Earnings Call Transcript
Lloyds Banking Group plc (LYG)
Earnings Call Transcript - LYG Q2 2022
Operator, Operator
Thank you for standing by, and welcome to the Lloyds Banking Group 2022 Half Year Results Call. Please note this call is scheduled for 90 minutes and is being recorded. I will now hand over to Charlie Nunn. Please go ahead.
Charlie Nunn, CEO
Good morning, everyone, and thank you for our half-year results call. As you know, our purpose as an organization is to help Britain prosper. Despite the uncertain external environment, we see significant resilience within our customer franchise, and our financial strength positions us well to continue to focus on this as we move forward. I will talk more about this shortly, but let me start by turning to Slide 3. I'm going to take you through the key messages from the half, and then William will provide the usual review of the Group's financial performance before we open up for Q&A. There are five key messages that I'd like you to take away from today. First, in the context of the cost of living stress, we are seeing our customers adapting their spending where needed and making the necessary decisions to maintain their financial resilience. We've delivered a strong financial performance in the first half of 2022 based on improved income, increased investment, and benign asset quality alongside continued business momentum. Our financial performance in the first half has enabled us to enhance guidance for 2022. William will discuss this in more detail later. However, we will not provide updated guidance for 2023 or 2024 at the half-year. We're confident in the future and executing well, but it's simply too early to update longer-term numbers. The financial performance has also enabled the Board to announce an interim ordinary dividend of 0.80 pence per share, which is up around 20% compared to last year. Finally, our strategic delivery and conservative risk business model position the Group well for the future. So with that, I'll turn to Slide 4 to look at how we are well-positioned to navigate the external uncertainties. It is clear that our customers are facing a challenging period with increases in the cost of living. However, considering our customer base, the positioning of our balance sheet, and our conservative risk appetite, we see a resilient franchise today and looking forward. We are not currently seeing signs of stress in the portfolio, and our business is well-placed. In retail, we have a representative sample of deposit customers from across society, while our lending exposure is focused on higher income segments. We know that inflation has a greater impact on low-income customers, and they have lower levels of borrowing from us. We also observe that the majority of our lending is within secured business lines, with average loan-to-value ratios at historic lows, around 40% in both our retail and commercial businesses. Meanwhile, our unsecured businesses are focused on prime customers, and we are not witnessing any deterioration in their trends. It's also worth noting that, on average, customers are entering this period in better financial health than pre-pandemic, having increased their savings deposits and reduced their debts. In terms of customer behavior, we're seeing increased levels of spending, especially in higher income segments and discretionary categories such as travel and entertainment. Customers are also adapting their finances to accommodate the rising cost of living. For instance, we can see customers spending less on white goods and managing subscription services to adjust for higher energy, food, and fuel costs. Nonetheless, we see no increase in our customers cancelling insurance policies or opting out of auto-enrollment pensions. As we mentioned, we remain very focused on supporting our customers wherever necessary. We are fully resourced for this additional demand. However, the vast majority of our customers continue to demonstrate resilience. We've also taken early action to announce a one-off payment to all members of staff below the executive team. This was the right thing to do. By acting quickly and not spreading the payment, we can give our colleagues a cash injection that will help ease their financial pressure. Now turning to Slide 5 to look at an overview of the business and financial performance in the half. Lloyds Banking Group delivered a strong performance in the first half, and our business model positions the Group well for the future. Net income of ₤8.5 billion is up 12% year-on-year, supported by a higher net interest margin. BAU costs were stable, while operating costs are up 5%, driven by our increased strategic investment and new business lines. Asset quality remains benign given the resilient customer base I've just discussed. In turn, these factors support a return on tangible equity of 13.2%, capital generation of 139 basis points, and the increased interim dividend. This performance also enables us to enhance our guidance for 2022. Alongside our financial performance, we've achieved some important business milestones in the half, including maintaining a leading net promoter score of plus 68. Employee engagement of 72% has held stable since the end of last year, while we are also making progress on our diversity goals, including now having 39% of senior roles held by women. There's always more to do, but this represents good progress. Finally, turning to Slide 6. It has been five months since William and I articulated the Group's new strategy, which comprises three key pillars: grow, focus, and change. We're making good progress, and we've highlighted a few examples of our early achievements on this slide. Within our ambitions to grow the business, we've seen over ₤4 billion of net new money within insurance and wealth, along with a 1.5 percentage point increase in protection market share. In commercial banking, we increased our percentage share of the FX wallet by 20% and delivered a 10% increase in new merchant service clients. Our green lending initiatives are also on track, providing around ₤4 billion of sustainable financing in our commercial businesses. In retail, we are progressing with our green mortgage lending and have increased our funding for electric vehicles by over ₤0.9 billion in the first half. Our strategy also targets strengthened cost and capital efficiency under our focus pillar. We've continued to generate significant BAU cost savings, and you'll hear more about this from William shortly. Lastly, under the change pillar, we've announced a new organization structure and leadership team aligned with our strategic objectives. Additionally, we've reorganized around 20,000 colleagues, enabling us to implement change and enhance our digital and technology assets more effectively and swiftly. Furthermore, we've mobilized the skills and capabilities to deliver the incremental investments for our new strategy, having already made ₤0.3 billion of strategic investments to date. These are just a few examples of the progress we've made, and we will provide a more detailed update to the market in the first half of 2023. In summary, I'm pleased with the progress we've made and confident that we are well-positioned for the future. With that, I'll hand over to William to go through the financials in more detail.
William Chalmers, CFO
Thank you, Charlie, and good morning, everyone. Thank you for joining. Let me first turn to an overview of the financials on Slide 8. As Charlie mentioned, Lloyds Banking Group delivered a strong financial performance and continued business momentum in the first half of this year. Net income of ₤8.5 billion is up 12% from the prior year, supported by a higher net interest margin of 277 basis points and growth in other income. We remain committed to our market-leading efficiency. Operating costs of ₤4.2 billion were up 5% based on stable BAU costs before higher planned strategic investments and the costs associated with new businesses. Asset quality is in very good shape. The impairment charge of ₤377 million, equivalent to 17 basis points, is below pre-pandemic levels. This strong performance resulted in statutory profit after tax of ₤2.8 billion and a return on tangible equity of 13.2%. Alongside this, we continue to see balance sheet growth across our franchise areas. Meanwhile, tangible net assets per share of 54.8 pence are down 2.7 pence in the half, largely due to the upward movement in rates. I'll touch on this further towards the end of my comments. A good earnings performance bolstered by a reduction in risk-weighted assets and insurance dividends has delivered capital generation of 139 basis points. This, in turn, allows for the increased interim dividend that Charlie referenced earlier. I will now turn to Slide 9 to look at the continued recovery in customer activity and franchise growth we've seen in H1. Our mortgage portfolio has continued to grow, with balances up ₤2.2 billion in H1. Growth in the open book of ₤3.3 billion included ₤1.6 billion in the second quarter, demonstrating consistent progress throughout the half. Encouragingly, we saw growth of ₤400 million in the credit card book, all in the second quarter, as a result of improving spending levels, particularly in travel entertainment and retail. Led by transactors, this Q2 spend was 17% over the equivalent period in 2019. Looking ahead, we expect gradual growth in card balances to continue over the coming quarters. Motor Finance is also up ₤200 million in the half; however, we have a record order book as activity here continues to be impacted by ongoing global supply chain issues affecting all vehicle manufacturers. As you can see, commercial banking balances are up ₤4.3 billion in the half, primarily driven by attractive sponsor opportunities within the corporate institutional franchise, as well as some short-term refinancing business and FX revaluations in the portfolio, particularly in Q2. This growth has more than offset repayments of government support scheme loans in SME. On the other side of the balance sheet, we continue to see inflows to our trusted brands, with retail deposits up ₤3.3 billion in the half, showcasing growth in both quarters. Commercial has seen some short-term placements reversing as expected in Q2. Overall, Group deposits are up ₤2 billion in H1, growing almost ₤70 billion since the end of 2019. The substantial deposit growth provides the Group strategic opportunities to build our franchise while increasing our pool of hedgeable balances. I'll touch on this again shortly. Alongside our banking business, we've seen good organic growth within insurance and wealth across business lines, including over ₤4 billion of net new money in the first half. I will now turn to Slide 10 to discuss the improving net interest income performance in more detail. Net interest income of ₤6.1 billion is up 13% versus the first half of 2021 and up 7% on the second half of that year. This increase has resulted from both a modest rise in average interest-earning assets and a higher net interest margin. Average interest-earning assets of ₤450 billion are up ₤1.3 billion in the half, with mortgage growth more than offsetting the timing-related reductions within commercial banking. Our H1 margin of 277 basis points represents a 21 basis point increase on H2 '21. The Q2 margin of 287 was up 19 basis points from the previous quarter. The positive impact from rate rises here has more than offset the ongoing impact of competitive mortgage pricing. Looking ahead, we continue to expect low single-digit percentage growth in average interest-earning assets in 2022. This will be driven by continued growth in mortgages and the gradual recovery in unsecured balances. We are now assuming that the base rate increases to 2% in Q4, providing a further tailwind this year. Conversely, we expect the impact of mortgage repricing to continue to affect the Group margin. Nevertheless, the combination of these factors remains a substantial net positive, leading us to enhance our margin guidance to greater than 280 basis points for 2022. Given the significant focus on interest rate sensitivities, let me turn to Slide 11 for further clarification. As you may have heard us say previously, the Group is positively exposed to rising rates. We currently expect a 25 basis point parallel shift in the yield curve. This, along with the associated base rate rise, is expected to benefit interest income by about ₤175 million in year one. This figure is illustrative and based on assumptions, including a 50% deposit pass-through, similar to those previously set out. It's important to note that this pass-through could differ from the 50% illustration, as we've seen in the first half. This variation leads to a material difference in income. For instance, taking the 25 basis point increase as an example, for every 10 percentage point reduction in the assumed pass-through, we expect an additional ₤50 million of net interest income in year one. Therefore, if you assume a 40% pass-through, the sensitivity would be ₤225 million. I should also mention that the sensitivity does not account for asset spread compression, as seen again in the first half, especially in mortgage new business margins. Now transitioning to the individual asset portfolios, starting with mortgages on Slide 12. We continue to see growth in mortgage balances in H1. The open mortgage book now stands at ₤297 billion, with growth of ₤3.3 billion in the half and ₤1.6 billion in Q2. The standard variable rate book of around ₤57 billion is down 20% over the last 12 months. Q2 attrition levels were moderately higher than previous quarters. In light of the rising interest rate environment, customers have begun to re-fix their mortgages, and we are actively engaging with our customers to ensure they are aware of their alternatives and any necessary steps. Mortgage pricing has been competitive over the past quarters. Q2 completion margins were around 60 basis points. However, application margin dynamics are stabilizing as customer pricing increases in response to swap movements. In terms of outlook, we expect new business to continue to be priced below high-yielding maturities, considering our annual growth lending target of around ₤90 billion. With that said, current margins still render mortgages attractive concerning both returns and economic value. Now let's discuss our other asset books on Slide 13. Consumer Finance balances have increased by ₤1 billion since year-end. We are witnessing a recovery in credit card spend, particularly in discretionary categories, which translates to ₤400 million higher credit card balances, largely in the second quarter. As mentioned earlier, Motor Finance is up ₤200 million, although this positive trend is still impacted by the broader motor industry issues. Commercial Banking has risen by ₤4 billion in the half. As I mentioned earlier, the underlying commercial business has grown by ₤5.4 billion in H1, driven by attractive growth opportunities, particularly in the corporate institutional business as well as FX revaluations in the portfolio. However, we have noted a reduction of ₤1.1 billion in government-backed support scheme lending, which is more prominent in SME clients as they repay their COVID loans. Let's move on to the other side of the balance sheet on Slide 14. We continue to observe deposit growth in the first half of 2022, with total deposits increasing by ₤2 billion. That said, they declined in Q2 as some short-term commercial placements reverted, as anticipated. Importantly, we continue to see inflows to our trusted brands, with retail current account balances up by ₤1.9 billion or 2% in the half and ₤0.3 billion in Q2. Total Group deposits now approach ₤70 billion, which in turn affords the Group strategic opportunities to better serve customers as we develop our wealth proposition, for instance. The overall H1 deposit margin of 41 basis points is significantly higher than last year due to interest rate movements. Deposit growth also augments hedgeable balances, which we outline on Slide 15. Given the deposit growth over the last two years and the increased eligibility of existing deposits, structural hedge capacity has risen recently, including an increase of ₤10 billion in H1 to ₤250 billion. In light of the favorable swap curve movements this year, the nominal balance of the structural hedge is now fully invested up to this approved capacity. The weighted average duration of the hedge is around 3.5 years, slightly below the neutral position of about 4 years. We still have ₤13 billion of maturities in H2 and ₤35 billion in 2023, providing substantial flexibility. Despite these favorable developments, we have achieved gross hedge income of ₤1.2 billion during the first half. Looking ahead, we now expect structural hedge income to be stronger in 2022 than in 2021, continuing its upward trajectory into '23 and '24. Moving on to other income on Slide 16, other income of ₤2.5 billion is up 5% year-on-year. We continue to see signs of recovery in customer activity. In fact, retail has experienced an enhanced performance in current accounts and in credit cards due to this heightened activity. Other income in commercial has been bolstered by improving transaction banking volumes and resilient financial market performance overall during this period. Insurance and wealth now includes a modest contribution from Embark and some assumption benefits. However, year-on-year growth is primarily driven by improved new business income, for example, in workplace pensions and bulk annuities, particularly in Q2. The second-quarter performance of ₤1.3 billion aligns with the last few quarters. This quarter is relatively straightforward, with one-off charges in equity investments countered by insurance assumptions and asset-held benefits. Looking ahead, we anticipate the other income run rate to gradually build, which will undeniably be influenced by customer activity levels in uncertain macro conditions as well as our ongoing strategic investments. As a temporary constraint on that pattern, and as mentioned previously, we should remember that IFRS 17 will impact us in Q1 '23, and we'll talk more about this in future presentations. Moving on, the Group has maintained its focus on efficiency during 2022. Let me elaborate on this in Slide 17. Operating costs of ₤4.2 billion are up 5% from the prior year. As we previously guided, this includes broadly stable BAU costs combined with higher planned investment and costs associated with our new businesses. Our Q2 cost-to-income ratio of 50.2% remains market-leading. As you can see on the slide, the cost-to-income ratio excluding remediation is 49.6%, which is marginally better than previous quarters. We are clearly not immune to inflationary pressures, but we maintain our rigorous approach to cost management. We have attempted to mitigate inflation by absorbing an additional colleague compensation charge of ₤65 million in Q3 regarding the one-off payment to staff. Therefore, we continue to expect 2022 operating expenses to be around ₤8.8 billion. Finally, on remediation, the charge of ₤79 million in H1 reflects a number of pre-existing programs. There were no charges in the half associated with HBOS Reading, although the final outcome remains uncertain. Looking forward, we continue to expect ongoing remediation costs of ₤200 million to ₤300 million per year. Now let’s discuss impairments on Slide 18. The impairment situation remains benign. The net impairment charge of ₤377 million in H1 equates to an asset quality ratio of 17 basis points. Behind this figure, asset quality remains robust, and new arrears are low, with underlying charges below pre-pandemic levels. The underlying charge of ₤282 million includes charges of ₤315 million in retail and a release of ₤37 million in commercial. We then have a charge of ₤95 million concerning our updated economic scenarios. Our new base case economic assumptions comprise a slightly weaker GDP and unemployment forecast alongside higher inflation. Additionally, as part of our economic assessments, we've recognized the increased cost of living and other inflationary charges in retail and commercial this half, amounting to ₤400 million. This figure includes both modeled impacts and judgments, in addition to the ₤60 million we accounted for at the end of last year. In contrast, we released ₤300 million of the net COVID-related judgmental overlays in Q2, reflecting the reduced risks in this area. This includes ₤200 million of the ₤400 million central overlay. Hence, we maintain about ₤500 million of COVID-related provisions within our expected credit loss measures, both centrally and within the portfolios. As a result of our H1 performance and economic assumptions, our stock of expected credit losses remains stable at ₤4.5 billion, approximately ₤0.3 billion higher than at the end of 2019. In summary, we remain vigilant of any effects from rising inflation, but the Group is performing well and remains well-positioned. Consequently, we now expect the net asset quality ratio to be below 20 basis points for 2022. Moving ahead, let's turn to Slide 19 to explore the resilience of our retail portfolio. As Charlie noted earlier, we're very conscious of the potential impact on our customers of inflation. Nevertheless, our low-risk approach indicates we have limited exposure to those segments most at risk. We are proactively seeking to support customers where required, but we aren't seeing significant signs of distress. Our retail business is demonstrating stable and benign arrears performance. Credit card expenditure is increasing, particularly in discretionary sectors like travel and entertainment. About 90% of credit card spending is now from customers in middle and high-income segments, up from around 80% in 2019. Furthermore, we're observing the proportion of regular minimum payers to remain very stable, indicative of our customers spending within their means. As you know, our largest asset exposure is in mortgages, which comprise a high-quality, low-risk portfolio. Our book stands at ₤310 billion, with an average loan-to-value ratio of 40.2%. Currently, just 3% of mortgage balances have an LTV of greater than 80%, and 0.4% of balances have an LTV of greater than 90%. The considerable derisking we have undertaken in recent years, along with favorable house price movements, has resulted in our customers holding considerable equity in their homes. Let me now delve into Slide 20 and evaluate the current performance of our commercial portfolio. In commercial, we are seeing stable SME overdraft and corporate revolving credit facility utilization trends, with RCF drawings around 50% of the 2020 peak levels. We also observe low and stable levels of transfers onto watch lists or into our business support unit, which remains below pre-pandemic levels. Across commercial, we maintain strict sector caps and conducted recent stringent reviews of all portfolios in light of the macro outlook. Indeed, our current impairment judgments are based on this review. In commercial real estate, our exposure has been significantly derisked over recent years, with net exposure at ₤11.1 billion after accounting for risk transfer transactions. The business has an average LTV of 39%, with just 12% of clients having an LTV of over 60%. Average interest cover stands at more than 4.5 times. Naturally, we remain vigilant for signs of stress across our lending portfolios. At present, our customers are performing strongly, making discretionary choices with very high levels of security. Moving on, I will now refer to Slide 21, where we briefly look at the below-the-line items. Following the reporting changes implemented at year-end and as intended, underlying and statutory profit are converging. The limited costs booked below the line include restructuring costs comprising M&A and integration. The half-year charge of ₤47 million includes early integration costs related to the acquisition of Embark. Volatility in H1 includes favorable banking volatility arising from recent rates and FX movements, partly offset by negative insurance volatility driven by those rates. It also encompasses the usual fair value unwind and amortization of purchased intangibles. Given the prior-year comparative includes significant impairment and tax credits, the current period statutory PBT of ₤3.7 billion and PAT of ₤2.8 billion both reflect strong financial performance. The resulting return on tangible equity for H1 is 13.2%, well above our cost of capital. Given the improved income and impairment outlook, we now expect the RoTE for 2022 to be around 13%. It’s important to note that this figure includes a benefit of just under 1 percentage point due to movements in the cash flow hedge reserve, which we do not expect to recur in future years. Now turning to Slide 22 and evaluating risk-weighted assets and capital developments during the first half of the year. Capital generation in H1 is robust. Risk-weighted assets totaling ₤210 billion are down ₤2 billion, excluding the regulatory inflation of ₤16 billion previously noted. Underlying lending growth is more than offset by model reductions and ongoing portfolio optimization. We have observed no increase in risk-weighted assets due to credit migration. Looking ahead, we continue to expect closing risk-weighted assets for 2022 to be around ₤210 billion, with expected balance sheet growth broadly offset by continued optimization. Analyzing capital generation, strong banking profitability in the half is bolstered by lower risk-weighted assets, supplemented further by ₤300 million in dividends from the insurance business that benefits from interest rate rises. In total, the 139 basis points of capital generation represents strong performance. As previously mentioned, our capital generation has enabled the Group to make accelerated pension contributions. The full fixed pension contribution of ₤800 million for 2022 is complete, and we will make the remaining variable contribution in the second half. The strength of the Group's performance and prospects allows the Board to announce an interim dividend of 0.8 pence per share, an increase of around 20% on last year. We remain committed to returning excess capital, and we will consider further distributions at the year-end as appropriate. Based on current performance and outlook, our business model and macroeconomic context lead us to expect capital generation for 2022 as a whole to exceed 200 basis points. Finally, let's summarize on Slide 23. The Group has delivered a robust performance in H1, with net income up 12%, supported by a net interest margin of 277 basis points. Asset quality remains strong, with an AQR of 17 basis points reflecting sustained low levels of new arrears and resilience looking ahead. The return on tangible equity of 13.2% and capital build of 139 basis points in the first half represent a robust outcome. Collectively, these factors enable a significantly increased interim dividend of 0.8 pence per share, consistent with our progressive and sustainable dividend policy. As uncertainties persist, particularly concerning the increased cost of living and its potential impact on customers, the Group approaches the future with confidence. This is reflected in our enhanced guidance for 2022. We now expect the net interest margin to exceed 280 basis points, the asset quality ratio to remain below 20 basis points, the return on tangible equity to be around 13%, and capital generation to surpass 200 basis points. That concludes my comments this morning. Thank you for listening. Let me now hand back to Charlie for his closing remarks.
Charlie Nunn, CEO
Thank you, William. As I mentioned at the outset, there are five key messages I want you to take away today. First, in line with our clear purpose of helping Britain prosper, we are focused on proactively supporting our customers and colleagues amid the increasing cost of living. However, the vast majority of our customers are adapting to the changing economic environment and demonstrating financial resilience. We've delivered a strong financial performance in the first half with improved income, increased investment, and benign asset quality. This is anchored in continued business momentum and franchise growth. While uncertainties remain in the operating environment, we are confident in the future and have enhanced our guidance for 2022, as you've just heard from William. Our financial performance has enabled the Board to declare an increased interim dividend. Finally, our robust financial performance, alongside our resilient portfolios and promising early signs of strategic delivery, position the Group well for the future. That concludes our presentation for this morning. Thank you for listening. I will now hand back to our operator for the Q&A.
Operator, Operator
Our first question today comes from Joseph Dickerson of Jefferies. Please go ahead. Your line is open.
Joseph Dickerson, Analyst
Hi, good morning, gentlemen. Thank you for taking my question, and congratulations on a very strong set of numbers. I have two questions. You’ve provided some interest rate sensitivity with the 50% pass-through and agreed some sensitivities around that. Could you please explain what that was in the first half of the year or, say, in Q2, just to help us gauge where we've been on a slightly backward-looking view? Additionally, with the card commentary that you've mentioned, it seems like there could be some meaningful impact on the Group margin regarding favorable mix on the retail side. How is that factored into this year's net interest margin guidance, if at all? Thanks.
William Chalmers, CFO
Thank you, Joe. I'll take both questions. Regarding the first question about the pass-on, as you've noted, we've provided some increased sensitivity today to accompany our usual sensitivities. The pass-on assumption in the base case sensitivities, as you know, is 50%. We use this as an illustrative number to give you some insight into the effect of a parallel shift in market and base rates. We typically operate below that level in the first half, but don’t usually disclose precisely what our pass-on is in any given half or quarter. Again, I don’t think we will break that pattern today, but it is true that a reduction in pass-on from our planning assumptions yields a material difference to both net interest income and net interest margin. The illustration we've provided indicates that a 10% reduction in pass-on to 40% instead of 50% results in about ₤50 million of net interest income, which translates to roughly 1 basis point. So, if you will, this gives you some calibration. We have been operating at levels below that pass-on in the first half, determined by a few factors, notably competitive conditions in the market, overall funding position of the balance sheet, as you know, we are operating a loan-to-deposit ratio of about 95%, and ultimately, making sure that we provide great service and value to our customers. As I mentioned earlier, the first half we have typically operated at levels below the 50% in the illustration. I suspect, as rates rise, that we will see that gradually gravitate back toward levels that we use in our planning assumptions, which are slightly ahead of the illustrated 50%. In terms of the impact of cards, as you've noted, the Q2 margin is at 287, which is an improvement of 19 basis points over Q1. We've experienced several headwinds and tailwinds in that composition. We've benefitted from the bank base rate’s movements, along with reliable funding support and some capital benefits. This has been slightly offset by the mortgage headwinds as high-yielding maturities translate into slightly lower-yielding margins. For the future, we expect the dynamics to shift. While we will maintain support from bank base rate changes and the deployment of the hedge, the mortgage headwinds will intensify a little. On the topic of cards, while we expect spending behaviors to drive some beneficial impacts, the growth in card balances led by transactors has been modest to date. However, should this trend of increased spending persist, particularly in areas such as travel, we can expect improved interest-bearing balances offsetting the overall impacts on group margins. We are cautiously optimistic about continued growth in card spending as a reflection of ongoing customer behavior, which may yield a positive impact on margins as we move forward.
Joseph Dickerson, Analyst
Great! That’s helpful. Many thanks. Just to interpret your answer on the second question, if card loans pick up significantly, it’s essentially optionality on top of the guidance you’ve already provided regarding margins.
William Chalmers, CFO
Yes, we've assumed a level of gradual increase in unsecured balances generally in our business planning assumptions, Joe. That in turn supports our guidance of greater than 280 basis points for the margin this year. So while there's an element of increasing balances assumed there, it will have more or less effect on the Group margin depending on its actual execution as we progress. Overall, we are expecting these trends to support the margins going forward if they exceed expectations further.
Operator, Operator
Our next question comes from Omar Keenan of Credit Suisse. Please go ahead. Your line is open.
Omar Keenan, Analyst
Good morning, everybody. Thank you for taking the questions. I have two questions, please. First, regarding the RoTE target, I appreciate you said it is early to update the 2024 target. But at a high level, since the strategy day, the near-term NIM guide has shifted from above 260 to above 280 basis points, assuming base rates now stay around 2%. Simplistically, if I add 20 basis points of NIM to the 2024 target, does that imply the 10% becomes 12%? Presumably, the strategic initiatives still aim to deliver another incremental 2% by 2026? Essentially, is it correct to say that if higher rates are sustained, the current 10% in 2024 and 12% in 2026 will change to 12% and 14%? Also, in regards to waiting for the full-year results, is it the sustainability of the rate picture that you’re looking for? Secondly, regarding NIM, if we consider the 287 basis points delivered in the quarter, funding and capital benefiting contributed 4 basis points. That was strong, and likely the deposit pass-through was much better in the quarter; however, we aren’t yet observing deposit mix shifts. As the Bank of England is expected to hike next week, can you provide an idea of what the three variables on deposit pricing currently look like? Is everything still broadly favorable? At what level of interest rates do you think we might start to see a mix shift from current savings accounts? Thank you.
William Chalmers, CFO
Thank you, Omar. I'll comment on the RoTE first and then provide input on NIM. As you know, when we outlined our assumptions during the presentation on February 24, we anticipated a 2024 RoTE of greater than 10%. There have been significant developments across the market since then, including substantial rises in interest rates and rising base rate expectations. These changes have had ramifications for the business throughout H1 and are expected to continue into H2 and beyond. Many of the trends we've seen in market rates and changing base rates are leading to sustained improvements in both net interest income and margin, this year and into the future. Regarding guidance, though, we still prefer to revise only when we announce full-year results to have a comprehensive picture rather than making quarterly adjustments, but it is safe to say that the outlook is significantly more robust now than it was in February. Moving on to NIM, as previously mentioned, the margin delivered in H1 is a result of benefiting from both bank base rate changes and the deployment of the hedge, though we must account for certain headwinds from mortgages. We anticipate that the tailwinds from base rates and hedge support will carry through, offset by some headwind from mortgages. So, overall, we expect a gradual improvement in margins as we pass the 287 basis points. In terms of deposits, during the first half, we experienced continued inflows, including into the current accounts. While it may shift towards savings as rates potentially increase, we have not noted that shift yet. We do foresee a future in which our mix might contain a larger portion in savings, particularly in H2, but we'll await further clarity as we progress.
Charlie Nunn, CEO
William, I’d like to add one thing, if that's alright. The guidance we provided regarding the 50% pass-through on base rates has always been considered a through-cycle perspective. Obviously, competitive conditions have differed this first half, and we should observe that at around 2%, interest rates would normalize this kind of 50% pass-through. We will need to see how market dynamics play out this time, and we know that price chief mechanisms between assets and liabilities are carefully monitored by everyone. But envisaging the next 25 to 75 basis points, you would typically have observed a more normalized through-cycle pricing around liabilities.
Omar Keenan, Analyst
That’s great. So if I understood your comments correctly, the flat NIM moving forward from here assumes that we revert back to the 50% pass-through?
William Chalmers, CFO
It's actually slightly different, Omar. Our expectations for NIM will trend flat as we continue into H2. The pass-through assumptions that we have in our planning models are actually slightly ahead of the 50% illustration you see. To date, we have had pass-through below that figure in line with competitive conditions. While we’ll observe how the second half evolves, our planning assumptions suggest levels above 50%. Overall, we foresee a generally flat margin as we go forward.
Operator, Operator
We will take our next question from Jonathan Pierce of Numis. Please go ahead.
Jonathan Pierce, Analyst
Hello there. Staying on margin, I understand that the exit margin as you transitioned from Q2 to Q3 should be a bit above 287 basis points, given the developments throughout the quarter. It seems as though you may be downplaying, in terms of margin consistency in the second half. If that is indeed the case, could you share what might bring the margin down if it indeed exits above 287? My second question pertains to broader concerns about the dynamic you're experiencing, where you're offering deposit customers a minimal interest return of 20 to 25 basis points, then placing it overnight with the Bank of England at 125 basis points. Is there a risk of political pressure to elevate savings rates, or more likely, action by the Bank of England not to pay a full base rate on overnight reserve balances? What do you think about the sustainability of this attractive environment you're currently experiencing?
William Chalmers, CFO
Thank you, Jonathan. I’ll address your margin question and then a bit on the broader market dynamics related to rates. Regarding margin, we reported a Q2 margin at 287. We expect that margin to hold steady into H2, which has informed our new guidance for over 280 basis points. We've noted that mortgage headwinds have increased for part of this latest margin. When considering what might cause downward shifts in margin as we move forward based on ceilings, we consider several components. The first points are base rate changes and the pass-through decisions we choose to adopt based on competitive conditions as noted. The second aspect houses mortgage shifts along with application margins transitioning. We mentioned earlier that we are currently observing an improvement in application margins, which is a positive indicator. However, as we evaluate our planning, the primary mortgage headwind is anticipated to strengthen somewhat. So if we see growth in mortgage pricing combined with a modest shift in the competitive landscape, we'd be able to maintain steady margins going into the latter part of the year. Regarding your second question related to political pressure, there are few modifications. Firstly, we haven’t had any conversations with the government or the Bank of England about those topics. I cannot predict future events. As it stands, it’s essential to note that the banking industry's net interest margin is still considerably lower than pre-COVID levels. This context resonates when engaging in discussions regarding potential future adjustments or pressures.
Charlie Nunn, CEO
To reiterate Jonathan's concern expressed regarding political pressure on deposit rates as they relate to the environment. We see significant growth in our deposits across the customer base, which remains stable, and we should be cautious before making sweeping changes or adjustments in that regard. We've worked hard to earn and bolster customer trust in our deposit offerings. However, a multitude of contributing factors is also at play that we navigate to provide optimal support for our customers.
Jonathan Pierce, Analyst
That would make sense. Thank you for that. And I’d like to follow up very briefly on this regulatory point. Just to confirm, you haven't faced any resistance regarding distribution channels due to the current uncertain economic outlook from the PRA?
William Chalmers, CFO
No, we haven’t seen any restrictions or resistance regarding distribution at all.
Operator, Operator
Thank you. We will take our next question from Rohith Chandra-Rajan of Bank of America. Please go ahead.
Rohith Chandra-Rajan, Analyst
Right. Thank you. Good morning. I would like to follow up on the margin again if I may. Your previous comments have been really useful, but I would just like to clarify. In terms of the flat margins in the second half of the year versus Q2, I presume you still have about half the benefit of the 50 basis points of rate increases we had during Q2 still to come through. Hence, we should see that in Q3. Additionally, if I understand your remarks correctly, William, you're suggesting that the greater than 280 basis points figure affirms a high pass-through than 50%. Considering your earlier statements, you're likely anticipating that all deposit benefits will essentially be countered by mortgage repricing. While I appreciate that you don't like to give forward guidance, with the Bank of England poised to raise rates, can you give us a brief indication with respect to deposit pricing? What are the three values looking like now? Is it still broadly favorable? Additionally, at what level of interest rate would we begin to see noticeable shifts in customer behaviors away from current accounts? Thank you.
William Chalmers, CFO
Thank you, Rohith. I'll address the margin question and some underlying assumptions. I would reiterate that our guidance for our net interest margin for the second half will broadly remain flat. The guidance level of greater than 280 reflects our pass-through assumptions from our planning. Thus far, our pass-through has been below our planning expectations. As we move into target ranges of 2%, we anticipate that 50% or more would then be a more standard pass-through. Nevertheless, we will continue to monitor how rates shift as this will provide us a better understanding of any customer deposit mix changes. Looking ahead, as we navigate through the latter part of the year, we’ll see how the economic conditions translate into behavioral changes.
Charlie Nunn, CEO
And Rohith, just a brief addition: the estimates of our forward guidance and mortgage prices are relative to where we see the current application margins. The overall sentiment here is relative to customer behavior amid changing economic conditions, which will largely guide our future trajectory.
Operator, Operator
We will take our next question from Chris Cant of Autonomous. Please go ahead.
Christopher Cant, Analyst
Good morning. Thanks for taking my questions. If I may come back to Slide 11 where you provided interesting booking disclosures on the sensitivity to beta inputs. Could you help clarify this for me? If each 10 percentage point reduction in the assumed beta adds ₤50 million for a 25 basis point hike, it would imply managed margin deposit balances of approximately ₤200 billion. Conversely, the ₤175 million sensitivity for a 50% pass-through on a 25 basis point parallel shift would imply around ₤140 billion of managed margin deposits, assuming hedge roll. This seems to lead me to conclude there might be roughly ₤100 billion to ₤105 billion of managed margin deposits. Could you help me sort out these apparent contradictions? Additionally, on Slide 15, regarding the size of your structural hedge, as rates rise, could you comment on customer behaviors in terms of moving back out of current account balances into non-current account balances? You've gradually increased your hedge capacity. It’s now 48% of the total balance sheet notional, a noticeable rise from about 41% at the end of 2019. What are you assuming about this behavior as rates elevate? Thank you.
William Chalmers, CFO
Sure, Chris. I can answer the first question and will also direct you to our team to quantify any specific numbers you may have in mind. Regarding the hedge sensitivity on Slide 11, the ₤175 million sensitivity reflects various components contributing to the total. We account for repricing lags, which represent a smaller portion of the ₤175. We're also mindful that hedge maturities yield cumulative results over time, so those elements will gain in significance over the coming period. In regards to reinvestment of the buffer and uninvested parts, these contribute around 25% overall to the figure. The margin management, as you noted in your pass-through question, comprises a major part of the sensitivity. The clarity surrounding the effects of reducing the pass-on to 40% affects the overall margin; drawing comparisons against deposit balances would yield a net of expected impacts. Now concerning Slide 15, the structural hedge is at ₤250 billion, entirely invested. Your observations regarding hedge capacity and eligibility are right; we have observed strong growth patterns since 2019. The majority of this growth has been attributed to newly qualified deposits. Concerning customer behavior, it’s essential to consider how rising interest rates may instigate shifts in deposit allocations among customers. We approach this with a prudent perspective; exploring how upcoming changes in rates might shift customer behavior is a critical piece of our strategy.
Operator, Operator
We will take our last question today from Guy Stebbings of BNP Paribas Exane. Please go ahead.
Guy Stebbings, Analyst
Hi, good morning. Thanks for taking the questions. Firstly, I wanted to revisit margin. I know you don't want to guide beyond 2022, but I wonder if we could think about some moving parts a little further out. There may be concerns about flat NIM in 2023 in light of margin headwinds rolling in from the second half of 2022. How should we think about this headwind beyond 2022? Is that largely confined to the second half of 2022, or should we consider ongoing effects into 2023? Lastly, on volumes and asset guidance, it appears somewhat more bullish than I would have expected. You’ve mentioned further growth from consumer lending and discretionary card spending, while recent data suggests some weakness in consumer spending. Please clarify your conviction levels regarding consumer lending growth in H2 this year. Moreover, are you starting to see any slowdown in the mortgage pipeline given higher mortgage rates, potentially reflecting customer caution?
William Chalmers, CFO
Thank you, Guy. To clarify on margin expectations, our guidance reflects a flat margin trajectory throughout the second half of 2022. The anticipated headwinds from mortgages are expected to grow through this period and will likely carry into 2023, making that year subject to some headwinds from the mortgages issued in previous years. Therefore, we might anticipate these effects persisting into 2023. However, as the mortgage pricing situation adjusts, we hope to see this mitigate somewhat over time. Regarding volumes and asset considerations, while we maintain cautious optimism about consumer lending growth, it is critical to assess the ongoing market movements. The environment remains dynamic, and we have noted signs of this shift in market behavior as rates increase, which would bear some impact, particularly in mortgage lending as borrowers reassess their positions. Overall, we see growth opportunities across multiple sectors, but we are monitoring market signals closely.
Operator, Operator
We have now reached the end of the allotted time for this call. If you have any further questions, please contact the Lloyds Banking Group investor relations team.
William Chalmers, CFO
Thank you for joining us this morning. I appreciate your questions and interest in our business.
Charlie Nunn, CEO
Thank you.
Operator, Operator
This concludes today's call. For those wishing to review this event, information for the replay is available on the Lloyds Banking Group website. Thank you for participating.