In order to provide more meaningful and relevant comparatives, the results of the Group and divisions are presented on a ‘combined businesses’ basis. The key principles adopted in the preparation of the combined businesses basis of reporting are described below.
In order to reflect the impact of the acquisition, the following adjustments have been made: – the 2008 results include the results of HBOS as if it had been acquired on 1 January 2008; – the 2009 results assume HBOS had been owned throughout the year; – the unwind of acquisition-related fair value adjustments is shown as one line in the 2009 combined businesses income statement and has not been back-dated to 2008; and – the gain on acquisition of HBOS and amortisation of purchased intangible assets have been excluded.
In order to better present the underlying business performance the following items, not related to the acquisition, have also been excluded: – the results of BankWest and St. Andrews which were sold in December 2008 and the related loss on disposal; – insurance and policyholder interests volatility; – integration costs; – goodwill impairment; and – Government Asset Protection Scheme (GAPS) fee.
A full version of our Annual Report and Accounts and information relating to Lloyds Banking Group is available at lloydsbankinggroup.com
OUR VISION IS TO BE RECOGNISED AS THE BEST FINANCIAL SERVICES COMPANY IN THE UK BY SHAREHOLDERS, CUSTOMERS AND COLLEAGUES
2009 at a glance: key highlights of the year together with a summary of group results and key performance indicators.
The main focus for the Group remains the financial services markets in the UK and our strategic position was significantly strengthened through the acquisition of HBOS in January 2009. We are a well diversified UK financial services Group and the largest retail financial services provider in the UK. We have leading positions in many of the markets in which we participate, a market leading distribution capability, well recognised brands and a large customer base. The scale of the organisation provides us with the opportunity to further invest in products and services, systems and training that combined will offer unparalleled choice and service to our customers.
All our businesses are focused on extending the reach and depth of our customer relationships, whilst enhancing product capabilities to build competitive advantage. Ensuring we understand and effectively meet the needs of our customers from core banking products to the more specialist services such as insurance, wealth management or corporate banking is at the heart of our business and is fundamental to ensuring we are developing long lasting customer relationships.
Executing our strategy effectively will only be possible if we ensure deliverables are effectively aligned with our corporate strategy and we manage our most valuable resource, our people, well. Our people have the skills and capabilities to deliver the strategy but in driving performance it is important to ensure we encourage, manage and develop our staff whilst creating a great place to work.
The effective integration of the two businesses will be a significant challenge over the next few years, but comprehensive plans are in place and excellent progress is already being made.
of total Group income1 of total Group income1 of total Group income1 of total Group income1
Statutory profit before tax of £1,042 million (2008: £760 million) includes an £11,173 million acquisition-related negative goodwill credit.
Integration ahead of schedule and cost synergies target increased to £2 billion run-rate by the end of 2011. Total cost synergies of £534 million have been realised during the year. Annualised run-rate savings totalled £766 million at the year end.
Total impairments significantly higher at £23,988 million for 2009. Second half impairments were 21 per cent lower than in the first half of 2009. We expect to see a similar pace of half-yearly improvement throughout 2010, with further substantial reductions in 2011 and beyond.
RECONCILIATION OF COMBINED BUSINESSES LOSS BEFORE TAX TO STATUTORY PROFIT BEFORE TAX Loss before tax – combined businesses (6,300) (6,713)
Our commitment to our customers continues to be at the heart of our business and our relationship with them is critical to our success. Only by focusing on the needs of our customers and offering products and services that address those needs can we expect to be successful and deliver benefit to all our stakeholders.
EU STATE AID In November the Group’s restructuring plan was agreed by the European Commission. The board approved the restructuring plan and is confident that this will not have a materially negative impact on the Group.
RESILIENT CORE BUSINESS PERFORMANCE Whilst the capital raising activities took much of the external attention during 2009, the Group has continued to deliver a resilient core business performance in a difficult economic environment. The integration of the two businesses is progressing ahead of schedule and the Group is now very well positioned for future earnings growth.
As we announced on 22 February 2010, our group chief executive, Eric Daniels decided to waive the bonus which the board on the recommendation of the remuneration committee had awarded him. Eric took this decision in the interests of the Group since he felt the public debate about bonuses in the banking industry was in danger of obscuring the very real advances which had been achieved in terms of capital creation, quality of revenues, earnings prospects and write-offs, and integration benefits. We are grateful to Eric for his action. At the same time, I believe it is important for the future that we and our shareholders find a way whereby remuneration models will be allowed to be honoured without the recipient being put in a position to feel he should waive the awards arising from them.
In February 2009 two new non-executive directors were appointed. Anthony Watson CBE brings with him over 40 years experience in the investment management industry. Timothy Ryan is a senior investment banker with a wealth of knowledge and understanding of the financial services industry and significant experience in the governmental sector. Lord Leitch was appointed deputy chairman in May 2009. In March 2010 we will be joined by Glen Moreno and David Roberts. Glen is chairman of Pearson plc and will be senior independent director. He has significant financial and banking industry and public company experience in the UK and abroad. David Roberts’ deep understanding at the most senior level of commercial and retail banking in the UK, Europe and internationally is particularly valuable in that core business of our Group. As you know I joined on 15 September 2009. The full particulars and background of all our directors are set out on pages 96 and 97.
The successful execution of our strategy which is to focus on core markets, on customer and cost leadership, on capital efficiency and on a prudent risk and funding profile should enable the Group to deliver earnings growth and shareholder value whilst achieving its aim to be recognised as the best financial services company in the UK.
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Our significant achievements in 2009 will shape the future of the Lloyds Banking Group. We strengthened our franchise, attracting new customers and building deeper relationships. We have made excellent progress with the integration of HBOS, which we acquired in January 2009. The Group’s capital is robust and our funding profile was strengthened considerably during the period.
ADDRESSING THE KEY ISSUES CREATING THE PLATFORM FOR FUTURE GROWTH We now have market-leading positions in many of the financial markets in which we participate, a market-leading distribution capability, well recognised brands and a large customer base. Over the last 12 months we have appointed the management team and implemented the management structures to ensure delivery of our strategy going forward.
CAPITAL The successful capital raising in December significantly strengthened the Group’s capital ratios. The appropriateness of capital levels will continue to be a focus for the regulatory authorities but we will always seek to satisfy capital requirements in a way that protects and maximises value to shareholders.
Impairments in the year were £24 billion, which is reflective of the problem HBOS portfolios, in particular, the over-concentration in commercial real estate. When we released our half-year results, we said that total Group impairments would peak in that half, and the full-year numbers confirm that guidance.
The Lloyds TSB conservative approach to risk management has been implemented across the Group, and is making a difference. All new lending is within the Group’s risk appetite and the existing portfolios are being managed to Group standards. Looking forward, we expect to see a similar pace of half-yearly improvement throughout 2010, with further substantial reductions in 2011, and beyond. We expect reductions in all three customer divisions, although we remain cautious on the Irish portfolios, given the uncertain economic outlook.
The Group’s aim is to be recognised as the UK’s best financial services business and to deliver sustainable value through the cycle for our customers and shareholders. The principal element of the Group’s strategy remains the focus on building deep, long-lasting customer relationships in all its franchises. We continue to support this with a focus on driving down costs and maintaining effective capital management disciplines, within a strong, conservative, risk management framework.
The Group aims to: – Deliver high single-digit income growth from our continuing businesses within the next two years.
Moreover, the relationship between the Government and the Group falls within the framework document between HM Treasury and UKFI published on 2 March 2009, which states that UKFI will manage investments in the UK financial institutions in which HM Treasury holds an interest on a commercial basis and will not intervene in day-to-day management decisions of the investee companies (including with respect to individual lending or remuneration decisions).
During the last few months of 2009, HM Treasury and the Group were involved in detailed negotiations with the European Commission in relation to the terms of the restructuring plan in order to reach a mutually acceptable solution. The final approval of the UK Government’s state aid measures, including the terms of the final restructuring plan, was agreed by the College of Commissioners in November 2009. The plan consists of the following principal elements: a the disposal of a retail banking business with at least 600 branches, a 4.6 per cent share of the personal current accounts market in the UK and approximately 19 per cent of the Group’s mortgage assets. The business consists of: the TSB brand; the branches, savings accounts and branch based mortgages of Cheltenham & Gloucester; the branches and branch based customers of Lloyds TSB Scotland and a related banking licence; additional Lloyds TSB branches in England and Wales, with branch based customers; and, Intelligent Finance. These disposals need to be made within four years of the date of state aid approval; b an asset reduction programme to achieve a £181 billion reduction in a specified pool of end 2008 assets by 31 December 2014; and c behavioural commitments, including commitments; not to make certain acquisitions for approximately three to four years; and not to make discretionary payments of coupons or to exercise voluntary call options on hybrid securities from 31 January 2010 until 31 January 2012, which will also prevent the Group from paying dividends on its ordinary shares for the same duration.
We expect that the weakness of likely economic recovery will be mirrored in slow growth of major banking markets in 2010 as both households and businesses continue to restructure their finances. However, 2010 may see company failure rates rise again, since it is typically when companies have to restock to meet an upturn in demand that the financial pressures on them are greatest.
In addition, we have already made significant progress in capturing savings from areas such as procurement and, overall, £534 million of cost synergy savings have already been realised, which represent annual run-rate savings of over £760 million. As a result of the integration programme being ahead of schedule the Group has increased its commitment to deliver cost synergies and other operating efficiencies to achieve run-rate savings of £2 billion per annum by the end of 2011. One-off integration costs over this period are expected to total approximately 1.55 times the revised targeted cost synergies. The Group also expects to continue to improve its cost:income ratio by in excess of 2 percentage points per annum during this period, with further improvements thereafter as we seek to optimise the ratio over the medium term.
During 2009 we have experienced a significant rise in impairment levels in the Group’s lending portfolios. This largely represents falls in the value of commercial real estate and the impact of the economic deterioration during the year, including the effects of rising unemployment and reduced corporate cash flows, although the effects of some of these issues started to reduce in the second half of the year. This increase in impairment levels was however partially offset by the accelerated unwind of credit related fair value adjustments taken at the time of the HBOS acquisition totalling over £7 billion. The impairment charge in the second half of 2009 was 21 per cent lower than in the first half of the year, reflecting the peak of overall impairments in the first half.
The Wholesale charge for impairment losses increased significantly by £5,289 million to £15,683 million, reflecting, in particular, the year-on-year decline in commercial property valuations and reduced levels of corporate cash flows. In particular, the real estate related lending exposures in the legacy HBOS portfolios were more sensitive to the downturn in the economic environment.
In June 2009, the Group successfully completed a £4 billion placing and compensatory open offer with the proceeds being used to redeem the £4 billion of preference shares held by HM Treasury. The redemption of the HM Treasury preference shares removed the annual cost of the preference share dividends of £480 million and improves the Group’s cash flow generation.
On 3 November 2009 the Group announced further proposals to meet its current and long-term capital requirements by way of a £13.5 billion rights issue and the generation of at least £7.5 billion (subsequently increased to £9 billion) core tier 1 and/or contingent core tier 1 capital through a number of debt exchange offers. In doing so the Group announced that it would not participate in GAPS. This reflected the more positive economic environment than the conditions prevailing in March 2009 when the Group announced its intention to participate in GAPS. As a result of the highly successful conclusion of this transaction, reflecting the strong support received from shareholders and investors, the Group is now in a robust capital position. We note the various recently issued regulatory capital consultation papers and impact studies and will continue to work with our regulators to ensure this robust capital position is maintained as the ongoing capital requirements for banks continue to change.
The recent extended turbulence in global capital markets has been a severe examination of the banking system’s capacity to absorb sudden significant changes in the funding and liquidity environment, and individual institutions have faced varying, but significant, degrees of stress. The Group has a strong liquidity position which is supported by our robust and stable customer deposit base. The Group continues to benefit from a diversity of funding sources, which have recently been enhanced by the establishment of a US Medium Term Note programme, and a second regulated covered bond programme. The Group’s wholesale funding base
Annual Report and Accounts 2009 has proved to be resilient, supporting the Group’s balance sheet with a reduced dependence on short-term funding. During the year the Group has also significantly increased its holdings of liquid assets from £104.5 billion to £150.8 billion. In addition, the Group has improved the quality of its liquid asset portfolio by increasing its cash at central banks and Government debt securities, and reducing its holdings of eligible bank debt securities.
Impairment as a percentage of average advances3 0.97% 3.32% 1.05% 1.81%
Loans and advances to customers 377.1 234.6 64.6 – 0.9 677.2
Profit before tax and fair value unwind amounted to £975 million, a decrease of £1,567 million on 2008 primarily due to lower income and higher levels of impairment, partly offset by a decrease in operating expenses.
Loans and advances to customers have decreased by 2 per cent, reflecting the impact of customers reducing their personal indebtedness and not taking on new financial commitments.
Customer deposits have increased by 4 per cent, despite the high level of term deposits maturing in the period. The growth in deposits accelerated in the second half of 2009, increasing by £5.6 billion, or 3 per cent.
In Lloyds TSB the role of the bank manager is being re-defined, backed by a marketing campaign, with the focus on traditional customer service and advice, building relationships with the customer within a modern banking environment. Retail also continues to lead the market in the provision of mobile banking services which assist customers in monitoring their bank accounts by providing access through their mobile phone.
Total income has decreased by £1,419 million, or 13 per cent, to £9,774 million, reflecting the impact on margins referred to above, lower payment protection income and non-recurring one-off income in 2008. Total income is analysed as follows:
Consumer Banking (current accounts and unsecured lending) income was broadly unchanged in 2009 compared to 2008. As previously reported, on 1 January 2009 Retail introduced a monthly premium payment protection product and ceased selling single premium products. This new product offers customers the benefit of monthly payments whilst retaining the product’s valuable benefits and has been well received by both customers and the market. Income from this product is recognised over the life of the loan rather than all being recognised in the first year. This reduction in income, together with the effect of lower loan volumes, was broadly offset by a strong performance across the rest of Consumer Banking, including benefits from asset re-pricing.
Retail continued to make good progress in building its mortgage business in a contracting market by focusing on the prime mortgage market, particularly through its network rather than intermediaries, whilst maintaining a prudent approach to risk. Gross new mortgage lending totalled £35 billion during 2009, representing a market share of 24 per cent. Retail has maintained its strong commitment to the housing market and first time buyers, with more than 60 per cent of new lending in 2009 being for house purchase rather than for re-mortgage. In March 2009, the Group committed to increase its planned gross lending to homebuyers by £3 billion in the following 12 months – Retail is on track to deliver this commitment. The average loan-to-value ratio at the end of 2009 was 54.8 per cent compared with 54.9 per cent at the end of 2008, whilst the average loan-to-value ratio on new residential lending in 2009 was 59.3 per cent compared with 63.1 per cent in 2008. Retail continued to be an industry leader in its support for shared equity and share ownership schemes. Specialist lending balances (self-certified and sub-prime) decreased slowly following the decision, at the start of the year, to withdraw from this market. New buy to let lending remained broadly flat at 13 per cent of total mortgage lending; however, redemptions in this book were low. Buy to let mortgage balances have increased by £2.9 billion in the year. Retail continued to carefully assess the risks of such lending and as a result the average loan-to-value on new lending in the buy to let portfolio has fallen to 65.6 per cent at the end of 2009 compared to 73.1 per cent at the end of 2008.
Net interest income has decreased by 18 per cent to £4,710 million. The banking net interest margin decline of 33 basis points since prior year reflected higher wholesale funding costs partly offset by higher asset pricing. Margins fell in the first half of the year but have stabilised in the second half of 2009.
Balance sheet reductions, reflect active de-risking of the balance sheet by either selling down or reducing holdings in debt securities and available-for-sale positions, deleveraging by customers in Wholesale’s strategic segments and the impact of impairments and foreign exchange movements.
For customers who have been adversely impacted by the recession, Wholesale has continued to expand its dedicated Business Support Units across its Corporate, Commercial, Corporate Real Estate and Specialist Finance business areas. Business Support Units offer solutions to customers including providing finance to maintain cash flow and capital restructuring where appropriate. By focusing on effective customer turnaround during turbulent times, Wholesale is deepening relationships and retaining loyal customers.
Wholesale’s ‘through-the-cycle’ commitment to businesses is also supported by other key initiatives such as the SME Business Charter that expects by 2012 to help a further 300,000 people start in business and to stage at least 200 customer seminars a year to help them develop their businesses and to provide additional finance for growth. The Charter ensures that customer interest rates are transparent and reflect the cost of funds and risk in lending to Wholesale’s small business customers. In the fourth quarter of 2009, Commercial held a series of regional customer events aimed at helping customers plan for the upturn by providing practical guidance and maximising networking opportunities through bringing local business communities together.
In order to build capacity for this investment, Wholesale has systematically reviewed its assets, portfolios and businesses to identify those that are not consistent with its relationship-focused strategic vision. Wholesale aims to maximise near-term returns in these businesses, whilst exploring options for divestment during the next three to five years. These comprise approximately £160 billion of Wholesale’s total assets and form part of its commitment under the state aid restructuring plan.
Operating expenses decreased by £485 million, or 11 per cent, to £4,106 million. Excluding the cost of settlement of certain historic US dollar payments practices, expenses decreased by 7 per cent primarily as a result of reduced levels of operating lease business in Asset Finance and a continued focus on cost management including cost savings attributable to the integration programme.
Index to annual report 266 expects the volume of underlying impairments from traditional trading and manufacturing businesses to increase in 2010, as the full impact of economic conditions filters into business insolvencies and asset values. This is a factor of a typical lag effect as the economy passes through the recession, and reflects guidance provided in the first half of the year. However, the effects of this are expected to be significantly less than the benefit of lower absolute impairments from the HBOS Corporate Real Estate and HBOS (UK and US) Corporate portfolios.
Impairment losses as a % of average advances 6.09% 3.78% As at 31 December 2009 2008 Change £bn £bn %
Commercial Banking net interest income decreased due to the lower base rate environment which impacted margins on some current account and savings products, and other operating income decreased slightly, primarily reflecting lower customer transactions and activity in their businesses, as a consequence of the depressed economic environment.
Operating expenses decreased by £122 million, or 5 per cent to £2,461 million, as a result of continued focused cost management. After excluding the cost incurred in 2008 on settlement of certain historic US dollar payments practices, operating expenses increased by 2 per cent, with integration savings offset by increased investment in Wholesale’s customer focused business support functions, which now employ approximately 1,000 people.
Impairment losses increased by £4,959 million to £14,855 million, due to increased levels of impairments across all areas of Corporate Markets, notably in the HBOS Corporate Real Estate and the HBOS (UK and US) Corporate portfolio. The significant increase in impairments in 2009 was against the backdrop of weaker economic conditions; application of Lloyds Banking Group prudent valuation assumptions; portfolio concentration in property lending; material single name exposures; poorly structured lending agreements; and aggressive loan-to-value positions at origination in the legacy HBOS portfolios. However, impairment losses of £9,334 million in the first half of 2009 fell significantly in the second half to £5,521 million, a reduction of 41 per cent.
Loans and receivables: Loans and advances to customers 2.5 4.8 (48)
INCREASING THE PENETRATION OF THE WEALTH OFFERING INTO THE GROUP’S EXISTING CUSTOMER BASE PROVIDES A SIGNIFICANT GROWTH OPPORTUNITY
Wealth and International is a new division formed in 2009 to give increased focus and momentum to the private banking and asset management businesses and to closely co-ordinate the management of our international businesses. The division operates in more than 30 countries around the world.
The Wealth business comprises private banking, wealth and asset management businesses in the UK and overseas. The key operations are UK and International Private Banking, which operate under the Lloyds TSB and Bank of Scotland brands, the Channel Islands and Isle of Man offshore businesses, the expatriates business and the Asset Management business which, following the completion of the sale of Insight Investment, is now consolidated within Scottish Widows Investment Partnership (SWIP). SWIP is one of the largest asset managers in the UK, managing £142 billion worth of assets on behalf of a wide range of institutions. In addition the Group holds a 60 per cent stake in St James’s Place plc and a 55 per cent stake in Invista Real Estate, respectively the UK’s largest independent listed wealth manager and real estate fund management Group.
Profit (loss) before tax and fair value unwind by business unit
Impairment losses as a % of average advances 6.04% 1.05% As at 31 December 2009 2008 Change £bn £bn %
Wealth represents a key growth opportunity for the Group and, through deepening the relationships with existing Group clients alongside targeted external customer acquisition, Wealth’s goal is to be recognised as the trusted advisor to expatriate and private banking clients both in the UK and selected international markets. Wealth’s initial focus in the UK will be to increase the penetration of its offering into the Group’s existing customer base by referring wealthier customers to its private banking businesses where their wider financial needs can be more effectively met. Outside the UK, Wealth will be building on the strengths of its brand portfolio and existing expatriate, offshore and international private banking propositions.
Wealth also represents an opportunity to diversify income growth to less capital intensive businesses and, following an initial outflow of price sensitive deposits in 2009, contribute valuable relationship based customer deposits to improve the Group’s funding profile.
In the International businesses, the priority is to maximise value in the short to medium term. International’s immediate focus is close management of the lending portfolio, particularly in the Irish business, embedding the Group’s risk management policies and procedures and repricing assets where appropriate. At the same time International will be delivering operational efficiencies, reshaping the business models and rightsizing the balance sheet to reflect the ongoing environment.
DEEP AND ENDURING CUSTOMER RELATIONSHIPS In Wealth, the focus has been on driving additional income growth from the Group’s affluent and high net worth client base through more effective use of the opportunities afforded by the Retail and Wholesale franchises to cross-sell Wealth products to these customers. The total number of Wealth relationship clients increased by 8 per cent to approximately 300,000 at the end of 2009, including a 13 per cent increase within UK Wealth. Net new inflows of funds under management in the year were £7 billion.
INTEGRATION Wealth and International is making good progress with the integration of its Wealth operations, including private banking and in particular its asset management businesses. The internal funds management business of Insight Investment has now been transferred to Scottish Widows Investment Partnership (SWIP) pushing it into the top five largest UK active asset managers, with funds under management of £142 billion. Wealth and International is on track to deliver its annualised cost savings target by 2011.
Impairment losses as a % of average advances 0.70% 0.22% As at 31 December 2009 2008 Change £bn £bn %
Loss before tax and fair value unwind increased by £3,404 million to £3,496 million due to an increase in impairment losses, reflecting the significant deterioration in the credit risk environment, particularly in relation to commercial real estate lending in Ireland and Australia, and concentrations in sectors most impacted by the downturn in Australia such as printing, media and transport.
The UK Life, Pensions and Investment business is the leading bancassurance provider in the UK and has one of the largest intermediary sales forces in the industry. The business includes Scottish Widows which, for a number of years, has been a subsidiary of the Lloyds TSB Group and the provider of long term savings and investment products distributed through all Lloyds TSB channels. Following the acquisition of HBOS, our Life, Pensions and Investments business also includes business written through the intermediary and bancassurance channels under the Clerical Medical and Halifax brands respectively.
The combined General Insurance business is a leading distributor of home and payment protection insurance in the UK, with products distributed through the branch network, direct channels and strategic corporate partners. The business is one of the largest underwriters of personal insurance business in the UK and also operates significant brokerage operations for personal and commercial insurances. It operates primarily under the Lloyds TSB, Halifax and Bank of Scotland brands.
Life, Pensions and Investments european embedded value (EEV) new business margins for the year was 2.5 per cent. The margin for the second half of 2009 increased to 2.6 per cent from 2.4 per cent in the first half, reflecting strong cost control and increased focus on the profitability of the combined product range.
General Insurance profits have decreased by 32 per cent to £367 million, due to a £156 million increase in claims, primarily unemployment related, lower investment returns and the market wide move to monthly premium payment protection business.
Life, pensions and investments: Profit before tax and fair value unwind 1,024 1,540 (34)
INTEGRATING THE BUSINESSES The integration of the legacy Life, Pensions and Investments businesses and the legacy General Insurance businesses have progressed well with the 2009 synergy benefits of £55 million significantly exceeding initial expectations. This has been achieved by aligning management structures, moving to a consistent operating model in each business, reducing the number of servicing sites in Life, Pensions and Investments and removing duplicated support functions across both legacies. The full year impact of integration activities already completed and the benefit of planned synergies is expected to lead to further cost reductions in future.
OPERATIONAL AND CAPITAL EFFICIENCY The Insurance division continues to focus on cost reduction, with underlying costs decreasing by 8 per cent after allowing for the allocation of Lloyds TSB Insurance claims handling expenses to claims rather than expenses in 2009 and the non-recurrence of certain 2008 HBOS marketing costs. Another major factor has been a reduction in staff numbers. The synergy savings and additional operational efficiencies have been achieved without compromising the quality of customer service with customer satisfaction scores remaining robust across the businesses.
Improving capital efficiency remained a key priority throughout 2009. At a product level, initiatives focused on improving return on capital for example by continuing to move away from products with initial commission and changes in product design which allow for capital to be recovered more quickly. Capital efficiency was further enhanced through the repurchase of £0.6 billion of Clerical Medical’s subordinated capital. In 2009, dividends totalling £0.5 billion were paid by companies in the Insurance division to the Group and a number of hedging initiatives were completed with the aim of managing capital and profit volatility.
In General Insurance, Home insurance total gross written premiums through the bancassurance network increased by 5 per cent. Home retention rates for both brands in the retail business improved in the second half of the year as a result of a combination of an improving market and a customer loyalty programme.
As required under International Financial Reporting Standards (IFRS), products are split between insurance and investment contracts depending on the level of insurance risk contained. For insurance contracts, the new business profit includes the net present value of profits expected to emerge over the lifetime of the contract, including profits anticipated in periods after the year of sale; for investment contracts the figure reflects the profit in the year of sale only, after allowing for the deferral of initial income and expenses. Consequently the recognition of profit for investment contracts is deferred relative to insurance contracts.
Existing business profit has reduced by 10 per cent. The figure includes a reduction in expected return, reflecting lower asset values resulting from adverse investment markets in 2008, a lower assumed rate of return and the non-recurrence of one-off benefits in HBOS of £211 million relating to a more market consistent basis of embedded value and enhancements to the bond proposition. Those impacts have been partly offset by a significant reduction in charges for policyholder lapses in 2009. The customer loyalty programmes have proved to be increasingly successful during 2009 but given the potential volatility of behaviour caused by turbulent markets an appropriately prudent approach has been taken in the assessment of future trends.
Insurance group was £1.3 billion, with additional surplus within the Long Term Fund of an estimated £1.1 billion, and the estimated IGD capital surplus for the HBOS Insurance group was £1.6 billion. The IGD capital surpluses include £0.5 billion and £0.1 billion respectively of assets in the Long Term Fund, as allowed by the FSA in December 2009, not previously recognised in the calculation of IGD capital.
NEW BUSINESS An analysis of the present value of new business premiums for business written by the Insurance division, split between the UK and European Life, Pensions and Investments businesses is given below: UK Europe Total UK Europe Total Change £m £m £m £m £m £m %
New business profit has decreased by 39 per cent to £341 million, reflecting a reduction in sales volumes driven by adverse economic conditions and the reduction in new business from the withdrawal of legacy HBOS products with poor returns. The new business margin for Life, Pensions and Investments UK has increased in the second half of 2009 to 2.7 per cent from 2.5 per cent in the first half, reflecting strong cost control and increased focus on the profitability of the combined product range. The margin in respect of the heritage Scottish Widows products increased to 3.5 per cent in 2009 from 3.2 per cent in 2008.
Expected return on existing business has decreased by 33 per cent to £268 million, reflecting a reduction in the value of the opening balance sheet, driven by lower asset values from adverse investment markets in 2008, and a reduction in the assumed rate of return. The expected return on shareholders’ net assets has reduced by 25 per cent to £219 million for the same reasons.
RECONCILIATION OF OPENING EEV BALANCE SHEET TO CLOSING EEV BALANCE SHEET ON COVERED BUSINESS
ANALYSIS OF SHAREHOLDERS’ NET ASSETS ON AN EEV BASIS ON COVERED BUSINESS
The liabilities in respect of the Group’s UK annuity business are matched by a portfolio of fixed interest securities, including a large proportion of corporate bonds. In accordance with the approach adopted in December 2008, the value of the in-force business asset for annuity business has been calculated after taking into account an estimate of the market premium for illiquidity in respect of these corporate bond holdings.
For December 2008 onwards, the risk-free rate assumed in valuing the non-annuity in-force business is the 15 year government bond yield for the appropriate territory. The risk-free rate assumed in valuing the in-force asset for the UK annuity business is presented as a single risk-free rate to allow a better comparison to the rate used for other business. That single risk-free rate has been derived to give the equivalent value to the UK annuity book, had that book been valued using the UK gilt yield curve increased to reflect the illiquidity premium described above. The risk-free rate used in valuing financial options and guarantees in the Scottish Widows With Profit Fund is defined as the spot yield derived from the UK gilt yield curve. A similar approach is taken to valuing the financial options and guarantees in the HBOS Life, Pensions and Investments business. The table below shows the range of resulting yields and other key assumptions.
SENSITIVITY ANALYSIS The table below shows the sensitivity of the EEV and the new business profit before tax to movements in some of the key assumptions. The impact of a change in the assumption has only been shown in one direction as the impact can be assumed to be reasonably symmetrical.
Impact on new business profit before tax £m £m 100 basis points reduction in risk-free rate1 224 13 10 per cent reduction in market values of equity assets2 (276) n/a 10 per cent reduction in market values of property assets3 (17) n/a 10 per cent reduction in expenses4 229 51 10 per cent reduction in lapses5 205 48 5 per cent reduction in annuitant mortality6 (87) (3)
5 per cent reduction in mortality and morbidity (excluding annuitants)7 57 11 100 basis points increase in equity and property returns8 nil nil 25 basis points increase in corporate bond spreads9 (107) (6)
In sensitivities (4) to (7) and (9) assumptions have been flexed on the basis used to calculate the value of in-force business and the realistic and statutory reserving bases. A change in risk discount rates is not relevant as the risk discount rate is not an input to a market consistent valuation.
Against the background of a particularly competitive market in which the General Insurance business has a leading position, home insurance income generated modest growth of 1 per cent to £874 million. Payment protection insurance income decreased by £16 million, or 4 per cent, to £349 million as a result of the market wide move to monthly premiums on payment protection, partly offset by lower distribution commission payable to the Retail division.
Other income has reduced, primarily reflecting lower interest rates and the allocation of certain charges.
The division operates through four primary business functions; Information Technology; Operations; Procurement and Property. The Information Technology area provides technological expertise to each area of the Group whilst Operations includes Banking Operations, Collections and Recoveries and Payments and Business Services. The role of Procurement is to ensure that the Group gets the best value from its external expenditure and strategic suppliers and Property manages and maintains the Group’s estates portfolio.
Group Operations’ support function costs have increased by £12 million, or 13 per cent, to £101 million, primarily driven by costs of £15 million relating to investments to further improve payments filtering and ensuring that the demands of increased regulation are met. Underlying support function costs have remained flat compared to 2008.
The expected sterling investment returns used to determine the normalised profit of the business, which are based on prevailing market rates and published research into historical investment return differentials, are set out below: United Kingdom (Sterling) 2010
The application of accounting standards results in the introduction of other sources of significant volatility into the pre-tax profits of the life and pensions business. In order to provide a clearer representation of the performance of the business, and consistent with the way in which it is managed, equalisation adjustments are made to remove this volatility from underlying profits. The effect of these adjustments is separately disclosed as policyholder interests volatility; there is no impact upon profit attributable to equity shareholders over the long term.
The Group’s policy is to use natural turnover and to redeploy people wherever possible to retain their expertise and knowledge within the Group. Where it is necessary for colleagues to leave the Company, this is achieved by offering voluntary severance and by making less use of contractors and agency colleagues. Compulsory redundancies are a last resort.
2009 was significant in relation to people integration. We have successfully managed the initial stages, working at pace to establish controls and embed risk management practices, by defining and implementing the new organisational structure and selecting for it. The top 400 leaders were in place by month three and over 35,000 colleagues went through selection in 2009. Inevitably in bringing the two organisations together, there has been an opportunity to rationalise and this has led to a reduction in roles. Where possible we have either redeployed colleagues to other areas of the Group or reduced numbers through natural attrition. Where it has been necessary for colleagues to leave the company, this has been achieved by offering voluntary severance and by making less use of contractors and agency colleagues. Compulsory redundancies are always a last resort.
In 2009, we extended the scope of the Colleague Survey to include all UK and International colleagues across both Lloyds TSB and HBOS legacy organisations. We achieved a record response rate of 81 per cent in 2009 which represents a significant improvement on previous response rates achieved by Lloyds TSB between 2005 and 2008. This is regarded as ‘best in class’, particularly given the frequency and scope of the Group survey.
Looking forward to 2010 we will be expanding the foundation element to include a Risk placement so that our graduates get first hand experience in financial services control processes. We are consistently identified in The Times Top 100 organisations for graduate recruitment and in 2009 the Lloyds TSB heritage climbed to 39th.
We actively track and manage retention of our highest performers, retaining 95 per cent of top performers in 2009.
To deliver great service and results we ensure that we equip our colleagues with a range of appropriate technical capabilities to enable them to support our customers effectively. Our business-focused learning programmes cover critical business skills such as risk, relationship and financial management.
As part of this we support a range of programmes linked to professional qualifications or relevant external certification; these provide colleagues with relevant performance benchmarks and professional qualifications. Such programmes enable us to develop our colleagues in line with recognised industry standards and provide confidence to customers and other stakeholders.
Line managers have a vital role in helping bring our values to life for colleagues and a key focus remains the development and strengthening of management and leadership skills. In 2009 we have placed particular emphasis on performance management and leading during a period of rapid change.
In 2009 we have begun to build a leading edge diversity and inclusion strategy for Lloyds Banking Group, consulting with colleagues across the group and using the best elements of the respective Lloyds TSB and HBOS diversity programmes.
There has been a renewed focus in the regulatory environment, specifically relating to the link between business risk and the reward arrangements for individuals. In compliance with these requirements we have reviewed our governance arrangements to ensure they are best practice and comply with the FSA and G20 positions. They also ensure that our rewards are managed fairly and consistently, in line with our Group values.
Our corporate responsibility strategy is helping us to deliver this vision. That means: – Demonstrating financial strength and stability
– Being an employer of choice and maximising our colleagues’ potential
The board considers individual corporate responsibility issues throughout the year, and reviews our performance at the end of it. In 2009, we established a new corporate responsibility steering group, comprising senior executives from across the Group. Chaired by Angie Risley, Group HR Director, and reporting to the group chief executive, the steering group meets on a regular basis to review strategy, monitor progress and make sure we achieve our objectives.
Most of our corporate responsibility activity takes place in the business divisions. It is driven by a network of senior managers, who act as corporate responsibility champions. They ensure that we conduct our business in a responsible way and inform our corporate responsibility strategy.
PERFORMANCE IN INDEPENDENT CORPORATE RESPONSIBILITY BENCHMARKS We are included in the FTSE4Good Ethical Index; the Dow Jones Sustainability Index; the Carbon Disclosure Project’s Leadership Index and we are ranked Platinum in Business in the Community’s Corporate Responsibility Index.
Our approach to colleagues is covered separately on pages 50 and 51. Issues covered in this section include diversity, colleague engagement, reward and learning and development. Our philosophy is based on the premise that our people are a great asset for the Group and important advocates of our strategy and contribution to society. We are focused on bringing our corporate responsibility strategy to life with our colleagues through a range of internal communications throughout the year.
HELPING HOUSEHOLDS Lloyds Banking Group is the UK’s largest mortgage lender. In 2009, we wrote £34.7 billion of new mortgages.
We are the largest provider of finance to first time home buyers. In 2009, through our Lloyds TSB brand, we launched the market leading ‘Lend a Hand’ mortgage. This three year mortgage offers first time buyers a 95 per cent loan-to-value mortgage at 4.39 per cent by taking a legal charge on a savings account belonging to their parents. The legal charge means the parents retain ownership of their savings while earning a competitive fixed interest rate of 3.5 per cent.
In November 2009, we further underlined our support for UK businesses with the launch of a new 2012 SME Charter, setting out a series of commitments that form a three year programme of support for SMEs to help them grow as the recovery gains momentum. The Charter aims to encourage enterprise, boost access to finance and provide clear and fairer pricing for customers, as well as help 300,000 new start-ups across the country by 2012.
PROVIDING CONSUMER CREDIT As a responsible lender, we wish to ensure customers only borrow what they can afford to repay. Each customer’s circumstances are different and we use an affordability model, to better assess a customer’s ability to repay, in order to achieve this.
CORPORATE RESPONSIBILITY continued the capacity of further education colleges, providers of publicly funded training for apprenticeships, providers of local authority adult and prison education to improve the financial skills of the 10 million adults and young people which they serve. We plan to launch the programme in 2010.
Much of the Group’s charitable giving is channelled through the Lloyds TSB Foundations, which cover England and Wales, Scotland, Northern Ireland and the Channel Islands. In 2009, the Lloyds TSB Foundations received £29 million in grants from the Group to support their work in some of the most vulnerable communities in the UK.
Our main contribution to society is as a major employer and purchaser of goods and services. We are one of the UK’s biggest private sector employers and have a presence in almost every community. Our economic contribution to society is supported by our active investment in these communities and our community giving programme.
OUR COMMUNITY PROJECTS As the Official Banking and Insurance Partner of the London 2012 Olympic and Paralympic Games, we have a compelling vision: ‘To inspire and support young people, communities and businesses all over Britain on their journey to London 2012 and beyond’. London 2012 will touch every person in Britain and our employees and branches have a vital role to play in this.
We support the next generation of sporting talent through our Lloyds TSB Local Heroes Programme, providing funding to more than 250 emerging young athletes each year across Britain, at a time when they need it most.
Lloyds TSB National School Sport week is the biggest community sport programme in the UK and uses the power of the London 2012 Games to inspire young people to understand the benefits of sport and take part in more sporting activity. The programme is delivered in partnership with the charity Youth Sport Trust.
The initiative builds on Bank of Scotland’s on-going support for grassroots football in Scotland. Through a partnership with the Scottish FA, the bank supports programmes which operate in all 32 local authorities across Scotland to deliver football training and leagues involving over 300 schools and 10,000 young people.
We consider a range of factors when selecting suppliers, including their social, ethical and environmental credentials. In 2009, we launched a dedicated intranet site across the Group which provides colleagues with information, guidance and tools on incorporating social, environmental and ethical criteria in all of our sourcing activities; in the selection of suppliers and as part of supplier audits. We have collaborative relationships with suppliers, facilitating continuous improvement and implementing joint improvement plans. This ensures consistency across the Group in our approach to corporate responsibility in the supply chain.
No payments 2009 data represents the combined new Group. Historical data is Lloyds TSB only.
We have a long-standing commitment to managing our environmental impacts. We first introduced an environmental policy in 1996. In 2009, we reviewed the policy against best practice to ensure that it is fit for purpose across the whole of the Group. Further work will be undertaken during 2010 to produce and embed an enhanced and integrated environmental management system.
Understanding what the customer wants is at the heart of our business. Our new approach to measuring customer advocacy helps provide more insight into the service we deliver.
We have a crucial role to play in the recovery of the UK economy. Our support for households and small businesses was further underlined in 2009 by our participation in twelve Government schemes designed to help them.
This board level engagement, coupled with the direct involvement of senior management in group-wide risk issues at group executive committee level, ensures that issues are escalated on a timely basis and appropriate remediation plans are put in place. The interaction of the executive and non-executive governance structures relies upon a culture of transparency and openness that is encouraged by senior management. Key decisions are always taken by more than one person.
The Group has a conservative business model embodied by a risk culture founded on prudence and accountability, where everyone understands that they are accountable for the risks they take and that the needs of customers are paramount. The focus has been and remains on building and sustaining long-term relationships with customers, through good and bad economic times. The approach is supported by a ‘through the cycle’ approach to risk with strong central control and monitoring.
As part of its integration initiative, the Group has been rolling out the methodology and financial control framework that was used by the heritage Lloyds TSB Group; this includes compliance with the requirements of the US Sarbanes Oxley Act. This project is due to complete in time for reporting in February 2011.
Although the layout of the Risk Management section has been left largely unchanged from previous years, more quantitative and qualitative information has been provided for Credit and Liquidity.
The Group is subject to European state aid obligations as a result of the aid it received from HM Treasury. In November 2009 the College of Commissioners approved the Group’s restructuring plan, which is designed to address any competition distortions arising from the benefits of state aid. The Group agreed with HM Treasury in the deed relating to its withdrawal from GAPS that it will comply with the terms of the European Commission’s decision. This has placed a number of requirements on the Group including the disposal of certain portions of its business over the course of the next four years, including in particular the disposal of some parts of its retail banking business. This will require the Group to work closely with EU and UK authorities to demonstrate that it is complying with the terms of the European Commission’s decision.
United Kingdom Financial Investments has been appointed manager of HM Treasury’s shareholding and the framework document between UKFI and HM Treasury states that UKFI will manage the UK fi nancial institutions in which HM Treasury holds an interest ‘on a commercial basis and will not intervene in day-to-day management decisions of the Investee Companies (as defi ned therein)’. This document also makes it clear that such institutions will continue to be separate economic units with independent powers of decision and ‘will continue to have their own independent boards and management teams, determining their own strategies and commercial policies including business plans and budgets’.
In particular, the risk oversight committee, which comprises non-executive directors, oversees the development, implementation and maintenance of the group’s overall risk management framework and its risk appetite, strategy, principles and policies, to ensure they are in line with emerging regulatory, corporate governance and industry best practice. The risk oversight committee regularly reviews the Group’s risk exposures across the primary risk drivers and the detailed risk types.
The group executive committee assisted by the group business risk committee and the group asset and liability committee, supports the group chief executive in ensuring the effectiveness of the Group’s risk management framework and the clear articulation of the Group’s risk policies, whilst also reviewing the Group’s aggregate risk exposures and concentrations of risk. The GEC’s duties are described in greater detail on page 102.
The Lloyds Banking Group business strategy and objective is used to determine the Group’s high level risk principles and risk appetite measures and metrics for the primary risk drivers (see table 1.3). The risk appetite is proposed by the group chief executive and reviewed by various governance bodies including the group executive committee and the risk oversight committee. Responsibility for the approval of risk appetite rests with the board. The approved high level appetite and limits are delegated to individual group executive committee members by the group chief executive.
Detailed group policy – detailed policy that applies across the Group
Divisional policy – local policy that specifically applies to a division
Divisional and business unit policy is only produced by exception and is not necessary unless there is a specific area for which a particular division or business unit requires a greater level of detail than is appropriate for group level policy. The governance arrangements for development of, and compliance with, group, divisional and business unit policy and the associated accountabilities are clearly outlined to all colleagues. Colleagues are expected to be aware of policies and procedures which apply to them and their work and to observe the relevant policies and procedures. Line management in each business area has primary responsibility for ensuring that group policies and the relevant local policies and procedures are known and observed by all colleagues within that area.
Group and divisional risk functions have responsibility for overseeing effective implementation of policy. Group audit provides independent assurance to the board about the effectiveness of the Group’s control framework and adherence to policy. Policies are reviewed annually to ensure they remain fit for purpose.
Liquidity risk is managed within a board approved framework using a range of metrics to monitor the Group’s profile against its stated appetite and potential market conditions.
Customer treatment and how the Group manages its customer relationships affects all aspects of Lloyds Banking Group’s operations and is closely aligned with achievement of Lloyds Banking Group’s strategic aim – to create deep long lasting relationships with its customers. There is currently a high level of scrutiny regarding the treatment of customers by fi nancial institutions from the press, politicians and regulatory bodies.
The delivery of Lloyds Banking Group’s objectives is underpinned by the ability to attract, retain and develop the best talent in the industry. The challenges to the people agenda have never been greater with increased regulatory and public interest in remuneration practices, the effects of the Government shareholding and the impacts of integration. Lloyds Banking Group welcomes the regulation of remuneration provided there is an international consensus and will comply with the FSA Code. The Group has managed the initial stages of integration, working to establish control by defining and implementing the new organisational structures and continues to manage the relationship with colleagues during this period of change. The Group has policies, procedures and governance arrangements in place to ensure the effective management of people risk as the Group integrates and grows its business. The Group has published proposals to harmonise employee terms and conditions across the Group and is consulting with the various representative unions. The Group actively manages its relationships with unions, but is aware of the danger of industrial action, business disruption and reputational impact arising from union behaviour and communications. People risk is closely monitored as a key risk indicator, as well as being subject to oversight by the board.
RISK DRIVERS The Group’s risk language is designed to capture the Group’s ‘primary risk drivers’. A description of each ‘primary risk driver’, including definition, appetite, control and exposures, is included below. These are further sub divided into 29 more granular risk types to enable more detailed review and facilitate appropriate reporting and monitoring, as set out in table 1.3.
Through the Group’s risk management processes, these risks are assessed on an ongoing basis and seek to ensure optimisation of risk and reward and that, where required, appropriate mitigation is in place. Both quantitative and qualitative factors are considered in assessing the Group’s current and potential future risks.
RISK APPETITE Business risk appetite is encapsulated in the Group’s budget and medium-term plan, which are sanctioned by the board on an annual basis. Divisions and business units plans are aligned to the Group’s overall business risk appetite.
MITIGATION As part of the annual business planning process, the Group develops a set of management actions to prevent or mitigate the impact on earnings in the event that business risks materialise. Additionally, business risk monitoring, through regular reports and oversight, results in corrective actions to plans and reductions in exposures where necessary.
DEFINITION The risk of reductions in earnings and/or value, through financial or reputational loss, as a result of the failure of the party with whom the Group has contracted to meet its obligations (both on and off balance sheet).
Credit risk can also arise from debt securities, private equity investments, derivatives and foreign exchange activities. Note 18 to the financial statements shows the total notional principal amount of interest rate, exchange rate, credit derivative and equity and other contracts outstanding at 31 December 2009. The notional principal amount does not, however, represent the Group’s credit risk exposure, which is limited to the current cost of replacing contracts with a positive value to the Group. Such amounts are reflected in note 54 on page 231.
Credit risk exposures in the insurance businesses arise primarily from holding investments and from exposure to reinsurers. A significant proportion of the investments are held in unit linked and with profit funds where the shareholder risk is limited, subject to any guarantees given.
MITIGATION The Group uses a range of approaches to mitigate credit risk.
Internal control – Credit principles and policy: group risk sets out the Group credit principles and policy according to which credit risk is managed, which in turn is the basis for divisional and business unit credit policy. Principles and policy are reviewed regularly and any changes are subject to a review and approval process. Divisional and business unit policy includes lending guidelines, which define the responsibilities of lending officers and provide a disciplined and focused benchmark for credit decisions.
– Stress testing and scenario analysis: The credit portfolio is also subjected to stress-testing and scenario analysis, to simulate outcomes and calculate their associated impact. Events are modelled at a group wide level, at divisional and business unit level and by rating model and portfolio, for example, for a specific industry sector.
MONITORING – Portfolio monitoring and reporting: In conjunction with group risk, businesses and divisions identify and define portfolios of credit and related risk exposures and the key benchmarks, behaviours and characteristics by which those portfolios are managed in terms of credit risk exposure. This entails the production and analysis of regular portfolio monitoring reports for review by senior management. Group risk in turn produces an aggregated review of credit risk throughout the Group, including reports on significant credit exposures, which are presented to both the group credit risk committee and to the group business risk committee.
– The performance of all rating models is comprehensively monitored on a regular basis, to seek to ensure that models continue to provide optimum risk differentiation capability, the generated ratings remain as accurate and robust as possible and the models assign appropriate risk estimates to grades/pools. All models are monitored against a series of agreed key performance indicators. In the event that monthly monitoring identifies material exceptions or deviations from expected outcomes, these will be escalated to the group model governance committee.
The Group has formed a group level Credit Risk Assurance function with experienced credit professionals from both heritages. Together with Divisional Risk senior management, this team has carried out an independent risk-based review of the high risk wholesale and retail books. Nearly £150 billion of high risk wholesale assets, primarily HBOS commercial real estate and corporate exposures, have been reviewed by the team. This has required a detailed file by file review of the original credit application, subsequent management papers and an understanding of the supporting collateral. In addition, portfolio level analysis and investigation, together with statistically robust sampling of accounts, have been carried out for over £300 billion of retail assets. These comprehensive reviews have greatly enhanced the Group’s knowledge and understanding of the legacy portfolios and have enabled the Group to assess and manage these exposures confidently and effectively.
Within Collections and Recoveries the sharing of best practice and alignment of policies across the Group, has helped to drive more effective customer outcomes and achieve operational efficiencies. The Group has strengthened resources in Collections and Recoveries to help customers in distress by offering advice and access to a wider range of options such as short-term repayment plans or the government backed Homeowners’ Mortgage Support and Mortgage Rescue schemes. A core element of our relationship management approach is to contact customers showing signs of financial distress, discussing with them their circumstances and offering solutions to prevent their accounts falling into arrears. This year, nearly a quarter of a million customers have been contacted who were not yet in arrears.
The Group follows a through the economic cycle, relationship based, business model with robust risk management processes, appropriate appetites and experienced staff in place. These robust policies and procedures define chosen target market and risk acceptance criteria. These have been, and will continue to be, tightened and fine tuned as appropriate and include the use of early warning indicators to help anticipate future areas of concern and allow us to take early and proactive mitigating actions.
The Group’s gross loans and advances to customers, before impairment provisions and fair value adjustments, decreased by £44.9 billion to £660.0 billion. The reduction in gross advances was primarily driven by the alignment of heritage risk appetites in Retail, a reduction in wholesale lending in Corporate Markets and a reduction in Wealth and International before allowing for a transfer of £7 billion of advances from the Wholesale division to Wealth and International during the year in respect of the European loan portfolio.
TABLE 1.6: LEVERAGE FINANCE LENDING As at 31 December 2009 Drawn £bn
– Average loan-to-value on new mortgage lending has reduced to 59.3 per cent, compared to 63.1 per cent during 2008.
– The path of economic recovery in the UK remains uncertain; however, based on current trends, the Group expects impairment losses in 2010 to be lower than 2009.
Value of debt represents total book value of mortgages in arrears but not in possession.
As at 31 December 2008 Mainstream Buy to let Specialist Total
Specialist lending is now closed to new business and is in run-off.
In credit cards, Retail’s combined brands are market leaders in terms of new credit card issuance. Credit card balances outstanding at 31 December 2009 were £12.3 billion (31 December 2008: £13.8 billion). In addition, the Group was the leading UK debit card issuer in 2009.
In the second half of 2009 there were signs of improved underlying performance in all portfolios; management actions reduced the delinquency rates on new business. If current trends continue, Retail believes impairment losses in 2010 will be lower than in 2009.
Personal loans: Impaired personal loans decreased to 10.5 per cent of closing advances (31 December 2008: 11.6 per cent) and provisions, as a percentage of closing advances, decreased to 5.9 per cent (31 December 2008: 7.0 per cent).
– As a result of significant impairments taken in the first half of 2009, notably in HBOS Corporate Real Estate and HBOS (UK and US) Corporate portfolios, the Group expects this to represent the peak of total impairments given the Group’s economic assumptions. However, the Group expects the volume of underlying impairments from traditional trading and manufacturing businesses to increase in 2010, as the full impact of economic conditions filters into business insolvencies and asset values. This is a factor of a typical lag effect as the economy passes through the recession. However, the effects of this negative trend should be significantly less than the benefit of lower absolute impairments from the HBOS Corporate Real Estate and HBOS (UK and US) Corporate portfolios.
Wholesale’s gross loans and advances to customers have decreased by £36.2 billion to £210.9 billion. Since the date of acquisition, all business originated in Wholesale has been evaluated in accordance with the risk appetite and credit control criteria that had proved to be a prudent and successful approach for Lloyds TSB. Early assessment of HBOS portfolios identified those areas where there was close alignment with the Lloyds TSB heritage, those which could continue to be supported once the more restrictive appetite and policy were aligned and those where it was clear that there would be limited appetite to lend. As agreed with the UK government, the Group’s lending commitment is also subject to, and considered in the light of, the Group’s risk appetite and credit control criteria.
COMMERCIAL Impairment has been marginally higher than originally expected this year, reflecting the harsher economic conditions that the Group’s customers have experienced. The Group continues to refine its risk management and forecasting tools to reflect the economic environment and further increase control, monitoring and support of customers. In addition, the roll out of a combined Lloyds TSB and Bank of Scotland credit policy and risk strategy will benefit the business going forward, and the Group’s prudent through the cycle lending policies will ensure that asset quality remains appropriately robust.
KEY HIGHLIGHTS – Creation of credit risk teams and the establishment of Business Support Units in Ireland and Australia supported by divisional BSU sanctioning in the UK.
TABLE 1.12: IMPAIRMENTS ON WEALTH AND INTERNATIONAL LOANS AND ADVANCES As at 31 December 2009
IRELAND The total impairment charge for Ireland is £2,949 million of which £2,929 million relates to loans and advances and the remaining £20 million is in respect of equity. Impairment losses for loans and advances in Ireland represent 9.9 per cent of average gross loans and advances to customers, which has increased from 3.4 per cent at the half-year. The most significant contributor to impairment losses in Ireland is the Commercial Real Estate portfolios which make up 61 per cent of losses, representing 15.3 per cent of average Commercial Real Estate advances. As a percentage of Commercial Real Estate assets that have an impairment allowance, total provision coverage amounts to 47 per cent. With limited new business being written and very low levels of roll-off driven by a lack of liquidity in the commercial property market, overall exposures in local currency remain almost static. The severe economic downturn has significantly influenced performance with commercial property prices falling approximately 55 per cent from their peak, house prices falling approximately 31 per cent from their peak and unemployment levels currently at 12.5 per cent.
RISK APPETITE Market risk appetite is defined with regard to the quantum and composition of market risk that exists currently in the Group and the direction in which the Group wishes to manage this.
Banking – trading assets and other treasury positions Based on the commonly used 95 per cent confidence level, assuming positions are held overnight and using observation periods of the preceding 300 business days, the VaR for the years ended 31 December 2009 and 2008 based on the Group’s global trading positions was as detailed in table 1.14.
TABLE 1.14: BANKING – TRADING ASSETS AND OTHER TREASURY POSITIONS Lloyds Banking Group 31 December 2009
Base case market value is calculated on the basis of the Lloyds Banking Group current balance sheet with re-pricing dates adjusted according to behavioural assumptions. The above sensitivities show how this projected market value would change in response to an immediate parallel shift to all relevant interest rates – market and administered.
Insurance activities Investment holdings are diversified across markets and, within markets, across sectors. Holdings are diversified to minimise specific risk and the relative size of large individual exposures is monitored closely. For assets held outside unit-linked funds, investments are only permitted in countries and markets which are sufficiently regulated and liquid.
– Pricing-to-risk (new insurance proposals are priced to cover the underlying risks inherent within the products)
EXPOSURES The main sources of operational risk within the Group relate to the rate and scale of change arising from the Group’s current integration programme, particularly in respect of people and business processes, and the legal and regulatory environment in which financial firms operate both in the UK and overseas.
MEASUREMENT Both Lloyds TSB and HBOS had operational risk management and measurement frameworks that had been granted, by the FSA, Advanced Measurement Approach (AMA) Waivers, enabling the use of an internal model for the calculation of regulatory capital.
Throughout 2009, both frameworks have continued to operate, whilst a single integrated framework has been in the course of development. The integrated framework and capital model will be rolled out during 2010 and it is anticipated that the Group will seek a variation from the FSA to operate under a single AMA waiver.
– Risk assessment, including impact assessment of financial and non-financial impacts (e.g. reputational risk) for each of the key risks to which the business area is exposed.
– Scenarios for estimation of potential loss exposures for material risks.
During the year, the individual entities within the Group, and the Group, complied with all of the externally imposed liquidity and funding requirements to which they are subject.
During 2009, the Group has seen a stabilisation in the customer deposit base, in marked contrast to the volatility observed by parts of the heritage HBOS businesses in the second half of 2008. The customer loan/deposit ratio improved slightly to 169 per cent compared with 177 per cent at the previous year end. The challenge facing the Group over the medium term is to continue to access the term funding markets, and for the Group to continue to reduce its utilisation of government sponsored funding schemes. The combination of a clear focus on right-sizing the balance sheet, developing the Group’s retail liability base, and strategically accessing the capital markets will enable the Group to continue to strengthen its funding base.
In keeping with the Group’s strategy of right-sizing the balance sheet, total funding has reduced by £73 billion. During the year the Group has reduced its dependency on the repo market whilst also reducing its wholesale funding requirements. Additionally there has been a managed reduction in certain types of non-bank deposits, in particular certain aggressively priced corporate deposits which were sourced from HBOS customers during the crisis in the second half of 2008. Actions taken to right size the balance sheet have reduced the portion of the Group’s funding that is derived from wholesale markets.
Non-bank deposits comprise balances arising from banking businesses and consist of customer deposits.
The key dependencies on successfully funding the Group’s balance sheet include the continued functioning of the money and capital markets at their current levels; successful rightsizing of the Group’s balance sheet; the continuation of HM Treasury facilities in accordance with the terms agreed; limited further deterioration in the UK’s and the Group’s credit rating and no significant or sudden withdrawal of deposits resulting in increased reliance on money markets or UK Government support schemes. A return to the extreme market conditions of 2008 would place a strain on the Group’s ability to meet its financial commitments.
Secondary liquidity comprises a diversified pool of highly rated unencumbered collateral (including retained issuance)
A key input into the FSA’s ICG setting process is each bank’s Internal Capital Adequacy Assessment Process. The FSA’s approach is to monitor the available capital resources in relation to the ICG requirement. The Group has been given an ICG by the FSA and the board has also agreed a formal buffer to be maintained in addition to this requirement. The FSA has made it clear that each ICG remains a confidential matter between each bank and the FSA.
In addition to the minimum requirement for total capital, the FSA has made further statements to explain the approach it has taken to the capital framework. These include core tier 1 and tier 1 targets under stressed conditions.
The Group is subject to extensive regulation and regulatory supervision in relation to the levels of capital in its business. Specifically in relation to the consultation papers issued by the Basel Committee on Banking Supervision ‘Strengthening the resilience of the banking sector’ the group is participating in the industry-wide consultation and calibration exercises taking place through 2010.
TABLE 1.23: MOVEMENTS IN CORE TIER 1 AND TIER 1 CAPITAL DURING THE YEAR
TABLE 1.24: ANALYSIS OF RISK WEIGHTED ASSETS As at 31 December 2009
TABLE 1.25: ANALYSIS OF CAPITAL RATIOS Lloyds TSB Bank Group BOS Group £m £m £m
Capital is managed at Group level and surplus capital is retained, where possible, at Lloyds Banking Group holding company level as this provides the Group with maximum flexibility on how to deploy its capital.
RISK APPETITE The risk appetite is set by the board and reviewed on an annual basis. It includes complying with disclosure requirements within prescribed timescales and avoiding the need for restatement of published financial and prudential regulatory reporting, publicly disclosed information or tax reporting.
EXPOSURE Exposure represents the sufficiency of the Group’s policies and procedures to maintain adequate books and records to support statutory, prudential and tax reporting, to prevent and detect financial reporting fraud and to manage the Group’s tax position.
LIFE INSURANCE BUSINESSES At 31 December 2009, the principal subsidiaries involved in the Group’s life insurance operations were Scottish Widows plc (Scottish Widows) and Clerical Medical Investment Group Limited (Clerical Medical). These subsidiaries hold the only large with-profit funds managed by Lloyds Banking Group.
AVAILABLE CAPITAL RESOURCES Available capital resources represent the excess of assets over liabilities calculated in accordance with detailed regulatory rules issued by the FSA. Additional rules may apply depending on the nature of the fund, as detailed below.
‘Realistic’ basis. The FSA requires each life insurance company which contains a with-profit fund in excess of £500 million to also carry out a ‘realistic’ valuation of that fund. The Group has two such funds; one within Scottish Widows and one within Clerical Medical. The word ‘realistic’ in this context reflects the terminology used for reporting to the FSA and is an assessment of the financial position of a with-profits fund calculated under a prescribed methodology.
The valuation of with-profits assets in a with-profits fund on a realistic basis differs from the valuation on a statutory basis as, in respect of non-profits business written in a with-profits fund (a relatively small amount of business in the case of Scottish Widows and Clerical Medical), it includes the present value of the anticipated future release of the prudent margins for adverse deviation. The realistic valuation uses the market value of assets without the limit affecting the statutory basis noted above.
The realistic valuation of liabilities is carried out using a stochastic simulation model which values liabilities on a basis consistent with tradable market option contracts (a ‘market-consistent’ basis). The model takes account of policyholder behaviour on a best-estimate basis and includes an adjustment to reflect future uncertainties where the exercise of options by policyholders might increase liabilities. Further details regarding the stochastic simulation model are given in the section entitled ‘Options and guarantees’ on page 94.
New business and other factors 16 202 298 (25) 88 579
Insurance and participating investment contract liabilities 13,347 10,225 44,270 7,047 74,889
OTHER LONG-TERM FUNDS Outside the with-profit funds, assets backing actuarial reserves in respect of policyholder liabilities are invested so that the values of the assets and liabilities are broadly matched. The most critical non-economic assumptions are mortality rates in respect of annuity business written (lower mortality rates are more onerous). Reinsurance arrangements are in place to reduce the Group’s exposure to deteriorating mortality rates in respect of life insurance contracts. In addition, poor cost control would gradually depreciate the available capital and lead to an increase in the valuation of the liabilities (through an increased allowance for future costs).
– Investment volatility. The calibration of the stochastic simulation model uses implied volatilities of derivatives where possible, or historical observed volatility where it is not possible to observe meaningful prices. For example, as at 31 December 2009, the 10 year equity-implied at-the-money assumption was set at 26.6 per cent (31 December 2008: 34.6 per cent). The assumption for property volatility was 15 per cent (31 December 2008: 15 per cent). The volatility of interest rates has been calibrated to the implied volatility of swaptions which was broadly 15 per cent (31 December 2008: 16 per cent).
Total income, net of insurance claims 23,278 9,868 10,696 11,098 10,543
Profi t for the year attributable to equity shareholders 2,827 772 3,288 2,804 2,483
Net asset value per ordinary share 68p 155p 212p 195p 180p
Restated for IFRS 2 (Revised) and to separate share of results of joint ventures and associates from total income.
Joined the board in 2003. Joined Procter and Gamble in 1967 and held a number of senior and general management appointments in Europe, South America and North America, before retiring in 2001. A non-executive director of Cadbury, GfK AG and MIBA AG. Aged 67.
Joined the board in 2001 as group executive director, UK retail banking before his appointment as group chief executive in June 2003. Served with Citibank from 1975 and held a number of senior and general management appointments in the USA, South America and Europe before becoming chief operating offi cer of Citibank Consumer Bank in 1998. Following the Citibank/ Travelers merger in 1998, he was chairman and chief executive offi cer of Travelers Life and Annuity until 2000. Chairman and chief executive offi cer of Zona Financiera from 2000 to 2001. A non-executive director of BT Group. Aged 58.
Archie G Kane Group Executive Director Insurance (Board Representative for Scotland)
Chairman of Pearson, the media group, since October 2005. He is a director of Fidelity International, one of the world’s largest fund management companies, and chairman of its audit committee. From 1987 to 1991 he was chief executive of Fidelity International. Until mid 2009, he was a non-executive director and senior independent director of Man Group, the FTSE 100 fi nancial services group, and acting chairman of UKFI. He was a group executive at Citigroup; from 1969 to 1987 he held a number of senior positions at the bank in Europe and Asia. Aged 66
PRINCIPAL ACTIVITIES, BUSINESS REVIEW, FUTURE DEVELOPMENTS AND FINANCIAL RISK MANAGEMENT OBJECTIVES AND POLICIES
Information about share capital is shown in note 45 on pages 203 to 205; in the corporate governance report on pages 100 to 104; and in the directors’ remuneration report on pages 105 to 125.
The number of days required to be shown in this report, to comply with the provisions of the Companies Act 2006, is 32. This bears the same proportion to the number of days in the year as the aggregate of the amounts owed to trade creditors at 31 December 2009 bears to the aggregate of the amounts invoiced by suppliers during the year.
Each of the current directors, whose names and functions are shown on pages 96 and 97 of this annual report, confirms that, to the best of his or her knowledge: – the financial statements, prepared in accordance with International Financial Reporting Standards as adopted by the European Union, give a true and fair view of the assets, liabilities, financial position and profit or loss of the Company and Group; and
The chairman has a key role in the development (jointly with the group chief executive) of the Group’s strategy, as well as oversight of strategy implementation and performance delivery. He ensures that there is a constructive, close working relationship with the group chief executive and the rest of the board.
The Company requires all directors to stand for re-election at intervals of no more than three years. At the 2010 AGM, Dr Berndt, Mr Daniels and Mrs Weir will retire and seek re-election by shareholders.
COMPANY SECRETARY AND INDEPENDENT ADVICE The Company Secretary, Mr Baines, is responsible for advising the board on corporate governance matters and, in conjunction with the chairman, for ensuring good information flows between the board, its committees, non-executive directors and senior executives. All directors have access to his advice and services. Additionally, if required in the furtherance of their duties, non-executive directors (along with any other members of the board’s main committees) are entitled to seek independent, professional advice at the Company’s expense.
During the year, the audit committee received reports from, and held discussions with, management and the external auditors. In discharging its duties, the committee has approved the auditors’ terms of engagement, including their remuneration and, in discussion with them, has assessed their independence and objectivity (more information about which is given in note 11 to the consolidated financial statements, in relation to the procedure for approving fees for audit and non-audit work) and recommended their re-appointment at the AGM. The committee also reviewed the financial statements published in the name of the board and the quality and acceptability of the related accounting policies, practices and financial reporting disclosures; the scope of the work of the group audit department, reports from that department and the adequacy of its resources; the effectiveness of the systems for internal control, risk management and compliance with financial services legislation and regulations (more information about which is given in the note about internal control on page 104); the results of the external audit and its cost effectiveness; and reports from the external auditors on audit planning and their findings on accounting and internal control systems. Procedures for handling complaints regarding accounting, internal accounting controls or auditing matters and for staff to raise concerns in confidence have been established by the committee. The committee also had a meeting with the auditors, without executives present, and a meeting with the group audit director alone.
Chairman’s succession On 18 May 2009, following Sir Victor Blank’s decision to step down from the board, a sub-committee of the nomination committee was established to oversee the chairman’s succession. The committee was chaired by Sir Julian Horn-Smith. Membership was made-up entirely of independent non-executive directors, namely Dr Berndt, Mr Green, Sir David Manning and Mr Watson. There was an open invitation to other non-executive directors to attend meetings. Ms McCall was a regular attendee; Mr Ryan and Mr Scicluna also attended a number of meetings. As deputy chairman, Lord Leitch was kept advised of developments and, towards the latter end of the process, was invited to join meetings. The committee was advised by the group human resources director and the head of secretariat. Sir Victor Blank did not participate in any part of the process.
Short listed candidates were subject to an extensive interview process, initially by panels of committee members along with other directors. Ms McCall and Lord Leitch also participated in the interview process. All executive and non-executive directors were given the opportunity to meet the candidates prior to any decision being made. Detailed referencing and due diligence, both formal and informal, was also carried out. The appointment was subject to, and received, approval from the Financial Services Authority.
REMUNERATION COMMITTEE Information about the remuneration committee’s membership and work is given in the directors’ remuneration report on pages 105 to 125. Its terms of reference are available from the company secretary and are displayed on the Company’s website, www.lloydsbankinggroup.com.
ATTENDANCE AT MEETINGS The attendance of directors at board meetings and at meetings of the audit, nomination and governance, remuneration and risk oversight committees during 2009 were as follows: Board meetings Nomination and
Number of meetings during the year 9 19 28 8 2 13 4
Sir Winfried Bischoff 1 3 7 10 (max 10) 3 (max 3) 1 (max 1)
Sir Victor Blank 5 6 11 17 (max 18) 10 (max 10) 3 (max 3)
Appointed to the board, audit and risk oversight committees on 1 March 2009.
COMPLIANCE WITH THE BRITISH BANKERS’ ASSOCIATION DRAFT CODE FOR FINANCIAL REPORTING DISCLOSURE
In October 2009, the British Bankers’ Association published a draft Code for Financial Reporting Disclosure (the ‘Disclosure Code’). The draft Disclosure Code sets out five disclosure principles together with supporting guidance. The principles are that UK banks: commit to providing high quality, meaningful and decision-useful disclosures; commit to ongoing review of, and enhancement to, their financial instrument disclosures for key areas of interest; will assess the applicability and relevance of good practice recommendations to their disclosures acknowledging the importance of such guidance; will seek to enhance the comparability of financial statement disclosures across the UK banking sector; and will clearly differentiate in their annual reports between information that is audited and information that is unaudited.
The board of directors is responsible for the establishment and review of Lloyds Banking Group’s system of internal control, which is designed to ensure effective and efficient operations, quality of internal and external reporting, internal control, and compliance with laws and regulations. It should be noted, however, that such a system is designed to manage, rather than eliminate, the risk of failure to achieve business objectives. In establishing and reviewing the system of internal control, the directors have regard to the nature and extent of relevant risks, the likelihood of a loss being incurred and the costs of control. It follows, therefore, that the system of internal control can only provide reasonable but not absolute assurance against the risk of material loss.
The going concern of the Company and the Group is dependent on successfully funding their respective balance sheets and maintaining adequate levels of capital. In order to satisfy themselves that the Company and the Group have adequate resources to continue to operate for the foreseeable future, the directors have considered a number of key dependencies which are set out in the risk management section under Principal Risks: Liquidity and Funding on page 61 and Financial Soundness on pages 81 to 89 and additionally have considered projections for the Group’s capital and funding position. Having considered these, the directors consider that it is appropriate to continue to adopt the going concern basis in preparing the accounts.
– Governance and risk management, including the role, membership and advisors to the committee
The committee’s approach has continued in the review of remuneration for 2010, with any decisions on remuneration discussed extensively by the committee and shareholders consulted ahead of any decisions made. The committee does have concerns that by continuing to hold base pay levels at 2008 levels, remuneration for the executive directors is likely to become uncompetitive versus our peer group. However, by adding the share price related element to the 2010 LTIP it is hoped that this will go some way to addressing this. But this is an area that will be kept under close and continuous review by the committee and one where we will continue to engage with shareholders during 2010 as their views are essential in this debate.
Extensive work has been undertaken in 2009 and will continue in 2010 to ensure compliance with the FSA Code of Practice on Remuneration. The terms of reference of the remuneration committee were revised during 2009 to extend the remit of the committee to include the overall remuneration policy and philosophy for all colleagues, whilst retaining direct responsibility for the remuneration for certain colleagues. Divisional remuneration committees were introduced in 2009 to provide a robust framework for decisions on remuneration throughout the Group. The role of risk in remuneration decision making has been formalised and the chief risk officer now attends remuneration committee meetings as appropriate and divisional and group risk officers are members of the divisional remuneration committees. This work will continue in 2010 as the FSA refines its Code and takes into account the recommendations in Sir David Walker’s review of corporate governance in UK banks and other financial industry entities. The committee will take into account any change in disclosure requirements as they are formalised and reflect them in the 2010 report.
(The split in the components in the above chart are for executive directors. Comparable numbers for the group chief executive are: long term incentive 40 per cent, short term incentive 32 per cent and salary 28 per cent)
– Deferred annual incentive is subject to clawback; ie it is not released when information subsequently comes to light about the performance on which the incentive award is based, which had it been known prior to the determination of the awards would have affected the original award decision
An essential component of our approach to remuneration is the governance process that underpins it. This ensures that our policy is robustly applied and risk is managed appropriately.
The overarching purpose of the remuneration committee is to consider, agree and recommend to the board an overall remuneration policy and philosophy for the Group that is aligned to its long-term business strategy, its business objectives, its risk appetite and values, and recognises the interests of relevant stakeholders. The remuneration policy and philosophy covers the whole Group, but the committee pays particular attention to the top management group and those colleagues who perform significant influence functions for the Group and those who could have a material impact on the Group’s risk profile. The committee’s role is to ensure that these colleagues are provided with appropriate incentives to encourage them to enhance the performance of the Group and that they are rewarded for their individual contribution to the success of the organisation, whilst ensuring that there is no reward for excessive risk taking.
During 2009, Alithos Limited continued to provide information on behalf of the committee for the testing of total shareholder return (TSR) (calculated by reference to both dividends and growth in share price) performance conditions for the Group’s long-term incentive schemes.
Mr Daniels, Mrs Risley (Group Human Resources Director) and Ms Kemp (HR Director, Total Reward) provided guidance to the committee (other than for their own remuneration). Mrs Carol Sergeant (Chief Risk Officer) also attended the committee to advise on risk matters.
– The divisional remuneration committee will be responsible for ensuring the effective governance of divisional specific remuneration arrangements, especially the design and outcome of short-term incentive/bonus schemes.
We believe our approach is well aligned with the FSA Code of Practice on Remuneration but we will continue to work with the FSA to ensure ongoing compliance and implement changes as appropriate.
We build relationships with our customers and people rather than viewing them as counterparties in a money-making transaction and are in the process of extending this philosophy across the integrated Group. This means that working for the Lloyds Banking Group should be about more than pay. While our relationship with our people means that we will pay them fairly and competitively, our pay is positioned conservatively against the market and we will not seek to be among the highest payers in the sector. In setting pay for executive directors, we take account of the terms and conditions applying to other employees of the Group.
Economic profit is a key measure by which we manage our business. This measure takes into account the level of capital required to generate profits as well as the risks taken. The same level of profit generated at lower risk results in higher economic profit. Economic profit also measures risk based on an assessment of how business will perform through the economic cycle.
The majority of our executives’ pay is linked to stretching performance targets through annual and long-term incentives. Performance measures on the annual incentive are directly aligned to the Group’s financial and non-financial performance.
Executives are required to build up a holding in Lloyds Banking Group shares of value equal to 1.5 times salary for executive directors (2 times salary for the group chief executive). They are expected to retain 100 per cent of the net-of-tax proceeds of the 2009 LTIP until they reach this target. In addition they are required to retain any shares vesting from the share price performance element of the 2010 LTIP for a further two years post vesting.
Finally, we operate tough contract provisions whereby no executive has an entitlement to more than 12 months’ notice, compensation on termination is limited to basic salary, and any compensation is paid monthly over 12 months and is mitigated if the executive gets another job. This approach avoids the risk of payment for failure. These requirements are among the toughest in the FTSE 100.
In light of circumstances, no increase for 2010 and base salaries held at same level as for 2008
Long-term incentive plan 275 per cent of salary maximum, split as follows: 100 per cent on earnings per share 100 per cent on economic profit 75 per cent on absolute share price growth
Any shares vesting from the absolute share price growth element retained for a further 2 years post vesting
LONG-TERM INCENTIVE AWARD Given the extraordinary circumstances during 2008, the remuneration committee made a reduced maximum LTIP award of 200 per cent of salary in 2009, 175 per cent less than the maximum award for 2008. For 2010, the remuneration committee continues to believe that it is appropriate to make LTIP awards below the maximum levels that the plan allows (400 per cent) and less than the award levels for 2008 (maximum award 375 per cent). Notwithstanding the increased size and complexity of the Group since the HBOS acquisition and the concerns about retention and motivation, the committee believes that the current environment requires a demonstration of continued restraint in relation to remuneration. At the same time, the committee believes in the importance of aligning shareholder and executive motivation and therefore it has approved maximum awards for the group chief executive and executive directors for 2010 of 275 per cent of base salary of which 200 per cent of the award will be based on the same performance conditions as for 2009, namely EPS and economic profit, with the remaining 75 per cent based on the achievement of stretching share price targets.
Absolute share price growth (applying to award of 75 per cent of salary) The absolute share price element of the award will fully align shareholder and executives’ interests during a period of share price recovery.
CHAIRMAN’S REMUNERATION The chairman’s remuneration comprises salary and benefits. He does not participate in the annual bonus and long-term incentive arrangements, nor is he entitled to pension benefits.
INDEPENDENT NON-EXECUTIVE DIRECTORS’ FEES The fees of the independent non-executive directors are agreed by the board within a total amount determined by the shareholders. Directors may also receive fees, agreed by the board, for membership of board committees. The fees are designed to recognise the various responsibilities of a non-executive director’s role and to attract individuals with relevant skills, knowledge and experience. The fees are neither performance related nor pensionable and are comparable with those paid by other companies. The annual fees from 1 January 2010 are unchanged and are listed below.
A number of actions were taken during the year to create a robust capital position, including the £4 billion ordinary share placing and compensating open offer in June and the successful £22.5 billion equity raising at the end of the year.
The group chief executive has chosen to waive any payment under the scheme for the second successive year.
Index to annual report 266 2009 LONG-TERM INCENTIVE PLAN AWARDS The current LTIP rules allow for awards to be made of up to 400 per cent of base salary. Under normal circumstances, awards are made of 300 per cent of salary with the additional 100 per cent available for circumstances that the remuneration committee deems to be exceptional. In 2008, awards were made of 375 per cent of base salary to the chief executive and two of the executive directors for retention purposes, and in light of data reviewed by the committee which showed total remuneration to be behind median both for the FTSE 20 and the other major UK banks.
Sir David Manning (until 2 November 2009) 54,424 12,560 4,187 12,560 83,731
The following charts illustrate the shares available for the Group’s share schemes.
Pension accruals under the defined benefits scheme for Messrs Daniels and Kane will continue until April 2012. Thereafter they will have the opportunity to either participate in a defined contribution scheme or to receive a cash supplement with no compensation for ceasing final salary accrual. There is no entitlement to an immediate and unreduced pension should their employment be terminated before the normal date of retirement.
The group chief executive waived his entitlement to any bonus in respect of 2009 performance. There were no free shares awarded under Shareplan in respect of 2009.
Sir Victor Blank donated his salary from 30 September 2009 until 31 December 2009, amounting to £160,000 to charity. The Group was obligated to pay Sir Victor Blank’s remuneration in lieu of services rendered during 2010 of £53,333. This was also donated to charity.
DEFINED CONTRIBUTION SCHEME MEMBERS During the year to 31 December 2009 the employer has made the following contributions to the defined contribution scheme: T J W Tookey 147
Columns (a) and (b) represent the deferred pension to which the directors would have been entitled had they left the Group on 31 December 2009 and 2008, respectively.
Major changes to the legislation governing the provision of pensions in the UK (known as pension simplification) came into effect in April 2006. Benefits from an approved pension scheme will be limited to the Lifetime Allowance, currently £1.75 million which is equivalent to an annual pension of £87,500. Any benefit in excess of this amount will incur a tax charge for the individual. The Group has agreed that if an executive director has benefits in excess of the Lifetime Allowance they may cease to accrue benefits in the Scheme and receive a salary supplement as an alternative. This will not cost the Group more than the current arrangements. The Group will not compensate any individual in respect of any increased tax liability arising from pension simplification. To date, the executive directors affected have elected to continue to accrue benefits in the approved scheme.
At 1 January 2009 (or later date of appointment) At 31 December
g Not exercisable as the performance conditions had not been met.
The bonus shares are held on behalf of the executive for a period of three years before release.
March 2006 That the Company’s ranking based on TSR over the relevant period against a comparator group (15 companies including Lloyds Banking Group) must be at least eighth for any shares to be received. If ranked ninth or below no shares would be received. The maximum of two performance shares for each bonus share will be awarded only if the Company is first in the comparator group; one performance share will be awarded for each bonus share if the Company is placed fifth; and one performance share for every two bonus shares if the Company is placed eighth. Between first and fifth positions and fifth and eighth positions a sliding scale will apply.
The following table contains information on the performance conditions for awards made under the long-term incentive plan. The remuneration committee chose the relevant performance conditions because they were felt to be challenging, aligned to shareholders’ interests and appropriate at the time.
For the other 50 per cent of the award (the ‘TSR Award’) – the performance condition was as described for May 2006 with the relevant performance period commencing on 6 March 2008 (the date of the March award) and ending on 5 March 2011.
Economic profit: The release of the remaining 50 per cent of shares will be dependent on the extent to which Lloyds Banking Group achieves cumulative Economic Profit targets over a three year period.
The current targets prior to restatement are: EPS Vesting Growth in EPS
LLOYDS TSB GROUP EXECUTIVE SHARE PLAN 2003 Mr Tookey was granted an option under this plan to acquire 35,305 ordinary shares in Lloyds Banking Group plc. The option was not subject to any performance condition but would normally have become exercisable only if he remained an employee, and had not given notice of resignation, as at 19 April 2009. As Mr Tookey remained an employee, the option vested on 19 April 2009, and was exercised on 8 May 2009.
OPINION ON FINANCIAL STATEMENTS In our opinion the group financial statements: – give a true and fair view of the state of the group’s affairs as at 31 December 2009 and of its profit and cash flows for the year then ended; – have been properly prepared in accordance with IFRSs as adopted by the European Union; and – have been prepared in accordance with the requirements of the Companies Act 2006 and Article 4 of the lAS Regulation.
OTHER MATTER We have reported separately on the parent company financial statements of Lloyds Banking Group plc for the year ended 31 December 2009 and on the information in the Directors’ Remuneration Report that is described as having been audited.
Share of results of joint ventures and associates 13 (752) 4
Other comprehensive income for the year, net of tax 1,739 (2,388)
Trading and other financial assets at fair value through profit or loss 17 150,011 45,064
The directors approved the consolidated fi nancial statements on 25 February 2010.
Employee share option schemes: Value of employee services – – 116 – 116
CONSOLIDATED CASH FLOW STATEMENT for the year ended 31 December 2009
Cash and cash equivalents at end of year 55(D) 65,690 32,760
The financial information has been prepared under the historical cost convention, as modified by the revaluation of investment properties, available-for-sale financial assets, trading securities and certain other financial assets and liabilities at fair value through profit or loss and all derivative contracts. As stated on page 104, the directors consider that it is appropriate to continue to adopt the going concern basis in preparing the accounts.
– Improvements to IFRSs (issued May 2008). Sets out minor amendments to IFRS standards as part of annual improvements process. Most amendments clarified existing practice.
Investment vehicles, such as Open Ended Investment Companies (OEICs), where the Group has control, typically through acting as fund manager and the life funds having a beneficial interest greater than 50 per cent, are consolidated. The minority unitholders’ interest is reported in other liabilities.
(C) OTHER INTANGIBLE ASSETS Other intangible assets include brands, core deposit intangibles, purchased credit card relationships, customer-related intangibles and capitalised software enhancements. Intangible assets which have been determined to have a finite useful life are amortised on a straight line basis over their estimated useful life as follows: Capitalised software enhancements up to 5 years Brands (which have been assessed as having finite lives) 10-15 years Customer-related intangibles up to 10 years Core deposit intangibles up to 8 years Purchased credit card relationships 5 years
(D) REVENUE RECOGNITION Interest income and expense are recognised in the income statement for all interest-bearing financial instruments, except for those classified at fair value through profit or loss, using the effective interest method. The effective interest method is a method of calculating the amortised cost of a financial asset or liability and of allocating the interest income or interest expense over the expected life of the financial instrument. The effective interest rate is the rate that exactly discounts the estimated future cash payments or receipts over the expected life of the financial instrument or, when appropriate, a shorter period, to the net carrying amount of the financial asset or financial liability.
The effective interest rate is calculated on initial recognition of the financial asset or liability by estimating the future cash flows after considering all the contractual terms of the instrument but not future credit losses. The calculation includes all amounts expected to be paid or received by the Group including expected early redemption fees and related penalties and premiums and discounts that are an integral part of the overall return. Direct incremental transaction costs related to the acquisition, issue or disposal of a financial instrument are also taken into account in the calculation. Once a financial asset or a group of similar financial assets has been written down as a result of an impairment loss, interest income is recognised using the rate of interest used to discount the future cash flows for the purpose of measuring the impairment loss (see accounting policy 2(H)).
Fees and commissions which are not an integral part of the effective interest rate are generally recognised when the service has been provided. Loan commitment fees for loans that are likely to be drawn down are deferred (together with related direct costs) and recognised as an adjustment to the effective interest rate on the loan once drawn. Where it is unlikely that loan commitments will be drawn, loan commitment fees are recognised over the life of the facility. Loan syndication fees are recognised as revenue when the syndication has been completed and the Group retains no part of the loan package for itself or retains a part at the same effective interest rate for all interest-bearing financial instruments, including loans and advances, as for the other participants.
(2) Available-for-sale financial assets Debt securities and equity shares that are not classified as trading securities, at fair value through profit or loss or as loans and receivables are classified as available-for-sale financial assets and are recognised in the balance sheet at their fair value, inclusive of transaction costs. Available-for-sale financial assets are those intended to be held for an indeterminate period of time and may be sold in response to needs for liquidity or changes in interest rates, exchange rates or equity prices. Gains and losses arising from changes in the fair value of investments classified as available-for-sale are recognised directly in other comprehensive income, until the financial asset is either sold, becomes impaired or matures, at which time the cumulative gain or loss previously recognised in other comprehensive income is recognised in the income statement. Interest calculated using the effective interest method and foreign exchange gains and losses on debt securities denominated in foreign currencies are recognised in the income statement.
(5) Sale and repurchase agreements Securities sold subject to repurchase agreements (‘repos’) continue to be recognised on the balance sheet where substantially all of the risks and rewards are retained. Funds received under these arrangements are included in deposits from banks, customer deposits, or trading liabilities. Conversely, securities purchased under agreements to resell (‘reverse repos’), where the Group does not acquire substantially all of the risks and rewards of ownership, are recorded as loans and receivables or trading securities. The difference between sale and repurchase price is treated as interest and accrued over the life of the agreements using the effective interest method.
The Group designates certain derivatives as either: (1) hedges of the fair value of the particular risks inherent in recognised assets or liabilities (fair value hedges); (2) hedges of highly probable future cash flows attributable to recognised assets or liabilities (cash flow hedges); or (3) hedges of net investments in foreign operations (net investment hedges). These are accounted for as follows: 2 ACCOUNTING POLICIES continued
If there is objective evidence that an impairment loss has been incurred, an allowance is established which is calculated as the difference between the balance sheet carrying value of the asset and the present value of estimated future cash flows discounted at that asset’s original effective interest rate. If an asset has a variable interest rate, the discount rate used for measuring the impairment loss is the current effective interest rate.
For the Group’s portfolios of smaller balance homogenous loans, such as the residential mortgage, personal lending and credit card portfolios, allowances are calculated for groups of assets taking into account historical cash flow experience. For the Group’s other lending portfolios, allowances are established on a case-by-case basis. The calculation of the present value of the estimated future cash flows of a collateralised asset or group of assets reflects the cash flows that may result from foreclosure less the costs of obtaining and selling the collateral, whether or not foreclosure is probable.
If there is no objective evidence of individual impairment the asset is included in a group of financial assets with similar credit risk characteristics and collectively assessed for impairment. Segmentation takes into account such factors as the type of asset, industry, geographical location, collateral type, past-due status and other relevant factors. These characteristics are relevant to the estimation of future cash flows for groups of such assets as they are indicative of the borrower’s ability to pay all amounts due according to the contractual terms of the assets being evaluated. Future cash 2 ACCOUNTING POLICIES continued
– Leasehold improvements: shorter of 10 years or, if lease renewal is not likely, the remaining period of the lease
Operating lease assets are included within tangible fixed assets at cost and depreciated over their estimated useful lives, which equates to the lives of the leases, after taking into account anticipated residual values. Operating lease rental income is recognised on a straight line basis over the life of the lease.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued 2 ACCOUNTING POLICIES continued
Assumptions are made in respect of all material factors affecting future cash flows, including future interest rates, mortality and costs.
The Group’s contractual rights to benefits from providing investment management services in relation to non-participating investment contracts acquired in business combinations and portfolio transfers is measured at fair value at the date of acquisition. The resulting asset is amortised over the estimated lives of the contracts. At each reporting date an assessment is made to determine if there is any indication of impairment. Where impairment exists, the carrying value of the asset is reduced to its recoverable amount and the impairment loss recognised in the income statement.
Foreign exchange differences arising on the translation of a foreign operation are recognised in other comprehensive income and accumulated in a separate component of equity together with exchange differences arising from the translation of borrowings and other currency instruments designated as hedges of such investments (see accounting policy 2(F)(3)). On disposal of a foreign operation, the cumulative amount of exchange differences relating to that foreign operation are reclassified from equity and included in determining the profit or loss arising on disposal.
The preparation of the Group’s financial statements requires management to make judgements, estimates and assumptions in applying the accounting policies that affect the reported amounts of assets, liabilities, income and expenses. Due to the inherent uncertainty in making estimates, actual results reported in future periods may be based upon amounts which differ from those estimates. Estimates, judgements and assumptions are continually evaluated and are based on historical experience and other factors, including expectations of future events that are believed to be reasonable under the circumstances.
ALLOWANCE FOR IMPAIRMENT LOSSES ON LOANS AND RECEIVABLES The Group’s accounting policy for losses arising on financial assets classified as loans and receivables is described in note 2(H)(1). The allowance for impairment losses on loans and receivables is management’s best estimate of losses incurred in the portfolio at the balance sheet date. Impairment allowances are established to recognise incurred impairment losses in the Group’s loan portfolios carried at amortised cost. In determining whether an impairment has occurred at the balance sheet date the Group considers whether there is any observable data indicating that there has been a measurable decrease in the estimated future cash flows or their timings. Where this is the case, the impairment loss is the difference between the carrying value of the loan and the present value of the estimated future cash flows discounted at the loan’s original effective interest rate.
The collective impairment allowance is sensitive to changes in economic and credit conditions, including the interdependency of house prices, unemployment rates, interest rates, borrowers’ behaviour, and consumer bankruptcy trends. It is, however, inherently difficult to estimate how changes in one or more of these factors might impact the collective impairment allowance.
In the Wholesale division, the collective unimpaired provision is sensitive to the time between the loss event and the date the impairment is recognised. This is known as the loss emergence period (LEP). If the LEP moved by one month in respect of the loan portfolio assessed for collective unimpaired provisions, this would result in an increase in the collective unimpaired provision of approximately £420 million. 3 CRITICAL ACCOUNTING ESTIMATES AND JUDGEMENTS
In particular significant judgement is required by management in determining appropriate assumptions to be used for level 3 financial instruments. At 31 December 2009, the Group classified £7,460 million of financial assets and £235 million of financial liabilities as level 3 (note 53).
The largest asset class classified as level 3 is the Group’s venture capital and unlisted equity investments. Venture capital investments are valued using International Private Equity and Venture Capital (IPEV) Guidelines which require significant management judgement in determining appropriate earnings multiples to be applied in determining fair value. Unlisted equity investments are valued using a number of different techniques which require management to select the most appropriate assumptions, including earnings multiples, valuations relative to net assets, and estimated future cash flows. Certain of the Group’s asset-backed securities and derivatives, principally where there is no trading activity in such securities, are also classified as level 3. Fair value is determined using valuation models which require significant judgement in determining appropriate values for inputs including prepayment rates, probability of default, loss given default and yield curves.
Two important assumptions are the rate of inflation and the expected lifetime of the schemes’ members. The assumed rate of inflation affects the rate at which salaries are projected to grow and therefore the size of the pension that employees receive upon retirement and also the rate at which pensions in payment increase. Over the longer term rates of inflation can vary significantly. At 31 December 2009 it was assumed that the rate of inflation would be 3.4 per cent per annum (2008: 3.0 per cent), although if this was increased by 0.2 per cent the overall deficit would increase by approximately £795 million and the annual cost by approximately £69 million. A reduction of 0.2 per cent would reduce the overall deficit by approximately £763 million and the annual cost by approximately £60 million.
FAIR VALUE OF IDENTIFIABLE NET ASSETS OF HBOS The acquisition of the HBOS Group in January 2009 was accounted for in accordance with applicable accounting standards which require the recognition of the identifiable assets acquired and liabilities assumed at their acquisition-date fair values. As part of this process, it is also necessary to identify and recognise certain assets and liabilities which are not included on the acquiree’s balance sheet, for example the value of the internally generated brands and other intangible assets.
During 2009, the effects of the fair value adjustments have started to unwind and be recognised in the Group’s income statement. The determination of the extent to which the adjustments unwind often requires significant judgement principally relating to the assessment of the extent to which losses incurred subsequent to the date of acquisition were expected and consequently reflected in the fair value adjustment made to write down the value of the lending. In the period since the acquisition impairment losses of £6,859 million have been incurred which were reflected in the acquisition fair value adjustments.
The Group reviews the goodwill for impairment at least annually or when events or changes in economic circumstances indicate that impairment may have taken place. The impairment review is performed by projecting future cash flows, excluding finance and tax, based upon budgets and plans and making appropriate assumptions about rates of growth and discounting these using a rate that takes into account prevailing market interest rates and the risks inherent in the business. If the present value of the projected cash flows is less than the carrying value of the underlying net assets and related goodwill an impairment charge is required in the income statement. This calculation requires the exercise of significant judgement by management; if the estimates made prove to be incorrect or performance does not meet expectations which affects the amount and timing of future cash flows, goodwill may become impaired in future periods. Further details are given in note 27.
While management believes that the liability carried at year end is adequate, the application of statistical techniques requires significant judgement. An increase of 10 per cent in the cost of claims would result in the recognition of an additional loss of approximately £48 million. Similarly, an increase of 10 per cent in the ultimate number of such claims would lead to an additional loss of approximately £44 million; some relief would arise from reinsurance contracts held.
The Insurance division is a bancassurance provider in the UK providing a wide range of long-term savings, investment and protection products, together with individual and corporate pensions. It is also a distributor of payment protection and home insurance in the UK. The division consists of three business units: life, pensions and investments UK; life, pensions and investments Europe; and general insurance.
Other includes the results of managing the Group’s technology platforms, branch and head office property estate, operations (including payments, banking operations and collections) and procurement services, the costs of which are predominantly recharged to the other divisions. It also reflects other items not recharged to the divisions, including hedge ineffectiveness. The improvement in revenue of £1,376 million in 2009 compared to 2008 primarily reflects gains arising on the extinguishment of certain existing liabilities in 2009.
Investments in joint ventures and associates at end of year 30 189 123 (14) 151 479 4 SEGMENTAL ANALYSIS continued
Includes gain on acquisition, integration costs, amortisation of purchased intangibles and goodwill impairment.
As at 31 December 2008 Lloyds TSB Statutory HBOS Reclassifi- and HBOS Fair value Consolidation Reported basis statutory cations share issues2 adjustments adjustments basis £m £m £m £m £m £m £m
Restated for IFRS 2 (Revised) Includes £4,500 million of ordinary share capital and £1,000 million of preference shares issued by Lloyds TSB Group plc to HM Treasury on 13 January 2009 and 15 January 2009, respectively and £8,500 million of ordinary share capital and £3,000 million of preference shares issued by HBOS plc to HM Treasury on 15 January 2009 (net of costs).
Included within interest receivable is £971 million (2008: £435 million) in respect of impaired financial assets. Net interest income also includes a charge of £121 million (2008: charge of £16 million) transferred from the cash flow hedging reserve (see note 47).
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued 8 INSURANCE PREMIUM INCOME
In November 2009, as part of the restructuring plan that was a requirement for European Commission approval of state aid received by the Group, the Group agreed to suspend the payment of coupons and dividends on certain of the Group’s preference shares and preferred securities for the two year period from 31 January 2010 to 31 January 2012. This suspension gave rise to a partial extinguishment of the original liability, equivalent to the present value of the suspended cash flows. During December 2009, as part of the Group’s recapitalisation and exit from GAPS, preference shares, preferred securities and undated subordinated notes were exchanged for enhanced capital notes. These exchanges, together with the partial extinguishment of liabilities arising from the suspension of payments of coupons, resulted in a gain of £723 million.
The UK government has published draft legislation which, when enacted, will introduce a bank payroll tax of 50 per cent applicable to discretionary bonuses and other amounts over £25,000 awarded to bank employees in the period 9 December 2009 to 5 April 2010. The legislation has yet to be finalised and there remain significant uncertainties over aspects of its detailed application and the Group continues to assess its ultimate liability in respect of all of its schemes. However, in accordance with the requirements of IAS 19 ‘Employee Benefits’ the Group has provided in full for the estimated cost of the bank payroll tax; the amount is not significant.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued 11 OPERATING EXPENSES continued £m £m
Fees payable for other services: Audit of the Company’s subsidiaries pursuant to legislation 18.8 8.5
Other non-audit fees: Services relating to corporate finance transactions 0.3 0.4
The allocation of fees between those payable for the audit of the Company’s current year audit and those for the audit of the Company’s subsidiaries has been restated. There is no change in total fees payable.
Subsequent to the year end, on 11 February 2010 the Group announced the sale of its 70 per cent stake in esure to a management buyout vehicle.
Transferred to income statement in respect of disposals (97) 23 (74)
Transferred to income statement in respect of impairment 130 (28) 102
Movement in cash flow hedge: Effective portion of changes in fair value taken to other comprehensive income (33) 9 (24)
The basic and diluted weighted average number of ordinary shares in issue reflects the issue of 2,597 million ordinary shares on 13 January 2009, the issue of 7,776 million ordinary shares as purchase consideration for the acquisition of 100 per cent of the ordinary share capital of HBOS plc on 16 January 2009, the capitalisation issue of 408 million ordinary shares on 11 May 2009, the issue of 10,409 million ordinary shares on 16 June 2009 in respect of a placing and compensatory open offer, the issue of 36,505 million shares in respect of the rights issue on 27 November 2009 and the issue of 108 million ordinary shares on 11 December 2009. To the extent that such shares contain a bonus element, the average number of shares for 2009 has been adjusted to reflect that bonus element for the full year. Average shares for 2008 have been adjusted accordingly (see below).
EARNINGS PER SHARE RESTATEMENT Profi t attributable to equity shareholders has been restated for the adoption of IFRS 2 (Revised) as explained in accounting policies (see page 133).
Weighted-average number of ordinary shares in issue (diluted) as published 5,781
Loans and advances to customers 13,579 166 13,745 283 325 608
Asset-backed securities: Corporate and other debt securities 3,097 17,571 20,668 536 11,120 11,656
The maximum exposure to credit risk at 31 December 2009 of the loans and advances to banks and customers designated at fair value through profit or loss was £166 million (2008: £325 million); the Group does not hold any credit derivatives or other instruments in mitigation of this risk. There was no significant movement in the fair value of these loans attributable to changes in credit risk which is determined by reference to the publicly available credit ratings of the instruments involved.
The carrying value of assets that are subject to stock lending arrangements was £1,752 million at 31 December 2009 (31 December 2008: £809 million) all of which the secured party is permitted by contract or custom to sell or repledge.
The Group holds derivatives as part of the following strategies: – Customer driven, where derivatives are held as part of the provision of risk management products to Group customers; – To manage and hedge the Group’s interest rate and foreign exchange risk arising from normal banking business. The hedge accounting strategy adopted by the Group is to utilise a combination of fair value, cash flow and net investment hedge approaches as described in Note 54; and
– Derivatives held in policyholders funds as permitted by the investment strategies of those funds,
– Credit derivatives, principally credit default swaps, are used by the Group as part of its trading activity and to manage its own exposure to credit risk. A credit default swap is a swap in which one counterparty receives a premium at pre-set intervals in consideration for guaranteeing to make a specific payment should a negative credit event take place. The Group also uses credit default swaps to securitise, in combination with external funding, £6,455 million (2008: £8,360 million) of corporate and commercial banking loans.
Derivatives designated as cash fl ow hedges: Interest rate swaps 222,548 4,749 7,285
The principal amount of the contract does not represent the Group’s real exposure to credit risk which is limited to the current cost of replacing contracts with a positive value to the Group should the counterparty default. To reduce credit risk the Group uses a variety of credit enhancement techniques such as netting and collateralisation, where security is provided against the exposure. Further details are provided in Note 54(3) on page 231.
The embedded equity conversion feature of £1,797 million reflects the value at 31 December 2009 of the equity conversion feature contained in the Enhanced Capital Notes issued by the Group in December 2009 as part of the Group’s recapitalisation and exit from the Government Asset Protection Scheme (see note 44).
Total recognised derivative assets/liabilities 881,731 28,884 26,892 19 LOANS AND ADVANCES TO BANKS
Later than 5 years 5 3 21 SECURITISATIONS AND COVERED BONDS
Loans and advances to customers include balances that have been securitised but not derecognised, including residential mortgages and commercial banking loans, the carrying values of which are set out below together with any related liabilities. Residential mortgages are not derecognised because the Group remains exposed to the majority of the risk of any default in respect of them; commercial banking loans are not derecognised because the Group has not transferred the contractual rights to receive the cash flows from those loans nor has it assumed a contractual obligation to pay the cash flows from those loans to a third party.
The Group’s principal securitisation and covered bond programmes, together with the balances of the advances subject to securitisation and the carrying value of the notes in issue at 31 December, are listed below. The notes in issue are reported in note 35.
Exeter Blue1 PFI/PPP and project finance loans 877 45 859 48
Debt securities: Classified as loans and receivables 15 9,867 698 10,580
Asset-backed securities: Corporate and other debt securities – 19,904 19,904 – 2,183 2,183
Equity shares: Treasury bills and other bills: Treasury bills and similar securities – 2,532 2,532 – 2,402 2,402
Included within asset-backed securities are £12,421 million (31 December 2008: £13,792 million) managed by the Wholesale division. Further information on these exposures is provided in note 54.
All assets have been individually assessed for impairment. The criteria used to determine whether an impairment loss has been incurred are disclosed in note 2(H). Included in available-for-sale financial assets at 31 December 2009 are debt securities individually determined to be impaired whose gross amount before impairment allowances was £144 million (31 December 2008: £282 million) and in respect of which no collateral was held. In addition, included in available-for-sale financial assets at 31 December 2009 are equity securities individually determined to be impaired whose gross amount before impairment allowances was £621 million (31 December 2008: £31 million).
Direct operating expenses arising from investment properties that generate rental income 64 29
In 2009, the markets in which the Consumer Finance unit of Asset Finance operates have deteriorated further with both macroeconomic and market conditions worsening, leading to a fall off in demand and increasing arrears. This, together with continuing uncertainties over the likely short-term macroeconomic environment, has resulted in a reassessment of the carrying value of the consumer finance cash generating unit and the recognition of a goodwill impairment charge of £240 million at 31 December 2009 reflecting the write down of the entire balance of goodwill allocated to the Consumer Finance unit of Asset Finance leaving goodwill of £170 million in the Autolease unit of Asset Finance.
The movement in the acquired value of in-force non-participating investment contracts over the year is as follows: £m £m
The movement in the value of in-force insurance and participating investment contracts over the year is as follows: £m £m
Movement in the value of in-force business taken to income statement (note 9) 1,169 (325)
Further information about the effect of changes in key assumptions is given in note 37.
Balance sheet amount at 31 December 2008 – – – 51 146 197
The customer-related intangibles include customer lists and the benefits of customer relationships that generate recurring income. The purchased credit card relationships represent the benefit of recurring income generated from the portfolio of credit cards purchased and the core deposit intangible is the benefit derived from a large stable deposit base that has low interest rates.
Lloyds Banking Group Annual Report and Accounts 2009 30 TANGIBLE FIXED ASSETS Operating Total tangible
Liabilities in respect of securities sold under repurchase agreements 35,554 92
Included in customer deposits were deposits of £656 million (31 December 2008: £1,002 million) held as collateral. The fair value of those deposits approximates the carrying amount.
Trading liabilities: Liabilities in respect of securities sold under repurchase agreements 21,389 –
The amount contractually payable on maturity of the debt securities held at fair value through profit or loss at 31 December 2009 was £5,866 million, which was £294 million lower than the balance sheet carrying value (31 December 2008: £6,517 million, which was £231 million lower than the balance sheet carrying value). At 31 December 2009 there was a cumulative £55 million decrease in the fair value of these liabilities attributable to changes in credit spread risk; this is determined by reference to the quoted credit spreads of Lloyds TSB Bank plc, the issuing entity within the Group. Of the £55 million, £11 million arose in 2009 and £36 million arose in 2008.
Index to annual report 266 36 LIABILITIES ARISING FROM INSURANCE CONTRACTS AND PARTICIPATING INVESTMENT CONTRACTS
GUARANTEED ANNUITY OPTIONS Certain pension contracts contain guaranteed annuity options that allow the policyholder to take an annuity benefit on retirement at annuity rates that were guaranteed at the outset of the contract. For contracts that contain such options, key assumptions in determining the cost of options are economic conditions in which the option has value, mortality rates and take up rates of other options. The financial impact is dependent on the value of corresponding investments, interest rates and longevity at the time of the claim.
INVESTMENT VOLATILITY The calibration of the stochastic simulation model uses implied volatilities of derivatives where possible, or historical volatility where it is not possible to observe meaningful prices.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued 36 LIABILITIES ARISING FROM INSURANCE CONTRACTS AND PARTICIPATING INVESTMENT CONTRACTS continued
MORTALITY AND MORBIDITY The mortality and morbidity assumptions, including allowances for improvements in longevity for annuitants, are set with regard to the Group’s actual experience where this provides a reliable basis, and relevant industry data otherwise, and include a margin for adverse deviation. For German business appropriate industry tables have been considered.
KEY CHANGES IN ASSUMPTIONS A detailed review of the Group’s assumptions in 2009 resulted in the following key impacts on profit before tax: – Change in persistency assumptions (£79 million decrease)
Cash paid for claims settled in the year (245) 7 (238)
Cash paid for claims settled in the year (513) 14 (499)
Lloyds Banking Group Annual Report and Accounts 2009 36 LIABILITIES ARISING FROM INSURANCE CONTRACTS AND PARTICIPATING INVESTMENT CONTRACTS continued
Current estimate of cumulative claims 484 525 690 469 639 2,807
The liability of £492 million shown in the above table excludes £10 million of unallocated claims handling expenses.
This sensitivity shows the impact of a 25 basis point increase in credit default spreads on corporate bonds and the corresponding reduction in market values. Government bond yields, the risk-free rate and illiquidity premia are all assumed to be unchanged.
This sensitivity shows the impact of a 10 basis point increase in the allowance for illiquidity premia. It assumes the overall corporate bond spreads are unchanged and hence market values are unchanged. Government bond yields and the non-annuity risk-free rate are both assumed to be unchanged. The increased illiquidity premium increases the annuity risk-free rate.
The movement in liabilities arising from non-participating investment contracts may be analysed as follows: Gross Reinsurance Net £m £m £m
Change in unallocated surplus recognised in the income statement (note 10) 318 (284)
The expected return on scheme assets has been calculated using the following assumptions: Fixed interest gilts 3.7 4.5
Present value of defi ned benefi t obligation 27,073 15,617 16,795 17,378 17,320
During the year ended 31 December 2009 the charge to the income statement in respect of defined contribution schemes was £208 million (2008: £71 million), representing the contributions payable by the employer in accordance with each scheme’s rules.
Lloyds Banking Group Annual Report and Accounts 2009 41 RETIREMENT BENEFIT OBLIGATIONS continued
The movement in the net deferred tax balance is as follows: £m £m
DEFERRED TAX ASSETS Deferred tax assets are recognised for tax losses carried forward to the extent that the realisation of the related tax benefit through future taxable profits is probable. Group companies have recognised deferred tax assets of £5,925 million (2008: £856 million) in relation to tax losses carried forward. After reviews of medium-term profit forecasts, the Group considers that there will be sufficient profits in the future against which these losses will be offset.
Scottish Widows plc has a taxable difference of £152 million (2008: £152 million) in respect of its holding of a life insurance subsidiary. No deferred tax liability is required to be recognised in respect of this taxable temporary difference under IAS 12 as Scottish Widows plc does not intend to dispose of this subsidiary company.
CUSTOMER REMEDIATION PROVISIONS The Group establishes provisions for the estimated cost of making redress payments to customers in respect of past product sales, in those cases where the original sales processes have been found to be deficient. During 2009 management has reviewed the adequacy of the provisions held having regard to current complaint volumes and the level of payments being made and £130 million has been released to the income statement. At 31 December 2009 the remaining provisions held relate to past sales of a number of products, including mortgage endowment policies, sold through the branch networks.
9¾% Non-cumulative Irredeemable £1 preference shares (£100 million) b, c, e 72 –
5.92% Fixed-to-Floating Rate US$1 series B preference shares (US$750 million) b, c, e 90 –
6.657% Fixed-to-Floating rate US$1 preference shares (US$750 million) b, c, e 28 –
6.3673% fi xed-to-fl oating non-cumulative callable preference shares (£335 million) b, c, e 2 –
c As part of the Group’s recapitalisation and exit from GAPS, following an exchange offer, on 1 December , 10 December and 15 December 2009, certain holders of certain series elected to exchange some or all of the preference shares they held for enhanced capital notes issued by LBG Capital No. 1 plc and LBG Capital No. 2 plc or equity issued by Lloyds Banking Group plc.
Preferred securities 6.90% Perpetual Capital Securities (US$1,000 million) c 645 756 7.375 % Euro Step-up Non-Voting Non-Cumulative Preferred Securities callable 2012 (€430 million) c, d 306 459 7.875% Perpetual Capital Securities (€500 million) a – 472 7.875% Perpetual Capital Securities (US$1,250 million) a – 921 6.35% Step-up Perpetual Capital Securities callable 2013 (€500 million) c 456 512 7.834% Sterling Step-up Non-Voting Non-Cumulative Preferred Securities callable 2015 (£250 million) c, d 43 248 4.385% Step-up Perpetual Capital Securities callable 2017 (€750 million) c, d 82 720 6.071% Non-cumulative Perpetual Preferred Securities of US$1,000 each (US$750 million) b, c 240 –
6.461% Guaranteed Non-voting Non-cumulative Perpetual Preferred Securities Series A of £1,000 each (£600 million) b, c 398 –
4.939% Non-voting Non-cumulative Perpetual Preferred Securities (€750 million) b, c, d 10 –
a On 16 January 2009 Lloyds TSB Bank plc exercised the option to convert these securities into preference shares.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued 44 SUBORDINATED LIABILITIES continued
Undated Step-up Floating Rate Notes callable 2009 (€150 million) b – 144 65/8% Undated Subordinated Step-up Notes callable 2010 (£410 million) b, c, e 5 409 5.125% Step-up Perpetual Subordinated Notes callable 2015 (£560 million) (Scottish Widows plc) a 547 536 5.57% Undated Subordinated Step-up Coupon Notes callable 2015 (¥20,000 million) e – 189 5.125% Undated Subordinated Step-up Notes callable 2016 (£500 million) b, c, e – 455 6½% Undated Subordinated Step-up Notes callable 2019 (£270 million) b, c, e – 241 8% Undated Subordinated Step-up Notes callable 2023 (£200 million) b, c, e – 186 6½% Undated Subordinated Step-up Notes callable 2029 (£450 million) c, e – 444 6% Undated Subordinated Step-up Guaranteed Bonds callable 2032 (£500 million) c, e 10 452 13% Step-up Perpetual Capital Securities callable 2019 (£784 million) e 9 –
Floating Rate Primary Capital Notes (US$250 million) d, e 146 –
e As part of the Group’s recapitalisation and exit from GAPS, following an exchange offer, on 1 December, 10 December and 15 December certain holders of certain series elected to exchange some or all of the notes they held for enhanced capital notes issued by LBG Capital No. 1 plc and LBG Capital No. 2 plc.
Enhanced capital notes 7.5884% Enhanced Capital Notes due 2020 (Series 1) (£732 million) 690 –
6.50% Notes 2011 (US$150 million) b 102 – 5.50% Subordinated Fixed Rate Notes 2012 (€750 million) b 654 –
4.25% Subordinated Guaranteed Notes 2013 (US$1,000 million) b 594 – 57/8% Subordinated Guaranteed Bonds 2014 (€750 million) 768 821
4.375% Callable Fixed to Floating Rate Subordinated Notes 2019 (€750 million) b 602 – 6.9625% Subordinated Fixed to Floating Rate Notes due 2020 callable 2015 (£750 million) 755 754 Subordinated Floating Rate Notes 2020 (€100 million) 89 96 5.374% Subordinated Fixed Rate Notes 2021 (€160 million) b 132 – 6.45% Fixed/Floating Subordinated Guaranteed Bonds 2023 (€400 million) (Clerical Medical Finance plc) b, c 171 – 6.5% Subordinated Fixed Rate Notes 2023 (€175 million) b 128 – 5.75% Subordinated Step-up Notes 2025 callable 2020 (£350 million) 322 309 4.50% Fixed Rate Step-up Subordinated Notes due 2030 (€750 million) b 478 – 6.00% Subordinated Notes 2033 (US$750 million) b 477 –
a Issued by a group undertaking under the Company’s subordinated guarantee.
On 16 January 2009 the Company issued 7,776 million shares in consideration for the acquisition of HBOS, whereby 12,852 million HBOS shares were exchanged for Lloyds Banking Group shares at a ratio of 0.605 shares per HBOS share. This issue resulted in an increase of £1,944 million in share capital and an increase of £5,707 million in the merger reserve.
Information regarding signifi cant direct or indirect holdings of shares in the Company can be found on page 261.
The directors have authority to allot and issue ordinary and preference shares and to make market purchases of preference shares as granted at the general meeting on 26 November 2009. The authority to issue shares will expire at the annual general meeting, and the authority to make market purchases of preference shares expires on 25 November 2010. The directors also have authority to make market purchases of ordinary shares as granted at the general meeting on 5 June 2009. This authority expires either a year after the date of approval or at the annual general meeting. Shareholders will be asked, at the annual general meeting, to give similar authorities.
ORDINARY SHARES The holders of ordinary shares (excluding the limited voting ordinary shares), who held 98.7 per cent of the total ordinary share capital as at 31 December 2009, are entitled to receive the Company’s report and accounts, attend, speak and vote at general meetings and appoint proxies to exercise voting rights. Holders of ordinary shares (excluding the limited voting ordinary shares) may also receive a dividend (subject to the provisions of the Company’s articles of association and the restrictions noted below) and on a winding up may share in the assets of the Company.
Distributable reserves of £1,000 million arose on the issue of preference shares in January 2009 which were classifi ed as debt. In June 2009, these preference shares were redeemed out of the proceeds of the placing and compensatory open offer of ordinary shares and the distributable element of this issue was transferred from the share premium account to the merger reserve.
Revaluation reserve in respect of available-for-sale fi nancial assets (914) (2,982)
The revaluation reserve in respect of available-for-sale fi nancial assets represents the cumulative after tax unrealised change in the fair value of fi nancial assets classifi ed as available-for-sale since initial recognition, or in the case of available-for-sale fi nancial assets obtained on acquisitions of businesses, since the date of acquisition.
Distributable reserves of £1,000 million arose on the issue of preference shares in January 2009 which were classifi ed as debt. In June 2009, these preference shares were redeemed out of the proceeds of the placing and compensatory open offer of ordinary shares and the distributable element of this issue was transferred to the merger reserve.
In December 2009, the Group redeemed eight issues of preference shares in exchange for the issuance of enhanced capital notes. This resulted in a transfer of £26 million from the merger reserve to the capital redemption reserve and a transfer of £2,684 million from the merger reserve to the share premium account. Details of the preference shares redeemed are set out in note 44.
Change in fair value of available-for-sale fi nancial assets 2,234 (2,721)
Employee share option schemes – value of employee services 116 43
Retained profits are stated after deducting £48 million (2008: £40 million) representing 49 million (2008: 15 million) treasury shares held.
Bank of New York Nominees Limited have waived the right to all dividends on Lloyds Banking Group plc shares that they hold (holding at 31 December 2009: nil shares and at 31 December 2008: 10 shares).
For options granted up to March 2001 Options granted Performance conditions
In respect of options granted between March 1999 and March 2001, the relevant period for the performance conditions began at the end of the fi nancial year preceding the date of grant and continued until the end of the third subsequent year following commencement or, if not met, the end of such later year in which the conditions were met. Once the conditions were satisfi ed the options remain exercisable without further conditions. If they were not satisfi ed by the tenth anniversary of the grant the options would lapse.
The performance condition was measured over a three year period which commenced at the end of the fi nancial year preceding the grant of the option and continued until the end of the third subsequent year. If the performance condition was not then met, it was measured at the end of the fourth fi nancial year. If the condition was not then met, the options would lapse.
For the HBOS sharesave plan, no options were exercised during 2009 therefore the weighted average share price was £nil. The options outstanding at 31 December 2009 had exercise prices in the range of £2.20 to £3.64 and a weighted average remaining contractual life of 4.0 years.
Lloyds TSB Group Executive Share Plan 2003 The plan was adopted in December 2003 and under the plan share options may be granted to senior employees. Options granted under this plan have been granted specifically to facilitate recruitment and as such were not subject to any performance conditions. The plan has now been extended to not only compensate new recruits for any lost share awards but also to make grants to key individuals for retention purposes with, in some instances, the grant being made subject to individual performance conditions.
Options granted under this plan were adjusted on 2 July 2009 as a result of the Placing and Compensatory Open Offer. The adjustment was made using a standard HMRC formula, to negate the dilutionary impact of the capital raising event.
The options outstanding under the Bank of Scotland Executive Stock Option schemes at 31 December 2009 had exercise prices in the range of £8.834 to £10.009 and a weighted average remaining contractual life of 0.8 years.
The performance conditions for awards made in April, May and September 2009 are as follows: (i) EPS: The release of 50 per cent of the shares will be dependent on the extent to which the growth in EPS achieves cumulative EPS targets over the three-year period.
Performance against the first year of the award has been assessed and all targets have been met or exceeded.
The fair value calculations at 31 December 2009 for grants made in the year are based on the following assumptions: Other option Other share SAYE schemes plans
Matching shares The Group undertakes to match shares purchased by employees up to the value of £30 per month; these shares are held in trust for a mandatory period of three years on the employees’ behalf. The award is subject to a non-market based condition: if an employee leaves within this three year period for other than a ‘good’ reason, 100 per cent of the matching shares are forfeited. Similarly if the employees sell their purchased shares within three years, their matching shares are forfeited.
Deposits placed by key management personnel attracted interest rates of up to 6.5 per cent (2008: 6.0 per cent).
The Company also agreed to (i) pay to each of HM Treasury, the joint sponsors and joint bookrunners all legal and other costs and expenses, and those of HM Treasury’s fi nancial advisors incurred in connection with the placing and compensatory open offer, the redemption of the preference shares or any arrangements referred to in the 2009 Open Offer Agreement; and (ii) bear all costs and expenses relating to the placing and compensatory open offer and the preference share redemption. The costs and commissions incurred by the joint bookrunners in connection with the rump placing were deducted from the aggregate proceeds of the rump placing. The Company also gave certain representations and warranties and indemnities to each of HM Treasury, the joint sponsors and joint bookrunners under the 2009 Open Offer Agreement. The Company’s liabilities thereunder are unlimited as to time and amount. HM Treasury is entitled to novate its rights under the agreement to any entity that is wholly-owned, directly or indirectly, by HM Treasury.
Pensions funds At 31 December 2009, customer deposits of £99 million (2008: £23 million) and investment and insurance contract liabilities of £691 million (2008: £nil) related to the Group’s pension funds.
OEICs The Group manages 382 (2008: 105) Open Ended Investment Companies (OEICs), and of these 108 (2008: 47) are consolidated. The Group invested £1,271 million (2008: £455 million) and redeemed £1,076 million (2008: £343 million) in the unconsolidated OEICs during the year and had investments, at fair value, of £6,954 million (2008: £2,661 million) at 31 December. The Group earned fees of £217 million from the unconsolidated OEICs (2008: £206 million). The Company held no investments in OEICs at any time during 2008 or 2009.
On 1 July 2008 the Financial Ombudsman Service referred concerns regarding the handling of PPI complaints to the FSA as an issue of wider implication. The Group has been working with other industry members and trade associations in preparing an industry response to address regulatory concerns regarding the handling of PPI complaints. On 29 September 2009, the FSA issued a consultation paper on PPI complaints handling. The FSA has escalated its regulatory activity in relation to past PPI sales generally and has proposed new guidance on the fair assessment of a complaint and the calculation of redress and a new rule requiring fi rms to reassess historically rejected complaints.
Loans and advances to customers – – – – 626,969 – – 626,969
Deposits from banks – – – – – 82,452 – 82,452
Unallocated surplus within insurance businesses – – – – – – 1,082 1,082
Loans and advances to customers – – – – 240,344 – – 240,344
Deposits from banks – – – – – 66,514 – 66,514
Additional fair value gains/(losses) that would have been recognised had the reclassifi cations not occurred
From held for trading to loans and receivables: Reclassifi ed in 2009 £m
From available-for-sale fi nancial assets to loans and receivables: 53 FINANCIAL INSTRUMENTS continued
Trading and other fi nancial liabilities at fair value through profi t or loss 28,271 6,754 28,271 6,754
VALUATION METHODOLOGY Financial instruments include fi nancial assets, fi nancial liabilities and derivatives. The fair value of a fi nancial instrument is the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale.
Wherever possible, fair values have been calculated using unadjusted quoted market prices in active markets for identical instruments held by the Group. Where quoted market prices are not available, or are unreliable because of poor liquidity, fair values have been determined using valuation techniques which, to the extent possible, use market observable inputs, but in some cases use non-market observable inputs. Valuation techniques used include discounted cash fl ow analysis and pricing models and, where appropriate, comparison to instruments with characteristics similar to those of the instruments held by the Group.
VALUATION OF FINANCIAL INSTRUMENTS CARRIED AT FAIR VALUE The table below provides an analysis of the fi nancial assets and liabilities of the Group that are carried at fair value in the Group’s consolidated balance sheet, grouped into levels 1 to 3 based on the degree to which the fair value is observable.
Level 1 Level 2 Level 3 Total £m £m £m £m
Trading and other fi nancial assets at fair value through profi t or loss 103,853 43,246 2,912 150,011
Trading and other fi nancial liabilities at fair value through profi t or loss 511 27,760 – 28,271
Trading and other fi nancial assets at fair value through profi t or loss 38,019 5,373 1,672 45,064
Trading and other fi nancial liabilities at fair value through profi t or loss 6 6,748 – 6,754
The valuations of fi nancial instruments have been classifi ed into three levels according to the quality and reliability of information used to determine the fair values.
Level 3 portfolios level 3 portfolios are those where at least one input which could have a signifi cant effect on the instrument’s valuation is not based on observable market data. Such instruments would include the Group’s venture capital and unlisted equity investments which are valued using various valuation techniques that require signifi cant management judgement in determining appropriate assumptions, including earnings multiples and estimated future cash fl ows. Certain of the Group’s asset-backed securities and derivatives, principally where there is no trading activity in such securities, are also classifi ed as level 3.
Equity investments Various valuation techniques Earnings, net asset value, underlying asset values, property prices, forecast cash fl ows 1,867 n/a
Reasonably possible alternative valuations have been calculated for asset-backed securities by using alternative pricing sources and calculating an absolute difference. In respect of derivative fi nancial instruments, reasonably possible alternative valuations have been calculated by fl exing the spread between the underlying asset and the credit derivative, or adjusting market yields, by a reasonable amount.
The main products where level 3 valuations have been used are described below: Asset-backed securities Where there is no trading activity in asset-backed securities, valuation models, consensus pricing information from third party pricing services and broker or lead manager quotes are used to determine an appropriate valuation. Asset-backed securities are then classifi ed as either level 2 or level 3 depending on whether there is more than one consistent independent source of data. If there is a single, uncorroborated market source for a signifi cant valuation input or where there are materially inconsistent levels then the valuation is reported as level 3. Asset classes classifi ed as level 3 mainly comprise certain Residential Mortgage-Backed Securities, Collateralised Loan Obligations and Collateralised Debt Obligations.
Valuations of unlisted venture capital equities that are accounted for as trading and other fi nancial assets at fair value through profi t or loss are calculated using International Private Equity and Venture Capital Guidelines. The majority of investments are valued using the industry standard earnings model. This involves applying the relevant earnings multiple to the maintainable earnings of the business being valued. A number of earnings multiples are used in valuing the portfolio including price earnings, earnings before interest and tax and earnings before interest, tax, depreciation and amortisation. The particular multiple selected being appropriate for the type of business being valued and is derived by reference to the current market-based multiple. Consideration is given to the risk attributes, growth prospects and fi nancial gearing of comparable businesses when selecting an appropriate multiple. Recent transactions involving the sale of similar businesses may sometimes be used as a frame of reference in deriving an appropriate multiple. Another valuation technique involved, although rarely, is the discounting of projected cash fl ows at the appropriate cost of capital.
– Valuations using net asset values are often used for property-based businesses and use the latest valuations included in management or statutory accounts adjusted for subsequent movements in property valuations and other factors including recoverability.
For fund investments the most recent capital account value calculated by the fund manager is used as the basis for the valuation and adjusted, if necessary, to align valuation techniques with the Group’s valuation policy.
– Foreign exchange derivatives that do not contain options are priced using rates available from publicly quoted sources.
– Less complex interest rate and foreign exchange option products are valued using volatility surfaces developed from publicly available interest rate cap, interest rate swaption and other option volatilities; option volatility skew information is derived from a market standard consensus pricing service. For more complex option products, the Group calibrates its models using observable at-the-money data; where necessary, the Group adjusts for out-of-the-money positions using a market standard consensus pricing service.
Where credit protection, usually in the form of credit default swaps, has been purchased or written on asset-backed securities, the security is referred to as a negative basis ABS and the resulting derivative assets or liabilities have been classifi ed as either level 2 or level 3 according to the classifi cation of the underlying ABS.
Gains (losses) recognised in other comprehensive income – 191 – 191
Transfers out of the Level 3 portfolio (1,742) (2,174) – (3,916)
The table below analyses movements in the Level 3 fi nancial liabilities portfolio.
Transfers out of the Level 3 portfolio arise when inputs that could have a signifi cant impact on the instrument’s valuation become market observable after previously having been non-market observable. In the case of asset-backed securities this can arise if more than one consistent independent source of data becomes available. Conversely transfers into the portfolio arise when consistent sources of data cease to be available.
(1) INTEREST RATE RISK In the Group’s retail banking business interest rate risk arises from the different repricing characteristics of the assets and liabilities. Liabilities are either insensitive to interest rate movements, for example interest free or very low interest customer deposits, or are sensitive to interest rate changes but bear rates which may be varied at the Group’s discretion and that for competitive reasons generally refl ect changes in the Bank of England’s base rate. There is a relatively small volume of deposits whose rate is contractually fi xed for their term to maturity.
Many banking assets are sensitive to interest rate movements; there is a large volume of managed rate assets such as variable rate mortgages which may be considered as a natural offset to the interest rate risk arising from the managed rate liabilities. However, a signifi cant proportion of the Group’s lending assets, for example personal loans and mortgages, bear interest rates which are contractually fi xed for periods of up to fi ve years or longer.
The Group establishes two types of hedge accounting relationships for interest rate risk: fair value hedges and cash fl ow hedges. The Group is exposed to fair value interest rate risk on its fi xed rate customer loans, its fi xed rate customer deposits and the majority of its subordinated debt, and to cash fl ow interest rate risk on its variable rate loans and deposits together with its fl oating rate subordinated debt. The majority of the Group’s hedge accounting relationships are fair value hedges where interest rate swaps are used to hedge the interest rate risk inherent in the fi xed rate mortgage portfolio.
At 31 December 2009 the aggregate notional principal of interest rate swaps designated as fair value hedges was £80,085 million (2008: £37,243 million) with a net fair value asset of £3,004 million (2008: liability of £1,231 million) (note 18). The losses on the hedging instruments were £995 million (2008: losses of £584 million). The gains on the hedged items attributable to the hedged risk were £1,181 million (2008: gains of £426 million).
(2) CURRENCY RISK Foreign exchange exposures comprise those originating in treasury trading activities and structural foreign exchange exposures, which arise from investment in the Group’s overseas operations.
Deposit amounts available for offset and amounts available for offset under master netting arrangements do not meet the criteria under IAS 32 to enable loans and advances and derivative assets respectively to be presented net of these balances in the fi nancial statements.
Available-for-sale debt securities, treasury and other bills, and trading and other fi nancial assets at fair value through profi t or loss – the credit quality of the Group’s available-for-sale debt securities, treasury and other bills, and the majority of the Group’s trading and other fi nancial assets at fair value through profi t or loss held is set out below. An analysis of trading and other fi nancial assets at fair value through profi t or loss is included in note 17 and a similar analysis for available-for-sale fi nancial assets is included in note 25. The Group’s non-participating investment contracts are all unit-linked. Trading and other fi nancial assets at fair value through profi t or loss which back those investment contracts were £118,573 million (2008: £39,899 million). Movements in the fair value of such assets, including movements arising from credit risk, are borne by the contract holders.
Reverse repo and repo transactions – for reverse repo transactions which are accounted for as collateralised loans, it is the Group’s policy to seek collateral which is at least equal to the amount loaned. At 31 December 2009, the fair value of collateral accepted under reverse repo transactions that the Group is permitted by contract or custom to sell or repledge was £26,732 million (2008: £5,858 million). Of this, £26,732 million (2008: £5,855 million) was sold or repledged as at 31 December 2009. The fair value of collateral pledged in respect of repo transactions, accounted for as secured borrowings, where the secured party is permitted by contract or custom to repledge was £38,102 million (31 December 2008: £5,734 million).
Impaired – no provision required – 2,034 449 6,603 9,086 –
Neither past due nor impaired 38,716 110,148 33,571 86,707 230,426 608
A fi nancial asset is ‘past due’ if a counterparty has failed to make a payment when contractually due.
Lending decisions are based on an obligor’s ability to repay from normal business operations rather than reliance on the disposal of any security provided. Collateral values for non-mortgage lending are assessed more rigorously at the time of loan origination or when taking enforcement action and may fl uctuate, as in the case of fl oating charges, according to the level of assets held by the customer. Whilst collateral is reviewed on a regular basis in accordance with business unit credit policy, this varies according to the type of lending and collateral involved. It is therefore not practicable to estimate and aggregate current fair values of collateral for non-mortgage lending.
Renegotiated loans and advances Loans and advances that were renegotiated during the year and that would otherwise have been past due or impaired at 31 December 2009 totalled £3,919 million (31 December 2008: £144 million).
Customers can have their arrears balance recapitalised once they have demonstrated they can pay the original contractual minimum payment, but are unable to clear their arrears. This is usually demonstrated by the customer making six consecutive contractual monthly payments. Customers are not however able to recapitalise more than twice in a fi ve year period. Recapitalised mortgages will return to the non-impaired book and will be managed in accordance with the recapitalised terms of the mortgage.
Analysis by loan-to-value ratio of the Group’s residential mortgage lending which is neither past due nor impaired: Less than 70 per cent 142,614 55,040 70 per cent to 80 per cent 54,079 15,812 80 per cent to 90 per cent 52,238 15,954
Trading assets: Other public sector securities – – 6 – – – 6
Debt securities: Other public sector securities – – – – – 31 31
Asset-backed securities: Corporate and other debt securities 3,194 864 2,911 2,142 599 1,410 11,120
Debt securities: Other public sector securities – – – – – 12 12
Mortgage-backed securities: US residential mortgage-backed securities 4,826 – – 4,826 488
Collateralised debt obligations: Commercial real estate 509 – – 509 –
Trading and other fi nancial assets at fair value through profi t or loss 196 216 606 3,059 40,987 45,064
Loans and advances to customers 39,854 7,254 15,430 56,331 123,866 242,735
The above tables are provided on a contractual basis. The Group’s assets and liabilities may be repaid or otherwise mature earlier or later than implied by their contractual terms and readers are, therefore, advised to use caution when using data to evaluate the Group’s liquidity position.
Trading and other fi nancial liabilities at fair value through profi t or loss 14,592 3,668 6,116 3,224 1,275 28,875
Trading and other fi nancial liabilities at fair value through profi t or loss 29,479 1,077 5,295 7,203 3,818 46,872
Gross settled derivatives – net fl ows 2,074 251 1,354 990 1,154 5,823
Total derivative fi nancial liabilities 3,898 891 1,769 1,340 2,124 10,022
The principal amount for undated subordinated liabilities with no redemption option is included within the over fi ve years column; interest of approximately £555 million (2008: £412 million) per annum which is payable in respect of those instruments for as long as they remain in issue is not included beyond fi ve years.
Further information on the Group’s liquidity exposures is provided on pages 81 to 85.
Net assets acquired: Cash and balances at central banks 2,123 –
IFRS 9 is the initial stage of a project to replace IAS 39 Financial Instruments: Recognition and Measurement and will fundamentally change the way in which the Group accounts for fi nancial instruments. Future stages are expected to result in amendments to IFRS 9 to deal with classifi cation and measurement of fi nancial liabilities, amortised cost and impairment and hedge accounting. Until all stages of the replacement project are complete, it is not possible to determine the overall impact on the fi nancial statements from the replacement of IAS 39.
Amendment to IAS 39 Financial Instruments: Recognition and Measurement – ‘Eligible Hedged Items’
Amendments to IFRS 2 Share-based Payment – ‘Group Cash-settled Share-based Payment Transactions’ 1
Amendment to IAS 32 Financial Instruments: Presentation – ‘Classifi cation of Rights Issues’
IAS 24 Related Party Disclosures1 Simplifi es the defi nition of a related party and provides a partial exemption from the disclosure requirements for government related entities
Replaces those parts of IAS 39 Financial Instruments: Recognition and Measurement relating to the classifi cation and measurement of fi nancial assets. Requires fi nancial assets to be classifi ed into two measurement categories, fair value and amortised cost, on the basis of the objectives of the entity’s business model for managing its fi nancial assets and the contractual cash fl ow characteristics of the instrument. The available-for-sale fi nancial asset and held-to-maturity categories in existing IAS 39 will be eliminated.
REPORT OF THE INDEPENDENT AUDITORS ON THE PARENT COMPANY FINANCIAL STATEMENTS
INDEPENDENT AUDITORS’ REPORT TO THE MEMBERS OF LLOYDS BANKING GROUP PLC
Non-current liabilities: Current liabilities: Debt securities in issue 8 326 2,644
Issue of ordinary shares: Placing and open offer 649 3,781 – – 4,430
Employee share option schemes: value of employee services – – – 74 74
PARENT COMPANY STATEMENT OF CHANGES IN EQUITY for the year ended 31 December 2009
The movement in the net deferred tax asset is as follows: £m £m
Lloyds Banking Group Annual Report and Accounts 2009 5 OTHER RESERVES
In December 2009, the Group redeemed eight issues of preference shares in exchange for the issuance of enhanced capital notes. This resulted in a transfer of £26 million from the merger reserve to the capital redemption reserve and a transfer of £2,684 million from the merger reserve to the share premium account. Details of the preference shares redeemed are set out in note 44 to the consolidated fi nancial statements.
b In certain circumstances, these bonds would acquire the characteristics of preference share capital. They are accounted for as liabilities as coupon payments are mandatory as a consequence of the terms of the 6 per cent non-cumulative redeemable preference shares. At the callable date the coupon on these bonds will be reset by reference to the applicable fi ve year benchmark gilt rate. Holders of certain preference shares, preferred securities and undated subordinated notes issued by Lloyds Banking Group plc, Lloyds TSB Bank plc, HBOS plc, Bank of Scotland plc and other Group funding companies were invited to exchange their holdings in these notes under two exchange offers announced on 3 November 2009. Under these exchange offers holders had the option of exchanging their holdings for enhanced capital notes (the ‘ECNs’) issued by LBG Capital No.1 plc or LBG Capital No.2 plc or, in certain circumstances, new ordinary shares, cash or additional ECNs. Further information regarding this can be found in the liability management section of note 44 to the consolidated fi nancial statements.
Lloyds Banking Group Annual Report and Accounts 2009 8 DEBT SECURITIES IN ISSUE
KEY MANAGEMENT PERSONNEL The key management personnel of the Group and parent company are the same. The relevant disclosures are given in note 51 to the consolidated fi nancial statements.
Derivatives designated as Held for hedging instruments, held trading at fair Held at at fair value through value through Loans and amortised profi t or loss profi t or loss receivables cost Total £m £m £m £m £m
Financial assets: Cash and cash equivalents – – – 2,837 2,837
INTEREST RATE RISK AND CURRENCY RISK The Company is exposed to interest rate risk and currency risk on its debt securities in issue and its subordinated debt.
Lloyds Banking Group Annual Report and Accounts 2009 11 POST BALANCE SHEET EVENTS
The parent company fi nancial statements were approved by the directors of Lloyds Banking Group plc on 25 February 2010.
SUBSTANTIAL SHAREHOLDINGS At the date of this report a notifi cation had been received that The Solicitor for the Affairs of Her Majesty’s Treasury had a direct interest of 41.3 per cent in the issued share capital with rights to vote in all circumstances at general meetings. No other notifi cation has been received that anyone has an interest of 3 per cent or more in the issued ordinary share capital.
SHARE DEALING FACILITIES A full range of dealing services is available as follows: – Internet dealing. Log on to www.lloydstsbsharedealing.com
– Internet and telephone dealing services are available between 8.00am and 4.30pm, Monday to Friday.
Equiniti operates a web based enquiry and portfolio management service for you to receive shareholder communications electronically. In addition, you can change your address or bank details and register proxy appointments and voting instructions on your shareholding online. Visit www.shareview.co.uk for details.
Collateralised Debt Obligations Collateralised Debt Obligations are securities issued by a third party which reference Asset-Backed Securities (ABSs) and/or certain other related assets purchased by the issuer. Lloyds Banking Group has not established any programmes creating CDOs but has invested in instruments issued by other banking groups. These are primarily CLOs, CBOs, CREs and CDOs. Details of these investments are given in note 54.
Commercial Mortgage-Backed Securities are securities that represent interests in a pool of commercial mortgages. Investors in these securities have the right to cash received from future mortgage payments (interest and/or principal). Further information on the Group’s investment in CMBS is given in note 54.
Commercial Real Estate Commercial real estate includes offi ce buildings, industrial property, medical centres, hotels, malls, retail stores, shopping centres, farm land, multifamily housing buildings, warehouses, garages, and industrial properties.
Credit Default Swaps A credit default swap is also referred to as a credit derivative. It is an arrangement whereby the credit risk of an asset (the reference asset) is transferred from the buyer to the seller of protection. A credit default swap is a contract where the protection seller receives premium or interest-related payments in return for contracting to make payments to the protection buyer upon a defi ned credit event. Credit events normally include bankruptcy, payment default on a reference asset or assets, or downgrades by a rating agency.
Guaranteed mortgages Mortgages for which there is a guarantor to provide the lender a certain level of fi nancial security in the event of default of the borrower.
Negative basis bonds ABS held with a separately purchased matching credit default swaps to protect against the risk of default of the security. The Group refers to ABS without the benefi t of CDS protection as Uncovered ABS. Details of the Group’s exposure to negative basis bonds is given in note 54.
Prime Prime mortgages are those granted to the most creditworthy category of borrower.
Special Purpose Entities (SPEs) SPEs are entities that are created to accomplish a narrow and well defi ned objective. There are often specifi c restrictions or limits around their ongoing activities. The Group uses a number of SPEs, including those set-up under securitisation programmes, and as conduits. Where the Group has control of these entities or retains the risks and rewards relating to them they are consolidated within the Group’s results.
Value at Risk Value at Risk is an estimate of the potential loss in earnings which might arise from market movements under normal market conditions, if the current positions were to be held unchanged for one business day, measured to a confi dence level of 95 per cent.
Write Downs The depreciation or lowering of the value of an asset in the books to refl ect a decline in their value, or expected cash fl ows.