Earnings Call Transcript - LYG Q2 2020

António Horta-Osório, CEO

Thank you. Good morning, everyone, and thank you for joining our 2020 Half Year Results Presentation. It is a shame that we can't gather in person today, but I am pleased that we are still able to hold these virtual events. I will give an overview of our response to the coronavirus crisis, and how our strategic transformation to date has positioned the group well, despite the evolving environment. I will then hand over to William to run through the financials, and we will have time for questions at the end. Before I start, I would like to again thank my colleagues from all across the world. They have maintained their exemplary dedication and professionalism in the face of significant personal and professional challenges whilst remaining absolutely focused on supporting our customers.

William Chalmers, CFO

Thank you, António, and good morning everyone. I'm going to give an overview of the group's financial performance in the first half of this year. I'll also spend some time discussing our balance sheet strength, approach to IFRS9, and the impairment charge that we took in Q2. As usual, we'll then open up to Q&A at the end. Turning first to slide 10 with the summary of the financials. As you've heard, the group's financial performance has been impacted by a challenging revenue environment and a significant deterioration in the economic outlook for the quarter. Net income of £7.4 billion is down 16%, driven by a lower margin of 259 basis points and stable average interest-earning assets and other income of £2.5 billion. As António mentioned, our focus on costs remains strong and the 4% reduction in operating costs includes 6% lower BAU costs. The cost-to-income ratio meanwhile has been impacted by the pressure we've seen on the income line. Moving down the P&L, pre-provision operating profit of £3.5 billion is down 26%. This is lower than we liked, but it still gives the group significant loss-absorbing capacity. The impairment charge of £3.8 billion in the half reflects our prudent reserving, based on the updated economic outlook and we'll discuss this in more detail shortly. Despite the significant impact of the impairment charges on profits and returns in the first half, TNAV remained strong at 51.6p. Our CET1 ratios increased by 81 basis points to 14.6%, including transitionals, or 13.4% excluding transitionals. Both levels are comfortably ahead of our reduced regulatory requirements of around 11%.

Operator, Operator

Thank you. Your first question comes from the line of Raul Sinha; please go ahead, from JPMorgan. You're live in the call.

Raul Sinha, Analyst

Hi. Good morning António. Good morning William. I've got a couple both on NII if you don't mind. I just wanted to explore the reasoning of the drivers behind the step down in the NIM guidance and NII versus Q1. And within that I was wondering if you could expand on two things in particular. One, why do you assume the unsecured balances would be going flat given the cards book was down 9% in the second quarter? And then secondly, if I look at divisional trends and this is hard to judge on a quarterly basis, but on a half yearly basis, it looks to me that commercial NII is down 16% year-over-year with retail NII going down 7%. So if you could shed some light on what's driving those two trends, that would be helpful?

William Chalmers, CFO

Sure. Thanks for the question, Raul. I'll do my best to address it, but let me know if I miss anything. First, our Q2 margin guidance was as expected when we provided it during Q1. At that time, we aimed to guide you through a challenging economic period due to the lockdown, but we wanted to be cautious about giving guidance beyond that period until we were certain. The guidance we're providing for Q2 is based on the macroeconomic outlook and our balanced growth across the business in response to it. Regarding the H2 margin guidance, it is influenced by four factors—two positive and two negative, which roughly balance out following the Q2 margin of 2.40. The positive factors include the progression beyond interest-free overdrafts, which is beneficial from an unsecured standpoint, as well as positive trends in deposit repricing that we expect to see in Q3 and partially in Q4. On the negative side, we anticipate that about €15 billion of the structural hedge will roll off in H2, along with a mix contribution decline from higher-margin products like cards and loans, which we project will have consistently lower balances moving into H2. It's important to note that our view of activity in H2 is connected to these assumptions. Our macroeconomic assumptions, as outlined in the presentation, are relatively cautious, which informs our balance sheet projections. We expect unsecured assets like cards and loans to be around 5% to 10% lower than June levels due to a pickup in new business and ongoing repayments. Different perspectives on economic activity could lead to different outcomes, and if someone adopts a more optimistic view, they would expect increased balances to positively impact margin. Our aim is to provide a consistent and reasonable picture as conditions evolve through H2. Similarly for OI, there are key points to mention. We have a one-time item in the H1 results related to a liquidity premium methodology change, which accounts for about £90 million and won't recur in H2. Additionally, there is an asset management market review charge, which we estimate to be between £50 million to £100 million, presenting another headwind for OI in H2. Overall, we foresee subdued activity in line with our macro forecasts, which may cause OI to slightly decrease going into H2, although we aren't providing explicit guidance since it depends heavily on activity levels. I hope that addresses your initial questions, Raul. As for your inquiry about commercial NII versus retail, there isn’t anything notable to highlight; it’s mainly due to margin development resulting from the different products.

Raul Sinha, Analyst

Is there no impact sorry from the guaranteed schemes on the NIM in commercial? Or is that not material?

William Chalmers, CFO

Well, there is an impact from guaranteed schemes or the covenant-sponsored lending activities within commercial. And it comes through in CBILs and it comes through BBLs in particular. But I think the overall impact of that on commercial margin in H1 is pretty modest on the whole. So, I wouldn't want to belabor that point.

Raul Sinha, Analyst

Got it. Thanks so much.

William Chalmers, CFO

Thanks Raul.

Operator, Operator

Thank you. Next question comes from Aman Rakkar, Barclays. Please go ahead, you're live in the call.

Aman Rakkar, Analyst

Good morning. I have a couple of questions regarding the net interest margin. I've noticed your comments about mortgage margins, which appear to have widened significantly due to the 170 basis points data point. Does your net interest margin guidance take into account improved asset margins, or are you assuming that this is not sustainable? Can we consider this as a potential source of support for the net interest margin if these levels can be maintained? If so, could you provide an estimate of the benefit on a full-year basis, assuming the current levels hold? Additionally, I have a question regarding other income, which seems to be indicating a run rate of around £1 billion for both Q3 and Q4. Can you clarify that? What is the current underlying run rate for other income? It appears to be quite variable, and I understand it's activity-driven. Based on your perspective of recovery in 2021, what would be a normalized underlying run rate for other income that we should consider for modeling next year? Lastly, I'd like to ask about capital.

William Chalmers, CFO

Yeah.

Aman Rakkar, Analyst

I mean, there's quite a big gap between fully loaded and transitional. It sounds like, you're going to basically close about half of that gap towards year-end, given stage migration. But I guess in the context of potential distributions, is that you may or may not be able to take in Q3 you typically tie that to your CET1 ratio. I mean should we be thinking about your capital, when you think about how much capital you have? Should we be thinking about the fully loaded CET1 ratio? Or versus what might be 40, 50 basis points higher, including the transitional release? Thank you.

William Chalmers, CFO

Thanks, Aman. I will address your questions. First, regarding the mortgage new business margin, it has been favorable in recent months and continues to be so. In recent quarters, the mortgage margin has been around 160 to 170 basis points, which includes both new business and product transfers for retention. This margin is higher than the maturing front book, meaning that the rates we are offering on new incentive-based business are better than those dropping off from previous years. Overall, the mortgage margin is improving. The impact on the overall group margin will depend on volumes, which have been positive recently. However, it is uncertain whether this is due to pent-up demand or a sustainable trend; we hope it's the latter, but it’s still early to make that determination. If this demand is sustainable into the second half of the year, we would expect it to positively affect the business. Additionally, the SVR attrition has decreased slightly, which is beneficial. Previously, it hovered around 15%, but it has come down to about 11% or 12%, depending on the time. This decrease is likely due to lower activity levels, but it seems to be stabilizing in the first half of the year. Moving on to OI, I won’t provide specific trend lines since it is very activity-based and subject to macroeconomic conditions. Particularly in the first half, we need to exclude the ILP methodology change, which lowers our estimate from about 1.25 to approximately 1.15 or 1.16. We expect a one-off headwind from an AMR charge, likely in the third quarter. Beyond that, we will see how the markets develop. Currently, there is strong market activity in the commercial space, similar to what most banks are experiencing. We hope to see a return of transactional banking activity in the second quarter, aligning with economic trends. However, we are not relying on that yet. In retail, it largely depends on payment flows. As mentioned, there have been positive developments in payment flows, but credit card usage still lags behind debit cards, which affects our overall payment streams. Regarding insurance, the core product markets remain subdued. Low interest rates are dampening the annuity markets, although our individual annuity market is performing well. In contrast, our bulk annuity market, like many others in the sector, is relatively slow. I won’t project specific trends for OI, but I expect a slowdown in the second half compared to the first half, though I don’t want to exaggerate that. Regarding CET1, we have a fully loaded ratio of 13.4 and a transitional ratio of 14.6. The 120 basis point difference is significant and is due to changes in the transitional regime in the first half of this year. You mentioned closing half that gap, but we anticipate closing around 40 basis points in the second half as transitions run off. The increase in transitionals is 80 basis points, and we expect about 40 of that to go in the second half. This will depend on the evolution of assets from Stage 1 and 2 to Stage 3, where transitional relief drops off. Based on our macroeconomic forecasts, this 40 basis point estimate reflects how it will play out; if the developments are slower than anticipated, the runoff will also be delayed. Lastly, regarding whether we focus on the fully loaded or transitional CET1 ratio, we consider transitional ratios when discussing our CET1 ratio. However, we also take the economic outlook and regulatory changes into account. While the headline number we refer to is the transitional ratio, we remain aware of the overall economic outlook and potential regulatory changes affecting us in both positive and negative directions.

Aman Rakkar, Analyst

Perfect. Thank you very much.

William Chalmers, CFO

Thanks, Aman.

Operator, Operator

Thank you. Next question comes from the line of Andrew Coombs, Citi. Please go ahead. You're live in the call.

Andrew Coombs, Analyst

I have a clarification regarding the slides and then a follow-up question about capital return. I appreciate the coverage ratios you shared, particularly your adjusted coverage ratio for credit cards after taking the charge-off policy into account. You mentioned that Stage 3 would increase from 44% to 67% with that adjustment. Could you clarify what the 21% for Stage 2 would be if you also adjusted for the charge-off policy? The four months to 12 months period is advantageous for our comparative analysis. My second question is about capital return. Although it's early to discuss, I'd like your thoughts on two perspectives. Historically, you've maintained a substantial dividend complemented by a smaller buyback. Do you think you might consider the opposite approach in the future—having a larger buyback and a smaller dividend, especially given your share price is currently below book value and the flexibility it could provide you? Additionally, how do you view your payout policy overall? Is it based on earnings or the excess capital above the MDA? Thank you.

William Chalmers, CFO

Thank you, Andrew. Regarding your questions, Stage 2 is not in default, so we won't make adjustments or provide pro forma numbers like we do for Stage 3. Stage 3 involves assets that have already defaulted, and we essentially consider them as fully written off. Thus, the pro forma comparisons are relevant only to Stage 3 because they reflect a situation where we've accounted for total coverage after the write-off. On the topic of capital return, our capital strength is evident. We have a transitional capital ratio of 14.6% and a fully loaded ratio of 13.4%. Regardless of how you view it, these figures reflect a strong capital position relative to both our internal targets and regulatory requirements. Moving forward, our capital policy, as it stands in late July, remains unchanged. The Board will evaluate our capital and distribution policy at the year's end, considering factors like expected developments in the second half of the year and our outlook for 2021. They will also weigh options like dividends and buybacks, but the final decision rests with the Board later this year. For now, our capital policy remains steady. Also, I missed the ending of your last question; could you please repeat it? I'm happy to address it.

Andrew Coombs, Analyst

Yes. So the capital return question was the split A, the split between buyback and dividend; and B, how do you think about the capital return? Is there a function of the excess capital above MDA? Or is it as a function of a payout ratio of earnings?

William Chalmers, CFO

I see. Yes okay. It's that last part then maybe I'll cover. As said, I think it was all in the context of what are today and what we frankly expect to continue to be very solid capital ratios going forward. But the matter of distribution again is really for the Board at the end of the year. They'll look at a variety of different parameters. We look at capital metrics including the MDA and the buffer above MDA that we choose to have is certainly one of them. We look at one or two other metrics as well including external and our internal stress tests. The other ingredient to all of this is not surprisingly the outlook that we see. And so as we progress towards the end of this year again we'll take into account both what we've seen based upon what we believe are relatively prudent economic assumptions and also what we expect to see going forward in 2021. And then I think the Board will be positioned to decide on capital distribution at that point.

Andrew Coombs, Analyst

Thank you. And I guess just coming back to the first question on cards in that case. I appreciate your point on Stage two and Stage three and Stage three as well taking a charge-off through. I guess the issue is, when we look at your Stage three coverage, it does look comparable to peers as stage two coverage looks at all like. So any thoughts on why your Stage two coverage should be a little lower than some of your peer groups?

William Chalmers, CFO

Yes, happy to answer that Andrew. It's worth bearing in mind that the cards portfolio that we have is a prime portfolio and frankly has been increasingly prime over the years. It is lower risk versus others, and we show you some delinquency data in the presentation that we think lends testimony to that. There are different charge-off policies in that fair enough. But nonetheless even after you adjust for those, we think the delinquency point stands. We're also based on external data, externally available data CSL is having lower balances and higher credit scores versus others. And again that's based off of external data rather than our own internal observations. And then, we have that charge-off policy. But as you rightly say that's a stage three point as mentioned earlier on. So, I think the overall portfolio strength that we see combined with some of the deleveraging that we've seen in the first half of this year, including amongst high-risk customers who have been around 5% deleveraging on that cards portfolio. Makes us feel very comfortable in terms of A, our prudent macroeconomic assumptions; and B, our coverage levels within that.

Andrew Coombs, Analyst

Thank you. Thanks a lot for taking the questions.

William Chalmers, CFO

Thanks, Andrew.

Operator, Operator

Next question comes from the line of Robert Noble at Deutsche Bank. Please go ahead. You are live in the call.

Robert Noble, Analyst

Good morning all. Thanks for taking the question. Just clarification on NIM. If I look out to 2021, is 240 the level that we should be thinking of going forward? Or do you expect for that to improve in forward years? And then secondly, if you look at the kind of returns or normalized impairments that you're getting given the lower margins and lower activity okay so things should rebound a little bit but it's going to be much lower, what are you going to do about it in the long run to kind of get your returns to sustainable premium to cost of equity? And is it worth looking at collapsing the multi-brand strategy now given the high demand?

William Chalmers, CFO

Thanks for the question, Robert. Just for my own clarity the second part of your question was on returns on the business as a whole. Was it?

Robert Noble, Analyst

Yes.

William Chalmers, CFO

Thank you for the question. Regarding the interest margin, we are not providing guidance for 2021 today. However, we can say that there will be an interaction in 2021 concerning net interest margin based on activity levels, the speed of returns, product margins, and how the structural hedge develops throughout the year. All these factors will influence the margin. It's important to highlight the unusual relationship between activity levels and the margin at this time, especially since these activity levels have been affecting the relatively low levels of unsecured activity in the second half of the year. As these activity levels return to normal, we anticipate a shift in balances and margins. This relationship is particularly significant now, and we hope to see improvement throughout 2021. The same applies to our outlook for other income. If activity levels improve and the macro environment strengthens, we are positioned well for that. Our guidance remains focused on 2020 and we feel confident given the macro context we've shared. Moving on to your second question about business returns, I do not wish to provide guidance beyond 2020 at this time. The strategic review is ongoing, and we will kick off a strategic review aligned with the new CEO in 2021. Historically, this business has generated returns on equity above the cost of equity, and I do not expect that to change in the long term. Given our internal dynamics and business model, even in a stable rate environment, we anticipate returning to an ROE above the cost of equity within two to three years, recognizing that 2021 will likely be a transitional year. I hope this gives you some clarity on your question. António, do you have anything to add?

António Horta-Osório, CEO

Yes. To expand on what William just mentioned, there are two key points regarding your question. First, our multi-brand strategy is essential to our position and strategy in the U.K. The Halifax brand operates nationwide, while Lloyds and Bank of Scotland serve as primary brands in Scotland and England and Wales, respectively. Halifax has a distinct customer base, which differs significantly in attitudes and needs compared to Lloyds and Bank of Scotland customers, who, while geographically separate, share similar characteristics. Consequently, there is minimal overlap between the two brands. This segmentation allows us to maintain a much lower cost-to-income ratio compared to others. We've centralized functions that customers do not see, such as finance, HR, and risk, which, despite slightly higher costs due to differing brand offerings, contributes to better segmentation, leading to higher income and a lower cost-to-income ratio overall. This is a vital aspect of our proposition. The second point I want to highlight is our confidence in generating a return on equity that exceeds the cost of equity, which is closely linked to our advantageous cost-to-income ratio compared to the sector average. As previously noted in my presentation, this provides a fundamental competitive edge, allowing us to invest more into the business, enhance efficiencies through automation, improve customer experiences, and ultimately increase revenues over time. This dynamic contributes to a continuous reduction in cost-to-income, creating a beneficial cycle that allows us to deliver superior returns to investors. During the current pandemic, our cost-to-income ratio also offers an added benefit, permitting us to extend our provisions significantly, as a lower cost-to-income translates to higher pre-provision profits as a percentage of revenues. Thus, maintaining cost discipline is crucial in many respects and is a lever fully within management's control. Our history in this area speaks for itself.

Robert Noble, Analyst

Great. Thanks very much.

William Chalmers, CFO

Thank you, Robert.

Operator, Operator

Thank you. Next question comes from Martin Leitgeb, Goldman Sachs. Please go ahead. You are live in the call.

Martin Leitgeb, Analyst

Yes. Good morning. I just wanted to follow-up on earlier comments in terms of how to think about margins. And I was just wondering looking at your base scenario of a roughly 6% decline in house price index. What kind of offsetting factor could that be from the SCR book? Could there be a scenario where the attrition in the outlook could slow down significantly or even come to a halt, if house prices were to fall according to the 3-year scenario? And just given the sheer quantum of contraction in card debt year-to-date, I was wondering this seems to be a very unusual recession in terms of the speed of the economic impact. Could there be a scenario that we could see an equally fast speed in terms of recovery and was that build-up in terms of credit card book again from 2021? And the next question, I was just wondering what you hoped with regards to the discussion around negative rates in the U.K. Is just number one is the bank prepared for it? And maybe if you can help us with a sensitivity in terms of how much of an impact in terms of revenue headwind would be the introduction of negative rates in the U.K.? And finally on Brexit, I was just wondering I mean given where discussions are going in terms of the future agreement with the European Union, what potential impact do you see for your business going forward in terms of activity levels and so forth? Thank you.

William Chalmers, CFO

Yes. Thank you, Martin. I think there's four questions there which I'll work our way through. The first of all on the NIM and the SVR position in particular there. As you know, on the net interest margin for the second half of this year, we called out four factors two positive and two negative. I would rehearse those again. But in addition to those four factors, there are as you rightly point out, one or two other pieces going on the higher mortgage rates we discussed earlier on. The SVR churn is a further one of those. Built into our modeling is a sort of very kind of historic path dependent view on the SVR attrition, which isn't all different to what we've seen over the course of the last year or so. But it does not take into account the SVR tradition — sorry the SVR attrition at levels as low as we have recently seen them. And I think the SVR attrition recently has come down partly because activity is lower in the mortgage market. And I suspect that if we see that play out and maybe augmented as you say by HPI folds one would naturally expect that to have some relationship with SVR attrition i.e. if HPI does fall you would expect SVR attrition to perhaps be a little bit slower off the back of that. We saw that a little bit in the course of the last cycle. So we might see it in the course of this one albeit in the last cycle as you know the HPI hit was not particularly significant. So there could be a relationship there. We're not banking on it. It's not built into our expectations. But it is possible. Second point cards debt could we see a recovery fast? In the sense this point goes the other way. I think the answer to your question is, yes. One could see a very fast recovery. And we saw some of the early call-outs from the United States in particular, when some of that recovery was evident, so that may be backing up a little bit recently in the U.S. But nonetheless, it does illustrate the point that actually this is something that could turn around relatively quickly. I hesitate to be kind of too anecdotal about it, but you look at the holiday experience over the course of the summer. If that ever gets going in earnest, then you would expect payments volumes and in particular credit card payments volumes to accelerate off the back of that. And those transactional revenues are important to the business. Likewise, you would expect expenditure on consumer durables for which credit cards are normally used to start to increase. And so, we could see a relatively fast recovery in the card book. As I said, we've seen that in debit. We haven't seen it in credit. Our economic assumptions are what they are and are set out in the presentation materials. They are not banking on that recovery. To the extent that it occurs, it could be fast. And if it does, one would expect that to reflect itself in the business.

António Horta-Osório, CEO

Yes. And William just to add a point on what you just said which might be helpful to Martin in terms of the overall picture in unsecured because you're right Martin that could happen something that would go into the direction of your question. Because if you look at consumers' behavior so far during the pandemic as both William and I mentioned, the consumers are absolutely doing the right thing in the sense that they are decreasing leverage and they are increasing savings. So from a risk point of view they are taking the time of the furlough scheme to adjust their behavior in a prudent way. And if you look more broadly macroeconomically, you can see that the total unsecured debt as a percentage of disposable income is now more than a third lower than pre-crisis levels. So when you go to 2006 unsecured lending as a whole was around 22% of disposable income and the latest numbers are only 14%. And I should remind you that 14% includes 2% of guarantees through the PCP contracts. So it is more than a third down. And in that sense consumers would have room if the economy is quicker as you say than expected to put on more consumer debt given they have deleveraged very significantly and rightly so. And they are using as I said, the support measures from governments in order to continue to deleverage which puts them in a more prudent and stronger position.

William Chalmers, CFO

The third of your questions Martin negative rates. Negative rates is a difficult call actually. There are many different forms of negative rates introduction as you know. I mean, first of all, the debate is not there yet. It seems that the bank is committed Bank of England that is committed to trying out other forms of stimulation including in particular QE before we get into negative rates territory. And that stance is one that I think has been pretty clear. If it gets into a negative rate of discussion then I think there are very different forms in which negative rates can play themselves out or be introduced into the economy. There are also a number of different offsets that the government could put in place or the Bank of England rather could put in place to offset against the effect of negative rates as it plays out in the banking sector. And so TFS SME is one example of that or TFS more generally is one example of that. And whether or not there will be any compensating negative funding benefits for the bank to draw upon from the Bank of England would obviously be a question in terms of the negative rates impact on the overall business. And then further pricing strategies. We note the pricing strategies that have been adopted in Europe, particularly for commercial and large corporate accounts for charging for balances. We have not taken any view on what our pricing strategies would be in a negative rate environment. But the point is it is noted if you like that there are pricing strategies that could offset against the impact of negative rates depending upon how they're introduced. I think there's no doubt overall, negative rates are for the banking sector as a whole, not especially good news. They haven't been particularly in Europe they haven't been particularly in Japan. But I think there are a number of questions and indeed offset to the negative rate debate, which in turn would considerably soften the impact if it ever got there. But I think my concluding point on that would be to say we're not there today. And there's nothing that we're hearing at least that suggests that we're going to be there tomorrow but it is a risk as you're right to point out. It's a risk that's out there. And then finally Brexit, the multiple economic scenarios that we have taken as you know encompass a range of different outcomes. We've taken a base, a downside and a severe downside and actually an upside, which if you look at it closely is not terribly different to a base and therefore we think relatively conservative. But the severe is really as the name suggests quite a severe downside, for which we take a 10% weighting. That includes things like HPI down 30% over the forecast period. It includes things like 12.5% peak unemployment. It includes things in 2020 actually 17% GDP and thereafter a relatively slow improvement in the succeeding years. So severe is deliberately and self-consciously quite a severe downside. Now I don't know what Brexit will throw at us but I would very much hope that our severe downside encompasses more than what Brexit would trade us. And so again we don't have a Brexit overlay. We don't have a Brexit output. But we do have a set of MES assumptions that we think are pretty prudent and we believe should encompass some, if not all of what Brexit would throw at us.

Martin Leitgeb, Analyst

Thank you very much.

Operator, Operator

Thank you. Next question comes from the line of Guy Stebbings, Exane. Please go ahead. You’re live in the call Guy.

Guy Stebbings, Analyst

Good morning and thanks for taking the question. Firstly just wanted to talk about RWA growth and your guidance there so the flat to modestly up. Given some of the comments you made around assumptions on unsecured shrinkage and growth coming from lower risk-weight dense assets. Should we assume that that is building quite a reasonable amount of negative credit migration? Or is there anything else going on that you point to? And then secondly, I just wanted to ask on the insurance business and the solvency position which dropped to 140% if you could talk us through your risk appetite there in this environment? Any actions you might take or indications for future insurance dividends would be helpful. Thanks.

William Chalmers, CFO

Thank you, Guy. Let's address the first question regarding RWA growth. It's important to note that credit migration has had a minimal impact on our overall business. Analyzing the first half of the year, the effect of credit migration on RWA development has been very limited for both corporate and retail sectors. In retail, any increase in RWAs is primarily due to countercyclical models reflecting a stable arrears situation in the first quarter, not a deterioration in conditions. In commercial, credit migration has followed more traditional patterns but remained below £1 billion for the first half of the year. Therefore, we've observed very little overall change. Looking ahead, we anticipate that RWA levels will stay flat or rise modestly, leaving some flexibility to account for uncertainties and potential short-term fluctuations. Some correlation exists with volumes; for instance, if we see a decrease in unsecured lending, there could be an associated impact on RWAs, albeit not significant. Regulatory forbearance also plays a role, particularly if interest-free overdrafts continue, which would require us to assess customer need and could affect RWAs due to the forbearance classification. Default development will also influence RWAs, as we have a base case scenario for how defaults may unfold in the second half. Our ongoing optimization efforts in the commercial sector are expected to mitigate potential RWA increases. Credit migration remains uncertain; we don't foresee it to be substantial and expect it to be balanced by our ongoing optimization plans. We are cautious, leaving our RWA projections as flat to modestly up due to these uncertainties. A favorable scenario would see RWAs stay flat, while a less favorable outcome would be a modest increase, which frames the outlook we're providing. Now addressing your second question about insurance, the solvency ratio stands at 140%, aligning well with our desired operating standard. There may be times where it edges slightly above or below this mark, but 140% accurately reflects our preferred level for the insurance business in normal operations. Looking forward, the ongoing performance of the business will enhance solvency through earnings growth over time. We must also consider economic risks and potential downgrades as we move into the latter half of the year, which can influence our solvency ratio in both directions. Overall, our credit exposure portfolio within the insurance segment is of high quality. For instance, our £17 billion annuity backing portfolio has 40% rated at AAA or AA, and 75% when including single A ratings, with only 1% in lower investment grade. So far this year, we've recorded 87 downgrades, reflecting a modest downgrade rate in that portfolio. Thus, we view it as a high-quality asset moving forward. Regarding dividend considerations from the insurance business, we will need to evaluate the economic landscape and business performance, and no payments will be made to the insurance Board or the group Board at the year’s end.

Guy Stebbings, Analyst

Okay. Thank you.

Operator, Operator

Thank you. We have time for two more questions. Your next question comes from the line of Fahed Kunwar, Redburn. Please go ahead. You’re live in the call.

Fahed Kunwar, Analyst

Hi. More than thanks for taking my questions. I just had a couple of questions all on margins I'm afraid. One of your peers talked about the deposit cuts coming in at the back end of the quarter in the U.K. and then potentially have more cuts coming through this quarter. And are there any deposit cuts that happen and how much headroom do you have on the liability side of the balance sheet? The other question I had was just on back book from the mortgage. I appreciate you said the SPR cushion is slowing. But can you give us numbers on what the back book versus the comp is on your mortgage portfolio? And my third question kind of ties it together. I appreciate there are kind of pluses and minuses on margins. I understand right now your hedge is annualizing at £1.2 billion net that's 25 bps that is going to just pay on the yield curve steepen. I'm assuming your back book comp is negative as well. So there's quite a lot of just mechanical pressure on your margin probably kind of in the region of 89 bps per annum just before even think about activity levels. So am I right in thinking too quite a lot of positive things to fix the margin does it keep deteriorating from here? Or am I getting something wrong on that? Thanks.

William Chalmers, CFO

Thank you for the question. I might reiterate some of what I've mentioned, but I'll aim to provide more specific details regarding your inquiry. When analyzing the margin, we have several contributing factors. You specifically asked about deposit re-pricing and the potential for liability re-pricing going forward. We've experienced some deposit re-pricing thus far in the business, particularly in Q2, and I expect more of this to occur in Q3 and Q4, especially in the commercial sector, which will impact our metrics. I won't provide exact figures for what's already been executed or what lies ahead, but there has been movement with more expected in Q3 and Q4, all included in our margin guidance for the rest of the second half of the year. Regarding the remaining headroom in the retail and commercial liability portfolio, there's not a significant amount left. We're nearing the bottom of the liability margin, which likely doesn't surprise you given the current rates and the status of most products. While there are specific products that could be adjusted, we must also consider the long-term perspective and the need to preserve the franchise's strength. So, there's some opportunity but not extensively. Concerning the mortgage portfolio, it's an interesting situation with numerous dynamics at play. Recently, we’ve observed front-end mortgage margins ranging from 160 to 170 basis points, which is an improvement over the products being replaced under an incentive structure. The mix of new business and product transfers, or retention, is better compared to what we're retaining, which positively influences the margin. Historically, in times of crisis when capital bases are impacted, many competitors tend to withdraw products from the market. This withdrawal generally supports margins, not just in mortgages, but across the board. We witnessed this in the last crisis and may see a similar trend in the current situation, potentially reflected in the mortgage comments I've just shared. However, it's vital to approach the notion of a continuous decline in margins with caution. Typically, in banking crises, when capital is pressured, margins tend to rise as a compensation measure. We will see if this scenario plays out here, but it's a reasonable perspective to maintain.

António Horta-Osório, CEO

If I can just add two points on what William said, which might be helpful. I mean the first one on mortgages is that you have to bear in mind as well that given that the market has been shut for two or three months, activity now is booming. And the customers are now doing transactions again. There could be more time than usual in terms of new business application margins translating into completions margins, because of this as of the coronavirus. So, normally you have 90 days between applications converting into completions margins. And this could take a bit longer. And so go into next year to the points William was saying and has mentioned in a question before. And the second point is about the mix. I mean we are forecasting a recovery next year. So GDP could go down on base case 10% this year, but up 6% next year. That should bring activity up and that should bring the mix again into the normal direction. And through mix with the credit cards, for example, recovering, motor has already recovered. You also will have an impact back on margin through mix as we now have credits negatively in the second quarter, as William was explaining this to revert next year.

Fahed Kunwar, Analyst

Perfect. Thank you.

William Chalmers, CFO

Thanks very much.

Operator, Operator

Thank you. Given the time, the final question comes from the line of Jonathan Pierce, Numis. Please go ahead.

Jonathan Pierce, Analyst

Yeah. Good morning, both. Quick questions please. Just to check my math on the structural hedge. All in yield 1.4%, I think the five-year swap today is about 50 basis points. You've mentioned, William, straight-line roll off over the next few years. So, are we looking from that component within margin a sort of 10 basis points headwind in year 2021, 2022? That would be the first question. The second question on capital on, obviously, the capital number is looking good at the moment. There are some headwinds building. The one I wanted to ask about though was pensions. Now you may just say, look, we're not telling you yet. But I’d be interested in how those discussions are going given the fairly sizable contributions currently planned for the next few years there? Thank you.

William Chalmers, CFO

Okay. Thanks Jonathan. On the structural hedge just to take the first of those two questions. The roll off, as I mentioned in the comment earlier on, is pretty much in a straight line. The weighted average life is now 2.5 years. The hedge itself has a life of about five years, so pretty much straight line within that five-year profile. I would be a little bit careful before necessarily directly correlating that to the income streams in a very precise way, because there are different maturities that have different yields attached to them. So, it might be a little bit bumpy. But I think in the absence of us giving you more precise guidance, I think just take that as an assumption but just be aware of that there may be a few bumps on the road. I do think that when we look at the structural hedge as you know we take a view that around protecting shareholder value and we take a view that is around protecting the consistency of earnings. And when we look to the structural hedges we seek to deploy over the coming years, obviously, we'll be subject to whatever it is the rates environment throws at us, but we'll also be judicious about what we do with the structural hedge and win to ensure that we both achieve income consistency and also shareholder returns. So the profile of it will depend upon how we reinvest the structural hedge over what time. And in that context, what opportunities the rates market may give us and what the trends in the rates market may be. The capital price as you said, and I would endorse, the capital position remains and will remain very strong. The contribution of pensions to that, it's worth just noting that our Pillar 2a has come down by 30 basis points in the second quarter and that is because we accelerated our 2020 pension contributions by around £600 million, which in turn led to RWA come down off the back of that and leads to our regulatory capital requirements if you like coming down at the back of that. So that's helpful. As we look forward and as you pointed out, we are also in negotiation with the trustees, which takes place as of the balance sheet drawn at the end 2019. That balance sheet is drawn into 2019. That's kind of close of play for negotiations if you like. We are in the process of discussing with the trustees about how we make contributions to the scheme going forward, taking into account all of their objectives but also taking into account our objectives. I'm sure that we will end up at a reasonable spot if you like that considers each of those two in a way that's mutually satisfactory. But I'm not going to go beyond that Jonathan just because it's the middle or even the start really of a negotiation.

Jonathan Pierce, Analyst

It's interesting that the Pillar 2a has decreased in the same half year as those contributions increased. Should we expect a similar immediate decline in the Pillar 2a as these contributions are made in the future?

William Chalmers, CFO

There's a couple of capital points worth pointing out as we go forward. We talked about transitional effect. And yeah we'll see exactly the timing of how that plays out. But the other couple of capital points are worth making are we have the developments are in the countercyclical buffer and we'll see how those play out during the course of the year. But at the moment it looks like there may be a 25 basis points equity release if you like in the context of the countercyclical buffer. There are discussions exactly how that will play out particularly in the context of its reintroduction in the year subsequently and that's up in the air clearly. The other point is intangibles. Intangibles would get around a 25 basis point benefit from if that comes through in the form that is being discussed for the end of this year. So it does not amount to 8.2 precisely Jonathan, but hopefully that gives you some guidance.

Jonathan Pierce, Analyst

Okay, brilliant. Thanks a lot.

William Chalmers, CFO

I'm sorry but we've run out of time. So I just want to thank everybody for dialing in. We'll contact all of those who are unable to ask questions and make sure that anybody who asked questions are able to do so to the IR team. So throughout after this call and during the course of today and tomorrow, we'll make sure that any questions that we answered do indeed get picked up. But I hope it's been a useful call. We've been going for now over 1.5 hours, which hopefully has given everybody an opportunity to both hear the speeches and to address some questions. Thank you very much indeed for dialing in.

António Horta-Osório, CEO

Thank you everyone.

Operator, Operator

Ladies and gentlemen, this concludes the Lloyds Banking Group 2020 half year results event. For those of you wishing to review this event, information for the replay is available on the Lloyds Banking group website. Thank you for listening.