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

Good morning, and welcome to Paragon's 2021 Full Year Results Presentation. Today, we'll run through the results in detail as well as providing an overview of the trading environment, updating you on our strategy and our observations on the outlook. But before we get into the detail, I'd like to spend a couple of minutes looking at the highlights of our results and our current priorities. Whilst the results announced today cover the year to 30 September, it certainly was a game of 2 halves. The first half where society and the economy were dominated by the effects and consequences of COVID-19, including periods of lockdown and restrictions, and the second half influenced by the economic recovery as GDP clawed its way back to levels approaching those last seen in 2019. I'm absolutely delighted with the way our business has performed, not just its resilience during the depths of the pandemic but also 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. Whilst the 62% increase in operating profits has been heavily influenced by the impairment charge, including a partial release of overlays, what this masks is a strong underlying performance with pre-provision profits increasing by 12.6%, driven by loan book growth in excess of 6% and NIM increasing from 224 basis points to 239 basis points, supported by continued tight cost control and excellent customer credit performance across all divisions and all contributing to the delivery of a record operating profit of GBP 194 million. Lending volumes have been strong across the group, exceeding both the guidance set at the beginning of the year and as reset at the half year. Mortgage Lending increased by over 29% and Commercial Lending by 23%, with good momentum evident at the year-end with strong pipelines, providing a good base from which to build further growth into the new financial year. This growth was funded by a strong performance by our savings and treasury teams delivering record inflows whilst driving down funding costs supporting the NIM improvements mentioned earlier. Our balance sheet has always been a great source of strength. We've always sought to operate with a cautious risk appetite, both operationally and prudentially. And this has, of course, been maintained. And the balance sheet itself is strong with 99% of the loan book secured largely on property. Our capital ratios have been strengthened further this year by healthy retained earnings, a funding restructuring that released further capital and all of which has delivered a CET1 of 15.4% and which has enabled us to commence a GBP 40 million buyback program during the financial year and has also enabled us to announce today an extension to that program by a further GBP 50 million. Not only is this a strong financial and operational performance but the business has also made good progress with its strategic priorities and objectives, which have evolved as the environment has changed and which we can see on the next slide. The pandemic caused us to reset our priorities, and we performed well against these. As the year progressed, the priorities changed from one of defense and protection to an increased focus on recovery and opportunity. During these changing phases, our people have been inspiring, showing great passion, commitment and importantly, agility in supporting our customers through the pandemic's various challenges and helping us to support our customers' own recovery strategies. Over 90% of our colleagues have worked from home during the depths of the lockdown periods and have made huge contribution to this excellent outcome. We are now testing various hybrid working models which are ably supported by cloud-based technology, which is delivering greater agility and flexibility to our operating model. If we do need to invoke further working from home strategies again, these could be executed within a matter of a few days, if needed. Payment holidays have all but disappeared with very few customers requiring ongoing support, although we continue to stand ready to help our customers generally and specifically through the recovery loan scheme. The capital, as you've already seen, has been well protected. The balance sheet is strong. We've been prudent with provisioning and leading capital base materially above regulatory requirements and which is more than capable of supporting our growth ambitions. The group's reputation and franchise has been strengthened over this period. There is frequent engagement with our customers and feedback is positive, reflecting the hard work over the last 2 years. New digital technology has been employed to improve customer experience, enhance efficiency and strengthen our decision-making processes and the digitalization program is now being accelerated as part of our strategy to become the 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 our income statement overview. The summary shows our total operating income had increased by more than 10% during the year with net interest up almost 12% and a reduction in other income being seen as our serviced portfolios continue to amortize. Costs were higher in the year, the largest factor being higher share-based costs, reversing the reduction seen in 2020. Impairments saw a small write-back in the year. The write-back reflects portfolio performance and model reductions, but our overlays remain broadly unchanged from their 2020 position given the continued period of heightened uncertainty. We also saw further credits from fair value movements in the second half. These largely reflect yield curve movements on swaps held against our new business pipeline, which fall outside the hedging relationship requirements. These various influences have contributed to a pre-provision profit increasing by 12.6% from its 2020 level. Operating profits increased by 61.8% and pretax profits rose by 80.5%. While not detailed on this slide, it's worth noting that the group's tax charge equates to 23% for the year. Headline tax rates will be rising in '23 and '25, but the changes to the banking surcharge will mitigate these increases to some extent. For 2022, we expect a modest increase in the tax rate as a greater proportion of group profits will be subject to the banking surcharge. However, this rate is likely to be below the 23.9% implied by the current consensus. Reported earnings per share have grown materially in 2021, benefiting from both the growth in post-tax profits and the lower share count, which comes from our buyback program. Moving forward to my next slide, we can see how this translates to the segmental level. Our 2 growth divisions have both seen really strong progress in 2021 with good growth at both the pre-provision and operating profit levels. Idem Capital continues to amortize steadily with income dropping by around quarter as a result. The Central area continues to bear the cost of unallocated funding up around GBP 3.3 million year-on-year and central overheads where the most material movement was the GBP 8.7 million swing in share-based payments. The next slide looks in a little more detail trends on our net interest margin. Following the impact of the COVID-led base rate changes last year, the previous NIM trajectory to the group has now been resumed. The historic reported NIM for the group was skewed by the impact of the Idem Capital division. So in recent periods, we've separated the Idem effects to demonstrate the underlying progress, as is shown in the bottom chart. The 15 basis point improvement in group NIM in the year translates to an underlying 19 basis point improvement when excluding the Idem Capital portfolio. Each of the Mortgages and Commercial Lending divisions delivered both stronger margins and higher balances when compared to 2020. The mix of the rate and volume variances is summarized in the appendix of this presentation. Our NIM progress continues to reflect both assets and liability side effects. The following slide details asset side influences on our structural NIM improvement. The front book, back book dynamic on mortgages continues to be a favorable one. The back book comprising of variable LIBOR linked or rather now termed SONIA-linked loans, and the front book is mainly fixed rate in nature and carries a high yield. Our growing Commercial Lending book delivers a stronger yield than either the front or back mortgage books. And as demonstrated on the previous slide, the amortization of the high-yielding Idem Capital portfolio is having an increasingly small effect. Moving on to my next slide. The development of our funding base has also contributed to the NIM improvement. During the year, we've continued to grow our savings base, which now exceeds GBP 9.3 billion and delivers a significant growth potential for the group at attractive rates. We have drawn TFSME, repaid TFS and refinanced the group's legacy securitizations during the year. The securitization refinancing has facilitated our LIBOR transition, generated capital and reduced group incumbents. Overall, interest income dropped 24 basis points in the year, reflecting the lower base rate environment and the group's cost of funds fell by 39 basis points. Our NIM outlook for 2022 is a minimum increase of 5 basis points. This could be a little more, but while absolute rates generate higher returns for the group's net assets, the timing of rate increases can skew this given quarterly resets on our variable rate loan book. My next slide looks at the emerging trends in the cost-to-income ratio. As with the net interest margin, the influence of Idem Capital has a skewing effect on the group's cost-to-income ratio. However, this influence is now much reduced given the smaller portfolio size in Idem. As I mentioned earlier, the largest individual element of the 2021 cost growth was the GBP 8.7 million increase in share-based payment accruals, reflecting a very different share price profile and performance in 2021 when compared to 2020. In aggregate, this accounted for the entirety of the cost increase in the year. Our expectation for 2022 and beyond sees a return to underlying cost growth as wages increase and our investment in our change program, which is mainly technology related, continues and accelerates. Our guidance for 2022 costs is for a charge in the low GBP 150 millions. Moving on to the economic outlook. Under IFRS 9, the economic projections we use and the weightings we apply to the different scenarios have a direct impact on the provisions we hold for expected credit losses. We've updated our scenarios from the 2020 levels but maintained the relative scenario weightings across the year. The charts show the profiles we've used for our most important variables being GDP and house prices. Our severe scenario follows the Bank of England's 2021 stress, but materially slows the house price recovery that was embedded within the Bank of England's own scenario. The top right table shows the impact on impairments if we weighted the individual scenarios at 100% each. At September 2020, the same analysis showed a GBP 52.5 million impact from weighting the severe scenario at this level. The reduction is just over GBP 40 million this year, reflects the strong house price growth experienced in 2021, offset to some extent by the slower pace of house price recovery in our current severe scenario. Having calculated our model provisions, we then undertook a separate assessment to consider the potential impacts that the U.K.'s approach to managing the COVID pandemic will have had on disguising the drivers of credit losses. So moving on the slide. These overlays are detailed in the top right table, with the PMA levels at September '21 being split fairly evenly between the mortgages and SME portfolios. The bottom left table shows the impacts of weightings on the impairment calculations. The GBP 46 million of modeled impairments would be GBP 7.8 million lower if we use the scenario weightings that we used when we first moved on to IFRS 9, which reflected a far more benign period. The bottom right table shows the relative movement in behavioral scores on our books since 2020, demonstrating the underlying stability and credit strength of the portfolio. You will see from my following slide that the combination of growth, profitability and capital management policies have left us with stronger capital ratios than we entered 2021 with. Retained earnings and the results from refinancing our securitizations added 3.3% to our capital resources during the year. These are shown in the 2 blue boxes on the bridge diagram. We've also seen a small adjustment to the IFRS 9 transition, net lending growth, dividends and buybacks, which together have utilized 2.2% of this increase, leaving our overall CET1 position up 1.1% over the year to 15.4%. The group's old Tier 2 bond was replaced during the year with a new, more attractively priced green Tier 2 instrument. This takes the total capital position to 17.6% at the year-end. If we're looking on a fully loaded basis, the CET1 and total capital ratios stood at 15.1% and 17.3%, respectively. The spot position and associated ratios are summarized on my next slide. In addition to the increase in capital resources during the year, our regulatory requirements fell following the PRA's capital [ construct ] process. This reduction sees the group's surplus over its regulatory capital now exceeding GBP 0.4 billion, giving us capacity for stronger growth and further capital management [indiscernible]. The slide also notes the progress being made with the group's IRB application. We are now well into our Phase II engagement with PRA. This is a protracted and extremely thorough process and we're still not in a position to give guidance and the exact timing or content of the final impact. As soon as these become clear, we will update you. My final chart looks at dividends. The chart details the progress made on our dividend per share. The step-up in impairments during 2020 contributed 4.8p per share to the reduction in the dividend when we looked at it compared to 2019's level. In addition to impairment write-backs in the current year, 2021 has also benefited from material fair value gains. To give you a feel for these impacts, we have shown how the movements in fair values and impairment write-backs have influenced our final dividend level for the year. The impairment effect is calculated by reference to the 7 basis point cost of risk that we saw in 2019 being our last pre-COVID reported period. With the overall dividend for 2021 standing at 26.1p per share, the impairment normalized equivalent would have been 22.1p. The 4p difference comprising 2.3p for fair value movements and 1.7p for impairments, if we'd rebase those at the 7 basis point level that we saw in 2019. Thank you very much for your time. I'll now hand you back to Nigel.

Thank you, Richard. I'll now turn to the wider business performance, our strategy and outlook. This slide represents our strategic framework, including our key priorities of growth, diversification, digitalization, capital management and sustainability. We are a specialist bank focused on sectors where we have a competitive edge because of our extensive and deep knowledge of the markets in which we operate, the customers we serve, the products we provide, the services we offer and the risks we take. This excellence is created from our deep through-the-cycle experience combined with our extensive access to information and data analytics, some of which goes back decades and creates distinct competitive advantages for the group. These are being applied across our business, particularly our strategic priorities. As you've already seen, we've achieved strong lending growth, not just in the last year, but over a sustained period, delivering compound annual growth rate of 12.6% since 2016. Despite this, growth is a strategic priority for the future. We have a strong presence in the specialist markets in which we trade, and we have significant capital capacity and operational leverage to deliver this growth. And additionally, IRB has the potential to enhance these strengths even further. Alongside our growth strategy, we also want to achieve further diversification. This diversification can be seen over the recent years and is being driven by our Commercial Lending division, which generated over GBP 75 million of contributions in the last year, and we expect this to rise further over time. In many ways, to date, this has offset the runoff of Idem's income stream, but with Idem now only contributing 4% of profits, we should see Commercial Lending as a growth engine coming more to the fore going forward. It should also be understood that realistically, Commercial Lending is not one product line. As can be seen on the right-hand chart, it is 4 separate divisions that have little or no overlap. But one thing they do all have in common is that they are all benefiting from the increased digitalization in their markets and importantly, in their business models. Technology is becoming increasingly important to all banks, and this is also true at Paragon. Our strategy to create the leading technology-enabled specialist bank is being achieved through a digitally focused, cloud-based modular development program, which is delivering modern technology across key areas of the group. Some phases have already been delivered such as the new savings platform which is 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, which is increasing the scale of our addressable market. Additionally, the launch of our Commercial Lending portal in the SME market is using Open Banking capability to deliver an enhanced service, greater efficiencies and improved data for analytics. These capabilities are helping us to erode some of the competitive advantages held by the large banks. Additional digital systems have been rolled out recently where the benefit will be seen in the years ahead, but there are many more exciting initiatives in process. The scale and significance of the benefits of our digitalization strategy has led us to accelerate this program, and we expect to deliver material technology changes in both customer and intermediary engagement by extensively employing Open Banking functionality. The next slide considers how we are using capital management to support these strategies as well as optimizing the efficiency of our balance sheet. We have always seen the management of capital as an important discipline and this will be even clearer in the future. As Richard has already said, we're making good progress with our IRB accreditation, which is initially focused on buy-to-let, but where we expect to also move on to development finance. The crucial driver here is the enhanced risk management capabilities it provides, leading to a more direct relationship between risk and capital requirements, providing opportunities for further growth and allowing us to offer more risk-based pricing due to differential capital segmentation. The impact of Basel 3.1 has eased, as it now seems likely that the Bank of England will follow the EU's decision to defer implementation until 2025. We have never been reluctant to balance our growth ambitions alongside returning cash to shareholders. And over the period since 2015, we have delivered dividends totaling GBP 317 million and announced buyback programs totaling GBP 308 million, which combined represents nearly 50% of our current market capitalization. And we have today extended our capital management program with a further GBP 50 million buyback on top of the GBP 40 million buyback announced last year. We have been capital generative adding 2.6% to CET1 at the pre-distribution level over the last year. And as at the end of September, we had a surplus of capital over our regulatory minimum in excess of GBP 400 million. So despite the buyback program, we still have plenty of capital to support our ambitious growth plans. Turning next to sustainability. 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 as is the case for many, we recognize that this is work in progress, not just in terms of our own operations and our funded emissions but also in the way in which we communicate. With our full year results, we have today published our first sustainability report, which sets out our progress on the main ESG issues for our business. We have also launched a range of green initiatives and products during the year, and these product ranges have continued to be extended over the last few months. We issued the first ever U.K. Tier 2 green bond where the proceeds will be used to provide environmentally enhancing lending products. And in addition, we are also offering incentives for highly rated EPC buy-to-let mortgages and support an environmentally friendly house building projects as well as offering finance on electric vehicles. These new products provide further evidence that we are back in our words with real action to support our commitment at doing what is right. Whilst there is much more to be done, we are determined to support our customers in achieving their sustainability ambitions for the benefit of all of our stakeholders. I'll now turn to reviewing each of our key product lines, starting with buy-to-let. Momentum has been strong with lending exceeding GBP 1.6 billion. The buy-to-let pipeline stood at GBP 1 billion at the end of September and is currently in excess of this level, and we therefore expect 2022 to deliver further growth in volumes. Redemptions remain low, driven by customer retention activities, thereby continuing to support growth of the loan book, which increased by 8% year-on-year. The post global financial crisis book increased by 19%, the difference showing how much of a drag the old book can be, although this clearly reduces over time. Rental demand has been strong throughout the last 2 years, with the exception of London, although even that has now seen a recovery in rental levels as people return to the office. Customer and market feedback suggests that lending demand is expected to remain robust in the year ahead. Whilst interest rates may well increase in the coming year, the application of stringent underwriting stress test will, we believe, continue to show the resilience of the buy-to-let market and our book in particular. We have deep experience in buy-to-let going back over 25 years with extensive data capable of supporting the stress testing, our IRB program and our underwriting processes as well as our portfolio management. The quality of the loan book has been evident through the customer credit performance over time and across economic cycles. Even under the stresses in the pandemic and the global financial crisis, with an average LTV of only 61% and importantly, only 1.9% greater than 80% LTV, the strong 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 supporting intermediary engagement, has been well received. Separately, every month, our systems analyze 650 million pieces of customer data which is used to produce behavioral scoring models in our portfolio management teams. We can, therefore, be confident that despite the strong growth we're seeing, it's being delivered by maintaining our disciplined approach to risk which has been successfully applied over the last 25 years. Turning now to our Commercial Lending division. Commercial Lending equally had a strong recovery with volumes reaching GBP 971 million, a 23% increase on last year. And with its enhanced risk-adjusted margins helped drive the improvement in NIM seen at a group level. I will cover development finance and SME lending in a little more detail but also of interest was the second half performance of motor finance where we saw a significant step-up in activity which we anticipate continuing into the future and which has been recently enhanced by our entry into the growing electric vehicle market. Now looking specifically at development finance. We have a strong franchise and reputation in the SME development finance market and the strength of our client relationships and the support provided during lockdown has paid dividends with our new lending exceeding GBP 500 million for the first time. Although the loan book didn't grow in 2021, this was primarily due to the interruptions to the normal repayment patterns seen in lockdown during the previous year. Margins have been stable and the credit performance has been exemplary with LTVs around 62%. The development finance pipeline has been stable, and we're optimistic that 2022 will see further growth in new lending volumes although it's evident across the market that there is some supply chain disruption, which is causing delays and adding to cost. However, similar to all of our lending, stress testing is used as part of the underwriting process. Our SME lending division has been impacted by customers deferring investment decisions and making extensive use of the government schemes such as CBILS, bounce back loans and more recently, the recovery loan scheme, in effect, prefunding future requirements. Non-governmental SME lending is down by 19% since the start of the pandemic. However, we have outperformed the sector and our origination levels witnessed a good recovery across the year, increasing by 17% compared to 2020, and with the loan book up by 12%. Our CBILS and bounce back loans was relatively modest by comparison with balances ending at only GBP 92 million, primarily due to our focus being on supporting existing customers. Payment holidays, which were a feature of last year's accounts, have virtually unwound with only 1% of the book requiring some form of ongoing support. We also recently launched the first phase of our digitalization platform in SME lending, being a cloud-based portal which uses full open banking functionality. It's been successfully rolled out across the intermediary community and will be used alongside data-driven models, accessing nearly 4,000 pieces of customer data on every loan as part of the underwriting process. And finally, turning to funding. Our savings and treasury divisions have had an outstanding year. The deposit book is up 18% over the last year, and balances currently stand at over GBP 9 billion. This has been achieved whilst rapidly reducing retail funding costs, down from 134 basis points in September 2020 to 109 basis points at the half year and 91 basis points by the year-end. With a still favorable front book, back book dynamic, there are still some benefits to come. However, we are conscious of the interest rate cycle turn in, and our balance sheet is structured deliberately with that in mind. We have also refinanced over GBP 2 billion of legacy securitizations, which 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 at nearly 300 basis points lower than the existing deal, virtually, all of which was due to improvements in Paragon's credit spreads. New technology is already playing an important role within our savings business and a new digital platform was launched during the year. As I mentioned earlier, this is being used to manage our third-party relationships but has the potential to deliver enhanced capability in due course. Additionally, we have continued to extend our product range, recently entering the SME savings market, and we will continue to seek to innovate and develop alternative distribution opportunities going forward. Our view is that there is potentially a big prize on the saving side with over GBP 860 billion of deposit balances held with the clearers, earning virtually nothing and where open banking technology could help break down the inertia within the current system, leading to a more level playing field and an erosion of one of the big bank's key competitive advantages. This will, of course, take time but the scale of the opportunity is meaningful. So in conclusion, the recovery in the group's performance reflects how well positioned the business was going into the pandemic, including the resilience of our operations and our ability to be agile in dealing with the challenges of the pandemic as well as the subsequent opportunities that have emerged. Clearly, the emergence of a new variant causes some uncertainties on the shape of the economic recovery. It also poses questions about whether the working from home model will return, but we are well prepared and can execute this strategy within days if it's required. The strong loan growth in the year has continued with good momentum. We're investing further and on an accelerated basis in new digitalization technologies to support our growth plans. Nevertheless, there's still a level of uncertainty in the speed of the economic recovery. And unless the variant destabilizes matters, it's likely that interest rates will rise. Consequently, whilst we expect to see good growth in new business levels, we will maintain our disciplined approach to risk and we will review further the COVID overlays in 2022. So looking forward and to provide some guidance on the year ahead, we anticipate mortgage volumes exceeding GBP 1.7 billion; Commercial Lending exceeding GBP 1.1 billion. We expect NIM to grow by at least 5 basis points, although clearly, this is subject to interest rate changes. And costs will settle at around the low GBP 150 million area. The delivery of an underlying 15% return on tangible equity is tantalizingly close. And with strong capital ratios, significant liquidity, continued operational capacity and leverage and a clear focus on optimizing capital, we are well placed to support growth and to react to opportunities, both organic and inorganic, in the period ahead. I am incredibly proud of the way the business has performed across recent times and due credit must go to my incredible colleagues across the business, who have supported our customers, each other and the wider community, ensuring that we always seek to do the right things. Whilst the environment holds some uncertainties, we are in exciting times which are providing a range of opportunities for our business. We have evidenced our resilient model and the strength of our balance sheet across cycles and we are confident in realizing the bank's potential and in becoming the U.K.'s leading technology-enabled specialist bank. Thank you.

And the first question is from the line of Benjamin Toms from RBC.

First on costs and the second is on ESG. On costs, your guidance for next year is in the low GBP 150 million, that implies quite significant increase from this year. Can you just break down the year-on-year delta in cost-to-income ratio terms on the back of envelope? I think it implies that the cost-to-income ratio will go up in FY '22 compared to consensus expectations of the cost-to-income ratio going down. Is that broadly the right way to think about it? I know it depends on what you assume for NIM growth, but even if I double your 5 bps increase guidance year-on-year, I still get the cost-to-income ratio going up. And on the prerecorded call, you also used the language of settling at the low GBP 150 million region. Does that mean you expect flattish costs post full year '22? And then on ESG, 62% of your loan book has an EPC rating of below C. I think that's [ back ] in line with the private rented sector average. Are you seeing 2028 requirements around private rented property happens to be [ anytime ] C or above as a risk or an opportunity?

Ben, it's Richard. I'll pick up on the costs. In terms of the changes, as you'd imagine, for the bulk of the business, we've got a pretty stable position, but we have a few areas where we're seeing some quite material growth. On top of that, we have also a period where we've got more material wage growth. So we're looking at around 5% inflation, if you like, to start the year in terms of the delta. We've got 3 other areas where we've moved up quite materially in the year. One of those is on savings, where our outsourced approach actually is linked to the size of the savings book rather than inflation factors. So that grows with the size of savings, which, as it's becoming the predominant funding source, is probably going to be up 15% to 20% year-on-year. You also have a lot of growth going on in our Commercial Lending division, where, again, you're looking at around a 15% growth in the cost base. Probably the most -- the other big area to look at though is on systems and IT. And if you recall, when we discussed this before, we tend to expense our IT investments. We've only carried around just over GBP 3 million of capitalized software on the balance sheet. So most of our development cost goes through OpEx rather than CapEx and the loan depreciation curve. So that's one of the reasons things are going to be up a little bit, and we're expecting our systems cost to be up around 20% year-on-year in 2022. So those are the main items. And that should take you to something at or just over GBP 150 million. In terms of the cost-to-income ratio, you absolutely get it. If we capitalize a little bit more on costs, we could get that flat year-on-year. We see cost-to-income as an output rather than a target. It informs us where we are efficiency-wise, but we would rather have those expenses actually put through the P&L rather than capitalized for a later date. So those are the main points on cost, but you're right directionally in terms of cost-to-income ratio for next year.

Is that okay, Ben?

Yes.

Okay. So on the ESG point, yes, so the 62% of the book with EPC lower than C. That's, as you say, pretty standard across the industry. I'd say, it's pretty standard across the high ownership industry as well. And your question is, this is an opportunity or a threat. I think it's both in that regard. I think the threat will be mitigated by the fact that there would be -- in order for the industry -- bear in mind, this is -- it's not us, it's our customers as it were, but there is obviously indirect consequences. There is an expectation from government that there is enough capacity in the market to be able to achieve all of the retrofits that would be needed across that period in that timescale. My personal opinion is that it does not exist. There's not enough capacity for that to happen in that time scale. So one suspects the government will have to go back and revisit that time scale in due course. However, we stand ready to support customers. We already have a number of green initiatives out there. We have pricing discounts for landlords with EPC. We have products on the new build side with the development finance offering discounted pricing in order to encourage people, builders or landlords, to buy properties that are of better quality in terms of the EPC side. We offer further advances to help people with the retrofit program. So I do see it as an opportunity. I think there will be a lot of demand over the coming years to support the needs of the population of the U.K., let's not make it all about landlords here for a second, to achieve what they need to achieve to manage the emissions levels. But it would naturally be a supply chain. It can't all happen in the limited time scales that the government seem to be indicating. There's no firm guidance at the moment. These are only -- it's certainly supposition at this stage. But if that comes to pass, then there is just not enough capacity to be able to deliver it.

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

I've got 3 questions, if I can, all these, actually, so dividend, digitalization and diversification. So just starting on the dividend. I know you sort of called out the sort of roughly 4p of benefit that came from the low impairment charge and also from the fair value gains. If I look at earnings for next year on a reported basis, I mean it's entirely possible that they could be flat or down slightly. So on that basis, are you willing to have a dividend that I would actually step backwards in the current year if you stick to your 40% payout ratio? That's the first one. Second one on digitalization. Again, just sort of following on from the previous question around costs. I don't know if you can quantify the absolute level of spend that you had on digitalization in 2021, and therefore, we've got a sort of a base of which to project the growth that you talked about. And then also maybe talk about how that evolves going forward, whether this is sort of one-off lump of investment that will then reduce or whether this is a sort of step up to a sustained higher level. And then lastly, on diversification. You've talked quite a bit about this, particularly in the commercial business. And I'm just wondering if that's really just all about sort of organic growth in the existing businesses or whether you're still looking to sort of add additional capabilities and therefore, whether inorganic growth would come into the equation, too.

Yes, Gary, it's Richard. In terms of the dividend, we've tried to demonstrate what I say, the underlying, if you call it, normalized level of 22.1p would be. And we would portray any growth against that. It's very difficult where you have a period where you put in very substantial provisions 1 year and then release them the next to maintain a steady progress in terms of the absolute level of the dividend. I think on a normalized basis, we would absolutely look to be seeing that as being progressive. But you're quite right. Subject to where your numbers come out for 2022, it is -- it would be possible that our pay on that dividend would be less. So we've maintained the payout ratio and the underlying core normalized growth rate actually ought to be the thing that we would point out to investors. We did actually think clearly. It was very important to reward investors in this very good year after the difficult year last year.

Is that clear, Gary?

Yes, that's perfect. Yes.

Okay. So -- I'll just deal with the rest. So the digitalization. So during the course of the year, there's probably around sort of GBP 2 million to GBP 3 million worth of expenditure in there. And we would expect that to sort of just move up a bit from there. I don't think it's an abnormal one-off lump this year and/or an abnormal one-off lump next year or in the years afterwards. This is a steady progression of investment on this side. But also just to point out the level of capitalization that we do is very low. You sort of do it side by side across the industry. You just see ours is down with low single million pound figures that we choose to capitalize and hold as a balance sheet asset because that's a part of just a very prudent approach we take to things. So we do have a phased transformation program. So we're not trying to do one big bang project that comes all together in one weekend during the course of this year or next. So -- because we're dealing with it on a modular and sequential basis, it means we can phase the introduction of this over a number of years. But every one of our business areas is going to go through a digital transformation program, some of which is already done. So we've already absorbed some of it. We've already put in place the third-party digital platform systems for -- when we deal with the third-party accounts, the third-party relationships, like the Hargreaves Lansdown, et cetera. Additionally, we've already introduced the SME new business portals and the mortgage portals. So these are already up and running. And so there are now phases going on to sort of build additional modules attached to that as we go through. So I think that, that modular approach ensures that we don't try and do perhaps a highly risky big bang event that happens over a weekend, but equally, it also helps us phase the -- it also helps us phase the work over a number of years. In terms of diversification, I mean there is a longer-term plan here to create better -- greater diversification for the business. Some of that is being done organically already. So you can just see -- and I tend to view diversification as more about diversification of earnings rather than balance sheet assets. And so you can see the way in which we have increased the contribution of income streams from the commercial area increasing at a faster rate. I mean clearly, buy-to-let had a pretty buoyant year. And so the speed of that change, maybe it's not as dramatic in this last year as it would otherwise have been. But what you can expect to see is further continued growth in revenue in commercial, probably ahead of buy-to-let, just by virtue of a combination of good growth in the net loan assets in that particular area, combined by a higher yielding product -- set of products as well. If M&A comes to pass, then clearly, one of the things that we would like to do is find that can also deliver diversification. We look long and hard. You can see we've got quite a bit of capital to support growth, whether that be organic or inorganic. But we're very fussy as you well know. And we're also quite conscious that we're only ever going to buy anything that represents the right business for us and at the right value. There's lots of things for sale at the moment. There's lots of things for sale at the wrong value. So we're very patient and we'll bide our time.

The next question is from the line of Jason Napier from UBS.

I have 2. Let's begin with costs, if we can go back to that topic. I mean the group has delivered under your stewardship extraordinary changes in sort of mix and product capabilities. But I guess that's come at the cost of fairly sustained negative jaws and a steady upward margin in cost-to-income ratio. And so I wonder, in the light of forecast that we have for revenues that grow faster than costs on a sustained basis, I just wonder whether there's a component of travel and arrive where the transformation matures and we could expect to deliver faster revenues than cost growth on a multiyear basis Or whether there are, I guess, offensive and defensive moves put to broaden your product reach or your customer reach that should see us positioned for sustained investments that have costs grow faster than revenues over the longer term. And then secondly, I wonder whether you could just comment on what you're seeing in competitive terms in terms of product spreads and how that might play into sort of overall longer-term net interest margin expectations. Richard, I appreciate what you're saying about the timing of rate changes potentially skewing rate outcomes. But I wonder whether just in broad terms, you could talk about what should happen to group NIMs over, I don't know, a 2-year period if we've got rates going up perhaps 50 basis points.

Okay. Jason, right. So -- Richard might add a comment or 2 in. I mean your travel and arrive point is an interesting one. I think the cost-to-income ratio point, which was also raised a little earlier, is something where we regard that as an output rather than an objective or a target in itself because when you take a business as we had before, sort of largely monoline, and then diversify into a range of different asset classes and then become a bank or probably vice versa, the other way around, become a bank and then diversify a range of asset classes, which typically structurally would have a higher cost-to-income ratio model anyway. And then continue to go through a post global financial crisis, well, where regulation has only got added to rather than taken away. But what you tend to see there is a level of investment that precedes the revenue benefit that's come through. What we believe is we have quite a lot of operational gearing -- operational capacity and also a capital capacity as it were. You see there's over GBP 400 million above our regulatory minimum that we have in that regard. So there's a lot there that's at our fingertips to be able to do, all of which will contribute to enhancing revenue faster than incremental costs. But there's been quite a level of investment over the years in order to get to that point. Now -- but I do think this is a multiyear opportunity, but it's also something that happens over the medium term. So you can see why, with a variety of aspects about the current year, the cost-to-income ratio won't necessarily make the progression that it could do over the medium term. We're in the low 40%. And I do think we could see further improvement for that in the coming years. But it will be a medium-term output rather than a short-term target. The other thing to bear in mind is also one of the structural things is Idem. We did put a -- we put, over a number of years, a page in the presentation pack about the effects of Idem, which has -- which created, I think, a probably artificially high NIM for a business on an ongoing basis. Idem's cost-to-income ratio is less than 10%, if you isolated that by itself. And that tends to create in it a headwind. But as Idem unwinds gets to sort of modest proportions, its effect on the overall results starts to get diminished as well. So if you look, Idem is contributing a relatively tiny amount towards profits and -- now. And so its effect and contribution to the cost-to-income ratio is less significant than it has been in the past. So there's a bunch of structural reasons, investments -- investments being a bank, investments because we're in a digital process change and also the unwinding of the Idem position relating to -- it's kind of quite a significant effect on the revenue line in previous years. So I'd sort of leave that at that. In terms of competition, there's competition. There's good healthy competition in all of the markets in which we operate. The thing that we've always sought to do is trade in the areas where, because of the product complexity or the specialist nature of them, it tends to not attract the mass market sort of price-led initiatives where some of the sort of the larger lenders will seek to operate. So as a consequence, during the course of this last year, we've seen massive spread compression taking place on the mortgage side, where the big players have used excess -- capital excess liquidity to really drive those yields down. That's not been the case on buy-to-let. There's been sort of some asset yield compression, but it's modest by comparison and certainly less than the compression that we've seen on the liability yields. So overall, I would say that -- I think that position is there. And I think it's likely to maintain itself over a period of time. Also, don't forget, we are going through the process on IRB. And so within the type of products that we can offer, we've been largely constrained by the somewhat flat capital charge that tends to apply on a standardized basis. So once IRB arrives, we can then start to look at our business on a more credit segmental basis which will, therefore, give us a broader market reach and allow us to compete in areas that we have not hitherto been engaged in. I think the final point you raised was on the rate rise. Richard, if you want to cover that?

Yes, sure. So with around GBP 1 billion of net assets invested in variable rate assets typically cash that we stick back at the Bank of England, what you find is that at absolute higher rates, we earn more on NIM. And we don't put hedging in for that sort of structural position. We have it there deliberately. The view is that at very high rates, you would probably see some potential higher bad debt, but that will be offset by the stronger NIM you'd achieved. So that's the reason we don't want a structural position there. But you will, on a rested basis, see higher income for higher rate. And typically, it's around -- it will be around GBP 10 million for a 1% increase. So if rates are going to be up 50 bps, that's going to have what a 2 or 3 basis point impact on NIM. So relatively modest in the overall group sense. You did mention the timing, and that is important for us. Our -- the bulk of our variable rate assets reset at the quarter end. So if there's a bank -- if bank increase -- if bank rate increases happened in December, March, June, September, actually, we get little, if nothing, in the way of any funding disadvantage in a rising rate environment. If they go up in January, April, July and October, we typically face a whole quarter's worth of higher funding cost before the asset side catches up, and it's just the way we structured the balance sheet. So much like the cost in terms of journey and arrival. Apologies for this. We've got a fire line going off. Sorry. So the resting rate for higher rates is stronger, but the movement can cause disruption depending on the profile of that movement. And to be honest, we saw a little bit last year, if you remember. We had that very material reduction in our cost of funds, which very quickly got related through to the asset side, and it took us a while then to catch up on the liability.

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

Few questions from me. First of all, look, sorry to flog the cost point to death, but just wanted to come back to kind of, I think, the first question on outlook beyond FY '22. Looking at FY '23, I mean presumably, the significant step-up is next year and then we think -- I mean should we think about it in pretty flat year-on-year terms for FY '23? Or should we expect to see continued absolute cost increases? And I note your reference to the investment spend program being kind of a multiyear process in that respect. My second question is on asset yields and -- look, I know you've spoken already on the call about competition in your markets. And just wondering how sensitive in buy-to-let, particularly, you are to the likes of when foundation home loans are tending to get quite aggressive on pricing. We've seen your yields remain pretty stable, albeit with some compression. And I guess -- look, with that in mind, what -- how resilient are your units to that kind of sporadic increases and competition that we see on the part of some of your smaller peers? If I can just, as an adjunct to that as well, some -- probably on the rate sensitivity point. Just a little bit curious around assumptions underpin your sort of GBP 10 million guidance for a 100 basis point impact. I suppose my own concern there is, is it hard to pass on the higher rates, especially if we see a series of rate increases to the borrowers, just given default risk -- given the rates are already purchased at relatively high absolute levels, whereas on the term deposit pricing, we'll see most of that come through? And then finally, just on IRB. Look, you've given some very clear guidance again this morning in terms of the progression in that respect. Is there anything you can say specifically on timing expectations? How long a typical Phase II process takes with respect to the mortgage book? And what kind of stage of advancements you are specifically at with respect to the development finance portfolio, i.e., could we see both potentially receive accreditation at the same time? Or is development finance likely to be 12 months plus behind mortgages?

Good. John, so on costs, as Nigel said, it's a multiyear program, but we're very, very busy with this at the moment. I think the -- if you're looking at proportionate increases, I think 2022 should be much greater than '23, but I'd still expect a little bit more cost in '23. And to be honest, the other thing we've got to bear in mind is what the inflationary environment is in terms of wages. So I think it will be odd for us to see growth in '22 and then flat thereafter. But hopefully, the rate of growth will be much reduced and caught up by -- and overtaken by the growth in NIM, to Jason's point earlier, in terms of that longer-term progression.

And in terms of asset yields, I mean you highlighted some of the nonbank competition there. What -- these guys have kind of entered the market in recent years and have had varying degrees of activity from time to time. They are part of a much wider tapestry of competition, whether that be from the bigger banks, building societies. So this market has never been without its competition. And we don't take out this competitive threats all very seriously. But I will repeat the point, one of the things that we have not had in our competitive armory is the application of IRB. And IRB, it's not -- people just naturally assume it's all about how much capital we can give back on the back of it. One of the fundamental things is it provides an alignment between capital and risk. And therefore, at the moment, as a bank, we have pretty much the same capital requirement, whether it's a 10% loan to value or a 90% loan to value. So here, you will be able to apply much greater segmentation of risk, much greater segmentation between product offerings and therefore, will be able for us to compete at a much more interesting level than we've ever done before, ever been able to do before. So yes, there'll always be competition, and we will always keep a very close eye on it. We've got a very strong franchise, a very strong brand within the sector, very focused on the professional end of the buy-to-let market where it's not just about the lowest price on the block, it's the broader product offering that you bring and the service and the experience which goes back many decades. So it is something to keep an eye on, but we're very confident of our competitive position across the whole sector. Just on IRB, I mean we can't give any guidance because the timing of this is in the hands of the PRA. But we are well advanced on our mortgage program. We are well advanced within the Phase II part of the mortgage program. But what that means between now and when the accreditation is delivered is an uncertain time scale and certainly lots of science. Development finance won't be landed on the same day. But I would suspect it is not as complicated a process because development finance uses the slotted model -- uses the slotting model approach rather than using the advanced modeling approach that tends to be used for mortgages. In terms of development finance, we won't have to do a Phase 1. We've done that, and we will go straight into Phase 2. And as I said, that's because there is a less complicated route through on that side. So whilst it won't be delivered on the same day as mortgages, I don't think you've got the same duration to wait for your accreditation on that side. And I think the other question was on interest rates in terms of the -- what happens in the event that if rates go up and what happens to the yield side. We've got -- on the liability side, again, we'll have to wait and see. It's all been a bit stop start, isn't it, in terms of what happens with interest rates because one month, it's going up, the next month, it's not. But in terms of the expectations, there is a market expectation that deposit rates won't get passed on in full. And we can't talk about what we'll do and what others will do specifically. But there is an expectation out there that not all of the deposit rate increases -- not all of the base rate increases will be passed on in deposit rates. But in terms of the -- on the asset side, one of the things, just bear in mind, it's a fixed rate market. Pretty much everything we do on the asset side, it tends to be largely fixed rate. And so as a consequence, it's more about the yield curve and the shape of the yield curve and what people think about will be happening in sort of 2, 3, 4, 5 years' time rather than necessarily what is happening today. And there's a lot of uncertainty about that, and we've seen an expectation recently of rates rising and then going nowhere beyond a certain period of time. So again, I'll just go back to Richard's earlier point. It's complicated to try and determine what happens in a movement up in interest rates of 1 basis point. A 1% increase in rates will typically flow through to a net positive GBP 10 million in the net interest income line on a settled basis. But there are timing and phasing differences on that which are all driven by the pipelines and how the liabilities reset relative to the assets, but that would be the medium term unwinding effect of it all.

[Operator Instructions] The next question is from the line of James Invine from Societe Generale.

I've got 2, please. The first is just a quick one on IRB. And to what extent you're factoring any IRB benefits into your pricing at the moment? And then the second one is just -- I wonder if you could help us think about the group's returns on equity as the mix changes. So basically, what are the returns on equity in the 2 businesses? And maybe just kind of help us think about that -- the biggest part of your cost base is in unallocated items. And I know it's called unallocated, but I was just wondering if you might be able to kind of indicate broad proportions between mortgages and commercial, please?

Okay. Very clear statement, IRB benefits. Nothing is taken into account in terms of IRB yet apart from the cost and I wouldn't categorize that as a benefit. That's more of a pain in the neck. The -- so that's very clear, nothing in there, but that's future opportunity rather than anything taken into account today. I would say the return on tangible equity point is less about what's achieved in a relative position between each of the divisions. It's more about the fact that we have the regulatory capital in excess -- sorry, the capital in excess of the regulatory minimum of over GBP 400 million. If you consider that is being not utilized, therefore, the return on that capital, which is probably largely held in deposits for the Bank of England, is earning you 10 basis points. So the more significant effect is if we can employ more of our capital into higher yielding assets, then you should see further improvements in the return on tangible equity. All of our businesses are -- we seek to achieve the minimum return on tangible equity of at least 15%, that we strive to achieve and we achieve on each of the business lines. However, the bigger prize is in employing that surplus capital rather than leaving it idle or leaving it with a very modest return. Richard, do you want to cover the unallocated cost point?

Yes, sure. So we've run a centralized model. So we have one IT department. And last year, for example, we did a lot of work on the SME division in terms of getting that portal done. This year, the focus is more on mortgages. So we don't allocate it because it's not allocated on a sustained basis. So where we have those efforts, they vary from period to period. So it's very difficult to do it and, say, well, actually, that's -- the all-in cost for mortgages may be X, where it could be X minus GBP 5 million the next year. So we very deliberately keep those costs centrally. We keep all of our savings costs centrally. I suppose, if you wanted to, you could allocate those by the relative proportions of the drawn balances. But what we try to do is to optimize the overall efficiency. But those areas are costly. We keep all of our regulatory costs centrally. And that's a big number. We've got a lot that we put into things like the IRB program. Now the bulk of that work over the last couple of years has been on buy-to-let. There's been more on development finance. But the other divisions will also then benefit because they don't have to do a Phase 1 going forward. So you start to get to very, very spurious levels of accuracy and allocation if you try to properly move those areas out to the divisions. Now overall, if I look at the position between buy-to-let and the commercial divisions, and once you've got towards an IRB end state, I don't think there's much of a difference between the returns we get from both.

Fine. Okay. And can I just have a follow-up, please, on the costs. I mean can you say what the head count in Commercial Lending has done over the past few years? I mean it's just notable that the direct costs really haven't grown very much. I mean I think there was a GBP 24 million this year and it was kind of GBP 21 million, I think, looking back even, when was that, 2018. So you haven't seen much growth in the direct cost base despite a huge growth in the business franchise.

No. And the area that you would expect to see more head count growth will be the SME division. And clearly, the whole U.K. SME market has been put under a little bit of pressure over the last 18 months. So one of the reasons we haven't seen the head count growth to date that we are forecasting is the fact that the business has not been there and available to frank those overheads. We expect them to come through now, and we're spending more money again, as I said, on the systems and other development side within that area. We've started to add some heads on the -- on our development finance business, and that program should continue. So you will see a more material step-up in costs directly in those areas in 2022. And I think I mentioned earlier, we're looking at somewhere between 15% and 20% of the uplift there.

The next question is from the line of Perlie Mong from KBW.

Just one on impairment. So just really actually on the cladding issue. So how much do you think that's going to be an issue for your portfolio? And to the extent that it may be an issue, how much provision you might have taken on that?

So as a lender, we always had a very underweight position with regards to high-rise blocks. We -- you probably may know that we have our own in-house team of surveyors, very focused on our business. And one of the things that we've always, going back to pre-global financial crisis, we always had a very restrictive policy on high-rise properties and city center properties. So as a consequence, there is not a very -- there is not a big exposure at all to properties within the -- that have got a so-called cladding issue. I mean ultimately, this is an issue for the customer rather than us. But clearly, the secondary effect is it might impact the value of our security. Clearly, as you would expect, we've done assessments of our portfolio and we don't think it's necessitated any specific provision as a consequence.

Yes, that makes sense. And I can just see that your PMA hasn't really changed very much this year. So what are the sort of preconditions for you to release more of that PMAs?

Yes. So what you will notice, we've skewed it more towards the SME side of the business rather than buy-to-let. I think the -- clearly, there were a lot of customers due to payment holidays last year. But the performance of those subsequently has been very good. There's been a bit more volatility in those loans. So we've seen a greater proportion of them go through to both having additional arrears, but also clearing arrears. So there's just a bigger delta, if you like, in performance of those. So we've maintained the P&A there, but the very material increase in house prices over that period has meant that loss given default is actually much reduced. So as a consequence, we've reduced the level in mortgages. Overall, I think the SME area is a little more opaque. And clearly, it's an area where there are more businesses that are prone to interruptions and continued interruptions and things like Omicron if there are further lockdowns or closures in the economy. So with that sort of lack of line of sight to -- from the impact of all of the government reliefs and the like to our underlying models, we felt that we needed to put additional P&As there. But overall, let's just say, it's very little -- there's been a little change in the aggregate position. And the main movement in the year has just been a like-for-like in terms of the actual underlying modeling.

[Operator Instructions] There are no further questions at this time, and I would like to hand back to Nigel Terrington for any closing remarks.

Thank you very much. Well, I hope this has given you a good opportunity to run through the results with us and to discuss any particular questions that you have. Richard is available to discuss with you today and tomorrow -- the -- any particular areas you want to cover and also to ensure that you've got as much information as you could possibly need in order to sort of update your models, et cetera. In this regard, just some sort of final remarks from me, will be, as I said earlier, we're absolutely delighted with these results, not just in the financial results, as we delivered this year, the 62% increase in profits, but actually in the fact that over the last 2 years, we have continued to show the strength of the operational resilience of the business, the financial resilience of the business in terms of how good the asset quality is and the strength of the growth in new lending, a reflection of how good the franchise is. And with further developments, more structural developments, whether that be on the transformation program or IRB, it gives us a lot of confidence about the prospects for the future. And we, therefore, look forward to 2022 with increasing degrees of excitement and opportunity. And on that note, I will finish there and look forward to, no doubt, catching up with you in due course. Thank you very much.