Credit Opinion: Lloyds TSB Bank Plc

Transcription

1 Credit Opinion: Lloyds TSB Bank Plc Global Credit Research - 22 Aug 2013 London, United Kingdom Ratings Category Moody's Rating Outlook Negative(m) Bank Deposits A2/P-1 Bank Financial Strength C- Baseline Credit Assessment (baa2) Adjusted Baseline Credit Assessment (baa2) Senior Unsecured Subordinate A2 Ba1 Jr Subordinate Pref. Stock Ba1 (hyb) Ba2 (hyb) Commercial Paper P-1 Other Short Term -Dom Curr (P)P-1 Parent: Lloyds Banking Group plc Outlook Negative(m) Senior Unsecured Subordinate MTN A3 (P)Ba1 Pref. Stock Pref. Stock Non-cumulative Ba3 (hyb) Ba3 (hyb) Clerical Medical Investment Group Limited Outlook Insurance Financial Strength Stable A2 Contacts Analyst Phone Carlos Suarez Duarte/London Ferenc Csoke/London Johannes Wassenberg/London Elsa Dargent/London Key Indicators Lloyds Banking Group plc (Consolidated Financials)[1] [2]12-12 [2]12-11 [2]12-10 [2]12-09 [2]12-08 Avg. Total Assets (GBP million) 922, , ,427.01,027, ,686.0[3]20.6 Total Assets (EUR million) 1,137,754.91,161,261.81,157,050.31,156, ,638.4[3]26.1 Total Assets (USD million) 1,500,006.51,507,486.11,552,233.41,658, ,408.6[3]24.4 Tangible Common Equity (GBP million) 42, , , , ,766.2[3]37.8 Tangible Common Equity (EUR million) 52, , , , ,170.0[3]44.0 Tangible Common Equity (USD million) 68, , , , ,916.9[3]42.1 Net Interest Margin (%) [4]1.4 PPI / Average RWA (%) [5]2.0 Net Income / Average RWA (%) [5]-0.2 (Market Funds - Liquid Assets) / Total Assets (%) [4]12.9 Core Deposits / Average Gross Loans (%) [4]71.0

2 Tier 1 Ratio (%) [5]11.1 Tangible Common Equity / RWA (%) [5]10.7 Cost / Income Ratio (%) [4]64.7 Problem Loans / Gross Loans (%) [4]7.3 Problem Loans / (Equity + Loan Loss Reserves) [4]69.4 (%) Source: Moody's [1] All figures and ratios are adjusted using Moody's standard adjustments [2] Basel II; IFRS [3] Compound Annual Growth Rate based on IFRS reporting periods [4] IFRS reporting periods have been used for average calculation [5] Basel II & IFRS reporting periods have been used for average calculation Opinion SUMMARY RATING RATIONALE We rate the debt and deposits of Lloyds TSB Bank plc (Lloyds TSB) A2/ Prime-1. These ratings are underpinned by the bank's standalone credit strength (reflected in a baseline credit assessment (BCA) of baa2), and by our view that senior depositors and bondholders will very likely benefit from government support if needed. This support provides three notches of uplift from the bank's baa2 BCA. We rate the senior debt ratings of the group holding company - Lloyds Banking Group plc (LBG) - one notch below Lloyds TSB's senior debt and deposit ratings to reflect the structural subordination of the holding company to its operating subsidiary. Lloyds TSB's BCA reflects its leading franchise in the UK retail and commercial banking sector, which provides a strong earnings stream that allows the bank to generate capital organically and absorb material unexpected losses. The BCA also incorporates the bank's significant progress in reducing its non-core portfolio, streamlining its operations and strengthening its capital ratios. These factors are partially constrained by risk posed by its portfolio of non-core assets, including a sizeable portfolio of commercial real estate loans and considerable ongoing conduct remediation charges, especially associated to payment protection insurance claims. In addition, although LBG has significantly improved its liquidity and funding profile, its reliance on wholesale funding remains higher than most similarly rated peers. Rating Drivers - Improving capital levels driven by organic capital generation and asset disposals - Leading retail and commercial banking franchise provide material "shock absorbers" - Despite significant progress, the level of impairments is still high and continues to pose downside risk - Improved liquidity and funding profile, albeit reliance on wholesale funding still high Rating Outlook The outlook on Lloyds TSB's standalone C- bank financial strength rating (BFSR) is stable. The outlook remains negative on Lloyds TSB's A2 long-term ratings for debt and deposits, reflecting our medium-term view of lower systemic support for large UK banks, following the expected implementation of a number of regulatory initiatives (described in more detail below), including the proposal for ring-fencing in the UK and further steps towards implementation of an effective recovery and resolution regime. What Could Change the Rating - Up Upward pressure could develop on the bank's BCA if it is able to (1) continue reducing the impact of non-core assets and conduct remediation on its profitability and return to stable net income; and (2) complete the ongoing improvements to its funding profile, by further extending the maturity profile of its wholesale funding and maintaining a balanced mix between short term and long term funding. What Could Change the Rating - Down Downward pressure could be exerted on Lloyds TSB's BCA as a result of (1) a material deterioration in the

3 operating conditions in the UK including a significant deterioration in the housing market; (2) a noticeable change in direction on use of wholesale funding; and (3) sizeable unexpected conduct remediation charges beyond Moody's expectations. Downward pressure on the senior debt and deposit ratings could result from material regulatory progress in the UK and Europe enabling burden sharing with senior debt holders in the resolution of large financial institutions. DETAILED RATING CONSIDERATIONS The data in the following sections is sourced from LBG's financial statements unless otherwise stated. IMPROVING CAPITAL LEVELS DRIVEN BY ORGANIC CAPITAL GENERATION AND ASSET DISPOSALS LBG's capital ratios have improved significantly since 2009 driven by balance sheet reduction and earnings retention. The group's pro forma fully loaded Basel III capital ratio increased to 9.6% at the end of June 2013 from 8.1% at the end of December This improvement was mainly due to earnings retention as the bank returned to profitability, as well as the sale of government securities, the disposal of a portion of its US residential mortgagebacked securities (RMBS) portfolio and the sale of shares in asset management group St James's Place. In addition, LBG received a GBP1.6 billion dividend payment from Scottish Widows before the end of June However, the group's capital ratios will continue to improve as it aims to comply with a minimum fully loaded Basel III requirement of 7% by year end 2013 following the exercise undertaken by the UK financial services regulator - the Prudential Regulation Authority - after making deductions to reflect future losses and conduct remediation charges, and adjusting the calculation of risk weighted assets. According to LBG's calculations, its fully loaded leverage ratio (including Tier 1 instruments) improved to 4.2% at the end of June 2013 from 3.8% at the end of December LEADING RETAIL AND COMMERCIAL BANKING FRANCHISE PROVIDE MATERIAL "SHOCK ABSORBERS" LBG is the largest provider of residential mortgage loans, savings and current accounts in the UK. During the first half of 2013, the group recorded a further expansion in the core lending portfolio following a significant contraction in LBG also continues to benefit from the revenue diversification provided by its bancassurance subsidiaries, Scottish Widows and Clerical Medical. Although the bank has to dispose of at least 600 branches and approximately 4.6% market share of the personal account market in the UK (known as "Project Verde"), in line with European Commission requirements, we believe that the group will continue to maintain its leading position within the UK retail and commercial market. Following a significant decline in the level of impairment charges, the bank recorded a pre-tax statutory profit of GBP2.1 billion during the first half of 2013 compared with a pre-tax statutory loss of GBP456 million in the same period of LBG's net interest margin improved to 2.01% in the first half 2013 from 1.93% in the first half 2012 driven by lower funding costs. With the recent introduction of forward policy guidance in the UK, we expect that short-term rates will remain low over the medium term. This policy development is likely to keep LBG's funding costs down while supporting housing affordability, and as a result bank asset quality. The bank's results included GBP377 million of additional costs related to "Project Verde" and GBP500 million of additional provisions for payment protection insurance claims. Although we expect that the bank will be able to record lower levels of conduct remediation charges, we believe that regulatory and conduct remediation charges will likely continue to add volatility to the group's earnings. DESPITE SIGNIFICANT PROGRESS, THE LEVEL OF IMPAIRMENTS IS STILL HIGH AND CONTINUES TO POSE DOWNSIDE RISK Although LBG's credit quality metrics are improving, the level of impairments and problem loans is still elevated and remains above the system average. The volume of impaired loans reached GBP40 billion at the end of the first half 2013 compared with GBP53 billion at the end of the first half As a result, according to LBG's calculations, the proportion of gross impaired loans as a proportion of total loans declined to 7.7% as at June 2013 from 9.4% as at June We expect the group's asset quality to continue to improve and we note favourably the high level of provisions on its Irish commercial and residential property portfolio with a provisions-to-impaired loans ratio of 75% according to LBG's published financial statements. However, at the end of June 2013, the bank still had a material commercial real estate portfolio (CRE) in the UK of GBP29.7 billion (GBP9.4 billion in its non-core portfolio which faces significantly higher expected losses). We believe that CRE portfolios across UK banks remain highly exposed to downside risk given the sizeable refinancing challenges and the extent of forbearance

4 applied to these loans by most lenders. RELIANCE ON WHOLESALE FUNDING - ALBEIT STILL HIGH - CONTINUES TO DECLINE In line with the reduction in the size of its non-core portfolio, LBG continues to reduce its reliance on wholesale funding. Total wholesale funding declined to GBP157 billion as of June 2013, a 38% decline since December 2011, and over the same period short-term wholesale funding with a maturity of less than one year increased slightly by 1% to GBP31.3 billion from GBP31 billion. At the same time, customer deposits (excluding repos) increased by 3% to GBP431 billion between the end of June 2012 and June Therefore, LBG's loan-to-deposit ratio, as reported by the group, declined to 117% in June 2013 (June 2012: 126%). While LBG's funding profile shows a very positive evolution, we still note a sizable reliance on confidence-sensitive wholesale funding relative to other UK peers. Despite recording a material reduction in its primary liquid assets to GBP86.5 billion as at June 2013 (June 2012: GBP105 billion), the group maintains an adequate level of liquid assets since it represents about 1.7 times the wholesale funding maturing in less than one year (June 2012; 1.4 times). The bank has also maintained a significant amount of secondary liquidity at GBP128 billion at the end of June Global Local Currency Deposit Rating (Joint Default Analysis) Given Lloyds TSB's position as the largest retail and commercial bank in the UK, and the government's stake in the group, we incorporate a high probability of systemic support for the Group in the event of need, which leads to a three-notch uplift for Lloyds TSB's A2 deposit and debt ratings from the baa2 BCA. The senior debt ratings of LBG are one notch below the senior debt ratings of Lloyds TSB to reflect structural subordination. Notching Considerations LBG's lower Tier 2 enhanced capital notes (ECNs) issued by LBG Capital No1 plc and LBG Capital No2 plc are rated Ba2(hyb) and Ba1(hyb), respectively. The rating is in line with Moody's revised Global Banks methodology for rating bank hybrid securities, contractual non-viability securities (which are one type of contingent capital securities), and subordinated debt. The relevant ECNs issued by LBG are dated subordinated debt containing a conversion trigger to ordinary shares in whole (and not in part) occurring if LBG's consolidated Core Tier 1 ratio is lower than 5%. The ratings reflect the potential uncertainty associated with the timing to equity conversion by rating the securities one notch lower than "plain vanilla" subordinated debt. The rating of the ECNs issued by LBG Capital No1 is positioned two notches below the adjusted BCA, in line with Moody's standard notching guidance for contractual non-viability subordinated debt. The ECNs issued by LBG Capital No1 plc - guaranteed by Lloyds Banking Group (A3 negative) - are rated one notch lower than the ECNs issued by LBG Capital No2 plc guaranteed by Lloyds TSB Bank (deposits A2 negative, BFSR C-/BCA baa2 stable) to reflect the structural subordination of the holding company (Lloyds Banking Group) to its operating subsidiary. The ratings of the subordinated debts issued by Lloyds with a substitution clause are two notches below the adjusted BCA, reflecting the uncertainty linked with the substitution clause. The ratings of the remaining subordinated capital instruments of LBG are linked to the BCA of the bank (adjusted to incorporate one notch structural subordination for the holding company). The "plain vanilla" subordinated debt instruments are one notch below the adjusted BCA, junior subordinated instruments and cumulative preferred securities are two notches below the adjusted BCA, and non-cumulative preference shares are three notches below the adjusted BCA. We reverted to normal notching for all hybrid securities including those which did not pay coupon during the two years to 31 January 2012 under the EC moratorium. We note that Lloyds TSB resumed coupon payment on those securities in Recent steps towards enabling the resolution of failed banks - without access to the public purse - include (1) the introduction to the Parliament on 4 February 2013 of the Financial Services (Banking Reform) Bill; (2) the July 2013 publication of HM Treasury's draft secondary legislation relating to ring fencing and loss absorbency requirements; (3) the Financial Services Authority's publication in August 2011 of a consultation paper on Recovery and Resolution Plans (RRPs), together with a discussion paper on resolution; and (4) the September 2011 proposals of the EU's Independent Commission on Banking. In our opinion, the aforementioned steps will be credit-negative for bondholders over the as they indicate that new structures, such as ring-fencing, will be introduced to aid resolution and facilitate burden sharing with senior bond holders in the event of bank failure. Nevertheless, we recognise that the authorities do not yet have all the necessary tools to effect the orderly

5 resolution particularly of the largest, most complex banks, and many of the measures being considered (RRPs, ring-fencing) could take years to implement. Consequently, we still incorporate a very high level of support in the ratings of the largest banks, such as Lloyds TSB. ABOUT MOODY'S BANK RATINGS Bank Financial Strength Ratings Global Local Currency Deposit Rating A deposit rating, as an opinion of relative credit risk, incorporates the BFSR as well as Moody's opinion of any external support. Specifically, Moody's Bank Deposit Ratings are opinions of a bank's ability to repay punctually its deposit obligations. As such, they are intended to incorporate those aspects of credit risk relevant to the prospective payment performance of rated banks with respect to deposit obligations, which includes: intrinsic financial strength, sovereign transfer risk (in the case of foreign currency deposit ratings), and both implicit and explicit external support elements. Moody's Bank Deposit Ratings do not take into account the benefit of deposit insurance schemes which make payments to depositors, but they do recognize the potential support from schemes that may provide assistance to banks directly. According to Moody's joint default analysis (JDA) methodology, the global local currency deposit rating of a bank is determined by the incorporation of external elements of support into the bank's Baseline Risk Assessment. In calculating the Global Local Currency Deposit rating for a bank, the JDA methodology also factors in the rating of the support provider, in the form of the local currency deposit ceiling for a country, Moody's assessment of the probability of systemic support for the bank in the event of a stress situation and the degree of dependence between the issuer rating and the Local Currency Deposit Ceiling. National Scale Rating National scale ratings are intended primarily for use by domestic investors and are not comparable to Moody's globally applicable ratings; rather they address relative credit risk within a given country. A Aaa rating on Moody's National Scale indicates an issuer or issue with the strongest creditworthiness and the lowest likelihood of credit loss relative to other domestic issuers. National Scale Ratings, therefore, rank domestic issuers relative to each other and not relative to absolute default risks. National ratings isolate systemic risks; they do not address loss expectation associated with systemic events that could affect all issuers, even those that receive the highest ratings on the National Scale. Foreign Currency Deposit Rating Moody's ratings on foreign currency bank obligations derive from the bank's local currency rating for the same class of obligation. The implementation of JDA for banks can lead to high local currency ratings for certain banks, which could also produce high foreign currency ratings. Nevertheless, it should be noted that foreign currency deposit ratings are in all cases constrained by the country ceiling for foreign currency bank deposits. This may result in the assignment of a different, and typically lower, rating for the foreign currency deposits relative to the bank's rating for local currency obligations. Foreign Currency Debt Rating Foreign currency debt ratings are derived from the bank's local currency debt rating. In a similar way to foreign currency deposit ratings, foreign currency debt ratings may also be constrained by the country ceiling for foreign currency bonds and notes; however, in some cases the ratings on foreign currency debt obligations may be allowed to pierce the foreign currency ceiling. A particular mix of rating factors are taken into consideration in order to assess whether a foreign currency bond rating pierces the country ceiling. They include the issuer's global local currency rating, the foreign currency government bond rating, the country ceiling for bonds and the debt's eligibility to pierce that ceiling. About Moody's Bank Financial Strength Scorecard Moody's bank financial strength model (see scorecard below) is a strategic input in the assessment of the financial strength of a bank, used as a key tool by Moody's analysts to ensure consistency of approach across banks and regions. The model 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.

6 Rating Factors Lloyds Banking Group plc Rating Factors [1] A B C D E Total Score Trend Qualitative Factors (50%) C Factor: Franchise Value C Market share and sustainability x Geographical diversification x Earnings stability x Earnings Diversification [2] Factor: Risk Positioning D Corporate Governance [2] Ownership and Organizational Complexity Key Man Risk Insider and Related-Party Risks Controls and Risk Management x - Risk Management x - Controls x Financial Reporting Transparency x - Global Comparability x - Frequency and Timeliness x - Quality of Financial Information x Credit Risk Concentration Borrower Concentration Industry Concentration Liquidity Management x Market Risk Appetite x Factor: Operating Environment B Economic Stability x Integrity and Corruption x Legal System x Financial Factors (50%) D+ Factor: Profitability D PPI % Average RWA (Basel II) 1.90% Net Income % Average RWA (Basel II) -0.12% Factor: Liquidity D (Market Funds - Liquid Assets) % Total Assets 10.24% Liquidity Management x Factor: Capital Adequacy A Tier 1 Ratio (%) (Basel II) 12.63% Tangible Common Equity % RWA (Basel II) 12.96% Factor: Efficiency C Cost / Income Ratio 64.25% Factor: Asset Quality E+ Problem Loans % Gross Loans 8.45% Problem Loans % (Equity + LLR) 69.31% Lowest Combined Financial Factor Score (15%) E+ Economic Insolvency Override Neutral Aggregate BFSR Score C- Aggregate BCA Score baa1/baa2 Assigned BFSR C- Assigned BCA baa2

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