Lloyds threatened by uncertainty

Lloyds found itself singled out in the interim report from the earlier this month. The commission was unhappy that Lloyds' merger with HBOS had left it with 30 per cent of the UK's current accounts and concluded that the European Commission's requirement that Lloyds should sell 600 branches to compensate just wasn't enough. "This divestiture will have a limited effect on competition unless it is substantially enhanced," concluded the commission. Admittedly, that's not as a painful as an enforced de-merger, which some analysts had feared, but it's still a worry.

Most of Lloyds' problems reflect the HBOS merger. In 2008, as the financial crisis began to overwhelm HBOS, Lloyds' former chief executive, Eric Daniels, saw a merger as an opportunity to grab a dominant slice of the UK's mortgage and retail market. And the previous government, knowing that HBOS was effectively bust, promised to waive competition concerns - unthinkable in settled times. Not only has that promise proved worthless, but the deal also lumbered Lloyds with a huge bad debt crisis.

In 2008, before the deal was completed, Lloyds' bad debt charge was £3bn. The following year it was £16.7bn, mainly because of provisions against HBOS's dud loans. The scale of the capital destruction was enough to force Lloyds to seek government bailout funds. That left the state with a 40.6 per cent stake in Lloyds and a requirement that it axe dividends (a return to the dividend list doesn't look likely until 2012). That said, thanks to December 2009's £13.5bn rights issue, Lloyds is now well capitalised with a tier-one capital ratio of 10.2 per cent.

Lloyds, then, has endured immense pain for the sake of the UK market share it gained. Now to be facing a severe dilution of that benefit, as regulators prepare to force Lloyds to sell many branches, won't help investors' sentiment in the run up to the banking commission's final report in September. It also casts doubts over the timescale for the sale of the government's stake as it's hard to see the shares being bought by the private sector before it's clear just how far Lloyds must go to meet competition worries. As analyst Nic Clarke of broker Charles Stanley points out, the commission's approach is enough to leave a "cloud over the stock until at least the final report is published". Yet a plan to return ownership of Lloyds fully to private hands is probably the clearest way to signal that the lender is back on track. As the commission has only issued interim findings so far, it's even possible that it could adopt a tougher stance in its final report.

Still, Lloyds saw credit quality improve as the UK economy began slowly to recover during 2010 and its bad-debt charge fell 34 per cent last year to £11bn. Rapidly falling bad debts in the wholesale arm also allowed that unit to turn 2009's £4.7bn loss into a £3.3bn profit in 2010. But progress is mixed. For example, the Irish operation's bad debt charge soared 45 per cent in 2010 to £4.3bn. And with the biggest slice of its profits - £4.7bn in 2010 - being generated from its UK retail operation, Lloyds is more exposed to the weak UK economy than its big-bank rivals. The government's austerity measures are now biting, too - the UK's economy shrank 0.5 per cent in 2010's fourth quarter and unemployment looks set to rise. That's bad news for loan demand and could even mean another lurch upwards in bad debt charges. Broker Evolution Securities thinks new chief executive António Horta-Osório could identify additional impairments: "We calculate that the kitchen-sinking will at least amount to £8bn, but it could get to £10bn," they say.