Lloyds: The big income squeeze

The biggest contributor to Lloyds' £3.5bn loss was the £3.2bn cost of compensating customers missold PPI credit insurance. So in a sense it is old news.

But even without that charge Lloyds would have fallen back into losses of a few hundred million pounds in 2011, compared with £281m of profit in 2010.

The big story at Lloyds is how much weaker the British economy has been than it expected a year ago - and the semi-nationalised bank is also pretty gloomy about the outlook.

Perhaps the most striking trend is that what's called the interest margin - the difference between the interest Lloyds charges for loans and what it pays out in interest - has shrunk and will shrink again this year. The interest margin fell from 2.21% to 2.07% and is expected to fall by a similar amount in 2012.

One of the main reasons for this income squeeze is the rising cost for banks of borrowing money on wholesale markets, or from other financial institutions, at a time when what banks can charge for loans to customers remains under pressure - partly because central banks, and in its case the Bank of England, are keeping official rates at record lows, and partly because the demand for credit is subdued.

Lloyds is becoming less dependent on these less reliable wholesale sources of funding - as part of a strategic effort to make itself safer. And there has been considerable progress in that regard: its more dependable retail deposits represent 62% of all its funding today, compared with 56% a year ago.

But the price of wholesale funds is still a big influence on Lloyds' profits.

What's more, a year ago Lloyds was still borrowing significant sums from taxpayers, through the Bank of England's Special Liquidity Scheme. The Bank of England has now been repaid all that cheap, subsidised money, which is another reason why Lloyds' costs of borrowing are rising.

And, to repeat, that rise has been intensified by a general tightness in the wholesale funding market.

By October, Lloyds also has to repay £23bn of debt that is guaranteed by the Treasury though the Credit Guarantee Scheme, so that too will increase its funding costs.

And while Lloyds is earning relatively less from its core business, three other factors are depressing Lloyds' earnings: the regulatory burden is increasing sharply for all banks (a big hello to the 2008 banking crisis, horses and stable doors), Lloyds is offloading unwanted assets, and customers are borrowing less.

Some good news

That said, although Lloyds' customers in the round are repaying debts and borrowing less - largely because the penny has dropped that prospects for the UK economy are not what they were - Lloyds has succeeded in a lending a bit more to small businesses than what small businesses repaid.

Or to put it another way, Lloyds seems the only one of the big British banks to have increased its net lending to small businesses (although I think Santander, which is much smaller in the market, may have done this too).

Also on the more positive side, Lloyds is incurring smaller losses on loans going bad - although the Irish bad debt loss is still over £3bn.

As I implied, Lloyds is a stronger bank than it was, less dependent on unreliable wholesale funding, and with more capital to absorb potential losses. And in stark contrast to RBS, it appears to have offloaded unwanted assets and shrunk its balance sheet without taking substantial losses on these disposals.

However with prospects for growing mainstream income worse than they were, the chief executive Antonio Horta-Osorio is having to redouble efforts to cut costs - which presumably means that there won't yet be any respite in job cuts.

Lloyds, the UK's biggest mortgage lender, does not expect to be bailed out by any bounce in the property market: it forecasts house prices to be flat in 2012 and 2013.

That said, Mr Horta-Osorio is trying to increase income by encouraging staff to sell more insurance - which he'll have to do with some care, since he presumably won't want a repeat of the PPI credit-insurance misselling debacle.

I spoke to Mr Horta-Osorio this morning, and he says Lloyds is only one year into a three-to-five year process of rehabilitating the bank.

On the brighter side, he says that by the start of 2013, Lloyds may have adequate capital for the board to start thinking about the resumption of dividend payments.

Which matters to all of us, since until those dividends are being paid again, it is impossible to see how taxpayers' 40% stake in the bank could be sold at anything other than a colossal loss. For what it's worth, at the current share price our holding in Lloyds is worth around £10bn less than we paid for it.

In a way therefore British taxpayers are in exactly the same boat in respect of our investments in both Lloyds and RBS: both banks look stronger than they did, less likely to go horribly wrong and at-a-stroke kill the UK government's AAA credit rating; but goodness only knows when they will be making the kind of returns that would allow them to be privatised at a profit.