DBRS Confirms Lloyds Banking Group at A (high), Trend Revised to Negative

DBRS Ratings Limited (DBRS) has today confirmed the ratings of Lloyds Banking Group plc (Lloyds or the Group) including its A (high) Issuer and Long-Term debt ratings. The ratings of Lloyds TSB Bank plc are also confirmed at AA (low) for the Senior debt and deposit rating and R-1 (middle) for the Short-term rating. The Trend on all long-term ratings has been revised to Negative from Stable. The Trend on the Short-term rating remains Stable. The Intrinsic Assessment (IA) for Lloyds Banking Group is “A” while for Lloyds TSB Bank plc the IA is A (high). DBRS views the Group as systemically important within the U.K. (categorised as SA-2) and the ratings incorporate one notch of uplift from the IA for systemic support.

In revising the trend to Negative, DBRS reflects its concerns that despite the steady progress the Group has made over the past 3 – 4 years in strengthening and cleaning up the balance sheet, positive momentum on statutory earnings and restoration of organic capital generation has been held back by significant regulatory and conduct charges, as well as the scale of the restructuring task. The A (high) intrinsic assessment of Lloyds TSB Bank has incorporated DBRS’s expectation that the benefits of the costly HBOS acquisition will be realised and that the Group will be able to generate strong and steady earnings. However, the Group’s ability to return to profitability has been hampered by the very high cost of past missteps (notably Payment Protection Insurance (PPI) misselling), and in addition DBRS expects future profitability to be constrained by the difficult economic environment in the U.K. and the tough regulatory environment that U.K. banks face.

The ratings could see further downward rating pressure if conduct issues remain a problem for the Group, there are delays in completing the final – but significant - stages of the Group’s restructuring, or DBRS has concerns that regulatory requirements could affect the return to profitability of the Group. In addition, further delays in a recovery in the U.K. economy could affect ratings. Conversely, a stronger than expected recovery in the Group’s net income could lead to the trend being revised to Stable.

Lloyds’ ratings incorporate DBRS’s view that the Group has a powerful retail and commercial banking franchise in the U.K.. The Group faced a large restructuring job following the acquisition of HBOS in 2008, but has made significant progress to date. Over the past year the Group’s Non-core assets fell by 30% to GBP 98.4bn at the end of 2012 from GBP 140.7 billion at the end of 2011. The NPL ratio moved down to 8.6% in 2012 from 10.1% in 2011 as the Group continues to write down and sell non-performing assets. In particular, the Group has managed to steadily reduce its very large exposure to problematic real estate, such that Property/ Construction made up 11.25% of gross customer loans and advances in 2012, down from 12.7% in 2011.

Similarly, the funding profile, which has been a key challenge for the Group, has continued to improve with wholesale funding down 32% YoY to GBP 169.6 billion at year-end 2012. Meanwhile, the usage of short-term funding (all wholesale funding under 1 year) is down 55% to GBP 50.6 billion from GBP 113.3billion. The Group’s loan-to-deposit (LTD) ratio has also fallen to 121% from 135% a year ago, while the Core LTD ratio was solid at 101%.

Despite reporting losses for the past two years, the Group has built up relatively strong capital ratios and continues to wind-down the Non-core assets in a capital accretive way. The Group’s Core Tier 1 capital ratio was 12.0% at the end of 2012. The pro-forma fully loaded CRD IV Core Tier 1 ratio is estimated to be 8.1% and although the Group will have further work to do to exceed the required 10%, DBRS considers that it has the ability to do so.

Nevertheless, Lloyds continues to face significant economic and regulatory pressures. The provisions taken for PPI over 2011 – 2012 have reached GBP 6.8 billion, and although the Group has a buffer against further claims as total costs incurred have currently reached 64% of provisions, the misselling continues to impose a heavy financial, reputational and management cost on the Group. Other provisions and costs include GBP 400 million for Interest Rate Hedging Product sales and GBP 325 million for German insurance.

DBRS expects the ongoing tightening of international and domestic regulatory requirements to continue to pose challenges for the Group: these include tougher consumer protection standards, stricter risk weightings, the U.K.’s Banking Reform Bill, CRD IV and Solvency II. In addition Lloyds, which is 39.2% owned by the U.K. Treasury, has still to complete the requirements imposed by the European Union as the condition for receiving State Aid. The key remaining requirement is the divestment of 632 branches and around GBP 24 billion of assets and liabilities due by November 2013, known as Project Verde. Lloyds has reached a non-binding heads of terms with The Co-Operative Group, but has also made plans for an IPO as a fallback. The preparations for this divestment have been at a significant cost for Lloyds and have contributed to slower progress than DBRS had anticipated in realising the benefits from the Group’s enlarged market share post-acquisition of HBOS.

Against a backdrop of a weak economy in the U.K., margin pressure remains and the Group’s Banking NIM dropped to 1.93% in 2012 from 2.07% in 2011. Although some of this reflects adjustments to the Group’s Gilts portfolio and continued margin compression in the Non-Core portfolio, DBRS expects the fragile economic environment in the U.K. and likely delays in any increase of the Bank of England base rate to continue to lead to pressure on margins. DBRS notes that Lloyds is trying to offset some of these challenges with its ongoing cost and simplification programme, which has reached a run-rate of GBP 847 million (with costs of GBP 861 million to date).

Concurrent with today’s rating action, DBRS has also upgraded by one notch the junior debt instruments and preference shares of the Group that resumed coupon/ dividend payments in January 2012 after having been halted from 31 January 2010 in line with EC restrictions on Lloyds as a recipient of State Aid. DBRS had rated these instruments one notch below the standard notching policy to reflect the additional risk due to non-payment. These instruments include the preference shares of Lloyds Banking Group, as well as the Cumulative and Non-Cumulative Discretionary Pay Subordinated Debt instruments of Lloyds Banking Group, Lloyds TSB Bank, HBOS, Bank of Scotland (see full details in the rating table below).

Separately, DBRS has also withdrawn the AAA ratings on government-guaranteed debt, as this debt has been repaid.

Notes:
All figures are in GBP unless otherwise noted.

The principal applicable methodologies are the Global Methodology for Rating Banks and Banking Organisations, and DBRS Criteria – Intrinsic and Support Assessments, Rating Bank Subordinated Debt and Hybrid Instruments with Discretionary Payments, and Rating Bank Preferred Shares and Equivalent Hybrids. Both can be found on the DBRS website under Methodologies.

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

Ratings assigned by DBRS Ratings Limited are subject to EU regulations only.

Lead Analyst: Elisabeth Rudman
Rating Committee Chair: Alan G. Reid
Approver: Alan G. Reid
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.