From a standing start, Lloyds Banking Group (LLOY) has improved its returns to equity investors in each of the last five years. Within this rising distribution, an increasing proportion has come from buybacks, at once propping up the share price and magnifying the impact of future dividends. Why then, shareholders might wonder, does the UK lender’s stock continue to drift sideways?
Claims that the core loan book has been restructured since 2010 are probably overdone. The mortgage portfolio may be 8 per cent smaller and lower risk, but in absolute terms, the group’s exposure to various slices of the UK economy are similar.
From an operational viewpoint, there’s more to crow about. Lloyds’ net interest margin – the difference between the interest earned from lending and paid to depositors – came in at 2.91 per cent for the first quarter, well ahead of UK peers. Compensation to payment protection insurance claimants are finally starting to unwind. And when it comes to efficiency, the group is also well ahead of peers: its cost-to-income ratio led the pack by a distance in 2018, and fell to an impressive 44.7 per cent in the first three months of 2019.
Management believes this can fall further, and expects operating costs to drop below £8bn in 2019. But judging by recent history, this is becoming harder to achieve. While business-as-usual overheads have fallen 15 per cent since 2014, most of this has been largely offset by rising investments, including a ring-fenced commitment to spend at least £3bn on strategic initiatives between 2018 and 2020.
Lloyds calls this capital expenditure a “virtuous cycle of efficiency”, though with every bank striving to improve their customer experience and fend off digital-only challengers, it’s not yet clear what return these investments promise, or if greater efficiency means higher revenues.
For income-seeking investors this is a critical question, especially while potential tailwinds from the UK economy and the Bank of England remains motionless. Indeed, various sell-side analysts suggest Lloyds investors should assume no growth in adjusted net profits to 2021.
But there’s going to have to be a trade-off, and it’s not yet clear where shareholder returns will sit in the pecking order. Two months ago, the market excitedly reacted to the news that Lloyd’s board had determined its own common equity tier-one ratio could drop from 14 to 13.5 per cent, inclusive of a management buffer, after the Prudential Regulation Authority’s revised the systemic risk buffer applied to Lloyds’ ring-fenced bank. To some, the implication was clear: an additional £1bn buy-back was on the way.
There are at least three reasons why shareholders shouldn’t leap to conclusions. The first is the hand the bank has been dealt: namely, the persistently negative impact of Brexit-induced uncertainty on the economy, to which Lloyds is most-geared of any of this year’s 10 income majors. Second, and considering the economic backdrop, it seems unlikely that the European Banking Authority will welcome any decline in regulatory capital levels among systemically important lenders, having just suggested large banks’ reserves need further strengthening. Third, shareholder returns are just one of four priorities – alongside increased technological investment, loan growth and market expansion – which management has decided will compete for the forecast free capital build of 170-200 basis points per year.
