DBRS Downgrades Lloyds Banking Group plc Ratings to A (high), Trend Negative

DBRS has today downgraded its ratings of Lloyds Banking Group plc (Lloyds or the Group) and related entities, including the Group’s Issuer and Long-Term Debt Rating to A (high) from AA (low). Concurrently, the Senior Debt & Deposits ratings of Lloyds TSB Bank plc (Lloyds TSB) and HBOS plc (HBOS) (together, the Banks) have been downgraded to AA (low) from AA. The trend on all long-term ratings remains Negative. The Short-Term Debt and Commercial Paper ratings have been downgraded to R-1 (middle) from R-1 (high). The trend on all short-term ratings is Stable. Today’s rating action does not affect the ratings of Lloyds TSB and Bank of Scotland plc debt guaranteed by the Commissioners of Her Majesty’s Treasury (the HM Treasury), which remain at AAA with a Stable trend.

This rating action follows the Group’s 13 February 2009 trading update in which it disclosed that HBOS’s performance worsened considerably since its last update on 12 December 2008. HBOS is expected to report an underlying loss before tax of GBP 8.5 billion for full-year 2008. On a statutory basis, the loss before tax is expected to be approximately GBP 10 billion. Driving the loss are GBP 4 billion of charges related to market dislocation and GBP 7 billion of impairments in HBOS’s corporate loan book. Impairments were GBP 1.6 billion higher than Lloyds had previously anticipated, reflecting the more conservative provisioning methodology of Lloyds TSB as well as the rapid decline in the U.K. economy during October to December 2008. Lloyds TSB’s stand-alone results were also pressured by market dislocation and weaker asset quality in the second half of 2008. Importantly, on a stand-alone basis, Lloyds remained profitable despite the difficult operating environment, which DBRS views as an illustration of Lloyds TSB’s core earnings ability. Lloyds TSB estimates that 2008 profit before tax (PBT) from its continuing businesses, including the impact of approximately GBP 1.3 billion from market dislocation, was GBP 2.4 billion, compared with GBP 3.9 billion earned in 2007. DBRS had previously factored in a level of deterioration in performance; however, the expected losses at HBOS disclosed last week are well beyond DBRS’s tolerance levels and the levels factored in to the previous ratings.

The rating action takes into consideration the reduced level of captialisation. As the result of the sizeable loss, Lloyds now estimates that core Tier 1 will be in the range of 6% to 6.5%, which is significantly in excess of its regulatory capital requirements. Tier 1 capital will be in excess of 9%, within the previously estimated 9% to 10% range.

The Group’s liquidity and funding remain acceptable in DBRS’s view. Lloyds benefits from its leading U.K. deposit franchise and the Group maintains significant short-term liquid reserves (estimated at GBP 80 billion). Also, the Group benefits from actions taken by the HM Treasury, including various liquidity facilities, as well as the HM Treasury’s guarantee scheme for certain debt issuances.

The Group’s ratings are underpinned by its strong franchise. However, DBRS believes that the enlarged group’s near-term earnings potential has been significantly weakened by the addition of the weaker HBOS balance sheet and the current challenging operating environment. Moreover, Lloyds faces integration challenges associated with acquiring the larger HBOS. Although DBRS believes that the Group will benefit from its leading market position and its increased earnings generation ability in the long term, the near-term headwinds are significant as credit deterioration accelerates and capital markets remain disrupted. Though focused almost entirely in the U.K., the Group’s diverse product lines and leading market shares are also important rating considerations.

The Negative trend reflects DBRS’s view that the operating environment in the U.K. will continue to be extremely challenging. The economy continues to weaken at an accelerated pace and property markets and asset valuations remain under considerable stress, which is expected to further pressure the Group’s near-term earnings. Additionally, the Negative trend considers the enlarged Group’s credit exposures and the elevated risk profile resulting from the acquisition of HBOS’s loan book. DBRS had long viewed the Group’s conservative risk culture as a positive rating consideration; however, the addition of HBOS assets and the unprecedented deterioration in the U.K. economic environment and the global market dislocation have negatively affected the enlarged Group’s risk and near-term earnings profile.

DBRS believes that the Group’s ratings are underpinned by its dominant position in U.K. retail banking. Furthermore, the ratings are bolstered the U.K. government’s sizeable equity stake and DBRS’s view that Group is a systematically important to the U.K. and likely to receive additional timely systemic support should the need arise.

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

This is a Corporate (Financial Institutions) rating.