Good morning. Welcome to the OSB Group PLC 2023 interim results. My name is Glenn, I'll be the operator of today's call. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star one on your telephone keypad. To withdraw your questions, please press star two. I would now like to turn the conference call over to our host, Andy Golding, CEO of OSB Group. Please go ahead.
Thank you. Good morning, everybody. Thank you for attending the OSB Group's 2023 half year results. It's good to get back to an in-person meeting and good to see a number of familiar faces in the room. Firstly, I am truly sorry that this reporting period is impacted by the recent announcement we made regarding the impact of changing customer behavior in our Precise Mortgages book on the EIR accounting and consequently, the adverse adjustment we had to book in the first six months. This has, of course, reduced our financial KPIs in the period, and whilst we are here to provide any further color that analysts and shareholders may require, I cannot emphasize enough that the business remains in a fundamentally strong position.
I hope that sharing some of our key operational successes with you through this presentation will only seek to remind you of a number of the positives that make the group a strong and long-term proposition for both customers and owners alike. I'm going to start by giving a brief summary of the key highlights in terms of performance for the first half. April will then take you through some of the more detail in terms of the numbers. You'll then hear a little bit more from me on how our lending and savings franchises have performed, followed by the outlook before we open up to Q&A. Just checking it changed. Gross organic lending increased by 2% in half one to GBP 2.3 billion, despite a clear softening of the wider market, driven by the increased living and borrowing costs, denting purchaser confidence.
The net loan book grew in the first half by 4%, 5% before the impact of the adverse EIR adjustment, demonstrating the strength of our lending franchise. We are now the fourth largest buy-to-let lender in the U.K., according to the UK Finance data. We've continued to increase our market share of new business flow during half one, without compromising our underwriting standards. We have focused Precise Mortgages on growth in the residential sector and Kent Reliance on really serving the professional landlords who still are making purchasing decisions, as well, of course, as having more complex refinancing needs, which play well to the Kent Reliance strengths.
Our InterBay brand has seen more than a twofold increase in lending during the period, and retention performance across the board has been strong, with now 75% of borrowers in Kent taking a new product with the group within three months of their deal maturing, and an already very encouraging 59% in Precise Mortgages as our choices program there gains traction, enabling us to lock in long-term income generation for the future. We remain committed to doing the right thing for our customers. I'm pleased to confirm that we're embedding the new Consumer Duty rules into our business and have signed up to the government's Mortgage Charter.
Turning to our strong credit and risk management, ECL provisions have increased during the first half, driven by moderation in house prices, a continued worsening, sorry, of the macroeconomic outlook, modeled IFRS 9 staging migration, and a handful of specific provisions. However, importantly, three month plus arrears have remained broadly stable at 1.2%. The group remains well capitalized and highly liquid, a position that we feel is very important when facing into macro headwinds. We've enjoyed strong growth in retail savings and attractive post-swap costs, and customer Net Promoter Scores remain excellent. Our capital position is strong, with CET1 at 15.7%, and in April, the group issued GBP 250 million of MREL qualifying Tier 2, making further progress on optimizing our capital stack.
We have declared an interim dividend of 10.2 pence per share in line with our stated policy. We continue to target a medium-term CET1 ratio of 14% once the capital stack has been fully optimized. The board remain committed to returning excess capital to shareholders. This, of course, is contingent on us being able to issue senior Holdco debt to meet our interim and end state MREL requirements. I'll cover more about the outlook and our guidance later on. We remain excited by the opportunities in our core markets. I hope that my introduction has provided a useful reminder of the simple fundamentals that provide the backdrop for us to continue to deliver attractive and sustainable returns across the cycle. These two slides show our strategy and our underlying financial highlights. On the underlying slide, we've shown our KPIs, excluding the EIR adjustment.
I think it's important to understand the underlying strong shape of the business. For example, excluding the EIR adjustment, the ROE would have been 22%. April will cover each of these for you in her review, but I hope this snapshot reiterates my points regarding the fundamentals of the group under normalized trading. I'll now hand you over to April to talk you through the numbers in more depth.
Thank you, Andy, and good morning, everybody. Before I start, I would like to add my own apology for the EIR adjustment we announced in our trading update on the 6th of July, and the impact it's clearly had on our financial performance in the first half. Today, we are confirming a total underlying EIR adjustment for the group of GBP 180.7 million, which is GBP 208.5 million on a statutory basis, based on behavioral assumptions consistent with those outlined in the trading update, and also consistent with an additional month of behavioral observations since then. I'll talk more about the EIR adjustment later, and I'm sure we'll cover it in Q&A as well.
Turning to the slide, we've presented the performance in the first half on an underlying basis, before and after the EIR adjustment. This slide explains the key drivers of the first half ROE of 8%, or as Andy mentioned, 22%, excluding the impact of the adjustment. The group delivered an underlying pre-tax profit of GBP 117 million for the first six months of the year, down 60% from GBP 294 million in the prior period, with the benefit of net loan book growth and improved margins, more than offset by the adverse EIR adjustment and a higher impairment charge. Excluding the EIR adjustment, underlying PBT would have been GBP 297 million.
Again, excluding this adjustment, underlying net interest income grew by 25% to GBP 461 million, due primarily to growth in the net loan book and a strengthened net interest margin, which was up 31 basis points to 333 basis points on an underlying basis, marginally exceeding expectation and reflecting the beneficial impact of rate-rising base rates. More on that later. We continue to maintain our strong focus on cost discipline and efficiency, with administrative expenses coming in slightly below our expectation in the first half. The underlying management expense ratio of 78 basis points was 6 basis points higher than the prior period, reflecting the anticipated impact of inflation and planned investment in people and operations. The underlying cost to income ratio increased to 40% in the first half due to the lower income following the EIR adjustment.
Excluding this adjustment, it increased marginally by 1 percentage point to 24%. Looking ahead, we expect an underlying cost to income ratio of around 29% in the second half due to planned further investment in the business, as we make further progress on the next phase of our technology investment, focusing on improving efficiency in our business operations. Taking that second half guidance would result in a full year ratio of circa 33%. We recognized an underlying loan loss equivalent to a ratio of 37 basis points in the first half of the year, due primarily to moderation in house prices and a worsening of the economic outlook, as well as modeled IFRS 9 stage migration. I'll provide more detail on the key drivers a bit later.
Turning to the income statement, you'll see that we recognized a net underlying fair value loss on financial instruments of GBP 12.1 million, compared to a gain of GBP 11.1 million in the previous period. The key driver behind this change was a loss in respect of the ineffective portion of hedges that arose from recent swap volatility and will unwind over the remaining life of the hedged fixed rate retail savings bonds and mortgages. This was partially offset by further gains on pipeline mortgage swaps, which will also reverse over the life of the swaps. Underlying earnings per share of GBP 0.195 in the first half, reduced by 60% versus the prior period, commensurate with the reduction in profit. Underlying EPS would have increased to GBP 0.513, excluding the EIR adjustment.
Turning to the next slide, which summarizes our strong, secure balance sheet. Thank you, Andy. Our net loan book increased by 4% or 5%, excluding the EIR adjustment in the first half, to GBP 24.6 billion, supported by GBP 2.3 billion of gross new lending, which was up 2% versus the first half of 2022. Retail deposits grew by 5% to GBP 20.7 billion as at the 13th of June, as the group continued to attract new savers. We remain predominantly retail funded, with the diversification provided by Bank of England funding schemes and securitizations. We repaid GBP 301 million of funding under the Indexed Long-Term Repo scheme during the first half, and drawings under the TFSME scheme remained unchanged at GBP 4.2 billion.
As Andy mentioned in June, we completed a GBP 330 million FTS securitization of owner-occupied prime mortgages, originated by Precise Mortgages under the CMF program, which really demonstrated investor demand for group issuance. The credit quality of our loan book remains strong, with three-month plus arrears broadly stable for the group at 1.2%, and that includes OSB at 1.3% and CCFS at 1%. Andy will talk to the interest coverage ratios for buy-to-let originations a bit later. Our loan book is secured at sensible loan to values. The weighted average book LTV for the group increased marginally to 63% in the first half, from 60% at 2022 year end, reflecting a moderation in house prices in the period.
The new lending LTV improved marginally to 68% from 71% in the first half of last year, demonstrating our continued focus on the risk assessment of new lending. Turning to the next slide, more about the EIR adjustment, as promised. The EIR adjustment of GBP 178 million related to the Precise Mortgages book and the estimated time that borrowers would spend on the reversion rate at the end of their fixed rate term. The Precise Mortgages products were designed to move to a revert rate, which was similar to both the initial fixed rate and open market rates, and you can see that on the red line of the graph. In contrast, our Kent Reliance brand has historically had a high step up in reversion, providing a clear incentive to refinance.
In light of this, Kent Reliance has a long and well-established broker-led choices program to encourage borrowers to switch to a new product with us quickly, and we assume that on average, they spend circa one month in reversion. The graph on this slide demonstrates this difference in how each band stepped up or down in reversion, using five-year fixed buy-to-let through time. You can see that sharp acceleration and step up, especially from late 2022 and through the first half of this year, due to the unexpected rapid rise in base rate. These rate rises and the volatile rates outlook led to customer behavioral changes for Precise borrowers, and over the course of the first half, we observed a step change in how long customers were spending on the reversion rate before selecting a new product with us or refinancing.
In particular, the attrition rate of borrowers who stay on the reversion rate for several months. This moved our expectation of the number of months spent on the reversion rate down by 12 months to five months, as at the end of June, giving rise to the EIR adjustment. Following this adjustment, the potential impact of any future behavioral changes is much reduced. The impact on net interest income of ±3 months spent on reversion is GBP 70 million. We've also disclosed the impact on the group's net interest margin for new origination, assuming 12 months less spent in reversion for the Precise customers. Keeping all other assumptions unchanged, including pricing, swap spreads, cost of funds, and product mix, would lead to a reduction of just 11 basis points based on group applications in June.
This will obviously take time to come through in the overall group net interest margin due to the size of the back book. The next slide shows our NIM waterfall, where you can see the high-level drivers behind the NIM in the period. Underlying NIM reduced to 203 basis points from 303 basis points in the second half of last year, with the benefit of base rate rises more than offset by the adverse EIR adjustment, which accounted for 130 basis points. Moving from left to right on this waterfall, the retail funding spread benefited from delays in the market, passing base rate rises on to savers in full. The cost of new retail funding also benefited from widening swap spreads, particularly at the one and two-year points where we raise retail funds.
There were also delays, though, in mortgage pricing, reflecting the rate rises in full and volatile swap spreads. Slightly lower impact you can see in the amber bar. Other funding primarily relates to the benefit of increased average funding from Bank of England and equity, as well as favorable swap margin calls. The underlying net interest margin for the second half of 2023 is expected to be broadly flat to 2022 after the expected impact of further planned MREL qualifying debt issuance, subject to market conditions, resulting in a full year NIM of circa 2.6%. The next slide provides a waterfall of the movement in the statutory impairment provision in the first half.
As you can see from the chart, and again, moving left to right, we adopted more adverse forward-looking macroeconomic scenarios in our IFRS 9 models, which, together with house price moderation in the period, accounted for a GBP 12.6 million increase in provisions. Enhancements to models and updates to post-model adjustments to reflect the potential impact of the rising cost of borrowing on customer affordability led to an increase of GBP 8.4 million. A GBP 4.5 million increase in provisions related to accounts with arrears of three months or more, and a further GBP 15.8 million related to changes in the credit profile of borrowers as they transitioned through modeled IFRS 9 impairment stages. This transition was primarily movements from Stage 1 to Stage 2. Individually assessed provision increases, net of write-offs and other items, totaled GBP 0.8 million.
You can see that our total coverage ratio has increased by 15 basis points in the first six months and remains more than twice the level it was pre-pandemic at the end of 2019, as geopolitical, inflationary, and cost of living concerns have replaced pandemic-related concerns. We will continue to proactively review our forward-looking economic scenarios and coverage ratios as the outlook evolves. Okay, let's take a look at capital. You can see that the group's CET1 ratio remains strong at 15.7% at the end of June. Again, going from left to right in the waterfall, which explains the movement in the CET1 ratio in the period, you can see our very strong capital generation from profitability of 2% prior to the EIR adjustment. We utilized 0.8% to support the 4% growth in the loan book during the period.
The impact of the declared interim ordinary dividend was 0.4%, and the full effect of the GBP 150 million share repurchase program announced in March was immediately deducted from capital with an impact of 1.4%. We also had non-cash transitional and other items of 0.8%. Finally, the impact of the statutory EIR adjustment on capital and RWAs was 1.2%. The next slide provides an overview of the components of the group's minimum capital requirements, its capital resources at the end of June, and our interim MREL requirement from July next year. Total capital resources as at the end of June of 19.2% include the benefit of our successful 250 million MREL qualifying Tier 2 issuance in April.
As Andy said, this marks further progress on our journey to optimizing our capital stack. The group continues to target a CET1 ratio of 14% once the capital structure has been optimized fully. We intend to come to the market with a program of further MREL qualifying debt issuance ahead of our July 2024 interim MREL requirements, likely in two separate benchmark sized issues. We expect to operate above the 14% target in the meanwhile. As we wait for clarity on the implementation of Basel 3.1 later this year and its timing versus the group's IRB accreditation, the group continues to actively engage with the PRA on the timing of our IRB application relating to rating systems covering our core buy-to-let and residential first charge mortgages. The group is ready to submit module 1 when regulatory consent is provided.
In line with our stated dividend policy, we've announced an interim dividend of GBP 0.102 per share. As with previous years, the board will make its full year dividend recommendation with the full year results, taking account of, amongst other factors, the economic outlook at that time and continuing, continuing progress against the group's MREL eligible debt issuance program. The board is confident that the group's strategy and proven capital generation capability can support both strong net loan book growth and further capital returns to shareholders, supported by further planned issuance of MREL qualifying debt in advance of the group's interim MREL requirement in July, subject to market conditions. I'll now pass back to Andy, who'll give an update on our lending and funding franchises.
Thank you, April. Philip, I'll have to check the slide is on the right one for you. Our award-winning lending franchises continue to drive retention and deliver growth while maintaining our position at the forefront of the market. Originations in both buy-to-let and residential have been encouraging, despite that more subdued overall market, both in terms of volume and quality. Our carefully selected commercial lendings perform well, too, reporting a near doubling of originations following our renewed focus in that subsegment, through our InterBay brand. Average interest coverage ratios for new originations have reduced, as expected, given the significant increase in underlying mortgage rates, but clearly demonstrate that landlords have been able to balance raising rents with their costs. In H1, they were healthy at 178% and 154% for OSB and CCFS, respectively.
Despite house price moderation, our LTVs remain sensible across the group. Professional landlords accounted for 91% of OSB's buy-to-let completions in the period, and limited company mortgages represented 86% of Kent Reliance and 65% of Precise completions, an increasing trajectory that continues to play to our strengths. Our funding platform continues to deliver to our savings strategy of attract, retain, and satisfy. We opened circa 86,000 new savings accounts in the period, despite increasing competition for deposits, and we retained, through reinvestment into new fixed rate products, 90% and 87% of maturing deposits in OSB and CCFS, respectively. Net promoter scores stayed high at over 60+ in Charter Savings Bank and 71+ in Kent Reliance.
We've been working hard on our technology development during the first half and expect to be able to launch a new customer-facing savings platform in H1 2024, which will enhance the journey for our savers while delivering operational efficiency within the business. Our Bank of England funding through TFSME remained unchanged at GBP 4.2 billion. In June, we completed that GBP 330 million securitization transaction of prime residential mortgages. In summary, a strong operational performance and the fundamentals still good. Clearly, I'm disappointed that the period has been impacted by the adverse EIR adjustment. We remain cognizant of uncertain macroeconomic outlook and the impacts of the higher cost of living and borrowing on the mortgage market and specifically customer affordability.
However, we have a healthy pipeline of new business and have a proven track record of retaining and attracting new customers and working with high-quality borrowers. Based on current pipeline and application volumes, we continue to target underlying net loan book growth of circa 7% for 2023, supported by that widely reported demand mismatch in rental property supply. As we look at current pricing and funding costs, we expect underlying NIM for half two 2023 to be broadly flat to the full year 2022, resulting in a full underlying net interest margin of circa 2.6% after the expected impact of further planned MREL qualifying debt issuance, subject to market conditions.
We expect the underlying cost to income ratio to be circa 29% for H2, therefore 33% for the full year as we continue to invest in improving customer experience and upgrading some of our core systems. The group does have a track record of delivering strong results, whilst the adverse EIR adjustment has had a disappointing impact on H1, I hope that you will agree that our underlying strengths of our business model are not in doubt, that despite some macroeconomic uncertainty and headwinds, we look forward to the future with cautious optimism. Thank you for listening, we will now open up to Q&A. We're going to do Q&A from the room first, then we'll ask if we've got questions. First hand I saw was Gary, so...
It's Gary Greenwood from Shore Capital. I, I just wanted to ask about the impairment charge, which I think during the first half was higher than what I've done on standard for the full year. I was just wondering, to what extent are you, you just taking a prudent view there? Because it looks like it's mainly provisions that will... ... rather than actual underlying losses. Obviously, the EIR change, assumption changes, were a surprise to most. Is this just management trying to be very cautious? Then how should we think about impairment charges coming through in the second half of the year? Should they be lower?
Thanks, Gary. April.
Thanks, Andy. Morning, Gary. I mean, a lot of this was a worsening in the economic outlook, and obviously the knock-on impact that has on our post-model adjustments from an affordability assessment perspective. Really, it's because of the worsening outlook through to June when it came to both inflation and interest rates. You're right, the underlying performance of the book remains very strong. I suppose, as we sit here today, I think everything looks a little bit better, but it clearly has been quite a volatile ride, hasn't it, from a macroeconomic outlook over the last year or so. I think we're, we're suitably positioned. I mean, I think we've always been a little bit more conservative, perhaps, than the pack when it comes to our assumptions for HPI.
I think the main change in our scenarios, other than a higher peak for base rates, was the HPI would be just like a little bit steeper peak to trough, but also a more prolonged trough, and that's really what's been driving it. Clearly, the expectation of higher sort of end peak rate for base rate has had an impact on our post-model adjustments as well for affordability. As I said, I think, you know, whether it's credit performance, economic outlook, the SONIA curve, you know, everything's looking a little bit better now. If that continued, then one would expect a more benign second half.
Thank you.
Okay. We'll go here next.
Hello, it's Perlie from KBW. Can I ask you about margins? First of all, I think the second half guidance is effectively 303 basis points, right? A flat to full year 2022. It's quite a large step down, 30 basis points, when obviously some of that would be MREL issuance cost. I guess the cost of fund and passing on, on the lending side probably broadly balance each other out a bit. Is it all because of the MREL? Because that sounds quite a lot. Just what else is in there, in that assumption? Yes, that's number one.
The second question is: What are your assumptions with regards to the unwind or of the forward-looking part of the EIR adjustment that you've taken, and whether that 303 half two guidance includes that? I guess, more broadly, how does that unwind interact with the 11 basis point impact on the sort of front end, that impact that you're seeing on the front end?
You've hit me with a technical EIR accounting question. I'll try and be succinct. I think those are both for me, aren't they? Drive to the second half NIM. Well, clearly, you're absolutely right. Part of the impact, but only part, is due to the coupons on both the Tier 2 issued in April, but also a few months of coupons on our planned further issuance program of senior Holdwhole loan debt. The other item is that we've got mortgages which are maturing onto lower prevailing rates. As we honored our application pipeline, I think we've spoken about this in the past, we honored the application pipeline and our offered retention pricing through a period of swap spread volatility and periods of time when those swap spreads widened.
I suppose that, that was a very deliberate stance, and it's stood us in very good stead when it comes to our broken Net Promoter Score, and also our ability to grow, our market share during the first half. It has had some impact on margins in the second half. We're also assuming that the cost of retail funds settles at closer to SONIA through the bulk of the year. Over the last 18 months, we've had opportunities to raise retail funds that's significantly below SONIA. You'll also, if you think about the more longer term view for NIM, clearly as the, you know, that 18 months worth of funds that significantly sub-SONIA comes to refinance, and if I'm right, that will sort of settle closer to the SONIA mark.
Clearly, that's going to provide a drag, unfortunately, on, on margins going forward. I think you've probably heard much the same from other banks through the reporting season as well. Technical EIR, let me try and be succinct. Because of the mechanisms of EIR, the impact of the unwind of the liability we've created is, is really balance sheet. It, it's a balance sheet reversal because the cash we'll receive over the life of the mortgages will be less than the interest accrual we continue to make, because you don't change your EIR % and your interest accrual for behavioral changes.
Ben, at the front.
Morning, gentlemen.
I'll ask one about the market then, not about EIR.
Dividends.
There's a way in there about EIR. You mentioned about your new savings platform coming online next year. You obviously don't have a current account offering currently. I was wondering whether you'd give any color on whether you intend to fill that gap, either organically or organically. Secondly, on slide 17, you talk about the Precise EIR assets, reflecting time spent on reversion and early repayment charges. I'm just interested in any assumptions you're making around early repayment charges. We've recently seen mortgage holders making overpayments in the resi market, and I was wondering if there's any upside there, if you've modeled repayments for EIR in a similar way to the reversionary duration, i.e., using actual experience rather than future expectations.
If I can squeeze in a third one, just in relation to your reversionary assumption of five months and using the actual experience, you'll be aware that other U.K. banks take a slightly different approach. I know you won't want to comment on peers, so my question is a bit more specific. Have you had conversations with your accountants around OSB's accounting in this area and why it's different to peers? If yes, what was the outcome of those conversations? Thank you.
Okay, thanks, Ben. I'll, I mean, I'll talk about the, the, the savings development work and, and current accounts. We're, we're not building a, you know, a, a platform to launch a new current account. We're currently building a, a much slicker, much more self-service oriented, app-based, et cetera, savings platform. It makes it very easy for savers to, you know, pick a new products, switch from one product to another, renew when their product comes to maturity. Just a, a much smoother customer journey, and we think that's really important as a fairly big provider now into that retail savings mark. No, we're not planning to build a current account franchise. You know, you kind of always toy with, with the, with the benefit of, of effectively zero rate funding, be of assistance.
You've got a lot of infrastructure costs that go with running a current account franchise. You know, are, are there offerings out there which are for sale and potentially achievable? I don't know. We always do market evaluations. You know, Kleinman's printed his article about Shawbrook and, and, and one current account provider. We will continue to look at the market and see opportunities, and if, if something presents, which we think adds long-term value for shareholders, we'll come back and talk about it. But, nothing that we can talk about further at this point.
Well, I think you're right. I mean, I, I can't comment on what some, you know, other competitors may be saying about their EIR accounting. We certainly do take a forward view as well, based on the data we have available to us. It's not rigidly sticking to, you know, a run rate of, of behavior, we have to pin it on something. Yes, we've had conversations with the accountants. Their support continue to support our accounting methodologies being appropriate for our circumstances. Circumstances are different across the different banks, both from a product design perspective, and from perhaps their availability of data through the cycle. There's no question in their mind that our accounting was, was appropriate. You asked about ECL assumptions.
We do make some assumptions, but it's just not material for any of our books. We're very conscious that we've seen quite a bit of volatility and behavior. We saw, you know, for example, when there was a fear of rapidly rising rates post the mini-budget, we saw a real acceleration of people paying the 1% early redemption charge in the last year of their mortgage in order to fix again. We're not expecting that's going to happen again. Yeah, if it was in any way material, we would have disclosed sensitivities in the accounts. Obviously, that's, that's valid across our books, you know, Kent Reliance and InterBay and the Precise books. I think that was it, wasn't it? Yeah. Thank you.
Yeah, I mean, just adding on, on some of that customer behavior on mortgages. I mean, interestingly, two-year fixed rate mortgages haven't been the flavor for a really long time, actually, we're seeing some savvy borrowers that are saying: We're gonna, we're gonna shorten the product term because rates are high, because they're taking a, a forward-look view. Even some that are just saying, we're, you know, we're going to stick on variable for a bit because we think the long-term or medium-term prognosis is, is a better direction of travel on swap rates, and therefore, fixed pricing.
You know, in, in part, that's the beauty of dealing with some professional landlords, is they are taking a, a portfolio-based financial decision rather than Mr. and Mrs. Smith worrying about whether their mortgage is going to go up a couple of GBP 100. That's interesting behavior that we haven't seen for a long time in the low risk rate environment.
Yes, that's it.
Hi, Grace Dargan from Barclays. Maybe just coming back on impairments. Appreciate a good chunk of the impairment was model driven. Guess another good chunk was Stage 1 to Stage 2 increase. I guess, what in particular were the increase in credit risk indicators that you saw change as a result of that? I guess, how are you expecting those to evolve from here? Are you expecting a similar run rate? I guess noting you're saying actually underlying is still quite strong, so it'll be interesting to hear thoughts on that. Maybe I will ask one on, on capital. Appreciate it's difficult to talk about full year 2023, but maybe looking more medium term. You've got, I would say, a bit more visibility now on kind of your thinking around optimizing the capital stack.
It'd be really good to get your kind of latest thoughts on balancing distributions and loan growth, and also kind of how you're thinking over the next maybe two or three years around timing your distributions. Put another way, how much above 14%, if you're fully optimized, you're kind of comfortable operating at, given the changes that are coming through with Basel. Thank you.
Gosh, all good questions. You're absolutely right. There was an impact, GBP 15.8 million from staging. That was predominantly Stage 1 to Stage 2. I suppose it's the only part of the IFRS 9 framework where you really don't use perfect foresight, because if it's Stage 1, then you take a 12-month view of your potential losses, and when it goes into Stage 2, it's lifetime. Some of it was arrears-based, but a lot of it wasn't, and I suppose it's the usual factors of a worsening credit score, perhaps higher personal indebtedness, and, you know, other factors we look at, which give us those sort of early warning indicators.
Of course, once you've entered into a stage, it takes a time before you can cure out of it, particularly, you know, Stage 3 to Stage 1, but also Stage 2 to Stage 1 as well. You could find yourself broadly flat when it comes to portfolio arrears, but still see a growth because of that difference between people going in and people coming out. If that makes sense. Does that answer your question for-
I guess into H2 in particular.
Oh, sorry.
Are you concerned-
Yeah, yeah.
That you'll see a, a similar charge?
Well, I mean, we've obviously got the benefit of a, you know, a month and a half or so since then. I mean, as I mentioned earlier, every way you look at it, things look a little bit better. I mean, really, it's, it's the, you know, it's the expectation of where rates will go, in particular, and it's the HPI performance which really makes a difference. You know, we don't wait to see arrears before we put people through the stages based on those early warning indicators. You know, we, we've got a little ways to go this year, but what we see today is looking mildly positive.
Yeah.
Capital, I guess you're asking more medium term rather than the dividend for this year. I mean, I don't think there's really any change to our policy. You know, as we optimize that stack, we can free up more CET1 to distribute to shareholders. So it's quite linked to the timing of that, some optimization of the stack and the debt issuance. You know, I personally, and the board, think of the capital we generate every period through profitability as kind of fueling growth and a progressive dividend. The size of the back book, the capital generation capability of it, can do both.
I think about the excess of CET1 above our minimum requirement and our target of 14%, once you've optimized the stack, as being available for distribution back to shareholders through share repurchases. Of course, we've got that uncertainty to some extent on what will happen with Basel 3.1, we should know by the end of the year and be able to give a lot more clarity. I would say there's been a lot of lobbying from industry, industry bodies, governments, against some of the platinum plating. Also the lack of transitional relief for standardized firms, despite Basel bending over backwards to give relief to IRB firms. I think it's broadly helpful, perhaps, as to how the US has come out in the last few weeks with their consultation paper. It's a slightly later implementation date.
It's a much higher threshold, GBP 100 billion, before you have to adopt it. More importantly, they have stated quite clearly that they don't necessarily feel that the risk weights are always appropriate for their market. I think hopefully that just gives the PRA a little bit more wiggle room to listen to the feedback. I'm, of course, just speculating, and we'll find out as we go to the end of the year. Really, no change from anything we've said in the past when it comes to our philosophy on capital. You know, this is a business that generates considerable capital through profit. We do have a strong position. We've got a good access, which means we are in a good position, whichever way you look at it. Over the medium term, that should allow us to return further capital to our shareholders.
That's great. Okay, I think we will now open up to the phones, please.
Thank you. We have our first question comes from John Cronin from Goodbody. John, your line is now open.
Hi, guys. Thanks for the presentation. Just a few from me, please. Okay, following up on some of the previous questions on net interest margin, look, I appreciate you've outlined it, the trends we should expect to see in the second half, contributing to a downdraft, half on half in underlying NIM. Just trying to think beyond 2023, how should we think about NIM evolution, given the kind of profile of mortgages rolling off, you know, further issuance plans, and, you know, maybe broad-based kind of pressures on asset yields and deposit costs, perhaps? Just trying to get a sense of, you know, where, where, where you think we should be moving our NIM forecasts to beyond 2023. Secondly, just to follow up as well on costs.
Look, I guess two kind of questions on costs. One is, you know, you've, you've obviously got costs growing at a pretty strong one rate as guided. The planned investment in the business, we'll continue to see that come through. I mean, are you concerned in any way, I guess, around, you know, around potential further investment beyond what you were initially expecting, perhaps as a result of this EIR adjustment and the kind of influence that that might have in terms of required cost spend for the IRB program, without trying to overdraw the links between the two? Then, and then secondly, look, just in terms of kind of percentage uplift, how should we think about cost growth trajectory beyond, beyond 2023? Finally, just one on product fees.
Thanks for the updated H1 ICR disclosures. If you were to adjust for those to account with the kind of uptick that there has been in product fees and average terms, I mean, what kind of an impact does that roughly have on? I mean, how much would that reduce interest coverage ratios by, if you were to overlay that differential between where product fees were, say, 18 months ago and where, where they are today?
Yeah. Thanks. Thanks, John.
Thank you.
Let's do them in reverse order, I'll take the ICR point and touch on costs, then April can add on costs and talk about the NIM bridge and journey. I mean, the ICR piece, we do our ICRs at a stress rate. If that's a five-year fixed, it's the pay rate. Of course, you do in higher interest rates environments, and you'll see it not just in our product availability, but our competitors. We, you know, will offer customers an opportunity to pay a higher fee, and therefore, a lower fixed. We are talking about a five-year fixed costing forward, you know, over a significant amount of time when rents will undoubtedly rise during that period.
Actually, the prognosis is that, that the exit onto another five-year fixed rate in five years' time will be lower. That's just kind of engineering products really to suit market taste. No different from what we were doing when, you know, back in sort of 2013, when we were rising buy-to-let mortgages in the mid, in the mid-fives. Then, you know, we started to push them down to the fours, but, but up the, the fee so that landlords that had the capability wanted to do that. I mean, we, we've disclosed the, the flow ICRs in terms of the half year. I think they're still very strong, particularly given that, you know, interest rates versus what we were looking at 12 months ago for an underlying mortgage cost are higher.
You know, many of our buy-to-let loans are in the sixes, particularly in the OSB and the InterBay brands, yet we're still delivering 178% ICR coverage, which I think is very strong. You know, as swap rates come down, and we hope the overarching price of mortgages comes down, and rents continue to go up because of that demand, supply mismatch, I think that position will only improve. Of course, book ICRs on existing loans are higher, because typically we've been originating around that sort of 198%-202% ICR mark. I can't answer the question in exactly the way you asked it.
If it isn't a five-year fixed, it's at a stress rate, and that's a fairly significant stress rate over and above, and that's how we calculate the ICR. There's no, there's no funny business, I guess, is, is the words in the way that we calculate and disclose them.
I suppose the, the one point is actually, if you think about the first half, a lot of it, we still thought base rate was gonna peak around 4%, and therefore, we weren't loading fees on. I think it's only at the point where you suddenly see a real widening of the swap spread, and things have come back a bit since then, that we might have put a bit more fee on the product.
Yeah, I think that's right. I mean, in terms of cost, John, I mean, you, you know, we're always a sort of, you know, a, a cost control animal. We try to make sure that, that the management expense ratio is in line with the growth in the balance sheet. Clearly, we've had to absorb, like every other business, a fair chunk of inflation, both in terms of our sort of, you know, our own costs for energy and other bits and pieces. Also, obviously, trying to do the right thing by our staff, which I think is, is pretty important in a, in a high inflationary environment. I think the cost base is in good shape.
We have invested a fair chunk during the course of the first half of this year in terms of development, that, that new savings platform that I talked about. We try and balance carefully the difference between capital expenditure and revenue expenditure. You know, if my IT, CIO, or my COO wanna spend money on enhancing a system, they need to show me the benefits case that says, "When am I gonna get it back then in terms of, of operational efficiency?" We're, we're quite balanced in the way that we look at that. I mean, I don't think the EIR adjustment has a, has a bearing on cost. I don't think it changes. I mean...
Yeah.
You know, IRB is about credit risk modeling, and, and, and, you know, the way in which we manage credit and operational risk in the business, it's not, it's not about accounting. I don't think it has any bearing on that. You know, clearly, April will touch on, on NIM. Some of the costs that we face are around coupons on, on elements that come through the net interest margin. We will continue to grow the cost base in line with the balance sheet if, if we need to.
We'll try and continue to keep that management expense ratio right, and our cost to income ratio, as you know, John, is always wildly, moved by either income, upward or in this case, on the EIR adjustment downward, which has a, which has an impact, but costs are generally pretty well controlled.
If we get to a stage where we want to invest a bit more beyond the growth in the balance sheet, of course, that's the point we'll come back, and we'll talk to the market about it, with a good business case for synergies, just like our colleagues have to come to us if they want to spend some money. I think going back to NIM, you're asking me, great question, as always, more of the medium-term drivers. You're absolutely right, Andy. We do have further issuance requirements. You only have to look at the capital stacks for our MREL requirement to know and have a good estimate of the amount we're looking to raise.
I mentioned a couple of benchmark-sized trades on top of that tier two trade before we get to July and some more after that. That clearly is a drag. I think I mentioned earlier that over the last sort of 18 years, we've been raising retail deposits at significantly sub-SONIA, SONIA - 40, SONIA - 50. That's more weighted towards one year than two year, because that's been what investors have been looking for, retail depositors have been looking for, through this period of rate volatility. That will start to mature from next year, really onto whatever the prevailing rate is, and I'm calling that closer to SONIA. That is gonna be a drag. I think you'll see that across the industry.
We have an awful lot of borrowings across the industry from Bank of England under the TFSME scheme. You know, as long as wholesale markets are liquid, I would expect a lot of that to be refinanced through covered bonds, securitization, that is, more expensive than retail savings at the moment. We will probably do some of that through securitization ourself. It could, of course, have a knock-on impact to the savings market if the wholesale markets are not liquid. Certainly the whole, you know, that amount of funding happened to be refinancing, I, I'm calling that that's gonna have an impact on everybody's cost of funds. When it was given to us, we all were told we had to drop mortgage pricing.
We'll have to wait and see what the competitive dynamic is on mortgage pricing, to see whether that increased cost gets passed on to borrowers, and that is also, obviously impacted by the affordability constraints of higher rates. I guess I mentioned earlier, in the short term, and it is obviously a factor for the medium term as well, on the lending side, where perhaps business the industry wrote five years ago, was on higher yields to what we're facing today. That's because of, you know, the mortgage market hasn't passed on all of that widening of swap spreads and rate rises on to borrowers either. I mentioned earlier, the sort of short term impact is just the way we honored our application pipeline. We hedged some of our application pipeline, but not all of it.
Therefore, we have had some, you know, ups and downs when it comes to what the actual NIM is of that front book, between the application point and when we actually completed. Of course, there are ups as well as downs there. I should finish with some upsides, which is that we've obviously been very cautious in our lending appetite, really since the pandemic, and we're not doing so much of the high yielding business that we're very good at. As soon as that outlook stabilizes, I hope you should expect us to start doing more of those high yielding businesses, development, finance, bridging, commercial, asset finance, et cetera. That, I hope is a real potential upside to our net interest margin as well.
That's very helpful, guys. Can I come back on one more? The cost point. I'm modeling cost growth of about 14% in 2024, 9% in 2025. I mean, look, not looking for specific guidance on this, obviously, but, you know, look, we hear from a lot of banks around the intense of costs involved, the IRB programs. You know, kind of directionally, would you be guiding to double-digit growth over the next five?
Well, I mean, I, we're not going to give guidance for 2024. I think there's clearly some inflationary impacts and wage inflation. We did the right thing by our staff in this sort of challenging environment. We, it-it's all about how much investment we want to do in the business, and whether we can do that within the, the sort of the, the economies of scale we naturally generate, plus any further inflationary pressures. I think, you know, inflation, thankfully, is starting to come down.
I think demonstrably, we've done a pretty good job in the first half of this year of absorbing what was fairly chunky inflation on staff costs.
Yeah.
Other bits and pieces, because of growth in the balance sheet and therefore, management of the, the management expense ratio. You know, that's, that's the denominator, John, we always come back to is, you know, if you're going to grow your cost base, you've got to grow your balance sheet to pay for it. You know, the... You won't always do that in exact harmony. If you're, if you're doing cost more than growth, you need to have a pretty good business case to, to make it so.
We're not shy about coming back to the market and saying, you know, "We want to invest a bit more money, but we're going to generate the following synergies.
Yeah.
We've just not had to do that so far, given the sort of the growth in our business, and we've been able to fund things we want to do through economies of scale, as we can sort of continue to really modernize our, technology stack. Which I think is like every other bank, we've just been, I think, quite lucky with the, our ability to do it within the economies of scale we've generated.
Okay, thanks, John. Conscious of time, I want to ask if there's a couple more on the phone that are waiting to ask. Are there any?
Thank you. We are finding.
Sorry, operator, do we have any further questions on the phone?
Yes, we have our next question comes from Portia Patel from Canaccord. Portia, you're live now. Open.
Thank you very much. I'm afraid my question is on EIR again, and just two, please. The sensitivity you provided to the reversion period is very useful, so thank you for that. I was wondering, if we should expect one-off impacts like we've seen in this period in the future, if the, if reversion period is moved either way? Should we expect it to be re-reassessed on a more frequent basis going forward, such that the impact can be smoothed? Perhaps this is a function of the accounting treatment. If you could just explain, that would be really helpful.
Secondly, I just wondered if there had been any changes or if you, if you're intending to make any changes to the design of the Precise Mortgages product to encourage behavioral trends more akin to what we see in the Kent book? Or you believe that the Precise products are, are, are fit, fit as is? Thank you.
I mean, will we expect any more? I mean, it really depends on what happens to interest rates and the interest rate outlook, because that's really what's driven this. You know, perhaps after this adjustment, there's more chance of people spending a bit longer if rates start to fall. You know, portfolio landlords, as Andy mentioned, there are reasons why they might stick on the revert rate, despite it looking like a very high step up, as they assess their overall cost of funds across the portfolio. They'll have their own view about what's going to happen to rates and whether it's worth a little bit of short-term pain in order to sort of lock in at, at a rate as it starts to fall.
We have a lot of anecdotal evidence that residential customers are actually thinking the same way as well. It's very much driven by the absolute level of rates, but also by the outlook. I suppose there's always chance of it, of people spending longer or less. I mean, we look at this frequently anyway. I mean, the very formal process involving our auditors from a challenge perspective is six monthly, but this is something where we're collecting data every month, and we'll continue to do so.
I mean, the size of this adjustment really was a result of such a rapid increase in rates over such a short period of time, which meant that the entire back book was suddenly facing a material step up and an, and an incentive to refinance, whereas previously, it had reverted to a rate slightly above or very slightly below the fixed rate. It was the speed of the rate changes which really caused this. Clearly heightened sense, I'm sure, across the organization and the board, on, on looking at this even more frequently than we did previously. It wasn't that we were asleep at the wheel. We were looking at this. It was just a sudden change. I don't think there's anything wrong with the design of that product.
In fact, you know, designing a product that has a relatively modest step up, in reversion, there's nothing wrong with it. It's just, you know, vulnerable to 12 consecutive base rate rises in a very short period, I suppose.
Yeah. I mean, Portia, I would, I would say, I mean, products that we're writing today have a different step up than those that were written five years ago, as in, it's not quite so high, a margin over base, that has a sort of forward impact in terms of behavior. I think, you know, going forward, for us, it is important that we continue to build the choices program in Precise Mortgages, which does over time mean you know, you will try and get more people onto a new product when their product matures. Of course, that locks them in for a further period in terms of a new fixed rate, a new product fee, you know, et cetera, et cetera.
You know, a couple of, a couple of sort of city people have said to me, "Well, you know, why would anyone stay on a revert rate for anything, anything at all? I wouldn't." The average borrower, particularly residential through Precise Mortgages, is not that kind of individual. You know, by the time they realize that their payment's gone up, then there's a three-month kind of window to get a refinance done, and, you know, that takes a while, and We all know solicitors are a bit slow and whatever, so there's always some time. That's why, for us, it's important that we keep pushing the choices program message. It, you know, it, it amazes me.
Some people, you write, and you say, "Look, here's a, here's another deal, and it's, it's a good deal," and they still think about it for quite some time. We will over the years, we will work hard to change that behavior. I mean, you, you talked about it being one-offs. We'll, we'll monitor the thing. You know, we've taken EIR adjustments all the way through in the past. They're typically normal course adjustments that are absorbed within our, you know, our ability to grow the bank and make profit. That's the way I think we're trying to think about it going forward.
We have applied the same assumption to parts of the back book that were originated more recently, that are likely to reach reversion in what we expect to be a falling rate environment. Perhaps there's some, some elements of prudency there. You know, we've been wrong on what's going to happen with the rate outlook over the last 18 months, so I'm not gonna, I'm not gonna call it. We're certainly just looking at what the SONIA curve is implying at the moment.
Okay. I'm conscious of time, we will just take one more from the phone, because I know we have... If there is one. Operator, is there a further question on the phone?
There are no further questions over the phone line.
Okay. Thank you. Any final questions or points from the room here?
Got one minute.
Okay, we'll give you the minute back. Thank you very much, everybody, for attending, and have a good day and a good weekend, as we're nearing that point. Cheers!