At the beginning of August, Lloyds (LSE: LLOY) published its figures for the first half of 2018.
Investors had plenty to celebrate with statutory profit before tax jumping 23% to £3.1bn and underlying income rising 7% to £4.2bn. The bank also managed to improve its capital position by 121 basis points.
With the CET1 capital ratio now at 15%, up from 13.5% at the end of Q2 2017, City analysts are getting quite excited about the prospect for additional cash returns. However, while these positive headlines have attracted plenty of attention, there is a worrying trend developing on the Lloyds balance sheet, which could derail the bank’s recovery.
Money troubles
As one of the UK’s four primary banks, and the largest mortgage lender in the country, its balance sheet strength is highly sensitive to the health of the UK economy and consumer.
Since the financial crisis, consumer finances in the UK have only improved as rising wages and record low-interest rates have helped borrowers.
Over the past 12 months, the situation has started to change. Households are now borrowing far more than they can afford as inflation and stagnating wages have eaten away at disposable income.
According to the Office for National Statistics, last year British households took out £80bn in loans but deposited £37bn with banks. On average, each British household spent £900 more than it received in income throughout 2017.
Lenders such as Lloyds have been more than happy to provide this credit because profit margins on unsecured lending can be in the double-digits. The problem is, consumers have been borrowing more than they can afford, which is why the Bank of England warned lenders last year to rein in credit supply.
Turning bad
Some of these loans are already turning bad. In the first quarter of 2018, Lloyds reported that its loan impairment charge as a percentage of its loan book was 0.12%. Even though this is just a tiny fraction of its overall £40bn unsecured credit book, impairments are multiplying. During the second quarter, they jumped 67% to 0.2%. Management expects the ratio to be less than 0.25% for the full year, which implies further growth throughout the rest of the year.
What concerns me is what the rest of the year might hold. Since the end of the second quarter, the BoE has increased interest rates by 0.25% to 0.75% adding an extra £224 a year in interest costs to a £150,000 variable rate mortgage. At the same time, the rate of consumer borrowing has only intensified. For the year to the end of June, borrowing on credit cards rose 9.5% year-on-year.
Right now, default rates on these loans are low and manageable, and this situation might continue. If Lloyds has been a responsible lender, impairments should never pose a threat to the business.
However, after being bailed out by the government in 2008 for this reason, the risks of rising loan losses are still fresh in the minds of many investors and analysts.
With this being the case, I believe Lloyds’ share price growth will remain subdued and if impairments expand substantially, it could be time to sell. Personally, despite the potential for additioanl capital returns, I’m avoiding shares in the bank for this reason.
