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

Hello, and welcome to the Paragon 2021 Half Year Results Presentation. My name is Rosie, and I'll be your coordinator for today's event. Please note, this call is being recorded. [Operator Instructions] I will now hand you over to Nigel Terrington, CEO, to begin today's conference. Thank you.

Good morning, and welcome to Paragon's 2021 Interim results presentation. Today, we'll be running through the results in some detail as well as providing you with some background to the trading environment, updating on our strategy and with further observations on the outlook, particularly for the second half of the year. Before we get into the detail, I would like to just spend a couple of minutes looking at the half year highlights and our current priorities. So if we turn to the first slide. This presentation and the results announced today cover the 6-month period to the 31st of March, during which society and the economy have continued to be dominated by the direct and indirect effects and consequences of COVID-19. Most of this period, we have all been subjected to varying degrees of lockdown and restrictions. And in this context, I'm absolutely delighted with the way our business has performed, not just in its resilience but in the way strong momentum has been created alongside the economic recovery and the way in which meaningful progress has been achieved in the development of the group's strategic aspirations. While the 45% increase in operating profits has been heavily influenced by the impairment charge reducing to normalized levels, what this masks is a robust underlying performance with strong recovery in lending volumes and pipelines near record highs, good momentum in the growth of the loan book, NIM increasing from 229 basis points to 232 basis points and is on an upward trajectory which we can expect to continue for the foreseeable future and, of course, an excellent customer credit performance across all divisions. The underlying momentum of the business is strong. The interruption to new business flows, particularly in the second half of last year, has largely unwound. With lending volumes up 45% on the second half of 2020 and with strong pipelines in most of the group's divisions means that we can expect a strong second half in activity levels as well as the further improvement in margins. We have always sought to operate with a cautious risk appetite, both operationally and prudentially, and this has, of course, been maintained. The balance sheet is strong with 99% of the loan book secured, largely on property. Our capital ratios have been strengthened by retained earnings, our funding restructuring that has released further capital, all of which has led to delivering a CET1 of 16% and has enabled us to announce today a GBP 40 million buyback program. Not only is this a strong financial and operational performance, but the business has also made good progress in its strategic priorities and objectives, which we can turn to on the next slide. A year ago, the onset of the pandemic caused us to reset our priorities. We have performed well against these objectives and remain committed to keeping them at the heart of our operational decision-making. Our people have been inspiring, showing great passion, commitment and dedication in supporting our customers through this difficult time. Over 90% of our colleagues have worked from home over the last 15 months and have made a huge contribution to this excellent outcome. In turning to the future, our operating model will, of course, change but this will only be implemented when we have fully analyzed and completely understood the consequences of a hybrid model. We are now in the pilot stage of the return-to-office phase, testing different types of hybrid models and making further use of cloud-based technology that will add to the capability of an already flexible and agile team. Payment holidays have been provided across most product lines and was supplemented with CBILS and bounce-back loan facilities, particularly in SME lending. Whilst payment holidays have all but disappeared, we continue to stand ready to support customers and the economy should it be required, including through the Recovery Loan Scheme where we were one of the first participants when this latest government initiative was launched. The capital supporting our business has been well protected. The balance sheet, as I have already said, is strong and is prudently provisioned with a capital base materially above regulatory requirements. The group's reputation and franchise has been strengthened over this period. There is frequent engagement with our customers, and feedback is both positive and reflective of the hard work over the last 15 months. New technology has been employed to improve customer experience, enhance efficiency and strengthen decision-making processes, and a broader technology program is being accelerated as part of our strategy to become a leading U.K.-based technology-enabled specialist bank. I'll now hand over to Richard to cover the financials in detail.

Thank you, Nigel. I'll start with my income statement slide. As you can see, we've delivered strong headline performance with operating profits and pretax profits up strongly when compared to last year's first half outturn. I'll talk in more detail to the main items over the coming slides. But in summary, we've seen further progress on net interest income, with our margin recovering strongly following the decline in the second half of last year. Our third-party servicing portfolios are steadily amortizing, resulting in the period-on-period reduction in other income. Operating costs were up year-on-year, but the main movement relates to share-based accruals. These represent a catch-up after the write-back that we reported at the interim last year. Impairment charges were materially lower at GBP 6 million. Within these, we've made additional overlays to our impairment models, which now hold coverage ratios steady from their 2020 year-end position. Yield curve movements have contributed to a rapid recovery in fair value movements. These tend to 0 over time but, if you recall, were a sizable debit in 2019. Moving on to look at our segmental results. Our 2 core operating divisions, Mortgages and Commercial Lending, saw strong increases in the contributions they made to the group results in the period. Whilst the most material item was the reduction in impairment charges, first half pre-provision profits increased by 7.3% in Mortgages and 27.1% in Commercial Lending, demonstrating the underlying strong performance in these divisions. Idem Capital's performance was little changed year-on-year, with the ongoing amortization of the portfolio remaining stable, building on a continued strong cash flow. The central area reflects the share-based costs I mentioned earlier in the overheads line but also a combination of both higher liquidity and lower returns on that liquidity in the income line. My next slide looks at net interest margin. The charts clearly show that the drag effect coming from the Idem Capital portfolio runoff is having an increasingly small impact over time. The material change in base rate seen at the onset of the pandemic in 2020 resulted in a short-term NIM impact on the second half, with the margin falling to 2.18%. Benefits of the lower rate were immediately passed on to our borrowers, but it took a while for funding to readjust. This impact was fully unwound during the period with NIM now ahead of its first half 2020 level. We continue to benefit from a structural NIM accretion with new buy-to-let loans being originated at wider margins in the back book and commercial loans also being written at wider rates. This is shown very clearly on my following slide. The legacy portfolio is gradually amortizing but at a slow, steady rate. New buy-to-let loans are being written at yields at around 2% more than the back book. And with even stronger Commercial Lending yields, our overall portfolio generates the underlying structural NIM enhancement. My next slide shows the change in funding mix across the period. The first half of 2021 has been a really busy and a very productive period for our savings and treasury teams. Nigel will show a longer-term profile later on, but we've seen some material movements in the last 6 months, with savings balances increasing at increasingly attractive rates for the group. TFSME has been drawn, TFS has largely been repaid and the legacy SPVs have continued to be refinanced. Savings deposits continue to be the focus of our liability expansion, with the core proposition being enhanced by a broader development of relationship platforms. Moving on to operating expenses. Our cost-to-income ratio has been materially influenced over the past few years by the profile of Idem Capital's earnings, Idem being a high-yield, low marginal cost business. The chart shows the profile of the trend movements in the ex Idem ratio, together with the reported level. The reported ratio has been broadly unchanged now since 2018, reflecting continued business investment, IRB costs and some relative swings on share-based expenses. On this latter point, we saw a write-back in H1 '20 and a catch-up again in the last half year, the average of the 2 periods being in line with the previous reported levels. Whilst not material relative to our peers, we have increased the scale of our software capitalization when compared to 2020 as our technology enhancements get rolled out. The bulk of our costs continue to be expensed, but the capitalized element has risen from GBP 0.4 million in the first half of last year to GBP 1.4 million in the latest period. Our underlying costs continue to run a little below expectation. But the pickup in share-based costs means we'll be leaving our full year cost guidance of around GBP 138 million unchanged from the level we gave you at the end of last year. My next few slides cover various aspects of the impairment charge for the group. I'll start with our economic outlook and the scenarios we've used for our underlying impairment modeling. As you can see from the charts at the bottom of the sheet, our GDP forecasts for the base upside and downside scenarios reflect varying degrees of recovery from the COVID pandemic. They're all overlaid with different assumptions regarding house prices, which are only expected to remain positive in the short term in the upside scenario. Our scenarios continue to reflect rising unemployment, peaking at between 7.8% on our base case and 11.9% in our severe case. Now clearly, we note recent performance and forecast which suggest these levels may well not be reached. Our preference, though, at the interim, has been to remain prudent here given the 4-plus million people who remain on furlough. For our severe case, we have taken out the 2021 Bank of England stress and overlaid this with a harsher house price profile. This represents a near 35% peak trough reduction in house prices and a very slow recovery from that position. The scenarios table on the slide details the impact of the different economic scenarios have on our interim provision. And there's a GBP 65 million swing between the upside and severe cases. This potential volatility in outcomes has contributed to our thinking and our approach to post-model adjustments at the interim, and I'll come on to those in a moment. My next slide looks at payment holidays. And clearly, there's been a particular feature of the COVID response. We hit peaks in the summer of 2020 of around GBP 2.5 billion of customers taking holiday reliefs. The levels are almost fully back at normal payment arrangements, and only GBP 30 million or so of balances are still remaining with payment holidays in force. Of those customers that took holidays, there's been a pretty even distribution between those that saw their arrears worsen afterwards and those where their position improved. Whilst the net figure in the little box on the left is minimal, there's a greater degree of volatility in these accounts, which again contributes to our thinking around post-model adjustments. If we can move forward a slide, this one details the actual impairments, PMA approach and coverage ratios. Starting with the table on the top right, the multiple economic scenarios used before any PMA would have delivered a reduction in the calculated provision to GBP 54.9 million. The effect of this would have been to take the impairment coverage ratio down from 64 basis points at the year-end to 47 basis points at the interim. A consistent application of the PMAs we used at the year-end, which reflect the general lagging impacts of government interventions on impairment emergence and the specific effects on payment holding accounts, would have taken the coverage ratio to 57 basis points. Given the volatility we've seen around scenarios, at the interim, we've added a further PMA. This serves to maintain coverage ratios at their September 2020 level. The table at the bottom left shows, in the right-hand column, the actual levels reported at the interim. To give some additional transparency around the impact of weightings and PMAs, we have shown the level of provision required if PMAs were retained at their September 2020 levels but instead applied to the weightings that we used when we first transitioned to IFRS 9. This is in the left-hand column and reflects more benign times. As always, we'll keep a close watch on consumer -- customer performance and macro developments to determine the right levels of scenario weightings of PMAs at the year-end. My final table on this page details the year-on-year comparison of indexed behavioral scores for each of our retail portfolios. Whilst there will always be volatility within them in the average, the overall position for each portfolio is improved from its March 2020 level. My next slide summarizes the main movements in capital from September '20 to March '21. The first one we note is on the IFRS 9 transitional adjustment, and the impacts here are immaterial at just 0.01% of CET1. Profit levels have been strong in the period, as we've reported, and has contributed a 1.1% CET1 improvement. The balance sheet was little changed in the period, and the overall risk weight density actually fell. However, we expect this to reverse going forward as our Commercial Lending portfolio expands. In numbers terms, our risk weight density was 44.6% at September '20 but has reduced to 43.5% at March '21. The interim dividend has been set in line with policy but half of last year's final dividend. This represents a 0.3% use of CET1. Other movements are a bit more material this time around. We've seen favorable impacts on the deficit on our defined benefit pension scheme. This fell to GBP 11.8 million at 31st of March, contributing 0.1% to our CET1 figure. Fair value movements on portfolio hedges have contributed further benefit and the repackaging of extant securitizations removed GBP 0.2 billion of risk-weighted assets from the balance sheet. These represented the fair values of currency derivatives and associated CVA adjustments within those deals. This contributed some 0.5% CET1. At 31st of March, we had a further GBP 0.2 billion of fair values ascribed to currency swaps and vehicles where calls have now been placed. As such, there'll be a further small CET1 gain in the second half of this year from this activity, but this won't repeat again going forward. Our U.K. leverage position continues to be strong and generates no constraint on our operations. My final slide summarizes our capital position at the interim. The impacts from the previous slide have contributed to a strong capital position at March with CET1 at 16% and a total capital ratio standing at 18.2%. In addition to our actual capital levels increase, we've also seen our regulatory requirements fall during the period following the PRA's review of our ICAP in their periodic SREP process. We would always look to operate at a level above the regulatory minimum, and we should also note that the countercyclical buffer currently stands at 0. But notwithstanding those, our capital position still remain strong. This exceeds our near-term organic growth requirements. So we've chosen to announce the buyback of up to GBP 40 million that Nigel mentioned at the -- as part of his introduction. My slide also notes the ongoing progress we're making with our IRB application. As I mentioned last year, we've started with buy-to-let and our phase 2 documents are with the PRA for review where we await their feedback and the confirmation of their requirements for the next stage of our engagement with their expert teams. We are also well progressed on our development finance IRB rollout and would expect the application for that portfolio to be made in early '22. In summary, I'm really pleased to be able to summarize such a strong set of results with record first half profits, continued caution in our impairment assessments, a capital base that reflects the strong earnings, a quality loan book and careful balance sheet management. And I'll now pass you back to Nigel. Thank you.

Thank you, Richard. I will now cover the wider business performance, our strategy and outlook. This slide represents our strategic framework, something we set out in some detail at the last year-end. And it is clear how we applied this in practice in the first half of the year. The use of the deep knowledge and multi-cycle experience across the group, supported by extensive data analytics, can be evidenced in each business line and will be seen across the next few pages. Importantly, this capability enables us to take a low-risk approach in specialist lending sectors where larger banks would struggle to achieve the same outcomes. The increasing focus on specialist markets also needs to be set in the context of a need for scale. Banking has relatively high fixed cost structures, and certain markets do not generate adequate revenue either through yields or in absolute scale. And consequently, we seek to avoid them. This can be seen by the recent decision to exit our presence in the second charge market. The market is small and was not capable of generating sufficient revenue to justify the investment required. Technology is becoming increasingly important to all banks, and this is also true at Paragon. Our strategy to create a technology-enabled specialist bank is being achieved through a digitally focused cloud-based modular approach, delivering modern technology across key areas of the group. Some phases have already been delivered, such as the new savings platform, enabling the bank to source deposits from a multitude of third-party relationships such as Hargreaves Lansdown, Monzo and Revolut, to name but a few, thereby increasing the scale of our addressable market. These capabilities are helping us to erode some of the competitive advantages held by the clearers, such as their cost of funds and capital efficiency via IRB. However, always, we will retain our key points of differentiation, particularly around our focus as a specialist bank. We stated at the year-end that we remain committed to the return on tangible equity target of 15%. There has been nothing this year that has shaken us from this belief, and our decision to launch a buyback program is part of the process of delivering on this commitment. Although, it should be emphasized, this is not to the exclusion of employing capital to support growth organically or inorganically. Turning to the next slide, we can look at our wider responsibilities. Financial institutions are becoming increasingly aware of the responsibilities they have towards the environment, society and their wider stakeholders. We take these responsibilities very seriously but recognize, as is the case for many, that this is work in process not just in terms of our operations and our funded emissions but also in the way in which we communicate. In our full year results, we expect to share with our stakeholders a more meaningful description and explanation of our activities and plans. However, we have not been idle. We recently issued the first ever U.K. bank Tier 2 green bond where the proceeds will be used exclusively to provide environmentally enhancing lending products. In addition, some of our lending products, such as the recently launched EPC A- to C-rated buy-to-let mortgage provide further evidence of our commitment to doing what is right. As I said, this is work in progress for all of us, but we have more to say at the year-end. I can now turn to reviewing each of the key product lines, starting on the next slide with buy-to-let. For the comparable period, last year was, in reality, largely pre-pandemic. So achieving 95% of the 2020 equivalent period's volume is pleasing in itself. However, momentum is strong with H1 lending of GBP 715 million, which itself was 58% above H2 last year and where this year's quarter 2 was 16% above quarter 1. The buy-to-let pipeline stood at GBP 930 million as at the end of March but has strengthened further since then. We, therefore, expect the second half of the year to deliver further growth in volumes. Redemptions remain low driven by customer retention activities, thereby continuing to support growth in the loan book. There is, of course, a lot of noise around the housing market due to the stamp duty holiday as well as lockdown-driven changes in property demand. The freezing of the market last spring thawed by the summer. And although some softening was evident in Central London, this has now stabilized, with all other regions remaining steadfastly robust in terms of both purchase activity and rental demand. Turning to the next slide, we can look at the buy-to-let credit performance. As you are aware, we have extensive experience in buy-to-let going back over 25 years, with data capable of being used to support stress testing, our important IRB program, underwriting as well as portfolio management. The quality of the loan book has been evident through the customer credit performance over time and under stress in the pandemic as well as during and after the global financial crisis. With an average LTV of only 64.4% and, importantly, only 2.9% greater than 80% LTV, the asset backing of the portfolio is clearly evident. Data analytics and technology are playing an increasingly important role. Our new intermediary portal, a cloud-based platform with open banking and API capability has been well received. Separately, our systems analyze 750 million pieces of customer data and are used in behavioral scoring models in our portfolio management teams. We can, therefore, be confident that despite the strong growth we are seeing, it is being delivered with the same cautious risk appetite that has been successfully applied for approaching 3 decades. Turning now to our commercial division. Commercial Lending is, of course, a more cyclical business line, and new business activities were more immediately impacted by the onset of a pandemic last year, something that was particularly true in SME lending. As can be seen from the graph on this page, activity levels were particularly affected by the first lockdown last year. However, the first 3 months of this calendar year witnessed a good recovery where it is notable that the economy as a whole has learned how to adapt to lockdowns. This recovery has continued into our quarter 3, which has also been supplemented by motor finance, restarting a broader range of products. We can now look at the commercial business lines individually over the next few pages. Development finance has had a comparatively robust and stable pandemic with new lending up 16% on last year, and the portfolio seeing a 10% increase to over GBP 550 million with yields being maintained. With a pipeline that has seen further growth and is close to an all-time peak, the prospects for our development finance division is increasingly encouraging. If we now turn to the next page, we can look at our SME division. SME was our most impacted division, with customers deferring investment decisions and making extensive use of government initiatives such as CBILS and bounce-back loans which, in effect, substituted for more traditional facilities. Whilst we have participated in these schemes, our focus was very much supporting our existing customers rather than using those schemes as a marketing initiative. In credit terms, the portfolio has performed well, with payment holidays reducing to negligible levels. Only 1% of the book now requires some form of ongoing support. The page shows how well diversified the portfolio is and has only GBP 32 million of balances in the more COVID-affected sectors. And of this, only GBP 2 million is at Stage 2 and 3 under IFRS 9. New technology will also play a role here as well. A cloud-based, open banking and API-capable intermediary portal is being developed, which will be used alongside data-driven decisioning model, accessing over 3,000 pieces of data as part of the underwriting process. Customers have been more optimistic about the future and increase the investment is being seen. Month on month, progress is now being achieved as the economy recovers, and we expect strong outperformance in the second half of the year compared to 2020. So finally, let's look at the savings and funding side of our business. Our savings business has been a real standout performer. Deposit balances are up 25% over the last year and up 10% since September and more recently passed through the GBP 9 billion portfolio milestone. This has been achieved whilst rapidly reducing retail funding costs, down from 134 basis points in September to 108 at the half year and now has fallen below 100 basis points. With a still favorable front book/back book dynamic, we expect further reductions in funding costs in H2. Not only has the savings business funded the growth in the loan book, it also refinanced over GBP 800 million of legacy securitizations, which also supported the LIBOR transition process, improved NIM and release capital tied up in old SPVs. As previously mentioned, the group also refinanced its Tier 2 bond with a new green Tier 2 debt issuance. On this occasion, at nearly 300 basis points lower than the existing deal, virtually all of which was due to the improvements in Paragon's credit spreads. We have not had to issue MREL debt. And although the framework is currently being reviewed by the Bank of England, we do not believe MREL will apply to us for the foreseeable future. New technology is already playing an important role within our savings business. The new digital platform being used to manage third-party relationships, as I mentioned earlier, has the potential to deliver enhanced capability in due course. Our view is that there is potentially a big prize due to the structural changes in the savings market with over GBP 800 billion of deposit balances held with the clearers, earning virtually nothing and where open banking and API technology could help break down the inertia within the current system and lead to a more level playing field and an erosion in one of the big banks' key competitive advantages. This will, of course, take time, but the scale of the opportunity is meaningful. So finally, in conclusion, the first half of 2021 has evidenced how well the business was positioned going into the pandemic, how well the disruption was managed and how we are in a strong position as the economy moves out of recession. Lending volumes have been growing on a monthly basis as momentum has seen quarter 2 outperform quarter 1. And with strong pipelines, we are expecting further growth in the second half of the year. These are, of course, unusual times, and numbers have been more volatile from period to period. In order to help, we are providing some explicit guidance. Although, please, do not expect this to happen every year. We previously expected buy-to-let volumes of GBP 1.35 billion for the year. We now expect GBP 1.5 billion. Commercial Lending expectations are that volumes should now exceed GBP 900 million for the full year. Our original NIM expectation was for 229 basis points for the year. This has already been exceeded in the first half. And with good asset yields, the continued structural shift in the business mix and further funding cost benefits to come, we are now looking at NIM for the full year to be at least 235 basis points with the upward trajectory set to continue for the foreseeable future. Costs should be in line with the original expectations of GBP 138 million. The quality of the balance sheet, underpinned by strong capital ratios, has ensured the group is incredibly well positioned to deal with any disruption caused by the unwinding of the government support programs as well as being well placed to support growth and to react to opportunities, organic or inorganic, that may arise. These have been challenging times, and this pandemic is not over, but I'm incredibly proud of the way our business has responded in supporting our customers, our staff and the wider community by doing the right thing and doing them well. Whilst there are unknowns in the periods ahead, we are also excited by the opportunities that may emerge and in continuing to develop and grow the business to become the U.K.'s leading technology-enabled specialist bank. That concludes the presentation part of today's event. We are now ready to take questions.

[Operator Instructions] And the first question comes from the line of Benjamin Toms from RBC.

Two for me, please. Firstly, on the dividend buyback. Can you just talk through the Board's thought process of the balance you've chosen between dividends and buyback and the quantum of the buyback? And then secondly, in December '20, there was a government paper requiring all nondomestic buildings to have an EPC rating of B or higher by 2030 to be let or sold. Just interest on your thoughts on, one, whether a similar rule could be imposed on residential property in the near future and, secondly, whether this would be a big deal if it was.

Okay. So let me just handle that. So the mix between our different letters of capital repatriation and, frankly, more broadly, the employment of capital, is always something that needs to strike a balance. So you've clearly seen a very strong accretion to our capital ratio. And our strategy and policy in terms of dividends has always been, in the past, that our dividend -- it's a phrase, it's a bit of a cheesy phrase, but yes, a dividend is for life. That's what you want to maintain to the absolute extent possible. So we've always taken a more cautious approach to dividends. Our payout ratio of 40%, 2.5x covered, has been something that we've always wanted to adhere to and then use buybacks as a form of a method of regulating our capital. If you look back over the last 5 or 6 years, we've been a frequent user of that strategy, and we've had extensive buyback programs in the past. So this should not be any great surprise, and it's actually just a continuation of what we have done in the past. And you should read nothing more into that. The important bit, though, is the -- our view is that you should not also view a GBP 40 million buyback as being anything to do with we're lacking ideas, we're lacking growth. You can clearly see strong growth in the expectations for the business going forward. But clearly, we have a very high level of capital, and we just think it's appropriate to regulate that a little bit further. In terms of the EPC question, I think the journey -- the travel, the journey, that we're on here is that we should expect continuing tightening of the various standards on the various sustainability measures. So you've seen us launch product this year where we have offered particularly attractive terms for landlords with an EPC rating of A to C. It's like an encouragement for landlords to upgrade their properties. I think the -- if you address this to the wider market, there's a lot that has to happen between now and 2030, as you pointed out, in terms of improving the -- or upgrading the standards in the property. But I think the government -- we've got COP26 later this year. The government is very intent on its strategy towards wanting to get as many improvements across the economy as a whole in terms of sustainability. I do think that this is one of the big potential strategic initiatives for the banking sector across the next 10 to 20 years. It's -- clearly, none of this is going to happen overnight. But I think the industry will have to pay a lot of attention to upgrading -- or getting the properties to be upgraded over the course of the next sort of here 9 years or so.

The next question comes from the line of Gary Greenwood from Shore Capital.

I've got 2 questions, if I can, please. So the first one is just following on from Ben's question on capital and just thinking about your RoTE target. I think historically, you talked about maybe getting down to about a 13% core Tier 1 ratio as the right sort of level for the group to operate. So I was just wondering if that's still ultimately the target in order to deliver that 15%-plus RoTE target? And then second question is on funding. Obviously, good to see the green bond launched, price well inside the older bond. I was just wondering how much of the improvement in pricing you would put down to the fact that this is a green bond, and, therefore, you are getting those sort of ESG benefits? And then also related on funding, obviously, your loan-to-deposit ratio has been coming down as you've been growing the retail funding within the business. Do you have sort of a target, ultimately, that you want to get that down to sort of the right balance there for the business?

So let me just deal with the green bond to start with. And maybe, Richard, you'll pick up on the capital point earlier. In terms of the green bond, I think we made a comment in there that most of that 300 basis point improvement was attributed to a tightening of the Paragon premium, the credit premium, over the risk-free rate compared to where we were 5 years ago. I would say this is still very early days for the development of the ESG agenda and the investor community looking at these bonds as being -- where there's sufficient degree of differentiation taking place because it is a green bond as opposed to a nongreen bond. I also think that deal was a sort of sub-sterling benchmark issue. So a typical sterling benchmark issue is around GBP 250 million. It's only GBP 150 million. So because of that, a lot of the bigger funds, some of the more household names, it's just below their radar. So I think that would have attracted a broader ESG following if it had been. So I don't think there was much in the price because of it, but I do think that there is a lot more to come from that in the future. Richard, do you want to cover the ROE?

Yes, sure. Gary. To start with, I'd stick with that 13% CET1 level as our broad guide. I think that there will be further updates that we'll need to give as we go through the rollout of IRB in years to come. The relationship between the Pillar 1 requirements and Pillar 2 capital means that, that appropriate figure may change over time a little bit but, certainly, fewer plans at the moment, I would stick on that basis.

And just on the retail funding and that target you'd get that down to.

Yes. So the if you go back to the point that we launched the bond -- sorry, the bank, clearly, we were pretty much 100% encumbered. The group's funding then came in the form of warehouse and securitization lines. If you look at the typical balance around most European banks, you're in -- you've got incumbents who are probably between 20% and 30%. I would have thought that in a BAU environment, that's the sort of range that we would end up looking to operate within. Slightly inverse of your loan deposit point, but you get to the same answer.

The next question comes from the line of John Cronin from Goodbody.

I have a few. The first one is on buy-to-let asset yields. Just in relation to your full year NIM expectation of greater than 235 basis points, does that embed assumes stable pricing through the second half? And maybe if you could talk a little bit about what you're seeing in the market in terms of competition, rate competition, particularly. Secondly, I just wanted to ask as well on Basel 3.1 and when you expect to have some more clarity from the PRA in terms of the recalibration of the standardized risk weights regime. Look, I appreciate that your IRB application with respect to buy-to-let is in train and could well be approved before the 1st of January 2023. But I just wanted to get a sense of the kind of latest in terms of your thinking on the standardized risk weights and how they might move. And then finally, just a quick one really on -- given your prefunding and excess capital and albeit, you've done -- you've announced a GBP 40 million buyback. What kind of opportunities are you seeing in the market for potential inorganic expansion? What -- how is pricing in relation to any potential such transactions? How -- is that pretty -- are price expectations excessive on the part of vendors? If you could speak a little bit there around -- probably might or might not see, I suppose, on a medium-term view, that would be helpful.

So Richard, cover Basel 3.1, and then I'll pick up the others.

Yes, sure. So in terms of the process on Basel 3.1, we understand that the PRA are going to run a consultation process later on this year with an idea then that they will produce a policy standard in the middle of 2022. And the latest that we've heard is they're still very much aiming at the 1st of January '23 introduction. So I think there'll be a lot going on over the next few months. Certainly, by the time we report the full year, we would have expected for that consultation period to have been completed, and we'll be able to update you then and what our views around that consultation is. Until we see it, it's hard to tell. In terms of the piece around the risk of any potential risk weight inflation that comes from Basel 3.1, it's worthwhile noting that during this period, we've had an update on our regulatory capital requirements from the PRA, which has resulted in a much reduced level of Pillar 2 away from the levels that we were operating at previously. In terms of capital risk in Basel 3.1, that mitigates that risk very, very materially, if not wholly. And so we can look forward confidently in terms of our capital position, almost absent any consideration of the timing of IRB or that Basel 3.1 introduction. And on that basis, that's why we're happy to announce the buyback today.

Okay. So in terms of the buy-to-let, I presume, John, you're talking about mortgage yields as opposed to the underlying property yields. But they -- where you saw our pricing -- let's call it, a mini-correction take place a year ago for the mainstream mortgage market, it was -- just as people rebased in a risk environment, rebased pricing upwards. It was less pronounced in the buy-to-let market. And -- but there was also a fair bit of LTV adjustments that took place at that point as well. So for a low LTV, the pricing was maintained. So on a risk-adjusted basis, the -- there was sort of certainly an enhanced mortgage yield that was coming through. I would say if you look at the data, there's nothing to suggest -- I'd say there is some softening taking place in the mainstream mortgage market now. But that's not feeding through so significantly, certainly, in the data on to the buy-to-let market. We do see a little bit of noise out there. There's been -- typically, credit standards have been -- people have been very sensible on that. But there's been a little bit of price competition, I would say, coming from some of the nonbanks. I think they have had a bit of a run on very much cheaper wholesale funding costs that have come through in the last few months or so. And so I think they've got a little bit of a benefit from that. But we're getting a very, very strong return on equity on our buy-to-let products. We have certainly got a much better funding position than we had a year ago, than we had 6 months ago. And I think as I pointed out in the presentation, our front book/back book dynamics is such that we expect to see further liability margin improvements coming through not just over the next 6 months but probably for at least a year or so, maybe longer, beyond that as well. So whilst there's a bit of competition, it's certainly not -- it's not something that is being massively disruptive. And so that's that. In terms of the M&A side, I mean you've seen the fact that a little bit like we've not been frightened to use capital buybacks as a method of regulating our capital. Also, one of the things I like about buyback is that there's a discipline. There's always a danger for banks. If they've got too much capital, it burns a hole in their pocket, and they have a need to spend it. We've never felt that. And so for us, we always wanted to sort of use any capital on the acquisition side to develop the business. So you've seen us make 4 acquisitions in 5 years. All of them have been very, very useful and supportive of the diversification strategy and have basically helped us form the Commercial Lending division as it is today. All acquisitions, in fact, all organic initiatives and growth, has to pass the centralized 15% return on tangible equity objectives. So although we've refined M&A opportunity, it will have to get through that test. Now for as long as I can remember, vendors have always had a high expectation of value. And sometimes, those can be realized, not with us but they can be realized, and sometimes they're not. We're very patient and we will not dive in unduly on any part of our business in terms of the M&A front. And we also have the discipline there to say we're happy to return capital if we cannot employ it in any useful and meaningful time scale.

Very clear. Can I come back on one point, actually, for you, Richard. Just on the receipt of the policy standard in mid '22 from the PRA and your expectations. Like, is that enough time for the industry to get itself prepared to the extent that there is substantive change in the risk weight recalibration context? I mean, look, I appreciate, from of your perspective, you've made a point that you must reduce P2A requirements, so there's -- that's naturally going to mitigate some -- you might as well have IRB anyway, I guess. But is it enough time for a systems change? Could you see, I suppose, a potential push on the part of the industry to have the kind of implementation date of 1st of January '23 pushed out? Or am I overthinking this on the systems capability point?

I think more notice would obviously be better than less. The requirements have been pretty well trailed for some time. So the market's got a pretty good idea of what's going to come along. I do think there are some nuances that people's existing systems for their risk weight reporting don't cover that easily in terms of their core reports at the moment. One of the obvious things is the potential for using original valuations rather than indexed valuations for their reporting and analysis. So again, the degree to which that is a major systems recalibration, I think, is going to be one that each individual firm would need to look at. It feels like a very tight period, and you would normally expect something a little bit more material in terms of time frames to deliver that, but I think a lot will depend on the interpretation that the PRA take. If they -- there'll be a range of national discretions and interpretations that they need to incorporate. And if those are more consistently and closely aligned with the approach of banks at the moment, it may well be quite possible then to get that done in time. The more radical the change is, the more challenges there will be in terms of implementation.

The next question comes from the line of James Invine from Societe Generale.

I just wanted to ask, please, about any insight you can give us on the resilience, the financial resilience, of landlords. I mean I presume you saw the English Housing Survey that came out fairly recently. And that was suggesting that 9% of private rental tenants are in arrears. So that's up from about 3% prior to COVID which, given that you have a reasonably decent [ measurement ] on credit quality, means that the landlords are able to take the pain. How much more pain could they take? I mean just assuming the unemployment numbers don't turn out quite as well as expected and so on, how much more pain can your landlords absorb before they start passing it on to you?

Okay. So yes, we did see the English Housing Survey, and we obviously conduct a lot of our own private surveys. We also do -- one of the things I referenced in the presentation was the analysis that we do on a monthly basis where we download 750 million pieces of data. This is not our own. This is our customers' data, but from public information, and this gives us a little bit of an insight into their lives. Appreciate, that sounded a little bit Big Brother. But -- and it tells us, even though the loan is fully performing and they haven't missed a beat, it will give us a little bit of a warning, a heads-up, if there's anything odd going on in their lives. And there's -- frankly, there's nothing that gives us any cause for concern about the underlying behavioral modeling characteristics of our landlords. Now turning to your point specifically on what tenants are doing, there is -- invariably, some tenants will have come under some pressure during the course of this last 12-month period. What landlords have done, where they have come across those situations, I think they've behaved very responsibly and very sensibly. And they've worked with the tenants where that has been necessary. And they have agreed maybe a temporary reduction in rents. They have agreed that they can pay, let's say, 80%, and the 20% would get, in effect, capitalized into a payment plan over an extended period of time. What we are seeing is no undue levels of stress applying across that, across the book, and no notable levels of stress even in some subcategories or even geographic regions as a consequence. Unemployment, I think, has surprised us all about how resilient it has been. You've seen the forecasts were 8%, 9% when this all kicked off. And here we are at 5% and seemingly heading south. We've clearly got the unwinding of the furlough scheme still to come later in this year. But we also see significant talks of labor shortages taking place across key parts of the economy. So overall, we always keep an eye on it. We're monitoring our portfolio on a very regular basis. There are no levels of stress that give us any cause for concern. But we have been cautious, which is one of the reasons why we've maintained our coverage ratio where it is. Also, I would point to the loan to values. At 64% loan-to-value, you've got a lot of asset coverage. Only 2.9% of that is above 80% loan-to-value. And when you look at -- one of the things that people have highlighted is Central London, has been a bit of an area of weakness, which there has certainly been some weakness in rental demand up until maybe 6 months ago. It's stabilized then, and it's actually -- rents are starting to rise again in that area. But our average loan-to-value in London -- we don't have much, by the way, in London, but the average loan-to-value is below 50%. So I feel pretty confident that the position could be maintained.

[Operator Instructions] Our next question comes from the line of Edward Firth from KBW.

I have 2 questions, please. The first one was just coming back to this question of your yield on new mortgages, which I think, in the presentation, you said was almost 4%. I'm just trying to really understand that because, I mean, rental yields in the U.K. are running at, what, somewhere just under 5%. I could go out tomorrow and get a buy-to-let mortgage at 1.5%. And I just don't really understand why, when the market is so benign for house prices, the outlook is so good, unemployment is so great. But firstly, people are prepared to pay that to you, and the yields they're getting can't be much in excess of that and/or why other banks aren't sort of piling into that market and undercutting you. So I guess that would be my first question. Should I go on to second one? Or do you want to answer that one first?

Okay. Let me deal with that one. So the mortgage yield that you're referring to, that's lifted from the package, the EIR, okay? So that would include fees. So that's not the headline rate. And secondly, whilst you can get mortgages up 1.5% and, obviously, lower than that in the mainstream market, it will also depend on a whole bunch of other characteristics, one of which is whether they are a specialist landlord, whether they are dealing with more complex properties for example, HMOs, student blocks or anything like that. So there's a whole range of factors here, in why 1.5%, because if that rule applied, everyone in the world would get a mortgage at 1.5%.

No, exactly. That's what I was thinking.

It is more complicated than that, and there is a broad range of criteria that apply. You've seen that about 96% of our new lending is in a category called complex. And complex will be the professional landlord. It will be corporate situations. It will be complex properties like an HMO, a student block or something like that. So you can see that those are not done by the mainstream, high street lenders, just because it requires a bit more experience and it's less commoditized in its approach. So that's why we justify a premium yield, mortgage yield, relative to some of those more mainstream products. The rental yields, 5% or so, and there is a range, you'd be lower than that in London, but you can get quite a bit higher than that depending on whether you have -- different parts of the country and whether you have a complex property. Student lets, for example, do not get 5%. They are higher than that, and they need to be higher than that because there's usually more maintenance costs involved in it. So it is a variety of factors that go into this. And you shouldn't look at a 5% return versus a 1.5% or a 4% or whatever because that's assuming 100% gearing as your cost, which clearly never happens. The average of 64% would mean that you're looking at, what, 3.5% versus 5%, in your example, and so where you're approaching there, whatever it is, 140%, 150% debt service coverage ratios. So I think it is for a whole bunch of those reasons why I don't think that's actually necessary, just -- it's not -- life is not as simple as that. Did you want to come to the second question?

Yes. So just it was sort of slightly related to that. I mean you might have quoted this to someone, and I apologize, do you know what your sort of average rental yield of your finance book is? Do you have some sort of measure of that?

Well, I mean I think we can measure it against what we -- what is current, as in what we've originated now, but we've got loans on the book. We've got GBP 4 billion worth of loans that predate the financial crisis. There's been fairly strong rental inflation since that time. And so we can index it, but it wouldn't be as accurate a piece of data as a relatively new. But the yields off of our new flow will typically be in the order of somewhere between 5.5% and 6%.

Okay. That's very helpful. And then I guess my other question was related to house prices, not really -- sort of broader sector question. But I mean if I'll go back this time last year, everybody was sort of super bearish on house prices and very cautious and prudent. And we come on a year, and house prices are up, what, 11%. And now everybody seems super bulled up on house prices and super optimistic. And yet, we're also thinking about rising interest rates, stamp duty coming back in. So it's not impossible to think of a situation where that might not necessarily come through in the same way it didn't come through the last few as we expected. What's your thinking on that, both in terms of how you manage the business but also just generally in terms of are you as optimistic as perhaps many commentators are? Or do you see more reason for caution? Let's put it that way.

Okay. So yes, I mean you're right. I mean this -- there's a lot of things in the last 12 months that surprised us, and the strength of the housing market -- or strength of house prices and the housing market have been one of them. Clearly, you can't have 11% increase in house prices taking place year in, year out. And what you've got is a couple of factors. You've clearly got the extra spurt of activity being caused by the stamp duty changes. Now I think the actions that the government took to phase out stamp duty is sensible. We've always seen stamp duty changes being used as a bit of a blunt instrument that accelerates activity. And then there's a cliff edge, and it all comes off in the next quarter. Here, there was a small blip that took place in March. I think there will be a small blip in June. There will be a small blip in September. But phasing that out is both helpful for the market, helpful operationally, and also is something that will at least mitigate, to a degree, that cliff edge-type event that we have seen in the past. I think that you will undoubtedly get a final quarter of the year, which will be a quieter quarter than we would have seen in the previous year. But when you look at the long-term situation, I think you have to always come back to affordability. Affordability is running at kind of half the levels at which you would say this looks like a problem. And clearly, it's a combination of very low interest rates and incomes that have been generally supported over x number of years. So I think house prices would have to still run up quite some way -- I'm not suggesting this will happen, by the way -- in order to show affordability constraints like the times that we saw running up into the financial crisis. And actually, any other time when there was a house price correction, you always -- it was -- the precursor was when affordability was getting stretched, and it is a long, long, long way from getting stretched. So I get your point about 11% is not sustainable, and it's not, but nor do I think it's in correction territory either.

We have no further questions coming through. So I will now hand back to Nigel for any closing remarks.

Okay. So thank you for your time this morning. I mean you will have got a real sense from us about how pleased we have been with the performance of the business. The operational resilience has been very evident and very strong. And my hats go off to our colleagues who have been absolutely wonderful in the way in which this business -- they've supported this business and our customers throughout the difficult period. And then just when they need to take a breath, they're now supporting the growth phase as we emerge from that difficult 12 months. The business is in really good shape. We've got a lot of capital to the extent that we can afford buybacks. We've got a lot of capital to support organic growth, and if the right opportunities come along, in organic growth. But more importantly than that, it's just the underlying business trend with good momentum in terms of new lending. And actually, quite importantly, I really want to emphasize this, is the NIM. It's -- we make our money by the loan book, the size of the loan book increasing, multiplied by the NIM. That generates the vast majority of our income. And that NIM, there is the structural improvements that are taking place on the asset side as the business mix changes. But also, we're seeing the real benefits of the way in which the funding side has kicked into gear over recent times and the way in which the NIM is being improved by benefits on the liability management of the business. And the dynamic there is that there is more to come from that side, both in the short term, but I also think there is a longer-term structural shift taking place in the way liability management is done in the banking system in the U.K., which should bring us advantages. One of the key bits we're seeking to do is this leveling-up concept. And it's not like trying to jump on the government's bandwagon, but it's a leveling up in terms of the competitive position versus the giants in our industry. And we're trying to do it on our capital side through IRB and through the developments on our liability side. Those 2 big advantages there of improved capital efficiency and improved funding efficiency, will give us so much more flexibility in order to expand and grow our Lending side. So we're very excited by the opportunities ahead, both organically and across any opportunities that may occur on the wider sense. We're never going to be frightened about returning capital because I think it operates as a very good and strict discipline for our business. But we always will keep a weathered eye on the wider situation. As I said in the presentation, we're in the middle of a pandemic. There's -- some of the numbers are going in the wrong direction. The vaccines are great, but we need to get them rolled out. And -- but we also live in a world where every country is interconnected in some way. So there is a pandemic. And therefore, we've chosen to be cautious in terms of the way in which we have managed the provisions and also cautious in the risk appetite that we continue to adopt through the business. So very excited, and we see some very interesting times and opportunities ahead. Richard already got some meetings lined up with you over the next day or so. If any of you want to speak to him a bit more, we're here to help. We're trying to help you with this. We've given specific guidance this year on some of the numbers because we do understand there's a lot of moving parts, and it is quite involved. So please feel free to get in touch with this. We're happy to speak with you further. So once again, thank you for your attention this morning. Thank you for your interest, and we look forward to speaking with you in the near term or, if not, in 6 months' time. Thank you very much. Bye.

Thank you, everyone, for joining today's conference. You may now disconnect your lines. Thank you.