DBRS Morningstar Confirms Lloyds Bank at AA (low), Trend Remains Negative

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 remains Negative.

The Intrinsic Assessment (IA) for the Bank is AA (low) and the Support Assessment of the Group is SA3. Please see a full list of the rating actions at the end of this press release.

KEY RATING CONSIDERATIONS
The confirmation of the long-term ratings reflects our view that the impact of the COVID-19 pandemic and the UK’s departure from the EU on Lloyds’ credit profile and earnings generation has been contained to date. The strength of Lloyds’ domestic franchise is characterised by leading market shares across most retail and business segments in the UK, and its strong underlying profitability is underpinned by stable core activities, a generally low risk profile, and strict cost discipline. It also reflects the solid funding and liquidity position, as well as robust capital levels. In addition, the legacy and conduct issues that have in recent years weighed on the Group’s statutory profitability have been largely dealt with.

The Negative trend takes into account the challenges the Group is facing on its earnings generation ability, with revenues expected to remain under pressure from the lower interest rate environment, given net interest income is the Group’s largest contributor to total income. It also incorporates DBRS Morningstar’s view that the full impact of the COVID-19 crisis is yet to fully materialise, and as such we anticipate that Lloyds’ asset quality could weaken once the government’s and the banks’ support measures are withdrawn. Lastly, the full impact of the UK’s withdrawal from the European Union still remains unclear.

RATING DRIVERS
An upgrade of the Long-Term Issuer Rating is unlikely given the Negative trend. However, the trend could revert to Stable if the impact from the COVID-19 pandemic on the Group’s risk profile and earnings power remains contained and the Group is able to achieve profitability and efficiency metrics in line with similarly rated peers.

The Long-Term ratings would be downgraded if the Group’s profitability and/or asset quality metrics experience a sustained deterioration.

RATING RATIONALE
With total assets of GBP 870 billion at end-Q1 2021, Lloyds is one of the largest banking groups in the UK. The Group enjoys significant market shares in retail and commercial banking, and has a strong position in life insurance. In recent years, the Group has been focused on transforming into a digitised, low risk financial services provider through leveraging the Group's multi-brand strategy and product capabilities. As part of its Strategic Review 2021, the Group targets growth in its two core segments of retail banking and commercial banking by deepening customer relationships across various retail products and by further strengthening its SME and corporate franchise within the UK.

DBRS considers that Lloyds’ earnings generation ability has been affected in recent quarters. In FY20, total income on an underlying basis was down 16% Year-on-Year (YoY) to GBP 14.4 billion, with the sizeable decrease mainly driven by lower levels of NII, despite growth in mortgage volumes, as a result of the lower base rate. Furthermore, other operating income (excluding the impact of operating lease depreciation) was affected by lower customer activity and lower non-recurring items compared to 2019. Similarly, Lloyds’ NII declined by 9% YoY to GBP 2.7 billion in Q1 2021, in spite of a strong growth in the mortgage book. Nevertheless, the Group reported an increase in statutory profit after tax in Q1 2021 largely thanks to loan loss reversals. Statutory profits were up to GBP 1.4 billion in Q1 2021 from GBP 480 million in Q1 2020 and GBP 680 million in Q4 2020.

With revenues under pressure, the Group remains focused on further reducing costs. For 2021, Lloyds targets a cost base of circa GBP 7.5 billion, which compares to operating expenses of GBP 9.3 billion in 2020. The reported cost-to-income ratio was 55.3% in 2020, while on a quarterly basis it was 52.3% in Q1 2021, having slightly deteriorated from 49.7% in Q1 2020. Overall, Lloyds’ return on tangible equity (RoTE) improved to 13.9% in Q1 2021 from 3.7% in Q1 2020 and 5.9% in Q4 2020. Nevertheless, the Group is targeting a RoTE of between 5% and 7%, which compares to a very low RoTE of 2.3% in 2020, and which we still consider to be towards the lower end of its similarly rated peers.

It remains difficult to judge the full impact of this crisis on the Group’s fundamentals as a deterioration in borrowers' payment capacity has not yet materialised, helped by the unprecedent government and banks’ support measures in place since the onset of the COVID-19 pandemic. Lloyds’ risk profile is characterised by a large domestic mortgage loan book, and we note new mortgage lending in the UK was very strong in Q1 2021 with the temporary stamp duty tax relief originally due to end at the end- March 2021 but extended to end-June 2021, which will likely continue to encourage strong mortgage activity. Lloyds’ GBP 295 billion mortgage book represented 83% of the retail book at end-2020, with an average Loan-to-Value (LTV) ratio of 43.5% (end-2019: 44.9%) and with just 0.6% of mortgages having an LTV greater than 90%. Meanwhile, sectors affected by COVID-19 represented GBP 10.8 billion or about 2.1% of the loan book. In this context, the Group's share of Stage 3 loans was 1.8% at end-Q1 2021, flat on end-2020 and end-2019. However, we also note that Stage 2 loans, i.e. loans for which credit risk has increased significantly since initial recognition and which are seen as early indicators of deteriorating asset quality, accounted for 13.0% of the retail book and 16.2% of the commercial book at end-2020, up from 9.4% and 6.2% at end-2019.

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 increased by GBP 50.6 billion to GBP 462.4 billion at end- Q1 2021 from GBP 411.8 billion at end-2019. This, combined with marginal overall loan growth resulted in the Group's net loan-to-deposit ratio improving to 96% at end-Q1 2021 compared to circa 110% in previous years. The Liquidity Coverage Ratio (LCR) was a strong 134% at end-Q1 2021 (136% at end-2020). The Group does not publicly disclose its Net Stable Funding Ratio.

DBRS Morningstar views Lloyds as having a solid capital profile. This is supported by a steady and recurrent internal capital generation. Lloyds maintains large cushion over regulatory minimal requirements with a Group’s CET1 ratio at 16.7% at end-Q1 2021 (16.2% at end-2020) which compares to an MDA trigger of 9.2% at end-March 2021. At the same time, the Group is targeting a CET1 ratio of c. 12.5%, plus a management buffer of c. 1% partly reflecting an expected increase in risk-weighted assets driven by the BOE mortgage floor and the implementation of Basel IV. Nonetheless, the UK leverage ratio was a strong 6.0% at end-March 2021.

ESG CONSIDERATIONS

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.

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

DBRS Morningstar notes that this Press Release was amended on August 5, 2021 to correct the solicitation status as “Unsolicited Participating Without Access".

Notes:
All figures are in GBP unless otherwise noted.

The principal methodology is the Global Methodology for Rating Banks and Banking Organisations (8 June 2020) https://www.dbrsmorningstar.com/research/362170/global-methodology-for-rating-banks-and-banking-organisations. Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (3 February 2021) https://www.dbrsmorningstar.com/research/373262/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings.

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 Company Documents, Lloyds Annual Report 2020, Lloyds Pillar III Report FY20, Lloyds Investor Presentations Q1 2021, Q4 2020, FY20, and S&P Global Market Intelligence. DBRS Morningstar considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, this is an unsolicited credit 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 12-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. DBRS Morningstar understands further information on DBRS Morningstar historical default rates may be published by the Financial Conduct Authority (FCA) on its webpage: https://www.fca.org.uk/firms/credit-rating-agencies.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/379598

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

Lead Analyst: Vitaline Yeterian, Senior Vice President, Global FIG
Rating Committee Chair: Elisabeth Rudman, Managing Director, Global FIG
Initial Rating Date: 01/29/2009
Last Rating Date: 06/05/2020

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