Lloyds Bank

Lloyds Is Laughing in the Face of Brexit

But the country's largest mortgage lender has a lot riding on a painless departure from the EU.

A year ago, only the most rabid of Brexiteers would have believed that, with Britain poised to trigger its exit from the European Union, the country's biggest mortgage lender would be in profit, increasing dividends, boosting capital and promising an even better performance in 2017.

Yet here we are.

Forget Brexit

The U.K.'s No. 1 mortgage lender's shares reflect optimism for 2017 after solid 2016 results

Source: Bloomberg

Intraday times are displayed in ET.

Lloyds Banking Group has set investors' pulses racing with its earnings and its promise of a wider net interest margin in 2017 and a smaller jump in loan impairments than analysts expected.

This all seems like the stretchiest of stretch goals.

Britain's economy is expected to hit a bump this year. Inflation is on the rise and house prices are already falling faster than you can say "Article 50." Interest rates are likely to stay low, heaping pressure on banks' margins. Competition is also heating up, with some 40 challenger banks nipping at incumbents' heels.

A forecast of a 2.7 percent net interest margin in 2017, up from 2.69 percent in the second half of 2016, seems as optimistic as the way some of the tabloids see Brexit.

Things Can Only Get Better

Lloyds is forecasting a rise in net interest margins this year, despite economic headwinds

Source: Company filings, Bernstein research

But Britain's four biggest lenders still have the power to milk more profits out of an uncertain economy. Ultra-low rates don't just make loans cheaper for customers -- they also mean banks don't have to pay as much out to depositors.

Thanks to its large market share, Lloyds has been able to protect margins as interest rates fell after the June referendum by passing on those declines to customers. It can go further: smaller competitors are unlikely to mount much of a challenge, and policy makers are unlikely to exert much pressure for the time being.

Lloyds also gets the benefit of programs such as the Bank of England's Term Funding Scheme, which offers ultra-cheap funding to banks as long as they boost lending to customers.

That cut in funding costs and what Lloyds calls a "disciplined" approach to pricing deposits helped the company to lift its net interest margin by 8 basis points in 2016. I'd wager the first quarter will show more flexing of muscles in this regard.

Granted, Lloyds is a tightly run ship and CEO Antonio Horta-Osorio deserves credit for boosting capital, dividends and market share while holding back on mortgage lending in Britain's overheated housing market. The results were flattered, too, by the absence of a whopping bill for compensating customers who were wrongly sold payment-protection insurance.

The coming year will be a test of how well the country's banks can juggle their funding costs in the face of Brexit. It will also reveal just how competitive the U.K. market really is. Will banks lose significant deposits to rivals offering better rates?

A Nordic Bank In Brexit Britain

Lloyds' price-to-book multiple is above average and more in line with a Scandinavian bank

Source: Bloomberg Intelligence

Lloyds currently trades at a 10 percent premium to its book value -- a near-Scandinavian valuation. Its 2017 guidance on margins and impairments implies a 5 percent increase in earnings, according to Bernstein analysts.

Yet this is still a British bank and a play on the U.K. economy, its housing market and consumer health. Skeptics reckon the market's current optimism is a Brexit fantasy. Like Prime Minister Theresa May, Lloyds has a lot riding on a relatively painless departure from the EU.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Lionel Laurent in London at llaurent2@bloomberg.net

    To contact the editor responsible for this story:
    Edward Evans at eevans3@bloomberg.net

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