Lloyds: get back on the horse

Lloyds has said it plans to pay dividends equivalent to half its sustainable earnings and that it will be looking at handing back capital - through share buybacks or special dividends - above a tier-one capital ratio of 12 per cent plus a further year's ordinary dividend. This regulatory ratio, which presents core capital as a percentage of risk-weighted assets, was 13.3 per cent at the halfway mark, compared with 12.8 per cent at the year-end, so there is headroom.

While returns of surplus capital may be a way off, Lloyds has already kick-started dividends and the forecast yield is starting to look attractive. Based on predictions from broker Investec Securities (see table) the shares should yield 3 per cent this year, rising to 5 per cent next year. The broker also has a 5p payout pencilled in for 2017, equivalent to a 6.5 per cent yield.

Lloyds' growth prospects look promising, too. The bank is a play on the UK economic recovery, as felt through consumers and businesses. In the first half, net lending to small- and medium-sized enterprises (SMEs) was up 5 per cent, consumer finance grew by 17 per cent and motor finance increased by a third. The improving debt environment fed through to a 15 per cent increase in underlying profit to £4.3bn, largely due to a big drop in loan impairments.

Income was 2 per cent higher during the half-year, while operating costs were flat - the group remains on target to deliver £1bn in run-rate savings by the end of 2017. This meant the crucial ratio of costs to income improved by 70 basis points to 48.3 per cent at the end of June, comfortably the lowest of the big five banks. The main concern for the retail business is the potential loss of mortgage customers if rising interest rates encourage them to shop around for better deals. Elsewhere, the group's Scottish Widows insurance business is also growing its asset base and has made its first steps into the bulk annuity market.

The government's stake in Lloyds is now below 13 per cent, down from more than 40 per cent at its height. The ongoing departure of a major seller from the scene can only be good news for the bank. The other big headache for the sector, the ringfencing of investment banking away from retail banking, should be less of a headache for Lloyds given that most of its business will sit outside the ringfence.

The major unknown is what the eventual size of the bill for past mis-selling of payment protection insurance will be. The bear case suggests that, following a recent Supreme Court judgment on what is becoming known as the Pelvin case, banks could be on the hook for further claims via the Consumer Credit Act. There is also an ongoing Financial Conduct Authority review to worry about, which could lead to a wider awareness campaign for would-be claimants. On the other hand, the regulator could decide to put a time limit on PPI claims, which would provide some relief to Lloyds. Market-watchers have factored in further redress costs - the forecasts in our table from Investec assume a further £1.5bn over the next two years.