The Group is the UK’s largest retail bank and has a large and diversified customer base. Services are offered through a number of well recognised brands including Lloyds TSB, Halifax, Bank of Scotland, Scottish Widows, Clerical Medical and Cheltenham & Gloucester, and a range of distribution channels including the largest branch network in the UK.
Chairman’s statement We have a great platform for the future and have established a strong financial and operational trajectory.
Wealth and International focuses on the private banking and asset management businesses of the Group and also operates the Group’s international business. Key product markets: Wealth management
OUR MULTI-BRAND APPROACH The Group operates a range of well recognised brands across our four divisions with different brands utilised for different customer segments, geographies and markets.
Overview Business review Governance Financial statements Other information 3 Group profile 1
Good trading performance against the backdrop of modest growth in the UK
Strong cost performance with a 6 per cent reduction in operating expenses
Our corporate strategy identifies the key strategic deliverables required to implement the business model effectively and deliver our Group vision.
– Developing strong customer franchises that are based on deep customer relationships
Building a high performance organisation In delivering a high performance organisation the Group is focused on improving our cost efficiency and utilising our capital more effectively whilst maintaining a prudent approach to risk.
Good progress continues to be made in reducing the cost:income ratio, which fell to 46 per cent in 2010. This was driven by both higher underlying income and lower operating expenses. The Group continues to expect the cost:income ratio to reduce to approximately 40 per cent in the medium term excluding the Bank Levy.
OUTPUT MEASURES Significant progress has been made against our strategic goals and objectives during 2010, and the key performance indicators below highlight the overall progress being made by the Group. Further detail on these measures is contained within the business review.
Although 2010 brought some increase in global confidence and stability, the banking industry continued to operate amidst challenging conditions.
At the same time, as a responsible lender, we will seek to ensure that we lend to customers who can afford to repay their borrowing and to businesses that have a fundamentally sound business model. These are principles to which we must adhere.
Our partnership of the London 2012 Olympic and Paralympic Games will bring the Games to life in the heart of communities all over Britain and 2011 will be an exciting year in the countdown to 2012. Since the launch of our Local Heroes programme we have supported 600 athletes. We have also pledged £1 billion of funding to help businesses benefit from London 2012 Games associated opportunities. In this way we have supported one in three of all businesses who have won London 2012 Olympic Games related contracts.
Our people have faced a difficult year with great commitment and purpose. It is not easy or pleasant to work for a group which is continuously in the media headlines. All the more so when the delivery of our day-to-day banking and personal financial services are, in numerous surveys of our customers, judged to be at the very top or near it. On behalf of the Board I thank our colleagues for their significant achievements in 2010, which from letters and emails I receive, are as much appreciated by our shareholders as our customers.
The Group is primarily a retail and commercial bank. This means that the payout under our Group bonus schemes for 2010 is a small percentage of overall revenues. Though profitability increased substantially our total compensation for 2010 is lower than that for 2009.
On 28 February 2011, Eric Daniels will retire as Group Chief Executive and Director of Lloyds Banking Group plc and, in line with his contractual commitments, will retire from the Group in September 2011. His knowledge of the Group and our customers will, I am pleased to say, remain available to the Board and myself as required until then.
We achieved a step change in our financial performance despite modest economic growth, returning the Group to profitability while absorbing the substantial costs of reducing risk in the business. While the significant decrease in impairments was a key driver in our return to profitability, we also saw a good performance in the core business where underlying income grew 7 per cent.
We also realised substantial cost savings, and we are on track to deliver our target of £2 billion of run-rate cost synergies from the integration of HBOS by the end of 2011.
On a combined businesses basis, the Group reported a £2.2 billion profit in 2010, compared to a £6.3 billion loss before tax in 2009. Underlying income grew by 3 per cent to £23.6 billion, reflecting good underlying income growth of 7 per cent in our core business, partially offset by a reduction of 9 per cent in our non-core business as a result of planned asset reductions. Operating expenses fell by 6 per cent, resulting in an improvement in our underlying cost:income ratio of 4.5 percentage points to 46.2 per cent.
We see strong growth opportunities in Wealth, through deepening relationships with existing Group customers and through the targeted acquisition of new customers. In 2010, we saw encouraging early results from the development of our customer offerings, and we grew our UK relationship customer base by 12 per cent.
In Insurance our focus on sustainable and profitable growth led to a 13 per cent increase in profit before tax. While this strategy led to a reduction in overall sales volumes in our UK Life, Pensions and Investments business, as we stopped selling a number of low return heritage HBOS products, this resulted in a substantial increase in new business margin.
During 2010 the Group continued to support the UK’s economic recovery through new lending to our mortgage and business customers. The Group extended £30 billion of gross mortgage lending (including remortgages) to UK homeowners and supported over 50,000 first time buyers.
We continued to make good progress on the integration of Lloyds TSB and HBOS, one of the largest and most complex programmes undertaken in the UK, exiting the year with run-rate cost synergies of £1.4 billion, as expected. We achieved savings across a wide range of Group activities, including implementing improved processes which are now being used on a harmonised basis across the Group, and driving savings in property and procurement. As part of the integration, we have also commenced the implementation of a number of major systems changes, which will complete in 2011.
We have now achieved asset reductions totalling £105 billion in the two years since the inception of the programme, against our target of a £200 billion reduction.
Term issuance during the year enabled us to materially reduce the liquidity we receive from government and central bank sources, by £61 billion to £97 billion at the year end and we have made further progress since then.
I am proud of the high levels of support and service our staff have continued to deliver to our customers over the past year, in what remains a challenging environment, and in the context of the considerable changes to the Group arising from the integration. Their dedication is reflected in our significant achievements in 2010, and the Board and I are very appreciative of their contribution.
As a result of the recapitalisation of the banking sector which included the capital raisings, the Government now holds a significant stake in Lloyds Banking Group. As at the date these accounts were approved the Government’s shareholding in Lloyds Banking Group was approximately 40.6 per cent. This holding is managed by United Kingdom Financial Investments (UKFI) on behalf of HM Treasury.
Going forward the Group is focused on delivering strategy and subsequently value to all our shareholders. The Government holding does not affect this management focus and we remain committed to operating as a wholly privately owned, self supporting, dividend paying, commercial enterprise over time.
The European Commission required the Group to agree a restructuring plan as a result of the investment in the Group by HM Treasury. 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: – 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, so by November 2013.
Overview Business review Governance Financial statements Other information 11 Group profile 1
The Commission will make recommendations covering both: – Structural measures to reform the banking system and promote stability and competition, including the complex issue of separating retail and investment banking functions; and
The recent financial position of the Group along with the behavioural commitments we entered into as part of the State Aid Restructuring Plan have prevented us paying dividends on our ordinary shares.
We fully understand the hardship that the lack of dividend has caused many of our shareholders, and we are working diligently to restore the ability to pay dividends and create shareholder value.
The Board intends to resume dividend payments on ordinary shares as soon as market conditions and the financial performance of the Group permit, subject to the expiry, in 2012, of the restrictions on paying dividends arising from the European Commission’s remedies.
As previously outlined within the Strategy and Progress section (pages 4 and 5) the integration of the HBOS business is a key deliverable for the Group.
Wholesale Markets Corporate business now trading under the Lloyds Bank brand.
The weak economic recovery has kept growth in our markets subdued.
Statutory profit before tax was £281 million (2009: £1,042 million, including an £11,173 million gain on the acquisition of HBOS); after charging integration costs of £1,653 million and other adjusting net charges of £278 million including a loss on disposal of businesses of £365 million.
Continued active support for the UK’s economic recovery by providing £30 billion of gross mortgage lending (including remortgages) and £49 billion of committed gross lending to businesses, of which £11 billion for SMEs.
Underlying total income increased by 3 per cent to £23,641 million, including core business income growth of 7 per cent.
Strong cost performance with a 6 per cent reduction in operating expenses to £10,928 million. Further improvement in the underlying cost:income ratio to 46.2 per cent (2009: 50.7 per cent).
Continued strong progress with the integration programme delivering annual run-rate savings of £1,379 million. Confident of delivering a run-rate of £2 billion per annum by the end of 2011.
Capital position significantly improved with core tier 1 ratio increased to 10.2 per cent, primarily reflecting a reduction in risk weighted assets by 18 per cent to £406.4 billion.
Excellent progress against term funding objectives with £50 billion of wholesale term issuance in the year.
Overview Business review Governance Financial statements Other information 15 Group profile 1
Our medium-term targets remain unchanged. However, having joined the Group in January, António Horta-Osório will be appointed Group Chief Executive on 1 March and will be reviewing the business to further develop the strategy and actions needed to realise its full potential. He expects to report to the Board and subsequently to shareholders on the outcome of his strategic review and his plans at the end of the first half of 2011.
A good revenue performance Total income, net of insurance claims, decreased by 2 per cent to £23,444 million, which included a reduction of £1,075 million in gains from the Group’s liability management exercises and a £193 million increase in the mark-to-market losses arising from the equity conversion feature of the Group’s Enhanced Capital Notes. The total mark-to-market loss relating to the ECNs in 2010 was £620 million, and comprised a gain of £192 million in the first half of the year and a loss of £812 million in the second half.
Underlying income, excluding these items, increased by 3 per cent. The Group delivered a good revenue performance in its core business in 2010 despite subdued growth in lending markets. Core business underlying income growth of 7 per cent was, however, partially offset by a reduction in non-core income of 9 per cent, in line with progress against the Group’s strategy to reduce the size of its balance sheet.
The majority of the net interest margin increase was achieved in the first half of the year, with only modest improvement in the second half, as previously guided, given rising wholesale market funding costs, a slowing migration of mortgages to standard variable rates, continued liability
Within Group Operations and Central Items, underlying income decreased by £126 million primarily due to a reduction in the fair value of derivatives not mitigated through hedge accounting. Net interest expense was broadly unchanged at £823 million, but included capital and wholesale liquidity funding costs of £601 million (2009: £260 million) not recovered from the divisions, with the increase primarily due to higher wholesale market funding spreads and the Group’s decision to accelerate its wholesale funding in 2010. These increased costs were offset by improved net interest from interest rate risk management activities.
Group Operations and Central items (251) – (251) (125) – (125)
Overview Business review Governance Financial statements Other information 17 Group profile 1
Strong cost management delivering benefits The Group has an excellent track record in managing its cost base, and has delivered a strong cost performance in 2010. During 2010, operating expenses decreased by 6 per cent to £10,928 million, as substantial integration related savings were captured, together with lower levels of operating lease depreciation. After investment, ongoing business as usual expenses were held within inflationary levels. Our underlying cost:income ratio also saw further improvement to 46.2 per cent.
Outlook – expenses We expect that our costs will be broadly flat in 2011, with further absolute cost savings likely to be partially offset by increased investment proposed to support the growth of the core business, increasing regulatory costs, costs resulting from the introduction of the Bank Levy (which is expected to cost around £260 million in 2011), and the combined cost in the region of £100 million of the recent rise in VAT and employers’ National Insurance contributions. Excluding the cost of the Bank Levy, the Group continues to target a cost:income ratio of approximately 40 per cent in the medium term.
In Retail, the improvement in credit performance was faster than expected a year ago, with the impairment charge as a percentage of average loans and advances to customers decreasing to 0.74 per cent in 2010, significantly lower than 1.11 per cent in 2009. The core business impairment charge decreased by 34 per cent, reflecting the improved quality of new business and effective portfolio management and the continuing slow recovery of the economy.
Outlook – balance sheet We are confident of achieving our targeted further reductions in non-core assets of approximately £100 billion over the next three years. In addition, we continue to progress plans to execute the divestment of retail assets and liabilities in line with our state aid obligations.
Overview Business review Governance Financial statements Other information 21 Group profile 1
The Group has continued to reduce its reliance on short-term wholesale funding. During the year the absolute level of Group wholesale funding fell to £298.0 billion, from £325.5 billion at the end of 2009, reflecting a reduction in balance sheet assets. By the end of 2010, our loan to deposit ratio, excluding repos and reverse repos, had improved to 154 per cent. Strong term issuance in 2010 also allowed the Group to maintain its maturity profile of wholesale funding with 50 per cent of wholesale funding having a maturity date greater than one year at 31 December 2010.
With the Group having returned to profitability in 2010, the risk in the business further reduced, and our improved capital, funding and liquidity positions, we now have a stronger business, which is well positioned for the future.
Impairment as a percentage of average advances4 0.74% 2.08% 8.90% 2.01%
Impairment as a percentage of average advances4 1.11% 5.92% 6.04% 3.25%
Net interest income increased by £1,408 million or 18 per cent to £9,378 million, largely as a result of the continuing re-pricing of risk, mortgage customers moving onto standard variable rates and a decrease in the LIBOR to Base Rate spread.
Operating expenses remain tightly controlled, increasing by only 2 per cent to £4,644 million, which combined with strong income growth led to a significant reduction in the cost:income ratio to 42.3 per cent. Operating expenses benefited from continuing cost control as well as cost synergies.
Overview Business review Governance Financial statements Other information 27 Group profile 1
During 2010, Retail successfully delivered a number of elements of the strategy, with a focus on rebuilding trust with customers. A primary focus was the development of products that are simple, transparent and easy for customers to understand. Customer demand for these products has been very positive. For example, the customer response to the Halifax’s Clarity card has been strong with 145,000 new cards issued since its launch in July 2010. This card leads the market in terms of transparency and simplicity with a single customer interest rate and no usage fees for balance transfers, cash withdrawals and international usage.
Internet banking continues to grow in popularity amongst Retail’s customers. To support the development and broaden the potential of this format Retail has introduced a new internet platform which was rolled out to Lloyds TSB customers during 2010. One example of the new services being delivered on this platform is Money Manager which provides an innovative tool for customers to better manage their finances.
Overview Business review Governance Financial statements Other information 29 Group profile 1
Total income increased by £1,211 million, or 12 per cent, to £10,985 million. This was driven by a strong increase in net interest income of £1,408 million, partially offset by a reduction in other income of £197 million.
Asset Finance consists of a number of leasing and speciality lending businesses including Contract Hire (Lex Autolease and Hill Hire) and Consumer Finance (Black Horse Motor and Personal Finance).
2010 HIGHLIGHTS Profit before tax was £3,257 million compared to a loss before tax of £4,703 million in 2009.
Profit before tax and fair value unwind was £127 million, a £11,727 million improvement on the loss of £11,600 million in 2009, primarily reflecting the significant decrease in the level of impairment charge.
Net interest income decreased by 6 per cent to £4,426 million. This decrease reflected the lower interest earning asset balances, in-line with targeted balance sheet reductions and lower net interest income in Treasury and Trading, partially offset by a 36 basis point increase in the banking net interest margin.
Assets decreased by 14 per cent to £240.9 billion continuing on from a 28 per cent reduction in 2009. This reflects the targeted reduction in the balance sheet, mainly in loans and advances to customers and banks in non-core business and through reductions in debt securities and available-for-sale positions.
Customer deposits excluding repos decreased 3 per cent to £114.1 billion, due to a reduction in short-term deposits in Treasury and Trading partially offset by higher deposits in Corporate Markets in line with the Group’s funding strategy.
Continued progress in deepening customer relationships. Cross-selling has increased by 9 per cent, reflecting increased product capabilities and opportunities arising from applying a single sales force model on the combined customer base.
Share of results of joint ventures and associates (95) (720) 87
Profit (loss) before tax and fair value unwind 127 (11,600) Fair value unwind 3,130 6,897 (55)
Investment and change in the core growth areas continues to be embedded, with new talent joining the Group and new processes introduced to our client facing businesses. Cross-selling from deepening relationships increased by 9 per cent reflecting these enhanced product capabilities.
Profit before tax was £3,257 million compared to a loss before tax of £4,703 million in 2009. The improvement of £7,960 million is after taking into account fair value unwind of £3,130 million, which decreased by £3,767 million compared to 2009.
The division’s asset balances (comprising loans and advances to customers and banks, debt securities and available-for-sale financial assets) reduced by £38.4 billion, or 14 per cent to £240.9 billion, primarily reflecting deleveraging by customers and continuing active de-risking of the balance sheet by either selling down or reducing holdings in debt securities and available-for-sale positions.
Loans and advances to customers decreased £18.6 billion, or 10 per cent to £173.2 billion. In Corporate Markets, balances decreased by £17.5 billion or 10 per cent, as demand for new corporate lending and refinancing of existing facilities were more than offset by the level of maturities, reflecting a continued trend of subdued corporate lending, customer deleveraging and asset sales in non-core sectors. Despite this overall reduction, net lending to core customers in the SME sector increased by 2.1 per cent. In Asset Finance, the decrease of £2.7 billion, or 23 per cent, reflected the targeted reduction in this asset class. Available for sale financial assets balances reduced by £7.4 billion, or 20 per cent, to £29.5 billion and debt securities decreased by £5.9 billion, or 19 per cent, to £25.8 billion, as Corporate Markets reduced the non-core balance sheet by either selling down or not replenishing total holdings after amortisations or maturities. Loans and advances to banks decreased £6.5 billion, or 34 per cent as the division refocused the balance sheet.
Customer deposits excluding repos decreased by £3.8 billion, or 3 per cent to £114.1 billion, due to a reduction in short-term deposits in Treasury and Trading, which was partially offset by higher deposits in Corporate Markets in line with Group’s funding strategy.
Risk-weighted assets decreased by £63.3 billion, or 22 per cent to £222.7 billion, primarily reflecting the balance sheet reductions and the move to Foundation IRB from Advanced IRB for all HBOS non-retail portfolios.
In 2010, non-core businesses generated income of £3,022 million and impairment of £3,170 million, compared to 2009 income of £3,573 million and impairment of £13,496 million.
Share of results of joint ventures and associates (95) (717) 87
Impairment as a % of average advances 2.08% 6.09% As at 31 December 2010 2009 Change £bn £bn %
The impairment charge decreased by £10,673 million to £4,182 million reflecting a sustained decrease since the peak in first half 2009. As well as reflecting stabilising economic conditions, a significant amount of the decrease was also due to the application in 2009 of Lloyds Banking Group provisioning policy and risk review processes which were applied to the heritage HBOS corporate real estate and real estate related portfolios and heritage HBOS Corporate (UK & US) portfolio.
Impairment of tangible fixed assets of £150 million was incurred on assets held on the balance sheet as a result of the consolidation of certain entities over which the Group exercised control. A £365 million loss was recorded in 2010 on the disposal of these entities which is excluded from the Group’s combined businesses profit before tax.
Impairment as a % of average advances 2.34% 5.86% As at 31 December 2010 2009 Change £bn £bn %
Profit before tax and fair value unwind was £396 million compared to a loss before tax and fair value unwind of £459 million in December 2009. The £855 million improvement was due to a lower impairment charge and lower operating expenses.
PROFILE Wealth and International was formed in 2009 to give increased focus and momentum to the private banking and asset management businesses and to manage the Group’s international businesses.
Net interest income decreased by 3 per cent to £1,176 million, as an 8 basis points decline in the banking net interest margin more than offset the favourable impact of foreign currency movements, particularly the Australian dollar, and the income on the £7 billion European loan portfolio transferred in from the Wholesale division in the second half of 2009.
Customer deposits increased by £3.8 billion, or 13 per cent, to £32.8 billion, due to strong inflows in UK Private Banking and Bank of Scotland Germany, partly offset by outflows in Ireland following the closure of the Irish retail branch network.
Against its strategic objectives, Wealth has demonstrated continuing strength in client acquisition through the UK franchise with a 12 per cent increase in customer numbers. In International, resources have been deployed to manage arrears, and the balance sheet reduction strategy resulted in underlying local currency advances decreasing by £4.1 billion, or 7 per cent.
Overview Business review Governance Financial statements Other information 37 Group profile 1
Share of results of joint ventures and associates (8) (21) 62
As previously announced, the Group completed a strategic review of Bank of Scotland (Ireland) Limited (BOSI) during the year, concluding that there was little opportunity for scalable growth in the future and that the business currently carried on by BOSI would merge, pursuant to a court process, into Bank of Scotland plc. This announcement followed the closure earlier in the year of BOSI’s retail and intermediary business in Ireland, including all 44 Halifax retail branches.
Impairment as a % of average advances 0.48% 0.70% As at 31 December 2010 2009 Change £bn £bn %
Profit before tax and fair value unwind increased by 36 per cent to £269 million due to lower costs and lower impairment charges.
Sale of Insight and Bank of Scotland Portfolio Management Service2 (0.8) (84.3)
Insight Investment was sold on 2 November 2009. The Bank of Scotland Portfolio Management Service business was transferred to Rathbone Brothers Plc over the course of 2010.
Share of results of joint ventures and associates (7) (23) 70
Impairment as a % of average advances 10.30% 6.99% As at 31 December 2010 2009 Change £bn £bn %
Loans and advances to customers decreased by £8.1 billion or 15 per cent, to £46.2 billion due to net repayments of £4.1 billion across all businesses and higher impairment provisions, partly offset by an increase due to foreign exchange movements of £1.1 billion. The division is focused on de-risking and right-sizing the balance sheet, focusing on key Group relationships, as well as reducing concentrations in Commercial Real Estate. In the International businesses, drawn exposures in local currency have decreased with limited new business written within a tightened risk appetite that has been applied across the division since early 2009.
Consistent with the division’s strategic approach to maximising value in the medium term, a number of businesses are considered to be non-core, predominately the remaining Irish lending portfolio. As at 31 December 2010, non-core businesses included loans and advances to customers of £37.2 billion (2009: £44.3 billion), risk weighted assets of £35.0 billion (2009: £40.1 billion) and customer deposits of £0.3 billion (2009: £3.7 billion). In 2010, these non-core operations contributed income of £657 million (2009: £744 million) and an impairment charge of £5,767 million (2009: £3,889 million).
life, Pensions and investments europe: the european life, Pensions and investments business distributes products primarily in the German market under the Heidelberger leben and Clerical Medical brands.
General insurance: the General insurance business is a leading distributor of home insurance in the uK, with products sold through the branch network, direct channels and strategic corporate partners. the business also has significant brokerage operations for personal and commercial insurances. it operates primarily under the lloyds tsB, Halifax and Bank of scotland brands.
2010 hIGhLIGhts profit before tax increased by 13 per cent to £1,102 million, compared to £975 million in 2009.
Operating expenses decreased by 12 per cent or £120 million to £854 million due to a continued focus on cost management and delivery of integration synergies.
Share of results of joint ventures and associates (10) (22) 55
Other income – impact of PPI new business closure (70) –
Sustainable growth The UK Life, Pensions and Investments business continues to make excellent progress in improving the profitability of the combined product set. Certain low returning products sold through the HBOS heritage channels have been discontinued and replaced with products providing an improved customer proposition, and enhanced shareholder value. The decision to change the mix of business from investment to protection products, while resulting in higher margins has contributed relatively lower PVNBP due to the premium size, with PVNBP in the UK business decreasing by 20 per cent. However the focus on value has resulted in strong increases in new business profits, new business margins and internal rates of return.
This focus on value over volume will continue, establishing a realistic base from which to continue to grow a business that is both profitable and focused on meeting customer needs.
Other income – impact of PPI new business closure (70) – –
Total new business profit increased by £135 million, or 102 per cent, to £267 million. The increase primarily reflects a reduction in initial commission on OEICs sold through the branch network and cost reductions through integration across our sales channels in addition to progress made on product participation choices.
The capital positions of the UK life insurance companies within the Insurance division remain robust. The estimated Insurance Groups Directive capital surplus for both the Scottish Widows and HBOS Insurance groups remained consistent with last year at £1.3 billion and £1.6 billion, respectively.
European business Profit before tax increased by 47 per cent to £110 million driven largely by experience and assumption changes. New business sales reflect difficult economic and market conditions in Germany, our main European market.
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 2010 Total UK Europe 2009 Total Change
Expected return on existing business has increased by 29 per cent to £347 million, reflecting an increase in the value of the opening balance sheet, driven by higher asset values due to higher investment markets in 2009, and an increase in the assumed rate of return. The expected return on shareholders’ net assets has reduced by 16 per cent to £184 million primarily reflecting hedging initiatives.
Analysis of shareholders’ net assets on an EEV basis on covered business
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 is defined as the spot yield derived from the yield curve for the relevant government bond. The table below shows the range of resulting yields and other key assumptions.
Non-economic assumptions Future mortality, morbidity, lapse and paid-up rate assumptions are reviewed each year and are based on an analysis of past experience and on management’s view of future experience. These assumptions are intended to represent a best estimate of future experience.
5 per cent reduction in mortality and morbidity (excluding annuitants)7 50 5 100 basis points increase in equity and property returns8 Nil Nil 25 basis points increase in corporate bond spreads9 (115) (5)
Claims paid on insurance contracts (net of reinsurance) (542) (637) 15
Operating expenses decreased by £54 million, or 21 per cent, to £208 million primarily as a result of the alignment of commission arrangements on home insurance, the delivery of integration savings and a continued focus on cost management.
Overview Business review Governance Financial statements Other information 51 Group profile 1
Net interest expense was broadly unchanged at £823 million, but included higher capital and wholesale liquidity funding costs of £601 million (2009: £260 million) not recovered from the divisions, with the increase primarily due to higher wholesale market funding spreads and the Group’s decision to accelerate its wholesale funding in 2010. This has been offset by improved net interest from interest rate risk management activities compared to 2009.
Operating expenses reduced by £187 million to £107 million due to lower professional fees and other costs associated with capital transactions and projects.
The Insurance division experienced positive volatility of £100 million during 2010. This was primarily driven by strong performance on equity and property investments relative to the expected return. During 2010, equity market values increased by 9 per cent and property returns reached 19 per cent. Partly offsetting this was lower than expected returns on cash and fixed interest assets. This benefit is lower than the £237 million positive volatility reported in 2009, as 2009 included significant benefits from reductions in corporate bond spreads, which did not occur in 2010, and greater out-performance of equity markets.
The application of accounting standards results in the introduction of other sources of significant volatility into the pre-tax profits of the life, pensions and investments business. In order to provide a clearer representation of the performance of the business, and consistent with the way in which it is managed, 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.
During the year ended 31 December 2010, the statutory profit before tax in both the Insurance and Wealth and International divisions included credits to other income which relate to the policyholder interests volatility charge of £216 million (2009: policyholder interests volatility charge of £298 million). Strong market conditions in the latter part of 2010 resulted in increased policyholder tax liabilities and led to a policyholder tax charge of £315 million (2009: £410 million) for the year in the Group’s tax charge.
Procurement benefits in 2010 were also significant at £236 million and supplier negotiations resulted in over 90 per cent of Group expenditure being consolidated within our top 1,000 suppliers.
The software build of the Integrated IT Platform was completed in the first half of 2010 and following extensive testing largely implemented by the end of 2010 and is now live and operational for most Lloyds TSB processes and transactions. Roll out of the Lloyds TSB counter system across Halifax and Bank of Scotland branches commenced in late 2010 and will complete during the first half of 2011. Similarly HBOS ATMs are being migrated and the Group’s target mortgage sales platform rolled out to mortgage sales advisers creating a single platform for mortgage sales.
Total cost reductions from synergies of £1,361 million were achieved in the year against the integration baseline and in line with target include other operating efficiencies and one-off savings which are excluded from the reported run rate synergies. The total cost reductions relate primarily to reductions in colleague numbers, procurement and IT savings.
Banking net interest income is analysed for asset and liability margins based on interest earned and paid on average assets and average liabilities respectively, adjusted for Funds Transfer Pricing, which prices intra-group funding and liquidity. Centrally held wholesale funding costs and related items are included in the Group banking asset margin.
Average interest-earning assets and average interest-bearing liabilities relate solely to customer and product balances in the banking businesses on which interest is earned or paid. Funding and capital balances including debt securities in issue, subordinated debt, repurchase agreements and shareholders’ equity are excluded from the calculation of average interest-bearing liabilities. However, the cost of funding these balances allocated to the banking businesses is included in banking net interest income.
CORE AND NON-CORE BUSINESS Non-core portfolios consist of non-relationship assets and liabilities together with assets and liabilities which are outside the Group’s current appetite. An analysis of non-core assets and liabilities and the associated income and impairment charge is shown in the table below.
Insurance 2,009 – – – – Group Operations and Central items (251) – 0.4 15.7 0.9
Net of insurance claims. Excluding liability management gains and the reduction in the fair value of the equity conversion feature of the Group’s Enhanced Capital Notes.
Total income, net of insurance claims 24,956 23,278 9,868 10,696 11,098
Net asset value per ordinary share 68p 68p 155p 212p 195p
Restated in 2009 for IFRS 2 (Revised) and to separate the share of results of joint ventures and associates from total income.
Lloyds Banking Group’s continued success depends on people. Banking is about helping people to reach their goals in life by getting the most from their money. Lloyds Banking Group makes business sense but we also need it to make sense for people – for our employees and customers. Our employees are focused on providing our customers with great service every day. They know that successful relationships are at the heart of how we do business and how we support our customers through the cycle.
At Lloyds Banking Group, we are committed to making a significant investment in our people. Life here is fast-moving and full of challenges as we strive to be the best. It’s also incredibly rewarding. In 2010 we recorded our highest ever employee engagement score. Engaged employees are more motivated to understand customer needs and deliver outstanding service, time and time again. This is one of the ways in which we will rebuild trust in our industry. Our rewards and benefits packages, which go beyond salary and bonus, are designed to keep our employees motivated to do this.
As a leader in financial services, we are committed to professional development and creating outstanding learning opportunities that allow people to reach their full potential. We invest in our people, offering the best coaching and training. Learning @ Lloyds Banking Group is one of the largest corporate learning facilities in Europe.
We also provide our people with the opportunity to contribute to our leading corporate and social responsibility practices, a strong part of our culture. Employees celebrated raising £3.4 million for the British Heart Foundation in just two and a half years at the end of 2010. They also demonstrated their continued commitment and enthusiasm for good causes when 21,500 voted for the 2011 Charity of the Year, Save the Children.
Integration 2010 was significant in relation to people integration. Shaping our new business for the future means having the very best people in every single role and being as efficient as possible. We have successfully managed the impact of change on our people by working at pace to establish controls and embed risk management practices, by defining and implementing the new organisational structure and selecting for it.
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 organisation, 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.
The focus has been on enabling the business to integrate, while also building foundations for the future to ensure the organisation can attract, retain and develop the best talent. People have been at the heart of the change programme, and a robust communications process has been followed to ensure that colleagues are aware of the changes before they happen. We have four recognised Unions who have been consulted on all proposed changes.
We have focused on bringing the majority of colleagues on to one core colleague system which involved the migration of over 63,000 colleagues on to a new platform which is now accessible to colleagues from both heritages.
We also implemented a number of new Lloyds Banking Group platforms for colleagues. In 2010 we built an integrated colleague proposition for the future with a focus on recruiting, performance management, learning, and reward and improving the direct links between these factors.
The implementation of the Resourcing Candidate Management System in 2010 provides us with one integrated Lloyds Banking Group internal role recruitment tool and also one external Lloyds Banking Group careers website. Combined, they enable integration, simplification and improvement of key elements of the recruitment process.
In 2010 we recruited 147 people into the Lloyds Banking Group Graduate Leadership Programme. The strength of our Graduate Programme has been externally acknowledged with The Times rating us in the Top 30 UK organisations for graduate recruitment.
Throughout the year, line managers provide colleagues with regular open and honest feedback to help them develop the right skills and behaviours and to help them address any challenges they may face in meeting performance standards. In 2010 we launched a single approach to performance management across Lloyds Banking Group, the success of which was acknowledged at the 2010 Personnel Today Awards where it was one of the reasons why we received the top award for Managing Change.
A key focus for training across Retail has been the transformation of our approach in handling customer complaints. This has resulted in over 30,000 customer facing colleagues receiving training across Lloyds TSB, Halifax and Bank of Scotland Branch Networks. The key purpose of this training was to improve the experience for customers when advising us of a complaint – this included colleagues taking ownership of each complaint at first point of contact, accurate recording and effective and timely resolution. A blend of training approaches was adopted including e-learning, testing, validation and face to face sessions supported by comprehensive Senior Manager engagement. This programme has resulted in a significant improvement in the number of complaints resolved at first point of contact and is having a positive impact on our Customer Service measures.
Technical capabilities Our colleagues need appropriate technical capabilities to enable them to support our customers effectively. Our business-focused learning programmes cover critical business skills such as risk, relationship management and financial management. A key focus has been supporting colleagues through the changes needed to successfully progress our integration programme.
Significant activity has taken place to support the implementation of common enhanced IT platforms designed to deliver improved customer service through our branches. Colleagues in our Telephone Banking teams also received significant investments in customer service training.
Radiate is the network of high-fliers with disabilities or health conditions. It is supported by RADAR (the UK’s largest disability campaigning organisation) and Lloyds Banking Group
The following pages set out how we are delivering on our responsibilities to all of our stakeholders. We report under three headings, Responsible Business Management; our Economic and Social Impact; and, Building Relationships.
The Board considers corporate responsibilty issues throughout the year, and reviews our performance on an ongoing basis. The Corporate Responsibility Steering Group, chaired by Group HR Director Angie Risley, meets on a regular basis to drive corporate responsibility strategy. Most of our activity, however, takes place in the business itself, driven by a network of senior managers who act as Corporate Responsibility champions.
Reflecting the importance that we place on risk management, risk is included as one of the five principal criteria within the Group’s balanced scorecard on which individual staff performance is judged. We work very closely with the FSA and UK Financial Investments to ensure that our remuneration structure is aligned to prudent risk management. Business Executives have specific risk management objectives and incentive schemes take account of performance against these. Full disclosure on Executive remuneration is on pages 124 to 141 of this report.
Overview Business review Governance Financial statements Other information 61 Group profile 1
The Equator Principles reporting January to December 2010 are as follows.
Resource efficiency Reducing our own use of resources helps us minimise our impact on the environment as well as keeping our costs under control. In 2010, we launched Smart & Responsible, our new targeted environmental action plan. It aims to deliver significant environmental and cost savings, as well as improving colleagues’ work-life balance.
We also registered for the Carbon Reduction Commitment Energy Efficiency Scheme in 2010 and will now be required to purchase allowances for each tonne of energy-related CO2 we emit. It has significant cost implications for the Group which provides a further incentive to reduce our carbon emissions. We are already working towards achieving the Carbon Trust Standard for the Group – this standard recognises organisations that are genuinely measuring and reducing CO2 emissions. Our goal is to reduce our energy consumption by 30 per cent by 2020.
We strengthened our approach in 2010 with the introduction of TRAVELwise, part of the Smart & Responsible programme. We have set a TRAVELwise target to avoid 1 in 5 business flights by 2015.
As a UK-focused bank, we have an important role to play in supporting the UK’s economic recovery. We need to demonstrate that we are meeting our obligations to our customers by continuing to give them access to the finance they need. Whilst our main contribution to society is our direct economic impact, we strongly believe that this must also be supported by our active investment in the communities in which we operate.
In 2010, we published our first standalone Financial Inclusion Report, setting out our financial inclusion strategy and our future agenda. We have established a Financial Inclusion Steering Group to oversee our activities and strengthen our strategic approach.
Money for life – supporting financial capability in the UK’s further education sector
Our Charity of the Year programme Our Charity of the Year programme is our flagship fundraising initiative. It is one of the largest corporate fundraising programmes in the UK. The British Heart Foundation (BHF) was our Charity of the Year from July 2008 to December 2010. We raised £3.4 million in total for the BHF through a wide range of employee, customer and shareholder fundraising projects. The money we raised funds
Overview Business review Governance Financial statements Other information 63 Group profile 1
Save the Children – our Charity of the Year in 2011
Matched giving Through our Matched Giving scheme, operated by our charitable Foundations, we enable employees to maximise their contributions to the charities and causes that are important to them. In 2010, employees could claim up to £500 from the Foundations to match funds they raised for charity, including our Charity of the Year, or time given in volunteering. This has been raised to £1,000 per employee in 2011.
As a relationship-led business, our people are our most valuable resource. They are the Group’s ambassadors. Building strong relationships with our people, and helping them to develop, is therefore fundamental to the success of the business and achieving our vision of being the UK’s best financial services organisation. Our approach to building relationships with our people is covered separately on pages 57 to 59 of this report.
Building relationships with our suppliers Our suppliers are important to us. We actively encourage our employees to build strong working relationships with them. We are a signatory to the Prompt Payment Code, committing to paying suppliers on time and not changing the payment terms agreed at the outset of the contract. This Code requires that we provide clear guidance on payment procedures, including redress for any disputes, and encourage similar good practice amongst our suppliers and other businesses.
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 initiated. 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 maintenance of a strong control framework remains a priority for the Group and is the foundation for the delivery of effective risk management. The Group optimises performance by allowing divisions and business units to operate within approved capital, liquidity and risk parameters and within the Group’s policy framework. The Group’s approach to risk management ensures that business units remain accountable for risk whilst undertaking individual strategies to meet business performance targets. The combination of divisional and group risk management maintains effective independent oversight.
As part of its integration initiative, the Group has rolled out the methodology and financial control framework that was used by the heritage Lloyds TSB Group; including compliance with the requirements of the US Sarbanes Oxley Act.
Reflecting the importance the Group places on risk management, risk is included as one of the five principal criteria within the Group’s balanced scorecard on which individual staff performance is judged. Business executives have specified risk management objectives, and incentive schemes take account of performance against these.
HM Treasury currently holds approximately 40.6 per cent of the Group’s ordinary share capital. United Kingdom Financial Investments Limited (UKFI) as manager of HM Treasury’s shareholding continues to operate in line with the framework document between UKFI and HM Treasury managing the investment in the Group on a commercial basis without interference in day-to-day management decisions. There is a risk that a change in Government priorities could result in the framework agreement currently in place being replaced leading to interference in the operations of the Group, although there have been no indications that the Government intends to change the existing operating arrangements.
Overview Business review Governance Financial statements Other information 67 Group profile 1
The risk governance structure is intended to strengthen risk evaluation and management, whilst also positioning the Group to manage the changing regulatory environment in an efficient and effective manner. The risk governance structure for Lloyds Banking Group is shown in table 1.1.
The Group Risk Directors and Divisional Risk Officers meet on a regular basis under the Chairmanship of the Chief Risk Officer to review and challenge the risk profile of the Group and to ensure that mitigating actions are appropriate. Aggregate risk reports are reviewed by this group before submission to Group Business Risk Committees and then to Risk Committee.
The Director of Group Audit provides independent assurance to the Audit Committee and the Board that risks within the Group are recognised, monitored and managed within acceptable parameters. Group Audit is fully independent of Group Risk, seeking to ensure objective challenge to the effectiveness of the risk governance framework.
BU Risk BU RiskBU Risk BU Risk 2nd line of defence Group and Divisional Oversight Functions 3rd line of defence Group Audit
The Lloyds Banking Group business strategy and objectives are 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 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.
The more detailed description of the risk principles and distribution of the risk appetite measures amongst the divisions and businesses are determined by the Group Chief Executive, in consultation with the Group Business Risk Committee and the Group Asset and Liability Committee.
At group level, a consolidated risk report is produced which is reviewed and debated by the Group Business Risk Committee, Group Executive Committee, Risk Committee and the Board to ensure that they are satisfied with the overall risk profile, risk accountabilities and mitigating actions. The consolidated risk report provides a quarterly assessment of the aggregate residual risk for the primary risk drivers, comparing the assessment with the previous quarter and providing a forecast for the next six months.
Overview Business review Governance Financial statements Other information 71 Group profile 1
Legal and regulatory: Legal and regulatory risk is the risk of reductions in earnings and/ or value, through financial or reputational loss, from failing to comply with the laws, regulations or codes applicable.
The Group continues to face political and regulatory scrutiny as a result of the Group’s perceived systemic importance following the acquisition of HBOS. At the time of the acquisition, the Office of Fair Trading (OFT) identified some competition concerns in the UK personal current accounts and mortgages markets and for SME banking in Scotland. The OFT reiterated that it would keep these under review and consider whether to refer any banking markets to the Competition Commission if it identifies any prevention, restriction or distortion of competition.
From April 2011, lead regulation and supervision of the Group’s activities will begin transitioning from the FSA to the new Financial Conduct Authority for conduct of business supervision and the Prudential Regulatory Authority for capital and liquidity supervision. In addition, from 2011, the European Banking Authority, the European Insurance and Occupational Pensions Authority and the European Securities and Markets Authority as new EU Supervisory Authorities are likely to have greater influence on regulatory approaches across the EU. These could lead to changes in how the Group is regulated and supervised on a day-to-day basis.
Liquidity and funding: Liquidity risk is defined as the risk that the Group has insufficient financial resources to meet its commitments as they fall due, or can only secure them at excessive cost.
Continuing concerns about the scale of deficits in Ireland and southern European countries resulted in increased credit spreads in the areas affected, and fears of contagion affected the Euro and widened spreads between central bank and interbank rates.
The Group’s trading activity is small relative to its peers and is not considered to be a principal risk. The average 95 per cent 1-day trading Value at Risk (VaR) was £7.4 million for 2010.
Overview Business review Governance Financial statements Other information 73 Group profile 1
People: The risk of reductions in earnings and/or value, through financial or reputational loss, from inappropriate colleague actions and behaviour, industrial action, legal action in relation to people, or health and safety issues. Loss can also be incurred through failure to recruit, retain, train, reward and incentivise appropriately skilled staff to achieve business objectives and through failure to take appropriate action as a result of staff underperformance.
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.
Revenue and capital investment decisions require additional formal assessment and approval. Formal risk assessment is conducted as part of the financial approval process. Significant mergers and acquisitions by business units require specific approval by the Board. In addition to the standard due diligence conducted during a merger or acquisition, group risk conducts, where appropriate, an independent risk assessment of the target company.
Overview Business review Governance Financial statements Other information 75 Group profile 1
This statement of the Group’s overall appetite for credit risk is reviewed and approved annually by the Board. With the support of the Group Credit Risk Committee and Group Business Risk Committee, the Group Chief Executive allocates this risk appetite across the Group. Individual members of the Group Executive Committee ensure that credit risk appetite is further delegated to an appropriate level within their areas of responsibility.
In terms of loans and advances, credit risk arises both from amounts lent and commitments to extend credit to a customer as required. These commitments can take the form of loans and overdrafts, or credit instruments such as guarantees and standby, documentary and commercial letters of credit. With respect to commitments to extend credit, the Group is potentially exposed to loss in an amount equal to the total unused commitments. However, the likely amount of loss is less than the total unused commitments, as most retail commitments to extend credit can be cancelled and the creditworthiness of customers is monitored frequently. In addition, most wholesale commitments to extend credit are contingent upon customers maintaining specific credit standards, which are regularly monitored.
MEASUREMENT In measuring the credit risk of loans and advances to customers and to banks at a counterparty level, the Group reflects three components: (i) the ‘probability of default’ by the counterparty on its contractual obligations; (ii) current exposures to the counterparty and their likely future development, from which the Group derives the ‘exposure at default’; and (iii) the likely loss ratio on the defaulted obligations (the ‘loss given default’).
Internal control The Group follows a through the economic cycle, relationship based, business model with risk management processes, appetites and experienced staff in place. These policies and procedures define chosen target market and risk acceptance criteria. These have been, and will continue to be 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.
Credit scoring: In its principal retail portfolios, the Group uses statistically based decisioning techniques (primarily credit scoring models). Divisional risk departments review model effectiveness, while new models and model changes are referred by them to divisional model governance committees for approval. The most material changes are referred to the Group Model Governance Committee.
MONITORING 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 the Group Credit Risk Committee, Group Business Risk Committee and Risk Committee.
The performance of all rating models is monitored on a regular basis, in order to seek to ensure that models provide appropriate risk differentiation capability, the generated ratings remain as accurate and robust as practical, 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 appropriate Model Governance Committee.
INTENSIVE CARE OF CUSTOMERS IN DIFFICULTY To support corporate customers that encounter difficulties during the current economic downturn, the Group has continued to expand its dedicated business support unit (BSU) model and established a central team managing this activity globally. Teams have been strengthened in both Wholesale and especially Wealth and International to deal with the rise in workloads experienced during the year as the recessionary conditions took hold both in the UK and overseas. In Wholesale three teams operate to support customers experiencing difficulties in Corporate Real Estate, Corporate and Commercial, and Specialist Finance. In Wealth and International, teams have been created in Ireland and Australia. Under this model, relationship management passes early and fully to BSU; because the BSU specialists receive the customers at an early stage in the process they have more time to develop effective solutions. The strategy is to work alongside management teams and key stakeholders to turn around businesses in distress and re-establish these as viable entities.
– ‘Breathing space’ initiative: This is a Government led initiative which requires the banking industry to allow a ‘breathing space’ of up to sixty days to allow borrowers in difficulty to agree a repayment plan with a debt advice charity prior to any action being taken by the bank to recover the outstanding debt.
– Business Lending Taskforce: The Group through its banking businesses is actively involved in the recently set up Business Lending Taskforce, which has committed to 17 actions in three broad areas: (i) improving customer relationships; (ii) ensuring better access to finance; and (iii) providing better information and promoting understanding.
– The closure of our Bank of Scotland (Ireland) Limited business was completed on the 31 December 2010 and a new operating structure came into existence, focused on intensive management of the closed book to optimise the winding up of our lending.
OUTLOOK – GROUP (unaudited) Based on its latest economic assumptions, as set out on page 12, the Group expects an improved impairment charge in 2011 compared with 2010.
The Group’s exposure to Ireland and Australia is being closely managed. In post bail-out Ireland, the fragility of the economy and political system could cause further credit quality deterioration within our closed book. Australia, while benefiting from a commodities export boom, continues to be affected by deteriorating property markets in the geographic areas and property classes where the Group is exposed. Base rate increases are an additional threat to affordability in our Australian property and acquisition finance books.
OVERVIEW (unaudited) – The Retail impairment charge was £2,747 million in 2010, a decrease of £1,480 million, or 35 per cent, from 2009.
– The decrease in the Retail impairment charge was driven primarily by the improved quality of new business and effective portfolio management, coupled with a continuing slow recovery of the economy. The Retail impairment charge for loans and advances to customers, as an annualised percentage of average loans and advances to customers, decreased to 0.74 per cent from 1.11 per cent in 2009.
The Retail division’s loans and advances to customers are analysed in the following table: TABLE 1.8: RETAIL LOANS AND ADVANCES TO CUSTOMERS (audited) As at 31 December 2010 2009 £m £m
OUTLOOK – RETAIL (unaudited) The Group remains cautious about the pace and consistency of economic recovery and how this may impact our customers. The outlook assumes a slow economic recovery resulting in an improvement in the unsecured impairment charge. In the secured portfolio however, there are a mixture of signals from lead indicators, including falling house prices and an increase in secured arrears in the second half of 2010, which lead Retail to expect a higher secured impairment charge in 2011. Overall the Group anticipates a modest reduction in Retail’s 2011 impairment charge based on the current outlook of a modestly improving economic environment.
The stock of repossession cases rose from 2,720 at 31 December 2009 to 3,043 at 31 December 2010. This still represents a relatively low proportion of the portfolio and was broadly consistent with prior years.
TABLE 1.10: ACTUAL AND AVERAGE LTVS ACROSS THE PRINCIPAL MORTGAGE PORTFOLIOS (audited) As at 31 December 2010 Mainstream Buy to let Specialist1 Total
Average loan-to-value: Specialist lending is closed to new business and is in run-off.
A combination of reduced demand from customers for personal unsecured borrowing and the Group’s prudent risk policy contributed to loans and advances to customers reducing by £4.2 billion to £27.9 billion at 31 December 2010.
Impairment provisions decreased by £0.6 billion, compared with 31 December 2009, to £1.5 billion. Impairment provisions, as a percentage of impaired loans, decreased to 50.6 per cent at 31 December 2010 from 55.3 per cent at 31 December 2009, largely driven by more stringent criteria for new and existing unsecured collections repayment plans resulting in highly provided assets being written-off.
Wholesale’s impairment charge decreased by £11,237 million, or 72 per cent, compared to £15,683 million for 2009. Impairment charges as an annualised percentage of average loans and advances to customers reduced to 2.08 per cent from 5.92 per cent in 2009. Significant actions were taken in the first half of 2009 on the heritage HBOS portfolios, including the identification of large impairments post the HBOS acquisition especially in corporate real estate, real estate related and Corporate (UK and US) portfolios. Together with the stabilising UK and US economic environment in 2010, a low interest rate environment helping to maintain defaults at a lower level and a number of write backs due to asset disposals, impairment charges have decreased substantially compared with 2009.
Corporate Real Estate – The focus is to continue to improve and re-balance the risk profile of the existing portfolio and apply conservative and prudent lending policies in relation to new business. A significant percentage concentration of customer lending is in real estate and real estate related investment lending, especially heritage HBOS and sustainability of its cashflow in 2010 has been key to the relative resilience seen in the investment market to date. The portfolio remains vulnerable to tenant default and asset price falls due to a significant element of investment lending in the portfolio, a large element of which is supported by secondary or tertiary assets. Refinancing risk remains an emerging issue with significant maturities due in the next few years.
COMMERCIAL (unaudited) The Commercial portfolio’s impairment experience has remained steady throughout the year, although a slightly higher run rate was observed in the second half, but overall was materially below that incurred in 2009. Portfolio metrics including delinquencies and assets under close monitoring, while improving through supportive management actions, remain above benign levels.
The portfolio comprises £10.7 billion of loans and advances to banks, £6.0 billion of Available-for-Sale debt securities and £1.1 billion of loans and advances to customers (excluding reverse repos).
The majority of Treasury and Trading’s funding and risk management activity is transacted with investment grade counterparties and much of it is on a secured basis, such as repos. Derivative transactions with wholesale counterparties are typically collateralised under a Credit Support Annex in conjunction with the ISDA Master Agreement. Treasury and Trading has reduced the government bond portfolio in response to growing concern over market conditions in Europe. The credit quality of the government bond portfolio is almost solely AAA rated sovereign debt.
Overview Business review Governance Financial statements Other information 87 Group profile 1
OUTLOOK – WEALTH AND INTERNATIONAL (unaudited) Impairment charges in the division are expected to reduce in 2011 compared to the current year charge, although economic conditions in Ireland continue to be monitored closely. The outlook also remains cautious for the Group’s Australian exposures, where there continues to be limited liquidity in regional property markets to which the Group is exposed.
AUSTRALIA Total impaired loans increased by £2,157 million, or 106 per cent to £4,187 million compared with £2,030 million at 31 December 2009 and as a percentage of closing loans and advances increased to 28.7 per cent from 14.4 per cent at 31 December 2009. Impairment charges increased by £513 million to £1,362 million compared to £849 million in 2009. Impairment charges as a percentage of average loans and advances to customers increased to 9.3 per cent from 6.3 per cent in 2009.
OTHER INTERNATIONAL Total impaired loans increased by £206 million, or 143 per cent to £350 million compared with £144 million at 31 December 2009 and as a percentage of closing loans and advances increased to 4.6 per cent from 1.8 per cent at 31 December 2009. Impairment charges increased by £26 million to £106 million compared to £80 million in 2009. Impairment charges as a percentage of average loans and advances to customers increased to 1.3 per cent from 1.0 per cent in 2009. The most significant contribution to the impairment charge is from a limited number of corporate exposures which at the year end comprised 82 per cent of impaired lending and 92 per cent of the impairment charge in 2010.
This statement of the Group’s overall appetite for market risk is reviewed and approved annually by the Board. With the support of the Group Asset and Liability Committee, the Group Chief Executive allocates this risk appetite across the Group. Individual members of the Group Executive Committee ensure that market risk appetite is further delegated to an appropriate level within their areas of responsibility.
Overview Business review Governance Financial statements Other information 89 Group profile 1
– Unit-linked liabilities are matched with the same assets that are used to define the liability but future fee income is dependent upon the performance of those assets. (This forms part of the Value of in Force see note 30 to the financial statements on page 194.)
– Surplus assets are held primarily in four portfolios: (a) in the long term funds of Scottish Widows plc, Clerical Medical Investment Group Limited and their subsidiaries; (b) in the shareholder funds of life assurance companies; (c) investment portfolios within the general insurance business and (d) within the main fund of Heidelberger Lebensversicherung AG.
Standard Stresses: Interest Rates 25bp; Equities 10 per cent; Credit Spreads relative 30 per cent widening
TABLE 1.16: BANKING – TRADING ASSETS AND OTHER TREASURY POSITIONS As at 31 December 2010 2009
Close Average Maximum Minimum Close restated £m £m £m £m £m
Interest rate risk (impact of 25 basis point reduction pre-tax) 82.1 64.0
Banking – non-trading activities Interest rate risk arising from the different repricing characteristics of the Group’s non-trading assets and liabilities, and from the mismatch between interest rate insensitive liabilities and interest rate sensitive assets, is managed centrally. Matching assets and liabilities are offset against each other and internal interest rate swaps are also used.
Banking activities Trading is restricted to a number of specialist centres, the most important centre being the treasury and trading business in London. These centres also manage market risk in the wholesale non-trading portfolios, both in the UK and internationally. The level of exposure is strictly controlled and monitored within approved limits. Active management of the wholesale portfolios is necessary to meet customer requirements and changing market circumstances.
Overview Business review Governance Financial statements Other information 91 Group profile 1
Insurance risk exposures are reported and monitored regularly by the Group Executive Committee.
Customer treatment The risk of reductions in earnings and/or value, through financial or reputational loss, from inappropriate or poor customer treatment.
People The risk of reductions in earnings and/or value, through financial or reputational loss, from inappropriate colleague actions and behaviour, industrial action, legal action in relation to people, or health and safety issues. Loss can also be incurred through failure to recruit, retain, train, reward and incentivise appropriately skilled staff to achieve business objectives and through failure to take appropriate action as a result of staff underperformance.
Supplier management The risk of reductions in earnings and/or value through financial or reputational loss from services with outsourced partners or third-party suppliers.
The Group continues to face risks relating to its ability to attract, retain, and develop high calibre talent, as a result of challenges arising from ongoing regulatory and public interest in remuneration practices, delivery of the Group’s integration commitments; and uncertainty from EU state aid requirements and Independent Commission on Banking proposals on banking reform.
– Oversight and assurance of the risk management framework in divisions and businesses.
Details of contractual maturities for assets and liabilities form an important source of information for the management of liquidity risk. Note 56(4) to the financial statements on page 263 sets out an analysis of assets and liabilities by relevant maturity grouping. In order to reflect more accurately the expected behaviour of the Group’s assets and liabilities, measurement and modelling of the behavioural aspects of each is constructed. This forms the foundation of the Group’s liquidity controls.
The ability to deploy assets quickly, either through the repo market or through outright sale, is also an important source of liquidity for the Group’s banking businesses. The Group holds sizeable balances of high grade marketable debt securities as set out in Table 1.21 which can be sold to provide, or used to secure, additional short term funding should the need arise from either market counterparties or central bank facilities (European Central Bank, Federal Reserve, Bank of England and Reserve Bank of Australia).
The Group is reliant on both wholesale funding markets and the legacy Government and central bank facilities to support its balance sheet. The liquidity and funding challenges facing the Group over the medium term continue to be ensuring sustainable access to wholesale funding markets, and the repayment of Government and central bank facilities. The combination of a clear focus on right-sizing the balance sheet, continued development of the Group’s customer deposit base, and strategic access to the capital markets will enable the Group to strengthen its funding base while reducing its overall wholesale funding requirement.
Overview Business review Governance Financial statements Other information 95 Group profile 1
TABLE 1.20: GROUP FUNDING POSITION (audited) As at 31 December 2010 2009 Change £bn £bn %
Excludes £15.6 billion (31 December 2009: £15.1 billion) of loans and advances to banks within the insurance businesses and £4.2 billion (31 December 2009: £4.2 billion) of reverse repurchase agreements.
Cash balances and Balances at central banks – primary are combined in the Group’s balance sheet.
Other assets and other liabilities primarily include balances in the Group’s insurance businesses and the fair value of derivative assets and liabilities.
Medium-term notes include £45.4 billion of funding from the Credit Guarantee scheme.
TERM ISSUANCE The stabilisation of the term wholesale markets observed in the first quarter of 2010 and the continued functioning of these markets throughout the year, despite the European Sovereign credit concerns, enabled the Group to outperform its term issuance plan for 2010. The Group has taken advantage of the improved market sentiment by successfully accessing a number of markets, both secured and unsecured. The table below summarises the Group’s term issuance during 2010. Exceeding term funding plans in 2010 contributed to the acceleration in repaying Government and central bank facilities during the year.
Following the introduction of the FSA’s Individual Liquidity Guidance under ILAS, the Group now manages its liquidity position as a coverage ratio (proportion of stressed outflows covered by primary liquid assets) rather than by reference to a quantum of liquid assets; the liquidity position reflects a buffer over the regulatory minimum. The Group receives no recognition under ILAS for assets held for secondary liquidity purposes.
Total 680.5 35.1 As at 31 December 2009 Included in funding analysis (above)
In order to address the requirements of pillar 2 of the Basel II framework, the FSA currently sets additional minimum requirements through the issuance of Individual Capital Guidance (ICG) for each UK bank calibrated by reference to the CRR. A key input into the FSA’s ICG setting process is each bank’s Internal Capital Adequacy Assessment Process. The Group has been given an ICG by the FSA and the Group maintains a buffer in addition to this requirement. The FSA has made
In addition to the minimum requirements for total capital, the FSA has made statements to explain it also operates a framework of targets and expected buffers for core tier 1 and tier 1.
The Group seeks to ensure that the regulatory minimum requirements are met at all times and undertakes an extensive series of stress analyses during the year to determine the adequacy of the Group’s capital resources against the FSA minimum requirements in severe economic conditions.
TABLE 1.26: CAPITAL RESOURCES As at 31 December 2010 £m 20091 £m
Restated to reflect a prior year adjustment to Available-for-Sale revaluation reserves (see note 1 to the financial statements on page 153).
Risk weighted assets decreased by £86,935 million to £406,372 million. This reflects balance sheet reductions across all banking divisions, a revised assessment of Retail secured lending risk weighted assets following improvements in the economic outlook and changes introduced as a result of continuing the process of integrating the two heritage organisations’ regulatory capital approaches which have impacted particularly on Wholesale.
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, prudential regulatory and tax reporting or publicly disclosed information.
MONITORING The Group has in place a disclosure committee whose responsibility is to review all significant disclosures made by the Group and to assist the Group Chief Executive and Group Finance Director fulfil their responsibilities under the Listing Rules and regulations emanating from the US Sarbanes Oxley Act of 2002. A programme of work designed to support an annual assessment of the effectiveness of internal controls over financial reporting, in accordance with the requirements of section 404 of the US Sarbanes Oxley Act is undertaken. The Group also has in place an assurance mechanism over its prudential regulatory reporting; additionally, monitoring activities are designed to identify and maintain tax liabilities and to assess the impact of emerging regulation and legislation on financial, prudential regulatory and tax reporting.
Overview Business review Governance Financial statements Other information 103 Group profile 1
For Scottish Widows and Clerical Medical, no Resilience Capital Requirement is required. However, a further test is required in respect of the With Profit Funds. This involves comparing the statutory basis of assessment with a realistic basis of assessment as described 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 fact that assumptions are bestestimate as opposed to prudent. This realistic valuation is an assessment of the financial position of a With Profit Fund calculated under a methodology prescribed by the FSA.
Shareholders’ funds: Held outside the long-term funds – – – 1,414 721 2,135
FORMAL INTRA-GROUP CAPITAL ARRANGEMENTS Scottish Widows has a formal arrangement with one of its subsidiary undertakings, Scottish Widows Unit Funds Limited, whereby the subsidiary company can draw down capital from Scottish Widows to finance new business which is reinsured from the parent to its subsidiary. Scottish Widows has also provided subordinated loans to its fellow group undertaking Scottish Widows Bank plc. No such arrangement exists for Clerical Medical.
Requirement to maintain a Support Account: The Scheme requires the maintenance of a ‘Support Account’ within the Non-Participating Fund. The quantum of the Support Account is calculated with reference to the value of assets backing current with-profits policies which also existed at the date of demutualisation and must be maintained until the value of these assets reaches a minimum level. Assets can only be transferred from the Non-Participating Fund if the value of the remaining assets in the fund exceeds the value of the Support Account. Scottish Widows has obtained from the FSA permission to include the value of the Support Account (or,if greater, the excess of realistic liabilities for business written before demutualisation over the relevant assets) in assessing the realistic value of assets available to the With Profit Fund. At 31 December 2010, the estimated value of surplus admissible assets in the Non-Participating Fund was £1,693 million (31 December 2009: £1,627 million) and the estimated value of the Support Account was £197 million (31 December 2009: £222 million).
Overview Business review Governance Financial statements Other information 105 Group profile 1
Changes in estimations and in demographic assumptions used to measure life assurance liabilities (2) 2 (40) 11 64 35
New business and other factors 12 (471) 305 39 (1) (116)
WITH PROFITS FUNDS Available capital in the Scottish Widows With Profit Fund at 31 December 2010 is unchanged from 31 December 2009 at an estimated £257 million.
Assets held in excess of those backing reserves are invested predominantly in cash and cash like instruments. The investment strategy is determined in line with the policy of Lloyds Banking Group to minimise both the profit volatility and the working capital (defined as available capital less minimum required capital) required to ensure all capital requirements continue to be met under a range of stress tests.
For those policies written in Scottish Widows pre-demutualisation containing potentially valuable options and guarantees, under the terms of the Scheme a separate memorandum account was set up within the With Profit Fund of Scottish Widows called the Additional Account which is available, inter alia, to meet any additional costs of providing guaranteed benefits in respect of those policies. The Additional Account had a value at 31 December 2010 of £1.8 billion (2009: £1.6 billion). The eventual cost of providing benefits on policies written both pre and post demutualisation is dependent upon a large number of variables, including future interest rates and equity values, demographic factors, such as mortality, and the proportion of policyholders who seek to exercise their options. The ultimate cost will therefore not be known for many years.
As noted above, under the realistic capital regime of the FSA, the liabilities of both the Clerical Medical and Scottish Widows With Profit Funds are valued using a market-consistent stochastic simulation model. This model is used in order to place a value on the options and guarantees which captures both their intrinsic value and their time value.
OPTIONS AND GUARANTEES OUTSIDE THE WITH PROFIT FUNDS A number of typical guarantees are provided outside the With Profit Funds such as guaranteed payments on death (e.g. Term assurance) or guaranteed income for life (e.g. annuities). In addition, certain personal pension policyholders in Scottish Widows, for whom reinstatement to their occupational pension scheme was not an option, have been given a guarantee that their pension and other benefits will correspond in value to the benefits of the relevant occupational pension scheme. The key assumptions affecting the ultimate value of the guarantee are future salary growth, gilt yields at retirement, annuitant mortality at retirement, marital status at retirement and future investment returns. There is currently a provision, calculated on a deterministic basis, of £57 million (31 December 2009: £64 million) in respect of those guarantees. If future salary growth were 0.5 per cent per annum greater than assumed, the liability would increase by some £3 million. If yields were 0.5 per cent lower than assumed, the liability would increase by some £10 million.
Joined the Board in 2005 and was appointed Deputy Chairman in May 2009. Appointed Chairman of Scottish Widows in 2007. Held a number of senior and general management appointments in Allied Dunbar, Eagle Star and Threadneedle Asset Management before the merger of Zurich Group and British American Tobacco’s financial services businesses in 1998. Subsequently served as Chairman and Chief Executive Officer of Zurich Financial Services United Kingdom, Ireland, Southern Africa and Asia Pacific, until his retirement in 2004. Chairman of the Government’s Review of Skills (published in December 2006) and Deputy Chairman of the Commonwealth Education Fund. Chairman of BUPA and Intrinsic Financial Services. Chancellor of Carnegie College. Former Chairman of the National Employment Panel and of the ABI. Aged 63.
Joined the Board on 1 December 2010. Chairman of Victrex, the FTSE 250 global manufacturer of high performance polymers, having previously been the Senior Independent Director. Since 2000, she has held a portfolio of Non-Executive Directorships, currently holding positions as Senior Non-Executive Director of Aberdeen Asset Management and as Non-Executive Director of IMI and Northumbrian Water. Prior to this she was Executive Director of Abbott Mead Vickers, Director of Corporate Development at WPP Group, and has held various investment and marketing roles at Scottish Provident and the Royal Bank of Scotland. Aged 53.
Joined the Board on 1 March 2010. Executive Director, member of the Group Executive Committee and Chief Executive, International Retail and Commercial Banking at Barclays until December 2006. Joined Barclays in 1983 and held various senior management positions, including Chief Executive, Personal Financial Services and Chief Executive, Business Banking. Was also a Non-Executive Director of BAA until June 2006 and a Non-Executive Director of Absa Group Limited, one of South Africa’s largest financial services groups, until October 2006. From 2007 to 2009 he was also the Chairman and Chief Executive of BAWAG P.S.K. AG, the second largest retail bank in Austria. Non-Executive Chairman of The Mind Gym. Aged 48.
Joined the Board in April 2009. Previously Chief Executive of Hermes Pensions Management. Held a number of senior appointments in AMP Asset Management from 1991 to 1998. A Non-Executive Director of Hammerson, Vodafone and Witan Investment Trust, a member of the Norges Bank Investment Management Advisory Board and Chairman of Marks and Spencer Pension Trust and Lincoln’s Inn Investment Committee. A former Chairman of MEPC, the Asian Infrastructure Fund and of the Strategic Investment Board (Northern Ireland) and a former member of the Financial Reporting Council. Aged 65.
Overview Business review Governance Financial statements Other information 111 Group profile 1
Joined the Group in 1986 and held a number of senior and general management appointments before being appointed to the Board in 2000, as Group Executive Director, IT and Operations. Appointed Group Executive Director, Insurance and Investments in October 2003. After some 10 years in the accountancy profession, joined General Telephone & Electronics Corporation in 1980, serving as Finance Director in the UK from 1983 to 1985. ABI Board member (and former ABI Chairman, 2007-10). Member of TheCityUK Advisory Council and Scottish Government’s Financial Services Advisory Board. Aged 58.
POST BALANCE SHEET EVENTS Details are given in note 59 on page 270.
DIRECTORS Biographical details of directors are shown on pages 110 and 111. Particulars of their emoluments and interests in shares in the Company are given on pages 124 to 141. Changes to the composition of the Board since 1 January 2010 are shown below: Dr W C G Berndt retired from the Board on 6 May 2010. Mr G R Moreno and Mr D L Roberts joined the Board on 1 March 2010 and Ms A M Frew joined the Board on 1 December 2010. Mr A Horta-Osório joined the Board on 17 January 2011. Mr J E Daniels will retire from the Board on 28 February 2011 and will be succeeded as Group Chief Executive by Mr A Horta-Osório on 1 March 2011.
DIRECTORS’ CONFLICTS OF INTEREST The Board, as permitted by the Company’s articles of association, has authorised all potential conflicts of interest declared by individual directors. Decisions regarding these conflicts of interest could only be taken by directors who had no interest in the matter. In taking the decision, the directors acted in a way they considered, in good faith, would be most likely to promote the Company’s success. The directors had the ability to impose conditions, if thought appropriate, when granting authorisation. Any authorities given will be reviewed at least every 15 months. No director is permitted to vote on any resolution or matter where he or she has an actual or potential conflict of interest. The Board confirms that it did not authorise any material conflicts during the year.
SHARE CAPITAL Information about share capital is shown in note 47 on pages 222 to 224.
Overview Business review Governance Financial statements Other information 113 Group profile 1
GOING CONCERN 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 72 and Financial Soundness on pages 93 to 102 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.
The number of days required to be shown in this report, to comply with the provisions of the Companies Act 2006, is 44. 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 2010 bears to the aggregate of the amounts invoiced by suppliers during the year.
A sound relationship between the Chairman and Group Chief Executive based on a mutual understanding of our respective responsibilities is essential to maintaining an open culture with the wider Board. The Group Chief Executive manages the business day to day which in my view is the number one priority for any company. The Chairman manages the Board. There are in addition many other areas which we in turn share or to which each one of us contributes in varying degree. Of course, responsibilities are clearly defined both in our terms of appointment and in the Board Governance Framework which sets out the respective roles and responsibilities of the Chairman, Group Chief Executive, Senior Independent Director and Non-Executive Directors.
Overview Business review Governance Financial statements Other information 115 Group profile 1
Through the Executive Governance Framework approved by the Board, the Group Chief Executive reserves certain matters to himself and, subject to financial limits, delegates responsibilities to the Executive Directors and his other direct reports who collectively make up the Group Executive Committee.
The frameworks are reviewed by the Board at least annually. In 2010, a comprehensive review of both frameworks was undertaken to ensure that they remained appropriate for the enlarged group. Changes were made to ensure that the Board devotes the right amount of time and attention to key matters.
Mix of Independent and Executive Directors Our Board’s preference is to ensure a strong majority of independent directors. At year end, our Board comprised five Executive Directors, eight independent Non-Executive Directors and myself as Chairman. The Code requirement that at least half the Board should be independent Non-Executive Directors has been met throughout the year.
The appointment of Glen Moreno presented an opportunity to separate the roles of Deputy Chairman and Senior Independent Director both previously carried out by Lord Leitch. With effect from 1 March 2010, Glen Moreno was appointed Senior Independent Director; Lord Leitch remains Deputy Chairman.
As Senior Independent Director, Glen Moreno acts as the primary sounding board to me as Chairman and as an intermediary for other Non-Executive Directors. He is supported in this latter task by the Deputy Chairman. The Deputy Chairman is also Chairman of Scottish Widows Group, the UK’s largest life insurance company and an important component of our Group.
– Anita Frew joined the Board on 1 December 2010. In March 2010, after strengthening the banking experience on the Board, it was agreed that there was a need for someone with a more diverse financial and commercial background. Anita’s extensive experience of public companies across a range of sectors, including manufacturing as well as banking and asset management, has enhanced the diversity of perspectives on the Board.
– In September 2010, consistent with his contractual obligations and entitlements, Eric Daniels gave twelve months notice of his intention to retire as Group Chief Executive and director of Lloyds Banking Group plc (and principal subsidiaries). Eric Daniels will retire from the Board on 28 February 2011, but in line with his contractual obligations, he will remain an employee of the Company for the remainder of his notice period. Under this arrangement, I will be able to draw on his knowledge and experience of our operations and customers, and these skills will also be available to support the Group, where needed.
SUCCESSION PLANNING The Nomination & Governance Committee oversees the Board’s arrangements for the longer term succession of Board and Committee members.
In September 2010, immediately following the announcement of Eric Daniels’ retirement, a subcommittee of the Board (the Succession Committee) was established under my Chairmanship to lead the search for a suitable successor. Other members of the Succession Committee were Lord Leitch (Deputy Chairman), Glen Moreno (Senior Independent Director) and Anthony Watson (Chairman of the Remuneration Committee), all independent Non-Executive Directors. The Succession Committee met at least once a week between September and November 2010 and was supported by the Group HR Director and the Head of Secretariat.
The starting point for identification of suitable candidates was our Chief Executive Succession plan which included António Horta-Osório. We also considered other candidates, including one internal candidate.
– the ability to provide leadership and strategic direction, to deliver growth in tough market conditions.
THE WALKER REVIEW In November 2009, Sir David Walker published his ‘Review of corporate governance in UK banks and other financial industry entities’ (the Walker Review). The Nomination & Governance Committee was responsible for overseeing the Group’s implementation of the Walker Review recommendations. Although not yet fully in force, the Group has agreed to adopt those recommendations that did not require further clarification or regulatory pronouncement including with respect to the annual re-election of all Directors. A review of Board procedures was undertaken including: Directors’ induction All Directors are expected to make an informed contribution based on an understanding of the Group’s business model and the key challenges facing the Group and its businesses. To ensure they can contribute from an early stage, they undergo an extensive induction on appointment.
An overview of the Remuneration Committee is set out on pages 120 and 121. The work of the Remuneration Committee is explained in the Directors’ remuneration report on pages 124 to 141.
The Board recognises the importance of promoting mutual understanding between the Company and its shareholders through greater engagement. In 2010, there was regular dialogue with institutional shareholders with more than 300 equity investor meetings undertaken in the year. Many of these meetings were undertaken by senior management (primarily the Group Chief Executive and Group Finance Director) or Board members. As Chairman, I have attended a number of meetings with shareholders to discuss governance and strategic direction. Anthony Watson, as Chairman of the Remuneration Committee, regularly meets our larger shareholders to discuss executive remuneration issues while Glen Moreno, the Senior Independent Director, separately meets with a range of major shareholders.
Appointed to the Board, Audit and Risk Committees on 1 December 2010.
Appointed to the Nomination & Governance Committee on 6 May 2010.
To monitor and review the formal arrangements established by the Board in respect of: (a) the financial statements and reporting of the Group; (b) internal controls and the risk management framework; (c) internal audit; and
Sir Winfried Bischoff Sir Julian Horn-Smith Lord Leitch Glen Moreno David Roberts Martin Scicluna Anthony Watson
To review and report its conclusions to the Board on: (a) the Group’s risk appetite; and
– discussed the level of impairments, specifically in Ireland, amongst other countries.
– reviews the structure, size and composition of the Board; – oversees the selection process for prospective Directors; – makes recommendations to the Board on potential appointments and reappointments of Directors at the end of their specified term; – considers Board succession; – oversees the annual evaluation of the performance of the Board; – reviews the Board’s governance arrangements; – oversees the Group’s implementation of governance requirements; and
– reviewed and recommended to the Board the appointment of a new Group Chief Executive and three Non-Executive Directors; – adopted a Board Governance Framework and Executive Governance Framework; – reviewed the time commitment of Board Directors; – reviewed updates on corporate governance at each meeting; – reviewed the Board evaluation process and results; and
COMPLIANCE WITH THE BRITISH BANKERS’ ASSOCIATION CODE FOR FINANCIAL REPORTING DISCLOSURE
Both the Board and the external auditors have safeguards in place to protect the independence and objectivity of the external auditors. The Audit Committee has a comprehensive policy to regulate the use of auditors for non-audit services. This policy sets out the nature of work the external auditors may not undertake, which includes work which will ultimately be subject to external audit, internal audit services and secondments to senior management positions in the Group that involve decision-making. It also includes the Group’s policy on hiring former external audit staff. For those services that are deemed appropriate for the auditors to carry out, the policy sets out the approval process that must be followed for each type of assignment. The Chairman of the Audit Committee must be consulted regarding potential instructions in respect of allowable non-audit services with a value above defined fee limits.
As the new Chairman of the Group’s Remuneration Committee I am pleased to present the Directors’ remuneration report for 2010, for which we will be seeking approval from shareholders at our annual general meeting in May.
Firstly I would like to extend my thanks to Dr Wolfgang Berndt who chaired the Committee admirably through a challenging period and I am delighted to be given the opportunity to lead the Committee as we build the trust with all our stakeholders to ensure the best remuneration structure possible.
– We have ensured that any bonuses paid in respect of performance in 2010 have been rigorously tested against targets. The use of risk-adjusted and non-financial measures under this plan has been highly successful in promoting a long-term focus within the senior management team.
Based on financial measures and on a balanced scorecard of non-financial measures30% Deferred into shares until at least March 2013, subject to malus
Overview Business review Governance Financial statements Other information 125 Group profile 1
Our principal focus was to ensure an appropriate alignment between performance and pay in terms of both business strategy and risk profile.
– Awards under the LTIP remain below 2008 levels and will be limited to 300 per cent of salary (except for António Horta-Osório).
– The performance measures for the LTIP will include Economic Profit and EPS, as in previous years, together with a measure of delivery to shareholders using absolute Total Shareholder Return (TSR).
The Board has appointed António Horta-Osório as our new Group Chief Executive who starts on 1 March 2011. He will be undertaking a review of strategy. When this is complete we will review the remuneration arrangements to ensure they remain consistent with the strategy and if appropriate will consult with shareholders on any changes needed.
– We strike an appropriate balance by considering both the sensitivity of the current environment and the longer term policy objectives to support the Group’s business strategy.
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, business objectives, risk appetite and values and recognises the interests of relevant stakeholders. The Group has a conservative business model characterised by a risk culture founded on prudence and accountability. The remuneration policy and philosophy covers the whole Group, but the Committee pays particular attention to the top management population, including the highest paid employees in each division, 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 and reward to encourage them to enhance the performance of the Group and that they are recognised for their individual contribution to the success of the organisation, whilst ensuring that there is no reward for excessive risk taking.
The Committee monitors the application of the authority delegated to the Group Executive Committee and the divisional Remuneration Committees to ensure that policies and principles are being fairly and consistently applied. The Committee liaises closely with the Risk Committee and the risk function in relation to risk-adjusted performance measures, including consideration of both current and future risk. Together the management of remuneration and risk form an integral part of the Board’s determination of Group corporate strategy.
The members of the Committee during 2010 were as follows: – Dr Wolfgang Berndt (chairman to 6 May 2010)
– Determination of bonus pools based on Group performance and risk adjustments
The Committee appoints independent consultants to provide advice on specific matters according to their particular expertise. During the year, the Committee conducted a review of their independent advisors and appointed Deloitte LLP to advise the Committee. Deloitte has voluntarily signed up to the Remuneration Consultants’ Code of Conduct and are judged by the Committee to be independent. Kepler Associates were also retained by the Committee during 2010 to advise on various matters relating to executive remuneration.
Eric Daniels, Angie Risley (Group HR Director), Liz Jackson (HR Director, Reward from March 2010) and Harriet Kemp (HR Director, Total Reward until March 2010) provided guidance to the Committee (other than for their own remuneration). Carol Sergeant (Chief Risk Officer) and Tim Tookey (Group Finance Director) also attended the Committee to advise as and when necessary on risk and financial matters.
Overview Business review Governance Financial statements Other information 127 Group profile 1
Following review in 2010, the Group’s remuneration policy continues to support our business values and strategy, based on building long-term relationships with our customers and employees and managing the financial consequences of our business decisions across the entire economic cycle.
Our executives’ annual and long-term incentives are based on stretching performance objectives and targets in the Group Balanced Scorecard. This balanced scorecard is derived from the Medium Term Plan which defines the financial and non-financial targets within our agreed risk appetite over a three year period.
Executives are also aligned with shareholders through the LTIP, which pays out in shares to improve alignment with shareholders based on performance against Group financial targets over a three year period.
Based on Group financial targets relating to profit before tax and economic profit as well as balanced scorecard measures covering divisional financial targets, customers (e.g. SME lending), people, risk and building the business
Annual awards of up to 300 per cent of salary vesting based on financial measures including Economic Profit and EPS and alignment with shareholders based on absolute TSR
Overview Business review Governance Financial statements Other information 129 Group profile 1
Eric Daniels On 20 September 2010, Eric Daniels announced his intention to retire from Lloyds Banking Group on 30 September 2011. Mr Daniels will stand down from the Board on 28 February 2011.
He will continue to receive his basic salary, pension contribution and other benefits under the terms of his contract until retirement. 100 per cent of his bonus received in respect of 2010 will be deferred into shares in two equal tranches, vesting in March 2013 and March 2014 and subject in part to a holding period on vesting.
He will be eligible for a pension allowance in respect of future service of 50 per cent of reference salary per annum including his flexible benefit allowance. He has the option to take this as a cash allowance or contribution to a pension scheme/vehicle. He has been granted a number of one-off awards to compensate him for outstanding share and cash awards forfeited on his resignation from the Santander Group. These include: – Performance shares of 1,707,763 due to vest in 2013 subject to the Group’s TSR performance against sector peer group, broadly equivalent to the performance conditions of Santander Group
– Restricted shares of 4,348,029 due to vest between 2011 – 2013 subject to remaining in employment
Overview Business review Governance Financial statements Other information 131 Group profile 1
Five year financial summary 56 our people 57 corporate responsibility 60
At this time the committee is not in a position to determine the metrics that will attach to these performance measures as the new Group chief executive is completing a strategic review of the business. We believe it is critical to ensure that the 2011 Ltip is aligned with the new strategic direction of the company and the goals we will set for ourselves over the medium term. therefore the committee intends to determine the appropriately stretching and challenging metrics following the completion of the strategic review and to consult with shareholders on the metrics during the summer prior to communicating them to participants. the committee recognise this is an unusual approach but given the circumstances believe it is the best way to align management reward and the strategy over the next three years.
the metrics set by the committee following the strategic review and consultation with major shareholders will be put to the annual general meeting in 2012 for approval.
PENSION executive directors are entitled to participate in the Group’s defined contribution scheme (under which their pension entitlement will be based upon both employer and employee contributions). company contributions are 25 per cent of salary, with the exception of António Horta-osório who is eligible for 50 per cent of reference salary, including his flexible benefit allowance. these can be taken as cash or pension contributions.
Details of pension contributions and accruals are shown on page 135.
SHAREHOLDING GUIDELINES executives are required to build up a holding in Lloyds Banking Group shares of value equal to 1.5 times gross salary (2 times gross 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.
the chairman’s salary was reviewed as part of the remuneration review in 2010. the review took into account market information and also the significant amount of time the chairman would be expected to focus on the Group’s activities particularly during the current period. Following this review, it was determined to maintain the chairman’s salary at £700,000 per annum.
The following charts illustrate the shares available for the Group’s share plans.
The Group recognises that Executive Directors may be invited to become Non-Executive Directors of other companies and that these appointments may broaden their knowledge and experience, to the benefit of the Group. Fees are normally retained by the individual directors as the post entails personal responsibility.
The graph below illustrates the performance of the Group measured by TSR against a ‘broad equity market index’ over the past five years. The Group has been a constituent of the FTSE 100 index throughout this five year period.
Rebased to 100 on 31 December 2005 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec 31 Dec
The non cash column includes amounts relating to the use of a company car, use of a company driver and private medical insurance. It also includes the value of any matching shares which are received under the terms of Sharematch, through which employees have the opportunity to purchase shares up to a maximum of £125 per month and receive matching shares on a one for one basis up to a maximum value of £30 per month, rounded down to the nearest whole share.
Overview Business review Governance Financial statements Other information 135 Group profile 1
The Executive Directors are currently members of one of the pension schemes provided by Lloyds TSB Group with benefits either on a defined benefit or defined contribution basis. Those directors who joined Lloyds TSB Group after 1 June 1989 and are members of a defined benefit scheme have pensions provided on salary in excess of the earnings cap through membership of or by an unfunded pension promise. Retirement pensions accrue at rates of between 1/60 and 1/30 of basic salary.
The beneficial interests, of those who were directors at 31 December 2010 in ordinary shares of Lloyds Banking Group were: NUMBER OF SHARES
The changes in beneficial interests between 31 December 2010 and 24 February 2011 related to ‘partnership’ and ‘matching’ shares acquired under the Lloyds Banking Group Share Incentive Plan. 1
Overview Business review Governance Financial statements Other information 137 Group profile 1
e Exercisable to the extent at which the performance condition vested.
Overview Business review Governance Financial statements Other information 139 Group profile 1
At Awarded Vested Lapsed At during the year during the year during the year Share adjustment
March and April 2008 For 50 per cent of the award (the ‘EPS Award’) – the performance condition was as described for March 2007 with the relevant performance period commencing on 1 January 2008 and ending on 31 December 2010.
Performance for each of the first two years of the award has been assessed and all targets have been met or exceeded.
Notes to the consolidated financial statements 153 1. Basis of preparation 2. Accounting policies 3. Critical accounting estimates and judgements 4. Segmental analysis 5. Net interest income 6. Net fee and commission income 7. Net trading income 8. Insurance premium income 9. Other operating income 10. Insurance claims 11. Operating expenses 13. Investments in joint ventures and associates 14. Gain on acquisition in 2009 15. Loss on disposal of businesses 16. Taxation 17. Earnings per share 18. Trading and other financial assets at fair value through profit or loss 19. Derivative financial instruments 20. Loans and advances to banks 21. Loans and advances to customers 22. Securitisations and covered bonds 23. Special purpose entities 24. Debt securities classified as loans and receivables 25. Allowance for impairment losses on loans and receivables 26. Available-for-sale financial assets 27. Held-to-maturity investments 28. Investment properties 29. Goodwill 30. Value of in-force business 31. Other intangible assets 32. Tangible fixed assets 33. Other assets 34. Deposits from banks 35. Customer deposits 36. Trading and other financial liabilities at fair value through profit or loss 37. Debt securities in issue 38. Liabilities arising from insurance contracts and participating investment contracts 39. Life insurance sensitivity analysis 40. Liabilities arising from non-participating investment contracts 41. Unallocated surplus within insurance businesses 42. Other liabilities 43. Retirement benefit obligations 44. Deferred tax 45. Other provisions 46. Subordinated liabilities 47. Share capital 48. Share premium account 49. Other reserves 50. Retained profits 51. Ordinary dividends 52. Share-based payments 53. Related party transactions 54. Contingent liabilities and commitments 55. Financial instruments 56. Financial risk management 57. Consolidated cash flow statement 58. Future accounting developments 59. Post balance sheet events 60. Approval of financial statements
INDEPENDENT AUDITORS’ REPORT TO THE MEMBERS OF LLOYDS BANKING GROUP PLC We have audited the group financial statements of Lloyds Banking Group plc for the year ended 31 December 2010 which comprise the consolidated income statement, the consolidated statement of comprehensive income, the consolidated balance sheet, the consolidated statement of changes in equity, the consolidated cash flow statement and the related notes. The financial reporting framework that has been applied in their preparation is applicable law and International Financial Reporting Standards (IFRSs) as adopted by the European Union.
SCOPE OF THE AUDIT OF THE FINANCIAL STATEMENTS An audit involves obtaining evidence about the amounts and disclosures in the financial statements sufficient to give reasonable assurance that the financial statements are free from material misstatement, whether caused by fraud or error. This includes an assessment of: whether the accounting policies are appropriate to the group’s circumstances and have been consistently applied and adequately disclosed; the reasonableness of significant accounting estimates made by the directors; and the overall presentation of the financial statements.
OTHER MATTER We have reported separately on the parent company financial statements of Lloyds Banking Group plc for the year ended 31 December 2010 and on the information in the Directors’ Remuneration Report that is described as having been audited.
Other comprehensive income for the year, net of tax 278 1,739
Loans and receivables: Loans and advances to banks 20 30,272 35,361
Currency translation differences, net of tax – (129) – (129) – (129)
Share capital Other Retained Non-controlling and premium reserves1 profits1 Total interests Total £ million £ million £ million £ million £ million £ million
Currency translation differences, net of tax – (200) – (200) (19) (219)
CONSOLIDATED CASH FLOW STATEMENT for the year ended 31 December 2010
Overview Business review Governance Financial statements Other information 153 Group profile 1
The Group has adopted the following new standards and amendments to standards which became effective for financial years beginning on or after 1 January 2010. None of these standards or amendments have had a material impact on these financial statements.
(1) Subsidiaries Subsidiaries include entities over which the Group has the power to govern the financial and operating policies which generally accompanies a shareholding of more than one half of the voting rights. The existence and effect of potential voting rights that are currently exercisable or convertible are considered when assessing whether the Group controls another entity. Subsidiaries are fully consolidated from the date on which control is transferred to the Group; they are de-consolidated from the date that control ceases. Details of the principal subsidiaries are given in note 9 to the parent company financial statements.
Core deposit intangibles up to 8 years Purchased credit card relationships 5 years
Reclassifications are made at fair value as of the reclassification date. Fair value becomes the new cost or amortised cost as applicable. Effective interest rates for financial assets reclassified to the loans and receivables and held-to-maturity categories are determined at the reclassification date. Any previous gain or loss on a transferred asset that has been recognised in equity is amortised to profit or loss over the remaining life of the investment using the effective interest method or until the asset becomes impaired. Any difference between the new amortised cost and the expected cash flows is also amortised over the remaining life of the asset using the effective interest method.
Overview Business review Governance Financial statements Other information 157 Group profile 1
(F) DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGE ACCOUNTING All derivatives are recognised at their fair value. Fair values are obtained from quoted market prices in active markets, including recent market transactions, and using valuation techniques, including discounted cash flow and option pricing models, as appropriate. Derivatives are carried in the balance sheet as assets when their fair value is positive and as liabilities when their fair value is negative. Refer to note 3 (Critical accounting estimates and judgements: Fair value of financial instruments) and note 55(3) (Financial instruments: Fair values of financial assets and liabilities) for details of valuation techniques and significant inputs to valuation models.
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: (1) Fair value hedges Changes in the fair value of derivatives that are designated and qualify as fair value hedges are recorded in the income statement, together with the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk; this also applies if the hedged asset is classified as an available-for-sale financial asset. If the hedge no longer meets the criteria for hedge accounting, changes in the fair value of the hedged item attributable to the hedged risk are no longer recognised in the income statement. The cumulative adjustment that has been made to the carrying amount of the hedged item is amortised to the income statement using the effective interest method over the period to maturity.
Overview Business review Governance Financial statements Other information 159 Group profile 1
(2) Available-for-sale financial assets The Group assesses, at each balance sheet date, whether there is objective evidence that an available-for-sale financial asset is impaired. In addition to the criteria for financial assets accounted for at amortised cost set out above, this assessment involves reviewing the current financial circumstances (including creditworthiness) and future prospects of the issuer assessing the future cash flows expected to be realised and, in the case of equity shares, considering whether there has been a significant or prolonged decline in the fair value of the asset below its cost. If an impairment loss has been incurred, the cumulative loss measured as the difference between the acquisition cost (net of any principal repayment and amortisation) and the current fair value, less any impairment loss on that asset previously recognised, is reclassified from equity to the income statement. For impaired debt instruments, impairment losses are recognised in subsequent periods when it is determined that there has been a further negative impact on expected future cash flows; a reduction in fair value caused by general widening of credit spreads would not, of itself, result in additional impairment. If, in a subsequent period, the fair value of a debt instrument classified as available-for-sale increases and the increase can be objectively related to an event occurring after the impairment loss was recognised, an amount not greater than the original impairment loss is credited to the income statement; any excess is taken to other comprehensive income. Impairment losses recognised in the income statement on equity instruments are not reversed through the income statement.
(I) INVESTMENT PROPERTY Investment property comprises freehold and long leasehold land and buildings that are held either to earn rental income or for capital appreciation or both. The Group’s investment property primarily relates to property held for long-term rental yields and capital appreciation within the life insurance funds. Investment property is carried in the balance sheet at fair value, being the open market value as determined in accordance with the guidance published by the Royal Institution of Chartered Surveyors. If this information is not available, the Group uses alternative valuation methods such as discounted cash flow projections or recent prices. These valuations are reviewed at least annually by an independent valuation expert. Investment property being redeveloped for continuing use as investment property, or for which the market has become less active, continues to be measured at fair value. Changes in fair value are recognised in the income statement as net trading income.
(1) As lessee The leases entered into by the Group are primarily operating leases. Operating lease rentals payable are charged to the income statement on a straight-line basis over the period of the lease.
Deferred tax is provided in full, using the liability method, on temporary differences arising between the tax bases of assets and liabilities and their carrying amounts in the consolidated financial statements. However, deferred tax is not accounted for if it arises from initial recognition of an asset
(ii) ACCOUNTING FOR NON-PARTICIPATING INVESTMENT CONTRACTS The Group’s non-participating investment contracts are primarily unit-linked. These contracts are accounted for as financial liabilities whose value is contractually linked to the fair values of financial assets within the Group’s unitised investment funds. The value of the unit-linked financial liabilities is determined using current unit prices multiplied by the number of units attributed to the contract holders at the balance sheet date. Their value is never less than the amount payable on surrender, discounted for the required notice period where applicable. Investment returns (including movements in fair value and investment income) allocated to those contracts are recognised in insurance claims.
The estimates and judgements applied to these areas in the preparation of the Group’s financial statements are summarised below.
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 made up of two components, those determined individually and those determined collectively.
In particular, significant judgement is required by management in determining appropriate assumptions to be used for level 3 financial instruments. At 31 December 2010, the Group classified £7,468 million of financial assets and £257 million of financial liabilities as level 3. The effect of applying reasonably possible alternative assumptions in determining the fair value of the Group’s level 3 financial assets is set out in note 55.
The effect on the gross defined benefit pension scheme asset or liability and on the pension charge in the Group’s income statement of changes to the principal actuarial assumptions is set out in note 43.
VALUATION OF ASSETS AND LIABILITIES ARISING FROM LIFE INSURANCE BUSINESS At 31 December 2010, the Group recognised a value in-force business asset of £5,898 million (2009: £5,140 million) and an acquired value in-force business asset of £1,469 million (2009: £1,545 million). The value in-force business asset represents the present value of future profits expected to arise from the portfolio of in-force life insurance and participating investment contracts. The acquired value in-force business asset represents the contractual rights to benefits from providing investment management services in relation to non-participating investment contracts acquired in business combinations and portfolio transfers. The methodology used to value these assets is set out in note 2(O)(1). The valuation or recoverability of these assets requires assumptions to be made about future economic and operating conditions which are inherently uncertain and changes could significantly affect the value attributed to these assets. The key assumptions that have been made in determining the carrying value of the value in-force business assets at 31 December 2010 are set out in note 30.
At 31 December 2010, the Group carried liabilities arising from insurance contracts and participating investment contracts of £80,729 million (2009: £76,179 million). The methodology used to value these liabilities is described in note 2(O)(1). Elements of the liability valuations require assumptions to be made about future investment returns, future mortality rates and future policyholder behaviour and are subject to significant management judgement and estimation uncertainty. The key assumptions that have been made in determining the carrying value of these liabilities are set out in note 38.
Overview Business review Governance Financial statements Other information 167 Group profile 1
The Group Executive Committee has been determined to be the chief operating decision maker for the Group. The Group’s operating segments reflect its organisational and management structures. The Group Executive Committee reviews the Group’s internal reporting based around these segments in order to assess performance and allocate resources. This assessment includes a consideration of each segment’s net interest revenue and consequently the total interest income and expense for all reportable segments is presented on a net basis. The segments are differentiated by the type of products provided, by whether the customers are individuals or corporate entities and by the geographical location of the customer.
The Group’s activities continue to be organised into four financial reporting segments: Retail, Wholesale, Wealth and International and Insurance. The segmental results and comparatives are presented on the basis reviewed by the chief operating decision maker and as a consequence the comparatives for 2009 include the pre-acquisition results of HBOS for the period from 1 January 2009 to 16 January 2009.
Retail offers a broad range of retail financial service products in the UK, including current accounts, savings, personal loans, credit cards and mortgages. It is also a major general insurance and bancassurance distributor, selling a wide range of long-term savings, investment and general insurance products.
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 and certain capital and wholesale liquidity funding costs.
Total income, net of insurance claims 10,985 8,562 2,336 2,009 (448) 23,444
Costs: Impairment of tangible fixed assets – (150) – – – (150)
Overview Business review Governance Financial statements Other information 171 Group profile 1
Lloyds Banking Group Annual Report and Accounts 2010 4 SEGMENTAL ANALYSIS continued
Interest and similar income: Loans and advances to customers, excluding lease and hire purchase receivables 4.28 3.58 25,459 24,171
Interest payable on liabilities held at amortised cost 2.19 2.13 (15,896) (17,591)
Change in provision for ceded unearned premiums (note 38(2)) (9) 26
Gains less losses on disposal of available-for-sale financial assets (note 49) 399 97
Overview Business review Governance Financial statements Other information 175 Group profile 1
Claims and surrenders: Change in insurance and participating investment contract liabilities (note 38(1)): Change in gross liabilities (4,622) (5,922)
Change in non-participating investment contract liabilities: Change in gross liabilities (4,872) (7,458)
Life insurance and participating investment contracts gross claims can also be analysed as follows: Total life insurance gross claims (9,397) (8,010)
A non-life insurance claims development table is included in note 38.
Amortisation of acquired value of in-force non-participating investment contracts (note 30) 76 75
Overview Business review Governance Financial statements Other information 177 Group profile 1
Other non-audit fees: Services relating to corporate finance transactions 1.9 0.3
Total fees payable to the Company’s auditors by the Group 40.4 40.7
Impairment losses on loans and receivables: Loans and advances to banks (13) (3)
Share of income statement amounts: Insurance claims – (465) – – – (465)
Share of net assets at 31 December 326 370 103 109 429 479
At the time of the recommended offer for HBOS in September 2008, it had become increasingly difficult for HBOS to raise funds in wholesale markets and their Board sought to restore confidence and stability through an agreement to be acquired by Lloyds TSB Group plc announced on 18 September 2008 at the original terms of 0.833 Lloyds TSB Group plc shares for each HBOS share. However turbulence in the markets continued and the UK Government decided in October 2008 that it would be appropriate for the UK banking sector to increase its level of capitalisation. As a consequence of the recapitalisation of HBOS and the impact of the deteriorating market conditions the terms of the final agreed offer were revised down to a ratio of 0.605 per HBOS share.
During 2009, the Group acquired an oil drilling rig construction business through a previous lending relationship and consolidated the results and net assets of the business from the date it exercised control.
In the second half of 2010, the Group reached agreement to dispose of its interests in the two wholly-owned subsidiary companies through which this business operates; the sale was completed in January 2011. These companies, which had gross assets of £860 million, were sold to Seadrill Limited; a loss of £365 million arose on disposal.
UK corporation tax: Current tax on profit for the year (146) (227)
Weighted average number of ordinary shares in issue – basic 67,117 37,674
The weighted-average number of anti-dilutive share options and awards excluded from the calculation of diluted earnings per share was 92 million at 31 December 2010 (2009: 393 million).
Loans and advances to banks 2,734 – 2,734 4,702 635 5,337
Equity shares: Treasury and other bills 227 – 227 – – –
Other financial assets at fair value through profit or loss include the following assets designated into that category: (i) financial assets backing insurance contracts and investment contracts of £129,702 million (31 December 2009: £118,573 million) which are so designated because the related liabilities either have cash flows that are contractually based on the performance of the assets or are contracts whose measurement takes account of current market conditions and where significant measurement inconsistencies would otherwise arise; (ii) loans and advances to customers of £109 million (31 December 2009: £166 million) which are economically hedged by interest rate derivatives which are not in hedge accounting relationships and where significant measurement inconsistencies would otherwise arise if the related derivatives were treated as trading liabilities and the loans and advances were carried at amortised cost; and
The Group’s Wholesale division had exposure to negative basis asset-backed securities of £1,067 million (31 December 2009: £1,174 million) of which £1,067 million (31 December 2009: £970 million) were protected by monoline financial guarantors (note 56).
Derivatives are classified as trading except those designated as effective hedging instruments which meet the criteria under IAS 39. Derivatives are held at fair value on the Group’s balance sheet. A description of the methodology used to determine the fair value of derivative financial instruments and the effect of using reasonably possible alternative assumptions for those derivatives valued using unobservable inputs is set out in note 55.
The fair values and notional amounts of derivative instruments are set out the following table: Contract/notional Fair value Fair value amount assets liabilities £m £m £m
Derivatives designated as fair value hedges: Interest rate swaps 75,831 4,366 1,200
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 56(3).
Overview Business review Governance Financial statements Other information 187 Group profile 1
Hedged forecast cash flows expected to occur: Hedged forecast cash flows affect profit or loss: 20 LOANS AND ADVANCES TO BANKS
Total loans and advances to banks before allowance for impairment losses 30,292 35,510
Overview Business review Governance Financial statements Other information 189 Group profile 1
Later than 1 year and not later than 5 years 44 46
Gross assets Notes Gross assets Notes securitised in issue securitised in issue £m £m £m £m
Lloyds Banking Group Annual Report and Accounts 2010 23 SPECIAL PURPOSE ENTITIES
In addition to the special purpose entities discussed in note 22, which are used for securitisation and covered bond programmes, the Group sponsors four asset-backed conduits, Argento, Cancara, Grampian and Landale, which invest in debt securities and client receivables. All the external assets in these conduits are consolidated in the Group’s financial statements and are included in the credit market exposures set out in note 56. The total consolidated exposures in these conduits are set out in the table below: Argento £m
Debt securities classified as available-for-sale financial assets (note 26): Asset-backed securities 1,436 2,587 – – 4,023
Included in the amounts reported above are assets subject to repurchase agreements with a carrying value of £1,386 million (2009: £11,752 million); the value of the related liability is £1,043 million (2009: £7,970 million). In all cases the transferee has the right to sell or repledge the assets concerned.
25 ALLOWANCE FOR IMPAIRMENT LOSSES ON LOANS AND RECEIVABLES Loans and Loans and advances advances Debt to customers to banks securities Total £m £m £m £m
Recoveries of advances written off in previous years 216 – – 216
Debt securities: Other public sector securities – 29 29 – 31 31
Bank and building society certificates of deposit – 407 407 – 1,014 1,014
Asset-backed securities: Corporate and other debt securities 463 11,669 12,132 – 19,904 19,904
Details of the Group’s asset-backed conduits shown in the table above are included in note 23.
Included in the amounts reported above are assets subject to repurchase agreements with a carrying value of £1,467 million (2009: £7,438 million); the value of the related liability is £1,378 million (2009: £6,834 million). In all cases the transferee has the right to sell or repledge the assets concerned.
Overview Business review Governance Financial statements Other information 193 Group profile 1
Direct operating expenses arising from investment properties that generate rental income 77 64
The recoverable amount of Asset Finance has also been based on a value in use calculation using cash flow projections based on financial budgets and plans approved by management covering a five-year period and a discount rate of 15 per cent (gross of tax). The cash flows beyond the five-year period are extrapolated using a growth rate of 0.5 per cent which does not exceed the long-term average growth rates for the markets in which Asset Finance participates.
Overview Business review Governance Financial statements Other information 195 Group profile 1
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 table below shows the resulting range of yields and other key assumptions at 31 December for UK business: Risk-free rate (value of in-force non-annuity business) 3.99 4.45
Accumulated amortisation: Disposals of businesses – – – (12) – (12)
Overview Business review Governance Financial statements Other information 197 Group profile 1
Accumulated depreciation and impairment: Exchange and other adjustments (19) (12) 113 82
In addition, total future minimum sub-lease income of £55 million at 31 December 2010 (£79 million at 31 December 2009) is expected to be received under non-cancellable sub-leases of the Group’s premises.
The impairment charge of £202 million comprises £150 million relating to oil drilling rigs under construction acquired from a previous lending relationship in Wholesale (note 15) and £52 million relating to integration activities (note 11).
Costs deferred, net of amounts amortised to the income statement 69 (84)
Liabilities in respect of securities sold under repurchase agreements 24,017 27,558
Liabilities in respect of securities sold under repurchase agreements 11,145 35,554
Overview Business review Governance Financial statements Other information 199 Group profile 1
The amount contractually payable on maturity of the debt securities held at fair value through profit or loss at 31 December 2010 was £6,607 million, which was £58 million lower than the balance sheet carrying value (31 December 2009: £5,866 million, which was £294 million lower than the balance sheet carrying value). At 31 December 2010 there was a cumulative £11 million increase 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 £11 million increase, none arose in 2010 and £11 million arose in 2009.
The primary purpose of the conventional and unitised business written in the with-profit funds is to provide a long-term smoothed investment vehicle to policyholders, protecting them against short-term market fluctuations. With-profit policyholders are entitled to at least 90 per cent of the distributed profits, with the shareholders receiving the balance. The policyholders are also usually insured against death and the policy may carry a guaranteed annuity option at maturity.
(III) ASSUMPTIONS Key assumptions used in the calculation of with-profit liabilities, and the processes for determining these, are: Investment returns and discount rates The realistic capital regime dictates that with-profit fund liabilities are valued on a market-consistent basis. This is achieved by the use of a valuation model which values liabilities on a basis calibrated to tradable market option contracts and other observable market data. The with-profit fund financial options and guarantees are valued using a stochastic simulation model where all assets are assumed to earn, on average, the risk-free yield and all cash flows are discounted using the risk-free yield. The risk-free yield is defined as the spot yield derived from the relevant government bond yield curve. Further information on significant options and guarantees is given on page 107.
(I) BUSINESS DESCRIPTION The Group principally writes the following types of life insurance contracts within its non-profit funds. Shareholder profits on these types of business arise from management fees and other policy charges.
(II) METHOD OF CALCULATION OF LIABILITIES The non-profit fund liabilities are determined on the basis of recognised actuarial methods and consistent with the approach required by regulatory rules. The methods used involve estimating future policy cash flows over the duration of the in-force book of policies, and discounting the cash flows back to the valuation date allowing for probabilities of occurrence.
Overview Business review Governance Financial statements Other information 207 Group profile 1
The movement in the unallocated surplus within long-term insurance businesses over the year can be analysed as follows: £m £m
Rate of increase for pensions in payment 3.20 3.20 Years Years
SENSITIVITY ANALYSIS The effect of changes in key assumptions on the pension charge in the Group’s income statement and on the gross defined benefit pension scheme asset or liability is set out below: Increase (decrease) in the income statement charge
At 31 December 2010, the assumed rate of inflation is 3.4 per cent (31 December 2009 3.4 per cent).
The expected return on scheme assets in 2011 will be calculated using the following assumptions: %
The expected return on plan assets was determined by considering the expected returns available on the assets underlying the current investment policy. Expected yields on fixed interest investments are based on gross redemption yields at the balance sheet date at a term and credit rating broadly appropriate for the bonds held. Expected returns on equity and property investments are long-term rates based on the views of the plan’s independent investment consultants. The expected return on equities allows for the different expected returns from the private equity, infrastructure and hedge fund investments held by some of the funded plans. Some of the funded plans also invest in certain money market instruments and the expected return on these investments has been assumed to be the same as cash.
Present value of defined benefit obligation (26,862) (27,073) (15,617) (16,795) (17,378)
Experience gains (losses) on scheme liabilities 496 31 (39) (185) (50)
Following changes by the Group to the terms of its principal UK defined benefit pension schemes, all future increases to pensionable salary will be capped each year at the lower of: Retail Prices Index inflation; each employee’s actual percentage increase in pay; and 2 per cent of pensionable pay. In addition to this, during the second half of the year there was a change in the commutation factors in certain defined benefit schemes. The combined effect of these changes is a reduction in the Group’s defined benefit obligation of £1,081 million and a reduction in the Group’s unrecognised actuarial losses of £171 million, resulting in a net curtailment gain of £910 million recognised in the income statement and an equivalent reduction in the balance sheet liability.
For the principal post-retirement healthcare scheme, the latest actuarial valuation of the liability was carried out at 30 June 2008; this valuation has been updated to 31 December 2010 by qualified independent actuaries. The principal assumptions used were as set out above, except that the rate of increase in healthcare premiums has been assumed at 7.54 per cent (2009: 7.33 per cent).
Overview Business review Governance Financial statements Other information 213 Group profile 1
Lloyds Banking Group Annual Report and Accounts 2010 44 DEFERRED TAX
Income statement (charge) credit (note 16): Due to change in UK corporation tax rate (137) –
Amount (charged) credited to equity: Available-for-sale financial assets (note 49) (330) (395)
Asset at 31 December 3,917 4,797 Asset at 31 December 3,917 4,797
Lloyds Banking Group Annual Report and Accounts 2010 44 DEFERRED TAX continued
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 £6,572 million (2009: £5,925 million) in relation to trading 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 (2009: £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.
Overview Business review Governance Financial statements Other information 217 Group profile 1
Lloyds Banking Group Annual Report and Accounts 2010 46 SUBORDINATED LIABILITIES continued
The movement in subordinated liabilities during the year was as follows: £m
c These securities are callable at specific dates as per the terms of the securities at the option of the issuer and with approval from the FSA. In November 2009, as part of the state aid restructuring plan, the Group agreed not to exercise any call options on these instruments for the two year period from 31 January 2010 to 31 January 2012.
Overview Business review Governance Financial statements Other information 219 Group profile 1
6½% Undated Subordinated Step-up Notes callable 2019 (£270 million) b 1 –
6% Undated Subordinated Step-up Guaranteed Bonds callable 2032 (£500 million) b 10 10 5.625% Cumulative Callable Fixed to Floating Rate Undated Subordinated Notes (£500 million) b – 1 4.875% Undated Subordinated Fixed to Floating Rate Instruments (€750 million) b 65 60
Floating Rate Primary Capital Notes (US$250 million) b, c, d 118 146 10.25% Subordinated Undated Instruments (£100 million) b 1 1 12% Perpetual Subordinated Bonds (£100 million) b 21 22 8.75% Perpetual Subordinated Bonds (£100 million) b 4 6 13.625% Perpetual Subordinated Bonds (£75 million) b 20 33 9.375% Perpetual Subordinated Bonds (£50 million) b 16 26 5.75% Undated Subordinated Step-up Notes (£500 million) 3 3 4.25% Perpetual Fixed/Floating Rate Reset Subordinated Guaranteed Notes (€750 million) (Clerical Medical Finance plc) 215 190 7.375% Subordinated Undated Instruments (£150 million) b 1 –
With the exception of the two series identified in note b, the ECNs were issued in lower tier 2 format and are convertible into ordinary shares on the breach of a defined trigger. The trigger on the ECNs offered in the exchange will be if the published core tier 1 ratio of the Group falls below 5 per cent (as defined by the Financial Services Authority in May 2009).
Overview Business review Governance Financial statements Other information 221 Group profile 1
Issued on redemption of preference shares and other subordinated liabilities in 2010 4,299,422,579 – 429 –
(3) SHARE CAPITAL AND CONTROL There are no restrictions on the transfer of shares in the Company other than as set out in the articles of association and: – certain restrictions which may from time to time be imposed by law and regulations (for example, insider trading laws); – pursuant to the UK Listing Authority’s listing rules where directors and certain employees of the Company require the approval of the Company to deal in the Company’s shares; and
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. Consequently, the terms of these instruments prevent the Company from making dividend payments on ordinary shares.
On 18 February 2010, the Company issued 3,141 million ordinary shares as consideration for the redemption of certain preference shares and preferred securities; and during May and June 2010, the Company issued a further 1,158 million ordinary shares in relation to three separate exchanges for preference shares and other subordinated liabilities issued by the Group. A total share premium of £1,808 million was recorded in respect of these transactions.
The revaluation reserve in respect of available-for-sale financial assets represents the cumulative after tax unrealised change in the fair value of financial assets classified as available-for-sale since initial recognition, or in the case of available-for-sale financial assets obtained on acquisitions of businesses, since the date of acquisition.
Overview Business review Governance Financial statements Other information 227 Group profile 1
No dividends were paid on ordinary shares during 2009 or 2010 and the directors do not propose to pay a final dividend in respect of 2010; 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. Consequently, the terms of these instruments prevent the Company from making dividend payments on ordinary shares.
Executive and SAYE plans: Options granted in the year 59 13
Options granted under these plans were adjusted on 13 August 2010 as a result of the Capitalisation Issue, the Placing and Compensatory Open Offer and the Rights Issue of 2009. The adjustment was made using a standard HMRC formula, to negate the dilutionary impact of these corporate actions.
Lloyds Banking 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 under this plan have been granted specifically to facilitate recruitment and as such were not subject to any performance conditions. The plan’s usage 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.
As a consequence of the acquisition of HBOS and the general market turmoil, in March 2009 the Remuneration Committee decided that the performance test for the 2007 awards should be based on the performance of the Group up to 17 September 2008, the date prior to the announcement of the HBOS acquisition. The performance test was on a fair value basis, on the estimated probability, as at that date, of achieving the performance conditions. As a consequence, for all participants, other than those who were Executive Directors at the time the award was granted and a small number of other senior executives, the share awards vested at 31 per cent in March 2010.
The performance conditions for awards made in April, May and September 2009 are as follows: (i) EPS: relevant to 50 per cent of the award. Performance will be measured based on EPS growth over a three-year period from the baseline EPS of 2008.
Performance against the first two years of the award has been assessed and all targets have been met or exceeded.
Overview Business review Governance Financial statements Other information 233 Group profile 1
Overview Business review Governance Financial statements Other information 235 Group profile 1
No provisions have been recognised in respect of loans given to key management personnel (2009: £nil).
Deposits placed by key management personnel attracted interest rates of up to 4.25 per cent (2009: 6.50 per cent).
Lending commitments On 23 March 2010, the Company entered into a deed poll in favour of HM Treasury, the Department for Business, Innovation and Skills and the Departments for Communities and Local Government confirming its lending commitments for the 12 month period commencing 1 March 2010. The Company agreed, subject to, amongst other things, sufficient customer demand, to provide gross new lending to UK businesses of £44,000 million and to adjust the undertakings (but not the level of lending agreed in 2009) given in connection with lending to homeowners for the 12 month period. This additional lending is expressed to be subject to the Group’s prevailing commercial terms and conditions (including pricing and risk assessment) and, in relation to mortgage lending, the Group’s standard credit and other acceptance criteria.
There were no other material transactions between the Group and HM Treasury during 2010 that were not made in the ordinary course of business or that were unusual in their nature or conditions.
In addition to the above balances, the Group has a number of other associates held by its venture capital business that it accounts for at fair value through profit or loss. At 31 December 2010, these companies had total assets of approximately £12,216 million (2009: £14,840 million), total liabilities of approximately £11,937million (2009: £15,300 million) and for the year ended 31 December 2010 had turnover of approximately £3,829 million (2009: £10,570 million) and made a net profit of approximately £182 million (2009: net loss of £572 million). In addition, the Group has provided £3,316 million (2009: £6,014 million) of financing to these companies on which it received £93 million (2009: £191 million) of interest income in the year.
Overview Business review Governance Financial statements Other information 237 Group profile 1
UNARRANGED OVERDRAFT CHARGES In April 2007, the Office of Fair Trading (OFT) commenced an investigation into the fairness of personal current accounts and unarranged overdraft charges. At the same time, it commenced a market study into wider questions about competition and price transparency in the provision of personal current accounts.
The Supreme Court published its judgment in respect of the fairness of unarranged overdraft charges on personal current accounts on 25 November 2009, finding in favour of the litigant banks. On 22 December 2009, the OFT announced that it will not continue its investigation into the fairness of these charges. The Group is working with the regulators to ensure that outstanding customer complaints are concluded as quickly as possible and anticipates that most cases in the county courts will be discontinued. The Group expects that some customers will argue that despite the test case ruling they are entitled to a refund of unarranged overdraft charges on the basis of other legal arguments or challenges. It is not practicable to quantify the claims. The Group is robustly defending any such complaints or claims and does not expect any such complaints or claims to have a material adverse effect on the Group.
The ultimate impact on the Group of the FSA’s complaints handling policy (if implemented in full) and the FOS’s most recent approach to PPI complaints could be material to the Group’s financial position, although the precise effect can only be assessed once the legal proceedings have been finally determined and the steps the Group may be required to take identified and implemented. In addition, it is not practicable to quantify the potential financial impact of the implementation of the Policy Statement given the material uncertainties around, for example, applicable time
Following concerns expressed by the FSA, it announced in its statement on 29 September 2009 that several firms had agreed to carry out reviews of past sales of single premium loan protection insurance. Lloyds Banking Group has agreed in principle that it will undertake a review in relation to sales of single premium loan protection insurance made through its branch network since 1 July 2007. The precise details of the review are still being discussed with the FSA. The ultimate impact on Lloyds Banking Group of any review could be material but can only be known at the conclusion of these discussions.
Later than 1 year and not later than 5 years 1,120 1,213
Debt securities in issue – – – – – 228,866 – 228,866
Overview Business review Governance Financial statements Other information 241 Group profile 1
Derivative financial instruments 8,687 31,798 – – – – – 40,485
Liabilities arising from insurance contracts and participating investment contracts – – – – – – 76,179 76,179
Total carrying value and fair value 4,518 4,606 2,227 2,244 3,337 3,328
From available-for-sale financial assets to loans and receivables – – 69 69 – 161 161 (108) (108)
Actual amounts recognised in respect of reclassified assets After reclassification the reclassified financial assets contributed the following amounts to the Group income statement.
From held for trading to loans and receivables: Reclassified in 2010 £m
Trading and other financial assets at fair value through profit or loss 156,191 150,011 156,191 150,011
Loans and receivables: Loans and advances to banks 30,272 35,361 30,236 35,335
Trading and other financial liabilities at fair value through profit or loss 26,762 28,271 26,762 28,271
DEBT SECURITIES IN ISSUE AND SUBORDINATED LIABILITIES The fair value of short-term debt securities in issue is approximately equal to their carrying value. Fair value for other debt securities and for subordinated liabilities is estimated using quoted market prices.
Trading and other financial assets at fair value through profit or loss 113,242 40,113 2,836 156,191
Trading and other financial liabilities at fair value through profit or loss 864 25,898 – 26,762
MOVEMENTS IN LEVEL 3 PORTFOLIO The table below analyses movements in the level 3 financial assets portfolio.
The table below analyses movements in the Level 3 financial liabilities portfolio.
Included within the gains (losses) recognised in other comprehensive income are gains of £269 million (2009: £190 million) related to financial instruments that are held in the level 3 portfolio at the year end.
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 classified 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 significant valuation input or where there are materially inconsistent levels then the security is reported as level 3. Asset classes classified as level 3 mainly comprise certain residential mortgage-backed securities, collateralised loan obligations and collateralised debt obligations.
Equity investments (including venture capital) Unlisted equities and fund investments are accounted for as trading and other financial assets at fair value through profit or loss or as available-for-sale financial assets. These investments are valued using different techniques as a result of the variety of investments across the portfolio in accordance with the Group’s valuation policy and are calculated using International Private Equity and Venture Capital Guidelines.
Depending on the business sector and the circumstances of the investment, unlisted equity valuations are based on earnings multiples, net asset values or discounted cash flows.
Overview Business review Governance Financial statements Other information 249 Group profile 1
Lloyds Banking Group Annual Report and Accounts 2010 55 FINANCIAL INSTRUMENTS continued
Level 3 derivative assets also include £96 million (31 December 2009: £140 million) in respect of credit default swaps written on level 3 negative basis asset-backed securities calculated as set out in the table below: 2010 £m 2009 £m
(i) Uncollateralised derivative valuation adjustments, excluding monoline counterparties The following table summarises the movement on this revaluation adjustment account during 2010.
In circumstances where a counterparty becomes impaired, any associated derivative valuation adjustment is transferred and assessed for specific loss alongside other non-derivative assets and liabilities the counterparty may have with the Group.
The Debit Valuation Adjustment (DVA) is sensitive to the Group’s own CDS spread. A 1 per cent rise in this spread would lead to an increase in the DVA of £65 million to £363 million.
Overview Business review Governance Financial statements Other information 251 Group profile 1
As a bancassurer, financial instruments are fundamental to the Group’s activities and, as a consequence, the risks associated with financial instruments represent a significant component of the risks faced by the Group.
In addition the Group has cash flow hedges which are primarily used to hedge the variability in the cost of funding within the wholesale business. Note 19 shows when the hedged cash flows are expected to occur and when they will affect income for designated cash flow hedges. The notional principal of the interest rate swaps designated as cash flow hedges at 31 December 2010 was £112,507 million (2009: £222,548 million) with a net fair value liability of £843 million (2009: £2,536 million) (note 19). In 2010, ineffectiveness recognised in the income statement that arises from cash flow hedges was a gain of £160 million (2009: nil). There were no transactions for which cash flow hedge accounting had to be ceased in 2010 or 2009 as a result of the highly probable cash flows no longer being expected to occur.
The Group hedges part of the currency translation risk of the net investment in certain foreign operations using currency borrowings and cross currency derivatives. At 31 December 2010 the aggregate notional principal of these currency borrowings was £5,135 million; the aggregate notional principal of the cross currency derivatives was £86 million (2009: cross currency swaps £2,507 million) with a net fair value asset of £2 million (2009: asset of £25 million) and they were designated on an after-tax basis as hedges of net investments in foreign operations. In 2010, an ineffectiveness loss of £28 million before tax and £20 million after tax (2009: ineffectiveness of £nil before tax and £nil after tax) was recognised in the income statement arising from net investment hedges. 56 FINANCIAL RISK MANAGEMENT
Total structural foreign currency exposures, after net investment hedges (742) 442
Overview Business review Governance Financial statements Other information 253 Group profile 1
Trading and other financial assets at fair value through profit or loss (excluding equity shares) 65,972 65,861
Loans and advances to banks – the Group may require collateral before entering into a credit commitment with another bank, depending on the type of the financial product and the counterparty involved, and netting agreements are obtained whenever possible and to the extent that such agreements are legally enforceable.
Stock borrowing – Securities held as collateral as stock borrowed or under reverse repurchase agreements amounted to £93,419 million at 31 December 2010 (2009: £95,881 million), of which £55,554 million at 31 December 2010 (2009: £77,455 million) had been resold or repledged as collateral for the Group’s own transactions.
Overview Business review Governance Financial statements Other information 255 Group profile 1
Allowance for impairment losses on loans and advances to customers 18,373 14,801
Allowance for impairment losses on loans and advances to customers on a combined businesses basis 29,635 25,988
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 2010 totalled £5,475 million (31 December 2009: £3,919 million).
Forbearance arrangements The Group operates a number of schemes to assist borrowers. Further details of these schemes is set out in the risk report on pages 78 and 79.
As at 31 December 2010 Debt securities, treasury and other bills held at fair value through profit or loss Trading assets: Bank and building society certificates of deposit – 3,086 506 100 – – 3,692 Other asset-backed securities 191 633 196 – – – 1,020 Corporate and other debt securities 1,205 1,209 1,839 183 13 470 4,919 Total debt securities held as trading assets 2,047 5,816 2,541 367 13 470 11,254 Treasury bills and other bills 219 8 – – – – 227 Total held as trading assets 2,266 5,824 2,541 367 13 470 11,481 Other assets held at fair value through profit or loss: Bank and building society certificates of deposit 52 107 447 – – – 606 Asset-backed securities: Corporate and other debt securities 3,870 1,619 4,397 3,269 1,275 1,760 16,190 Total other assets held at fair value through profit or loss 25,766 3,341 5,826 3,711 1,351 1,951 41,946 Total held at fair value through profit or loss 28,032 9,165 8,367 4,078 1,364 2,421 53,427 Derivative financial instruments
Debt securities classified as loans and receivables Asset-backed securities: Corporate and other debt securities 163 164 459 106 166 758 1,816 Total debt securities classified as loans and receivables 14,222 5,534 2,893 1,421 1,211 1,012 26,293 Available-for-sale financial assets Debt securities: Other public sector securities – – – – – 29 29 Bank and building society certificates of deposit – 225 162 20 – – 407 Asset-backed securities: Corporate and other debt securities 1,135 4,824 5,150 913 42 68 12,132
Mortgage-backed securities: US residential mortgage-backed securities 4,242 – – 4,242 4,826
Collateralised debt obligations: Commercial real estate 306 – – 306 509
The exposure to monolines arising from credit default swaps is calculated as the mark-to-market of the CDS protection purchased from the monoline after credit valuation adjustments.
Cash and balances at central banks 38,569 – 23 – 402 38,994
Change in derivative financial instruments, trading and other financial assets at fair value through profit or loss (7,378) 12,063
Less: amounts with a maturity of three months or more (4,998) (7,937)
Share capital (including share premium account and merger reserve): Issued on acquisition of HBOS – 7,651
Cash and cash equivalents acquired, net of acquisition costs – 16,341
Net cash (outflow) inflow arising from acquisitions in the year (65) 16,262
Lloyds Banking Group Annual Report and Accounts 2010 58 FUTURE ACCOUNTING DEVELOPMENTS
Amendment to IAS 32 Financial Instruments: Presentation – ‘Classification of Rights Issues’
Dealt with on a standard by standard basis but not earlier than annual periods beginning on or after 1 July 2010.
Applies when an entity is subject to minimum funding requirements in respect of its defined benefit plans and makes an early payment of contributions to cover those requirements and permits such an entity to treat the benefit of such an early payment as an asset.
Amendments to IFRS 7 Financial Instruments Disclosures – ‘Disclosures-Transfers of Financial Assets’
At the date of this report, IFRS 9, the Amendments to IFRS 7 and the Amendments to IAS 12 are awaiting EU endorsement.
Overview Business review Governance Financial statements Other information 271 Group profile 1
We have audited the parent company financial statements of Lloyds Banking Group plc for the year ended 31 December 2010 which comprise the parent company balance sheet, the parent company statement of changes in equity, the parent company cash flow statement and the related notes. The financial reporting framework that has been applied in their preparation is applicable law and International Financial Reporting Standards (IFRSs) as adopted by the European Union and as applied in accordance with the provisions of the Companies Act 2006.
OPINION ON FINANCIAL STATEMENTS In our opinion the parent company financial statements: – give a true and fair view of the state of the Company’s affairs as at 31 December 2010 and of its cash flows for the year then ended; – have been properly prepared in accordance with IFRSs as adopted by the European Union and as applied in accordance with the provisions of the Companies Act 2006; and – have been prepared in accordance with the requirements of the Companies Act 2006.
MATTERS ON WHICH WE ARE REQUIRED TO REPORT BY EXCEPTION We have nothing to report in respect of the following matters where the Companies Act 2006 requires us to report to you if, in our opinion: – adequate accounting records have not been kept by the parent company, or returns adequate for our audit have not been received from branches not visited by us; or – the parent company financial statements and the part of the Directors’ Remuneration Report to be audited are not in agreement with the accounting records and returns; or – certain disclosures of directors’ remuneration specified by law are not made; or – we have not received all the information and explanations we require for our audit.
OTHER MATTER We have reported separately on the group financial statements of Lloyds Banking Group plc for the year ended 31 December 2010.
The directors approved the parent company financial statements on 24 February 2011.
Costs incurred in respect of the acquisition of HBOS plc – (138)
The Company has applied International Financial Reporting Standards as adopted by the European Union in its financial statements for the year ended 31 December 2010. IFRS comprises accounting standards prefixed IFRS issued by the International Accounting Standards Board and those prefixed IAS issued by the IASB’s predecessor body as well as interpretations issued by the International Financial Reporting Interpretations Committee and its predecessor body. The EU endorsed version of IAS 39 Financial Instruments: Recognition and Measurement relaxes some of the hedge accounting requirements; the Company has not taken advantage of this relaxation, and therefore there is no difference in application to the Company between IFRS as adopted by the EU and IFRS as issued by the IASB.
Overview Business review Governance Financial statements Other information 277 Group profile 1
Lloyds Banking Group Annual Report and Accounts 2010 5 OTHER RESERVES
Fixed/Floating Rate Non-Cumulative Callable Preference Shares callable 2016 (US$1,000 million) a 279 327 7.875% Non-Cumulative Preference Shares (€500 million) a 57 115 7.875% Non-Cumulative Preference Shares (US$1,250 million) a 119 236 91/4% Non-Cumulative Irredeemable Preference Shares (£300 million) a 239 216 93/4% Non-Cumulative Irredeemable Preference Shares (£100 million) a 49 79 6.475% Non-Cumulative Preference Shares (£186 million) a 34 45 6.0884% Non-Cumulative Fixed to Floating Rate Preference Shares (£745 million) a 9 10 6.3673% Non-Cumulative Fixed to Floating Rate Preference Shares (£335 million) a 2 2 6.413% preference shares (US$750 million) a 98 82 5.92% preference shares (US$750 million) a 110 167 6.657% preference shares (US$750 million) a 115 97 6% Non-Cumulative Redeemable Preference Shares a – –
Undated subordinated liabilities 6% Undated Subordinated Step-up Guaranteed Bonds callable 2032 (£500 million) b 11 117 6.475% Undated Subordinated Notes callable 2024 (£102 million) 80 72 6.0884% Undated Subordinated Notes callable 2015 (£732 million) 578 520 6.3673% Undated Subordinated Notes callable 2019 (£331 million) 266 234 6.369% Undated Subordinated Notes callable 2015 (£597 million) 480 420 6.413% Undated Subordinated Notes callable 2035 (US$375 million) 155 133 5.92% Undated Subordinated Notes callable 2015 (US$378 million) 164 135 6.657% Undated Subordinated Notes callable 2037 (US$316 million) 130 112 6.267% Undated Subordinated Notes callable 2016 (US$466 million) 198 166
Lloyds Banking Group Annual Report and Accounts 2010 10 FINANCIAL INSTRUMENTS
As discussed in note 9, the Company has entered into interest rate and currency swaps with its subsidiary, Lloyds TSB Bank plc, to manage these risks.
CREDIT RISK The majority of the Company’s credit risk arises from amounts due from its wholly owned subsidiary, Lloyds TSB Bank plc, and subsidiaries of this company.
Details of the Company’s post balance sheet events are set out in note 59 to the consolidated financial statements.
Lloyds Banking Group plc was incorporated as a public limited company and registered in Scotland under the UK Companies Act 1985 on 21 October 1985 with the registered number 95000. Lloyds Banking Group plc’s registered office is The Mound, Edinburgh EH1 1YZ, Scotland, and its principal executive offices in the UK are located at 25 Gresham Street, London EC2V 7HN.
Shareholders in the Lloyds Banking Group Shareholder Account can only trade by telephone through the Halifax Share Dealing Service on 08705 711 117.
AMERICAN DEPOSITARY RECEIPTS (ADRs) Lloyds Banking Group shares are traded in the USA through an NYSE-listed sponsored ADR facility, with The Bank of New York Mellon as the depositary. The ADRs are traded on the New York Stock Exchange under the symbol LYG. The CUSIP number is 539439109 and the ratio of ADRs to ordinary shares is 1:4.
For details contact: The Bank of New York Mellon Shareowner Services, PO Box 358516, Pittsburgh, Pennsylvania 15252-8516. Telephone: 1-866-259-0336 (US toll free), international callers: +1 201-680-6825. Alternatively visit www.adrbnymellon.com or email shrrelations@bnymellon.com
ANNUAL GENERAL MEETING The annual general meeting will be held at 11.00am on Wednesday 18 May 2011 in Hall 5 at the Scottish Exhibition and Conference Centre in Glasgow.
Overview Business review Governance Financial statements Other information 285 Group profile 1
Credit Default Swap 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 defined credit event. Credit events normally include bankruptcy, payment default on a reference asset or assets, or downgrades by a rating agency.
Short-term funding agreements which allow a borrower to sell a financial asset, such as ABS or Government bonds as collateral for cash. As part of the agreement the borrower agrees to repurchase the security at some later date, usually less than 30 days, repaying the proceeds of the loan.
Special Purpose Entities (SPEs) SPEs are entities that are created to accomplish a narrow and well defined objective. There are often specific 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.
Synthetic CDO A security that it similar in structure to a CDO whereby the pool of referenced assets is created synthetically usually by credit default swaps.
Write Downs The depreciation or lowering of the value of an asset in the books to reflect a decline in their value, or expected cash flows.
AVAILABLE-FOR-SALE FINANCIAL ASSETS Accounting policies 156, 160 Notes to the consolidated financial statements 192 Valuation 244
Currency risk 251, 282 Fair values of financial assets and liabilities 243, 282 Insurance risk 91 Interest rate risk 251, 282 Liquidity and funding risk 93, 263, 282 Market risk 88 Measurement basis of financial assets and liabilities 240, 281
GOODWILL Accounting policy 154 Notes to the consolidated financial statements 194
Life insurance sensitivity analysis 206 Options and guarantees 107 Unallocated surplus within insurance businesses 207 Value of in-force business 194 Volatility arising in insurance businesses 52
INTANGIBLE ASSETS Accounting policy 155 Notes to the consolidated financial statements 196
OTHER FINANCIAL INFORMATION Banking net interest margin 54 Core and non-core business 55 Integration 53 Volatility arising in insurance businesses 52
SEGMENTAL REPORTING Central items 51 Combined businesses segmental analysis 24, 25 Group Operations 50 Insurance 42 Notes to the consolidated financial statements 167 Retail 26 Wealth and International 36 Wholesale 30
VOLATILITY Insurance 52 Policyholder interests 52 Summary of Group results 22
REGISTRAR Equiniti Limited Aspect House Spencer Road Lancing West Sussex BN99 6DA Telephone 0871 384 2990 Textphone 0871 384 2255 Overseas +44 (0)121 415 7066 www.equiniti.com