DBRS Downgrades Lloyds TSB and HBOS to AA, Trend Negative

DBRS has today downgraded the long-term debt ratings of Lloyds TSB Bank plc (Lloyds TSB), including its Senior Debt & Deposit rating to AA from AA (high). Concurrently, the long-term ratings of HBOS plc and the Bank of Scotland, plc (together HBOS), including the Senior Debt & Deposit ratings, have been downgraded to AA from AA (high). The Commercial Paper ratings of both Lloyds TSB and HBOS have been confirmed at R-1 (high). The trend on all ratings is Negative. The long-term ratings of Lloyds TSB and all ratings of HBOS have been removed from Under Review with Negative Implications, where they were placed on 18 September 2008. Today’s rating action does not impact the ratings of Lloyds TSB and HBOS debt guaranteed by HM Treasury, which remain at AAA with a Stable trend.

This rating action follows the completion of Lloyds TSB’s acquisition of HBOS and reflects DBRS’s concern that the combined entity, which is now named Lloyds Banking Group plc (the Group) will face certain near-term challenges. DBRS sees substantial integration risks, given the size and scale of this transaction. Moreover, in DBRS’s view, the deteriorating U.K. economic environment will likely add negative pressure to earnings, owing to the Group’s sizeable exposure to the U.K. property, corporate and mortgage markets. Additionally, the continued dislocation in the global capital markets increases the probability of significant earnings volatility from further asset impairments, especially should valuation adjustment exceed the GBP 10 billion (after tax) valuation allowance. Ultimately, DBRS views the current financial profile of Lloyds Banking Group plc as weakened by this acquisition.

However, in the longer term, DBRS expects that the Group will benefit from its stronger market position. DBRS considers the acquisition as having strategic value, as in the long term, this transaction should enhance the Group’s financial profile, its underlying earnings generation ability and its overall franchise strength. The transaction creates one of the world’s largest financial institutions with leading market shares. Lloyds Banking Group plc will become the U.K. leader in all major retail products (mortgages, current accounts, savings, personal loans and cards) and will have a top-three position in U.K. commercial and corporate banking. Furthermore, the enlarged Group has the leading branch network in each of England, Wales and Scotland.

DBRS views Lloyds Banking Group plc’s funding and liquidity profile as acceptable, yet it is now considered weaker than Lloyds TSB’s pre-acquisition profile. Post-transaction, 55% of the Group’s total funding requirements are funded though customer deposits. Historically, HBOS was more reliant on wholesale funding than Lloyds TSB. However, going forward, DBRS does expect that the Group will continue its focus on reducing the level of wholesale funding. DBRS acknowledges that the Group anticipates having GBP 80 billion in short-term liquid reserves, which should alleviate near-term refinancing or liquidity pressures. Importantly, funding and liquidity also benefit from the actions taken by HM Treasury, including various liquidity facilities, as well as HM Treasury’s guarantee scheme for certain debt issuances.

DBRS views positively the Group’s GBP 17 billion capital raise, as the current environment calls for a higher level of capital. The added capital consists of GBP 4 billion of preference shares issued to HM Treasury and GBP 13 billion of ordinary shares underwritten and ultimately purchased by HM Treasury. Following the offerings, HM Treasury owns approximately 43% of the combined company. The pro forma core Tier 1 capital ratio (at time of closing) is expected to be greater than 7%, although final capital ratios have yet to be determined.

The ratings are underpinned by the Group’s strong franchise, solid underlying earnings ability and well-positioned deposit franchise. Furthermore, the ratings consider the Group’s conservative risk culture, diverse product lines and leading market shares in the U.K. DBRS notes that both HBOS and Lloyds TSB have historically been efficient operators, reporting better-than-peer cost-to-income ratios. The Group expects to realise GBP1.5 billion of cost saves post-closing.

Given the Group’s dominant position in U.K. retail banking and considering the government’s sizeable equity stake, DBRS views the Group as systematically important to the U.K. and, as such, DBRS expects it will continue to receive timely systemic support should the need arise. Accordingly, the ratings benefit from government support.

The Negative trend considers DBRS’s opinion that the Group faces noteworthy integration challenges, given the size of HBOS relative to Lloyds TSB and the overall size of the transaction. This is further exacerbated by the significant turmoil in the financial markets and the challenging operating environment. That said, DBRS recognises the track record of Lloyds TSB’s management in successfully integrating prior acquisitions, notably, Trustee Savings Bank (TSB) and Cheltenham & Gloucester plc. Finally, the trend reflects DBRS’s view that earnings of U.K. banks will remain under pressure from elevated credit costs due to ongoing deterioration in the quality of their loan books as the recessionary environment in the U.K. deepens. Ratings of the enlarged Group could be negatively pressured should weaker earnings signify that integration challenges are adversely affecting the franchise or should credit performance deteriorate significantly. Moreover, ratings could be pressured should further impairments related to the significant U.K. property, specialist mortgage and capital markets exposures be beyond DBRS’s tolerance levels. Conversely, the trend could revert to Stable should the Group illustrate a smooth integration and solid financial results, whilst reducing its wholesale funding component.

Notes:
All figures are in GBP unless otherwise noted.

The applicable methodology, Analytical Background and Methodology for European Bank Ratings, Second Edition, can be found on our website under Methodologies.

This is a Corporate (Financial Institutions) rating.