Lloyds: The Strongest Banking Franchise in the UK

Equity Analyst

Niklas Kammer

Lloyds is a pure UK banking play, with 95% of its assets based domestically. Since its massive restructuring, which started in 2011, the bank has emerged as a low-risk domestic retail and commercial bank. It has shed about GBP 190 billion in runoff assets and GBP 200 billion in risk-weighted assets and has significantly reduced its dependence on wholesale funding. Today, Lloyds operates one of the strongest retail franchises in the United Kingdom.

Mortgage pricing is under pressure in the UK as challenger banks look to gain scale and ring-fencing regulations increase liquidity in the market. Although mortgages constitute the lion’s share of loans to customers (66%), Lloyds has delivered robust net interest margins, speaking to its large deposit funding base and policy to prioritize margins over volume. Additionally, as competitive pressure in this market segment has risen, Lloyds has shifted its focus to building out its financial planning offerings, beefed up its credit card loan book, and targeted loan growth in small and medium-size enterprises.

Business Strategy & Outlook

We find a narrow moat in Lloyds’ operations. The group benefits from cost advantages and switching costs stemming from its strong position in the UK, which makes up about 95% of its assets. We view cost advantages as the primary source of moats for banks with large retail and commercial banking operations and divide costs into three categories: credit, operating, and funding. Also, we believe switching costs play a key role in a bank’s ability to maintain low-cost funding. Underlying our moat assessment for Lloyds is our view of the UK market, which we rate as fair overall, although we believe the competitive environment is good.

Core to our moat methodology for banks is our view of the regulatory and competitive environment. Our assessments range from poor to very good, increasing or lowering the hurdle we think a bank needs to overcome to gain a moat. We see the regulatory environment as fair and note that it has improved significantly since the global financial crisis. Poor oversight was a key factor in UK banks' poor performance during the crisis. Antibank sentiment remains in the UK, and partially as a result, banking regulation changes frequently and is more onerous than elsewhere in Europe. We think that the higher cost of operating in the UK system, such as the bank tax and levy, will make it more difficult for UK banks to outearn their costs of equity over time. Additionally, regulatory changes such as ring-fencing requirements—he separation of UK retail from investment banking—increase pricing competition in retail lending and have been costly to implement for UK banks.

We think the competitive environment in UK for banks is good. The UK banking market is dominated by five high street banks (Lloyds, RBS, Barclays, HSBC UK, and Santander UK), which control about 60% of gross lending assets. We think this constitutes a comfortable oligopoly, allowing the largest banks in the system to realize scale effects and reap the rewards from a high share of cheap and sticky deposit funding. Indeed, we find that to a varying degree all five high street banks benefit from this market segmentation. While this does not result in a moat by default, we do think the good competitive environment in the UK is a supportive factor in a bank’s ability to carve out a moat. 

Cost Advantages

We believe Lloyds enjoys cost advantages in the form of a sizable deposit base establishing a low-cost and sticky funding source as well as low operating costs. We typically assign moat ratings for retail and commercial operations based on access to a large pool of deposit funding, particularly non-interest-bearing checking accounts, which form one of the cheapest types of funding a bank can obtain. The strength of the moat based on this potential funding advantage is enhanced if we find switching costs that prevent clients from moving this inexpensive source of funding to competitors in search of higher rates. Preferably, the deposit base consists mostly of retail rather than wholesale deposits, as the former tend to be stickier and lower cost than the latter. 

Lloyds finances roughly 52% or GBP 416 billion of its asset base via deposits, which can be broken down to 30% retail deposits and 22% commercial deposits, giving it what we believe to be a strong funding advantage in its retail and commercial operations. Although we would like to see a higher share of retail deposits given the large mortgage book—a loan/deposit ratio of 143% in the retail segment seems high to us—we believe Lloyds performs well on this metric in absolute terms. It controls GBP 236 billion in retail deposits in the UK, which makes it the largest retail deposit holder of the high street banks (RBS GBP 180 billion, Barclays GBP 154 billion, HSBC GBP 132 billion, Santander GBP 130 billion). Finally, Lloyds has one of the highest current account shares in the UK (22%), the cheapest and stickiest source of funding, which we think is indicative of a strong retail deposit position. 

We believe Lloyds’ operating efficiency of about 50% in its retail and commercial segments creates a competitive advantage allowing the bank not only to generate a higher return on risk-weighted assets (pretax about 4.6% retail and 2.5% commercial) , but also allows for capital reinvestment in the business, a crucial ability to fend off digital challenger banks in UK’s open banking environment. Admittedly, operating efficiency is partially a result of the competitive landscape and a bank’s position therein. The concentrated UK market allows high street banks to deploy scale effectively, resulting in good efficiency ratios across the peer group as it enables the leverage of costly branch networks over a vast customer base. This does not take away from Lloyds’ ability to keep operating costs low, however.

We don’t see a competitive advantage in Lloyds’ ability to manage credit costs better than peers. Generally speaking, comparing credit costs across banks yields little insight, given different geographical, sector, and product exposures as well as differing risk appetites. Additionally, credit costs are the outcome of past underwriting decisions coupled with the current macroeconomic environment rather than an indication of the present or future risk culture in the bank. We therefore look for a record of consistently low credit costs through the cycle. Although Lloyds has significantly improved its loan book since its acquisition of HBOS and the resulting loan losses leading to a government bailout totaling GBP 20 billion in 2009, as well as substantial losses stemming from its Irish mortgage book, we don’t see any indication that it can underwrite loans better than peers. As Lloyds operates primarily in the UK, which comprises highly correlated and homogeneous markets, we don’t see any strong diversification effects that could help manage spikes in credit costs. 

Switching Costs

We believe Lloyds enjoys switching costs through a broad palette of products it can offer customers and typically low customer switching rates in the UK Products offered to retail clients range from mortgages, which takes the lion share of products sold, over credit cards—Lloyds has a market share of 24%, second only to Barclays—to automobile loans and life and auto insurance, while affluent customers can find a financial planner in the personal wealth joint venture with Schroders. 

The bank further enjoys sticky relationships with small and medium-size businesses and corporations, which value Lloyds’ long-standing history, wide product offering, and ability to grow with the business. Costs of switching for small and medium-size businesses can be substantial even if just implicit. The threat of losing business due to teething problems after switching banks often outweighs anticipated gains from converting. We don’t see particularly strong switching costs with large corporations, however, as such clients often bank with multiple institutions and are keen to shop around for better rates or commissions. 

While Lloyds’ product offerings are not meaningfully different from those of other high street banks, we do think they shield the bank from digital-only and regional challenger banks encroaching on its market. We don’t see challenger banks materially cutting into market shares of the high street banks and believe opportunities for smaller competitors only lie in niche geographical or product markets where high street banks cannot play out their scale effectively. 

Lloyds’ product range is a strong attraction and retention factor of customers relative to single-feature digital banks. We believe customer switching rates are comfortably in the single digits, suggesting 10-year-plus average customer retention. Lastly, we think high street banks take roughly their current market share in new business. This can fluctuate as competitive pressures change, but we would be careful not to extrapolate slow market share attrition at high street banks too far into the future. Due to size and cost advantages, high street banks can be more selective as to which products and risks to take on their balance sheet when competition of mostly wholesale funded challengers increases, driving down prices and risk-adjusted returns. Lloyds takes about 18% and 21% of new digital and branch business volume, respectively. We think this is right around its overall market share across products in the UK. 

Lloyds generates its cost advantages in the retail and commercial banking segments, which contribute 53% and 27% of groupwide underlying profits, respectively. According to our calculation, returns on equity of 14% in 2018 sit well above our cost of equity assumption of 9% in the retail segment, building the backbone of what we believe to be a groupwide narrow moat. Competition in this segment has increased after ring-fencing regulation forces competitors to redeploy UK funding to the UK market. But we think Lloyds’ large deposit base protects the bank better than peers from pricing pressure.

The commercial banking segment adds to the moat through deposit-gathering, which is redeployed in the retail business, which has higher returns on risk-weighted assets, but we don’t think this segment would earn a moat on a stand-alone basis. We think returns in this segment are below cost of equity and will likely remain so for the foreseeable future, given higher risk weights for corporate lending products. Nevertheless, we believe the segment adds to Lloyds’ groupwide narrow moat rating through its deposit-taking ability paired with switching costs from smaller companies and an admirable operating efficiency. 

Lloyds’ insurance and wealth business, which we believe will be a growth area, adds to the switching costs the bank can generate throughout its business segments, but we don’t see the unit itself as particularly moaty in the current form.

Narrow

Economic Moat

Lloyds Banking Group

Bank of Scotland is a commercial and clearing bank based in Edinburgh, Scotland. With a history dating to the 17th century, it is the fifth-oldest surviving bank in the United Kingdom (the Bank of England having been established one year before), and is the only commercial institution created by the Parliament of Scotland to remain in existence. It was one of the first banks in Europe to print its own banknotes and it continues to print its own sterling banknotes under legal arrangements which allow Scottish banks to issue currency.

Bank of Scotland

Lloyds Banking Group Plc is a financial services company, which engages in the provision of banking and financial services. It operates through the following segments: Retail, Commercial Banking, Insurance and Wealth, and Other. The Retail segment offers broad range of financial service products, including current accounts, savings, mortgages, motor finance and unsecured consumer lending to personal, and small business customers. The Commercial Banking segment provides a range of products and services such as lending, transactional banking, working capital management, risk management and debt capital markets services to SMEs, corporates, and financial institutions. The Insurance and Wealth segment focuses on the insurance, investment, and wealth management products and services. The Other segment refers to income and expenditure not attributed to the group’s financial reporting segments. These amounts include those arising from the group’s equities business, residual net interest income after transfer pricing, and certain gains from gilt sales. The company was founded by George Truett Tate in 2009 and is headquartered in London, the United Kingdom.

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