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

[Presentation] So good morning, and welcome to Paragon's 2022 Full Year Results Presentation. The video we've just shown you shows how our purpose of supporting the people and businesses of the U.K. in achieving their ambitions is being delivered by our unswerving focus as a specialist bank and which will be evident to you throughout today's presentation. We will, of course, as normal run through the financial and operational performance in detail addressing our strategic priorities and the strength of our position as we approach a more challenging environment in the year ahead. But first, I want to draw out 5 key messages from this year's performance. First is that these results clearly show the value created due to our specialization through the investments we've made over many years and ensuring we have a deep understanding of our markets, our customers and the risks we incur. We don't seek to challenge the large banks but we operate in focused areas where we can achieve strong and sustainable returns, achieving better margins with low impairment outcomes. We see specialization as a key element of our franchise, noting that this year, it has represented 97% of our buy-to-let lending. And whether it's the unique approach of employing our own in-house surveying team or the 600 million pieces of data we access as part of our monthly customer behavioral scoring models or our highly experienced development finance relationship teams, there is a consistent application of specialization that is driven from our purpose. Second, the balance sheet and funding structure is positively and deliberately geared to higher interest rates, which has enabled further improvements in NIM this year alongside the existing long-standing diversification strategies, structural widening margins that you've witnessed over many years. We achieved good margins when interest rates were close to 0, and we're achieving and expect to continue to achieve better margins at higher rates. Third is the continued adherence to our prudent risk appetite, which has delivered another year of exemplary credit performance backed by a loan book, which is 99% secured largely on property, all with low loan to values. Notwithstanding this, we have further tightened criteria across the year. ensuring we positioned our origination flows dynamically in line with the change in environment. With the average loan to value of the pipeline at 63%, we expect 2023 and beyond to continue to reflect our cautious risk appetite. The fourth key message is the strong internal capital generation that has continued to support robust growth as well as increased levels of capital distribution and repatriation. We completed a GBP 75 million buyback last year and have added a further GBP 50 million that we've announced today. Since 2015, we have declared dividends and undertaken buybacks, which, in total, are in excess of GBP 700 million alone representing 65% of our current market cap. With the return on tangible equity targeted over 15%, strong internal capital generation is set to continue. And with IRB making further progress, capital management will continue to be a core component of our strategic priorities. And finally, our important digitalization programs are helping to improve customer and intermediary experiences. Good progress has already been made, and we can see clear evidence of positive feedback leading to stronger new business flows and improved retention levels. Furthermore, there is still a lot more to come. Digitalization is also improving efficient -- sorry, improving efficiency and cost -- the cost income ratio is now below 40%, which is where we expect it to stay. These factors have helped us deliver our strong financial and operational performance over the last 12 months and which also enhances our existing strong foundations, enabling us to be well positioned with the challenges in the period ahead more of which later. So as you can imagine, we are absolutely delighted with this year's performance. Net interest income increased by nearly 20% with new lending up 24% to GBP 3.2 billion, alongside widening margins. Tight cost control helped reduce the cost income ratio to 39.4%. And notwithstanding a cautious approach to strengthening provisioning, we delivered record operating profits of GBP 226 million, leaving an underlying return on tangible equity of 16% and EPS growth at 17.9%. Richard will now run through the financial performance in detail, and I'll return later to discuss our strategy, the individual business lines and the outlook for the year ahead.

Good morning. As Nigel has mentioned, the group has delivered an extremely strong result for 2022. We leave the year with a strong pipeline, a plus trend margin growth, cautious provisioning and high-quality and almost entirely secured loan book. I'll start by looking at the overall income statement. Net interest result was up 19.5% on 2021's level with growing volumes, margins that have widened beyond our normal 5 to 10 basis point accretion and this reflects the group's positive gearing to higher rates. Other income has also outperformed in previous years with leasing and activity-related fees elevated and higher than normal servicing fees as we near the end of a large third-party contract. Operating costs were in line with expectations at GBP 153 million. And when combined with a 19.5% increase in our total income, our cost-to-income ratio has moved to 39.4%. Pre-provision profits rose 24.2% from the previous year, and impairment charges were increased. This reflects a more cautious economic outlook, harsher scenario weightings and continued judgmental overlays and these have added over 30% to the calculated provisions that we've used. The disposal of our residual item capital portfolio, the unsecured element, generated a one-off gain of GBP 4.6 million in the year and fair value gains, and these are linked primarily to the hedging of our buy-to-let pipeline totaled GBP 191.9 million. This takes reported pretax profits to over GBP 417 million. My next slide looks at the segmental performance. The first thing to call out is the sale of the Idem portfolio has resulted in the removal of the item as a separate segment. The bulk of the remaining assets have now moved to the Mortgage Lending segment. Overall, Mortgage Lending operating profits rose by 4.2% in the year, with impairments moving from a release in 2021 to a charge in the current year. Pre-provision profits rose by 9.8% to GBP 244.5 million. Commercial lending profits grew by 16% to GBP 88.6 million with pre-provision profits in the division increasing by over 20% to GBP 98 million. The Central area benefited from the funding environment. We earn higher income on our cash balances and this more than offsets the higher cost of Central overheads. This left the Central cost -- a Central area loss at GBP 5.3 million lower than it was last year at GBP at 107.1 million. Now moving on to margins. For a number of years now, we've discussed our structural NIM enhancement. New buy-to-let assets carry a higher yield than the old book and Commercial Lending margins are wider still. This underlying favorable mix effect still holds. We're also positively geared to rising rates, with our net assets largely invested in interest-bearing assets. The rising rate environment accelerated our normal 5% basis point accretion to 30 basis points. But however, some of this is down to timing differences as savings rates tend to move gradually after a rate change rather than there being a once-and-for-all step. We do expect further rate rises during 2023, and these should underpin another year of outperformance with NIM accretion again to be above trend. However, this is not likely to be as strong as last year and given the general higher pass-through rates, we're seeing and the catch-ups from previous rate rises. So our guidance for 2023 is a 20 basis point NIM enhancement in the coming year. We actively hedge our mortgage pipeline. And this approach has resulted in a very material fair value gain in the year and is detailed on my next slide. So our fixed rate mortgage pipeline includes both new business and also offers to existing customers who are reaching the end of an incentive period on their initial fixed rate. These offers can be made up to 6 months ahead of the switch date, and therefore, we need to hedge them to safeguard margins. Until the swap is matched with an underlying completed mortgage loan, that's the point at which hedge effectiveness is achieved, accounting uses market-based point-in-time fair values. With the pipeline largely comprising 5-year fixes, the absolute greater scale and longer duration has doubled the amount of the average hedge that we need to hold. And we've also seen a nearly a four-fold increase in the level of swap changes during the year, which has really added to the scale of this year's impact. Following loan completion, these fair value gains start to reverse across the remaining lives of the swap. And this is typically 5 years. So while the cash flows and the swaps are unchanged and these contribute to our net interest margins. These fair value items are fully noncash items and will reverse. However, they do demonstrate the value of the hedging strategy. If we hadn't hedged the pipeline as rates were rising and actually completed the swap set completion of the loans, net interest margin would have been tighter in the remaining years simply because the swaps would have been written at higher rates. Given the position reverses over time, we exclude these from our underlying fair value performance -- sorry, underlying performance stats but they do get included within our capital, and they contribute around 2% to the 2022 CET1 level. The final point on fair values is they rise in the bank. They therefore increase the proportion of the group's income that's subject to the surcharge. And so this has taken the group's tax rate to 25% from an underlying 23% in 2022. So moving on to operating expenses. I reported last year that our 2021 annual salary award is 5%. Given the inflationary environment and the cost of living challenges, we've given additional support to our people during the summer. Our year-end pay [ rand ] took effect from the first of October '22, with an increase of 5% given to the people below the leadership group. With the continued investment in our digitalization program expected for the current year, core wage inflation and inflationary impacts on non-salary contacts -- contracts, sorry, we expect 2023 that turn to be 2% or 3% above the level that is the current consensus of GBP 165 million. So we're guiding to GBP 170 million of cost for the year. As Nigel has noted, we're in combination with our continued margin accretion, we're looking for the cost income ratio, therefore, to remain below 40%. Move on to the economic outlook. Our multiple economic scenarios have been updated to reflect the development of the outlook since the half year. In addition to generally harsher assumptions, we've increased the weighting of our severe scenario, which now stands at 20% compared to 15% in 2021. The scale of the change in the outlook is shown most clearly in the center bottom table in the chart, where our weighted average scenario for 2023, see a 4% GDP decline, an additional 10% CPI increase, slightly lower unemployment, and that reflects the very strong starting position we have now and an additional 7.5% house price decline when compared to the assumptions we made for 2023 this time last year. As always, we show the impact of 100% weighting for each of the scenarios as a guide to the possible downside risk. And despite the harsher economics, the 100% severe scenario, the impact has declined from its 2021 level, largely given the impact of house price increases across the year. The economic scenarios have generated an underlying impairment requirement of GBP 48.5 million as summarized on my next slide. In addition to our model impairment, our COVID-related overlays were written back in the year and substantially replaced by GBP 15 million judgmental overlay. This judgmental assessment reflects the uncertain economic outlook and CPI levels that didn't exist when we calibrated our models. This gives a total provision of GBP 63.5 million, which if we flip back to the previous page, is GBP 1 million more than the level we would need if we weighted 100% to the downside. And by way of background, that downside scenario has peaked CPI of 14%, a fall in 2023 GDP of 2.2%, 6.3% peak in unemployment and a 14% peak to trough reduction in house prices. Including the overlays, the coverage ratio is 44 basis points from 49 basis points in 2021. With the impairment skewed to Stages 1 and 2, the ECLs are largely precautionary in nature. This reflect the underlying strong credit performance of the portfolio. The net balance of Stage 3 loans was GBP 95.9 million at the year-end. This compares to GBP 125 million in 2021 and nearly GBP 136 million in 2019, which was a much more benign environment. We also continue to monitor the behavioral scores of our various portfolios. This gives a good early warning of credit challenges amongst our customers. We do this at customer level and over differing time periods, but the year-on-year movement shown in the chart demonstrate a very stable position at the year-end. Also, the 3-month arrears figure in the buy-to-let book fell from 21 basis points in 2021 to 15 basis points now. Again, this demonstrates the resilience of that customer group. My next slide shows the bridge in the capital position from 2021 to '22. Retained earnings here, they include fair value gains, noted above. The after tax value of these is 2% of the 4.6% growth in the chart. Our net loan growth utilized 0.9% of our resources, the dividend 1% and the buyback further 1.1%. Although the buyback wasn't completed until after the year-end, our irrevocable instruction meant that we accelerated the full recognition into 2022. Other movements include the capital required to actually support the fair values and derivatives on the balance sheet. This is 0.4% of the 0.7%. And so that partially offsets the 2% value in our retained earnings from the fair values. The table on my following slide gives us a little bit more detail of the group's strong capital base. The credit risk element on the table translates to group-wide risk weight density for the loan book remains absolutely unchanged year-on-year at 44.3%. However, with higher cash balances and fair value adjustments, it takes our aggregate risk weight for all of our exposures down from 41% last year to 39.1% this year. As noted again, all of our Tier 1 requirements are met by equity with no AT1 issuance. The impact of the IFRS 9 transitions take the fully loaded CET1 to 16%, which remains very materially above our regulatory requirements. As Nigel mentioned, we've announced a GBP 50 million buyback for the year. The 2022 buyback was achieved at an average price of GBP 4.92 a share, which compares to the GBP 5.33 of tangible net asset value at the year-end. Since my interim update, we've also started to receive initial feedback from the PRA on Phase 2 of our IRB application. This is very constructive engagements ongoing, and I'll give more color as we go through the process on our IRB journey. Finally for this slide, the Bank of England published its long-awaited consultation on the Basel 3 implementation last Wednesday. Our initial view of the impact is pretty much in line with our initial expectations with the Bank of England having stayed very, very close to the original Basel construct. However, the consultation does include important proposals around IRB, in particular, the accreditation process. It also proposes an increase in the strong and simple regime to balance sheets of up to GBP 20 billion, which would therefore include Paragon. All in all, we see the proposals as a strong positive for the group. We'll contribute to the consultation over the coming months, and we'll update the market as and when we get new tangible updates. My final slide looks at dividends. Adjusting for the noncash fair value items, but including the gain on the Idem Capital disposal, we are proposing a final dividend of 19.2 pence per share. This takes the dividend for the year to 28.6 pence, restoring the trend improvement seen in the dividend levels, as shown in the chart. I'll then hand you back to Nigel. Thank you.

Okay. Thank you, Richard. Our strategic priorities and the pillars are the building blocks of how we set the bank up and we've run it over the long term. It's the interplay between each discipline and how we calibrate them to reflect the external environment and risk appetite in a dynamic way that shapes the strategy, allowing us to execute our strategic plans while delivering for each of our stakeholders. At the heart of what banks do day-to-day is the trade-off between growth, returns and risk. At Paragon we think about this a lot, and we're always trying to strike the right balance driving our strategic objectives whilst maintaining an equilibrium that works through the cycle, not just when times are good. History shows that any single measure can be delivered in the short term, but history also shows that taking a short-term view of things is dangerous, especially when you're a bank. It's why we focus on delivering consistent growth, not growth at any cost and increased diversification built on strong prudential foundation of capital, funding and liquidity. These are all wrapped up in a consistent application of a low-risk appetite that allows us to target and now deliver a greater than 15% return on tangible equity on a sustainable basis. These attributes have never been more important than in the last few years, and it feels like they're going to be as equally important in the period ahead. We are clearly mindful of the current environment, but we are well placed and while growth is naturally likely to be tempered compared to 2022, margins are better, and our position with our customers is growing stronger so that we can capitalize when the cycle turns, which inevitably it will do. A key part of our customer proposition and franchise enhancement is being delivered through our digitalization and sustainability strategies. Paragon is a specialist bank with a technology strategy targeted at delivering a better customer proposition through faster delivery with enhanced service levels. Providing enhanced data to facilitate better decision-making and enhance cost efficiencies and increased operational leverage. We are undergoing a multiyear, multi-business line cloud-based re-platforming programming, utilizing open banking and API technologies, which will transform the way we engage with both the intermediary market and also new and existing customers. New digital technology has been introduced into virtually every corner of the bank with a prioritization towards customer-facing areas. The new in-house savings platform has helped support the increasing number of our third-party relationships, enabling us to increase deposit balances from these sources to over GBP 1.3 billion over the year, now representing 13% of all savings balances. The SME front-end broker portal launched during the year is receiving positive feedback from the intermediary market and supporting good growth in our market share and is a significant step-up in our operational capacity. Further upgrades will be rolled out this year to enhance our proposition even further. A new end-to-end development finance platform was delivered this year, which will provide significant benefits as the division moves into the next stages of our IRB program. There are numerous digitally focused new platforms to be installed in the future, one of the most significant being a digital mortgage underwriting and processing system which will complement the existing broker portal and the new customer retention system delivered during the year and where we have seen improvements to internal switching levels and this will become increasingly important in the provision of further advanced facilities as our customers seek to upgrade their properties as part of their own sustainability requirements. So now turning to sustainability. We have been active in our broader responsibilities in our sustainability agenda. Significant work has been undertaken using our advanced data analytic capabilities to measure the level of our operational and funded emissions as well as the risks these bring. Alongside this, we are delighted to announce that we have signed up to Bankers for Net Zero. We also published today, our second responsible business report highlighting increased disclosure and public engagement. With regard to funded emissions, we've released product initiatives across our divisions designed to encourage our customers to invest in improving their own emissions on their own properties or in their businesses including a 43% increase in A to C-rated properties in buy-to-let new lending. We are also offering finances to support electric motor and commercial vehicles, a trend which will, of course, only grow rapidly from here. We have also offered a wide range of facilities to SME customers supporting their environmental plans. A range of operational initiatives have also been undertaken, which will continue in order to improve the emissions directly under our control as we move towards our target of operational net zero by 2030. We have also become conscious that the consequences of the inflationary environment are also likely to impact our employees. Consequently, we made a one-off payment in the summer to all non-leadership employees an accelerated part of the full year profit-related pay. The balance, which is an even distribution representing 1% of pretax profits or around GBP 3,300 each is also being paid this month, again, to non-leadership employees. We're also conscious that our broader responsibilities are not just related to climate change as important as that is. We have continued to actively support the communities we work with and of course our colleagues, particularly through the challenges of recent years as we've all learned to adapt to new ways of working. Finally, we are particularly proud to -- delighted to announce that we were credited Platinum status by Investors in People during the year, the highest possible rating, which is held by less than 5% of those reviewed and less than 1% of all companies across the U.K. So turning now to our business lines. 2022 has clearly been an outstanding year for Paragon's buy-to-let business and the wider market. Our new lending has been strong with advances up 18% year-on-year and is more specialist than ever before as we continue to adapt to the needs of our professional landlords who are themselves taking increased share of a wider buy-to-let market as amateur landlords step back. While the year to September saw good growth across the market, it ended rather abruptly as the markets reacted aggressively to the mini budget, pushing up swap rates materially. The consequence was that the mortgage market temporarily froze in some ways, similar to what we saw in the early phases of the pandemic. However, we work closely with landlords and brokers to ensure that the deals in the pipeline could be executed and we were able to do this due to our hedging policy, which we enhanced as rates started increasing from earlier in the year and which allowed us to provide certainty and value to our customers at such difficult moments whilst also protecting our margins. As the external factors became clearer, rate expectations stabilized. Application flows are now back to where they were in the same period of 2021. And with a good pipeline, we remain confident in our ability to support our customers' needs in 2023 and beyond. In the triangular relationship I shared earlier, we will always prioritize risk and margin over growth, and it will continue to be the same this year. As we look into 2023, it will be heroic to assume that the market is going to be anything other than slower than 2022. Whilst this is an easy prediction to make, the fundamental strength of demand in the buy-to-let market coupled with the continued season of 5-year mortgages coming up for refinancing means that volumes are likely to be below '22 levels, albeit only moderately. We are well positioned in a market that is becoming increasingly complex and is therefore benefiting from our specialization focus. Nevertheless, we've done a fantastic job retaining customers 70% of which are our professional landlords, and that will be as important, if not more important, in 2023. The uptick in retentions, you can see during the year is centered around our legacy book which has additional amateur customers compared to the post-financial crisis portfolio. Data analytics and technology have always been used extensively in our buy-to-let business over our history, which now extends more than 1/4 of a century and this has been used extensively in supporting our IRB application as we employ methodologies to more accurately align capital allocation with risk. Our buy-to-let credit performance has always outperformed the sector, and this remains the case today. Arrears stand at just 15 basis points, virtually 1/3 of industry averages and with average LTVs below 58% and only 1.4% of the loan book, greater than 80% loan-to-value, the asset backing of portfolio is incredibly strong. As mentioned earlier, the average LTV of the pipeline is 63%, and there is nothing above 80% loan to value. When looking at this from the perspective of our landlords, their equity holdings in our buy-to-let loan book now totals in excess of GBP 10 billion. Higher interest rates always pose challenges for affordability tests, especially if they've not been vigorously applied in the past. We have always operated with conservative affordability tests. Whilst also applying an additional future affordability stress test over and above regulatory requirements. Rental demand is very strong and is significantly in excess of the private rented sector's available stock. Our further research directly with the tenants and other market data points to continued resilience in their payment performance, providing confidence in the strength of our customers' cash flows. Whilst 2023 will undoubtedly hold some challenges, our landlords and our buy-to-let business is very well positioned to deal with them, and there will inevitably be opportunities as the competitive landscape will shift further towards professional landlord specialist lenders and to those lenders, which have significant diversification of funding. So now turning to our commercial lending division. The graph at the top right of this slide shows the share of new lending in our commercial division since 2018, which now represents 41% of the group's volumes, reflecting our long-term diversification strategy. The bottom graph shows the pre-COVID growth trajectory has now been fully restored, continuing the trend upwards, supporting the diversification of income and contributing to the group's structural NIM accretion. Turning to the various business lines within commercial, first, let's look at development finance. Lending across the year in development finance increased by 24% to GBP 632 million, taking the loan balances to just shy of GBP 720 million an 18.4% increase on a year ago. The pipeline underpinning future facilities currently remains strong, which is likely to result in robust volumes in the current year as facilities draw down. However, through a combination of supply chain disruption and the uncertainty of the environment, the growth momentum is likely to slow over 2023. Our typical development finance customer is a highly experienced SME house builder who has been through many cycles and where we've had a relationship for many years and in many cases, decades. We are highly selective of the developers we work with and they value our extensive experience and our ability to deliver, particularly in more challenging environments. We undertook a series of credit tightening measures across the year, and the portfolio is performing very well, and we expect this to continue throughout 2023. So now turning to SME lending. Whilst market-wide SME cost of demand in recent years has been disrupted by the CBILS and Bounce Back Loan Scheme, we have achieved strong growth and outperformed the market with new lending across the year approaching GBP 450 million, a 32% increase on last year, and the loan book reached GBP 722 million, a 17% uplift on 2021. Whilst this growth in new lending saw us take market share, it is still only 1.5% of the asset finance sector, and we believe there is considerable opportunity to expand this division further over time, part of which is being delivered by the new cloud-based end-to-end re-platforming program. The new broker portal is already being used on over 70% of applications and has an ability to access over 4,000 pieces of customer data on every single application including built-in online access to the customer's current account information as part of the underwriting process. This is a significant benefit for us and is data which was historically only accessible by the large banks. The portfolio is performing well, and there is no evidence of credit deterioration. Turning now to the remaining components of the commercial divisions. First, motor finance. This experienced a sharp slowdown during the pandemic and for a period, operated at virtually tip over levels. However, following the review of its strategy, it launched with a more targeted approach in specialist sectors where risk reward could be better optimized. New vending increased to GBP 166 million across the year a near 66% increase on 2021. New product launches commenced in the leisure markets and in the electric vehicle sector where we should naturally expect to see significant growth as the sector delivers and matures in the coming years. And finally, structured lending which provides asset-backed lending to nonbank specialist lending firms has seen an encouraging recovery from the pandemic with an increasing number of facilities being added alongside an improved utilization of existing credit lines. Clearly, good progress has been achieved across our commercial lending divisions. However, we are conscious that these asset classes are more cyclical in nature and that the environment could be more challenging in the year ahead. All the portfolios are performing well, and the combination of the tightening lending criteria across the year combined with the strong disciplined approach we've always taken in the past will put us in good stead and will continue to be applied going forward. Finally, turning to funding. The deposit book is up nearly 15% year-on-year and now exceeds GBP 10.7 billion. We've continued to strengthen our franchise, enhancing flows in the direct-to-market proposition and through our third-party relationships like Monzo, Revolut and Hargreaves Lansdown. The higher interest rate environment has provided a tailwind to NIM with saving rates delivering sub SONIA cost of funding. Although the environment carries many uncertainties, we expect to see further NIM progression in 2023 with expectations of around 20 basis points above 2022 levels. Technology is also playing an important role in our savings business. And a new platform support to our third-party deposit relationships is effective and is working well, delivering improved efficiencies, strong operational controls and enhanced resilience. The demonstrable success of our funding strategy has also been recognized externally with Fitch upgrading our long-term debt rating to BBB+. Looking forward, Open banking is becoming more embedded in the banking sector. There are over GBP 1 trillion of balances with the major banks, earning modest returns even after recent base rate rises. New technology will reduce friction and should improve inertia. We're already seeing this today with GBP 12.7 billion of new term deposit flows across the market last month. The highest ever recorded and the vast majority of which moving from the large banks. There is a big prize here, and we are seeking to exploit the opportunities that should emerge. The group has a long history and a strong presence in the securitization markets. And whilst pricing is unattractive at present, it remains open to us to tap this funding source opportunistically. So in conclusion, 2022 has been an outstanding year in terms of our delivery. Loan growth has been strong, and our improved customer relationship management leading to greater retention levels and supporting good balance sheet growth with widening margins. We expect to continue into -- which we expect to continue into 2023. The strength of our profits and capital accretion supported last year's GBP 75 million buyback and a further GBP 50 million for the current financial year. However, I am particularly delighted in seeing return on tangible equity on an underlying basis to be above 15%. Basel 3.1 seems to be landing where we expected it to. IRB is inextricably linked here and the changes announced look positive. We are encouraged by the strength of our franchises and the growth prospects these can deliver over time. 2023 will hold challenges in growing lending volumes, but we have always prioritized margins and the maintenance of a low-risk appetite. There is a significant cloud-based technology re-platforming program underway across the group, which will improve both our customer and market propositions and improve our decision-making and cost efficiency. Much of it has the potential to help level the playing field with the larger banks. The volatile market conditions have eased, although the economic effects have yet to be seen in any material way. Our portfolio has been underwritten prudently and carefully managed over the years. We, therefore, expect our business will perform resiliently both financially and operationally. We are well prepared for a weaker environment, both in the provisions already taken and with the quality of the loan book and stand ready to support our customers in a more difficult environment, strengthening resources in our customer support teams in advance of any requirement. So whilst the environment will create challenges, it will inevitably create opportunities, and we are well positioned to react to them as and when they emerge. So thank you very much. We are now happy to take questions. So what we're going to do -- easy guys. There's a mic that will come around because it needs to link up for the webcast. So what we'll ask you to do is if you give us your name and company, even though we know who you are, but the -- also, we'll take initially questions in the room, and then we'll go to the conference call itself and then the webcast. So we're ready so put your hands up.

Good morning. It's Ben Toms from RBC. Two for me, please. Firstly, on the Basel 3.1 paper from last week. I think you previously guided that the impact could be somewhere between 75 to 150 basis points depending on whether indexation was allowed. An indexation is allowed, although not annually. So that kind of brings you to the 75 basis points if the paper was in line with your expectations, which you say that it was. And given that the small and simple regime, which you now qualify for should be nicer than the 4 Basel 3.1 rules, can we, therefore, conclude that the impact from Basel 3.1 should be less than 75 basis points? And then the second question is around the buyback, GBP 50 million announced today. When you have the discussions around whether it should be, say, 50 or 60 million, can you just talk about what stopped you from going further because it doesn't feel like it was capital given that on an underlying basis, your CET1 ratio is probably mid 14% kind of level.

Great. Okay. So Richard will give you his views on the relative value of the indexation point. I mean, first of all, we don't know what strong and simple holds because so far, the PRA have only published a consultation on the scale as in the threshold, which is initially GBP 15 billion, and that's been -- with the latest [ CP ] has been moved up to GBP 20 billion. But we don't know yet what the capital consequences or the other aspects relating to strong and simple will be. So it's actually quite difficult to judge the relative benefit -- or this benefit until more detail has been provided. Why don't you touch on that? I'll come back to the buyback point on the valuations.

So in addition to the previous expectation, there was also a slightly harsher treatment for HMOs in Basel 3.1, which probably takes the impact a few basis points above the levels that we were originally showing, but there was still that broad -- broad mix. And essentially the indexation if fully allowed was half the impact. So that position still holds. It will be interesting to see whether that makes it to the end of the consultation. It does feel odd that the bulk of the U.K. mortgage stock is -- falls under the IRB banks remit where indexation is permitted as part of that piece. So it just looks a little odd for that position to hold but I'm sure it will be part of the consultation pushback.

So I think the point we were making earlier is that you have to look at Basel 3.1 and IRB almost together. And I think the PRA had provided some acknowledgment of that by announcing changes to the IRB process alongside Basel 3.1. I mean obviously, there are output floors that will take effect, but not until phased in up until the point of 2030. But when you look at the fact is that whilst Basel 3.1 will add to your capital requirements, IRB pulls that right back. And Richard, I'm sure someone will ask the question more about how you're getting on with your IRB process, but -- and I'll leave that until then. But actually, you need to look at those 2 things side by side because they are now more inextricably linked than probably ever before. In terms of the buybacks, I think one of the issues there is that if you look at the capital in isolation and go like, you've got more, why didn't you do more is we're all subject to a 6-month PRA limit as to how much their approval will last for. And it's also then tied into how much we think we can realistically take from the market in any given period. If we see further opportunities to do further buybacks in due course, we'll go back and talk to the PRA again.

It's James Invine here from SocGen. I wanted to ask about the savings business, please. It's another strong year of growth. And if you carry on growing at this rate, then you'll have all the deposits you need. So I was just wondering at what point are you going to kind of pivot away from growth and a little bit more to margin management and then just how much difference will that make? I mean I know the environment already is giving you a tailwind on that. But if you change from a growth mode to just matching the loan growth, that could take -- have another shift.

Okay. So the relationship between how much we want to fund from deposits and/or other sources is kind of -- is part of a longer-term strategy. So once upon a time, many moons ago, we were a wholesale funder. And gradually, we have not just met the growth in our balance sheet, but we've also refinanced our historic wholesale funding. At the moment, there is a significant advantage towards retail funding versus wholesale funding. And we remain capable or opportunistically reacting if those relationships were to shift, but there's quite a gap, frankly, at the moment. The -- you kind of probably should look that the regulatory framework tends to point to a preference around no more than 30% of your funding coming from non-retail sources. Now running right up against those limits is probably not ideal. So probably you might want to think of a level -- a normalized long-term level maybe around a 20% wholesale, 80% retail. However, you will then move that around depending on where the relative advantages are. I mean at the moment, there is significant pricing advantages and if you get to the point where the evolution of our retail offering has got you to your 80% level, and you are still seeing strong inflows because we are constantly looking at ways of diversifying our various platforms at which we target the fundraising. But then also if you get to that point, then margin management becomes a more active part of your life. That being said, margin management is already -- the guys running our retail savings business are constantly -- I wouldn't like to describe it like a frenzied dealing room, but they are constantly looking at various parts of the market along the yield curve because you can issue 3-year money and swap it back to sub-SONIA. So you can look at various ends of the duration curve all against the relative kind of almost like arbitrage value points along that line. So margin management is already there, but if we constantly expand our addressable market, it will become a more pronounced and bigger opportunity, we hope.

It's Perlie Mong from KBW. Just 2 questions. And the one -- the first one is on loan volume. So your guidance this year -- for next year suggest it's fairly moderate reduction versus what you've done in full year '22. Just wondering what sort of what gives you that confidence? Because at current rates, the rental yield is already below the mortgage rate. So have you seen or would you expect any of your landlords to sort of sell up that's one part of it. And the other part of it is what rental interest cover are you assuming in these numbers? Because I think previously, maybe last year, you were talking about something like maybe 200%. But at current rates, it's -- you would assume that some of that would have come down. So just wondering what you're seeing and what you're expecting. That's the first question. And the second question, very quickly, is the pipeline hedge. So you would -- I would expect that to unwind over the next few years. But what sort of time line are you expecting that unwind to take place?

Okay. So let me deal with the first question. Richard will be able to give you the details around the hedge. So I think the -- if you look at the marketplace as a whole, you've got a component there of landlords buying properties and then a component of landlords refinancing. 2023 is going to have market-wide, more properties coming up to that, more landlords coming up to the end of their 5-year fixes in 2023, than there was in 2022. So first of all, the scale of the addressable remortgage market will increase over the next 12 months. However, I expect existing lenders will be more active in wanting to try and retain customers like we were very active last year. So that will all depend on, therefore, on the competitive dynamics. The question you posed is how do -- how the landlords cope in this environment. The thing is if you look at the rental yield in our pipeline, it's 7%, just a tad shy of 7%. And if you borrow 63% loan-to-value against that, then your weighted debt costs are basically providing you with a very strong margin for the landlord, they are getting probably the full tax cover because they're doing this through a corporate structure. So you don't have the same problems that some of the amateurs have. And so the consequence is you get your still generating a good margin for the rents. And part of that is because whilst interest rates have moved up, rents have been rising for quite some time. So the landlords have benefited from rental growth and now also benefiting from perhaps an easing from where interest rates were at their peak. And it was interesting to note that when that kind of very disruptive period took place during October, the kind of the activity centered more towards the variable rate products rather than landlords wanting to lock in longer duration where the market just looked wrong at that point. So I think landlords behave quite rationally. But I think you see the landlords, particularly the professional landlords, are achieving quite strong rental yields against their property. Do you want to cover the pipeline hedge.

Yes. So our year-end fell at probably the most volatile part of the whole year. So September, saw a very material element of that GBP 192 million adjustment. Some of that will already have unwound because swaps have moved back to the -- to still elevated but a slightly lower level. There are 2 elements to the way the pipeline hedges unwind. Firstly, as and when loans complete, the hedges then get effectiveness and then the credit then unwinds through a debit for the next 5 years, given its a 5 years swap. But to the extent that they are still unhedged -- sorry, unmatched actually then fair value of the adjustment. So my best estimate at this point would be around GBP 100 million of amortization for this year and then probably an average GBP 25 million a year for the next 4 to take that GBP 200 million movement. However, all it needs is a spike in rates one way or the other. And also that only looks at the current pipeline. There'll be a new pipeline that's delivered along the way as and when there's volatility on rates, it could go either way. But if you -- if all my planning is right and the market interest rates are correct, that's the sort of profile we'd expect to see from there.

It's Gary Greenwood at Shore Capital. I've got 3 questions, please. So the first one on NIM and interest rates. You talked about how you're positively geared deliberately to rising interest rates, and that's going to be a further benefit next year. But I was wondering whether you can do anything to lock in those benefits as and when the rate cycle turns thereafter? Second one on credit quality. I think a feature of the entire industry at the moment is that actual arrears and losses still remain very low and that's no different for you, but which are the areas of your portfolio that you're looking most closely at the moment in terms of risk? And then the last question was on noninterest income. You mentioned that you had a better-than-expected year on noninterest income. So could you just talk about thoughts for 2023 there.

Okay. So the NIM, I think, is -- what you've seen is that NIM accretion has come around for a couple of reasons. One, over many years, you've seen the structural NIM accretion as our business mix has changed. So less of the legacy buy-to-let book, more of the post-financial crisis book. You're getting old margins going off, new margins coming on. And you've also had the commercial business coming on where naturally it has wider margins. I think the other aspect though is the gearing effect you said with higher rates leading to the deposit beater in effect, providing a move from above SONIA to sub-SONIA. Now I think your question was like, can you lock the benefit of that in? So obviously, you're referring to the more structural hedges that the bigger banks have tended to use. And we will look at that. We haven't made any decisions about it yet, about locking in our return on our capital in effect through a series of rolling swaps. However, one of the things that has been -- historically been used is that the reason we haven't done that is that as rates rise, it tends to be a credit negative generally, not necessarily specific for any one bank but generally, but also so we would see impairments rise. So if you're making an extra return, which historically we guided to every 1% increase in base rates will add GBP 10 million to the net interest income line. So you can see that there is a hedge between net interest income and impairments on that basis. However, what we will be working on and looking at is to whether that is adequately modeled in this environment or whether it would be appropriate to look at structural hedges as an additional item to look at. So no decisions yet. But it's been looked at. Do you want to cover the net interest income point, Richard, components.

Noninterest?

Noninterest income.

Yes. Sure. Yes. So with higher volumes, we see higher activity fees. So that's been -- that's just driven through naturally. That's been a small increase in the year. The leasing business has done really well. We had a very good second half. And so that drives additional income. But also a number of years ago when we bought the Titlestone development finance business, we only bought half of the portfolio. We've been managing that for a third party. The way that works is towards the end of the servicing contract, there's some higher earnings. And so we have the first of those payments fell into this year, we were actually expecting it next originally. So there's a favorable timing difference there, but there's still a little bit more to come in 2023. That won't be repeated in '24. But the absolute activity levels we're seeing should mean that the level is higher than the previous trend but probably below '22 for 2023, if that helps.

And so the second question that you had was the -- which of the portfolios do you -- going to keep more of a weathered eye on in 2023. So you'd start by looking at the buy-to-let book and saying, it's very low LTV, less than 58% on the stock, 63% on the pipeline. It's demonstrably shown through many cycles over many years, a more resilient outcome. I tried to argue maybe not necessarily successfully that there is a countercyclical element to that because when the economy is weak, people don't buy, they rent for longer. So it increases demand. And we've certainly got that at the moment. However, so the commercial area would be regarded as more cyclical in its nature. But as I said earlier, as of today, we are not seeing any credit deterioration in any of those portfolios. I would suppose the one that is the most cyclical is likely to be the motor finance division because, in effect, it is largely consumers there. It's secured against the value of the car but it is still a consumer exposure. That being said, we have been deliberately very cautious, very focused in the nature of that lending and tightening lending criteria there as we have done everywhere across the year, pulling down LTVs across that product line, notwithstanding the increase in the lending that's been able to be achieved. So we look at everything. We're cautious about everything at the point of underwriting. We're cautious about things the way we provide. Hence, you've seen the approach that we've taken this year. We are very analytical. We download, as I said, 600 million pieces of data on our customers every single month. So we try and see what's going on in their lives before a payment gets missed. And then we try and anticipate that, reaching out to the customers to try and see what level of support we can provide. We're not seeing anything of significance coming through those early warning indicators either. So it's all good, but we're very cautious, very conscious of the environment, and we'll be there ready to support customers if that's what's needed.

I have 3 questions. It's John Cronin from Goodbody. The first one is on IRB. So if you overlay the impacts of the expected reduction in risk weights you would see accruing from IRB accreditation to the revised Basel 3.1 standardized template. What are you seeing there in terms of potential benefit from a capital perspective? The second question is on just looking at -- and further into one of the previous questions, just trying to unbundle that a little bit more for '23. So 20 basis points of accretion is quite strong. Obviously, your cost of deposits have remained quite low throughout H2, but have ticked up towards the end. And I think you did see a significant increase by period end. So just trying to understand what you're assuming in terms of deposit cost migration through '23 as well as asset rates and spreads. And then thirdly, look, coming back to the point on credit quality, very clear, very, very strong message again on arrears and loan loss experience. Clearly, look, your provision [indiscernible] all through the form of overlays. But I did note that there was a significant pickup in the imbalances that have seen a significant increase in credit risk in the buy-to-let book. And I'm just thinking about how comfortable you are with your provisions from a Stage 2 loans perspective, particularly given they screen quite low relative to peers, although I appreciate I'm comparing apples with oranges in many respects by drawing those comparisons. But just how confident you are in your coverage levels.

Okay. So let me just deal with the deposit side, and then Richard, maybe you can cover IRB and the impairment flows. So on the deposit side, you can see that with a 30 basis points accretion this year guiding to 24 -- sorry, last year guided for 24 for 2023 we've allowed for an easing of that. And if you look at the relative rates, we have passed on rates well in a number of areas here to customers. Now when you look at the phasing of these things and sometimes when base rates are moving like monthly, and then you move and deposit rates move in the market, you're never quite sure whether it's playing catch up to the last base rate move, the one before or the one to come. So we all kind of want to see a dynamic here where market peak, interest rates peak, we get some stability about where rates will be. And then you'll guide to get the terminal -- where terminal base rates will be and then you'll see the relative deposit relationship compared to SONIA or base rates. Now I think when you look at that and actually because we've just spent the last 15 years at near 0 interest rates, then it's kind of difficult to look at recent history for a trend there. So you go back to the pre-financial crisis when life existed around 5% base rates, you typically had a healthy 2% spread on the deposit side to base rates. That's not -- it's a different world. There's a different dynamic. There's a different set of circumstances. So we won't be absolutely the same going forward. But what we see is that ignoring any short-term dynamics between one competitor suddenly having a flurry of activity, but trying to look at the longer-term trend is that we expect there to be further base rate rises to come. Our view is that base rates will settle out at 4%, but look, we will continue to see rates being passed on to customers. And so the 20 basis points is a more cautious view of the accretion that we saw in '22 over to '23. So I don't think that the expectations are that all of this massive widening that has taken place in the sub-SONIA deposit rate is there and permanent to stay. I think there's a catch-up still to come, and hence, that's why we've narrowed that deposit spread for '23. You want to cover the others?

We've been asked several times about the impact of IRB. I think until we've got to the stage that we've cleared that with the regulator, we're not going to be able to give proper guidance. The reason we're doing it, though, is not just to defray a downside from Basel 3.1. But our basic IRB position would give a better capital outcome than the current standardized so I think the -- that's probably as far as we can take it at the moment. There will be an interplay with the risk weight floors down the line on getting accreditation. There are some things that have been added into this latest consultation that we still need to reflect in models. There's an element of a PD floor on some of your mortgages, which we need to we need to calibrate properly. But again, we're still expecting the IRB outcomes to be better than current standardized. And I think that's the -- in terms of, if you like, the downside risk of 3.1, that's probably the main takeaway.

I think just to add to that point, if you're seeing risk weight inflation coming through across the market for, let's call it, the professional landlords, multiple property landlords. Then the significance of IRB has just become even more important. So one of the things is there is a question as to if you're a small bank and you don't see IRB as remotely achievable or affordable, then there's potentially a competitive disadvantage likely to emerge more as a consequence of Basel 3.1 than existed before. Now that may be alleviated under standardized -- under strong and simple, but we simply don't know because there is no rules and guidance as to what will be included on the capital side for strong and simple. One thing you do know is regulators rarely give up capital, they only tend to add.

That's very clear on IRB. But can I come back on one further question, and I appreciate you don't want to be drawn on what the possible impact would be. But just in terms of how the -- so at the stage of introduction, so for argument's sake, if you were to migrate to IRB on the first of January 2025, at which stage the 50% output floor is applicable, do you think the PRA was in a bit to try and minimize capital ratio volatility, look at maybe -- and I guess there is a precedent for new to IRB banks carrying a slightly higher risk weight on their books relative to banks that have been using IRB for a long time. I suppose what I'm getting at is, look, theoretically, you could see a substantive immediate benefit as you move to 50% and then that partially unwinds over the course of the following 5 years as you move up to the 72.5% output floor? Do you think the PRA will try and smooth out a bit.

I'm not sure they'll necessarily try to do that overtly. But that's why we've not given guidance yet because until we've been through exactly where our ratios are landing, it's hard to answer that question. We know where our models are looking. And that still gives that favorable to standardized approach. I think the bigger downside price is that all firms who are currently standardized will be holding capital in case of Basel 3.1. I think if that threat is removed, even just the removal of that piece actually ought to give strong additional capital resources for us to grow the business, buy things, conduct more capital management, all of the above. Sorry. And in terms of the [ Sika ] movement, one of the key drivers of whether you've actually described something as having had a significant increase in credit risk is if when you put it through your IFRS 9 models, the PDs have gone up by a particular amount. So the increase in [ Sika ] that you've seen there is a function of the economic scenarios that we put in place. So that's the thing that has driven the increase in the balance in that in that category.

Not the performance of the portfolio.

Yes, not the spot performance.

Yes. And then on coverage levels.

Yes. And again, the driver there is LTVs. So whilst you can see some movement on PD -- actually, back to Nigel's point, when you're starting with a 58% loan-to-value for the portfolio as a whole -- though clearly the A distribution within that. But the vast, vast, vast majority of that is sub 80%. So it doesn't translate through to crystallizing losses at that point.

Okay. I think we have time for one more question.

Portia Patel from Canaccord. Just 2 really quick ones, please. Just on the NIM guidance. Really simply, what is your 20 bps accretion based on in terms of base rate expectation for FY '23, i.e., it gets to what level and when? And secondly, given what you mentioned earlier about increasing remortgage activity. How would you encourage us to think about redemptions in the mortgage book in FY '23 and beyond?

Okay. Do the first one.

Yes. So we've got another percent from here, so up to 4%, and we've seen that from the summer next year in terms of base rates. So that's what would underpin that 20 basis points.

So on the remortgage side, so I mentioned earlier that 2023, there will be more market-wide 5-year seasoned loans coming up for the refinancing than there were in '22, that's a market-wide phenomenon. The same is true for us. We have more coming up in the current financial year compared to last year. What we also have is more within that, there are more professional landlords compared to the number of the component out of the total. We'll be more competitive in terms of our product offering with a professional landlord than we will be with an amateur. So we are optimistic that we will have good retention levels in '23.

That's really helpful. And just a final one. The rule of thumb that you have, the 1% increase in rates is GBP 10 million to PBT. Does that still hold at a 4% base rate level?

Generally, yes. Yes. The GBP 10 million for 1% is in a steady state. So it won't be at the day you have it because there'll be lags and lead times in terms of further passing on of rates to certain customers and the savings customers. Steady state, you'd be at that level.

Okay. So thank you very much for attending this morning. You know where we are. We're happy to have conversations with you for the analysts to discuss anything they want in terms of -- oh, sorry, I've just been -- sorry, I've just been told I failed in my first job here, which is the webcast. Is there any questions from the webcast. No? Anything from the telephone lines? No. Okay. I didn't really fail then. So as I was saying, we're very happy to have further conversations with you. Richard's set aside a good amount of time over the next day or so. If you haven't got a meeting with him already, then please get in touch. We're around for a while. So happy to carry on the conversation. Thank you very much.