DBRS Confirms Lloyds Banking Group at A, Lloyds Bank at A (high); Trends Stable

DBRS Ratings Limited (DBRS) confirmed the ratings of Lloyds Banking Group plc (Lloyds or the Group) and its related entities, including the Group’s ‘A’ Long-Term Issuer Rating and Lloyds Bank plc’s (the Bank) A (high) Long-Term Issuer Rating. The Trend on all ratings remains Stable. The Intrinsic Assessment (IA) for the Bank is A (high), and the Support Assessment remains SA3.

The confirmation of the ratings reflects the strength of the Group’s domestic franchise based on its leading market shares across a wide variety of retail and SME business lines in the United Kingdom (UK), including residential mortgages, consumer and SME lending, current accounts and life insurance. The confirmation also incorporates the further improvement in the Group’s risk profile and strengthening of the balance sheet. At the same time, while the drag on statutory profitability from legacy conduct issues has been declining, it continues to have a substantial impact on statutory earnings and adds to their volatility.

Positively, the Group’s underlying earnings generation capacity is strong, supported by the significant domestic franchise, as well as the market leading cost efficiency and the low cost of risk, both of which have continued to improve in recent years. Legacy conduct provisions, most notably those related to Payment Protection Insurance (PPI), declined substantially in 2016. However, in 1H17, conduct provisions, again mainly due to PPI, were GBP 1,590 million (1H16: GBP 460 million). As a result, statutory pre-tax profit in 1H17 was equivalent to 57% of the underlying profit while profit attributable to ordinary shareholders declined 13% YoY. In DBRS’ opinion, while the drag from past conduct issues is likely to reduce in future periods, they could continue to add some volatility to statutory earnings in the near to medium term. DBRS does, however, positively note the healthy 8% increase in underlying profit in 1H17, supported by solid growth in income and a moderate decline in operating expenses.

In DBRS’ opinion, Lloyds’s risk profile remains conservative, benefitting from consistent underwriting and the substantial deleveraging of the run-off portfolio. The Group’s loan book consists predominantly of mortgages (63% of the gross loan book) with the rest of the portfolio mainly comprising of consumer credit and commercial and SME lending. In DBRS’ view, risk in the UK consumer finance book, which comprises 10% of the gross loan book, consisting of credit cards, motor finance and leasing and personal loans is mitigated by the Group’s conservative risk appetite. The acquisition of the MBNA loan book in June 2017 increased the share of cards in total customer loans from 2.1% to 3.8%, but did not impact the Group’s asset quality ratios. DBRS also views positively that the Run-off portfolio has continued to decline and at end-1H17 comprised only 2% of gross loans. Asset quality remains strong with, at end-1H17, impaired loans accounting for 1.8% of gross loans and advances, flat compared to the end-2016 and 30bps below the end-2015 level. The quality of the mortgage book is solid with the share of impaired loans at 1.4%. The share of mortgages with a loan-to-value (LTV) ratio in excess of 80% reduced to 10% at end-1H17, from 13.6% at end-2015. Specialist mortgages (in run-off since 2009) and buy-to-let (BTL) mortgages, which jointly represented close to a quarter of secured retail mortgage exposures, continued to perform well. Interest-only mortgages were 24% of the mortgage book. The Group’s cost of risk (Asset Quality Ratio - AQR - as defined by Lloyds) was a low 15bps in 2016 and 12bps in 1H17. Due to a reduction in the level of provision releases and write-backs, DBRS would expect the cost of risk to increase from the current lows and Lloyds has recently guided for the cost of risk measure to be less than 20 basis points in full year 2017.

DBRS does however note the significant uncertainty resulting from the ongoing negotiations between the UK and the European Union (EU) on the UK’s departure from the EU, which could lead to a deterioration in UK macroeconomic conditions. However, DBRS would not expect this potential outcome to have a significant impact on the Group’s risk profile given the conservative underwriting and the robust liquidity and capital profiles.

Lloyds’ funding profile is strong, benefiting from a leading position in UK current accounts and savings and access to a range of funding markets. Despite an increase in customer loans during 1H17, mainly due to the acquisition of MBNA, the loan-to-deposit ratio remained stable at 109%. Total wholesale funding was reduced by 8% to GBP 102 billion and 70% of this had maturities in excess of one year. An increased share of funding is being raised by the holding company, as needed to transition towards final UK Minimum Requirements for Own Funds and Eligible Liabilities (MREL).

The Group also has a significant liquidity buffer. At end-1H17, the liquidity portfolio totalled GBP 122.3 billion, equivalent to over four times the Group’s short-term wholesale funding (excluding derivative collateral margins and settlement). The LCR meets the Liquidity Coverage Ratio (LCR) requirements, with a ratio in excess of 100 percent.

DBRS also views Lloyds as having strong capitalisation, comparing favourably with most domestic and many international peers. At end-1H17, the Group reported a fully loaded CET1 ratio of 13.5% and a leverage ratio of 4.9%, both pro forma for dividend received from the insurance business in July 2017. DBRS highlights the Group’s strong capital generation capacity, supported by a narrowing gap between underlying and statutory earnings. During 2016, the Group generated c190bps of CET1 capital (pre-dividend) leaving it well positioned to meet MREL requirements from 2020. During 2016 and 1H17 Lloyds issued senior unsecured securities from the holding company, which, while not included in total capital, are eligible to meet MREL. The transitional MREL ratio was 22.7% at end-1H17.

Concurrently DBRS has also assigned to the Group a Short-Term Debt rating of R-1 (low), harmonising the ratings of the Group with peers.

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

RATING DRIVERS
Positive rating pressure could result from the maintenance of the Group’s low risk profile and balance sheet strength, combined with a longer track record of reduced drag from conduct provisions, resulting in statutory earnings stabilising at levels more in line with the Group’s strong underlying profitability.

Negative rating pressure could result from a material deterioration in any of the key elements of the credit profile, including franchise, earnings, funding, liquidity or capital. It could also result from a significant deterioration in the risk profile.

Notes:
All figures are in GBP unless otherwise noted.

The principal applicable methodology is the Global Methodology for Rating Banks and Banking Organisations (May 2017). This can be found can be found at: http://www.dbrs.com/about/methodologies

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

DBRS 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’s outlooks and ratings are under regular surveillance

For further information on DBRS 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.

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

Lead Analyst: Tomasz Walkowicz, Vice President, Global Financial Institutions
Rating Committee Chair: Ross Abercromby, Senior Vice President, Global Financial Institutions
Initial Rating Date: January 19, 2009
Last Rating Date: July 14, 2017

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