So a very good morning, and welcome to Paragon's 2023 full year results presentation. So today, as normal, we will run through the financial and operational performance in some detail and provide you with our view on the outlook, as well as, of course, leaving plenty of time for your questions afterwards. But first, let me start with a few key messages. Our business model is designed to deliver above average risk-adjusted returns, driven by a superior understanding of the specialist markets in which we trade, the products we offer, the services we provide, and the customers we support. The strength of our franchise is the product of a deep knowledge and awareness, which lay at the very core of our specialization focus and which is deep-rooted in our purpose.
Itself is embedded in the extensive through-the-cycle experience of our people, the knowledge we have, the data we hold, which, in the case of Buy-to-let, goes back over 28 years, and which is something genuinely unique in the U.K. The value of this franchise continues to grow from strength to strength. The last two years have seen significant volatility in domestic politics, and the economy has had to deal with inflationary pressures, a cost of living crisis, 14 base rate rises, and the consequences of heightened geopolitical conflict. Yet throughout, Paragon has continued to deliver outstanding results, growing the loan book, widening margins, controlling costs, and witnessing continued resilience in the high-quality customer base. Higher interest rates are a significant factor in banking, and you will see it is changing the shape of our business.
We believe this is a net positive, not a negative, and something which we will come back to during the presentation. We are also on a journey to transform our technology platforms, seeking to strengthen the relationships we have with our customers and intermediaries, delivering even greater levels of information and insight whilst improving operational efficiency. A lot has been done, but there is more technology change underway, and I believe the best is yet to come. But let me turn briefly to the results that we've announced today. As you can imagine, we are absolutely delighted with this year's outstanding performance, reflecting the growing specialist franchise of the group and the continued strong progress in our strategic development. All of our key metrics are either in line with or above guidance.
The loan book growth was above our expectations set at the beginning of the year, with new lending outperforming in a weaker market, where we have been able to take market share and where we have seen improvements in our customer retention strategies. NIM expanded to over 3% on the back of the rise in interest rates and the structural shift in income, driven by our diversification strategy. Operating costs were below guidance and helped drive down the cost-income ratio further to 36.6%, driven by tight cost management and some early benefits of our digitalization program. The deposit book has increased by over 24%, benefiting from changing market dynamics, including the switch to fix, where we have always had a particularly strong presence. The credit performance was, again, excellent.
Notwithstanding the environment, only required a charge of 12 basis points for the year, with a prudently positioned balance sheet provision of 49 basis points. Underlying operating profits increased by over 25% to GBP 277.6 million, the highest we have ever recorded, and which delivered a return on tangible equity of 20.2%. There are clearly some benefits arising from the transition to a higher rate environment, some of which are temporary, but some are permanent. Consequently, we expect to be capable of delivering a higher return on tangible equity than the 15% target in the future, more of which later.
Our internal capital generation is strong, as are our capital ratios, supporting our growth ambitions and facilitating the announcement of a further GBP 50 million buyback announced today, on top of the GBP 100 million completed in the last financial year. These are outstanding results, of which we are rightly proud, and Richard will now run through them in detail, and I will return later.
Thank you. As Nigel just mentioned, we've performed really well over the last year, generating some very strong results. In addition to my usual suite of slides, I'll spend a bit more time on net interest income this year. On the income statement, total income for the year rose by 20% to GBP 466 million. Operating costs rose to GBP 170.4 million, as guided, delivering an overall cost-income ratio of 36.6%. Impairments rose slightly in the year, primarily as a result of the inputs to our multiple economic scenarios. Overall coverage ratios rose by 5 basis points to 49 bps. Underlying profits are up 25.4%, year-on-year at GBP 277.6 million.
I talked about fair values this time last year after a strong gain from our pipeline hedging as rates had risen. The unwind of the adjustment was GBP 77.7 million this year, and the balance of the previous year's gain is expected to amortize pretty evenly over the coming four years. The strong growth in operating profits was further supported by our share buyback in 2023. As a result, underlying earnings per share, which exclude fair value items, rose to GBP 0.942. Moving on to our segmental performance. The group's two operating segments saw increased profitability year-over-year at both the pre and post-impairment levels. Most of this growth was driven by increases in total income, particularly on the net interest line. The central area, which incurs the costs or benefits from surplus liquidity, also had a strong year.
My next slide covers the net interest margin. If you recall, we've said before that with no structural hedge, our net interest would rise by around GBP 10 million for every 1% increase in rates, and we've seen that clearly in 2022 and 2023. In the final quarter of 2023, we started to protect this position by hedging against falling rates, by hedging the group's net free reserves. Around GBP 300 million of this hedge have been put in place at the year-end, increasing to over GBP 600 million now, and eventually, we expect to hedge the full GBP 1.2 billion. This hedge is very straightforward, being provided by a fixed rate loan book rather than by any complex derivatives.
The hedging limits the upside should rates rise again from here, but protects the downside if rates fall, and the average tenor of the hedge will be around 4 years. In addition to the greater earnings on our net assets, as rates have risen, the scale of the premium over SONIA for new asset pricing has reduced, whereas the funding position relative to SONIA has widened. The asset side reflects demand and affordability constraints at higher rates, and the liability benefit still allows us to offer more attractive savings pricing to our customers than the traditional larger deposit takers. At Paragon, our management, margin management focuses on product margins, not specific asset or, liability side spreads. Finally, on this page, I've highlighted our group-wide EIR balance of just over GBP 20 million.
Given the interest in this topic, we've given a few more sensitivities in our accounts this time around. I've got some further margin detail on my next slide. Our core NIM accretion guidance has been 5-10 basis points per annum range for some time now, reflecting the, diversification strategy and the run-off of the legacy assets, primarily the legacy buy-to-let and Idem Capital loans. If we grounded that progression in 2019 and looked through the post, through the COVID dip, our expected NIM for 2023 would have been somewhere between 249 and 269 basis points. So the 309 that we've reported for the year represents a material overperformance. Up to 25 basis points of this has arisen from the higher returns we make on our equity as rates have risen.
If rates fall and product mix and margins are maintained, this would naturally reverse. However, our continued diversification and actions like adding on net free reserve hedge are intended to protect this outperformance going forward. On operating expenses, the year-end cost outcome was in line with expectations and translated to the cost-income ratio of 36.6%. The biggest area of cost growth continues to be in our tech spend, where we progress our digitalization plans. The vast majority of this investment is expensed along the way rather than capitalized. This digitalization program is set to continue for at least a couple more years, with efficiency savings and capacity creation franking that investment over time.
Our impairment modeling leans on a combination of portfolio performance and our expected credit losses as modeled under IFRS 9, the latter calculated in a series of different economic scenarios. We continue to model four economic scenarios and have maintained our scenario weightings at their 2022 levels. The chart summarizes the key movements in assumptions for 2024 and shows this graphically for house prices, which continues to be a key driver. However, we're in an environment where rates have risen, inflation has been high, GDP is depressed, and house prices are lower. So when running our multiple economic scenarios from here, we see a tighter range of outcomes than we've seen historically.
The table in the top right continues to show the impact of single scenarios, with a range between 100% upside and 100% downside severe, generating a GBP 36.8 million spread. 12 months ago, this spread was GBP 53 million, and a year before that, it was GBP 59 million, suggesting much of the anticipated deterioration from a poorer economy is already embedded within the group's balance sheet. In terms of actual impairments, these flow from our economics and are summarized in the table at the top. While the overall provisions and coverage ratios are below their 2020 peak, they remain high. The lower level of volatility I've just mentioned, together with a generally less febrile environment when compared to our 2022 year-end, have allowed us to reduce the level of judgmental overlays that we're carrying.
In addition, we've upgraded our IFRS 9 modeling in the year on our SME portfolio, with the latest generation of the model being materially more sophisticated than the last, leaning on additional data, improving our confidence in the outputs, and reducing the need for any overlays. The bottom center table shows the impairment provision would have been if we used our original MES weightings and held no overlays, again, demonstrating low volatility. Finally, on this page, I've included our usual behavioral score analysis. This shows the legacy buy-to-let customers' credit scores falling slightly for the first time in many years. We've also seen higher arrears on that portfolio, where the loans are variable rate trackers and have therefore seen rate increases with each base rate hike.
My capital movement slide details the main influences in the movement of the CET1 ratio to 15.5% at the year-end. Profits were a little higher year on year in CET1 terms, adding 2.8% compared to 2.6% in 2022. New lending growth used 0.6%, the dividend, 1.1, and the share buyback, 1.3. The biggest year-on-year movement, though, came from fair values, which used 0.8% of CET1 in 2023 by having generated a whole 2% the previous year. Summarizing the capital position, we carry a surplus over our regulatory requirements of over GBP 300 million, and have three years before we need to refinance our Tier 2 bond.
The capital surplus is more than sufficient to finance our planned lending growth and reserves capital for a July 2025 Basel 3.1 implementation. However, this is on a precautionary basis as we continue to pursue an IRB accreditation. We've continued to make progress with our IRB application, leaning on great data, strong modeling, but accreditation and timing decisions rest firmly with the PRA. Lastly, I'll cover capital management. We continue to deliver strong dividend growth, and today's GBP 50 million buyback announcement means we'll have completed or announced GBP 483 million of share buys, share buybacks since we started the program in 2015. The GBP 100 million buyback last year was delivered at an average discount of almost 5% to the year-end TNAV, supporting the earnings accretion and in turn, the growth of the dividend.
It is worth noting, though, that the current buybacks do have a dampening effect on NIM, given the higher rate environment, unlike the buybacks from 2015 to 2020, where the very low rates meant there was very little in the way of opportunity cost at the time. I'll hand you back to Nigel now. Thank you.
Okay. Thank you, Richard. Let me turn our attention to how the business has progressed against our key strategic priorities and provide you with our view on the outlook for the period ahead. We have shared with you previously how we focus on these priorities and how they are interconnected and supported by the structural pillars of a strong customer-focused culture, our passionate and committed people who hold such incredible values, and strong financial foundations with a high-quality customer base, strong capital, and significant liquidity. Turning now to how we have performed against the individual strategic priorities. As expected, new lending volumes were tempered this year as we prioritized margin and risk. However, we outperformed the market, delivered a loan book growth of 4.7%. While the market has been subdued, we are starting to see some optimism beginning to emerge.
Furthermore, we see more resilience in the specialist markets and believe they will continue to outperform the mainstream markets in the years to come. Our diversification strategy is an important ingredient in exploiting operational leverage and the broadening of the sources of income. Commercial lending now represents 37.5% of new lending, and its profit contribution is over GBP 113 million, up from GBP 44 million in 2020. Our digitalization transformation has accelerated this year. We now have 84% of our core and support systems based in the cloud, and we are systematically transforming our customer-facing platforms across every corner of the group, enhancing our customer experience and further improving cost efficiencies and operating leverage. 2024, we'll see the delivery of a number of new, exciting platform changes that will continue to strengthen our market position.
AI may still be in its infancy, but we already have a number of pilots underway. Internal capital generation has been particularly strong this year, where the group delivered a 2.8% accretion to CET1. This is a powerful and sustainable strength for the group and provides the ability to support growth and enhance returns to shareholders. With today's announcement, we will, once complete, have returned a total of GBP 483 million via buybacks since 2015, while also delivering GBP 465 million by way of dividends, a total of GBP 948 million returned to shareholders. We therefore see capital management as a core strategy, and particularly attractive opportunity, given the current share price relative to TNAV, even after today's favorable share price movement. Finally, we continue to make good progress in doing the right thing.
We've improved our operational emissions further, reducing them by 42% since 2019, and we are on course to achieve net zero by 2030. Our financed emissions are very much in the hands of our customers, and therefore, more difficult to deliver, particularly given the change in government policy this year. Nevertheless, our strategy is unchanged, and we continue to offer a number of products to support our customers' own sustainability plans and requirements, and we will continue to provide, develop, and extend these into the future. We've delivered good structural growth over many years whilst dealing with the run-off of the pre-financial crisis legacy portfolio, which inevitably acts as a drag on earnings. As I've said, our focus is on specialist lending markets, which we believe will outperform mainstream markets into the future.
However, at the heart of what banks do day to day is the trade-off between growth, return, and risk. At Paragon, we think about this a lot, always trying to strike the right balance, driving forward our strategic objectives, while maintaining the equilibrium that works through the cycle, not just when times are good. History shows that any single measure can be delivered in the short term, but history also shows that taking a short-term view of things is dangerous, especially when you're a bank. Of the three disciplines, we will always prioritize risk and return over growth, especially in weaker economic cycles. It is why we focus on consistent and stable long-term growth, not growth at any cost, and this has enabled us to achieve our 15% return on tangible equity target, and which has provided us with the ability and confidence to revisit this target today.
We are clearly mindful of the current environment, and while customer demand has weakened over the last year, margins are better, and our customer franchise is stronger, so that when the cycle turns, we will be able to respond. Turning now to the operating performance of the business lines. Housing market activity has reduced this year by 23%, back to levels last seen at the time of the financial crisis. The buy-to-let market has not been immune, with mortgage lending across the sector reducing by 32% year-on-year. However, it is clear that we've outperformed and achieved market share gains, a reflection of the continuing shift in the professionalization of the buy-to-let market and the strength of our specialist franchise. The mortgage market has been disrupted at the beginning of our financial year and again in the final quarter.
If you recall that last September and October, following the mini budget, banks effectively withdrew from the sector as they could not price their funding costs with any confidence. With good and prudent hedging, we protected our customers and margins, resulting in a step up in conversion levels and strong first half volumes. We've seen interest rate volatility throughout the year, with some seven base rate increases across the 12 months alone. As highlighted at the half year, we expected 2023 to be a year of two halves, and this indeed is what happened. The second half has seen lower external volumes, particularly as we've remained disciplined on pricing. However, this is a cyclical dynamic we have all seen before. It will change, and importantly, the demand for rented property is as strong as ever, and professional landlords are taking an increasing share of this market.
After two years of negative sentiment, landlords are starting to show signs of optimism. It's too early to call this feedback a trend, but perhaps it is not surprising given interest rate expectations and the continuing strong rental demand. Notwithstanding the weakness in the market, we've seen strong levels of customer retention, with some 80% of customers with maturing fixes going on to take a new product with us, enabling the mortgage loan book growth to exceed 5%, with our post-financial crisis book, largely focused on professional landlords, growing by over 13%. So while external volumes in the pipeline are lower, the dynamics of our ability to generate further growth in income remains healthy.
There is clear evidence that amateur landlords, which are more likely to be focused in our legacy book, have been exiting the market, whereas professionals have been looking to invest and benefit from the excess of rental demand over supply. Indeed, over 40% of our new business flow is typically from a house purchase rather than a remortgage. We see our landlords generating healthy rental yields, particularly in the specialist property segments, where we are a market leader, benefiting from the expertise that our in-house property valuation team provide. There is therefore clear bifurcation in customer behavior that can be seen in the redemption chart in the middle, where despite strong growth in the so-called new book, the legacy portfolio has contracted by 14.5% to GBP 3 billion, and it will, over time, become a smaller part of the whole.
So while 2024 will be a softer market, given our focus on professional landlords, we expect to outperform the sector, and we remain confident of the long-term growth opportunities. We continue to use extensive data analytics in our buy-to-let business, supporting our comprehensive underwriting process, in-life portfolio monitoring, as well as the IRB program, where the extent and depth of our data is unrivaled in the U.K. and which acts as a clear differentiator in our decision-making process, processes, including those for IRB. Arrears have ticked up over the last year, but from a very low base and remain well inside industry averages. Much of this increase is located in the legacy book, largely variable rate, largely amateur landlords. The average LTV on the portfolio stands at 62.8%, and only 3.6% is greater than 80% loan to value.
We are conscious that affordability has been in the spotlight in this higher interest rate environment. We have always operated conservative stress testing in this area and have applied it rigorously throughout, including employing tests over and above regulatory requirements. Our current debt service ratio, the ICR, sits at 190%, even at current rates. Although loans coming off five-year fixes are seeing rates move up meaningfully, rental yields have also increased materially. Rents have increased by 10.5% over the last 12 months and by 31% over the last five years. If you simply look at our pipeline, it has a rental yield of 6.7%, a mortgage charge rate of 5.2%, and an LTV of 67%, delivering the ICR of 190%.
Further, it needs to be understood that the ICR and the LTV are interconnected, such that should interest rates rise without a compensating benefit to rents, our credit assessment will demand a lower LTV to adjust the position and equalize the cash flow coverage. So now let's turn to the commercial business lines. Commercial lending has been the means by which we have been able to diversify our business over a number of years in pursuit of our key strategic priorities. While commercial lending represents 13% of the balance sheet, it is 38% of new business volumes, and importantly, 32% of income. Additionally, commercial lending is not one homogeneous product line, but a number of different businesses providing further diversification in itself.
Within SME, there is a broad, broad spectrum of customers, including SMEs, corporates, and even the U.K. government, and a range of sectors from construction to logistics, from agriculture to education, manufacturing to transport, and indeed many others. Let's turn to each of the lines individually. As signaled, we expected that our development finance division was likely to see weaker activity in 2023 due to the combination of supply chain disruption, cost growth, and the uncertainty of the environment, including the potential softness in house prices. Nevertheless, the existing facilities continued to roll out their build programs and supported robust cash drawings and average balances, leaving the loan book approaching 4% higher year-on-year. The portfolio is performing well, a product of the high quality developers we choose to work with and the rigorous standards we apply to our underwriting.
Structurally, the business is very well positioned, with a team of deeply experienced professionals that will be ready to react when market conditions allow. Notwithstanding the environment, our SME division performed robustly with stable origination, origination flows and a 5% increase in the loan book to GBP 758 million. The competition has been pricing aggressively, but we've been disciplined, instead choosing to prioritize risk and return over growth. We have continued to invest in new technology in this area. 80% of new business goes through our new lending business portal, which assesses over 4,000 pieces of customer data with each application, including access to customers' current account information as part of the underwriting and in-life monitoring process. Further technology changes in SME will be delivered over the next year and into 2025.
Despite higher business insolvencies across the U.K. as a whole, the portfolio is performing incredibly well, and there is no evidence of credit deterioration or any concerns emerging from the early warning indicators. Turning now to the remaining areas of the commercial division. Our motor finance loan book growth was strong, up 14% year-on-year, with success being particularly evident in the leisure vehicle market, one of the more strongly supported subsectors we target. The portfolio is performing very well, and as with SME, we are seeing no credit deterioration in the book or in the lead indicators. Finally, structured lending, which provides asset-backed lending to non-bank specialist firms and has had a stable year in terms of activity, delivering good customer retention and good profitability. The new business pipeline is strong, and we anticipate healthy growth in the year ahead.
As seen elsewhere, the credit performance here is exemplary. Our commercial lending divisions are regarded as more cyclical in nature than mortgages, but have performed particularly resiliently in this more challenging economic environment, and with a NIM of over 7%. It provides the group with a strong, risk-adjusted margin and structural NIM benefit, as there is much further growth expected in the years ahead. Whilst a lot of people are calling the top of the interest rate cycle, we all know credit stress can be delayed. However, the business is well positioned to deal with these challenges, and we will therefore maintain our cautious risk appetite, prudent provisioning coverage levels, and continue to apply close in-life monitoring across the various portfolios.
Our savings division has been a significant beneficiary of the rising interest rate environment, where our cost of funds has moved from circa 100 basis points above SONIA to now being sub-SONIA. We have also seen a significant shift in customer demand, with a material increase in flows into fixed-term products. Since September 2022, there has been GBP 58 billion switched from easy access and personal current accounts into term deposits across the market. If you compare the position to pre-financial crisis, a time of comparable interest rate levels, term deposit flows should remain healthy, albeit the pace of change has already started to slow as the peak of rates appear to have been reached. The deposit book is up over 24%, standing at GBP 13.3 billion at the year-end, and has continued to grow strongly in the current financial year.
We've continued to strengthen our franchise, enhancing flows into our direct-to-market proposition and through our third-party platform relationships like Hargreaves Lansdown, Monzo, Revolut, and many others. New technology has already played an important role in the development of our savings division, and will continue to be a crucial driver to growth, helping to broaden the proposition in the future. Of course, we can also access wholesale funding, where the group has a long history in the securitization markets. And while pricing has improved, it still remains unattractive at present. However, it remains open to us to access this funding source tactically as and when conditions improve. You will have seen that we have issued mortgage-backed securities this year, but they have all been fully retained and will be used as collateral for contingent funding lines, including repo facilities.
The strength of our liquidity position and the strength of our savings franchise has meant that we can accelerate the repayment of the TFSE-- I mean, the TF SME program. We expect to have repaid GBP 400 million by the end of the month, and we'll look for opportunities to continue to repay the central bank facilities well ahead of the end date in 2025. As we look forward, we are expecting the deposit beta to continue to close as TF SME is repaid, and this impact is fully embedded in our NIM guidance for 2024. So in conclusion, 2023 has witnessed an outstanding financial performance.
Notwithstanding the significant interest rate volatility and the month-on-month rises leading to a weaker economic backdrop and subdued housing market, new business flows have been robust, and we have gained market share due to the strength of our franchise and enhanced customer relationship management, all of which has supported good loan book growth. For 2024, we are guiding buy-to-let lending in the range of GBP 1.3 billion-GBP 1.6 billion, and commercial lending of GBP 1 billion-GBP 1.2 billion. But we expect stronger growth thereafter as the cycle turns again. NIM has widened, partly due to the structural mix in the balance sheet, and partly due to the transition to a higher interest rate environment.
The higher rate environment is still playing out, and despite the rise in deposit betas, we expect to hang on to much of these gains, and we are guiding NIM of 3%-3.1% for 2024. Furthermore, we are building a capital hedge that will protect returns should rates fall in the years ahead. The credit performance continues to be resilient, and operating costs are being well controlled, notwithstanding the ongoing technology investment program. Here, we are guiding to operating costs not exceeding GBP 180 million, an increase of 5.6%. The 2023 underlying operating profit is the highest in the group's history. As has been seen, we generate strong levels of capital, and the buyback program has been enhanced this year and shows our ongoing commitment to managing our capital base for the benefit of our shareholders.
To date, we have resisted revisiting our return on tangible equity mark target until both Basel 3.1 and IRB are resolved. However, we now appear to be in a more permanent higher interest rate environment, and it's appropriate this target is revisited. We will do this in two stages. Today, we are going to guide into a new medium-term target of 15%-20% and expect 2024 to be towards the top end of that range. We will subsequently revisit this range once Basel 3.1 and the IRB outcomes have been determined. While the economic backdrop is likely to remain subdued in 2024, we are firmly of the view that specialist lending markets will continue to outperform the wider sector, and we are confident in our long-term, ambitious growth plans.
We continue to want to diversify our business, spreading the sources of income and defraying the fixed cost structures that inevitably exist in a highly regulated sector. We believe Basel 3.1 could well prove to be challenging for some small and mid-tier banks. Whilst we await the final outcomes, we are also increasingly turning our attention to the opportunities that may emerge from the long-expected, perhaps much needed, consolidation in the sector, and we are incredibly well positioned in this regard. So while 2024 may prove to have a weaker economic backdrop, our business is in great shape. We have a high-quality customer base and a strong balance sheet, and we stand ready to react to the opportunities and challenges as and when they arise. So thank you very much, ladies and gentlemen, and we are now happy to take your questions. Right.
So we'll take the questions in the room first. We obviously, we're gonna go to the calls afterwards. Can I just ask, you've got a microphone, and otherwise, you won't get picked up. So yeah, Perlie. Do you... There's a microphone. Yeah. I think you have to hold a button, will it?
Yeah. Hello, it's Perlie from KBW. So I guess just two questions. First is on credit, so, especially in the commercial loan book, because if I look at your stage 3 balances, it seemed to have gone from somewhere like 23 to 64, something like that. So it's quite substantial in the half, but, in the presentation, all of the commercial, segments seem to be performing well. So just wondering exactly why that has gone up so much. And, and I guess if you look at the entire stage 3 book, that's gone up about 30, 30%, half and half as well. But of course, you have also released some of your overlay. So just your thinking around, the credit, provisions. And then I guess the second question is, on your comments about, optimism returning to the market.
I mean, I don't know whether the buy-to-let book is that similar to the normal mortgage book, but broadly speaking, it's about a third rolling off a year for the sort of wider market. So how much of the book has rolled through, and how much is there still to come? Because presumably, you know, like as you mentioned, it's still, you know, the five-year mortgage is still rolling off to substantially higher rates. And I guess part of the reason why it's done so well is that as you also mentioned, that rental yield has been very strong, and but I guess, you know, at 10.5%, that's higher than wage growth for the year already, and wage growth is looking to slow a little bit.
So where's the optimism coming from, if that makes sense?
Okay, so let me deal with that. You deal with the provision thing in a second?
Yeah, sure.
So just dealing with that. So we've got about GBP 1.9 billion rolling over into, from fixed rates into a refix over the 12-month period. When you look at that, and you look at the kind of what you might call the payment shock, you can see that the average rate—Don't forget, buy-to-let rates don't tend to be ever as low as residential mortgage rates. So recent CACI data pointed to the fact that about 50% of fixed rates in the resi market that are rolling over are coming from a sub 2% level. The average rate of the fixes that are rolling over in the next 12 months is 3.67%.
Yes, that means if you look at the average rate in the pipeline, which is 5.2%, that's still a big increase. It's just over 40%. But over the last five years, you've seen rental increases go up by over 30%. So yes, while those numbers show a higher level of mortgage rate increases, I think the rental increase is significantly higher and significantly mitigate that payment shock aspect. Do you want to cover the pre-? Let me just talk about the quality of the book, and then you go through the provisions. So, you know, if you look at the buy-to-let book, you've got, as I pointed out, there's a kind of a two parts to that portfolio.
That kind of GBP 9 billion plus of the new book and the GBP 3 billion of the legacy book. The arrears increase is located in the legacy book. You know, it's seen, it's a variable rate book, so it's seen 14 base rate rises. The new book, the more professional, focused landlords, actually, if you looked at year-on-year, there is a down on that book. You know, it might astound you to believe that, but, you know, the quality is there. When you look at those arrears, we have a very, very close in-life monitoring process. We know those arrears, those customers that are in arrears, and we provide help to them, we provide support. We know the details of that intimately. So what we also have is very significant asset coverage.
So when you look, you can see the average loan-to-value on that portfolio. But appreciate averages are only one data point. You have to look at the distribution as well, but you also have a 62%, 63% average loan-to-value. And also bear in mind, while the arrears have gone up, we're still significantly below industry averages. So it is not one that I'm losing sleep out overnight. I'd probably say the commercial book is, it, and perhaps in many ways, is counterintuitive because you kind of expect the commercial book to be a little more cyclical in, in nature. When you look, the development finance business is one.
You know, you're financing a series of projects that, you know, that started a couple of years ago, and they're running off now, or started 12 months, and they got another year, 18 months to run. Each of them is a kind of a, you know, a tightly managed process, all in it, all in itself. What we're seeing is the property sales process, when they're coming up to, there's probably sometimes a bit of extension on the time, the build program. There's forever a constant toing and froing with the planning authorities. But there is a, an aspect here where there is a, well, the key thing to look at is what prices are our customers achieving versus the estimated valuations that we put in at the beginning. And they have continuously, month in, month out, outperformed those original valuations and remained very stable.
So we're very confident of that position. When you look at the SME and things like the motor finance business, we have things where we use a combination of obviously the arrears monitoring that takes place within the in-life aspects. But then we also have access to customer data. So it ranges from using the credit reference agency data that drives our behavioral scoring models, right the way through to the current account data. So when we make a loan, we can go in and access current account information. It's not something, you know, go back in history, we were ever able to do, and it was one of the great detriments between us and the clearers. They had that data, we didn't. Now we get access to it.
So we use it at the point of underwriting, and we use it as a point of monitoring. So every month, we go in and we look at the customer's current account information, what's happening? Are we seeing, you know, cash flow being maintained? Are we seeing unusual behaviors in terms of payment levels? So it's a fantastic tool, and it's one of the great benefits of our digitalization program that have been brought through. So do you wanna cover the, if that's okay, would you cover the provisioning point now?
Yeah, sure. So there are a couple of points. Firstly, for the development finance piece, our provisioning leans effectively offer a RAG status that we would have for the different loans that link to that extension. So we often see loans that would be in a higher stage for IFRS 9 purposes, that don't actually result in losses. So just in terms of the allocation. Similarly, we've in the second half recalibrated our SME model. It's a lot more sensitive. You got more in the way of if like indicators of increased credit risk that we would put in. It's a much more sensitive model, as I say, which again drives that allocation for stage one, two, three. But we're not actually seeing greater levels of default.
If you look at the disclosures right at the back of the pack on the credit side, you'll see the arrears levels for the asset finance book, and they're very, very small, they're less than 1%. So the performance is extremely strong, but the IFRS 9 staging drives some of that allocation.
Presumably, stage 3 is when you actually see a sign of default?
Well, yes. But so it may well be that a loan is technically in default, but you're not gonna make a loss. You know, it may still have a 60% loan-to-value. So there's a difference between, if you like, the probability of default element, which more links to the staging and the absolute loss that comes through.
Could I just remind you to use the microphone? Ben.
Good morning. Benjamin Toms from RBC. Can I just ask a question on your new structural hedge, please? I guess investors might be familiar with the larger U.K. banks and their hedges on equity and non-interest-bearing deposits. Can you just give a bit more color about how your hedge differs from those traditional structural hedges and any risk that you're taking? Presumably, the risk here is if the swap curve steepens from the point at which you locked in the hedge. And then secondly, on the weighting of your loan book between commercial and buy-to-let, I think you've historically talked about the reweighting of that book, and you can see organically that that's happening towards commercial.
Is the organic pace that you're going at enough, or now that you've got a bit more capital, in your stack, could potentially we see some inorganic to help speed up that process? Thank you.
To deal with the hedge, I'll come back to you.
Yeah, sure.
So, we've got our treasury team in the back of the hall here who can answer your questions afterwards in a bit more detail, but we're doing it very in a very straightforward basis. So, we got around GBP 1.2 billion, or just over GBP 1.2 billion of tangible net assets. And these are the ones where historically, as rates have risen, we've had the benefit, and if rates fell, we would effectively. Because most of our assets are actually they ultimately, they're interest bearing in one form or another. So if rates go up, you get more, if rates come down, you earn less.
So what we're doing now is where we would normally hedge our fixed rate loan book, fixed rate mortgage, in which case, if rates fall, you'd pay less, and if rates went up, you'd receive more. By not doing that, that provides effectively the hedge for the falling rate. So you're quite right. If rates did lurch higher, there's an opportunity cost that we'd be facing. I think our view is, at this stage in the cycle, it's a better time to be putting the hedge on. We're not calling it a full structural hedge, because if rates were down at 0.5% again, I don't think we would be putting the hedge on.
So it's just, you know, we've got the opportunity at this stage in the rate cycle to, we believe, protect the margin that we've made, if you like, as rates have gone up. So let's say there's opportunity risk, but not, if you like, complete downside risk.
Yeah. So, and to your second question. You know, we have long had a strategy to diversify the business. We think it's good, prudent business management to have a diversified portfolio. In addition to that, I think I also highlighted the fact that we've got, you know, banking is a highly regulated sector, and it creates high fixed cost structures that go with it. So it's better to sort of find other ways of generating additional lines of revenue. Now, so that's a kind of a long-stated strategy. We've made four acquisitions in the past, which was kind of the core of that diversification strategy, and we then built some organically from that, and then we've grown that further.
To make it clear, you know, while, you know, we have been and continue to be interested in opportunities to achieve inorganic growth, it's not because we lack ambition or potential from the organic growth. It's a clearly cyclical weak point in the economy at present, but it'll change, and we expect to see continued strong medium-term growth coming across all of our sectors into the future, and we're kind of very well positioned for that.
But I think, as I said, earlier with a few words around the fact is, you know, this environment, we do see as more challenging for the, for the small and medium-sized banks, because Basel 3.1 is going to load additional layers of capital, well, depending on what ultimately comes through, it will layer additional levels of capital on a sector that is already quite heavily capitalized, and that will put more and more demands on that sector to, you know, think about what the right strategy is for their businesses. So we think it can potentially act as a catalyst, to create more opportunities, but, you know, we remain ambitious in our growth plans, whether that be, primarily organic, but, you know, we will supplement it and develop our strategy further if the right opportunities came along.
We certainly have, you know, a decent amount of capital, with strong internal capital generation as well. Gary?
Hi, it's Gary Greenwood from Shore Capital. I, I have two questions. One was just a clarification on the hedge. Just mechanically, how your hedge works, does it imply therefore a duration sort of around about five years, given most of your fixed rate products are five years?
Yeah, I think I said an average of four.
Average of four.
So there'll be. Yeah, we'll have a spread. You know, a lot of it would be five, but we do two year fixes as well, so.
And then just, I guess, a more philosophical question around cost of equity. Obviously, it's good to see the increased guidance on return on equity to the 15%-20%. Obviously, the stock's trading at a discount to book, and that's not unusual in the sector at the moment. Nearly everything's trading at a discount to book, even with a number of banks earning returns above 10%. So it appears that the market is implying a cost of equity that's probably 20% or higher at the moment. So I'm just interested, sort of how you're thinking about cost of equity, sort of on a longer term basis. And then also, in terms of your conversations you have with regulators, the government, et cetera, are they cognizant of the sector rating and what the implications are of that with regards to capital allocation?
Yeah, so cost of equity. I've read the books, seen the film, still don't understand it. It's a, you know, it's a methodology using a bunch of assumptions. You can kind of make the number up to whatever you want it to be, frankly. And I don't understand cost of equity. I mean, you spoke about, you know, cost of equity of, implied cost of equity of 20%. I mean, there's probably tax adjustments to be made to get to that figure, but either way, it feels like it's a very high number relative to a business that has consistently delivered year in, year out, strong performances with a pretty low risk profile. And we just get caught in the kind of the wider impact on the sector.
You know, no one—I mean, nobody seems to like the equity markets, nobody likes the U.K., nobody likes the banking sector, nobody likes landlords, and so, you know, we're in the kill zone here. So despite our performance, you know, we've got all of that backdrop to have to deal with. But you know, and I mean, I'm not sure much more I can say about cost of equity. It's, everyone's got a view, everyone's got an opinion, but
So, do you think that the regulators and politicians-
Yeah
... et cetera, are sort of cognizant of what that sort of valuation implies in terms of what lenders should do with regards to capital allocation? I mean, in theory, if all banks are stuck with a price to book below 1x, they should all be shrinking their balance sheets.
Yeah.
Which, of course, they're not, but, but that's what they should do rationally, which wouldn't be good for the economy.
Yeah. Yeah. So I mean, I think regulators' job is to keep the system safe, not to advise banks as to how they should run their business. But in one sense, there's a lot of capital in the banking system already, and the fact you're taking, you know, every, you know, most banks are looking at buyback programs of, you know, public entities of one form or another, it still means at the end of the year, particularly as capital generation in the banking sector is strong, you've still got the same amount of capital in the banking sector. So I think there's plenty of capital in the banking sector. I mean, Basel 3.1 might regulate that a bit. But I don't think.
Actually, I don't think it's the job of the regulator to tell us how to run our business. I think the politicians probably could do with thinking about what risk appetite they want the system to run, and what they could, how they could use the banking system in order to support growth in the economy. I mean, we've long held the view that there's lots of things they certainly could do with the mid-tier banks to support growth just from that subsector relative to the whole. But you'll get me into a whole ballgame of political debate there, which I probably shouldn't do, 'cause my political advisors up there will turn around and, like, yank me off the stage very quickly.
Thank you.
Sanjena Dadawala from UBS. Could you give a bit more detail into your NIM guidance for the year, including assumptions on the policy rate and the timing, and what you expect on the deposit dynamics? And then if you could, like, even further out, what you think, how things will play out, especially given that the sector as a whole has TFSME refinancing coming up?
Yeah. So cover the, kind of, more detailed bit. In terms of, you know, we're not going to go beyond 2024 in terms of guidance. I think there's too many variables. Beyond that, you certainly identified one TFSME. We expect TFSME to have an impact on deposit betas, and we've allowed for that in our guidance. I don't think people are going to wait till, you know, the last day in 2025 to start repaying. So I think, you know, you'll start to see further repayments taking place in 2024. Not just from us, I mean, I think from others. And I think, you know, we will. But we have allowed for that in our guidance. But, you know, beyond 2024, we're not gonna - I think it's too...
Well, we never go beyond one year anyway, but, but I think there's so many variables in the longer term over, over NIM, that we, it's probably, probably one to not really get into too much detail on.
Yeah.
Do you want to cover the specifics?
Yeah. So in terms of the rate profile, you know, we've got rates starting to drop from, you know, probably into our quarter three. Now, I know, you know, the market's now pricing those as being a little lower. One of the things to bear in mind in terms of the way we manage margins, and it goes back to the way before we had the bank, where we were, everything was wholesale funded, everything was matched, and so everything was hedged. And we've applied those same principles with the liability side of the balance sheet, as well as the asset side. So a lot of our fixed rate bonds are swapped.
And actually, the more important element for us in terms of our developing margin is the if like that after swap cost of those liabilities. So it may have been, you know, coming into this last year that we've just reported, at the end of 2022, I think we had about 58% of our deposit book that was on a fixed rate basis. As rates have gone up, because we'd hedged those, actually, they became quite expensive through the year, because actually they float up with the new rates. And but similarly, the loans that we've now been putting on and went out to around 65% of the book, that is fixed rate bonds.
If rates start to drop, actually this, by swapping them to a variable rate, we'll start to benefit. And so the forecasting for a bank that takes that approach is a little bit different to the way you'll be looking at margin progression for the biggest banks, who tend not to do that. So it just makes it a little more complex from a, the people who would, if you like, follow a normal, if you like, clearing bank model in terms of, in terms of NIM progression. I think the, you know, the, the point we made is that, you know, we very much focus on product margins.
So if, you know, there's a dynamic where we're making a little bit more on the, potentially on the, because the way the, the deposit beta is coming through, we're up to 64%, 64% at the end of the year. If that carries on tightening a little bit, we would expect the flip side of that to come through in asset pricing, and asset pricing has widened since September in terms of position against swap. So that market is working in a fairly balanced way at the moment, and that's what we've put into our models. We've also assumed that we have the hedge fully put in place, I think, by about February.
From that point, we'll continue to benefit if rates do drop.
Jason.
Jason Napier from UBS. Two, please. The first on costs. This morning, you have the distinction of being one of the sort of, you know, smaller banks who's not missing on costs in terms of guidance. I wonder whether you could talk to the various moving parts around replatforming, delayering, and so on, because we've got others in the sector whose spend on things like cyber and so on seem to have taken us by surprise as being higher than we'd expected. And then secondly, in a similar vein, you've spoken for a while about the monthly downloads of credit bureau data and so on. One of your peers has increased their provisioning on the back of data they believe they see from that same source that suggests that customers are taking debt elsewhere and becoming ever more levered into a weaker environment.
If you could just talk about what you're seeing on that front, that'd be helpful as well. Thank you.
Okay. So in terms of costs, you know, we don't have the heavy infrastructure branch network to worry about, and we have therefore, always sought to make the cost-income ratio kind of a, an opportunity target to try and make ourselves more efficient relative to the competition. And it's, after all, one of the key things we can control. We commenced a technology change program a couple of years ago, and as you can understand, these things don't happen overnight. There's a kind of a long gestation period to the project planning, to the execution implementation, and we're doing it on a sequential basis and a modular basis. So it's not like one weekend there's gonna be a big bang, and we're all gonna be like, Monday morning, it's all gonna be great, or maybe not, if it doesn't work.
So these are kind of things are just getting rolled out. It's a very prudent and very cautious way of doing it. The other thing that you'll see is if you look at, and you may know the numbers, Rich, is the amount we capitalize is very low. If you put us on a stage side by side with, you know, others in the industry, and you see how much of their kind of project costs they get to capitalize, it's significantly more than us.
GBP 4.4 million.
GBP 4.4 million.
Balance sheet.
Is that the balance sheet figure. It's not even the figure we did in the year. The rest is expensed. Now, again, that's a very cautious way of doing things, so a lot of the project work is, despite it being a project, you know, is getting expensed as we, as we go through. And so just bear that in mind when—I, I'd like to say that one day these projects will finish. We know that won't happen. There'll be other projects that will come in, but there is a significant replatforming. It is a big, big change program for us. Kind of every facet of our customer-facing life is being, is being changed. So I think that probably rolls out kind of in bulk terms, probably by 2025.
But thereafter, you know, I'm sure AI and machine learning, there'll be all sorts of other things will be kicking in at that point. Now, you'll notice we don't have a cost-income ratio target, and that's deliberate, because I think it's too difficult a science at the moment to try and predict what that will pan out to be, because the rate of change of technology is so fast at present, that, you know, you've got to be able to see that to happen. On the way through, you know, we also want to make sure our business is in the right shape. So you'll have seen someone in there, we restructured, we did a bit of restructuring during the year.
That's just to make sure we, you know, looked at the organizational design, we looked at the shape of the business, we looked at the management layers, and we decided to sort of, you know, redesign it. You know, that inevitably involved taking out some costs. So that was kind of dealt with in the year. But you know, the year before, we also had IRB costs that were observed. So we don't, like, throw these in as exceptional items every year. There's always costs running in the business, and they're all designed to improve the business, improve the efficiency, improve the regulatory frameworks that we operate under, all of these things. But we don't, like, try and draw them out as to be one-off costs every year.
But the tech spend has grown high. You know, we're probably up 80% or 90% over the last four or five years in terms of the run rate, in terms of the scale of the overall investment there. But you know, it's still coming through and delivering that good cost-income ratio and not the scale of increase in overall cost that we're seeing elsewhere. Sorry, James, what was your second leg?
The debts on the customers.
Yes. So, on the impairment pages, we show that behavioral score analysis across our customer books. Those behavioral scores, you know, the level of indebtedness, we have credit card utilization, you know, there's, as you imagine, the great raft of data that we get from the agencies and, you know, the performance we see from the customers themselves all go into those models. And in the main, you know, year-on-year, we're seeing an improvement on each portfolio. We've seen a slight deterioration this year for the first time on that variable rate legacy portfolio. But those loans have gone from paying, you know, 1.7, 1.8%, you know, 18 months ago, to not far shy of 7% now.
So you'd have expected a little bit in the way of a little bit of stress because they're just tracker loans. But in the main, we haven't seen that over-indebtedness as a particular feature, but that's probably down to the class of customers that we've got.
It's Robert Sage from Peel Hunt. I've got a couple of questions, actually. One quite high level, one quite detailed. I think you made reference to AI in your sort of introductory comments, and I was just wondering whether you could expand a little bit in terms of how you would see possible applications in your business, in terms of how that goes forward. The second point is quite technical. Close Brothers just on an AT1 issue, and I see that you're renewing your authorization to do it. And I was just thinking in terms of how likely is that? What the timing might be? Is it something you're more likely to do once you sort of see IRB or the outcome of Basel 3.1, et cetera?
Okay. So in terms of AI, we've been using it in the business for a while. We have it in our cybersecurity operations, ensuring that actually we've got good technology, kind of watching and monitoring, and being able to identify any heightened risks that may emerge. We have it in our SME business, where I think I mentioned when I was talking about where we access 4,000 pieces of customer data, and that's basically pulling data from various external sources into a core database and then doing some analysis over it. You know, that's artificial intelligence in action, literally, with our customer information, as we speak today. And we've also been using it to write code in our IT development team.
It's. We don't just let the computer loose. We actually have a peer reviewed by a human being. So it's, you know, it's live and working already in our business, and we've got separately a bunch of projects running, and we want to ex- kind of experimenting with how it is, including ranges from. You know, we're using it to do contract reviews through to speech to text, being able to kind of allow the computer to listen to things and then turn it into a detailed minutes, reports, or actions that come right. And it's an experiment, so we'll see, you know. It might turn out to be gobbledygook, or it might turn out to be, you know, absolutely amazing.
But there's a range of projects going on, and I think the team, the teams in the business are very excited about the opportunities that could arise from it. It's got a way to run. I mean, I think it's, you know, no good presentation is complete without mentioning AI, but I think there's a long way to run to ensure you can let it loose on a regulatory system, on a regulatory business. But, you know, we do see the opportunities as quite exciting.
AT1.
Yeah, AT1. Yeah, so, you know, we renew the AT1 licence every year, so in that sense, you might regard it as a free option. What we have is no immediate plans. But because, you know, if you look, we've got a very strong CET1 position, we don't need it. And if we issued one today, all it would do is reduce earnings. So it would be... But, you know, when you looked at the capital stack, it's a sensible tool that a bank could use, but there's no point in diluting earnings when you don't need it. Portia, I think you had a question?
Thank you. Yeah, Portia Patel from Canaccord. Nigel, you touched on politics, and I can understand if you don't want to comment because you've got your political advisors here, but obviously, the election is probably going to be a key theme for next year. So just interested in any thoughts, hopes, expectations for the next 12 months in that regard.
That's definitely taking the fifth on that one, I think. I tell you what, stability, certainty, all of those things, but, you know, you kind of like, you would hope for that all the time. You know, we're not political, you know, we're apolitical. We run a business, so our job is to run a business, whoever is in charge. We engage with the current government, we engage with the Labour Party, and so it's like our job to work with them to try and optimize and get the best solutions possible for the business. Beyond that, I will not get drawn. I think that probably draws to a conclusion the questions in the room.
Now, what we're going to do now is try and take any calls from the phones, and then we'll do some questions from the webcast, if there is any. So I think we hand over to the operator now.
Yes, thank you very much. We have our first question from the telephone today. It's from John Cronin of Goodbody. Please go ahead.
Hi, John.
Mr. Cronin, your line is open. Maybe unmute your phone, please.
Okay, so can we move on to the next call and maybe come back to John?
At the moment, that was the only one. I will see if he registers, and then I will let you know. Thank you.
Okay. So, John, if you're listening, Richard's around, give him a call later. I love the delegation. So, we'll take some questions now, I think if there's some questions from the webcam, webcast.
We don't have any so-
There's no questions?
Okay.
Oh, okay. So, I thought maybe unless John can send one quickly through to the webcast. But, so, in which case, if there's no other questions from the room, we'll leave it there. As I said, Richard's kept the rest of today and tomorrow available to talk to you. It's really important that we know that you—we give you the best opportunity for you to make sure you've understood these results as best possible. So Richard is at your disposal. And, thank you once again. We're around, so, if anybody wants to have a chat after this, we're happy to do so as well. Otherwise, let me wish you a great festive period.
I hope you have a great break, and otherwise, we look forward to seeing you in six months' time. Thank you very much.