The traditional business of any retail bank is simple – you take money from one set of people, in return for a modest interest payout, and you loan that money to another set of people to receive a far less modest interest payment.
A complex mechanism means commercial interest rates effectively have to move in line with the Bank of England base rate, but unfortunately for banks, the reduction in the interest it pays is far outweighed by the reduction in interest it receives. This, says Lloyds Banking Group (LSE: LLOY), will lead to a drop in its profitability next year.
Return on equity
Being fairly complex creatures, banks have many terms in the annual accounts that are somewhat different to those of other industries. One of these is Return on Tangible Equity (here is a case where it does what it says on the tin, so to speak), which is one of the main profitability measurements Lloyds uses.
The bank said that its ROTE figure for this year is now likely to be in the 12%-13% range, as opposed to the 14%-15% target it had previously set. In addition to the “low interest rate environment” (a phrase I have heard, read and written more times than I care to remember), Lloyds is also suffering due to increased competition in the mortgage market.
Here Lloyds has an advantage over some of its peers however, as it has been able to somewhat offset weakness in its mortgage arm with growth in higher return areas, such as unsecured consumer lending and car loans.
Just looking at its profit warning, a reduction in expectations from 14% to 13% hardly seems like the worst news. Indeed compared to its rival the Royal Bank of Scotland, which also reduced its target return on equity recently, the Lloyds forecast is higher than even the top end of RBS’s.
Job losses and pay cuts
Even so, Lloyds is not taking these concerns lying down. At the start of February, it said it would be unveiling a new, revamped bonus policy that is likely to slash executive bonuses by about 50%, and closely tie executive compensation with the wellbeing of the company. CEO António Horta-Osório, Britain’s best-paid banker, is likely to see his £6m pay package take a cut of more than £1m.
At the lower end of the employee spectrum, the bank announced it will be cuttting around 780 roles from its UK branches to reduce overheads. This is, I think, a very sensible decision. True we have all felt the frustration of going into our local bank branch and having to wait to see someone or even arrange meetings for things that a few years ago we could simply pop in for, but in truth, these event are few and far between. So many of us now do our banking online.
Lloyds has said that these staff/role reductions (a fine distinction that may include not replacing employees as well as letting some go) will not bring about any branch closures, but will mean “we can shape our service according to customer behaviour and local demand”.
The profit warning may not be the best news for Lloyds, but the measures it is taking to change things, I think, certainly are. Sensible belt tightening is usually good for share prices long term.
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Karl has no position in any of the shares mentioned. The Motley Fool UK has recommended Lloyds Banking Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.