Lloyds Banking Group Plc: Significance of Impairment

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The Lloyds Banking Group plc (formerly Lloyds TSB Group plc) is a UK based financial services conglomerate that offers a wide range of banking and financial services for its corporate and retail clientele.

The impairment of assets in all industries, especially so in financial services, assumes significant importance in the difficult contemporary economic environment.

The objective of this Report is to examine the significance of impairment for the financial progress and position of the Lloyds Banking Group, with particular emphasis on the amounts set aside for impairment and their impact on the income statement and the Balance Sheet.

The causes of impairment during the six months to June 30, 2009, as well as the management's assessment of the significance of impairment for the group's future are also addressed.

This analytical report has been prepared at the behest of a client who has expressed an interest in investing in the equity stock of Lloyd's plc.

Introduction

It is exceedingly important for companies to reflect the true and fair view of the state of affairs of their organisations, as on the date of the preparation of the balance sheet. It has historically not been easy to understand the fair market values of assets and liabilities in the financial results reported to stakeholders. Accounting standards, to this end, now postulate that assets and liabilities need to be largely stated at their present values, taking account of accepted methodologies to assess requisite write-downs, or charge to income statements, on the basis of discounted future cash flows, for arriving at consequent reduction in asset values. Such write-downs are known as "impairments".

A careful study of the significance of impairment on the financials of the group allows for a clear understanding of the financial numbers elaborated in the company's annual report and a realistic appraisal of future prospects.

Analysis

The company has a detailed and comprehensive system for assessment of impairment. Each group company assesses, at least once a year, all the evidence of financial assets and asset groups to determine the need for impairment of such assets after their initial recognition in the accounts (Annual Report, 2008). The need for impairment is assessed on the basis of specific features, namely (a) delinquency in contracted payments of principal or interest, (b) indications that borrowers may be in financial trouble, (c) debt restructuring and renegotiation of loans to ease borrowing terms, (d) violation of loan terms and conditions, and (e) commencement of bankruptcy proceedings (Annual Report, 2008).

The concerned group company management evaluates its portfolio to determine the period between the emergence of the loss and its detection, which by and large varies from two months to a year; the establishment of occurrence of such loss results in the computation of the charge, which is represented by the difference between the value of the asset, as of the last balance sheet, and the present value of anticipated cash flows after discounting them at the original interest rate (Annual Report, 2008). A case-by-case approach is adopted for smaller loans and other portfolios for ascertaining impairment allowances (Annual Report, 2008). The financial assets that are available for sale and renegotiated loans are also subjected to impairment tests in order to ascertain their carrying values in financial accounts (Annual Report, 2008). The factors that are considered to be relevant for impairment assessment include credit risk features, asset types, industry, geographical position, nature of collateral, history of past dues, and prospects of recovery. It is important to note that renegotiated loans are reckoned as fresh loans and not past dues (Annual Report, 2008).

The consolidated impairment losses for the bank increased by GBP10,885 million from GBP 2,514 million to GBP 13,399 million in the first half 2009 (Interim Results, 2009). The impairment charge on loans and advances to customers was 3.47 % of average lending, compared to 0.70 % in 2008. Impaired assets increased to GBP 49,019 million, i.e. by 57 %, and now account for 7.2 % of total customer loans and advances, compared to from 4.4 % at the close of the previous year. Around three fourths of the group's impairment charges for the first half relate to assets expected to be considered in the Government Asset Protection Scheme (Interim Results, 2009).

"Consistent with our announcement given earlier this year, during the first half of 2009 we have experienced a significant rise in impairment levels in the Group's lending portfolios. This largely represents falls in the value of commercial real estate, the impact of the further economic deterioration during the half, including the effects of rising unemployment, reduced corporate cash flows and the continuing impact of lower house prices." (Interim Results, 2009)

The management of the bank feels that the overall impairment charge should not exceed the levels indicated in the interim results (Interim Results, 2009). The bank's management expects that impairment levels should reach their peak within two years of the lowest recession point. Considering that the wholesale segment's charge of GBP 9,738 million in the first half of 2009, which were chiefly driven by the HBOS Plc property and other property associated business segments, was incurred earlier than anticipated, the management feels that the charge in the second half of 2009 will be lesser than in the first. It consequently expects the 2010 charge to be significantly less than that incurred in 2009 (Interim Results, 2009).

Tim Tookey, the finance director, reports, in the course of 2009 interim reports that the bank's performance has shown resilience and whilst interest margins are under pressure, they are expected to recover in the coming months (Interim Results, 2009). The bank has good cost management abilities and plans to achieve good synergies through attractive future acquisitions. The management believes that the group's overall impairment charge has peaked, and expects a significant reduction in the impairment charge in the second half of 2009 (Interim Results, 2009). The bank has a strong capital position and robust funding abilities, which are expected to improve because of its proposed participation in the Government Asset Protection Scheme (Interim Results, 2009).The second half of the year is expected to be difficult but manageable, with good upsides on medium term earnings (Interim Results, 2009).

Conclusions

The substantial decline in the UK economic environment during the last six months has created a particularly challenging situation for the group. The considerable increase in impairments, against this backdrop, has expectedly resulted in the group incurring a loss in the first half of 2009, before the impact of credit from goodwill on acquisition of HBOS Plc (Interim Results, 2009). The Group has strong risk management abilities and the resources to manage immediate challenges; it stands to gain from the inevitable UK economic revival, as and when it occurs (Interim Results, 2009).

The group's achievement of economic stability during the ongoing economic downturn bodes favourably for the future, despite the significant impairment incurred in 2009. With the management expecting the impairment to abate in 2010, it would be advisable to make good use of the depressed prices and invest in the group's share for achievement of medium to long term returns.

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