Earnings Call Transcript - NWG Q3 2022

Operator, Operator

Good morning, and welcome to the NatWest Group Q3 Results 2022 Management Presentation. Today's presentation will be hosted by CEO, Alison Rose; and CFO, Katie Murray. After the presentation, we will open up for questions. Alison, please go ahead.

Alison Rose, CEO

Good morning and thank you for joining us today. I'm here with Katie Murray, our CFO. And I'll start with the business update before Katie takes you through our financial performance, and we'll then open it up for questions. So let's start with the headlines on Slide 3. Against a volatile and challenging economic backdrop, we continue to demonstrate the strength and resilience of our business, delivering a strong financial performance while supporting our customers. Operating profit for the first nine months of the year was £4.1 billion, up 15% on the same period last year, and attributable profit was £2.1 billion. Our return on tangible equity was 10%, and we are reporting positive growth of 21% as a result of strong year-on-year income growth of 23% generated across our core customer franchises, along with cost growth of 1.8%. We maintain our cost reduction target of around 3% for the full year and are on track to deliver that. Our cost/income ratio for the nine months was 54%. We continue to lend responsibly and support our customers with strong net lending growth of 5.4% since the year-end to £372 billion. Our strong capital generation gives us confidence in our ability to continue delivering for all our stakeholders in challenging times. Our common equity Tier 1 ratio of 14.3% is approaching our 2022 target of around 14%, and we continue to return excess capital to shareholders. We have now paid or accrued £750 million towards our committed dividend distribution of at least £1 billion in 2022. And together with a special dividend of £1.75 billion announced at the half year and the directed buyback of £1.2 billion in March, this brings total distributions accrued or paid in the nine months to £3.7 billion. Clearly, the macroeconomic environment has become more uncertain since we spoke with you in July. Inflation, interest rates and energy costs have increased further amidst a heightened market volatility, while supply chain disruption continues. The outlook is now more challenging for our customers with a drop in business and consumer confidence, together with lower economic growth. In light of this, we have revised the combined weighting to our downside scenarios to 55% compared to 34% at the half year. As a result, we have taken an impairment charge of £242 million in the third quarter compared to a release of £39 million in the second. However, we are not revising our full year impairment guidance. While we believe our economic scenarios are conservative, it is important to note that we have not yet seen any material signs of stress from customers. We continue to grow our lending responsibly with disciplined risk management. We have remained open for business, deploying capital in the mortgage market whilst pricing appropriately. We have a well-diversified, high-quality loan book with limited exposure to areas such as unsecured personal lending, mortgages with a high loan-to-value and commercial real estate. We are on track to deliver our 2022 targets on cost and capital and have increased our income guidance for this year to around £12.8 billion, based on the current Bank of England interest rate of 2.25%. In this uncertain economic environment, our purpose-led strategy puts us in a position of strength. Our four strategic priorities remain as relevant as ever, and we continue to deliver against them to create and protect long-term value for all our stakeholders. Let me talk more about how we're supporting our customers on Slide 6. Though we are yet to see signs of customer stress in our credit metrics, we know that many people, families and businesses are worried about the pressures they face. And we are doing what we can to stand alongside them as they navigate through this economic uncertainty. Our strong balance sheet and capital generation enable us to lend a helping hand to those most in need. So we have created a £4 million hardship fund to support individuals and businesses through charities such as Citizens Advice and Money Advice Trust. This includes £2 million to fund a dedicated team at the Debt Charity Step Change, helping small businesses that are struggling to manage their finances. We are supporting mortgage customers who face higher financing costs by extending the refinancing window from four to six months. Some eligible customers who took advantage of this early window during the quarter saved around 2% on their next mortgage rate. We have also carried out around 600,000 free financial health checks in the first nine months this year via our app, whilst also helping people to understand and improve their credit rating. This month, we launched a benefits calculator, which enables customers to check their eligibility for state benefits and access income they may not have realized they were entitled to. And year-to-date, we have made over 8 million approaches to personal customers with information to help them manage the increased cost of living. For commercial customers, we are tailoring support to sectors that are most likely to be impacted. For example, we're helping 40,000 customers in agriculture, which has been hit by rising prices, especially in fertilizers. And this includes making available a £1.25 billion lending package for U.K. farmers with capital repayment holidays where appropriate. We have a well-established ecosystem for SMEs, providing them with sector specialists as well as business hubs around the U.K. In July, we froze SME current account fees for 12 months, and we continue to monitor our customers carefully to identify those that are having difficulties early on. We have also reduced transaction fees for micro businesses to help them weather the increased cost of living. We're also supporting our colleagues by making targeted pay rises for the lowest paid across the group as well as investing in learning and development programs and parental leave. So we are working with our customers, colleagues and communities to alleviate the worries of those who are most vulnerable. Let me turn now to how we are delivering our strategic priorities on Slide 7. Notwithstanding the near-term challenges, we continue to invest for the long term and grow across our core franchises by acquiring new customers and broadening our product offering to meet more of their needs. In doing so, we are diversifying our income by customer, by product and by generating more fees and commissions. We are also actively supporting our customers in their transition to a net zero economy. A good example of how we're investing for the future is the strategic partnership we recently announced with Vodeno, which aims to create a leading U.K. Banking as a Service business. This will enable other businesses to embed digital banking services such as payments, deposits, point-of-sale credit and merchant cash advances directly into their own propositions and customer journeys. Our new strategic partnership combines Vodeno's technological capabilities and cloud platform with banking technology developed in Metal, our digital bank for small businesses. This allows us to leverage our position as a leading supporter of U.K. businesses in order to meet the evolving needs of our corporate customers and expand our client base in a rapidly growing market. It also enables us to grow our fee income and diversify our revenue streams. As importantly, we will continue to lend responsibly and support our customers and, in turn, the wider U.K. economy. We're delivering a wider range of our products and services more effectively across our franchises. For example, by extending our asset management expertise to customers in retail as well as private banking, we have increased our affluent investment customer base and attracted new net inflows, which amount to £1.7 billion for the first nine months of 2022, of which 17% was via digital channels. And finally, on Slide 7, as the U.K.'s leading underwriter of green, social and sustainability bonds, we are well placed to help our customers transition to a net zero economy. Last year, we set a target of delivering £100 billion of climate and sustainable funding and financing by 2025. And we have contributed £26 billion towards that target to date. Slide 8 shows how our investment in digital transformation is continuing to improve the customer experience as well as increase our own productivity. 90% of retail customers and 84% of commercial customers now interact with us digitally. And we are making this easier and simpler as we continue investing to improve customer journeys. 72% of retail bank accounts and 96% of credit card applications are now opened with straight-through processing, and we're seeing this feed into continued improvement in customer satisfaction. For example, our retail NPS is now 20 compared to just four in 2019. Our affluent score has increased to 29 from minus two, and we have one of the leading scores in commercial banking at 22. In the current environment, a strong balance sheet, disciplined risk management and effective capital allocation are important differentiators. Our loan book is well balanced between personal and wholesale lending and well diversified by sector, and the level of defaults across the group remains low. Our personal lending book is largely secured, and 93% of our mortgage book is fixed. We have limited mortgages with a high loan to value. Those above 80% represent less than 3% of our book. Commercial real estate represents around 5% of our total loan book, and the average loan-to-value is 48%. Looking at liabilities, deposits remain elevated in both Personal and Commercial Banking, supporting our strong liquidity position. We continue to actively manage our liabilities, offering strong propositions for youth in digital savers and fixed term accounts for business customers. We're managing our capital allocation to maintain a strong balance sheet and our phased withdrawal from Ulster Bank Republic of Ireland, which we expect to be capital accretive is on track. We have binding agreements in place for 90% of the loan book, and deposits have reduced 42% since the year-end as customers move to other providers. Our strong capital generation gives us the ability to support our customers in difficult times as well as invest for growth, consider other strategic options that create value and return capital to shareholders. As I outlined earlier, capital distributions accrued for or paid in the nine months amount to £3.7 billion. And with that, I'll hand over to Katie to take you through our Q3 results.

Katie Murray, CFO

Thank you, Alison. I'll start with the performance of the Go-forward group in the third quarter using the second quarter as a comparator. We reported total income of £3.3 billion for the quarter, up 2.1% from the second. Excluding all notable items, income was £3.4 billion, up 10.7%. Within this, net interest income was up 14.3% at £2.6 billion, and noninterest income was broadly stable at £800 million. Operating expenses rose 5.3% to £1.8 billion. And we made a net impairment charge of £242 million compared to a release of £39 million in the second quarter. This reflects an increased weighting to our downside economic scenarios rather than any underlying deterioration in the book, which remains robust. Taking all of this together, we reported operating profits before tax of £1.2 billion for the quarter. Attributable profit to ordinary shareholders was £187 million, after the impact of losses in Ulster Bank associated with our withdrawal from the Republic of Ireland. And the return on tangible equity for the Go-forward group was 12.1%. I'll move on now to net interest income on Slide 12. We saw continued strong momentum in net interest income, which increased 14.3% to £2.6 billion as a result of strong lending and higher margins. Net interest margin increased by 27 basis points to 299 basis points, driven by wider deposit margins, which added 47 basis points. This reflects the benefit of higher U.K. base rates, which increased by a further 100 basis points in the quarter, and higher swap rates on our structural hedge, net of pass-through to customers. These increases were partly offset by lower mortgage margins on the front book, which reduced net interest margin by 7 basis points and by the mix effects in Commercial & Institutional, which decreased NIM by a further 8 basis points. Net interest margin of 273 basis points for the first nine months was supported by the faster-than-expected pace of interest rate rises. And at current interest rates, we now expect NIM to be above 280 basis points for the full year with strong momentum into 2023. I'll move on now to look at volumes on Slide 13. We are pleased to have delivered another quarter of balanced growth across the group. Gross loans to customers across our three franchises increased by £9.2 billion or 2.7% to £347 billion. Taking Retail Banking together with Private Banking, mortgage balances grew by £4.2 billion or 2.2%, with flow share of 13% and good retention. Unsecured balances increased by a further £200 million across credit cards and personal loans. In Commercial & Institutional, gross customer loans increased by £4.8 billion. Lending to large corporates and institutional customers was up £5.6 billion, driven by growth in working capital and supply chain finance as well as funds lending. This was partly offset by continued repayments on government lending schemes of £600 million. I'll turn now to look at deposits on Slide 14. Our robust deposit profile with a loan-to-deposit ratio of 76% has allowed us to support our customers through this period of market volatility, maintain our mortgage offering and provide lending across the economy. Customer deposits across our three franchises decreased by £7 billion or 1.5% in the quarter to £448 billion. This was driven by outflows of £8 billion across Commercial & Institutional, reflecting the withdrawal of short-term institutional inflows made in the second quarter, coupled with some seasonality. Across Retail Banking and Private Banking, deposits increased by £1 billion, a slower rate of growth than in prior quarters. We are not seeing any significant change in customer behavior in terms of switching balances between noninterest-bearing current accounts and savings. In retail, we saw some seasonal reductions in saving balances over the summer holidays, offset by higher current account balances. We have provided new disclosure on the split for deposits for commercial and institutional by customer segment to match our loan disclosure. You will also see on this slide the cumulative pass-through on our interest-bearing deposits by franchise, including customer rate changes effective on October 18. This equates to an average pass-through of 25% to 30% across interest-bearing deposits, which account for around 60% of total Go-forward group customer deposits. Our deposit pass-through decisions consider current and expected behavior across all our customer accounts. We continue to expect pass-through rates to increase with higher levels of interest rates. And our interest rate sensitivity disclosure provided at the half year, which incorporates a 50% pass-through, remains relevant. Turning now to our hedge, where we have an ongoing income tailwind into 2023 as maturing swaps are being reinvested at higher yields. As you know, we hedge the majority of our current accounts and a small portion of savings. So £205 billion of balances are included in the structural hedge. The notional increase by £1 billion during the quarter, reflecting growth in balances over the last year. And if deposits were to remain broadly flat from here, we would expect the hedge to increase a further £5 billion over the next three to six months. I'd like to turn now to noninterest income on Slide 15. Noninterest income, excluding notable items, was £800 million, stable on the second quarter. Within this, income from trading and other activities increased a further £28 million to £250 million, driven by higher foreign currency cash management and treasury. Fees and commissions decreased by £25 million to £550 million due to seasonal lower financing fees and to our no-fee foreign exchange offer for our retail customers through the summer. Turning now to costs on Slide 16. We have delivered strong operational leverage or positive jaws of 21% over the first nine months. Other operating expenses for the Go-forward group were £4.9 billion for the first nine months. That's up £87 million or 1.8% on the same period last year, reflecting higher strategic spend in areas such as financial crime and data. Along with strong income growth, this has contributed to a 10 percentage point improvement in the cost/income ratio to 54%. We continue to expect to reduce costs by around 3% for the full year. As we told you at the half year, we expect inflationary impacts on our cost base to be more significant next year, but inflation is now forecast to be higher than projections at the half year. So we no longer expect costs to be broadly stable year-on-year in 2023. As you would expect, given our strong track record, we remain committed to maintaining cost discipline and improving operating leverage. Turning now to credit risk on Slide 17. We have a well-diversified prime loan book. Over 50% of our Go-forward group lending consists of mortgages where the average loan-to-value is 53%. 64% of balances are on five-year fixed rates, 27% at two-year and just 9% are on variable rates, including SVR. Our personal unsecured credit exposure is less than 4% of group lending and is performing in line with expectations. On the wholesale side, we have derisked over the past decade to bring down concentration in single-name exposures. You can see this from the reduction in our RWA intensity, which is down 15 percentage points since the end of 2019. For example, our commercial real estate exposure represents less than 5% of group loans with an average LTV of 48%. Our corporate book is well diversified, and we have shown here selected exposures that we expect to be more vulnerable to cost of living pressures. So our strategy has delivered a well-diversified, high-quality loan book, which is not showing any significant signs of stress. However, we recognize the economic outlook has deteriorated. So let me tell you how we've addressed this on Slide 18. We will update our economic forecast at the end of the year, but you can see at the top of the slide that we have increased our weightings to the downside and extreme downside scenarios from 34% to 55%. This has driven a deterioration in our weighted average expectations for GDP growth and unemployment, the key drivers of expected loss sensitivity. You can find details in the appendix and the IMS. The net effect of these changes is £127 million increase in the good book expected credit loss provision, which was more than offset by the reclassification of Ulster mortgages to fair value. The post-model adjustment for economic uncertainty reduced slightly in the quarter to £545 million due to further releases of COVID-related adjustments. We continue to be cautious on the release of these provisions as we have yet to see the full impact of the economic challenges play out. We reported a net impairment charge for the group of £247 million in the third quarter, equivalent to an annualized 26 basis points of loans. While the economic outlook remains uncertain, we continue to expect the full year loan impairment charge to be under 10 basis points, given the current performance of the book. As you know, our through-the-cycle impairment guidance is 20 to 30 basis points. And as I sit here today, I see this as an appropriate level to think about for 2023. Turning now to look at capital and risk-weighted assets on Slide 19. We ended the third quarter with a common equity Tier 1 ratio of 14.3%, in line with the second quarter, as Go-forward group earnings were offset by Ulster exit costs as well as dividend and linked pension contributions. This includes IFRS 9 transitional relief of 19 basis points, up from 16 basis points at Q2. We generated 46 basis points of capital from Go-forward group earnings, net of changes to IFRS 9 transitional relief. This is partially offset by higher RWAs, which increased by £1.5 billion due to growth in lending balances and market volatility. Progress on our phased withdrawal from the Republic of Ireland consumed 9 basis points of capital in the quarter, as we incurred EUR 514 million of the EUR 900 million expected exit costs. This is net over EUR 2.8 billion reduction in RWAs due to the ongoing transfer of the corporate loan book to AIB. Turning now to our balance sheet strength on Slide 20. Our CET1 ratio of 14.3% is moving towards our target range of 13% to 14% as planned. Our U.K. leverage ratio of 5.2% is in line with Q2 and a 195 basis points above the Bank of England minimum requirement. We have maintained strong liquidity levels with a high-quality liquid asset pool and a stable diverse funding base. Our liquidity coverage ratio of 156% is down from Q2 due to growth in customer lending and dividend payments of £2.1 billion. Headroom above our minimum is £68 billion. We are pleased that Moody's has recognized our strong balance sheet by upgrading both NatWest Group plc and NatWest Markets by one notch. Turning to guidance on my final slide. As you heard from Alison, we have strengthened our income guidance for 2022. We now expect to deliver income, excluding notable items, of around £12.8 billion, with net interest margin of more than 280 basis points for the year. This assumes U.K. base rates remain at the current level of 2.25%, though we clearly expect U.K. base rates to increase further before the end of the year. Rather than predicting that increase, I suggest you look at our interest rate sensitivity disclosures to help understand the benefit this may bring in the final two months of the year. On costs, we expect to deliver a reduction of around 3% this year. And on loan impairments, we still expect to remain below 10 basis points for the full year given the current performance of our book, and we reaffirm our guidance on capital. As we look ahead to 2023, we are confident in our plan to deliver a return on tangible equity of 14% to 16%. However, we expect the makeup of these returns to change given the evolving macroeconomic outlook. Inflation is pushing up interest rates and, in turn, we expect both income and cost to be higher next year, together driving an improved cost/income ratio. And based on the current performance of the loan book, we expect impairments to be within our 20 to 30 basis points through-the-cycle average. And with that, I'll hand back to Alison.

Alison Rose, CEO

Thank you, Katie. So to conclude, against an uncertain economic backdrop, we are pleased to report another strong performance as we continue to focus on supporting our customers, communities and colleagues and delivering our strategic priorities. You have heard today how we're helping those most in need as well as investing to create sustainable growth for the long term, continuing our digital transformation to deliver product innovation and improve customer experience and higher productivity and deploying our capital carefully. With a strong balance sheet, well-diversified loan book and robust risk management, we continue to drive operating leverage in the business whilst managing the macroeconomic challenges. And we remain confident in our ability to deliver returns in the range of 14% to 16% next year. Katie and I will talk more about our outlook for 2023 and beyond at our results in February. Thank you very much, and we're now happy to take your questions.

Operator, Operator

Now our first question comes from Aman Rakkar of Barclays.

Aman Rakkar, Analyst

I have two questions, if I may. First, regarding costs in 2023, I noticed a shift from the previously stated flat cost guidance. Could you clarify what has changed since the guidance was issued a few months ago? It seems that the inflation backdrop hasn't significantly altered compared to the prior discussions. Your insights on what changed would be very helpful. Additionally, if you're not ready to provide a specific number for 2023, could you share the factors that could influence costs and offer a range or some details to narrow it down? This information is quite important given the current market reactions and ongoing discussions. My second question is about revenues. I've noted the £12.8 billion revenue projection for this year, which suggests Q4 revenues around $3.5 billion, translating to an annualized figure of £14 billion. While I understand you might be hesitant to provide exact figures for next year, do you see potential for that annualized revenue run rate to increase? I believe this largely pertains to net interest income. Do you anticipate that the Q4 annualized net interest run rate could grow in 2023?

Alison Rose, CEO

Great. Thank you. So let me take the revenue one, and the short answer to your question is yes. But a slightly more detail, I think, look, for the remainder of '22 and into '23, we will see the full year benefits from the previous rate rises flowing both through the hedge and the managed margin. So that is going to give us a significant tailwind into next year. And I think if you can see from our rate sensitivity disclosure, we're also going to benefit further from any further rate rises and that will also drive improvements in NIM. So I think a very positive and significant tailwind into next year on revenues. So hopefully, that gives you comfort on that. Katie, do you want to pick up the cost question?

Katie Murray, CFO

Yes, we acknowledge that costs have fluctuated throughout the year, similar to last year. I have a slightly different perspective. Since the first half of 2022, macroeconomic uncertainty has increased, leading to higher inflationary pressures. This is what we're experiencing operationally. While we anticipate further interest rate hikes, we no longer expect costs to remain broadly flat due to these inflationary pressures. It's important to note that cost management is a top priority for Alison, myself, and our executive team. We will continue to manage costs carefully as we have over the years, and we have a strong track record in this area. We expect to see positive jaws and an improved cost/income ratio in 2023. We will share more about our 2023 outlook for the business in February.

Aman Rakkar, Analyst

Can I just ask one small follow-up, which is sort of what inflation assumption are you making now around 2023?

Katie Murray, CFO

If you examine inflation, the assumptions we've applied in relation to IFRS 9 are likely your best reference. The Consumer Price Index for 2023 is 6.2%, with a 9% forecast for this year and a 6.2% weighted average. We will provide an update during the year-end review, but our approach to IFRS 9 has been thorough, ensuring that the economics are consistent across the entire income statement and balance sheet. This should serve as a good reference for now.

Operator, Operator

Our next question comes from Jonathan Pierce of Numis Securities.

Jonathan Pierce, Analyst

Sorry, I got to push you on this cost point again, if that's okay. I mean we've had, prior to today, two revisions to cost guidance this year. And it's understandable, inflation is obviously much higher than one would have thought, certainly early part of this year. But we're flying very blind now into 2023 with no guidance at all, and I really would encourage you to help us as much as you can on this. I mean maybe if you're not going to be any more precise on full year '23 versus '22 guidance, is it sensible for us, as you just alluded to, to look at the CPI on your weighted economic scenarios, which is now 6.2%? That was 3.9% at the interim, so call the delta 2.5%, maybe add a little bit on. Is that the sort of way we should be thinking about this if you were guiding to flat before? We should now maybe be thinking about up 3%, maybe up 4%. We just need, I think, any sense of scale because if it is up 3% or up 4%, your shares probably wouldn't have been down 9% this morning. So a bit of help with that would be useful. The second question on deposits. I mean you've encouraged us to look at the Go-forward deposit number ex central items where the repos are, which makes sense. And then most of the rest of the drop is in corporate and institutional at £5.5 billion in the quarter. Is that very low margin stuff? So the stuff that's really generating the deposit revenue in the retail bank, the SME, to some extent, commercial mid-market, deposits there are pretty stable. Is that the way to read the deposit numbers?

Alison Rose, CEO

Thanks, Jonathan. Yes, on the deposits, yes, that's the way I would read the deposits. In terms of on our commercial bank, the deposits that have fallen have really been a combination of just timing of year-end sort of and timing of the quarter end and some payroll. We're still seeing a lot of excess liquidity sitting in our SME and our commercial book, which are the valuable deposits, and deposits remain at high levels. So I think that's exactly how you should read the deposits. Katie, do you want to take the cost?

Katie Murray, CFO

Yes, I understand your question, Jonathan, but I won't be able to provide more detailed guidance on costs at this time. We have a solid history of managing our expenses and plan to keep enhancing our operating leverage by reinvesting our savings. Looking ahead to next year, we anticipate positive growth throughout 2023 and an improved cost-to-income ratio. Thank you, Jonathan.

Operator, Operator

Our next question comes from Benjamin Toms of RBC.

Benjamin Toms, Analyst

Firstly, thank you for the disclosure on the cumulative deposit betas. I think your weighted average cumulative deposit beta is about 27%. Do you have a feeling of how it will take this number to converge to 15%? And the FDA came out this quarter and said that they expect banks to clearly explain to them how they've decided on the pace at which banks pass on base rate increases to savers. Does this nudge change the trajectory of deposit beta progression from here, do you think? And then secondly, I guess you're not going to push any further on costs, but maybe you could give us a direction of the magnitude of any headcount reductions or direction of headcount reductions for next year. Louis told us this week that they're hiring about 1,000 people to help manage the cost of living crisis on NatWest Group doing something similar.

Alison Rose, CEO

Let me address a couple of those points, and Katie will provide additional insights. Regarding FTE reductions, we always communicate with our staff first about any changes, but we are not adding extra staff to manage cost of living. We've made significant investments in our digital transformation and our financial health support team to address issues related to defaults and distress. It's important to note that we're not experiencing any defaults or distress in our portfolio, and we've invested significantly in enhancing digital customer journeys, which allows us to assist customers in self-serving. We have sufficient capacity to handle any challenges. A prime example of our operational capacity can be seen during the recent volatility in the mortgage market, where we managed five times the usual volume without any issues. Therefore, we do not anticipate an increase in FTE as some other companies have indicated. Regarding deposits, as we mentioned, we will manage our deposits sensibly and competitively, focusing on how to assist our customers. We have implemented support measures and attractive deposit rates, such as our digital regular saver at 5% and youth accounts at 1%, along with favorable fixed-term deposit rates for our business clients. Overall, most customers are opting to remain liquid and keep their cash in transactional accounts. We will continue to manage this actively and competitively. Katie, do you want to add anything?

Katie Murray, CFO

I would like to mention the sensitivity regarding the 50% rate, which we believe is quite appropriate. In the most recent rate increase, we passed through about 40%. You're correct about your numbers, Benjamin. It's gradually increasing from its initial low rate, which is natural. We've consistently stated that as rates rise, we would expect to see more pass-through, and that’s what we are currently observing. I hope you found our analysis on interest-bearing and noninterest-bearing helpful. We put a lot of effort into understanding customer behavior and their reactions to rate increases. Alison has already discussed the rates available, and currently, we’re not seeing significant movement from customers in that regard, though we are actively monitoring for any signs of change. Thank you, Benjamin.

Operator, Operator

Our next question comes from Fahed Kunwar of Redburn.

Fahed Kunwar, Analyst

Just a couple. The first one is just on assumptions. I mean, from what we can see, the CPI hasn't changed that much in the cost guidance and that's clearly led to an increase in or a change in your cost guidance. On your loan loss guidance for 20 to 30 bps next year, how are you confident on that number? I mean, no one else has really given the '23 or proper '23 guidance is quite low. Given the small change in inflation leading to a cost change, why are you confident enough to give that 20 to 30 basis point guidance on loan losses given the uncertain environment we're in? That was question one. And the second question was just kind of following up on Aman's question earlier, actually. If I look at your exit NIM, obviously, it depends what greater than means. You're looking at like 315 to 325 basis points of 4Q. A, is that right? And secondly, does the NIM grow from that level, flat? Does it go down from that level? Just some color on how it progresses through 2023 would be incredibly helpful.

Alison Rose, CEO

I'll let Katie provide more details, but I want to highlight our impairments and outlook. It's important to note the structure of our portfolio; we maintain strong risk management practices. Our portfolio is well diversified and mostly secured, with less than 4% of our loans being unsecured. Most of our loans are fixed-rate mortgages, and commercial real estate accounts for less than 5% of the portfolio with a loan-to-value ratio of 48%. Our overall loan portfolio has a loan-to-value ratio of 53%, and we've actively managed our capital. So, we are well diversified, and we're assisting our customers proactively without seeing significant signs of stress. I think that gives you a good starting point regarding our portfolio. Katie, would you like to add some insights and take the next question?

Katie Murray, CFO

Yes, no, absolutely. So in terms of the assumptions, so we moved from slightly below 20 to 20 to 30 basis points. Well, what we've done is, obviously, we've updated our economics in terms of changing the weightings that we're applying to them. And then we spent a lot of time looking at the book and what we're seeing within there. What I would say and point you to is that we still hold significant PMAs, £545 million. There was a small release. That gives us some protection as we move into next year. But when we look at what we've seen in terms of how these books are performing, we look at what we think the economics could do. And now they could actively manifest themselves in terms of Stage 3 and also look at the sensitivities that we had at the half year. That is what got us comfortable in terms of that 20 to 30 basis points. Looking at the book, looking at what we know today, we felt that that was a good place to land. If I look at the NIM, obviously, 299 for the quarter, we're guiding you to over 280 for the year. So clearly, a further increase in NIM as we go into next year. And going to the last quarter, you need to take your own view of what the NPC might do next week. But looking at the market, I think we could all be comfortable there will be more rising rates. That's obviously going to be positive to that as we go through. And I think the other thing, obviously, to remember as part of the NIM is the importance of the structural hedge within there.

Operator, Operator

Our next question comes from Guy Stebbings of Exane.

Guy Stebbings, Analyst

If I could revisit costs once more. It seems reasonable not to expect a flat cost base next year given the inflationary environment and favorable rate trends. I believe most people, certainly the consensus, is anticipating significant positive operating leverage next year, not just 10% for us. Can I confirm we’re not discussing low single-digit positive operating leverage and something more substantial? Given the anticipated revenue growth, we’re seeing over 5% cost growth when nearly six months ago the guidance was a 3% reduction, and this level of change seems consistent with the inflationary environment. It might be useful to clarify that we’re not referring to low single digits today for the market. Additionally, on capital, I understand there are no changes to the headline targets, but considering the uncertain environment, would it make sense to aim for the upper end of the range to provide more of a buffer?

Alison Rose, CEO

Thank you, Guy. I believe you can anticipate very positive cost efficiencies next year as we concentrate on enhancing our operational effectiveness. For instance, we're recognizing ongoing improvements in areas such as digital adoption and our straight-through processing, as well as the advantages of our investments in digital and technology. Therefore, you can expect to see favorable cost efficiencies in the coming year. We view the current higher interest rates as beneficial, leading to more favorable conditions than challenges. This increases our confidence in our guidance of 14% to 16%. Additionally, there are no changes to our capital guidance; we remain committed to our target of 13% to 14%, focusing on maintaining a well-rounded and risk-managed business. We have ensured that our portfolio is secure, and we are lending responsibly within the economy. The returns from our investment program are yielding significant benefits, contributing to ongoing customer acquisition and improvement in customer satisfaction. I maintain my guidance confidently. Our risk diversification is solid, the portfolio is performing well, and we are proactively managing it, which we will continue to do moving forward.

Operator, Operator

Our question comes from Martin Leitgeb of Goldman Sachs.

Martin Leitgeb, Analyst

Could you provide more detail on the revenue outlook? I'm trying to grasp what it means if the market's suggested policy rate outlook is accurate, indicating we're moving towards a 4% rate environment. I appreciate your cautious guidance based on the current 2.25% rate. With your stated sensitivity to interest rates indicating a £275 million benefit in the first year from a 25 basis point increase, could you clarify how to interpret the potential net interest income figure for 2023 as we advance? The consensus seems to suggest total revenues around 13.9 and net interest income around 11, with much of the increase from 2022 to 2023 attributed to the hedge rollover, estimated at about £100 million annually for each 25 basis points increase, considering we've had around an eight-point-something hike so far. I'm curious about how conservative, if at all, this consensus might be. Additionally, regarding deposits, thank you for the new information on Slide 14 detailing the split between interest-bearing and noninterest-bearing deposits. Am I correct that the pass-throughs you've shown refer only to interest-bearing accounts? On a blended basis, it appears that pass-throughs are currently below 20%, with your future assumption for sensitivity being around 50% pass-through across the entire deposit base, suggesting nearly full pass-through for interest-bearing deposits.

Alison Rose, CEO

Thanks, Martin. I think I'll let Katie go into more detail. We continue to maintain a cautious outlook. The NPC is next week, and our assumptions are at 2.25. I want to emphasize that we believe the advantages we have heading into next year are stronger, and this should provide us with significant benefits. However, a lot of fiscal policies are set to be announced in the coming months, and we remain cautious in our assumptions. Katie, would you like to address the detailed question?

Katie Murray, CFO

Martin, I won't go into too much detail about your calculations, but let me share how I view the situation. Looking at the hedge, when we discussed it at H1, we noted a £600 million benefit compared to 2021 for the full year. That figure has now increased to £700 million due to improvements in the second half. As you know, the initial year of rate benefits from the hedge is lower, but it grows in subsequent years. In years two and three of your sensitivity analysis, the managed margin remains relatively stable, while the hedge increases by nearly £100 million each year. Considering the number of rate hikes we've experienced, you can form your own thoughts on that. Additionally, we have a volume benefit from the growth of the hedge and a margin benefit as well, both contributing positively to income moving into next year. I mentioned earlier that we're rolling off about 7 to 8 basis points during Q3, with an average addition around 305 basis points. In Q4, we anticipate slightly higher numbers. This growth more than compensates for any pressures we're feeling regarding mortgage margins, resulting in a strong tailwind for income in 2023. Regarding deposits, we've provided extra disclosures, and in the financial supplement, you can see how the commercial book has evolved over the last several quarters. So, yes, the pass-through applies to interest-bearing balances. Since 40% of our balances are non-interest-bearing, the pass-through we discuss only relates to those we do pay pass-through to. Our sensitivity assumes that 50% of any rate increase will be passed through. As rates rise, you'll notice the pass-through adjust, but the exact timing will depend on market activity. I hope this clarifies things a bit.

Operator, Operator

Our next question comes from the Fahed Kunwar of Redburn.

Fahed Kunwar, Analyst

Alison Rose, CEO

I'll have Katie provide the details, but I want to emphasize our impairments and outlook. It's important to note the structure of our portfolio; we maintain strong risk discipline. Our portfolio is well diversified, predominantly secured, with less than 4% of our loans being unsecured. The majority of our book consists of fixed-rate mortgages, and commercial real estate makes up less than 5% of our portfolio with a loan-to-value ratio of 48%. Our loan book has a fixed-rate component with a loan-to-value ratio of 53%, and we've engaged in active capital management. Overall, our portfolio remains well diversified, and we are actively assisting our customers without observing any significant signs of stress. I'll let Katie add more context and address the next question.

Katie Murray, CFO

Operator, Operator

Our next question comes from Guy Stebbings of Exane.

Guy Stebbings, Analyst

If I could revisit costs once more, it seems reasonable to assume you wouldn't want to maintain a flat cost base next year given the inflation and favorable rate trends. However, I believe most people are anticipating substantial positive operating jaws next year, not just 10% for us. Can I confirm that we’re discussing more significant positive operating jaws rather than low single digits? Considering the expected revenue growth, we are facing over 5% cost growth, and nearly six months ago, the guidance indicated a 3% reduction. This level of revision appears consistent despite the inflationary climate. It would be helpful to clarify that we aren't referring to low single-digit figures. Additionally, regarding capital, I understand there are no changes to the overall targets. However, in light of the uncertain environment, would it be fair to consider targeting the upper end of the range to provide a bit more cushion?

Alison Rose, CEO

Thanks, Guy. I believe you can expect very positive cost efficiencies next year. We are focused on enhancing operational efficiency in our business. For instance, we are seeing ongoing improvements in our digital adoption and straight-through processing, along with the advantages of our investments in technology. Therefore, you can look forward to positive cost efficiencies heading into next year. We view the higher interest rate environment as beneficial for us, with favorable factors outweighing the challenges. This gives us increasing confidence in our guidance of 14% to 16%. Regarding capital, our guidance remains unchanged. We are committed to our strategy of maintaining a well-diversified and well-managed business. Our portfolio is securely positioned, and we are lending responsibly within the economy. The results of our investment program are producing tangible benefits, and we continue to acquire customers while improving customer satisfaction scores. I'm confident in maintaining our guidance. Our risk diversification is solid, the portfolio is performing well, and we will remain proactive in our management moving forward.

Operator, Operator

Our question comes from Martin Leitgeb of Goldman Sachs.

Martin Leitgeb, Analyst

Could you provide more details about the revenue outlook? I'm trying to gauge the implications of the market’s anticipated policy rate, which seems to suggest we might be moving towards a 4% rate environment. I recognize your cautious guidance given the current 2.25% rate. With the disclosed sensitivity indicating a £275 million benefit in the first year from a 25 basis point increase, could you clarify how to interpret the potential NII figure for 2023 as we move forward? Current consensus suggests total revenues around 13.9 million and NII at about 11 million, with much of the increase from 2022 to 2023 attributed to the hedge rollover, estimated at around £100 million annually for a 25 basis point hike, and considering we've already seen an increase of about 8 basis points. I’m curious about how conservative the consensus projections are. Additionally, thank you for the new information on Slide 14 regarding the breakdown of your deposit base into interest-bearing and noninterest-bearing categories. I want to confirm that the pass-through rates you provided refer only to the interest-bearing deposits. It appears that pass-throughs so far are below 20%, and your forward-looking sensitivity indicates about 50% pass-through across the entire deposit base, suggesting near 100% pass-through for the interest-bearing portion.

Alison Rose, CEO

Thanks, Martin. So, I think I'll let Katie go into more detail. We are maintaining a cautious outlook moving forward. Clearly, the NPC is next week, and our assumptions are set at 2.25. I want to emphasize that we believe the advantages for us next year are substantial, which will be beneficial. However, there will be a lot of fiscal policies announced in the upcoming months, and we will continue to take a conservative approach in our assumptions. Katie, would you like to address the detailed question?

Katie Murray, CFO

Martin, I won’t delve into the specifics of your calculations, but I’d like to share my perspective. When we discussed the hedge earlier this year, we noted that it was providing a £600 million benefit compared to 2021 for the full year. Now, it has increased to a £700 million benefit as we’ve seen improvements in the second half. We know from the sensitivity you’re familiar with that the benefits from the hedge in the first year are lower, and they increase over time. For years two and three, the managed margin remains fairly steady, while the hedge grows by nearly another £100 million each year. Considering the number of rate increases we’ve had, this is important to think about. Additionally, there’s a benefit in volume as the hedge has expanded, bringing in further margin advantages. Both factors positively contribute to our income as we head into next year. Earlier, I mentioned it’s rolling off about 7 to 8 basis points during Q3, and we initiated it at an average of approximately 305 basis points. Clearly, the rate in early October was slightly higher. This benefit more than offsets any pressure on the mortgage margin, providing a strong boost to our income for 2023. Regarding the deposits, we’ve included additional information, and when you have a chance, you’ll see the shape of the commercial book over recent quarters. It shows how it has evolved. You are indeed correct that the pass-through is associated with the interest-bearing balances, and 40% of our balances are noninterest-bearing. So, when we talk about pass-through, it pertains to those we are compensating, not those we are not. Our sensitivity assumes 50% of any rate rise being passed through. We have always indicated that as rates increase slightly, you will see the pass-through adjust. The exact timing will depend on market activity as well. I hope this clarifies things for you.

Operator, Operator

Our next question comes from Omar Keenan of Credit Suisse.

Omar Keenan, Analyst

I just had three questions, if I may, actually. So firstly, I just wanted to ask about deposits. I appreciate your comments on deposit migration being limited. I was hoping perhaps you could give us some idea of how deposits are changing in October? Are balances growing again after the seasonality points that you made on the third quarter? And are you seeing any changes right now in terms of terms and mix? And if not, do you have an idea as to what level of interest rates might start to induce changing behaviors? So that was my first question. My second question was just on the structural hedge. Could you just give us maybe just a bit of elaboration on what buffers you have on modeled deposits? And then just lastly on RWA rating migration. I was just wondering if you could perhaps give us a sensitivity on RWAs if house prices were to fall by 10%? And also maybe just give us some help with how to think about rating migration in the corporate book.

Alison Rose, CEO

Thank you. Regarding deposits, we are not observing any significant changes. There has been a slight reversal of commercial outflows in Q3, but overall, deposits remain stable. I previously mentioned the £300 billion in inflated deposits across the economy. Currently, we haven't seen a depletion or significant shift of deposits from non-interest to interest-bearing accounts. People appear to prefer maintaining transactional and liquid accounts. It’s not just about a specific interest rate that would trigger a change in behavior. Interestingly, while retail depositors are utilizing their savings accounts for expenses like vacations, their transactional balances have actually increased. During our financial health assessments with customers, we’ve seen individuals using their funds to reduce credit card debt, despite our minimal unsecured lending. As the cost of living continues to rise with inflation, it's likely that individuals will rely on their transactional accounts to manage expenses. However, we're not registering notable increases in debit or credit card spending, indicating that the situation is more complex than simply interest rates. We will continue to monitor these behavioral trends. Katie, would you like to address the other points?

Katie Murray, CFO

I'll address the structure hedge in the RWA. Omar, if I misunderstood your structural hedge questions, please feel free to correct me. Regarding that, we don't disclose the buffer details, including the exact amount we hold back, but we do adopt a conservative approach toward the eligible balances we hedge. We hedge based on a 12-month rolling average to ensure there is no exposure to short-term fluctuations in balances. Things have started to shift, but I am confident this won't pose a problem. Additionally, it's worth noting that the product hedge amounts to approximately £35 billion to £40 billion per year. If adjustments are needed due to customer behavior, we can implement them easily. This aspect doesn't concern me. On the topic of RWAs, house price movements are significant. Our loan-to-value ratio is 54%, allowing us to withstand a 10% change in the security for that portfolio, while the new business averages a 69% loan-to-value ratio. We are comfortable within that range. Procyclicality in RWAs appears when we see actual defaults. Although house prices might fluctuate, it doesn't necessarily lead to immediate defaults, as mortgages have fixed two- or five-year rates. Thus, while house price movements can cause some worries, they don't significantly impact cash flow. We need to observe that cyclicality. Over the past few quarters, we have experienced positive procyclicality, which was evident again this quarter with figures of 0.7 overall, 0.1 from retail, and 0.6 from C&I. Also, remember that we anticipate a further reduction in RWAs this year for UBIDAC, hoping to see about €4 billion decrease in the quarter. However, lending activities and market volatility could influence that figure in the opposite direction.

Operator, Operator

And our last question comes from Omar Keenan of Credit Suisse.

Omar Keenan, Analyst

I just had three questions, if I may, actually. So firstly, I just wanted to ask about deposits. I appreciate your comments on deposit migration being limited. I was hoping perhaps you could give us some idea of how deposits are changing in October? Are balances growing again after the seasonality points that you made on the third quarter? And are you seeing any changes right now in terms of terms and mix? And if not, do you have an idea as to what level of interest rates might start to induce changing behaviors? So that was my first question. My second question was just on the structural hedge. Could you just give us maybe just a bit of elaboration on what buffers you have on modeled deposits? And then just lastly on RWA rating migration. I was just wondering if you could perhaps give us a sensitivity on RWAs if house prices were to fall by 10%. And also maybe just give us some help with how to think about rating migration in the corporate book.

Alison Rose, CEO

Thank you. On deposits, we haven't seen any significant changes. There was a slight reversal of commercial outflows in Q3, but overall, deposits have remained stable. I've mentioned before that there are inflated deposits, estimated at around £300 billion across the economy. We have not yet observed any substantial cash burn, a decline in deposits, or a notable shift from non-interest to interest-bearing deposits. Currently, people seem to prefer keeping their accounts transactional and liquid. I believe it isn't straightforward to claim there's a specific interest rate that would drive a change in behavior. It's notable how retail deposits are being utilized; for instance, people are using their savings accounts for expenses like holidays, while their transactional balances have increased. During our financial health checks with customers, we've noticed that individuals are using their funds to pay down credit card debt, despite holding a relatively small amount of unsecured debt. As the cost of living continues to rise due to higher expenses and inflation, people might start using their transactional accounts more to manage these costs. However, we haven't seen significant increases in debit or credit card spending, indicating that the relationship isn't solely driven by interest rates. We'll continue to monitor these behavioral trends. Katie, would you like to address the other questions?

Katie Murray, CFO

I'll address the structural hedge in the risk-weighted assets. Omar, if I misunderstood your questions about the structural hedge, please jump back in. Regarding that, we don't disclose the exact amount we retain, but we adopt a conservative approach to the eligible balances we hedge. We hedge a portion based on a 12-month rolling average to minimize exposure to short-term balance fluctuations. While things are changing, I feel confident it won't pose a problem. It's also important to note that the product hedge encompasses around £35 billion to £40 billion annually, so we can easily adjust if customer behavior shifts. I don't have concerns on that front. Considering RWAs, house price fluctuations are significant; our portfolio has a loan-to-value ratio of 54%, allowing us to absorb a 10% change in the security of that portfolio, while even new business averages a 69% loan-to-value ratio. Thus, we are fairly comfortable within that range. We start to observe procyclicality in RWAs when actual defaults occur. House prices may change, but that doesn't directly lead to defaults since mortgages are locked in at agreed two- or five-year rates. Thus, while fluctuations may cause concern, they don't substantially impact cash flow. We are looking for procyclicality to emerge. Over the past several quarters, we've experienced positive procyclicality, including this quarter with increases of 0.7 overall, 0.1 from retail, and 0.6 in commercial and industrial. Regarding RWAs, we anticipate a further reduction this year for UBIDAC, aiming for about €4 billion decrease in the quarter. However, lending activities and market volatility may also influence those figures in the opposite direction.