Since the end of April 2024, the Lloyds Banking Group (LSE:LLOY) share price has risen over 35%. Given that its 2024 earnings per share of 6.3p was 1.3p lower than in 2023, this strong performance is a little surprising to me. Although, I’m sure the 15% increase in the dividend has played a part.
A simple business model
Like all banks, Lloyds attracts customer deposits by paying interest on their savings. This money is then lent to others. Due to the risk involved, a higher rate is charged on borrowings. The difference between the interest paid on deposits and that earned on loans — expressed as a percentage of interest-bearing assets — is called the net interest margin (NIM).
Monetary policy decisions by the Bank of England (BoE) are, therefore, going to impact earnings. Conventional wisdom is that banks do better when interest rates are higher. Indeed, this is one of the reasons why Lloyds’ 2023 result was better than in 2024.
Since reaching a 15-year high of 5.25% in the summer of 2023, the BoE’s cut the base rate by 0.75%. Three-quarter-point reductions in August 2024, November 2024 and February, means the benchmark’s currently 4.5%.
And with another cut expected on Thursday (8 May), and some economists predicting another three reductions over the remainder of 2025, Lloyds’ NIM could come under pressure.
A positive outlook
But I don’t think this is necessarily the case. Indeed, analysts are expecting the bank’s margin to increase over the next three years. The average of their forecasts is 3.02% (2025), 3.15% (2026) and 3.22% (2027).
To see why, let’s look at Lloyds’ 2024 accounts. By charging an effective rate of 6.88% on loans, and paying an average of 3.99% on savings, it generated net interest income of £12.28bn.
However, reducing both of these by one percentage point would have increased income by 1.6% to £12.48bn. It’s the relative value of total loans and deposits that has the biggest influence on earnings.
Pros and cons
But there are signs that the sector’s becoming increasingly competitive. All major banks are now offering fixed rate mortgages below 4%. Regardless of what decisions are made by the UK’s central bank, this could adversely impact earnings.
And there’s another challenge that Lloyds faces. The investigation into the alleged mis-selling of car finance could result in significant compensation having to be paid. The bank’s set aside £1.35bn as an estimate of potential costs. However, one forecast I’ve seen is suggesting the final bill could be as high as £3.9bn.
Also, with nearly all of its earnings coming from the UK, the bank’s finances – in particular, the value of bad loans – is heavily influenced by the performance of the domestic economy.
But even if the car finance investigation goes against the bank, and the UK economy struggles, it has the size and balance sheet strength to cope. At 31 December 2024, it had gross assets of £906.7bn, including cash of £62.7bn.
Although interest rates are likely to fall, the bank’s earnings – and therefore its share price – could continue to rise. As long as it’s able to generate new business and grow its loan book, as analysts are expecting, its NIM could go up. On this basis, long-term investors could consider taking a position.
