Lloyds (LSE: LLOY) (NYSE: LYG.US) is becoming stronger by the day as the bank continues to slim down its balance sheet and bolster its capital position.
A key part of the bank’s plan to strengthen its balance sheet has been to sell off mortgage assets. In particular, the bank’s loss-making Irish operation, which had £19.7bn of net exposure at its peak in 2010. Now, after years of unwinding, the mortgage book has fallen to around £6bn.
Of this £6bn, there’s only £1bn of net exposure to Irish non-performing loans. The rest of the book is still performing but forms part of the bank’s non-core Irish division, which is being steadily wound down.
Cash generation
Winding down its mortgage portfolio should help strengthen Lloyds’ balance sheet. Further, as the bank cuts costs over the next few years profitability and cash generation should increase.
Lloyds’ three-year plan will involve 9,000 job losses and 200 branch closures. 50 new branches will be opened in under-represented areas.
Additionally, £1bn will be invested to boost the bank’s online offering, it plans to develop new technology that will mean mortgages being approved in seven days, rather than 25, and business clients being signed up within a week instead of six. According to CEO, Antonio Horta-Osorio, Lloyds wants to be “as lean and as mean as possible”.
These changes should save the bank £1bn per annum. Services previously offered by these branches will be available online at a fraction of the cost to the bank. Moreover, it’s estimated that as a result of cost cutting, Lloyds’ return on equity — a key measure of profitability — will jump to 13.5% to 15% by the end of 2017. A high return on equity not seen since before the financial crisis, although this time the bank is taking less risk to achieve the return.
Budget changes
Unfortunately, while Lloyds itself makes changes to boost profitability, the recent changes to UK bank taxation rules will impact profits over the next few years. The new rules, introduced by the Chancellor in the autumn statement, cap the amount of profit in established banks that can be offset by losses carried forward.
At present, banks are allowed to carry forward losses racked up during the financial crisis to offset profit and eliminate their corporate tax bill. The profit cap will be set at 50%.
This cap is expected to raise £3.5bn for the exchequer over the next three years, a good chunk of which will comes from Lloyds, although other banks such as RBS and Bank of America will be hit as well.
Still, as the cap is only designed to eliminate losses incurred during the financial crisis, it should not have much effect to forecasts over the long-term.
The bottom line
Lloyds has spent the last few years recovering from the financial crisis but the bank is now in better shape than ever before. Cash generation is increasing and management has outlined plans for growth.
However, the real test will come when the Bank of England releases the results from its recent stress test. Lloyds only just passed the European Central Bank’s stress test, conducted earlier this year but the bank has been working to strengthen its capital position ever since. The BOE’s test should reveal a marked improvement in the bank’s financial stability.