Lloyds Banking

Lloyds reported first-half underlying profits of GBP 4.2 billion, up 18% versus last year. Solid income momentum in both interest and noninterest income, paired with flat operating expenses, created a positive operating leverage effect.

Why it matters: Lloyds runs a large mortgage book, which is a competitive market. The headwind from pricing remains in mortgages, but is offset by a strong contribution from the structural hedge. The banking net interest margin expanded 5 basis points from the first quarter to the second quarter. Lloyds is focusing on a cross-selling strategy to leverage its large mortgage book and expand volumes in unsecured and commercial loans, driving a solid income performance across interest income (up 9%) and other income (up 11%). Operating expenses were flat year over year as cost savings and lower severance payments compared with the first half last year offset wage inflation and business-as-usual growth investments. We think full-year guidance of costs below GBP 9.9 billion is achievable given this result.

The bottom line: We increase our fair value estimate to GBX 111 per share from GBX 97 per share previously. We have lifted our net interest margin expansion assumption through 2028 and model a higher operating efficiency, assuming more cost savings to structurally lower the cost base. Our new assumptions allow for a greater capacity for capital distribution to shareholders. We now model a progressive dividend with a payout ratio of 45% and GBP 3 billion in share buybacks per year. With base-rate expectations firmly pointing toward hikes over the next couple of years, we have lifted our net interest margin assumptions by 10 basis points. We now think that the structural hedge tailwind can offset more of the margin pressure headwinds in our explicit forecast window.

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Our fair value estimate is $5.95 per share and corresponds to a multiple of 2.0 times the 2026 estimated tangible book value.

We anticipate that net interest margins will peak in 2028 as the structural hedge supports a strong baseline net interest income. Competitive pressures in mortgage markets and deposits are likely to offset some of this benefit, but we expect the structural hedge to remain dominant in the medium term.

We expect further efficiency gains primarily through decommissioning legacy systems and reducing maintenance costs. We see the cost/income ratio, excluding remediation charges, dropping to 45% in 2026 from 49% in 2025. We pencil in a GBP 200 million annual remediation charge through our explicit forecast period, down from the elevated GBP 968 million charge related to the motor finance probe in 2025.

Our midcycle return on tangible equity is 19% versus a cost of equity assumption of 9.8%.

We assign Lloyds a narrow moat rating.

We believe Lloyds has a durable competitive advantage, allowing the bank to consistently outearn its cost of equity. Through its retail franchise in the UK, Lloyds has access to low-cost and stable funding, which we believe creates a cost advantage. Although barriers to entry in the UK banking market are relatively low, barriers to scale are high, protecting Lloyds’ position as one of the largest UK-focused banks.

We believe that Lloyds’ retail bank benefits from a deposit-funding-based cost advantage. The four large banks, Barclays, Lloyds, NatWest, and HSBC, hold the majority of retail current account deposits (non-interest-bearing or low-interest-bearing accounts) in the UK. While household and corporate lending are competitive, the ability to earn a spread on the funding side sets these four banks apart.

Despite the launch of a customer current account switching service in 2013, the dominance of the large four UK banks controlling the majority of deposits has not changed materially. We believe that the large four banks in the UK benefit from scale and scope advantages that improve the unit economics of owning and attracting deposits. Paired with low incentives to switch (that is, product homogeneity across the industry), we believe a large portion of the deposit funding controlled by the four large UK banks is sticky.

As of the first half of 2025, Lloyds’ structural hedge includes GBP 214 billion of non-interest-bearing and low-interest-bearing deposits that display sticky and structurally stable characteristics. This covers about 32% of Lloyds’ total funding requirement compared with 33% at NatWest and 13% at Barclays.

The UK banking regulatory environment encourages new entries into the banking space, as is evidenced by the relatively high issuance of banking licenses in the UK. That said, growing a bank from midtier to large in the UK is difficult, as capital and funding rules are tilted to the advantage of large-scale players. Banks with assets above GBP 40 billion are required to issue costly bail-in debt, which disproportionately puts smaller challenger banks at a disadvantage. Large UK banks also find it easier to spread the costs of operating internal risk-based models across their business compared with smaller banks. The advantage of running an internal risk-based model can be substantial, allowing a bank to apply lower risk weights to asset classes for which it can show that standardized risk weights would have overcapitalized the bank through the last full credit cycle. Challenger banks often do not have a track record spanning a full credit cycle that could be used to build these advantageous risk models. Last, ring-fencing rules prevent large non-UK banks from quickly gaining scale within the UK. Any UK retail bank with assets above GBP 25 billion is required to be its own separate entity, with its own operations and infrastructure, and its own funding and capitalization.

Material value destruction is possible, but the potential impact is limited. Lloyds’ balance sheet is primarily focused on mortgage lending (about 70%), exposing it to the UK economy and potential credit defaults of its borrowers. We view the likelihood of material value destruction as low and its impact as modest.

The bank’s business model is well positioned for the challenges that the current economic outlook poses.

The structural hedge supports a widening net interest margin despite expectations of base rate cuts.

Due to its strong deposit base, Lloyds can earn a healthy spread on above-zero base rates again.

Its heavy reliance on net interest income makes Lloyds' performance more susceptible to interest rate changes.

Its pure UK exposure leaves little room for earnings diversification.

The motor finance probe is a risk to shareholder value, given the wide range of economic outcomes for Lloyds.