Lloyds Banking Group (LYG) H1 2014 Results - Earnings Call Transcript

Jul.31.14 | About: Lloyds Banking (LYG)

Lloyds Banking Group (NYSE:LYG)

H1 2014 Earnings Call

July 31, 2014 5:00 am ET

Executives

António Mota de Sousa Horta-Osório - Group Chief Executive and Executive Director

Mark George Culmer - Chief Financial Officer and Executive Director

Juan Colombás - Chief Risk Officer and Executive Director

Analysts

Raul Sinha - JP Morgan Chase & Co, Research Division

Thomas Rayner - Exane BNP Paribas, Research Division

Manus Costello - Autonomous Research LLP

Andrew P. Coombs - Citigroup Inc, Research Division

Chirantan Barua - Sanford C. Bernstein & Co., LLC., Research Division

Claire Kane - RBC Capital Markets, LLC, Research Division

Edward Firth - Macquarie Research

Chris Manners - Morgan Stanley, Research Division

Michael Trippitt - Numis Securities Ltd., Research Division

Fahed Kunwar - Redburn Partners LLP, Research Division

António Mota de Sousa Horta-Osório

Good morning, everyone. It's good to see so many people here very close to August. Welcome, and thank you for joining us for our 2014 half year results. George will shortly present the financial results in detail, and we have then set aside some time for Q&A as well.

I will start with the key strategic and financial highlights in 2014 so far, describing the progress we have made on our strategy to be the Best Bank for Customers. We continue to successfully execute our strategy to deliver a low-risk, highly-efficient, U.K. retail and commercial bank, focused on our customer needs and on supporting the U.K. economic recovery, which continues to accelerate.

Our strategy of putting our customers at the heart of our business has resulted in lending growth in all of our key customer segments. And ahead of the markets, in SMEs, mid-market corporates and consumer finance. Similarly, deposits have grown 3% over the last 12 months, where we have focused on growing our relationship brands at least in line with the market. I will come back to lending and deposit growth shortly.

Our U.K.-focused, low-risk approach is embodied in our Helping Britain Prosper Plan, which we launched in the first quarter. We are the first U.K. bank to launch a plan like this, and it directly supports our business strategy. This is simple, but ambitious plan sets out our 7 long-term commitments and aspirations to help our customers and their communities to prosper. We are also continuing to deliver benefits for our customers through our Simplification program and at the same time, further improving our efficiency. Our cost-to-income ratio, already the lowest in the sector, reduced further to 50.5% in the first half. And we remain firmly on target to meet our full year guidance. Achieving consistently low costs is one of the key elements of our competitive positioning. It ensures that we can offer better volume for our customers and at the same time, better returns for our shareholders. Moreover, it is, in my opinion, the only consistent approach to the recent regulatory trends and a low interest rate environment.

In the first half, we have also continued to make progress in the reshaping of the group and on improving the strength of the balance sheet. We now have more than 95% of our assets in the U.K., have reduced our run-off portfolio by a further GBP 8 billion in a capital-accretive way and have further increased the coverage of our NPLs. We also executed the TSB IPO in June, which was very well received, as you know, meeting another milestone in our strategic plan. We were able to increase the size of the offering to 38.5% of TSB shares from the original expected 25%, as a result of strong demand from both retail and institutional investors. We were also very pleased with the quality of investor base and that the price went up by around 10% in the aftermarket and has kept to those levels.

In terms of the strength of the balance sheet, our common equity Tier 1 capital ratio increased to 11.1% at the first half. This is up by 40 basis points since the end of quarter 1 and by 80 basis points since the end of 2013. This increase has been driven mainly by improved underlying profitability and a reduction in the group's risk-weighted assets, in spite of charges for remaining legacy issues and for our AT1 exchange offer. This exchange offer, however, contributed to the improvement on our leverage ratio, which now stands at a strong 4.5%.

Underlying profit in the first half was GBP 3.8 billion, an increase of 32% compared to the first half of 2013, and at 58%, excluding the effects of St. James's Place, which we had last year, driven by progress on all the lines of the profit and loss accounts, revenues, costs and impairments. We have delivered a statutory profit of GBP 863 million, after making provisions for further legacy charges of GBP 1.1 billion, mainly for PPA, which George will cover shortly, and the LIBOR and repo rate issues we announced earlier this week. These issues were extremely disappointing, and I reiterate that the management team and the board are absolutely determined to make Lloyds an organization of the highest integrity and standards.

In summary, the group has had a strong first half at the same time as continuing to resolve the remaining legacy issues. We are supporting and benefiting from the acceleration of the U.K. economic recovery and are well placed to continue to make further progress in the remainder of 2014 and beyond.

Turning now to an overview of our financial performance. The increase in underlying profit to GBP 3.8 billion was supported by loan growth in our key customer segments and by an expansion in net interest margin, which increased by 39 basis points to 2.40%. As a result, net interest income grew by 12%, driving income growth, excluding St. James's Place, of 4%. At the same time, costs reduced by a further 6% year-on-year, excluding charges for FSCS, as we further simplify the business. Impairments also fell sharply by 58%, as we continue to de-risk the balance sheet and economic conditions continued to strengthen. The improved profitability, together with a reduction in run-off assets, drove an increase in the group's return on risk-weighted assets to 2.90%, an improvement of 95 basis points on H1 2013. George will take you through the details of the balance sheet shortly.

Our underlying profitability was the primary driver behind the improvement in our fully loaded capital ratio to 11.1%. We also saw an increase in the Basel III leverage ratio by 7-0, 70 basis points to 4.5% in the half year, driven again by the underlying profitability, as well as the issuance of the new AT1 securities we undertook in April, as I mentioned at the beginning. Our total capital ratio is now circa 20%, in line with what we expect will be the total capital requirements set by the regulators.

Turning now to look at the U.K. economy. I have said many times that the strong economy requires a strong banking sector in the same way as a strong banking sector requires a healthy economy. We are the largest retail and commercial bank in the country. And therefore, our future and the prosperity of the U.K. economy are inextricably linked. Therefore, we have a special responsibility to help Britain and its communities to prosper. In terms of the U.K.'s economic performance, GDP is now growing robustly, and unemployment is falling. And as a result, there has been an increase in both consumer and business confidence. The U.K. housing market has improved across the U.K., with year-on-year price increases of nearly 9% in the last 12 months, indicating increasing confidence in the housing markets. While we are still in the early days of the Mortgage Market Review, we can see that both regulators and lenders are taking steps to ensure the current affordability levels do not become stressed when base rates rise in the future. The growth in the economy and the increase in employments, together with an increase in disposable incomes, are having a positive effect on our key markets. We are starting to see an increase in volumes, a greater demand for credits and also increased confidence in business investments. I will now look at this in greater depth.

In the first half of 2014, we grew our net lending in mortgages by 2% year-on-year, in line with the market. Our gross new mortgage lending was GBP 20 billion, an increase of 40% versus the first half of 2013. And we continue to support first-time buyers, lending around 1/3 of these amounts to these customers. For SMEs, which are a key driver of employments and economic growth, we have grown net lending 5% in the last 12 months, compared to a market that has contracted by 3%. While in mid-markets, we have continued to gain share in a market that has contracted by around 3% as well.

Regarding SMEs, we have now grown for more than 3 consecutive years, increasing our net lending by over 15% in the period, when the market in the same period has contracted by more than 10%. In global corporates, lending was up 3% year-on-year, although it fell in the first half, mainly as a result of small number of large repayments in the first quarter and our selective participation strategy, given a decrease in margins in this segment. I was pleased to see that growth in our newly formed Consumer Finance business accelerated strongly, as we targeted, with U.K. assets increasing by 11% year-on-year and then annualized 16% increase over the last 6 months, driven by strong growth in motor finance.

In summary, on lending, at the group level, if you exclude run-off in global corporates, which we don't target in terms of net lending, we grew our net lending by 1% in the first half, so with 2% annualized growth rates. In the context of a recovering economy, where the demand for credit lags GDP growth, this is above the markets and is confirmation of our determination to support our customers and the U.K. economy. I see this growth accelerating in the future, as the economy continues to strengthen.

On the liability side in retail, our multibrand approach has continued to deliver, with deposits increasing in all of our relationship brands, notably in Lloyds Bank and in Halifax. We also saw strong growth in the deposits we gather through our Transaction Banking platform in the commercial division, which we have increased 11%, thanks to the technology investments we have made in this area. As we have substantially completed the reshaping of the balance sheet, we are increasingly deemphasizing the use of some our tactical brands and our international online deposit business, while keeping our loans and deposits growing in a synchronized way. This, in turn, supports stronger returns, given the corresponding additional reduction in our cost of funds through mix on top of the ongoing reduction, given our ratings upgrade and lower credit default swaps level in the marketplace.

Let me now make some comments on performance at a divisional level. In Retail, underlying profits increased by 32%, mainly driven by impairment reductions. Supporting first-time buyers with appropriate mortgages and providing banking services to start-up small businesses are key commitments of our Helping Britain Prosper Plan. In the first half of 2014, we delivered on this commitments, supporting over 40,000 first-time buyers and 52,000 business start-ups, as well as launching innovative new products such as our Club Lloyds current account. We also undertook a significant re-segmentation that involved moving our small business customers, with sales up to GBP 1 million, into the retail network. This will enable those customers to receive a greater focus from the bank and the corresponding better service and products that better meet their needs. This should see Lloyds gaining market share in this segment going forward.

Commercial Banking profitability and returns have improved significantly, driven by a very strong impairment performance. This shows the underlying strength of the Commercial division's income generation in the face of quite adverse market conditions, which shows the adequacy of our customer-focused strategy. Profits grew by 35%, and the return on risk-weighted assets increased to 1.96%, getting close to our 2015 target of returns over 2%.

There was a resilient performance in the insurance business, which has been affected by significant legislative and regulatory change and also by higher-than-expected weather-related claims in the first quarter. We continue to focus on leveraging the benefits of insurance as part of the wider group. We are seeing growing operational benefits, which resulted in a further 2% reduction in costs and also in terms of capital and balance sheet efficiency, which has enabled insurance to pay dividends to the group of GBP 0.7 billion in the first half.

Our newly formed Consumer Finance division made an excellent start in the first half. We increased U.K. loans by 11%, and underlying profit increased by 5%. In credit cards, where we are investing heavily, we saw a 5% increase in new accounts and an 11% increase in balance transfers. In Asset Finance, where we are now reaping the rewards of the restructuring we have done since 2011, there has been very strong growth with Lex Autolease seeing a 17% growth in fleet deliveries, while Black Horse increased new business by 70%, 7-0, both areas increasing their market shares in growing markets.

And with that, let me now hand over to George for a more detailed look at our financial performance.

Mark George Culmer

Thank you, António, and good morning, everyone. I'll give my usual overview of the financial performance and position of the business.

Beginning with the P&L. As you've just heard, we've made further significant progress on our strategy in the first 6 months, and this is reflected in the group's financial performance. Underlying profit increased 32%, GBP 3.8 billion, with movements in total income more than offset by 6% reduction in underlying costs, excluding FSCS timing effects and a 58% improvement in impairments. Excluding SJP from last year's numbers, income was up 4%, while underlying profit was up 58%, with underlying jaws a positive 8%. Statutory profit before tax for the group was GBP 863 million, and include simplification costs, TSB builds and dual running costs, as well as legacy and other items such as the ECN exchange that we flagged in Q1.

Statutory profit after tax was GBP 699 million with effective tax rate of 19%, largely reflecting the impact of tax-exempt disposals predominantly swept in the first quarter.

Looking at P&L in more detail, and starting with net interest income. NII was up 12% on prior year at GBP 5.8 billion. As in the first quarter, this was driven by better deposit pricing, lower wholesale funding costs and loan growth in key segments, partly offset by expected asset pricing headwinds and run-off reductions. In Q2, we'll also have the accounting benefit of the ECN exchange, which boosted income by around GBP 100 million in the quarter. The net interest margin for the first half is 2.40%, is 39 basis points higher than first half of 2013, and 17 basis points higher than the second 6 months. In the second quarter, the margin strengthened to 2.48%, mainly due to a 10-basis-point benefit from the ECN exchanges. Looking forward, we would expect the margin to stabilize at around the second quarter level for the remaining 6 months of the year, giving us an expected full year net interest margin of around 2.45%. This is obviously a further improvement from the revised guidance of 2.40% that we gave in Q1.

Total other income. The operating environment for other income remains challenging. In the second quarter, we've seen stabilization with Q2 margin ahead of Q1 at GBP 1.7 billion, bringing the 6 months total for other income to GBP 3.4 billion. As we said out in Q1, other income has been affected by disposals, the challenging financial and capital markets operating environments in commercial banking and the impact of regulatory changes in our key businesses, particularly in insurance where we've also seen higher weather claims. Looking forward, disposals will have less of an impact with our underlying businesses continuing to form resiliently, we would expect the quarterly total for other income to be close to the Q2 level.

Turning to costs. Costs totaled GBP 4.7 billion in the first half. This is 2% lower than last year and 6% lower excluding FSCS costs, which are recognized in the first half of this year, as opposed to the second half in previous years. Our market-leading cost-to-income ratio now stands at 50.5%, 2.2 percentage points better than the year ago, adjusting for SJP. Disposals and run-off accounted for GBP 254 million of the year-on-year cost reduction, while Simplification delivered further incremental savings of GBP 235 million. Simplification has now achieved annual run rate savings of GBP 1.8 billion and remain on track to achieve our target of GBP 2 billion of run rate cost savings by the end of the year. Included within the GBP 4.7 billion of costs is GBP 0.2 billion of TSB's cost base, giving us group costs of GBP 4.5 billion for this first 6 months. And we, therefore, remain on target to deliver a full year 2014 costs base, excluding TSB, of around GBP 9 billion.

On impairments, we've seen a further 58% reduction in the impairment charge in the first half to GBP 758 million. With the AQR improving significantly to 30 basis points compared to 69 and 45 basis points in the first and second half of 2013, respectively. Impairments reduced in every division and continued to benefit from better credit quality, improving economic conditions, provision releases and the reductions in the run-off portfolio. As a result of the better-than-expected trends across our portfolios, we are revising our full year guidance, and we now expect the AQR for full year to be around 35 basis points, again a further improvement from the revised guidance of around 45 that we gave in Q1.

In terms of impaired loans and coverage, the quality of the group's loan portfolio continues to improve. Impaired loans now stand at 5% of total advances. This compares to 6.3% in December and 8.6% at the end of 2012, with reduction in reflected disposals and reductions from the core business and run-off portfolio.

At the same time, we've also seen improvement in coverage, with the coverage ratio increasing to 54% from 50% from the 2013 year end and from 48% at the end of 2012.

Looking at underlying profitability at a divisional level, we've driven strong increases in Retail, Commercial and Consumer Finance, as well as improvements in run-off due to lower impairments and other items. In Retail, we continue to deliver strong profits and returns, with a 32% increase in underlying profit, reflecting net interest income, which was up 15%, as well as a 40% reduction impairments. Reported costs were 10% higher than last year. This is largely due to accelerated timing of FSCS and the reallocation of the support costs previously charged to TSB. In commercial, the 35% improvement in underlying profit is a very strong performance in tough market conditions. Underlying profit benefited from a very significant reduction impairments, while income was 3% higher, with other income more than offset by increase in net interest income.

Consumer Finance also benefited from reduced impairment charges, as well as higher income from Asset Finance. And these more than offset the increased investments in the business and were the key drivers of the 5% increase in underlying profit.

Insurance, as you know, was impacted by one-off charges and adverse weather, with underlying profit down by 18%. Most of these one-offs were, however, Q1 items, and the Q2 result of GBP 323 million is more than double the profits delivered in the first 3 months.

Finally, TSB saw a significant improvement in reported performance. This is largely due to reallocation of the support costs I just mentioned. TSB is reported within our results on a stand-alone basis, with its ongoing direct costs including underlying profits and dual running costs shown below the line.

Set out here is the usual reconciliation from underlying to statutory profit. The GBP 857 million charge in asset sales and volatile items mostly comprises the GBP 1.1 billion relating to the ECN exchange, as well as fair value unwind charge. These are partly offset by credit from the changes to our defined benefit pension scheme and gains on disposals. As you recall, the gain in 2013 of GBP 793 million was dominated by gains on sales of government bonds, and there've been no such sales in 2014.

On Simplification, we expensed GBP 519 million in the first half. This brings total program costs to GBP 2.2 billion out of an estimated total costs of around GBP 2.4 billion will be expensed by the time the program concludes at the end of this year. TSB costs in the half amounted to GBP 309 million and comprised build costs of GBP 171 million and dual running costs of GBP 138 million, again bringing the total incurred to date to GBP 1.8 billion. These dual running costs will continue be shown outside of underlying profit until we de-consolidate TSB.

Legacy charges totaled GBP 1.1 billion, and included a further GBP 600 million for PPI, GBP 226 million for the LIBOR and BBA repo settlements announced earlier this week, just over GBP 200 million for retail conduct provisions and GBP 50 million for interest rate hedging product sales.

Finally, the tax charge in the half is GBP 164 million, with as previously mentioned, the 19% effective rate mostly reflecting tax-exempt gains on disposals. For the full year, I expect a number of those items, which impacted statutory profit in the first 6 months, to either not be repeated or to reduce in the second half. Given our continued strong underlying profitability and in contrast to the last couple of years, I therefore expect full year statutory profit before tax to be significantly ahead of the first half's total.

On PPI, as just mentioned, we've increased our provision by GBP 600 million to reflect an upward revision in expected claims volumes, as well as additional PBR and related costs. Costs were initiated claims volumes were down in the second quarter with the average of 39,000 per month in Q2, 7% lower than Q1 and 27% lower in the second quarter of 2013. Claims volumes are, however, still slightly higher than previously forecast. Around 2/3 of the increase in the provision relates to higher expected future volumes and associated expenses.

On the PBR, we've now substantially completed the proactive mailings related to GBP 2.8 million PPI policies, where we've identified the potential risk of missed sale, with over 95% of all PBR customers mailed. While response rates in most cohorts were in line with expectations, certain asset finance rates are running ahead, and we're also seeing a higher number of policies per customer than expected. In terms of our overall cash spend, this continues to run at about GBP 200 million per month. I think the 3 key elements of spend, I'd expect PBR costs to be substantially complete in the first quarter of next year and remediation in the first half. Ongoing costs, at that point, will overwhelmingly relate to reactive complaints. I would, therefore, expect the cash out to be very significantly less than the current level.

Turning into the balance sheet. Our strong balance sheet and key ratios continue to improve. Over the first half, we generated some GBP 19 billion funds, thereby GBP 8 million reduction in run-off portfolio and deposit growth of GBP 7 billion, which have driven a further reduction of the group's loan-to-deposit ratio to 109%. The GBP 8 billion reduction in the run-off portfolio is well ahead of the run rate to hit our original full year guidance of GBP 23 billion. And we now expect the portfolio to be below GBP 20 billion at the end of the year.

Elsewhere on the balance sheet, equity increased by 17%, driven by underlying profits in the issue of over of GBP 5 billion of AT1 securities as part of the ECN exchange. Underlying profits also contributed to the 2% increase in TNAV to 49.4p, while the reduction in TNAVs during the second quarter primarily reflected legacy items and the charges relating to the ECNs.

Finally, RWAs on a fully loaded basis reduced by 6% to GBP 257 billion, as we continue to improve our low-risk -- implement our low-risk strategy and de-risk the balance sheet. The 6% reduction takes the total decrease in RWAs over the last 3 years to 33%, reflecting progress we've made in de-risking the balance sheet and particularly the run-off reduction in noncore and run-off assets.

Finally, looking at capital leverage. As you've heard our fully loaded common equity tier 1 position increased to 11.1% from 10.7% in Q1 and 10.3% at the year end. This increase is obviously after the GBP 1.1 billion of net charges related to the ECNs, as well as PPI, another legacy, and has again been driven by underlying profits, the dividends received from insurance and the reduction in risk-weighted assets.

Our leverage remained in a strong position. We increased our ratio on a Basel III 3 basis to 4.5% from 3.8% to the start of the year, including a 50-basis-point benefit from our AT1 issuance adding to the positive effect of strong underlying profitability. The continued strengthening of our key capital and leverage ratios are clear evidence of the successful execution of our low-risk strategy and the capital-generative nature of our business. That concludes my review. And I'd now like to hand back over to António.

António Mota de Sousa Horta-Osório

Thank you, George. In summary, our 3-year strategic plan, as set out in June 2011, has now been substantially delivered. We have strengthened the balance sheet, reshaped and simplified the organization and stepped up the investment in new and improved products and services for customers by reinvesting more than 1/3 of our Simplification program's cost savings.

At the same time, we have addressed head-on and sought to resolve our legacy issues. This week's extremely disappointing announcement on past behavior demonstrates that we absolutely took the right decision to refocus the group on becoming a low-risk U.K. retail and commercial bank, focused upon the customer and ensuring we operate to the highest standards. It is that strategy which will ensure that we don't have issues in the future like the past cases we are dealing with. By seeking to place customers at the heart of everything we do, having a low-risk culture and prudent risk appetite and by achieving a leading cost position, we have been able to grow income, restore profitability and improve returns. We have continued to grow lending in each of our key customer segments and further strengthened our capital position. I believe the increase in underlying profits and returns in the first half of 2014 clearly demonstrates the strength of our chosen business model.

Before I finish, I think it's worth touching upon the regulatory environment in which the group operates. As well as the PRA stress tests announced in April, the Bank of England has recently issued a consultation paper focused on bank leverage. Lloyds is very well placed regarding these indicator, with a leverage ratio of 4.5% versus a current minimum of 3%. We also continue to work with the relevant authorities on the evolution of regulation in relation to ring fencing. Given that we are now predominantly a U.K.-focused retail and commercial bank, we anticipate that the vast majority of our business will be within the ring fence. Therefore, not anticipating any shift or uncertainties in relation to our strategic direction. It is clear to me that the regulatory environment in which banks exists has changed, I would say, forever. I strongly believe that our strategy and business model ensure that we are very well positioned to respond to this new regulatory environment. As a result of the progress we have made on implementing this strategy and the consequent improvement in our performance, the U.K. government, in March of this year, was able to continue the process of returning Lloyds to full private ownership at a price of 75.5p, with its shareholding now reduced to 24.9%. We are increasingly well positioned to continue to support and benefit from the accelerating U.K. economic recovery, and I am confident in the delivery of strong and stable returns to shareholders as a consequence of the strategic decisions we took in 2011 and of their successful and timely implementation. Consequently, I can confirm, as previously stated, that we will be applying to the PRA in the second half of the year, seeking approval to resume dividend payments starting at a modest level. Also looking forward, with many of the targets we set out for our organization in 2011 already achieved, we have been looking at how we will take the group into 2015 and beyond. This plans are well developed, and we intend to share them with you in the autumn.

Thank you. This concludes our presentation. We'd now like to take any questions you may have.

Question-and-Answer Session

Raul Sinha - JP Morgan Chase & Co, Research Division

It's Raul Sinha from JPMorgan, Cazenove. Sorry, I got to mic first, so I'll go first. Can I have 2, please? Firstly, on capital. You're now at 11.1% on Bal III Core Tier 1. And clearly, based on what you're flagging for the second of the year, this is going to continue to build pretty strongly. In the past, you've talked about 11% being a sort of broadly the right level for you. So I was just wondering if you can talk about what you plan to do with the bucket loads of excess capital that you will have. That will be helpful. And then, secondly, António, if I can just clarify, does the dividend payment -- is the dividend payment subjective to stress test? Or is that a conversation that's separate with the PRA?

Mark George Culmer

So I'll go first. I may touch on some that second question as well. Yes, we did. We've said that based on our bottom-up analysis that we think in a requirement of around 11% on a steady-state basis was the number we should be shooting for. That remains the position around this, still some uncertainties out there. Steady-state, I think as I said before, if you struck the numbers today, you'd probably slightly higher number because there's some de-risking in the things like the pension scheme that well underway. But we just want to complete that and get credit for that. And similarly, it won't surprise you to know that when I look under stress conditions for PPI have to hold some capital for that, but that will -- I will journey through that, I'll get through that, and we think around 11 is still about the right number to talk about. In terms of where we go and in terms of discussions to come, obviously, the discussion of the PRA, when we talk about dividend, they will look at a number of things, they will look at statutory profit, they will look at capital position and capital generation. And I think they will also look, well, they will also look at your second point about stress tests in terms of our resilience. What I think this first half numbers demonstrate is that we go into those discussions in a good position. We generated a statutory profit, as I said in the presentation, and as you picked up on, I expect statutory profits for the full year to be significantly in excess of the half-year position, and I'd accordingly, expect the capital position to continue to improve. So -- and on the stress tests, I suppose, we submitted our numbers on the 15th of July, and we feel in a good position in terms of the data that we submitted. So I get into these discussions with confidence. I think they reflect the bank in a good position and good capital-generative. We await the outcome when we see how those conversations develop, but we go in a good position.

António Mota de Sousa Horta-Osório

Tom?

Thomas Rayner - Exane BNP Paribas, Research Division

It's Tom Rayner from Exane BNP Paribas. Can I just have a couple of questions on your guidance, please? Just on the AQR of 35 basis points, obviously, implies a pickup in the second half. So just to get a feel for whether the second half is a sort of base to move forward from. And on the stable margin, in the second half, really why do you think it's going to be stable? And on Slide 9, if you focus on that sort of left-hand chart, maybe you could explain in line with the different drivers because it certainly looks as if a further margin improvement would flow through naturally into the second half, but I wonder if you could comment on both of those, please.

Mark George Culmer

You're right. When you look at the margin evolution, Tom, over the last few quarters, we came in, what it was Q4 2.28%, 2.29%, 2.32% in Q1, 2.48% in Q2. Within that 2.48%, there's about 10 basis points of ECN pickup. So if I strip that out, there's sort of 5 or 6 basis points, which you've seen in the last couple of quarters. It's a similar thing Q2 to Q1, as we saw Q1 to sort of Q4. On the saving side, I've got about 4, 5 basis points of benefits coming through. And that's just shaving a few basis points here, whether it's on the fixed or whether it's on the instant access that we're benefiting from, and that drives about 4 or 5 basis points. There's a bit of benefit from wholesale funding, but I'm down in the 1 or 2 basis points. And going against that, I've got some asset pricing headwinds of 1 or 2 basis points. I think the guidance that we've given is appropriate. There may be some limited more upside in terms of liabilities. There was also in terms of where that asset pricing moves. There's a potential for that to pick up. The bank will naturally benefit as we continue to cleanse and run-off things like the run-off book in terms of the overall available margin. But we think the guidance accurately reflects what was seen on sort of an underlying basis and some of the headwinds that might be out there.

António Mota de Sousa Horta-Osório

Yes. On the AQR, the trend is very positive compared with the previous year, quarter 1 was 35, quarter 2 is 26. So average of the year is -- in the first half is 30. And we are guiding for a 35 for the year, so it's kind of 44 second half. The reason for that is that even though you're seeing -- we are seeing very improving trends in all the portfolios, in mortgages, in commercial, the run-off is decreasing the weight of it and also the impairment charges lowering. So what we -- we're -- I mean, we prefer to be a bit cautious because some of the improvements is due to the write-backs and releases that we have seen. So the write-back in the first half has been GBP 300 million, which is a bit lower than in the second half of last year, kind of GBP 700 million. And it is mainly because of run-off contributions to the write-backs is lower, no? Because the portfolio is lower and the reduction is lower. So this combination of improving trends with the lower write-backs, we'll prefer to be cautious to see what is the final number in write-backs in the second half. The portfolios in itself are performing very well. And you see the loan -- the impaired loan ratio continue to improve. And it has been from a 6.3, as George has said from 6.3 to 5, which is a very good indication that all the things are going in the right direction. And we're not seeing anything to change the trend. It's just a cautious view.

Thomas Rayner - Exane BNP Paribas, Research Division

[indiscernible] just on the coverage ratio. The increase we've seen, is that mechanical, just driven by mix? Or is there any sort of decision there to increase the coverage? Could you just explain the...

António Mota de Sousa Horta-Osório

Well, it's a combination of things. So it, in part, is because we are decreasing the impaired loans and therefore, some of the provisions that we have in IBNR, the weight of IBNRs in impaired loan increases and some of things [indiscernible] mix as well. So -- but I think it's a good reflection that the improvements in the AQR is not a consequence of releases and new releases of provisions in the ownership [ph].

Mark George Culmer

Because the coverage have decreased. And just one point, Tom, which I think is quite important within this competitive advantage that we are trying to build, both in terms of a low-risk strategy, low cost of equity and simply the cost to income position. On your question about margin, and I have said this in several times in different occasions we have been here together, I think it's important to mention that this is part of a deliberate build-up over time of what I think is a competitive advantage in the way we manage our multibrand, multichannel approach in terms of pricing. Because as I've said to many of you individually, we do this on a weekly basis, we manage not each of them separately, assets and liabilities, but we manage them together. And what we really focus on, having a core loan-to-deposit ratio of 100%. What we really focus on is on the difference of the 2. We manage them on a weekly basis at the highest level of the organization. And the fact that we have multibrand and multichannel simultaneous approach enables us to serve customers better according to their differentiated needs, and this is especially relevant, as I said many times, in a low interest rate environment. Manus, please. I see that you are eager to -- something.

Manus Costello - Autonomous Research LLP

It's Manus Costello from Autonomous. I had a couple questions, please. António, you mentioned the growth of your international online deposit base. I wondered if you could update us on what size the German deposit base is at the moment and whether you have any indications of what you might do with that. Would you think about growing international assets particularly, and Consumer Finance might be an interesting growth area internationally, I wondered. And secondly, I think for George, a question not so much on NIM as on the interest-earning assets. I get very confused exactly how you calculate your interest-earning assets. Because if I look at your gross loan balance in the first half, it averaged GBP 508 billion, but your interest-earning assets were only GBP 489 billion. And I would imagine it would be higher, especially given that you got GBP 50 billion of liquid assets, which are coming to there. And the reason I ask is just for us, for forecasting perspective, we're trying to work out when interest-earning assets are going to go up. And it's very difficult to do that if we don't know how that calculated.

António Mota de Sousa Horta-Osório

That's a fair question. I think I will give some time for George to think about that while I answer your first question. And look, on the first question, maybe you did not get exactly what I said on the presentation. We are not increasing the online deposit business. We are shrinking it. What I try to mention in the -- in my speech was, given that we have, as you know, for some time, 100% old core loan to deposit ratio. As the noncore decreases eventually to 0, the group loan-to-deposit ratio, which is now 109%, will turn to 100%. In that context, we have clear objectives, because we take a customer approach, on market share of deposits on our franchise brands. So Lloyds, Bank of Scotland and Halifax, and these have been growing, and again, in the first half, above the market. And we manage all of our tactical brands and nonfranchise deposits for value. In that context, we have decreased the value of our online deposit in Germany which are now around GBP 17.5 billion that have decreased slightly in the first half, or around 10%, more or less. And that enables us, given that Internet deposits, as you know, are absolutely much more price-sensitive from a customer perspective that enables us, as I said on my speech, to have 2 effects in terms of lowering our funding costs. We have effects through mix, like on online deposits, or on nonfranchise brands like Birmingham Midshires or Scottish Widows Bank, to give you an example. On top of the normal funding cost reduction that we are experiencing from the fact that we have been upgrading in terms of ratings, we have a much better credit default swap level. And overall funding costs in the market are going down. So we are decreasing online deposits in Germany, and we don't have any intention of increasing international assets on the other side, to leave that clear. And now, I think George will be able to tell you everything [ph] on the second part.

Mark George Culmer

Thanks [ph] for giving me some time. It didn't help. Let's see if we could be more helpful after this in terms of the calculation of the different trends, and we'll try and come back and be more helpful.

Manus Costello - Autonomous Research LLP

[indiscernible] generally [ph] then. When are interest-earning assets going to start going up?

António Mota de Sousa Horta-Osório

Okay, yes. And that's partly [ph] strategically, Manus, I think, apart from the technical point. Strategically, I think you should think about the following. We have, as I said, on Q1 results, to clarify that out, we have a closed book of mortgages, which is now part of our normal bank because they are our customers, they have our current accounts. They have our credit cards. We see this on a customer approach. So we move, as you know, our self -- old self-certified book into the normal bank. It's seasoning very well. It's performing well. There's no issues with the book. But that book is a closed book in the sense that we don't do, for several years now, self-certified mortgages. So you have to consider, in terms of your calculation that, that closed book is shrinking as it matures over time. The rest of our mortgages will grow in net terms, as I have said many times, and since September '13 now with the market. So we grew them by 2% in the first half, and you should expect our mortgages, in net terms, to continue to grow with the market. The second point is, as I also mentioned in my speech, the large corporates. We do -- we never targeted large corporate growth because that is not in our point of strategic key success factor. What we target in large corporate in the commercial division is the client's share of wallet, which may be a loan, as it may be a debt [ph] capital markets issue. And in this quarter, both through much better conditions in debt capital markets, with lower interest rates, as you know, and also because we had some large repayments in quarter 1, large corporates went down. I cannot tell you how large corporate will evolve in the future because, as I tell you, we don't target it, but I would assume that with more erratic behavior, they will have a normal evolution over time. The remaining of the segments. So SMEs will continue to grow at 5%, midmarket should increase its growth rate to around 3% in H2, as I have said at the Q1 as well, and our Consumer Finance division building on the extraordinary year that the U.K. economy is having on car sales. It was at 9% overall in quarter 1, it's now at 11%. The 6-month annualized rate is 16%, so you should expect to see this accelerating. The final point -- and I'm sorry about the long answer, but the final point is the remaining noncore assets, which we said would be around GBP 23 billion at year end. And given the excellent performance in H1, we'll be now lower than GBP 20 billion in H2, and you can model whatever you think is that consequence. So I would expect, as I said in my speech, that our key customer segments, so SMEs, midmarkets, mortgages and consumer finance, which are growing at an annualized rate of 2%, to increase these growth rates and to ultimately be the growth rate of the bank in the future, as large corporates, it's probably even over time, and the noncore book disappears. Sorry, I was going to give you the word before, and then I forgot. Please.

Andrew P. Coombs - Citigroup Inc, Research Division

It's Andrew Coombs from Citi. Three questions from me please. Just firstly, you mentioned that you were happy with your total capital ratio. You said you've thought the regulator would end up around 20%. So it implies you're happy with your levels of AT1 and Tier 2 outstanding. But perhaps you could comment on the GLAP [ph] proposals and what that means for your senior debt that you need to hold on top of the AT1 and Tier 2. Second question would then be on the Club Lloyds PCA. Clearly, it's quite an attractive headline level, 4% on up to a GBP 5,000 balance. But perhaps, you could give us an idea of how the average cost of that product compares to your existing deposit balance. And then, the final question would just be the Consumer Finance division. Thank you for breaking that out. And as you referred to, very strong growth there in the loan balance. But it does seem to have come at a bit of a cost. The NIM is down 15 basis points in that division half-and-half. So just interested to know what you're seeing there in terms of pricing, and also if it's a volume-led strategy over a margin strategy there at the moment?

António Mota de Sousa Horta-Osório

Okay. Thanks a lot for your 3 questions. I think George will take the first one. I'll take the second and third.

Mark George Culmer

Yes, on the total capital, yes, we do think -- first, to start off with -- we are in group position and have a total capital ratio of around about -- at the 20%, as António mentioned. In terms of where that finally ends up, in terms of what's decided on Australia, et cetera, later on this year, we watch with interest, but we do start from a good place. In terms of composition, yes, we have a number of options from that and whether we end up having to hold senior with the ability to Berlin or whether we just stick with sub, I mean, those are all questions for future. But also, it's something you look at obviously is the point of entry onto the bank and again, what time period one has got to actually be able have to move that debt to the PRA's preferred entry point, which is likely to be a single entry for us. So I mean, I'm not going to give you anything particular about what I expect to see in terms of senior or sub composition of that [ph] tower. We're in a good space in terms of total. From an optimum perspective, we will have to do some reorientating of that debt as we move to the PRA's preferred source of issuance. But I see that all -- that's sort of perfectly reasonable within BAU over the next couple of years.

António Mota de Sousa Horta-Osório

Okay. On questions 2 and 3, relating to Club Lloyds, which we are really very excited about because it's going very well, both for new and for existing customers. I think you should see Club Lloyds in the context of a segmentation strategy. So throughout the Lloyds brand, we are now segmenting. And Club Lloyds is a loyalty product, driven at our top customers, both in terms of mass affluent and wealth. And we launched it around 2, 3 months ago, so it's very early days for me to tell you about the cost and their implications which we can discuss at later updates. But as you know, and I mentioned that to Tom, we are very, very careful, and I really think it's a competitive advantage of us on the way we manage pricing in these overall multibrand and multichannel strategy. So I think this product will be very -- it's being very well received in terms of loyalty from our existing top customers. You should see it on a segmentation context. It's going very well. It is early days. On the Consumer Finance division question, we are not following at all a volume-led strategy. We always have into consideration as in any other division, ultimately, return on equity. And what is happening, this division, to give you a bit more color, is -- are several different trends. We are increasing volumes very significantly in a growing market, as I mentioned. But underlying, you have 2 gains. You have the gain of dealerships and activity with -- if you want, on a like-for-like -- like you mentioned in retail organizations, in a like-for-like or fruit-for-fruit-like basis, but you also have a very important gain in the beginning of this year, which will continue, which was driven by the fact that we won an important dealership, which was Jaguar Land Rover. So you have both a perimeter change, if you want, in that context. We won a very important brand, and you have gains on the current dealerships. Point one. Second point, you are correct, as we've shown on the numbers, that the margin is trending downwards, which I think is a function of the overall market's attitude in the last 6 to 12 months, in terms of risk approach. As you know, the market has been seeking deals [ph] and has been less concerned about risks or margins have been going down, in general. In large corporates, as I mentioned as well, in terms of Manus' question, a bit as well in Consumer Finance, given this general approach. But we measure very clearly volumes versus margin. And the impact of the increasing volumes and market shares versus margins is clearly positive. We expect this to continue to be so, obviously depending on competitive behavior, which I cannot anticipate. And the final point, which is quite important, is we have, as I said many times, by strategy, a prudent risk appetite. And when we see markets expanding very much, we always will keep a very prudent risk appetite. So these are the 3 points, which will be important in terms of how we react in the future.

Chirantan Barua - Sanford C. Bernstein & Co., LLC., Research Division

This is Chira from Bernstein. Two questions for you. One is if you can just walk us through the dependencies on the Scottish referendum that's coming up in September for the business assets and liability side. That's number one. Second. It would be great to get some color on capital and financial markets. It still takes a significant amount of capital balance sheet and cost, right? How is it -- the capital and financial markets side of the business and the wholesale on the high end. So what kind of capital and balance sheet does it consume right now? You've highlighted that it hasn't done well. And what are your plans in turning around that side of the business?

António Mota de Sousa Horta-Osório

So George, will you take the first and I'll take the second?

Mark George Culmer

Yes. And I mean, on Scotland, I mean, I think, as we've said previously and we'll say again, it's a matter for the Scottish people. And we look with interest in terms of how they vote on the 18th of September, with the outcome on the 19th. As a bank, we have looked at various contingency plans, and we feel comfortable with those plans. Should they vote -- the Scots vote yes for separation, et cetera, should they vote -- should it lead to single currencies out of EU, et cetera, there will be disruption, but we feel comfortable in the sort of time period and the transitional arrangements that will be in place that will be able to affect the necessary actions in a sort of ordered way. So it will be upheaval. There'll be an element of disruption, but we feel we'll be able to manage with it.

António Mota de Sousa Horta-Osório

All right. On your second question, we have -- I mean, we are, at heart, a retail and a commercial bank. And within the Commercial division, as you correctly said, we have a small activity of capital markets and financial markets, which is basically orientated at serving other customers in terms of the needs they have on foreign exchange, in terms of debt capital markets, credit products, et cetera. As you can see from the numbers we've reported, this is small in the sense that our RWAs on the division continue to go down. And this shows that the change in RWA, through the new methodology, a new regulation that is impacting wholesale and universal banks is not a factor for us because we really, number one, work on it on a customer approach, so we serve our customers in terms of their needs. In that sense, we have some of these activities I told you, but quite small. And altogether, and also because our large corporates have gone down in the half, as I have previously answered, our RWAs on the division went down and will continue to be tightly monitored. That's why the RWAs have improved so much and the division in a tight -- a very -- in very tight conditions in the market. In terms of income, as I said, is performing ahead of the plan, in terms of the target that was set last year for a 2.0% or above written on RWAs. We are now at 1.96% in very difficult conditions on the markets. And I am quite pleased, as I said, about the performance of the Commercial division.

Claire Kane - RBC Capital Markets, LLC, Research Division

It's Claire Kane from RBC. I've got 3 follow-up questions, please. The first is related to the capital composition. Can you give us an update on when you expect to find out about the eligibility on the residual ECNs? And is it fair to assume that once you get to the all-clear that they are no longer recognized, you can redeem these and you would not need to issue any AT1 in their place? And then, my second question is on your guidance for capital generation. You previously said you thought you could do 2.5 percentage points through to the end of 2015, and you've done 0.8 so far, even with GBP 3 billion of below-the-line items. So is it may be time to update the guidance on that? And my final question, really, is on the provision coverage. I think we could see that there's high coverage ratios in Ireland. You have GBP 6 billion of balance sheet provisions there. Can you talk us through the trends you're seeing and whether likely it is for provision relief in Ireland? And can we maybe expect that you have to wait for those assets to be disposed of first?

António Mota de Sousa Horta-Osório

Thank you, Claire. So George will take the first 2 ones, and Juan will answer you the third one.

Mark George Culmer

Yes. So in terms of eligibility, yes, we obviously have not seen anything that constitutes as either capital disqualifying event. Came close to it in terms of the stress test assumptions that came out, but that was not categoric. It is still our firm belief that it is likely that the ECNs will not apply as we move forward. I can't give you the date in which I expect that event to occur, but it's still my strong presumption that they will cease to apply. In terms of what we do with them at that point, I should confirm that I won't be moving them into AT1s. But in terms of whether it's redemption or moving into some instrument, it sort of goes back to the earlier question in terms of GLAC and total capital stack. They do count towards that overall 20%, and I would expect to be staying around about that 20% level. So if I was purely to redeem my dropdowns, so it's more likely it's going to be turning to something else, but it will not be AT1s. On capital, yes, you're right, as I said, we previously disclosed that we thought that capital generation would be about 2.5% for this year and next year, and then 1.5% for 2 thereafter. And when we said the 2.5%, we were -- say there are certainties when we sort of look at that number. And those certainties included things like strong underlying profit generation, which we know is going to come through. When we gave that amount as well, we also knew there was some uncertainties out there. Some those are past. For example, the capital cost of doing the ECN conversion, we knew that lay ahead of us. Some of them, such as things like the TSB, which, actually, when we come to deconsolidate the TSB, we have to recognize some of the costs that we will be committed to as part of that will flow through. So that is an uncertainty. All that said, your basic math is dead correct. So we said 2.5%. We're currently at a run rate of about 3%. I'm not going to change my 2.5% guidance today, but what I will tell you is I am pretty confident of beating it.

Juan Colombás

Yes. For Ireland, the way we imagine our operations in Ireland is very similar to the rest of the portfolio. So we -- that we try to be conservative in the way we provision our portfolios and the right pacts that we have seen in the past is a consequent effect. And so it is not different. In Ireland, there's -- I mean, we feel very comfortable in our situation there because the profit is GBP 2 billion net in the wholesale commercial book and GBP 5 billion [indiscernible] in the mortgage book. You know that last year, we sold our portfolio of nonperforming loans and mortgages and [indiscernible] and a lot of releases, and we have some write-backs in this sale. And while we prefer to be cautious on our focus on Ireland, it is true that the prices in Ireland are improving. So the year-on-year house prices in Ireland, as of June, was 12% up. Last year, it was 6% in December. So the situation in Ireland is improving, and we will see what is the result.

António Mota de Sousa Horta-Osório

Okay. To your left. Thank you very much.

Edward Firth - Macquarie Research

It's Edward Firth here from Macquarie. I just got a couple of questions. I guess, the first is back on the margin because I'm quite struck by your reasonably optimistic outlook on that. And I guess, if one looks at the broader context, we've got -- and now it looks like some sort of competition commission investigation into the SME market. We've got people looking at the personal current account market. The FCA are talking about pricing on savings. You got a lot of new entrants coming in who are all talking about growing market share. So I'm not going to much talk about looking to this year, but as we look out into the next 2 or 3 years, it seems to me there's a lot of reason why one might expect some of those -- some of that pressure to come through in the overall margins. So just sort of some comment from you about how you think that is going to play out in terms of the business and the wider market over the next year or 2? Do you want my second question as well or...

António Mota de Sousa Horta-Osório

Yes, please.

Edward Firth - Macquarie Research

Again, the second question is just on the restructuring charges as a whole. Because again, I was sort of struck [ph] looking at the -- listening to TSB this morning, that they're talking about what GBP 79 million of profits, and you're talking of over GBP 200 million. And I can see where the difference is in terms of -- mathematically. But as we look into next year and this restructuring program is now finished, what sort of assurances can you give us that we will not just going to have and load more restructuring charges next year?

António Mota de Sousa Horta-Osório

Right. Well, George will take the second question, although I think we have already said publicly that's below the line restructuring that we'll finish this year, but George will elaborate on it. On the first question, I don't think we gave any -- I did not mention any optimistic guidance in terms of a margin. I mean, unless you find the 2.45% optimistic. I basically elaborated on the loan growth, but not exactly on margin. What I said, that we have a competitive advantage on managing margin, and that will happen either up or down. So competitive advantages versus the sector, but I was not trying to be optimistic, unless, I repeat, you consider 2.45% optimistic, which, as George said, only implies that we keep margin where it is now. I had said last year that as the bank was turning into a growth phase, we would no longer -- you should no longer expect significant margin uplift as were targeting market share growth in all divisions, and I added that it is normally not a very good recipe to try to gain market share and margin at the same time. In spite of this, and although we have been gaining market share in all the target segments, as I described before, we have been able to increase margin more than we thought. And that's why we have upgraded the guidance from 2.28% to 2.45%. In terms of your -- the second part of the question. So how do I see it going forward, not for this year, not for the following years, although that's -- the more -- in the future, we build [ph] the more obviously obscure situation with you because it will depend exactly on, as you mentioned, competitive behavior. And exactly at the light, as you said, of new competitors coming into the market, et cetera, et cetera, my view would be the following. For this year, as we said, margin should be 2.45%. You should expect our loan growth in our core segments to accelerate in line with an improving economic situation. I see the economic situation in the U.K. getting more and more robust. We have 20% of the market overall in terms of the corporate sector and in terms of retail and we see that happening, not through all segments, but through the whole of the country. Confidence is improving. Business investment is now starting to pick up. We continue to have calm and stability in the euro zone. So in terms of net trading, we do not expect any significant changes. And this additional business confidence -- sorry, this additional retail consumer and business confidence, which is translating into more investment, is exactly what the economy needs in terms of having investments for future supply and a healthy growth. So I see the U.K. economic recovery continuing to get -- to gather pace. And I think the growth will be around 3% this year, and the risks are on the upside. In terms of the specific behavior within this environment, I think you're absolutely right that competition is increasing in terms of number of players. We have TSB, for example, which we just referred to, which I think has very good conditions and a great infrastructure in order to be able to grow in the market. So it is, as you know, in terms of loan-to-deposit ratios, capital position, number of customers, market share, and I'm not going to elaborate because they're announcing results today as well. So absolutely right, you have virgin [ph] money, you have other banks applying for licenses, et cetera. But my opinion is that the retail market is already very competitive. And I don't see that situation -- deteriorating margins. Why don't I see deteriorating margins? Because I do believe that the biggest impact over the next 2 years will be the leverage ratio. And the leverage ratio, by definition, will change and will impact the behavior of the mortgage-orientated players, i.e. building societies or similar, and you have several important players in the country, which have a leverage ratio of around 3%, and we have 4.5%, so it's 50% more or 40% more. So the leverage ratio impact may be so significant that I think that impact will probably be the major impact when you think on a 2-, 3-year view. But again, 2-, 3-year view is very much into the future, and it will depend on competitive behavior, and it's a very competitive retail market out there. Right, the second question on restructuring charges, do you want to...

Mark George Culmer

Yes, yes, I'll give you a 1-year view. Yes. So as you've seen in the results of the half year, we continue to have a number of below-the-line items as we have the last couple of years. Some of those were enforced upon us, such as the TSB build costs, some of it is our choice in terms of the Simplification, which has been a great success in terms of driving down the results. As I said in my presentation, in terms of the shape -- actually, if I start with this year, I would expect a number of those to not repeat during the second half of 2014 or at least reduce. So ECN charge won't repeat. I would see a reduction in the Simplification. I think we got a couple of hundred million spend as that completes. TSB, I would say, have ongoing running costs but are no longer building, so there may be a couple of hundred million there in terms of TSB for the second 6 months. So you'll see a reduction and a nonrepeat. And then, as we go to next year, to repeat what António said on the outset of your question, you're into a clean year. So absolutely, there is no intention for perpetuating restructuring charges below the line, so there's no further Simplification charges below the line. TSB build costs have gone. And so at that point, you are seeing the full weight, the full impact of that underlying profit that will come through, flow through into the statutory profit obviously and then into the capital position.

António Mota de Sousa Horta-Osório

Other questions? Please, Chris.

Chris Manners - Morgan Stanley, Research Division

It's Chris Manners from Morgan Stanley. Just 3 questions, if I may. Firstly, just on the leverage ratio. You've got 4.5% currently. We've got a consultation out there. I mean, do you think you actually got excess leverage ratio there? Or do you think it could be tipping towards more like a sort of 5%? And just where -- how high do you think the leverage ratio should go in the U.K.? Second point, I don't know if I missed it, but did you put the Pillar 2A requirement out in the document, the x [ph] obviously, that require interest, and just help us realize where -- exactly how much of that was capital that's all you have. And the third one was on interest rate sensitivity. Obviously, interest rates should be going up towards the end of this year or start of next. In the annual report, it looks like your interest rate sensitivity has been -- still quite -- a lot reduced, but that looks like a static analysis. So how should we think about interest rate sensitivity for Lloyds if the Bank of England starts hiking?

António Mota de Sousa Horta-Osório

I'll take the first one, and George will answer to you to the number two and number three. Now on the leverage ratio, I mean, as I said, the consultation paper is just out. And given it is a consultation paper and it is very recent, I think it's too early to speculate about what that would imply in terms of specific numbers. What is clear for me is that the 3% will increase. That is clear for me, and it was already clear, as you know, from previous discussions we have had. And therefore, we have prepared our strategy well ahead in order to have a substantially higher leverage ratio than the 3%. Therefore, the AT1 exchange we did, which, in a sense, decreased our fully loaded core Tier 1 ratio, although it is at 11.1% [ph], it has a negative impact, but substantially improved the leverage ratio. And I think -- my point was -- given that in the U.K. banking sector, you have at least 3 important players, with leverage ratios around 3%, and we are at 4.5%. The difference is so big that whatever happens, in my opinion, will imply a change of behavior on those players. The product which is most effective by the leverage ratio versus the fully loaded core Tier 1 ratio, our mortgages, by definition, because they have 1:1 in leverage and much less RWAs. And therefore, I think the behavior in that space is going to be very much orientated at the higher capital requirement that mortgage will imply through the leverage ratio and also the mix allocation that those banks will have to do in terms of mortgages versus the others. And that's why I think that will imply that is a very strong point to consider in terms of your longer-term margin evolution in the U.K., you see? But we are absolutely in a very good position given the difference that we have versus the minimum and our balance mix between the corporate bank, which is growing very well and above the markets, in mid markets and in SMEs versus mortgage where we're growing in line with the market will continue to balance the leverage ratio and make it grow with underlying profits in a very healthy way. That is the context. And I don't want to go into -- very detailed because we'll have to see what comes out of the consultation.

Mark George Culmer

Yes. And on the other -- in your second and third questions, no, you didn't miss the P2A. It's not buried in there, if you [ph] like that. We haven't disclosed them. We haven't disclosed for a couple of reasons. One, as you probably know, the PRA are going through consultation in terms of disclosure. I know a number of our peers do. But again, through consultation, at the moment, on this subject. And secondly, we have a submission that's working its way through the PRA on this, on the Pillar 2A. So my expectation would be that we will be disclosing by the end of the year, when sort of the PRA have decided and once we've had our submission looked at and reviewed. So that's reasons for not now. And then in terms of interest rate sensitivity, I mean, the bank is essentially set up not to be too much hostage to interest rate movements. So my -- our expectation, because of things like pass-through to customers and because of our position and things like the structural hedge is that for the first sort of -- first, 225 basis point movement, for example, you will see relatively little, if any, movement upon reported earnings. And it's only when you get sort of subsequent to that when you start seeing sort of net benefits come through. So in the early days, in the early moves, because we're passing through, because of our setup, you are not going to see a big impact on earnings.

António Mota de Sousa Horta-Osório

Can I have the microphone here in the second row, please? Here in the second row, please. Thank you.

Michael Trippitt - Numis Securities Ltd., Research Division

It's Mike Trippitt at Numis. Can I -- I just want to ask a follow-up on the margin question. I mean, there's obviously a hefty sort of GBP 1 billion benefit in net interest income that's come from liability mix and spread. And obviously, I think we understand what's happening and what has happened in the retail deposit market. But I guess, you've also benefited from wholesale funding reduction and refinancing. And I'm just wondering if you could help quantify that and give any guidance and whether you think there's further benefit to come in H2 from that reduction and refinancing and wholesale.

Mark George Culmer

I mean, the answer is yes. We've seen a couple of basis points come through, and I would probably expect a sort of repeat to that as we move into second half thereafter. Again, there's some of that more expensive -- also funding continues to roll off. It will be increasing. It will be a continued support of the net interest margin. So as I said, it helped despite a couple of basis points in Q1, a couple of basis points in Q2 to a continuation of that. You're not seeing a vast amount of refinancing in terms of the second half, but what you will probably just see is a steady support as the set of the older financing rolls off.

António Mota de Sousa Horta-Osório

And Mike, I would just add on top of what you said on the retail market, that our overall cost of funding going down is also a function of the commercial division, whereas, as I told you, our Transaction Banking deposits. And so our relationship core part of the Commercial division, Transaction Banking deposits are going up not more than 11%, and the fact that our rating has been upgraded, our credit default swap level is now around only 60 basis points. That has -- it had a very big impact as well on the funding cost in the Commercial division. We are attracting deposits from corporates in a very healthy way. And fourth, so to your point, George, is this one. The fourth point is, as I mentioned, online deposits, which are also managing downwards, given that we have, if you want in a sense, excess deposits and given it is not a relationship brand, we manage them for value as well, as I mentioned in the beginning. So you should consider those factors as well. Any more questions? Please. Can we have the microphone up there? Sorry. Thank you very much.

Fahed Kunwar - Redburn Partners LLP, Research Division

It's Fahed from Redburn. Just another question about PPI and then just thinking about litigation and legacy issues. On the PPI, you've let your utilization rate go up to 78%, I think, now. And I think you've always been in the kind of high 60s, low 70s. The only peer you've disclosed is on the low 70s. So considering the kind of pre-2005 claims that seem to be coming through now, why were you confident in doing that? And on the second question as well, just thinking about your kind of significant ahead comment on statutory profits. I mean, they're still kind of -- interim [ph] is selling out there, PPI still seems to be increasing and the FX charge could come through this year as well. So how do you get confident or how do we get confident that you will be significantly ahead? And I appreciate that the things you can control won't be coming through, but there are things -- a lot of things you can't control out there.

Mark George Culmer

Okay. I'm not sure about the stats in terms of utilization and the history. I mean, when you look at the unutilized balance on PPI, with the actions we've taken at the half year now, that takes it to GBP 2.3 billion, which is actually a similar number to where we came into this year. And I think the outlook, as we look now, is actually slightly different. And the reason for that -- let me explain. First up, the GBP 600 million we've taken, about 2/3 of that relates to basically reactive complaints that have come in, together with associated expenses of dealing with that, that and the 1/3 to the PBR. On the reactive, as we've disclosed to Q1, complaints are running slightly higher. They came down in Q2, down 7%, but it's still slightly ahead of our forecast that we've reprojected that. And on the PBR, the past book reviews, as I've said, we're getting slightly high response rate from certain cohorts and slightly more policies. What -- when you look at the spend, the cash spend on PBR, we currently spend about GBP 200 million per month and have done for a while. When you look at the 3 elements of that, they are on slightly different trajectories, which I think is important. So if you take those 3 elements of PBR, remediation activity and the reactive complaints, PBR, as we disclosed, with -- essentially through the mailings, we've mailed, 95%, as I said in my presentation. And we would expect cash payments out with regards to PBR to basically cease in the sort of first quarter of next year. So I can see the end of the tunnel with regards to past book reviews. Remediation, we're going to both embrace it and we're going to make sure that we have dealt with the old customers fairly and go back and look at the book. And I would expect that would complete in about the first half of next year. So there are still some variabilities around those 2, but I can see how the story ends on those, and I can see the end. The most uncertain, the most volatile obviously remains the reactive complaints, and that's where the CMCs play. A couple of points to make. First, when I've dealt with PBR, when I've dealt with remediation, when I'm left with predominantly just those reactive complaints, the monthly cash payment is going to be very significantly less than the GBP 200 million that I pay as of the moment. And at that point, PBR, I'm in to a different league, I'm into a different paradigm with regards to cash payments, with regards to provision and et cetera. On CMC activity, we haven't seen any step change in CMC activity over the last few months. They remain there, but they've been there. So in terms of reactive complaints that come in, we would -- we see about -- it's about sort of anywhere between 55% to about 58%, 59% of those reactives come from CMC activity. And their participation has been pretty constant. So I don't see any step change. Similarly, when I look at age of policy that's come in pre-2005, it's probably anywhere between about -- that's slightly at about 65% to 68%. And once that's slightly ticked up, again, we haven't seen the step change in that. So I have GBP 2.3 billion set aside for PPI. I see different trajectory for those 3 components. Two, I can see where it's headed. Reactive is uncertain. We are dependent upon behaviors, we're dependent on CMCs. But as I say, when I move towards just reactives, I'm into a different league in terms of that PPI provision. In terms of overall conduct, yes, of course, we continue to work through things. And I think what matters most is that on a prospective basis, we're doing the right thing by our customer making sure that the sales process -- the culture of the business is fit for doing the right thing with the customer and the regulatory environment in which we operate. On the legacy items, we will continue to work through and we will continue to remedy in the way that we think is fit and proper. Yes, we've taken unreasonable [ph] conduct charge at the half year, but we will continue to work and clear those things.

António Mota de Sousa Horta-Osório

Any more questions? Okay. So thank you very much for being with us, and see you next time.

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