Europe Equity Research

02 June 2010

RBS.L, RBS LN

UK Banks
Government Exit Strategies - Looking at the Options

Underweight 47p

Price Target: 42p LLOY.L, LLOY LN
Underweight 57p

Price Target: 50p

• At the crux of this debate is the conflict of interest of owning large stakes in the banks whilst trying to implement significant regulatory changes in a global forum and balancing this with influencing banks' lending behaviour. We see 3 main costs to the UK; • 1 – During the temporary ownership period the stakes account for c.4% of net debt to GDP under the Maastricht definition. Whilst we do not see the stakes as long-term holdings, if fully consolidated, UK net debt to GDP would go from 64% (2009) to 165%; • 2 – Indirectly, there is a cost to the sovereign from providing guarantees to the sector (both implicit and explicit) – for every 10bps of additional financing costs, we estimate annual costs of c.£1bn for the government; • 3 – Last but not least, we estimate a financing cost of c.£3.2bn annually of holding these stakes, equivalent to a meaningful 8% of 2010E UK budget interest expense. • Despite comment that disposals of the stakes are not imminent, with the change of government we believe the breakeven prices are less relevant, esp if the government were to structure a transaction similar to the British Gas & BT privatisations, where there could be a focus on retail investors, not least because this would ‘democratise’ any potential future share upside. News flow around the exit strategies will be a drawn out process, providing trading opportunities, and may remain unclear. • While stocks have come off their highs on the back of sovereign concerns and both Lloyds and RBS are now trading on 0.9x 11E P/NAV, we remain UW on both. Fundamentally, we see NAV per share as a ceiling rather than as a floor as we currently struggle to see returns exceeding CoE. TP for Lloyds remains unch at 50p with modest earnings changes (-1.1% 2012E) and unch at 42p for RBS, where we raise 12E EPS by 6.7% on reduced loss estimates for non core activities. • Given the strain on public finances we believe the likelihood of a specific tax charge along the lines of a wholesale liability tax is high and could remove c.10-20% of sector earnings, raising a much needed £5-10bn. Beyond that, further regulatory changes will likely have to be pushed back, as we believe regulation goes hand in hand with economic stability.
Equity Ratings and Price Targets
Company Royal Bank of Scotland Group P Lloyds Banking Group Plc Symbol RBS.L LLOY.L Mkt Cap (£ mn) 50,172.13 36,109.41 Price(p) 47 57 Rating Cur UW UW

Banks Carla Antunes da Silva
AC

(44-20) 7325-8215 carla.antunes-silva@jpmorgan.com

Amit Goel, CFA
(44-20) 7325-6924 amit.x.goel@jpmorgan.com J.P. Morgan Securities Ltd.

For Specialist Sales advice, please contact: Oliver Doeltl
(44-20) 7779-2187 oliver.doeltl@jpmorgan.com

Nick Gough
(44-20) 7325-9459 nick.c.gough@jpmorgan.com

Justine Shih
(44-20) 7779 2149 justine.shih@jpmorgan.com
Price Performance
100 p 70 40
May-09 Aug-09 Nov-09 Feb-10 May-10

LLOY.L share price (p) MSCI-Eu (rebased)

Abs Rel
55 p 40 25
May-09

YTD 8.3% 12.4%

1m -15.7% -10.2%

3m 12.7% 14.6%

12m -12.9% -29.5%

Price Performance

Aug-09

Nov-09

Feb-10

May-10

RBS.L share price (p) MSCI-Eu (rebased)

Abs Rel

YTD 45.6% 49.7%

1m -15.0% -9.5%

3m 27.4% 29.3%

12m 24.9% 8.3%

Prev n/c n/c

Price Target Cur Prev 42 n/c 50 n/c

Source: Company data, Bloomberg, J.P. Morgan estimates. n/c = no change. All prices as of 28 May 10.

See page 44 for analyst certification and important disclosures, including non-US analyst disclosures.
J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

Carla Antunes da Silva (44-20) 7325-8215 carla.antunes-silva@jpmorgan.com Amit Goel, CFA (44-20) 7325-6924 amit.x.goel@jpmorgan.com

Europe Equity Research 02 June 2010

Table of Contents
Why should the government reduce the stakes? ..................4
What has been the history of government stakes? .......................................................4 Conclusion for the UK .................................................................................................5

UK fiscal position and the impact on the government bank stakes ........................................................................................8
Exit price has some bearing but is not critical to the fiscal position ............................9 The potential impact on bank taxes and special levies...............................................12

What are the potential mechanisms and associated impact? .................................................................................................18
Share sale ...................................................................................................................19 Convertible bonds ......................................................................................................22 Buyback .....................................................................................................................22 An asset swap.............................................................................................................24

Index implications ..................................................................25
Tracker demand .........................................................................................................25 Timing of Index re-weighting ....................................................................................27

Stock implications..................................................................28 Lloyds Banking Group ...........................................................29 Royal Bank of Scotland .........................................................36 Valuation Methodology and Risks ........................................41

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Carla Antunes da Silva (44-20) 7325-8215 carla.antunes-silva@jpmorgan.com Amit Goel, CFA (44-20) 7325-6924 amit.x.goel@jpmorgan.com

Europe Equity Research 02 June 2010

With the UK general election now over, and a new coalition government in place, we turn our thoughts to the potential implications for the government’s holdings in RBS and Lloyds Banking Group. This is especially relevant in light of the upcoming budget announcement due on 22nd June. We note that with the Conservative Party working with the Liberal Democrats there could be greater uncertainty, as the Liberals have been keen on retaining the stakes, whereas the Conservatives have been more in favor of rapid disposals. Nevertheless, we also note that the current government may be less price sensitive compared to the previous Labour government, as they are less associated with the average entry prices for either of the banks. One factor that may complicate proceedings is the commitment to establishing an independent commission to investigate the separation of retail and investment banking. This commission is being given one year to report, and some market participants question whether this would prohibit any significant exit strategies, especially in the case of RBS where the outcome could significantly impact the profitability of the group. Whilst this could be an issue, we still think that it is important to look at the options available to the UK government in terms of strategies as this is one of the main areas of consideration in terms of investor uncertainty.

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Carla Antunes da Silva (44-20) 7325-8215 carla.antunes-silva@jpmorgan.com Amit Goel, CFA (44-20) 7325-6924 amit.x.goel@jpmorgan.com

Europe Equity Research 02 June 2010

Why should the government reduce the stakes?
At this stage, we avoid the intellectual debate on whether banks are better managed in state or public hands, but instead focus on three main themes which we think are crucial discussion points – international precedent, the potential bearing on the UK's fiscal position and the potential conflict of interest the holdings create, in particular when the government is looking at proposals to reform the banking system.

What has been the history of government stakes?
In the recent crisis several governments supported their banks by injecting capital both at the equity and preference share levels, in addition to providing liquidity facilities and asset insurance schemes. Already we have seen governments reduce and exit holdings in several countries, and the UK appears to be on this track. Table 1 on page 6 highlights the main transactions we have seen so far, and we below we discuss some of the precedents. The Swedish crisis The recent credit crisis has been compared several times to the Swedish financial crisis of the 1990s. In 1992 during the Swedish crisis Nordbanken was nationalized and then subsequently Listed in 1995. In the IPO, 34.5% of the company was listed with shareholders split along the following lines:
Figure 1: Nordbanken Offering: Investor Split
Other International 30% Sw edish Institutions 22%

Nordic Institutions 5% US Institutions 15%
Source: J.P. Morgan, Company data.

Sw edish Public 28%

Swedish retail investors were offered a 7.6% discount to the other investors for 90% of the shares offered to them. The Swedish government’s 65.5% remaining stake was reduced via a series of M&A transactions down to 19.9% in the descendant bank Nordea. The US banks The largest US banks have generally repaid TARP funds relatively quickly. Only in the case of Citigroup were TARP preferred shares converted into equity giving the US government ownership.

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2mn shares via an accelerated book build (ABB). French banks Credit Lyonnais was nationalized in 1945 after WW2. In September 2009 the government sold its 332.9% if less).3bn profit excluding financing costs. unconfirmed press reports (FT 25/05/10) have suggested that the Qatar Investment Authority has expressed interest in buying part of the remaining stake.com Amit Goel.5% if more than 4% of the share capital was purchased. This was done by selling shares into the market over a period of time.21 and carried a 12.9% that was sold in 2002.antunes-silva@jpmorgan. CFA (44-20) 7325-6924 amit. the conclusions are equally valid for the UK government's holdings in Northern Rock and Bradford & Bingley. Conclusion for the UK So far. 1. although in some cases the exit has taken several years (in the case of Sweden it is still not complete. In the IPO the French government sold 89. (i) the French public. having started in the 1990s) and the methods of exit have varied significantly. and was eventually privatized in 1999. We also note that although we have focused on RBS and Lloyds Banking Group in this report. (ii) Employees (10%) and (iii) Institutions. In public offerings it appears that local retail investors have been given disproportionate allocations and discounted prices. Note in the case of Citigroup the US government has been able to sell part of its holding at a profit – the purchase price was $3.Carla Antunes da Silva (44-20) 7325-8215 carla. with a first tranche of 19. The French public offering was at a 2.com Europe Equity Research 02 June 2010 This stake is now being sold.25 per share. leading to a loss on the stock but more than offset by coupons received SF1.3% stake in UBS as part of a balance sheet restructuring exercise announced in October 2008.x. (The premium was 3. We believe that if the holdings in RBS and Lloyds were expected to become semi permanent then the EU would have applied tougher penalties for state aid than the ones announced last autumn.7% discount. The remaining 10.5% of the holding having been placed. Credit Agricole took the largest stake at 10% of the offering. The rest of the IPO was allocated to three types of investor. at CHF 16.goel@jpmorgan.5% coupon.13 giving $1. retaining 10. This could be a means to avoid criticism of ‘selling too early’ as the retail public benefits if the share price appreciates after sale.1% of the bank. 5 .8bn. In the IPO 33% of the equity was allocated to strategic investors who paid a premium depending upon the size of their investment. and if shares were held for more than 18months additional (free) shares were awarded. most countries have had an exit strategy. SF18. with Morgan Stanley mandated to execute a pre arranged trading plan. who subsequently sold the holding to Credit Agricole. The Swiss banks The Swiss government attained a 9. Further.9% was sold to BNP via a rapid auction on 24 Nov 2002. and on the shares sold so far the average sale price was $4.50. where it injected SF6bn in exchange for mandatory convertible notes (MCNs) that converted into equity at min.

CFA (44-20) 7325-6924 amit.com Amit Goel.com Europe Equity Research 02 June 2010 Furthermore whilst there may be limited pressure to sell when the sovereign's fiscal position is sound.Carla Antunes da Silva (44-20) 7325-8215 carla. 6 .x. given the magnitude of bank balance sheets in relation to national balance sheets.goel@jpmorgan. they could lead to significant distortions in national accounts. and if stakes are considered permanent. if there is uncertainty it may be beneficial to sell earlier rather than later.antunes-silva@jpmorgan. There could be significant funding costs. We explore this topic in the next section.

1bn Preferred shares Oct-09 €1.5bn 12% preference share conversion Nov-09 £5.7bn Preferred shares Oct 09 €8. 9. Morgan estimates. Exit Nov 09 Aug-09 Lloyds exited the APS for a £2.1bn €3.0bn initial recapitalisation May-09 £1.com Amit Goel.5bn rights offer) Oct-08 CHF6bn mandatory convertible notes. Company data.0bn initial recapitalisation Mar-09 £5.4bn capital redeemed MS paid back $10bn Warrant repurchased for $.9bn (43% share of 13.7bn Subordinated debt €1.5bn fee Swiss Confederation placed all shares with institutional investors (CHF5.8bn for 25% stake $10bn preferred shares (TARP) and warrants Jun-09 Aug-09 $10bn preferred shares and warrants Jun-09 Jul-09 Oct-08 Dec-08 Jan-09 $25bn perpetuity preferred stock and a warrant to purchase common stock (partially converted to common shares (27% stake) in 2009) $20bn perpetuity preferred stocks and a warrant to purchase common stock $5bn capital benefit from asset guarantee Dec-09 May-10 Bank of America Oct-08 Jan-09 Jan-09 ING Oct-08 $15bn preferred shares and warrants $10bn preferred shares and warrants $20bn preferred shares and warrants Dec-09 €10bn 8.5bn worth B-shares Oct 08 £13.5bn convertible notes) US Treasury planning to sell its 27% stake in Citigroup over the course of 2010 Repurchased all preferred stocks for $45bn and paid outstanding dividend ING Repurchased €5bn preferred shares(capital generated using rights issue) 7 .5bn) and received FV of coupons(CHF1.0bn preference share conversion Nov-09 £25.2bn silent participation(preference shares) €8.Summary of Equity Injections since 2007 RBS Lloyds UBS CASA BNP Soc Gen Commerzbank Morgan Stanley Goldman Sachs Citigroup Capital Injection Oct 08 £15. CFA (44-20) 7325-6924 amit.5% preferred shares Dec-09 Source: J.2bn silent participation(preference shares) €1.x.com Europe Equity Research 02 June 2010 Table 1: Global Banks .P.goel@jpmorgan.3% stake if converted Dec-08 May-09 Dec 08 May 09 Nov-08 Jan-09 Jan-09 Oct-08 Oct-08 €3bn perpetual super subordinated Oct-09 €5.Carla Antunes da Silva (44-20) 7325-8215 carla.1bn Citi repaid $20bn (generated capital by selling $17bn common shares and $3.95bn GS bought back $10bn preferred shares Repurchased TARP Warrant for $1.8bn) from UBS Redeemed €3bn notes (using capital from issuance of highly subordinated notes) Paid back €5.antunes-silva@jpmorgan.

taking the consolidated liabilities of the entire public sector. Note the Maastricht Treaty’s deficit and debt target limits are 3% and 60% respectively.e. the balance sheet impact. Allan Monks (44-20) 777-1188 allan. and so we first summarise each metric and the associated impact from the government bank holdings. This measure includes the liabilities of the banks that have government stakes.goel@jpmorgan.e.x. £66bn for RBS and Lloyds Banking Group in total. Under this measure the balance sheets of the state owned banks are not included. Table 2 shows an estimate of each of these measures based on the March 2010 UK Budget projections and our estimates of the impact from consolidating the RBS and Lloyds liabilities in the PSND. i. and only the general government is included. net of their liquid assets. There are other differences from the PSND. deposits. and whether any impact could encourage a sale earlier rather than later. The three main measures we have focused on are (i) the ‘Public Sector Net Debt’ (PSND). primarily that the gross liabilities are used. Note we do not think that the UK’s fiscal deficit means that the stakes have to be sold. in this section we review the impact of the government stakes on the UK’s fiscal position. • General Government Gross Debt (GGGD) – This is a European Union standard that is used in accordance with the Excessive Deficit Procedure of the Maastricht Treaty. which will significantly increase debt levels. (ii) the PSND ex temporary effects of financial interventions (PSND ex) and (iii) ‘General Government Gross Debt’ (GGGD).This is the most commonly cited measure of debt in the UK. and this summer the Office of National Statistics (ONS) will incorporate Lloyds Banking Group and RBS. referring to pages 52-53 and JPM UK Economics team: Malcolm Barr (44-20) 777-1080 malcolm. not public corporations (although this is small).barr@jpmorgan. i. Currently. This measure was introduced by the previous administration to the current coalition.com There are several measures of the debt position. For more details on the specifics of UK economics we refer the reader to Malcolm Barr and Alan Monks: • Public Sector Net Debt (PSND) . and netting out only liquid assets (such as official reserves.com Europe Equity Research 02 June 2010 UK fiscal position and the impact on the government bank stakes Given the concerns over the fiscal positions of UK and European governments. there is no netting for liquid assets.com Note the incoming government is setting up an Office for Budget Responsibility (OBR) to make an independent assessment of the public finances and may present the data in a different way.antunes-silva@jpmorgan. 8 . For more information please see JP Morgan’s ‘Global Data Watch 30 Apr 2010’.com Amit Goel. the reported numbers include the Northern Rock and Bradford & Bingley exposures. but nevertheless it is an interesting debate. and other shortterm instruments). • Public Sector Net Debt excluding financial interventions (PSND ex) – This adjusted measure of PSND removes the impact of the financial interventions that is deemed to be temporary. but retains the aspects that are potentially more permanent such as the potential losses on holdings (based on a mark to market approach).Carla Antunes da Silva (44-20) 7325-8215 carla.monks@jpmorgan. only the funding requirements for the stakes.j. CFA (44-20) 7325-6924 amit.

as the more important measure in this regard being the GGGD. Morgan estimates.8% 6.7% 3.2% 3.1% 4.7% 6.527 1.441 1.9p 3.0p 3.4% 3.e.6% 3.6% 80.653 2014E 145.8% 12.601 2013E 149.3% RBS Exit Gain / Loss -30%/35.339 1.4% 3.0% 4. If the stakes are sold the measure would reduce debt level by the consideration received. As can be seen the PSND will potentially balloon this year when the RBS and Lloyds Banking Group liabilities net of liquid assets are included.1% 3.9% 73.0% 8.7% 3.2% 4.2% 30%/95.5% 4.7% 742 617 2009 63.7p 3.5p 2. This could be especially important when we consider the commentary from Standard & Poor’s credit research. 9 .6% 3.8% 4.095 2.739 Source: J.6p 3. S&P reiterated its negative outlook for UK sovereign debt in Mar 2010 and said that it expects GGGD to continue to trend towards 100% of GDP. UKFI Exit price has some bearing but is not critical to the fiscal position From this exercise it would appear that whilst the exit prices do have some bearing.3% 4.6% 54.218 2.3p Source: J.7% 4. The table below shows the benefit to 2012E GGGD depending on different exit prices for the government stakes in RBS and Lloyds.5% 89.5% 6. and the public finances will look highly leveraged. Note the figures are based on an end March year end.5% 3.2% 5. 2010E represents the period end Mar 2009 to end Mar 2010.7% 4.8% 5.0% 5.5% 10.3% 1.0% 6.2% 8.1% 20%/88. Morgan estimates.P.8% 4.9% 5. What is more relevant is that the stake is sold. a level which if sustained over the medium term would be incompatible with a 'AAA' rating.6% 6.2p 30%/65.216 1.546 2012E 155.1% 71.1% 63.3% 4.7% Lloyds Exit Gain / Loss -10%/66.6% 1.9% 1.1% 5.6% 4.P.7% 43.9% 74.081 952 2. it is not critical.4% 4.7% 74.3% 3.7% 4.4. Lloyds 52.0% 4.9% 4.3p 3.2% 5.7% 4. and largely symbolic.9% 3.x.antunes-silva@jpmorgan.1% 11.0% 88. HMT.2p 10%55.3% 3.8% 55.5% 8.1% 4. CFA (44-20) 7325-6924 amit.2% 1.7% 6.1p -20%/40. Table 3: UK .1% 4. this is due to the potential losses on the stakes and the exclusion of potential gains from the SLS and asset purchase facility.National Debt Based on March Budget Estimates £ billion 2008 PSND %GDP PSND ex % GDP GGGD % GDP PSNB %GDP PSNB ex % GDP Deficit % GDP PSND PSND ex PSND inc RBS.9% 88.8% 4.0% 4. the public sector net borrowings (PSNB) excluding the temporary effects of financial interventions is greater than that including.4% 4.0% 4.com Europe Equity Research 02 June 2010 Table 2: UK . If the holdings in RBS and Lloyds become more permanent then clearly the PSND ex figure becomes less relevant.320 2.2p 20%/60.Carla Antunes da Silva (44-20) 7325-8215 carla.4% 11.471 2011E 161.8% 5.2p 0%/50.0% 11. Interestingly.com Amit Goel.2p 0%/73. i.8% 5.5% 2010E declining inline with nominal GDP growth.5% 3.0% 10%/81.406 2.4% 4.2% 4.goel@jpmorgan.6% -20%/58.1p -10%/45.4% 3.2% 1.0% 3.7% 11.9% 4.Sensitivity of GGGD to exit prices relative to average entry price 2012E -30%/51.2% 913 777 2010E 165.5% 86.6% 69. Note that we do not think this will have a meaningful impact on sovereign funding costs. as the funding requirement still has a noticeable bearing on public finances. On this measure the contribution from the stakes is c.5% 4.

5% 0.3% 1. -5.a.0%* 88.7% n.2% -10.a.8% -5.3% 2.a.a. -5.4% -11.2% n. This would add relevance to the PSND measure. n.2% n.5% 52.0% -5.a. Source: J.P.a. S&P 2014E is based on the text of the statement. -6. Based on current projections.5% 0.6% 88.GGGD and Deficit Estimates 2008 GGGD %GDP S&P HMT IMF OECD Fiscal Deficit %GDP S&P HMT IMF OECD Real GDP Growth S&P HMT IMF OECD 52.3% -6. n. In this context.0% -4. n.2% -5.a. -10.9% n. debt affordability is best captured by the ratio of debt interest payments to government revenues.2% n.6% n.5% 1. 1.3% -6.a.a.Carla Antunes da Silva (44-20) 7325-8215 carla.8% 3. -8.a. and as such may be competing with the governments for credit.6% -9.3% -8.9% -4.6% 2009 68.5% n. n.5% 2.9% n.a. 2014E 100.a.a.a.2% n.9% 2010E 77. 2.5% 2012E 88.2% 3.a.7% n.a.7% -4. Given how close to 100% we may be.0% n.5% -12.0% 55. -11. this affordability ratio is expected to move close to the 10% threshold that delineates the Aaa-Aa boundary.3% 1.0%* -4.2% 1. -9.” Moody’s Investors Service: UK General Election: Hung Parliament No Direct Threat to UK’s Aaa Rating – May 2010 10 . HMT. we note that whilst we have discounted including RBS and Lloyds liabilities from the sums. and hence be a reason for the government to sell sooner rather than later. n.a.2% n.5% 78.6% n. 90.goel@jpmorgan.3% 86.4% -10.1% 80.a. what is the benefit that the government can derive from having more direct control of credit to the economy versus the benefit from a sale? The risk to other stakeholders in RBS and Lloyds being that the government’s interests may not be aligned to theirs and more directed lending could be negative for profitability. 2013E n.2% -11.4% 71.a.a. 89.5% 2. n.3% 0. When we look at Moody’s comments the key metrics are slightly different but the conclusions are broadly similar. -4.8% n.6% n. OECD. n.9% -11. Further.antunes-silva@jpmorgan.a. 2.3% -5.7% 90. the benefit from a sale may be significant.0% 84.3% 2011E 83.a.4% 68. IMF.2% 90. n. Perhaps the question is. Moody's states. “Moody’s defines an Aaa government as a government that has sufficient balance sheet flexibility to keep its debt highly affordable through cycles and crises.a. one could make the argument that they will have significant funding requirements over the next few years. and debt is deemed highly affordable when this ratio remains in single-digit territory.9% -11. 2015E n.a.x.a. Morgan estimates.a. n. n.a. 2.3% 2. S&P.a. Table 4: UK .com Europe Equity Research 02 June 2010 Table 4 below illustrates expectations for GGGD from several sources.5% 0.com Amit Goel.3% n.9% -7.7% 88.0% -6. CFA (44-20) 7325-6924 amit.

1% 1. the cost of borrowing the £66bn invested in the stakes.0% 7.095 1. The impact from the bank stakes is potentially twofold: • Direct funding requirements for the holdings – i.3 0.8 3.5 0. Table 5: Interest Expense to Revenue – Impact from bank stakes £ billion 2008 Interest Expense Revenue Interest / Revenue PSND ex Average Debt Interest Rate Gross Issuance Redemptions Net Issuance Stake Funding Stake Interest Expense Interest/ Revenue ex stakes Difference Sovereign Funding Costs 5bps spread impact % Revenue Source: J.1% -0.7% 617 147 -21 126 From the analysis we see that a sale of the stakes could make a material difference to the interest expense to revenue ratio.x.1% -0.1% 777 697 4.8 3.10% 31 534 5.363 5.08% 2011E 50 582 8.0% -0.goel@jpmorgan.5% -0.P.6% 0.5% -0.157 5.6 0.320 1.5% 0.8 3.6% 0.4% 117 -43 74 65.4% 228 -17 211 65.6% 1.4 0.0% -0.4 9.P. Table 5 below we attempt to quantify these impacts.5% 0.2% 159 -48 111 65.0% 9.5% 0. especially whilst the banks are not paying dividends.6% 0.0% 2008 2009 2010E 2011E 2012E 2013E 2014E Source: J. Company data.8 3.4 9.Carla Antunes da Silva (44-20) 7325-8215 carla. as can be seen.2 7.0% 5.7% 952 864 4.10% 2014E 74 699 10.6% 1.e.269 5.8 2.com Europe Equity Research 02 June 2010 Figure 2 below illustrates the interest expense to revenue ratio as projected in the March 2010 budget: Figure 2: Ratio of Interest Expense to Revenues 11.0% 10. the current projection is for the ratio to be above this level in 2013E.09% 2013E 66 660 10. Morgan estimates.024 4. 2009 31 508 6.8% 187 -39 148 65.6% 1.218 1.7 0.0% 6.com Amit Goel.2% 141 -47 94 65. Note if the stakes were to become more permanent it 11 . HMT Budget projections So. • Impact of the ownership on sovereign funding costs – the impact on sovereign borrowing costs from the 'implicit guarantees' enjoyed by the banks.406 1.8 3.07% 2010E 42 541 7.09% 2012E 60 621 9.6 0.antunes-silva@jpmorgan.9 5.9% 187 -49 138 65.2 8.6 10. Morgan estimates. CFA (44-20) 7325-6924 amit.0% 8.

The potential impact on bank taxes and special levies A secondary consequence of the UK's fiscal deficit and other national fiscal deficits is on the risk of additional taxes on banking profits and possibly bonus payments. (ii) total tax receipts in the UK and the fiscal position. not least because it is an additional source of much needed government revenue.antunes-silva@jpmorgan. Additional taxation is one of the items that the coalition government has highlighted in its agreement document: “'…We will introduce a banking levy and seek a detailed agreement on implementation…” Conservative Liberal Democrats Coalition Agreement. May 2010 This was a discussion point at the G20 Finance ministers meeting in April. Clearly on top of the direct impact on profitability additional taxation will slow the process of banks rebuilding their balance sheets.com Europe Equity Research 02 June 2010 may be fair to include the income of the banks in revenues along with the financing costs of their debt. and relate that to (i) the impact on bank profitability.x. but this is an area where we believe regulatory change is very likely. Figure 3 below illustrates the movement in sovereign CDS spreads for the UK over the past 12 months where we have seen more limited widening compared to other G20 economies as expectations remain that the UK will be able to address its fiscal deficit. and hence will have further consequences on the availability of credit and on economic growth. CFA (44-20) 7325-6924 amit.Carla Antunes da Silva (44-20) 7325-8215 carla. Figure 3: UK Sovereign CDS spreads (5Yr Senior) bps 200 150 100 50 0 08/08/2008 08/11/2008 08/02/2009 08/05/2009 08/08/2009 08/11/2009 08/02/2010 08/05/2010 Source: Bloomberg.com Amit Goel. and we expect detailed proposals to be presented at the summit at the end of June. 12 . In the tables below we estimate the potential direct revenues that such a tax could generate in the UK assuming a 15bps fee on UK wholesale liabilities.goel@jpmorgan.

Barclays.687 21. in the tables below we show the potential impact in isolation on our estimates and in combination with a 15bps wholesale liability levy applied at a local level.416 134.555 11.939 1.15% 0.294 2010E Chg -20% -5% 56% -147% -10% -20% 2011E Chg -17% -3% -112% -32% -10% -12% 2012E Chg -16% -2% -16% -16% -9% -9% Reducing profitability by c. Table 7: UK Banks .022.P.15% 0.com Amit Goel. i.938 535.Impact of Fee on Profitability (based on UK liabilities) £ million Barclays HSBC RBS Lloyds Santander UK Total Source: J.186 -1. Table 8: UK Banks: Potential Impact of Lower Corporation Tax in UK £ million Barclays HSBC RBS Lloyds Santander UK Total Source: J.877 -38 1. 2010E 4.389 8.077 547 1.10% 12E. £2.P. 2010E 249 0 0 33 54 336 2011E 298 270 24 127 58 778 2012E 312 348 169 248 64 1.997 17. Morgan estimates.676 -224 1.802 23.com Europe Equity Research 02 June 2010 Table 6: UK Banks .056 2012E 4. We note that so far £2bn (net receipts) were raised from the UK banks bonus tax for the fiscal year of 2009.609. Note that we have not included possible receipts from building societies and other international banks present in the UK.028 3.677.798 1.148 278. concentrated at those banks with more significant wholesale funded structures. RBS and Lloyds.P.077 3.Potential Revenues from a Bank Fee (based on UK liabilities) £ million Barclays HSBC RBS Lloyds Santander UK Total Source: J.e.747 8. CFA (44-20) 7325-6924 amit.963 1. but a final figure is yet to be reached.x. Please refer to Table 13 for more details.741 143. Morgan estimates.15% 0. as this was an item in the Conservative party election manifesto. Clearly the impact on the banks would be significantly greater if the fees are adopted globally.784 983. Note there has been some discussion about a reduction in the corporate tax rate from 28% to 25%.302 406.864 Based on these assumptions such a fee could generate c.004 536 2.069 4.571 2010E Chg -15% -5% 56% -141% -7% -18% 2011E Chg -11% -1% -107% -27% -6% -9% 2012E Chg -10% 0% -12% -11% -6% -5% 13 .213 1.583 -1.726 4.9bn per annum in the UK from these banks alone. Whilst we think this is an unlikely change. as has also been suggested.867 31.796 398.474 1.15% Annual Cost/ Rev 892 397 598 804 173 2.320.160 1.326 13.922 115.goel@jpmorgan. Morgan estimates.673 14.141 2010E Chg 6% 0% 0% 6% 3% 2% 2011E Chg 6% 2% 5% 5% 3% 3% 2012E Chg 6% 2% 5% 5% 3% 3% Table 9: UK Banks: Potential Overall Impact from Tax Changes £ million Overall Barclays HSBC RBS Lloyds Santander UK Total Source: J.387 453.587 2011E 4.449 751.485 18.15% 0.578 264.115 2011E 5.296 4.909.P.276. 2010E 3.383 1. nevertheless it was not in the coalition agreement.544 40.577 17.142 2012E 5.976 33.385 UK Wholesale 594.447 Charge 0.15% 0.610 UK Deposits 322.893 1.455 351.antunes-silva@jpmorgan. UK Liabilities 1.778 UK Derivatives 403.732 12. Morgan estimates.977 424.Carla Antunes da Silva (44-20) 7325-8215 carla.

995 0.001 1.479 -1.955 -166.415 0.383. Table 10: Global Banks: Potential Impact of Global Liability Tax 2011E $ million Assets Adjustments to US GAAP Adjusted Assets deduct Tier 1 Capital deduct Insured Retail Deposits Covered Liabilities Levy Total Potential Fee Liability reduction from other areas Adj Covered Liabilities Fee Paid Net impact % 2011E net income BoA Citi 2.445 -1.426 1.443 0.15% 1.420 -57. with the UK government collecting c. Note this exercise does not show our anticipated charges from the Obama proposal as we are applying the idea in a slightly different way.696.857 -13% -12% -12% Source: J.15% 1.515.069 962.968 -55.614 514.15% 1.511 -1.063.823.345 -949.523. potentially changes could be negative for banks that have structured their businesses to minimise their tax burden.£6. Furthermore.803 1.681 -636.658 -915.447.470 -64.296 0.995 -2.883 1.996 0.672 1. it could be based on the consolidated balance sheets of the UK banks. or the UK entities of all banks operating in the UK.678.396.319 -83.931 1.638.15% 2.159 -1.15% 2.159 -55.601 22.595 -239. for BoA and Citi. and tackling avoidance.486 1.g.15% 1.362 378.$900bn for BOA and $327bn for Citi.643 1.576 -120.484 815.com Europe Equity Research 02 June 2010 Note.415 -1.174 -420.552 -1.731 1.420 0 773.000 0 849.483 -25. It is unclear whether a levy will be structured in this way.802 -150.733.450.054 0 702.637 -65.276.428 1.804 -1.599 -11% -15% 963.032 -3.600 -14.365.332.15% 771 -20.400 0 0. Note further the coalition statement is: “…We will reform the corporate tax system by simplifying reliefs and allowances.552 0 -346.189 -267.15% 1.393 26.792 -4.541 1.082.391 -4.553.15% 568 0 0.125 -731 -7% MS 773.402 -40.062 696.405 -109.552.430 1.572 1. one of the big difficulties for governments is to make sure they avoid taxation arbitrage and so global coordination will be crucial to underpin any of these measures discussed.551 1.265 0.466 -139.520 933.259 1.577 -25.275 -248.643 1.383.869 1.624 -1.309.324 -2.444-. Our aim is to create the most competitive corporate tax regime in the G20.045 -836 -11% -125.000 -86.110 1. or those that profit from the structuring of such business for corporates.869.325 -142.235 -980 -1.564 -770.15% 1.142 -219.120.116 -17.349 -8% -10% 493.460 -657.389.154.15% 1.097.167 2.232 -236.15% 1.914 0 STAN BNP SocGen SAN UCG Avg Total 566. while protecting manufacturing industries…” Among many other challenges.120.419 1. The press has reported (Independent 23/05/10) that the government is seeking to raise c.076 -1.15% 1.066.945 -226.286 -1.207 -70.386 -258.076 0 GS 849.400 -1.171.667 529.244 1.583 -73.681 0 0.943 0.136 -257.598 -1.594 1.806 1.626.0bn per annum gross from the group of 5 banks included in this exercise.495 0.545 -6.051. The French banks have insurance subsidiaries that potentially inflate the size of their balance sheets.259 1.276. Morgan estimates.931.727 2.758 -90.084.702 -96.285 -438 -1.235 2.846.324 0 0.15% 25.407 1.369 -8% -17% -14% -12% -18% -23% 378.090 -568 -2.125 0 749.223 -119.616.681 -2.233.110 1.x.040 -1.458 16.259.352.15% 2.439.137 -1.com Amit Goel.869.296 -740 -1.712 0.733.333 -1.667 749.371 -43.396. In Table 10 below we illustrate the potential cost if the levy is applied to the consolidated liabilities of the UK banks.390 -277.692 1.667. In this case the impact would be much greater.866 702.15% 2.034. E.804 0 0.623 -28.antunes-silva@jpmorgan.054 -685 -10% CS UBS DB Barc HSBC Lloyds RBS 962.£8bn per annum from the levy.960 2.854 1. 14 .914 -592 -1.143 -1. in order to reduce headline rates.943 -1.202 -2.568 -427.408.019 0.013 988.329 -29. in looking at the banking levy we have focussed on the UK entity liabilities.212 0.149 2.023 -90.034.086 2.096.086 -16% -8% 933.15% 1.572 1.goel@jpmorgan. CFA (44-20) 7325-6924 amit.520 1.440 0 -468.454 17.277 -13.163 1.521 0. the US proposal deducts all assessed deposits – c.872 -93.15% 1.692 685.577 1.955 0 0 2.283 1.P.549.549.173 -94.531 1.381 -1.291 -36.644 -13.479 0.841 1.447.034 -193.065.841 1.072 1.647 -32.869 1.Carla Antunes da Silva (44-20) 7325-8215 carla.

1 5.7 26.4 -3.7 507.8 8.8 2.8 26.3 2.7 23.6 50 -166.9 78.7 24.9 -4.6 3.7 7. HMT 2010E 144.4 16. Morgan estimates.8 1.7 4.5 604.2 2.com Amit Goel.3 0.6 19.7 0.antunes-silva@jpmorgan.0 -0. CFA (44-20) 7325-6924 amit.P.8 -0. Table 11: UK .7 3.0 24.2 0.5 -116.7 25.4 1.6 22.6 -0.5 563.4 2.6 27.2 40 -163.Carla Antunes da Silva (44-20) 7325-8215 carla.0 4.7 476.4 7. looking in more detail at government revenues and expenditure.8 4.3 1.0 78.7 0.8 18.4 2.6 2011E 146.8 644 20 -123.8 6.3 2.Breakdown of government revenue and net borrowing £ billion 2009 HM Revenue and Customs Income tax (gross of tax credits) Income tax credits National insurance contributions Value added tax Corporation tax1 Corporation tax credits2 Petroleum revenue tax Fuel duties Capital gains tax Inheritance tax Stamp duties Tobacco duties Spirits duties Wine duties Beer and cider duties Betting and gaming duties Air passenger duty Insurance premium tax Landfill tax Climate change levy Aggregates levy Customs duties and levies Temporary bank payroll tax3 Total HMRC Vehicle excise duties Business rates Council tax4 Other taxes and royalties5 Net taxes and NICs6 Accruals adjustments on taxes Less own resources contribution to Less PC corporation tax payments Tax credits adjustment7 Interest and dividends Other receipts8 Current receipts Expenditure Depreciation Surplus Net Investment Net Borrowing (PSNB ex) Source: J.4 43.2 -96.1 0.com Europe Equity Research 02 June 2010 In the following tables we highlight the potential impact on the fiscal position.8 533.5 1.4 -5.2 -5.7 507.1 15 .2 153.7 8.0 8.2 0.2 0.9 70.6 3.0 507.7 0.9 47.1 -0.6 2.4 -5.0 36.3 2.4 2.6 1.0 42.7 18.5 1.6 24.goel@jpmorgan.0 406.0 431.8 0.5 2.4 1.5 540.0 439.0 0.9 2.x.8 2.6 96.2 28.8 15.9 24.6 2.6 0.8 2.5 5.3 1.7 0.7 2.4 1.7 -0.2 2.6 7.1 -0.6 94.8 8.0 3.9 2.5 2.0 -4.1 3.9 97.7 0.3 9.7 -48.4 -5.4 29.

2% 0.5% -1. n.5 -1.a. Morgan.9% Note one area of potential contention is whether the revenues collected from a bank levy are maintained in a fund to pay for future potential bailouts of the banking sector or are treated as general revenue for the government.7% 0.8 2.a. CFA (44-20) 7325-6924 amit.3 -2.5 2.a.1 1.5% 2011E 541 644 20 -123 40 -163 2.1bn excluding the contributions from Morgan Stanley and J.P.x.3% From this data just looking at the impact on five UK banks.a. n. n. n.a. 2010E 508 605 20 -117 50 -167 2. Cost (lcl) £368 £20 $355 £225 $58 $465 $400 $600 €225 Cost (GBP) £368 £20 £234 £225 £38 £306 £263 £395 £200 £2.1% -2. The key difference depends on whether a payment to general revenues leads to changes to other taxes or spending. there is also the discussion surrounding whether the payroll tax is extended in duration.8% -0.P.3 2.a.1 4.2 6. HMT 2009 534 564 19 -49 47 -96 n.9 -0. the impact of additional taxation could be significant.6 -1. n.9 -0.2% -1. In 2009/10 this is anticipated to have raised £2bn according to the Treasury. n.antunes-silva@jpmorgan.050 Impact on 2012E -4. Morgan estimates.5bn.8% 0. with some estimates at closer to £2.a. n. as illustrated in the following example provided by the IMF in its interim report for the G-20 (16/04/2010): 16 .9% -1.3% -1.3 2.9% -0. n.a. Furthermore.9 -1.7 -1.P. Table 13: UK Bonus Tax £ million RBS Lloyds HSBC Barclays Standard Chartered Bank of America Citigroup Goldman Sachs Deutsche Bank Total Source: J.3% 2012E 582 662 21 -102 29 -131 2. Morgan estimates.9 -0.a.com Europe Equity Research 02 June 2010 Table 12: UK Banks: Potential Impact on public finances from additional taxation £ billion Current receipts Expenditure Depreciation Surplus Net Investment Net Borrowing (PSNB ex) Liabilities Tax Lower Corporation Tax Total Taxation Cumulative Impact Liabilities Tax Lower Corporation Tax Total Taxation % Net Borrowing Liabilities Tax Lower Corporation Tax Total Taxation Source: J.com Amit Goel.goel@jpmorgan.6 -2.Carla Antunes da Silva (44-20) 7325-8215 carla.7 8. When we sum the reserves the banks have taken for this charge we derive £2. Company data.1 5.

with a fund. The only difference is that payment to general revenues reduces the gross amount of debt issued. which determines the interest burden—is lower. financing needs can be met by the government selling new debt on the open market. and by the same amount. but could be tiered above threshold rates of return.com Europe Equity Research 02 June 2010 It makes no substantive difference to the public sector’s financial position whether a levy accrues to general revenues or to a fund that invests in government securities. but with part of debt now held by a public entity—the fund. as it is unclear for multinational organizations who collects the levies and hence which government's securities the funds are invested in (the proportional split).Carla Antunes da Silva (44-20) 7325-8215 carla. a tax on financial transactions (a Tobin tax). Payment to a fund which then purchases government debt has the same effect. The proposal for a financial activities tax is on the sum of profits and renumeration of financial institutions. 17 . which the report says does not appear to be well suited to the specific purposes set out in the mandate from the G-20 leaders.4trn.x.antunes-silva@jpmorgan.goel@jpmorgan. and a financial activities tax. We think the analysis is not quite as simple as the example suggests. Payment to general revenue leads.2-4% of GDP should be sufficient. financing needs are met by selling its own holdings of government debt or passing them to institutions which may sell them. CFA (44-20) 7325-6924 amit. Regarding the size of the charges. Private sector -100 -100 Flow of Payments Fund Government Revenues 0 +100 +100 0 Government Debt Gross Debt Net Debt -100 -100 0 -100 No fund Fund When failure occurs and cash is needed. although for countries where the financial sector is particularly large relative to GDP this provision should be correspondingly higher – this could lead to a higher charge in the UK.£1. net public debt—the net amount owed to the private sector by the government and the fund combined. the document states that past experiences suggest that for many countries provisioning for c. for a levy of 100.com Amit Goel. whereas payment into a fund leaves gross debt unchanged. The table below illustrates. In that report the IMF proposed two new taxes: • (i) Financial Stability Contribution (FSC) – It is unclear whether a charge should be kept in a fund or should feed into general government revenues. • (ii) Financial Activities Tax (FAT) – Two approaches are reviewed. to less need for the government to sell debt on the open market. In both cases. in the absence of changes to other taxes or spending. the impact is again the same: with no fund. so the potential annual impact could be very significant for the UK banks. but the idea is that there are levies to build a provision for future losses. Note UK GDP is c.

Morgan estimates.com Europe Equity Research 02 June 2010 What are the potential mechanisms and associated impact? In this section we review possible ways for the government to reduce its holdings in RBS and Lloyds Banking Group if it decides to exit.315 -376 27.521 15.939 -2.969 5.9 Per Share p 65.058 25. adjusted for accrued divs and redemption premiums of £230mn. CFA (44-20) 7325-6924 amit. Notes *Total investment adjusted to take account of accrued dividends and redemption premiums received of around £270 million. including the recapitalisation and preference share conversion 18 .500 17.500 45. • An asset swap. Table 15: RBS: Average Entry Price for the UK Government Shares m 22. **Underwriting fees on transactions paid to HM Treasury. UKFI data.527 -305 90.5bn.222 49.2 63.goel@jpmorgan.508 5.957 1.609 Total Investment £m 12.antunes-silva@jpmorgan.645 82% 45.43 37. • Buy back.x. Pre Dec 2009 rights price based on UKFI data.2 Per Share p 182. • Issuance of convertible bonds.8 50.com Amit Goel.P.810 27.2 Initial Recapitalisation Preference Share Conversion* APS B Shares Total Investment Return on Investment Fees Received** Dividends received Profit/Loss on disposals Total Investment % stake held by Government Source: UKFI.6 Initial Recapitalisation Preference Share Conversion* Rights Issue Total Investment Return on Investment Fees Received** Dividends received Profit/Loss on disposals Total Investment APS fee (Gross) Total Investment less APS fee % stake held by Government Source: J.439 72.791 51.000 90.5 38.Carla Antunes da Silva (44-20) 7325-8215 carla.609 27.0 50. This is by no means an exhaustive list but we have highlighted four main methods of potential exit: • Share sales. Table 14: Lloyds Banking Group: Average Government Entry Price £ million Shares m 7.609 41% 19.277 4.8bn after tax. was £1.645 Total Investment £m 14. Company data. APS fee taken gross at £2. The table below shows the current holdings of RBS and Lloyds Banking Group and the average government entry prices.854 16.5 31.0 73.850 20.

or a strategic investor such as a sovereign wealth fund. BT employees and pensioners. Clearly. and then there were two follow-on offerings in 1991 and 1993 spanning a period of 9 years. the general public.com Europe Equity Research 02 June 2010 Share sale There are several ways that a share sale could be executed. we review both below.goel@jpmorgan. and the Conservative party has discussed this possibility for the bank stakes. Percentage shares issued 19 .P. • Private placing – potentially the government could sell shares to a closed group of investors without a broader public offering. Canada and Japan.x. • A 'drip feed' – similar to the strategy that the US government is employing for the sale of its Citigroup holding. Morgan estimates. Figure 4: British Telecom IPO (November 1984) Internatio Employ e es/Pensi oners 5% nal 14% Institutio s 47% 3rd issue 22% 1st issue 51% Public 34% 2nd issue 27% First Issue Allocations Source: J. The two most notable transactions are the privatisations of British Telecom and British Gas. Public offering The stakes could be sold in a similar manner to previous privatizations of government assets. the most common being: • A public offering – in the UK there have been several privatizations. Potentially stock could be offered to institutional and retail investors at different pricing points and depending on previous ownership. The charts below show the allocations and the relative size of the offerings. • An additional listing – the government could potentially list the B-shares in the case of RBS. Below we review each of these methods in greater detail. British Telecom privatisation BT was the first major privatisation of the 1980s and potential shareholders were split into four categories: institutions. Note there have been some questions whether the government could sell the RBS shares whilst there is a commission looking at the separation of retail and investment banking activities. We think that this makes a placing more difficult. but with the right disclosures should not be prohibitive and would be reflected in the pricing achieved.antunes-silva@jpmorgan.Carla Antunes da Silva (44-20) 7325-8215 carla. CFA (44-20) 7325-6924 amit. and buyers in the US.com Amit Goel. Initially 51% of the company was offered. this can be executed in combination with occasional accelerated book builds.

Company Reports Lloyds Investor Base YE09 We note that both Lloyds Banking Group and RBS have substantial institutional investor bases and high weightings of UK investors.Carla Antunes da Silva (44-20) 7325-8215 carla. Currently the shareholder structures of RBS and Lloyds Banking Group are split as illustrated below. Morgan estimates. Morgan estimates. Figure 6: RBS and Lloyds YE09 Shareholder Profiles Other 13% UK Retail 17% Foreign Institution al 29% UK Institution al 41% Foreign Institution al 32% UK Retail 19% UK Institution al 49% RBS Investor Base YE09 Source: J.antunes-silva@jpmorgan. Ultimate Allocations From both of these transactions there is a heavy bias towards UK retail investors.goel@jpmorgan.com Amit Goel. but due to over subscription they ultimately received 65%. Initially UK retail investors were to be allocated 40% of the shares. 96% of the company was offered with the government retaining only 4%. i. from Apr 2012 for both RBS and Lloyds Banking Group. 20 . and UK institutions were also given preferential allocations.x. Figure 5: British Gas IPO (November 1986) Internatio nal 20% UK Retail 40% Internatio nal 11% UK Institution al 40% UK Institution al 24% UK Retail 65% Planned Allocations Source: J. Managements may be under greater pressure to resume dividend payments as soon as EU restrictions are lifted. Shares were offered to retail investors at c25% discounts. who were typically offered a discount to institutional investors.P.com Europe Equity Research 02 June 2010 British Gas privatisation British Gas was the second privatisation and broadly followed the British Telecom model. If the mix were to become more skewed towards retail investors then this could increase the focus on dividends and payout ratios.P.e. CFA (44-20) 7325-6924 amit.

goel@jpmorgan. but the increased liquidity could have a positive impact in terms of where the shares trade in relation to fundamental valuation.x. If it is possible for the preferential dividend rights to be maintained this could be a way for the government to extract more value from its holding. however this 21 .com Amit Goel. QIA currently has a 12% stake in Barclays (including 2% from Challenger.’ So potentially the government could require RBS to list the B-shares separately to the common equity. Summary of impact from a share sale Overall we believe a share sale would have a neutral impact on valuation.P. we could possibly see such a transaction for the UK banks. at the expense of reinvestment in the businesses. HM Treasury is entitled to require RBS to seek a listing of the B Shares.antunes-silva@jpmorgan. potentially increasing the turnover. Further there would be index implications which we discuss later in pages 25-27. Table 16: UK Banks: Time to Sell RBS and Lloyds at 15% of the volume Gov Shares Average Daily Volume 15% ADV Implied Days Years Source: J. The Dividend Access Share will not be listed on any stock exchange. CFA (44-20) 7325-6924 amit.4 years for RBS and 1. 9. Morgan estimates. An increase in the retail investor base could shift the focus more towards dividend distributions. a related entity).645 176 26 3. as the government sells the free float increases.4 Lloyds 27. a sale would add incrementally more liquidity. but based on current average trading volumes it would take c. Private placement It may be possible for the government to sell part of its holding to a strategic buyer. Bloomberg RBS 90.Carla Antunes da Silva (44-20) 7325-8215 carla. and a strategic buyer may add value to other stakeholders.9 years for Lloyds if sales were limited to 15% of average daily volume. Further as the UKFI does not currently 'loan' shares in its holdings.9 This method would have limited impact on the strategies of the groups and their earnings potential in our view. the main issue being the amount of time that this would take.434 9.com Europe Equity Research 02 June 2010 Slow drip feed The government could sell the stakes into the market slowly over time. There have been unconfirmed reports in the press recently (FT 25 May 2010) that Qatar Investment Authority (QIA) has expressed interest in buying part of the US Treasury’s stake in Citigroup.609 259 39 711 1. This could be effective. Additional listing According to the terms of the RBS Accession Agreement: ‘The B Shares will not initially be listed on any stock exchange. such as a foreign bank or sovereign wealth fund. in a similar way to the US government's approach with its Citigroup stake. Clearly.

it will not convert any B Shares issued to and held by it into Ordinary Shares unless the market price of Ordinary Shares is at least 50p on the date on which HM Treasury delivers its Conversion Notice. Buyback In the Acquisition and Contingent Capital Agreement between HM Treasury and RBS it says: ‘that in relevant circumstances. HM Treasury has agreed with the European Commission: 1. Such repurchase would be subject to FSA approval and take account of the Regulatory Group’s capital position at the time of the proposed repurchase and prevailing market conditions’ Furthermore.com Europe Equity Research 02 June 2010 benefit would be partially offset if shares are mainly acquired by retail investors (who also loan limited amounts of stock). offsetting the additional gain).com Amit Goel. and may be executed alongside another exit method such as an equity placing. That without the prior approval of the European Commission.x.Carla Antunes da Silva (44-20) 7325-8215 carla. and for the government the attraction could be a conversion price at a premium to current share prices (although this should be neutral from a deficit point of view as the additional yield expense is reflected in government expenditure. CFA (44-20) 7325-6924 amit.antunes-silva@jpmorgan. 65p. We think that this approach could be used but in limited size. In each of these cases. 22 . 60p. and (d) for purchases from 31 December 2014. The difficulty of this approach is the volume of issuance required.goel@jpmorgan. We think a share sale with possibly a combination of the measures outlined above is the most likely exit route. 2. it will not agree to sell to the Company any B Shares issued to and held by HM Treasury below the following minimum purchase prices: (a) for purchases before 31 December 2012. and given some investor mandates. if the price of the Ordinary Shares is higher than the above agreed price when the sale is agreed. the Company will repurchase the B Shares if it is prudent and practicable. the price of the Ordinary Shares will be the minimum price. some may not be able to participate. This price is subject to adjustment in line with adjustments to the Conversion Price. and acknowledging the conversion feature applicable to the B Shares set out in the B Share terms. That without the prior approval of the European Commission. (c) for purchases between 31 December 2013 and 30 December 2014. These could be similar to the instruments issued by Barclays in October 2008 to Middle Eastern investors and institutions. The attraction for investors could be the ability to earn a yield during the period when RBS and Lloyds cannot distribute earnings. 55p. (b) for purchases between 31 December 2012 and 30 December 2013. 50p. Convertible bonds It may be possible for the government to issue mandatory convertible notes (MCNs) that convert into RBS or Lloyds shares.

6% 2013E 63.5% 383 1. and in fact if the capital position allows it. it is possibly an EC requirement.417 36.500 1.643 54. Morgan estimates.257 438 -128 566 11.447 -435 63. Company data.882 471 -11 482 13. CFA (44-20) 7325-6924 amit.4% 2012E 55.x.530 36.829 503 -56 558 11.106 53. it will request the Company to purchase from it an appropriate number of B Shares (within the above-mentioned price parameters) or to retire an appropriate amount of the Contingent Subscription.0% 9.4% 25.5% 13.607 -2.antunes-silva@jpmorgan.5% 383 765 24.500 1. 200-300bps.Carla Antunes da Silva (44-20) 7325-8215 carla.5% 0 Whilst in 2013E from the table above the capital ratio looks better. If the capital position of the Company allows this and subject to any consent required from the FSA.852 7.com Europe Equity Research 02 June 2010 3.7% 2011E 50.0% 25. which would offset any potential positive impact for common equity holders. 23 .223 57.108 -4. Table 17: RBS: Capital ratios if the B shares were redeemed £ million 2009 Core Tier 1 Capital ow APS deduction CT1 ex deduction RWAs ow APS deduction RWAs ex deduction Core Tier 1 Ratio Core Tier 1 Ratio ex APS B share capital Net Yield Earnings on B shares Cumulative Earnings CT1 post buyback CT1 post buyback ex APS CT1 ratio post buyback CT1 ratio post buyback ex APS Source: J. the calculations above do not incorporate the potential Basel III changes which could further reduce capital ratios by c. We do not think that the opportunity will arise however in the short term.225 27.3% 8.5% 383 383 23.195 27.8% 5.7% 7.460 53. given the capital impact and the regulatory uncertainty surrounding the potential changes to capital requirements and business models. In an environment where there is still significant macro uncertainty we expect that whilst some regulation may be pushed back.2% 9.500 1. 2010E 49.7% 48.5% 383 1. In Table 17 below we illustrate the group's capital ratios if there was a buyback without additional capital raise.500 1.500 1.com Amit Goel.151 -5.182 5.685 4. regulators will still limit the amount of capital distribution to investors. It would be very risky for the FSA to permit such a move in the absence of a further capital raise.8% 4.568 483 -111 595 10.4% 25.5% 25.P.148 28. So under the agreement it appears possible for RBS to buy back the B shares.1% 10.839 4.4% 4.959 31.104 545 -91 637 9.3% 25.goel@jpmorgan.460 -3.

i. and it is not clear whether it is legally possible. and is £8. £320mn per annum at the origination.Carla Antunes da Silva (44-20) 7325-8215 carla. This seems unlikely to us. Currently the facility is triggered if the core tier 1 ratio for the group falls below 5%. CFA (44-20) 7325-6924 amit. The fee for the facility is 4% of the total size. and the company set aside £1. i.458mn.com Europe Equity Research 02 June 2010 Terms and Impact of exiting the contingent capital facility Whilst we think it is unlikely that the B shares are bought back. The company can terminate the facility if it has the FSA’s consent at any time.0bn in size. so if there is early termination part of this reserve could be released.antunes-silva@jpmorgan. and could be similar to the restructuring of Northern Rock.goel@jpmorgan.208mn towards a contingent capital reserve. but it could transfer value from other stakeholders to the taxpayer. 2%. it could be a means to break up the banks to create more competition in the market place. An asset swap The fourth method that the government could use to maximise the value of its holding could be to restructure the businesses and swap the holdings for various assets.x. 1p.com Amit Goel. we think that RBS could seek to terminate the contingent capital facility early. The potential benefit is small however in the context of the group – if 100% of the reserve was released it would benefit NAV by c. 24 .e.e. It is triggered in tranches (provisionally set as £6bn and £2bn) and is scheduled to last for 5 years. Further. At the YE09 the fair value of the consideration payable was £1. and if RBS exits or reduces their participation the fee is reduced proportionately.

P.j.com Europe Equity Research 02 June 2010 Index implications Currently several of the key indices tracked by investors base their weighting methodology on the free floats of stocks. Figure 7: Estimated Passive Indexed Assets $bn Trista J Rose (44-20) 7325 4402 trista.goel@jpmorgan. potential timing differences could lead to trading opportunities. In the section below we review the potential impact.com Source: J.antunes-silva@jpmorgan. Whilst the overall supply would dwarf the potential demand. Figure 7 below illustrates the amount of passive money benchmarked to each. For further details please refer to. and (iii) a sale of the government’s common equity holdings and B share holdings in RBS. there will be some significant index implications. CFA (44-20) 7325-6924 amit. MSCI and DJ Stoxx.com Amit Goel.x. (ii) a sale of 100% of the government's common equity holding in RBS. As such.Carla Antunes da Silva (44-20) 7325-8215 carla. if the UK government does reduce its stakes in the banks. Data as of Dec 2009. The tables below show the potential demand in three cases: (i) a sale of 100% of the government holding in Lloyds Banking Group. For more details on Index implications please contact: Equity Derivatives & Delta One Strategy Tracker demand For the UK banks the main indices are the FTSE. JPM: 2010 Global Index Handbook. Jan 2010 We would like to thank Trista Rose for her collaboration in this section. 25 . Morgan Derivatives and Delta One Strategy.rose@jpmorgan.

12 38.antunes-silva@jpmorgan.06 3. Stoxx Ltd.83 22.57 0.93 15. Overall the passive demand from index trackers is c.17 2.26 2.983.59 9.60 1.26 218.541. Note additions can only be made to this index during the annual review (every September).68 38.555% 0. Morgan Derivatives and Delta One Strategy.97 127.058% 0.35 838.312% 0.05 197. MSCI Barra.66 xADV 8.76 51.com Europe Equity Research 02 June 2010 Table 18: Simulated Demand – Lloyds free float increased to 100% Old weight FTSE FTSE 100 FTSE ALL SHARE FTSE AW MSCI MSCI EAFE MSCI EUROPE MSCI KOKUSAI STOXX Stoxx 600 TOTAL 1.983% 0.44 xADV 3.54 90.607% Demand .119% 0. Stoxx Ltd.28 59.58 1.47 101.322% 0.20 396.025.46 xADV 1.49 0.40 2.483% New weight 2.28 135.US 448.207. Bloomberg.15 0. CFA (44-20) 7325-6924 amit.193% 0.743.463.180% New weight 3.261% 0.68 865.77 602.16 180.25 7.59 3.20 131.717.500% 0.64 Source: J.119% 0.985.822% Demand .x. 26 .570% 0.396% 0.049% 0.555% 0.536% 0.361.471% 0.567.Carla Antunes da Silva (44-20) 7325-8215 carla. MSCI Barra. MSCI Barra.09 39. FTSE.38 6.USD 372.93 6.024.849% 1.068.215% 0.968.29 Source: J.66 4.03 4.189.058% 0. Morgan Derivatives and Delta One Strategy.16 Demand .157% 0. Stoxx Ltd.615% 0.20 906.shares 674.55 87.80 10.44 30.55 300.18 118.609% 2. FTSE.55 Demand .367% 1.33 79.US 1.82 2.12 0. further increasing demand.P. FTSE.53 5.233% 0.69 10. Morgan Derivatives and Delta One Strategy.172% 0.471% 0.goel@jpmorgan.shares 1.164% 0.77 3.302.30 17.185% 0.43 62.52 274.P.68 271.185% 0.93 669.137% 0.24 0.85 263.05 452. Bloomberg Table 19: Simulated Demand – RBSs free float increased to 100% no B share sale Old weight FTSE FTSE 100 FTSE ALL SHARE FTSE AW MSCI MSCI EAFE MSCI EUROPE MSCI KOKUSAI STOXX Stoxx 600 TOTAL 0.17% of the supply based on our estimates.15 16.539% 1.180% New weight 1.156% Demand .636. Bloomberg Table 20: Simulated Demand –RBS free float increased to 100% and B shares listed Old weight FTSE FTSE 100 FTSE ALL SHARE FTSE AW MSCI MSCI EAFE MSCI EUROPE MSCI KOKUSAI STOXX Stoxx 600 TOTAL 0.P.049% 0.644.754% 1.307% 0.512% 2.shares 466.55 2.05 Demand . Further if the free float was increased to 100% for both banks they could re-enter the Stoxx 50 Index.34 0.96 2.14 78.com Amit Goel.82 1.77 1.833% 0.40 1.17 Source: J.

Carla Antunes da Silva (44-20) 7325-8215 carla.goel@jpmorgan. 27 .x.antunes-silva@jpmorgan. If there is a placing the treatment is slightly different: • FTSE – if the impact is more than 10% then the rebalance is done within 2-4 days typically • MSCI – if the placing is expected to have significant market impact the reweighting can be delayed to the next quarterly review • Stoxx – for the Stoxx if the impact is greater than 5% then the rebalance is usually executed within 2-4 days Note whilst these are the times that the rebalancing occurs.com Amit Goel. MSCI and Stoxx rebalance occurs at the close on the last day that the stock is cum rights. there can be some flexibility build into their mandates to reduce the potential for their trading to minimise price impact. passive funds do not have to execute at the exact same time. CFA (44-20) 7325-6924 amit.com Europe Equity Research 02 June 2010 Timing of Index re-weighting In the event of a rights issue (not our base case scenario) the FTSE.

28 . Fundamentally.com Amit Goel.goel@jpmorgan. We go through each stock in turn as we try to explain why we struggle to see RoEs exceeding 11-12% over the next three years or so.Carla Antunes da Silva (44-20) 7325-8215 carla. both RBS and Lloyds Banking Group have outperformed the European banks index by 71.93x NAV 2011E respectively.com Europe Equity Research 02 June 2010 Stock implications Despite the stocks having corrected in the wake of sovereign concerns.antunes-silva@jpmorgan.7% and 23. we believe that returns are capped for both these banks until they address certain issues.x. CFA (44-20) 7325-6924 amit.8% respectively YTD and are currently trading at 0.92x NAV and 0.

0 1. to achieve a 15% return on total equity attributable profit would need to be significantly greater but also the book value is that much higher).01% in 2008. Morgan estimates.1% 41. In fact in the Q1 IMS the management stated that due to lower wholesale impairments this goal had already been achieved in Q1.4% Over the last few months on the back of management guidance.05 NAV/Sh FY (p) 164.com Europe Equity Research 02 June 2010 Lloyds Banking Group Company Data Price (p) Date Of Price Price Target (p) Price Target End Date 52-week Range (p) Mkt Cap (£ bn) Shares O/S (mn) 57 28 May 10 50 31 Dec 10 76 .492 71.19 0.2% RoNAV in 2012E.0 (941) 547 NM 8.3 65. 61.775 Lloyds Banking Group Plc (LLOY.1% 2010E -0. and (iii) a further reduction in provisioning requirements.474 1. what would it take for the group to earn a 15% RoNAV. J.3 P/NAV FY 0. Morgan estimates. (i) Sensitivity to increasing banking NIM The first area that we explore is the potential for greater NIM expansion than currently estimated. 2009A -0. of Shares (mn) 2012E Net Attrib 2012E RoNAV Required Estimates 2011E NAV Implied 2012E Net Attrib % change in estimate Implied 2012E EPS (p) Implied 2012E NAV Implied 2012E NAVps (p) Implied 2012E RoNAV Source: J.725 6.40 36.goel@jpmorgan.7 69.837 2. Bloomberg.733mn as illustrated below (note we are referring to return on tangible equity.827 NM 8.antunes-silva@jpmorgan.3% 2011E 0.x. Table 21: Lloyds Banking Group: 2012E 15% RoNAV Net Attributable Profit Calculation £ million Current Estimates NAVps 2011E (p) NAVps 2012E (p) Average NAVps 2012E (p) No.11 63.0% To drive such an outperformance in earnings there are potentially three key levers: (i) an increase in net interest margins.9 3. EPS FY (p) -0. Management guidance at the FY 2009 results 29 .01 0.9 9.761) Net Attributable Income FY (£ 772 mn) Adj P/E FY NM Core Tier One Ratio FY 6.633) 2. We go through each in turn.0 (11. In H209 banking NIM expanded to 1.Carla Antunes da Silva (44-20) 7325-8215 carla.04 0.P.L.04 58. and to generate a 15% RoNAV the net attributable profit would need to be 36% higher at £6. CFA (44-20) 7325-6924 amit. expectations have moved towards the group earning an operating profit on a combined business basis in 2010E.0 48. and hence justify multiple expansion? Based on our estimates the group will earn an 11.P. after declining from 2. (ii) a reduction in costs. The next question that investors have been asking is.3 1.666 4.3 Pretax Profit Adjusted FY (£ mn) (5.com Amit Goel.463.01 58.04 61.7 0.939 11.766 37% 10.7 15.72% in H109.46 Headline EPS FY (p) 0.5 67.83% from 1.2% Source: Company data.LLOY LN) FYE Dec 2008A Adj.

246 1.Carla Antunes da Silva (44-20) 7325-8215 carla.4% 38.924 613.246 2012E 13.2% -9.944 2011E 13.096 6.969 2.642 15% RoNAV 18.antunes-silva@jpmorgan. Morgan estimates.0%.396 586. Morgan estimates. as illustrated in the charts below.1% 0.4% 18.002 6.0% 74.892 -126 6.7% 33.0% -100.70% 6.986 -6.378 28.747 6.6% 71.019 5. with an upward trajectory beyond then.4% 41.466 -11.462 674.com Amit Goel.726 2010E 12.8% -100.1% -243.9% 16.169 1.100 9.25% 11.8% % Change 15% RoNAV/12E 32. data from the Council of Mortgage Lenders (CML) suggests that the back book of existing business has largely re-priced.2% -63.3% 94.376 -5.37% 13.0% 139. Management has guided to a further £140bn reduction by end 2014E.640 -2.com Europe Equity Research 02 June 2010 for 2010E is c2.397 15.462 534.44% 46.4% -9.084 -2. Company data.77% 51.01% 14. In the analysis below to illustrate the combined effect.246 % Change 12E/09A 9.4% in 2012E.6% 0.7% 3.0% 18.7% % Change 15% RoNAV/09A 44.768 666.6% -12.0% -100. it appears that the net interest margin would need to increase by 167bps from 2009 levels.315 12. This will put pressure on the absolute level of net interest income despite the margin expansion.1% 36.goel@jpmorgan. but in H209 it was broadly the same.284 2008 13.0% 825. What we are seeing in the market however is that asset pricing has started to stabilize and in some markets actually contract slightly.99% 7. Note that whilst the NIM may be increasing. For the UK mortgage market.6% 0. Group net interest income is historically greater than banking net interest income. Based on the table above.9% -69.042 H208 6.5% 28.1% -4.355 2012E 13.903 2009 11.827 1.724 671.736 9.183 655.1% 36.P.6% -20.924 588.042 1.726 9.77% 12.4% 18.0% -100.989 2.953 686.453 2.740 22. of which £100bn is in customer loans and £40bn in Treasury assets.131 -1.4% -4.1% -173.984 -400 500 0 7. and a further 107bps from JPMe 2012E to achieve a 15% RoNAV.9% 53.37% 46.0% -153.03% 7.84% 6.4% -100. Table 22: Lloyds Banking Group: Banking NIM Progression £ million Banking NII AIEA Banking NIM Group NII H108 6.0% 37. Company data.6% -75.6% 0.415 644.2% Net Interest Income Non Interest Income Total Income Operating Costs Pre Provision Operating Profit Provisions Underlying PBT Restructuring Charges Fair Value Unwind Other Exceptionals Profit Before Tax Tax Profit After Tax Minorities Net Attributable Profit NIM Cost Income Ratio Impairment Charge Banking Net Interest Income Average Customer Loans AIEA Source: J.8% -205.944 618.642 588.5% -10.0% -100.5% 19.609 10. We have assumed that they are equal going forwards.4% -9. in the 15% RoE scenario we have assumed that this 'right sizing' has taken place.861 H109 5.771 2.642 2.988 -13.953 674.065 -126 4.396 10. Table 23: Lloyds Banking Group: Potential for NIM expansion £ million 2009A 12.355 601.0% 45.P.1% in 2010E. the size of the balance sheet is shrinking.766 3.0% 0.773 -13.5% -91.889 1.5% 8.8% 133.1% 15. 30 .2% -2.378 24.4% 0.0% 579.857 -23.0% na 36.98% 18.924 Source: J.924 10.442 H209 6229 676548 1. increasing to 2.x.1% 0.6% 6.5% 0.22% 13.301 -11.09% 12.9% -69.939 2.0% 32.911 2. CFA (44-20) 7325-6924 amit.953 -126 2.4% 6.640 0 0 0 9.944 1.9% -14. In our base case we expect 2.6% -76.98% 13.

50% 5. Further. pushing up yield requirements. c.60% 0. Over this period integration costs are estimated to total 155% of the annual benefit.antunes-silva@jpmorgan. Our UK economists estimate a 0.50% 6.80% 0. There is also potentially an issue with the sheer volume of paper that needs to be issued by sovereigns. however we think this would likely be on the back of effective austerity plans. on the liability side we have several concerns: Whilst deposit spreads have been compressed and are likely to improve we expect greater amounts of competition than what we have seen in previous cycles. Since then this figure has been revised upwards to £2.00% 5. As observed in the report.20% -0. Given £766mn has already been achieved.00% Jan-04 Figure 9: Spread between new business and outstanding balances 1.4% benefited from £1.00% 4. CFA (44-20) 7325-6924 amit. For further details on this topic please see JP Morgan's 'European Banks H2'10 Outlook . but is negative in the medium term.0bn.40% 0.00% -0. (ii) Sensitivity to reducing costs At the time of the HBOS acquisition.5bn gains on exchange and tender offers.00% 0.60% Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Outstanding Balances Source: CML / BOE New Business Source: CML / BOE Spread Clearly new business prices can pick up again from these levels but that is largely in our forecasts.The Big Squeeze' 27 May 2010 by Roberto Henriques.2% reductions in the cost income ratio per annum for the next few years (note in 2009 the ratio of 48. excluding this item the ‘clean’ cost income ratio 31 . In fact there is a risk that banks are forced to resort to central bank facilities as they are effectively ‘crowded out’ from term debt issuance.x.50% 3.Carla Antunes da Silva (44-20) 7325-8215 carla.goel@jpmorgan.25bn to be done by end 2011E.com Europe Equity Research 02 June 2010 Figure 8: Yield on mortgages 6. and hence more limited benefit.5x multiplier between fiscal tightening and GDP growth (please see JP Morgan's 'UK fiscal policy: the coming tightening and its impact' 21 May 2010 by Malcolm Barr).20% 0. helping earnings.28% of the HBOS cost base. c37% of the HBOS cost base. Further.com Amit Goel.5bn of cost synergies. this leaves £1. This may result in the duration of liabilities shortening in the near term.50% 4. banks and corporates over the coming 18-24 months.40% -0. Overall management guidance is for c. with regards to wholesale funding we expect investors to require higher margins to compensate for the increased risk that is associated with less valuable sovereign protection.00% 3. management guided to £1. which would have their own impact on economic growth and hence bank earnings. if sovereign concerns were to diminish this would be less of an issue.

32 .97% 3.5% 8.P.0% 37. in total savings of 64% of the HBOS cost base or 28% of the combined 2008 cost base. Table 25: Lloyds Banking Group: Provisioning Guidance & Expectations % Group Retail Wholesale Wealth & International 2010 Guidance Significantly lower than 2009 Lower than 2009 Significantly lower than 2009 Peaked but risk in Ireland FY08 1.7% 0.924 10.61% 36.4% -100.25% 11.2% Net Interest Income Non Interest Income Total Income Operating Costs Pre Provision Operating Profit Provisions Underlying PBT Restructuring Charges Fair Value Unwind Other Exceptionals Profit Before Tax Tax Profit After Tax Minorities Net Attributable Profit NIM Cost Income Ratio Impairment Charge Banking Net Interest Income Average Customer Loans AIEA Source: J. Based on this analysis the cost income ratio would need to decline to 37% to achieve a 15% RoNAV.4% 6.42% FY12E 0.0% -100.640 0 0 0 9. Company data.1% 36.4% -9. continuing in 2011E and 2012E.726 9.11% 5.747 6.100 9.3% 47.1% 0.924 613.986 -6.98% 13.5% -10.6% 2012E.1% 41.6% -76.1% -173.953 686.7%).83% 2.0% -4.8% -205.939 2.301 -11.5% 19.0% 0.0% -100.301 -8.90% 0.376 -5.2% -2.131 -1.32% 1.1% 18.246 % Change 12E/09A 9. We model the cost income ratio declining to 46.11% 4.6% 71. Morgan estimates. in line with management guidance.0% 0.0% 139.04% FY10E 1.4% -9.0% -100.5% -14.6bn.com Europe Equity Research 02 June 2010 was 51.988 -13.857 -23.7% % Change 15% RoNAV/09A 9.9% -69.04% 2.e.51% 1.1% 36. We have assumed a significant improvement.81% 0.042 1.04% Source: J.169 1.0% -100.P.984 -400 500 0 7.25% 1.0% 579.1% -243.642 588.4% -4. Company data.462 534. We note that this would imply a further absolute cost reduction of £2.892 -126 6.736 9.8% -100. Table 24: Lloyds Banking Group: Potential for Cost Reduction £ million 2009A 12.7% 33.1% 0.7% 3.93% 3. (iii) Sensitivity to reducing provisions The biggest delta in 2010 results compared to 2009 will be the level of provisioning.246 2012E 13.378 24.925 15.2% -21.98% 0.33% 0.74% 1.8% 133.0% -21.58% FY11E 1.0% 10.9% -69.2% -23. Table 26 shows how we would have to further reduce our provisioning estimates to achieve a 15% RoNAV in 2012E.084 -2.4% 6.740 22. Morgan estimates.98% 13.766 2.019 5.5% -91.0% 0.6% -12.640 -2. i.462 674. Table 24 below illustrates the reductions in costs to achieve a 15% RoNAV.827 1.0% 825.5% 0.4% 0.378 24.com Amit Goel.6% 0.2% -63.466 -11.0% na 36.Carla Antunes da Silva (44-20) 7325-8215 carla.9% 16.goel@jpmorgan.6% -75.92% 6.315 12.37% 46.002 6.0% 74.924 586.953 -126 2.065 -126 4.609 10.911 2.5% 8.x.antunes-silva@jpmorgan.0% -153.05% FY09 3.924 10. CFA (44-20) 7325-6924 amit.8% % Change 15% RoNAV/12E 0.6% -20.4% 38.0% -28.77% 51.9% 16.096 6.642 15% RoNAV 13.

goel@jpmorgan.9% -69.0% na 36.096 6.169 1.P.59% 4.11% H209 1.6% 0.911 2.246 % Change 12E/09A 9.9% -82.5% -91.7% % Change 15% RoNAV/09A 9.642 588.1.93% 3.4% -9.640 -2.0% -4.1% 36.766 2.2% -63. Company data.4% 16.953 -126 2.924 613.0% 37. For details on changes to provisioning methodology please refer to.378 24.7% 33.002 6. Note that at FY09 the company based its 2010E guidance on a UK GDP growth rate of 1. Morgan estimates.0% 74.2% 0.5% -10.315 12. CFA (44-20) 7325-6924 amit.12% 7.7% 3.0% -173.25% 11.1% -243.315 12.5% 19.57% 13.726 9.0% -100.084 -2.50% 0.827 1.9% 16.609 10.11% 11.301 -11.68% 0.301 -11.09% 0. Morgan estimates.988 -13.986 -6.0% 10.83% 5.7% 0.0% 139.0% -41.4% -100.924 586.5% -14.50% 0.77% 0.3% 47. JP Morgan ‘European Banks: Asset Quality – Assessing the impact of regulatory changes’ 17 May ‘10 Table 27: Lloyds Banking Group: Normalised Provisioning Rate % Retail Secured Unsecured Wholesale Corporate Markets Treasury and Trading Asset Finance Wealth & International Wealth International Total Source: J.924 10.042 1.83% 0.892 -126 6.3%.953 686.1% 36.98% 13.09% 6.16% 0.0% 0.4% 0.00% 7.100 9.246 2012E 13.25% Whilst at the start of this year impairments have tracked better than our expectations.48% 1.8% -205.8% 133.0% -100.6% 0.2% -2.com Europe Equity Research 02 June 2010 Table 26: Lloyds Banking Group: Potential for Further Provisioning Reduction £ million 2009A 12.1% 0.131 -1.34% 4.6% -12.5% 0.378 24.2% -2.52% 5.0% 0.0% -100.466 -11.8% -100. Based on this analysis the group would need to report a provisioning rate of 57bps on a normalized basis.462 534.4% 6.01% 0.00% 1.x.0% -9.Carla Antunes da Silva (44-20) 7325-8215 carla.0% 0.740 22.00% 1.5% 8.55% 0.antunes-silva@jpmorgan. In Table 27 below we show our normalized provisioning estimates.00% 0.0% 0.0% -153.0% -44.8% in 2010E which appears high relative to current consensus expectations of c.462 674. and we do not expect to need to downgrade our provisioning estimates.5% 8.924 10. if global (and particularly UK) growth assumptions are reduced the pace of improvement could be slowed.857 -23.019 5.6% -20.642 15% RoNAV 13.4% 6.61% 46.2% 38.16% 5.6% -75.16% 8.984 -400 500 0 7.87% 9.91% H109 1.6% 71.6% -86.37% 46.5% 19.346 9. Normalised 2012E 0.77% 51.00% 6.2% Net Interest Income Non Interest Income Total Income Operating Costs Pre Provision Operating Profit Provisions Underlying PBT Restructuring Charges Fair Value Unwind Other Exceptionals Profit Before Tax Tax Profit After Tax Minorities Net Attributable Profit NIM Cost Income Ratio Impairment Charge Banking Net Interest Income Average Customer Loans AIEA Source: J.P.0% -100.939 2.986 -3.640 0 0 0 9.747 6.96% 9.0% 825.com Amit Goel.87% 0. 33 .8% % Change 15% RoNAV/12E 0.065 -126 4.4% -9.34% 9.0% 579. Company data.05% 1.

2008 1.058 4.6% share of the UK personal current account market and c.goel@jpmorgan.7% 30. Morgan Lloyds Banking Group – With or Without APS. £30bn of deposits.3 48% 1.0 30. We refer the reader to J. 11th August 2009 for more details on how we reached the underlying earnings potential.9% 226% 0.132 4.19% of the group’s mortgage assets.6 50% 1.467 -675 792 -263 529 72. EU sanctions As a consequence of the state aid that the group has received.230 2.5 20. Company data.0 46% 2.2 30. Company data.0 18.50% 2010E 1.879 2.560 5. as discussed below.x.392 3.186 -593 593 -354 239 71.118 2.872 2004 2. within 4 years. Morgan estimates.9% 28.263 -631 631 -334 298 71. This was slightly more substantial than our original estimates. but in addition the group is required to dispose of a retail banking business with at least 600 branches. Table 29: Lloyds + HBOS Historic Earnings £ million LLOY HBOS HBOS Adj Total Source: J. even without the impact of additional taxation that we have discussed earlier in this report or other regulatory changes.£500mn of PBT.363 2007 3.0 43% 2.670 5. had £70bn of loans.3% 233% 0.493 3.4 19. Table 28: Lloyds Banking Group: UK Retail Disposal Assets £ million UK Retail Divestment Contribution Income Expenses PPOP Provisions PBT Loans Deposits RWAs Cost Income Asset Margin Risk Weight LDR Provisions/ Loans Source: J.1 50% 1.41% 2012E 1. 4. Below we illustrate its potential contribution.618 4. In the analysis above we have included the impact of balance sheet reduction. Morgan estimates. there are sanctions that have been applied by the EU which we expect will act as a further headwind.P.452 1.com Europe Equity Research 02 June 2010 Summary of potential for 15% RoNAV So to achieve a 15% RoNAV would be a stretch.8% 30.0% 26% 233% 0. 2003 3.959 34 .antunes-silva@jpmorgan. Furthermore.P.289 4.2% 217% 0.0% 26.5 33.625 2006 2.43% 2009E 1.351 -648 702 -294 408 71.4 31. The combined profits in 2007 are 13% short of the 2012E requirement for a 15% RoNAV or 22% short.36% Table 29 below shows the historic earnings of Lloyds TSB and HBOS adjusted for the unsustainability of its revenue base.47% 2011E 1.803 3.254 2.450 2005 2.045 2.5 22. if we include a UK liability tax impact.P. The company has said that at YE08 this business consumed £18bn of RWAs.6 21.Carla Antunes da Silva (44-20) 7325-8215 carla. CFA (44-20) 7325-6924 amit.2% 221% 0.400 -600 800 -300 500 70.9 32. the European Council has imposed several requirements on the business. and generated c.com Amit Goel.

193 832 781 -534 3.g/CoE . For more details please see J.8 1.5 14.0x 1.3% 62.3 P/BV (x) 1.4% 61.9x 6.8% 0.1% 43. NAV growth (%) Old JPM adjusted NAV (p) % difference New reported NAV (p) Reported NAV growth (%) Old reported NAV (p) % difference New DPS (p) DPS growth (%) Old DPS (p) % difference PE Stated P/NAV Stated RoNAV(%) Source: J.460 4. Morgan estimates.7 -1.1% 58.4x 1.8x 11.0% 0.5% 69.P.0 35 .1% 30.1 -8.684 17.474 Value 14.9 66.1 1.0 -0.5% 58.3 13.1 -0. Our SoP based TP of 50p remains unchanged.7 41.P. Morgan estimates.0 0.643 -3.0 0.7 1.826 5.1% Table 31: Lloyds Banking Group: 2010E Based SoP £ million Retail Banking Wholesale Banking Insurance Wealth & International Underlying Core Earnings Corporate Center Capital Excess/ Shortfall ow Pillar 2 Lloyds Banking Group Price Target Source: J. Table 30: LBG: Changes to Estimates New basic EPS (p) EPS growth (%) Old basic EPS (p) % difference New JPM adjusted NAV (p) JPM adj.0% -64.9 18.4% 69.8 -81. Our new estimates are shown in Table 30 below.6% 0.0 0.goel@jpmorgan.7 6.4% 43.3 99.6% 0.0 0. Morgan’s ‘Lloyds Banking Group: Exchange Offer of Upper Tier 2 Securities' 01/06/10.g RoE .antunes-silva@jpmorgan.g/CoE .942 9.0% 14.1% 3.3 12.4 -1.0 1.9% 52.6% 7.g BV/ P/E Value per share (p) 22 26 14 7 69 -5 -13 50 50 P/E (x) 6.6 12.7 352.7x 0.com Europe Equity Research 02 June 2010 Overall Lloyds Banking Group valuation We have revised our estimates to reflect the recent exchange offer announcement.x.0% 7.704 -8.272 -529 -269 2.9x 0.0% 0.7% 0.558 46.4 -0.9% 30.1% 51.2 -0.g RoE .0 0.4% 2011E 3.P.0% 0.578 34.5 1.5 56. CFA (44-20) 7325-6924 amit.Carla Antunes da Silva (44-20) 7325-8215 carla. 2010E 0.0 0.com Amit Goel.8 -0.1% 2012E 7. Earnings 2.113 Valuation Basis RoE .g/CoE .9 -0.7 21.9 -0.

9 0.077) (1.P.59 29.718) 14.4% 2011E (New) 2012E 3.160 6. of Shares (mn) 2013E Net Attrib 2013E RoNAV Required Estimates for a 5% RoNAV 2012E NAV Implied 2013E Net Attrib % change in estimate Implied 2013E EPS (p) Implied 2013E NAV Implied 2013E NAVps (p) Implied 2013E RoNAV Source: J. Table 32: RBS: Net Attributable Profit Requirement to Achieve a 15% RoNAV £ million Current Estimates NAVps 2012E (p) NAVps 2013E (p) Average NAVps 2013E (p) No.607) (5.44 51. J.13-14% going forwards. Morgan estimates. and so for RBS we have asked the same question – can the group earn a 15% RoNAV? Note this is management's target for the core business in 2013E.366 Adj.antunes-silva@jpmorgan.75 NM -60.637 0.04 51.9 0.RBS LN) FYE Dec 2008A 2009A 2010E 47 28 May 10 42 31 Dec 10 59 .com Amit Goel.com Europe Equity Research 02 June 2010 Royal Bank of Scotland Company Data Price (p) Date Of Price Price Target (p) Price Target End Date 52-week Range (p) Mkt Cap (£ bn) Shares O/S (mn) Royal Bank of Scotland Group Plc (RBS. EU sanctions The asset disposals mandated by the EU could reduce the core group's earnings capacity by c. In the section below we illustrate the change in our estimates required to get there.8bn.34 NM -4. Based on our estimates the group would fall significantly short where in 2013E we expect the group to earn a 9.1 -0.3 0.0% This is despite the regulatory and taxation concerns that we have discussed previously and EU sanctions that are more stringent than those imposed on Lloyds Banking Group.9 (1.goel@jpmorgan.17 107.38 2011E (Old) 1.1 0.9 49 1.7 60.726 5.276 9.89 52.6% RoNAV. CFA (44-20) 7325-6924 amit. Morgan estimates.98 52.2 57.49 53. Bloomberg.P.051 63.4% 0.99 73.Carla Antunes da Silva (44-20) 7325-8215 carla.29 160.78 12.6% 60.6 (24.700) 12. EPS FY (p) Adj P/E FY Headline EPS FY (p) NAV/Sh FY (p) P/NAV FY Net Attributable Income FY (£ mn) Operating profit FY (£ mn) Tier One Ratio FY -45.4 3.L.9% -1.x. Potentially the EU sanctions reduce core PBT by 14%.137 12.9 536 811 11.7% Source: Company data. As we have discussed for Lloyds Banking Group market expectations have improved substantially over the past six months. 54.775 61% 8.5 110.9 70.28 50.5 0.052 9. whilst also reducing the capital requirements. For further details please refer to ‘UK Banks: Upgrading Barclays to Neutral and 36 . Note we are referring to tangible equity.2% 3.051) (8.9 (3.7 0. Flexing a 15% RoE To achieve a 15% RoNAV in 2013E net attributable income would need to be 61% greater than our current forecast at £9.6 15.8 0.127) 9.

7 -1.978 800 4.938 -8.2% 2011E -147 -269 -558 -71 -1. 2003 3.4% 2.x.6% 6.192 2006 6.325 8. 2007 earnings are still 17% short and a much more significant 61% compared to our estimates.2 483 453 -6.006 -31.Carla Antunes da Silva (44-20) 7325-8215 carla. Morgan estimates. Morgan estimates.6% 2009 -52 -249 -58 146 -213 8.8bn 15% RoNAV scenario.044 7.5 -18.3 -1.266 6.6 545 510 -6.com Amit Goel.com Europe Equity Research 02 June 2010 Revisiting RBS which remains UW’ 04 Dec 2009.413 3.8% 2010E -163 -261 -413 -36 -873 7.392 800 6.P.4% 801 -72 nm 2010E -10. Note the level of capital gains that could be generated is unclear.P.196 8.5% 2012E -151 -277 -597 -171 -1. PBT shown before items such as integration costs.7 578 551 -4.407 4.0 503 467 -7.778 2004 5.798 7.287 5.5 -19. In Table 34 below we illustrate the historic peak earnings of RBS in relation to the £9.2 -1.345 nm 2008 -10.6 -18.2 -1.091 -19% 2013E -15.5 -14. Table 33: RBS: Potential impact on core and group PBT from disposals £ million PBT Impact Sempra GMS Insurance UK Total Core Core ex Assets % Change Group Group ex Assets % Change RWA Impact Sempra GMS UK Total Group Group ex Assets % Change 2008 -209 -267 -584 -347 -1.603 -13. 37 .2 -36.112 -2.2% Source: J.antunes-silva@jpmorgan.5 -18. Company data.2 -30.8 -35. Company data.511 1.002 2007 7.445 nm 2009 -10.6% -6.018 6.5 -26.goel@jpmorgan.0 438 408 -6.222 -14.9% -6.349 Changes to earnings estimates and valuation The tables below show our revised divisional forecasts and the changes to our estimates.912 2005 5.5 -30.146 -12. Table 34: RBS + ABN historic earnings £ million RBS Net Attrib ABN Contribution* Total Source: J. CFA (44-20) 7325-6924 amit.549 800 8.232 -6.467 -42% 2011E -15.202 800 7.112 800 5. APS fees and liability management gains.3 -1.

829 2.520 64 379 119 321 253 -85 -43 11 120 1.9% 49 4.0% 58 3.com Europe Equity Research 02 June 2010 Table 35: RBS: Revised Divisional Estimates £ million 2009 Q3 UK Retail UK Corporate Wealth Global Banking & Markets Global Transaction Services Ulster Bank US Retail & Commercial RBS Insurance Central Items Total Core Non Core Operating Profit Source: J.664 -1.0% 47 5.2% 2013E 6.067 -576 240 408 0 7.466 233 -137 40 -50 200 2.536 -1.077 -70% -1.2 6.182 -296 530 588 0 8.0% 3.0 989.8% 0.018 -6.1% 5.1% 45 -7. 2009 Q4 128 340 89 871 224 -275 -19 -170 -5 1.2% 0.536 -30% -1.798 -2.5 62.6% 52 11.5 -149.218 801 2011E FY 1.351 -6.P.052 62% 5.6% 53 4.0 -77.160 12.3 -121.2% 3.goel@jpmorgan.3% 110.709 973 -368 -113 58 292 8.125 420 5.353 2010 Q1 140 318 62 1. Company data.559 713 2008 FY 723 1.3% 8.6 443.7% 3.2% 60 10.325 -14.6% 483 10.8% 51 -0.7% 51 1.4 595.antunes-silva@jpmorgan.4% 0.1 1.497 7% 3.879 1.4% 44 -1.610 485 2. 38 .160 11.7% 5.8% 13.2% 110.035 587 3.com Amit Goel.568 983 -580 158 182 200 7.0% 49 4.5% 96.1% 43 3.569 1.796 1.4% 2011E 536 -150% 49 988% 0.249 59 711 664 0 10.845 4% 5.0% 1.P.428 -908 9.511 2012E FY 1.755 2.140 1. partially offset by slightly lower estimates for the core businesses.x.3 3.1% 471 13.8 138.5 -1.1% 110.798 548 2.8% -0.1% 3.2% 2012E 3.160 13. of Shares Tier 1 Ratio Source: J.4 -29.525 Table 36: RBS: Changes to estimates New Net Attributable Growth (%) Old Net Attributable % Difference New basic EPS EPS growth (%) Old basic EPS % difference New diluted underlying EPS EPS growth (%) Old diluted underlying EPS % difference New NAVps NAV growth (%) Old NAVps % difference New JPM NAVps JPM NAVps growth (%) Old JPM NAVps % difference PE RoNAV JPM Adj RoNAV RWAs (bn) Core Tier 1 Ratio No.287 2013E FY 1.5% 110. Morgan estimates.8% Our SoP based price target remains unchanged at 42p despite the slight increase to estimates as the upgrade is primarily in the non core division.9% 0.557 -6.7% 45 2.6% 43 3.5% 51 2.8% 503 11.272 -1.6% 545 9.2% 55 6.002 218 528 584 1025 4. CFA (44-20) 7325-6924 amit.511 6.232 2010E FY 733 1.183 -2.266 -4.293 1. 2010E -1.4% 8.139 -2.6% 12.9 78.Carla Antunes da Silva (44-20) 7325-8215 carla.892 1.7 -142.6 2.726 595% 3.7 52.8 6.355 419 3. Morgan estimates.938 2009 FY 229 1.781 348 -1.8% -1.160 15.5 9.6% -47.413 -11.6 5.5% 5.

159 349 -415 173 294 5.2 12.238 5.05 0.862 Per Share (£) 0.218 5.x.6 0.082 768 821 1.P.2 1.829 1.3 12.02 0.g RoE .g RoE .23 0.412 4.930 -7.493 8.231 -3.711 45.04 0.42 1.4 85.6 4.g RoE .g PE RoE . Net Profit 2011E 2.9 39 .g/CoE .7 7.g/CoE .862 45.antunes-silva@jpmorgan.0 0.01 0.0 1.0 6.g/CoE .09 0.57 -0.388 9.08 0.800 62.7 1.g/CoE .05 0.4 1.com Amit Goel.g RoE .00 -0.0 P/BV (x) 1. Morgan estimates.357 0 -9.42 PE (x) 12.2 1.g/CoE .Carla Antunes da Silva (44-20) 7325-8215 carla.4 -5.0 x BV Value (£m) 25.552 2.423 -715 -557 536 Valuation Basis RoE .4 31.goel@jpmorgan.07 0.3 1.6 1.3 16.g/CoE . CFA (44-20) 7325-6924 amit.g DCF 0 1.08 0.1 0.g RoE .com Europe Equity Research 02 June 2010 Table 37: RBS: 2010E Based SoP £ million Division GLOBAL BANKING & MARKETS GLOBAL TRANSACTION SERVICES UK RETAIL UK CORPORATE WEALTH ULSTER US RETAIL & COMMERCIAL RBS INSURANCE CORE GROUP POST TAX CORE EARNINGS NON CORE APS IMPACT CAPITAL EXCESS/(SHORTFALL) vs 2011E EC Capital Total RBS Group Adjusted discount factor Fair Value Source: J.g/CoE .

Carla Antunes da Silva (44-20) 7325-8215 carla.x. CFA (44-20) 7325-6924 amit.goel@jpmorgan.com Amit Goel.antunes-silva@jpmorgan.com Europe Equity Research 02 June 2010 40 .

Price Target 42p) Valuation Methodology Our Dec-10 target price is 42p. based on our sum-of-the-parts analysis. We base this on a peer multiple rating as well as incorporating adjustments to our net asset value for the Group's capital position. Being one of the more geared plays into UK retail banking and the UK economy it is also exposed to a faster recovery. more specifically the US dollar both through Corporate Markets and Citizens. Risks to Our View Post the HBOS acquisition. which present risks to the upside and downside. Royal Bank of Scotland (Underweight.goel@jpmorgan. the quality of the Lloyds Banking Group loan portfolio deteriorated significantly.com Amit Goel. CFA (44-20) 7325-6924 amit. We have increased our price target to reflect improved provisioning guidance and lower costs.x.Carla Antunes da Silva (44-20) 7325-8215 carla. Risks to Our View Several risks could prevent the stock from achieving our target price and rating.antunes-silva@jpmorgan. based on our sum-of-the-parts analysis. the bank is highly exposed to corporate credit quality and to some extent the market conditions in fixed income. Through Corporate Markets.com Europe Equity Research 02 June 2010 Valuation Methodology and Risks Lloyds Banking Group (Underweight. We believe that without the Asset Protection Scheme the company is now more exposed to a possible double dip in the economy. Price Target 50p) Valuation Methodology Our Dec-10 price target is 50p. in our view. RBS is also exposed to the UK general insurance cycle and currency risks. and also the euro. 41 .

4%) Return ratios .786 14.139 27.4%) (5.218.4% 1.75 53.46 56.1%) (0.RoRWA 12.8% 1.3% 438.34 0.251 (10.8%) 443.6% ROE 5.839 809.212 879.0% 48 48 (1.712 7.0%) (43.559 74.324 14. year end Dec Per Share Data 13.154 1.565 349.227 10.8%) (2.7% 12.45 73.814 (0.7% (14.278 335.596 1.2% 20.5%) 50.49 3.2% 5.786 14.074 DPS 2.7% 5.916 -17.296 (103.200 (24.682 25.4% 27.567 28.068 (42.9% 6.0%) (104.386 14.786 2.483 2.4% 2.2% 124.6% 1.2% 138.2% 0.1% 1.252 2.3% (1.451.329 115.988 44.808 2.856 641.1% (0.0% 0.0%) 246.0% 9.7% 1.0% 0.3% 204.078 (3.4%) (1.5% (0.434.0% 15.799 13.019 490.4%) (1.0% - 1.547 5.718 (190.3%) (147.182.9%) 28.755 RoNAV 1 5.2% 23.182.286 3.800 18.x.899 49.2% 18.296 (114.3 106.428 13.3% 7.019 708.0% Payout ratio .com Europe Equity Research 02 June 2010 Royal Bank of Scotland: Summary of Financials Profit and Loss Statement £ in millions.5%) 13.0% -38.1% (5.29 1.736 479.758 2.268 907.0%) 145.9% 23.9% 49.051) (3.436 - 414.8%) -17.95 57.222 2.78 (157.042 Pre-tax ROE 9.3% 54.1% 21.474 10.065 1.765 751.8%) 10.484 12.597 59.719 789.111.59 3.522.1% 14.com Amit Goel.182.7% Shares outstanding -16.0% 29.9% 577.3%) 8.98 0.9%) (1.638 12.9% 1.0% 0.4% 185.382 1.2% -0.5% 0.8% 189.899 0 0 -8.321.2%) 9.89 51.650 (2.6%) (1.578 Non-IR / average assets 28.0% 199.9% 7.9%) 5.2%) 11.90 52.963 % Change Y/Y 9.26 39.6% 225. year end Dec Cost ratios Cost / income Cost / assets Staff numbers Balance Sheet Gearing Loan / deposit Investments / assets Loan / assets Customer deposits / liabilities LT Debt / liabilities Asset Quality / Capital Loan loss reserves / loans NPLs / loans LLP / RWA Loan loss reserves / NPLs Growth in NPLs RWAs % YoY change Core Tier 1 Total Tier 1 FY08A FY09A FY10E FY11E FY12E 691.500 59.9% NIM (NII / RWA) 1.6% 251.7%) (29.311.195 6.9%) -437 5.3%) (8.690 1.939 13.2% 15. year end Dec ASSETS Net customer loans % change Y/Y Loan loss reserves Investments Other interest earning assets % change Y/Y Average interest earnings assets Goodwill Other assets Total assets LIABILITIES Customer deposits % change Y/Y Long term funding Interbank funding Average interest bearing liabs Other liabilities Retirement benefit liabilities Shareholders' equity Minorities Total liabilities & Shareholders Equity FY08A FY09A FY10E FY11E FY12E £ in millions.6%) (1.2% 12.716 843.6% 0.0% 14.3% 11.479 491.2% 23.940 730.929 8.09 56.1% 0.2% 16.786 14.6%) (100.642 776.8% 1.6%) 1.996 624.046 - 150.55%) 13.525 52.0% -0.2% 32.0% 180.8%) (3.0% 101.311.447.1% 133.227 - 420.99 -4.3% -15.3 - (51.4% 10.693 1.3% 10.2% 23 0 0 0 0 (27.1% 1.607) 13.8%) (5.2% - Source: Company reports and J.188 178.3%) 1.3%) (3.7%) (425) 227 25.058 -16.477 0 0 -1.420 671.3% 15.3 106.227 - 1.726 Fees / Total revenues Trading / Total revenues FY08A FY09A FY10E FY11E FY12E -60.P.361 95.077) 536 Ratio Analysis FY12E £ in millions.17%) 32.1% 21.358 87.5% 145.9% 1.1% 35.8%) (5.944 16.049 52.2% (1.700 811 (70.4% 2.goel@jpmorgan.3% (3.383.9% 412 648 (24.13%) 19.0% 28.1% (2.4%) 11.043 2.481 1.38 -45.6%) (2.458 2. Morgan estimates.7% (1.75 -1.9% 2.0% 0.8% - 460.7% 0.6%) (97.2%) (1.127 -5.29%) 62.0% 36.0% % Change Y/Y 3.703 EPS Reported 0.592 -437 5.889 Dividend yield 2.8% EPSAdjusted 12.988 10.1%) 9.9% 94.401 (4.290 105.8% 9.734 24.9%) 16.598 2.2% 13.280) (339) 15.0% 483.227 - 430.876 554.2% (1.44 -0.759 2.5% 114.753 1.0% 49. year end Dec Net interest income % Change Y/Y Non-interest income Fees & commissions % change Y/Y Trading revenues % change Y/Y Other Income Total operating revenues % change Y/Y Admin expenses % change Y/Y Other expenses Pre-provision operating profit % change Y/Y Loan loss provisions Other provisions Earnings before tax % change Y/Y Tax (charge) % Tax rate Minorities Net Income (Reported) FY08A FY09A FY10E FY11E 15.7% 0.antunes-silva@jpmorgan.0% 10.1%) (121.0% Total rev / average assets 48 NII / Total revenues 3.3% 269.8% 8.637 Revenues 594.0%) 545.5% (2.227 - 436.9%) 0.Carla Antunes da Silva (44-20) 7325-8215 carla.0%) 0.9%) (8.042 7.667 (43.647 530.318 5.7%) (7.7% 12.774 1. CFA (44-20) 7325-6924 amit.6%) (0.215 12.0% 171.715 2.0%) (2.622 451.0% 0.BV per share 28.120 NAV per share 1.2%) (27.8% - Balance sheet £ in millions.0% 28.9% 2.654 522.0% 36.1% 31.281 8.296 510.0% (19. 42 .081 10.1% (52.5% 31.2 106.

0%) 37.0%) Return ratios .04 0.609 -11.8% NIM (NII / RWA) 2.1% 2.8% (5.2% -14.5% 7.127.0% 0.8% 0.288 121.2% 35.9%) (4.730 72.702 -481 -637 -637 -637 21. year end Dec Per Share Data 13.3% 0.649 913.291 12.Core Tier 1 829 829 829 829 Total Tier 1 - 2.964 22.07 (100.com Europe Equity Research 02 June 2010 Lloyds Banking Group: Summary of Financials Profit and Loss Statement £ in millions.4%) (29.6% 1.119 12.2% - 173.264 760 1.0% 0.700 20.29 58.9% 2.1% 64.315 (0.301 951.29 16.1% 1.6% 57.5% 391.66 69.974 324.4% 57.827 547 2.1% 168.2% 3.1%) (3.6%) 86.3% 5.0% 35.881 340.452 79.027.0% 0.255 991.1% (9.939 Fees / Total revenues Trading / Total revenues FY08A FY09A FY10E FY11E FY12E 0.1% 22.4%) (5.30 58.1% 4.700 20.59 67.7% 22.6%) 7.101 70.2%) 0.9%) (1.1% 11.249 137.7% 87.665.0%) (2.9% (26.0% 36.6% (1.4% 4.413 215. year end Dec Cost ratios Cost / income Cost / assets Staff numbers Balance Sheet Gearing Loan / deposit Investments / assets Loan / assets Customer deposits / liabilities LT Debt / liabilities FY08A FY09A FY10E FY11E FY12E 677.1% 1.8% 249. year end Dec Net interest income % Change Y/Y Non-interest income Fees & commissions % change Y/Y Trading revenues % change Y/Y Other Income Total operating revenues % change Y/Y Admin expenses % change Y/Y Other expenses Pre-provision operating profit % change Y/Y Loan loss provisions Other provisions Earnings before tax % change Y/Y Tax (charge) % Tax rate Minorities Net Income (Reported) FY08A FY09A FY10E FY11E 14.389 -11.474 Ratio Analysis FY12E £ in millions.320 119.04 0.2% 1.700 20.2% 2.3% 1.307 482.002 RoNAV 7.875 10.109 LLP / RWA 82.2% 14.500 493.355 144.05 0.3% 1.Dividend yield .9% 85.019 Non-IR / average assets 28.726 12.8% 60.3% 35. year end Dec ASSETS Net customer loans % change Y/Y Loan loss reserves Investments Other interest earning assets % change Y/Y Average interest earnings assets Goodwill Other assets Total assets LIABILITIES Customer deposits % change Y/Y Long term funding Interbank funding Average interest bearing liabs Other liabilities Retirement benefit liabilities Shareholders' equity Minorities Total liabilities & Shareholders Equity FY08A FY09A FY10E FY11E FY12E £ in millions.68 78.4%) 28.074 2.03 70.6% 9.933 11.0% 0.680 23.7% 7.Growth in NPLs .3% 0.1% 8.86% 2.084 Revenues 94.042 942 3.8% 5.8% (7.815 450.637 (81.0% 0. Morgan estimates.1% 2.360 222.241 356.015 % Change Y/Y .Payout ratio -637 BV per share 24.735 Loan loss reserves / loans (5.7 0.236 -11.480 249.6% 1.725 1.RWAs 780 750 716 682 % YoY change .RoRWA 12.880 -23.4% 12.9% 4.6% 9.P.98% 4.246 626.483 225.2%) 6.2% (38) (1.0% 3.1% 5.323.1% - 50.301 NAV per share 3.DPS % Change Y/Y .5%) (4.9% 208.969 590.9% 11.04 0.2% 3.0% 2.2% (5.2% - 46.7% 171.19 -0.01 0.5% (8.103 6.x.1% 34.665.2% 1.1% 0.01 61.31 164.4% (14.0% 0.0% 22.355 23.07 -0.665.5% 28.421 95.988 -12.4% 9.4%) 498.6% 179.1% 1.3% 89.antunes-silva@jpmorgan.4%) (538.011 150.2% 8.3% ROE -6.86 67.0% 2.0%) (95.8% 165.01 0.924 EPS Reported 4.1% 35.1% 14.9%) (0.355 11.6%) (20.7 67.103 6.5% Total rev / average assets (126) NII / Total revenues 4.903 12.com Amit Goel.Carla Antunes da Silva (44-20) 7325-8215 carla.0% 11 (68.0% 0.7% 3.1% 0.83% 1.2% 53.46 -0.2%) 0.207 583.479 1.7% - 50.4% 3.2% 6. 43 .5% 22.2% 2.0%) (183.0% 24103.396 584.0% 1.897 7.0% 0.4% 7.6%) 286.9% 69.53% 1.0% 0.1%) (6.4% 9.6% 2.605 - Asset Quality / Capital 371.38% 45.8% 11.4%) 3.103 1.6%) (3.3% -12.1% 2.373 10.6%) 9.4% 1.8%) NPLs / loans 234.2% 57.2% 47.583 57.0% 2.3% 9.3% 0.7% 59.2% 4.4% 4.4% 3.3% 1.263 75.230 6.0 67.3% 8.3% 6.5% 9.5% (26) (126) (126) (126) 772 2.8% 22.5% 61.goel@jpmorgan. CFA (44-20) 7325-6924 amit.232 -8.8% 0.9% 4.0 63.152 20.5% 61.103 6.6%) 1.775.150.0% Balance sheet £ in millions.665 155.4% 0.5% 36.944 13.1% 9.986 Pre-tax ROE 7.8% 67.1% - 48.366 205.0% 0.2% Source: Company reports and J.0% 2.700 .0% 2.062 149.911) 268 1.9%) (58.7 67.8% Shares outstanding -11.3% EPSAdjusted 11.935 436.1%) (1.2% 6.123 Loan loss reserves / NPLs .036 (5.0% 0.

is. JPMSI provided to the company investment banking services. Morgan ratings: OW = Overweight. price data adjusted for stock splits and dividends. An affiliate of JPMSI has received compensation in the past 12 months for products or services other than investment banking from Lloyds Banking Group. the research analyst denoted by an “AC” on the cover or within the document individually certifies.P. Beneficial Ownership (1% or more): JPMSI or its affiliates beneficially own 1% or more of a class of common equity securities of Lloyds Banking Group.P. non-investment banking securities-related services and non-securities-related services. Investment Banking (next 3 months): JPMSI or its affiliates expect to receive. 44 .com Amit Goel.Carla Antunes da Silva (44-20) 7325-8215 carla. Morgan.antunes-silva@jpmorgan.L) Price Chart 810 N 550p 675 UW 580p 540 UW 530p Price(p) 405 N 600p N 480p UW 180p UW 14p UW 40p UW 44p N 610p UW 150p UW 50p UW 67p Date Rating Share Price (p) 421 441 429 398 398 302 213 98 38 48 98 51 60 UW N N N Price Target (p) 530 580 600 610 550 480 180 150 67 14 40 44 50 18-Dec-06 UW 24-Feb-07 05-Jun-07 31-Jul-07 18-Jan-08 25-Sep-07 N 22-Sep-08 UW 19-Nov-08 UW 18-Feb-09 31-Mar-09 UW UW 270 135 0 Sep 06 Jun 07 Mar 08 Dec 08 Sep 09 11-Aug-09 UW 18-Dec-09 UW 22-Mar-10 UW Source: Bloomberg and J. compensation for investment banking services in the next three months from Lloyds Banking Group.com Europe Equity Research 02 June 2010 Analyst Certification: The research analyst(s) denoted by an “AC” on the cover of this report certifies (or. This chart shows J. 2006 . UW = Underweight. Lead or Co-manager: JPMSI or its affiliates acted as lead or co-manager in a public offering of equity and/or debt securities for Lloyds Banking Group. J.Feb 07. Analyst Position: The following analysts (and/or their associates or household members) own a long position in the shares of Lloyds Banking Group: Amit Goel. Royal Bank of Scotland. or intend to seek. with respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views expressed in this report accurately reflect his or her personal views about any and all of the subject securities or issuers. during the past 12 months. Royal Bank of Scotland. Non-Investment Banking Compensation: JPMSI has received compensation in the past 12 months for products or services other than investment banking from Lloyds Banking Group. Royal Bank of Scotland is or was in the past 12 months a client of JPMSI. JPMSI provided to the company investment banking services. Royal Bank of Scotland within the past 12 months. N = Neutral. during the past 12 months. CFA (44-20) 7325-6924 amit. non-investment banking securities-related services and non-securities-related services. Royal Bank of Scotland.goel@jpmorgan. Royal Bank of Scotland. and (2) no part of any of the research analyst’s compensation was. where multiple research analysts are primarily responsible for this report. Break in coverage Jan 31. Royal Bank of Scotland. Morgan's continuing coverage of this stock.P. the current analyst may or may not have covered it over the entire period. Important Disclosures • • • • • Market Maker/ Liquidity Provider: JPMSL and/or an affiliate is a market maker and/or liquidity provider in Lloyds Banking Group. Client of the Firm: Lloyds Banking Group is or was in the past 12 months a client of JPMSI.x. Investment Banking (past 12 months): JPMSI or its affiliates received in the past 12 months compensation for investment banking services from Lloyds Banking Group. • • • Lloyds Banking Group (LLOY. or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst(s) in this report. Royal Bank of Scotland. 2006.

L). our Neutral rating falls into a hold rating category. 45 .] Neutral [Over the next six to twelve months. as of March 31. Coverage Universe: Carla Antunes da Silva: Barclays (BARC. we expect this stock will perform in line with the average total return of the stocks in the analyst’s (or the analyst’s team’s) coverage universe. A list of these analysts is available on request. Morgan uses the following rating system: Overweight [Over the next six to twelve months.P.L) Price Chart Date N 730p 910 OW 2.com .L) J. CFA (44-20) 7325-6924 amit. we expect this stock will underperform the average total return of the stocks in the analyst’s (or the analyst’s team’s) coverage universe. Morgan ratings: OW = Overweight. J.] J. price data adjusted for stock splits and dividends.com Amit Goel.Carla Antunes da Silva (44-20) 7325-8215 carla. not to those analysts’ coverage universe. or you can contact the analyst named on the front of this note or your J. 2006 .P. For purposes only of NASD/NYSE ratings distribution rules. among other business units. N = Neutral. Institutional Equities and Investment Banking.Feb 07.400p 728 OW 2. 2010 Overweight (buy) 45% 48% 42% 70% Neutral (hold) 42% 46% 49% 58% Underweight (sell) 13% 32% 10% 48% JPM Global Equity Research Coverage IB clients* JPMSI Equity Research Coverage IB clients* *Percentage of investment banking clients in each rating category.L). Morgan. Valuation and Risks: Please see the most recent company-specific research report for an analysis of valuation methodology and risks on any securities recommended herein. The analyst or analyst’s team’s coverage universe is the sector and/or country shown on the cover of each publication. Explanation of Equity Research Ratings and Analyst(s) Coverage Universe: J. competitive factors.P. our Overweight rating falls into a buy rating category. and our Underweight rating falls into a sell rating category.P.270p OW 800p Price(p) 546 N 470p UW 120p UW 17p UW 26p UW 42p OW 730p N 420p UW 50p UW 38p N 320p UW 25p Rating Share Price (p) 558 552 547 477 494 323 337 312 214 42 21 23 40 56 45 Price Target (p) 2270 2400 800 730 730 470 420 320 120 50 25 17 26 38 42 18-Dec-06 OW 21-Dec-06 OW 21-May-07 OW 07-Aug-07 OW 08-Aug-07 N 18-Jan-08 N N 29-Feb-08 N 22-Apr-08 22-Sep-08 UW 19-Nov-08 UW 18-Feb-09 UW 364 182 0 Sep 06 Jun 07 Mar 08 Dec 08 Sep 09 31-Mar-09 UW 21-Jul-09 UW 21-Sep-09 UW 30-Mar-10 UW Source: Bloomberg and J. Royal Bank of Scotland (RBS. UW = Underweight.x.P. which include revenues from. each stock’s expected total return is compared to the expected total return of the FTSE All Share Index. HSBC Holdings plc (HSBA. 2006.] Underweight [Over the next six to twelve months. including the quality and accuracy of research. Break in coverage Jan 31.antunes-silva@jpmorgan.L). Research is available at http://www. client feedback. See below for the specific stocks in the certifying analyst(s) coverage universe. the current analyst may or may not have covered it over the entire period. Lloyds Banking Group (LLOY.morganmarkets. Morgan representative.P. we expect this stock will outperform the average total return of the stocks in the analyst’s (or the analyst’s team’s) coverage universe. however.goel@jpmorgan. Morgan's continuing coverage of this stock.com Europe Equity Research 02 June 2010 Royal Bank of Scotland (RBS. and overall firm revenues. Morgan Cazenove’s UK Small/Mid-Cap dedicated research analysts use the same rating categories. This chart shows J. Morgan Equity Research Ratings Distribution.P. Analysts’ Compensation: The equity research analysts responsible for the preparation of this report receive compensation based upon various factors.

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com Europe Equity Research 02 June 2010 48 .com Amit Goel.antunes-silva@jpmorgan.x.Carla Antunes da Silva (44-20) 7325-8215 carla. CFA (44-20) 7325-6924 amit.goel@jpmorgan.

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