Hopes of lower bad debts and a bumper buyback may be premature

The last 20 years have certainly been eventful for Lloyds Banking (LLOY), a stock owned by a large number of retail investors thanks to a history of generous dividends.

From a sleepy high street also-ran it has grown through a series of mergers and acquisitions (M&A) into the largest UK-focused retail and commercial lender.

Given a relatively benign economic backdrop, analysts are predicting a significant recovery in profits in the coming 18 months and a large share repurchase programme.

Even so, we believe there are good reasons not to rush in and buy the shares just yet, particularly given the uncertainties over the outlook for a UK economy to which Lloyds’ fortunes are heavily wedded.


The current structure of Lloyds is the result of a decade of frenzied M&A in UK banking during the late 1990s and early 2000s.

In the five-year period leading up to the market peak in March 2000, Lloyds took over the Cheltenham & Gloucester building society, Trustee Savings Bank (TSB), Birmingham Midshires and life insurance group Scottish Widows.

At the same time, Halifax Building Society, one of the UK’s biggest mortgage lenders with more than 7m account holders, demutualised and went on an acquisition spree of its own, taking over the Leeds Permanent Building Society and life assurance company Clerical Medical.

In 2001 Halifax bought Bank of Scotland to create the ill-fated HBOS. This ‘new force’ in British banking set out to become the UK’s largest savings and mortgage provider.

However HBOS expanded so rapidly that by the time the financial crisis struck in 2008 the problems with its loan portfolio were so extensive that it had to be rescued. By acquiring HBOS, Lloyds instantly became the largest retail lender in the UK and today the group has over 25m retail customers.


As well as retail and commercial banking, which includes niche businesses such as agricultural mortgages (via AMC), credit cards (MBNA) and motor finance (Black Horse and Lex Autolease), Lloyds offers insurance and investments through Scottish Widows and its newly-formed Schroders Personal Wealth unit.

Retail banking in its various guises accounts for 36% of total revenue, commercial banking accounts for 28% and insurance and investments make up the remainder.

As of 31 March 2019, Lloyds had £441bn of loans and advances – a slight decrease on December 2018 – and £417bn of customer deposits, also slightly down on last December.

Its net interest margin – the difference between what it makes on lending money out and what it pays customers on their deposits – was just 2.9%, which shows how narrow the margins are on its core business.


Given that Lloyds has the most exposure of all the high street banks to UK consumer and business sentiment, which is holding up for now thanks to a 40-year low in unemployment, analysts are predicting that charges for bad loans should fall sharply this year and next year.

Combined with lower operating costs and lower charges for PPI mis-selling, they argue that pre-tax profit should rise considerably allowing the bank to buy back more than £4bn of shares, equivalent to 10% of its current market value.

Analysis by investment bank Investec – which rates Lloyds a ‘buy’ – contrasts the initial expectations of Lloyds’ bad loan charges for 2017 and 2018 just after the Brexit vote in 2016 with the actual outcomes.

Immediately following the vote, analysts were forecasting charges of £1.8bn for both 2017 and 2018. By mid-2017 those estimates had fallen to £1bn for 2017 and £1.6bn for 2018. The actual impairment charges were £795m for 2017 and £937m for 2018.

Looking ahead, Investec and others argue that the level of bad loans, currently just 0.25% of Lloyds’ total assets, should fall over the next two years rather than rise, allowing it to reduce the level of charges.

Could banks ultimately become redundant?

The most interesting recent development in finance has been the apparent ‘coming of age’ of crypto-currencies.

While Bitcoin accounts for over half of the estimated $285bn global ‘coin’ market and most of the column inches in the press, it’s the emergence of so-called ‘stablecoins’ backed by real-world assets and their potential to disrupt the mainstream of commerce and finance which is really significant.

There is no question that Facebook’s launch of Libra, which is backed by established payment providers including Mastercard, Paypal and Visa, is a genuine competitive threat to the current payment system dominated by the banks.

In time, if Facebook’s suppliers and its 2.7bn customers establish a trend for using crypto-currencies, the traditional role of banks could shrink much faster than anticipated.


Even if revenue is flat for the next two years, Lloyds’ cost of funding has fallen sharply while its operating cost-to-income ratio – which is already the lowest in the industry – is set to fall from 49% to the low 40s by 2020 according to the bank’s own forecasts.

Meanwhile payments for PPI mis-selling are falling ahead of the expiry date for claims this August, and analysts argue that the bank may not need to use the full £1bn worth of provisions left on its books.

In this scenario, as well as offering a prospective dividend yield of 5.9% rising to 6.3% in 2020, the bank would be so over-capitalised that it could afford to return £2.75bn this year and possibly £1.75bn next year through share buybacks.


In contrast to this rosy scenario, analysis by investment bank Jefferies – which also rates Lloyds as a ‘buy’ – shows that the size of its loan portfolio and the ratio of bad loans are the biggest factors driving the share buyback and valuation arguments.

Jefferies’ current base case, on which it believes the bank is worth 99p per share or 73% above today’s price, sees bad loans rising to 0.34% of total assets by 2021 while revenue grows very slightly and costs fall very slightly.

A slight positive tweak to bad loans, revenue and costs sees the valuation rise to 113p or 98% above today’s price.

However a slight downward tweak to revenues, an upward tweak to costs and a bad loan ratio of 0.53% of total assets sends the valuation down to 52p or 9% below today’s price.


It’s worth flagging that Lloyds’ core lending business is likely to be less profitable and more heavily regulated going forward.

The Bank of England has warned the banks that the current mortgage market is ‘dysfunctional’ and that it is watching their capital levels ‘like a hawk’. It is unhappy with the current high loan-to-value and loan-to-income ratios on new mortgages and is concerned that not enough capital has been put aside if values suddenly fall.

With the central bank pushing for lenders to have higher capital ratios when bad debts are low – and they are at historic lows right now – the hoped-for buyback of £4bn-plus shouldn’t be taken as a given in our view.

Meanwhile the RICS survey still paints a grim picture of the housing market with most chartered surveyors downbeat about the outlook for prices and transactions and analysts are starting to grow concerned that the new housing market may be weaker than they have forecast.

At the same time, the Government is giving the Competition and Markets Authority (CMA) new powers to fine banks which have overcharged customers on mortgages and insurance firms which have overcharged or misled customers. The CMA believes that up to 1m mortgage customers and 12m insurance customers may have been wrongly treated.

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