lloyds bank plc · 4 7 july 2016 lloyds bank plc: post rating action update including credit cards...

FINANCIAL INSTITUTIONS

CREDIT OPINION7 July 2016

Update

RATINGSLloyds Bank Plc

Domicile United Kingdom

Long Term Rating A1

Type LT Bank Deposits - FgnCurr

Outlook Stable

Please see the ratings section at the end of this reportfor more information.The ratings and outlook shownreflect information as of the publication date.

Contacts

Carlos Suarez Duarte 44-20-7772-1061VP-Senior [email protected]

Maija Sankauskaite 44-20-7772-1092Associate [email protected]

Laurie Mayers 44-20-7772-5582Associate [email protected]

Nick Hill 33-1-5330-1029Managing Director [email protected]

Michael Eberhardt,CFA

44-20-7772-8611

VP-Sr Credit [email protected]

Lloyds Bank PlcPost Rating Action Update

Summary Rating RationaleOn 28th June, we affirmed all ratings of Lloyds Bank plc (Lloyds) and its holding companyLloyds Banking Group (LBG) and changed the outlooks to stable from positive on their longterm senior unsecured debt and deposit ratings.

The change in outlooks reflect our view that a prolonged period of uncertainty for the UK,expected following the outcome of the UK referendum, will have negative implicationsfor the country’s medium-term growth outlook and could lead to: (1) weaker operatingprofitability due to slower domestic credit demand; (2) weaker credit quality due to a likelymodest increase in unemployment and downward pressure on property prices in the UK; and3) potentially higher and more volatile funding costs. These drivers will pressure revenues,asset quality and profitability metrics for all banks in the system, although some are moreresilient to these strains. These factors led us to revise the outlooks on many UK banks andbuilding societies ratings to negative from stable. We revised our outlook on the UK bankingsystem itself to negative from stable at the same time.

Despite these challenges, Lloyd's credit fundamentals remain strong as reflected in its baa1baseline credit assessment (BCA), which is underpinned by: (1) solid retail, commercial andinsurance franchise; (2) strong capital metrics; and (3) improved asset quality. However, theBCA also reflects: (1) the sizable conduct remediation costs; (2) rapid expansion in riskierlending segments such as consumer finance and SME; and (3) increased competition, whichis likely to put negative pressure on net interest margins.

We rate Lloyds' long-term deposits and senior unsecured debt at A1. These ratings areunderpinned by (1) the bank's baa1 BCA; (2) the results of our Advanced Loss Given Failure(LGF) analysis which leads to a Preliminary Rating Assessment (PRA) for both depositsand senior unsecured debt two notches above the BCA and; (3) a moderate probability ofgovernment support, resulting in a further notch of uplift above the PRA for both deposit andsenior unsecured debt ratings.

The ratings of the bank's short term deposits and short term debt are Prime-1. We also assigna Counterparty Risk Assessment (CRA) of Aa3(cr)/P-1(cr) to Lloyds.

The ratings of Lloyds' holding company, Lloyds Banking Group's (LBG's) long- and short-termsenior unsecured debt are Baa1 and Prime-2, respectively. These instruments do not benefit

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MOODY'S INVESTORS SERVICE FINANCIAL INSTITUTIONS

This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page onwww.moodys.com for the most updated credit rating action information and rating history.

2 7 July 2016 Lloyds Bank Plc: Post Rating Action Update

from the same level of subordination as the senior unsecured debt issued by the operating entity and do not benefit from any uplift forgovernment support.

The ratings of Lloyds' and LBG's subordinated, junior subordinated and preferred shares are Baa2, Baa3 and Ba1 (hyb), respectively.

The outlook on Lloyds' deposits and senior unsecured debt and on LBG's senior unsecured debt is stable.

Credit Strengths

» Improved asset quality;

» Capital metrics are strong;

» Leading retail and commercial banking franchise provides “shock absorbers”;

» Substantial amount of liquid assets.

Credit Challenges

» Challenging operating environment following the outcome of the EU referedum

» Fast expansion of relatively riskier lending segments - consumer finance and SME lending - makes the bank's asset quality moresensitive to a deterioration in the economic environment;

» The bank is facing interest margin pressures amid the increasing competition within the UK banking sector;

» Conduct remediation costs and other non-core losses remain sizable generating earnings volatility;

» The use of wholesale funding remains high.

Rating OutlookThe outlook on Lloyds' deposits and senior unsecured debt and on LBG's senior unsecured debt is stable, reflecting the improvingtrends in asset quality and its strong capitalisation. But also, reflecting the negative pressures on the bank's profitability and assetquality driven by our expectation that a weaker operating environment following the outcome of the UK referendum.

Factors that Could Lead to an UpgradeLloyds' BCA could move up if the bank is able to (1) reduce the impact of conduct remediation on its profitability and return to stablenet income; and (2) maintain strong asset quality and capital metrics under the more challenging operating environment.

Factors that Could Lead to a DowngradeLloyds' BCA could be lowered following (1) A more acute deterioration in the UK's operating environment, in particular in terms ofeconomic growth, unemployment and the property market; and/or (2) a material decline in its capital or leverage metrics. A downwardmovement in Lloyds' BCA would likely result in downgrades to all ratings.

Key Indicators

Exhibit 1

Lloyds Banking Group plc (Consolidated Financials) [1]12-152 12-142 12-132 12-123 12-113 Avg.

Total Assets (GBP million) 778063.0 822299.0 815557.0 890499.0 924052.0 -4.24

Total Assets (EUR million) 1055689.5 1059604.4 980283.9 1097925.1 1106245.9 -1.24

Total Assets (USD million) 1146790.6 1282177.7 1350774.3 1447495.1 1436067.5 -5.54

Tangible Common Equity (GBP million) 42499.4 43674.1 34912.3 35072.0 37521.8 3.24



Tangible Common Equity (EUR million) 57664.0 56277.9 41964.0 43241.4 44919.9 6.44

Tangible Common Equity (USD million) 62640.1 68099.2 57823.9 57009.1 58312.6 1.84

Problem Loans / Gross Loans (%) 1.8 2.7 5.6 7.5 9.0 5.45

Tangible Common Equity / Risk Weighted Assets (%) 19.1 18.2 12.8 11.3 10.6 16.76

Problem Loans / (Tangible Common Equity + Loan Loss Reserve) (%) 18.6 26.1 60.8 79.0 91.2 55.15

Net Interest Margin (%) 1.5 1.4 0.9 0.9 1.3 1.25

PPI / Average RWA (%) 1.5 1.5 1.6 1.5 1.9 1.56

Net Income / Tangible Assets (%) 0.2 0.8 0.1 -0.1 -0.2 0.25

Cost / Income Ratio (%) 81.0 79.4 76.6 76.3 64.0 75.55

Market Funds / Tangible Banking Assets (%) 20.6 19.7 19.5 25.0 32.0 23.45

Liquid Banking Assets / Tangible Banking Assets (%) 27.1 26.3 22.6 24.2 23.7 24.85

Gross loans / Due to customers (%) 109.5 108.3 115.6 124.8 139.8 119.65

[1] All figures and ratios are adjusted using Moody's standard adjustments [2] Basel III - fully-loaded or transitional phase-in; IFRS [3] Basel II; IFRS [4] Compound Annual Growth Rate basedon IFRS reporting periods [5] IFRS reporting periods have been used for average calculation [6] Basel III - fully-loaded or transitional phase-in & IFRS reporting periods have been used foraverage calculationSource: Moody's Financial Metrics

Detailed Rating ConsiderationsThe financial data in the following sections are sourced from LBG's financial statements unless otherwise stated.

Strong asset quality but we expect modest increase in impairments

In Q1 2016, Lloyds saw a further decline in its reported impaired loan ratio to 2.0%, following an 80 basis points fall during the courseof 2015 to 2.1%, largely driven by the sale of the Irish commercial loan portfolio. Lloyds' run-off portfolio declined to £11.4 billion in2015 from £18.3 billion in 2014, and now accounts for only 2.5% of gross lending and 4.6% of risk-weighted assets. The bank's costof risk could show a modest deterioration, if the weaker expected economic growth has an impact on employment. Furthermore,we believe that the cost of risk has very limited room for improvement: at 14 basis points in Q1 2016 it is at the lowest level in thepast few years. However, we expect only a moderate increase in impairments given the low interest rate environment and the bank'sconservative underwriting standards.

Exhibit 2

Lloyds' credit risk is declining

Q1 2016 coverage ratio is Moody's estimateSource: LBG results presentations

The bank continues to expand significantly its UK consumer finance and SME portfolios: net lending in these segments grew by 17%and 5%, respectively, in 2015. We believe these asset types are riskier by nature than Lloyds' traditional mortgage and corporatecredit products, potentially exposing the firm to greater downside risk, if the economic environment deteriorates. Consumer finance,



including credit cards and asset finance in the UK and Europe accounted for 5.2% of Lloyds' total lending net of impairments excludingreverse repos and other items, while SME lending accounted for 6.4% as of December 2015.

The bank continues to face significant operational risk from legacy products, which has been reflected in the record £4.8 billionprovisions set aside during 2015, of which £4.0 billion relate to mis-sold payment protection insurance (PPI) policies. The remaining£0.8 billion charge encompasses the customer redress of a number of other products, including the £117 million settlement with theFinancial Conduct Authority following a process failure in appropriately handling customer's complaints. In the first three months of2016 Lloyds took a further conduct charge of £115 million for miscellaneous retail items. Despite the fact that Lloyds front-loaded thePPI charges in 2015 in response to the proposed introduction of a deadline for customers to claim compensation, it may have to setaside further provisions, given the unpredictable nature of the claims, but we expect them to be smaller.

Our assigned Asset Risk score of baa1 incorporates the factors described above.

Despite deleveraging Lloyds maintains a strong retail and commercial franchise, which provides a stable base of earnings...

Lloyds' leading commercial and retail banking franchise continues to generate significant revenues, providing a good quality earningsstream capable of absorbing further credit impairments and conduct-related costs. The bank remains the largest mortgage lender anddeposit-taker in the UK despite the sale of TSB Banking Group plc (TSB, Baa3 stable) to Banco Sabadell (Baa3/Ba1 stable, ba3).

Lloyds continues to benefit from the revenue diversification provided by its bancassurance subsidiaries, Scottish Widows and ClericalMedical. During 2015, Lloyds insurance business reported an underlying profit of £962 million, up from £922 million in 2014. However,we note that as part of the implementation of the UK's "ring-fencing" legislation, Lloyds plans to transfer the ownership of its insuranceactivities to the holding company. Therefore, LBG will be the entity receiving the revenue diversification benefits from these businessesonce the ring-fencing is implemented. The bank plans to include the vast majority of its banking activities within the ring-fenced entity.If its plans are accepted, we see few challenges for Lloyds to implement the ring-fencing legislation and therefore fewer potentialchanges in its credit profile compared to its large UK competitors.

...however, ongoing conduct remediation costs and potential further litigation charges likely to prolong earnings volatility

Lloyds reported a profit before tax of £0.7 billion in the first three months of 2016, a 46% decline on the same period in 2015, mainlydriven by a £790 million charge related to the redemption of Enhanced Capital Notes (ECNs). The bank will nevertheless benefit fromannual interest savings of about £200 million a year (Lloyds' estimate) following the redemption of these instruments. In addition tothe ECNs charge, the bank made a £115 million provision for retail conduct costs in the period and incurred a number of other items,such as volatile items, asset sales and high business restructuring costs. Excluding the items mentioned and the contribution of nowdeconsolidated TSB, Lloyds reported a flat underlying pre-tax profit of £2.1 billion in the first quarter of 2016, compared to the sameperiod in 2015.

Lloyds reported a 3% higher net interest income of £2.9 billion in Q1 2016, and its net interest margin (NIM) strengthened to 2.74%from 2.60% in Q1 2015, driven by lower funding costs following the ECNs redemption and improved deposit pricing. We expect thebank's interest margin to come under pressure in the near term as interest rates remain lower for longer following the outcome ofthe EU referendum and competition in the UK mortgage market intensifies. Counterbalancing the NIM challenges, Lloyds' operatingcosts continue to fall, reflecting the acceleration of the business simplification initiatives: the bank's reported cost-to-income ratio was47.4% in Q1 2016 - a good operating efficiency level compared to peers.

Scottish Widows (SW, A2 Positive) faces some headwinds on several business lines, reflecting the challenging UK life market and thesharp decline in higher-margin bancassurance sales through Lloyds branches. This could negatively affect its contribution to the group'sprofitability.

In summary, profitability remains a relative weakness for the BCA. Our assigned Profitability score of ba1 is higher than that suggestedby historic earnings, which were weighed down by PPI and loan loss provisions, and thus anticipates some recovery.

Strong capital metrics



Despite the negative impact of the £0.8 billion ECNs redemption charge and other extraordinary items, Lloyds' fully loaded commonequity tier 1 (CET1) ratio remained stable at 13% as of March 2016. The fully loaded CET1 ratio has decreased by 20 basis points sinceend-2015 to 12.8%, but is unchanged on a pro forma basis that includes an insurance dividend. The group’s risk-weighted assetsremained unchanged from at £223 billion. The bank's fully loaded leverage ratio remained unchanged at to 4.8% as of March 2016compared to December 2015 (pro-forma), largely owing to the increase in the balance sheet exposure, but remains comfortably abovethe 3% regulatory requirement. Including high trigger contingent capital instruments, the bank had a Tangible Common Equity (TCE) /RWA ratio of 19.1% as of December 2015, up from 18.2% as of December 2014, according to our calculations. We note that this ratiois significantly different from the regulatory ratio since it does not include deductions from significant investments and includes all ofthe bank's high trigger additional tier 1 securities.

Exhibit 3

The bank's fully-loaded CRDIV CET1 and leverage ratios are strong

Source: LBG results presentations

Our assigned Capital score of aa3 reflects the strength of the group's capital and leverage position. The score also incorporates (1)the adjusted values of the two capital ratios after deducting the capital deployed at insurance subsidiaries; and (2) the vulnerability ofthe bank's capital position to a material downturn in the UK housing market. Although we expect risk-weighted capital and leveragemetrics to remain strong, increasing dividend payments will limit any sizable improvements.

Relatively stable funding profile and adequate liquidity, although the use of wholesale funding remains high

The bank's funding position has improved as its use of market funding has declined significantly in recent years, mainly because of thereduction in the size of the bank's non-core portfolio. Nevertheless, market funding remains high by global standards and represented20.6% of Lloyds' tangible banking assets at end-2015, up from 19.7% at end-2014 as a result of TSB's deconsolidation. Lloyds' grossloan-to-deposit ratio increased slightly to 109.5% in December 2015 (108.3% in December 2014), as per our calculations, as totalwholesale funding increased to £120 billion at end-2015 from £116 billion at end-2014. It increased by a further £5 billion betweenDecember 2015 and March 2016 as the bank fulfilled some of its issuance requirements early in the year. Short-term wholesale fundingwith maturity of less than one year increased to £46 billion as of March 2016 from £38 billion in December 2015 and now constitutes37% of total wholesale funding, although the proportion of money-market as a percentage of total wholesale funding remainedunchanged at 18.4%. Our Funding Structure score of baa1 reflects the bank's relatively high use on market funds as well as our viewthat Lloyds benefits from a solid and granular retail deposit base.

Lloyds' liquid banking assets accounted for 27.1% of its tangible banking assets at the end of 2015 according to our calculations, a slightincrease from 26.3% at end-2014. We calculate that the bank's primary liquid assets (£117 billion) accounted for 3.1 times the group'sshort-term wholesale funding as of December 2015, suggesting a strong level of coverage against the risk of an interruption in theavailability of wholesale funding. Lloyds also reports that its regulatory liquidity coverage exceeded 100% at end-Q1 2016. We expectthe bank to reduce some of its primary liquid assets as it returns to positive lending growth. As a result, we assign a Liquid Resourcesscore of baa1 to reflect these factors.



Our BCA of baa1 is positioned one notch below the mid-point of the a2-baa1 range offered by our scorecard. This suggests thepotential for a higher BCA in time, once the downside risk arising from conduct costs and operational risk declines, driving the positiveoutlook on our long-term senior unsecured debt and deposit ratings discussed above.

Notching ConsiderationsLoss Given Failure and additional notching

We apply our Advanced Loss Given Failure (LGF) analysis to Lloyds because it is domiciled in the UK, which is subject to the EU BankResolution and Recovery Directive (BRRD), and which we consider to be an operational resolution regime. We assume residual tangiblecommon equity of 3% and losses post-failure of 8% of tangible banking assets, a 25% run-off in "junior" wholesale deposits, a 5%run-off in preferred deposits, and assign a 25% probability to deposits being preferred to senior unsecured debt. We also assume thatthe junior proportion of Lloyds' deposits is in line with the estimated EU-wide average of 26%. These are in line with our standardassumptions.

Under these assumptions, Lloyds' deposits are likely to face very low loss-given-failure, due to the loss absorption provided bysubordinated debt and, potentially, by senior unsecured debt should deposits be treated preferentially in a resolution, as well as thevolume of deposits themselves. This results in a Preliminary Rating Assessment (PRA) for Lloyds' deposits of a2, two notches abovethe bank's baa1 BCA. For Lloyds' senior unsecured debt, our LGF analysis also shows a very low loss-given-failure resulting from acombination of its own volume and the amount of debt subordinated to it. This results in a PRA of a2, two notches above the BCA.

For the holding company LBG's senior unsecured debt, which we assume to be economically subordinated to Lloyds' senior unsecureddebt - our LGF analysis shows a moderate loss-given-failure resulting from the combination of its own volume and the amount of debtsubordinated to it. This results in a PRA in line with Lloyds' BCA, or baa1.

For junior securities issued by Lloyds and LBG, our LGF analysis confirms a high level of loss-given-failure, given the small volume ofdebt and limited protection from more subordinated instruments and residual equity. We also incorporate additional notching forjunior subordinated and preference share instruments reflecting coupon suspension risk ahead of failure. The resulting PRAs are set outat the end of this report.

Government Support

The implementation of BRRD has caused us to reconsider the potential for government support to benefit certain creditors. GivenLloyds systemic importance to the UK economy, we believe there is a moderate probability of government support for the operatingcompany's junior deposits and senior unsecured debt, resulting in a one-notch uplift from the PRA.

For holding company LBG's senior unsecured debt, we consider the probability of government support to be low. This is because suchsupport would only be likely to be provided to the operating entity, to be able to maintain its critical functions and mitigate risks tofinancial stability arising from its failure, while holding company creditors would be expected to bear losses if necessary.

For other junior securities, we continue to assume a low probability of government support, and, as such, the ratings for theseinstruments do not include any related uplift.

Counterparty Risk Assessment

CR Assessments are opinions of how counterparty obligations are likely to be treated if a bank fails and are distinct from debt anddeposit ratings in that they (1) consider only the risk of default rather than both the likelihood of default and the expected financial losssuffered in the event of default and (2) apply to counterparty obligations and contractual commitments rather than debt or depositinstruments. The CR assessment is an opinion of the counterparty risk related to a bank's covered bonds, contractual performanceobligations (servicing), derivatives (e.g., swaps), letters of credit, guarantees and liquidity facilities.

The CR Assessment is positioned at Aa3(cr)/P-1(cr). The CR Assessment, prior to government support, is positioned three notchesabove the Adjusted BCA of baa1, based on the cushion against default provided to the senior obligations represented by the CRAssessment by more subordinated instruments - including junior deposits and senior unsecured debt - amounting to about 23% ofTangible Banking Assets. The main difference with our Advanced LGF approach used to determine instrument ratings is that the CR



Assessment captures the probability of default on certain senior obligations, rather than expected loss, therefore we focus purely onsubordination and take no account of the volume of the instrument class.

The CR Assessment also benefits from one notch of government support, in line with our support assumptions on deposits andsenior unsecured debt. This reflects our view that any support provided by governmental authorities to a bank which benefits seniorunsecured debt or deposits is very likely to benefit operating activities and obligations reflected by the CR Assessment as well,consistent with our belief that governments are likely to maintain such operations as a going-concern in order to reduce contagion andpreserve a bank's critical functions.

About Moody's Bank Scorecard

Our Scorecard is designed to capture, express and explain in summary form our Rating Committee's judgment. When read inconjunction with our research, a fulsome presentation of our judgment is expressed. As a result, the output of our Scorecardmay materially differ from that suggested by raw data alone (though it has been calibrated to avoid the frequent need for strongdivergence). The Scorecard output and the individual scores are discussed in rating committees and may be adjusted up or down toreflect conditions specific to each rated entity.

Rating Methodology and Scorecard Factors

Exhibit 4

Lloyds Banking Group plcMacro FactorsWeighted Macro Profile Very Strong - 100%

Financial ProfileFactor Historic Ratio Macro

Adjusted ScoreCredit Trend Assigned Score Key driver #1 Key driver #2

SolvencyAsset RiskProblem Loans / Gross Loans 3.4% a2 ← → baa1 Quality of assets Operational

riskCapitalTCE / RWA 19.1% aa1 ← → aa3 Capital retention Stress capital

resilienceProfitabilityNet Income / Tangible Assets 0.2% b1 ↑ ba3 Expected trend Earnings

qualityCombined Solvency Score a2 baa1LiquidityFunding StructureMarket Funds / Tangible BankingAssets

20.6% baa1 ← → baa1 Expected trend Extent ofmarket funding

relianceLiquid ResourcesLiquid Banking Assets / TangibleBanking Assets

27.1% a2 ↓ baa1 Expected trend Quality ofliquid assets

Combined Liquidity Score a3 baa1Financial Profile baa1Business Diversification 0Opacity and Complexity 0Corporate Behavior 0Total Qualitative Adjustments 0



Sovereign or Affiliate constraint: Aa1Scorecard Calculated BCA range a3-baa2Assigned BCA baa1Affiliate Support notching 0Adjusted BCA baa1

Instrument Class Loss GivenFailure

notching

Additional notching PreliminaryRating

Assessment

GovernmentSupport notching

Local Currencyrating

ForeignCurrency

ratingCounterparty Risk Assessment 3 0 a1 (cr) 1 Aa3 (cr) --Deposits 2 0 a2 1 A1 A1Senior unsecured bank debt 2 0 a2 1 A1 A1Dated subordinated bank debt -1 0 baa2 (hyb) 0 Baa2 Baa2Junior subordinated bank debt -1 -1 baa3 (hyb) 0 Baa3 (hyb) Baa3 (hyb)Cumulative bank preference shares -1 -2 ba1 (hyb) 0 Ba1 (hyb) Ba1 (hyb)Senior unsecured holding companydebt

0 0 baa1 0 Baa1 Baa1

Dated subordinated holding companydebt

-1 0 baa2 (hyb) 0 Baa2 Baa2

Holding company cumulativepreference shares

-1 -2 ba1 (hyb) 0 -- Ba1 (hyb)

Holding company non-cumulativepreference shares

-1 -2 ba1 (hyb) 0 Ba1 (hyb) Ba1 (hyb)

Source: Moody's Financial Metrics

Ratings

Exhibit 5Category Moody's RatingLLOYDS BANK PLC

Outlook StableBank Deposits A1/P-1Baseline Credit Assessment baa1Adjusted Baseline Credit Assessment baa1Counterparty Risk Assessment Aa3(cr)/P-1(cr)Senior Unsecured A1Subordinate Baa2Jr Subordinate Baa3 (hyb)Pref. Stock Ba1 (hyb)Commercial Paper P-1Other Short Term -Dom Curr (P)P-1

PARENT: LLOYDS BANKING GROUP PLC

Outlook StableSenior Unsecured Baa1Subordinate Baa2Bkd Jr Subordinate -Dom Curr Baa3 (hyb)Pref. Stock Non-cumulative Ba1 (hyb)Preference Shelf (P)Ba1



Other Short Term -Dom Curr (P)P-2LLOYDS TSB BANK PLC HONG KONG BRANCH

Commercial Paper P-1LLOYDS BANK PLC (AUSTRALIA)

Outlook StableSenior Unsecured MTN (P)A1Subordinate MTN (P)Baa2Other Short Term (P)P-1

SCOTTISH WIDOWS LIMITED

Outlook StableInsurance Financial Strength A2Subordinate -Dom Curr Baa1 (hyb)

CHELTENHAM & GLOUCESTER PLC

Jr Subordinate -Dom Curr Baa3CLERICAL MEDICAL FINANCE PLC

Outlook StableBkd Jr Subordinate -Dom Curr Baa1 (hyb)

Source: Moody's Investors Service



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REPORT NUMBER 1031189

lloyds bank plc · 4 7 july 2016 lloyds bank plc: post rating action update including credit cards...

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