DBRS Morningstar Revises Trend on Lloyds Bank to Negative, Confirms AA (low) LT Issuer Rating

DBRS Ratings Limited (DBRS Morningstar) confirmed the Long-Term Issuer Ratings of Lloyds Banking Group plc (Lloyds or the Group) and its related entities. The Group’s Long-Term Issuer Rating was confirmed at A (high) and Lloyds Bank plc’s (the Bank) Long-Term Issuer Rating was confirmed at AA (low). The Bank’s R-1 (middle) Short-Term Issuer Rating and the Group’s R-1 (low) Short-Term Issuer Rating were both confirmed. The trend on the long-term ratings has been revised to Negative from Stable. The Intrinsic Assessment (IA) for the Bank remains AA (low) and the Support Assessment of the Group remains SA3. Please see a full list of the rating actions at the end of this press release. Concurrently, DBRS Morningstar confirmed the rating on the Group’s Preference Shares at BBB (high) and withdrew the rating for business reasons.

KEY RATING CONSIDERATIONS

The change of the Trend to Negative on the long-term ratings reflects our view that Lloyds’ credit profile and earnings generation are likely to be adversely affected by a major economic slowdown, driven by the COVID-19 pandemic (COVID-19). The impact of these items is likely emerge in the coming quarters, whilst the implications for the medium to long-term will depend on the depth of the economic crisis. In addition, DBRS Morningstar notes the uncertainty around the terms of UK’s departure from the EU, which in the case of a disorderly exit, could lead to a further deterioration in UK macroeconomic conditions. We expect the economic downturn to be offset, in part, by the support measures announced by the UK Government and the Bank of England.

The confirmation of the Bank’s IA reflects the strength of the Group’s domestic franchise with leading market shares across most retail and business segments in the UK, and its strong underlying profitability, underpinned by profitable core activities and market-leading cost efficiency. It also reflects the conservative risk profile, and solid funding and liquidity position. The Group’s capital ratios are robust and the underlying internal generation has been very strong in recent years.

RATING DRIVERS

An upgrade of the Long-Term Issuer Rating is unlikely given the change in trend. However, the trend could revert to Stable if the impact of the economic downturn on the Group’s risk profile and earnings is less severe than currently anticipated, while the impact of legacy and conduct issues on statutory profitability continues to diminish.

Ratings could be downgraded in the event that the downturn in the UK economy, as a result of the Covid-19 pandemic, leads to further pressure on the Group’s profitability and asset quality metrics in the near to medium term. This could also be driven by a Brexit outcome, which, through its economic impact, leads to a deterioration in Lloyds’ credit profile.

RATING RATIONALE

Lloyds is one of the largest UK banking groups, with total on-balance sheet assets of GBP 862 billion at end-Q1 2020. The Group has a substantial market share in UK retail and commercial banking and a strong position in life insurance. In 2018, Lloyds announced a new strategic plan for the 2018-2020 period, focused on transforming the Group into a digitised, low risk UK financial services provider, leveraging its multi-brand model. In 2019, we view that Lloyds made good progress in implementing the targeted outcomes.

Statutory profit before tax declined sharply to GBP 74 million (down 95% YoY) in Q1 2020, mainly due to the impact of COVID-19. Underlying profit was GBP 558 million (down 74% YoY), reflecting a significant increase in the cost of risk and a decline in revenues. In recent years, the Group’s underlying earnings generation capacity has been strong, supported by the significant domestic franchise, as well solid cost efficiency levels. However, statutory profitability has been weighed down by legacy issues, most notably in the form of conduct provisions, such as those required for Payment Protection Insurance (PPI). In 2019, reported statutory pre-tax profit was GBP 4.4 billion, down 26% YoY, mainly reflecting a substantial increase in PPI provisions to GBP 2.5 billion, compared to GBP 0.8 billion in 2018. Underlying profit before tax declined by 7% YoY to GBP 7.5 billion, driven by a combination of lower revenues and higher impairment charges, in part offset by a decline in total costs. Cost discipline remained strong with the underlying cost-to-income ratio at a low 48.5% (2018: 49.3%).

Lloyds’ risk profile is conservative, supported by cautious underwriting and the large domestic mortgage loan book. At end-2019, Stage 3 exposures under IFRS 9 (assets, which have defaulted or are otherwise considered to be credit impaired) accounted for 1.8% of gross loans and advances on an underlying basis, down from 1.9% a year earlier. The early impact of COVID-19 did not have an immediate impact on asset quality ratios reported in Q1 2020, and the share of Stage 3 in total customer loans remained stable at 1.8%. However, we expect asset quality to deteriorate in the coming quarters.

The Group has suffered a significant financial and reputational impact from conduct risk issues in recent years. Following the large PPI provisions taken in 2019 to reflect the higher than expected complaint volumes in the run-up to the August 2019 industry deadline for claims, the Group did not take any further provisions for PPI in Q1 2020. Remediation charges related to other outstanding legal and regulatory matters totalled GBP 445 million in FY19 and GBP 87 million in Q1 2020. Further substantial PPI claims are unlikely and the overall drag from litigation and conduct on Lloyds' earnings should diminish substantially from 2020. We note, however, that some legacy conduct issues remain outstanding representing a reputational risk.

Lloyds’ funding position remains robust, benefiting from a leading position in UK current accounts and savings and access to a range of funding markets. Customer deposits, excluding repos, were GBP 412 billion at end-2019, covering 68% of the Group’s funding requirement. The loan-to-deposit ratio was 107% at end-2019, flat YoY. The Group maintains a solid liquidity profile, with a liquidity portfolio of GBP 118 billion at end-2019, equivalent to almost three times the outstanding short-term wholesale funding. The Group comfortably meets the Liquidity Coverage Ratio (LCR) requirements, with a ratio of 138% at end-Q1 2020.

DBRS Morningstar views Lloyds as having a solid capital profile, comparing well with similarly rated peers. The pro forma Common Equity Tier 1 (CET1) ratio was 13.8% at end-2019, slightly down from 13.9% at end-2018, but above the target of around 12.5% plus a management buffer of 1%. In Q1 2020, the pro forma CET1 ratio improved 45bps to 14.2%, boosted by the cancellation of the 2019 dividend (+83bps), net of RWA growth (-29bps) and other impacts. Following the Financial Policy Committee’s March 2020 decision to reduce the Countercyclical buffer rate for UK exposures to 0% with immediate effect, the Group’s CET1 capital requirement declined to 11.3% from 12.2% (excluding the confidential PRA buffer), increasing the Group's capital cushion over regulatory requirements. DBRS Morningstar takes into account the Group’s very strong underlying capital generation capacity. Internal capital generation based on underlying performance, which excludes PPI charges and incorporates the Insurance dividends, was 210 bps in 2018 and 198 bps in 2019. However, during Q1 2020, capital generation was largely offset by the impact of COVID-19. The end-Q1 2020 UK leverage ratio was a strong 5.3% and the transitional pro-forma MREL ratio was 34.5%, positioning Lloyds well to meet future MREL requirements.

The Grid Summary Grades for Lloyds Banking Group plc are as follows: Franchise Strength – Very Strong/Strong; Earnings – Strong/Good; Risk Profile – Strong/Good; Funding & Liquidity – Strong; Capitalisation –Strong.

ESG CONSIDERATIONS

DBRS Morningstar views the Product Governance and Business Ethics ESG subfactors as significant to the credit rating. These are included in the Social and Governance categories. The Group has suffered a significant financial and reputational impact from legacy conduct issues, in particular mis-selling of PPI products for a number of years. Charges related to past misconduct remained high in 2019 as Lloyds made another significant provision for PPI mis-selling, driven by the surge in PPI customer compensation claims in the run-up to the August 2019 industry-wide deadline for claims. Further substantial PPI claims are unlikely and the overall drag from litigation should diminish substantially from 2020. We note, however, that some legacy conduct issues remain outstanding. While their earnings impact should be manageable, they represent a reputational risk, which we incorporate in the Group’s Franchise and Risk Profile grid grades.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

Notes:
All figures are in GBP unless otherwise noted.

The principal methodology is the Global Methodology for Rating Banks and Banking Organisations (11 June 2019). https://www.dbrsmorningstar.com/research/346375/global-methodology-for-rating-banks-and-banking-organisations

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883

The sources of information used for this rating include, Lloyds Banking Group plc
Annual Report and Accounts 2019, Lloyds Banking Group plc Q1 2020 Interim Management Statement, S&P Global Market Intelligence, Bank of England, HM Treasury, and IMF. DBRS Morningstar considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

This is an unsolicited rating. This credit rating was not initiated at the request of the issuer.

With Rated Entity or Related Third-Party Participation: YES
With Access to Internal Documents: NO
With Access to Management: NO

DBRS Morningstar does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period. DBRS Morningstar’s outlooks and ratings are under regular surveillance.

For further information on DBRS Morningstar historical default rates published by the European Securities and Markets Authority (“ESMA”) in a central repository, see: http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

The sensitivity analysis of the relevant key rating assumptions can be found at:
http://dbrsmorningstar.com/research/362104

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

Lead Analyst: Tomasz Walkowicz, Vice President, Global FIG
Rating Committee Chair: Ross Abercromby, Managing Director, Global Financial Institutions Group
Initial Rating Date: January 19, 2009
Last Rating Date: June 10, 2019

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DBRS Morningstar notes that this Press Release was amended on June 11, 2020, to incorporate the telephone number of the issuing office.