2021 Q1 Interim Management Statement

REVIEW OF PERFORMANCE

Solid financial performance reflects business momentum and improved economic outlook

The Group's statutory profit before tax for the first quarter of 2021 was £1,898 million, benefiting from solid business momentum and a net impairment credit as a result of the UK's improved economic outlook. Underlying profit was £2,071 million, compared to £558 million in the first three months of 2020, reflecting both the improved impairment outcome and lower total costs, partially offset by lower net income. Trading surplus is recovering at £1,748 million, down 12 per cent compared to the first three months of 2020, but up 21 per cent on the fourth quarter of 2020.

Net income
Net interest income of £2,677 million was down 9 per cent year on year, impacted by a reduced banking net interest margin of 2.49 per cent, reflecting the lower rate environment. The Group's banking net interest margin was up 3 basis points compared to the fourth quarter of 2020 reflecting the continued optimisation of the Corporate and Institutional book within Commercial Banking, strong customer deposit inflows and funding and capital benefits following the liability management exercise in the fourth quarter of 2020. Relative to the fourth quarter of 2020, lower structural hedge net interest income was largely offset by growth in mortgage volumes at attractive margins.

Average interest-earning banking assets were up 2 per cent compared to the first quarter of 2020 at £439 billion, driven by growth in the open mortgage book and an increase in government-backed lending. This was partially offset by lower balances in credit cards, motor finance and unsecured personal loans, as well as the effects of the continued optimisation of the Corporate and Institutional book within Commercial Banking. Low single-digit percentage growth in average interest-earning assets is now expected in 2021.

The Group manages the risk to its earnings and capital from movements in interest rates centrally by hedging the net liabilities which are stable or less sensitive to movements in rates. As at 31 March 2021 the Group's structural hedge had an approved capacity of £210 billion (in-line with year-end 2020), a nominal balance of £207 billion (31 December 2020: £186 billion) which has increased towards approved capacity and a weighted-average duration of around three-and-a-half years (31 December 2020: around two-and-a-half years). The Group generated £0.5 billion (on a 3 month LIBOR basis) of gross income from the structural hedge balances in the first quarter of 2021 (first quarter of 2020: £0.7 billion, fourth quarter of 2020: £0.5 billion) with emerging benefits from higher market rates seen in the quarter. Following the end of the quarter, the Group's approved structural hedge capacity has been increased to £225 billion, capturing part of the liability growth since the beginning of 2020 and reflecting the Group's continued success in attracting current account balances over the last year.

The Group now expects the net interest margin for 2021 to be in excess of 245 basis points.

Other income of £1,135 million was 7 per cent lower than in the first quarter of 2020 reflecting lower levels of customer activity and new business as a consequence of the coronavirus pandemic, particularly within Retail and Insurance and Wealth. This was in part mitigated by strong performance in the Group's equity investment businesses. In aggregate the Group's other income was up 6 per cent relative to the fourth quarter of 2020, when the Group took a charge in Insurance and Wealth for the annual basis review.

Operating lease depreciation reduced to £148 million (three months to 31 March 2020: £224 million) as a result of the continued impact of a smaller Lex fleet size, combined with a benefit from the more resilient used car price outlook of
c.£30 million.

Total costs
Total costs of £1,916 million were 2 per cent lower than in the first three months of 2020, driven by continued control of operating costs, down 1 per cent at £1,851 million whilst continuing to prioritise investment in the business.

The Group continues to expect operating costs for 2021 to reduce to c.£7.5 billion including net coronavirus-related costs and compensation headwinds.

REVIEW OF PERFORMANCE (continued)

Remediation charges of £65 million (three months to 31 March 2020: £87 million) were related to pre-existing programmes. As highlighted in the 2020 results, in relation to HBOS Reading, decisions from the independent panel re-review on direct and consequential losses will start to be issued during 2021. This is likely to result in further charges but it is not possible to estimate the potential impact at this stage.

Impairment
The impairment charge in the quarter was a net credit of £323 million, compared to a charge of £1,430 million in the first quarter of 2020. The net credit in the quarter was driven by continued strong asset quality with a low charge of £209 million given the continued benign credit environment and a £459 million release of expected credit loss (ECL) allowances resulting from improvements to the UK's economic outlook. The Group has retained the judgemental overlays applied at year end and has continued to offset modelled releases not deemed reflective of underlying risk. Management judgements in respect of coronavirus of c.£1 billion (31 December 2020: c.£0.9 billion) include a central £400 million overlay (31 December 2020: £400 million), as well as c.£600 million of judgements within the underlying portfolios (31 December 2020: c.£500 million).

The Group's ECL allowance reduced in the quarter from £6.9 billion to £6.2 billion, of which £459 million resulted from improvements to the economic outlook, including the impact of the extension of the Government's Coronavirus Job Retention Scheme. Reductions in Commercial Banking ECL also reflect improved outcomes on restructuring cases, lower flows to default and recent reductions in exposures due to asset optimisation.

The ECL allowance remains high by historical standards and is consistent with the Group's updated macroeconomic projections. It assumes that a large proportion of expected losses will crystallise over the next 12 to 18 months as support measures subside and unemployment increases.

Observed credit performance has remained stable in the quarter, with the flow of assets into arrears, defaults and write-offs remaining at low levels in part due to the continued effectiveness of support schemes, including the Coronavirus Job Retention Scheme and payment holidays extended by the Group which have now largely matured. The Group has maintained judgemental ECL allowances in respect of losses assumed to have been suppressed over the last 12 months by support schemes, given that cumulative losses remain lower than would have ordinarily been anticipated.

The Group's £400 million central overlay was added at year end in recognition of the significant uncertainty with regard to the efficacy of the vaccine, the vaccination rollout, potential virus mutations and economic performance post lockdown restrictions and Government support. Although the base case outlook has improved in the first quarter, the Group still considers these risks to remain and that the conditioning assumptions for the base case and associated scenarios around this do not necessarily capture these unprecedented risks.

Given the benefit recognised in the first quarter of the year, the full year charge is now expected to be materially lower than the guidance set out at year-end. Based on the Group's improved economic assumptions, the net asset quality ratio for 2021 is now expected to be below 25 basis points.

REVIEW OF PERFORMANCE (continued)

Impairment charge

¹        Charges based on economic assumptions as at 31 December 2019.

²        Additional (releases)/charges on cases subject to restructuring at the end of 2019, where the coronavirus pandemic is considered to have had a direct effect upon the recovery strategy.

ECL allowance as a percentage of drawn balances

¹        Underlying basis. Refer to basis of presentation on page 19.

²        Expected credit loss.

³        Total and Stage 3 ECL allowances as a percentage of drawn balances are calculated excluding loans in recoveries in Retail and Commercial Banking of £321 million (31 December 2020: £317 million). Comparatives restated to reflect exclusion of Commercial Banking recoveries.

⁴        Includes reverse repos of £52.8 billion (31 December 2020: £58.6 billion).

REVIEW OF PERFORMANCE (continued)

Statutory profit
Restructuring costs of £173 million, up from £63 million in the first quarter of 2020 but down from £233 million in the fourth quarter of 2020, reflected increased severance and technology research and development costs, as well as slightly higher property transformation costs. Volatility and other items reduced to net nil in the first quarter of 2021 (three months to 31 March 2020: net loss of £421 million) with positive insurance volatility and other gains offsetting fair value unwind and the amortisation of purchased intangibles.

Return on tangible equity for the period was 13.9 per cent (three months to 31 March 2020: 3.7 per cent) and earnings per share were 1.8 pence (three months to 31 March 2020: 0.5 pence), both reflecting the benefit of the impairment credit.

The Group recognised a tax expense of £501 million in the period compared to a credit of £406 million in the first three months of 2020. The prior year credit included an uplift in deferred tax assets following the announcement by the UK Government that it would maintain the corporation tax rate at 19 per cent. On 3 March 2021, the Government announced its intention to increase the rate of corporation tax from 19 per cent to 25 per cent with effect from 1 April 2023. Had this change in corporation tax rate been substantively enacted at 31 March 2021, the impact would have been to recognise a      c.£1 billion deferred tax credit in the income statement and a c.£150 million debit within other comprehensive income, increasing the Group's net deferred tax asset by c.£850 million.

Given the improved outlook for both the net interest margin and asset quality ratio, the statutory return on tangible equity for 2021 is now expected to be between 8 and 10 per cent, excluding a c.2.5 percentage point benefit from tax rate changes.

Balance sheet
Loans and advances to customers were up £3.3 billion in the quarter at £443.5 billion, benefiting from an increase of £6.0 billion in the open mortgage book, more than offsetting lower unsecured Retail, Corporate and Institutional, and closed mortgage book balances. Customer deposits of £462.4 billion were up £11.7 billion in the quarter compared to £450.7 billion at 31 December 2020 and included a further increase in Retail current accounts of £5.6 billion to £103.0 billion. The Group's loan to deposit ratio of 96 per cent provides a strong liquidity position and significant potential to lend into recovery.

Capital
The Group's CET1 capital ratio has increased from 16.2 per cent at 31 December 2020 to 16.7 per cent, reflecting capital build in the quarter of 54 basis points, prior to the impact of the dividend accrual. Banking business capital build (pre impairments credit) of 55 basis points and underlying risk-weighted asset reductions of 31 basis points were partly offset by pension contributions and other movements of 26 basis points. The net impact of the impairments credit and partial release of IFRS 9 transitional relief during the quarter was a 6 basis points reduction which included 5 basis points relating to the phased reduction in static relief. The impact of the dividend accrual in the quarter equated to 5 basis points and is currently based upon a pro-rated amount of the 2020 full year dividend.

As previously noted the Group will update the market on interim dividend payments with the half-year results, subsequent to reviewing the PRA's update on distributions which is expected ahead of the half-year results reporting cycle for the large UK banks. In the interim the Group's dividend accrual has been made on an appropriately prudent basis (as set out above) in accordance with PRA guidance. As previously stated, the Board intends to resume its progressive and sustainable ordinary dividend policy with the dividend at a higher level than 2020.

The PRA is continuing to consult on a proposal to reverse the revised capital treatment of intangible software assets that was implemented in December 2020 via EU capital regulations. Should the PRA proceed with their proposal then the reinstatement of the original requirement to deduct these assets from capital will come into force during the year. This would lead to a c.50 basis points reduction in the Group's CET1 capital ratio (net of a reduction in associated risk-weighted assets) and based on the position at 31 March 2021 the ratio would reduce to 16.2 per cent.

REVIEW OF PERFORMANCE (continued)

Risk-weighted assets reduced by £3.8 billion during the quarter, primarily driven by optimisation activity undertaken in Commercial Banking of around £2.5 billion and foreign exchange and other market impacts of £1.1 billion, alongside limited credit migration and balance sheet growth. The Group continues to expect 2021 risk-weighted assets to be broadly stable on 2020.

The Board's view of the ongoing level of CET1 capital required by the Group to grow the business, meet regulatory requirements and cover uncertainties remains at c.12.5 per cent, plus a management buffer of c.1 per cent. The Group's CET1 capital regulatory requirement is currently c.11 per cent.

The transitional total capital ratio reduced to 23.0 per cent (31 December 2020: 23.3 per cent) and the transitional minimum requirement for own funds and eligible liabilities (MREL) reduced to 36.1 per cent (31 December 2020: 36.4 per cent) reflecting the impact of movements in rates and the annual reduction in transitional limits applied to legacy tier 1 and tier 2 instruments, which more than offset the increase in CET1 capital. The UK leverage ratio increased to 6.0 per cent.