Lloyds banking group (NYSE: LYG) will face further headwinds from weaker economic growth and inflationary pressures following the Russian invasion of Ukraine. The bank posted an impressive turnaround in earnings last year, but earnings momentum could falter due to rising borrowing costs and the prospect of lower interest rates over the medium term.
Supported by a faster-than-expected recovery in the UK economy, Lloyds’ annual profits more than quadrupled to £5.9bn (~$7.7bn). Its return on tangible equity (RoTE), a key measure of profitability, reached 13.8%, its highest level in more than a decade.
The release of £1.7 billion (~$2.2 billion) that had previously been set aside as loan loss provisions was by far the significant factor in the rebound in profitability. And that has only been made possible by the improvement in the UK’s macroeconomic outlook over the past year, which has reduced the likelihood of borrowers defaulting on their loans. The underlying impairment credit for the year was £1.2 billion (~$1.6 billion), compared to a charge of £4.2 billion recorded in 2020 (~$5.5 billion of dollars).
Nonetheless, higher-than-expected remediation costs for compliance failures caused Lloyds to miss analysts’ earnings expectations. The group reported an additional charge of £1.3 billion (~$1.7 billion) relating to historic fraud at its HBOS Reading branch, previous home insurance renewals and other legacy issues.
Medium term targets
Following strong results, new management guidelines for its medium-term profitability have been published – RoTE is now expected to be above 10% from 2024, and exceed 12% by 2026.
In addition, it plans to provide the following:
Generate incremental revenue from strategic initiatives of approximately £0.7 billion (~$0.9 billion) by 2024 and more than double to approximately £1.5 billion (~$2 .0 billion) by 2026
Stable business as usual costs in 2024 compared to 2021, with a cost/revenue ratio below 50% by 2026
Asset quality ratio below 30 basis points between 2022 and 2024
Capital generation of approximately 150 basis points per year from 2022 to 2024, increasing to 175 to 200 basis points by 2026.
The bank also gave guidelines for the current financial year. For 2022, the bank plans:
The net bank interest margin will be above 260 basis points
Operating costs of approximately £8.8 billion (~$11.5 billion) on the new base, with an increase from the 2021 equivalent of £8.3 billion (~$10 $.9 billion)
Asset quality ratio around 20 basis points
RoTE of about 10%
Risk-weighted assets at the end of 2022 would be around £210 billion (~$275 billion)
Real household income
The British lender may find it more difficult to achieve these goals following the Russian invasion of Ukraine. Soaring commodity prices, in a context of supply problems for the main industrial and agricultural products, have clouded the prospects for a recovery in the British economy.
The recent decline in long-term sterling-denominated bond yields and the flattening of the yield curve suggest that the likelihood of a recession is now significantly higher. Even if a recession did not materialize, Lloyds would be impacted by a slower pace of central bank rate hikes and longer for longer interest rates.
Indeed, as real household incomes in the UK will be squeezed by the impending supply shock, loan demand and affordability would be affected. Analysts expect household energy bills to hit over £3,000 (~$3,900) a year from October this year, up from around £1,200 (~$1,600) currently . Additionally, inflationary pressures from food prices, transportation costs, and other industrial products would affect nearly every other category of consumer spending.
At the same time, planned tax increases are also expected to weigh – with the 1.25 percentage point increase in contributions to National Insurance, the UK’s social security scheme, due to come into force on April 6, 2022.
These pressures will likely weigh on expectations for economic growth, unemployment rates and house price growth; and in turn, this would impact loan demand, fee income growth and credit quality.
Interest rate tailwinds
As things stand, it is still possible for Lloyds to meet its mid-term RoTE targets. The rising interest rate environment will remain a very significant tailwind, although expectations have recently been downgraded.
The structure of the balance sheet and the low pass-through of rate increases to depositors make Lloyds particularly sensitive to changes in interest rates. A parallel upward shift of 50 basis points in the yield curve is expected to add approximately £375m (~$490m) to net interest income in the first full year. Cumulative profit would increase to around £800 million (~$1.0 billion) after three years.
Estimated cumulative impact on net interest income of parallel shifts in the yield curve (in millions of pounds sterling)
|Year 1||Year 2||Year 3|
|+25 basis points||200||275||400|
Source: Lloyds Banking Group 2021 results presentation
Management’s interest rate outlook appears cautious. Its base economic scenario puts the Bank of England’s base rate at 1.0% by the end of the year, suggesting a 75 basis point hike in 2022. That would equate to three rate hikes in a quarter of a percentage point (another two after the February quarter-point increase) – lower than many analysts and futures markets expect.
Currently, a total of four quarter-point rate hikes are scheduled for 2022, up from five to six in February. This should be enough to offset a slight increase in credit costs and a slight slowdown in revenue growth. Of course, all of this could change if the risk of recession continues to rise.
It would be harder to hit its 2022 guidance, however, as the benefits of higher interest rates take some time to fully trickle down to its bottom line. It is therefore more costly for the bank to meet its asset quality ratio target of around 20 basis points over the year, in order to meet its shorter-term RoTE target of 10%. And that would be really difficult in a deteriorating macroeconomic environment.
Meeting investor expectations would then be even more difficult. Currently, consensus earnings forecasts in 2022 and 2023 imply that the bank should generate a RoTE above 11% in each of the next two years. Achieving this higher level of profitability objective seems to be conditional on the cost of risk remaining historically very low, or even necessitating new write-backs of provisions.
Further downward revisions to earnings estimates are likely yet to come.
Helping to secure medium-term growth is also Lloyds’ ambitious plan to generate new revenue streams. The strategy is to extend its wealth management offering to the affluent masses, broaden its financing proposition to attract larger corporate clients and grow Citra Living, its private home rental business.
Management expects the proposed strategic initiatives to add almost 10% to its annual revenue by 2026. But unlike the benefit of higher interest rates, this additional revenue will not unequivocally translate on its net income, due to higher operating expenses and the investment costs necessary for the growth of these new businesses.
Yet with limited growth prospects in the core retail lending business, the bank is keen to grow its generation of excess capital, rather than simply return more capital to shareholders. New sources of income would also increase diversification and increase its share of income from fees and commissions, thereby reducing its sensitivity to interest rates.
The bank certainly has the ecosystem and customer relationships it can leverage to expand its offering, which could give it a competitive edge over its existing rivals.
That said, the execution risks are high. The group has long struggled to find new sources of growth. That’s why, after failed forays into investment banking and international expansion before the 2007/8 financial crisis, the bank pulled out to focus on its core UK retail banking operations. , an area where it has been an undisputed market leader.
Lloyds’ recent joint venture with Schroders in the financial planning and wealth management market still has a lot to prove. It attracted just £0.3 billion (~$0.4 billion) in net new business in 2021, roughly equivalent to its net outflows the previous year.
Lloyds Banking Group’s earnings outlook looks much less rosy than it did a few weeks ago. As a retail lender, its fortunes cannot be divorced from the pressures facing its customers or the broader macroeconomic environment.
Although interest rate tailwinds should still be a major driver of a recovery in pre-provision profitability, for now it appears that the risks are tilted to the downside.