Lloyds Bank Plc. Post Rating Action Update. CREDIT OPINION 7 July Update

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1 CREDIT OPINION 7 July 216 Lloyds Bank Plc Post Rating Action Update Update Summary Rating Rationale On 28th June, we affirmed all ratings of Lloyds Bank plc (Lloyds) and its holding company Lloyds Banking Group (LBG) and changed the outlooks to stable from positive on their long term senior unsecured debt and deposit ratings. RATINGS Lloyds Bank Plc Domicile United Kingdom Long Term Rating A1 Type LT Bank Deposits - Fgn Curr Please see the ratings section at the end of this report for more information.the ratings and outlook shown reflect information as of the publication date. Contacts Carlos Suarez Duarte VP-Senior Analyst carlos.suarezduarte@moodys.com Maija Sankauskaite Associate Analyst maija.sankauskaite@moodys.com Laurie Mayers Associate Managing Director laurie.mayers@moodys.com Nick Hill Managing Director Banking nick.hill@moodys.com Michael Eberhardt, CFA VP-Sr Credit Officer michael.eberhardt@moodys.com The change in outlooks reflect our view that a prolonged period of uncertainty for the UK, expected following the outcome of the UK referendum, will have negative implications for the country s medium-term growth outlook and could lead to: (1) weaker operating profitability due to slower domestic credit demand; (2) weaker credit quality due to a likely modest increase in unemployment and downward pressure on property prices in the UK; and 3) potentially higher and more volatile funding costs. These drivers will pressure revenues, asset quality and profitability metrics for all banks in the system, although some are more resilient to these strains. These factors led us to revise the outlooks on many UK banks and building societies ratings to negative from stable. We revised our outlook on the UK banking system itself to negative from stable at the same time. Despite these challenges, Lloyd's credit fundamentals remain strong as reflected in its baseline credit assessment (BCA), which is underpinned by: (1) solid retail, commercial and insurance franchise; (2) strong capital metrics; and (3) improved asset quality. However, the BCA also reflects: (1) the sizable conduct remediation costs; (2) rapid expansion in riskier lending segments such as consumer finance and SME; and (3) increased competition, which is likely to put negative pressure on net interest margins. We rate Lloyds' long-term deposits and senior unsecured debt at A1. These ratings are underpinned by (1) the bank's BCA; (2) the results of our Advanced Loss Given Failure (LGF) analysis which leads to a Preliminary Rating Assessment (PRA) for both deposits and senior unsecured debt two notches above the BCA and; (3) a moderate probability of government support, resulting in a further notch of uplift above the PRA for both deposit and senior unsecured debt ratings. The ratings of the bank's short term deposits and short term debt are Prime. We also assign a Counterparty Risk Assessment (CRA) of Aa3(cr)/P(cr) to Lloyds. The ratings of Lloyds' holding company, Lloyds Banking Group's (LBG's) long- and short-term senior unsecured debt are Baa1 and Prime-2, respectively. These instruments do not benefit

2 from the same level of subordination as the senior unsecured debt issued by the operating entity and do not benefit from any uplift for government support. The ratings of Lloyds' and LBG's subordinated, junior subordinated and preferred shares are, Baa3 and, respectively. The outlook on Lloyds' deposits and senior unsecured debt and on LBG's senior unsecured debt is stable. Credit Strengths Improved asset quality; Capital metrics are strong; Leading retail and commercial banking franchise provides shock absorbers ; Substantial amount of liquid assets. Credit Challenges Challenging operating environment following the outcome of the EU referedum Fast expansion of relatively riskier lending segments - consumer finance and SME lending - makes the bank's asset quality more sensitive to a deterioration in the economic environment; The bank is facing interest margin pressures amid the increasing competition within the UK banking sector; Conduct remediation costs and other non-core losses remain sizable generating earnings volatility; The use of wholesale funding remains high. Rating The outlook on Lloyds' deposits and senior unsecured debt and on LBG's senior unsecured debt is stable, reflecting the improving trends in asset quality and its strong capitalisation. But also, reflecting the negative pressures on the bank's profitability and asset quality driven by our expectation that a weaker operating environment following the outcome of the UK referendum. Factors that Could Lead to an Upgrade Lloyds' BCA could move up if the bank is able to (1) reduce the impact of conduct remediation on its profitability and return to stable net income; and (2) maintain strong asset quality and capital metrics under the more challenging operating environment. Factors that Could Lead to a Downgrade Lloyds' BCA could be lowered following (1) A more acute deterioration in the UK's operating environment, in particular in terms of economic growth, unemployment and the property market; and/or (2) a material decline in its capital or leverage metrics. A downward movement in Lloyds' BCA would likely result in downgrades to all ratings. Key Indicators Exhibit 1 Lloyds Banking Group plc (Consolidated Financials) [1] Total Assets (GBP million) Total Assets (EUR million) Total Assets (USD million) Tangible Common Equity (GBP million) Avg This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on for the most updated credit rating action information and rating history. 2 7 July 216

3 Tangible Common Equity (EUR million) Tangible Common Equity (USD million) Problem Loans / Gross Loans (%) Tangible Common Equity / Risk Weighted Assets (%) Problem Loans / (Tangible Common Equity + Loan Loss Reserve) (%) Net Interest Margin (%) PPI / Average RWA (%) Net Income / Tangible Assets (%) Cost / Income Ratio (%) Market Funds / Tangible Banking Assets (%) Liquid Banking Assets / Tangible Banking Assets (%) Gross loans / Due to customers (%) [1] All figures and ratios are adjusted using Moody's standard adjustments [2] Basel III - fully-loaded or transitional phase-in; IFRS [3] Basel II; IFRS [4] Compound Annual Growth Rate based on IFRS reporting periods [5] IFRS reporting periods have been used for average calculation [6] Basel III - fully-loaded or transitional phase-in & IFRS reporting periods have been used for average calculation Source: Moody's Financial Metrics Detailed Rating Considerations The financial data in the following sections are sourced from LBG's financial statements unless otherwise stated. Strong asset quality but we expect modest increase in impairments In Q1 216, Lloyds saw a further decline in its reported impaired loan ratio to 2.%, following an 8 basis points fall during the course of 215 to 2.1%, largely driven by the sale of the Irish commercial loan portfolio. Lloyds' run-off portfolio declined to 11.4 billion in 215 from 18.3 billion in 214, and now accounts for only 2.5% of gross lending and 4.6% of risk-weighted assets. The bank's cost of risk could show a modest deterioration, if the weaker expected economic growth has an impact on employment. Furthermore, we believe that the cost of risk has very limited room for improvement: at 14 basis points in Q1 216 it is at the lowest level in the past few years. However, we expect only a moderate increase in impairments given the low interest rate environment and the bank's conservative underwriting standards. Exhibit 2 Lloyds' credit risk is declining Q1 216 coverage ratio is Moody's estimate Source: LBG results presentations The bank continues to expand significantly its UK consumer finance and SME portfolios: net lending in these segments grew by 17% and 5%, respectively, in 215. We believe these asset types are riskier by nature than Lloyds' traditional mortgage and corporate credit products, potentially exposing the firm to greater downside risk, if the economic environment deteriorates. Consumer finance, 3 7 July 216

4 including credit cards and asset finance in the UK and Europe accounted for 5.2% of Lloyds' total lending net of impairments excluding reverse repos and other items, while SME lending accounted for 6.4% as of December 215. The bank continues to face significant operational risk from legacy products, which has been reflected in the record 4.8 billion provisions set aside during 215, of which 4. billion relate to mis-sold payment protection insurance (PPI) policies. The remaining.8 billion charge encompasses the customer redress of a number of other products, including the 117 million settlement with the Financial Conduct Authority following a process failure in appropriately handling customer's complaints. In the first three months of 216 Lloyds took a further conduct charge of 115 million for miscellaneous retail items. Despite the fact that Lloyds front-loaded the PPI charges in 215 in response to the proposed introduction of a deadline for customers to claim compensation, it may have to set aside further provisions, given the unpredictable nature of the claims, but we expect them to be smaller. Our assigned Asset Risk score of incorporates the factors described above. Despite deleveraging Lloyds maintains a strong retail and commercial franchise, which provides a stable base of earnings... Lloyds' leading commercial and retail banking franchise continues to generate significant revenues, providing a good quality earnings stream capable of absorbing further credit impairments and conduct-related costs. The bank remains the largest mortgage lender and deposit-taker in the UK despite the sale of TSB Banking Group plc (TSB, Baa3 stable) to Banco Sabadell (Baa3/Ba1 stable, ba3). Lloyds continues to benefit from the revenue diversification provided by its bancassurance subsidiaries, Scottish Widows and Clerical Medical. During 215, Lloyds insurance business reported an underlying profit of 962 million, up from 922 million in 214. However, we note that as part of the implementation of the UK's "ring-fencing" legislation, Lloyds plans to transfer the ownership of its insurance activities to the holding company. Therefore, LBG will be the entity receiving the revenue diversification benefits from these businesses once the ring-fencing is implemented. The bank plans to include the vast majority of its banking activities within the ring-fenced entity. If its plans are accepted, we see few challenges for Lloyds to implement the ring-fencing legislation and therefore fewer potential changes in its credit profile compared to its large UK competitors....however, ongoing conduct remediation costs and potential further litigation charges likely to prolong earnings volatility Lloyds reported a profit before tax of.7 billion in the first three months of 216, a 46% decline on the same period in 215, mainly driven by a 79 million charge related to the redemption of Enhanced Capital Notes (ECNs). The bank will nevertheless benefit from annual interest savings of about 2 million a year (Lloyds' estimate) following the redemption of these instruments. In addition to the ECNs charge, the bank made a 115 million provision for retail conduct costs in the period and incurred a number of other items, such as volatile items, asset sales and high business restructuring costs. Excluding the items mentioned and the contribution of now deconsolidated TSB, Lloyds reported a flat underlying pre-tax profit of 2.1 billion in the first quarter of 216, compared to the same period in 215. Lloyds reported a 3% higher net interest income of 2.9 billion in Q1 216, and its net interest margin (NIM) strengthened to 2.74% from 2.6% in Q1 215, driven by lower funding costs following the ECNs redemption and improved deposit pricing. We expect the bank's interest margin to come under pressure in the near term as interest rates remain lower for longer following the outcome of the EU referendum and competition in the UK mortgage market intensifies. Counterbalancing the NIM challenges, Lloyds' operating costs continue to fall, reflecting the acceleration of the business simplification initiatives: the bank's reported cost-to-income ratio was 47.4% in Q a good operating efficiency level compared to peers. Scottish Widows (SW, A2 Positive) faces some headwinds on several business lines, reflecting the challenging UK life market and the sharp decline in higher-margin bancassurance sales through Lloyds branches. This could negatively affect its contribution to the group's profitability. In summary, profitability remains a relative weakness for the BCA. Our assigned Profitability score of ba1 is higher than that suggested by historic earnings, which were weighed down by PPI and loan loss provisions, and thus anticipates some recovery. Strong capital metrics 4 7 July 216

5 Despite the negative impact of the.8 billion ECNs redemption charge and other extraordinary items, Lloyds' fully loaded common equity tier 1 (CET1) ratio remained stable at 13% as of March 216. The fully loaded CET1 ratio has decreased by 2 basis points since end-215 to 12.8%, but is unchanged on a pro forma basis that includes an insurance dividend. The group s risk-weighted assets remained unchanged from at 223 billion. The bank's fully loaded leverage ratio remained unchanged at to 4.8% as of March 216 compared to December 215 (pro-forma), largely owing to the increase in the balance sheet exposure, but remains comfortably above the 3% regulatory requirement. Including high trigger contingent capital instruments, the bank had a Tangible Common Equity (TCE) / RWA ratio of 19.1% as of December 215, up from 18.2% as of December 214, according to our calculations. We note that this ratio is significantly different from the regulatory ratio since it does not include deductions from significant investments and includes all of the bank's high trigger additional tier 1 securities. Exhibit 3 The bank's fully-loaded CRDIV CET1 and leverage ratios are strong Source: LBG results presentations Our assigned Capital score of aa3 reflects the strength of the group's capital and leverage position. The score also incorporates (1) the adjusted values of the two capital ratios after deducting the capital deployed at insurance subsidiaries; and (2) the vulnerability of the bank's capital position to a material downturn in the UK housing market. Although we expect risk-weighted capital and leverage metrics to remain strong, increasing dividend payments will limit any sizable improvements. Relatively stable funding profile and adequate liquidity, although the use of wholesale funding remains high The bank's funding position has improved as its use of market funding has declined significantly in recent years, mainly because of the reduction in the size of the bank's non-core portfolio. Nevertheless, market funding remains high by global standards and represented 2.6% of Lloyds' tangible banking assets at end-215, up from 19.7% at end-214 as a result of TSB's deconsolidation. Lloyds' gross loan-to-deposit ratio increased slightly to 19.5% in December 215 (18.3% in December 214), as per our calculations, as total wholesale funding increased to 12 billion at end-215 from 116 billion at end-214. It increased by a further 5 billion between December 215 and March 216 as the bank fulfilled some of its issuance requirements early in the year. Short-term wholesale funding with maturity of less than one year increased to 46 billion as of March 216 from 38 billion in December 215 and now constitutes 37% of total wholesale funding, although the proportion of money-market as a percentage of total wholesale funding remained unchanged at 18.4%. Our Funding Structure score of reflects the bank's relatively high use on market funds as well as our view that Lloyds benefits from a solid and granular retail deposit base. Lloyds' liquid banking assets accounted for 27.1% of its tangible banking assets at the end of 215 according to our calculations, a slight increase from 26.3% at end-214. We calculate that the bank's primary liquid assets ( 117 billion) accounted for 3.1 times the group's short-term wholesale funding as of December 215, suggesting a strong level of coverage against the risk of an interruption in the availability of wholesale funding. Lloyds also reports that its regulatory liquidity coverage exceeded 1% at end-q We expect the bank to reduce some of its primary liquid assets as it returns to positive lending growth. As a result, we assign a Liquid Resources score of to reflect these factors. 5 7 July 216

6 Our BCA of is positioned one notch below the mid-point of the a2- range offered by our scorecard. This suggests the potential for a higher BCA in time, once the downside risk arising from conduct costs and operational risk declines, driving the positive outlook on our long-term senior unsecured debt and deposit ratings discussed above. Notching Considerations Loss Given Failure and additional notching We apply our Advanced Loss Given Failure (LGF) analysis to Lloyds because it is domiciled in the UK, which is subject to the EU Bank Resolution and Recovery Directive (BRRD), and which we consider to be an operational resolution regime. We assume residual tangible common equity of 3% and losses post-failure of 8% of tangible banking assets, a 25% run-off in "junior" wholesale deposits, a 5% run-off in preferred deposits, and assign a 25% probability to deposits being preferred to senior unsecured debt. We also assume that the junior proportion of Lloyds' deposits is in line with the estimated EU-wide average of 26%. These are in line with our standard assumptions. Under these assumptions, Lloyds' deposits are likely to face very low loss-given-failure, due to the loss absorption provided by subordinated debt and, potentially, by senior unsecured debt should deposits be treated preferentially in a resolution, as well as the volume of deposits themselves. This results in a Preliminary Rating Assessment (PRA) for Lloyds' deposits of a2, two notches above the bank's BCA. For Lloyds' senior unsecured debt, our LGF analysis also shows a very low loss-given-failure resulting from a combination of its own volume and the amount of debt subordinated to it. This results in a PRA of a2, two notches above the BCA. For the holding company LBG's senior unsecured debt, which we assume to be economically subordinated to Lloyds' senior unsecured debt - our LGF analysis shows a moderate loss-given-failure resulting from the combination of its own volume and the amount of debt subordinated to it. This results in a PRA in line with Lloyds' BCA, or. For junior securities issued by Lloyds and LBG, our LGF analysis confirms a high level of loss-given-failure, given the small volume of debt and limited protection from more subordinated instruments and residual equity. We also incorporate additional notching for junior subordinated and preference share instruments reflecting coupon suspension risk ahead of failure. The resulting PRAs are set out at the end of this report. Government Support The implementation of BRRD has caused us to reconsider the potential for government support to benefit certain creditors. Given Lloyds systemic importance to the UK economy, we believe there is a moderate probability of government support for the operating company's junior deposits and senior unsecured debt, resulting in a one-notch uplift from the PRA. For holding company LBG's senior unsecured debt, we consider the probability of government support to be low. This is because such support would only be likely to be provided to the operating entity, to be able to maintain its critical functions and mitigate risks to financial stability arising from its failure, while holding company creditors would be expected to bear losses if necessary. For other junior securities, we continue to assume a low probability of government support, and, as such, the ratings for these instruments do not include any related uplift. Counterparty Risk Assessment CR Assessments are opinions of how counterparty obligations are likely to be treated if a bank fails and are distinct from debt and deposit ratings in that they (1) consider only the risk of default rather than both the likelihood of default and the expected financial loss suffered in the event of default and (2) apply to counterparty obligations and contractual commitments rather than debt or deposit instruments. The CR assessment is an opinion of the counterparty risk related to a bank's covered bonds, contractual performance obligations (servicing), derivatives (e.g., swaps), letters of credit, guarantees and liquidity facilities. The CR Assessment is positioned at Aa3(cr)/P(cr). The CR Assessment, prior to government support, is positioned three notches above the Adjusted BCA of, based on the cushion against default provided to the senior obligations represented by the CR Assessment by more subordinated instruments - including junior deposits and senior unsecured debt - amounting to about 23% of Tangible Banking Assets. The main difference with our Advanced LGF approach used to determine instrument ratings is that the CR 6 7 July 216

7 Assessment captures the probability of default on certain senior obligations, rather than expected loss, therefore we focus purely on subordination and take no account of the volume of the instrument class. The CR Assessment also benefits from one notch of government support, in line with our support assumptions on deposits and senior unsecured debt. This reflects our view that any support provided by governmental authorities to a bank which benefits senior unsecured debt or deposits is very likely to benefit operating activities and obligations reflected by the CR Assessment as well, consistent with our belief that governments are likely to maintain such operations as a going-concern in order to reduce contagion and preserve a bank's critical functions. About Moody's Bank Scorecard Our Scorecard is designed to capture, express and explain in summary form our Rating Committee's judgment. When read in conjunction with our research, a fulsome presentation of our judgment is expressed. As a result, the output of our Scorecard may materially differ from that suggested by raw data alone (though it has been calibrated to avoid the frequent need for strong divergence). The Scorecard output and the individual scores are discussed in rating committees and may be adjusted up or down to reflect conditions specific to each rated entity. Rating Methodology and Scorecard Factors Exhibit 4 Lloyds Banking Group plc Macro Factors Weighted Macro Profile Very Strong - 1% Financial Profile Factor Historic Ratio Macro Adjusted Score Credit Trend Assigned Score Key driver #1 Key driver #2 Solvency Asset Risk Problem Loans / Gross Loans 3.4% a2 Quality of assets Operational risk Capital TCE / RWA 19.1% aa1 aa3 Capital retention Stress capital resilience Profitability Net Income / Tangible Assets.2% b1 ba3 Expected trend Earnings quality Combined Solvency Score Liquidity Funding Structure Market Funds / Tangible Banking Assets Liquid Resources Liquid Banking Assets / Tangible Banking Assets Combined Liquidity Score Financial Profile Business Diversification Opacity and Complexity Corporate Behavior Total Qualitative Adjustments 7 7 July 216 a2 2.6% Expected trend Extent of market funding reliance 27.1% a2 Expected trend Quality of liquid assets a3

8 Sovereign or Affiliate constraint: Scorecard Calculated BCA range Assigned BCA Affiliate Support notching Adjusted BCA Instrument Class Counterparty Risk Assessment Deposits Senior unsecured bank debt Dated subordinated bank debt Junior subordinated bank debt Cumulative bank preference shares Senior unsecured holding company debt Dated subordinated holding company debt Holding company cumulative preference shares Holding company non-cumulative preference shares Aa1 a3-baa2 Loss Given Failure notching Additional notching Government Support notching Local Currency rating -2 Preliminary Rating Assessment a1 (cr) a2 a2 baa2 (hyb) baa3 (hyb) ba1 (hyb) Aa3 (cr) A1 A1 Baa3 (hyb) Baa1 Foreign Currency rating -A1 A1 Baa3 (hyb) Baa1 baa2 (hyb) -2 ba1 (hyb) ba1 (hyb) Source: Moody's Financial Metrics Ratings Exhibit 5 Category LLOYDS BANK PLC Bank Deposits Baseline Credit Assessment Adjusted Baseline Credit Assessment Counterparty Risk Assessment Senior Unsecured Subordinate Jr Subordinate Pref. Stock Commercial Paper Other Short Term -Dom Curr Moody's Rating A1/P Aa3(cr)/P(cr) A1 Baa3 (hyb) P (P)P PARENT: LLOYDS BANKING GROUP PLC Senior Unsecured Subordinate Bkd Jr Subordinate -Dom Curr Pref. Stock Non-cumulative Preference Shelf 8 7 July 216 Baa1 Baa3 (hyb) (P)Ba1

9 Other Short Term -Dom Curr (P)P-2 LLOYDS TSB BANK PLC HONG KONG BRANCH Commercial Paper P LLOYDS BANK PLC (AUSTRALIA) Senior Unsecured MTN Subordinate MTN Other Short Term (P)A1 (P) (P)P SCOTTISH WIDOWS LIMITED Insurance Financial Strength Subordinate -Dom Curr A2 Baa1 (hyb) CHELTENHAM & GLOUCESTER PLC Jr Subordinate -Dom Curr Baa3 CLERICAL MEDICAL FINANCE PLC Bkd Jr Subordinate -Dom Curr Baa1 (hyb) Source: Moody's Investors Service 9 7 July 216

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