other areas. It typically relates to facility extensions or interest deferrals, factors which are not uncommon in normal trading environments, and so it is not really on a like-for-like comparable to the other divisions. Nevertheless, these stand at 16% of the portfolio. And the overall loan-to-gross development value on the forborne portfolio is 62%. Turning now to Slide 24, the SME lending. SME lending has made excellent progress in recent years, following the acquisition of Five Arrows and a number of smaller businesses that we then integrated into it. Lending in the first half was over GBP 200 million, taking the portfolio to GBP 606 million, a 12% increase on the equivalent period last year with a continued improvement in yields driven by an ongoing focus on specialization. The chart on the bottom left reflects the highly diversified nature of the SME portfolio, with 6% categorized in the high-risk sectors, such as media, travel, tourism and hospitality. 90% of the portfolio is secured with the vast majority linked against hard assets. Of the near GBP 60 million of unsecured million -- unsecured lending, GBP 50 million is typically to strong, credit-grade solicitors. SME has been more impacted by the pandemic with a number of part- and full-business temporary closures. Slide 25 will set this out in more detail. Payment holidays here sit at higher levels compared to the other portfolios. However, the vast majority of those customers where forbearance has been provided, in fact 84%, are making their interest payments in full. We have commenced a detailed customer engagement process, obtaining up-to-date and real-time information on our customers' financial position and needs. This enables us to understand the degree to which further forbearance may be required and what level of CBILS and bounce back loans demand exists. The analysis to date suggests a further period of forbearance will be required for some, with 9% of the forborne portfolio, or 4.5% of the whole SME portfolio, being now on our watch list. These facilities and these customers will be monitored very closely. In terms of current trading across the Commercial Lending portfolios, this is now -- can be seen on the next slide. So Slide 26 shows the combined position of the Commercial Lending -- new lending over every month for this calendar year. The impact on SME and motor finance lending was quite sharp in April and May. March was also expected to be a strong month for both, whereas development finance activity has been more robust, as previously highlighted. Looking forward, we expect to see further recovery as lockdown eases. SME lending should also benefit from CBILS and bounce back loans, and most areas will benefit from reduced competition from nonbank lenders. Finally, on the operational areas, turning to Slide 27, we can look at the funding position. This has been one of the real standout successes in this period. Deposit balances -- deposit inflows have been strong, increasing to GBP 6.9 billion at the period end. And that was enhanced by a further, quite extraordinary GBP 600 million between March and the end of May, bringing the new revised balance figure to GBP 7.5 billion. And this has been achieved despite sharp falls in the marginal cost of deposits, which fell from 1.68% in September to 1.08% in May. Clearly, this is the marginal cost of deposits, but it will feed through over time into the stock. There may also be additional moves to come following the news today that Marcus has actually withdrawn from activity in the deposit market, and we'll wait to see the effect that, that will bring. The addressable market has continued to broaden through extending product ranges, enhancing distribution and continuing to deliver excellent customer service as is evidenced by the Net Promoter Score currently standing at a positive 62. Opportunity exists to extend this further. There is over GBP 800 billion of deposits on the balance sheets of the large banks, where interest rates are next to 0. Whilst inertia will remain for some, maybe many, however, as digital engagement increases, some of that, which will have been accelerated during COVID-19, we would expect more of these balances to become mobile over time. Alongside retail savings, we have also issued a new securitization during the period. This has been done to enhance contingent funding. And with access to TFSME being increased and extended for a further 4 years, this has now increased the range of options -- funding options available to us. So turning to our conclusion. This has been quite an unbelievable period, one that we could not remotely have anticipated a few months ago, let alone at the beginning of the accounting year. I'm therefore particularly pleased at the way we responded and reacted to the situation. I cannot thank my colleagues across the whole company enough for their flexibility, skill, passion and commitment to achieve what has been done on behalf of our customers, shareholders and all of the stakeholders. We have reacted quickly and got ahead of the emerging crisis. It helped by already having high levels of operational agility, but this was supported by our balance sheet, defensively constructed to be sustainable and focused on the long term. 98% of the loan book is secured with a CET1 standing at 14.4%. The dividend was passed at the interim, but we will revisit this at the full year. But this will be dependent on the environment that exists and the uncertainties we may see ahead. We have sought to prioritize the protection of our staff and support of our customers while safeguarding the capital base and the franchise of the business. We will continue to do this. Payment holidays and funding through CBILS and bounce back loans will continue to provide support to our customers. Our stance on IFRS 9 is reflective of our cautious approach generally. Whilst the new lending environment has been challenging, particularly in certain areas like SME, although robust in others, we are expecting volumes in all divisions to improve. And with strong capital and liquidity, we're well positioned to achieve this. However, it is right to keep lending criteria tight. The pandemic is not over and the economic impact has yet to bite in many parts of the real economy. We will remain vigilant and cautious. We have also commenced planning in anticipation of the way life and business will change in the future, and we will all need to adapt to the changing customer needs and requirements. We anticipate there will be increasing digital engagement from our customers and expect operating models to be reviewed, affecting the way the market works and the way we will work. While the period ahead will hold challenges, we also believe it will present opportunities. And we will be ready when that time comes. So that is now the end of the presentation. So I'm now happy to hand over to questions.

[Operator Instructions] Our first question today is from Benjamin Toms of RBC Capital Markets.

If later in this year, the Bank of England cuts into negative rates, can you just give us an idea of your interest rate sensitivity, say, to a 25 bps further cut into negative rate? And secondly, what do you expect for impairments for the second half of the year? I know there's a lot of unknowns there, but let's say there's no further deterioration in the macroeconomic outlook. Do we expect similar kinds of levels or a significant reduction in impairments?

Okay. Thanks, Benjamin. I'll deal with the first. Richard, if you pick up on the impairments, please. So we do not believe negative rates will exist anytime soon. I think it's -- a lot of it has been talked about. But we have spoken to the Bank of England, and they have made that position clear that what they are doing is this is part of the armory that they are considering. There is a belief that the transmission of interest rate cuts at this level of interest rates is quite poor. And the degree to which it would, therefore, genuinely benefit the economy is considered to be doubtful. However, the question is still what would happen. We -- a couple of years ago in one of the presentations, we posted that sensitivity. And what it basically estimated for every 1% move in interest rates, it would impact the net interest income line and, therefore, the operating profits by around GBP 10 million. So a 25 basis points would be GBP 2.5 million. Or clearly, either way. Richard, do you want to answer the question on impairments for the second half?

Yes, sure. So the second half position will largely be driven by the position we take in terms of economic outlook at the end of September. IFRS 9 is massively procyclical, and it accelerates your expectation of bad news and, similarly, in terms of improving positions. If everything is flat, I'd say we have the same outlook then as we have now. What you should expect is that there shouldn't be an additional catch-up. But what you would see is that the higher level of, in particular, Stage 1 provisioning that we are putting through would then apply to your -- wherever you are in terms of the net loan book movements. So in the main, if you're looking at your forecast, depending on where the overall balance sheet is moving between the commercial and the mortgage segments, using the disclosures we've given around Stage 1, in particular, coverage ratios ought to give you a guide as to what you think the underlying provision movement may be for H2.

Our second question is from Nicholas Herman of Citi.

I have 3 questions -- or 3 broad questions, I guess. But the first one does have a couple within it. So there on impairments, costs and capital piece. And thank you, first of all, for the disclosure in Note 11. That's helpful. On impairments, I think your point is these look like relatively conservative assumptions and also the relatively low sensitivity of ECLs by moving to the adverse scenario. But all the same, it does just feel to me, I guess, a little bit prudent. Let's say, for the impairments on the commercial side in particular, it's still a little bit low. So just dig into that. I know one of your peers in the specialist commercial area, [indiscernible], has taken a 460 basis points cost of risk in the last quarter. My guess is, by contrast, you've taken something in the range of 350 to 360 in Q2. And similarly, when I look on the commercial coverage ratio, that's only 1.6%, "only." But if I look at larger peers that do more mainstream commercial lending, their cover -- average cover ratios are something in the range of 1.7%. And I think, clearly, your mix is a bit more to the niche end. And just another question on the impairment side. Mortgages, it looks like the coverage ratio is broadly [indiscernible] versus September. So curious as to why you think that's appropriate. And on the Idem side, I'd also note that the coverage ratio has fallen from 216 basis points to 153 now. So what's happened there for Idem to be now seen as less risky despite the change in the environment? So that's the question on impairments. And sort of...

So Nick, can I just interrupt? Bear in mind how many questions you're asking within a question. Can we just deal with the first question and then give you the opportunity to ask the rest?

Sure. The other 2 questions are pretty quick. But yes, that pretty much makes more sense.

Yes. So I mean, as a general point, just doing straight side-by-side comparisons with different businesses is kind of difficult because the word commercial means a lot of things to a lot of people, and it all depends on the underlying asset classes that go into that division. And it will also depend on the nature of whether they're commercial but lending to prime credits or in the more subprime end of the world or whether they're secured or unsecured. So just -- that is sort of one general point. Richard, I think you can respond with some of the detail. But I think, of the Idem point, we missed the fact that Idem has been -- is a business where we buy the loans at discounts to par. So in effect, you are buying them based on an expected cash flow into the future, which is already taking into account in effect, because you're buying them at a discount, there is a form of impairment already coming through the purchase price. So that's why that may change from 1 year to the next and not necessarily reflecting what you see in terms of the coverages. But Richard, if you could pick up the other aspects in terms of the detail. I just wanted to give those general points.

Yes, sure. So on Idem, in particular, we would expect the bulk of any changes to come through the income line rather than appear as a coverage point or an impairment point for exactly that reason. So the average carry value of an Idem asset is materially below par. And so a degree of future impairment is locked in, if you like, on day 1. In terms of the other areas, again, as Nigel said, comparisons with different firms are -- you would need to look at them over a longer period. So I think for the firms you've mentioned there, their go-to provisioning levels and impairment levels have been higher than ours in those segments historically, reflecting the mix of business that they're writing. So it's more the multiple. But I think as well, clearly, within our commercial area and compared to the way a number of others show it, disproportionately, it is dealt with the development finance portfolio, which are a lot of other banks would class as a property book. And that 65% loan-to-value that Nigel talked about gives an awful lot of coverage in terms of provisioning stresses. So I think that at the aggregate level, I think it's difficult to draw those comparables, to be honest, with most banks. But I think we've tried to give as much disclosure as we can to show the quality of the portfolios within those different segments and also the staging. But again, I would also stress, we put most of our SME overlay into a Stage 1 position, not allocated into individual accounts. So you do want to look at that combination of 1 and 2 when looking at coverage ratios as opposed to just the straight Stage 2 position.

Clearly, we tried to do some work of our own in looking what other people say. And actually, when we look at it, there is -- we have produced a lot more granularity and a lot more divisional analysis than is evident, at least so far from others. So where somebody might report an overlay against the whole of their commercial book, you won't necessarily be able to work out whether that's coming from SME or motor or from development finance or any other form of asset class they may have. So maybe more detail from others would be helpful for a better comparison. And maybe that will come when, clearly, we're kind of early out here with more detailed disclosure because we're early on in the cycle here.

Got it. That's helpful. Just the 2 other questions I had on cost and capital, and they're a lot quicker, I hope. Just on cost flex, I know you talked about having closer control of costs in response to a more challenging revenue environment. Just interested in terms of how much cost flex you really have bid on the investment cycle otherwise. And on capital, it's good to see the module 1 IRB application has been submitted. You talked about IRB being a phased -- a staged process. So you submitted module 1. What proportion of mortgages does this cover, please? And are there more modules to come on the mortgage side? And then commercial as well.

So in terms of IRB, it is -- we have submitted this for our mortgage book, which is the most significant and largest asset class in the business. And to be honest, the -- if you'd looked at the other mortgage asset classes, so that would be resi and second mortgages, they're very, very modest indeed. So there is a plan, but it is not something that would have much of an effect in the immediate term in terms of it. So the areas that we would be looking at next to roll out on IRB would be development finance and SME.

Got it. Sorry about that. My question was not -- the point is it covers all of the buy-to-let mortgages.

Yes, all of the buy-to-let.

Okay. Got it. Right.

And in terms of costs, as Richard said earlier, the costs in the business, what we have done is there are a number of decisions made about the timing of investments that were taken during this period, some of which have already been recommenced. So we would expect that to be continuing to H2. And some of the things of recruitment where we were planning to recruit people into the future, some of those have just been put on hold. But that's just because you just -- there's a level of uncertainty here, and we'll wait and see what happens to determine that. So overall, we always try and keep a tight control of costs. But equally, as a business, we're also looking to try and generate more revenue in order to enhance the cost/income ratio. You should never forget there's the -- for the cost-to-income ratio, there's always 2 sides to it.

Our third question comes from Gary Greenwood of Shore Capital.

I've got 2 questions, please. So the first one is on net interest income and net interest margin. So there seems to be a lot of moving parts moving into the second half of the year. So in terms of tailwinds, you've got the GBP 3.7 million on Idem effectively dropping out, assuming there's no change to the outlook. And you've got some mix benefit flowing through from the first half of the year. You've got lower funding costs. But then you've got lower activity as well and you've also got the CBILS and bounce back loans building up there. So I'm just trying to understand how all those dynamics sort of stick together and, therefore, whether we should expect the net interest margin to continue to increase in the second half of the year and whether it [Audio Gap] And then secondly, just a strategic question in the area around actually sort of competition might reduce as a result of COVID, which I agree with. And I'm sure some of the smaller competitors might get into some difficulties. I just wonder, given the sort of strength of your balance sheet and your competitive position, whether that might create some M&A opportunities for you if you're brave enough to do so.

Okay. Richard, do you want to answer the first one? And I'll cover the second.

Yes, sure. Gary -- and there are a few more moving parts that you mentioned as well. So clearly, the reduction in base rates means we'll be losing less on our -- sorry, we'll be earning less on our free equity. We will be able to access TFSME. We've been -- we've got a base allowance that's already been agreed and has been published on the [ bank website ]. That's an additional GBP 1.2 billion. But clearly, we need to grow into that. And it's unlikely that, that would be very materially drawn much before the end of the year. So the low-cost benefit would be -- will take some time to come through. We've also passed on in full to all of our standard variable rate customers the reduction in the base rate. And you'll have seen as well that LIBOR has taken a bit longer to come down. And so where we have LIBOR funding and base rate or SVR customers, there will be a little squeeze there as well. So I would say there are a number of moving parts. The fundamental driver, though, is the relative runoff of Idem and the relative growth on our commercial business. So Nigel showed the progress in terms of the -- what's happened in terms of new business volumes on commercial. If that chart bounces back quickly, then that probably puts you into a position of equilibrium. If it slows -- and it's also worth noting as well that in terms of the bounce back lending and -- or bounce back lending in particular, at a 2.5% rate, those loans would not be NIM accretive. So from that perspective, you may find a little bit more of a challenge in H2.

And turning to your other question. So to date, I think I alluded in the presentation that a number of areas have seen reduction in competition through the withdrawal of nonbank lenders. The -- those -- that situation remains. And whilst some have products out there, I think their product pricing and attractiveness is just reflective of the funding situation. We'll just have to see whether that changes. The one thing that is very different from 2008 is that the banking system is well capitalized, and it is highly liquid. So what there is, is there's no shortage of the availability. Now that may not determine the willingness to compete. We have seen a number of competitors have reduced their credit appetite as a response to the pandemic. Some have eased back in. Some have stuck where they are. And it's probably, in reality, too early to tell the degree to which this is a more permanent feature. We've seen, as we all know, over many cycles, when you do get an impact, there is usually a reaction that causes spreads to widen and credit to be tightened. Now I think the Bank of England is doing its level best to ensure certainly that credit is not being tightened, but inevitably, that will happen. But the question I would sort of pose is -- today is, one, environment. I think the position would have to be made clearer once the furloughing schemes have ended, payment holidays have ended, and we tend to -- we will be able to see the real scarring on the U.K. economy. Only then, I think, you'll be able to determine what the true competitive landscape will start to look like. We've said that we are taking a cautious stance. We've always been a cautious lender, and we continue to believe that, that is the right position to take given the range of uncertainties that are out there. Will there be opportunities? Undoubtedly, yes. I think there will be opportunities over the next few years. I don't think this is something that will come and go inside the next couple of weeks. But I think we'll all have to be a little patient. And by opportunities, I mean there could be opportunities organically or there could be opportunities on the M&A front. I would say at the moment, I think it would be foolhardy to dive in headfirst into the M&A world with so much uncertainty out there. We need to see how this plays itself out. However, the important bit, which I highlighted, you have to be able to have a ticket at the game. And we have strong capital, strong liquidity, a strong balance sheet. And so should those opportunities materialize, we'll be there.

Our next question is from Robert Sage of Peel Hunt.

It was just really a follow-on to some of Nigel's comments and sort of trying to look more at your risk appetite. And there's 2 questions here, one of which is in terms of these CBILS, C-B-I-L-S, loans. Some of the other banks have been less than positive about this. They seem not to like the fact that it's not 100% guaranteed. And I was just sort of wondering in terms of you sort of quite -- I know you said that you will be doing some. And I was just sort of wondering whether you'll sort of be automatically waiving them through, whether you'll actually be sort of very, very cautious indeed in terms of sort of who you extend to. And the second question goes back to Idem, and I very much hear what you say in terms of you might have to wait a couple of years before you see what opportunities are. But I was wondering, if there were to be some very attractive-looking distressed portfolios available in the short term, would you actually have the appetite to sort of step in at this stage and sort of take advantage of them?

Okay. Dealing with the CBILS loans, we are only making these available to our existing customers at this stage. We, therefore, are lending money to people we know, we have done previous analysis, we've got a track record and experience with. So I think that is one factor that mitigates against the perceived risk of -- that you highlight. I know your comment was some banks don't like it because it's not 100% guaranteed. I mean that just goes back to the age-old prejudice of banks only wanting to lend money when it's sort of -- people don't need it. I think the CBILS loan is 80% guaranteed, but the guarantee doesn't extend to interest. And also, there are a lot of procedural matters you have to get right. And so we've built in a lot of quality controls through the underwriting and due diligence process there. And so it is not a loan that just gets waived through, and we are expecting for a number of those situations for them not to be approved. The bounce back loan scheme is a different matter. That has limited conditions attached to it and is 100% guaranteed, which is reflective in the relative yields. You only get 2.5% yields on the bounce back loans, but you get -- well, it's a range of yields that are available. But the aim that the CBILS loan should give you a normal return on capital, even allowing for losses against the 80% -- against the 20% position. On Idem then, I think the same situation applies. There's a lot of uncertainty and a lot of clarity and, hence, why we have taken the provisions that we have done today. The situation would be, I would say, very surprising if we were to look actively at a distressed or otherwise portfolio at this stage given how early we are into this crisis, it is still only a couple of months, and the uncertainties that still exist ahead. You would never say never. However, I would say it's in the unlikely category.

We have a question from Ian White of Autonomous.

Just 2, please. One follow-up on the impairment assumptions first. I'm just trying to wrap my head around the extent to which you have factored in the risk of falling collateral values within the commercial segment, so maybe just 2 specific bits within that. What would you typically hope to recover on a defaulted motor finance loan? And what are you assuming within your forward-looking projections, please? And maybe can you give us some -- is there another similar sort of benchmark you can point us to within the asset finance business more broadly? What would the typical recovery rate look like? And what are you assuming within the numbers that you put out this morning, please? That's question one. And just on question 2, around capital. I think I'm right in saying there should be some -- or the PRA had said they expect to offset the planned increase in the countercyclical buffer to 2% through firms' Pillar 2A requirements. So are you expecting a cut to your Pillar 2A requirement of 100 bps? And if so, when do you think we might see that come through, please?

Okay. Richard, do you want to handle both of those?

I might as well -- I might just pick both of those up, if you like.

Yes. Yes, go ahead.

Yes. So for our provisioning, we put in quite material haircuts over and above the levels that we've experienced for all of those asset classes, and they vary by the scenario. So if you were looking at our severe case, you'll be including probably something around 50% as a haircut on motors and something over 30% on average for the asset business. We also -- they do get some other VAT recoveries on the SME business in terms of those net LGD numbers. So we do have some quite material haircuts included in those projections. In terms of the countercyclical buffer, the PRA is consulting on how they're going to do that. And the expectation is that will be sorted by the end of the year. This is actually a [ cease-rep ] year for us. So certainly, in the final quarter, probably running up to Christmas, we would expect some update in terms of our general capital requirements. But that ought to then factor in whatever is going to be happening around the new resting rate on the countercyclical buffer.

We have one more question from Jason Napier of UBS.

Can I just reiterate our thanks for very detailed disclosures this morning? It's really useful stuff. Two, please. Firstly, on the liability side of the balance sheet. Quite clearly, you have been extraordinarily successful in bringing deposits, and the flow rates are well below your averages. But I just wonder whether you could give some precision around how quickly that repricing takes place and, secondly, whether volumes actually might be a headwind to sort of P&L outcomes, bringing in such significant quantities. With access to TFSME finance too, perhaps those are ahead of loan growth in the near term. So some sort of sense as to what the mark-to-market on the deposit side of the business might mean in pounds rather than NIM in the next little while. And then secondly, I mean, as you've highlighted, you'd expect credit spreads to sort of improve in the wake of COVID-19. I'm just wondering how you feel given all the work that you've done around scenarios and downside risks by portfolio or what you think the mix of business you'll be looking to write in the foreseeable future looks like? Is it sort of demand-driven? Or is there a change in emphasis in terms of risk appetite and the sort of business you think you'll be doing on a flow basis?

Okay. Richard, if you could answer the question about -- which is essentially when does flow impact stock and how does that play out, maybe the second half of the year and a bit. Jason, I wasn't quite sure what you meant by the volumes, the volumes being a headwind, meaning with volumes, maybe demand in the system-wide volumes are clearly weak, that would mean that we don't need so many deposits. Is that what you meant?

That's right. In the past, you've seen situations where you've brought in so much deposit finance that, in a sense, your balance sheet is prefunded for activity [ deep ] into the future?

Yes. Yes. Okay. Well, I mean, just in regard to that, and also it deals a little bit with the second question, I think one of the things I said right at the beginning is that you have to retain some dynamic stance in the way you're managing the business in this situation. We are not unhappy with the risk appetite that we have at the moment. It is tighter than it was pre-COVID, but we are not unhappy with that. We've made the adjustments that we need to adjust, but we will have to keep that under -- constantly under review. We've perhaps been a little surprised to see some people creeping back up the LTV curve already. And as I say, it's only a couple of months into this crisis, and we're yet to see some of the impacts as to how it may play out maybe later in the year. Different markets may react in different ways, and it will all depend on the competitive landscape. I think we see that certain of those sectors are, I would say, more resilient to demand. So some have been impacted quite sharply. Motor finance when they -- basically, you can't get in a car to do a test drive, then it's sort of stopped activity on a sixpence. Similarly, the SME market has also been -- had quite an impact. So when you look at the demand side of that equation, I think that will be -- I think at the given risk appetite that we exist today, that will be probably a bigger factor. We would see fairly decent growth. And the pipeline in our development finance business clearly has -- came off during the crisis but has built back up again. And actually, it's starting to look at more encouraging levels, not quite at the position that it was. And I think that's because the competitive landscape in that area was more influenced by nonbank lenders than in, say, SME lending. But I would say that, yes, I think it is going to be more demand-driven at this given risk appetite. But I think we will have to be -- we'll have to retain some dynamic stance on that. Richard, could you give some guidance as to when flow feeds into stock?

Yes, sure. So if you look at the mix of our deposits, we increased the easy access proportion a little bit across the 6-month period. So it moved from around 28% of deposits up to 30%. So the bulk of our deposit book is on some fixed rate. And the average period over which those come off is the next 27 months. So there is a regular schedule of maturity where people will come off an old 6 and either go for new or for -- to look for another product. So from that perspective, there is a -- like a steady profile of that process. Having only 30% of your book on easy access does mean that it's quite difficult to reprice everything, but that is clearly the area that you can have the most immediate impact on pricing on. And that's where we've seen most of the movement over the last 3 months. But it is a very fair point that as those flows are coming in, it does mean that your ability to draw TFSME and deploy it profitably will potentially be deferred. But we do have a year to make those drawings. And to the extent that you draw them and you use them, effectively, just to put the liquidity back means there's pretty much a neutral cost from that drawing for an initial period, but they do then run for 4 years. So I think that, as I mentioned -- I forget whether it was Nicholas or Gary that asked the question. It will be a while before we can fully draw those cheaper funding sources to entirely frank the reductions in earnings that will -- sorry, NIM that we'll see from the lower absolute interest earning on our net assets.

We have a question from Edward Firth of CPW (sic) [ KBW ].

A very quick one. Just in terms of your dividend cancellation, was that just something that was done in discussions with the PRA? Or was that something you did on your own? And I guess the interest in the question is more about your comments about restarting dividend payments at your full year, which seems somewhat earlier than perhaps we're getting in terms of guidance from everybody else who's talking more about next year. So just sort of some sense of the sensitivities around that would be very helpful.

Okay. No, it was our decision and not the PRA's. Obviously, we have seen the exchange of correspondence between Sam Woods and the CEOs of the banks, and that position was made clear. However, we weren't told what to do or influenced with our decision. We thought it was the right decision given the uncertainties that existed at the time. Uncertainties, I'm afraid, still exist. But I think my point is that we will reconsider the dividend position at the full year. It is the right time to do that. But it will have to be done in the light of the full information that we have at our disposal then, and that will be based on what we see within our business; what we need to do, as in the demands that may exist for our customers; and equally, it may also -- will also be influenced, and quite heavily, by the uncertainties that may still exist at that time. So I can't be any clearer, I'm afraid, just because, you'll understand, it's just too difficult to be definitive as to whether we would do anything at the full year or at some point in 2021.

Sure. No, I'm just thinking if the furlough scheme, for example, is going on until October, it seems to be extremely unlikely that the uncertainty is going to have reduced materially by then.

Yes. But government schemes have been rolled out every few days in recent times, and we'll have to see whether there's been talk of a summer budget or some form of economic stimulus package. We don't know yet because -- and we'll just have to see what it looks like in November.

Okay. So it really isn't -- it is very much a wait-and-see rather than any definitive expectation that we're going to be back on track.

Yes.

We have a final question from Nicholas Herman of Citi.

Just one quick follow-up, please, on the dividend. I assume you may have seen the ESRB's recommendation to national regulators. Now it is advisory. But just curious to know, given that your financial year ends in September, does that -- would that capture you in terms of ability to pay dividends in the -- for FY '20?

We've received no instructions, guidance from our regulator on this matter. And again, I think it is not something that we have yet to consider. Again, I'd refer to the last answer, is we are not going to look at this until the year-end, and we'll take into account all of the things. And if there is an order, an instruction coming from the Bank of England/PRA, then clearly, that will be a factor that will weigh heavily on any decision. If that, frankly, in fact, was an order, then it probably wouldn't be a decision. But I think let's just wait and see. Okay. So that, I think, brings the end to the Q&A. We always like to try and make ourselves available to you today, and I think Richard is making himself available tomorrow. I think a couple of people have booked up calls with him. I would suggest if you do have further questions, then reach out to Richard either directly or via our IR team. On that note, thank you for listening in, and look forward to hopefully seeing you in the flesh next time.