DBRS Comments on Lloyds Banking Group plc’s 1H12 Results; Senior Unaffected at A (high), Stable

DBRS, Inc. (DBRS) has today commented that the ratings for Lloyds Banking Group plc (Lloyds or the Group), including its Issuer and Long-Term Debt rating of A (high) and the ratings of Lloyds TSB Bank plc, including its Senior Debt & Deposits rating of AA (low), are unaffected by the Group’s announcement of results for 1H12. The trend for all ratings is Stable.

Despite a statutory loss, Lloyds’ results evidence a resilient performance by the core businesses in the face of a slowing U.K. economy and heightened uncertainties in the Euro zone. DBRS sees the results as demonstrating the progress achieved by Lloyds in strengthening the balance sheet, reshaping the business and removing risk. For 1H12, Lloyds reported a statutory loss before tax of GBP 439 million compared to a loss before tax of GBP 291 million in 2H11. The weaker half-year linked results primarily reflect a GBP 1.1 billion provision for PPI contact and redress incurred in 1H12 and the absence of such a charge in 2H11. Lloyds’ generated a profit before tax of GBP 1.1 billion compared to a profit before tax of GBP 289 million in 2H11 on an underlying basis, which excludes the impacts of integration, simplification and Project Verde costs, volatility items arising from the insurance business, PPI, amortisation of purchased intangibles, past service pensions credit, liability management gains, fair value unwind, asset and bond sales, fair value of own debt and other volatile items. The improved underlying results were driven by a substantial decline in credit costs and reduced operating costs partially offset by lower revenues.

Underlying income, at GBP 9.2 billion net of insurance claims, was 7% lower on half-year linked basis, reflecting reduced demand for lending, customer deleveraging, the low rate environment and higher wholesale funding costs. Importantly, results benefitted from impairments that were lower across all four core segments resulting in a 28% reduction from 2H11 to GBP 3.2 billion. While still elevated at GBP 1.3 billion, Wealth, Asset Finance and International, impairment charges, declined 40% from 2H11. Notably, in Ireland, which has been a significant driver of high credit costs in recent periods, impairments were 36% lower than 2H11, reflecting moderation in the rate of increase in newly impaired loans and the reduction in non-core assets in Ireland. From DBRS’s view, the results achieved in a challenging operating environment illustrate the resiliency of the underlying earnings power of the core businesses and the considerable strength of the franchise, both of which are key considerations underpinning the ratings. Further, DBRS considers the results as demonstrating the progress management has made in removing credit risks from the balance sheet, whilst remodelling the business.

Credit performance continued to illustrate favourable trends despite the slowing U.K. economy. Group-wide asset quality ratio (AQR) improved 36 basis points (bps) from year-end to 1.10%, while in the Core businesses the AQR stood at 0.44%, or 12 bps lower compared to year-end 2011. The overall improvement in Group-wide AQR reflects the positive trends in the Core loan book as well as the reduced size and improving asset quality of the Non-Core book. Within the Core business, all divisions reported positive trends in credit performance with new cases moving to arrears and impaired declining once again on a half-year linked basis. Importantly, in Ireland, Lloyds experienced a significant reduction in the pace of newly impaired loans. DBRS considers the favourable trends in credit metrics across the Group as illustrating the prudent risk appetite and sound credit risk management of Lloyds. Nevertheless, given the weakening economic conditions in Lloyds domestic market, DBRS remains cautious regarding further near-term improvement in credit performance.

Group-wide net interest margin (NIM) and Core business NIM were resilient with Group-wide NIM declining 6 bps from 31 December 2011 to 1.91%, while Core business NIM declined just 2 bps from year-end to 2.32%, but was stable quarter-on-quarter. The solid margin performance in the Core business reflects the benefits of asset pricing and the increased preponderance of deposits in the funding mix, which largely offset higher wholesale funding costs. Lloyds continues to make good progress in its strategic goal to simplify the Group and take out costs. Illustrating the success of management’s efforts, total costs were 5% lower on a half-year linked basis to GBP 5.0 billion representing the fifth consecutive half-year period of declining costs. Nonetheless, the cost-to-income ratio increased modestly to 54.0% from 53.2% in 2H11 owed to the decline in revenues outpacing the reduction in costs.

The Group continues to lower balance sheet risk by reducing the non-core portfolio. Importantly, despite challenging market conditions, Lloyds disposal of GBP 23 billion of non-core assets was capital accretive. Non-core assets, at GBP 118 billion, were reduced 16% from year-end 2011. As a result, Non-Core assets represent 12% of total assets, down significantly from 23% at year-end 2009. DBRS notes that, out of the GBP 3.2 billion of impairment charges in 1H12, GBP 2.2 billion were attributable to assets in the non-core books.

Lloyds continues to advance the reshaping and strengthening of its funding and liquidity profile. The Group’s sizeable deposit base is the foundation of the enhanced funding profile accounting for 66.2% of total funding compared to 57% a year ago. During 1H12, Lloyds deposit growth once again outpaced overall industry-growth, which in DBRS’s view evidences the benefits of the increased investment in the core brands and the overall strength of the Lloyds’ franchise. At 30 June 2012, Group-wide deposits, excluding repos, totalled GBP 419.1 billion, a 3% increase from year-end. As a result, the loan-to-deposit ratio improved to 126%, and within the core business the ratio stood at 103% at the half year end. During the half-year, wholesale funding was reduced by 15% to GBP 213.8 billion. Furthermore, the Group has further extended the maturity profile of its wholesale funding profile with 66% of wholesale funding having maturities greater than one year as compared to 55% at year-end 2011. Importantly, despite turbulent conditions in the capital markets, Lloyds maintains good market access, illustrated by the Group’s ability to complete its 2012 wholesale term issuance plan by the end of April 2012. Liquidity is substantial with GBP 105.0 billion of primary liquid assets, which equates to 240% of money market positions and 140% of all wholesale funding maturing in less than one year.

With regards to capitalisation, Lloyds continues to strengthen its position through solid internal capital generation and lower RWAs. At 30 June 2012, the Group’s core Tier 1 ratio was 11.3%, 50 bps higher than at year-end 2011. Lloyds estimates that its fully loaded Basel III core tier 1 ratio at 30 June 2012 was 7.7%, up 60 bps from December 2011.

DBRS notes that on 19 July 2012, Lloyds announced that it had agreed to non-binding heads of terms with the Co-operative Group plc for the mandated retail and commercial divesture known as Verde. Upon completion which is anticipated by the end of November 2013, Lloyds will sell to the Co-operative 632 branches, 4.8 million customers (including 3.1 million current account customers), a matched balance sheet of approximately GBP 24 billion and the TSB and Cheltenham & Gloucester (C&G) brands. While these divestures will reduce Lloyds’ market share in certain businesses and geographic regions, DBRS sees Lloyds’ strong U.K. retail franchise as remaining very solid following the sale of these entities.

Notes:
All figures are in GBP unless otherwise noted.

The principal applicable methodology is the Global Methodology for Rating Banks and Banking Organisations. Other methodologies used include the Enhanced Methodology for Bank Ratings – Intrinsic and Support Assessments. Both can be found on the DBRS website under Methodologies.

The sources of information used for this rating include company documents and SNL Financial. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This commentary was disclosed to the issuer and no amendments were made following that disclosure.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

Lead Analyst: Roger Lister
Approver: William Schwartz
Initial Rating Date: 19 January 2009
Most Recent Rating Update: 14 November 2011

For additional information on this rating, please refer to the linking document under Related Research.