Lloyds Banking Group - Q2 2023

Transcript

Operator (participant)

Thank you for standing by, welcome to the Lloyds Banking Group 2023 half year results call. At this time, all participants are in a listen only mode. There will be presentations from Charlie Nunn and William Chalmers, followed by a question and answer session. If you wish to ask a question, you will need to press star one on your telephone. 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)

Thank you, good morning, everyone, and thank you for joining our 2023 half-year results presentation. Another dynamic, media morning for us to do our results. I'll begin with a short overview of the Group's financial and strategic performance. I'll also highlight some of the actions that we're taking to support customers, given the ongoing changes in the macroeconomic environment. William will then provide the usual detail on our financials, and following a brief summary, we'll take your questions. Let me begin on slide three. The external environment continues to change significantly, with persistently high inflation and higher than anticipated interest rates. Against this backdrop, I'd like to take away four key points from the presentation today. Firstly, uncertainty for our customers has increased given the changes in the external environment.

To this end, we've once again stepped up our support for customers, especially for those most in need. I'll discuss specific actions we'll be taking shortly. Secondly, in line with our guidance, our Q2 profits and net interest margin have stepped down versus our first quarter. This is due to the continued low margins on mortgages, as well as passing on more to our savings customers. However, the Group is performing well, and our financial performance remains robust. As you'll hear later in the presentation, we've either reconfirmed or slightly enhanced our guidance for 2023. Thirdly, we're making good progress on delivering our strategy. We remain on track to deliver the strategic benefits we laid out in February of last year for both 2024 and 2026. This is despite a more challenging environment, and as a result, slower growth in AIEAs.

Our performance in other income in the first half showed positive business momentum and is an example of the progress we're making. Finally, as we look ahead, our capital position and financial strength, together with our prudent approach to risk, positions us well. Regardless of future uncertainties, we are well-placed to support our customers, safeguard deposits, support the U.K. economy, and continue to deliver for our shareholders. On slide four, I'd now like to highlight how we've delivered for our customers and other stakeholders in the first half. We're playing our part to provide proactive and targeted support to customers through a period of increased uncertainty, while ensuring we provide good and fair outcomes for all. Increasing mortgage rates are a notable area where customers across the industry are experiencing challenges. To mitigate this, we've proactively contacted over 200,000 customers, most affected, to offer additional support.

We've also committed to the government's mortgage charter and offer product transfers for all residential mortgage customers, even if they're in arrears. We're also keen to ensure that our deposit customers benefit from rising rates with a range of attractive savings options. We've used our significant reach to proactively encourage 10 million customers to review their savings rates through prompts within our mobile app, contributing to 1.9 million new savings accounts being opened in the first half of 2023. Our proactive support also extends to businesses, providing more than 550,000 customers with guidance on how to build their financial resilience. It should be noted that we continue to see significant resilience across our portfolio, with customers adapting to the environment. We deem these actions appropriate, prudent, and aligned to our purpose of helping Britain prosper.

We also remain highly focused on our broader stakeholder objectives, such as building an inclusive society and supporting the transition to a low carbon economy. For example, in the first half of the year, we announced a new goal to double the representation of colleagues in senior roles with a disability by 2025, and we continue to make great strides on our green financing initiatives. Our continued support for customers and other stakeholders is made possible by our robust financial performance. On slide five, I'll provide a brief overview of the trends that influenced our second quarter results. The Group is performing in line with expectations. We reported a net interest margin of 314 basis points in the second quarter, consistent with guidance provided earlier in the year, given expected headwinds.

Customer deposits of GBP 470 billion reflect a resilient performance in a competitive market and amid the continued shift in mix across the industry. Our second quarter return on tangible equity of 13.6% was lower than Q1, as expected, but demonstrates that the group is performing well and provides us with confidence for the full year. As a result of this confidence, we've today announced an interim ordinary dividend that is 15% up on the first half of last year and represents an attractive return for shareholders. William will provide more information on how we expect financial performance to develop over the second half of the year, including our enhanced 2023 guidance. I'll now briefly discuss our strategic progress, starting with slide six.

We're now in the second year of our five-year strategic transformation and halfway towards our first strategic milestones at the end of 2024. You'll recall that at the full year, I highlighted that in 2022, we prioritized reorganizing the Group and laying the foundations for our strategic success. Having achieved this, we're now building momentum across our strategic initiatives. This is supported by continued investment, with a further GBP 0.6 billion invested in the first half of the year, bringing the total to GBP 1.4 billion of additional strategic investments to date. I'm pleased to say that we are on track to deliver against our 2024 strategic outcomes, and in some cases, have already surpassed these. This is translating into financial benefits, which will grow more meaningful in future periods.

We're on course to deliver the circa GBP 0.7 billion of additional revenues from strategic initiatives by 2024, as well as the GBP 1.2 billion of gross cost savings, a target that we increased at full year. On slide seven, I'll highlight some examples of the strategic priorities we've delivered in the first half. Our strategic pillars are focused on driving revenue growth and diversification, strengthening cost and capital efficiency, and maximizing the potential of our people, technology and data. We're making good progress across our priority growth areas. This includes further increasing our unrivaled level of digital engagement. We're now operating with 20.6 million digitally active customers, surpassing our original target of greater than 20 million by the end of 2024.

We've also made good progress in developing our mass affluent offering in the first half, including the rollout of ready-made investments and tiered savings proposition. We're attracting new customers and increasing balances, we expect to build great momentum as we develop the offering further. Our enablers are critical to both our execution efforts and ensuring that we deliver a more cost-efficient and less capital-intensive business. We've now reduced our office footprint by around one-fifth since the start of the plan. Actions such as these have supported the delivery of approximately 50% of our 2024 gross cost savings target to date. Finally, we're increasing the number of new hires in both technology and data as we continue to improve our ways of working to better unlock the potential of our people. Turning now to future delivery on slide eight.

Our progress to date increases our confidence in successfully executing our strategic transformation. In addition to our achievements in the first half, we have a clear pipeline of deliverables for the rest of 2023. This includes launching a new dedicated offering to support our mass affluent ambition, as well as investing further in our markets capabilities to improve our competitiveness, support more client needs, and deliver other income growth. Alongside customer focus developments, our disciplined approach to cost and capital efficiency will remain unchanged. We'll continue to progressively modernize our technology and data capabilities. I'll now end by opening remarks on slide nine, with a look ahead to future updates. As a reminder, it is our intention to provide you with a series of deep dive seminars over the coming 12 months, focused on four priority growth areas.

They'll provide you with an opportunity to hear more from the respective management teams and to spend more time focusing on our progress to date and our vision for the future. We're really excited about sharing our ambitions with you. Hope that you'll join these sessions, starting in October with a look at our consumer franchise. Thanks for listening. I'll now hand over to William for the financials.

William Chalmers (CFO)

Thank you, Charlie. Good morning, everyone, and thanks again for joining. Let me start with an overview of the financials on slide 11. As you heard from Charlie, the business delivered a robust financial performance in H1 and in Q2. Statutory profit after tax of GBP 2.9 billion is up 17% from the prior year. Return on tangible equity was 16.6%. Net income is up 11% year-on-year, supported by a margin of 318 basis points and growth in other income. Total costs, including remediation, of GBP 4.5 billion, are up 5% year-on-year, in line with expectations. Asset quality is resilient. The impairment charge of GBP 662 million equates to an asset quality ratio of 29 basis points.

Tangible net assets per share were GBP 0.457, down slightly in H1, given the sharp movement in rates in Q2. Capital generation of 111 basis points was strong and supported our increased interim dividend. With that, I'll turn to slide 12 to look at the customer franchise. The customer franchise continues to be resilient. Total lending balances stand at GBP 451 billion, down slightly in the second quarter. Retail balances were essentially flat in the quarter, as a small reduction in mortgages was largely offset by continued growth in cards, motor finance, and loans. Commercial banking balances were down GBP 1 billion in the quarter, continuing to see net repayments significantly relating to government-guaranteed loans. Total deposits stand at GBP 470 billion.

Performance was resilient, with retail essentially flat in the second quarter and commercial down GBP 2.9 billion, the latter driven by expected short-term placements flagged at Q1. We continue to see steady growth in insurance, with around GBP 1.4 billion of net new money in the quarter. Turning now to net interest income on slide 13. Net interest income performance was strong in H1. NII of GBP 7 billion in the first half is up 14% year-on-year, although stable on H2 last year. Average interest earning assets are down slightly in the quarter. Small reductions in the mortgage book and commercial banking were partly offset by growth in the other lending portfolios. Net interest margin of 318 basis points in the half, includes 314 basis points in the second quarter.

This fell eight basis points from Q1, given the mortgage and deposit pricing headwinds that we called out at that time. Having said that, base rate changes were stronger than we expected then, implying the step down in margin was a little less. Looking forward, we expect AIEAs for 2023 as a whole, to be slightly lower than Q4 2022, as the unsecured growth is offset by lower mortgage balances and repayment of government guaranteed loans. We now expect the margin for 2023 to be greater than 310 basis points. We're forecasting a peak base rate of 5.5%, significantly ahead of our previous expectations. This will support the margin through H2, in particular, driving stronger hedge income. Going the other way, mortgage margin pressures and deposit mix shift are both expected to continue in the second half.

Non-bank NII was about GBP 80 billion in Q2. This is driven by volumes within our non-banking businesses as well as rates. Given the increase in rates in Q2 and increasing levels of activity, we expect non-banking NII funding costs to increase slightly from here, and the run rate to be slightly higher, therefore, in the second half. Moving on to the mortgage portfolio on slide 14. The mortgage book is resilient and now stands at GBP 306 billion. The open book is down GBP 1.7 billion in H1, partly due to the legacy portfolio sale in the first quarter. The bank book continues to run down and is now around GBP 39 billion. Customers continue to refinance their mortgages given higher rates. Indeed, we are actively supporting them in doing so. Mortgage pricing remains competitive.

Front book maturities rolled off at about 180 basis points in Q2, while completion margins remain at around 50 basis points. Of course, that will depend upon swap rate volatility and indeed, margins in other parts of the balance sheet. That said, mortgage lending remains attractive from a returns and economic value perspective. Let me now look at the other lending books on Slide 15. Consumer balances are performing well. Balances are up GBP 1.8 billion in the half, including GBP 1 billion in Q2. We continue to see credit card spend recovering, although repayments are still somewhat dampening interest bearing balance growth. Motor finance is up GBP 0.6 billion in the half, as industry supply issues continue to ease.

Within commercial, corporate institutional is up GBP 0.6 billion, including client growth alongside FX impacts. As said previously, government backed borrowing repayments, alongside limited customer demand, are impacting the net SMB performance. We expect this to continue. Now moving on to deposits on slide 16. Deposit performance in the half has been solid. Total customer deposits of GBP 470 billion are down 1.2% in the half, or GBP 5.5 billion. Retail deposits were down GBP 4.9 billion in H1, and essentially flat in Q2, with current accounts down and savings up. The retail current account reduction in Q2 was a smaller movement than we saw in Q1. This reflects inflationary spend pressures offset by wage increases and transfers into savings as customer behaviors evolve.

We estimate around GBP 4 billion of current account outflows, or around 2/3, have been retained within our savings proposition. Supported by this retention activity, alongside new money, retail savings balances were up GBP 3.1 billion in H1. Commercial deposits were flat across the half, albeit decreasing GBP 2.9 billion in Q2. Notably, while this reflected expected outflows of some short-term placements from Q1, business banking current accounts were much more stable in Q2. Recognizing that it's a fast changing environment, we continue to expect total deposits to be broadly stable from here through the second half of 2023. Having said that, the mix shift to term savings is likely to continue. As you know, the performance of our deposit franchise supports the structural hedge. I'll now look at this further on slide 17. Our structural hedge remains a significant tailwind to earnings.

Today, the structural hedge capacity remains around GBP 255 billion. The notional balance is fully invested. As you know, we manage the hedge prudently and maintain a buffer of hedgeable balances outside of the approved capacity. Given the deposit movements highlighted, this buffer has reduced. Accordingly, assuming deposit movements continue into H2, we expect a modest reduction in the hedge notional balance. This will be managed out of upcoming maturities. That said, the circa 1 percentage point movement in the curve over the last quarter means the expected income effects of this are negligible. The hedge will continue to provide a very material and a consistent income tailwind looking forward. In H1, we saw gross hedge income of GBP 1.6 billion, an earnings rate of around 1.2%.

Looking forward, we expect hedge income will be around GBP 0.8 billion higher in 2023 than 2022, with a similar increase again in 2024. Moving to other income on slide 18. We continue to build confidence in our growth potential in other income across the franchise. Other income of GBP 2.5 billion in the first half includes GBP 1.3 billion in the second quarter. Retail is seeing improved current account and credit card performance, alongside a growing contribution from motor finance. Commercial other income benefited in the first half from improved performance in markets and a successful bond franchise. Insurance, pensions, and investments saw improved performance in life and pensions, general insurance, and stockbroking, together driving higher income in H1.

The operating lease depreciation charge of GBP 356 million in the half included GBP 216 million in the second quarter. After two years of low charges during the pandemic, it is now normalizing. It picked up in Q2 as a result of higher value new vehicles and lower gains on sale, growth from the Tusker acquisition, and an adjustment to take account of recent price declines in electric vehicles. As we look forward, we expect operating lease depreciation to be broadly stable at the Q2 level through the rest of 2023, with EV prices steadying but offset by growth in business volumes and normalizing car prices. Overall, we expect other income to continue to develop, supported by our ongoing franchise investments. This is, of course, dependent on activity levels, but the underlying business trends are favorable.

Moving on, let me focus on costs on slide 19. Cost management remains very close to our hearts. Operating costs of GBP 4.4 billion for the half are up 6%, given our planned strategic investments, the costs associated with our new businesses, and inflation. This gives us a cost income ratio of 48.8%. In the context of persistent inflationary pressures, we remain focused. We are on track to deliver operating costs of circa GBP 9.1 billion in 2023. Remediation remains low, just GBP 70 million in H1 and GBP 51 million in Q2. Looking now at impairment on slide 20. Observed asset quality is resilient. This reflects our prime customer base and our prudent approach to risk. GBP 662 million charge in the first half is equivalent to an asset quality ratio of 29 basis points, in line with our guidance.

First half includes a small charge of GBP 5 million in respect of updated macroeconomic scenarios, alongside the GBP 657 million underlying charge. GBP 419 million in the second quarter includes GBP 84 million for updated economics. Excluding this, the pre-MES quarterly charge of GBP 335 million is stable on Q1 and on Q4. Notably, this includes both the stage one provision roll forward into a more adverse economic environment and bank base rate effects on recoveries, which do not represent actual defaults. Together, this equates to an AQR of 29 basis points, again, in line with guidance. Our stock of ECLs increased marginally in the half to GBP 5.4 billion. This provides coverage of 1.2% across the portfolio. Away from the assumptions, we are seeing sustained low levels of new through arrears.

Importantly, 92% of our stage two balances are up to date. Alongside, stage three balances were broadly stable during H1 and Q2. Based on our latest projections, we continue to expect the net asset quality ratio for 2023 to be around 30 basis points. Given the importance of our macroeconomic assumptions to the impairment outcome, let me now briefly look at our updated base case on slide 21. Overall, we see 2023 as better than expected at Q1, but slower growth thereafter, partly down to higher rates. We now expect base rates to peak at 5.5% in Q3 this year, and for inflation to reduce more slowly than previously anticipated. We expect unemployment to remain low, but forecast a gradual increase to around 5.3% by 2025.

After strong house price growth in 2022, we now model HPI declining 5% in 2023 and see a peak to trough decline of around 12%. Moving on, let me now turn to slide 22 to look at the performance across our lending portfolios. Performance across our portfolios is consistently reassuring. We've seen a modest increase in new through arrears in mortgages and to a lesser extent, credit cards. This is from a very low base. Trends in most portfolios remain similar to or favorable to pre-pandemic levels. We continue to see stable trends in SME overdrafts, alongside our RCF utilization remains more than 30% below pre-COVID levels. We have a very high quality commercial portfolio. Around 90% of SME lending is secured, whilst more than 75% of commercial exposure is to investment grade clients.

We also have a modest and well-diversified commercial real estate portfolio. Net exposure after significant risk transfers is around GBP 11 billion, and lending is focused on cash flows. 80% of the book has interest cover of two times or more. The average LTV of the portfolio is 44%, while around 91% have an LTV below 70%. Given the focus on mortgages in recent weeks, let me now turn to slide 23 to give some further insight on the strength of that business. The mortgage book is very resilient. We're seeing a modest increase in new to arrears, but again, from a very low level, and overall, remaining below 2019 levels. The increase is also focused on the legacy, predominantly variable rate business, originated in 2006 to 2008.

This legacy book now has an average LTV of 34%, an average loan size of around GBP 100,000. Over two-thirds of this book are on variable rate products, and so have been dealing with progressively higher rates for over a year now. Arrears remain at low levels and have stabilized over the last couple of months. The rest of the book remains very resilient, with just 0.2% due to arrears. The average household income in our portfolio is over GBP 75,000 per year. In this context, average payments for customers refinancing onto fixed rates since October of last year, have increased by GBP 185 per month, or GBP 2,200 per year.

Looking forward, in H2 in 2024, an average capital repayment mortgage moving to a 6.5% pay rate from a fixed rate of 2%, will see the customer paying an additional GBP 390 per month. Our affordability testing in recent years means customers refinancing in 2023 have, in fact, been tested to over 6.5%. Most customers are finding these levels manageable. For any that have difficulties, we will, of course, support them. Our customers have significant equity in their homes. The average loan to value of the portfolio is 42%, and 92% of the book is below 80 LTV. Putting this all together, based on our client profile, our lending criteria and security, and testified to by our experience, the mortgage portfolio is very well positioned for higher interest rates.

Let's now move to slide 24. The below the line items from TNAV. Underlying statutory profit continue to be convergent. Restructuring costs of GBP 25 million reflect only M&A and integration costs. The volatility line includes GBP 182 million of negative insurance volatility, largely driven by higher interest rates in the second quarter. Taken together, statutory profit after tax of GBP 2.9 billion, and the return on tangible equity of 16.6% in the first half, constitute, as said, a robust performance. Looking forward, driven by both income performance and TNAV, we now expect the RoTE for 2023 to be greater than 14%. Turning to TNAV, tangible net assets per share were GBP 0.457, down GBP 0.08 in the half, including GBP 0.39 in the second quarter.

The quarterly movement is significantly driven by higher rates impacting the cash flow hedge reserve. As we look forward, we continue to expect TNAV per share to grow as it benefits from the unwind of current headwinds over the medium term. Turning to slide 25 and looking at risk-weighted assets and capital. We have seen strong capital generation so far in 2023. Risk-weighted assets ended the half at GBP 215 billion, up GBP 4.4 billion. This includes a GBP 3 billion impact anticipated from CRD IV models, and remains in line with our 2024 expectation of GBP 220 billion-GBP 225 billion RWAs. Capital generation of 111 basis points in the half was, as said, a strong result. This is after taking the full GBP 800 million fixed pension contribution in Q1.

If we deduct the CRD IV mortgage model changes and the phase unwind of IFRS 9 relief in January, capital generation was 75 basis points in the half. The closing CET1 ratio of 14.2% is also after 21 basis points for the acquisition of Tusker, and 44 basis points dividend accruals. We have a very strong capital position, well ahead of our ongoing target of around 13.5%. You will have also seen that the Group passed the recent stress test comfortably. The strength of the Group's capital position and prospects enables the board to announce an increased interim dividend of GBP 0.92 per share, up 15% on last year. As usual, we'll consider further capital distributions at year-end.

We continue to expect capital generation for 2023, even after CRD IV and the phased unwind of IFRS 9 release, to be around 175 basis points. This represents a very healthy level of capital generation from a strong business. I'll now move on to slide 26 to wrap up the financials. In summary, the Group has delivered a robust financial performance in the half. Strong income and resilient credit trends support capital generation of 111 basis points and an increased interim dividend.

Looking forward, we are enhancing our guidance for 2023, and now expect the net interest margin to be greater than 310 basis points, operating costs to be around GBP 9.1 billion, the asset quality ratio to be circa 30 basis points, the return on tangible equity to be more than 14%, and capital generation to be around 175 basis points. In a changing external environment, the Group consistently performs well. That concludes my comments for this morning. Thank you for listening. I'll now hand back to Charlie to wrap up.

Charlie Nunn (CEO)

Many thanks, William. To recap, the Group continues to deliver in a changing external environment. These changes have increased uncertainty for our customers, and in response, we've been proactive in providing support where necessary, in line with our purpose of helping Britain prosper. At the same time, the Group is performing well. This includes a robust financial performance in the first half of the year, which supports enhanced guidance for 2023, and continued delivery on our strategic ambitions. Our confidence in the future is increasing, and we expect to achieve both the revenue and cost benefits that we laid out at the start of this plan. This will drive higher, more sustainable returns and capital generation. Taken together, our purpose-driven business, financial strength, resilient franchise, and continued strategic execution enable the Group to better support customers both now and in the future. Thanks for listening.

That concludes our presentation, and we're now happy to take any questions.

Operator (participant)

Thank you very much. As a reminder, if you wish to ask a question, please press star one on your telephone keypad. To withdraw your question, you may do so by pressing star two to cancel. There will be a brief pause while questions are being registered. Our first question today is from Guy Stebbings, from Exane BNP Paribas. Your line is unmuted. Please go ahead.

Guy Stebbings (Executive Director of European Banks Research)

Hi. Morning, Charlie, morning, William. Thanks for taking questions. Really around the deposits, the hedge and margins. If I come back to the guidance on the hedge contribution this year being unchanged versus prior guidance, despite the higher swaps, can you help us think a little bit more in terms of what fall in notional advance the hedge you're expecting and how this differs with the prior views? I think shortly after Q1 results, you're talking quite positively about deposit mix. Has that mix different gathered steam during the quarter, been more and more attractive to deposits on offer, et cetera? And in that context, you see the quantum of outflows in current accounts and commercial deposits in Q2 as a substantial run rate as we look forward, or would you expect that to moderate?

I don't know if you're able to share the size of the hedging buffer now. Just a sort of final big picture margin question. Thanks for the headline guidance revisions. Previously, you supplemented that with saying no quarter below 300 basis points. I don't know if that floor has moved up at all alongside the full year guidance or still sits as it did before. Thank you.

Charlie Nunn (CEO)

Guy, just before we get going, can I just ask you to repeat the last question? I didn't quite catch it.

William Chalmers (CFO)

The floor of 300 basis points.

Guy Stebbings (Executive Director of European Banks Research)

The last question.

Charlie Nunn (CEO)

Sorry, Guy, I think I've got it. Are we saying is that meeting up as well, the floor of 300 basis points that we guided you in Q1?

William Chalmers (CFO)

Yeah. Fine.

Charlie Nunn (CEO)

I think, Guy, mostly it's for William.

William Chalmers (CFO)

Sure. No, happy to, happy to answer. Well done, William. Guy, thanks very much indeed for the question. In terms of modest reduction, we didn't define the term precisely, of course, but modest reduction is single digits we expect. Let's see how we fare, but single digits, I think, is a decent guide. In terms of deposit performance, I think overall, actually, the deposit performance has been pretty pleasing, as I said in my comments, solid in Q2. If you look at Q2 overall, it's down about 1%, about GBP 3.3 billion. Within that, you've basically got flat retail performance and you've got a slight reduction in CB, but actually, the reduction in CB was very substantially composed of the short-term placements that we flagged at Q1 and expected to come off in the course of Q2.

Charlie Nunn (CEO)

Looking within that retail, flat performance, as said, balances overall flat. We saw PCAs down a nudge, we saw savings up. Actually, if you look at the flow of PCAs, the PCA performance in Q2 was slightly stronger than it was in Q1. Both outflows, to be clear, but about GBP 2.7 billion in Q2 versus over GBP 3 billion in Q1. Actually a flattening off in terms of PCAs. When we look at that overall, that gives us a view that as we look into H2, and this gets to the third of your questions, that we'll expect to see customers continue to make choices as to where they put their savings in the course of Q2. We expect movements from PCA into savings to continue in Q2.

Overall, in the context of fewer bank base rate changes than perhaps we've seen in H1, we would expect to see fewer prods, if you like, to those customers to instigate deposit movements going forward into the second half. Likewise, a lot of the money that is likely to move has moved to an extent already, so that works its way through. Alongside, of course, our internet access rates are getting progressively stronger and better for customers. All of that means that we continue to expect to see PCA into savings moves into H2. Likewise, within savings, we expect to see moves too, but probably a flattening off in terms of the customer behaviors. That leads us to, as said, suggest that the structural hedge change will be a modest reduction, as we've defined.

It is worth noting, just before moving on from that, the structural hedge, the effect, if you like, on the structural hedge earnings, as said in my comments earlier on, Guy, any modest reduction is outweighed, in fact, as we stand today, probably more than outweighed by the interest rate changes that we've seen. Just to take a moment of that, if we looked at Q1 versus Q2 today, we've seen the three-year rate up over 1 percentage point higher. Likewise, we've seen the five-year rate up almost 1 percentage point higher. These are significant moves in terms of the earnings rates on the hedge at which we will be deploying maturities. I don't think there's any lack of confidence in the structural hedge.

As a hedge, I don't think there's any lack of confidence in the earnings ability of the structural hedge as we move forward. Guys, this is more around tweaks around the edges. Second question, when we look at your, the base rate question that you asked and the floor around more around margins. As said, we've increased the margin guidance today from greater than 3.05% to greater than 3.10%. That is off the back of bank base rate changes that we have seen being in excess of what we thought would happen at Q1. It is also complemented by deposit moves, perhaps being a bit more benign than we had expected at Q1 too, in line with the comments that I just made a second ago.

As that flows through into the second half of this year, it is likely to lead to a margin performance for Q3 and Q4 that is a nudge ahead of where we have previously expected it and talked to you about, either at year end or at Q1. In that sense, the improved margin guidance of greater than 3.10% does indeed flow through to a little nudge up in respect of Q3 and Q4, and we'd expect to see that play out.

Guy Stebbings (Executive Director of European Banks Research)

Thank you. Very helpful.

William Chalmers (CFO)

Thanks, Guy.

Operator (participant)

Thank you very much. Our next question today is from Chris Cant from Autonomous. Your line is unmuted. Please go ahead.

Chris Cant (Head of Banks Strategy)

Good morning. Thank you for taking my questions. If I could just have a quick follow-up on the previous question, then I have another one. The follow-up is specifically thinking about what you've been seeing so far during July. Has there been any real change in the sort of pace of customer behavior change and turning out that you've seen, or has it really been sort of steady as she goes so far for the third quarter? The other thing I wanted to ask about was the controversy that I think you were referring to with your very initial remarks, Charlie. Do you see de-banking as an issue, potentially becoming a conduct problem for the U.K. banks? There's obviously a lot of political focus on this at the moment.

I'm very conscious that a lot of the decisions that you may have made in respect of customers may have been done for AML or other reasons, but there does seem to be some political steam building up behind this issue, and I'm just wondering whether you see any potential conduct risk around decisions you may have made in the recent past. Thank you.

Charlie Nunn (CEO)

Thanks, Chris. Maybe William will build on the 1st question, and then I'll take the 2nd one.

William Chalmers (CFO)

Thanks, Guy. Chris, the short answer to your question is no. No behavior changes in July that are of any note. I think if anything, actually, it's probably tilting marginally in favor, by customer behavior changes that are slightly better than we had expected from a deposit point of view. The reason I say that is because, as per my comments earlier on, we've seen probably better deposit performance in Q2 as a general matter. As we go into June and July, actually, we're seeing some beneficial effects of some of the wage and salary changes that we've seen feeding through into our PCA balances, which is a nudge ahead of perhaps where we had previously thought.

You know, it's a little too early to call that, but nonetheless, I think July, no noticeable changes with that slight, you know, bit of context around it. I'll perhaps stop there and hand over to Charlie.

Charlie Nunn (CEO)

Yeah, just one build on that, which I won't do on other comments. As William said, we've seen increased wage inflation in the range that we were all expecting, which is kind of the 6%-8% increases. When you look at how customers are adapting their spend, we know inflation has obviously been higher, but spending on all of our current accounts and cards has also been in that kind of 6%-8% range. That's why I think partly why we saw the stability in Q2.

Just on your de-banking issue, or kind of when we look to exit customer relationships, it's a good question, Chris. I think the simple answer is no, I don't see that at this stage. I can't talk for all U.K. banks, what I can talk for is Lloyds Banking Group. We've always had a clear policy, and obviously I've gone back in the last few weeks and checked how our policy is being implemented, that didn't look at customers, personal or political beliefs, either at the point of onboarding or when we do periodic reviews, as we do with PEPs, or if there were a decision to exit, customers.

I think in the specific issue, where there's strong political sentiment, and obviously we're going to have a discussion with the economic secretary later today, and there'll be some regulatory oversight around this, I don't think that's an issue. As you say, we exit customers today for very specific reasons. One of the examples is economic crime, so anti-money laundering, fraud and sanctions, and there's very specific obligations we have around that. At Lloyds Banking Group, I'm comfortable our policy doesn't expose us to this risk. Obviously, what's in the minds of the regulators, the government, or what other banks are doing, I can't comment on, Chris. Thank you.

Chris Cant (Head of Banks Strategy)

That's very helpful. Thank you.

William Chalmers (CFO)

Thanks, Chris.

Operator (participant)

Thank you very much. Our next question is from Edward Firth from KBW.

Edward Firth (Managing Director)

Good morning, everybody. Thanks so much for the presentation this morning. My only question would be just picking up on your comments then about wage inflation, which is clearly running ahead of perhaps what you were expecting, certainly earlier this year, than we were expecting anyway. I'm just asking that in the context that if I look at the consensus cost to the point, they're still looking at about a 1% cost growth for 2024 and 2025, which feels like it would be a very impressive performance in the current inflationary environment. I just wanted to get you to comment on that, what you're thinking about that. I mean, do you agree that that's where the risks are? I mean, how do you think that might develop as we go through? Thanks so much.

Charlie Nunn (CEO)

Thanks, Ed. Perhaps I'll take that question. The on the wage inflation that we're seeing, as said, that's been benefiting the PCA balances. It's also composed not just of regular wage inflation, but also back payments, don't forget. There's a lot of that going on right now. That clearly overall benefits balances. Your question was about how that feeds into our cost base going forward. As you know, we have two cost targets out there right now. GBP 9.1 billion in respect to 2023, which as said in my comments, we expect to achieve and GBP 9.2 billion in respect to 2024, which of course stands.

When we look at inflation in the costs over the plan period, we obviously took a look at this at the close of 2022 before coming to the market to present the full-year results. We see cost inflation in a variety of areas. We certainly see it in wages, and that is a big part of our overall OpEx, around 40%. We also see it in terms of technology suppliers, in terms of utilities, in terms of third-party services provided to us, including consultants. So there is a wide spread of cost inflation sources. It comes from, if you like, a number of different places in addition to our overall wages bill. We also have a number of tools to try to offset cost inflation as a general matter.

You'll be familiar with these, whether it's the regular matrix cost management structure that we deploy, whether it's forward hedging of things like commodity prices and utilities expenses, whether it's some of the strategic initiatives, that, as you know, we've had a target of GBP 1 billion out there. We've now increased that target to GBP 1.2 billion. These are all ways in which we try to tackle cost inflation, Ed. Let's be clear, it is tough, it is demanding, but the organization has a good track record of doing it. As said, that's what allows us to give the cost targets that we have given, and that's what allows us to continue to be committed to them in the environment that we're in.

Edward Firth (Managing Director)

Great. Thanks so much.

Operator (participant)

Thank you. Our next caller is Jonathan Pierce from Numis. Your line is unmuted. Please go ahead.

Jonathan Pierce (Equity Research Analyst)

Morning, both. A couple of questions, please. The first, just coming back to the structural hedge, I mean, there's a lot of focus on the size of the hedge notional. Just so I try and understand this properly, if you decide in the second half not to reinvest single-digit amounts on the maturities that are coming through, but the deposit base itself remains pretty stable, you're simply going to be essentially reinvesting those maturing hedges into floating rate assets, rather than fixed rate assets. The notional hedge size drops, but the income effect is actually slight positive than I thought, because the overnight rate is currently above the five-year swap rate. Just want to check that thinking is correct. The second question is on the TNAV.

I mean, obviously the cash flow hedge reserve weighed down appreciably in the second quarter, but it looks like, and we don't have detailed enough disclosure to be sure of this, but it looks like the pension remeasurement was pretty big in Q2 as well, a big negative. Can you help us think about movements in TNAV going forward? What's the big driver of the pension remeasurement? Is it simply rates as well? As we see rates start to come off in the third quarter, TNAV will get a bit of a kicker. Maybe just a supplementary to this, how much of the TNAV drop in Q2 is behind the RoTE improvements, or would you have been improving the RoTE to circa 14% today, even if that TNAV hadn't come off very much in Q2? Thanks so much.

William Chalmers (CFO)

Yeah, thanks, Jonathan. Three questions there. I think one on the structural hedge, one on pension remeasurement and relationship to TNAV, and then one on the sources of the RoTE improvement. In terms of structural hedge, a couple of comments to make. One is, as said, modest structure, around GBP 20 billion of maturities in the second half of this year, around GBP 40 billion of maturities next year. As you can see, maturities very significantly outweighing whatever adjustment around the edges that we might make to the overall hedge balance. I think that's one point. The second point to the topic that you were raising there, Jonathan, it depends upon what happens to the deposits that we take out of the structural hedge.

On the assumption that those deposits stay with us, then, as you say, we're going to be putting them, let's say, at bank base rate, for sake of argument, which is currently around 5%, which, as you know, is actually ahead of the five-year rate right now, which is more like 4.8%. There's a marginal earnings improvement from putting those funds into the base rate as opposed to a five-year swap. Now, having said that, if it goes into a fixed term deposit, we're clearly going to be swapping against that fixed term exposure, and therefore, while we will make a margin on the fixed term deposit for sure, we are making the margin of the difference between the customer pay rate versus the swap in which we invest the fixed term.

Yeah, we should be clear about that. It depends upon where the money goes. If the money sits on the balance sheet and just adds to the buffer, which, you know, has been the pattern to a degree, so far, it earns a base rate. It's a net neutral, in fact, almost net positive change. If the money goes into a fixed term deposit, that's determined by the margin on the fixed term deposit. Second point, on the pensions remeasurement and how that plays into TNAV. As you know, we saw a TNAV reduction of GBP 0.039 per share over the course of the first, sorry, second quarter of this year, a marginal reduction over the course of the first half. A number of factors played into that TNAV adjustment, a significant part of which was the rate.

if I just focus on the GBP 0.39 per share in Q2, for example, about half of that was the cashflow hedge reserve adjustment to rates. you've got other effects, including the dividend being paid out, for example, but including the one that you mentioned, which is around the pensions remeasurement. to come back to your question there, Jonathan, the rates impact is the primary mover of the pensions remeasurement. There are other pieces at play. gilt is clearly one of them. Obviously, that relates to rates, but also credit spreads, likewise. These factors all go into the pensions remeasurement in any given quarter, but rates is, I would say, probably the most important, and maybe the most consistent mover of the pensions remeasurement in any given quarter. Your third question on TNAV, and the relationship of that to ROTE improvement.

In short, we have seen some reasonably significant income additions and indeed, earnings improvements to the business over the course of H1 and projecting into H2, versus what we might have expected at the beginning of the year. That's the R part of the ROTE equation, clearly. It also happens that as you've seen in Q2 and H1, some of that return improvement has been offset by below-the-line volatility, which means that the share of the R component in improving the ROTE guidance has been somewhat dampened by that volatility component. The TNAV, meanwhile, as we've just discussed, has gone down a fraction over the half, GBP 0.039 in the quarter, and that contributes to the ROTE improvement.

Jonathan, the short answer to your question is that both returns and TNAV reduction have contributed to our guidance of in excess of 14% ROTE for this year, but on balance, it's probably a little bit more of the TNAV reduction versus the earnings enhancement because of that volatility point that I just mentioned. Final point I'll make, Jonathan, is that these TNAV changes that we're talking about, they should unwind, and they will unwind for two main reasons. One is because, as you know, the rates projections that we have, suggest that at some point, a little further out than we thought at Q1, but rates are going to come down. That's going to unwind the TNAV effect.

The second is, as the structural hedge matures, you're going to see a lot of those balances repriced from 1.2%, which is roughly what they are right now, to something like the 4%-5% rate environment that we're seeing. As those structural hedges mature, again, GBP 20 billion second half, GBP 40 billion next half, sorry, next year, that is gonna rebuild the TNAV. There's a pretty automatic unwinding process at play there. It's just that it's hard to predict exactly what happens in any given quarter in a period of interest rate volatility.

Jonathan Pierce (Equity Research Analyst)

Brilliant. Very comprehensive. Thanks a lot, William.

William Chalmers (CFO)

Thank you, Jonathan.

Operator (participant)

Thank you very much. Our next question is from Aman Rakkar, from Barclays Capital. Your line is unmuted. Please go ahead.

Aman Rakkar (Director of Banks Equity Research)

Good morning, Charlie. Good morning, William. Thanks very much for taking the questions. Sorry, I wanted to labor the questioning around the hedge. Can you just clarify what I think something's gone on with the size of the hedge, maturity profile in Q2 and H2? I think, as at Q1, you talked about GBP 35 billion of maturities, and forgive me if I'm wrong, but I thought the best part of GBP 30 billion was coming in H2. Obviously now that looks like it's more like GBP 20 billion that's coming in H2. It seems like there's some trading of the structural hedge that may have taken place in Q2. Could you clarify if that's kind of the correct reading of the situation?

Because presumably you've kind of pulled forward some of the benefit of the hedge maturity gains, you know, in and this year's NIM. I guess as a related question, I'm just thinking about the tailwind of the structural hedge in 2024. I think you talk about GBP 800 million in 2023 and a similar number in 2024. That, to me, sounds quite low, given the maturity profile that you're calling out. You know, GBP 20 billion that will run rate into next year, the GBP 40 billion that you're calling out. I would have thought that that hedge tailwind could be 50% higher than that GBP 800 million that you're kind of calling out. Can you help us to kind of understand what's going on there?

I guess, you know, just to close this off, that I feel like your structural hedge is a really, really important driver of your medium-term earnings and longer-term earnings. You're clearly going through a period of adjustment around net interest income right now. There's an uncertainty around your deposit dynamic near term. The thing that presumably gives you confidence longer term is this really quite substantial hedge tailwind. Any kind of color you can give us around your confidence there, around the size and the income profile would be great. Thank you.

William Chalmers (CFO)

Thanks, Aman. I will. There's three questions there around what happened to hedge maturities over the course of this year, around the tailwind looking into 2024, and around structural hedge drivers going forward. I'll answer all three, but I will turn to Charlie, actually, on some of the deposit dynamics on the third, in particular, to add further context. Aman, on the first question, around structural hedge maturities, as said, it's maturities of around GBP 20 billion looking into H2 as we stand today. I think at Q1, I probably talked about H2 maturities of around GBP 25 billion, something like that number. What's gone on to reduce that GBP 5 billion? It's effectively pre-hedging, Aman.

We manage the structural hedge according to principles of income stability, in order to produce a predictable earnings profile, which in turn allows us to make predictable distributions to shareholders, the source of value. The second principle being we want shareholder value. When we see opportunities to manage at the margin, if you like, you know, we'll lock in some of the hedges in accordance with that. That's what we saw in the period during Q2. As a result, the hedge maturities in Q3 and Q4 have gone down from circa GBP 25 billion to more like GBP 20 billion, as we have sought to lock in the shape of the curve in the interest of securing income on a stable basis for the Group going forward. It's pre-hedging, in short, Aman.

Secondly, on your question, structural hedge tailwind going into 2024, we, as you say, we've put forward a circa GBP 800 million further tailwind to the Group, looking into 2024, as a result of the GBP 40 billion of structural hedge maturities that we expect to see. Those hedge maturities, I won't give you a precise number, but it'll be a little bit in excess of the 1.2%, but it'll be around that zone for the 2024 period. That suggests that based upon the rates that we looked at as of the 30th of June, that GBP 800 million tailwind is what makes sense. Generally speaking, we manage this reasonably conservatively so that we can predict with confidence what we're going to deliver to you.

That, in turn, is then subject to the volatilities of markets at any given point. If we overlay a kind of market-implied analysis, if you like, on top of the hedge analysis that we give you, there's probably a little bit of conservatism built in there. It's not 50%, to be clear, Aman. You know, it isn't going to be a question of delivering GBP 1.2 billion versus GBP 800 million. Based upon market implied analysis, it might be a nudge higher than GBP 800 million, but not of the order of magnitude that you are indicating. Let's be clear, what we're talking about here is around the edges, right? We are talking a marginal reduction, a modest reduction, as we've termed it, in the overall size of the structural hedge of GBP 255 billion.

As I said earlier on, we've seen rate changes in between quarter one and quarter two for the three-year rate, for example, relevant obviously to three and half year weight average life of the hedge, of over 1%. If you take that as a proportion of what the rates were as of Q1, that's like 25% of the rates at Q1. It's gone from roughly 4.25 to roughly 5.25 over that time period. That's a very significant, in fact, I would say overwhelming adjustment, versus the type of modest reduction that we see in the overall size of the hedge. That's the context to put it in. Just final point before handing over to Charlie on this, Aman, is that, again, the deposits picture, it feels pretty robust.

When we look at that, as I mentioned earlier on, the PCA performance in Q1 versus Q2, down from over GBP 3 billion outflows to around GBP 2.7 billion outflows. To Chris's question earlier on, some, you know, healthy signs during the course of the last few weeks or so. Looking forward, we're likely to have fewer bank base rate changes. Looking forward, much of the money that was going to move off the back of higher rates probably has moved or is moving over the course of quarter one and particularly quarter two. We're nudging instant access rates up a little bit. Looking forward, the forward curve is likely to be a touch lower. The competitive offers will have to reflect that. Again, looking forward, we've got inflation on salaries.

We've seen them so far, we'll continue to see them going forward. These are all reasons, I think, why we have confidence in the deposit base going forward, which in turn leads us to the guidance that we have on the structural hedge today. I'm going to pause there and hand over to Charlie.

Charlie Nunn (CEO)

Yeah, the only thing I was going to add, William, but thanks for the question, Aman, is just kind of the investment piece to say over the next three years. Definitely, the structural hedge is part of it, as you say, and we have real confidence around that, as William just laid out. There's two other things that I'd still mention, which are really important. First of all, as you know, we've committed to GBP 1.5 billion of additional revenues linked to our strategic initiatives. you know, it's better to be lucky than good sometimes, and we got going on that before Russia invaded Ukraine, and we went through this rate cycle, and I hope what you can see today, and we'll give you another update at the end of the year, we've got momentum.

The other operating income, we think, shows some green shoots of that's a reason to believe that we will navigate the next three years very strongly. The second one is, you know, none of us can sit here and predict what the economy is going to do or what will happen to rates, but it's just really important. We know as rates go up and down, what you need to deliver for shareholders and customers through that cycle is a balance sheet that is well leveraged, is well diversified, and has a mix of assets across commercial and retail, and secured and unsecured. We've got the best balance sheet in the U.K. If rates were to come down, we'll be able to continue to compete and generate capital returns based on our assets.

We've got the structural hedge giving us a strong kind of driver underlying the business, as William just laid out. We've committed to and we're reconfirming our strategic revenue growth initiative. That's why we feel confident about the capital return that we've laid out over the next few years.

Aman Rakkar (Director of Banks Equity Research)

Thank you very much, Charlie. Thank you so much, William, for your really extensive answer.

William Chalmers (CFO)

Thank you, Aman.

Operator (participant)

Thank you. Our next question is from Robin Down from HSBC. Your line is unmuted. Please go ahead.

Robin Down (Managing Director and Senior European Banks Equity Researcher)

Hi, good morning. I'm not going to ask about structural hedge. Nothing to be repeated here. Can I ask about the other income line? It looked quite good in the first half. I'm just wondering if you could give us a little bit more color on what it was leading well, then if you can on the retail side, and your expectations then for H2 on the other income line?

Charlie Nunn (CEO)

Yeah. Thank you, Robin. Thank you for the question, not being about the structural hedge, actually, I should add. Nonetheless, it's OOI, as said in my comments earlier on, has been a source of decent performance, I would say, actually, in the first half. What's behind it is your question, how we look at H2 in that respect. When we look at what's behind it in respect of H1, it's contributions really from all of our three main business areas. I look at retail, for example, and that has seen contributions year and a half from a combination of customer activity in respect to PCAs, consumer finance business, the motor finance business, including not just Lex, the business that we already own, but also the acquisition of Tusker, especially in Q2.

Those businesses all contributed to a decent performance. If you look at half one last year versus half one this year, it's up around GBP 150 million. If you look at commercial, similar comparison, up around GBP 125 million. What's leading to that? It's a combination of financial markets, i.e., flow-driven business, together with a developing capital markets business, in particular, bond financing business, over the course of the first half of this year. To be fair, a touch stronger in Q1 than it was in Q2, but nonetheless, a really decent performance year and a half. Moving on, insurance protection and investments, a number of moving pieces there. The three that I would point out in respect of a half year performance are, first of all, the unwind of the CSM.

That, as you know, has been an adjustment, IFRS 17 adjustment between 2022, 2023. The CSM now stands around GBP 4 billion pre-tax, around GBP 3 billion post-tax. That CSM, in addition to a further GBP 1 billion of risk adjustment, unwinds over time into our earnings. That has led to a stronger contribution during the course of the first half of 2023. Alongside of that, Robin, the general insurance business is doing better. The combined ratio is now below 90, sorry, below 100% within the general insurance business. That, together with the absence of weather events, has allowed us to see decent, in fact, improved performance from the general insurance business. Obviously, the weather events have previously fed into a combined ratio, which is higher than we would like to see it on a long-term basis. Now, it's adjusting back down.

Finally, the return on free assets, Robin, is a further factor. As we've moved into a higher rate environment, so the return on free assets in the insurance business, has strengthened, and that's led to about a GBP 90 million increase half last year versus half this year. Across each of those three elements, we're seeing some decent progress. There are always underlying elements. Second point, there are always underlying elements, Robin, within OOI. We like to strip those out internally and take a look at what's going on underneath the hood, as it were.

When we look at that on an underlying basis, first half this year versus first half last year, we think we're seeing around a 7% underlying growth rate after stripping out any of the anomalies that you might see at any given quarter or any given half. That's the overall picture, albeit that growth rate was less than 7% if you look at it Q2 versus Q1, and that's the reasons that I mentioned around one or two of the individual business lines right there.

When we look into H2, the second part of your question, Robin, we would expect the growth to continue as a function of two points, one being activity levels in the businesses as I described a second ago, and two is the gradual effect of some of the strategic investments being built into the overall operating performance of the business. We haven't guided on OOI, so I'll be a bit careful about what I say in respect of the full year's expectations for that number, but I think we would expect to see continual, let's say, measured growth going into the second half of this year, even if it's not quite as strong as the 7% year-on-year growth that I mentioned in H1.

Robin Down (Managing Director and Senior European Banks Equity Researcher)

Sorry, just to clarify, when you say growth, do you mean growth versus H1 or growth versus H2 of last year?

Charlie Nunn (CEO)

I mean, well, I mean growth versus H2 of last year, Robin, but overall, it's the comparison, the weighting between H1 and H2, that growth expectation, if you like, may be slightly more heavily weighted towards H1.

Robin Down (Managing Director and Senior European Banks Equity Researcher)

Great. Thank you.

Operator (participant)

Thank you. Our next question is from Rahul Sinha from JPMorgan. Your line is unmuted. Please go ahead.

Rahul Sinha (Credit Risk Analyst)

Morning, Charlie. Morning, William. Thanks so much for taking my questions. Just given some of the recent rate hikes, you had a 50 basis point rate hike at the end of this quarter. I was just wondering if I could draw you a little more on the profile of the NIM in the second half of the year. I guess within that, I was looking for a little more color in terms of how much deposit beta you have seen in terms of what you passed through so far, and what you expect to pass through in terms of your assumptions. If we think about the broader picture of NIM, you know, on one hand, you've got the mortgage churn headwinds. On the other hand, you obviously got the maturities on the hedge coming back.

How far would we be from a sort of flattish margin trajectory, in the second half of the year? Thanks so much.

William Chalmers (CFO)

Thanks, Rahul. To give you some thoughts on that, as you know, we saw the margin come down in Q2 from 322 in Q1 to 314 in Q2. There were a couple of things going on there already. In terms of tailwinds, first of all, a little bit of tailwinds from funding and capital, but frankly, not very much. As you know, the absence of the hedge in Q2 meant that not much was coming from there either. The headwinds that brought it down, as I said in my comments earlier on, predominantly mortgages and then the deposit pass on, pertinent to your question. That's what led to the 8 basis point reduction in Q2.

When we look forward to the remainder of this year, as you know, we've increased the margin guidance from greater than 305% to greater than 310%. That is partly off the recognition of what was achieved in H1, being a little bit stronger than we'd expected, and it is partly recognizing that what we think is going to be achieved in H2 is also going to be a little bit stronger than we expected. The headwinds and the tailwinds, looking forward, Rahul, first of all, the tailwind, perhaps, the structural hedge starts to kick in. As said, GBP 20 billion of maturities, less whatever modest reduction we might see, but nonetheless, a significant tailwind going into H2 of this year.

Second, the headwinds, as we look at them going into H2, again, it's a continued expectation around mix shift within overall deposits, alongside the mortgage refinancing that we expect to see. We might see a bit of compression in margins in some of the other retail and CBS. Again, it's basically those two. Deposit mix shift, number one, and mortgages refinancing, number two. That's the mix. What will that produce? We expect it to produce a margin that is slightly higher than we had previously indicated. At the year end, we talked about a floor, as I think Guy mentioned in his earlier question, of around GBP 300. We expect it to perform a little bit better than that now, going into Q3 and Q4.

The beta in that mix, Rahul, we haven't put a number on the beta in that mix. As you know, the pass on decisions are basically determined by what offers best value to our customers, particularly in the context of consumer duty, clearly. What is the competition doing, and how should we best respond to that? What are the funding needs of the business? Those three are the criteria, if you like, that we use to assess the pass on decision. It's safe to say two things, I think, Rahul. One is that so far, we've been very much in line with the sector, in terms of the overall pass-on decision.

Two is, as we look forward and consistent with what I think Charlie and I have always said, we do expect the pass-on to increase as we get into a higher base rate environment. Indeed, we expect some of the pass on to continue even after base rate changes have stopped. That will increase a little bit beyond where we are today. At the moment, we are below 50%, but we do expect it to increase towards that level as we go forward, consistent with the comments that I've just made. Rahul, I'll perhaps pause there. I hope that answers your question, let me know if it doesn't.

Rahul Sinha (Credit Risk Analyst)

Yeah. Thank you. Yeah, that's really helpful, William. I've got an unrelated question on the Buy to Let arrears profile. I don't know if you're seeing anything specific around. I think you flagged the 2006, 2008 vintage, and there's some helpful disclosure on the slides. I guess my question is specifically around Buy to Let. If you're seeing any specific arrears trends within there, would you call out anything in terms of that business going forward? Thank you.

William Chalmers (CFO)

I think the short answer is no, Rahul. As we look at the Buy to Let portfolio, it's obviously one of our portfolio's businesses. It's not seeing arrears trends that are significantly different to what we're calling out in the materials that we've provided today. As you know, today, we called out a mortgage portfolio that is performing well inside of our 2019 new to arrears experience. The Heritage portfolio is a little different from that, not terribly much so, but the reason why we put the slide in is just to provide further color, if you like, on that point. Buy to Let isn't a particular portfolio that we call out as being any different to anything else that's going on.

The one point I would make, Rahul, in before concluding, is more of a flow point, actually, which is, I think because of governmental changes, perhaps because of the rate environment and so forth, we are seeing Buy to Let as a proportion of new business on the portfolio go to very low levels. It is much more about the residential portfolio right now than it is about the Buy to Let. New to lending in Buy to Let is much smaller than it used to be.

Rahul Sinha (Credit Risk Analyst)

Got it. Thank you.

William Chalmers (CFO)

Thanks, Rahul.

Operator (participant)

Thank you. Our next question is from Rohith Chandra-Rajan , from Bank of America. Your line is unmuted. Please go ahead.

Rohith Chandra-Rajan (Director of Equity Research)

Hi, good morning. Thank you very much. I had a couple, please. The first one was just a follow-up, actually, on the deposit beta. You sort of had said historically, you thought over time, a combination of pricing and mix would move towards 50%. It sounds like you just reiterated that, William. Obviously, we're now talking about materially higher policy rates than we were all expecting previously. That implies a much wider deposit spread than you might have been anticipating before. Just wondering if that's the correct read of that, or whether actually, over time, you might think that deposit beta could overshoot the 50%. That was the first one.

Just coming back to the TNAV and thinking about the short term. You know, if I look at five-year rates today versus the end of June, that would imply something like a third of the cash flow hedge reserve impact in Q2 might actually flow back in Q3. Just wanted to check if that was the right way to think about that, please, as well as the kind of maturities you talked about before. Thank you.

William Chalmers (CFO)

Yeah, thanks, Rohith. I'll answer both, but Charlie will want to add, I think.

Charlie Nunn (CEO)

Yeah

William Chalmers (CFO)

on the deposit point in particular, Rohith. Let me just start on that, hand over to Charlie, and then come back on the TNAV afterwards. In terms of the deposit beta, it's worth, first of all, just saying that this is a cumulative number that is, that is given. When we talk about 50% deposit beta, it is cumulative over time. What that means is that in the early stages of rate rises, as you know, is essentially all banks sought to rebuild the margin from what had been a very compressed level during the zero interest rate period. Not that much of the initial rate rises were passed on. As those rate rises have increased, so the cumulative beta has moved up.

There's still a little way to go, as I indicated in my comments to Rahul, before we necessarily hit the 50% mark. As to whether it then exceeds it over time, I'll leave Charlie Nunn to comment further, but, you know, at the margins, it's not impossible. I think we have to see how things develop. We're a little way off that right now, so, you know, that's not a concern for now. It's not a concern, I suspect, for this year. Indeed, our expectations as to the gathering pace of deposit beta are fully built into our margin expectations for this year. Which, as you know, and by the way, and importantly to your question, have just increased from greater than 305 to greater than 310. That partly, I think, answers your questions.

I'm gonna pause there and hand over to Charlie. Then I'll come back on TNAV.

Charlie Nunn (CEO)

Well, I know, actually, William, I think you said what I would've said. Just strategically, when we gave you this guidance at the start, I'm thinking back 18 months now, my experience from having, you know, managed big deposit businesses through multiple rate cycles in the last 10 years, is that you typically end up both through people, you know, valuing liquidity at the start of a rate cycle, i.e., when there's more uncertainty, they want instant access. As they get more confidence around the economic environment, being willing to shift some of their savings into fixed products. What you typically see is across the whole deposit base, about a 200 basis point spread between the bank base rate and the deposit base.

As we've been going through this last couple of years, I think we've said a couple of times, a 50% pass-through, which would take two or three years for our customers to adjust where they've got deposits, has always been where we thought made sense as we were thinking about rates at 300 or 400 basis points. The reality is we're now looking at rates which are a bit higher, of course, is the real question is: How long do they stay at that rate, and what are the expectations around it? Especially as you start to think about time deposits, that's obviously priced based on the one or two-year curve. Actually, you could, you know, when we look at our forecast for rates, we're not gonna stay at these highly elevated levels or higher levels for long.

I think the answer is, we're building towards the 50 basis points. As William would say, we've got some way to go. That's because customers massively value liquidity, and we've got such a strong retail franchise and strong transactional capabilities and services. We should continue to expect that to shift. If we think that, the rates and the yield curve and customer behavior is gonna push us above that 50%, we'll tell you as we get there. I think what's good about that from our perspective as a shareholder, is if we're in that environment, we're gonna be able to look at ways of optimizing our NIM. That's what William just said. Despite the higher rates, we're guiding to higher NIM.

William Chalmers (CFO)

Just moving back to TNAV, Rohith, on the second of your... Sorry, Rohith, did you wanna...

Rohith Chandra-Rajan (Director of Equity Research)

Sorry.

William Chalmers (CFO)

Go ahead, if you'd like to carry on.

Rohith Chandra-Rajan (Director of Equity Research)

Yeah. Let's come back on that very briefly before we move on, just to clarify, please. Mechanically, if we were expecting rates to go from pretty much 0 to 300, that would have been a 50% pass-through, would have been a 150 basis point spread. At 5%, that's 250. I think, Charlie, what you're telling us is that because you don't expect rates to stay at that very elevated level for, or that elevated level for an ongoing, a significant period of time, that actually the fixed rate spreads would be lower than that, reflecting expectations of lower rates. Is that the right way to think about those comments?

Charlie Nunn (CEO)

Yeah. Rohith, I know we're not being as specific as I think would be helpful. The reason is, you know, we're gonna have to see how the competitive and customer behavior develops. What I can say is, I've managed businesses like this through rate cycles over the last 10 years in other countries. The broad theme I just laid out, which is at least 200 basis points of margin, it takes two-three years for customers to decide how they move their deposits, and for the competition to play out. You know, when the landing point for rates is about 4%, that 50% is a good assumption.

Something I'll give you an example, in Mexico, when it was 7%, you know, the 2% was paid compared to more like 4.5%-5% pass-through after three or four years of that cycle. Yes, you interpreted it right. We're not gonna fill out a very, very detailed forecast around this because it's gonna be down to customer behavior and competitive behavior. Our assumptions to date have been pretty helpful, I think, for you. We said people don't typically start moving money until they get to about 3% base rate, which is what we saw happen last November. We've guided that we will end up towards the 50% basis pass-through, and our NIM guidance includes those assumptions around churn and pass-through. It's very hard to be more specific than that, Rohith.

It's not to be unhelpful, but I do hope that you feel we have some, you know, track record here, and we have some confidence from other experience that's helpful to you as you, as you develop your model here.

Rohith Chandra-Rajan (Director of Equity Research)

Yeah. That's helpful. Thank you.

William Chalmers (CFO)

Rohith, your question around TNAV. Again, just to repeat some of the inputs to that. As you know, the TNAV was down, a fraction, well, about GBP 0.07 in the course of the half, GBP 0.039 in the course of the second quarter. As said in the discussion with Jonathan, the cash flow hedge reserve is responsible for about half of that. We had one or two other elements going on, notably the dividend, and then the offsetting impact between the buyback going out and the number of shares being reduced. That also is a modest net negative, contributing to the GBP 0.039 per share down before you get to the pensions fund. As we move forward, your question is about how does that evolve? Couple of points to make there.

One is the sensitivity, which I think we disclosed, certainly at the half year, at the full year rather, I think we disclosed. It's around GBP 13 million, GBP 12 million-GBP 13 million post-tax for a one basis point change in rates. That will enable you to, you know, do a sensitivity based upon your expectation as to where rates will go. When we look at our expectations as to where rates will go, over the course of this year, we've given them to you in our forecast, at least. We do, as your question suggests, see quite a significant unwind in the context of the TNAV, and particularly the cash flow hedge reserve in the second half of this year.

Based upon that, based upon profitability, based upon our expectations as to the buyback performance of the pension and so forth, we would expect to see the TNAV per share by the end of this year, I won't give you a precise number, but much closer to GBP 0.50 than where we stand today. I don't want to kind of be held captive by that remark, because, of course, we can't dictate interest rates and exactly where they go. Based upon our forward look, with those inputs that I've just given you, we're looking at a number that is much closer to GBP 0.50. Final point on the TNAV, which I think is worth stressing, Rohith, is that none of this has anything to do with capital or distributions to you as shareholders and the market more generally.

Whatever the movements are in TNAV, appreciate they have been slightly volatile over the course of this half, but none of it has anything to do with capital generation or capital distributions. I think that's just important and worthwhile for people to remember.

Rohith Chandra-Rajan (Director of Equity Research)

Okay, thank you very much.

William Chalmers (CFO)

Thanks, Rohith.

Operator (participant)

Our next question is from Martin Leitgeb, from Goldman Sachs. Your line is unmuted, please go ahead.

Martin Leitgeb (Equity Research Analyst)

Yes, good good morning. Can I have a follow-up on the outlook for net interest income? I was just wondering if you would be willing to comment on the trajectory for net interest income going forward. Obviously, multiple moving parts, the margin comments earlier, the comments on deposits, migration, somewhat fading as we progress. Also the impact of a hedge tailwind, or tailwind from hedge rollover, late in the year. Would it be fair to assume, from your perspective, that net interest income continues to build in absolute terms from here?

The second question, I was just wondering, with regards to the health of the U.K. consumer, you disclose your own slide 23, in terms of average impact, in terms of mortgage payments, being up just about GBP 200 a month so far, potentially rising closer to GBP 400 per year. You also disclosed that the average income for this mortgage share owner holder is actually well above average for the U.K at GBP 75,000. Is the message here that you see the U.K. consumer holding up well, basically wage growth in this category is potentially more than offsetting some of the headwinds from higher mortgage rates and the outlook for the U.K. consumer overall being fairly benign? Thank you.

William Chalmers (CFO)

Thanks, Martin. Why don't I take the first of those two questions, and then Charlie perhaps takes the second on mortgage payments. When we look at NII for 2023, we don't guide to a particular number in respect of NII. What we do is give you a sense as to what we think average interest earning assets are, what we think the margin expectations are going to be, and then allow you to kind of draw your own conclusions around the NII contribution. I won't breach that line, as it were. I won't go beyond that. Safe to say that, you know, when we look at the NII expectations, net interest income expectations, it is those factors, as given to you, that are at play. I would also highlight the non-banking interest income as part of this.

We talked about it in Q1, clearly. It's gone to about GBP 80 million versus, I think it was GBP 74 million in Q1, so GBP 80 million in Q2 versus GBP 74 million in Q1. As said earlier on, because our activities are increasing... By the way, that does generate income in OOI, amongst other lines. As those activities increase, the volumes of those activities increase, number one, and as rates increase, and therefore the cost of funding them, number two, that will nudge up non-banking interest income a little bit in Q3 and Q4. Not terribly much, but we'll see a slight movement in non-banking interest income in accordance with that. Those factors are at play in determining the net interest income over the course of this year.

Today's obviously not the year, the day rather, to give guidance into 2024, but hopefully that's useful without breaching too many of our guidance, guidelines.

Charlie Nunn (CEO)

Great. Martin, thanks for the question on our mortgage customers. First thing, we included this slide because we thought and we'd heard that some of you would be keen just to get a forward look on our mortgage customers, given that we've seen a step up in mortgage payments, and the intent of this slide is to give you confidence that we think our mortgage customers can withstand the higher payments. One thing, which is probably more for the media, but than you, Martin, but just to be clear, I'm not saying it's easy for our mortgage customers. I'm just saying that we are confident they have the financial decisions and a better capacity to absorb the kind of difficult uptick in mortgage costs that we're talking about.

What's the reason for that? As you said, overall household income is significantly above the average, and you can do the math relatively quickly. Although we're talking about, for so many customers, GBP 3,000-GBP 5,000 post-tax incremental payments, people are then able to make choices to offset other discretionary payments. We've done the stress test, or the affordability test for our customers over the last 10 years at above 6.5%, so we know they have the capacity to absorb this. Bluntly, our experience and the data you can see over the last nine months since we've had elevated mortgage rates post, the mini budget has shown that customers can absorb this cost. Not easy for our customers by any means.

We also have a very sharp view, as you'd expect from us and what, given our business model, for those customers that have a more significant shock on their interest to income payments. One of the levels we've looked at historically is about 40%. When the mortgage payment goes above 40% of their income, we know that's a moment in time that they sometimes are looking for support. We have a very modest percentage of our portfolio today in that level.

Interestingly, when we model that going forward for the next two years, it doesn't grow very much as a percentage of our portfolio, and that's because a lot of those customers are on standard variable rates, so they've already experienced, you know, 5% of what we think will be a 5.5% base rate. You know, not easy for those customers, but we think the customers are well-placed to make the difficult choices to deal with this. One other thought, and you can see this from the data, which is obviously a mortgage is, you know, it's very expensive in the context of U.K. consumers, and that's why the average income is GBP 75,000.

We also know that for that end of the market in the UK, people have broader financial resilience. One of the indicators, as you know, is we've talked about the incremental savings that we have in our customers since COVID. We talked during COVID, that peaked about GBP 70 billion of growth in savings. We still have over GBP 60 billion of those incremental savings, and that will tend to be for customers in the higher deciles of the wealth income distribution. We know these customers have financial resilience. That's then validated by the spend behavior we're seeing more broadly. Thanks, Bobby.

Operator (participant)

Thank you. Our next question is from Andrew Coombs, from Citi. Your line is unmuted, please go ahead.

Andrew Coombs (Equity Research Analyst)

Good morning. I have two questions on mortgages, please. Firstly, looking at the movement in the mortgage book, perhaps you could just comment on what you're seeing both in terms of people repaying down on SVR, but also those taking advantage of the 10% window, on the fixed pieces. Are you seeing greater prepayment? How does that then feed through into your EIR assumption, for the mortgage, NII? Second question, previously, you've given some color on the split between product transfer and new business, margins within that 50 basis points. Anything you can say on that would also be interesting. Thank you.

William Chalmers (CFO)

Andrew, sorry, the second question was on.

Andrew Coombs (Equity Research Analyst)

Product transfer.

Charlie Nunn (CEO)

Product transfer.

Andrew Coombs (Equity Research Analyst)

Okay, fine.

William Chalmers (CFO)

Yeah. Sorry, right. Thank you, Andrew. I'll make a couple of comments, Charlie may want to add. On the SVR book, as noted in my comments, is now down to about GBP 39 billion. That has seen, as a proportion of the book, some relatively high repayments. I think we quoted a number of around 30% in the course of Q2. Actually, if you look at the absolute number of repayments, that is much more stable. What you're seeing is the absolute number is staying relatively stable, in fact, maybe even coming down a touch. Because it's against a smaller denominator as a percentage, it's accordingly a bit more. What that means is that the...

In absolute terms, Andrew, the pace of the SVR runoff, if you like, is reducing over time, as I think customers value in the SVR product, the ability to repay whatever it is they want to repay at any point in time. In the context of the SVR book, which, by the way, has pretty low average balances of less than GBP 50,000, the incremental interest cost to them is not necessarily that much when you compare it to the convenience that they derive from being on an SVR that allows them to pay back again, whatever it is they want to pay back, whenever they want to pay back. We do keep in regular touch with our customers on the SVR book and make sure that they are aware of all of the opportunities to refinance or indeed pay back at any given moment.

There is no concept, if you like, of mortgage prisoners or anything like that in the SVR book, and customers are free to do what they want. Hopefully, that gives you a bit of a sense as to what's going on there. You asked about EIR. I'm not quite sure whether I caught the question or not, but if it's relevant to what went on recently in the EIR market, when we look at our EIR, first of all, the asset is less than GBP 200 million. Second, as we account for EIR, we do not take account of or accrue for any benefits that we might see off the back of the customer staying on SVR after they've come off the fixed rate deal.

All of our EIR is accounted for up to, and only up to, the point in which the fixed rate deal stops. That means in turn, that we are unlikely to see, in fact, I think it's conceptually impossible for us to see the type of issue that came up in the market most recently. Your second question, Andrew, around product transfer versus new business. You're right to point it out. We have a completion margin that is 50 basis points. That 50 basis points is a blended average based upon new business and based upon product transfer. Just to give you some idea, without putting too precise a numbers on it, product transfer is materially ahead of that... sorry, forgive me. New business is materially ahead of that 50 basis points completion margin. Quite a bit ahead of it.

Product transfer is, typically, we've seen it around sort of 35-40 basis points in that zone. The issue with both of these numbers, both new business and product transfer, Andrew, is that in a time of swap volatility, the spreads go up and down in line with the swap. You have a price out there that then gets affected by the swaps, even though obviously we are hedging our exposures as best we can to make sure that we're not exposed. I think what we need, Andrew, in order to figure out what is the true equilibrium pricing within the mortgage market, is a period of swap stability that then allows people to price with a degree of certainty as we go forward, which in turn will give us some insight as to what a true swap, mortgage equilibrium margin looks like.

As you know, in the past, we've thought that it is north of 50 basis points. I think we continue to think that, in part, in no small part, because actually the 50 basis points completion margin is produced at a time of tremendous and mostly upwards swap volatility, which is compressed margins. We continue to adhere to the view that over time, if we do get that period of stability, we should see margin spreads moving out from the 50 basis points that we're seeing. To be clear, we're not banking on that in the guidance that we're giving you for group margins as we stand today.

Charlie Nunn (CEO)

(Uncertain) William, which I know you've said a few times, but just it's worth reinforcing, in this context is, because product transfers are for existing customers, we understand their risk. We can look at their broader relationship. We see good economic returns at the kind of rates that William's talking about. We're very comfortable with the returns on this margin. I think the opportunity with that stability that we should see starting to come around to offset, see what happens, as William said, on the upside. Thanks, Andrew.

William Chalmers (CFO)

I think there may be one more question. Then there's one comment I'd like to make actually before we wrap up. Let's take the question first.

Operator (participant)

Thank you. As you know, this call is scheduled for 90 minutes, we have now reached the end of the allotted time. This will be the last question we have time for this morning. If you have any further questions, please contact the Lloyds investor relations team. Our final question is from Joseph Dickerson from Jefferies. Your line is unmuted. Please go ahead.

Joseph Dickerson (European Banks Research Analyst)

Hi. Thank you, gentlemen, for taking my question. You've provided a very strong return on tangible equity guidance of greater than 14% this year. I think your existing ROTE guidance for next year is greater than 13. I guess, is that stale at this point, or could you discuss the moving parts as to how we go from 13, greater than 14 down to greater than 13? Is this a normalization of TNAV? Is it, you know, lower rates and the impact on NIM? I guess, what's the, what would be the drivers of that, or is this one that's likely to be updated in the future? Thanks.

William Chalmers (CFO)

Yeah. Thanks, Joe. Couple of points to make there. First, I'm afraid it's a bit predictable, which is to say that today we're not going to comment further on 2024 expectations, beyond what we've already said. We won't give precise guidance on 2024. I don't think that'll surprise you. Second, our ROTE guidance that is extant for 2024, as we announced at the beginning of this year, is actually, just to be clear, circa 13% rather than greater than. A small point, but perhaps just worth mentioning. Third, just to give you a bit of a sense of direction as we move forward into 2023, and therefore, kind of set the stage, I suppose, for 2024. We've talked about the expectations for ROTE during the course of this year.

That is a function of some of the banking earnings trends that we've mentioned. The margin, the AIA contributions, together with things like operating lease appreciation normalizing. Those in turn, are likely to continue as we go into 2024 in terms of patterns. Again, we'll leave the guidance to the end of the year, as we normally do. Secondarily, we talked a lot about TNAV on this call, and TNAV is going to build in the second half of 2023, is our expectation. That gives you a stronger starting point for 2024. Joe, I apologize, it's not very detailed, but hopefully it gives you a bit of a sense as to the trends that we expect to see continuing into the next year. Before we wrap up, I mentioned that I just wanted to add...

Sorry, Joe, did you have any further questions on that, or does that address your query?

Joseph Dickerson (European Banks Research Analyst)

I'll let you go with your comment. I'll follow up later. Thanks.

William Chalmers (CFO)

Thank you. It's just a very small point, actually, which is that Robin Down asked a question as to whether or not OI was expected to grow off the back of H1 of this year or off the back of H2 of last year. I just wanted to clarify, looking back at the numbers, Robin, to address your question, the answer is both. I think I answered your question as to H2 of last year. In fact, looking at my numbers, the answer is both. I think that wraps it up, operator. Thank you to everybody for attending the call and taking the time.

Charlie Nunn (CEO)

Yeah, thanks for the time.

Operator (participant)

Thank you. This concludes today's call. There will be a replay of the call and webcast available on the Lloyds Banking Group website. Thank you for participating. You may now disconnect your lines.