Lloyds Banking Group PLC
Annual Report 2008

Plain-text annual report

AnnuAl RepoRt And Accounts 2008 Creating the UK’s leading finanCial serviCes provider This publication contains the 2008 report and accounts for lloyds Banking Group plc (formerly lloyds TSB Group plc). HBoS plc was acquired by lloyds Banking Group plc on 16 January 2009 and, accordingly, is dealt with in the accounts only as a post balance sheet event (see note 52, page 181). The 2008 report and accounts for HBoS plc therefore do not form part of this publication. CoNTeNTS OvERviEw Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends BusinEss REviEw finAnciAl stAtEMEnts 1 2 4 6 8 Summary of Group results Divisional results Corporate responsibility our people risk management five year financial summary gOvERnAncE The board Directors’ report Corporate governance Directors’ remuneration report 10 18 36 40 42 65 66 68 70 74 report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 report of the independent auditors on the parent company financial statements 182 parent company financial statements 183 Notes to the parent company financial statements shAREhOldER infORMAtiOn Shareholder information index to annual report financial calendar 2009 186 191 192 195 pREsEntAtiOn Of infORMAtiOn in order to provide a more comparable representation of underlying business performance in certain commentaries in the overview and Business review, insurance and policyholder interests volatility have been separately analysed for the Group’s insurance businesses. further information on these items is shown on pages 34 and 35. in addition, a provision in respect of certain historic uS dollar payments, a provision in respect of the financial Services Compensation Scheme levy and goodwill impairment in 2008, and the profit on the sale of businesses, the results of discontinued businesses and the settlement of overdraft claims in 2007 have been separately analysed in the Group’s results. A reconciliation of this continuing businesses basis of presentation to the statutory profit is shown on page 1. Certain commentaries also separately analyse the impact of market dislocation from the results for both years. fORwARd lOOking stAtEMEnts This annual report includes certain forward looking statements within the meaning of the uS private Securities litigation reform Act of 1995 with respect to the business, strategy and plans of lloyds Banking Group and its current goals and expectations relating to its future financial condition and performance. Statements that are not historical facts, including statements about lloyds Banking Group’s or management’s beliefs and expectations, are forward looking statements. Words such as ‘believes’, ‘anticipates’, ‘estimates’, ‘expects’, ‘intends’, ‘aims’, ‘potential’, ’will’, ‘would’, ‘could’, ‘considered’, ‘likely’, ‘estimate’ and variations of these words and similar future or conditional expressions are intended to identify forward looking statements but are not the exclusive means of identifying such statements. By their nature, forward looking statements involve risk and uncertainty because they relate to events and depend upon circumstances that will occur in the future. examples of such forward looking statements include, but are not limited to, projections or expectations of the Group’s future financial position including profit attributable to shareholders, provisions, economic profit, dividends, capital structure, expenditures or any other financial items or ratios; statements of plans, objectives or goals of lloyds Banking Group or its management including in respect of the integration of HBoS and the achievement of certain synergy targets; statements about the future business and economic environments in the united Kingdom (uK) and elsewhere including trends in interest rates, foreign exchange rates, credit and equity market levels and demographic developments, competition, regulation, dispositions and consolidation or technological developments in the financial services industry; and statements of assumptions underlying such statements. factors that could cause actual results to differ materially from the plans, objectives, expectations, estimates and intentions expressed in such forward looking statements made by lloyds Banking Group or on lloyds Banking Group’s behalf include, but are not limited to, general economic conditions in the uK and internationally; inflation, deflation, policies of the Bank of england and other G7 central banks and interest rate, exchange rate, market and monetary fluctuations; changing demographic developments including consumer spending, saving and borrowing habits, technological changes, natural and other disasters, adverse weather, terrorist acts and other acts of war or hostility and responses to those acts; changes in laws, regulations, taxation, Government policies or accounting standards or practices and similar contingencies outside lloyds Banking Group’s control; the ability to derive cost savings and other benefits as well as mitigate exposures from the acquisition and integration of HBoS; inadequate or failed internal or external processes, people and systems; exposure to regulatory scrutiny, legal proceedings or complaints; changes in competition and pricing environments; the inability to hedge certain risks economically; the adequacy of loss reserves; the ability to secure new customers and develop more business from existing customers; the degree of borrower credit quality; the ability to achieve value-creating mergers and/or acquisitions at the appropriate time and prices and the success of lloyds Banking Group in managing the risks of the foregoing. lloyds Banking Group may also make or disclose written and/or oral forward looking statements in reports filed with or furnished to the uS Securities and exchange Commission, lloyds Banking Group annual review, half-year announcement, proxy statements, offering circulars, prospectuses, press releases and other written materials and in oral statements made by the directors, officers or employees of lloyds Banking Group to third parties, including financial analysts. The forward looking statements contained in this annual report are made as of the date hereof, and lloyds Banking Group undertakes no obligation to update any of its forward looking statements. viEw OuR AnnuAl REpORt OnlinE A full version of our Annual report and Accounts and information relating to lloyds Banking Group is available at www.lloydsbankinggroup.com Group profile 1 lloyds Banking Group Annual report and Accounts 2008 OUR GROUP lloyds Banking Group is a leading uK based financial services group providing a wide range of banking and financial services, primarily in the uK, to personal and corporate customers. lloyds Banking Group was formed in January 2009 following the acquisition of HBoS and our main business activities are retail, commercial and corporate banking, general insurance, and life, pensions and investment provision. The new Group also operates an international banking business with a global footprint in 40 countries. The Group is the largest uK retail bank and has a large and diversified customer base. Services are offered through a number of well recognised brands including lloyds TSB, Halifax, Bank of Scotland, Scottish Widows, Clerical Medical and Cheltenham & Gloucester, and via a unique distribution capability comprising the largest branch network in the uK and intermediary channels. lloyds Banking Group is quoted on both the london Stock exchange and the New York Stock exchange and is one of the largest companies within the fTSe 100. 2008 highlights statutory profit before tax reduced by 80 per cent to £807 million. A resilient underlying business performance was offset by the impact of market dislocation and adverse volatility relating to the Group’s insurance businesses. A resilient business performance. profit before tax, on a continuing businesses basis, totalled £2,426 million, a decrease of 35 per cent which reflected the impact of £1,270 million of market dislocation and higher impairment levels. Robust income performance. income, excluding market dislocation, grew by nine per cent reflecting strong revenue growth from the Group’s relationship banking businesses. on a statutory basis, income was eight per cent lower at £9,872 million. Excellent cost management. The Group’s cost:income ratio, excluding market dislocation, improved by 1.1 percentage points to 47.0 per cent. in a difficult economic environment, asset quality remains satisfactory. impairment losses increased by 68 per cent to £3,012 million, reflecting the impact of market dislocation, the slowdown in the uK economic environment and the impact of the falling house price index. Robust capital ratio and a strong liquidity and funding position maintained throughout the recent turbulence in global financial markets. OuR visiOn To be recognised as the best financial services organisation in the uK by customers, colleagues and shareholders. gROup REsults suMMARy OuR stRAtEgy our corporate strategy supports this vision and is focused upon: Building strong customer franchises that are based on deep customer relationships – extending reach and depth of customer relationships – enhancing product capabilities to build competitive advantage Building a high performance organisation – improving processing efficiency – Applying our more prudent ‘through the cycle’ approach to risk to the enlarged Group – Working capital harder – Delivering flawlessly for the customer Managing our most valuable resource, our people Net interest income other income Total income insurance claims Total income, net of insurance claims operating expenses Trading surplus impairment profit before tax – continuing businesses* Volatility – insurance – policyholder interests Discontinued businesses profit on sale of businesses provision in respect of certain historic uS dollar payments provision for financial Services Compensation Scheme levy Goodwill impairment Settlement of overdraft claims profit before tax – statutory 2008 £m 7,709 521 8,230 2,859 11,089 (5,651) 5,438 (3,012) 2,426 (746) (471) – – (180) (122) (100) – 807 2007 £m 6,022 11,777 17,799 (6,917) 10,882 (5,330) 5,552 (1,796) 3,756 (277) (222) 162 657 – – – (76) 4,000 * excluding volatility, a provision in respect of certain historic uS dollar payments, a provision for the financial Services Compensation Scheme levy, goodwill impairment and, in 2007, results of discontinued businesses, profit on sale of businesses and the settlement of overdraft claims. 2 lloyds Banking Group Annual report and Accounts 2008 CHAirMAN’S STATeMeNT Sir Victor Blank 2008 was a very difficult and challenging year for the banking industry, both in the uK and overseas. Asset values fell significantly in many developed markets. Wholesale funding contracted in a dramatic fashion as the expansionary credit conditions that had prevailed for some time ended abruptly. The uK Government had to intervene in the banking system by providing capital and liquidity where the markets had failed. in short, markets and economies behaved in ways which, i think it is fair to say, we have not seen in living memory. At times of great economic and financial uncertainty, many apparently settled ideas come under great scrutiny. There is no doubt that there is a great deal of rethinking going on now and a new banking system will emerge both in this country and elsewhere in the coming years. Some certainties continue to prevail, however. for us, our emphasis on our relationship with our customers will remain very much at the core of how we do things as a business. indeed, we believe this emphasis on customer relationships was a great asset to us last year and it will be at the core of how we develop our enlarged business in the future. 2008 was also, of course, the year when lloyds TSB announced it was acquiring HBoS plc; the transaction was subsequently completed on 16 January 2009. it is this transaction to which i will now devote most of my attention in this review. i will also cover a number of other important issues, however, which i know shareholders would like me to discuss. They include the state sponsored banking recapitalisation last autumn and more recent significant Government measures, our dividend policy, our obligations to society, our corporate governance and the outlook for your company. thE hBOs tRAnsActiOn lloyds TSB and HBoS had, on a number of occasions over the years, discussed the possibility of a combination. it was only the unique circumstances of last autumn, however, that enabled this transaction to happen. When we decided to acquire HBoS, we were doing so at a time when the economy was already deteriorating with the prospect of further declines to come. We were very mindful of the difficult economic backdrop to this transaction. We were also very aware, however, of the compelling logic of this transaction, including the substantial market positions we would secure and the significant synergies that would be generated. in short, we see the deal as being strategically imperative for us. The size and scale of the new group is very significant indeed and it offers opportunities for growth for the future which a stand-alone lloyds TSB might not have been in a position to deliver to the same degree. our senior management team, given its track record and strength in depth, is very well placed to exploit these opportunities on behalf of all our shareholders. We believe that the HBoS transaction will prove to be very successful for our shareholders and our other stakeholders as well. lloyds Banking Group is now the largest financial services franchise in the uK with a range of leading market positions in important product lines, such as savings, current accounts, mortgages, insurance and long-term savings. We are also a leading player in the Small and Medium enterprise (SMe) and wholesale banking sectors. The Group clearly has a very significant retail banking footprint and, with approximately 3,000 branches, is present in more uK locations than any other financial institution. We will also have the benefit of substantial synergies. There is no doubt that the immediate outlook is challenging as indeed it is for most other banks in the uK and overseas. lloyds TSB’s trading performance in 2008 was by no means immune from the continued turbulence in the global financial markets which contributed to the decline in profit before tax to £807 million. HBoS was adversely affected by the challenging market conditions, a sharp decline in asset values and the dramatic contraction in the wholesale markets. Taking all these factors together, HBoS recorded a loss of £10.8 billion. Against this backdrop, it is unsurprising that questions have been asked about the HBoS transaction. i think it is important to remember, as i have already mentioned, that we purchased HBoS when the economic downturn was already well underway. in short, the opportunity to acquire HBoS only came about in the middle of great economic adversity and in conditions which are unlikely to be repeated. in purchasing HBoS we acquired £17.9 billion of net asset value for £7.7 billion so, as a board, we remain very much convinced that this is the right transaction for your company. The short-term outlook is indeed difficult. Your board believes, however, that the earnings potential of lloyds Banking Group will be significant in the longer term. thE ROlE Of gOvERnMEnt A great deal has been said in recent months about the nature of the Government’s involvement with the banking sector. We believe that most of the Government’s initiatives have been positive and well considered. in particular, we very much welcome the Government’s interventions to stabilise the banking system, provide liquidity and to encourage more lending. The dramatic unfolding of events across the world following the collapse of lehman’s meant that the Government needed to take swift and decisive action. it did so. That is why, despite lloyds TSB’s relative strength, in october 2008 we, together with other uK banks, were required by the uK Government to strengthen capital ratios as part of an industry wide initiative to reduce the systemic risk in the uK banking system. This led to us raising an additional £5.5 billion in capital, (£4.5 billion in ordinary shares and £1 billion in preference shares). HBoS were also required under the recapitalisation scheme to raise £11.5 billion, (£8.5 billion in ordinary shares and £3 billion in preference shares). The uK Government, as part of the capital raising process, has now become a 43.4 per cent shareholder in the Group. OvERviEw Group profile chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 BusinEss REviEw Summary of Group results Divisional results Corporate responsibility our people risk management five year financial summary 10 18 36 40 42 65 gOvERnAncE The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finAnciAl stAtEMEnts shAREhOldER infORMAtiOn report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 report of the independent auditors on the parent company financial statements 182 parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information index to annual report financial calendar 2009 191 192 195 3 lloyds Banking Group Annual report and Accounts 2008 OutlOOk The unprecedented market conditions which i sketched out at the start of this review have continued into 2009. At the same time, the economy is continuing to deteriorate; the debating point now is how deep the recession will be and how long will it take for it to end. one thing is certain – we are facing a prolonged period of economic difficulty for many households and companies up and down the country. As a bank with a strong focus on customer relationships, we are committed to helping our customers wherever possible to manage their way through these challenging times. We know the short-term outlook for the enlarged Group is challenging. Whenever economic conditions do begin to normalise, however, we believe your company will be in a very strong position to reap the benefits. our strong franchise across the whole range of product lines will enable us to do just that. in the meantime, our imperative is to manage your business as effectively as possible on your behalf during these challenging times. i believe we have the right people to do so. one of the most important ways in which leading businesses differentiate themselves from their peers is through the quality of their people. i have no doubt that we at lloyds Banking Group are very fortunate in having many of the best people in our industry working for us. The last 12 months, however, have been exceptionally difficult for many of our customers and colleagues alike. The unprecedented levels of market turbulence have meant that my colleagues have spent a great deal of time helping customers to understand what is happening and providing them with the necessary reassurance. The job that our colleagues do for our customers is very valuable and highly valued by us. i would therefore like to take this opportunity to thank them on our behalf for their outstanding contribution in 2008. sir victor Blank Chairman 26 february 2009 dividEnd As part of the HM Treasury recapitalisation scheme, the Group was required to suspend the payment of cash dividends to ordinary shareholders until the HM Treasury preference shares issued as part of the scheme are repaid. in the meantime, however, as we indicated in our shareholder circular last year, the board has approved a capitalisation issue of one for 40 ordinary shares held. OuR ROlE in sOciEty At a time when there is a great deal of public debate about the role of the banking system, i think it is important to reflect on the contribution that banks, and lloyds Banking Group in particular, make to our society. our company is the largest provider of social banking accounts in the uK. We provide four million of these accounts and are proud of the way in which we help our low income customers to access the banking system and, where appropriate, move up to a full service current account. We also have a substantial community investment programme through activities within the Company as well as the four lloyds TSB foundations. our overall community investment programme is now somewhere in the region of £100 million a year and is, as a result, one of the most significant contributions by any major corporate to uK society. We are determined to continue to play an important role in the many communities in which we operate up and down the country. Turning to broader societal issues, a great deal has been said in recent months about the role of bonuses in the banking system. We recognise the legitimate public interest in this subject. We have worked closely with the Government to devise a bonus system which is fair to our colleagues and sensitive to the wider needs of society as a whole. We do think that a necessary process is now underway to reassess the way in which some incentives in the banking system were structured and awarded – typically in areas in which we don’t have a great deal of involvement. Specifically, we are very much a retail and commercial banking business with very little in the way of investment banking activity. We also recognise how important it is to align bonus and remuneration schemes with the interests of our shareholders, something we believe we have done over the years. from our perspective, it is particularly important that we retain our best talent both in the uK and overseas and we believe that it is an important factor that should also be taken into account when designing total reward systems. OuR cORpORAtE gOvERnAncE We are committed to ensuring that the Group has a robust governance structure in place. Good corporate governance matters even more now than ever before. As we integrate HBoS we are now moving quickly to common governance standards. i believe this is important as there is a clear link between high quality governance and shareholder value creation. During the year, we have continued the board’s renewal process with the appointment of three new non-executive directors, each of whom brings a wealth of experience to the board. They are Carolyn McCall, Sir David Manning and Martin Scicluna and brief biographical details can be found on pages 66 and 67. in addition, Tim ryan and Tony Watson will join us on 1 March and 2 April 2009, respectively. These appointments ensure that your board has a broad range of skills and senior experience, qualities which i believe are even more important now than they might have been before the economic turmoil began. in october, Tim Tookey was appointed our new group finance director following Helen Weir’s move from this role to become group executive director, uK retail Banking after Terri Dial’s decision to leave the Group. Mike fairey, deputy group chief executive, retired in June following a 17 year career with the Group. on behalf of the board, i would like to thank Mike for his invaluable contribution to the Group over such a long period of time and wish Terri well in her new career. 4 lloyds Banking Group Annual report and Accounts 2008 Group CHief exeCuTiVe’S reVieW J eric Daniels This has been an extraordinary year, by any measure and, as many commentators have observed, we are in the most severe global downturn since the 1930s. it was triggered by problems in the uS housing market, spread to the financial services industry and has now moved on to the broader economy. The uK has been profoundly impacted by the crisis and, as a bank that primarily does its business in the uK, lloyds TSB has felt the impact. in a year when many financial institutions declared losses, lloyds TSB did deliver profits, albeit lower than in previous years and i am very aware that, as with the rest of the industry, there has been a sharp reduction in our share price. The year also brought opportunities, and we began the process to acquire the HBoS business, which is probably the most far reaching event in our 243 year history. over the past five years, i have reported on our progress towards the aspiration of building the uK’s best bank and our approach to developing deep, long-lasting customer relationships. Banking is fundamentally a risk business, and early on we took the decision to manage risk on a ‘through the cycle’ basis. This means the business will be less impacted by the extreme points in the cycle and that we can continue to support our customers through the changes in the economic climate. As a result, our rate of growth in earnings in prior periods did not always match those of our competitors but the quality of our earnings has been demonstrated in this past year. in my review this year, i will cover three areas; first, the strategic rationale for the transaction and the benefits it will bring, second, the performance of lloyds TSB in 2008, and third the outlook for lloyds Banking Group. thE hBOs AcquisitiOn Throughout the year, it became clear that there were a number of institutions facing significant challenges, both here in the uK and overseas. During the summer months there was a further collapse in confidence in the wholesale markets and, for all but the strongest, the pressures of funding reached crisis proportions. lloyds TSB had pursued a very successful relationship-focused strategy that had delivered good results for all our stakeholders, and we were continuing to perform relatively well. However, as the financial crisis gathered pace and a number of competitors recognised that they could not survive on a standalone basis, it became clear that the industry would begin to consolidate around a smaller number of larger players. it was against this backdrop that we decided to revisit our earlier strategic thinking regarding HBoS. The opportunity to acquire HBoS was considered against our other strategic options, and before deciding to proceed the board considered a number of alternatives which included continuing with our existing organic growth strategy, acquiring parts of HBoS and alternate acquisitions. After a thorough review, the board decided that the HBoS acquisition would offer the highest value-creating strategy for our shareholders and we announced the transaction on 18 September 2008. We are acquiring £17.9 billion of tangible net asset value with consideration valued at £7.7 billion, even taking into account the losses HBoS announced for 2008. All in, we have acquired a franchise that brings extensive distribution, a large customer base, good people and excellent brands. HBoS had developed a number of specialist businesses that brought greater returns at greater risk, and these did not fit the lloyds TSB risk appetite. We recognised this in our due diligence and this was reflected in the price we agreed to pay. We are buying the business in the down part of the economic cycle, at a significant discount to book value, which increases the likelihood of value creation, and we paid in shares rather than cash which in some part insulated the lloyds TSB shareholders from market risk. The transaction allows us immediately to gain scale in a consolidating market, and it profoundly changes the long-term trajectory for the Group. The acquisition allows us to occupy leading positions in current accounts, retail savings and insurance, mortgages and personal lending, and will also provide substantial scale in our corporate and commercial businesses; something that would not have been possible through organic growth alone. There will clearly be revenue synergies arising from the acquisition, as we take the best of the relationship development skills from each business and apply them across the enlarged Group. Whilst these synergies are real, and we will report on them in future periods, they are always more difficult to measure and so we have not included any value for these benefits. The transaction is essentially an in-market deal, which have historically proven to be amongst the most successful, given they allow greater cost synergies to be captured. We are targeting annualised savings in excess of £1.5 billion in 2011, which represents some 14 per cent of the combined cost base. Work is already underway, with early synergies starting to come from procurement benefits and the more efficient management of the property portfolio. over £100 million of cost efficiencies have been identified immediately from ceasing projects that will no longer be required in the enlarged Group. Clearly, there will be some staffing reductions resulting from the broad range of programmes we will initiate, but we anticipate that we can accommodate the majority of any reductions through natural staff turnover or limited voluntary redundancy programmes. The combination of the two businesses provides a strong platform for us to pursue our customer focused growth strategy, built around acquiring relationships and then deepening them. The scale we have now achieved will also allow us to be more efficient and to better leverage future investments. Whilst it is still relatively early days in terms of the transaction, we have made considerable progress, with the senior 500 executives being appointed to run the new Group and we will quickly integrate the businesses. We are identifying those businesses that are priorities for future investment, those OvERviEw Group profile Chairman’s statement BusinEss REviEw Summary of Group results Divisional results 1 2 group chief executive’s review 4 Corporate responsibility Group chief executive’s Q&A Marketplace trends 6 8 our people risk management five year financial summary 10 18 36 40 42 65 gOvERnAncE The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finAnciAl stAtEMEnts shAREhOldER infORMAtiOn report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 report of the independent auditors on the parent company financial statements 182 parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information index to annual report financial calendar 2009 191 192 195 5 lloyds Banking Group Annual report and Accounts 2008 where we are adjusting the risk policies to reflect the current environment and those that will require significant change to meet our return hurdles and risk appetite. This is allowing us to focus on developing and growing those core business areas that fit with our relationship-based, lower-risk model, whilst we squarely address the issues that affect the higher-risk portfolios. in evaluating the HBoS portfolios last year, we had taken a more conservative forecast than the HBoS internal estimates, recognising they were subject to greater volatility in an economic downturn. once we took control of HBoS in January, we analysed the portfolios in granular detail, updated our diligence and have begun to apply the lloyds TSB operating model across the enlarged business. As we began to apply our more conservative provisioning methodologies to their portfolios, and took account of the economic deterioration in the final quarter of the year, the expected losses in that final quarter increased and were finally set at a level £1.6 billion higher than our initial estimate of £8 billion. Whilst this figure is higher than our earlier estimates, it does reflect the size and nature of the HBoS portfolios and the scale of the change in the economic environment. in line with our plans, we have completed substantial further work to analyse the portfolios. We understand the challenges faced by these portfolios and are taking the necessary actions; for instance, we have reviewed the major exposures in key lines, identified the significant concentrations, revised the credit criteria for key products and withdrawn from certain business lines. We are prudently managing the capital base, as has been a hallmark of lloyds TSB. The enlarged Group retains a robust capital position, with an adjusted pro forma core tier 1 capital ratio of 6.4 per cent as of 31 December 2008, which means we are well placed to withstand the impact of any slowdown in the economy. thE llOyds tsB gROup pERfORMAncE in 2008 let me now reflect on the performance of the lloyds TSB Group in 2008. Whilst all the headlines this past year have been about the economy, the financial crisis and, for us, the HBoS transaction, it is easy to overlook the fact that the Group and our businesses have performed satisfactorily, delivering positive earnings despite the most difficult operating environment in many years. our results for the year show a decline in earnings, and on a statutory basis the Group’s profit before tax fell by 80 per cent to £807 million. However, i believe a more appropriate way to view the results is to look at our performance on a continuing business basis, and taking this approach the Group profit before tax was £2,426 million, a reduction of 35 per cent. on a continuing business basis we saw income rise by 2 per cent, as the ongoing market dislocation impacted on an otherwise good performance. Costs rose by 5 per cent, reflecting good cost control in our day-to-day operations which allowed us to further invest in our plans to support the growth of the franchise, with additional relationship staff and improvements to our systems and product range. impairments were up 68 per cent, reflecting the general slowdown in the economy and a number of specific losses related to the financial crisis and economic downturn. i would have liked to have delivered an even stronger performance for our shareholders, but in the context of the environment and when many organisations will be reporting losses, i do feel this is a reasonable out-turn. We again used the year well, strengthening the overall business franchise, with an improvement in efficiency, increases in market share, higher customer advocacy scores and we also added to the depth and experience of the management team. our focus on developing strong franchises continues to offer a strong and sustainable platform for our future growth. in building our business model, over this period, we have used a balanced scorecard approach throughout the organisation to measure our progress. The balanced scorecard contains five sections: financial performance, franchise growth, customer satisfaction, risk management and people development. As a result of managing each section of the scorecard assiduously, and focusing on a balanced approach to growth, your company was well positioned as the financial crisis struck the industry. dividEnd As part of the HM Treasury recapitalisation scheme, the Group was required to suspend the payment of cash dividends to ordinary shareholders until the HM Treasury preference shares issued as part of the scheme are repaid. in the meantime, however, as we indicated in our shareholder circular last year, the board has approved a capitalisation issue of one for 40 ordinary shares held. suppORting OuR custOMERs There has been considerable comment about the performance of the financial services sector this last year and, in particular, support for customers seeking mortgages and the owners of small businesses. i am very proud of the way your company has maintained its support to customers, in line with our relationship-based strategy. using Bank of england data for the year to December 2008, our lending to individuals grew by 10.7 per cent against the industry average of 5.4 per cent, whilst our lending to private non-financial corporates grew by 22.2 per cent against the industry average of 3.7 per cent. The commitment to our customers is critical to our business strategy, and will continue to be so in 2009. OutlOOk Against a backdrop of recession and an ongoing global financial crisis, we expect 2009 to be another challenging year. our revenues will be less impacted than many other institutions, as we have a much lower reliance on transactional income, but we will nevertheless be affected by factors such as lower margins driven by lower interest rates and the accounting impact of replacing our single premium payment protection insurance product with a new monthly premium product, as well as the general slowdown in the economy. We will continue to manage expenses tightly, as you have come to expect of us, but we will incur some additional costs in order to realise the synergies we have announced. impairments will continue to run at high levels, especially in the higher risk parts of the legacy HBoS portfolios. Despite the outlook for 2009 being tough, we will use this year to make significant progress in our strategy and to build the uK’s leading financial services company. Given the relationship nature of our business, the markets in which we operate, the focus on what i describe as the fundamentals of banking and the return to the more appropriate pricing of risk all play to our strengths and will support our longer-term growth. We are now focused on the integration of the two businesses, which will allow us to offer unparalleled choice and service to our customers, create the platform for the next stage of our growth and provide long-term value for our shareholders. suMMARy our key businesses have continued to grow, attracting new customers, improving the service to our customers and building our market share. As the crisis continued to impact the uK banking industry, we acquired HBoS in a deal that brought greater stability to the uK banking system and which has allowed lloyds TSB to rapidly advance its strategic priorities. The success of this organisation is built on the wonderful contributions of our thousands of colleagues, and i am very grateful for all they have achieved this last year in serving our customers and executing our plans. it is this consistent level of performance over the last few years which left us so well placed. The next year will be challenging but i am very confident we will make further substantial progress in building our business, as we begin to establish the uK’s leading financial services company. J Eric daniels Group Chief executive 26 february 2009 6 lloyds Banking Group Annual report and Accounts 2008 Group CHief exeCuTiVe’S Q&A iSSue: thE chAllEnging MARkEtplAcE iSSue: thE hBOs AcquisitiOn THe GloBAl fiNANCiAl CriSiS THAT HAS rAGeD oVer THe lAST 18 MoNTHS HAS leD To THe DeMiSe of MANY fiNANCiAl SerViCeS CoMpANieS ArouND THe WorlD. hOw hAs thE cRisis AffEctEd thE gROup? Clearly the last 18 months have seen unprecedented change for the worldwide financial services sector and the uK sector has been no different. Within the uK we have seen the nationalisation of Northern rock, the acquisition of Alliance & leicester, the break up of Bradford & Bingley and the recapitalisation of the uK banking sector. lloyds Banking Group has not been immune from the market dislocation as even the safest banks like lloyds TSB with strong capital bases and limited exposure to risky assets have been impacted. like many other financial institutions the lloyds TSB Corporate Markets business has been significantly affected by the market dislocation; however the relationship focus of our strategy has meant that the impact on the Group’s profit before tax was comparatively limited at £1,270 million in 2008. Although significant in absolute terms, this remains relatively low compared to many of our global peers. importantly in the current turbulent markets, the enlarged Group has a robust capital position, continues to fund at competitive prices and has diverse funding capabilities. The Group continues to offer security through its relative credit strength and our strong credit ratings are representative of this position. The board remains convinced that the combination of lloyds TSB and HBoS will bring long-term benefits for our shareholders. The unprecedented turmoil in the global financial markets has also had a significant impact on bank share prices, many of which have fallen considerably. it is not easy to offer simple explanations as to why the stock market has marked down bank share prices to such a degree in recent months but clearly there are a number of factors at play including the current view of, and future projections for, the uK economy and its impact on future asset write downs and impairments. it is also undoubtedly the case that there is currently a great deal of nervousness in the markets which is reflected in volatile bank share prices. We are living through difficult times but lloyds Banking Group remains a strong institution focused on building deeper relationships with our customers and delivering long-term shareholder value. THe ACQuiSiTioN of HBoS HAS CreATeD THe uK’S leADiNG fiNANCiAl SerViCeS Group. hOw will this influEncE thE gROup’s stRAtEgy? The strategy for the new lloyds Banking Group will be similar to that successfully adopted by lloyds TSB. We will continue to implement our ‘through the cycle’ customer relationship based approach. The new enlarged entity has significant scale advantage and both organisations enjoy a terrific reputation for managing efficiency. We will adopt the more conservative lloyds TSB risk disciplines, which have served us well, and we will embed them across the combined business. We will also maintain the economic profit disciplines we use to allocate capital efficiently. At the same time, we will continue to invest in people and systems to serve our customers better and we will look to set customer and staff satisfaction standards that are unparalleled in the market. The lloyds TSB management team has a strong track record of delivery built up over the last five years as we have consistently executed against our strategy to attract more customers to our franchise business, to deepen relationships with these customers over time, to deliver sustainable cost and productivity improvements in our operations and to make the most effective use of all our resources. These skills will all remain important for lloyds Banking Group. The acquisition of HBoS provides a unique strategic opportunity to create the best financial services business in the united Kingdom. The combination of lloyds TSB and HBoS creates a new stronger organisation and helps support the stability of the uK financial system. We are bringing together two of the most efficient customer franchises in the country and providing an unrivalled distribution network for our customers. The information advantage from the large customer base is a real differentiating edge, and the size of our operations gives us a clear opportunity for better productivity. We are targeting benefits in excess of £1.5 billion per annum through cost synergies, or some 14 per cent of the enlarged Group’s cost base, by 2011. The enlarged Group has the capital strength and diverse funding capabilities which will enable us better to meet the current industry challenges and continue to lend to and support our customers. Despite our relative strength, the shape of the financial services markets is changing all the time and we will continue to operate in highly vibrant and competitive markets. We believe we have a great case for value creation in the long-term, through building the largest financial services company in the uK, with the attendant benefits of a strong market position and large scale. All in, we believe this is a unique opportunity to create the uK’s leading financial services company. OvERviEw Group profile Chairman’s statement Group chief executive’s review group chief executive’s q&A Marketplace trends 1 2 4 6 8 BusinEss REviEw Summary of Group results Divisional results Corporate responsibility our people risk management five year financial summary 10 18 36 40 42 65 gOvERnAncE The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finAnciAl stAtEMEnts shAREhOldER infORMAtiOn report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 report of the independent auditors on the parent company financial statements 182 parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information index to annual report financial calendar 2009 191 192 195 7 lloyds Banking Group Annual report and Accounts 2008 iSSue: thE gOvERnMEnt shAREhOlding iSSue: Risk MAnAgEMEnt lloYDS TSB HAS TrADiTioNAllY BeeN perCeiVeD AS HAViNG A CoNSerVATiVe riSK profile. dOEs thE hBOs AcquisitiOn signAl Any chAngE in thE gROup’s Risk AppEtitE? No, lloyds TSB has clearly demonstrated a strong track record of delivery with a prudent risk appetite and the new lloyds Banking Group has no intention of changing this successful approach. lloyds Banking Group will continue to take a prudent approach to risk management and our philosophy remains to take a ‘through the cycle’ relationship based approach to lending. We are committed to this relationship approach, are focused on the needs of our customers and recognise that we have a role to play in helping our customers through the economic downturn, particularly when they face financial difficulty. The new Group has already exited a number of non core areas in which HBoS previously participated and will continue to assess participation in business areas on a conservative basis. our conservative approach to managing the Group’s risk has meant that we remain well positioned to capture growth opportunities at a time when others have pulled back from the market. As a result, we have been able to capture market share in a number of key areas without impacting the overall quality of business. AS A reSulT of THe reCApiTAliSATioN of THe BANKiNG SeCTor AND THe ASSoCiATeD plACiNG AND opeN offer, THe GoVerNMeNT NoW HolDS A SiGNifiCANT STAKe iN THe eNlArGeD lloYDS BANKiNG Group. whAt ARE thE iMplicAtiOns Of this And hOw dOEs thE gOvERnMEnt’s shARE OwnERship iMpAct thE gROup’s BusinEss gOing fORwARd? The Government’s recapitalisation of the banking sector in october 2008 was necessary to restore confidence and stability to the financial services sector at that time, and although they now hold a significant stake in the organisation we are comfortable that the Government’s investment was the right way of achieving that capital increase for our company. it is important to note that the board believes that HM Treasury will act as a value-oriented shareholder with regard to the strategic development of the Group and the Government has stressed the importance of institutional and individual investors as well as HM Treasury. A number of specific requirements stem from Government ownership which primarily relate to corporate governance and lending, as outlined below. Dividend restrictions, as outlined below, have been introduced due to the presence of the Government preference shares. lEnding We have a commitment to maintain the availability and active marketing of competitively priced mortgage lending and lending to Small and Medium enterprises (SMes) but do not expect any impact on our lending policies or on our conduct of business. As a major lender in the uK economy focused on developing enduring relationships with our customers, we recognise that our success is based on a commitment to helping our customers throughout the economic cycle. We are able to do this because we have a robust capital position. We remained open for business last year and grew our lending prudently. lending to SMes grew by 20 per cent at lloyds TSB in 2008 and over 100,000 small businesses chose to bank with lloyds TSB last year. Both lloyds TSB and HBoS also launched charters setting out the practical steps they will take to support small businesses through the economic downturn. in addition, on the retail side, we are the biggest mortgage provider in the first time buyer market and more basic banking customers bank with lloyds Banking Group than any other bank. cORpORAtE gOvERnAncE The Government are also keen to see an enlarged board and we are appointing two new independent non-executive directors, in consultation with HM Treasury (see page 66). it is important to note that the new directors will have precisely the same role and responsibilities as any other director on the board. dividEnd As part of the HM Treasury recapitalisation scheme, the Group was required to suspend the payment of cash dividends to ordinary shareholders until the HM Treasury preference shares issued as part of the scheme are repaid. in the meantime however, as we indicated in our shareholder circular last year, the board has approved a capitalisation issue of one for 40 ordinary shares held. 8 lloyds Banking Group Annual report and Accounts 2008 MArKeTplACe TreNDS THE ECONOMY AND OUR MARKETS Coming into 2008, the uK economy had enjoyed 60 consecutive quarters of sustained expansion. inflation remained very low during that time, helped by globalisation and the emergence of low cost economies as suppliers to the developed world. Muted global inflation enabled central banks everywhere, including in the uK, to meet inflation objectives whilst maintaining interest rates at very low levels by historical standards. in this environment, uK real household incomes had grown strongly, as had corporate profits, and asset markets had boomed, notably housing. As in the uS economy, low interest rates, low inflation, a booming housing market and high real income growth encouraged sustained high levels of consumer spending. Savings rates had fallen to very low levels and household debt had grown faster than income. We had anticipated that this benign environment was unlikely to last, and had as a result positioned our business to avoid riskier parts of the lending market and to focus on the likely longer-term rebound of savings. However, it was unclear what the trigger might be for the change in the economic environment and the readjustment by consumers towards lower borrowing and higher savings. The initial cause of the readjustment was a gradual rise in interest rates globally as the extremely rapid growth of the newly industrialising economies greatly increased demand for raw materials and sharply higher commodity prices caused inflation to surge. The current financial crisis started in August 2007, with growing evidence that weakness in uS sub-prime lending due to higher interest rates was affecting the value of securitised assets held on the balance sheets of financial institutions globally. But by the start of 2008 this had not affected the global economy materially. However, the outlook for the global, and uK, economy deteriorated significantly during last year. thE EcOnOMy in 2008 At the start of 2008, the consensus view was that the uK economy would grow by around 1.8 per cent on 2007. But as consumers’ spending power was squeezed by higher inflation and interest rates, and as consumer and business confidence collapsed, the consensus forecast gradually drifted downwards. The first full year figures for 2008 Gross Domestic product (GDp) growth, released in late January 2009 showed a final outcome of 0.7 per cent, with the second half showing negative growth. The last quarter of 2008 was particularly weak, due in large part to sharply lower manufacturing output, both in the uK and globally, as consumers cut spending on non-essentials, businesses cancelled investments and retailers reduced stocks. So far the slowdown owes more to lower business investment and weaker manufacturing and construction than it does to the consumer. Whilst spending had been strong in the preceding period, and savings rates had fallen to very low levels, there was not such an obvious consumer boom as had been the case prior to the 1990s recession. UK GDP GROWTH 5 4 3 2 1 0 -1 VOLUME, % CHANGE ON PREVIOUS YEAR 1 9 9 1 5 8 9 1 6 8 9 1 7 8 9 1 8 8 9 1 9 8 9 1 0 9 9 1 2 9 9 1 3 9 9 1 4 9 9 1 5 9 9 1 6 9 9 1 7 9 9 1 8 9 9 1 9 9 9 1 0 0 0 2 1 0 0 2 2 0 0 2 3 0 0 2 4 0 0 2 5 0 0 2 6 0 0 2 7 0 0 2 8 0 0 2 Source: ONS By the end of last year, house prices were down 16 per cent on a year earlier, using the Halifax measure. That decline had improved affordability, with the ratio of house prices to average earnings having fallen from a peak of 5.8 in July 2007 to an estimated 4.4 by December 2008, but still above its long term average of 4.0. UK CONSUMER PRICE INFLATION 6 5 4 3 2 1 0 -1 End 2008 projection Target: 2% 2002 2003 2004 2005 2006 2007 2008 2009 Source: ONS and Lloyds Banking Group Compared to the last recession, average household finances do not yet seem to be under the same pressure, perhaps because the preceding consumer boom had not been so strong but also because interest rates have fallen faster and further. The percentage of mortgagors reporting payment problems is around half the levels seen in the early 1990s. OvERviEw Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 BusinEss REviEw Summary of Group results Divisional results Corporate responsibility our people risk management five year financial summary 10 18 36 40 42 65 gOvERnAncE The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finAnciAl stAtEMEnts shAREhOldER infORMAtiOn report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 report of the independent auditors on the parent company financial statements 182 parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information index to annual report financial calendar 2009 191 192 195 9 lloyds Banking Group Annual report and Accounts 2008 other indicators of households’ financial distress, such as mortgage arrears and repossessions, are at low levels compared with the early 1990s. However, in late 2008 unemployment levels were rising at a faster rate than at a similar point during the early 1990s, with companies seemingly responding more quickly to worsening economic conditions this time around. The deterioration of economic prospects globally, combined with the initial impact of the financial crisis, has triggered a period of balance sheet adjustment by banks and other financial services companies, by non-bank companies and by individuals. Spreads in wholesale financial markets, on which many banks rely to fund their lending, widened sharply, with negative consequences for the availability and cost of credit for the broader economy. Balance sheet adjustment and high funding costs could, if left unchecked, make the global downturn even steeper and more damaging. Governments worldwide have responded by expansionary budget policy changes, by injecting capital into banks and by providing guarantees and other forms of support for wholesale funding markets. Central banks have also responded – by sharply lowering the interest rates they control and by expanding their balance sheets to support financial markets. As a result, by early 2009, spreads in many financial markets had started to shrink, though remaining well above pre-crisis levels. house prices have depressed consumer confidence and curbed demand for both secured and unsecured borrowing. on the supply side, weak capital and funding positions have caused the withdrawal of some lenders from the market. Combined with increased perception of risk and falling asset values, this has restricted the aggregate supply of credit. However, the relative strength of lloyds TSB’s capital and funding position, and our relationship-based approach, has enabled us to continue to grow our lending, thereby increasing our share of new lending. in commercial and corporate banking markets, lending growth has also slowed. Again this is due to both supply and demand factors. The withdrawal of some banks from active participation in the market has reduced the aggregate supply of credit, and the increased cost of wholesale funding has raised the cost of finance. At the same time, cutbacks in investment – in reaction to a worsening economic outlook – have enabled many companies to cut their financing needs, although the reduced availability of trade credit plus tighter margins has weakened the cash flow of some. Weaker cash flow also helps to explain why corporate deposit growth turned negative in 2008. Shrinking corporate deposits, plus slowing household deposit growth has required those banks still growing their balance sheets to rely more heavily on wholesale funding. UK CONSUMER SPENDING GROWTH thE OutlOOk 8 6 4 2 0 -2 VOLUME, % CHANGE ON PREVIOUS YEAR 1 9 9 1 5 8 9 1 6 8 9 1 7 8 9 1 8 8 9 1 9 8 9 1 0 9 9 1 2 9 9 1 3 9 9 1 4 9 9 1 5 9 9 1 6 9 9 1 7 9 9 1 8 9 9 1 9 9 9 1 0 0 0 2 1 0 0 2 2 0 0 2 3 0 0 2 4 0 0 2 5 0 0 2 6 0 0 2 7 0 0 2 8 0 0 2 Source: ONS iMpAct On OuR MARkEts During the long upturn that preceded the recession, consumer and corporate borrowing had grown at a strong pace, boosted by booming asset prices and seemingly low levels of risk. Savings growth had been modest by comparison. The recession will see a significant change in that pattern, as households and businesses adjust to the new world. The first signs of that change are evident already. Against the backdrop of a weakening economy, most major uK banking product markets slowed in 2008. With house prices falling throughout last year, and with some banks withdrawing, mortgage lending growth slowed. By late 2008, growth in mortgage balances outstanding was down to below 4 per cent, and approvals for new mortgages were around 75 per cent below the level of a year earlier. However, those banks, like lloyds TSB, who were still active in the market, were continuing to experience stronger growth due to the withdrawal of other lenders. unsecured personal lending growth also moderated, although balances outstanding on credit cards grew more strongly, suggesting that financial pressures on households were reducing the number paying off credit card outstandings in full each month. The slowdown in both mortgages and unsecured lending is due to both demand and supply factors. A worsening economic outlook and falling The slowdown during the second half of 2008 means that the economy is now technically in recession (defined as a period of at least two consecutive quarters of negative growth). 2009 is likely to see that recession deepen. Views on 2009 economic prospects have also changed radically during the last year. At the start of 2008, the consensus forecast was that the uK economy would grow by 2 per cent in 2009. By early 2009, the consensus was for a fall of more than 2 per cent. Against such an economic environment, we expect growth in our main markets to slow further during 2009, again driven by a mixture of demand and supply factors. Net mortgage lending may well turn negative in 2009 as house prices continue to fall. unsecured lending will slow further as consumer spending on non-essentials is reduced. Savings growth will also be slow as pressures on household finances offset a desire to save more in an uncertain environment. Growth in commercial and corporate lending is expected to weaken as companies reduce investment spending further, and corporate deposit growth will remain weak. Given weak deposit growth by both households and firms, banks in aggregate will continue to rely on wholesale markets to fund net new lending. The likely continued high cost of wholesale funding, relative to base rates, will constrain banks’ ability to support the economy through credit growth. unemployment will continue to rise, although the extent of that rise is uncertain, depending for instance on how much companies have reacted more quickly on layoffs in this recession than they did last time round. By the end of this year the housing market is expected to bottom out as affordability improves further. it is likely that further house price falls in 2009, combined with growth in average earnings, will reduce the ratio of house prices to average earnings to below the long term average. And very low interest rates, combined with lower house prices, should make borrowing to buy a house more affordable than at almost any time during the last 30 years. By 2010, our scenarios all project the gradual restoration of growth, as growing confidence that the worst is over feeds through into a weak recovery in consumer spending and business investment, lower spreads in financial markets and a levelling off for asset prices. This will be reflected in some strengthening of growth in our main markets. 10 Lloyds Banking Group Annual Report and Accounts 2008 SUMMARY OF GROUP RESULTS OUR STRATEGY The strategy for the enlarged Group remains to grow the business through developing long-term customer relationships and building our customer franchise. All our businesses are focused on extending the reach and depth of our customer relationships, whilst enhancing product capabilities to build competitive advantage. The prudent Lloyds TSB ‘through the cycle’ approach to risk will apply to the enlarged Group and will be increasingly important as we strive to improve our processing efficiency and make our working capital work harder. Executing the strategy effectively will only be possible if we manage our most valuable resource, our people, well. By successfully delivering these objectives we are likely to achieve our vision of being the best financial services provider in the United Kingdom. The focus for the Group remains within the UK and our position was significantly strengthened through the acquisition of HBOS in January 2009. The effective integration of the two businesses will be a significant challenge over the next few years, but the combination of the two businesses provides a real opportunity to create the UK’s leading financial services organisation. During 2008 there were three primary operating divisions: UK Retail Banking; Insurance and Investments; and Wholesale and International Banking. The key product markets in which they participate and relative contribution to the Group is presented below and a more detailed analysis of their strategy, business and performance is outlined within the Business Review. Following the acquisition of HBOS these divisions will be restructured with elements from some existing businesses coming together to form another division. The new Wealth and International division has been created to focus on Wealth Management, Asset Management and International Banking. oUR dIvISIonS dIvISIon oveRvIeW ConTRIbUTIon To GRoUP* UK ReTAIL bAnKInG Secured lending – mortgages Unsecured lending – credit cards, loans and overdrafts Internet and telephone banking 42% Current accounts Savings accounts Wealth Management InSURAnCe And InveSTmenTS Life assurance, pensions and investments General Insurance Asset Management WHoLeSALe And InTeRnATIonAL bAnKInG Corporate Markets Commercial Banking Asset Finance International Banking Key HIGHLIGHTS Statutory profit before tax reduced by 80 per cent to £807 million. A resilient underlying business performance was offset by the impact of market dislocation and adverse volatility relating to the Group’s insurance businesses. A resilient business performance. Profit before tax, on a continuing businesses basis, totalled £2,426 million, a decrease of 35 per cent which reflected the impact of £1,270 million of market dislocation and higher impairment levels. Robust income performance. Income, excluding market dislocation, grew by nine per cent reflecting strong revenue growth from the Group’s relationship banking businesses. On a statutory basis, income was eight per cent lower at £9,872 million. excellent cost management. The Group’s cost:income ratio, excluding market dislocation, improved by 1.1 percentage points to 47.0 per cent. In a difficult economic environment, asset quality remains satisfactory. Impairment losses increased by 68 per cent to £3,012 million, reflecting the impact of market dislocation, the slowdown in the UK economic environment and the impact of the falling house price index. Strong liquidity and funding position maintained throughout the recent turbulence in global financial markets. Robust capital ratios. Adjusting the year end capital ratios for the Government’s recapitalisation of UK banks, completed in January 2009, and the estimated impact of the acquisition of HBOS, the enlarged Lloyds Banking Group’s pro forma core tier 1 capital ratio stands at 6.4 per cent, the tier 1 ratio at 9.8 per cent and the total capital ratio at 12.5 per cent. PRofIT AnALySIS by dIvISIon UK Retail banking Insurance and Investments Wholesale and International banking 2008 £m 2007† £m Change % 1,793 1,720 911 748 4 22 – Before impact of market dislocation 1,544 1,580 – Impact of market dislocation (1,270) (280) Central group items 274 (552) 1,300 (12) (79) Profit before tax†† – continuing businesses 2,426 3,756 (35) Volatility – Insurance – Policyholder interests Discontinued businesses Profit on sale of businesses 22% (746) (471) – – (277) (222) 162 657 Provision in respect of certain historic US dollar payments, provision for Financial Services Compensation Scheme levy and goodwill Impairment 36% Settlement of overdraft claims Profit before tax – statutory earnings per share † Restated, see page 17. (402) – 807 14.3p – (76) 4,000 58.3p (80) (75) * Before impact of market dislocation and excluding volatility, a provision in respect of certain historic US dollar payments, a provision for the Financial Services Compensation Scheme levy and Goodwilll impairment. Also excludes central group items. † † Excluding volatility, a provision in respect of certain historic US dollar payments, a provision for the Financial Services Compensation Scheme levy, goodwill impairment; and, in 2007, results of discontinued businesses, profit on sale of businesses and the settlement of overdraft claims. oveRvIeW Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 bUSIneSS RevIeW GoveRnAnCe fInAnCIAL STATemenTS SHAReHoLdeR InfoRmATIon Summary of Group results 10 The board Divisional results Corporate responsibility Our people Risk management Five year financial summary 18 36 40 42 65 Directors’ report Corporate governance Directors’ remuneration report 74 66 68 70 Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 GRoUP Key PeRfoRmAnCe IndICAToRS – fInAnCIAL STATUTORY PROFIT BEFORE TAX £m EARNINGS PER SHARE † (80%) 2006 2007 2008 807 4,248 (39%) 4,000 2006 2007 2008 PROFIT BEFORE TAX † £m RETURN ON EQUITY † (35%) 2006 2007 2008 3,588 3,756 2,426 2006 2007 2008 INCOME AND COST GROWTH 2008 † % TOTAL SHAREHOLDER RETURN Income 2 Costs 6 (70.7) ECONOMIC PROFIT † £m DIVIDEND (58%) 2006 2007 2008 1,604 1,725 (68%) 2006 2007 731 2008 11.4 11 Lloyds Banking Group Annual Report and Accounts 2008 29.7 15.8 pence 45.3 48.6 % 24.4 24.3 % 2006 24.8 (12.1) 2007 2008 pence 34.2 35.9 GRoUP Key PeRfoRmAnCe IndICAToRS – non-fInAnCIAL ENGAGEMENT INDEX †† % NET PROMOTER SCORE ††† 2006 2007 2008 74.5 75.3 78.3 (4.3) 2007 2008 5.5 † Excluding volatility, a provision in respect of certain historic US dollar payments, a provision for the Financial Services Compensation Scheme levy, goodwill impairment; and, in 2007, results of discontinued businesses, profit on sale of businesses and the settlement of overdraft claims; and, in 2006, the pension scheme related credit. †† Read more in Our People section (page 40). ††† Read more in Corporate Responsibility section (page 37). 12 Lloyds Banking Group Annual Report and Accounts 2008 SUMMARY OF GROUP RESULTS continued During 2008, the Group delivered a resilient core business performance against the backdrop of significant turbulence in global financial markets and a marked slowdown in the UK economic environment. Statutory profit attributable to equity shareholders however decreased by 75 per cent to £819 million and earnings per share decreased by 75 per cent to 14.3p, reflecting the impact of market dislocation, insurance volatility, caused by lower equity markets and wider credit spreads in fixed income markets, and a significant increase in impairment levels. Profit before tax fell by 80 per cent to £807 million. To enable meaningful comparisons to be made with 2007, the income statement commentaries below are on a continuing businesses basis (see ‘Presentation of information’ on contents page). bUILdInG STRonG CUSTomeR ReLATIonSHIPS The Group’s strategy is to build strong customer franchises and we have continued to extend the reach and depth of our customer relationships, achieving good sales growth, whilst also improving productivity and efficiency. As a result, the Group’s core relationship businesses have continued to perform well, growing market share in many key areas. Like many other financial institutions, the Group’s Corporate Markets business has been significantly affected by the ongoing impact of market dislocation; however, the relationship focus of our strategy and conservative risk management approach has meant that the impact on the Group’s profit before tax was limited to £1,270 million during 2008 (£925 million reduction in income; £345 million increase in impairment). In the extremely challenging and turbulent operating environment in global financial markets, this compares favourably to the impact on many other major financial services companies. The market dislocation largely reflects the impact of continuing mark-to-market adjustments in certain legacy trading portfolios, resulting from the marketwide repricing of liquidity and credit, together with the write-down of a number of Asset Backed Securities. Notably, even after fully absorbing this impact, the Wholesale and International Banking division delivered profit before tax of £274 million. The Group continues to maintain a strong funding and liquidity profile and has continued to obtain funding at market leading rates, with the overall margin impact of funding the Group’s balance sheet remaining broadly unchanged. The Group has benefited from improvements in a number of individual product margins, particularly in new mortgages and corporate lending, however the lower interest rate environment in the second half of the year has led to increased pressure on deposit spreads. ConTInUed momenTUm THRoUGHoUT THe bUSIneSS Profit before tax, excluding the impact of market dislocation, decreased by £340 million, or eight per cent, to £3,696 million, as good relationship banking and insurance business momentum was offset by a significant increase in levels of impairment. On this basis and adjusting for insurance grossing, revenue growth of eight per cent exceeded cost growth of five per cent. Good InCome GRoWTH Overall income growth of eight per cent, excluding the impact of market dislocation and insurance grossing adjustments, reflected continued good progress in delivering our divisional strategies. We have increased income from both new and existing customers, with strong growth in both assets and liabilities leading to higher net interest income, as well as an increase in fee-related income. Group net interest income, excluding insurance grossing, increased by £1,457 million, or 26 per cent, to £7,058 million. Over the last 12 months, total assets increased by 23 per cent to £436 billion, with a 16 per cent increase in loans and advances to customers, reflecting strong levels of customer lending growth in Commercial Banking, Corporate Markets and mortgages. Customer deposits increased by nine per cent to £171 billion, supported by good growth in savings balances in the retail bank, where bank savings increased by 12 per cent and wealth management balances by 20 per cent. Customer deposits in our Corporate Markets, Commercial and International businesses increased by 15 per cent. The net interest margin from our banking businesses was unchanged at 2.78 per cent, as improved product margins offset an adverse mix effect. Overall product margins were 12 basis points higher, reflecting stronger new business product margins in the mortgage and corporate businesses. Stronger growth in finer margin corporate and mortgage lending than in the wider margin unsecured consumer lending contributed to the negative mix effect which offset the increase in product margins. Other income, net of insurance claims and excluding insurance grossing, decreased by £1,290 million, or 25 per cent, to £3,952 million, largely reflecting the impact of market dislocation. In the retail bank, higher fees and commissions receivable as a result of good growth in added value current accounts and card services were offset by lower creditor insurance commissions and the impact of changes in product design leading to a greater proportion of earnings being recognised as net interest income rather than fee income. In addition, good levels of growth were achieved in fee based product sales to commercial banking customers. bUSIneSS RevIeW GoveRnAnCe fInAnCIAL STATemenTS SHAReHoLdeR InfoRmATIon oveRvIeW Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 Summary of Group results 10 The board Divisional results Corporate responsibility Our people Risk management Five year financial summary 18 36 40 42 65 Directors’ report Corporate governance Directors’ remuneration report 74 66 68 70 Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 13 Lloyds Banking Group Annual Report and Accounts 2008 exPoSURe To ASSeTS AffeCTed by CURRenT CAPITAL mARKeTS UnCeRTAInTIeS The Group’s relationship focused business model means our Corporate Markets business has limited exposure to assets affected by current capital markets uncertainties. During 2008 the Group has successfully taken steps to reduce and restructure these exposures and the related risk and it is anticipated that this process will continue in 2009. Following the amendment to International Accounting Standards (IAS) 39, the Group has reclassified certain assets for which there is no longer an active market and which are now being managed as lending. Assets totalling £2,993 million previously classified as held for trading (measured at fair value through profit and loss) were transferred to loans and advances with effect from 1 July 2008 and a further £437 million of assets previously classified as available for sale (measured at fair value with changes taken to equity) were transferred to loans and advances with effect from 1 November 2008. If these reclassifications had not been made, the Group’s income statement for 2008 would have included additional losses of £406 million. InSURAnCe voLATILITy A large proportion of the investments held by the Group’s insurance business are invested in assets which are expected to be held on a long-term basis and which are inherently subject to short-term investment market fluctuations. Whilst it is expected that those investments will provide enhanced returns over the longer term, the single year impact of investment market volatility can be significant. In 2008, a decline in equity and property markets and a widening of credit spreads in fixed income markets contributed to adverse volatility of £746 million, after adjusting for the effect of illiquidity premia within the annuity business. This principally reflects a reduction in the market consistent valuation of the annuity portfolio, driven by the continued widening of corporate bond spreads in 2008, and lower expected future shareholder income from contracts where the underlying policyholder investments are in equities. STRonG CoST mAnAGemenT The Group continues to invest in improving processing efficiency, resulting in continued tight control over day-to-day operating costs. During 2008, operating expenses increased by five per cent to £5,582 million excluding the insurance grossing adjustment. Over the last 12 months, staff numbers increased by 678 (one per cent) to 58,756, as investment in higher levels of customer facing staff more than offset further efficiency improvements in back-office processing centres. These improvements in operational effectiveness have resulted in a further reduction in the Group cost:income ratio, excluding market dislocation, from 48.1 per cent to 47.0 per cent. The Group’s programme of productivity initiatives has continued to deliver significant benefits, improving underlying cost efficiency and creating greater headroom for further investment in the business. During 2008, the Group exceeded its expected net cost benefits target of £250 million in 2008 by delivering a total of £311 million net cost benefits from the programme. ASSeT qUALITy In UK Retail Banking, impairment losses increased by £248 million, or 20 per cent, to £1,472 million, particularly reflecting the impact of lower house prices on the mortgage impairment charge. In terms of unsecured lending, our asset quality remains satisfactory. However, in the context of the uncertain UK economic environment and the potential for increased consumer arrears and insolvencies, we are continuing to enhance our underwriting, collections and fraud prevention procedures. Mortgage credit quality remains good although the slowdown in economic activity and rising unemployment in the UK has led to arrears rising by 44 per cent over the last 12 months, a trend that is expected to continue. The fall in the house price index during the year has led to an increase of approximately £150 million in the secured impairment charge. Looking forward, our view is for a further fall of similar magnitude in house prices during 2009. The Wholesale and International Banking charge for impairment losses increased significantly by £936 million to £1,508 million, including a £345 million impairment charge relating to the impact of market dislocation during 2008. The remaining charge reflects an increase in the level of impairments as a result of the economic slowdown in the UK and the impact of a number of high profile financial services company collapses. Overall, impairment losses increased by 68 per cent to £3,012 million. Our impairment charge on loans and advances expressed as a percentage of average lending was 1.13 per cent, excluding the impact of market dislocation, compared to 0.82 per cent in 2007 (also excluding the impact of the 2007 Finance Act). Impaired assets increased by 64 per cent to £8,700 million and now represent 3.5 per cent of total lending, up from 2.5 per cent at 31 December 2007. 14 Lloyds Banking Group Annual Report and Accounts 2008 SUMMARY OF GROUP RESULTS continued PRovISIon ReLATInG To CeRTAIn HISToRIC US doLLAR PAymenTS In January 2009, the Group announced that it had reached a settlement with both the US Department of Justice and the New York County District Attorney’s Office in relation to a previously disclosed investigation involving those agencies into certain historic US dollar payment practices by Lloyds TSB. The Group disclosed in its interim results for the first half of 2008 that it was in discussions regarding a resolution of the investigation and that it had provided £180 million in respect of this matter. The provision was hedged into US dollars at the time and fully covers the settlement amount announced in January 2009. The Group is continuing discussions with the Office of Foreign Assets Control (OFAC) regarding the terms of the resolution of its investigation. OFAC has confirmed to the Group that the amount paid to the US Department of Justice and the New York County District Attorney’s Office will be credited towards satisfying any penalty it imposes. The Group does not currently believe that any additional liability requiring provision will arise following the conclusion of the discussions with OFAC. The Group does not anticipate any further enforcement actions as to these issues. PRovISIon foR fInAnCIAL SeRvICeS ComPenSATIon SCHeme Levy The recent arrangements put in place to protect the depositors of Bradford & Bingley and other failed deposit taking institutions involving the Financial Services Compensation Scheme (FSCS) will result in a significant increase in the levies made by the FSCS on the industry. The Group has made a provision of £122 million in its 2008 accounts in respect of its current obligation for the estimated interest cost on the FSCS borrowings. Going forward further provisions in respect of these costs are likely to be necessary until the borrowings are repaid. The ultimate cost to the industry, which will also include the cost of any compensation payments made by the FSCS and if necessary the cost of meeting any shortfall after recoveries on the borrowings entered into by the FSCS, remains uncertain although it may be significant. GoodWILL ImPAIRmenT During the year, the basis of goodwill allocation in parts of our Asset Finance business has been changed to treat the consumer finance business as a single cash generating unit encompassing the motor and personal finance operations which provide direct and point of sale finance. The markets in which these units operate have been affected by the UK economic downturn, which has been characterised by falling demand and increasing arrears at this point of the cycle. This, together with uncertainties over the likely short term macroeconomic environment, has resulted in a reassessment of the carrying value of the consumer finance cash generating unit and the recognition of a goodwill impairment charge of £100 million at 31 December 2008. TAxATIon The Group’s tax for 2008 was a credit of £38 million. This primarily reflects a significant policyholder interests related tax credit offsetting in full the charge for policyholder interests included in the Group’s profit before tax. RobUST CAPITAL PoSITIon At the end of December 2008, the Group’s capital ratios remained robust with a total capital ratio on a Basel II basis of 11.2 per cent, a tier 1 ratio of 8.0 per cent and a core tier 1 ratio of 5.6 per cent. In September 2008, the Group completed the placing of 284.4 million ordinary shares at a price of 270 pence per share, raising approximately £760 million. Over the last 12 months, risk-weighted assets increased by 20 per cent to £170 billion, reflecting the growth in our Corporate Markets and mortgage businesses, as well as the impact of exchange rate movements which represented 8 percentage points of the increase. Scottish Widows remains strongly capitalised and, at the end of December 2008, the working capital ratio of the Scottish Widows Long Term Fund was an estimated 21.6 per cent. During 2008 a regular dividend of £0.2 billion was paid to the Group, bringing the total capital repatriation since the beginning of 2005 to over £3.8 billion. As at 31 December 2008, the estimated Insurance Groups Directive (IGD) capital surplus was £0.8 billion, with additional surplus within the Long Term fund totalling an estimated £1.5 billion. This IGD surplus would be unchanged in the event of a 40 per cent reduction in equity markets from the 31 December 2008 position. mAInTAInInG A STRonG LIqUIdITy And fUndInG PoSITIon The current turbulence in global capital markets has been a severe examination of the banking system’s capacity to absorb sudden significant changes in the funding and liquidity environment, and individual institutions have faced varying, but significant, degrees of stress. Throughout this period, the Group has maintained a strong liquidity position which is supported by our strong and stable retail and corporate deposit base. Both retail and corporate deposit inflows have been robust and the Group continues to benefit from its diversity of funding sources. The Group’s wholesale funding base has proved to be resilient, supporting the Group’s balance sheet growth with an increased level of longer term funding (greater than one year). New initiatives introduced during the course of 2008 by The Bank of England and HM Treasury to facilitate banks’ access to senior funding include the Special Liquidity Scheme and Credit Guarantee Scheme, respectively. The Group welcomed these initiatives and, like many of its peers, continues to make use of them for term funding. Going forward, where markets permit and it is economic to do so, the Group expects to reduce this utilisation and further develop and diversify its unguaranteed funding programmes. Following completion of the HBOS acquisition in January 2009, all of the major rating agencies have updated their ratings for the enlarged Group. Each agency has issued the Group the highest possible short-term rating, and a long-term deposit rating in the ‘double A’ range. This provides the Group with a strong overall suite of credit ratings. oveRvIeW Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 bUSIneSS RevIeW GoveRnAnCe fInAnCIAL STATemenTS SHAReHoLdeR InfoRmATIon Summary of Group results 10 The board Divisional results Corporate responsibility Our people Risk management Five year financial summary 18 36 40 42 65 Directors’ report Corporate governance Directors’ remuneration report 74 66 68 70 Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 15 Lloyds Banking Group Annual Report and Accounts 2008 ACqUISITIon of HboS In September 2008, Lloyds TSB and HBOS announced that they had reached agreement on the terms of a recommended acquisition by Lloyds TSB of HBOS, creating a compelling opportunity to accelerate Lloyds TSB’s strategy and create the UK’s leading financial services group. In October 2008, both Lloyds TSB and HBOS announced that they intended to participate in a co-ordinated package of capital and funding measures for the UK banking sector being implemented by HM Treasury. This led to Lloyds TSB’s participation in the raising of £5.5 billion new capital (consisting of £4.5 billion in ordinary shares and £1 billion in preference shares). In addition, HBOS participated in the raising of £11.5 billion (consisting of £8.5 billion in ordinary shares and £3 billion in preference shares). Both of these capital raisings and the HBOS acquisition were completed in January 2009. The Group’s board believes that its participation in the Government funding proposal provided the capital necessary to complete the acquisition in a timely fashion, with certainty and on terms that were the best available in current market conditions. The board believes that HM Treasury, which is now a 43.4 per cent shareholder of the Group, will act as a value-oriented shareholder with regard to the strategic development of the Group. Following the completion of the acquisition and the capital raisings in January 2009, the proforma adjusted capital ratios for Lloyds Banking Group, at 31 December 2008, were 6.4 per cent for core tier 1, 9.8 per cent for tier 1 capital and 12.5 per cent for total capital. The proforma adjusted net tangible asset value of the enlarged Group totalled an estimated £29.5 billion, equivalent to 179p per share. A CHALLenGInG oUTLooK 2008 has been an immensely challenging period for all banks, and the assets on the enlarged Group’s balance sheet have shown increasing signs of stress during the year. Whilst our risk management and business support culture is strong, the continuing economic deterioration in the UK will make 2009 another difficult year. We currently expect retail impairment levels to rise significantly in 2009, largely reflecting the expected increase in unemployment levels in the UK and the impact of further house price falls. Corporate impairment levels are expected to remain at the high levels seen during 2008, whilst Treasury asset and investment portfolio write-downs are expected to be significantly lower. Overall, before the recognition of negative goodwill, we expect the enlarged Group to report a loss for 2009. Tim Tookey Group Finance Director 26 February 2009 16 Lloyds Banking Group Annual Report and Accounts 2008 SUMMARY OF GROUP RESULTS continued SUmmARISed SeGmenTAL AnALySIS 2008 Net interest income Other income Total income Insurance claims Total income, net of insurance claims Operating expenses Trading surplus (deficit) Impairment Profit (loss) before tax* Volatility – Insurance – Policyholder interests Provision in respect of certain historic US dollar payments Provision for Financial Services Compensation Scheme levy Goodwill impairment Profit (loss) before tax UK Retail banking £m 4,110 1,766 5,876 – 5,876 (2,611) 3,265 (1,472) 1,793 – – – (119) – 1,674 Insurance and Investments** £m (62) 1,749 1,687 (193) 1,494 (591) 903 (2) 901 (746) – – (3) – 152 Wholesale and International banking £m 3,303 829 4,132 – 4,132 (2,350) 1,782 (1,508) 274 – – (180) – (100) (6) Central group items £m (293) (199) (492) – (492) (30) (522) (30) (552) – – – – – (552) Group excluding insurance gross up £m 7,058 4,145 11,203 (193) 11,010 (5,582) 5,428 (3,012) 2,416 (746) - (180) (122) (100) 1,268 Insurance gross up ** £m 651 (3,624) (2,973) 3,052 79 (69) 10 – 10 – (471) – – – (461) Group £m 7,709 521 8,230 2,859 11,089 (5,651) 5,438 (3,012) 2,426 (746) (471) (180) (122) (100) 807 * Excluding volatility, a provision in respect of certain historic US dollar payments, the Financial Services Compensation Scheme levy and goodwill impairment. ** The Group’s income statement includes income and expenditure which are attributable to the policyholders of the Group’s long-term assurance funds. These items have no impact upon the profit attributable to equity shareholders. In order to provide a clearer representation of the underlying trends within the Insurance and Investments segment, these items are shown within a separate column in the segmental analysis above. In the year ended 31 December 2008, the contribution from central group items was a negative £552 million compared to a negative contribution of £12 million in 2007. The result in 2008 has been significantly affected by the impact of yield curve volatility on the fair value of derivatives entered into for risk management purposes, after taking into account the effect of hedge accounting adjustments. In addition, there were increased central costs that were not recharged to the divisions in connection with professional advice received during the year and an impairment charge in respect of an available-for-sale investment. oveRvIeW Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 bUSIneSS RevIeW GoveRnAnCe fInAnCIAL STATemenTS SHAReHoLdeR InfoRmATIon Summary of Group results 10 The board Divisional results Corporate responsibility Our people Risk management Five year financial summary 18 36 40 42 65 Directors’ report Corporate governance Directors’ remuneration report 74 66 68 70 Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 17 Lloyds Banking Group Annual Report and Accounts 2008 SUMMARISED SEGMENTAL ANALYSIS continued 2007† Net interest income Other income Total income Insurance claims Total income, net of insurance claims Operating expenses Trading surplus (deficit) Impairment Profit (loss) before tax* Volatility – Insurance – Policyholder interests Discontinued businesses Profit on sale of businesses Settlement of overdraft claims Profit (loss) before tax UK Retail Banking £m 3,695 1,797 5,492 – 5,492 (2,548) 2,944 (1,224) 1,720 – – – – (76) 1,644 Insurance and Investments ** £m (106) 1,741 1,635 (302) 1,333 (611) 722 – 722 (277) – 145 272 – 862 Wholesale and International Banking £m 2,380 1,644 4,024 – 4,024 (2,152) 1,872 (572) 1,300 – – 28 385 – Central group items £m (368) 362 (6) – (6) (6) (12) – (12) – – – – – Group excluding insurance gross up £m 5,601 5,544 11,145 (302) 10,843 (5,317) 5,526 (1,796) 3,730 (277) – 173 657 (76) Insurance gross up ** £m 421 6,233 6,654 (6,615) 39 (13) 26 – 26 – (222) (11) – – 1,713 (12) 4,207 (207) Group £m 6,022 11,777 17,799 (6,917) 10,882 (5,330) 5,552 (1,796) 3,756 (277) (222) 162 657 (76) 4,000 ** Excluding volatility, results of discontinued businesses, profit on sale of businesses and the settlement of overdraft claims. ** The Group’s income statement includes income and expenditure which are attributable to the policyholders of the Group’s long-term assurance funds. These items have no impact upon the profit attributable to equity shareholders. In order to provide a clearer representation of the underlying trends within the Insurance and Investments segment, these items are shown within a separate column in the segmental analysis above. † Segmental analyses for 2007 have been restated as explained in note 4 on page 114. 18 Lloyds Banking Group Annual Report and Accounts 2008 DIVISIONAL RESULTS: UK RETAIL BANKING OUR bUSinESS During 2008, UK Retail Banking provided a wide range of banking and financial services through our diversified, proprietary distribution network and highly recognised and well-regarded brands (Lloyds TSB, Cheltenham & Gloucester and Scottish Widows) to some 16 million personal customers through over 1,950 branches across the UK. At the end of 2008 Lloyds TSB had the UK’s largest personal current account base with over 12 million current account customers, had the largest number of internet banking customers in the UK and operated 11 call centres, all in the UK, taking over 70 million calls per year. In 2008 Lloyds TSB was voted by Reader’s Digest the most trusted bank in Britain for the eighth year running. Following the acquisition of HBOS, the new ‘Retail’ division now includes the HBOS branch operations and is the largest retail bank in the UK. The Group is now the UK’s leading provider of current accounts, savings, personal loans, credit cards and mortgages and has the largest branch network in the UK, with approximately 3,000 branches, and one of the largest fee free ATM networks in the UK with around 6,800 cash machines. The new ‘Retail’ division has approximately 30 million customers. In addition to being the largest provider of current accounts in the UK with approximately 22 million current account customers, we are also the largest provider of social banking providing over four million basic bank or social banking accounts in the UK. The new ‘Retail’ division operates a multi brand strategy with a range of highly recognised and well regarded brands including Lloyds TSB, Halifax, Bank of Scotland and Cheltenham & Gloucester. Following the acquisition, the wealth management business is being transferred to the new ‘Wealth and International’ division. no 1 foR UK CURRenT ACCoUnTS Lloyds TSB took on over 1 million new customers for the second year in a row, maintaining the position of No 1 UK Current Account provider (GfK Financial Research Survey ‘FRS’ data). This success has been driven by launching innovative new products and services, such as Vantage and Control accounts and the market leading mobile banking services. Key HIGHLIGHTS Good profit performance, against a backdrop of slowing economic activity. Profit before tax increased by four per cent to £1,793 million. Strong income momentum maintained, up seven per cent, supported by overall sales growth of seven per cent. Good growth in deposits resulted in a five per cent increase in overall deposit balances, with 12 per cent growth in bank savings, and 20 per cent growth in wealth management deposits. excellent market share of net new mortgage lending, at 27.5 per cent. Mortgage balances outstanding increased by 11 per cent to £112.9 billion. Improved net interest margin, nine basis points higher than in 2007, reflecting improved key product margins, particularly in unsecured personal lending and new mortgages. Continued effective cost management, with a clear focus on investing to improve service quality and processing efficiency. Operating expenses increased by only 2 per cent and there was an improvement in the cost:income ratio to 44.4 per cent. Strong trading surplus performance, up 11 per cent to £3,265 million. The quality of new lending continues to be good, reflecting continued strong credit criteria, although the fall in the house price index over the last 12 months has led to an increase of approximately £150 million in the secured impairment charge during the year. We currently expect retail impairment levels to rise significantly in 2009, largely reflecting the expected increase in unemployment levels in the UK and the impact of further house price falls. dIvISIonAL PeRfoRmAnCe Continuing business Net interest income Other income Total income Operating expenses Trading surplus Impairment Profit before tax Cost:income ratio Total assets Risk-weighted assets Customer deposits † Restated, see page 17. 2008 £m 4,110 1,766 5,876 (2,611) 3,265 (1,472) 1,793 44.4% 2007† £m Change % 3,695 1,797 5,492 (2,548) 2,944 (1,224) 1,720 46.4% 11 (2) 7 (2) 11 (20) 4 31 december 2008 £bn 31 December 2007 £bn 127.5 49.6 85.9 115.0 44.8 82.1 Change % 11 11 5 oveRvIeW Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 bUSIneSS RevIeW Summary of Group results divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 GoveRnAnCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 fInAnCIAL STATemenTS SHAReHoLdeR InfoRmATIon Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 19 Lloyds Banking Group Annual Report and Accounts 2008 OUR STRATEGY ‘Retail’s’ strategic goal is to create Britain’s best retail bank. This will be achieved by building deeper relationships with our customers through providing products that they need, at prices they can afford, as well as delivering a high quality service. At the same time, we will seek to improve the management of our costs and capital by continuing to apply a prudent approach to risk. effective and efficient service as well as strengthening our relationships which, in turn, will generate new sales. This is backed by our extensive multi channel distribution network providing our customers with a wide range of choice and added convenience. We will drive down operating costs by improving efficiency in our processes and effectively managing risk across the bank. A major focus in the implementation of this strategy will be upon ‘putting the relationship back into banking’. We will, through deeper customer insight, offer customers first class products backed by an The integration of HBOS will give us additional opportunities to provide products and services to all of our customers whilst carefully managing risk and delivering cost synergies. KEY PERFORMANCE INDICATORS PROFIT BEFORE TAX † £m CUSTOMER DEPOSITS 4% INCOME † 7% 2006 2007 2008 2006 2007 2008 INCOME AND COST GROWTH 2008 †† Income Costs 2 one In foUR neT neW moRTGAGeS In 2008, Lloyds TSB achieved its best-ever performance in mortgages, by providing one in four net new mortgages in the UK last year (total completed mortgage business less redemptions and repayments), demonstrating Lloyds TSB remains very much open to new mortgage business and to supporting customers through difficult economic times. 1,549 5% 1,720 1,793 2006 2007 2008 £bn 75.7 82.1 85.9 £m GROUP UK MORTGAGE BALANCES £bn 5,263 5,492 5,876 11% 2006 2007 2008 95.3 102 112.9 % 7 NET PROMOTER SCORE (4.3) 2007 2008 5.5 † The 2007 figures have been restated (see page 17). The 2006 figures are as originally published. †† Excluding the settlement of overdraft claims and the Financial Services Compensation Scheme levy. SUCCeSSfUL yeAR foR SAvInGS And PeRSonAL LoAnS 2008 was the most successful year ever for savings and personal loans. Savings balances grew by £5 billion with over two million accounts opened, 28 per cent higher than 2007. A really impressive performance given the market uncertainty and low interest rate environment. Lloyds TSB continues to be the number one provider of personal loans (CACI data). 20 Lloyds Banking Group Annual Report and Accounts 2008 DIVISIONAL RESULTS UK RETAIL BANKING continued By making its customers central to its strategy, UK Retail Banking continued to make substantial progress in each of its key strategic priorities: growing income from its existing customer base; expanding its customer franchise; and improving productivity and efficiency. In each of these areas, a key focus has been on sales of recurring income products, such as current accounts and savings products which, combined with higher lending related income, has supported the strong rate of revenue growth. This has been achieved whilst continuing to operate our lending principles in a responsible manner, by maintaining lending criteria appropriate to the position in the economic cycle, by working with our customers who are experiencing financial difficulties and by ensuring we pass on base rate cuts to our Standard Variable Rate mortgage customers. Profit before tax from UK Retail Banking increased by £73 million, or four per cent, to £1,793 million, reflecting strong levels of franchise growth and effective cost management which offset the higher impairment charge. Total income increased by £384 million, or seven per cent, whilst operating expenses remained well controlled, increasing by two per cent. The trading surplus increased by 11 per cent to £3,265 million. GRoWInG InCome fRom THe CUSTomeR bASe The retail bank has continued to make good progress, delivering strong product sales growth and revenue momentum, notwithstanding the challenging UK economic environment. Overall sales increased by seven per cent, with improvements over a broad range of products and through our wide variety of distribution channels. Both the internet and telephone banking channels performed strongly with sales growth of 29 per cent and 19 per cent respectively. Our continued good sales growth has been driven by strong sales of personal loans, bank savings and wealth management products. Our market share of new business in these key product areas has continued to increase, as the retail bank has successfully leveraged the benefit of the Group’s strong brand and balance sheet to support increasing customer sales. Customer deposits have increased by five per cent during the year, with particularly strong progress in growing our relationship focused bank savings and wealth management deposit balances, with increases of 12 per cent and 20 per cent respectively. The retail bank opened over two million new savings accounts during 2008. Current account and savings balances Bank savings C&G deposits Wealth management UK Retail Banking savings Current accounts Total customer deposits 31 december 31 December 2007 £m 2008 £m Change % 46,941 12,433 5,910 65,284 20,642 85,926 41,976 14,861 4,939 61,776 20,305 82,081 12 (16) 20 6 2 5 Over the last 12 months, the Group has made significant progress in building its mortgage business, in a mortgage market that has slowed considerably. The Group continues to focus on those segments of the prime mortgage market where value can be created whilst taking a conservative approach to credit risk. The Group continues to manage for value, targeting growth in profitable new business rather than overall market share. This approach, together with a recent uplift in interest spreads, has led to new business net interest margins strengthening over the last 12 months. exPAndInG THe CUSTomeR fRAnCHISe In addition to the strong growth in product sales from existing customers, the Group has continued to make progress in expanding its customer franchise. The retail bank opened over one million new current accounts during the year, with a strong performance from the Group’s range of added value current accounts with enhanced product features. Despite tightened credit criteria and a slowdown in consumer demand, we have maintained our market leading position in personal loans, growing our market share of the unsecured personal loans market whilst remaining primarily focused on lending to our current account customer base. Unsecured consumer credit balances increased by six per cent, with personal loan balances outstanding at 31 December 2008 up nine per cent at £12.2 billion, whilst credit card balances were stable at £6.6 billion. The demand for the Lloyds TSB Airmiles Duo credit card account has continued to be strong, with 1.4 million customers now signed up to use the account. Duo customers tend to be higher quality, more transactional customers. As a result, Lloyds TSB has maintained its position as a UK market leader in new credit card issuance during 2008, and has maintained an estimated new business market share of 13 per cent. In addition, Lloyds TSB was the leading consumer debit card issuer in the UK during the year. The Group’s market share of gross new mortgage lending increased to 10.8 per cent (2007: 8.1 per cent), as the Group continued to maintain its substantial presence in the UK mortgage market. Overall, new lending in the UK mortgage market fell by 29 per cent to £258 billion (2007: £363 billion) however the Group’s gross new mortgage lending in 2008 fell by only five per cent to £27.8 billion (2007: £29.4 billion). The higher market share of gross mortgage lending, in conjunction with a reduction in the Group’s share of mortgage redemptions, has led to a significant increase in our market share of net new lending to 27.5 per cent, which partly reflects the withdrawal of a number of competitors from the UK mortgage market. Group mortgage balances outstanding increased by 11 per cent to £112.9 billion. Wealth management continues to make good progress with its expansion plans to deliver an enhanced wealth management offer comprising private banking, open architecture portfolio management, retirement planning, insurance and estate planning services. New funds under management increased by 22 per cent, investment portfolio cases grew by 16 per cent and wealth management banking deposits increased by 20 per cent. During a period when the FTSE 100 index fell by 31 per cent, investment portfolio funds under management decreased by 11 per cent and this led to an overall reduction of three per cent in total customer assets. oveRvIeW Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 bUSIneSS RevIeW Summary of Group results divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 GoveRnAnCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 fInAnCIAL STATemenTS SHAReHoLdeR InfoRmATIon Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 21 Lloyds Banking Group Annual Report and Accounts 2008 ImPRovInG PRodUCTIvITy And effICIenCy We have continued to benefit from the recent investment in reducing the levels of administration and processing work carried out in branches. This has enabled us to further increase our focus on meeting the needs of our customers and has supported improved productivity in the branch network sales effort. These improvements have supported a further improvement in the retail banking cost:income ratio to 44.4 per cent, from 46.4 per cent last year. Average sales by staff in the branch network have shown good growth on the levels achieved in 2007. Telephone banking has continued to improve the quality of the service which it provides to customers, allowing us to focus on better meeting the needs of our customers whilst also improving efficiency. ARReARS PeRfoRmAnCe RemAInS SATISfACToRy Impairment losses on loans and advances were 20 per cent higher at £1,472 million, particularly reflecting the impact of lower house values on the mortgage impairment charge. The impairment charge as a percentage of average lending was higher at 1.22 per cent, compared to 1.10 per cent in 2007. Over 99 per cent of new personal loans and 90 per cent of new credit cards sold during 2008 were to existing customers. The level of arrears in the credit card and personal loan portfolios increased by 26 per cent and 15 per cent respectively reflecting the impact of the slowdown in the UK economic environment. In terms of unsecured lending, our arrears performance remains satisfactory. However, in the context of the uncertain UK economic environment and the potential for increased consumer arrears and insolvencies, we are continuing to enhance our underwriting, collections and fraud prevention procedures. We currently expect retail impairment levels to rise significantly in 2009, largely reflecting the expected increase in unemployment levels in the UK and the impact of further house price falls. Mortgage credit quality remains good although the slowdown in economic activity and rising unemployment in the UK has led to arrears rising by 44 per cent over the last 12 months. This compares to a rise of 72 per cent in Council of Mortgage Lenders (CML) industry averages in the 12 months to 31 December 2008. The fall in the house price index over the last 12 months has however led to an increase of approximately £150 million in the secured impairment charge during the year. Looking forward, our view is for a further fall of similar magnitude in house price index during 2009. In Cheltenham & Gloucester, the average indexed loan-to-value ratio on the mortgage portfolio was 56 per cent, and the average loan-to- value ratio for new mortgages and further advances written during 2008 was 63 per cent. At 31 December 2008, 15 per cent of balances had an indexed loan-to-value ratio in excess of 100 per cent reflecting the significant fall in house prices during the year. Compared to the CML industry averages at 31 December 2008, UK Retail Banking had less than half the industry average for properties in possession and new repossessions as a percentage of total cases in 2008. In addition, arrears in the Group’s buy-to-let portfolio represent only a small fraction of our prime portfolio and CML industry averages. We extensively stress-test our lending to changes in macroeconomic conditions and we remain confident in the quality of our mortgage portfolio. 22 Lloyds Banking Group Annual Report and Accounts 2008 DIVISIONAL RESULTS: INSURANCE AND INVESTMENTS Our business The Insurance and Investments division offered life assurance, pensions and investment products, general insurance and fund management services during 2008. These products were delivered through a number of brands including Scottish Widows, Lloyds TSB General Insurance and Scottish Widows Investment Partnership. The Scottish Widows brand was the main brand for new sales of Lloyds TSB Group’s life, pension, Open Ended Investment Companies (OEICs) and other long-term savings products in 2008. Scottish Widows was voted Best Individual Pensions Provider by IFAs and was voted the most trusted choice for pensions amongst UK consumers in 2008. Lloyds TSB General Insurance was the leading distributor of home insurance in Britain, with products distributed through Lloyds TSB branches and strategic corporate partners. Scottish Widows Investment Partnership (SWIP) managed funds for Lloyds TSB Group’s retail life, pensions, and investment products. Other key clients covered both the retail and institutional segments, with SWIP occupying a top three position in terms of Retail funds under management. Retail and Institutional SWIP had £83 billion of funds under management at the end of 2008. Following the acquisition of HBOS, the Insurance and Investments division has been renamed ‘Insurance’ and now includes the Clerical Medical and HBOS General Insurance businesses which were previously part of the HBOS Insurance and Investments division. The investment management business, Scottish Widows Investment Partnership, is being transferred to the new Wealth and International division. Lloyds Banking Group is now the major bancassurance provider in the UK and provides a full range of equity based long-term savings and investment products. Key HIGHLIGHTS Strong profit performance. Profit before tax increased by 22 per cent to £911 million. Good income growth and strong cost management. Income increased by three per cent, whilst operating expenses decreased by three per cent. Robust sales performance, in a challenging market environment resulting in an increase in estimated market share. Scottish Widows’ bancassurance sales increased by four per cent, whilst sales through the Independent Financial Adviser (IFA) distribution channel decreased by eight per cent. Continued high returns. On a European Embedded Value (EEV) basis, the post-tax return on embedded value remained high at 11.4 per cent. New business margins remained resilient at 2.9 per cent. Strong profit performance in General Insurance. Profits more than doubled in 2008 reflecting the absence of the severe weather related claims experienced in 2007, good increases in home insurance income and more efficient claims processing. Resilient performance by Scottish Widows Investment Partnership, as profit before tax increased against the backdrop of a significant reduction in equity market levels. DIvISIonaL PeRfoRmanCe Continuing businesses Net interest income Other income Total income Insurance claims Total income, net of insurance claims Operating expenses Impairment Profit before tax, excluding insurance gross Insurance grossing adjustment (page 16) Profit before tax Profit before tax analysis Life, pensions and OEICs General Insurance Scottish Widows Investment Partnership Profit before tax Present value of new business premiums (PVNBP) PVNBP new business margin (EEV basis) total Post-tax return on embedded value (EEV basis) † Restated, see page 17. 2008 £m (62) 1,749 1,687 (193) 1,494 (591) (2) 901 10 911 635 234 42 911 2007† £m (106) 1,741 1,635 (302) 1,333 (611) – 722 26 748 597 110 41 748 Change % 42 – 3 36 12 3 25 (62) 22 6 113 2 22 10,094 10,424 (3) 2.9% 3.1% 11.4% 10.7% oveRvIeW Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 BuSIneSS RevIeW Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 GoveRnanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 fInanCIaL STaTemenTS SHaReHoLDeR InfoRmaTIon Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 23 Lloyds Banking Group Annual Report and Accounts 2008 OUR STRATEGy The strategic priorities for the new ‘Insurance’ division are: – Delivering profitable, market-led product propositions – Increasing the proportion of business sold through the Lloyds Banking Group franchise whilst profitably growing independent financial adviser (IFA) sales – Leveraging scale into new channels – Improving service and operational efficiency – Managing risk effectively and optimising capital management – Attracting, developing and retaining the best people KEy PERFORMANCE INDICATORS Within the life assurance operations this will be achieved by developing strong and enduring relationships, developing market-led propositions and being easy to do business with. Scottish Widows’ products are distributed through the Lloyds TSB channels, independent financial advisers and other intermediaries, whilst Clerical Medical products are distributed through the HBOS channels, independent financial advisers and other intermediaries. The General Insurance operations are targeting growing share in their chosen customer segments, developing key insurance partnerships, improving margins by better customer management and improving service and efficiency. PROFIT BEFORE TAX † NEW BUSINESS SALES (PVNBP) £m £m NEW BUSINESS SALES (PVNBP) 22% (3%) 2006 2006 2007 2007 2008 2008 9,740 973 (3%) 748 10,424 911 10,094 2006 2007 2008 RETURN ON EMBEDDED VALUE* NEW BUSINESS SALES (PVNBP) £m % NEW BUSINESS MARGINS (PVNBP) † (3%) 2006 2006 2007 2007 2008 2008 9.3 9,740 10.7 10,424 10,094 11.4 2006 2007 2008 £m 9,740 10,424 10,094 % 3.6 3.1 2.9 INCOME AND COST GROWTH 2008(cid:31)† Income % 3 Costs (3) moST TRuSTeD CHoICe Scottish Widows was voted most trusted choice for pensions in an independent survey. (IPSOS, February 2008) † The 2007 figures have been restated (see page 17). The 2006 figures are as originally published. *EEV basis. ◆Excluding volatility and insurance grossing. BeST Home InSuRanCe WeBSITe Assessed against 550 different criteria and measured according to 1,000 insurance customer feedback responses, www.lloydstsbinsurance.co.uk has been ranked as the best Home Insurance website for the second year in succession by Global Reviews 2008. (November 2008) 24 Lloyds Banking Group Annual Report and Accounts 2008 DIVISIONAL RESULTS INSURANCE AND INVESTMENTS continued ScottiSh WidoWS life, penSionS and oeics optiMiSing capital ManageMent The capital position of Scottish Widows has remained robust despite recent market turbulence. Scottish Widows’ approach to capital management, including its investments and hedging strategy, has been successful in mitigating the impact of market shocks on its current capital base. Additionally, Scottish Widows’ capital management strategy is designed to generate sufficient free cash flow to fund new business and maintain dividend flow to the Group. Accordingly, Scottish Widows continues to focus on improving the capital efficiency of its products and identifying further opportunities to improve its capital position. The post-tax return on embedded value, on an EEV basis, increased to 11.4 per cent, partly reflecting a lower value of in-force business resulting from recent falls in investment markets. During 2008, £0.2 billion of capital was paid to the Group via the regular annual dividend payment, giving a total capital repatriation of over £3.8 billion since the beginning of 2005. preSent value of neW buSineSS preMiuMS (pvnbp) 2008 £m 2007 £m Change % Life and pensions: Protection Creditor Savings and Investments Individual pensions Corporate and other pensions Retirement income Managed fund business Life and pensions OEICs 317 680 437 2,125 2,482 939 217 7,197 2,897 275 685 913 2,073 2,141 1,044 486 7,617 2,807 life, pensions and oeics 10,094 10,424 Single premium business Regular premium business 7,346 2,748 8,375 2,049 life, pensions and oeics 10,094 10,424 Bancassurance Independent financial advisers Direct 4,247 5,367 480 4,096 5,817 511 life, pensions and oeics 10,094 10,424 15 (1) (52) 3 16 (10) (55) (6) 3 (3) (12) 34 (3) 4 (8) (6) (3) Profit before tax, excluding volatility, increased by £38 million, or six per cent, to £635 million. Life and pensions new business profit, on an IFRS basis and excluding volatility, increased by 46 per cent to £238 million, reflecting a higher volume of protection business and the development of an investment bond product which has resulted in a higher proportion of the new business written containing insurance features, which is therefore accounted for on an embedded value basis. Existing business profit decreased by 12 per cent, to £363 million, as an increase in expected profits from the existing business was more than offset by the adverse impact of changes in assumptions, principally reflecting an increase in long-term lapse assumptions. During 2008, Scottish Widows has continued to make good progress in its key business priorities: to maximise bancassurance success; to profitably grow IFA sales; to improve service and operational efficiency; and to optimise capital management. MaxiMiSing bancaSSurance SucceSS During 2008, the value of Scottish Widows’ bancassurance new business premiums increased by four per cent, building on the success of the simplified product range for distribution through the Lloyds TSB branch network, commercial banking and wealth management channels. Sales of OEICs through the wealth segment were particularly strong, offsetting a reduction in volumes through the mass market segment, where a reduction in the sales of equity-backed OEICs has been partly offset by strong sales of capital protected savings products. Sales of protection products also increased significantly reflecting the benefit of product enhancements during the year. ifa SaleS Sales through the IFA distribution channel decreased by eight per cent, reflecting the general contraction in sales in the IFA market. Scottish Widows’ participation in the IFA market remains focused on achieving financial returns which meet the Company’s internal targets. Sales performance was strong in corporate pensions where an increase in volumes of 19 per cent was achieved whilst maintaining satisfactory margins and returns. Within individual pensions, sales of the Retirement Account, a capital efficient product with a more transparent charging structure, increased by 75 per cent benefiting from product enhancements introduced during the year. Sales of investment bonds reduced by 56 per cent, partly driven by changes in Capital Gains Tax regulations, but also reflecting the Company’s unwillingness to participate in markets which do not generate an economic return. iMproving Service and operational efficiency The business has made further improvements in service and operational efficiencies, and the benefits can be seen in a further reduction of three per cent in operating expenses, notwithstanding ongoing investment in product and distribution enhancements. In addition, the strength of Scottish Widows’ product and service proposition was recognised through an increased number of industry awards and ratings in 2008; the Company was voted best personal pensions provider, achieved two ‘5 star’ service awards and was rated highly for its strong e-commerce platform. overvieW Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 buSineSS revieW Summary of Group results divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 financial StateMentS Shareholder inforMation Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 25 Lloyds Banking Group Annual Report and Accounts 2008 reSultS on a european eMbedded value (eev) baSiS ScottiSh WidoWS inveStMent partnerShip Profit before tax from Scottish Widows Investment Partnership (SWIP) increased to £42 million (2007: £41 million). The adverse impact on income of volatile equity and bond markets was more than offset by strong cost management. With the FTSE All-Share Index falling to levels not seen since 2003, SWIP’s assets under management decreased by £14.6 billion to £83.0 billion. MoveMentS in fundS under ManageMent The following table highlights the movement in retail and institutional funds under management. opening funds under management Movement in retail funds Premiums Claims Surrenders Net inflow of business Investment return, expenses and commission Net movement Movement in institutional funds Lloyds TSB pension schemes Other institutional funds Investment return, expenses and commission Net movement Proceeds from sale of Abbey Life Dividends and surplus capital repatriation closing funds under management Managed by SWIP Managed by third parties closing funds under management 2008 £bn 102.7 2007 £bn 105.7 11.2 (4.3) (5.7) 1.2 (12.5) (11.3) – (0.8) (2.5) (3.3) – (0.2) 87.9 83.0 4.9 87.9 11.7 (4.8) (6.4) 0.5 2.4 2.9 (5.7) (0.6) 1.3 (5.0) 1.0 (1.9) 102.7 97.6 5.1 102.7 Including assets under management within our UK Wealth Management and International Private Banking businesses, groupwide funds under management decreased by 10 per cent to £109 billion. In addition to reporting under IFRS, the Group, as in previous reporting periods, provides supplementary financial reporting for Scottish Widows on an EEV basis. continuing buSineSSeS* 2008 life, pensions and oeics £m 2007 Life, pensions and OEICs £m 295 326 Change % (10) 321 52 4 377 146 818 – 818 2.9% 296 41 (32) 305 166 797 21 818 3.1% £4,932m £5,365m 11.4% 10.7% 24 (12) 3 – New business profit Existing business – Expected return – Experience variances – Assumption changes Expected return on shareholders’ net assets profit before tax, adjusted for capital repatriation* Impact of capital repatriation to Group profit before tax* New business margin (PVNBP) Embedded value (period end) – continuing businesses Post-tax return on embedded value* * Excluding volatility and other items (page 26). Adjusting for the impact of capital repatriation to Group, EEV profit before tax from the Group’s life, pensions and OEICs business increased by three per cent to £818 million in challenging market conditions. New business profit fell by £31 million, or 10 per cent, to £295 million and the overall new business margin reduced to 2.9 per cent, from 3.1 per cent last year, primarily reflecting higher commission payable on OEIC products. In difficult trading conditions, life and pensions new business profit remained satisfactory with a continued focus on improving product profitability resulting in the new business margin increasing to 3.6 per cent (page 27). Existing business profit increased by 24 per cent to £377 million. Expected return increased to £321 million driven by an increase in expected income from our annuity portfolio. The net impact of experience variances in both years is broadly comparable and reflects adverse lapse experience being more than offset by other favourable experience. The net impact of assumption changes in the current year is not significant and reflects a charge from more pessimistic lapse assumptions in life and pensions business which is broadly offset by favourable lapse assumptions in OEICs and other modelling changes. The expected return on shareholders’ net assets decreased by £20 million as a result of a lower volume of free assets, driven by lower investment markets. Overall the post-tax return on embedded value increased to 11.4 per cent. 26 Lloyds Banking Group Annual Report and Accounts 2008 DIVISIONAL RESULTS continued INSURANCE AND INVESTMENTS continued european eMbedded value reporting – reSultS for year ended 31 deceMber 2008 ANALySIS OF ShAREhOLDERS’ NET ASSETS ON AN EEV BASIS ON COVERED BUSINESS This section provides further details of the Scottish Widows EEV financial information. COMPOSITION OF EEV BALANCE ShEET 31 december 2008 £m 31 December 2007 £m Value of in-force business (certainty equivalent) 2,360 2,779 Value of financial options and guarantees Cost of capital Non-market risk total value of in-force business Shareholders’ net assets total eev of covered business (90) (90) (57) 2,123 2,809 4,932 (53) (178) (61) 2,487 2,878 5,365 as at 1 January 2007 Total profit (loss) after tax – Continuing businesses – Discontinued businesses Dividends Disposal of Abbey Life (EEV basis) as at 31 december 2007 Total (loss) profit after tax Dividends required capital £m free surplus £m Shareholders’ net assets £m 2,207 1,365 3,572 (214) (24) – (232) 1,737 (823) – 794 105 580 81 (1,866) (1,866) 743 511 1,141 2,878 974 (220) 151 (220) as at 31 december 2008 914 1,895 2,809 RECONCILIATION OF OPENING EEV BALANCE ShEET TO CLOSING EEV BALANCE ShEET ON COVERED BUSINESS SUMMARy INCOME STATEMENT ON AN EEV BASIS – CONTINUING BUSINESSES as at 1 January 2007 Total profit after tax – Continuing businesses – Discontinued businesses Profit on disposal of Abbey Life (EEV basis) – Sale proceeds – Assets disposed Dividends as at 31 december 2007 Total profit (loss) after tax Dividends Shareholders’ net assets £m 3,572 580 81 985 (474) 511 (1,866) 2,878 151 (220) value of in-force business £m total £m New business profit 2,841 6,413 Existing business profit – Expected return 102 5 682 86 – Experience variances – Assumption changes – (461) (461) Expected return on shareholders’ net assets 985 (935) profit before tax, excluding volatility and other items* 50 Volatility – (1,866) Other items* 2,487 (364) – 5,365 total (loss) profit before tax (213) (220) Taxation Impact of corporation tax rate change total (loss) profit after tax – continuing businesses 2008 £m 295 321 52 4 377 146 818 (1,176) 60 (298) 85 – 2007 £m 326 296 41 (32) 305 187 818 (287) 58 589 (29) 122 (213) 682 * Other items represent amounts not considered attributable to the underlying performance of the business. as at 31 december 2008 2,809 2,123 4,932 overvieW Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 buSineSS revieW Summary of Group results divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 financial StateMentS Shareholder inforMation Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 27 Lloyds Banking Group Annual Report and Accounts 2008 BREAKDOWN OF INCOME STATEMENT BETWEEN LIFE AND PENSIONS, AND OEICs – CONTINUING BUSINESSES 2008 New business profit Existing business – Expected return – Experience variances – Assumption changes Expected return on shareholders’ net assets profit before tax* life and pensions £m oeics £m total £m 258 37 295 254 40 (48) 246 138 642 67 12 52 131 8 176 321 52 4 377 146 818 New business margin (PVNBP) 3.6% 1.3% 2.9% Post-tax return on embedded value* 11.4% 2007 New business profit Existing business – Expected return – Experience variances – Assumption changes Expected return on shareholders’ net assets profit before tax* New business margin (PVNBP) Post-tax return on embedded value* * Excluding volatility and other items. 270 56 326 245 (2) (92) 151 179 600 3.5% 51 43 60 154 8 218 2.0% 296 41 (32) 305 187 818 3.1% 10.7% 28 Lloyds Banking Group Annual Report and Accounts 2008 DIVISIONAL RESULTS continued INSURANCE AND INVESTMENTS continued econoMic aSSuMptionS SenSitivity analySiS A bottom up approach is used to determine the economic assumptions for valuing the business in order to determine a market consistent valuation. The valuation of the Group’s annuity business has been affected by the recent upheaval in the capital markets which has caused a significant widening in corporate bond spreads. Based on available market analysis, an element of this widening in corporate bond spreads has been assessed as arising from an increase in the illiquidity premium. As a result, in 2008 the value of the in-force business asset for annuity business has been calculated after taking into account an estimate of the market premium for illiquidity derived using a portfolio of investment grade bonds with similar cash flow characteristics as the annuity liabilities. For 2008, the risk-free rate assumed in valuing the non-annuity in-force business is the 15 year UK gilt yield. The risk free rate assumed in valuing the in-force asset for the annuity business is presented as a single risk-free rate to allow easier comparison to the rate used for other business. That single risk-free rate has been derived to give the equivalent value to the annuity book, had that book been valued using the UK gilt yield curve increased to reflect the illiquidity premium described above. The risk-free rate used in valuing financial options and guarantees is defined as the spot yield derived from the UK gilt yield curve, in line with Scottish Widows’ FSA realistic balance sheet assumptions. The table below shows the range of resulting yields and other key assumptions. 31 december 2008 % 31 December 2007 % Risk-free rate (value of in-force non-annuity business) Risk-free rate (value of in-force annuity business) 3.74 5.22 4.65 4.65 Risk-free rate (financial options and guarantees) Retail price inflation Expense inflation 1.11 to 4.24 4.28 to 4.81 2.75 3.50 3.28 4.18 non-econoMic aSSuMptionS Future mortality, morbidity, lapse and paid-up rate assumptions are reviewed each year and are based on an analysis of past experience and on management’s view of future experience. These assumptions are intended to represent a best estimate of future experience. For OEIC business, recent lapse assumption experience has been collected over a period that has predominantly coincided with favourable investment conditions. Management have used a best estimate of the long-term lapse assumption which is higher than indicated by this experience. In management’s view, the approach and lapse assumption are both reasonable. non-Market riSk An allowance for non-market risk is made through the choice of best estimate assumptions based upon experience, which generally will give the mean expected financial outcome for shareholders and hence no further allowance for non-market risk is required. however, in the case of operational risk and the With Profit Fund these are asymmetric in the range of potential outcomes for which an explicit allowance is made. The table below shows the sensitivity of the EEV and the new business profit before tax to movements in some of the key assumptions. The impact of a change in the assumption has only been shown in one direction as the impact can be assumed to be reasonably symmetrical. 2008 eev/new business profit before tax 100 basis points reduction in risk-free rate1 10 per cent reduction in market values of equity assets2 10 per cent reduction in market values of property assets3 10 per cent reduction in expenses4 10 per cent reduction in lapses5 5 per cent reduction in annuitant mortality6 5 per cent reduction in mortality and morbidity (excluding annuitants)7 100 basis points increase in equity and property returns8 25 basis points increase in corporate bond spreads9 25 basis points decrease in illiquidity premium10 Impact on EEV £m 186 (170) (25) 84 70 (56) 23 nil (59) (97) Impact on new business profit before tax £m 6 n/a n/a 31 17 (2) 4 nil (4) n/a 1 2 3 4 5 6 7 8 9 In this sensitivity the impact takes into account the change in the value of in-force business, financial options and guarantee costs, statutory reserves and asset values. The reduction in market values is assumed to have no corresponding impact on dividend yields. The reduction in market values is assumed to have no corresponding impact on rental yields. This sensitivity shows the impact of reducing new business, maintenance expenses and investment expenses to 90 per cent of the expected rate. This sensitivity shows the impact of reducing lapse and surrender rates to 90 per cent of the expected rate. This sensitivity shows the impact on our annuity and deferred annuity business of reducing mortality rates to 95 per cent of the expected rate. This sensitivity shows the impact of reducing mortality rates on non-annuity business to 95 per cent of the expected rate. Under a market consistent valuation, changes in assumed equity and property returns have no impact on the EEV. This sensitivity shows the impact of a 25 basis point increase in corporate bond yields and the corresponding reduction in market values. Government bond yields, the risk-free rate and illiquidity premia are all assumed to be unchanged. 10 This sensitivity shows the impact of a 25 basis point reduction in the allowance for illiquidity premia. It assumes that the overall corporate bond spreads are unchanged and hence market values are unchanged. Government bond yields and the risk-free rate are both assumed to be unchanged. In sensitivities (4) to (7) and (9) assumptions have been flexed on the basis used to calculate the value of in-force business and the realistic and the statutory reserving bases. A change in risk discount rates is not relevant as the risk discount rate is not an input to a market consistent valuation. overvieW Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 buSineSS revieW Summary of Group results divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 financial StateMentS Shareholder inforMation Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 29 Lloyds Banking Group Annual Report and Accounts 2008 General Insurance continues to make good progress against its key strategic initiatives: groWing Share in our choSen cuStoMer SegMentS Growth in total home insurance sales developed good momentum during 2008, with sales through the branch network increasing by nine per cent, supported by a positive customer reaction to our 5 Star Defaqto Rated home insurance product and strong claims service proposition. developing key inSurance partnerShipS General Insurance continues to invest in the development of its Corporate Partnership distribution arrangements. New partnerships with Resolution Life, Reader’s Digest, Budget and Post Office Financial Services are expected to underpin further profit delivery over future years. iMproving efficiency and Service Investment in our claims processes continues to deliver improved service and efficiency, with a reduction in property claims ratios and recognition of our customer service teams at the European Call Centre Awards. An ongoing review of our advertising expenditure and the introduction of further improvements to the targeting of promotional activity have led to further efficiencies, and the cost per product sale improving by 13 per cent. We have also continued to focus on making our key processes easier for our customers to use. For the second year in succession our website www.lloydstsbinsurance.co.uk has been ranked as the best home insurance website by worldwide benchmarking organisation, Global Reviews. In addition, in October 2008 Defaqto recognised LloydsTSBCompare.com as the best car insurance price comparison site. general inSurance Profit before tax from our general insurance operations increased by £124 million, to £234 million, reflecting a £109 million reduction in claims due to the absence of the severe weather related claims experienced in 2007 and the continued benefits from ongoing investment in our claims processes. Net operating income increased by £22 million, reflecting good increases in new and renewal home insurance premium income. New business premium income increased by nine per cent and continued investment in our pricing and business retention capabilities delivered four per cent growth in renewal earned premiums. 2008 £m 2007† £m Change % home insurance Underwriting income (net of reinsurance) Commission receivable Commission payable creditor insurance Underwriting income (net of reinsurance) Commission receivable Commission payable other Underwriting income (net of reinsurance) Commission receivable Commission payable Other net operating income Claims paid on insurance contracts (net of reinsurance) operating income, net of claims Operating expenses profit before tax Claims ratio Combined ratio 441 50 (78) 413 163 428 (494) 97 8 71 (33) 32 78 588 (193) 395 (161) 234 30% 76% 418 50 (77) 391 164 510 (574) 100 9 88 (41) 19 75 566 (302) 264 (154) 110 49% 93% 6 (1) 6 (1) (16) 14 (3) (11) (19) 20 68 4 4 36 50 (5) 113 † Restated, see page 17. Within the above analysis, profit share receivable has been allocated across product groups, whereas it was previously allocated to other. Comparative figures have been restated accordingly. Claims were £109 million lower, principally reflecting the absence of severe weather related claims experienced last year, which more than offset an increase of £15 million in payment protection insurance unemployment claims. Adjusting for the severe weather related claims, the claims ratio improved from 31 per cent to 30 per cent, reflecting continued benefits from ongoing investment in our claims processes and further efficiencies from improved process management. 30 Lloyds Banking Group Annual Report and Accounts 2008 DIVISIONAL RESULTS: WhOLESALE AND INTERNATIONAL BANKING Our business During 2008, our businesses within the Wholesale and International Banking arena covered a broad scope, serving thousands of customers, ranging from start-ups and small enterprises to large organisations and global corporations. Combining the respective strengths of some 3,000 people in Corporate Banking and Products & Markets, Corporate Markets plays an integral role in leveraging and expanding the customer franchise and building deep, long-lasting relationships with around 26,000 corporate customers and was awarded jointly with Commercial Banking the ‘Real Finance/CBI FDs’ Excellence Awards - Bank of the year’ for the fourth year running. Commercial Banking is a growing business with some 6,000 people serving nearly one million customers across the UK from one-person start-ups to large, established enterprises. Lloyds TSB has increased its lending to SMEs by nearly 20 per cent in 2008. We also participate in specialist markets with a range of solutions including personal and international expatriate and private banking, motor and leisure finance and auto leasing. Following the acquisition of hBOS, the Wholesale and International Banking division has been renamed ‘Wholesale’. The Group’s international businesses, with the exception of corporate in North America (including Canada), will form part of the new Wealth and International division. The new ‘Wholesale’ division operates a multi brand strategy primarily through the Lloyds TSB and Bank of Scotland brands but also trades through a number of more specialist brands including Lloyds TSB Development Capital and Black horse. key highlightS resilient profit performance despite the turbulence in global financial markets. The division remained profitable even after absorbing the increased impact of its exposure to assets affected by current capital markets uncertainties and a significant rise in corporate impairments. The impact of recent market dislocation, however, has been to reduce profit before tax in 2008 by £1,270 million (2007: £280 million), to £274 million. continued strong relationship banking momentum. Excluding the impact of market dislocation, profit before tax decreased by two per cent, to £1,544 million, reflecting good levels of core business momentum which were offset by a significant increase in corporate impairment levels reflecting the challenging economic environment and additional write-offs relating to a number of high profile financial services company collapses. Strong progress in expanding our corporate Markets franchise, with a 34 per cent increase in Corporate Markets income, excluding market dislocation, supported by an 85 per cent increase in cross-selling income. This was largely offset however by the significant rise in impairments. good franchise growth in commercial banking, with a further increase in our market share of higher value customers, supporting a seven per cent growth in income, which was partially offset by an £89 million increase in impairments. Significant lending growth, as our Corporate Markets and Commercial Banking businesses continued to provide substantial support to our mid-corporate market and SME customers. our risk management remains strong with satisfactory asset quality, despite a rise of £936 million in impairment losses, largely as a result of the £253 million year-on-year impact of market dislocation, a number of high profile financial services company collapses and an increase in the level of impairments reflecting the economic slowdown in the UK. diviSional perforMance Continuing businesses Net interest income Other income Total income Operating expenses Trading surplus Impairment profit before tax Cost:income ratio Cost:income ratio, excluding market dislocation Post-tax return on average risk-weighted assets Total assets Risk-weighted assets Customer deposits † Restated, see page 17. 2007† £m Change % 2008 £m 3,303 829 4,132 (2,350) 1,782 (1,508) 274 56.9% 2,380 1,644 4,024 (2,152) 1,872 (572) 1,300 53.5% 46.5% 51.1% 0.16% 1.14% 31 december 2008 £bn 31 December 2007 £bn 238.8 115.7 82.9 163.3 92.8 72.3 39 (50) 3 (9) (5) (79) Change % 46 25 15 overvieW Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 buSineSS revieW Summary of Group results divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 financial StateMentS Shareholder inforMation Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 31 Lloyds Banking Group Annual Report and Accounts 2008 OUR STRATEGy The acquisition of the hBOS corporate and commercial customer base provides the new ‘Wholesale’ division with a significant and exciting opportunity to accelerate our relationship-led wholesale banking strategy. Our strategic vision is to be recognised as the UK’s leading, ‘through the cycle’, wholesale bank. As a relationship bank, we place our customers at the forefront of this vision and we strive to understand and meet their needs whilst maintaining satisfactory asset quality. The way we manage our customer relationships is the vital ingredient which differentiates us from our competition. Making ‘Wholesale’ a great place for our customers to bank remains our number one priority and we seek to achieve this by deepening and maintaining profitable customer relationships. Building insight into customer needs and providing them with a broad range of banking and capital markets solutions will enable us to become our customers’ first choice so we prosper together. KEy PERFORMANCE INDICATORS PROFIT BEFORE TAX †* £m GROWTH IN CROSS-SELLING INCOME (2%) 2006 2007 2008 1,640 1,580 1,544 2006 2007 2008 48 42 CORPORATE MARKETS PROFIT BEFORE TAX* £m COMMERCIAL CUSTOMER LENDING BALANCES % 85 £m (1%) 2006 2007 2008 INCOME AND COST GROWTH 2008 †* Income Costs 9 1,030 1,010 1,002 % 20 20% 2006 2007 2008 14,943 17,140 20,504 †The 2007 figures have been restated (see page 17). The 2006 figures are as originally published. *Before impact of market dislocation. corporate bank of the year Lloyds TSB (Commercial/Corporate Markets) won Bank of the year for the fourth consecutive year, receiving great feedback for the quality of service and degree to which relationship managers understood the customers’ business. (Real FD/CBI FDs’ Excellence Awards, April 2008) aWardS for coMMercial Lloyds TSB (Commercial) won two awards in the 2008 National Association of Commercial Finance Brokers Awards, scooping Business Bank of the year and Commercial Mortgage Provider of the year. The winners were nominated by NACFB members in its annual survey. (December 2008) 32 Lloyds Banking Group Annual Report and Accounts 2008 DIVISIONAL RESULTS continued WhOLESALE AND INTERNATIONAL BANKING In Wholesale and International Banking, the Group has continued to make progress in its strategy to develop the Group’s strong corporate and small to medium business customer franchises, however the division has continued to be significantly affected by the impact of market dislocation and the increase in impairments relating to the deteriorating economic environment and a number of high profile financial services company collapses. In Corporate Markets, further good progress has been made in developing our relationship banking franchise supported by a strong cross-selling performance and in Commercial Banking, strong growth in business volumes, further customer franchise improvements and good progress in improving operational efficiency, were offset by the significant increase in impairment levels. Overall, the division remained profitable, however profit before tax decreased by 79 per cent to £274 million, largely reflecting the £990 million reduction in profits, compared to last year, as a result of market dislocation. A strong revenue performance in our relationship banking businesses contributed to overall income growth, excluding the impact of market dislocation, of 20 per cent, driven by strong Corporate Markets and Commercial Banking income growth of 34 per cent and seven per cent respectively. This exceeded cost growth of nine per cent, which largely reflected further investment in building the Corporate Markets business, higher depreciation charges in Asset Finance and the impact of exchange rate movements. The cost:income ratio, excluding the impact of market dislocation, improved to 46.5 per cent, from 51.1 per cent last year. The charge for impairment losses was £936 million higher at £1,508 million, as a result of an increase of £253 million in the impact of market dislocation, and a significant increase in the level of impairments reflecting the economic slowdown in the UK and the impact of a number of high profile financial services company collapses. Despite this increase in the impairment charge, we believe that we remain relatively well positioned to withstand the economic slowdown as a result of our prudent credit management policy over the last few years. profit before tax by buSineSS unit 2008 £m 2007† £m Change % Corporate Markets – Before impact of market dislocation – Impact of market dislocation Commercial Banking Asset Finance International Banking Other Profit before tax – Before market dislocation – Market dislocation † Restated, see page 17. 1,002 (1,270) (268) 454 2 149 (63) 1,544 (1,270) 274 1,010 (280) 730 469 39 138 (76) 1,580 (280) 1,300 corporate MarketS Net interest income Other income Total income Operating expenses Trading surplus Impairment Profit before tax † Restated, see page 17. 2008 £m 1,784 (316) 1,468 (691) 777 (1,045) (268) 2007† £m 982 620 1,602 (632) 970 (240) 730 Change % 82 (8) (9) (20) In Corporate Markets, profit before tax fell by £998 million, compared to last year, reflecting a combination of the impact of market dislocation and a substantial increase in impairment charge. Excluding the impact of market dislocation, profit before tax decreased by £8 million. On this basis, income increased by 34 per cent, supported by strong growth in corporate lending and an 85 per cent increase in cross-selling income. This growth in cross-selling income has continued to be supported by the Group’s ability to leverage its strong funding capabilities and obtain funding at market leading rates, which has enabled the Corporate Markets business to continue to grow during a difficult 2008. Throughout this period, Corporate Markets has continued to invest in building its product capabilities and has been fulfilling substantially increased customer demand for interest rate and currency derivative products. This has enabled the business to further deepen its customer relationships, with Corporate Banking the only UK bank lender to have a positive net promoter score (TNS survey) as well as being awarded with ‘Real Finance/CBI FDs’ Excellence Awards – Corporate Bank of the year’ for the fourth year running. Operating expenses increased by nine per cent to £691 million, reflecting significant further investment in people to support the substantial business growth in our Corporate Markets relationship business. The substantial increase in the impairment charge reflects an increase in the level of impairments as a result of the economic slowdown in the UK, market dislocation and the impact of a number of high profile financial services company collapses during the second half of the year. (1) credit Market poSitionS in corporate MarketS The Group’s high quality business model means that it has relatively limited exposure to assets affected by current capital markets uncertainties. The following table shows credit market positions in Corporate Markets, on both a gross and net basis. (3) (95) 8 (2) (79) overvieW Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 buSineSS revieW Summary of Group results divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 financial StateMentS Shareholder inforMation Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 33 Lloyds Banking Group Annual Report and Accounts 2008 CREDIT MARKET POSITIONS 31 december 2008 2008 31 December 2007 net exposure £m gross exposure £m p&l impact £m Net exposure £m Gross exposure £m 60 60 92 130 130 available-for-sale assets – ABS CDO loans and advances – ABS* – ABS CDO** – secondary loan trading* – SIV capital notes – SIV liquidity backup 318 128 310 – 318 128 310 – facilities 22 22 – investment grade bank bonds* 2,566 2,566 103 – 15 84 11 9 – – – 78 – – – 78 370 370 – – financial instruments held at fair value through profit or loss – ABS – trading book* – monoline hedged** – major global bank cash – – – – 97 275 collateralised – secondary loan trading* – other*** Market dislocation – – 1,279 1,867 – 1,533 – 40 544 1,270 474 – – 665 3,895 474 470 1,861 863 3,895 * ** *** Items reclassified from trading to loans and advances on 1 July 2008 in accordance with amendment to IAS 39. Restructured ABS CDO removing monoline wrap and recorded within loans and advances. £2,265 million exposure was reclassified to loans and advances on 1 July 2008 in accordance with amendment to IAS 39. coMMercial banking Net interest income Other income Total income Operating expenses Trading surplus Impairment profit before tax † Restated, see page 17. 2008 £m 968 463 2007† Change % £m 908 429 1,431 1,337 (789) 642 (188) 454 (769) 568 (99) 469 7 8 7 (3) 13 (90) (3) Profit before tax in Commercial Banking fell by £15 million, or three per cent, as strong growth in business volumes, growth in the Commercial Banking customer franchise and further improvements in operational efficiency and effectiveness, were more than offset by an £89 million increase in the impairment charge, primarily reflecting the impact of recent deterioration in the UK economy. Income increased by seven per cent to £1,431 million, reflecting disciplined growth in lending and deposit balances, and an increased focus on the more valuable higher turnover customer relationships which have substantially greater product needs. During 2008, Commercial Banking has continued to extend lending support throughout its customer franchise and, as a result, the Group’s lending to SME customers increased by 20 per cent to £20.5 billion. Over the last 12 months, the Group has increased its market share of high value customers in the £0.5 to £2 million turnover range by 2 percentage points to 18 per cent, as a result of continuing to make good progress in attracting customers ‘switching’ from other financial services providers. Costs were three per cent higher. Cost management remains a priority and the business is now starting to capture significant benefits from recent investments in improved IT infrastructure, allowing further improvement in relationship manager productivity. Asset quality in the Commercial Banking portfolios has remained satisfactory with 90 per cent of the portfolio supported by security, however the impairment charge rose by £89 million partly reflecting the impact of recent deterioration in the UK economy. The impairment charge as a percentage of average lending remained below one per cent in 2008. aSSet finance Net interest income Other income Total income Operating expenses Trading surplus Impairment profit before tax † Restated, see page 17. 2008 £m 305 463 768 (496) 272 (270) 2 2007† £m 283 423 706 (439) 267 (228) 39 Change % 8 9 9 (13) 2 (18) (95) Profit before tax in Asset Finance decreased by 95 per cent to £2 million reflecting the significant combined impacts of higher impairments and lower residual values in response to the deteriorating economic conditions. Income increased by £62 million, or nine per cent, as a result of continued margin improvement across the Black horse consumer businesses and growth in Autolease, our contract hire fleet business. Costs increased by £57 million, or 13 per cent, largely reflecting the impact of higher operating lease depreciation on the enlarged Contract hire Fleet and exceptional residual value losses, but were otherwise flat year-on-year reflecting tight cost management and discipline. The impairment charge increased by £42 million to £270 million reflecting the impact of the economic slowdown in the UK. international banking Net interest income Other income Total income Operating expenses Trading surplus Impairment profit before tax † Restated, see page 17. 2008 £m 245 201 446 (291) 155 (6) 149 2007† £m 201 179 380 (244) 136 2 138 Change % 22 12 17 (19) 14 8 Profit before tax in International Banking grew by eight per cent to £149 million reflecting strong income growth from meeting the needs of our customers, as the Group has increased its focus on growing its customer franchise in the increasingly global mobile affluent and high net worth wealth management market. Total income grew to £446 million, up 17 per cent (10 per cent excluding the impact of exchange rate movements), reflecting strong customer franchise growth, improved lending volumes at increased margins and strong growth in customer deposits. Costs increased by 19 per cent (nine per cent excluding the impact of exchange rate movements) reflecting increased investment in our target Private Banking and Expatriate Banking markets, and the trading surplus increased by 14 per cent. 34 Lloyds Banking Group Annual Report and Accounts 2008 CENTRAL GROUP ITEMS The four independent Lloyds TSB Foundations support registered charities throughout the UK that enable people, particularly those disabled and disadvantaged, to play a fuller role in society. The Foundations receive 1 per cent of Lloyds Banking Group’s pre-tax profit after adjusting for gains and losses on the disposal of businesses and pre-tax minority interests, averaged over three years, instead of a dividend on their shareholdings. In 2008, £27 million was accrued for payment to registered charities. Income Operating expenses Impairment loss before tax 2008 £m (492) (30) (30) (552) 2007 £m (6) (6) – (12) In the year ended 31 December 2008, the contribution from Central group items was a negative £552 million compared to a negative contribution of £12 million in 2007. The result in 2008 has been significantly affected by the impact of yield curve volatility on the fair value of derivatives entered into for risk management purposes after taking into account the effect of hedge accounting adjustments. In addition, there were increased central costs that were not recharged to the divisions in connection with professional advice received during the year and an impairment charge in respect of an available-for-sale investment. VOLATILITy inSurance volatility The Group’s insurance businesses have liability products that are supported by substantial holdings of investments, including equities, property and fixed interest investments, all of which are subject to variations in their value. The value of the liabilities does not move exactly in line with changes in the value of the investments, yet IFRS requires that the changes in both the value of the liabilities and investments be reflected within the income statement. As these investments are substantial and movements in their value can have a significant impact on the profitability of the Insurance and Investments division, management believes that it is appropriate to disclose the division’s results on the basis of an expected return in addition to the actual return. The difference between the actual return on these investments and the expected return based upon economic assumptions made at the beginning of the year is included within insurance volatility. Changes in market variables also affect the realistic valuation of the guarantees and options embedded within products written in the Scottish Widows With Profits Fund, the value of the in-force business and the value of shareholders’ funds. Fluctuations in these values caused by changes in market variables, including corporate bond spreads, are also included within insurance volatility. The valuation of the Group’s annuity business has been affected by the recent upheaval in the capital markets which has caused a significant widening in corporate bond spreads. Based on available market analysis, an element of this widening in corporate bond spreads has been assessed as arising from an increase in the illiquidity premium. Annuity contracts cannot be surrendered and have reasonably certain cashflows best matched by assets of equivalent maturity with similar liquidity characteristics. As a result, in 2008 the value of in-force business for the annuity business has been calculated after taking into account an estimate of 154 basis points for the market premium for illiquidity, which has been derived using a portfolio of investment grade bonds with similar cash flow characteristics as the annuity liabilities. The effect of this has been to increase the value of in-force business by £842 million as at 31 December 2008 with a similar increase in profit before tax. This amount is reported within volatility and does not therefore impact profit before tax on a continuing business basis. The expected investment returns used to determine the normalised profit of the business, which are based on prevailing market rates and published research into historical investment return differentials, are set out below: Gilt yields (gross) Equity returns (gross) Dividend yield Property return (gross) Corporate bonds in unit linked and With Profit funds (gross) Fixed interest investments backing annuity liabilities (gross) 2009 % 3.74 6.74 3.00 6.74 2008 % 4.55 7.55 3.00 7.55 2007 % 4.62 7.62 3.00 7.62 4.34 5.15 5.22 5.87 5.56 5.09 During 2008, profit before tax included negative insurance volatility of £746 million, being a credit of £9 million to net interest income and a charge of £755 million to other income (2007: negative volatility of £277 million, being a credit of £7 million to net interest income and a charge of £284 million to other income). This charge mainly reflects the significant falls in global equities markets during the year, which resulted in total returns some 33 percentage points lower than expected. These lower than expected returns reduced the value of in-force business held on the balance sheet. The impact of the widening corporate bond credit spreads more than offset the inclusion of an allowance for the illiquidity premium referred to above, and resulted in a net reduction in the value of the annuity portfolio. Lower equities and bond prices also affected the valuation of the Group’s investments held within the funds attributable to the shareholder; there was no exposure to assets held at fair value through profit or loss valued using unobservable market inputs. policyholder intereStS volatility The application of accounting standards results in the introduction of other sources of significant volatility into the pre-tax profits of the life and pensions business. In order to provide a clearer representation of the performance of the business and consistent with the way in which it is managed, equalisation adjustments are made to remove this volatility from underlying profits. The effect of these adjustments is separately disclosed as policyholder interests volatility; there is no impact upon profit attributable to equity shareholders. The most significant of these additional sources of volatility is policyholder tax. Accounting standards require that tax on policyholder investment returns should be included in the Group’s tax charge rather than being offset against the related income. The impact is, therefore, to either increase or decrease profit before tax with a corresponding change in the tax charge. Other sources of volatility include the overvieW Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 buSineSS revieW Summary of Group results divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 financial StateMentS Shareholder inforMation Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 35 Lloyds Banking Group Annual Report and Accounts 2008 The UK Office of Fair Trading (OFT) is carrying out an investigation into certain current account charges which are also subject to a legal test case (see note 48). In addition, on 16 July 2008, the OFT published a market study report on personal current accounts. This was followed by a period of consultation until 31 October 2008, and the OFT is expected to release a summary of the responses received, and is aiming to publish a further report in 2009 which will contain recommendations for the banking industry. The OFT is continuing its investigation into interchange fees set by card networks and paid to card issuers. This investigation is in parallel with the European Commission’s own investigation into Visa cross-border interchange fees, the European Commission having issued its decision ordering MasterCard to set its cross-border interchange rate to zero by June 2008. This decision is now being appealed to the European Court of First Instance. Lloyds TSB Bank plc along with a number of other UK and European banks will intervene in the appeal supporting the MasterCard position. At the same time the FSA, The Bank of England and her Majesty’s Treasury (hMT) are considering UK financial stability and depositor protection proposals. The Banking Act 2009 (the Act) came into force on 22 February 2009. The Act introduces a statutory objective of promoting financial stability for the Bank of England, working with hMT and the FSA. The Act also introduces a special resolution regime (SRR) in advance of a potential bank insoivency, which consists of three stabilisation tools: (i) private sector transfer; (ii) transfer to a ‘bridge bank’ established by the Bank of England; and (iii) temporary public ownership (nationalisation). In May 2008, the UK implemented the EU Unfair Commercial Practices Directive through the Consumer Protection from Unfair Trading Regulations. In addition, a number of EU directives, including the Payment Services Directive and Consumer Credit Directive are currently being implemented in the UK. The EU is also considering regulatory proposals for, inter alia, Mortgage Credit, Deposit Guarantee Schemes, expanding the Single European Payments Area, conducting a Retail Financial Services Review, including Financial Inclusion issues and reviewing capital adequacy requirements for insurance companies (Solvency II). minorities’ share of the profits earned by investment vehicles which are not wholly owned by the long-term assurance funds. During 2008, profit before tax included negative policyholder interests volatility of £471 million, being a charge to other income (2007: negative volatility of £222 million, being a charge to other income). In 2008, substantial policyholder tax losses have been generated as a result of a fall in property, bond and equity values. These losses reduce future policyholder tax liabilities and have led to a policyholder tax credit during the year. REGULATION In the UK and elsewhere, there is continuing political and regulatory scrutiny of financial services. The Competition Commission launched an investigation into the supply of Payment Protection Insurance (PPI) services (except store card PPI) to non-business customers in the UK. Various members of the Group underwrite PPI, while other members of the Group distribute PPI, by offering it for sale with various of the credit products which they supply. On 5 June 2008, the Competition Commission issued its provisional findings, to the effect that there are market features which prevent, restrict or distort competition in the supply of PPI to non-business customers, with an adverse effect on competition and with resulting detriments to consumers. Following consultation, the Commission published its final report on 29 January 2009 setting out its remedies. The remedies include a prohibition on the sale of PPI within seven days of the distributor’s sale of credit, although the customer may initiate this after 24 hours, and a prohibition on a single premium product, together with wide information and reporting requirements. The Commission expects that the measures will come into force during 2010 (information remedies in April 2010 and other measures by October 2010). The adoption of statutory orders implementing the remedies could have a significant adverse impact on the level of sales and thus the revenue generation and profitability of the payment protection insurance products which the Group offers its customers. The ultimate impact will be determined by a number of factors including the extent to which it is able to mitigate the potentially adverse effects of such statutory changes through restructuring the payment protection products it offers its customers and developing alternative products or revenue streams. On 12 December 2008 the Group announced its commercial decision to sell only regular monthly premium PPI to its personal loan customers from January 2009. On 1 July 2008, the Financial Ombudsman Service referred concerns regarding the handling of PPI complaints to the Financial Services Authority (FSA) as an issue of wider implication. The Group and other industry members and trade associations have made submissions to the FSA regarding this referral. The matter was considered at the FSA Board meeting on 25 September 2008. The Group is working with industry members and trade associations in preparing an industry response to address regulatory concerns regarding the handling of PPI complaints. On 30 September 2008, the FSA published a statement arising from its ongoing thematic review of PPI sales. In the statement, which was directed at the industry generally, the FSA highlighted certain concerns and indicated that it was escalating its regulatory intervention and considering appropriate action to deal with ongoing non-compliant sales practices and to remedy non-compliant past sales. The FSA plans to publish an update on the third phase of the thematic work in the first quarter of 2009. Managing corporate responsibility The board reviews overall corporate responsibility performance annually and the chairman receives a quarterly progress report. Individual issues are subject to board consideration throughout the year. The chairman has board-level responsibility for corporate responsibility. Our corporate responsibility steering group is chaired by the Group human resources director and comprises senior executives from all business divisions and relevant Group functions. The steering group meets quarterly to recommend strategy and provide direction. Overall, the board is satisfied that the systems in place to manage corporate responsibility risks are effective and that the relevant risks have been assessed during 2008 and managed in compliance with relevant policies and procedures. For several years, we have adopted the European Foundation for Quality Management’s Corporate Responsibility Framework to help us align corporate responsibility with business strategy and also with individual balanced scorecard priorities. As part of the process we have a network of senior managers across all business divisions, through whom we conduct an annual self-assessment of our performance with independent oversight and assurance. This allows us to identify strengths and areas for improvement and to prioritise objectives and actions. It also provides a benchmark against which we can compare our performance both internally and externally. During 2008, Lloyds Banking Group has led a European Commission- sponsored working group along with a number of other major European businesses, business schools, consultancies and non-governmental organisations, in developing a framework for improved communication of non-financial performance between business and investors. The framework mirrors the priorities developed in Lloyds Banking Group in recent years with an emphasis on colleagues, customers and innovation, community and suppliers, the environment and corporate governance. It is subject to consultation and final proposals will be published in the first half of 2009 but we intend using the framework as the basis of our 2008 corporate responsibility report. 36 Lloyds Banking Group Annual Report and Accounts 2008 CORPORATE RESPONSIBILITY Supporting buSineSS Strategy Lloyds Banking Group’s strategy focuses on building deep, long-lasting relationships with our customers in order to deliver high quality, sustainable results over time. We believe that corporate responsibility, built around the creation of colleague motivation, customer satisfaction and brand loyalty, has a major part to play in supporting our business strategy. Against the backdrop of unprecedented market turbulence, our reputation for effective risk management is widely recognised. In 2008, Lloyds TSB was rated the sixth safest bank in the world by Global Finance and awarded the Reader’s Digest readers’ most trusted UK bank or building society for the eighth year running. Our commitment to corporate responsibility helps promote trust in the brand and reinforces customer loyalty and advocacy. Lloyds Banking Group is rooted in local communities throughout the UK and we take our responsibilities to those communities very seriously. By investing in the communities where we operate we not only create economic value but we also make a positive social contribution. Through the Lloyds TSB Foundations, over £37 million was distributed to local charities in 2008. Our corporate vision is to be recognised as the best financial services organisation by customers, colleagues and shareholders. Our corporate responsibility strategy is to support that vision by creating value for all our stakeholders through: – increased colleague engagement; – increased customer satisfaction; – more effective risk management. Our approach to embedding corporate responsibilty management over recent years has, we believe, helped us achieve competitive advantage. All colleagues have a balanced scorecard of objectives that takes account of a range of business drivers rather than just pure financial measures. 2012 local Heroes Local Heroes is Lloyds TSB’s first initiative to deliver its London 2012 vision of inspiring and supporting young people, businesses and communities across Britain. The programme recognises young sporting talent and provides funding support as they start out on their journey in performance sport with optimism and determination. Identifying 250 emerging young sportspeople each year in the run up to 2012 and beyond, Lloyds TSB Local Heroes is being delivered in partnership with SportsAid, a registered charity. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 Financial stateMents sHareHolder inForMation Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 37 Lloyds Banking Group Annual Report and Accounts 2008 our custoMers We want to build a great organisation, which is recognised for operating to high standards and is built on strong customer relationships. We want to be the bank recommended most by customers and staff. We have put in place the essential building blocks; providing excellent customer service from well-trained staff; appropriate products that meet real needs; treating customers appropriately at all times; and following ethical business practices to build a sustainable, profitable business. custoMer satisFaction For seven years, we have measured our customers’ satisfaction with the service they receive using our CARE Index. After extensive research and consideration we have decided to move from CARE to a new advocacy programme to help us achieve our vision. We will monitor our progress using a Net Promoter Score, which measures the customers’ likelihood of recommending Lloyds Banking Group to a friend or colleague. During 2008, we have introduced a number of initiatives aimed at increasing customer advocacy. These include: better and more direct information to branch managers on their teams’ performance; net promoter scores built in to reward and recognition criteria; the mapping of customer experience across a wide range of our activities; quality assurance programmes in telephone banking; and identification of the most critical impacts on customer perception. Around 2,000 customers are contacted monthly and their view of the bank measured. The percentage of those with the highest scores are set against those with the lowest to give the net promoter score*. Over 2008, the average score increased by 10 points. In a poll of finance directors across the UK, Lloyds TSB Corporate Banking was voted ‘Bank of the Year’ for the fourth year running at the Real Finance/Confederation of British Industry FDs’ Excellence Awards, in recognition of our quality of service and understanding of our customers’ businesses. responsible lending We are committed to being a responsible lender. It is in our interest to help customers borrow only those amounts they can afford to repay. We have a responsible lending programme with internal management reporting and accountability. This approach is reflected in our mortgage lending where we have maintained a significant share of net new mortgage lending, whilst continuing to focus on the prime mortgage market with a prudent average loan to value. Our colleagues are trained to offer the necessary advice and support to help customers manage their borrowing. Over 1,500 customer advisers have been specifically trained over the last year to counsel customers with concerns about their financial circumstances. We actively look at our customers’ account behaviour and proactively contact those that show signs of pressure on their finances. We can then help them to find an appropriate solution through more effective budgeting or rescheduling their borrowing. We have a customer support unit that can deliver more intensive help and we also support independent money advice networks including the Money Advice Trust and Consumer Credit Counselling Service. Payments totalling more than £3.4 million were made in 2008. coMbating Financial criMe We take protecting our customers and their assets extremely seriously and continue to invest in activities to deter, detect and prevent fraud. These include transaction monitoring tools to identify suspicious account activity and procedures to verify customer transactions. * See chart on page 11. We also work to ensure our customers are aware of how to protect themselves including dedicating a section of our website to information on common internet fraud types, an annual fraud awareness campaign, support of industry education initiatives and through our sponsorship of the charity Crimestoppers. proMoting Financial inclusion Our share of customers belonging to the lowest income groups is higher than our normal market share, reflecting our commitment to greater financial inclusion. By the end of 2008, nearly 540,000 Cash Accounts have been opened for those customers who prefer a basic bank account or who do not meet our standard account opening criteria but are not undischarged bankrupts. We now also offer an added value account with enhanced customer features for customers prepared to pay a modest fee while retaining the simplicity of a basic bank account. We have also been at the forefront of developing alternative forms of financial provision and support for those communities where mainstream financial services have traditionally been considered inappropriate or inaccessible. We have one of the largest UK high street networks and, through our partnership with the Post Office, our personal customers can access their banking through more than 12,500 local post offices. We support community finance initiatives and loan and venture capital funds which offer funding to individuals and businesses in some of the most deprived areas in the UK. Lloyds Banking Group has currently committed £12 million to the community finance sector. Our Public and Community Sector team within Corporate Banking is one of the largest funders of the UK social housing sector with £8 billion committed in 2008. Lloyds Banking Group welcomes and fully supports the FSA’s initiatives to increase financial capability in the UK. We have seconded a senior executive to develop, launch and manage the financial capability in the workplace project, to deliver the parents’ guide to money initiative and help develop the operational delivery capability within the FSA programmes. These two initiatives have provided educational material and training to over three million adults throughout the UK. Feedback from all parties has been very encouraging and these initiatives are helping to improve financial capability. sMall business Lloyds TSB Bank has nearly 600,000 small business customers. They are an important part of our business and we are committed in supporting them in current economic conditions while seeking opportunities to grow our position in the market. Total lending to small businesses increased by 20 per cent over 2008. In November 2008, we issued a six-point charter of commitments to small business customers which promises that: future reductions in base rates over 2009 will be passed on in full; there will be no change in price or availability of overdrafts for customers operating within agreed terms; reasonable requests for short term finance will be agreed; overdraft limits or prices will only change if there is a material change in the customer’s risk profile; lending rates will continue to be linked to base rate; and we will provide expert guidance and support for small firms. A series of 120 advice seminars with Lloyds Banking Group specialists and independent experts, providing practical advice and support will take place around the UK in 2009. These will help forge closer relationships between our business customers and accountants and business support agencies. The Group also extended the opportunity for customers without adequate capital to borrow under the Government’s Small Firms Loans Guarantee Scheme. 38 Lloyds Banking Group Annual Report and Accounts 2008 CORPORATE RESPONSIBILITY continued partnersHips Continuing to grow a successful business is the best way for Lloyds Banking Group to create value for all its stakeholders. As a major employer, finance provider and purchaser of goods and services we are an important contributor to both national and local economies. tHe coMMunity In addition to our financial contribution, we recognise that it is in our long-term interest to help improve the social and commercial fabric of local communities where we operate. That is why we have one of the largest community investment programmes in the UK. lloyds tsb Foundations The majority of Lloyds Banking Group’s charitable giving is channelled through the four Lloyds TSB Foundations, which cover England and Wales, Scotland, Northern Ireland and the Channel Islands. Their mission is to improve the lives of disadvantaged people in local communities. Through their shareholding in Lloyds Banking Group, the Lloyds TSB Foundations together received £37.1 million to support their work in 2008, bringing the total contributions since 1997 to over £360 million, making Lloyds Banking Group one of the largest charitable donors in the UK. The Foundations recognise that their success as community and local funders depends on maintaining a presence in and actively engaging with communities. The England and Wales Foundation, for example, remains one of the few grant-makers with a significant regional presence and its regional structure enables the Foundation to respond directly and effectively to local needs. The England and Wales Foundation has a particular focus on supporting charities that improve social and community involvement, improve life choices and chances and help disadvantaged people to be heard. In 2008, funding focused on areas of geographical deprivation and the needs of both individuals and multiple communities. Where possible, the Foundation used its size and presence to facilitate the voice of smaller groups within their local, regional and national networks. The main grants programmes are designed to address essential community needs and in particular, to support small under-funded charities. 35 per cent of the charities supported by the England and Wales Foundation in 2008 had a total income of £100,000 or less and over 90 per cent had an income of £500,000 or less. colleague volunteering and Fundraising In addition to the Foundations’ support for local community causes, thousands of our colleagues volunteer to help in their communities, raise funds for the Group’s Charity of the Year or make direct donations to charity using the UK’s Give As You Earn system. In 2008, the Foundations provided matched funding for nearly 41,000 hours of time volunteered by Lloyds Banking Group colleagues in the community and also matched over £937,000 funds raised by colleagues for charities. Our Charity of the Year relationship with Barnardo’s was extended to 18 months and ended on 30 June 2008. Over £1.8 million was raised for the Lloyds TSB and Barnardo’s ‘Securing Futures’ partnership far exceeding the £1 million target. The money raised will provide thousands of vocational training and education places for some of the most vulnerable and disadvantaged young people across the UK to help them have a better start in life and a brighter future. Our new Charity of the Year is the British Heart Foundation, the overwhelming choice among the thousands of staff who voted to choose their charity of the year. Recognising the value of longer-term relationships, we have extended our partnership with the British Heart Foundation to two years. We aim to raise at least £2 million to fund the appointment of 15 specialist heart nurses across the UK. our london 2012 partnersHip in tHe coMMunity As the first Partner of the London 2012 Olympic Games and Paralympic Games, we are delighted at the record breaking successes of Team GB and Paralympics GB in Beijing. Our Partnership however, is not just about focusing on elite sport, and the action that will take place for 17 days in 2012. Research amongst staff and customers showed a real interest in supporting young athletes in their local community and helping them share in the excitement of Britain’s journey to 2012. Thus, the vision for our Partnership was created, to inspire and support young people, communities and businesses all over Britain on their journey to London 2012 and beyond. For every Olympic or Paralympic medallist, there are thousands of genuine hopefuls without recognition or funding. Lloyds TSB Local Heroes has been set up to help more of those young hopefuls when they need it most. There are currently 250 Local Heroes, representing aspiring Olympians and Paralympians from all walks of life, from all sporting disciplines, from all over Great Britain. The funding we provide helps them on their journey in a variety of ways, from travel costs and new equipment, to competition entry fees and nutritional support. our suppliers Our suppliers are important to us and we want to ensure that we treat them fairly and pay them on time. Our supplier relationships are governed by a strict Code of Purchasing Ethics that defines the way we do business. We have been working throughout 2008 to update our long-established supplier review process that allows us to consider our suppliers’ social, ethical and environmental performance as part of the tendering process. We have also been working with a number of other financial services companies to develop an industry wide corporate responsibility questionnaire which is available on-line and benefits suppliers who only have to complete one questionnaire for all participating financial services companies, as well as benefiting Lloyds Banking Group by providing comparable information across different suppliers. payMent oF suppliers 2008 2007 2006 2005 Number of payments 335,713 320,579 344,422 379,613 Value (£bn) 2.67 2.20 2.29 2.16 Average time to pay (days) Number/amount of compensation payments for late settlement 26.03 28.78 29.72 27.01 no payments No payments No payments No payments overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 Financial stateMents sHareHolder inForMation Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 39 Lloyds Banking Group Annual Report and Accounts 2008 tHe environMent Examples of initiatives we have taken include: Lloyds Banking Group has a long-standing commitment to managing its environmental impacts. We first introduced an environmental policy in 1996 and followed this with an environmental management system that follows the ISO 14001 standard. We were also one of the first UK banks to develop an environmental risk assessment system for all our business lending. In 2007, we adopted the Equator Principles for project finance, a financial sector initiative aimed at improving the social and environmental impacts of major projects such as road building and power stations. – leading the development of the smallbusinessjourney.com website to provide advice and guidance to small businesses on how they can reduce their environmental impact; – provided guidance to vehicle fleet operators through Lloyds TSB Autolease to help them structure their fleet selection policies to promote more fuel-efficient vehicles; and, – created an on-line guide to help customers taking out a car loan to select a model with lower CO2 emissions. cliMate cHange greenHouse gas eMissions Tonnes CO2 Property 2008* 2007 2006 2002 Baseline 177,033 180,526 181,086 198,950 Property renewable (19,037) (18,164) (18,944) n/a Travel Total 26,479 30,474 29,705 26,333 184,475 192,836 191,847 225,283 Combined heat and power (28,823) (31,635) (30,945) n/a Net total 155,652 161,201 160,902 225,283 * In 2008 DEFRA introduced changes to the conversion factors to be used for calculating CO2 emissions from energy consumption and travel. In addition, they introduced new guidelines for the treatment of ‘renewable energy’ in calculating total CO2 emissions. The total CO2 emissions reported above have been calculated using the old conversion factors to provide a more accurate like-for-like comparison against the baseline. Using the new guidelines, our total emissions for 2008 would increase to 245,385 tonnes. In 2009, a priority for Lloyds Banking Group will be to baseline our environmental impacts across the combined Group. Climate change has been described by the UK Government as the greatest long-term challenge facing the world today. We recognise that businesses have a role to play in helping to address the risks of climate change. Measures to tackle climate change will have potential implications for regulation, taxation and public policy. As well as physical, financial and market risks posed by climate change, there are also significant potential opportunities. While our direct carbon intensity is relatively low compared to other industry sectors, we still need to fully understand the potential financial impact of climate change on others that we may lend to or invest in, so that we can manage the risks and identify business opportunities. In 2007, we set a stretching target to reduce our CO2 emissions by 30 per cent by 2012 based on 2002 levels. We are very pleased to report that by the end of 2008 we have achieved a 31 per cent reduction in CO2, meeting our target four years ahead of schedule. We identified specific projects and prioritised investment to deliver significant CO2 reductions. We have also purchased renewable electricity and electricity from combined heat and power (CHP) sources, which have a lower carbon footprint than standard grid electricity. During 2008, we have improved our systems for collecting car mileage information and energy consumption data. Using actual mileage and engine sizes rather than fleet averages gives a more accurate travel total. This, allied to a 40 per cent increase in teleconferencing to 422,000 meetings, has significantly reduced our travel related CO2 emissions. Future environMental risks and opportunities We want to inspire Lloyds Banking Group colleagues to rise to the challenge of tackling climate change. We have put in place a structured communication programme including dedicated intranet site, regular staff magazine and news features, competitions and seminars. In 2008, we established a Group-wide sustainability network for colleagues at all levels to meet, share experiences and ideas and to help fulfil our commitment to reducing our environmental impact. Our staff have responded enthusiastically to our carbon reduction plans and are keen to help with their delivery. Beyond managing our own immediate impact, Lloyds Banking Group can be part of the response to climate change by engaging customers and suppliers. Lloyds Banking Group provides finance to all sectors of industry and by understanding the risks and opportunities our customers face, we are better able to help them develop appropriate solutions. 40 Lloyds Banking Group Annual Report and Accounts 2008 OUR PEOPLE BUILDING LONG LASTING RELATIONSHIPS THROUGH PEOPLE We are a business based on building strong and long lasting relationships through the efforts of our people. Colleagues are our most valuable resource. It is our colleagues who build long lasting relationships with our customers and, therefore, managing our colleagues effectively is fundamental to the success of the business and achieving our vision of being the best financial services organisation in the UK. Creating a great place to work is a core priority to enable the Group to be recognised, both within the financial services sector, but also more generally in the UK employment market, as the best organisation to work for. In creating a great place to work in this way, we believe we will attract the highest performing people to join us and secure the commitment of those who are the strongest performers and have the highest potential to stay. We are building a high commitment, high performance organisation. We are clear about what we expect from our colleagues. Our values guide us in all our dealings with colleagues, customers and the wider community. In Lloyds Banking Group, our values are that we: take ownership; act wisely; make it simple; stretch ourselves; and succeed together. Colleague engagement We pride ourselves in our people and we commit to giving them the training and tools to develop themselves, and to develop the relationships they have with customers and colleagues throughout the Group. We believe that to create a high commitment, high performance organisation, we need to have high levels of colleague engagement. In order to do this, we listen to what our colleagues tell us and act on the results. The Group uses a comprehensive, confidential online engagement survey to help us to measure and assess current levels of colleague engagement across the organisation. Our Group Chief Executive personally agrees the content of our colleague engagement survey, demonstrating our commitment to and investment in understanding their views. Over the last three years, the overall engagement index has continued to rise and in 2008, the Group achieved a record response rate and an all-time high engagement index, which put us above both the financial services norm and the high performance norm for the UK. In addition, our approach to colleague engagement saw us recognised in The Sunday Times as ‘One to Watch’ within their annual Best Big Company survey and accreditation. engagement index* Engagement index 2008 78.3 2007 75.3 2006 74.5 * The engagement index is based on the result of a survey conducted quarterly, asking Lloyds TSB colleagues a series of questions which reflect both the drivers and outcome of engagement. The data captures the percentage of total responses received which were favourable for each question, combined into a simple average overall score. (See chart on page 11). talent, reCruitment and retention Recruitment, retention and development of talented people continues to be one of the highest priorities for our leaders. Top performers are attracted to the Group because of our strong brand and values; together with top class development and career opportunities. Developing our current colleagues and succession planning are vital in supporting our growth strategy. In Autumn 2008, an Organisational Capability Review was completed. As a result, we have strong succession and development plans for all our senior leaders across the Group and have collected qualitative data on our top 300 colleagues. We are retaining people for an average tenure across our business of 13 years. We run a wide range of generalist and specialist development programmes to support career progression into management. In 2008, we recruited 125 people into our graduate trainee programme, offered 44 internships and 110 student placements. Following the launch of the new Graduate Programme for 2009, our focus is now on attracting top talent into the organisation who will become senior business leaders of the future. We have also introduced a ‘customer facing’ element to the main programme so that all our graduates gain core banking ‘front-line’ experience. We are consistently identified in The Times Top 100 organisations for graduate recruitment. We also ran numerous programmes across our more senior populations to develop our pipeline of leaders for the future. We actively track and manage retention of our highest performers, retaining 96.7 per cent of top performers in 2008 (up from 96 per cent in 2007). PerformanCe management Our business strategy is translated into the Group’s balanced scorecard and this is aligned at each level of the organisation. This ensures colleagues understand how their personal objectives relate to the strategy and that their contribution is measured against a range of factors, including long term growth of the business; customer service; risk management and personal development, as well as financial success. Through twice yearly formal reviews and feedback, all our people understand how their performance impacts on colleagues, customers and our overall business success. Together, these act as robust processes for differentiating high performance and addressing and managing underperformance. reward and reCognition Overall, we have taken a conservative approach to remuneration levels and we have differentiated reward for our high performing colleagues through a number of performance measures, including the management of risk and other balanced scorecard objectives. For 2008 bonus awards, we have worked with the UKFI, (the body responsible for the government’s shareholdings in UK banks) to undertake a review of our bonus arrangements. We are also undertaking an ongoing review for 2009. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 Business review Summary of Group results Divisional results Corporate responsibility our people Risk management Five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 41 Lloyds Banking Group Annual Report and Accounts 2008 Overall, through aligning reward to our balanced scorecard, our aim is to recognise performance against factors including how well our colleagues manage risk and therefore the long term health of the business. We have structured our reward arrangements with this in mind. We will continue to differentiate our reward for colleagues who fulfil our commitment to building relationships for the long-term. total reward We take a broader view on reward than financial benefits and our 2008 flexible benefits scheme enabled colleagues to select from a range of non-cash benefits including medical and life-assurance, additional pension, education vouchers, matched learning and childcare vouchers. In 2008, 68 per cent of colleagues participated in the scheme. In addition, in 2008, over 95 per cent of colleagues opted to participate in one of our various employee share plans. The vast majority of our colleagues are therefore shareholders and have a vested interest in our long term success. During 2009, we will undertake a full review of our approach to total reward as part of the integration of Lloyds TSB and HBOS. reCognition While our emphasis is on providing recognition through line management, we also formally recognise those who have exceeded expectations and pushed boundaries in areas such as colleague support, customer service and building community profile. One example of this is through our ‘Making a Difference’ awards, which in 2008 recognised the contribution of over 180 colleagues who made exceptional contributions to the business and the community last year. learning and develoPment We remain committed to investing in the development of our colleagues so that they can deliver great customer service and results. Our learning and development focuses on the capability and skills needed for current roles as well as those we will need to be successful in the future. Our line managers play a critical role in creating a positive learning environment, managing and supporting our colleagues to maximise development opportunities and embed learning to drive results. Developing and strengthening management capabilities remains a priority, along with personal learning plans built around the specific learning and future needs of our colleagues. Our business-focused learning programmes include critical business capabilities such as financial, risk and relationship management which enable us to support our customers effectively. CorPorate university We have one of the largest corporate universities in Europe, which delivers a range of business-focused learning programmes. In addition to internally developed content, the university continues to work with best-practice suppliers to develop and deliver learning. The availability of programmes carrying relevant external certification provides colleagues with performance benchmarks and portable qualifications. We also support a range of business focused and developmental professional qualifications. A range of delivery media is used including highly successful on-line modules and face-to-face workshops to support skills development. In 2008 the university website, which is accessible from both the corporate intranet and Internet, received over 4.2 million visits (33 per cent increase on 2007) and over 780,000 on-line assessments were completed. The learning environment in our Group Learning Centre has also been upgraded to further enhance our ability to meet the changing development needs of our leaders and managers. We now deliver an average of 2.9 days formal learning per full time equivalent (FTE), an increase of 26 per cent on 2007. training days Number of days formal learning per FTE 2008 2.9 2007 2.3 2006 1.8 CommuniCations The Group invests in a range of internal media, ensuring our colleagues are informed and involved. These include a company intranet, print publications, e-zines, audio and video. We have also recently introduced group-wide, monthly face-to-face communication briefings to all colleagues through their line managers. equality and diversity Equality and diversity is not just about complying with equality legislation. We believe that it is vital for achieving competitive advantage. We need to be close to our customers and provide them with the right products and services. By attracting and retaining a diverse workforce, we will better understand the needs of all our customers and be able to build lasting relationships. Over the last few years, we have been working to increase the number of women in management and senior management positions across the organisation. At the end of 2008, our group executive committee had one of the highest proportion of women for a FTSE 100 company, and 23.4 per cent of our senior managers were women. We’re also working to increase the representation of ethnic minorities in the workforce at every level. In 2008, Race for Opportunity* named us as top performer out of 85 organisations for our leading edge race programme. We became the first organisation in the campaign’s history to be awarded Platinum status. We continue to make significant progress with our disability and sexual orientation programmes. Our disability programme has been ranked first out of 116 organisations by the Employers’ Forum on Disability and we maintained our sixth place ranking in Stonewall’s† Index of the 100 best employers of lesbian, gay and bisexual people. diversity 2008 2007 2006 Women managers Women senior managers Ethnic minority managers†† Ethnic minority senior managers†† Disabled colleagues†† 41.1% 23.4% 5.1% 2.6% 1.9% Lesbian, gay and bisexual (LGB) colleagues†† 1.0% 40.1% 21.7% 4.9% 2.5% 2% 0.8% 38.5% 20.9% 4.3% 1.9% 1.5% 0.2% * Race for Opportunity (RfO) is a national business network of over 150 UK organisations from the private and public sectors working on race and diversity as a business imperative. † Stonewall is a campaigning organisation that works to achieve equality and justice for lesbians, gay men and bisexual people. †† Shows percentage of whole workforce although not all colleagues have supplied information on race, disability or sexual orientation. work environment Our objective is to provide great facilities and a safe environment for colleagues and customers, in all our business locations. Flexible working is increasingly important in the competitive workplace and we have created a balanced environment where we offer a multitude of flexible working practices including: reduced hours; variable hours; job sharing; compressed hours; term-time working and tele-working. 42 Lloyds Banking Group Annual Report and Accounts 2008 RISK MANAGEMENT AUDITED INFORMATION OUR APPROACH TO RISK The Lloyds TSB approach to risk is founded on strong corporate governance practices whereby the board takes the lead in establishing the tone at the ‘top’ and approving professional standards and corporate values for itself, senior management and other colleagues. The board ensures that senior management implements strategic policies and procedures designed to promote professional behaviour and integrity. The board also ensures that senior management implements risk policies and risk appetites that prohibit and, where appropriate, limit activities, relationships, and situations, that might diminish the quality of corporate governance. All colleagues from the group chief executive down are assessed against a balanced scorecard that explicitly addresses their risk performance. This board-level engagement, coupled with the direct involvement of senior management in group-wide risk issues at group executive committee level, ensures that issues are escalated on a timely basis and appropriate remediation plans are put in place. The interaction of the executive and non-executive governance structures relies upon a culture of transparency and openness that is encouraged by senior management. Key decisions are always taken by more than one person. Within Lloyds TSB there is a strong culture of command and control from the centre with short lines of communication between divisions and functions. The group business risk committee and the group asset and liability committee are chaired by the group chief executive and include all members of the group executive committee. The aggregate groupwide risk profile and portfolio appetite are discussed at their respective monthly meetings. This is a key component of the Lloyds TSB approach to risk management and provides oversight on behalf of the board to line management in specific business areas and activities. It is supported by the chief risk officer being a full member of the group executive committee and reporting to the group chief executive with direct access to the chairman and the risk oversight committee. Table 1.1 sets out the role of the second line of defence and in particular that of the risk oversight committee and its interaction with the chief risk officer, the group risk directors and the divisional risk officers. This structure which has been in place for a number of years, has evolved with the risk oversight committee reviewing regular reports on the Group’s risk exposures as well as taking a keen interest in the adequacy and capability of resources within the risk functions. Lloyds TSB has a conservative business model and risk culture. The focus has been and remains on building and maintaining long-term relationships with customers. This involves taking a ‘through the cycle’ view whereby the sustainability of a relationship through good and bad economic times is taken into account. The approach is supported by a ‘through the cycle’ approach to risk with strong central control and monitoring. There is a matrix approach to risk management which includes group risk directors being responsible for individual risk types in aggregate across the Group and divisional risk officers being responsible for the aggregate risk profile within their respective divisions. The group risk directors and divisional risk officers all have a direct reporting line to the chief risk officer. This matrix approach enables the group executive committee members to fulfil their accountabilities for risk management and enables the chief risk officer to inform the risk oversight committee of the aggregate risk profile of the Group. The paragraphs that follow set out the risk management policies, practices and structures that applied during the past year to Lloyds TSB Group plc. These policies, practices and structures were adopted by Lloyds Banking Group from the date of completion of the HBOS plc transaction. risk as a strategiC differentiator The Group seeks to optimise performance by allowing divisions and business units to operate within capital and risk parameters and the Group’s policy framework. They must do so in a way which is consistent with realising the Group’s strategy and meeting agreed business performance targets. The Group’s approach to risk management seeks to ensure the business remains accountable for risk whilst also ensuring there is effective independent oversight. The Group has continued to focus on enhancing its capabilities in providing both qualitative and quantitative data to the board on risks associated with strategic objectives and facilitating more informed and effective decision making. The Group‘s ability to take risks which are well understood and consistent with its strategy and plans, is a key driver of shareholder return. The maintenance of a strong control framework remains a priority and is the foundation for the delivery of effective risk management. Risk analysis and reporting capabilities support the identification of opportunities as well as risks and provide an aggregate view of the overall risk portfolio. Risk mitigation strategies clearly aligned with responsibilities and timescales are monitored at group and divisional level. Risk continues to be a key component of routine management information reporting. Reflecting the importance the Group places on risk management, risk is included as one of the five principal criteria within the Group’s balanced scorecard on which individual staff performance is judged. Business executives have specified risk management objectives, and incentive schemes take account of performance against these. market disloCation During 2008, the global dislocation in financial markets has resulted in exceptional instability and volatility impacting upon market and investor confidence which has been characterised by a marked reduction in liquidity. This crisis in the financial markets led the UK Government to inject liquidity into the financial system and to require (and participate in) recapitalisation of the banking sector to restore confidence to the market. During October 2008, as part of the co-ordinated package of capital and funding measures for the UK banking sector, implemented by HM Treasury, the Group participated in the Government Funding Package and thereby facilitated access to the UK Government backed provision of liquidity. There can be no assurance that the measures so far announced by the Government, will be sufficient to prevent any future strain on the Group’s ability to meet its financial obligations as they fall due. The recovery of wholesale and capital markets will depend upon renewed confidence in the UK banking system particularly if market conditions revert to the reduced levels of wholesale market liquidity and the availability of traditional sources of funding become more limited. The key dependencies on successfully funding the Group’s balance sheet include the continued functioning of the money and capital markets at their current levels; the continued access of the Group to central bank and Government sponsored liquidity facilities, including issuance under HMT’s credit guarantee scheme (CGS) and access to the Bank of England’s various facilities; limited further deterioration in the Group’s credit ratings; and no significant or sudden withdrawal of deposits resulting in increased reliance on money markets or Government support schemes. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 Business review Summary of Group results Divisional results Corporate responsibility Our people risk management Five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 43 Lloyds Banking Group Annual Report and Accounts 2008 AUDITED INFORMATION Based upon projections by management, which take into account the acquisition on the 16 January 2009 of HBOS plc, and assume the availability of the existing and announced Government Funding Package, the Group believes it has adequate resources to continue in business for the foreseeable future. resPonses to market disloCation and Banking Crisis During the market dislocation there has been even more rigorous focus on the governance, accountabilities and execution capabilities to ensure adherence to an even lower risk profile. It is part of the Lloyds TSB approach to learn from adverse situations – regardless of whether there has been any direct business impact. Accordingly, ‘lessons learned’ exercises form part of normal activity and have been carried out during this turbulent period. The Lloyds TSB risk culture has manifested itself in some clear and critical pre crunch wholesale and capital markets policy actions that served to limit exposure. The Group has developed its credit, liquidity and market risk control frameworks. Particular focus has been placed on the control of credit spread risk, associated stress testing and modelling. The Group during the year has further strengthened its oversight of liquidity, funding, capital and asset liability management issues with the upgrading of membership of the group asset and liability committee. Membership consists of group executive committee members and the treasurer, and it is chaired by the chief executive. A senior asset and liability committee has been created to support the group asset and liability committee. There have also been a number of further developments to our liquidity control frameworks that have been instituted including further developments of stress testing. During the height of the crisis, daily meetings with the group chief executive were held to assess the Group’s position which has held up well during the worst aspects of the market dislocation. In respect of credit risk, Lloyds TSB has reduced exposure via timely exit or scaling back of positions. In wholesale and capital market exposure, the Group has restricted investment policy for the Lloyds TSB conduit ‘Cancara’ (for example: no CDOs of asset backed securities); restricted exposure to monolines and leveraged loans; reviewed liquidity risk appetite and enhanced liquidity reporting; reduced holdings of equities in the insurance companies; progressed its pension scheme de-risking strategy and tightened policy parameters for US sub-prime mortgages. Also, all exposures were sanctioned on the basis of Lloyds TSB being content to hold the risk to maturity. In retail banking, risk mitigation activities and a prudent lending stance were maintained in the context of the changing environment: tightening of maximum loan to value criteria on all mortgage books; withdrawal of higher risk mortgage products; tightening of credit card eligibility criteria and tightening of policy rules and scorecard cut offs across all retail portfolios. Consistent with our ‘through the cycle’ approach, Lloyds TSB has a proactive and supportive approach to assist customers through difficult periods. We have also invested significantly in our highly successful collections and recoveries and business support units. risk governanCe struCtures The Group maintains a risk governance structure that is intended to strengthen risk evaluation and management, whilst also positioning the Group to manage the changing regulatory environment in an efficient and effective manner. This structure has been tried and tested by Lloyds TSB and will remain the same for Lloyds Banking Group. The risk governance structure for Lloyds TSB is shown in Table 1.1. Board and Committees The board, assisted by its committees, the risk oversight committee, the group executive committee, and the group audit committee, approves the Group’s overall risk management framework. The board also reviews the Group’s aggregate risk exposures and concentrations of risk to seek to ensure that these are consistent with the board’s appetite for risk. The role of the board, audit committee and risk oversight committee are shown in the corporate governance section on pages 70 to 72, and further key risk oversight roles are described below. There is strong cross membership of non-executive directors between remuneration, audit and risk oversight committees. The group executive committee, assisted by the group business risk committee and the group asset and liability committee, supports the group chief executive in ensuring the effectiveness of the Group’s risk management framework and the clear articulation of the Group’s risk policies, whilst also reviewing the Group’s aggregate risk exposures and concentrations of risk. The group executive committee’s duties are described in greater detail on page 71. The group executive committee members are also members of the group business risk committee and the group asset and liability committee, both of which are chaired by the group chief executive. The group business risk committee is supported by the following: The group compliance and operational risk committee is responsible for proactively identifying current and emerging significant compliance and operational risks or accumulation of risks and control deficiencies across the Group and reviewing associated oversight plans to ensure pre-emptive risk management action. The committee also seeks to ensure that adequate divisional engagement occurs to develop, implement and maintain the Group’s compliance and operational risk management framework. The group credit risk committee is responsible for the development and effectiveness of the Group’s credit risk management framework; clear description of the Group’s credit risk appetite; setting of high level Group credit policy; and compliance with regulatory credit requirements. On behalf of the group business risk committeee, the group credit risk committee monitors and reviews the Group’s aggregate credit risk exposures and concentrations of risk. The group model governance and approvals committee is responsible for setting the control framework and standards for models across the Group, including establishing appropriate levels of delegated authority; the approval of models that are considered to be material to the Group (including credit risk rating systems); and the principles underlying the Group’s economic capital framework. The group change management committee is responsible for ensuring that the aggregate risks associated with the Group’s project portfolio are identified, assessed and mitigated, thereby ensuring that the portfolio remains deliverable within an acceptable level of risk. The group asset and liability committee is supported by the senior asset and liability committee, which is responsible for the review and escalation of issues of group level significance to the group asset and liability committee relating to the strategic management of the Group’s assets and liabilities and the profit and loss implications of balance sheet management actions. It is also responsible for the risk management framework for market risk, liquidity risk, capital risk and earnings volatility. Supporting the chief risk officer, the risk forum consists of the divisional risk officers and the group risk directors. The risk forum regularly reviews a summary of risks across the risk management spectrum to determine areas of focus for remedial action across the Group. 44 Lloyds Banking Group Annual Report and Accounts 2008 RISK MANAGEMENT continued AUDITED INFORMATION Table 1.1: RISK GOVERNANCE STRUCTURES 1st line of defence Business Management The Lloyds TSB Group Board 2nd line of defence Group and Divisional Oversight Functions 3rd line of defence Group Audit Group Executive Committee Group Chief Executive Nominations Committee Group Asset & Liability Committee Group Business Risk Committee Senior Asset & Liability Committee Group Compliance and Operational Risk Committee Group Credit Risk Committee Group Model Governance Committee Group Change Management Committee Remuneration Committee Group Audit Committee Risk Oversight Committee Group Executive Director Insurance and Investments Group Executive Director UK Retail Banking Group Executive Director Wholesale and International Banking Director of IT & Operations Group Finance Director Group Human Resources Director Director of Group Audit Chief Risk Officer Risk Forum Divisional Risk Officer Divisional Risk Officer Divisional Risk Officer Divisional Risk Officer Divisional Risk Officer Divisional Risk Officer Group Risk s Director BU Risk BU Risk BU Risk BU Risk BU Risk BU Risk Governance Committees Oversight Business functions Reporting line Functional reporting line from BU risk officer or function to divisional risk officers Functional reporting line to support the committees Group executive directors have primary responsibility for measuring, monitoring and controlling risks within their areas of accountability and are required to establish control frameworks for their businesses that are consistent with the Group’s high level policies and within the parameters set by the board, group executive committee and group risk. Compliance with policies and parameters is overseen by the risk oversight committee, the group business risk committee, the group asset and liability committee, group risk and the divisional risk offi cers. risk management oversight The chief risk offi cer, a member of the group executive committee and reporting directly to the group chief executive, oversees and promotes the development and implementation of a consistent group wide risk management framework. The chief risk offi cer, supported by the group risk department and the divisional risk offi cers, provides objective challenge to the Group’s senior management. The chief risk offi cer also reports independently to the risk oversight committee (see page 72) that comprises non-executive directors and is chaired by the Group chairman. Group risk directors are allocated responsibility for specifi c risk types and are responsible for ensuring the adequacy of risk resources as well as the oversight of the risk profi le across the Group. Divisional risk offi cers provide oversight of risk management activity for all risks within each of the Group’s divisions. Reporting directly to the group executive directors responsible for the divisions and the chief risk offi cer, their day-to-day contact with business management, business operations and risk initiatives seeks to provide an effective risk oversight mechanism. The director of group audit provides the required independent assurance to the audit committee and the board that risks within the Group are recognised, monitored and managed within acceptable parameters. Group audit is fully independent of group risk, seeking to ensure objective challenge to the effectiveness of the risk governance framework. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 Business review Summary of Group results Divisional results Corporate responsibility Our people risk management Five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 45 Lloyds Banking Group Annual Report and Accounts 2008 AUDITED INFORMATION Table 1.2: RISK MANAGEMENT FRAMEWORK The Lloyds TSB Group business strategy and objectives Risk Identification Policy framework and accountabilities Risk Reporting Control Activities Risk & Control Assessment Risk Measurement Independent Reviews Monitoring Action plans and tracking People Systems and tools Business risk management Line management are directly accountable for the management of risks arising from the Group’s business. A key objective is to ensure that business decisions strike an appropriate balance between risk and reward, consistent with the Group’s risk appetite. The senior executive team and the board receive regular briefings and guidance from the chief risk officer to ensure awareness of the overarching risk management framework and a clear understanding of their accountabilities for risk and internal control. All business units, divisions and group functions complete a control self-assessment annually (described on page 73), reviewing the effectiveness of their internal controls and putting in place enhancements where appropriate. Managing directors and group executive directors certify the accuracy of their assessment. Business risk management forms part of a tiered risk management model, as shown on page 44, with the divisional risk officers and group risk providing oversight and challenge, as described above, and the chief risk officer and group committees establishing the group-wide perspective. This approach seeks to provide the Group with an effective mechanism for developing and embedding risk policies and risk management strategies which are aligned with the risks faced by its businesses. It also seeks to facilitate effective communication on these matters across the Group. risk management framework transferring risk, where appropriate; and exploit risks to gain competitive advantage, thereby seeking to increase shareholder value. The principal elements of the risk management framework are shown in Table 1.2. The risk management framework above comprises 10 interdependent activities which map to the components of the internal control- integrated framework issued by the committee of Sponsoring Organisations of the Treadway Commission (COSO). The framework is dynamic and allows for proportionate adjustment of policies and controls where business strategy and risk appetite is amended in response to changes in market conditions. the lloyds tsB group business strategy is used to determine the Group’s high level risk principles and risk appetite measures and metrics for the primary risk drivers (see Table 1.3). A key focus has been to develop earnings volatility measures to complement existing capital measures for risk appetite. The risk appetite is proposed by the group chief executive and reviewed by various governance bodies including the group executive committee and the risk oversight committee. Responsibility for the approval of risk appetite rests with the board. The approved high level appetite and limits are delegated to individual group executive directors by the group chief executive. The more detailed description of the risk principles and distribution of the risk appetite measures amongst the divisions and businesses are determined by the group chief executive, in consultation with the group business risk committee and the group asset and liability committee. The Group’s risk management principles and risk management framework cover the full spectrum of risks that a group, that encompasses both banking and insurance businesses, would encounter. The risk principles are executed through the policy framework and accountabilities. These principles are supported by the policy levels below: The Group uses an enterprise-wide risk management framework for the identification, assessment, measurement and management of risk, designed to meet its customers’ needs. It seeks to maximise value for shareholders over time by aligning risk management with the corporate strategy, assessing the impact of emerging risks from legislation, new technologies or the market, and developing risk tolerances and mitigating strategies. The framework seeks to strengthen the Group’s ability to identify and assess risks; aggregate group wide risks and define the corporate risk appetite; develop solutions for reducing or Principles – high level principles for the six primary risk drivers high level group policy – policy for the main risk types aligned to the risk drivers detailed group policy – detailed policy that applies across the Group divisional policy – local policy that specifically applies to a division Business unit policy – local policy that specifically applies to a business unit 46 Lloyds Banking Group Annual Report and Accounts 2008 RISK MANAGEMENT continued AUDITED INFORMATION Table 1.3: RISK DRIVERS Primary risk drivers Business Risk Credit Risk Market Risk Insurance Risk Operational Risk Financial Soundness Detailed risk types Strategy setting Execution of strategy Retail Wholesale Interest rate Foreign exchange Equity Credit spread Mortality Longevity Morbidity Persistency Property Expenses Unemployment Legal and regulatory Business process risk Financial crime risk Security risk People Change Governance Customer treatment Capital Liquidity and funding Financial & prudential regulatory reporting Disclosure Tax Divisional and business unit policy is only produced by exception and is not necessary unless there is a specific area for which a particular division or business unit requires a greater level of detail than is appropriate for group level policy. The governance arrangements for development of, and compliance with, group, divisional and business unit policy and the associated accountabilities are clearly outlined. All staff are expected to be aware of the policies and procedures which apply to them and their work and to observe the relevant policies and procedures. Line management in each business area has primary responsibility for ensuring that group policies and the relevant local policies and procedures are known and observed by all staff within that area. Group and divisional risk functions have responsibility for overseeing effective implementation of policy. Group audit provides independent assurance to the board about the effectiveness of the Group’s control framework and adherence to policy. Policies are reviewed annually to ensure they remain fit for purpose. Proportionate control activity strategy is in place to design mitigating controls, to transfer risk where appropriate and ensure executives are content with the residual level of risk accepted. risk and control assessments are undertaken to assess the effectiveness of current mitigations and whether risks taken are consistent with the Group’s risk appetite (this includes the annual control self-assessment exercise). The impact of risks and issues (including financial, reputational and regulatory capital) are determined through effective risk measurement including modelling and stress testing. The outcomes of independent reviews (including internal and external audit and regulatory reviews) are integrated into risk management activities and action plans. risk reporting is standardised through the use of standard definitions when reporting, to enable risk aggregation. Divisions monitor their risk levels against their risk appetite, seeking to ensure effective mitigating action is being taken where appropriate. Divisional risk reports are reviewed by divisional executive committees to ensure that respective senior management are satisfied with the overall risk profile, risk accountabilities and progress on any necessary mitigating actions. Reporting, including that of performance against relevant limits or policies, is in place to provide a level of detail appropriate to the exposures concerned and regular information is provided to group risk for review and aggregate reporting. Any significant issues identified in the monitoring process are appropriately reported, and an escalation process is in place to report significant losses to appropriate levels of management. Group risk reports on risk exposures and material issues quarterly to the group asset and liability committee, group business risk committee, group executive committee, risk oversight committee and the board. At group level a consolidated risk report is produced which is reviewed and debated by the group business risk committee, group executive committee, risk oversight committee and the board to ensure senior management and the board are satisfied with the overall risk profile, risk accountabilities and mitigating actions. The consolidated risk report provides a regular assessment of the aggregate residual risk for the primary risk drivers, comparing the assessment with the previous quarter and providing a forecast for the next 12 months. risk drivers The Group’s risk language is designed to capture the Group’s principal risks referred to as the ‘primary risk drivers’. A description of each risk, including definition, appetite, control and exposures, is included below. These are further broken down into 28 more granular risk types to enable more detailed review and facilitate appropriate reporting and monitoring, as set out in Table 1.3. Through the Group’s risk management processes these risks are assessed on an ongoing basis to ensure optimisation of risk and reward and that, where required, appropriate mitigation is in place. Both quantitative and qualitative factors are considered in assessing the Group’s current and potential future risks. PrinCiPal risks At present the most significant risks faced by the Group are: People risk: the Group’s recent improvement to its people risk exposure, driven by leadership development and succession planning strategies, is now challenged by integration events and market disruption. External pressure on incentivisation in the banking industry increases the risk of losing specialist resources. The Group is addressing these pressures and taking the necessary steps to retain resources. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 Business review Summary of Group results Divisional results Corporate responsibility Our people risk management Five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 47 Lloyds Banking Group Annual Report and Accounts 2008 AUDITED INFORMATION Credit risk: arising in the Retail and Wholesale and International Banking divisions and the Treasury function reflecting the risks inherent in the Group’s lending activities. Over the last year the banking crisis has impacted the financial services industry resulting in high profile losses and writedowns. The deteriorating economic outlook, both in the UK and overseas, is also leading to significant rises in impairments. The Group is impacted by the economic downturn and a further worsening of the business environment could adversely impact earnings. This poses a major risk to the Group and its lending businesses in: – Retail, where rising unemployment impacts the ability of customers to meet repayment dates on unsecured and secured lending and leads to a consequent increase in arrears. Additionally, the downturn in the housing market reduces collateral values for residential property and this impacts upon the profitability of secured lending. – Wholesale, where companies are facing increasingly difficult conditions, resulting in corporate default levels rising and leading to increases in corporate impairment. The Group follows a through the economic cycle, relationship based, business model with robust risk management processes, appropriate appetites and experienced staff in place. liquidity and funding: arising in the banking business of the Group and impacting the Retail and Wholesale and International Banking divisions reflecting the risk that the Group is unable to attract and retain retail/wholesale deposits or issue debt securities. Like all major banks, the Group is dependent on confidence in the short and longer term wholesale funding markets; should the Group, due to exceptional circumstances, be unable to continue to source sustainable funding and provide liquidity when necessary, it could impact its ability to fund its financial obligations. Throughout the market dislocation, the Group has maintained a robust liquidity position based on its significant retail and corporate deposit base and has funded strongly in the wholesale markets. Since completion of the HBOS transaction, the Group has been able to fund the Enlarged Group in the wholesale markets at rates comparable to the period prior to completion. In addition the Group has reinforced its strong funding position by actively participating in the support initiatives introduced by the Bank of England and HM Treasury. Prior to the year end 2008 additional liquidity resilience was built up to mitigate the potential for hightened liquidity risk faced by Lloyds TSB Group plc upon the acquisition of HBOS plc. The recent down grade by rating agencies has not had a material impact on the cost of short term wholesale funding. Capital: during the year there was unprecedented turbulence in global financial markets which led to the UK Government taking action to stabilise the UK banking system. After discussion with HM Treasury on the additional capital required by the UK Government if the Group was to continue to have access to the Government backed provision of liquidity, the board decided it was in the best interests of shareholders for the Group to participate in the industry wide recapitalisation exercise which took place in October 2008. However, should the economic downturn worsen and consequently the Group sustain further sudden and significant shocks to its capital base, it could be necessary to raise additional capital to remain above the FSA’s minimum target ratios. Any additional capital raised which was not taken up by existing shareholders would be dilutive to their earnings. market risk: In terms of potential impact on economic value, the principal market risks are a fall in equity markets reducing the value of assets in the Group’s pension schemes and in the Insurance and Investments division, and exposure to a fall in real interest rates increasing the value of liabilities in the Group’s pension schemes. In terms of potential impact on earnings, the principal market risks are exposure to a fall in equity markets reducing the value of assets in the Insurance and Investments division, and exposure to a widening of credit spreads reducing the value of assets in the Insurance and Investment division and in the Trading Book. Also, in the retail banking businesses, there is a potential impact on earnings arising from margin compression in a lower base rate environment. All risks are subject to regular review and mitigation activity via specific initiatives monitored by the group and senior asset and liability committees, including engagement with the pension scheme trustees. insurance risk: arising in Insurance and Investments division and the Group’s pension schemes reflecting the exposure to increasing longevity of annuitants and pensioners. The main mitigation option open to the Group is to hedge the risk in the reinsurance or the capital markets and the Group actively monitors the attractiveness of potential opportunities in these markets. legal and regulatory risk: arising in all divisions and reflecting the legal and regulatory environment in which the Group operates and the volume and pace of change from within the UK and the rest of the world. This impacts the Group, both operationally in terms of cost of compliance with uncertainty about legal and regulatory expectations, and strategically through pressure on key earnings streams. The latter could potentially result in changes to business and pricing models, particularly in the UK retail and smaller business markets. Our business planning processes continue to reflect change to the legal and regulatory environment. Major current legal and regulatory reviews and proceedings are described on page 35. In addition, the Group faces risk where legal or regulatory proceedings are brought against it. Regardless of whether such claims have merit, the outcome of such proceedings is inherently uncertain and could result in financial loss. integration risk: A further risk arises as a result of the acquisition of HBOS plc by Lloyds TSB Group plc reflecting the risk that Lloyds Banking Group may fail to realise the business growth opportunities, revenue benefits, cost synergies, operational efficiencies and other benefits anticipated from, or may incur unanticipated costs and losses associated with, the acquisition of HBOS plc. As a consequence Lloyds Banking Group results may suffer as a result of operational, financial, management and other integration risks. The Group has created an integration committee as a sub-committee to the group executive committee to oversee the integration process. imPaCt of lloyds tsB risk management PraCtiCes on hBos Following completion of the HBOS plc transaction, Lloyds Banking Group has moved swiftly to apply its risk management practices to the HBOS Group. As part of the completion process, we have amended Lloyds TSB Group high level policies so that they could be introduced for Lloyds Banking Group. The way we manage risk is central to the success of Lloyds Banking Group. The board takes its responsibility for risk management very seriously and all of the Group’s senior executives are actively involved in overseeing the risk profile for Lloyds Banking Group. 48 Lloyds Banking Group Annual Report and Accounts 2008 RISK MANAGEMENT continued AUDITED INFORMATION On the completion date the Lloyds TSB governance structure became the overriding governance structure for Lloyds Banking Group. This represented a change to the committee structures and delegated authorities for the heritage HBOS businesses. The major areas of change included material event escalation, sanctions, conflicts of interest, delegated authorities for expenditure and the credit sanctioning process where authorities were changed to align with those within the heritage Lloyds TSB Group plc businesses. Business risk definition Business risk is defined as the risk to economic profit in the Group’s budget and over the medium-term plan arising from a sub optimal business strategy or the sub optimal implementation of the plan as agreed by the board of directors. In assessing business risk, consideration is given to internal and external factors. risk aPPetite Business risk appetite is encapsulated in the Group’s budget and medium-term plan, which are sanctioned by the board on an annual basis. Divisions and business units subsequently align their plans to the Group’s overall business risk appetite. exPosures The Group’s portfolio of businesses exposes it to a number of internal and external factors: – internal factors: resource capability and availability, customer treatment, service level agreements, products and funding and the risk appetite of other risk categories; and – external factors: economic, technological, political, social and ethical, environmental, legal and regulatory, market expectations, reputation and competitive behaviour. measurement An annual business planning process is conducted at group and business unit level which includes a quantitative and qualitative assessment of the risks that could impact the Group’s plans. Within the planning round, the Group conducts both scenario analysis and stress tests to assess risks to future earning streams. Over the last few years, the Group has made significant progress with embedding stress testing and scenario analysis into its risk management practice with the dual objectives of adding value to the business whilst also meeting regulatory requirements. The Group assesses a wide array of scenarios including economic recessions, regulatory action scenarios, pandemics and scenarios specific to the operations of each part of the business. A common approach is applied across the Group to assess the creation of shareholder value. This is measured by economic profit (the profit attributable to shareholders, less a notional charge for the equity invested in the business). The focus on economic profit allows the Group to compare the returns being made on capital employed in each business on a consistent basis. During the year, as a result of the market dislocation and banking crisis, economic profit fell by £994 million to £731 million. mitigation As part of the annual business planning process, the group develops a set of management actions to prevent or mitigate the impact on earnings in the event that business risks materialise. Additionally, business risk monitoring, through regular reports and oversight, results in corrective actions to plans and reductions in exposures where necessary. Revenue and capital investment decisions require additional formal assessment and approval. Formal risk assessment is conducted as part of the financial approval process. Significant mergers and acquisitions by business units require specific approval by the board. In addition to the standard due diligence conducted during a merger or acquisition, group risk conducts, where appropriate, an independent risk assessment of the target company. monitoring The Group’s strategy is reviewed and approved by the board. Regular reports are provided to the group executive committee and the board on the progress of the Group’s key strategies and plans. Group risk conducts oversight to seek to ensure that business plans remain consistent with the Group’s strategy. Credit risk definition The risk of reductions in earnings and/or value, through financial or reputational loss, as a result of the failure of the party with whom the Group has contracted to meet its obligations (both on and off balance sheet). risk aPPetite Credit risk appetite is expressed both in terms of credit risk economic equity and in terms of the impact of credit risk on earnings volatility. Credit risk appetite is set by the board and is described and reported through a suite of metrics derived from a combination of accounting and credit portfolio model parameters which in turn use the various credit risk rating systems as inputs. These metrics are supplemented by a variety of policies, sector caps and limits to manage concentration risk at an acceptable level. exPosures The principal sources of credit risk within the Group arise from loans and advances to retail customers, financial institutions and corporate clients. The credit risk exposures of the Group are set out in note 49 to the financial statements. In terms of loans and advances, credit risk arises both from amounts lent and commitments to extend credit to a customer as required. These commitments can take the form of loans and overdrafts, or credit instruments such as guarantees and standby, documentary and commercial letters of credit. With respect to commitments to extend credit, the Group is potentially exposed to loss in an amount equal to the total unused commitments. However, the likely amount of loss is less than the total unused commitments, as most retail commitments to extend credit can be cancelled and the credit worthiness of customers is monitored frequently. In addition, most wholesale commitments to extend credit are contingent upon customers maintaining specific credit standards, which are regularly monitored. Credit risk can also arise from debt securities, derivatives and foreign exchange activities. Note 17 to the financial statements shows the total notional principal amount of interest rate, exchange rate, credit derivative and equity and other contracts outstanding at 31 December 2008. The notional principal amount does not, however, represent the Group’s credit risk exposure, which is limited to the current cost of replacing contracts with a positive value to the Group. Such amounts are reflected in note 49 on page 168. Credit risk exposures in the insurance businesses arise primarily from holding investments and from exposure to reinsurers. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 Business review Summary of Group results Divisional results Corporate responsibility Our people risk management Five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 measurement In measuring the credit risk of loans and advances to customers and to banks at a counterparty level, the Group reflects three components: (i) the ‘probability of default’ by the client or counterparty on its contractual obligations; (ii) current exposures to the counterparty and their likely future development, from which the Group derives the ‘exposure at default’; and (iii) the likely loss ratio on the defaulted obligations (the ‘loss given default’). The Group assesses the probability of default of individual counterparties using internal rating models tailored to the various categories of counterparty. For its retail lending, and a growing number of wholesale lending portfolios, exposure at default and loss given default models are also in use. All material rating models are authorised by executive management. They have been developed internally and use statistical analysis, combined, where appropriate, with external data and subject matter expert judgement. Each rating model is subject to a rigorous validation process, undertaken by independent risk teams, which includes benchmarking to externally available data, where possible. Each probability of default rating model segments counterparties into a number of rating grades, each representing a defined range of default probabilities. Exposures migrate between classifications if the assessment of the obligor probability of default changes. Each rating system is required to map to a master scale, which supports the consolidation of credit risk information across portfolios through the adoption of a common rating scale. Given the differing risk profiles and credit rating considerations, the underlying risk reporting has been split into two distinct master scales, a retail master scale and a wholesale master scale. (Note 49 to the financial statements provides an analysis of the portfolio.) The rating systems described above assess probability of default, exposure at default and loss given default, in order to derive an expected loss. In contrast, impairment allowances are recognised for financial reporting purposes only for losses that have been incurred at the balance sheet date based on objective evidence of impairment (see note 20 to the consolidated financial statements on page 129). Due to the different methodologies applied, the amount of incurred credit losses provided for in the financial statements differs from the amount determined from the expected loss model that is used for internal operational management and banking regulation purposes. The Group’s debt securities holdings, which are the subject of external agency ratings, are marked to market and independently checked by the middle office function within the products and markets business. Similarly, debt security investments within Scottish Widows are independently marked to market. The Group also employs a statistically-based credit portfolio model, which models portfolio credit risk based on defaults and calculates the economic equity employed and credit value at risk for each portfolio. mitigation The Group uses a range of approaches to mitigate credit risk. INTERNAL CONTROL – Credit principles and policy: group risk sets out the Group credit principles and policy according to which credit risk is managed, which in turn is the basis for divisional and business unit credit policy. Principles and policy are reviewed regularly and any changes are subject to a review and approval process. Divisional and business unit policy includes lending guidelines, which define the responsibilities of lending officers and provide a disciplined and focused benchmark for credit decisions. Credit policy also specifies maximum holding period limits for the credit trading portfolios. finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 49 Lloyds Banking Group Annual Report and Accounts 2008 AUDITED INFORMATION – Counterparty limits: Limits are set against all types of exposure in a counterparty name, in accordance with an agreed methodology for each exposure type. This includes credit risk exposure on individual derivative transactions, which incorporates potential future exposures from market movements. Aggregate facility levels by counterparty are considered and limit breaches are subject to escalation procedures. – Individual credit assessment and sanction: Credit risk in wholesale portfolios is subject to individual credit assessments, which consider the strengths and weaknesses of individual transactions and the balance of risk and reward. Exposure to individual counterparties, groups of counterparties or customer risk segments is controlled through a tiered hierarchy of delegated sanctioning authorities. Approval requirements for each decision are based on the transaction amount, the customer’s aggregate facilities, credit risk ratings and the nature and term of the risk. The Group’s credit risk appetite criteria for counterparty underwriting are the same as that for assets intended to be held over the period to maturity. – Credit scoring: In its principal retail portfolios, the Group uses statistically-based decisioning techniques (primarily credit scoring). Divisional risk departments review scorecard effectiveness and approve changes, with material changes to scorecards that form part of a probability of default rating system subject to group risk approval. – Controls over rating systems: The Group has established a robust and independent process built on a set of common minimum standards designed to challenge the discriminatory power of the systems, accuracy of calibration and ability to rate consistently over time and across obligors. The internal rating systems are developed and implemented by independent risk functions either in the business units or divisions with the business unit managing directors having ownership of the systems. They also take responsibility for ensuring the validation of the respective internal rating systems, supported and challenged by specialist functions in their respective division. – Cross-border and cross-currency exposures: Country limits are authorised by Country Limits Panel and managed by a dedicated unit taking into account economic and political factors. – Concentration risk: Credit risk management includes portfolio controls on certain industries, sectors and product lines to reflect risk appetite. Credit policy is aligned to the Group’s risk appetite and restricts exposure to certain high risk and more vulnerable sectors. Note 19 to the accounts provides an analysis of loans and advances to customers by industry (for wholesale) and product (for retail). Exposures are monitored to prevent excessive concentration of risk. These concentration risk controls are not necessarily in the form of a maximum limit on lending but may instead require new business in concentrated sectors to fulfil additional hurdle requirements. The Group’s large exposures are reported in accordance with regulatory reporting requirements. – Stress testing and scenario analysis: The credit portfolio is also subjected to stress-testing and scenario analysis, to simulate outcomes and calculate their associated impact. Events are modelled at a group wide level, at divisional and business unit level and by rating model and portfolio, for example, for a specific industry sector. – Specialist expertise: Credit quality is maintained by specialist units providing, for example: intensive management and control; security perfection, maintenance and retention; expertise in documentation for lending and associated products; sector-specific expertise; and legal services applicable to the particular market place and product range offered by the business. 50 Lloyds Banking Group Annual Report and Accounts 2008 RISK MANAGEMENT continued AUDITED INFORMATION – Daily settlement limits: Settlement risk arises in any situation where a payment in cash, securities or equities is made in the expectation of a corresponding receipt in cash, securities or equities. Daily settlement limits are established for each counterparty to cover the aggregate of all settlement risk arising from the Group’s market transactions on any single day. – Risk assurance and oversight: Divisional and group level oversight teams monitor credit performance trends, review and challenge exceptions to planned outcomes and test the adequacy of credit risk infrastructure and governance processes throughout the Group. This includes tracking portfolio performance against an agreed set of key risk indicators. Risk assurance teams are engaged where appropriate to conduct further credit reviews if a need for closer scrutiny is identified. COLLATERAL The principal collateral types for loans and advances are: – mortgages over residential properties; – charges over business assets such as premises, inventory and accounts receivable; – charges over financial instruments such as debt securities and equities; and – guarantees received from third parties. The Group maintains guidelines on the acceptability of specific classes of collateral. Collateral held as security for financial assets other than loans and advances is determined by the nature of the instrument. Debt securities, treasury and other eligible bills are generally unsecured, with the exception of asset-backed securities and similar instruments, which are secured by portfolios of financial assets. Collateral is generally not held against loans and advances to financial institutions, except where securities are held as part of reverse repurchase or securities borrowing transactions or where a collateral agreement has been entered into under a master netting agreement. Collateral or other security is also not usually obtained for credit risk exposures on derivative instruments, except where the Group requires margin deposits from counterparties. It is the Group’s policy that collateral should always be realistically valued by an appropriately qualified source, independent of the customer, at the time of borrowing. Collateral is reviewed on a regular basis in accordance with business unit credit policy, which will vary according to the type of lending and collateral involved. In order to minimise the credit loss, the Group may seek additional collateral from the counterparty as soon as impairment indicators are identified for the relevant individual loans and advances. The Group considers risk concentrations by collateral providers and collateral type, as appropriate, with a view to ensuring that any potential undue concentrations of risk are identified and suitably managed by changes to strategy, policy and/or business plans. MASTER NETTING AGREEMENTS Where it is efficient and likely to be effective (generally with counterparties with which it undertakes a significant volume of transactions), the Group enters into master netting agreements. Although master netting agreements do not generally result in an offset of balance sheet assets and liabilities, as transactions are usually settled on a gross basis, they do reduce the credit risk to the extent that, if an event of default occurs, all amounts with the counterparty are terminated and settled on a net basis. The Group’s overall exposure to credit risk on derivative instruments subject to master netting agreements can change substantially within a short period since it is affected by each transaction subject to the agreement. OTHER CREDIT RISK TRANSFERS The Group also undertakes asset sales, securitisations and credit derivative- based transactions as a means of mitigating or reducing credit risk, taking into account the nature of assets and the prevailing market conditions. monitoring – Portfolio monitoring and reporting: In conjunction with group risk, businesses and divisions identify and define portfolios of credit and related risk exposures and the key benchmarks, behaviours and characteristics by which those portfolios are managed in terms of credit risk exposure. This entails the production and analysis of regular portfolio monitoring reports for review by senior management. Group risk in turn produces an aggregated review of credit risk throughout the Group, including reports on significant credit exposures, which are presented to the group business risk committee. – The performance of all rating models is comprehensively monitored on a regular basis, to ensure that models continue to provide optimum risk differentiation capability, the generated ratings remain as accurate and robust as possible and the models assign appropriate risk estimates to grades/pools. All models are monitored against a series of agreed key performance indicators. In the event that monthly monitoring identifies material exceptions or deviations from expected outcomes, these will be escalated. market risk definition The risk of reductions in earnings and/or value, through financial or reputational loss, arising from unexpected changes in financial prices, including interest rates, exchange rates, credit spreads and prices for bonds, commodities, equities, property and other instruments. It arises in all areas of the Group’s activities and is managed by a variety of different techniques. risk aPPetite Market risk appetite is defined with regard to the quantum and composition of market risk that exists currently in the Group and the direction in which the Group wishes to manage this. This statement of the Group’s overall appetite for market risk is reviewed and approved annually by the board. With the support of the group asset and liability committee, the group chief executive allocates this risk appetite across the Group. Individual members of the group executive committee ensure that market risk appetite is further delegated to an appropriate level within their areas of responsibility. exPosures The Group’s banking activities expose it to the risk of adverse movements in interest rates, credit spreads, exchange rates and equity prices, with little or no exposure to commodity risk. Most of the Group’s trading activity is undertaken to meet the requirements of wholesale and retail customers for foreign exchange and interest rate products. However, some interest rate, exchange rate and credit spread positions are taken using derivatives and other on-balance sheet instruments with the objective of earning a profit from favourable movements in market rates. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 Business review Summary of Group results Divisional results Corporate responsibility Our people risk management Five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 Market risk in the Group’s retail portfolios and in the Group’s capital and funding activities arises from the different repricing characteristics of the Group’s non-trading assets and liabilities. Interest rate risk arises predominantly from the mismatch between interest rate insensitive liabilities and interest rate sensitive assets. Foreign currency risk also arises from the Group’s investment in its overseas operations. The Group’s insurance activities also expose it to market risk, encompassing interest rate, exchange rate, property, credit spreads and equity risk: – The management of the With Profit Fund within Scottish Widows involves mismatching of assets and liabilities with the aim of generating a higher rate of return on assets to meet policyholders’ expectations. – Unit-linked liabilities are matched with the same assets that are used to define the liability but future fee income is dependent upon the performance of those assets. – For other insurance liabilities the aim is to invest in assets such that the cash flows on investments will match those on the projected future liabilities. It is not possible to eliminate risk completely as the timing of insured events is uncertain and bonds are not available at all of the required maturities. As a result the cash flows cannot be precisely matched and so sensitivity tests are used to test the extent of the mismatch. – Surplus assets are held primarily in three portfolios: the surplus in the non-profit fund within the long term fund of Scottish Widows plc, assets in shareholder funds of life assurance companies and an investment portfolio within the general insurance business. The Group’s defined benefit staff pension schemes are exposed to significant risks from the constituent parts of their assets and from the present value of their liabilities, primarily equity and real interest rate risk. For further information on pension scheme assets and liabilities please refer to note 37. measurement The primary market risk measure used within the Group is the Value at Risk (VaR) methodology, which incorporates the volatility of relevant market prices and the correlation of their movements. This is used for determining the Group’s overall market risk appetite and for the high level allocation of risk appetite across the Group. Although an important measure of risk, VaR has limitations as a result of its use of historical data, assumed distribution, holding periods and frequency of calculation. In addition, the use of confidence levels does not convey any information about potential loss when the confidence level is exceeded. Where VaR models are less well suited to the nature of positions, the Group recognises these limitations and supplements its use with a variety of other techniques. These reflect the nature of the business activity, and include interest rate repricing gaps, open exchange positions and sensitivity analysis. Stress testing and scenario analysis are also used in certain portfolios and at group level, to simulate extreme conditions to supplement these core measures. During the year the Group introduced group wide stress testing to measure exposure to credit spread widening across all businesses in response to the market dislocation that has impacted the observable inputs to asset pricing. finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 51 Lloyds Banking Group Annual Report and Accounts 2008 AUDITED INFORMATION BANKING – TRADING AND OTHER FINANCIAL ASSETS AT FAIR VALUE THROUGH PROFIT OR LOSS Based on the commonly used 95 per cent confidence level, assuming positions are held overnight and using observation periods of the preceding 300 business days, the VaR for the years ended 31 December 2008 and 2007 based on the Group’s global trading positions was as detailed in table 1.4. The risk of loss measured by the VaR model is the potential loss in earnings. The total and average trading VaR does not assume any diversification benefit across the four risk types. The maximum and minimum VaR reported for each risk category did not necessarily occur on the same day as the maximum and minimum VaR reported as a whole. VaR numbers have increased during 2008 due to the significant rise in market volatility reflected in all the Group’s VaR models across all markets. taBle 1.4: Banking – trading and other finanCial assets at fair value through Profit or loss Interest rate risk Foreign exchange risk Equity risk Credit spread risk Total VaR Interest rate risk Foreign exchange risk Equity risk Credit spread risk Total VaR Close £m 6.73 2.95 0.00 7.97 17.65 Close £m 1.63 0.08 0.00 4.21 5.92 31 december 2008 average £m maximum £m minimum £m 3.36 1.22 0.25 4.94 9.77 14.67 4.06 2.67 8.08 24.95 0.96 0.08 0.00 4.14 5.35 31 December 2007 Average £m Maximum £m Minimum £m 2.20 0.23 0.29 3.60 6.32 4.66 0.53 3.02 8.30 11.00 1.27 0.04 0.00 2.06 4.28 BANKING – NON-TRADING The estimated impact of an immediate 25 basis point increase in interest rates on economic value for the years ended 31 December 2008 and 2007 is shown below (in the 2007 accounts a 200 basis point increase was used). Economic value is defined as the present value of the non-trading portfolios concerned. Impacts have only been shown in one direction but can be assumed to be reasonably symmetrical. No currency breakdown has been provided as most of the exposure is in pounds sterling. These calculations are made monthly using assumptions regarding the maturity of interest rate insensitive assets and liabilities. The portfolio is updated monthly to reflect any changes in the relationship between customer behaviour and the level of interest rates. This is a risk based disclosure and the amounts below would be amortised in the income statement over the duration of the portfolio. During the year, management reviewed the basis of reporting banking non-trading to a value at risk measure to reflect better the internal measurement used to control this exposure. The decrease compared to the previous year is due to the impact on retail balances of significant cuts in base rate during the last few months of 2008. In view of the unprecedented low interest rate environment in 2009, the assumptions underlying this particular risk measure are under review and likely to change. 52 Lloyds Banking Group Annual Report and Accounts 2008 RISK MANAGEMENT continued AUDITED INFORMATION taBle 1.5: Banking – non-trading BANKING ACTIVITIES Reduction in value INSURANCE PORTFOLIOS 31 december 2008 £m 31 December 2007 £m (158) 8 The Group’s market risk exposure in respect of insurance activities described above is measured using European Embedded Value (EEV) as a proxy for economic value. The pre-tax sensitivity of EEV to standardised market stresses is shown below for the years ended 31 December 2008 and 2007. Foreign exchange risk arises predominantly from overseas equity holdings. Impacts have only been shown in one direction but can be assumed to be reasonably symmetrical. Opening and closing numbers only have been provided as this data is not volatile or tracked on a daily basis. taBle 1.6: insuranCe Portfolios 31 december 2008 £m 31 December 2007 £m Equity risk (impact of 10% fall pre-tax) (236) Interest rate risk (impact of 25 basis point reduction pre-tax) Credit spread risk (impact of 25 basis point increase pre-tax) 59 (82) (248) 58 (110) mitigation Trading is restricted to a number of specialist centres, the most important centre being the products and markets business in London. These centres also manage market risk in the wholesale non-trading portfolios, both in the UK and internationally. The level of exposure is strictly controlled and monitored within approved limits. Active management of the wholesale portfolios is necessary to meet customer requirements and changing market circumstances. Market risk in the Group’s retail portfolios and in the Group’s capital and funding activities is managed within limits defined in the detailed Group policy for interest rate risk in the banking book, which is reviewed and approved annually. INSURANCE ACTIVITIES Market risk exposures from the insurance businesses are controlled via approved investment policies and limits set with reference to the Group’s overall risk appetite and regularly reviewed by the senior asset and liability committee: – The With Profit Fund is managed in accordance with the relevant fund’s principles and practices of financial management and legal requirements. – The investment strategy for other insurance liabilities is determined by the term and nature of the underlying liabilities and asset/liability matching positions are actively monitored. Actuarial tools are used to project and match the cash flows. – Investment strategy for surplus assets held in excess of liabilities takes account of the legal, regulatory and internal business requirements for capital to be held to support the business now and in the future. Various mitigation activities are undertaken across the Group to manage portfolios and ensure they remain within approved limits. The Group also agrees strategies for the overall mix of pension assets with the pension scheme trustees. BANKING – NON-TRADING ACTIVITIES Interest rate risk arising from the different repricing characteristics of the Group’s non-trading assets and liabilities, and from the mismatch between interest rate insensitive liabilities and interest rate sensitive assets, is managed centrally. Matching assets and liabilities are offset against each other and internal interest rate swaps are also used. The corporate and retail businesses incur foreign exchange risk in the course of providing services to their customers. All non-structural foreign exchange exposures in the non-trading book are transferred to the trading area where they are monitored and controlled. INSURANCE ACTIVITIES Investment holdings are diversified across markets and, within markets, across sectors. Holdings are diversified to minimise specific risk and the relative size of large individual exposures is monitored closely. For assets held outside unit-linked funds, investments are only permitted in countries and markets which are sufficiently regulated and liquid. monitoring The senior asset and liability committee regularly reviews high level market risk exposure including, but not limited to, the data described above. It also makes recommendations to the group chief executive concerning overall market risk appetite and market risk policy. Exposures at lower levels of delegation are monitored at various intervals according to their volatility, from daily in the case of trading portfolios to monthly or quarterly in the case of less volatile portfolios. Levels of exposures compared to approved limits are monitored locally by independent risk functions and at a high level by group risk. Where appropriate, escalation procedures are in place. insuranCe risk definition The risk of reductions in earnings and/or value, through financial or reputational loss, due to fluctuations in the timing, frequency and severity of insured/underwritten events and to fluctuations in the timing and amount of claim settlements. This includes fluctuations in profits due to customer behaviour. risk aPPetite Insurance risk appetite is defined with regard to the quantum and composition of insurance risk that exists currently in the Group and the direction in which the Group wishes to manage this. exPosures The major sources of insurance risk within the Group are the insurance businesses and the Group’s defined benefit staff pension schemes. The nature of insurance business involves the accepting of insurance risks which relate primarily to mortality, longevity, morbidity, persistency, expenses, property damage and unemployment. The prime insurance risk carried by the Group’s staff pension schemes is related to longevity. measurement Insurance risks are measured using a variety of techniques including stress and scenario testing; and, where appropriate, stochastic modelling. Current and potential future insurance risk exposures are assessed and aggregated using risk measures based on 1-in-20 year stresses and other supporting measures where appropriate, for example those set out in Note 33. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 Business review Summary of Group results Divisional results Corporate responsibility Our people risk management Five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 mitigation A key element of the control framework is the consideration of insurance risk by a suitable combination of high level committees/boards. For the life assurance businesses the key control body is the board of Scottish Widows Group Limited with the more significant risks also being subject to approval by the group executive committee and/or Lloyds TSB Group board. For the general insurance businesses the key control body is the Lloyds TSB General Insurance Limited board with the more significant risks again being subject to group executive committee and/ or Lloyds TSB Group board approval. All Group staff pension schemes issues are covered by the group asset and liability committee and the group business risk committee. The overall insurance risk is mitigated through pooling and through diversification across large numbers of uncorrelated individuals, geographical areas, and different types of risk exposure. Insurance risk is primarily controlled via the following processes: – Underwriting (the process to ensure that new insurance proposals are properly assessed) – Pricing-to-risk (new insurance proposals would usually be priced in accordance with the underwriting assessment) – Claims management – Product design – Policy wording – Product management – The use of reinsurance or other risk mitigation techniques. In addition, limits are used as a control mechanism for insurance risk at policy level. At all times, close attention is paid to the adequacy of reserves, solvency management and regulatory requirements. General insurance exposure to accumulations of risk and possible catastrophes is mitigated by reinsurance arrangements which are broadly spread over different reinsurers. Detailed modelling, including that of the potential losses under various catastrophe scenarios, supports the choice of reinsurance arrangements. Appropriate reinsurance arrangements also apply within the life and pensions businesses with significant mortality risk and morbidity risk being transferred to our chosen reinsurers. Options and guarantees are incorporated in new insurance products only after careful consideration of the risk management issues that they present. In respect of insurance risks in the staff pension schemes, the Group ensures that effective communication mechanisms are in place for consultation with the trustees and that risk management is in line with the Group’s risk appetite. monitoring Ongoing monitoring is in place to track the progression of insurance risks. This normally involves monitoring relevant experiences against expectations (for example claims experience, option take up rates, persistency experience, expenses, non-disclosure at the point of sale), as well as evaluating the effectiveness of controls put in place to manage insurance risk. finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 53 Lloyds Banking Group Annual Report and Accounts 2008 AUDITED INFORMATION oPerational risk definition The risk of reductions in earnings and/or value, through financial or reputational loss, from inadequate or failed internal processes and systems, or from people related or external events. There are a number of categories of operational risk: LEGAL AND REGULATORy RISK The risk of reductions in earnings and/or value, through financial or reputational loss, or from failing to comply with the laws, regulations or codes applicable. CUSTOMER TREATMENT RISK The risk of reductions in earnings and/or value, through financial or reputational loss, from inappropriate or poor customer treatment. BUSINESS PROCESS RISK The risk of reductions in earnings and/or value, through financial or reputational loss, resulting from inadequate or failed internal processes and systems, people-related events and deficiencies in the performance of external suppliers/service providers. FINANCIAL CRIME RISK The risk of reductions in earnings and/or value, through financial or reputational loss, associated with financial crime and failure to comply with related legal and regulatory obligations, these losses may include censure, fines or the cost of litigation. PEOPLE RISK The risk of reductions in earnings and/or value, through financial or reputational loss, from inappropriate staff behaviour, industrial action or health and safety issues. Loss can also be incurred through failure to recruit, retain, train, reward and incentivise appropriately skilled staff to achieve business objectives and through failure to take appropriate action as a result of staff underperformance. CHANGE RISK The risk of reductions in earnings and/or value, through financial or reputational loss, from change initiatives failing to deliver to requirements, budget or timescale or failing to implement change effectively or realise the desired benefits. GOVERNANCE RISK The risk of reductions in earnings and/or value, through financial or reputational loss, from poor corporate governance at group, divisional or business unit level. Corporate governance in this context embraces the structures, systems and processes that provide direction, control and accountability for the enterprise. SECURITy RISK The risk of reductions in earnings and/or value, through financial or reputational loss, resulting from theft of or damage to the Group’s assets, the loss, corruption, misuse or theft of the Group’s information assets or threats or actual harm to the Group’s people. risk aPPetite Operational risk appetite is defined as the quantum and composition of operational risk identified in the Group and the direction in which the Group wishes to manage it. The Group has developed an impact on earnings approach to operational risk appetite. This involves looking at how much the Group could lose due to operational risk losses at various levels of certainty. 54 Lloyds Banking Group Annual Report and Accounts 2008 RISK MANAGEMENT continued AUDITED INFORMATION In setting operational risk appetite, the Group looks at both impact on solvency and the Group’s reputation, including customer service requirements. operational risk framework across Lloyds TSB Group plc. The waiver allowed the Group to calculate its own regulatory capital charge for operational risk from its capital model with effect from 1 January 2008. The intention is to extend the same methodology to the insurance businesses within the Group where regulatory capital is currently determined under the ICA requirements. mitigation The Group’s operational risk management framework consists of five key components: – Identification of the key operational risks facing a business area. – Evaluation of the effectiveness of the control framework covering each of the key risks to which the business area is exposed. – Evaluation of the non-financial exposures (e.g. reputational risk) for each of the key risks to which the business area is exposed. – For material risks identified, an estimate of the exposure to financial losses that could result within the coming financial year, together with an estimate of losses in a stressed environment. – For material risks identified, an estimate of exposure to high impact, low frequency events through a scenario. The Group purchases insurance to mitigate certain operational risk events. monitoring Business unit risk exposure is aggregated at divisional level and reported to group risk where a group-wide report is prepared. The report is discussed at the monthly group compliance and operational risk committee. This committee can escalate matters to the chief risk officer, or higher committees if appropriate. The insurance programme is monitored and reviewed regularly, with recommendations being made to the Group’s senior management annually prior to each renewal. Insurers are monitored on an ongoing basis, to ensure counterparty risk is minimised. A process is in place to manage any insurer rating changes or insolvencies. The Group has adopted a formal approach to operational risk event escalation. This involves the identification of an event, an assessment of the materiality of the event in accordance with a risk event impact matrix and appropriate escalation. For legal and regulatory risk the Group has minimal risk appetite and seeks to operate to high ethical standards. The Group encourages and maintains an appropriately balanced legal and regulatory compliance culture and promotes policies and procedures to enable businesses and their staff to operate in accordance with the laws, regulations and voluntary codes which impact on the Group and its activities. exPosures The main sources of operational risk within the Group relate to uncertainties created by the changing business, in particular the legal and regulatory environment in which financial firms operate both in the UK and overseas. As a result the most significant operational risk exposures are legal and regulatory. Legal and regulatory exposure is driven by the significant volume of current legislation and regulation with which the Group has to comply, along with new legislation and regulation which needs to be reviewed, assessed and embedded into day-to-day operational and business practices across the Group as a whole. Further uncertainties arise where regulations are principles-based without the regulator defining supporting minimum standards either for the benefit of the consumer or firms. This gives rise to both the risk of retrospection from any one regulator and also to the risk of differing interpretation by individual regulators. For legal and regulatory issues there are significant reputational impacts associated with potential censure which drive the Group’s stance on appetites referred to above. There are clear accountabilities and processes in place for reviewing new and changing requirements. Each business has a nominated individual with ‘compliance oversight’ responsibility under FSA rules. The role of such individuals is to advise and assist management to ensure that each business has a control structure which creates awareness of the rules and regulations, to which the Group is subject, and to monitor and report on adherence to these rules and regulations. measurement Throughout 2008, there was ongoing development of operational risk appetites and metrics to ensure both current and potential future operational risk exposures are understood in terms of both risk and reward potential. The Group has a comprehensive and consistent operational risk management framework for the timely identification, measurement, monitoring and control of operational risk. Integral to this operational risk management framework is a hybrid approach to calculating capital to support unexpected losses. The capital model calculations are driven by internal data which captures past losses, and forward looking scenarios which value potential future risk events. External industry-wide data is collected to help with validating scenarios. The capital model outputs are used to determine the internal capital charge for the Group which is then allocated to the businesses within the Group. Following review and approval of the operational risk management framework and capital model, the FSA has granted the banking businesses within the Group an Advanced Measurement Approach (AMA) Waiver which recognises the embedding of the overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 Business review Summary of Group results Divisional results Corporate responsibility Our people risk management Five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 55 Lloyds Banking Group Annual Report and Accounts 2008 AUDITED INFORMATION finanCial soundness definition Financial soundness risk has three key risk components covering liquidity and funding risk; capital risk; and financial & prudential regulatory reporting, disclosure and tax risk. liquidity and funding Liquidity risk is defined as the risk that the Group does not have sufficient financial resources to meet its commitments when they fall due, or can secure them only at excessive cost. Funding risk is further defined as the risk that the Group does not have sufficiently stable and diverse sources of funding or the funding structure is inefficient. In recent months, the strain in the financial systems has increased substantially, leading to a significant tightening in market liquidity with the threat of a more marked deterioration in the global economic outlook and a consequent increase in recourse to liquidity schemes provided by central banks. Whilst various governments, including the UK Government, have taken substantial measures to ease the current crisis in liquidity, such as the measures announced in the UK on 8 October 2008 and 13 October 2008, there can be no assurance that these global measures will succeed in improving the funding and liquidity of the markets in which the major banks, including Lloyds Banking Group, operate. Consistent with regulatory requirements, the Banking and Insurance parts of the Group manage their liquidity independently on a standalone basis. Liquidity for all UK based banking business is managed centrally. Liquidity for International banking entities are managed on a standalone basis Liquidity risk in the Insurance business is managed at business unit level and is not considered further in this section. RISK APPETITE Liquidity and funding risk appetite for the banking businesses is set by the board and reviewed on an annual basis. It is reported through various metrics that enable the Group to manage liquidity and funding constraints. The chief executive, assisted by the group asset and liability committee and its sub-committee the senior asset and liability committee, regularly reviews performance against risk appetite. The board reviews liquidity and funding risk on a quarterly basis. ExPOSURE Liquidity exposure represents the amount of potential outflows in any future period less committed inflows. Liquidity is considered from both an internal and regulatory perspective. MEASUREMENT A series of measures are used across the Group to monitor both short and long term liquidity including: ratios, cash outflow triggers, and stress test survival period triggers. Strict criteria and limits are in place to ensure marketable securities are available as part of the portfolio of highly liquid assets. MITIGATION the Group’s balance sheet structure. Longer term is defined as having an original maturity of more than one year. The Group’s funding and liquidity position is underpinned by its significant retail deposit base, accompanied by appropriate funding from the wholesale markets. A substantial proportion of the retail deposit base is made up of customers’ current and savings accounts which, although repayable on demand, have traditionally in aggregate provided a stable source of funding. Additionally, the Group accesses the short-term wholesale markets to raise inter-bank deposits and to issue certificates of deposit and commercial paper to meet short-term obligations. The Group’s short-term money market funding is based on a qualitative analysis of the market’s capacity for the Group’s credit. The Group has developed strong relationships with certain wholesale market segments, and also has access to central banks and corporate customers, to supplement its retail deposit base. The ability to deploy assets quickly, either through the repo market or through outright sale, is also an important source of liquidity for the Group’s banking businesses. The Group holds sizeable balances of high grade marketable debt securities set out on page 172 of the financial statements which can be sold to provide, or used to secure, additional short term funding should the need arise from either market counterparties or central bank facilities (ECB, Federal Reserve, Bank of England). During the year the Group increased its stock of liquid assets by £47 billion to £63 billion (2007: £16 billion), which includes government securities, mortgage backed securities, corporate and other debt securities. MONITORING Liquidity is actively monitored at business unit and Group level at an appropriate frequency. Routine reporting is in place to senior management and through the Group’s committee structure, in particular the group asset and liability committee and the senior asset and liability committee which meet monthly. In a stress situation the level of monitoring and reporting is increased commensurate with the nature of the stress event. Liquidity policies and procedures are subject to independent oversight. Daily monitoring and control processes are in place to address both statutory and prudential liquidity requirements. In addition, the framework has two other important components: – Firstly, Lloyds Banking Group stress tests its potential cash flow mismatch position under various scenarios on an ongoing basis. The cash flow mismatch position considers on-balance sheet cash flows, commitments received and granted, and material derivative cash flows. Specifically, commitments granted include the pipeline of new business awaiting completion as well as other standby or revolving credit facilities. Behavioural adjustments are developed, evaluating how the cash flow position might change under each stress scenario to derive a stressed cash flow position. Scenarios cover both Lloyds Banking Group name specific and systemic difficulties. The scenarios and the assumptions are reviewed at least annually to gain assurance they continue to be relevant to the nature of the business. The Group mitigates the risk of a liquidity mismatch in excess of its risk appetite by managing the liquidity profile of the balance sheet through both short-term liquidity management and long-term funding strategy. Short-term liquidity management is considered from two perspectives; business as usual and crisis liquidity, both of which relate to funding in the less than one year time horizon. Longer term funding is used to manage the Group’s strategic liquidity profile which is determined by – Secondly, the Group has a contingency funding plan embedded within the Group Liquidity Policy Statement which has been designed to identify emerging liquidity concerns at an early stage, so that mitigating actions can be taken to avoid a more serious crisis developing. The information reviewed by the group executive committee, group asset and liability committee and senior asset and liability committee includes analysis set out in table 1.7. 56 Lloyds Banking Group Annual Report and Accounts 2008 RISK MANAGEMENT continued AUDITED INFORMATION taBle 1.9: residual maturity of london treasury wholesale funding as at 31 december 2008 £bn as at 31 december 2008 % As at 31 December 2007 £bn As at 31 December 2007 % Less than one year 127.8 One to two years Two to five years More than five years 5.7 18.1 14.3 77.0 3.5 10.9 8.6 107.0 5.0 11.1 8.2 81.5 3.8 8.5 6.2 total 165.9 100.0 131.3 100.0 Other Treasury operations include those businesses that are run on a standalone basis in jurisdictions outside London to support local banking businesses often in different time zones. The residual maturity profile of these operations is less than one year. taBle 1.10: reConCiliation of amounts shown aBove with the statutory BalanCe sheet 2008 Non-bank (Customer deposits) Deposits from banks Debt securities in issue and trading and other liabilities at fair value through profit or loss Subordinated liabilities total 2007 Non-bank (Customer deposits) Deposits from banks Debt securities in issue and trading and other liabilities at fair value through profit or loss Subordinated liabilities total london treasury functions £bn other treasury functions £bn repos £bn other retail £bn statutory Balance sheet £bn 48.7 27.9 21.0 13.7 – 101.2 170.9 24.9 – 66.5 73.4 9.1 15.9 165.9 1.4 45.2 London Treasury Functions £bn Other Treasury Functions £bn 39.5 28.6 18.5 9.8 – – – – 82.5 17.3 24.9 101.2 337.2 Other Retail £bn 98.6 – Statutory Balance Sheet £bn 156.6 39.1 Repos £bn – 0.7 51.3 3.5 11.9 131.3 – 31.8 – – – – 0.7 98.6 54.8 11.9 262.4 taBle 1.7: grouP BalanCe sheet assets Loans and advances to customers Wholesale assets Banking assets total assets liabilities Non-bank deposits Wholesale funding* Total Funding Total liabilities and shareholders equity * Excludes repos. 31 december 2008 £bn 31 December 2007 £bn 2008 growth % 242.7 72.5 315.2 436.0 170.9 141.4 312.3 209.8 57.7 267.5 353.3 156.6 105.1 261.7 15.7 25.6 17.8 23.4 9.1 34.5 19.3 436.0 353.3 23.4 GROUP RETAIL AND WHOLESALE FUNDING MIx Wholesale assets comprise balances arising from banking business and include loans and advances to banks, trading and other financial assets at fair value through profit and loss and available for sale assets. Non-bank deposits comprise balances arising from banking businesses and include customer accounts. The group balance sheet has grown by 23.4 per cent during the year. The funding for this has been primarily raised in the wholesale markets with customer deposit growth of £14.4 billion. Wholesale funding has been analysed between that monitored by the London Treasury operations and the Group’s overseas Treasury operations. The wholesale funding shown excludes any repo activity. The composition and quality of wholesale deposits are regularly reviewed by management and comprises deposits from corporates and government agencies that roll over on a regular basis and are reinvested. taBle 1.8: wholesale funding* as at 31 december 2008 £bn as at 31 december 2008 % As at 31 December 2007 £bn As at 31 December 2007 % Bank Non-bank Wholesale deposits Certificates of deposit Medium term notes Commercial paper Securitisation Subordinated liabilities London Treasury operations Other Treasury operations total * Table 1.8 excludes repo balances. 27.9 48.7 76.6 27.9 15.8 19.9 9.8 15.9 8.9 15.6 24.5 8.9 5.1 6.4 3.1 5.1 28.6 39.5 68.1 11.3 9.1 17.6 13.3 11.9 165.9 53.1 131.3 45.2 211.1 14.5 67.6 31.8 163.1 10.9 15.1 26.0 4.3 3.5 6.7 5.1 4.5 50.1 12.2 62.3 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 57 Lloyds Banking Group Annual Report and Accounts 2008 AUDITED INFORMATION Also a key input into the FSA’s ICG setting process (which addresses the requirements of Pillar 2 of the Basel II framework) is each bank’s Internal Capital Adequacy Assessment Process. The FSA’s approach is to monitor the available capital resources in relation to the ICG requirement. The Group has been given an ICG by the FSA and the board has also agreed a formal buffer to be maintained in addition to this requirement. Any breaches of the formal buffer must be notified to the FSA, together with proposed remedial action. No such notification has been made in 2008. The FSA has made it clear that each ICG remains a confidential matter between each bank and the FSA. In the context of the current market conditions the FSA has made further statements to explain the approach it has taken to the capital framework these include core tier 1 and tier 1 targets under stressed conditions. The Group has developed procedures meant to ensure that compliance with both current and potential future requirements are understood and that policies are aligned to its risk appetite. In addition to the regulatory framework, the Group also operates an internal capital framework. MITIGATION The Group is also able to raise equity either via a rights issue, placing or an open offer. A share placing was undertaken in September and the board also announced in October a further placing and open offer to shareholders as part of its participation in the recapitalisation of the banking sector. The Group is able to raise funds by issuing subordinated liabilities. The cost and availability of subordinated liability finance are influenced by credit ratings. A reduction in these ratings could increase the cost and could reduce market access. MONITORING Capital is actively managed at an appropriate level of frequency and regulatory ratios are a key factor in the Group’s budgeting and planning processes with updates of expected ratios reviewed regularly during the year by the Group asset and liability committee. Capital raised takes account of expected growth and currency of risk assets. Capital policies and procedures are subject to independent oversight. Regular reporting of actual and projected ratios is made to the senior asset and liability committee and to the group asset and liability committee. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 Business review Summary of Group results Divisional results Corporate responsibility Our people risk management Five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 CaPital Capital risk is defined as the risk that the Group has insufficient capital to provide a sufficient resource to absorb predetermined levels of losses or that the capital structure is inefficient. RISK APPETITE Capital risk appetite is set by the board and reported through various metrics that enable the Group to manage capital constraints and shareholder expectations. The chief executive, assisted by the group asset and liability committee, regularly reviews performance against risk appetite. The board formally reviews capital risk on an annual basis. ExPOSURE A capital exposure arises where the Group has insufficient regulatory capital resources to support its strategic objectives and plans, and to meet external stakeholder requirements and expectations. The Group’s capital management policy is focused on optimising value for shareholders. MEASUREMENT The Group’s regulatory capital is divided into tiers defined by the European Community Banking Consolidation Directive as implemented in the UK by the Financial Services Authority’s General Prudential Sourcebook. Tier 1 capital comprises mainly shareholders’ equity, tier 1 capital instruments and minority interests, after deducting goodwill, other intangible assets and 50 per cent of the net excess of expected loss over accounting provisions and certain securitisation positions. During the year the FSA has defined core tier 1 capital. Accounting equity is adjusted in accordance with FSA requirements, particularly in respect of pensions and available-for sale assets. Tier 2 capital comprises qualifying subordinated debt after deducting 50 per cent of the excess of expected loss over accounting provisions, and certain securitisation positions. The amount of qualifying tier 2 capital cannot exceed that of tier 1 capital. Total capital is reduced by deducting investments in subsidiaries and associates that are not consolidated for regulatory purposes. In the case of Lloyds TSB Group, this means that the net assets of its life assurance and general insurance businesses are excluded from its total regulatory capital. A number of limits are imposed by the FSA on the proportion of the regulatory capital base that can be made up of subordinated debt and preferred securities. The unpredictable nature of movements in the value of the investments supporting the long-term assurance funds could cause the amount of qualifying tier 2 capital to be restricted because of falling tier 1 resources. The Group seeks to ensure that even in the event of such restrictions the total capital ratio will remain adequate. The FSA sets Individual Capital Guidance (ICG) for each UK bank calibrated by references to its Capital Resources Requirement (CRR), broadly equivalent to 8 per cent of risk weighted assets and thus representing the capital required under Pillar 1 of the Basel II framework. 58 Lloyds Banking Group Annual Report and Accounts 2008 RISK MANAGEMENT continued AUDITED INFORMATION CaPital ratios (Basel ii) tier 1 Share capital and reserves Regulatory post-retirement benefit adjustments Other items Available-for-sale revaluation reserve and cash flow hedging reserve Goodwill Other deductions Core tier 1 capital Preference share capital Innovative tier 1 capital instruments* Less: restriction in amount eligible Total tier 1 capital tier 2 Undated loan capital Dated loan capital Innovative capital restricted from tier 1 Collectively assessed provisions Available-for-sale revaluation reserve in respect of equities Other deductions Total tier 2 capital Total tier 1 and tier 2 capital supervisory deductions Life and pensions businesses Other deductions Total supervisory deductions total capital risk-weighted assets (unaudited) Credit risk Market and counterparty risk Operational risk total risk-weighted assets risk asset ratios (unaudited) Core tier 1 Tier 1 Total capital 31 december 2008 £m 31 December 2007 £m 9,573 435 (108) 2,997 (2,256) (1,099) 9,542 1,966 3,169 (976) 13,701 5,189 5,091 976 21 8 (1,099) 10,186 23,887 (4,208) (550) (4,758) 19,129 £bn 149.7 8.5 12.3 170.5 5.6% 8.0% 11.2% 12,663 704 – 402 (2,358) (929) 10,482 1,589 1,474 – 13,545 4,457 3,441 – 12 12 (928) 6,994 20,539 (4,373) (491) (4,864) 15,675 £bn 127.2 5.3 10.1 142.6 7.4% 9.5% 11.0% * A firm is permitted to include innovative tier 1 capital in its tier 1 capital resources for the purposes of GENPRU1.2 (adequacy of financial resources) but is required to exclude these amounts from tier 1 for the purposes of meeting the main BIPRU firm Pillar 1 rules. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 Business review Summary of Group results Divisional results Corporate responsibility Our people risk management Five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial and Prudential regulatory rePorting, disClosure and tax The risk of reputational damage, loss of investor confidence and/or financial loss arising from the adoption of inappropriate accounting policies, ineffective controls over financial, prudential regulatory and tax reporting and the failure to disclose information on a timely basis about the Group. RISK APPETITE The risk appetite is set by the board and reviewed on an annual basis. It includes the avoidance of the need for restatement of published financial and prudential regulatory data, public disclosures about the Groups financial, including tax, performance and its legal constitution. ExPOSURE Exposure represents the sufficiency of the Group’s policies and procedures to maintain adequate books and records to support statutory, prudential and tax reporting, to present and detect financial reporting fraud and to manage the Group’s tax exposure. MITIGATION The Group maintains a system of internal controls, which are designed to be consistently applied, and to provide a reasonable assurance that transactions are recorded and undertaken in accordance with delegated authorities that permit the preparation and disclosure of financial statements, prudential regulatory reporting and tax returns in accordance with International Financial Reporting Standards, statutory and regulatory requirements. MONITORING The Group has in place a disclosure committee whose responsibility is to review all significant disclosures made by the Group and to assist the group chief executive and group finance director fulfill their responsibilities under the Listing Rules and regulations emanating from the Sarbanes-Oxley Act of 2002. A programme of work is undertaken and designed to support an annual assessment of the effectiveness of internal controls over financial reporting, in accordance with the requirements of section 404 of the US Sarbanes-Oxley Act; it also has in place an assurance mechanism over its prudential regulatory reporting; additionally, monitoring activities are designed to identify and maintain tax liabilities and to assess emerging regulation and legislation. finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 59 Lloyds Banking Group Annual Report and Accounts 2008 AUDITED INFORMATION life assuranCe Businesses At 31 December 2008, the principal subsidiary involved in the Group’s life assurance operations was Scottish Widows plc (Scottish Widows), which holds the only large With Profit Fund managed by Lloyds Banking Group. Basis of determining regulatory CaPital of the life assuranCe Businesses AVAILABLE CAPITAL RESOURCES Available capital resources represent the excess of assets over liabilities calculated in accordance with detailed regulatory rules issued by the FSA. Different rules apply depending on the nature of the fund, as detailed below. statutory basis. Assets are generally valued on a basis consistent with that used for accounting purposes (with the exception that, in certain cases, the value attributed to assets is limited) and which follows a market value approach where possible. Liabilities are calculated using a projection of future cash flows after making prudent assumptions about matters such as investment return, expenses and mortality. Discount rates used to value the liabilities are set with reference to the risk adjusted yields on the underlying assets in accordance with the FSA rules. Other assumptions are based on recent actual experience, supplemented by industry information where appropriate. The assessment of liabilities does not include future bonuses for with-profits policies that are at the discretion of management, but does include a value for policyholder options likely to be exercised. ‘realistic’ basis. The FSA requires each life assurance company which contains a With Profit Fund in excess of £500 million, including Scottish Widows, to carry out a ‘realistic’ valuation of that fund. The word ‘realistic’ in this context reflects the terminology used for reporting to the FSA and is an assessment of the financial position of a with-profits fund calculated under a prescribed methodology. The valuation of with-profits assets in a with-profits fund on a realistic basis differs from the valuation on a statutory basis as, in respect of non- profits business written in a with-profits fund (a relatively small amount of business in the case of Scottish Widows), it includes the present value of the anticipated future release of the prudent margins for adverse deviation. The realistic valuation uses the market value of assets without the limit affecting the statutory basis noted above. The realistic valuation of liabilities is carried out using a stochastic simulation model which values liabilities on a basis consistent with tradable market option contracts (a ‘market-consistent’ basis). The model takes account of policyholder behaviour on a best-estimate basis and includes an adjustment to reflect future uncertainties where the exercise of options by policyholders might increase liabilities. Further details regarding the stochastic simulation model are given in the section entitled ‘Options and guarantees’ on page 64. 60 Lloyds Banking Group Annual Report and Accounts 2008 RISK MANAGEMENT continued AUDITED INFORMATION REGULATORy CAPITAL REQUIREMENTS Each life assurance company must retain sufficient capital to meet the regulatory capital requirements mandated by the FSA; the basis of calculating the regulatory capital requirement is given below. Except for Scottish Widows, the regulatory capital requirement is a combination of amounts held in respect of actuarial reserves, sums at risk and maintenance expenses (the Long-Term Insurance Capital Requirement) and amounts required to cover various stress tests. The regulatory capital requirement is deducted from the available capital resources to give ‘statutory excess capital’. For Scottish Widows, no amount is required to cover the impact of stress tests on the actuarial reserves. However, a further test is required in respect of the With Profit Fund, which compares the level of ‘realistic excess capital’ to the ‘statutory excess capital’ of the With Profit Fund. In circumstances where the ‘realistic excess capital’ position is less than ‘statutory excess capital’, the Company is required to hold additional capital to cover the shortfall, but only to the extent it exceeds the value, calculated in a prescribed way, of internal transfers from the With Profit Fund. Any additional capital requirement under this test is referred to as the With -Profits Insurance Capital Component. The ‘realistic excess capital’ is calculated as the difference between realistic assets and realistic liabilities of the With Profit Fund with a further deduction to cover various stress tests. The determination of realistic liabilities of the With Profit Fund in respect of Scottish Widows includes the value of internal transfers expected to be made from the With Profit Fund to the Non-Participating Fund of Scottish Widows. These internal transfers include charges on policies where the associated costs are borne by the Non-Participating Fund. The With-Profits Insurance Capital Component is reduced by the value, calculated in the stress test scenario, of these internal transfers, but only to the extent that credit has not been taken for the value of these charges in deriving actuarial reserves for the Non-Participating Fund. CaPital statement The following table provides more detail regarding the sources of capital in the life assurance business. The figures quoted are based on management’s current expectations pending completion of the annual financial return to the FSA. The figures allow for an anticipated transfer of £110 million from the Long Term Fund to the Shareholder Fund as at 31 December 2008. with Profit fund £m non- Participating fund £m total long term fund £m shareholder fund £m as at 31 december 2008 Assets attributable to the shareholder held outside the long-term funds Assets attributable to the shareholder held within the long-term funds Total shareholders’ funds Adjustments onto a regulatory basis: Life assurance business Unallocated surplus within insurance business Adjustments to remove differences between IFRS and regulatory valuation of assets and liabilities Adjustment to include estimated ‘realistic’ liabilities payable to the shareholder Adjustment to replace ‘realistic’ liabilities with statutory liabilities Adjustment to remove the value of future profits recognised in respect of non-participating contracts written in the With Profit Fund Qualifying loan capital available capital resources – – – 293 – (406) 811 (49) – 649 total £m 862 2,562 3,424 – – 2,562 2,562 2,562 2,562 862 – 862 – (708) – – – – 293 (708) (406) 811 (49) – 1,854 2,503 – 293 (581) (1,289) – – – 604 885 (406) 811 (49) 604 3,388 The figures shown above for available capital resources within the insurance business relate to Scottish Widows plc only. The estimated total additional resources relating to the other life assurance subsidiaries within the Group as at 31 December 2008 are £310 million. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 Business review Summary of Group results Divisional results Corporate responsibility Our people risk management Five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 61 Lloyds Banking Group Annual Report and Accounts 2008 AUDITED INFORMATION The comparative position as at 31 December 2007 was as follows (again, relating to Scottish Widows plc only): With Profit Fund £m Non- Participating Fund £m Total Long Term Fund £m Shareholder Fund £m as at 31 december 2007 Assets attributable to the shareholder held outside the long-term funds Assets attributable to the shareholder held within the long-term funds Total shareholders’ funds Adjustments onto a regulatory basis: Life assurance business Unallocated surplus within insurance business Adjustments to remove differences between IFRS and regulatory valuation of assets and liabilities Adjustment to include estimated ‘realistic’ liabilities payable to the shareholder Adjustment to replace ‘realistic’ liabilities with statutory liabilities Adjustment to remove the value of future profits recognised in respect of non-participating contracts written in the With Profit Fund Qualifying loan capital available capital resources – – – 569 – (634) 3,695 (23) – 3,607 – 2,343 2,343 – (435) – – – – 1,908 – 2,343 2,343 569 (435) (634) 3,695 (23) – 5,515 Total £m 956 2,343 3,299 956 – 956 – 569 (602) (1,037) – – – 541 895 (634) 3,695 (23) 541 6,410 FORMAL INTRA-GROUP CAPITAL ARRANGEMENTS Scottish Widows has a formal arrangement with one of its subsidiary undertakings, Scottish Widows Unit Funds Limited, whereby the subsidiary company can draw down capital from Scottish Widows to finance new business which is reinsured from the parent to its subsidiary. Scottish Widows has also provided subordinated loans to its fellow group undertaking Scottish Widows Bank plc. CONSTRAINTS OVER AVAILABLE CAPITAL RESOURCES Scottish Widows was created following the demutualisation of Scottish Widows Fund and Life Assurance Society in 2000. The terms of the demutualisation are governed by a Court-approved Scheme of Transfer (the ‘Scheme’) which, inter alia, created a With Profit Fund and a Non-Participating Fund and established protected capital support for the with-profits policyholders in existence at the date of demutualisation. Much of that capital support is held in the Non-Participating Fund and, as such, the capital held in that fund is subject to the constraints noted below. requirement to maintain a support account: The Scheme requires the maintenance of a ‘Support Account’ within the Non-Participating Fund. The quantum of the Support Account is calculated with reference to the value of assets backing current with-profits policies which also existed at the date of demutualisation and must be maintained until the value of these assets reaches a minimum level. Assets can only be transferred from the Non-Participating Fund if the value of the remaining assets in the fund exceeds the value of the Support Account. Scottish Widows has obtained from the FSA permission to include the value of the Support Account in assessing the realistic value of assets available to the With Profit Fund. At 31 December 2008, the estimated value of surplus admissible assets in the Non-Participating Fund was £1,854 million (31 December 2007: £1,908 million) and the estimated value of the Support Account was £200 million (31 December 2007: £827 million). further support account: The Further Support Account is an extra tier of capital support for the with-profits policies in existence at the date of demutualisation. The Scheme requires that assets can only be transferred from the Non-Participating Fund if the economic value of the remaining assets in the fund exceeds the aggregate of the Support Account and Further Support Account. Unlike the Support Account test, the economic value used for this test includes both admissible assets and the present value of future profits of business written in the Non-Participating Fund or by any subsidiaries of that fund. The balance of the Further Support Account is expected to reduce to nil by the year 2030. At 31 December 2008, the estimated net economic value of the Non-Participating Fund and its subsidiaries for the purposes of this test was £3,603 million (31 December 2007: £4,026 million) and the estimated combined value of the Support Account and Further Support Account was £2,584 million (31 December 2007: £2,834 million). other restrictions in the non-Participating fund: In addition to the policies which existed at the date of demutualisation, the With Profit Fund includes policies which have been written since that date. As a result of statements made to policyholders that investment policy will usually be the same for both types of business, there is an implicit requirement to hold additional regulatory assets in respect of the business written after demutualisation. The estimated amount required to provide such support at 31 December 2008 is £162 million (31 December 2007: £183 million). Scottish Widows has obtained from the FSA permission to include the value of this support in assessing the realistic value of assets available to the With Profit Fund. There is a further test requiring that no amounts can be transferred from the Non- Participating Fund of Scottish Widows unless there are sufficient assets within the Long Term Fund to meet both policyholders’ reasonable expectations in light of liabilities in force at a year end and the new business expected to be written over the following year. 62 Lloyds Banking Group Annual Report and Accounts 2008 RISK MANAGEMENT continued AUDITED INFORMATION MOVEMENTS IN REGULATORy CAPITAL The movements in Scottish Widows plc’s available capital resources can be analysed as follows: As at 31 December 2007 Changes in assumptions used to measure life assurance liabilities Dividends and capital transfers Changes in regulatory requirements New business and other factors as at 31 december 2008 With Profit Fund £m 3,607 15 – – (2,973) 649 Non- Participating Fund £m 1,908 (29) (110) – 85 1,854 Total Long Term Fund £m 5,515 (14) (110) – (2,888) 2,503 Shareholder Fund £m 895 – (110) – 100 885 Total £m 6,410 (14) (220) – (2,788) 3,388 The primary reasons for the movement in total available capital resources during the year are as follows: SHAREHOLDER FUND During 2008, dividends of £220 million were paid. WITH PROFIT FUND Available capital in the With Profit Fund has decreased from £3,607 million at 31 December 2007 to an estimated £649 million at 31 December 2008. The key driver is investment market performance. NON-PARTICIPATING FUND Available capital in the Non-Participating Fund has decreased from £1,908 million at 31 December 2007 to an estimated £1,854 million at 31 December 2008. This is primarily a result of the anticipated transfer from the Non-Participating Fund to the Shareholder Fund at the year end of £110 million, and market movements offset by the return generated from the business. finanCial information CalCulated on a ‘realistiC’ Basis The estimated financial position of the With Profit Fund of Scottish Widows at 31 December 2008, calculated on a ‘realistic’ basis, is given in the following table, in the form reported to the FSA. As a result of the capital support arrangements, it is considered appropriate to also disclose the estimated ‘realistic’ financial position of the Long Term Fund of Scottish Widows as a whole, which consists of both the With Profit Fund and the Non-Participating Fund. Realistic value of assets of fund Support arrangement assets Realistic value of assets available to the fund Realistic value of liabilities of fund working capital for fund working capital ratio for fund 31 december 2008 31 December 2007 with Profit fund £m 13,155 362 13,517 (13,268) 249 1.8% long term fund £m 16,665 – 16,665 (13,062) 3,603 21.6% With Profit Fund £m 16,793 1,010 17,803 (16,858) 945 5.3% Long Term Fund £m 21,005 – 21,005 (16,979) 4,026 19.2% overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 Business review Summary of Group results Divisional results Corporate responsibility Our people risk management Five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 63 Lloyds Banking Group Annual Report and Accounts 2008 AUDITED INFORMATION The financial information calculated on a ‘realistic’ basis reconciles to the capital statement as follows: 31 december 2008 31 December 2007 Available regulatory capital Support arrangement assets Adjustments to replace statutory liabilities with ‘realistic’ liabilities Adjustments to include the value of future profits recognised in respect of Non-Participating business written in the With Profit Fund Recognition of future profits allowable for ‘realistic’ capital purposes Analysis of policyholder liabilities in respect of the Group’s life assurance business: as at 31 december 2008 With Profit Fund liabilities Unit-linked business (excluding that accounted for as investment contracts) Other life assurance business Insurance and participating investment contract liabilities Non-participating investment contract liabilities total policyholder liabilities as at 31 december 2007 With Profit Fund liabilities Unit-linked business (excluding that accounted for as investment contracts) Other life assurance business Insurance and participating investment contract liabilities Non-participating investment contract liabilities total policyholder liabilities with Profit fund £m long term fund £m 649 362 (811) 49 – 249 2,503 – (779) 49 1,830 3,603 scottish widows plc with Profit fund (in accordance with frs 27) £m 13,293 – – 13,293 – 13,293 Scottish Widows plc With Profit Fund (in accordance with FRS 27) £m 16,404 – – 16,404 – 16,404 With Profit Fund £m 3,607 1,010 (3,695) 23 – 945 other long-term funds £m – 11,480 8,364 19,844 14,243 34,087 Other long-term funds £m – 14,282 6,714 20,996 18,197 39,193 Long Term Fund £m 5,515 – (3,575) 23 2,063 4,026 total life business £m 13,293 11,480 8,364 33,137 14,243 47,380 Total life business £m 16,404 14,282 6,714 37,400 18,197 55,597 64 Lloyds Banking Group Annual Report and Accounts 2008 RISK MANAGEMENT continued AUDITED INFORMATION CaPital sensitivities SHAREHOLDERS’ FUNDS Shareholders’ funds outside the long-term business fund, other than those used to match regulatory requirements, are mainly invested in assets that are less sensitive to market conditions. WITH PROFIT FUND The with-profits realistic liabilities and the available capital for the With Profit Fund are sensitive to both market conditions and changes to a number of non-economic assumptions that affect the valuation of the liabilities of the fund. The available capital resources (and capital requirements) are sensitive to the level of the stock market, with the position worsening at low stock market levels as a result of the guarantees to policyholders increasing in value. However, the exposure to guaranteed annuity options increases under rising stock market levels. An increase in the level of equity volatility implied by the market cost of equity put options also increases the market consistent value of the options given to policyholders and worsens the capital position. The most critical non-economic assumptions are the level of take-up of options inherent in the contracts (higher take-up rates are more onerous), mortality rates (lower mortality rates are generally more onerous) and lapses prior to dates at which a guarantee would apply (lower lapse rates are generally more onerous where guarantees are in the money). The sensitivity of the capital position and capital requirements of the With Profit Fund is partly mitigated by the actions that can be taken by management. OTHER LONG-TERM FUNDS Outside the With Profit Fund, assets backing actuarial reserves in respect of policyholder liabilities are invested so that the values of the assets and liabilities are broadly matched. The most critical non-economic assumptions are mortality rates in respect of annuity business written (lower mortality rates are more onerous). Reinsurance arrangements are in place to reduce the Group’s exposure to deteriorating mortality rates in respect of life assurance contracts. In addition, poor cost control would gradually depreciate the available capital and lead to an increase in the valuation of the liabilities (through an increased allowance for future costs). Assets held in excess of those backing actuarial reserves are invested across a range of investment categories including fixed interest securities, equities, properties and cash. The mix of investments is determined in line with the policy of Lloyds Banking Group to minimise the working capital (defined as available capital less minimum required capital) required to ensure all capital requirements continue to be met under a range of stress tests. oPtions and guarantees The Group has sold insurance products that contain options and guarantees, both within the With Profit Fund and in other funds. OPTIONS AND GUARANTEES WITHIN THE WITH PROFIT FUND The most significant options and guarantees provided from within the With Profit Fund are in respect of guaranteed minimum cash benefits on death, maturity, retirement or certain policy anniversaries, and guaranteed annuity options on retirement for certain pension policies. For those policies written pre-demutualisation containing potentially valuable options and guarantees, under the terms of the Scheme a separate memorandum account was set up within the With Profit Fund of Scottish Widows called the Additional Account which is available, inter alia, to meet any additional costs of providing guaranteed benefits in respect of those policies. The Additional Account had a value at 31 December 2008 of £2.0 billion (2007: £1.7 billion). The eventual cost of providing benefits on policies written both pre and post demutualisation is dependent upon a large number of variables, including future interest rates and equity values, demographic factors, such as mortality, and the proportion of policyholders who seek to exercise their options. The ultimate cost will therefore not be known for many years. As noted above, under the realistic capital regime of the FSA, the liabilities of the With Profit Fund are valued using a market-consistent stochastic simulation model. This model is used in order to place a value on the options and guarantees which captures both their intrinsic value and their time value. The most significant economic assumptions included in the model are: – Risk-free yield. The risk-free yield is defined as spot yields derived from the UK gilt yield curve. – Investment volatility. The calibration of the stochastic simulation model uses implied volatilities of derivatives where possible, or historical observed volatility where it is not possible to observe meaningful prices. For example, as at 31 December 2008, the 10 year equity-implied at-the-money assumption was set at 34.6 per cent (31 December 2007: 25.5 per cent). The assumption for property volatility was 15 per cent (31 December 2007: 15 per cent). The volatility of interest rates has been calibrated to the implied volatility of swaptions which was broadly 16 per cent (31 December 2007: 11 per cent). The model includes a matrix of the correlations between each of the underlying modelled asset types. The correlations used are consistent with long-term historical returns. The most significant non-economic assumptions included in the model are management actions (in respect of investment policy and bonus rates), guaranteed annuity option take-up rates and assumptions regarding persistency (both of which are based on recent actual experience and include an adjustment to reflect future uncertainties where the exercise of options by policyholders might increase liabilities), and assumptions regarding mortality (which are based on recent actual experience and industry tables). OPTIONS AND GUARANTEES OUTSIDE THE WITH PROFIT FUND OF SCOTTISH WIDOWS Certain personal pension policyholders, for whom reinstatement to their occupational pension scheme was not an option, have been given a guarantee that their pension and other benefits will correspond in value to the benefits of the relevant occupational pension scheme. The key assumptions affecting the ultimate value of the guarantee are future salary growth, gilt yields at retirement, annuitant mortality at retirement, marital status at retirement and future investment returns. There is currently a provision, calculated on a deterministic basis, of £65 million (31 December 2007: £65 million) in respect of those guarantees. If future salary growth were 0.5 per cent per annum greater than assumed, the liability would increase by some £3 million. If yields were 0.5 per cent lower than assumed, the liability would increase by some £11 million. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends Business review Summary of Group results Divisional results Corporate responsibility Our people Risk management 1 2 4 6 8 10 18 36 40 42 five year financial summary 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 65 Lloyds Banking Group Annual Report and Accounts 2008 FIVE yEAR FINANCIAL SUMMARy The financial information set out in the table below has been derived from the annual report and accounts of Lloyds Banking Group plc for each of the past four years. 2005 was the first year in which the annual report and accounts were prepared under International Financial Reporting Standards (IFRS). 2004 figures have been derived from the comparative information disclosed in the 2005 annual report and accounts. Under IFRS, accounting standards dealing with financial instruments (IAS 32 and IAS 39) and insurance (IFRS 4 and FRS 27) were applied only from 1 January 2005. To aid comparison, IFRS balance sheet data is presented as at 1 January 2005 rather than 31 December 2004; the 2004 IFRS income statement data is not comparable to the data for the other years presented. The financial statements for each of the years presented have been audited by PricewaterhouseCoopers LLP, independent auditors. income statement data for the year ended 31 december (£m) Total income, net of insurance claims Operating expenses Trading surplus Impairment Profit before tax Profit for the year Profit for the year attributable to equity shareholders Total dividend for the year1 Balance sheet data (£m) Share capital Shareholders’ equity Net asset value per ordinary share Customer accounts Subordinated liabilities Loans and advances to customers Total assets share information Basic earnings per ordinary share Diluted earnings per ordinary share Total dividend per ordinary share1 Market price (year end) Number of shareholders (thousands) Number of ordinary shares in issue (millions)2 financial ratios (%)3 Dividend payout ratio Post-tax return on average shareholders’ equity Cost:income ratio4 Capital ratios (%)5 Total capital Tier 1 capital 2008 2007 2006 2005 2004 9,872 (6,053) 3,819 (3,012) 807 845 819 648 10,706 (5,567) 5,139 (1,796) 4,000 3,321 3,289 2,026 11,104 (5,301) 5,803 (1,555) 4,248 2,907 2,803 1,927 10,540 (5,471) 5,069 (1,299) 3,820 2,555 2,493 1,915 9,661 (5,297) 4,364 (866) 3,477 2,459 2,392 1,914 31 december 2008 31 December 2007 31 December 2006 31 December 2005 1 January 2005 1,513 9,393 155p 170,938 17,256 242,735 436,033 2008 14.3p 14.2p 11.4p 126.0p 824 5,973 2008 79.1 7.4 61.3 1,432 12,141 212p 156,555 11,958 209,814 353,346 2007 58.3p 57.9p 35.9p 472.0p 814 5,648 2007 61.6 28.2 52.0 1,429 11,155 195p 139,342 12,072 188,285 343,598 2006 49.9p 49.5p 34.2p 571.5p 870 5,638 2006 68.7 26.6 47.7 1,420 10,195 180p 131,070 12,402 174,944 309,754 2005 44.6p 44.2p 34.2p 488.5p 920 5,603 2005 76.8 25.6 51.9 1,419 9,489 167p 126,349 11,211 161,162 292,854 2004 42.8p 42.5p 34.2p 473p 953 5,596 2004 80.0 22.8 54.8 31 december 2008 31 December 2007 31 December 2006 31 December 2005 1 January 2005 11.2 8.0 11.0 8.1 10.7 8.2 10.9 7.9 10.1 8.2 1 2 3 4 5 Annual dividends comprise both interim and estimated final dividend payments. Under IFRS, the total dividend for the year represents the interim dividend paid during the year and the final dividend which will be paid and accounted for during the following year. This figure excludes 79 million limited voting ordinary shares. Averages are calculated on a monthly basis from the consolidated financial data of Lloyds Banking Group. The cost:income ratio is calculated as total operating expenses as a percentage of total income (net of insurance claims). Capital ratios for 2008 are in accordance with Basel II requirements; ratios for 2007 and earlier years reflect Basel I. 66 Lloyds Banking Group Annual Report and Accounts 2008 THE BOARD NON-EXECUTIVE DIRECTORS Sir Victor Blank Chairman Wolfgang C G Berndt Independent director Ewan Brown cbe frse Senior Independent director (retiring at the AGM in 2009) Jan P du Plessis Independent director Chairman of the nomination and risk oversight committees and a member of the remuneration committee Joined the board in 2006 as deputy chairman and became chairman in May 2006. Former partner in Clifford-Turner (now Clifford Chance) from 1969 to 1981 and chairman and chief executive of Charterhouse until 1997. Director of The Royal Bank of Scotland from 1985 to 1993 and of GUS from 1993 to 2006 (chairman from 2000). Chairman of Trinity Mirror from 1999 to 2006. A member of the Financial Reporting Council from 2002 to 2007 and a member of the Council of Oxford University from 2000 to 2007. A senior adviser to the Texas Pacific Group and appointed by the Prime Minister as a Business ambassador. Chairs two charities, WellBeing of Women and UJS Hillel, as well as the Council of University College School. Aged 66 Member of the nomination committee and chairman of the remuneration committee Member of the audit and risk oversight committees Joined the board in 2003. Joined Procter and Gamble in 1967 and held a number of senior and general management appointments in Europe, South America and North America, before retiring in 2001. A non-executive director of Cadbury, GfK AG and MIBA AG. Aged 66 Joined the board in 1999 and was chairman of Lloyds TSB Scotland until May 2008. Joined Noble Grossart in 1969 and was an executive director of that company until December 2003. A non-executive director of Noble Grossart and Stagecoach Group, chairman of Creative Scotland 2009, senior governor of the Court of the University of St Andrews and vice chairman of the Edinburgh International Festival. A former chairman of tie and non-executive director of John Wood Group. Aged 66 Chairman of the audit committee and a member of the nomination and risk oversight committees Joined the board in 2005. Chairman of British American Tobacco. Held a number of senior and general management appointments in Rembrandt Group from 1981, before joining Compagnie Financière Richemont as group finance director in 1988, a position he held until 2004. A non-executive director of Rio Tinto and Marks and Spencer Group. A former chairman of RHM from 2005 to 2007 and group finance director of Rothmans International from 1990 to 1995. Aged 55 Sir Julian Horn-Smith Independent director Lord Leitch Independent director Sir David Manning gcmg cvo Independent director Carolyn J McCall obe Independent director Member of the remuneration committee Joined the board on 1 October 2008. Appointed group chief executive of Guardian Media Group in 2006 having joined that organisation in 1986 and held a number of senior and general management appointments before becoming a director in 2000. Chair of Opportunity Now and a director of Business in the Community. Aged 47 Member of the nomination, remuneration and risk oversight committees Member of the audit, nomination and risk oversight committees Member of the nomination, remuneration and risk oversight committees Joined the board in 2005. Held a number of senior and general management appointments in Vodafone from 1984 to 2006 including a directorship of that company from 1996 and deputy chief executive officer from 2005. Previously held positions in Rediffusion from 1972 to 1978, Philips from 1978 to 1982 and Mars GB from 1982 to 1984. A non-executive director of Digicel Group, a member of the Altimo International advisory board and a senior adviser to UBS in relation to the global telecommunications sector. A former chairman of The Sage Group. Aged 60 Joined the board in 2005. Appointed chairman of Scottish Widows in 2007. Held a number of senior and general management appointments in Allied Dunbar, Eagle Star and Threadneedle Asset Management before the merger of Zurich Group and British American Tobacco’s financial services businesses in 1998. Subsequently served as chairman and chief executive officer of Zurich Financial Services United Kingdom, Ireland, Southern Africa and Asia Pacific, until his retirement in 2004. Chairman of the Government’s Review of Skills (published in December 2006) and deputy chairman of the Commonwealth Education Fund. Chairman of BUPA and Intrinsic Financial Services and a non-executive director of Paternoster. Former chairman of the National Employment Panel. Aged 61 Joined the board on 1 May 2008. Entered the Foreign and Commonwealth Office in 1972 and held senior appointments, including HM ambassador to Israel between 1995 and 1998, foreign policy adviser to the Prime Minister from 2001 to 2003 and HM ambassador to the USA from 2003 to 2007. A non-executive director of BG Group and Lockheed Martin UK Holdings. Aged 59 NON-EXECUTIVE DIRECTORS JOINING THE BOARD T Timothy Ryan, Jr Independent director and member of the audit and risk oversight committees (from 1 March 2009) Anthony Watson cbe Independent director (from 2 April 2009) President and chief executive of the Securities Industry and Financial Markets Association. Held a number of senior appointments in JP Morgan Chase from 1993 to 2008 including vice chairman, financial institutions and governments, from 2005. A director of the US-Japan Foundation and the International Foundation of Electoral Systems and a member of the Global Markets Advisory Committee for the National Intelligence Council. A former director in the Office of Thrift Supervision, US Department of the Treasury and Koram Bank. Aged 63 Previously chief executive of Hermes Pensions Management. Held a number of senior appointments in AMP Asset Management from 1991 to 1998. Retiring as chairman of the Strategic Investment Board (Northern Ireland) at the end of March 2009. A non-executive director of Hammerson, Vodafone and Witan Investment Trust and chairman of Marks and Spencer Pension Trust, Asian Infrastructure Fund and Lincoln’s Inn investment committee. A former chairman of MEPC and a former member of the Financial Reporting Council. Aged 63 OVERVIEW Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 BUSINESS REVIEW Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 GOVERNANCE The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 FINANCIAL STATEMENTS SHAREHOLDER INFORMATION Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 67 Lloyds Banking Group Annual Report and Accounts 2008 EXECUTIVE DIRECTORS Philip N Green Independent director J Eric Daniels Group Chief Executive Member of the audit and remuneration committees Joined the board in May 2007. Appointed chief executive of United Utilities in 2006. Former chief executive of Royal P&O Nedlloyd from 2003 to 2005. Previously held senior positions in DHL from 1990 to 1999, becoming chief operating officer for Europe and Africa in 1994, and the Reuters Group from 1999 to 2003, becoming chief operating officer in 2001. A director of Business in the Community and the UK Commission for Employment and Skills. A trustee of the Philharmonia Orchestra. Aged 55 Joined the board in 2001 as group executive director, UK retail banking before his appointment as group chief executive in June 2003. Served with Citibank from 1975 and held a number of senior and general management appointments in the USA, South America and Europe before becoming chief operating officer of Citibank Consumer Bank in 1998. Following the Citibank/ Travelers merger in 1998, he was chairman and chief executive officer of Travelers Life and Annuity until 2000. Chairman and chief executive officer of Zona Financiera from 2000 to 2001. A non-executive director of BT Group. Aged 57 Archie G Kane Group Executive Director Insurance G Truett Tate Group Executive Director Wholesale Joined the Group in 1986 and held a number of senior and general management appointments before being appointed to the board in 2000, as group executive director, IT and operations. Appointed group executive director, insurance and investments in October 2003. After some 10 years in the accountancy profession, joined General Telephone & Electronics Corporation in 1980, serving as finance director in the UK from 1983 to 1985. Chairman of the Association of British Insurers and a member of the Chancellor’s Financial Services Global Competitiveness Group, The Takeover Panel and the Chancellor’s Insurance Industry Working Group. Aged 56 Joined the Group in 2003 as managing director, corporate banking before being appointed to the board in 2004. Served with Citigroup from 1972 to 1999, where he held a number of senior and general management appointments in the USA, South America, Asia and Europe. He was president and chief executive officer of eCharge Corporation from 1999 to 2001 and co-founder and vice chairman of the board of Chase Cost Management Inc from 1996 to 2003. A non-executive director of BritishAmerican Business Inc. A member of the fund-raising board of the National Society for the Prevention of Cruelty to Children, a director of Business in the Community and a director and trustee of In Kind Direct. Aged 58 Martin A Scicluna Independent director Tim J W Tookey Group Finance Director Member of the audit and risk oversight committees Joined the board on 1 September 2008. Chairman of Deloitte UK from 1995 to 2007 and a member of the board from 1991 to 2007. Joined the firm in 1973 and was a partner from 1982 until he retired in 2008. A member of the board of directors of Deloitte Touche Tohmatsu from 1999 to 2007. A non-executive director of Great Portland Estates. A member of the council of Leeds University and a governor of Berkhamsted School. Aged 58 Joined the Group in 2006 as deputy group finance director, before being appointed acting group finance director in April 2008. Appointed to the board in October 2008 as group finance director. Previously finance director for the UK and Europe at Prudential from 2002 to 2006 and group finance director of Heath Lambert Group from 1996 to 2002. Prior to that, he spent 11 years at KPMG. Aged 46 Helen A Weir cbe Group Executive Director Retail Joined the board in 2004 as group finance director. Appointed as group executive director, UK retail banking in April 2008. Group finance director of Kingfisher from 2000 to 2004. Previously finance director of B&Q from 1997, having joined that company in 1995, and held a senior position at McKinsey & Co from 1990 to 1995. Began her career at Unilever in 1983. A non-executive director of Royal Mail Holdings. A member of the Said Business School Advisory Board and a former member of the Accounting Standards Board. Aged 46 Harry F Baines Company Secretary and General Counsel 68 Lloyds Banking Group Annual Report and Accounts 2008 DIRECTORS’ REPORT RESULTS AND DIVIDENDS The consolidated income statement shows a profit attributable to equity shareholders for the year ended 31 December 2008 of £819 million. An interim dividend of 11.4p per ordinary share was paid on 1 October 2008. This dividend absorbed £648 million. PRINCIPAL ACTIVITIES, BUSINESS REVIEW, FUTURE DEVELOPMENTS AND FINANCIAL RISK MANAGEMENT OBJECTIVES AND POLICIES The Company is a holding company and its subsidiary undertakings provide a wide range of banking and financial services through branches and offices in the UK and overseas. A review of the development and performance of the business during the financial year and an indication of the likely future developments are given on pages 2 to 64. Key performance indicators are shown on page 11. Information regarding the financial risk management objectives and policies of the Company and its subsidiary undertakings, in relation to the use of financial instruments, is given on pages 42 to 64 and in note 49 on pages 165 to 177. GROUP STRUCTURE On 16 January 2009, Lloyds TSB Group plc changed its name to Lloyds Banking Group plc, following the acquisition of HBOS plc. POST BALANCE SHEET EVENTS Details are given in note 52 on page 181. DIRECTORS Biographical details of directors are shown on pages 66 and 67. Particulars of their emoluments and interests in shares in the Company are given on pages 74 to 95. Ms T A Dial and Mr M E Fairey left the board on 18 April 2008 and 30 June 2008, respectively. Mr Ewan Brown will retire at the annual general meeting in 2009. Sir David Manning joined the board on 1 May 2008. Mr M A Scicluna, Ms C J McCall and Mr T J W Tookey joined the board on 1 September 2008, 1 October 2008 and 30 October 2008, respectively, and Mr T T Ryan and Mr Anthony Watson have been appointed directors from 1 March 2009 and 2 April 2009, respectively. In accordance with the articles of association, they offer themselves for election at the annual general meeting. Sir Victor Blank, Mr A G Kane and Lord Leitch retire at the annual general meeting and offer themselves for re-election. DIRECTORS’ INDEMNITIES The directors, including two former directors who left during the year, have entered into individual contracts of indemnity with the Company which constituted ‘qualifying third party indemnity provisions’ and ‘qualifying pension scheme indemnity provisions’ for the purposes of the Companies Act 2006. These contracts were in force during the whole of the financial year or from the date of appointment in respect of the four directors who joined the board in 2008. The contracts remain in force and are available for inspection at the Company’s registered office. SHARE CAPITAL Information about share capital is shown in note 41 on pages 152 to 154; in note 6 of the parent company accounts, included within this document, on page 187; in the corporate governance report on pages 70 to 73; and in the directors’ remuneration report on pages 74 to 95. It is intended to issue ordinary shares by way of a capitalisation issue in May 2009, at the rate of one share for every 40 shares held. CHANGE OF CONTROL The Company is party to significant contracts that are subject to change of control provisions in the event of a takeover bid as follows: The Company is party to a deed of covenant with each of the four Lloyds TSB Foundations (the ‘Foundations’) which hold limited voting shares in the Company (the limited voting shares are further described in note 41 on page 153). Under the terms of the deeds of covenant, the Company makes an annual payment to each of the Foundations. In the event of a successful offer for more than 50 per cent of the issued ordinary share capital of the Company, each limited voting share would convert to an ordinary share under the terms of the Company’s articles of association. The payment obligation under the deeds of covenant would come to an end one year following the conversion of the limited voting shares. OVERVIEW Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 BUSINESS REVIEW Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 GOVERNANCE The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 FINANCIAL STATEMENTS SHAREHOLDER INFORMATION Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 69 Lloyds Banking Group Annual Report and Accounts 2008 EMPLOyEES Lloyds Banking Group is committed to providing employment practices and policies which recognise the diversity of our workforce and ensure equality for employees regardless of sex, race, disability, age, sexual orientation or religious belief. In the UK, Lloyds Banking Group belongs to the major employer groups campaigning for equality for the above groups of staff, including Employers’ Forum on Disability, Employers’ Forum on Age, Stonewall and the Race for Opportunity. Our involvement with these organisations enables us to identify and implement best practice for our staff. Employees are kept closely involved in major changes affecting them through such measures as team meetings, briefings, internal communications and opinion surveys. There are well established procedures, including regular meetings with recognised unions, to ensure that the views of employees are taken into account in reaching decisions. Schemes offering share options or the acquisition of shares are available for most staff, to encourage their financial involvement in Lloyds Banking Group. DONATIONS The income statement includes a charge for charitable donations totalling £29,603,000 in 2008 (2007: £37,463,000), including £28,997,000 (2007: £37,183,000) which will be paid under the deeds of covenant to the four Lloyds TSB Foundations during 2009. POLICy AND PRACTICE ON PAyMENT OF CREDITORS The Company follows ‘The Better Payment Practice Code’ published by the Department of Business, Enterprise and Regulatory Reform (BERR), regarding the making of payments to suppliers. A copy of the code and information about it may be obtained from the BERR as shown on page 191. The Company’s policy is to agree terms of payment with suppliers and these normally provide for settlement within 30 days after the date of the invoice, except where other arrangements have been negotiated. It is the policy of the Company to abide by the agreed terms of payment, provided the supplier performs according to the terms of the contract. The number of days required to be shown in this report, to comply with the provisions of the Companies Act 1985, is 23. This bears the same proportion to the number of days in the year as the aggregate of the amounts owed to trade creditors at 31 December 2008 bears to the aggregate of the amounts invoiced by suppliers during the year. DIRECTORS’ RESPONSIBILITy STATEMENT Each of the current directors, whose names and functions are shown on pages 66 and 67 of this annual report, confirms that, to the best of his or her knowledge: – the financial statements, prepared in accordance with International Financial Reporting Standards as adopted by the European Union, give a true and fair view of the assets, liabilities, financial position and profit or loss of the Company and Group; and – the management report contained in the business review includes a fair review of the development and performance of the business and the position of the Company and Group, together with a description of the principal risks and uncertainties they face. AUDITORS AND AUDIT INFORMATION Each person who is a director at the date of approval of this report confirms that, so far as the director is aware, there is no relevant audit information of which the Company’s auditors are unaware and each director has taken all the steps that he or she ought to have taken as a director to make himself or herself aware of any relevant audit information and to establish that the Company’s auditors are aware of that information. This confirmation is given and should be interpreted in accordance with the provisions of section 234ZA of the Companies Act 1985. Resolutions concerning the re-appointment of PricewaterhouseCoopers LLP as auditors and authorising the audit committee to set their remuneration will be proposed at the annual general meeting. On behalf of the board Harry F Baines Company Secretary and General Counsel 26 February 2009 70 Lloyds Banking Group Annual Report and Accounts 2008 CORPORATE GOVERNANCE COMPLIANCE WITH THE COMBINED CODE The board is committed to ensuring that the Group has a robust governance structure in place. That has been uppermost in directors’ minds when applying the principles contained in section 1 of the 2006 combined code on corporate governance issued by the Financial Reporting Council. The Group has complied with the provisions of the code and has done so throughout the year regarding the provisions where the requirements are of a continuing nature. THE BOARD AND ITS COMMITTEES The Group is led by the board comprising executive and non-executive directors with wide experience. The appointment of directors is considered by the board and, following the provisions in the articles of association, they must stand for election by the shareholders at the first annual general meeting following their appointment and must retire, and may stand for re-election by the shareholders, at least every three years. Independent non-executive directors are appointed for three-year renewable terms, which may, in accordance with the articles of association, be terminated without notice or payment of compensation. The board usually meets at least nine times a year. It has a programme designed to enable the directors regularly to review corporate strategy and the operations and results of the businesses and discharge their duties within a framework of prudent and effective controls relating to the assessing and managing of risk. The roles of the chairman, the group chief executive and the board and its governance arrangements, including the schedule of matters specifically reserved to the board for decision, are reviewed annually. The matters reserved to the board for decision include the approval of the annual report and accounts and any other financial statements; the payment of dividends; the long term objectives of the Group; the strategies necessary to achieve these objectives; the Group’s budgets and plans; significant capital expenditure items; significant investments and disposals; the basis of allocation of capital within the Group; the organisation structure of the Group; the arrangements for ensuring that the Group manages risks effectively; any significant change in accounting policies or practices; the appointment of the Company’s main professional advisers and their fees; and the appointment of senior executives within the organisation and related succession planning. According to the articles of association, the business and affairs of the Company are managed by the directors, who have delegated to management the power to make decisions on operational matters, including those relating to credit, liquidity and market risk, within an agreed framework. All directors have access to the services of the company secretary, and independent professional advice is available to the directors at the Group’s expense, where they judge it necessary to discharge their duties as directors. During the year, Dr Tracy Long, of Boardroom Review, conducted a formal evaluation of the performance of the board, its committees and individual directors. Directors were invited to comment, through questionnaires and interviews, and Dr Long’s report was subsequently reviewed and discussed by the board. Where areas for improvement were identified, action has been agreed. The chairman’s performance was evaluated by the non-executive directors, taking account of the views of executive directors. This appraisal was discussed at a meeting of the non-executive directors, led by the senior independent director, without the chairman being present. The remuneration committee reviewed the performance of the chairman, the group chief executive and the other group executive directors, when considering their remuneration arrangements. The nomination committee reviewed the performance of all the directors and the independence of non-executive directors. Like all board committees, the nomination committee and remuneration committee report to the board on their deliberations, including the results of the performance and independence evaluations. The chairman has a private discussion at least once a year with every director on a wide range of issues affecting the Group, including any matters which the directors, individually, wish to raise. There is an induction programme for all new directors, which is tailored to their specific requirements and includes visits to individual businesses and meetings with senior management. Major shareholders are also offered the opportunity to meet new non-executive directors. Additional training and updates on particular issues are arranged as appropriate. DIRECTORS’ CONFLICTS OF INTEREST The board, as permitted by the Group’s articles of association, has authorised all potential conflicts of interest declared by individual directors. Decisions regarding these conflicts of interest could only be taken by directors who had no interest in the matter. In taking the decision, the directors acted in a way they considered, in good faith, would be most likely to promote the Company’s success. The directors had the ability to impose conditions, if thought appropriate, when granting authorisation. Any authorities given will be reviewed at least every 15 months. No director is permitted to vote on any resolution or matter where he or she has an actual or potential conflict of interest. MEETINGS WITH SHAREHOLDERS In order to develop an understanding of the views of major shareholders, the board receives regular reports from the group finance director and the director of investor relations. The chairman, the group chief executive and the group finance director also have meetings with representatives of major shareholders and the senior independent director also attends some of these meetings. In addition, all directors are invited to attend investment analysts’ and stockbrokers’ briefings on the financial results. All shareholders are encouraged to attend and participate in the Group’s annual general meeting. OVERVIEW Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 BUSINESS REVIEW Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 GOVERNANCE The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 FINANCIAL STATEMENTS SHAREHOLDER INFORMATION Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 71 Lloyds Banking Group Annual Report and Accounts 2008 Each resolution considered at the annual general meeting in May 2008 and the general meeting in November 2008 was decided on a poll. Votes representing approximately 50 per cent of the total number of shares in issue were cast at both meetings and each resolution was passed by a substantial majority. Details of the poll results were announced following the meetings and displayed on our website, www.lloydsbankinggroup.com. They are available from the company secretary. The resolutions to be considered at the annual general meeting in 2009 will also be decided on a poll. Details of the results will be announced following the meeting and will be displayed on our website, www.lloydsbankinggroup.com. They will also be available from the company secretary. AUDIT COMMITTEE The audit committee comprises Mr du Plessis (chairman), Mr Brown, Mr Green, Lord Leitch, Mr Ryan (from 1 March 2009) and Mr Scicluna. The committee’s terms of reference are available from the company secretary and are displayed on our website, www.lloydsbankinggroup.com. During the year, the audit committee received reports from, and held discussions with, management and the auditors. In discharging its duties, the committee has approved the auditors’ terms of engagement, including their remuneration and, in discussion with them, has assessed their independence and objectivity (more information about which is given in note 11 to the consolidated financial statements, in relation to the procedure for approving fees for audit and non-audit work) and recommended their re-appointment at the annual general meeting. The committee also reviewed the financial statements published in the name of the board and the quality and acceptability of the related accounting policies, practices and financial reporting disclosures; the scope of the work of the group audit department, reports from that department and the adequacy of its resources; the effectiveness of the systems for internal control, risk management and compliance with financial services legislation and regulations (more information about which is given in the note about internal control on page 73); the results of the external audit and its cost effectiveness; and reports from the external auditors on audit planning and their findings on accounting and internal control systems. Procedures for handling complaints regarding accounting, internal accounting controls or auditing matters and for staff to raise concerns in confidence have been established by the committee. The committee also had a meeting with the auditors, without executives present, and a meeting with the group audit director alone. CHAIRMAN’S COMMITTEE The chairman’s committee, comprising the chairman and the group chief executive, meets to assist the chairman in preparing for board meetings. The committee exercises specific powers delegated to it by the board from time to time. GROUP EXECUTIVE COMMITTEE The group executive committee, comprising the group chief executive, the group executive directors, the wealth and international director, the chief risk officer, the group human resources director, the group integration director and the director of group operations, meets to assist the group chief executive in performing his duties. Specifically, the committee considers the development and implementation of strategy, operational plans, policies and budgets; the monitoring of operating and financial performance; the assessment and control of risk; the prioritisation and allocation of resources; and the monitoring of competitive forces in each area of operation. The committee, assisted by its sub-committees, the group business risk and group asset and liability committees, also supports the group chief executive in endeavouring to ensure the development, implementation and effectiveness of the Group’s risk management framework and the clear articulation of the Group’s risk policies, and in reviewing the Group’s aggregate risk exposures and concentrations of risk. The committee exercises specific powers delegated to it by the board from time to time. To comply with the Company’s articles of association, only committee members who are also directors of the Company participate in the exercising of any powers delegated by the board. NOMINATION COMMITTEE The nomination committee, comprising Sir Victor Blank (chairman), Dr Berndt, Mr du Plessis, Sir Julian Horn-Smith, Lord Leitch and Sir David Manning, reviews the structure, size and composition of the board, taking into account the skills, knowledge and experience of directors and considers and makes recommendations to the board on potential candidates for appointment as directors. The committee also makes recommendations to the board concerning the re-appointment of any independent non-executive director by the board at the conclusion of his or her specified term; the re-election of any director by the shareholders under the retirement provisions of the articles of association; any matters relating to the continuation in office of a director; and the appointment of any director to executive or other office in the Company, although the chairman of the Company would not chair the committee when it was dealing with the appointment of a successor to the chairmanship of the Company. During the year, in accordance with the plans for the orderly succession for appointments to the board, the committee recommended the appointment of one executive director and three non-executive directors. In that regard, detailed role specifications were drawn up, external search consultants were engaged and candidates were interviewed by committee members and other directors. In addition, the directors agreed with the committee’s recommendation that Mr Brown be asked to remain on the board until the annual general meeting in 2009. This would enable the Group to continue to benefit from his wide experience and maintain an appropriate balance of skills and experience on the board, as part of the plans for orderly succession for appointments. His continuing membership of the audit committee and understanding of the Group’s activities was particularly helpful to the new chairman of that committee. Mr Brown remains the senior independent director until he is succeeded at the conclusion of the annual general meeting by Lord Leitch. The board considered the matter very carefully and concluded that both Mr Brown and Lord Leitch were independent in character and there were no relationships or circumstances which were likely to affect, or could appear to affect, their judgement. 72 Lloyds Banking Group Annual Report and Accounts 2008 CORPORATE GOVERNANCE continued The committee’s terms of reference are available from the company secretary and are displayed on our website, www.lloydsbankinggroup.com. REMUNERATION COMMITTEE Information about the remuneration committee’s membership and work is given in the directors’ remuneration report on pages 74 to 95 and its terms of reference are available from the company secretary and are displayed on the Company’s website, www.lloydsbankinggroup.com. RISK OVERSIGHT COMMITTEE The risk oversight committee comprises Sir Victor Blank (chairman), Mr Brown, Mr du Plessis, Sir Julian Horn-Smith, Lord Leitch, Sir David Manning, Mr Ryan (from 1 March 2009) and Mr Scicluna. All non-executive directors are also invited to attend meetings if they wish. The risk oversight committee’s duties include overseeing the development, implementation and maintenance of the Group’s overall risk management framework, and its risk appetite, strategy, principles and policies, to ensure they are in line with emerging regulatory, corporate governance and industry best practice. The committee also oversees the Group’s risk exposures; facilitates the involvement of non-executive directors in risk issues and aids their understanding of these issues; oversees adherence to Group risk policies and standards and considers any material amendments to them; and reviews the work of the group risk division. ATTENDANCE AT MEETINGS The attendance of directors at board meetings and at meetings of the audit, nomination, remuneration and risk oversight committees during 2008 were as follows: Board Audit Committee Nomination Committee Remuneration Committee Risk Oversight Committee 7 7 7 6 7 7 9 9 8 7 9 5 5 5 2 (max 3) 5 5 4 (max 4) 6 (max 7) 2 (max 3) 1 (max 1) Number of meetings during the year Current directors who served during 2008 W C G Berndt Sir Victor Blank Ewan Brown J E Daniels J P du Plessis1 P N Green Sir Julian Horn-Smith A G Kane Lord Leitch Sir David Manning 2 C J McCall 3 M A Scicluna4 G T Tate T J W Tookey 5 H A Weir Former directors who served during 2008 T A Dial 6 M E Fairey 7 6 6 6 5 6 2 18 16 18 17 18 17 15 18 17 17 10 (max 15) 5 (max 7) 11 (max 11) 18 3 (max 3) 18 2 4 1 2 3 4 5 6 7 Appointed to the risk oversight committee from 8 May 2008. Appointed to the board, nomination, remuneration and risk oversight committees on 1 May 2008. Appointed to the board on 1 October 2008. Appointed to the board, audit and risk oversight committees on 1 September 2008. Appointed to the board on 30 October 2008. Left the board on 18 April 2008. Left the board on 30 June 2008. OVERVIEW Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 BUSINESS REVIEW Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 GOVERNANCE The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 FINANCIAL STATEMENTS SHAREHOLDER INFORMATION Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 73 Lloyds Banking Group Annual Report and Accounts 2008 STATEMENT OF DIRECTORS’ RESPONSIBILITIES The directors are responsible for preparing the annual report, the directors’ remuneration report and the financial statements in accordance with applicable law and regulations. Company law requires the directors to prepare financial statements for each financial year. Under that law the directors have prepared the consolidated and parent company financial statements in accordance with International Financial Reporting Standards (IFRSs) as adopted by the European Union. The financial statements are required by law to give a true and fair view of the state of affairs of the Company and the Group and of the profit or loss of the Group for that period. The directors consider that in preparing the financial statements on pages 97 to 190 the Company and the Group have used appropriate accounting policies, consistently applied and supported by reasonable and prudent judgements and estimates, and that all accounting standards which they consider applicable have been followed. The directors have responsibility for ensuring that the Company and the Group keep proper accounting records which disclose with reasonable accuracy the financial position of the Company and the Group and which enable them to ensure that the financial statements and the directors’ remuneration report comply with the Companies Act 1985 and, as regards the consolidated financial statements, Article 4 of the IAS Regulation. They have general responsibility for taking such steps as are reasonably open to them to safeguard the assets of the Company and the Group and to prevent and detect fraud and other irregularities. A copy of the financial statements of the Company is placed on our website, www.lloydsbankinggroup.com. The directors are responsible for the maintenance and integrity of statutory and audited information on the Company’s website. Information published on the internet is accessible in many countries with different legal requirements. Legislation in the United Kingdom governing the preparation and dissemination of financial statements may differ from legislation in other jurisdictions. INTERNAL CONTROL The board of directors is responsible for the establishment and review of Lloyds Banking Group’s system of internal control, which is designed to ensure effective and efficient operations, quality of internal and external reporting, internal control, and compliance with laws and regulations. It should be noted, however, that such a system is designed to manage, rather than eliminate, the risk of failure to achieve business objectives. In establishing and reviewing the system of internal control, the directors have regard to the nature and extent of relevant risks, the likelihood of a loss being incurred and the costs of control. It follows, therefore, that the system of internal control can only provide reasonable but not absolute assurance against the risk of material loss. The directors and senior management are committed to maintaining a control-conscious culture across all areas of operation. This is communicated to all employees by way of published policies and procedures and regular management briefings. A requirement to comply with internal control risk policies is a key component of individual staff objectives expressed in the balanced scorecard. Key business risks are identified, and these are controlled by means of procedures such as physical controls, credit, trading and other authorisation limits and segregation of duties. In addition, there is an annual control self assessment exercise whereby the key businesses and head office functions review specific controls and attest to the accuracy of their assessments. The assessment covers all enterprise-wide risk management categories and is in accordance with the principles of the combined code. As in previous years, this exercise was completed for the year ended 31 December 2008. All returns have been satisfactorily completed and appropriately certified. The effectiveness of the internal control system is reviewed regularly by the board and the audit committee, which also receives reports of reviews undertaken around Lloyds Banking Group by group risk and group audit. The audit committee receives reports from the Company’s auditors, PricewaterhouseCoopers LLP (which include details of significant internal control matters that they have identified), and has a discussion with the auditors at least once a year without executives present, to ensure that there are no unresolved issues of concern. GOING CONCERN The going concern of the Company and the Group is dependent on successfully funding their respective balance sheets and maintaining adequate levels of capital. In order to satisfy themselves that the Company and the Group have adequate resources to continue to operate for the foreseeable future, the directors have considered a number of key dependencies as discussed in note 1 on page 102. Having considered projections of the Group’s capital and funding position, the directors consider that it is appropriate to continue to adopt the going concern basis in preparing the accounts. 74 Lloyds Banking Group Annual Report and Accounts 2008 DIRECTORS’ REMUNERATION REPORT This is a report made by the board of Lloyds Banking Group plc, on the recommendation of the remuneration committee. It covers the current and proposed components of the remuneration policy and details the remuneration for each serving director during 2008. CONTENT OF REMUNERATION REPORT – Statement from remuneration committee chairman – Remuneration decisions for 2008/9 key highlights – Governance and risk management, including the role, membership and advisers to the committee – Directors’ remuneration policy – Remuneration for 2009 – Remuneration for 2008 – Dilution limits – Pensions – Service agreements – External appointments – Performance graph – Audited information STATEMENT FROM WOLFGANG BERNDT CHAIRMAN OF THE REMUNERATION COMMITTEE It is my privilege once again to introduce the board’s report on remuneration policy and practice. INTRODUCTION 2008 was a year of unprecedented change and turmoil in financial services, in reality probably one of the most dramatic years that the sector has ever been through. The erosion of trust in the financial system, triggered by high profile failures both here and abroad, led to a change in business circumstances that no bank could escape. The problems in the financial sector have fed into the real economy and we now face a severe recession. This has understandably led to public anger and to questions being raised about the role of banks in the financial crisis. Deciding how executives should be paid in these extraordinary circumstances has been an immensely difficult task. We know that many of our stakeholders will want to understand how we came to our decisions. For this reason, we have adopted a different approach to this year’s remuneration report. In addition to the normal information provided, much of which is required by regulations, we have decided to set out the principles underlying our remuneration philosophy. We have also decided to describe how the committee came to the decisions it did during the year in more detail than would be normal. Given the current environment, we believe that our shareholders, customers, employees, and regulators are entitled to this information. We hope that in whatever capacity you are reading this report, you find it helpful. A PRUDENT REMUNERATION POLICy For some years now we have adopted a strategy based on building long-term relationships with our customers and through managing our business decisions based on our assessment of how they will perform through an entire economic cycle. This strategy is inherently long-term and requires a prudent approach to managing risk. It resulted in Lloyds TSB avoiding many of the more high-risk lending areas and funding strategies, even though this could have led to higher profits in the short-term during the boom years. Like many other banks, we have been unable to avoid the problems created by the sharp decline in the willingness of banks to lend to each other and by the recession in the UK and many other countries around the world. In addition we recognise that while the acquisition of HBOS creates significant opportunities for Lloyds Banking Group, in the short term it has created a number of challenges and the need to participate in the Government recapitalisation programme. However, we remain an inherently prudent and well-managed bank, and will be in a very strong position to continue to serve our customers and shareholders in the future. Historically our prudent business strategy has also been reflected in our approach to remuneration. Overall, we have taken a conservative approach to remuneration levels. We have typically positioned our base salaries and incentive levels at or below the levels offered by our direct competitors or by other UK companies of a similar size. The termination provisions within our contracts are among the toughest in the FTSE 100, ensuring no payment for failure. We have used targets in our incentive plans that encourage the prudent management of risk. The economic profit measure that we use takes account of the capital we need to generate our profits, and the risk of the business we are undertaking. For a given level of profit, higher risk will result in lower levels of annual incentive payout for our executives. Economic profit is measured on the performance of our business (and in particular default rates on loans) through an entire economic cycle. This discourages management from taking short-term risks that will have adverse long-term consequences. As a result we have been able to avoid the riskier types of lending or the less prudent funding strategies that were the downfall of some other UK banks. OVERVIEW Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 BUSINESS REVIEW Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 GOVERNANCE The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 FINANCIAL STATEMENTS SHAREHOLDER INFORMATION Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 75 Lloyds Banking Group Annual Report and Accounts 2008 Our annual incentive plan also reflects the fact that you cannot run a successful bank by entirely focusing on financial performance. The plan includes measures relating to how well we serve our customers, how committed and engaged our employees are, the success with which we are growing our franchise, and how we are managing risk. These are factors that have a direct and measurable impact on the future success of our business. This combination of financial and non-financial annual incentive targets encapsulated in a balanced scorecard reinforces to all of our executives the importance of doing business for the long-term in a way that is sustainable. This reflects our commitment to basing our business on building long-term relationships. GOVERNMENT RECAPITALISATION In October last year Lloyds TSB participated in a recapitalisation programme launched by the UK Government to ensure the stability of the UK banking system. Details of this arrangement are included in the Chairman’s statement. Participation in this programme has clearly impacted on our remuneration approach as well as our commitment to comply with the Financial Service Authority’s (FSA) principles on remuneration. In light of a review of the Group’s remuneration polices earlier in 2008 and following consultation with the FSA in October, we developed an approach which is aligned to these principles. Our approach is currently under further detailed review and any subsequent changes will be made as required to ensure our compliance with the FSA’s draft Code of Practice. Although we believe that our approach to remuneration has served the business well, we recognise that we are now operating in an entirely different environment for banks. This will be reflected in the changes we are making to our remuneration approach. In line with our prudent approach to remuneration we had already announced that for 2009 there would be no salary increases for the board and at their own request the executive directors would not be awarded any bonus for 2008. In addition long-term incentive awards for 2009 have been reduced by 175 per cent of salary. FUTURE REMUNERATION DESIGN During 2009 we will be undertaking a further review of our remuneration policy and practices. The committee intends to undertake this review mindful of the requirements of our shareholders and regulators whilst doing the utmost to ensure that we are not competitively disadvantaged against the market with respect to our approach to remuneration going forward; particularly our ability to attract and retain the best talent for the future of the Group. There are clearly many things to be learned by all banks from the current crisis. One of the areas receiving a lot of attention is the whole area of remuneration and risk management. During the year the committee reviewed an analysis of Lloyds TSB incentive schemes and the extent to which they support sound risk-management, and are aligned with customer and shareholder interests. This was started in the first half of the year, pre- dating the HBOS acquisition and the Financial Services Authority’s project looking at remuneration in the banking sector. The committee believes that we have an approach to remuneration aligned with our business strategy that remains sound in its fundamental principles. We do not believe that remuneration led to adverse behaviour at Lloyds TSB. Indeed we believe that our prudent approach to remuneration helped us to avoid many of the problems experienced by a number of our competitors. However, we are not complacent. We recognise that there are areas where our remuneration arrangements can be improved. We have studied the developments in the industry and the recommendations put forward by regulators and industry commentators. We are adopting many of these recommendations in our remuneration for 2009 and beyond. We are committed to rolling out these remuneration practices across the Lloyds Banking Group. CONCLUSION Our past approach to remuneration has been well received by shareholders and a key focus for the committee and the management team is to maintain that positive relationship. We have therefore consulted extensively with shareholders in relation to all of our 2008 and 2009 remuneration decisions. One key challenge that the committee has been grappling with has been how best to motivate and incentivise the management team of the Lloyds Banking Group to undertake the huge task ahead, while recognising that we are operating in a very difficult environment for banks generally. We recognise the extreme scrutiny that remuneration in the financial services sector is attracting and the current sentiment of shareholders. At the same time, the Board strongly believes that we have the executive management team required to take on the complexity of issues that the integration of HBOS will bring. The retention of this team is central to the future success of the bank and it is important that they are paid in a fair and responsible way. The remuneration committee unanimously recommends that you vote to approve the remuneration report at the 2009 Annual General Meeting. Dr Wolfgang Berndt Chairman, remuneration committee 76 Lloyds Banking Group Annual Report and Accounts 2008 DIRECTORS’ REMUNERATION REPORT continued REMUNERATION DECISIONS FOR 2008/2009 KEy HIGHLIGHTS In 2009, our remuneration package will continue to have the same main elements as for 2008: – base salary – annual incentive – long-term incentive plan In addition, executive directors participate in pension arrangements and receive benefits such as life assurance and medical insurance. The following key decisions have been made for 2008/2009 remuneration: – at their own request, the executive directors will not be awarded any bonus for 2008 – base salaries for executive directors frozen at 2008 levels – reduced the maximum level of incentives from 2008 levels by 175 per cent of salary – strengthened the role for non-financial measures, introducing a balanced scorecard into the long-term incentive plan focused on the HBOS integration – increased the role of risk-adjusted economic profit, by introducing it as a measure in the long-term incentive plan, in addition to its current use in the annual incentive – changed the annual incentive plan so that the payment is deferred over three years, and subject to claw-back if the performance on which the incentive is based is found not to be sustainable – determined that, from April 2012, executive directors will no longer participate in the final salary pension plan The approximate make-up of the main components of our new package for executive directors on an expected value basis is shown below. Long-term incentive Short-term incentive Salary 33% 33% 33% Based on a combination of performance targets comprising economic profit, earnings per share, synergy savings, and non-financial measures relating to the success of the integration Paid in shares after three years Based half on financial measures and half on a balanced scorecard of non-financial measures Deferred and paid in tranches over three years subject to clawback Based on role, market competitiveness, and performance Paid in cash The package is designed to encourage a long-term and risk-based focus: – Salary is a significant proportion of the total package, avoiding excessive leverage – All incentives will be paid on a deferred basis over three years – Deferred annual incentive is subject to claw-back, i.e. is not paid if performance on which the incentive is based is found to be unsustainable – A combination of financial and non-financial measures encourages a long-term focus – Economic profit, which is a risk-adjusted profit measure, is a core financial target We believe that these arrangements are well aligned with the Financial Services Authority’s draft Code of Practice on Remuneration. OVERVIEW Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 BUSINESS REVIEW Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 GOVERNANCE The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 FINANCIAL STATEMENTS SHAREHOLDER INFORMATION Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 77 Lloyds Banking Group Annual Report and Accounts 2008 GOVERNANCE AND RISK MANAGEMENT An essential component of our approach to remuneration is the governance process that underpins it. This ensures that our policy is robustly applied and risk is managed appropriately. The remuneration committee reviews the remuneration policy for the top management group. The committee’s role is to ensure that members of the executive management are provided with appropriate incentives to encourage them to enhance the performance of the Group and that they are rewarded for their individual contribution to the success of the organisation. The committee advises on major changes of employee benefits schemes and it also agrees the policy for authorising claims for expenses from the group chief executive and the chairman. It has delegated power for settling remuneration for the chairman, the group executive directors, the company secretary and any group employee whose salary exceeds a specified amount, currently £350,000. All the independent non-executive directors are invited to attend meetings if they wish, and they receive the minutes and have the opportunity to comment and their views taken into account before the committee’s decisions are implemented. The committee’s terms of reference are available from the company secretary and are displayed on the Group’s website, www.lloydsbankinggroup.com. The committee met on nine occasions during 2008, and the members were as follows: – Dr Wolfgang Berndt (chairman) – Sir Victor Blank – Mr Philip Green – Sir Julian Horn-Smith – Sir David Manning (from 1 May 2008) We welcomed Sir David Manning to the committee in May 2008, which was the only change to the committee membership during the year. The committee retains independent consultants to provide advice on specific matters according to their particular expertise. Towers Perrin, Hewitt New Bridge Street and Kepler Associates were retained by the committee during 2008 to advise on various matters relating to executive remuneration. In addition, PricewaterhouseCoopers LLP (PwC) were also retained in 2008 specifically to support the committee with a one-off project to review executive remuneration arrangements in light of the acquisition of HBOS, given their particular expertise in relation to the remuneration aspects of transactions. In recognition that PwC are also the auditors to the Lloyds Banking Group and to mitigate any threat to audit independence, Kepler Associates continue to be retained as the remuneration committee’s primary independent advisers, and were commissioned to provide comment on PwC’s advice. In addition to their advice on executive remuneration, during 2008 Towers Perrin also provided market remuneration data as well as other remuneration consulting services to the Group, Hewitt New Bridge Street provided pension consulting services and PwC were the Group’s auditors. During 2008, Alithos Limited continued to provide information on behalf of the committee for the testing of the total shareholder return (TSR) (calculated by reference to both dividends and growth in share price) performance conditions for the Group’s long-term incentive schemes. Mr Daniels, Mrs Risley (Group Human Resources Director), Mr Farley (Reward & Employment Policy Director) and Ms Kemp (HR Director, Total Reward) provided guidance to the committee (other than for their own remuneration). The remuneration committee takes an interest in ensuring that appropriate remuneration and governance arrangements are in place throughout the organisation, with the Group functions providing an oversight role in the development of remuneration policy and practice below the senior executive population. In particular, divisional remuneration decisions are subject to independent oversight from the human resources function and the appointment and remuneration for risk officers in the divisions is reviewed in conjunction with the chief risk officer for the Group. During 2008, the committee received a review of the Group’s remuneration practices against a number of criteria including customer, shareholder alignment, conflict of interest and risk. This was prior to the review of practices requested by the Financial Services Authority (FSA) in October 2008. In general, the review found that there was good alignment between remuneration practices and the policy objectives. However, changes are being implemented to the practice in some areas of the business. In particular we had put in place for those employees in our Wholesale and International Banking division a bonus deferral plan appropriate to the roles they perform. As described above we have also implemented a deferral arrangement for senior executives, and have increased the use of our risk-adjusted economic profit measure in our incentive plans. Following the FSA’s approach to a number of major UK banks in October 2008, we submitted an analysis of our current remuneration policies against their proposed good practice criteria. The assessment showed a generally favourable comparison. We have met with representatives from the FSA and will continue to co-operate with them as they develop their updated guidance in 2009. Their draft Code of Conduct was published as this report was being finalised. Although we believe our approach is well aligned with the Code of Conduct, our approach will be subject to a further detailed review. As a result of this review, and discussions with the FSA, we have identified some areas of governance where we will be implementing changes for the future, as part of our plan for integrating the Lloyds TSB and HBOS businesses: 78 Lloyds Banking Group Annual Report and Accounts 2008 DIRECTORS’ REMUNERATION REPORT continued – We will be enhancing the formal role of control functions in the oversight of remuneration. Input is already sought from the risk and finance functions into remuneration design and decisions. However, we believe that our governance would benefit from a more formalised role for control functions in our remuneration processes. – We will be reviewing the oversight of divisional remuneration. Already we apply independent oversight of divisional remuneration from the Group’s centre function. During the year, the group HR function, in conjunction with the risk function, undertook the group wide review of remuneration practices summarised above, and we will be reviewing the oversight processes and governance controls relating to divisions to identify areas where they can be further strengthened. Our particular emphasis will be on ensuring that the linkage between good risk practices and remuneration can be robustly demonstrated. – Regulators have identified the remuneration of risk officers as one of their areas of interest. The decision on risk officer remuneration is already held at the Group’s centre function. We will be reviewing the remuneration setting processes for all of our control functions to ensure that all potential conflicts of interest are identified and managed. DIRECTORS’ REMUNERATION POLICy The Group’s remuneration policy supports our business strategy, which is based on building long-term relationships with our customers and employees, and managing the financial consequences of our business decisions across the entire economic cycle. The policy is designed to ensure that cost effective packages are provided which attract and retain executive directors and senior management of the highest calibre and motivate them to perform to the highest standards. At the same time, the objective is to align individual rewards with the Group’s performance, the interests of its shareholders, and a prudent approach to risk management. In this way we balance the requirements of our various stakeholders: customers, shareholders, employees, and regulators. We believe that this approach is in line with the Association of British Insurers best practice code on remuneration as well the draft Financial Services Authority’s Code of Practice, as the policy seeks to reward long-term value creation whilst not encouraging excessive risk taking. We summarise below how each of these policy objectives is met by our remuneration packages. Policy objective How achieved Building long-term relationships We build relationships with our customers and people rather than viewing them as counterparties in a money-making transaction and will be seeking to extend this philosphy across the integrated Group. This means that working for the Lloyds Banking Group should be about more than pay. While our relationships with our people means that we will pay them fairly and competitively, our pay is positioned conservatively against the market and we will not seek to be among the highest payers in the sector. In setting pay for executive directors, we take account of the terms and conditions applying to other employees of the Group. Our incentive measures are not just financial. Half of the annual incentive for executives is linked to a scorecard including how we performed against targets that measure how satisfied our customers are with us, and the extent to which our employees feel engaged with and committed to working for the Lloyds Banking Group, both of which are important foundations of a relationship-based strategy. Managing the financial consequences of our business through the economic cycle Economic profit is a key measure by which we manage our business. This measure takes into account the level of capital required to generate profits as well as the risks taken. The same level of profit generated at lower risk results in higher economic profit. Economic profit also measures risk based on an assessment of how business will perform through the economic cycle. Aligning individual rewards with Group performance and shareholders Therefore, for example, in good times, when default rates on loans are low, we adjust the economic profit measure downwards based on a higher average expected default experience over the economic cycle. This encourages us to avoid business and funding strategies that are only profitable during boom times but turn bad in a recession. Economic profit plays a prominent role in our incentive plans for executives, a role which will be further enhanced in 2009, with its inclusion in the long-term incentive plan performance measures. The majority of our executives’ pay is linked to stretching performance targets through annual and long-term incentives. Performance measures on the annual incentive are directly aligned to the Group’s financial and non-financial performance. Executives are aligned with shareholders through the long-term incentive plan, which pays out based on performance against Group targets over a three year period, and which is paid in shares to improve alignment with shareholders further. The combination of incentive plans is designed to enable executives to achieve pay levels within the top 25 per cent of comparable companies, provided that performance is also in the top 25 per cent. Executives are required to build up a holding in the Lloyds Banking Group shares of value equal to 1.5 times salary for executive directors (2 times salary for the group chief executive). They are expected to retain half of the net-of-tax proceeds of share plan pay-outs until they reach this target. Finally, we operate tough contract provisions whereby no executive has an entitlement to more than 12 months’ notice, compensation on termination is limited to basic salary, and any compensation is paid monthly over 12 months and is mitigated if the executive gets another job. This approach avoids the risk of payment for failure. These requirements are among the toughest in the FTSE 100. OVERVIEW Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 BUSINESS REVIEW Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 GOVERNANCE The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 FINANCIAL STATEMENTS SHAREHOLDER INFORMATION Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 79 Lloyds Banking Group Annual Report and Accounts 2008 Policy objective How achieved A prudent approach to risk management Economic profit measures profit relative to the risk taken to generate that profit. Its use in our incentive plans therefore encourages executives to take a prudent approach to risk. We also have non-financial measures of performance against risk objectives in the plan for executives, which enables a more rounded assessment of risk-taking behaviour to be made. For the 2009 incentive we have increased the alignment to long-term prudent risk management by introducing deferral. For executive directors and other senior executives, any cash incentive earned will be deferred and paid-out over three years. If the performance that led to the incentive is found to be unsustainable, then this deferred portion may be forfeited. We pay competitively but not excessively. Our prudent approach to positioning compensation means that we reduce the incentives where excessive risk may be taken for personal gain. This means that we do not attract employees with an extreme appetite for risk. We have a robust governance framework with an independent remuneration committee reviewing all compensation decisions. This robust approach to governance and review is cascaded through the organisation. Cost effective packages to attract and retain executives We aim to ensure that the totality of remuneration for executive directors is competitive against our benchmark groups. These groups are other major UK banks, and also the top 20 companies in the FTSE 100, reflecting practices in comparably sized large UK companies across all sectors. We aim to be competitively but conservatively positioned against the market. We aim to choose incentive plan targets that are directly linked to the business strategy and priorities. This not only ensures alignment with company performance, but also means that the targets are meaningful to executives and therefore motivating. This ensures that incentive packages are valued by executives and therefore cost effective. REMUNERATION FOR 2009 The remuneration committee had already started a review of executive remuneration during 2008 prior to the announcement of the HBOS acquisition. This was in the light of concerns about the competitiveness of the package, which had led to the committee making long-term incentive awards of 375 per cent of salary in 2008, above the normal maximum of 300 per cent. The scope and context of this review was naturally altered by the acquisition of HBOS and by the rapidly evolving environment in the financial services sector. The changes introduced as a result of this review are summarised below. SUMMARy OF REMUNERATION ELEMENTS The key remuneration elements for 2009 as a result of the review are summarised below. Each individual element is then described in more detail in the subsequent sub-sections. Element Base salary Level/design for 2009 Key purpose Set competitively relative to FTSE 20 and banking sector competitors Meet essential commitments of executive Retention Annual incentive 200 per cent of salary maximum (225 per cent for CEO), as for 2008 Alignment with Group performance No increase for 2009 compared with 2008 Based 50 per cent on Group financial targets relating to profit before tax and economic profit Based 50 per cent on balanced scorecard covering, customers, people, risk and build franchise Subject to deferral with the first tranche released in 2011 Alignment with sound risk management Motivation of executives Long-term incentive plan 200 per cent of salary maximum, 175 per cent of salary less than the maximum award level in 2008, split as follows: Alignment with shareholder interests 120 per cent of salary Normal LTIP Award based: – 50 per cent on Earnings per Share – 50 per cent on Economic Profit 80 per cent of salary Integration Award based: – 50 per cent on financial synergy savings – 50 per cent on non-financial measures of the success of the HBOS integration Alignment with sound risk management Motivation and retention of executives 80 Lloyds Banking Group Annual Report and Accounts 2008 DIRECTORS’ REMUNERATION REPORT continued Element Pension Level/design for 2009 Key purpose A mixture of final salary and defined contribution pension arrangements Enable executives to build long-term retirement savings From April 2012, executive directors with final salary pensions will move to a defined contribution pension arrangement, with no compensation Retention Despite the significantly increased responsibilities of the executive directors, the maximum total pay opportunity for an executive director in 2009 is reduced by 175 per cent of salary from 2008. GENERAL CONSIDERATIONS When deciding the approach to take for remuneration in 2009, the remuneration committee considered a range of factors. In forming the Lloyds Banking Group, our senior executive team will be managing a combined business twice the size of Lloyds TSB, at the same time as integrating two highly complex businesses, one of which had a flawed business model. The balance sheet alone will be among the largest balance sheets in the world. There will be significant increases in workload and responsibilities. Shareholders, customers and tax-payers will want to ensure that the right team is in place, appropriately motivated and incentivised to take this bank forward, put appropriate risk management frameworks into HBOS, and deliver the value from the takeover. The terms on which senior executives have recently been appointed within the banking sector shows that shareholders remain convinced of the need to offer competitive compensation packages. At the same time, the committee has been very aware of developments in the financial services sector and in relation to remuneration practices more widely. The committee reviewed trends in relation to base salary and incentives at other major financial firms globally, including those participating in Government funding programmes. The committee also considered the implications of the Financial Services Authority’s draft code on remuneration. Finally the committee considered developments at the other UK and international banks, including the terms on which senior executives at banks were hired through the year (including executives departing from Lloyds TSB). BASE SALARy Basic salaries are reviewed annually, usually in December, taking into account individual performance and market information (which is provided by Towers Perrin) and then adjusted from 1 January of the following year. The remuneration committee confirmed during the 2008 review that the FTSE 20 was the most appropriate comparator group to use to benchmark overall competitiveness of the remuneration package whilst taking particular account of the remuneration practice of our direct competitors, namely the major UK banks. The FTSE 20 is regarded as providing a realistic and relevant comparison in terms of company size and complexity, as well as being a key market for talent. However, in recognition of the current operating environment and in common with many of our peers, base salaries for 2009 remain unchanged from the salaries set for 2008. Basic salary increases for other employees across the Group will remain in line with any market movement, but will, in general be significantly lower than in previous years. Name As at 1 January 2008 * With effect from appointment on 30 October 2008. J E Daniels A G Kane G T Tate T J W Tookey H A Weir £1,035,000 £590,000 £640,000 £600,000* £625,000 This approach has also been applied to the Chairman’s salary and non-executive director fees for 2009 which remain unchanged from 2008. ANNUAL INCENTIVE PLAN The Lloyds TSB annual incentive plan already had many good features, such as the combination of financial and non-financial measures, which supported our prudent approach to managing risk. We are proposing to keep these features, while enhancing the operation of the plan in order to increase the alignment between risk and reward still further. The remuneration committee has considered the preliminary guidance from the FSA relating to good practice criteria, and has reviewed emerging practice in other banks within the sector both in the UK and overseas. Although more than half of our total incentive opportunity was already deferred, through our long-term incentive plan, we have decided that the annual incentive for executive directors should be deferred also. Consistent with the aim of ensuring that short-term financial results are only achievable sustainably, the committee has decided that the incentive will be deferred and released in tranches over a three year period. The deferral will be on the same basis as for senior staff with the first tranche being released in June 2011. The deferred incentive will be subject to 100 per cent claw back if the performance that generated the incentive is found to be unsustainable. OVERVIEW Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 BUSINESS REVIEW Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 GOVERNANCE The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 FINANCIAL STATEMENTS SHAREHOLDER INFORMATION Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 81 Lloyds Banking Group Annual Report and Accounts 2008 The maximum annual incentive opportunity remains unchanged at 200 per cent (225 per cent for Mr Daniels) of basic salary for the achievement of exceptional performance targets. The remuneration committee believes that the structure of the incentive – in particular the use of risk-adjusted and non-financial measures – has been highly successful in promoting a long-term focus within the senior management team. Introducing this deferral element further enhances these aspects of the plan. LONG TERM INCENTIVE AWARD The current LTIP rules allow for awards to be made of up to 400 per cent of base salary. Under normal circumstances awards are made of 300 per cent of salary with the additional 100 per cent available for circumstances that the remuneration committee deems to be exceptional. In 2008, awards were made of 375 per cent of base salary to the CEO and two of the executive directors for retention purposes, and in light of data reviewed by the committee which showed total remuneration to be behind median both for the FTSE 20, and the other major UK banks. Further information viewed by the committee through 2008 continued to show that total remuneration for the executive directors was materially behind the median of our peer groups, even before allowing for the increased responsibilities of running the combined bank and the magnitude of the task of integrating the two businesses. However, there is a strong overall focus on cost control within the business, and rapid changes within the industry make it difficult to assess what will, in future, be market competitive. Therefore, the committee has determined not to seek authority from shareholders to increase the LTIP award to the level required to achieve a market median value of remuneration. Instead, the committee has determined that for 2009 the grant level for executive directors should be set at 200 per cent of base salary. This means that, in its totality, the maximum remuneration opportunity for executive directors in 2009 will be reduced by 175 per cent of salary from the maximum awarded to a director in 2008, despite a doubling in the size of the Group, and despite the challenges ahead in integrating the businesses to create the Lloyds Banking Group. LONG-TERM INCENTIVE PERFORMANCE MEASURES In reviewing measures, the remuneration committee has aimed to build on existing aspects of the remuneration policy that have been successful, with a focus on long-term performance, taking appropriate account of risk. At the same time, the committee has sought to develop arrangements that motivate executives to meet the near-term objectives of integrating the two businesses. The setting of the definitive performance targets for 2009 will be completed in time for publication prior to the Annual General Meeting. The committee will continue to engage with shareholders during this time and will share the detail of the performance targets once they are finalised. Performance targets will be set by reference to analysts’ expectations, internal business plans, competitive performance assessments and probability modelling. Stretch performance will be equated to the remuneration committee’s assessment of an upper quartile performance level or greater. Non-financial targets will be fully disclosed, and payments against them justified, in the year of vesting. The detailed rationale for the proposed measures is set out below. EARNINGS PER SHARE (APPLyING TO AWARD OF 60 PER CENT OF SALARy, BEING HALF THE REGULAR LTIP AWARD) Earnings per share continues to be an important measure of our profitability and ability to generate cash at a point in time. The committee has therefore decided to retain this well-recognised measure in our incentive system. ECONOMIC PROFIT (APPLyING TO AWARD OF 60 PER CENT OF SALARy, BEING HALF THE REGULAR LTIP AWARD) Economic profit has been used as a performance measure within Lloyds TSB for a number of years. It has been very successful at introducing a long-term, risk-based approach to managing our business. Given the increasing focus now being placed on risk-adjusted measures by shareholders and regulators, adoption of this established measure into the LTIP is felt by the committee to be a further enhancement of the alignment between our remuneration and business strategy. Our economic profit measure is a through-the-cycle measure, which encourages prudent risk management of our portfolio, considering the impact of decisions over an entire economic cycle. Economic profit replaces relative total shareholder return within the LTIP. The committee is of the view that at the current time, with extreme market volatility and the level of disruption in our peer group, TSR is not a robust performance measure. Moreover, the committee is concerned that relative TSR measures may not have been supportive of sound risk management policies during economic upswings. Indeed, such a measure can encourage a ‘strategic herd mentality’, with banks encouraged to take on more risk in order to improve the prospects of significantly out-performing their peers. Economic profit, by measuring risk-adjusted performance with targets reflecting the Company’s specific risk appetite, is, in the view of the committee, a better incentive for sustainable performance. The committee is aware that some shareholders favour relative TSR as a measure, and so will further consider its role for long-term incentive awards in 2010 and beyond during the review to be carried out later in 2009. However, it is the view of the committee that an economic profit measure is better aligned with the Financial Services Authority’s draft Code of Practice criteria. 82 Lloyds Banking Group Annual Report and Accounts 2008 DIRECTORS’ REMUNERATION REPORT continued SyNERGy TARGETS (APPLyING TO AWARD OF 40 PER CENT OF SALARy, BEING 50 PER CENT OF THE INTEGRATION AWARD) The Integration Award naturally includes a component relating to the achievement of our £1.5 billion synergy goal by the end of 2011. However, in order to demonstrate the credibility of our integration to the market, it is important that the trajectory of achieving the synergies, and the cost of achievement, are well balanced. Therefore, the synergy element will include targets for synergy savings in 2009 and 2010 (although awards will not ultimately vest until the end of 2011, and will be subject to an assessment by the remuneration committee at that point that the synergies have been achieved on a sustainable basis). INTEGRATION BALANCED SCORECARD (APPLyING TO AWARD OF 40 PER CENT OF SALARy, BEING 50 PER CENT OF THE INTEGRATION AWARD) The committee believes that an excessive focus on financial targets can potentially reward short-term actions that are detrimental to the long-term health of the business. For this reason a balanced scorecard has been operated in the annual incentive plan for a number of years, with great success. The committee has decided that this success should be built upon by measuring part of the 2009 LTIP on a long-term balanced scorecard of non-financial measures underpinning the success of the integration over 2009 to 2011. These measures will be grouped under the categories by which the integration is being managed: – Risk – Customer – People – Build business These measures are distinct from the similarly named areas under the annual incentive plan. The annual incentive measures focus on excellence of performance in business as usual activities. The non-financial measures in the integration balanced scorecard are specific to the integration. There is a major change programme to be undertaken within HBOS, particularly in relation to systems and processes for measuring and managing risk. The integration balanced scorecard will be built around outperformance of this change agenda. PENSION In April 2012, all executive directors will transition to defined contribution pension arrangements with contributions of 25 per cent of base salary for the chief executive and other executive directors, with no compensation for ceasing final salary accrual. FURTHER REVIEW OF EXECUTIVE REMUNERATION DURING 2009 The committee recognises that the above proposals for executive remuneration for 2009 are being made at a time of high uncertainty and great volatility, and therefore the committee has decided to undertake a further review of executive remuneration during 2009. This is to ensure that the overall positioning of remuneration remains appropriate when compared with the external market and ensures that the Lloyds Banking Group is able to attract and retain the high calibre of talent needed to lead the combined Group, while reflecting latest trends in the sector and any updated guidance from shareholders and regulators. The committee will continue to engage with shareholders during this review. OTHER SHARE PLANS The executive directors and the chairman are also eligible to participate in the Group’s ‘sharesave’ scheme and the Group’s ‘shareplan’. These are ‘all-employee’ share schemes. CHAIRMAN’S REMUNERATION The chairman’s remuneration comprises salary and benefits which are broadly similar to those extended to the executive directors. However, he does not participate in the annual bonus and long-term incentive arrangements, nor is he entitled to pension benefits. The chairman’s salary is reviewed annually, usually in December, taking into account performance and market information and then adjusted from 1 January of the following year. No adjustments will be made from 1 January 2009 and his salary remains unchanged at £640,000. OVERVIEW Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 BUSINESS REVIEW Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 GOVERNANCE The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 FINANCIAL STATEMENTS SHAREHOLDER INFORMATION Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 83 Lloyds Banking Group Annual Report and Accounts 2008 INDEPENDENT NON-EXECUTIVE DIRECTORS’ FEES The fees of the independent non-executive directors are agreed by the board within a total amount determined by the shareholders. To accommodate a potentially larger board following the acquisition of HBOS, a resolution was passed at the General Meeting on 19 November 2008 to increase this amount to £1 million. Directors may also receive fees, agreed by the board, for membership of board committees. The fees are designed to recognise the various responsibilities of a non-executive director’s role and to attract individuals with relevant skills, knowledge and experience. The fees are neither performance related nor pensionable and are comparable with those paid by other companies. The annual fees from 1 January 2009 are unchanged and are listed below. Board Audit committee chairmanship Audit committee membership Nomination committee membership Remuneration committee chairmanship Remuneration committee membership Risk oversight committee membership £65,000 £50,000 £20,000 £5,000 £30,000 £15,000 £15,000 Independent non-executive directors who serve on the boards of subsidiary companies may also receive fees from the subsidiaries. The fees paid in 2008 to the current non-executive directors are shown in the table below: REMUNERATION FOR 2008 2008 ANNUAL INCENTIVE SCHEME The annual incentive scheme for executive directors is designed to reflect specific goals linked to the performance of the business. Incentive awards for executive directors are based upon individual contribution and overall corporate results. Half of the incentive opportunity is driven by corporate performance based on the stretching budget relating to profit before tax and economic profit. The level of achievement against the targets for profit before tax and economic profit that results in the lower payout will determine the exent to which the target has been met. The other half of the incentive opportunity is determined by divisional achievement driven through individual performance. Individual targets relevant to improving overall business performance are contained in a balanced scorecard and are grouped under the following headings: – Financial – Franchise growth – Customer service – Risk – People development These targets are weighted differently for each of the executive directors, reflecting differing strategic priorities. The non-financial measures include key performance indicators relating to process efficiency, service quality and employee engagement. The maximum annual incentive opportunity is 200 per cent (225 per cent for Mr Daniels) of basic salary for the achievement of exceptional performance targets. The maximum payment under the corporate half of the annual incentive is only available if exceptional performance is achieved against the stretching corporate budget. An amount equal to 50 per cent of this element of the incentive is available on the achievement of the stretching corporate budget. Failure to achieve at least 90 per cent of the stretching budget would result in no payment under the corporate half of the incentive. In recognition of the current environment, the executive directors have elected not to receive any annual incentive in respect of 2008. 84 Lloyds Banking Group Annual Report and Accounts 2008 DIRECTORS’ REMUNERATION REPORT continued LONG-TERM INCENTIVE PLANS 2008 LONG-TERM INCENTIVE PLAN AWARDS In 2008, following shareholder consultation, three directors were granted enhanced awards of 375 per cent of basic salary. This was to ensure that for these directors, where there was a concern about retention, we continued to provide a fully market competitive remuneration framework. Details of the plan, including the specific performance conditions, can be found on page 93. 2008 NON-EXECUTIVE DIRECTORS’ FEES (£) W C G Berndt Ewan Brown J P du Plessis P N Green Sir Julian Horn-Smith Lord Leitch Sir David Manning C J McCall M A Scicluna * ** Lloyds TSB Scotland plc. Scottish Widows Services Ltd. Board 65,000 65,000 65,000 65,000 65,000 65,000 43,333 16,250 21,666 Lloyds TSB Group LTSBS* SW** Audit committee Remuneration committee Nomination committee Risk oversight committee Board Board 30,568 39,432 20,000 20,000 6,667 30,000 5,000 15,000 15,000 10,000 5,000 5,000 5,000 3,333 15,000 9,715 15,000 15,000 10,000 5,000 11,568 60,000 2008 Total fees 100,000 122,136 119,147 100,000 100,000 165,000 66,666 16,250 33,333 DILUTION LIMITS The following charts illustrate the shares available for the Group’s share schemes. ALL SCHEMES (10% IN ANY CONSECUTIVE 10 YEARS) 2008 2007 0 347.1 197.1 EXECUTIVE SCHEMES (5% IN ANY CONSECUTIVE 10 YEARS) 2008 35.6 2007 0 20.6 250.2 367.7 263.0 261.8 Shares used (million) Shares available (million) PENSIONS Executive directors are either entitled to participate in the Group’s defined benefit pension schemes (based on salary and length of service, with a maximum pension of two thirds of final salary), or the Group’s defined contribution scheme (under which their pension entitlement will be based upon both employer and employee contributions). The defined benefit schemes are closed to new entrants on recruitment. Pension accruals under the defined benefits scheme for Messrs Daniels and Kane will continue until April 2012. Thereafter they will have the opportunity to either participate in a defined contribution scheme or to receive a cash supplement with no compensation for ceasing final salary accrual. There is no entitlement to an immediate and unreduced pension should their employment be terminated before the normal date of retirement. OVERVIEW Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 BUSINESS REVIEW Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 GOVERNANCE The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 FINANCIAL STATEMENTS SHAREHOLDER INFORMATION Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 85 Lloyds Banking Group Annual Report and Accounts 2008 SERVICE AGREEMENTS The Group’s policy is for executive directors to have service agreements with notice periods of no more than one year. All current executive directors are entitled to receive 12 months’ notice from the Group, but would be required to give six months’ notice if they wished to leave. Executive directors normally retire at age 60. However, following the implementation of The Employment Equality (Age) Regulations 2006, they may now choose to delay their retirement until age 65. It is the Group’s policy that where compensation on early termination is due, it should be paid on a phased basis, mitigated in the event that alternative employment is secured, and that bonus payments should relate to the period of actual service, rather than the full notice period, and will be determined on the basis of performance. Any entitlements under the pension scheme or equity plans will be in accordance with the scheme rules on leaving. Notice to be given by the Company Date of service agreement/letter of appointment Sir Victor Blank J E Daniels A G Kane G T Tate T J W Tookey H A Weir Former directors who served during 2008 T A Dial M E Fairey 6 months 12 months 12 months 12 months 12 months 12 months 12 months 12 months 25 January 2006 22 January 2009 23 January 2009 9 February 2009 26 January 2009 21 January 2009 23 May 2005 28 August 1991 Independent non-executive directors do not have service agreements and their appointment may be terminated, in accordance with the articles of association, at any time without compensation. EXTERNAL APPOINTMENTS The Group recognises that executive directors may be invited to become non-executive directors of other companies and that these appointments may broaden their knowledge and experience, to the benefit of the Group. Fees are normally retained by the individual directors as the post entails personal responsibility. Executive directors are generally allowed to accept one non-executive directorship. During 2008, Mr Daniels and Mrs Weir received fees of £54,718 and £42,500 respectively, which were retained by them, for serving as non-executive directors of other companies. PERFORMANCE GRAPH The graph below illustrates the performance of the Group measured by TSR against a ‘broad equity market index’ over the past five years. The Group has been a constituent of the FTSE 100 index throughout this five year period. TOTAL SHAREHOLDER RETURN – FTSE 100 INDEX 150 125 100 75 50 25 0 31 Dec 2003 31 Dec 2004 31 Dec 2005 31 Dec 2006 31 Dec 2007 31 Dec 2008 Lloyds TSB Group plc Rebased to 100 on 31 December 2003 FTSE 100 Index Source: Datastream 86 Lloyds Banking Group Annual Report and Accounts 2008 DIRECTORS’ REMUNERATION REPORT continued AUDITED INFORMATION DIRECTORS’ EMOLUMENTS FOR 2008 Current directors who served during 2008 Executive directors J E Daniels A G Kane G T Tate T J W Tookey (from 30.10.08) H A Weir Non-executive directors Sir Victor Blank W C G Berndt Ewan Brown J P du Plessis P N Green Sir Julian Horn-Smith Lord Leitch Sir David Manning (from 01.05.08) C J McCall (from 01.10.08) M A Scicluna (from 01.09.08) Former directors who served during 2008 M E Fairey (until 30.6.08) T A Dial (until 18.4.08) Others Notes: Salaries/ fees £000 Other benefits Cash £000 1 Non-cash £000 2 Performance- related payments £000 3 2008 Total £000 2007 Total £000 1,035 108 22 25 4 95 12 8 23 24 – 22 17 590 640 104 625 640 100 122 119 100 100 165 67 16 33 315 340 18 128 4 2 5,111 412 100 – – – – – – – – – 1,151 635 689 108 742 669 100 122 119 100 100 165 67 16 33 337 470 2,884 1,377 1,386 1,586 661 90 151 80 56 95 130 1,440 1,995 124 5,623 12,055 1 2 3 The cash column under ‘other benefits’ includes flexible benefits payments (4 per cent of basic salary), the tax planning and education allowances for Mr Daniels, the housing allowance and pension scheme allowance for Ms Dial (paid until 30.6.08) , payments to certain directors who elect to take cash rather than a company car under the car scheme and the cash balance of a pension allowance for Mrs Weir. Sir Victor Blank has elected to take cash rather than a company car. The non cash column includes amounts relating to the use of a company car, use of a company driver and private medical insurance. It also includes the value of any matching shares which are received under the terms of Shareplan, through which employees have the opportunity to purchase shares up to a maximum of £125 per month and receive matching shares on a one for one basis up to a maximum value of £30 per month, rounded down to the nearest whole share. The executive directors waived their entitlement to any bonus in respect of the 2008 performance. There will be no free shares award under Shareplan in respect of 2008. OVERVIEW Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 BUSINESS REVIEW Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 GOVERNANCE The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 FINANCIAL STATEMENTS SHAREHOLDER INFORMATION Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 87 Lloyds Banking Group Annual Report and Accounts 2008 AUDITED INFORMATION WAIVED FEES For the period 1 January – 30 June 2008, Mr Fairey waived fees payable to him as a director of Lloyds TSB Group Pension Trust (No.1) Limited and Lloyds TSB Group Pension Trust (No.2) Limited, which totalled £5,000 (2007: £10,750 waived). For the period 1 July – 31 December 2008, Mr Fairey received fees payable to him as a director and chairman of the Lloyds TSB Group Pension Trust (No.1) Limited and Lloyds TSB Group Pension Trust (No.2) Limited which totalled £35,000. Mr Brown waived fees payable to him as a director and chairman of Lloyds TSB Group Pension Trust (No.1) Limited and Lloyds TSB Group Pension Trust (No.2) Limited for the period 1 January – 30 June 2008, which totalled £7,000 in 2008 (2007: £15,500 waived). DIRECTORS’ PENSIONS The executive directors are currently members of one of the pension schemes provided by the Lloyds TSB Group with benefits either on a defined benefit or defined contribution basis. Those directors who joined the Lloyds TSB Group after 1 June 1989 and are members of a defined benefit scheme have pensions provided on salary in excess of the earnings cap either through membership of a funded unapproved retirement benefits scheme (FURBS) or by an unfunded pension promise. Retirement pensions accrue at rates of between 1/60 and 1/30 of basic salary. For those directors who are members of a defined pension scheme, pension will continue to accrue until 5 April 2012. On 6 April 2012, defined benefit pension accrual will cease and directors will be offered the option to participate in the defined contribution pension scheme in operation at that date. Alternatively, they may choose not to join the scheme and elect to receive a pension cash allowance. Directors have a normal retirement age of 60. However, following the implementation of The Employment Equality (Age) Regulations 2006, they may now choose to delay their retirement until age 65. In the event of death in service, a lump sum of four times salary is payable plus, for members of a defined benefit scheme, a spouse’s pension of two-thirds of the member’s prospective pension. On death in retirement, a spouse’s pension of two-thirds of the member’s pension is payable. The defined benefit schemes are non-contributory. Members of defined contribution schemes are required to contribute. DEFINED CONTRIBUTION SCHEME MEMBERS During the year to 31 December 2008 (from 30 October 2008 for Mr Tookey), the employer has made the following (£000) contributions to the defined contribution scheme: G T Tate T J W Tookey H A Weir 128 23 56 DEFINED BENEFIT SCHEME MEMBERS Accrued pension at 31 December 2008 £000 (a) Accrued pension at 31 December 2007 £000 (b) 175 342 339* 147 305 322 Change in accrued pension £000 (a)-(b) 28 37 17 Transfer value at 31 December 2008 £000 (c) Transfer value at 31 December 2007 £000 (d) 3,263 6,146 n/a 2,878 5,701 7,469 J E Daniels A G Kane M E Fairey * Pension as at 30 June 2008 (i.e. normal retirement date). The disclosures in columns (a) to (d) are as required by the Companies Act 1985 Schedule 7A. Change in transfer value £000 (c)-(d) 385 445 n/a Additional pension earned to 31 December 2008 £000 (e) 23 25 n/a Transfer value of the increase £000 (f) 428 449 n/a Columns (a) and (b) represent the deferred pension to which the directors would have been entitled had they left the Group on 31 December 2008 and 2007, respectively. Column (c) is the transfer value of the deferred pension in column (a) calculated as at 31 December 2008 based on factors supplied by the actuary of the relevant Lloyds TSB Group pension scheme. The basic method used to arrive at the factors has not changed during the year, although minor adjustments have been made following the introduction of new requirements applicable to transfer calculations effective from 2008. Column (d) is the equivalent transfer value, but calculated as at 31 December 2007 on the assumption that the director left service at that date. Column (e) is the increase in pension built up during the year, recognising (i) the accrual rate for the additional service based on the pensionable salary in force at the year end, and (ii) where appropriate the effect of pay changes in ‘real’ (inflation adjusted) terms on the pension already earned at the start of the year. Column (f) is the capital value of the pension in column (e). 88 Lloyds Banking Group Annual Report and Accounts 2008 DIRECTORS’ REMUNERATION REPORT continued AUDITED INFORMATION The disclosures in columns (e) and (f) are as required by the UK Listing Authority listing rules. The requirements of the listing rules differ from those of the Companies Act. The listing rules require the additional pension earned over the year to be calculated as the difference between the pension accrued at the end of the financial year and the pension accrued at the start of the financial year less the increase in the pension earned over the year solely due to inflation. The transfer value in column (f) can differ significantly from the change in transfer value as required by the Companies Act because the additional pension accrued over the year calculated in accordance with the listing rules makes allowance for inflation, and the change in the transfer value required by the Companies Act will be significantly influenced by changes in the assumptions underlying the transfer value calculation at the beginning and end of the financial year. Members of the Lloyds TSB Group’s pension schemes have the option to pay additional voluntary contributions: neither the contributions nor the resulting benefits are included in the above table. Major changes to the legislation governing the provision of pensions in the UK (known as pension simplification) came into effect in April 2006. Benefits from an approved pension scheme will be limited to the Lifetime Allowance, currently £1.65 million which is equivalent to an annual pension of £82,500. Any benefit in excess of this amount will incur a tax charge for the individual. The Group has agreed that if an executive director has benefits in excess of the Lifetime Allowance they may cease to accrue benefits in the Scheme and receive a salary supplement as an alternative. This will not cost the Group more than the current arrangements. The Group will not compensate any individual in respect of any increased tax liability arising from pension simplification. To date, the executive directors affected have elected to continue to accrue benefits in the approved scheme. FORMER DIRECTORS WHO SERVED DURING 2008 Ms Dial elected to become a member of the pension scheme for life cover only. Mr Fairey retired as at 30 June 2008 and took his non-approved benefit entitlement in the form of a lump sum in accordance with the scheme rules. A tax free amount of £4.523 million was paid from the FURBS, with a further taxable amount of £2.446 million made by the bank from provisions set aside. The total amount of £6.969 million covered the bank’s liability to provide benefits in respect of salary in excess of the earnings cap. OVERVIEW Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 BUSINESS REVIEW Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 GOVERNANCE The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 FINANCIAL STATEMENTS SHAREHOLDER INFORMATION Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 89 Lloyds Banking Group Annual Report and Accounts 2008 DIRECTORS’ INTERESTS The interests, all beneficial, of those who were directors at 31 December 2008 in shares in Lloyds Banking Group were: SHARES Executive directors J E Daniels A G Kane G T Tate T J W Tookey H A Weir Non-executive directors Sir Victor Blank W C G Berndt Ewan Brown J P du Plessis P N Green Sir Julian Horn-Smith Lord Leitch Sir David Manning C J McCall M A Scicluna At 1 January 2008 (or later date of appointment) At 31 December 2008 At 26 February* 2009 166,023 137,000 8,112 2,252 10,511 200,000 170,000 4,677 10,000 5,000 5,000 10,000 4,500 – – 423,018 204,061 75,072 2,493 61,822 301,199 170,000 95,074 50,000 5,000 5,000 10,000 4,500 – 607,514 293,523 108,315 4,186 89,306 433,528 243,899 136,402 71,735 7,173 7,173 14,347 6,456 – 10,000 14,461 * The changes in beneficial interests between 31 December 2008 and 26 February 2009 related to applications made under the Placing and Open Offer, the Scheme of Arrangement relating to the acquisition of HBOS plc and ‘partnership’ and ‘matching’ shares acquired under the Lloyds TSB Group Shareplan. 90 Lloyds Banking Group Annual Report and Accounts 2008 DIRECTORS’ REMUNERATION REPORT continued AUDITED INFORMATION INTERESTS IN SHARE OPTIONS At 1 January 2008 (or later date of appointment) J E Daniels A G Kane G T Tate 939,177 521,876 2,236 50,000 27,000 64,786 11,841 34,759 5,783 523,255 300,474 268,336 195,409 300,474 3,851 T J W Tookey 2,798 H A Weir Sir Victor Blank 556,208 5,093 300,474 Other share plan T J W Tookey 35,305 6,906 6,906 6,906 6,906 6,906 4,897 6,906 Granted during the year Exercised during the year Lapsed during the year At 31 December 2008 807,693 131,484 91,329 430,547 2,236 50,000 6,906 27,000 64,786 11,841 34,759 – 5,783 Exercise periods From To Notes Exercise price 419.25p 474.25p 418p 139p 880p 887.5p 549.5p 615.5p 655p 284p 18/3/2007 17/3/2014 17/3/2008 16/3/2015 1/6/2009 30/11/2009 1/1/2012 30/6/2012 4/3/2001 3/3/2008 4/3/2002 3/3/2009 6/3/2003 5/3/2010 8/8/2003 7/8/2010 6/3/2004 5/3/2011 1/6/2008 30/11/2008 450,000 73,255 52,583 247,891 419.25p 474.25p 18/3/2007 17/3/2014 17/3/2008 16/3/2015 203,936 168,052 6,906 64,400 27,357 139p 1/1/2012 30/6/2012 419.25p 18/3/2007 17/3/2014 403p 12/8/2007 11/8/2014 52,583 247,891 474.25p 17/3/2008 16/3/2015 3,851 2,798 478,340 5,093 6,906 6,906 77,868 418p 139p 343p 139p 1/6/2011 30/11/2011 1/1/2012 30/6/2012 1/6/2011 30/11/2011 1/1/2012 30/6/2012 424.75p 29/4/2007 28/4/2014 321p 1/11/2009 30/4/2010 52,583 247,891 474.25p 17/3/2008 16/3/2015 4,897 6,906 6,906 139p 343p 139p 1/1/2012 30/6/2012 1/6/2013 30/11/2013 1/1/2012 30/6/2012 35,305 (see page 95) 20/4/2009 19/10/2009 d, f e, f a, n a, h b, j b, g c, g c, g c, g a, k d, f e, f a, h d, f d, f e, f a, n a, h a, n a, h d, f a, n e, f a, h a, n a, h h OVERVIEW Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 BUSINESS REVIEW Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 GOVERNANCE The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 FINANCIAL STATEMENTS SHAREHOLDER INFORMATION Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 91 Lloyds Banking Group Annual Report and Accounts 2008 INTERESTS IN SHARE OPTIONS continued At 1 January 2008 Granted during the year Exercised during the year Lapsed during the year At 31 December 2008 Former directors who served during 2008 M E Fairey T A Dial Other share plan T A Dial 48,000 57,000 85,896 10,931 42,884 555,992 344,754 1,789 464,134 242,825 † Funds from this Sharesave option were repaid to Mr Fairey after he left the board. Notes: Exercise price 859.5p 817p 549.5p 615.5p 655p 419.25p 474.25p 418p 474p Exercise periods From To Notes 15/5/2001 14/5/2008 2/8/2002 1/8/2009 6/3/2003 5/3/2010 8/8/2003 7/8/2010 6/3/2004 5/3/2011 18/3/2007 17/3/2014 17/3/2008 16/3/2015 1/6/2009 30/11/2009 b, f, j b, g c, g c, g c, g d, f e, f a, h 11/8/2008 10/8/2015 e, h, m 48,000 478,154 57,000 85,896 10,931 42,884 77,838 60,332 284,422 1,789† 464,134 0 242,825 – (see page 95) 1/6/2008 30/11/2008 i a) Sharesave. b) Executive option granted between March 1998 and August 1999. c) Executive option granted between March 2000 and March 2001. d) Executive option granted between March 2004 and August 2004. e) Executive options granted from March 2005. f) Exercisable to the extent at which the performance condition vested. g) Not exercisable as the performance conditions had not been met. h) Not exercisable as the option has not been held for the period required by the relevant scheme. i) Option lapsed on notice of resignation tendered prior to 31 May 2008. j) Option lapsed as not exercised by 10th anniversary of date of grant. k) Mr Kane exercised his 2003A Sharesave option on 7 August 2008. Market price on day of exercise was 318.75p. In that regard Mr Kane made a gain of £2,009.59. l) Exercisable Sharesave option. m) Lapsed on resignation. n) Cancelled Sharesave option. Mr Fairey retired from the Group on 30 June 2008. Mr Tookey was appointed to the board on 30 October 2008. Ms Dial resigned from the board on 18 April 2008 and left the Group on 30 June 2008. The market price for a share in the Company at 1 January 2008 and 31 December 2008 was 467.5p and 126p, respectively. The range of prices between 1 January 2008 and 31 December 2008 was 118.5p to 483.1229p. None of the other directors at 31 December 2008 had options to acquire shares in Lloyds TSB Group plc or its subsidiaries. 92 Lloyds Banking Group Annual Report and Accounts 2008 DIRECTORS’ REMUNERATION REPORT continued AUDITED INFORMATION The following table contains information on the performance conditions for executive options granted since 1998. The remuneration committee chose the relevant performance condition because it was felt to be challenging, aligned to shareholders’ interests and appropriate at the time. Options granted Performance conditions March 1998 – August 1999 March 2000 – March 2001 March 2004 – August 2004 March 2005 – August 2005 Growth in earnings per share which is equal to the aggregate percentage change in the retail price index plus two percentage points for each complete year of the relevant period plus a further condition that the Company’s ranking based on TSR over the relevant period should be in the top 50 companies of the FTSE 100. As for March 1998 – August 1999 except that there must have been growth in the earnings per share equal to the change in the retail price index plus three percentage points for each complete year of the relevant period. That the Company’s ranking based on TSR over the relevant period against a comparator group (17 UK and international financial services companies including Lloyds TSB) must be at least ninth, when 14 per cent of the option will be exercisable. If the Company is ranked first in the group, then 100 per cent of the option will be exercisable and if ranked tenth or below the performance condition is not met. Options granted in 2004 became exercisable as the performance condition was met on the re-test. The performance condition vested at 24 per cent for Mr Tate’s March option and at 14 per cent for all other options granted to executive directors during 2004. That the Company’s ranking based on TSR over the relevant period against a comparator group (15 companies including Lloyds TSB) must be at least eighth, when 30 per cent of the option will be exercisable. If the Company is ranked first to fourth position in the group, then 100 per cent of the option will be exercisable and if ranked ninth or below, the performance condition is not met. Options granted in 2005 became exercisable as the performance condition was met when tested. The performance condition vested at 82.5 per cent for all options granted to executive directors. LLOyDS TSB PERFORMANCE SHARE PLAN Under the plan, executive directors were required to defer 50 per cent of their bonus awards in 2005 and 2006 into shares in the Company, known as bonus shares. The number of bonus shares awarded was calculated after the deduction of income tax and national insurance from the deferred element of the bonus. The bonus shares are held on behalf of the executive for a period of three years before release. Executives received a further award of ’performance shares’ on the basis of two performance shares for each bonus share. The receipt of the performance shares is dependent on the satisfaction of a TSR performance condition measured over three financial years of the Company. The following table details the number of bonus and performance shares released in respect of their 2004 bonus and the number of bonus and performance shares remaining under the plan relating to the 2005 bonus. Bonus shares Performance shares At 1 January 2008 Released 18 March 2008 At 31 December 2008 At 1 January 2008 Vested 10 April 2008 Lapsed 10 April 2008 At 31 December 2008 Award price Bonus shares release date 479p 18/3/2008 J E Daniels A G Kane G T Tate H A Weir 57,737 22,171 22,710 16,628 57,737 50,944 22,171 20,531 22,710 27,358 16,628 20,062 195,720 97,860 97,860 50,944 172,694 172,694 566.10p 20/3/2009 75,156 69,598 76,982 92,738 56,366 68,008 20,531 27,358 20,062 37,578 37,578 479p 18/3/2008 69,598 566.10p 20/3/2009 38,491 38,491 479p 18/3/2008 92,738 566.10p 20/3/2009 28,183 28,183 479p 18/3/2008 68,008 566.10p 20/3/2009 Former directors who served during 2008 M E Fairey 31,901 31,901 108,140 54,070 54,070 479p 18/3/2008 T A Dial * ** Bonus shares released in June 2008. Performance Shares lapsed on resignation. 22,459 * 16,909 * 76,134 76,134 566.10p 20/3/2009 0 57,322 ** n/a n/a 0 566.10p 20/3/2009 OVERVIEW Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 BUSINESS REVIEW Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 GOVERNANCE The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 FINANCIAL STATEMENTS SHAREHOLDER INFORMATION Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 93 Lloyds Banking Group Annual Report and Accounts 2008 AUDITED INFORMATION The following table contains information on the performance conditions for performance shares. The remuneration committee chose the relevant performance condition because it was felt to be challenging, aligned to shareholders’ interests and appropriate at the time. Performance shares awarded Performance conditions March 2005 and March 2006 That the Company’s ranking based on TSR over the relevant period against a comparator group (15 companies including Lloyds TSB) must be at least eighth for any shares to be received. If ranked ninth or below no shares would be received. The maximum of two performance shares for each bonus share will be awarded only if the Company is first in the comparator group; one performance share will be awarded for each bonus share if the Company is placed fifth; and one performance share for every two bonus shares if the Company is placed eighth. Between first and fifth positions and fifth and eighth positions a sliding scale will apply. Whilst income tax was deducted from the deferred bonus before the conversion to bonus shares, where a match of performance shares is justified, these shares will be awarded as if income tax had not been deducted. This maintains the original design of the plan prior to the issue of guidance from HM Revenue & Customs in December 2004. The performance condition attached to the March 2005 award was met, with Lloyds TSB ranked in fifth place. Bonus shares were released on 18 March 2008, with one performance share awarded for every bonus share. Performance shares were released on 10 April 2008. LLOyDS TSB LONG-TERM INCENTIVE PLAN The following are conditional share awards available under the plan. Further information regarding this plan can be found on page 81. J E Daniels A G Kane G T Tate T J W Tookey H A Weir Former directors who served during 2008 M E Fairey T A Dial Notes At 1 January 2008 507,692 534,322 288,460 306,122 297,114 333,951 54,258 52,875 288,460 320,037 328,846 333,951 328,846 347,866 Awarded during the year Lapsed during the year At 31 December 2008 year of vesting Notes 838,735 413,309 518,638 71,220 506,482 507,692 534,322 838,735 288,460 306,122 413,309 297,114 333,951 518,638 54,258 52,875 71,220 288,460 320,037 506,482 328,846 333,951 – – 2009 2010 2011 2009 2010 2011 2009 2010 2011 2009 2010 2011 2009 2010 2011 2009 2010 2009 2010 b a b a b c d d 328,846 347,866 a) share price for the award made 6 March 2008 was 428.25p. b) share price for the award made 4 April 2008 was 462.75p. c) Mr Fairey’s LTIP awards will continue to vesting dates, but will be pro-rated depending on the number of months worked during each award. For the award made on 12 May 2006, this would be 30 months. For the award made on 8 March 2007, the half subject to the EPS performance condition would be over 18 months and the half subject to the TSR performance condition would be over 16 months. d) Ms Dial’s LTIP awards lapsed following her resignation from the Group. 94 Lloyds Banking Group Annual Report and Accounts 2008 DIRECTORS’ REMUNERATION REPORT continued AUDITED INFORMATION The following table contains information on the performance conditions for awards made under the long-term incentive plan. The remuneration committee chose the relevant performance conditions because they were felt to be challenging, aligned to shareholders’ interests and appropriate at the time. LTIP award May 2006 Performance conditions For 50 per cent of the award (the ‘EPS Award’) – the percentage increase in earnings per share of the Group (on a compound annualised basis) over the relevant period must be at least an average of 6 percentage points per annum greater than the percentage increase (if any) in the retail price index over the same period. If it is less than 3 per cent per annum, the EPS Award will lapse. If the increase is more than 3 but less than 6 per cent per annum, then the proportion of shares released will be on a straight line basis between 17.5 per cent and 100 per cent. The relevant period commenced on 1 January 2006 and ended on 31 December 2008. For the other 50 per cent of the award (the ‘TSR Award’) – it will be necessary for the Company’s TSR to exceed the median of a comparator group (14 companies) over the relevant period by an average of 7.5 per cent per annum for the TSR Award to vest in full. 17.5 per cent of the TSR Award will vest where the Company’s TSR is equal to median and vesting will occur on a straight line basis in between these points. Where the Company’s TSR is below the median of the comparator group, the TSR Award will lapse. The relevant period commenced on 1 January 2006 and ended on 31 December 2008. March 2007 For 50 per cent of the award (the ‘EPS Award’) – the performance condition was as described for May 2006 with the relevant performance period commencing on 1 January 2007 and ending on 31 December 2009. For the other 50 per cent of the award (the ‘TSR Award’) – the performance condition was as described for May 2006 with the relevant performance period commencing on 8 March 2007 (the date of award) and ending on 7 March 2010. March and April 2008 For 50 per cent of the award (the ‘EPS Award’) – the performance condition was as described for May 2006 with the relevant performance period commencing on 1 January 2008 and ending on 31 December 2010. For the other 50 per cent of the award (the ‘TSR Award’) – the performance condition was as described for May 2006 with the relevant performance period commencing on 6 March 2008 (the date of the March award) and ending on 5 March 2011. Alithos Limited provided information for the testing of the TSR performance conditions for the Company’s long-term incentive schemes. EPS is the Group’s normalised earnings per share as shown in the Group’s report and accounts, subject to such adjustments as the remuneration committee regards as necessary for consistency. OVERVIEW Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 BUSINESS REVIEW Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 GOVERNANCE The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 FINANCIAL STATEMENTS SHAREHOLDER INFORMATION Report of the independent auditors on the consolidated financial statements Consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 95 Lloyds Banking Group Annual Report and Accounts 2008 AUDITED INFORMATION OTHER SHARE PLAN Lloyds TSB Group executive share plan 2005. Ms Dial was the only participant in this plan where an option was granted to her, in June 2005, to acquire 242,825 ordinary shares in Lloyds TSB Group plc for a total price of £1. The option was not subject to any performance condition but would normally become exercisable only if she remained an employee, and had not given notice of resignation, on 31 May 2008. The option lapsed on notice of resignation tendered prior to 31 May 2008. Full details of the plan were set out in the 2005 annual report. LLOyDS TSB GROUP EXECUTIVE SHARE PLAN 2003 Mr Tookey was granted an option under this plan to acquire 35,305 ordinary shares in Lloyds TSB Group plc. The option was not subject to any performance condition but would normally become exercisable only if he remains an employee, and has not given notice of resignation, on 19 April 2009. In addition, on 26 March 2008 (prior to his appointment as an executive director), Mr Tookey was granted an award under the Lloyds TSB Executive Retention Plan 2006. The award is satisfied in cash only and, subject to continued employment, gives Mr Tookey the right to receive an amount equal to the value of 108,342 Lloyds Banking Group Shares on the date of vesting. The award vests as to 50 per cent on 26 March 2011 and 50 per cent on 26 March 2013. Mr Tookey has agreed to reinvest the cash proceeds into Lloyds Banking Group Shares. As an executive director, he is no longer eligible to be granted awards under this plan. None of those who were directors at the end of the year had any other interest in the capital of Lloyds Banking Group plc or its subsidiaries. The register of directors’ interests, which is open to inspection, contains full particulars of directors’ shareholdings and options to acquire shares in Lloyds Banking Group. On behalf of the board Harry F Baines Company Secretary and General Counsel 26 February 2009 96 Lloyds Banking Group Annual Report and Accounts 2008 REPORT OF THE INDEPENDENT AUDITORS ON THE CONSOLIDATED FINANCIAL STATEMENTS To The members of LLoyds banking group pLc We have audited the consolidated financial statements of Lloyds Banking Group plc for the year ended 31 December 2008 which comprise the consolidated income statement, the consolidated balance sheet, the consolidated statement of changes in equity, the consolidated cash flow statement and the related notes. These consolidated financial statements have been prepared under the accounting policies set out therein. We have reported separately on the parent company financial statements of Lloyds Banking Group plc for the year ended 31 December 2008 and on the information in the directors’ remuneration report that is described as having been audited. respecTive responsibiLiTies of direcTors and audiTors The directors’ responsibilities for preparing the annual report and the consolidated financial statements in accordance with applicable law and International Financial Reporting Standards (‘IFRSs’) as adopted by the European Union are set out in the statement of directors’ responsibilities on page 73. Our responsibility is to audit the consolidated financial statements in accordance with relevant legal and regulatory requirements and International Standards on Auditing (UK and Ireland). This report, including the opinion, has been prepared for and only for the Company’s members as a body in accordance with section 235 of the Companies Act 1985 and for no other purpose. We do not, in giving this opinion, accept or assume responsibility for any other purpose or to any other person to whom this report is shown or into whose hands it may come save where expressly agreed by our prior consent in writing. We report to you our opinion as to whether the consolidated financial statements give a true and fair view and whether the consolidated financial statements have been properly prepared in accordance with the Companies Act 1985 and Article 4 of the IAS Regulation. We also report to you whether, in our opinion, the information given in the directors’ report is consistent with the consolidated financial statements. The information given in the directors’ report includes that specific information presented in the Overview and the Business Review that is cross referred from the principal activities, business review, future developments and financial risk management objectives and policies section of the directors’ report. In addition we report to you if, in our opinion, we have not received all the information and explanations we require for our audit, or if information specified by law regarding directors’ remuneration and other transactions is not disclosed. We review whether the corporate governance statement reflects the Company’s compliance with the nine provisions of the Combined Code (2006) specified for our review by the Listing Rules of the Financial Services Authority, and we report if it does not. We are not required to consider whether the board’s statements on internal control cover all risks and controls, or form an opinion on the effectiveness of the Group’s corporate governance procedures or its risk and control procedures. We read other information contained in the annual report and consider whether it is consistent with the audited consolidated financial statements. The other information comprises only the Overview, the unaudited part of the Business Review, the directors’ report, the corporate governance disclosures, the unaudited part of the directors’ remuneration report, the shareholder information and all the other information listed on the contents page. We consider the implications for our report if we become aware of any apparent misstatements or material inconsistencies with the consolidated financial statements. Our responsibilities do not extend to any other information. basis of audiT opinion We conducted our audit in accordance with International Standards on Auditing (UK and Ireland) issued by the Auditing Practices Board. An audit includes examination, on a test basis, of evidence relevant to the amounts and disclosures in the consolidated financial statements. It also includes an assessment of the significant estimates and judgments made by the directors in the preparation of the consolidated financial statements, and of whether the accounting policies are appropriate to the Group’s circumstances, consistently applied and adequately disclosed. We planned and performed our audit so as to obtain all the information and explanations which we considered necessary in order to provide us with sufficient evidence to give reasonable assurance that the consolidated financial statements are free from material misstatement, whether caused by fraud or other irregularity or error. In forming our opinion we also evaluated the overall adequacy of the presentation of information in the consolidated financial statements. opinion In our opinion: – the consolidated financial statements give a true and fair view, in accordance with IFRSs as adopted by the European Union, of the state of the Group’s affairs as at 31 December 2008 and of its profit and cash flows for the year then ended; – the consolidated financial statements have been properly prepared in accordance with the Companies Act 1985 and Article 4 of the IAS Regulation; and – the information given in the directors’ report is consistent with the consolidated financial statements. pricewaterhousecoopers LLp Chartered Accountants and Registered Auditors Southampton, England 26 February 2009 overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 financiaL sTaTemenTs sharehoLder informaTion Report of the independent auditors on the consolidated financial statements consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 CONSOLIDATED INCOME STATEMENT for the year ended 31 December 2008 Interest and similar income Interest and similar expense net interest income Fee and commission income Fee and commission expense Net fee and commission income Net trading income Insurance premium income Other operating income other income Total income Insurance claims Total income, net of insurance claims Operating expenses Trading surplus Impairment Profit on sale of businesses profit before tax Taxation profit for the year Profit attributable to minority interests Profit attributable to equity shareholders profit for the year basic earnings per share diluted earnings per share The accompanying notes are an integral part of the consolidated financial statements. Shareholder information Index to annual report Financial calendar 2009 191 192 195 97 Lloyds Banking Group Annual Report and Accounts 2008 Note 5 6 7 8 9 10 11 12 13 14 15 15 2008 £ million 17,569 (9,851) 7,718 3,231 (694) 2,537 (9,186) 5,412 532 (705) 7,013 2,859 9,872 (6,053) 3,819 (3,012) – 807 38 845 26 819 845 14.3p 14.2p 2007 £ million 16,874 (10,775) 6,099 3,224 (600) 2,624 3,123 5,430 952 12,129 18,228 (7,522) 10,706 (5,567) 5,139 (1,796) 657 4,000 (679) 3,321 32 3,289 3,321 58.3p 57.9p 98 Lloyds Banking Group Annual Report and Accounts 2008 CONSOLIDATED BALANCE SHEET at 31 December 2008 assets Cash and balances at central banks Items in the course of collection from banks Trading and other financial assets at fair value through profit or loss Derivative financial instruments Loans and advances to banks Loans and advances to customers Available-for-sale financial assets Investment property Goodwill Value of in-force business Other intangible assets Tangible fixed assets Current tax recoverable Deferred tax assets Other assets Total assets The accompanying notes are an integral part of the consolidated financial statements. The directors approved the consolidated financial statements on 26 February 2009. sir victor blank Chairman J eric daniels Group Chief Executive Tim J w Tookey Group Finance Director Note 2008 £ million 2007 £ million 5,008 946 45,064 28,884 40,758 242,735 55,707 2,631 2,256 1,893 197 2,965 300 833 4,330 1,242 57,911 8,659 34,845 209,814 20,196 3,722 2,358 2,218 149 2,839 – – 5,856 436,033 5,063 353,346 16 17 18 19 21 22 23 24 25 26 38 27 overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 financiaL sTaTemenTs sharehoLder informaTion Report of the independent auditors on the consolidated financial statements consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 CONSOLIDATED BALANCE SHEET at 31 December 2008 equity and liabilities Liabilities Deposits from banks Customer accounts Items in course of transmission to banks Trading and other liabilities at fair value through profit or loss Derivative financial instruments Debt securities in issue Liabilities arising from insurance contracts and participating investment contracts Liabilities arising from non-participating investment contracts Unallocated surplus within insurance businesses Other liabilities Retirement benefit obligations Current tax liabilities Deferred tax liabilities Other provisions Subordinated liabilities Total liabilities equity Share capital Share premium account Other reserves Retained profits shareholders’ equity Minority interests Total equity Total equity and liabilities The accompanying notes are an integral part of the consolidated financial statements. Shareholder information Index to annual report Financial calendar 2009 191 192 195 99 Lloyds Banking Group Annual Report and Accounts 2008 Note 2008 £ million 2007 £ million 28 29 30 17 31 32 34 35 36 37 38 39 40 41 42 43 44 66,514 170,938 39,091 156,555 508 6,754 26,892 75,710 33,792 14,243 270 11,456 1,771 – – 230 17,256 426,334 1,513 2,096 (2,476) 8,260 9,393 306 9,699 436,033 668 3,206 7,582 51,572 38,063 18,197 554 9,690 2,144 484 948 209 11,958 340,921 1,432 1,298 (60) 9,471 12,141 284 12,425 353,346 100 Lloyds Banking Group Annual Report and Accounts 2008 CONSOLIDATED STATEMENT OF CHANGES IN EQUITy balance at 1 January 2007 Movement in available-for-sale financial assets, net of tax: – change in fair value – transferred to income statement in respect of disposals – transferred to income statement in respect of impairment – disposal of businesses Movement in cash flow hedges, net of tax Currency translation differences Net income recognised directly in equity Profit for the year Total recognised income for 2007 Dividends Purchase/sale of treasury shares Employee share option schemes: – value of employee services – proceeds from shares issued Repayment of capital to minority shareholders balance at 31 december 2007 Movement in available-for-sale financial assets, net of tax: – change in fair value – transferred to income statement in respect of disposals – transferred to income statement in respect of impairment – other transfers to income statement Movement in cash flow hedges, net of tax Currency translation differences Net income recognised directly in equity Profit for the year Total recognised income for 2008 Dividends Private placement of ordinary shares Purchase/sale of treasury shares Employee share option schemes: – value of employee services – proceeds from shares issued Repayment of capital to minority shareholders Attributable to equity shareholders Share capital and premium £ million 2,695 Other reserves £ million 336 Retained profits £ million 8,124 – – – – – – – – – – – – 35 – 2,730 – – – – – – – – – – 760 – – 119 – (436) (5) 49 (6) (15) 17 (396) – (396) – – – – – – – – – – – – 3,289 3,289 (1,957) (1) 16 – – (2,059) (19) 102 (66) (12) (362) (2,416) – (2,416) – – – – – – – – – – – – – 819 819 (2,042) – 16 (4) – – Total £ million 11,155 (436) (5) 49 (6) (15) 17 (396) 3,289 2,893 (1,957) (1) 16 35 – (19) 102 (66) (12) (362) (2,416) 819 (1,597) (2,042) 760 16 (4) 119 – Minority interests £ million 352 – – – – – (1) (1) 32 31 (19) – – – (80) 284 Total £ million 11,507 (436) (5) 49 (6) (15) 16 (397) 3,321 2,924 (1,976) (1) 16 35 (80) 12,425 – – – – – 28 26 54 (29) – – – – (3) 306 (19) 102 (66) (12) (362) (2,388) 845 (1,543) (2,071) 760 16 (4) 119 (3) 9,699 (60) 9,471 12,141 (2,059) 28 (2,031) balance at 31 december 2008 3,609 (2,476) 8,260 9,393 The accompanying notes are an integral part of the consolidated financial statements. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 financiaL sTaTemenTs sharehoLder informaTion Report of the independent auditors on the consolidated financial statements consolidated financial statements Notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 101 Lloyds Banking Group Annual Report and Accounts 2008 CONSOLIDATED CASH FLOW STATEMENT for the year ended 31 December 2008 profit before tax Adjustments for: Change in operating assets Change in operating liabilities Non-cash and other items Tax paid net cash provided by operating activities cash flows from investing activities Purchase of available-for-sale financial assets Proceeds from sale and maturity of available-for-sale financial assets Purchase of fixed assets Proceeds from sale of fixed assets Acquisition of businesses, net of cash acquired Disposal of businesses, net of cash disposed net cash used in investing activities cash flows from financing activities Dividends paid to equity shareholders Dividends paid to minority interests Interest paid on subordinated liabilities Proceeds from issue of subordinated liabilities Proceeds from issue of ordinary shares Repayment of subordinated liabilities Repayment of capital to minority shareholders net cash provided by (used in) financing activities Effects of exchange rate changes on cash and cash equivalents Change in cash and cash equivalents Cash and cash equivalents at beginning of year cash and cash equivalents at end of year The accompanying notes are an integral part of the consolidated financial statements. Note 50(A) 50(B) 50(C) 50(F) 50(G) 50(E) 50(E) 50(E) 50(E) 50(E) 50(D) 2008 £ million 807 (43,025) 80,933 (4,064) (810) 33,841 (144,680) 110,470 (1,436) 579 (19) – (35,086) (2,042) (29) (771) 3,021 879 (381) (3) 674 1,440 869 31,891 32,760 2007 £ million 4,000 (16,982) 21,541 2,784 (859) 10,484 (21,667) 19,468 (1,334) 982 (8) 1,476 (1,083) (1,957) (19) (709) – 35 (300) (80) (3,030) 82 6,453 25,438 31,891 102 Lloyds Banking Group Annual Report and Accounts 2008 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS 1 basis of preparaTion During 2008, global financial markets experienced difficult conditions which have been characterised by a marked reduction in liquidity. As a consequence of this, Governments and central banks carried out a series of actions to address the lack of liquidity within their respective banking systems. In the UK these actions have included the introduction of the Bank of England’s Special Liquidity Scheme whereby banks and building societies can exchange eligible securities for UK Treasury bills; and the creation of a credit guarantee scheme by HM Treasury, providing a Government guarantee for certain short and medium term senior debt securities issued by eligible banks. During 2008 the Group has made use of these measures in order to maintain and improve a stable funding position. The Group’s management of liquidity and funding risks is described on pages 55 and 56. In the context of this continued turbulence and uncertainty in the financial markets, combined with a deteriorating global economic outlook, the Group has also taken steps to strengthen its capital position (see note 52 for details of the preference and ordinary share capital issued by the Group in January 2009) in order to provide a buffer against further shocks arising from the financial systems and to ensure that it remains competitive. There is a risk that, despite the substantial measures taken by Governments, further deterioration in the markets could occur. In addition the economic conditions in the UK are deteriorating more quickly than previously anticipated placing greater strain on the Group’s capital resources. The key dependencies on successfully funding the Group’s balance sheet include the continued functioning of the money and capital markets at their current levels; the continued access of the Group to central bank and Government sponsored liquidity facilities, including issuance under HM Treasury’s credit guarantee scheme and access to the Bank of England’s various facilities; limited further deterioration in the Group’s credit ratings; and no significant or sudden withdrawal of deposits resulting in increased reliance on money markets or Government support schemes. Based upon projections prepared by management which take into account the acquisition on 16 January 2009 of HBOS plc together with the Group’s current ability to fund in the market and the assumption that the announced Government sponsored schemes will continue to be available, the directors are satisfied that the Company and the Group have adequate resources to continue in business for the foreseeable future. Accordingly, the financial statements of the Company and the Group have been prepared on a going concern basis. 2 accounTing poLicies The consolidated financial statements have been prepared in accordance with International Financial Reporting Standards (IFRS) as adopted by the European Union (EU). IFRS comprises accounting standards prefixed IFRS issued by the International Accounting Standards Board (IASB) and those prefixed IAS issued by the IASB’s predecessor body as well as interpretations issued by the International Financial Reporting Interpretations Committee and its predecessor body. The EU endorsed version of IAS 39 ‘Financial Instruments: Recognition and Measurement’ relaxes some of the hedge accounting requirements; the Group has not taken advantage of this relaxation, and therefore there is no difference in application to the Group between IFRS as adopted by the EU and IFRS as issued by the IASB. The financial information has been prepared under the historical cost convention, as modified by the revaluation of investment properties, available- for-sale financial assets, trading securities and certain other financial assets and liabilities at fair value through profit or loss and all derivative contracts. The following IFRS pronouncements relevant to the Group have been adopted in these consolidated financial statements: (i) (ii) IFRIC 11 IFRS 2 – Group and Treasury Share Transactions. This interpretation clarifies the application of IFRS 2 Share-based Payment to certain share-based payment arrangements involving own equity instruments and arrangements involving equity instruments of a parent entity. The application of this new interpretation has not had any impact for amounts recognised in these financial statements. IFRIC 14 IAS 19 – The Limit on a Defined Benefit Asset, Minimum Funding Requirement and their Interaction. This interpretation provides guidance on assessing the amount of a pension surplus that can be recognised as an asset and explains how a minimum funding requirement might either affect the availability of reductions in future contributions or give rise to a liability. The application of this new interpretation has not had any impact for amounts recognised in these financial statements. (iii) Amendments to IAS 39 Financial Instruments: Recognition and Measurement and IFRS 7 Financial Instruments: Disclosures – Reclassification of Financial Assets. The amendment to IAS 39 permits reclassification of non-derivative financial assets (other than those designated at fair value through profit or loss by the entity upon initial recognition) out of the fair value through profit or loss category in certain circumstances and permits the transfer of a financial asset from the available-for-sale category to the loans and receivables category where that financial asset would have met the definition of loans and receivables at the time of reclassification (if the financial asset had not been designated as available-for-sale) and where there is both the intention and ability to hold that financial asset for the foreseeable future. The amendment to IFRS 7 requires additional disclosures about the situations in which any such reclassification is made and the effects on the financial statements including details of the carrying amounts and fair values for all financial assets that have been reclassified until they are derecognised and the fair value gain or loss that would have been recognised in the income statement or equity, as appropriate, if the financial asset had not been reclassified. For eligible reclassifications made before 1 November 2008, these amendments became effective from 1 July 2008. Details of the financial assets reclassified in accordance with this amendment are set out in note 49. Details of those IFRS pronouncements which will be relevant to the Group but which were not effective at 31 December 2008 and which have not been applied in preparing these financial statements are given in note 51. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 financiaL sTaTemenTs sharehoLder informaTion Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 103 Lloyds Banking Group Annual Report and Accounts 2008 2 accounTing poLicies continued The Group’s accounting policies are set out below. (a) consoLidaTion The assets, liabilities and results of Group undertakings (including special purpose entities) are included in the financial statements on the basis of accounts made up to the reporting date. Group undertakings include all entities over which the Group has the power to govern the financial and operating policies which generally accompanies a shareholding of more than one half of the voting rights. The existence and effect of potential voting rights that are currently exercisable or convertible are considered when assessing whether the Group controls another entity. Group undertakings are fully consolidated from the date on which control is transferred to the Group; they are de-consolidated from the date that control ceases. Open Ended Investment Companies (OEICs) where the Group, through the Group’s life funds, has a controlling interest are consolidated; the unitholders’ interest is reported in other liabilities. Intercompany transactions, balances and unrealised gains and losses on transactions between Group companies are eliminated. The Group applies a policy of treating transactions with minority interests as transactions with parties external to the Group. Disposals to minority interests result in gains and losses for the Group that are recorded in the income statement. Purchases from minority interests result in goodwill, being the difference between any consideration paid and the relevant share acquired of the carrying value of net assets of the subsidiary. (b) goodwiLL Goodwill represents the excess of the cost of an acquisition over the fair value of the Group’s share of the identifiable net assets and contingent liabilities of the acquired entity at the date of acquisition. Goodwill is recognised as an asset at cost and is tested at least annually for impairment. If an impairment is identified the carrying value of the goodwill is written down immediately through the income statement and is not subsequently reversed. At the date of disposal of a Group undertaking, the carrying value of attributable goodwill is included in the calculation of the profit or loss on disposal except where it has been written off directly to reserves in the past. (c) oTher inTangibLe asseTs Other intangible assets comprise capitalised software enhancements and customer lists. Capitalised software enhancements are amortised over periods not exceeding five years, being their estimated useful lives, using the straight-line method. Customer lists are amortised over periods not exceeding 15 years, being their estimated useful lives, in line with the income expected to arise from those customers and are subject to annual reassessment. All other intangible assets are reviewed for impairment whenever events or any changes in circumstances indicate that the carrying amount may not be recoverable. In the event that an asset’s carrying amount is determined to be greater than its recoverable amount, it is written down immediately. (d) revenue recogniTion Interest income and expense are recognised in the income statement for all interest-bearing financial instruments, except for those classified at fair value through profit or loss, using the effective interest method. The effective interest method is a method of calculating the amortised cost of a financial asset or liability and of allocating the interest income or interest expense. The effective interest rate is the rate that exactly discounts the estimated future cash payments or receipts over the expected life of the instrument or, when appropriate, a shorter period, to the net carrying amount of the financial asset or financial liability. The effective interest rate is calculated on initial recognition of the financial asset or liability, estimating the future cash flows after considering all the contractual terms of the instrument but not future credit losses. The calculation includes all amounts paid or received by the Group including expected early redemptions and related penalties and premiums and discounts that are an integral part of the overall return as well as direct incremental transaction costs related to the acquisition, issue or disposal of a financial instrument. Once a financial asset or a group of similar financial assets has been written down as a result of an impairment loss, interest income is recognised using the rate of interest used to discount the future cash flows for the purpose of measuring the impairment loss (see J). Fees and commissions which are not an integral part of the effective interest rate are generally recognised when the service has been provided. Loan commitment fees for loans that are likely to be drawn down are deferred (together with related direct costs) and recognised as an adjustment to the effective interest rate on the loan. Loan syndication fees are recognised as revenue when the syndication has been completed and the Group retains no part of the loan package for itself or retains a part at the same effective interest rate for all interest-bearing financial instruments, including loans and advances, as for the other participants. Dividend income is recognised when the right to receive payment is established. Revenue recognition policies specific to life assurance and general insurance business are detailed below (see R). (e) Trading securiTies, oTher financiaL asseTs and LiabiLiTies aT fair vaLue Through profiT or Loss, and avaiLabLe-for-saLe financiaL asseTs Debt securities and equity shares acquired principally for the purpose of selling in the short term or which are part of a portfolio which is managed for short-term gains are classified as trading securities and recognised in the balance sheet at their fair value. Gains and losses arising from changes in their fair value together with interest coupons and dividend income are recognised in the income statement within net trading income in the period in which they occur. 104 Lloyds Banking Group Annual Report and Accounts 2008 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued 2 accounTing poLicies continued Other financial assets and liabilities at fair value through profit or loss are designated as such by management upon initial recognition. Such assets and liabilities are carried in the balance sheet at their fair value and gains and losses arising from changes in fair value together with interest coupons and dividend income are recognised in the income statement within net trading income in the period in which they occur. Financial assets and liabilities are designated as at fair value through profit or loss on acquisition in the following circumstances: – When doing so results in more relevant information because either: – it eliminates or significantly reduces the inconsistent treatment that would otherwise arise from measuring the assets and liabilities or recognising gains or losses on different bases; or – the assets and liabilities are part of a group which is managed, and its performance evaluated, on a fair value basis in accordance with a documented risk management or investment strategy, with management information also prepared on this basis. – Where the assets and liabilities contain one or more embedded derivatives that significantly modify the cash flows arising under the contract and would otherwise need to be separately accounted for. The fair values of assets and liabilities traded in active markets are based on current bid and offer prices respectively. If the market is not active the Group establishes a fair value by using valuation techniques. These include the use of recent arm’s length transactions, reference to other instruments that are substantially the same, discounted cash flow analysis, option pricing models and other valuation techniques commonly used by market participants. Refer to note 3 (Critical accounting estimates and judgements: Valuation of financial instruments) and note 49 (Financial risk management: Fair values of financial assets and liabilities) for details of valuation techniques and significant inputs to valuation models. The Group is permitted to reclassify, at fair value at the date of transfer, non-derivative financial assets (other than those designated at fair value through profit or loss by the entity upon initial recognition) out of the trading category if they are no longer held for the purpose of being sold or repurchased in the near term, as follows: – if the financial assets would have met the definition of loans and receivables (but for the fact that they had to be classified as held for trading at initial recognition), they may be reclassified into loans and receivables where the Group has the intention and ability to hold the assets for the foreseeable future or until maturity; – if the financial assets would not have met the definition of loans and receivables, they may be reclassified out of the held for trading category into available-for-sale financial assets in ‘rare circumstances’. Debt securities and equity shares, other than those classified as trading securities or at fair value through profit or loss, are classified as available-for- sale and recognised in the balance sheet at their fair value; available-for-sale investments are those intended to be held for an indeterminate period of time and may be sold in response to needs for liquidity or changes in interest rates, exchange rates or equity prices. Gains and losses arising from changes in the fair value of investments classified as available-for-sale are recognised directly in equity, until the financial asset is either sold, becomes impaired or matures, at which time the cumulative gain or loss previously recognised in equity is recognised in the income statement. Interest calculated using the effective interest method is recognised in the income statement. The Group is permitted to transfer, at fair value at the date of transfer, a financial asset from the available-for-sale category to the loans and receivables category where that asset would have met the definition of loans and receivables at the time of reclassification (if the financial asset had not been designated as available-for-sale) and where there is both the intention and ability to hold that financial asset for the foreseeable future. For assets transferred, gains or losses recognised in equity in respect of these assets as at the date of transfer are amortised to profit or loss over the remaining life of the asset using the effective interest method. Purchases and sales of securities and other financial assets and liabilities are recognised on trade date, being the date that the Group is committed to purchase or sell an asset. Trading securities and other financial assets and liabilities at fair value through profit or loss are initially recognised at fair value. Available-for-sale financial assets are initially recognised at fair value inclusive of transaction costs. These financial assets are derecognised when the rights to receive cash flows from the financial assets have expired or where the Group has transferred substantially all risks and rewards of ownership. (f) Loans and advances To banks and cusTomers Loans and advances to banks and customers, including any eligible assets transferred into these categories out of the fair value through profit or loss or available-for-sale financial assets categories, are accounted for at amortised cost using the effective interest method, except those which the Group intends to sell in the near term and which are accounted for at fair value, with the gains and losses arising from changes in their fair value reflected in the income statement. Loans and advances are initially recognised when cash is advanced to the borrowers at fair value inclusive of transaction costs. Loans and advances are derecognised when the rights to receive cash flows from them have expired or where the Group has transferred substantially all risks and rewards of ownership. The Group has entered into securitisation and similar transactions to finance certain loans and advances to customers. Such financial assets continue to be recognised by the Group, together with a corresponding liability for the funding except in those cases where substantially all of the risks and rewards associated with the assets have been transferred or a significant proportion but not all of the risks and rewards have been transferred and the transferee has the ability to sell the assets when the assets are derecognised in full. If a fully proportional share of all, or of specifically identified, cash flows have been transferred, then that proportion of the assets is derecognised. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 financiaL sTaTemenTs sharehoLder informaTion Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 105 Lloyds Banking Group Annual Report and Accounts 2008 2 accounTing poLicies continued (g) saLe and repurchase agreemenTs Securities sold subject to repurchase agreements (‘repos’) are recognised on the balance sheet where all of the risks and rewards are retained; the counterparty liability is included in deposits from banks or customer accounts, as appropriate. Securities purchased under agreements to resell (‘reverse repos’) are recorded as loans and advances to banks or customers, as appropriate. The difference between sale and repurchase price is treated as interest and accrued over the life of the agreements using the effective interest method. Securities lent to counterparties are retained in the financial statements. Securities borrowed are not recognised in the financial statements, unless these are sold to third parties, in which case the obligation to return them is recorded at fair value as a trading liability. (h) derivaTive financiaL insTrumenTs and hedge accounTing All derivatives are recognised at their fair value. Fair values are obtained from quoted market prices in active markets, including recent market transactions, and using valuation techniques, including discounted cash flow and options pricing models, as appropriate. Derivatives are carried in the balance sheet as assets when their fair value is positive and as liabilities when their fair value is negative. Refer to note 3 (Critical accounting estimates and judgements: Valuation of financial instruments) and note 49 (Financial risk management: Fair values of financial assets and liabilities) for details of valuation techniques and significant inputs to valuation models. Changes in the fair value of any derivative instrument that is not part of a hedging relationship are recognised immediately in the income statement. Derivatives embedded in financial instruments and insurance contracts (unless the embedded derivative is itself an insurance contract) are treated as separate derivatives when their economic characteristics and risks are not closely related to those of the host contract and the host contract is not carried at fair value through profit or loss. These embedded derivatives are measured at fair value with changes in fair value recognised in the income statement. In accordance with IFRS 4, a policyholder’s option to surrender an insurance contract for a fixed amount is not treated as an embedded derivative. The method of recognising the movements in the fair value of the derivatives depends on whether they are designated as hedging instruments and, if so, the nature of the item being hedged. Derivatives may only be designated as hedges provided certain strict criteria are met. At the inception of a hedge its terms must be clearly documented and there must be an expectation that the derivative will be highly effective in offsetting changes in the fair value or cash flow of the hedged risk. The effectiveness of the hedging relationship must be tested throughout its life and if at any point it is concluded that it is no longer highly effective in achieving its objective the hedge relationship is terminated. The Group designates certain derivatives as either: (1) hedges of the fair value of the particular risks inherent in recognised assets or liabilities (fair value hedges); (2) hedges of highly probable future cash flows attributable to recognised assets or liabilities (cash flow hedges); or (3) hedges of net investments in foreign operations (net investment hedges). These are accounted for as follows: (1) FAIR VALUE HEDGES Changes in the fair value of derivatives that are designated and qualify as fair value hedges are recorded in the income statement, together with the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk; this also applies if the hedged asset is classified as an available-for-sale financial asset. If the hedge no longer meets the criteria for hedge accounting, changes in the fair value attributable to the hedged risk are no longer recognised in the income statement; the adjustment that has been made to the carrying amount of a hedged item is amortised to the income statement over the period to maturity. (2) CASH FLOW HEDGES The effective portion of changes in the fair value of derivatives that are designated and qualify as cash flow hedges is recognised in equity. The gain or loss relating to the ineffective portion is recognised immediately in the income statement. Amounts accumulated in equity are recycled to the income statement in the periods in which the hedged item affects profit or loss. When a hedging instrument expires or is sold, or when a hedge no longer meets the criteria for hedge accounting, any cumulative gain or loss existing in equity at that time remains in equity and is recognised when the forecast transaction is ultimately recognised in the income statement. When a forecast transaction is no longer expected to occur, the cumulative gain or loss that was reported in equity is immediately transferred to the income statement. (3) NET INVESTMENT HEDGES Hedges of net investments in foreign operations are accounted for similarly to cash flow hedges. Any gain or loss on the hedging instrument relating to the effective portion of the hedge is recognised in equity; the gain or loss relating to the ineffective portion is recognised immediately in the income statement. Gains and losses accumulated in equity are included in the income statement when the foreign operation is disposed of. (i) offseT Financial assets and liabilities are offset and the net amount reported in the balance sheet when there is a legally enforceable right of set-off and there is an intention to settle on a net basis, or realise the asset and settle the liability simultaneously. (J) impairmenT of financiaL asseTs (1) ASSETS ACCOUNTED FOR AT AMORTISED COST At each balance sheet date the Group assesses whether, as a result of one or more events occurring after initial recognition, there is objective evidence that a financial asset or group of financial assets has become impaired. The criteria that the Group uses to determine that there is objective evidence of an impairment loss include: – Delinquency in contractual payments of principal and/or interest; 106 Lloyds Banking Group Annual Report and Accounts 2008 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued 2 accounTing poLicies continued – Indications that the borrower or group of borrowers is experiencing significant financial difficulty; – Restructuring of debt to reduce the burden on the borrower; – Breach of loan covenants or conditions; and – Initiation of bankruptcy or individual voluntary arrangement proceedings. The estimated period between a loss occurring and its identification is determined by local management for each identified portfolio. In general, the periods used vary between two months and twelve months. If there is objective evidence that an impairment loss has been incurred, an allowance is established which is calculated as the difference between the balance sheet carrying value of the asset and the present value of estimated future cash flows discounted at that asset’s original effective interest rate. For the Group’s portfolios of smaller balance homogenous loans, such as the residential mortgage, personal lending and credit card portfolios, allowances are calculated for groups of assets taking into account historical cash flow experience. For the Group’s other lending portfolios, allowances are established on a case-by-case basis. If an asset has a variable interest rate, the discount rate used for measuring the impairment loss is the current effective interest rate. The calculation of the present value of the estimated future cash flows of a collateralised asset or group of assets reflects the cash flows that may result from foreclosure less the costs of obtaining and selling the collateral, whether or not foreclosure is probable. If there is no objective evidence of individual impairment the asset is included in a group of financial assets with similar credit risk characteristics and collectively assessed for impairment. Segmentation takes into account such factors as the type of asset, industry, geographical location, collateral type, past-due status and other relevant factors. These characteristics are relevant to the estimation of future cash flows for groups of such assets as they are indicative of the borrower’s ability to pay all amounts due according to the contractual terms of the assets being evaluated. Future cash flows are estimated on the basis of the contractual cash flows of the assets in the Group and historical loss experience for assets with similar credit risk characteristics. Historical loss experience is adjusted on the basis of current observable data to reflect the effects of current conditions that did not affect the period on which the historical loss experience is based and to remove the effects of conditions in the historical period that do not exist currently. The methodology and assumptions used for estimating future cash flows are reviewed regularly by the Group to reduce any differences between loss estimates and actual loss experience. If, in a subsequent period, the amount of the impairment loss decreases and the decrease can be related objectively to an event occurring after the impairment was recognised, such as an improvement in the borrower’s credit rating, the allowance is adjusted and the amount of the reversal is recognised in the income statement. A loan or advance is normally written off, either partially or in full, against the related allowance when the proceeds from realising any available security have been received or there is no realistic prospect of recovery (as a result of the customer’s insolvency, ceasing to trade or other reason) and the amount of the loss has been determined. Subsequent recoveries of amounts previously written off decrease the amount of impairment losses recorded in the income statement. (2) AVAILABLE-FOR-SALE FINANCIAL ASSETS The Group assesses at each balance sheet date whether there is objective evidence that an available-for-sale financial asset is impaired. In addition to the criteria for financial assets accounted for at amortised cost set out above, this assessment involves reviewing the current financial circumstances (including creditworthiness) and future prospects of the issuer assessing the future cash flows expected to be realised and, in the case of equity shares, considering whether there has been a significant or prolonged decline in the fair value of the asset below its cost. If an impairment loss has been incurred, the cumulative loss measured as the difference between the acquisition cost (net of any principal repayment and amortisation) and the current fair value, less any impairment loss on that asset previously recognised, is removed from equity and recognised in the income statement. For impaired debt instruments, impairment losses are recognised in subsequent periods when it is determined that there has been a further negative impact on expected future cash flows; a reduction in fair value caused by general widening of credit spreads would not, of itself, result in additional impairment. If, in a subsequent period, the fair value of a debt instrument classified as available-for-sale increases and the increase can be objectively related to an event occurring after the impairment loss was recognised, an amount not greater than the original impairment loss is credited to the income statement; any excess is taken to the available-for-sale reserve. Impairment losses recognised in the income statement on equity instruments are not reversed through the income statement. (3) RENEGOTIATED LOANS Loans that are either subject to collective impairment assessment or individually significant and whose terms have been renegotiated are no longer considered to be past due but are treated as new loans. In subsequent years, the asset is considered to be past due and disclosed only if further renegotiated. (k) invesTmenT properTy Property held for long-term rental yields and capital appreciation within the long-term assurance funds is classified as investment property. Investment property comprises freehold and long leasehold land and buildings and is carried in the balance sheet at fair value, being the open market value as determined in accordance with the guidance published by the Royal Institution of Chartered Surveyors. If this information is not available, the Group uses alternative valuation methods such as discounted cash flow projections or recent prices on less active markets. These valuations are reviewed at least annually by an independent valuation expert. Investment property being redeveloped for continuing use as investment property, or for which the market has become less active, continues to be measured at fair value. Changes in fair value are recorded in the income statement. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 financiaL sTaTemenTs sharehoLder informaTion Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 107 Lloyds Banking Group Annual Report and Accounts 2008 2 accounTing poLicies continued (L) TangibLe fixed asseTs Tangible fixed assets are included at cost less accumulated depreciation. The value of land (included in premises) is not depreciated. Depreciation on other assets is calculated using the straight-line method to allocate the difference between the cost and the residual value over their estimated useful lives, as follows: Premises (excluding land): – Freehold/long and short leasehold premises: shorter of 50 years or the remaining period of the lease – Leasehold improvements: shorter of 10 years or, if lease renewal is not likely, the remaining period of the lease Equipment: – Fixtures and furnishings: 10-20 years – Other equipment and motor vehicles: 2-8 years The assets’ residual values and useful lives are reviewed, and adjusted if appropriate, at each balance sheet date. Assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. In the event that an asset’s carrying amount is determined to be greater than its recoverable amount it is written down immediately. The recoverable amount is the higher of the asset’s fair value less costs to sell and its value in use. (m) Leases (1) AS LESSEE The leases entered into by the Group are primarily operating leases. Operating lease rentals are charged to the income statement on a straight-line basis over the period of the lease. When an operating lease is terminated before the end of the lease period, any payment made to the lessor by way of penalty is recognised as an expense in the period of termination. (2) AS LESSOR Assets leased to customers are classified as finance leases if the lease agreements transfer substantially all the risks and rewards of ownership to the lessee; all other leases are classified as operating leases. When assets are subject to finance leases, the present value of the lease payments is recognised as a receivable within loans and advances to banks and customers. Finance lease income is recognised over the term of the lease using the net investment method (before tax) reflecting a constant periodic rate of return. Operating lease assets are included within tangible fixed assets at cost and depreciated over their estimated useful lives, which equates to the lives of the leases, after taking into account anticipated residual values. Operating lease rental income is recognised on a straight line basis over the life of the lease. The Group evaluates non-lease arrangements such as outsourcing and similar contracts to determine if they contain a lease which is then accounted for separately. (n) borrowings Borrowings (which include deposits from banks, customer accounts, debt securities in issue and subordinated liabilities) are recognised initially at fair value, being their issue proceeds net of transaction costs incurred. Borrowings are subsequently stated at amortised cost using the effective interest method. Preference shares and other instruments which carry a mandatory coupon or are redeemable on a specific date are classified as financial liabilities. The coupon on these instruments is recognised in the income statement as interest expense. (o) pensions and oTher posT-reTiremenT benefiTs The Group operates a number of post-retirement benefit schemes for its employees including both defined benefit and defined contribution pension plans. A defined benefit scheme is a pension plan that defines an amount of pension benefit that an employee will receive on retirement, dependent on one or more factors such as age, years of service and salary. A defined contribution plan is a pension plan into which the Group pays fixed contributions; there is no legal or constructive obligation to pay further contributions. Full actuarial valuations of the Group’s principal defined benefit schemes are carried out every three years with interim reviews in the intervening years; these valuations are updated to 31 December each year by qualified independent actuaries, or in the case of the Scottish Widows Retirement Benefits Scheme, by a qualified actuary employed by Scottish Widows. For the purposes of these annual updates scheme assets are included at their fair value and scheme liabilities are measured on an actuarial basis using the projected unit credit method adjusted for unrecognised actuarial gains and losses. The defined benefit scheme liabilities are discounted using rates equivalent to the market yields at the balance sheet date on high-quality corporate bonds that are denominated in the currency in which the benefits will be paid, and that have terms to maturity approximating to the terms of the related pension liability. The Group’s income statement includes the current service cost of providing pension benefits, the expected return on the schemes’ assets, net of expected administration costs, and the interest cost on the schemes’ liabilities. Actuarial gains and losses arising from experience adjustments and changes in actuarial assumptions are not recognised unless the cumulative unrecognised gain or loss at the end of the previous reporting period exceeds the greater of 10 per cent of the scheme assets or liabilities (‘the corridor approach’). In these circumstances the excess is charged or 108 Lloyds Banking Group Annual Report and Accounts 2008 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued 2 accounTing poLicies continued credited to the income statement over the employees’ expected average remaining working lives. Past service costs are charged immediately to the income statement, unless the charges are conditional on the employees remaining in service for a specified period of time (the vesting period). In this case, the past service costs are amortised on a straight-line basis over the vesting period. The Group’s balance sheet includes the net surplus or deficit, being the fair value of scheme assets less the discounted value of scheme liabilities adjusted for the corridor. Surpluses are only recognised to the extent that they are recoverable through reduced contributions in the future or through refunds from the schemes. The Group recognises the effect of material changes to the terms of its defined benefit pension plans which reduce future benefits as curtailments; gains and losses are recognised in the income statement when the curtailments occur. The costs of the Group’s defined contribution plans are charged to the income statement in the period in which they fall due. (p) share-based compensaTion The Group operates a number of equity-settled, share-based compensation plans. The value of the employee services received in exchange for equity instruments granted under these plans is recognised as an expense over the vesting period of the instruments, with a corresponding increase in equity. This expense is determined by reference to the fair value of the number of equity instruments that are expected to vest. The fair value of equity instruments granted is based on market prices, if available, at the date of grant. In the absence of market prices, the fair value of the instruments at the date of grant is estimated using an appropriate valuation technique, such as a Black-Scholes option pricing model. The determination of fair values excludes the impact of any non-market vesting conditions, which are included in the assumptions used to estimate the number of options that are expected to vest. At each balance sheet date, this estimate is reassessed and if necessary revised. Any revision of the original estimate is recognised in the income statement over the remaining vesting period, together with a corresponding adjustment to equity. (q) TaxaTion Current income tax which is payable on taxable profits is recognised as an expense in the period in which the profits arise. For the Group’s long-term assurance businesses, the tax charge is analysed between tax that is payable in respect of policyholders’ returns and tax that is payable on equity holders’ returns. This allocation is based on an assessment of the rates of tax which will be applied to the returns under current UK tax rules. Deferred tax is provided in full, using the liability method, on temporary differences arising between the tax bases of assets and liabilities and their carrying amounts in the consolidated financial statements. However, deferred tax is not accounted for if it arises from initial recognition of an asset or liability in a transaction other than a business combination that at the time of the transaction affects neither accounting nor taxable profit or loss. Deferred tax is determined using tax rates that have been enacted or substantially enacted by the balance sheet date which are expected to apply when the related deferred tax asset is realised or the deferred tax liability is settled. Deferred tax assets are recognised where it is probable that future taxable profit will be available against which the temporary differences can be utilised. Deferred tax is provided on temporary differences arising from investments in subsidiaries and associates, except where the timing of the reversal of the temporary difference is controlled by the Group and it is probable that the difference will not reverse in the foreseeable future. Income tax payable on profits is recognised as an expense in the period in which those profits arise. The tax effects of losses available for carry forward are recognised as an asset when it is probable that future taxable profits will be available against which these losses can be utilised. Deferred tax related to fair value re-measurement of available-for-sale investments and cash flow hedges, which are charged or credited directly to equity, is also credited or charged directly to equity and is subsequently recognised in the income statement together with the deferred gain or loss. Deferred and current tax assets and liabilities are offset when they arise in the same tax reporting group and where there is both a legal right of offset and the intention to settle on a net basis or to realise the asset and settle the liability simultaneously. (r) insurance The Group undertakes both life assurance and general insurance business. For accounting purposes the life assurance business issues three types of contract: Insurance contracts – these contracts contain significant insurance risk, which the Group defines as the possibility of having to pay benefits on the occurrence of an insured event which are significantly more than the benefits payable if the insured event were not to occur. Investment contracts containing a discretionary participation feature – these contracts do not contain significant insurance risk, but contain features which entitle the holder to receive, in addition to the guaranteed benefits, further amounts that are likely to be a significant proportion of the total benefits and the amount and timing of which is at the discretion of the Group and based upon the performance of specified assets. Contracts with a discretionary participation feature are referred to as participating investment contracts. Non-participating investment contracts – these contracts do not contain significant insurance risk or a discretionary participation feature. For accounting purposes the general insurance business only issues insurance contracts. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 financiaL sTaTemenTs sharehoLder informaTion Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 109 Lloyds Banking Group Annual Report and Accounts 2008 2 accounTing poLicies continued (1) LIFE ASSURANCE BUSINESS (i) Accounting for insurAnce And pArticipAting investment contrActs premiums And clAims Premiums received in respect of insurance and participating investment contracts are recognised as revenue when due, except as detailed below in respect of unit-linked contracts. Claims are recorded as an expense when they are incurred. liAbilities – insurance or participating investment contracts in the group’s With profit fund Liabilities of the Group’s With Profit Fund, including guarantees and options embedded within products written by that fund, are stated at their realistic values in accordance with the Financial Services Authority’s realistic capital regime, except that projected transfers out of the fund into other Group funds are not treated as liabilities. Further details on the realistic capital regime are given on page 62. – insurance or participating investment contracts which are not unit-linked or in the group’s With profit fund A liability for contractual benefits that are expected to be incurred in the future is recorded when the premiums are recognised. The liability is calculated by estimating the future cash flows over the duration of in-force policies and discounting them back to the valuation date allowing for probabilities of occurrence. The liability will vary with movements in interest rates and with the cost of life assurance and annuity benefits where future mortality is uncertain. Assumptions are made in respect of all material factors affecting future cash flows, including future interest rates, mortality and costs. – insurance or participating investment contracts which are unit-linked Allocated premiums in respect of unit-linked contracts that are either insurance or participating investment contracts are recognised as liabilities. These liabilities are increased or reduced by the change in the unit prices and are reduced by policy administration fees, mortality and surrender charges and any withdrawals. The mortality charges deducted in each period from the policyholders as a group are considered adequate to cover the expected total death benefit claims in excess of the contract account balances in each period and hence no additional liability is established for these claims. Revenue consists of fees deducted for mortality, policy administration and surrender charges. Interest or changes in the unit prices credited to the account balances and excess benefit claims in excess of the account balances incurred in the period are charged as expenses in the income statement. unAllocAted surplus Any amounts in the With Profit Fund not yet determined as being due to policyholders are recognised as an unallocated surplus which is shown separately from other liabilities. vAlue of in-force business The Group recognises as an asset the value of in-force business in respect of life insurance and participating investment contracts. The asset represents the present value of the shareholders’ interest in the profits expected to emerge from those contracts written at the balance sheet date. This is determined after making appropriate assumptions about future economic conditions and other matters such as future mortality and persistency rates and includes allowances for both non-market risk and for the realistic value of financial options and guarantees. Each cash flow is valued using the discount rate consistent with that applied to such a cash flow in the capital markets. The asset in the consolidated balance sheet is presented gross of attributable tax and movements in the asset are reflected within other operating income in the income statement. (ii) Accounting for non-pArticipAting investment contrActs All of the Group’s non-participating investment contracts are unit-linked. These contracts are accounted for as financial liabilities whose value is contractually linked to the fair values of financial assets within the Group’s unitised investment funds. The value of the unit-linked financial liabilities is determined using current unit prices multiplied by the number of units attributed to the contract holders at the balance sheet date. Their value is never less than the amount payable on surrender, discounted for the required notice period where applicable. Deposits and withdrawals are accounted for directly in the balance sheet as adjustments to the liability. The Group receives investment management fees in respect of services rendered in conjunction with the issue and management of investment contracts where the Group actively manages the consideration received from its customers to fund a return that is based on the investment profile that the customer selected on origination of the instrument. These services comprise an indeterminate number of acts over the lives of the individual contracts and, therefore, the Group defers these fees and recognises them on a straight-line basis over the estimated lives of the contracts. Directly incremental commissions that vary with and are related to either securing new or renewing existing non-participating investment contracts are deferred; all other costs are recognised as expenses when incurred. This asset is subsequently amortised over the period of the provision of investment management services and is reviewed for impairment in circumstances where its carrying amount may not be recoverable. If the asset is greater than its recoverable amount it is written down immediately through expenses in the income statement. 110 Lloyds Banking Group Annual Report and Accounts 2008 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued 2 accounTing poLicies continued (2) GENERAL INSURANCE BUSINESS The Group both underwrites and acts as intermediary in the sale of general insurance products. Underwriting premiums are included, net of refunds, in the period in which insurance cover is provided to the customer; premiums received relating to future periods are deferred and only credited to the income statement when earned. Broking commission is recognised when the underwriter accepts the risk of providing insurance cover to the customer. Where appropriate, provision is made for the effect of future policy terminations based upon past experience. The underwriting business makes provision for the estimated cost of claims notified but not settled and claims incurred but not reported at the balance sheet date. The provision for the cost of claims notified but not settled is based upon a best estimate of the cost of settling the outstanding claims after taking into account all known facts. In those cases where there is insufficient information to determine the required provision, statistical techniques are used which take into account the cost of claims that have recently been settled and make assumptions about the future development of the outstanding cases. Similar statistical techniques are used to determine the provision for claims incurred but not reported at the balance sheet date. Claims liabilities are not discounted. (3) LIABILITy ADEQUACy TEST At each balance sheet date liability adequacy tests are performed to ensure the adequacy of insurance and participating investment contract liabilities net of related deferred tax assets and acquired value of in-force business. In performing these tests current best estimates of discounted future contractual cash flows and claims handling and administration expenses, as well as investment income from the assets backing such liabilities, are used. Any deficiency is immediately charged to profit or loss by establishing a provision for losses arising from liability adequacy tests. (4) REINSURANCE Contracts entered into by the Group with reinsurers under which the Group is compensated for losses on one or more contracts issued by the Group and that meet the classification requirements for insurance contracts are classified as reinsurance contracts held. Insurance contracts entered into by the Group under which the contract holder is another insurer (inwards reinsurance) are included with insurance contracts. The benefits to which the Group is entitled under its reinsurance contracts held are recognised as reinsurance assets. These assets consist of short-term balances due from reinsurers as well as longer term receivables that are dependent on the expected claims and benefits arising under the related reinsured insurance contracts. Amounts recoverable from or due to reinsurers are measured consistently with the amounts associated with the reinsured insurance contracts and in accordance with the terms of each reinsurance contract and are regularly reviewed for impairment. Reinsurance liabilities are primarily premiums payable for reinsurance contracts and are recognised as an expense when due. (s) foreign currency TransLaTion The consolidated financial statements are presented in sterling, which is the Company’s functional currency. Foreign currency transactions are translated into the functional currency using the exchange rates prevailing at the dates of the transactions. Foreign exchange gains and losses resulting from the settlement of such transactions and from the translation at year end exchange rates of monetary assets and liabilities denominated in foreign currencies are recognised in the income statement, except when deferred in equity as qualifying cash flow or net investment hedges. Non-monetary assets that are measured at fair value are translated using the exchange rate at the date that the fair value was determined. Translation differences on equities and similar non-monetary items measured at fair value are recognised in profit or loss, except for differences on available-for-sale non-monetary financial assets such as equity shares, which are included in the fair value reserve in equity unless the asset is a hedged item in a fair value hedge. The assets and liabilities of foreign operations, including goodwill and fair value adjustments arising on the acquisition of a foreign entity, are translated into sterling at foreign exchange rates ruling at the balance sheet date. The revenues and expenses of foreign operations are translated into sterling at average exchange rates unless these do not approximate to the foreign exchange rates ruling at the dates of the transactions. Foreign exchange differences arising on the translation of a foreign operation are recognised directly in equity and included in profit or loss on its disposal. (T) provisions Provisions are recognised in respect of present obligations arising from past events where it is probable that outflows of resources will be required to settle the obligations and they can be reliably estimated. The Group recognises provisions in respect of vacant leasehold property where the unavoidable costs of the present obligations exceed anticipated rental income. Contingent liabilities are possible obligations whose existence depends on the outcome of uncertain future events or those present obligations where the outflows of resources are uncertain or cannot be measured reliably. Contingent liabilities are not recognised in the financial statements but are disclosed unless they are remote. (u) dividends Dividends on ordinary shares are recognised in equity in the period in which they are paid. (v) cash and cash equivaLenTs For the purposes of the cash flow statement, cash and cash equivalents comprise cash and non-mandatory balances with central banks and amounts due from banks with a maturity of less than three months. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 financiaL sTaTemenTs sharehoLder informaTion Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 111 Lloyds Banking Group Annual Report and Accounts 2008 3 criTicaL accounTing esTimaTes and JudgemenTs The preparation of financial statements requires management to make judgements, estimates and assumptions that affect the reported amounts of assets, liabilities, income and expenses. Due to the inherent uncertainty in making estimates, actual results reported in future periods may be based upon amounts which differ from those estimates. Estimates, judgements and assumptions are continually evaluated and are based on historical experience and other factors, including expectations of future events that are believed to be reasonable under the circumstances. Revisions to accounting estimates are recognised in the period in which the estimate is revised and in any future periods affected. The accounting policies deemed critical to the Group’s results and financial position, based upon materiality and significant judgements and estimates, are discussed below. impairmenT of financiaL asseTs LOAN IMPAIRMENT ALLOWANCES The Group regularly reviews its loan portfolios to assess for impairment. Impairment allowances are established to recognise incurred impairment losses in its loan portfolios carried at amortised cost. In determining whether an impairment has occurred at the balance sheet date the Group considers whether there is any observable data indicating that there has been a measurable decrease in the estimated future cash flows or their timings; such observable data includes information as to whether there has been an adverse change in the payment status of borrowers or changes in economic conditions that correlate with defaults on loan repayment obligations. Where this is the case, the impairment loss is the difference between the carrying value of the loan and the present value of the estimated future cash flows discounted at the loan’s original effective interest rate. At 31 December 2008 gross loans and advances to customers and banks totalled £287,220 million (2007: £247,067 million) against which impairment allowances of £3,727 million (2007: £2,408 million) had been made. There are two components of the Group’s loan impairment allowances: individual and collective. All impaired loans which exceed a certain threshold, principally within the Group’s corporate banking business, are individually assessed for impairment having regard to expected future cash flows including those that could arise from the realisation of security. The determination of these allowances often requires the exercise of considerable judgement by management involving matters such as local economic conditions and the resulting trading performance of the customer and the value of the security held, for which there may not be a readily accessible market. The actual amount of the future cash flows and their timing may differ significantly from the assumptions made for the purposes of determining the impairment allowances and consequently these allowances can be subject to variation as time progresses and the circumstances of the customer become clearer. Impairment allowances for portfolios of smaller balance homogenous loans, such as residential mortgages, personal loans and credit card balances that are below the individual assessment thresholds, and for loan losses that have been incurred but not separately identified at the balance sheet date, are determined on a collective basis. Collective impairment allowances are calculated on a portfolio basis using formulae which take into account factors such as the length of time that the customer’s account has been out of order, historical loss rates, the credit quality of the portfolios and the value of any security held, which is estimated, where appropriate, using indices such as house price indices. The variables used in the formulae are kept under regular review to ensure that as far as possible they reflect current economic circumstances; however changes in interest rates, unemployment levels and bankruptcy trends, particularly in the UK, could result in actual losses differing from reported impairment allowances. Assumptions used in calculating provisions for loan impairment have been updated to reflect market conditions, including those in respect of house price inflation, forced sale discount and probability of borrower default. If average house prices were 12.5 per cent lower than those in place as at 31 December 2008, the house price index related impact on the impairment charge would be an increase of approximately £85 million. IMPAIRMENT OF AVAILABLE-FOR-SALE FINANCIAL ASSETS In determining whether an impairment loss has been incurred in respect of an available-for-sale financial asset, the Group performs an objective review of the current financial circumstances and future prospects of the issuer and, in the case of equity shares, considers whether there has been a significant or prolonged decline in the fair value of that asset below its cost. This consideration requires management judgement. Among factors considered by the Group is whether the decline in fair value is a result of a change in the quality of the asset or a downward movement in the market as a whole. An assessment is performed of the future cash flows expected to be realised from the asset, taking into account, where appropriate, the quality of underlying security and credit protection available. The reduction in the fair value of available-for-sale financial assets during the year was £2,721 million (2007: £483 million). Impairment losses in respect of available-for-sale financial assets transferred from reserves to the income statement totalled £130 million (2007: £70 million). vaLuaTion of financiaL insTrumenTs Trading securities, other financial assets and liabilities at fair value through profit or loss, derivatives and available-for-sale financial assets are stated at fair value. The fair value of these financial instruments is the amount for which an instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. The fair values of financial instruments are determined by reference to unadjusted quoted prices in active markets where these are available. Where market prices are not available or are unreliable because of poor liquidity, fair values are determined using valuation techniques which, to the extent possible, use market observable inputs. Valuation techniques used include discounted cash flow analysis and pricing models and, where appropriate, comparison to similar instruments. The Group uses widely recognised valuation models for determining the fair value of common and less complex financial instruments that use only observable market data. Observable prices and model inputs are usually available in the market for listed debt and equity securities, exchange traded derivatives and simple over-the-counter derivatives like interest rate swaps. Availability of observable market prices and model inputs reduces the need for management judgement and estimation and any uncertainty associated with determination of fair values. Availability of that observable information depends on the products and markets and is prone to changes based on specific events and general conditions in the financial markets. 112 Lloyds Banking Group Annual Report and Accounts 2008 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued 3 criTicaL accounTing esTimaTes and JudgemenTs continued Financial markets in certain financial instruments such as asset backed securities (ABS) and secondary loans, which were previously active and had been valued using market observable inputs in previous years, became inactive during 2008. The fair values of those assets are determined predominantly from lead manager quotes and, where these are not available, by alternative techniques including reference to credit spreads on similar assets with the same obligor, market standard consensus pricing services, broker quotes and other research data. For interest rate and foreign exchange option products and more complex option products, some or all of the inputs into the Group’s valuation models may not be observable in the market and are derived from market prices or rates or are estimated based on market standard consensus data. The process of calculating the fair value of these instruments may necessitate the estimation of certain pricing parameters, assumptions or model characteristics. Management judgement and estimation are usually required when determining such matters as the expected cash flows on the financial instruments being valued, the probability of counterparty default, prepayment assumptions, and selection of appropriate discount rates. The fair values of the Group’s financial assets and liabilities are disclosed within note 49 on pages 175 to 177 together with an indication of the valuation technique used for each major asset or liability category, the inputs into valuation models that have the potential to significantly impact the value determined, the assumptions, if any, used for those inputs and the effects of applying reasonably possible alternative assumptions or, in the case of ABS within available-for-sale financial assets, a shift in credit spreads. pensions The net liability recognised in the balance sheet at 31 December 2008 in respect of the Group’s retirement benefit obligations was £1,771 million (2007: £2,144 million) of which £1,657 million (2007: £2,033 million) related to defined benefit pension schemes. This liability excludes actuarial losses of £267 million (2007: gains of £1,350 million) which the Group is permitted to leave unrecognised. The defined benefit pension schemes’ gross deficit totalled £1,924 million (2007: £683 million) representing the difference between the schemes’ liabilities and the fair value of the related assets at the balance sheet date. The schemes’ liabilities are calculated using the projected unit credit method, which takes into account projected earnings increases, using actuarial assumptions that give the best estimate of the future cash flows that will arise under the scheme liabilities. The resulting estimated cash flows are discounted at a rate equivalent to the market yield at the balance sheet date on high quality bonds with a similar duration and currency to the schemes’ liabilities. In order to estimate the future cash flows, a number of financial and non-financial assumptions are made by management, changes to which could have a material impact upon the overall deficit or the net cost recognised in the income statement. Two important assumptions are the rate of inflation and the expected lifetime of the schemes’ members. The assumed rate of inflation affects the rate at which salaries are projected to grow and therefore the size of the pension that employees receive upon retirement and also the rate at which pensions in payment increase. Over the longer term rates of inflation can vary significantly; at 31 December 2008 it was assumed that the rate of inflation would be 3.0 per cent per annum (2007: 3.3 per cent), although if this was increased by 0.2 per cent the overall deficit would increase by approximately £451 million and the annual cost by approximately £17 million. A reduction of 0.2 per cent would reduce the overall deficit by approximately £437 million and the annual cost by approximately £16 million. The cost of the benefits payable by the schemes will also depend upon the longevity of the members. Assumptions are made regarding the expected lifetime of scheme members based upon recent experience, however given the rate of advance in medical science and increasing levels of obesity, it is uncertain whether they will ultimately reflect actual experience. An increase of one year in the expected lifetime of scheme members would increase the overall deficit by approximately £318 million and the annual cost by approximately £22 million; a reduction of one year would reduce the overall deficit by approximately £323 million and the annual cost by approximately £24 million. The size of the overall deficit is also sensitive to changes in the discount rate, which is affected by market conditions and therefore potentially subject to significant variations. At 31 December 2008 the discount rate used was 6.3 per cent (2007: 5.8 per cent); a reduction of 0.2 per cent would increase the overall deficit by approximately £469 million and the annual cost by approximately £7 million, while an increase of 0.2 per cent would reduce the net deficit by approximately £393 million and the annual cost by approximately £9 million. goodwiLL At 31 December 2008 the Group carried goodwill on its balance sheet totalling £2,256 million (2007: £2,358 million), substantially all of which relates to acquisitions made a number of years ago. The Group reviews the goodwill for impairment at least annually or when events or changes in economic circumstances indicate that impairment may have taken place. The impairment review is performed by projecting future cash flows, excluding finance and tax, based upon budgets and plans and making appropriate assumptions about rates of growth and discounting these using a rate that takes into account prevailing market interest rates and the risks inherent in the business. If the present value of the projected cash flows is less than the carrying value of the underlying net assets and related goodwill an impairment charge is required in the income statement. This calculation requires the exercise of significant judgement by management; if the estimates made prove to be incorrect or performance does not meet expectations which affects the amount and timing of future cash flows, goodwill may become impaired in future periods. Further details are given in note 23. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 financiaL sTaTemenTs sharehoLder informaTion Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 113 Lloyds Banking Group Annual Report and Accounts 2008 3 criTicaL accounTing esTimaTes and JudgemenTs continued insurance LIFE ASSURANCE BUSINESS The Group carries in its balance sheet an asset representing the value of in-force business in respect of life insurance and participating investment contracts of £1,893 million at 31 December 2008 (2007: £2,218 million). This asset, which is presented gross of attributable tax, represents the present value of future profits expected to arise from the portfolio of in-force life insurance and participating investment contracts. This is determined after making appropriate assumptions about future economic conditions and other matters such as future mortality and persistency rates and includes allowances for both non-market risk and for the realistic value of financial options and guarantees. Each cash flow is valued using the discount rate consistent with that applied to such a cash flow in the capital markets. The valuation of the Group’s annuity business has been affected by the recent upheaval in the capital markets which has caused a significant widening in corporate bond spreads. Based on available market analysis, an element of this widening in corporate bond spreads has been assessed as arising from an increase in the illiquidity premium. Annuity contracts cannot be surrendered and have reasonably certain cash flows best matched by assets of equivalent maturity with similar liquidity characteristics. As a result, in 2008 the value of in-force business asset for annuity business has been calculated after taking into account an estimate of the market premium for illiquidity derived from market and other published sources using a portfolio of investment grade bonds with similar cash flow characteristics as the annuity liabilities. The effect of this has been to increase the value of in-force business by £842 million as at 31 December 2008 with a similar increase in profit before tax disclosed within other operating income. It is not practicable to estimate the effect of this change on the results of future periods. The assumptions made to derive the discount rates and cash flows are inherently uncertain and changes could significantly affect the value attributed. The process for determining key assumptions that have been made at 31 December 2008 is detailed in notes 24 and 32. At 31 December 2008 the Group also carried substantial liabilities to holders of life, pensions and investment contracts in its balance sheet. The methodology used to value the liabilities is described in note 2 (R) (1). Liabilities arising from insurance contracts and participating investment contracts were £21,518 million and £11,619 million respectively (2007: £22,526 million and £14,874 million) and those arising from non-participating investment contracts totalled £14,243 million (2007: £18,197 million). Elements of the liabilities require assumptions about future investment returns, future mortality rates and future policyholder behaviour. The impact on profit before tax of changes in key assumptions is detailed in note 33. GENERAL INSURANCE BUSINESS At 31 December 2008 the Group held a provision of £183 million (2007: £207 million) in respect of the estimated cost of claims notified but not settled and claims incurred but not reported at the balance sheet date. The provision for the cost of claims notified but not settled is based upon a best estimate of the cost of settling the outstanding claims after taking into account all known facts. In those cases where there is insufficient information to determine the required provision, statistical techniques are used which take into account the cost of claims that have recently been settled and make assumptions about the future development of the outstanding cases. Similar statistical techniques are used to determine the provision for claims incurred but not reported at the balance sheet date. While management believes that the liability carried at year end is adequate, the application of statistical techniques requires significant judgement. An increase of 10 per cent in the cost of claims would result in the recognition of an additional loss of approximately £18 million. Similarly, an increase of 10 per cent in the ultimate number of such claims would lead to an additional loss of approximately £18 million; some relief would arise from reinsurance contracts held. TaxaTion At 31 December 2008 the Group had a current tax asset of £300 million and a deferred tax asset of £833 million (2007: a current tax liability of £484 million and a deferred tax liability of £948 million). During 2008, the Group’s net tax position has shifted from a liability of £1,432 million at 31 December 2007 to an asset of £1,133 million at 31 December 2008. While the Group has taken account of tax issues that are subject to ongoing discussion with HM Revenue & Customs and other tax authorities in recognising these assets a significant feature is the management judgement in determining the timing, forecasting and probability of them reversing. This involved a detailed review of profit and loss numbers for 2007 and 2008 to ensure any carry forward positions were optimised at 31 December 2008. The outcome of this exercise has been mapped into 2009 profit and loss estimates and beyond and supports the above assets. Inherent in this exercise has been management’s assessment of legal and professional advice, case law and other relevant guidance. The various risks are categorised and appropriate weightings applied in arriving at the numbers. Where the expected tax outcome of these tax risks is different from the amounts that were initially recorded, such differences will impact the current and deferred tax numbers in the period in which such determination is made. 114 Lloyds Banking Group Annual Report and Accounts 2008 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued 4 segmenTaL anaLysis The Group is a leading financial services group, whose businesses provide a wide range of banking and financial services predominantly in the UK. At 31 December 2008 the Group’s activities were organised into three segments: UK Retail Banking, Insurance and Investments and Wholesale and International Banking. Services provided by UK Retail Banking encompass the provision of banking and other financial services to personal customers, private banking and mortgages. Insurance and Investments offers life assurance, pensions and savings products, general insurance and asset management services. Wholesale and International Banking provides banking and related services for major UK and multinational companies, banks and financial institutions, and small and medium-sized UK businesses. It also provides asset finance to personal and corporate customers, manages the Group’s activities in financial markets through its treasury function and provides banking and financial services in some overseas locations. Under the Group’s transfer pricing arrangements, inter-segment services are generally recharged at cost, with the exception of the internal commission arrangements between the UK branch and other distribution networks and the insurance product manufacturing businesses within the Group, where a profit margin is also charged. Inter-segment lending and deposits are generally entered into at market rates, except that non-interest bearing balances are priced at a rate that reflects the external yield that could be earned on such funds. For those derivative contracts entered into by business units for risk management purposes, the business unit retains the amount that would have been recognised on an accrual accounting basis (an amount equal to the interest element of the next payment on the swap) and transfers the remainder of the fair value of the swap to the central group segment where the resulting accounting volatility is managed though the establishment of hedge accounting relationships. Any change in fair value of the hedged instrument attributable to the hedged risk is also recorded within the central group segment. This allocation of the fair value of the swap and change in fair value of the hedged instrument attributable to the hedged risk avoids accounting asymmetry in segmental results, records volatility where it is managed and provides a fair presentation of the segments’ operating performance. It is the basis on which the segments are managed and measured internally and is the basis of the Group’s internal segmental reporting to the board. As part of its transition to Basel II on 1 January 2008, the Group has updated its capital and liquidity pricing methodology. The main difference in this approach is to allocate a greater share of certain funding costs, previously allocated to the Central group items segment, to individual divisions. To enable a meaningful period-on-period comparison, the segmental analysis for the year ended 31 December 2007 has been restated to reflect these changes. year ended 31 december 2008 Interest and similar income Interest and similar expense Net interest income uk retail banking £m 9,437 (5,327) 4,110 Other income (net of fee and commission expense) 1,766 Total income Insurance claims Total income, net of insurance claims Operating expenses Trading surplus (deficit) Impairment Profit (loss) before tax External revenue Inter-segment revenue Segment revenue External assets Inter-segment assets Total assets External liabilities Inter-segment liabilities Total liabilities Other segment items: Capital expenditure Depreciation and amortisation Movement in value of in-force business Impairment of goodwill Defined benefit scheme charges 5,876 – 5,876 (2,730) 3,146 (1,472) 1,674 9,804 1,002 10,806 127,502 5,679 133,181 97,929 31,361 129,290 167 215 – – 103 general Life, pensions and asset insurance management £m £m insurance investments £m wholesale and and international banking £m central group items £m inter-segment eliminations £m Total £m 1,176 (2,130) 25 (19) 6 579 585 (193) 392 (161) 231 – 231 65 1,241 1,123 564 1,687 904 74 978 9 16 – – 2 1,048 1,073 10,561 1,742 (5,244) 17,569 (7,258) (2,035) 5,244 (456) 592 (3,680) (3,088) 3,052 (36) (502) (538) (2) (540) 120 (2,010) (475) 598 (3,101) (2,503) 2,859 356 (663) (307) 3,303 829 4,132 – 4,132 (2,630) 1,502 (2) (1,508) (309) (954) 185 (769) (6) 7,679 2,395 10,074 – – – – – – – – – – (4,734) (4,734) (9,851) 7,718 (705) 7,013 2,859 9,872 (6,053) 3,819 (3,012) 807 17,558 – 17,558 (293) (199) (492) – (492) (30) (522) (30) (552) 1,029 1,152 2,181 3,150 65,426 66,549 238,832 – 436,033 2,779 68,205 56,509 7,088 3,343 143,842 98,190 (251,054) – 69,892 382,674 101,340 (251,054) 436,033 57,413 249,149 21,843 – 426,334 7,162 128,681 83,850 (251,054) – 63,597 64,575 377,830 105,693 (251,054) 426,334 227 34 (325) – 19 236 50 (325) – 21 837 421 – 100 85 196 – – – (45) – – – – – 1, 436 686 (325) 100 164 overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 financiaL sTaTemenTs sharehoLder informaTion Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 115 Lloyds Banking Group Annual Report and Accounts 2008 4 segmenTaL anaLysis continued year ended 31 december 2007 Interest and similar income Interest and similar expense Net interest income Other income (net of fee and commission expense) Total income Insurance claims Total income, net of insurance claims Operating expenses Trading surplus (deficit) Impairment Profit on sale of businesses Profit (loss) before tax External revenue Inter-segment revenue Segment revenue External assets Inter-segment assets Total assets External liabilities Inter-segment liabilities Total liabilities Other segment items: Capital expenditure Depreciation and amortisation Movement in value of in-force business Defined benefit scheme charges UK Retail Banking £m 7,964 (4,269) 3,695 1,797 5,492 – 5,492 (2,624) 2,868 (1,224) – 1,644 9,132 958 10,090 115,012 5,093 120,105 96,166 20,321 116,487 80 205 – 114 General Life, pensions and asset insurance management £m £m Insurance and Investments £m Wholesale and International Banking £m Central group items £m Inter-segment eliminations £m 1,040 1,063 23 (18) 5 554 559 (302) 257 (154) 103 – – 103 1,235 49 1,284 1,164 361 1,525 870 12 882 11 14 – 3 (682) 358 7,643 8,001 (7,220) 781 (501) 280 – 272 552 8,854 181 9,035 72,213 3,777 75,990 65,304 5,930 71,234 452 37 (93) 26 9,762 (7,353) 2,409 1,773 4,182 – 4,182 (2,282) 1,900 (572) 385 1,713 10,082 1,487 11,569 163,294 91,246 254,540 162,376 86,159 (700) 363 8,197 8,560 (7,522) 1,038 (655) 383 – 272 655 10,089 230 10,319 73,377 4,138 77,515 66,174 5,942 72,116 248,535 463 51 (93) 29 613 374 – 92 Total £m 16,874 (10,775) 6,099 12,129 18,228 (7,522) 10,706 (5,567) 5,139 (1,796) 657 4,000 29,603 – 29,603 (3,301) 3,301 – – – – – – – – – – – (4,266) (4,266) – 353,346 (165,131) – (165,131) 353,346 – 340,921 (165,131) – (165,131) 340,921 – – – – 1,334 630 (93) 175 1,386 (1,754) (368) 362 (6) – (6) (6) (12) – – (12) 300 1,591 1,891 1,663 64,654 66,317 16,205 52,709 68,914 178 – – (60) As the activities of the Group are predominantly carried out in the UK, no geographical analysis is presented. 116 Lloyds Banking Group Annual Report and Accounts 2008 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued 5 neT inTeresT income Interest receivable: Loans and advances to customers Loans and advances to banks Lease and hire purchase receivables Interest receivable on loans and receivables Available-for-sale financial assets Total interest receivable Interest payable: Deposits from banks Customer accounts Debt securities in issue Subordinated liabilities Liabilities under sale and repurchase agreements Interest payable on liabilities held at amortised cost Other Total interest payable Net interest income weighted average effective interest rate 2008 % 6.31 4.63 7.62 6.11 4.58 5.98 3.65 3.27 4.10 5.82 4.45 3.67 – 3.61 2007 % 6.89 5.14 6.34 6.58 4.83 6.44 5.00 3.58 5.08 5.65 4.81 4.24 4.28 4.24 2008 £m 13,855 1,861 706 16,422 1,147 17,569 (1,540) (4,932) (2,227) (896) (256) (9,851) – (9,851) 7,718 2007 £m 13,209 2,025 602 15,836 1,038 16,874 (1,919) (5,085) (2,680) (741) (155) (10,580) (195) (10,775) 6,099 Included within interest receivable is £435 million (2007: £395 million) in respect of impaired financial assets. Net interest income also includes a charge of £16 million (2007: credit of £1 million) transferred from the cash flow hedging reserve (see note 43). 6 neT fee and commission income Fee and commission income: Current accounts Insurance broking Credit and debit card fees Trust and other fiduciary fees Other Fee and commission expense Net fee and commission income 2008 £m 707 549 581 413 981 3,231 (694) 2,537 2007 £m 693 648 536 362 985 3,224 (600) 2,624 As discussed in note 2(D), fees and commissions which are an integral part of the effective interest rate form part of net interest income shown in note 5. Fees and commissions relating to instruments that are held at fair value through profit or loss are included within net trading income shown in note 7. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 7 neT Trading income Foreign exchange translation gains Gains on foreign exchange trading transactions Total foreign exchange Investment property losses (note 22) Securities and other (losses) gains Net trading income financiaL sTaTemenTs sharehoLder informaTion Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 117 Lloyds Banking Group Annual Report and Accounts 2008 2008 £m 66 75 141 (1,058) (8,269) (9,186) 2007 £m 34 159 193 (321) 3,251 3,123 Securities and other (losses) gains comprise net gains arising on assets and liabilities held at fair value through profit or loss and for trading as follows: Net income (expense) arising on assets held at fair value through profit or loss: Loans and advances to banks and customers Debt securities Equity shares Total net (expense) income arising on assets held at fair value through profit or loss Net expense arising on liabilities held at fair value through profit or loss – debt securities in issue Total net (losses) gains arising on assets and liabilities held at fair value through profit or loss Net (losses) gains on financial instruments held for trading Securities and other (losses) gains 2008 £m 20 918 (7,759) (6,821) (232) (7,053) (1,216) (8,269) 2007 £m 23 673 2,422 3,118 (153) 2,965 286 3,251 118 Lloyds Banking Group Annual Report and Accounts 2008 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued 8 insurance premium income Life insurance Gross premiums Ceded reinsurance premiums Net earned premiums non-life insurance Gross premiums written Ceded reinsurance premiums Net premiums Change in provision for unearned premiums Net earned premiums Total net earned premiums Life insurance gross written premiums can be further analysed as follows: Life and pensions Annuities Other Gross premiums Non-life insurance gross written premiums can be further analysed as follows: Credit protection Home Health 9 oTher operaTing income Operating lease rental income Rental income from investment property (note 22) Other rents receivable Gains less losses on disposal of available-for-sale financial assets (note 43) Movement in value of in-force business (note 24) Car dealership income Other income 2008 £m 4,841 (41) 4,800 651 (23) 628 (16) 612 2007 £m 4,937 (98) 4,839 632 (23) 609 (18) 591 5,412 5,430 2008 £m 4,182 645 14 4,841 2008 £m 203 441 7 651 2008 £m 392 209 32 19 (325) – 205 532 2007 £m 4,233 689 15 4,937 2007 £m 212 412 8 632 2007 £m 393 227 31 5 (93) 49 340 952 overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 10 insurance cLaims Insurance claims comprise: Life insurance and participating investment contracts Claims and surrenders: Gross Reinsurers’ share Change in liabilities: Gross Reinsurers’ share Change in unallocated surplus (note 35) Total life insurance and participating investment contracts non-life insurance Claims and claims paid: Gross Reinsurers’ share Change in liabilities: Gross Reinsurers’ share Total non-life insurance Total insurance claims credit (expense) Life insurance gross claims can also be analysed as follows: Deaths Maturities Surrenders Annuities Other A non-life insurance claims development table is included in note 32. financiaL sTaTemenTs sharehoLder informaTion Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 119 Lloyds Banking Group Annual Report and Accounts 2008 2008 £m 2007 £m (4,710) 65 (4,645) 7,364 49 7,413 284 3,052 (219) 7 (212) 24 (5) 19 (193) 2,859 (289) (1,888) (1,960) (516) (57) (4,710) (5,432) 73 (5,359) (1,955) (20) (1,975) 114 (7,220) (250) – (250) (58) 6 (52) (302) (7,522) (296) (1,516) (2,994) (568) (58) (5,432) 120 Lloyds Banking Group Annual Report and Accounts 2008 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued 11 operaTing expenses Salaries Social security costs Pensions and other post-retirement benefit schemes (note 37) Other staff costs Staff costs Other administrative expenses: Operating lease rentals Repairs and maintenance Communications and data processing Advertising Professional fees Provision in respect of certain historic US dollar payments (note 48) Provision for Financial Services Compensation Scheme levy (note 48) Settlement of overdraft claims Other Depreciation of tangible fixed assets (note 26) Amortisation of other intangible assets (note 25) Goodwill impairment charge (note 23) Total operating expenses The average number of persons on a headcount basis employed by the Group during the year was as follows: UK Overseas 2008 £m 2,183 176 235 337 2,931 265 151 455 194 229 180 122 – 740 2,336 648 38 100 6,053 2007 £m 2,127 167 238 372 2,904 250 154 462 192 279 – – 76 620 2,033 594 36 – 5,567 2008 64,355 2,118 66,473 2007 67,616 1,937 69,553 overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 financiaL sTaTemenTs sharehoLder informaTion Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 121 Lloyds Banking Group Annual Report and Accounts 2008 11 operaTing expenses continued Fees payable for the audit of the Company’s current year annual report Fees payable for other services: Audit of the Company’s subsidiaries pursuant to legislation Other services supplied pursuant to legislation Total audit fees Other services – audit related fees Total audit and audit related fees Services relating to taxation Other non-audit fees: Services relating to corporate finance transactions Other services Total other non-audit fees Total fees payable to the Company’s auditors by the Group 2008 £m 7.1 2.5 3.0 12.6 5.3 17.9 0.5 0.4 0.7 1.1 19.5 During the year, the auditors also earned fees payable by entities outside the consolidated Lloyds Banking Group in respect of the following: Audits of Group pension schemes Audits of the unconsolidated Open Ended Investment Companies managed by the Group Reviews of the financial position of corporate and other borrowers Acquisition due diligence and other work performed in respect of potential venture capital investments The following types of services are included in the categories listed above: 2008 £m 0.2 0.5 1.4 1.0 2007 £m 6.8 2.5 2.7 12.0 1.1 13.1 0.7 0.7 0.1 0.8 14.6 2007 £m 0.2 0.4 2.8 0.6 audit fees: This category includes fees in respect of the audit of the Group’s annual financial statements and other services in connection with regulatory filings. Other services supplied pursuant to legislation relate primarily to the costs associated with the Sarbanes-Oxley Act audit requirements together with the cost of the audit of the Group’s Form 20-F filing. audit related fees: This category includes fees in respect of services for assurance and related services that are reasonably related to the performance of the audit or review of the financial statements, for example acting as reporting accountants in respect of prospectuses and circulars required by the UKLA listing rules. services relating to taxation: This category includes tax compliance and tax advisory services. other non-audit fees: This category includes due diligence relating to corporate finance, including venture capital transactions and other assurance and advisory services. It is the Group’s policy to use the auditors on assignments in cases where their knowledge of the Group means that it is neither efficient nor cost effective to employ another firm of accountants. Such assignments typically relate to the provision of advice on tax issues, assistance in transactions involving the acquisition and disposal of businesses and accounting advice. The auditors are not permitted to provide management consultancy services to the Group. The Group has procedures that are designed to ensure auditor independence, including that fees for audit and non-audit services are approved in advance. This approval can be obtained either on an individual engagement basis or, for certain types of non-audit services, particularly those of a recurring nature, through the approval of a fee cap covering all engagements of that type provided the fee is below that cap. All statutory audit work as well as non-audit assignments where the fee is expected to exceed the relevant fee cap must be pre-approved by the audit committee on an individual engagement basis. On a quarterly basis, the audit committee receives a report detailing all pre-approved services and amounts paid to the auditors for such pre-approved services. 122 Lloyds Banking Group Annual Report and Accounts 2008 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued 12 impairmenT Impairment losses on loans and advances (note 20) Other credit risk provisions (note 39) Impairment of available-for-sale financial assets Total impairment charged to the income statement 13 profiT on saLe of businesses Profit on sale of Lloyds TSB Registrars Profit on sale of Abbey Life Other, including adjustments in respect of businesses sold in earlier years Profit on sale of businesses 2008 £m 2,876 6 2,882 130 3,012 2008 £m – – – – 2007 £m 1,721 5 1,726 70 1,796 2007 £m 407 272 (22) 657 During 2007 the Group completed the sale of the business and assets of Lloyds TSB Bank plc’s company registration business, Lloyds TSB Registrars; the sale of Abbey Life Assurance Company Limited, a UK life operation which had been closed to new business since 2000; and the sale of The Dutton-Forshaw Group Limited, a medium-size car dealership. In addition, provision was made for payments under an indemnity given in relation to a business sold in an earlier year. The businesses sold in 2007 did not represent separate material lines of business and consequently they were not treated as discontinued operations. 14 TaxaTion (a) anaLysis of crediT (charge) for The year UK corporation tax: Current tax on profit for the year Adjustments in respect of prior years Double taxation relief Foreign tax: Current tax on profit for the year Adjustments in respect of prior years Current tax charge Deferred tax (note 38) Tax credit (charge) 2008 £m (667) (19) (686) 91 (595) (144) 4 (140) (735) 773 38 2007 £m (763) 30 (733) 60 (673) (98) 3 (95) (768) 89 (679) As a result of the Finance Act 2007, the statutory rate of corporation tax in the UK was reduced from 30 per cent to 28 per cent with effect from 1 April 2008. Therefore the charge for tax on the profit for the year is based on a UK corporation tax rate of 28.5 per cent (2007: 30 per cent). The Group, as a proxy for policyholders in the UK, is required to record taxes on investment income, gains and losses each year. Accordingly, the tax attributable to UK life insurance policyholder earnings is included in income tax expense. The tax credit attributable to policyholders was £471 million (2007: £243 million credit), including a prior year tax charge of £4 million (2007: tax charge of £5 million). In addition to the income statement current tax charge, a total of £674 million of current tax has been credited to equity (2007: a total of £131 million credit to equity); a debit of £1 million (2007: a credit of £3 million) in respect of share based payments, a credit of £584 million (2007: a credit of £103 million) in respect of foreign exchange differences and a net credit of £91 million (2007: a net credit of £25 million) in respect of the revaluation of available-for-sale financial assets. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 financiaL sTaTemenTs sharehoLder informaTion Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 123 Lloyds Banking Group Annual Report and Accounts 2008 14 TaxaTion continued (b) facTors affecTing The Tax crediT (charge) for The year A reconciliation of the charge that would result from applying the standard UK corporation tax rate to profit before tax to the tax credit (charge) for the year is given below: Profit before tax Tax charge thereon at UK corporation tax rate of 28.5 per cent (2007: 30 per cent) Factors affecting charge: Goodwill impairment Disallowed and non-taxable items Overseas tax rate differences Gains exempted or covered by capital losses Policyholder interests UK corporation tax rate change Other items Tax on profit on ordinary activities Effective rate 2008 £m 807 (230) (28) 12 (39) 25 337 – (39) 38 2007 £m 4,000 (1,200) – (2) 4 274 173 110 (38) (679) (4.7%) 17.0% 15 earnings per share Basic earnings per share are calculated by dividing the net profit attributable to shareholders by the weighted average number of ordinary shares in issue during the year, which has been calculated after deducting 5 million (2007: 5 million) ordinary shares representing the Group’s holdings of own shares in respect of employee share schemes. Profit attributable to equity shareholders Weighted average number of ordinary shares in issue Basic earnings per share 2008 £819m 5,742m 14.3p 2007 £3,289m 5,637m 58.3p For the calculation of diluted earnings per share the weighted average number of ordinary shares in issue is adjusted to assume conversion of all dilutive potential ordinary shares. The Company has dilutive potential ordinary shares in respect of share options and awards granted to employees. The number of shares that could have been acquired at market price (determined as the average annual share price of the Company’s shares) based on the monetary value of the subscription rights attached to outstanding share options and awards is determined; the residual bonus shares are added to the weighted average number of ordinary shares in issue, but no adjustment is made to the profit attributable to equity shareholders. Profit attributable to equity shareholders Weighted average number of ordinary shares in issue Adjustment for share options and awards Weighted average number of ordinary shares for diluted earnings per share Diluted earnings per share 2008 £819m 5,742m 39m 5,781m 14.2p 2007 £3,289m 5,637m 46m 5,683m 57.9p The weighted average number of anti-dilutive share options and awards excluded from the calculation of diluted earnings per share was 59 million at 31 December 2008 (2007: 3 million). As discussed in note 52, the Group issued 2,596,653,203 ordinary shares at 173.3p on 13 January 2009 and issued 7,775,694,993 ordinary shares as purchase consideration for the acquisition of 100 per cent of the ordinary share capital of HBOS plc on 16 January 2009. 124 Lloyds Banking Group Annual Report and Accounts 2008 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued 16 Trading and oTher financiaL asseTs aT fair vaLue Through profiT or Loss Trading assets Other financial assets at fair value through profit or loss These assets are comprised as follows: Loans and advances to banks Loans and advances to customers Debt securities: Government securities Other public sector securities Bank and building society certificates of deposit Mortgage backed securities Other asset backed securities Corporate and other debt securities Equity shares: Listed Unlisted 2008 £m 857 44,207 45,064 2007 £m 4,663 53,248 57,911 2008 2007 other financial assets at fair value through profit or loss £m – 325 Trading assets £m – 283 38 7,326 – – – – 536 574 – – – 857 18 433 369 1,342 11,120 20,608 16,569 6,705 23,274 44,207 Other financial assets at fair value through profit or loss £m 1 403 4,848 – 811 70 1,805 13,564 21,098 23,598 8,148 31,746 53,248 Trading assets £m 29 756 62 – – 87 122 3,607 3,878 – – – 4,663 At 31 December 2008 £44,046 million (2007: £55,729 million) of trading and other financial assets at fair value through profit or loss had a contractual residual maturity of greater than one year. Other financial assets at fair value through profit or loss represent the following assets designated into that category: (i) (ii) financial assets backing insurance contracts and investment contracts which are so designated because the related liabilities either have cash flows that are contractually based on the performance of the assets or are contracts whose measurement takes account of current market conditions and where significant measurement inconsistencies would otherwise arise; certain loans and advances to customers which are economically hedged by interest rate derivatives which are not in hedge accounting relationships and where significant measurement inconsistencies would otherwise arise if the related derivatives were treated as trading liabilities and the loans and advances were carried at amortised cost; and (iii) certain private equity investments that are managed, and evaluated, on a fair value basis in accordance with a documented risk management or investment strategy and reported to key management personnel on that basis. The maximum exposure to credit risk at 31 December 2008 of the loans and advances to banks and customers designated at fair value through profit or loss was £325 million (2007: £404 million); the Group does not hold any credit derivatives or other instruments in mitigation of this risk. There was no significant movement in the fair value of these loans attributable to changes in credit risk; this is determined by reference to the publicly available credit ratings of the instruments involved. The carrying value of assets that are subject to stock lending arrangements was £809 million at 31 December 2008 (2007: £1,450 million) all of which the secured party is permitted by contract or custom to sell or repledge. The Group’s Corporate Markets business has no direct exposure to US sub-prime ABS and limited indirect exposure through asset-backed security collateralised debt obligations (ABS CDOs). During 2008, the market value of Corporate Markets’ holdings in ABS CDOs reduced and, as a result, there has been an income statement charge of £92 million (2007: £114 million). The Group’s Corporate Markets business has no exposure to mezzanine ABS CDOs. In addition, there are £1,867 million (2007: £1,861 million) of ABS CDOs which remain fully cash collateralised by major global financial institutions. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 financiaL sTaTemenTs sharehoLder informaTion Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 125 Lloyds Banking Group Annual Report and Accounts 2008 16 Trading and oTher financiaL asseTs aT fair vaLue Through profiT or Loss continued At 31 December 2008, the Group’s Corporate Markets business had fair value exposure to one monoline financial guarantor in the form of credit default swap (CDS) protection bought against a £256 million collateralised loan obligation (CLO) (2007: exposure to one monoline against a £198 million CLO and one monoline against a £467 million collateralised debt obligation). The exposure on this CDS was £10 million, following a £28 million adverse credit valuation adjustment. A restructuring of Corporate Markets’ other monoline hedged ABS CDO during 2008 has eliminated any reliance on the financial guarantor and has resulted in a much improved risk profile (AA) on a reduced holding of £128 million, included in loans and advances. Credit valuation adjustments and restructuring costs related to the cancelled CDS in the amount of £275 million were recognised in the income statement. At 31 December 2008, fair values of £956 million (2007: £1,570 million) of the Group’s trading and other financial assets classified as fair value through profit or loss, held within the Corporate Markets business, were valued using unobservable inputs. These assets largely represent the Group’s venture capital investments, for which values are determined using valuation techniques which follow British Venture Capital Association (BVCA) guidelines. In respect of these assets, during the year to 31 December 2008, a credit of £111 million (2007: credit of £51 million) was recognised in the income statement relating to the change in their fair values. 17 derivaTive financiaL insTrumenTs The principal derivatives used by the Group are interest rate and exchange rate contracts; particular attention is paid to the liquidity of the markets and products in which the Group trades to ensure that there are no undue concentrations of activity and risk. Interest rate related contracts include interest rate swaps, forward rate agreements and options. An interest rate swap is an agreement between two parties to exchange fixed and floating interest payments, based upon interest rates defined in the contract, without the exchange of the underlying principal amounts. Forward rate agreements are contracts for the payment of the difference between a specified rate of interest and a reference rate, applied to a notional principal amount at a specific date in the future. An interest rate option gives the buyer, on payment of a premium, the right, but not the obligation, to fix the rate of interest on a future loan or deposit, for a specified period and commencing on a specified future date. Exchange rate related contracts include forward foreign exchange contracts, currency swaps and options. A forward foreign exchange contract is an agreement to buy or sell a specified amount of foreign currency on a specified future date at an agreed rate. Currency swaps generally involve the exchange of interest payment obligations denominated in different currencies; the exchange of principal can be notional or actual. A currency option gives the buyer, on payment of a premium, the right, but not the obligation, to sell specified amounts of currency at agreed rates of exchange on or before a specified future date. Credit derivatives, principally credit default swaps, are used by the Group as part of its trading activity and to manage its own exposure to credit risk. A credit default swap is a swap in which one counterparty receives a premium at pre-set intervals in consideration for guaranteeing to make a specific payment should a negative credit event take place. As discussed in note 19, the Group also uses credit default swaps to securitise, in combination with external funding, £8,360 million (2007: £4,325 million) of corporate and commercial banking loans. Equity derivatives are also used by the Group as part of its equity based retail product activity to eliminate the Group’s exposure to fluctuations in various international stock exchange indices. Index-linked equity options are purchased which give the Group the right, but not the obligation, to buy or sell a specified amount of equities, or basket of equities, in the form of published indices on or before a specified future date. The principal amount of the contract does not represent the Group’s real exposure to credit risk which is limited to the current cost of replacing contracts with a positive value to the Group should the counterparty default. To reduce credit risk the Group uses a variety of credit enhancement techniques such as netting and collateralisation, where security is provided against the exposure. Fair values are obtained from quoted market prices in active markets, including recent market transactions, and using valuation techniques, including discounted cash flow and options pricing models, as appropriate. At 31 December 2008, £578 million (2007: £14 million) of fair value liabilities were valued using unobservable inputs; a charge of £512 million (2007: charge of £14 million) was recognised in the income statement relating to the change in fair value. The effect of using reasonably possible favourable and adverse valuation assumptions would be to increase or decrease net trading income by up to £80 million respectively. 126 Lloyds Banking Group Annual Report and Accounts 2008 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued 17 derivaTive financiaL insTrumenTs continued 31 december 2008 Trading Exchange rate contracts: Spot, forwards and futures Currency swaps Options purchased Options written Interest rate contracts: Interest rate swaps Forward rate agreements Options purchased Options written Futures Credit derivatives Equity and other contracts Total derivative assets/liabilities held for trading hedging Derivatives designated as fair value hedges: Interest rate swaps (including swap options) Derivatives designated as cash flow hedges: Interest rate swaps Derivatives designated as net investment hedges: Cross currency swaps Total derivative assets/liabilities held for hedging Total recognised derivative assets/liabilities contract/notional amount £m fair value assets £m fair value liabilities £m 157,572 29,463 9,185 10,143 206,363 368,176 153,930 37,175 33,130 587 592,998 32,495 5,447 5,788 4,367 714 – 10,869 4,102 1,463 – 743 6,308 11,797 12,639 405 843 – 44 13,089 4,257 234 28,449 395 – 627 3 13,664 2,670 81 22,723 37,243 434 1,665 867 1 91 6,318 – 435 28,884 2,413 4,169 26,892 At 31 December 2008 £16,200 million of total recognised derivative assets and £15,215 million of total recognised derivative liabilities (2007: £3,573 million of assets and £4,112 million of liabilities) had a contractual residual maturity of greater than one year. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 financiaL sTaTemenTs sharehoLder informaTion Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 127 Lloyds Banking Group Annual Report and Accounts 2008 17 derivaTive financiaL insTrumenTs continued 31 december 2007 Trading Exchange rate contracts: Spot, forwards and futures Currency swaps Options purchased Options written Interest rate contracts: Interest rate swaps Forward rate agreements Options purchased Options written Futures Credit derivatives Equity and other contracts Total derivative assets/liabilities held for trading hedging Derivatives designated as fair value hedges: Interest rate swaps (including swap options) Derivatives designated as cash flow hedges: Interest rate swaps Derivatives designated as net investment hedges: Cross currency swaps Total derivative assets/liabilities held for hedging Total recognised derivative assets/liabilities 18 Loans and advances To banks Lending to banks Money market placements with banks Total loans and advances to banks Allowance for impairment losses (note 20) Contract/notional amount £m Fair value assets £m Fair value liabilities £m 150,450 1,759 30,214 7,609 6,988 195,261 332,361 102,274 33,147 22,976 35,571 526,329 63,444 4,439 803 157 – 2,719 2,765 36 171 – 1 2,973 1,838 865 8,395 1,285 680 – 149 2,114 3,250 34 – 171 – 3,455 1,057 156 6,782 50,734 263 460 630 1 24 5,302 – 264 8,659 2008 £m 5,104 35,812 40,916 (158) 40,758 316 800 7,582 2007 £m 5,892 28,953 34,845 – 34,845 At 31 December 2008 £5,459 million (2007: £5,773 million) of loans and advances to banks had a contractual residual maturity of greater than one year. The Group holds collateral with a fair value of £10,739 million (2007: £9,109 million), which it is permitted to sell or repledge, of which £5,492 million (2007: £8,482 million) was repledged or sold to third parties for periods not exceeding three months from the transfer. 128 Lloyds Banking Group Annual Report and Accounts 2008 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued 19 Loans and advances To cusTomers Agriculture, forestry and fishing Energy and water supply Manufacturing Construction Transport, distribution and hotels Postal and telecommunications Property companies Financial, business and other services Personal: – Mortgages – Other Lease financing Hire purchase Allowance for impairment losses (note 20) 2008 £m 3,969 2,598 12,057 3,016 14,664 1,060 23,318 35,746 114,643 25,318 4,620 5,295 246,304 (3,569) 242,735 2007 £m 3,226 2,102 8,385 2,871 11,573 946 17,576 29,707 102,739 22,988 4,686 5,423 212,222 (2,408) 209,814 At 31 December 2008 £180,197 million (2007: £153,302 million) of loans and advances to customers had a contractual residual maturity of greater than one year. Included in loans and advances to customers are £6,342 million (2007: £4,201 million) held in Cancara, the Group’s hybrid Asset Backed Commercial Paper conduit (see note 21). During 2008 the Group’s Corporate Markets business wrote down the value of its structured investment vehicle (SIV) exposures by £95 million (2007: £22 million) and now has no residual exposure to SIV Capital Notes (2007: exposure of £78 million). Additionally, at 31 December 2008 the Group’s Corporate Markets business had a commercial paper back up liquidity facility totalling £22 million (2007: £370 million). The Group holds collateral with a fair value of £1,736 million (2007: £1,975 million), which it is permitted to sell or repledge, of which £366 million (2007: £1,818 million) was repledged or sold to third parties for periods not exceeding three months from the transfer. Loans and advances to customers include finance lease receivables, which may be analysed as follows: Gross investment in finance leases, receivable: Not later than 1 year Later than 1 year and not later than 5 years Later than 5 years Unearned future finance income on finance leases Rentals received in advance Commitments for expenditure in respect of equipment to be leased Net investment in finance leases The net investment in finance leases represents amounts recoverable as follows: Not later than 1 year Later than 1 year and not later than 5 years Later than 5 years 2008 £m 542 1,779 5,639 7,960 (3,038) (128) (174) 4,620 2008 £m 329 978 3,313 4,620 2007 £m 620 1,917 5,339 7,876 (2,875) (131) (184) 4,686 2007 £m 340 1,004 3,342 4,686 overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 financiaL sTaTemenTs sharehoLder informaTion Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 129 Lloyds Banking Group Annual Report and Accounts 2008 19 Loans and advances To cusTomers continued Equipment leased to customers under finance leases primarily relates to structured financing transactions to fund the purchase of aircraft, ships and other large individual value items. During 2008 and 2007 no contingent rentals in respect of finance leases were recognised in the income statement. The allowance for uncollectable finance lease receivables included in the allowance for impairment losses is £15 million (2007: £16 million). The unguaranteed residual values included in finance lease receivables were as follows: Not later than 1 year Later than 1 year and not later than 5 years Later than 5 years Total securiTisaTions 2008 £m 1 29 3 33 2007 £m – 7 11 18 Loans and advances to customers include balances that have been securitised but not derecognised, comprising both residential mortgages and commercial banking loans, the carrying values of which are set out below together with any related liabilities. Residential mortgages are not derecognised because the Group remains exposed to the majority of the risk of any default in respect of them; commercial banking loans are not derecognised because the Group has not transferred the contractual rights to receive the cash flows from those loans nor has it assumed a contractual obligation to pay the cash flows from those loans to a third party. Beneficial interests in certain residential mortgages have been transferred to special purpose entities which issue floating rate debt securities. Neither the Group nor any entities in the Group are obliged to support any losses that may be suffered by the note holders and do not intend to offer such support. The floating rate note holders only receive payments of interest and principal to the extent that the special purpose entities have received sufficient funds from the transferred mortgages and after certain expenses have been met. In the event of a deficiency, they have no recourse whatsoever to the Group. At 31 December 2008 the total amount of residential mortgages subject to securitisation was £34,293 million (2007: £46,284 million) in respect of which external funding at the year end amounted to £9,824 million (2007: £12,403 million); external funding is shown in debt securities in issue (see note 31). The Group participates in the securitisation through the provision of administration and other services, the provision of interest rate and currency swaps and in the form of unsecured loan financing which is subordinate to the interests of the floating rate note holders. A further £40,608 million of residential mortgages are subject to securitisation via a covered bond programme; the related bonds have been issued to Lloyds TSB Bank plc, and are available for use in connection with Lloyds TSB Bank plc’s participation in the Bank of England’s Special Liquidity Scheme. In addition the Group has entered into a number of securitisations of elements of its corporate and commercial loan portfolio. The total value of loans so securitised was £8,360 million (2007: £4,325 million), utilising a combination of external funding totalling £226 million (2007: £98 million) and credit default swaps. The external funding is shown in debt securities in issue (see note 31) and the credit default swaps are accounted for as derivatives (see note 17). 20 aLLowance for impairmenT Losses on Loans and advances Balance at 1 January 2007 Exchange and other adjustments Advances written off Recoveries of advances written off in previous years Unwinding of discount Charge (credit) to the income statement At 31 December 2007 Exchange and other adjustments Advances written off Recoveries of advances written off in previous years Unwinding of discount Charge to the income statement At 31 December 2008 Retail – mortgages £m 42 – (25) 2 – 18 37 – Loans and advances to customers Retail – other £m 1,918 – (1,439) 133 (101) 1,518 2,029 – Wholesale £m 233 2 (78) 2 (3) 186 342 43 Total £m 2,193 2 (1,542) 137 (104) 1,722 2,408 43 (23) (1,382) (205) (1,610) 1 – 171 186 111 (100) 1,687 2,345 – (2) 860 1,038 112 (102) 2,718 3,569 Loans and advances to banks £m 1 – – – – (1) – – – – – 158 158 Total £m 2,194 2 (1,542) 137 (104) 1,721 2,408 43 (1,610) 112 (102) 2,876 3,727 130 Lloyds Banking Group Annual Report and Accounts 2008 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued 20 aLLowance for impairmenT Losses on Loans and advances continued The analysis of allowances for impairment between retail and wholesale has been prepared based upon the type of exposure and not the business segment in which the exposure is recorded. Included within retail are exposures to personal customers and small businesses, whilst included within wholesale are exposures to corporate customers and other large institutions. The criteria that the Group uses to determine that there is objective evidence of an impairment loss are disclosed in note 2(J). All impaired loans which exceed a certain threshold, principally within the Group’s corporate banking business, are individually assessed for impairment having regard to expected future cash flows including those that could arise from the realisation of security. Included in loans and advances to customers and to banks were loans and advances individually determined to be impaired whose gross amount before impairment allowances was £2,699 million (2007: £684 million) and in respect of which collateral with a fair value of £518 million (2007: £193 million) was held. 21 avaiLabLe-for-saLe financiaL asseTs Debt securities: Government securities Other public sector securities Bank and building society certificates of deposit Mortgage backed securities Other asset backed securities Corporate and other debt securities Equity shares: Listed Unlisted Treasury bills and other bills: Treasury bills and similar securities Other bills cancara £m – – – 3,176 853 2,244 6,273 – – – – – – 6,273 2008 other £m 868 12 9,602 1,253 4,103 Total £m Cancara £m 868 12 9,602 4,429 4,956 – – – 4,136 1,015 4,346 20,184 6,590 3,117 26,457 8,268 3 38 41 3 38 41 2,402 2,402 26,807 26,807 29,209 49,434 29,209 55,707 – – – – – – 8,268 2007 Other £m 319 5 1,825 1,914 3,056 3,153 10,272 1 28 29 1,608 19 1,627 11,928 Total £m 319 5 1,825 6,050 4,071 6,270 18,540 1 28 29 1,608 19 1,627 20,196 Cancara is the Group’s hybrid Asset Backed Commercial Paper conduit. Total exposures in Cancara were £12,615 million (31 December 2007: £12,469 million) comprising the £6,273 million (31 December 2007: £8,268 million) of debt securities detailed above and £6,342 million (31 December 2007: £4,201 million) of loans and advances to customers (see note 19). Cancara, which is fully consolidated in the Group’s accounts, is managed in a very conservative manner, which is demonstrated by the quality and ratings stability of its underlying asset portfolio. At 31 December 2008, the asset-backed securities in Cancara were 91.8 and 94.2 per cent (31 December 2007: 100 per cent) Aaa/AAA rated by Moody’s and Standard & Poor’s respectively, and there was no exposure either directly or indirectly to sub-prime US mortgages within Cancara’s debt security portfolio. At 31 December 2008 loans and advances included no US sub-prime mortgage exposure (31 December 2007: £115 million). The other asset-backed securities not in the Cancara conduit of £4,103 million (31 December 2007: £3,056 million) comprise £2,917 million (31 December 2007: £2,643 million) of US Government guaranteed student loan asset-backed securities and £1,186 million (31 December 2007: £413 million) of unhedged asset-backed security collateralised debt obligations. At 31 December 2008 £15,627 million (2007: £15,265 million) of available-for-sale financial assets had a contractual residual maturity of greater than one year. All assets have been individually assessed for impairment. The criteria used to determine whether an impairment loss has been incurred are disclosed in note 2(J). Included in available-for-sale assets at 31 December 2008 are debt securities individually determined to be impaired whose gross amount before impairment allowances was £282 million (2007: £75 million) and in respect of which no collateral was held. In addition, included in available-for-sale assets at 31 December 2008 are equity securities individually determined to be impaired whose gross amount before impairment allowances was £31 million (2007: nil). overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 financiaL sTaTemenTs sharehoLder informaTion Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 131 Lloyds Banking Group Annual Report and Accounts 2008 22 invesTmenT properTy At 1 January Exchange and other adjustments Additions: Acquisitions of new properties Additional expenditure on existing properties Total additions Disposals Adjustments on deconsolidation of OEICs Changes in fair value (note 7) Disposal of businesses At 31 December 2008 £m 3,722 66 85 116 201 (300) – (1,058) – 2,631 The investment properties are valued at least annually at open-market value, by independent, professionally qualified valuers, who have recent experience in the location and categories of the investment properties being valued. In addition, the following amounts have been recognised in the income statement: Rental income Direct operating expenses arising from investment properties that generate rental income Capital expenditure in respect of investment properties: Capital expenditure contracted for at the balance sheet date but not recognised in the financial statements 23 goodwiLL At 1 January Exchange and other adjustments Disposals Impairment charge to the income statement At 31 December Cost* Accumulated impairment losses At 31 December 2008 £m 209 29 2008 £m 82 2008 £m 2,358 (2) – (100) 2,256 2,362 (106) 2,256 2007 £m 4,739 5 302 181 483 (271) (881) (321) (32) 3,722 2007 £m 227 24 2007 £m 111 2007 £m 2,377 – (19) – 2,358 2,364 (6) 2,358 * For acquisitions made prior to 1 January 2004, the date of transition to IFRS, cost is included net of amounts amortised up to 31 December 2003. The goodwill held in the Group’s balance sheet is tested at least annually for impairment. For the purposes of impairment testing the goodwill is allocated to the appropriate cash generating unit; of the total balance of £2,256 million (2007: £2,358 million), £1,836 million (or 81 per cent of the total) has been allocated to Scottish Widows and £410 million (or 18 per cent of the total) to Asset Finance. The recoverable amount of Scottish Widows has been based on a value in use calculation. The calculation uses projections of future cash flows based upon budgets and plans approved by management covering a five-year period, and a discount rate of 12 per cent (gross of tax). The budgets and plans are based upon past experience adjusted to take into account anticipated changes in sales volumes, product mix and margins having regard to expected market conditions and competitor activity. The discount rate is determined with reference to internal measures and available industry information. Cash flows beyond the five-year period have been extrapolated using a steady 3 per cent growth rate which does not exceed the long- term average growth rate for the life assurance market. Management believes that any reasonably possible change in the key assumptions would not cause the recoverable amount of Scottish Widows to fall below its balance sheet carrying value. 132 Lloyds Banking Group Annual Report and Accounts 2008 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued 23 goodwiLL continued The recoverable amount of Asset Finance has also been based on a value in use calculation using cash flow projections based on financial budgets and plans approved by management covering a five-year period and a discount rate of 15 per cent (gross of tax). The discount rate has been set at a premium over the Group’s weighted average cost of capital to take into account the specific risk profile of the Asset Finance business. The cash flows for each of the businesses of Asset Finance beyond the five-year period are extrapolated using steady growth rates, in each case not exceeding 2.5 per cent nor the long-term average growth rates for the markets in which the respective businesses of Asset Finance participate. During 2008, the basis of goodwill allocation and the related value in use calculation has been changed to treat the consumer finance business as a single cash generating unit encompassing the motor and personal finance operations which provide direct and point of sale finance; this reflects the strategic and operational interdependencies and shared market dynamics of these units. The markets in which these units operate have been affected by the UK economic downturn, which has been characterised by a fall off in demand and increasing arrears at this point of the cycle. This, together with continuing uncertainties over the likely short-term macroeconomic environment, has resulted in a reassessment of the carrying value of the consumer finance cash generating unit and the recognition of a goodwill impairment charge of £100 million at 31 December 2008. 24 vaLue of in-force business The asset in the consolidated balance sheet and movement recognised in the income statement are as follows: Gross value of in-force insurance and participating investment business At 1 January Movements in the year: New business Existing business: Expected return Experience variances Assumption changes Economic variance Movement in value of in-force business taken to income statement (note 9) Disposal of business At 31 December 2008 £m 2,218 368 (112) (46) (92) (443) (325) – 1,893 2007 £m 2,723 264 (166) (38) 69 (222) (93) (412) 2,218 This breakdown shows the movement in the value of in-force business only, and does not represent the full contribution that each item in the breakdown contributes to profit before tax, which would also contain changes in the other assets and liabilities of the relevant businesses. Economic variance is the element of earnings which is generated from changes to economic experience in the period and to assumptions over time. The presentation of economic variance includes the impact of financial market conditions being different at the end of the reporting period from those included in assumptions used to calculate new and existing business returns. The principal features of the methodology and process used for determining key assumptions used in the calculation of the value of in-force business are set out below: economic assumpTions Each cash flow is valued using the discount rate consistent with that applied to such a cash flow in the capital markets. In practice, to achieve the same result, where the cash flows are either independent of or move linearly with market movements, a method has been applied known as the ‘certainty equivalent’ approach whereby it is assumed that all assets earn the risk-free rate and all cash flows are discounted at the risk-free rate. A market consistent approach has been adopted for the valuation of financial options and guarantees, using a stochastic option pricing technique calibrated to be consistent with the market price of relevant options at each valuation date. The risk free rate used for the value of financial options and guarantees is defined as the spot yield derived from the UK gilt yield curve in line with Scottish Widows’ FSA realistic balance sheet assumptions. The valuation of the Group’s annuity business has been affected by the recent upheaval in the capital markets which has caused a significant widening in corporate bond spreads in 2008. Based on available market analysis, an element of this widening in corporate bond spreads has been assessed as arising from an increase in the illiquidity premium. Annuity contracts cannot be surrendered and have reasonably certain cash flows best matched by assets of equivalent maturity with similar liquidity characteristics. As a result, in 2008 the value of in-force business asset for annuity business has been calculated after taking into account an estimate of 154 basis points for the market premium for illiquidity, which has been derived from market and other published sources using a portfolio of investment grade bonds with similar cash flow characteristics as the annuity liabilities. The effect of this has been to increase the value of in-force business by £842 million as at 31 December 2008 with a similar increase in profit before tax. This is reflected as an economic variance in the table above, together with other market movements. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 financiaL sTaTemenTs sharehoLder informaTion Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 133 Lloyds Banking Group Annual Report and Accounts 2008 24 vaLue of in-force business continued The risk free rate assumed in valuing the in-force asset for annuity business is presented as a single risk free rate to allow easier comparison to the rate used for other business. That single risk free rate has been derived to give the equivalent value to the annuity book, had the book been valued using the UK gilt yield curve increased to reflect the illiquidity premium as described above. For 2008, the risk-free rate assumed in valuing the in-force asset for non-annuity business is the 15-year gilt yield. The table below shows the range of resulting yields and other key assumptions at 31 December: Risk-free rate (value of in-force non-annuity business) Risk-free rate (value of in-force annuity business) Risk-free rate (financial options and guarantees) Retail price inflation Expense inflation non-markeT risk 2008 % 3.74 5.22 2007 % 4.65 4.65 1.11 to 4.24 4.28 to 4.81 2.75 3.50 3.28 4.18 An allowance for non-market risk is made through the choice of best estimate assumptions based upon experience, which generally will give the mean expected financial outcome for shareholders and hence no further allowance for non-market risk is required. However, in the case of operational risk and the With Profit Fund there are asymmetries in the range of potential outcomes for which an explicit allowance is made. non-economic assumpTions Future mortality, morbidity, lapse and paid-up rate assumptions are reviewed each year and are based on an analysis of past experience and represent management’s best estimate of likely future experience. Further information about the effect of changes in key assumptions is given in note 32. 25 oTher inTangibLe asseTs Cost: At 1 January 2007 Additions Disposals At 31 December 2007 Additions At 31 December 2008 Accumulated amortisation: At 1 January 2007 Charge for the year Disposals At 31 December 2007 Charge for the year At 31 December 2008 Balance sheet amount at 31 December 2008 Balance sheet amount at 31 December 2007 Customer lists £m Software enhancements £m 54 3 – 57 6 63 – 5 – 5 7 12 51 52 198 47 (5) 240 80 320 114 31 (2) 143 31 174 146 97 Total £m 252 50 (5) 297 86 383 114 36 (2) 148 38 186 197 149 Software enhancements principally comprise identifiable and directly associated internal staff and other costs. 134 Lloyds Banking Group Annual Report and Accounts 2008 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued 26 TangibLe fixed asseTs Cost: At 1 January 2007 Exchange and other adjustments Adjustments on disposal of businesses Adjustments on deconsolidation of subsidiaries Additions Disposals At 31 December 2007 Exchange and other adjustments Additions Disposals At 31 December 2008 Accumulated depreciation and impairment: At 1 January 2007 Exchange and other adjustments Adjustments on disposal of businesses Adjustments on deconsolidation of subsidiaries Charge for the year Disposals At 31 December 2007 Exchange and other adjustments Charge for the year Disposals At 31 December 2008 Balance sheet amount at 31 December 2008 Balance sheet amount at 31 December 2007 Premises £m Equipment £m Operating lease assets £m Total tangible fixed assets £m 1,488 2,849 – (53) – 60 (58) 1,437 2 96 (19) 2 (89) – 286 (177) 2,871 18 341 (82) 1,516 3,148 675 – (11) – 83 (29) 718 1 81 (11) 789 727 719 1,960 2 (35) – 242 (162) 2,007 10 254 (63) 2,208 940 864 2,866 (24) – (1,015) 549 (945) 1,431 70 556 (493) 1,564 316 (3) – (86) 269 (321) 175 21 313 (243) 266 1,298 1,256 2008 £m 294 320 9 623 7,203 (22) (142) (1,015) 895 (1,180) 5,739 90 993 (594) 6,228 2,951 (1) (46) (86) 594 (512) 2,900 32 648 (317) 3,263 2,965 2,839 2007 £m 259 271 9 539 At 31 December the future minimum rentals receivable under non-cancellable operating leases were as follows: Receivable within 1 year 1 to 5 years Over 5 years Equipment leased to customers under operating leases primarily relates to vehicle contract hire arrangements. During 2008 and 2007 no contingent rentals in respect of operating leases were recognised in the income statement. In addition, total future minimum sub-lease income of £102 million at 31 December 2008 (£113 million at 31 December 2007) is expected to be received under non-cancellable sub-leases of the Group’s premises. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 financiaL sTaTemenTs sharehoLder informaTion Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 135 Lloyds Banking Group Annual Report and Accounts 2008 27 oTher asseTs Assets arising from reinsurance contracts held (note 32) Deferred acquisition costs Settlement balances Other assets and prepayments 2008 £m 385 196 751 4,524 5,856 At 31 December 2008 £1,833 million (2007: £1,781 million) of other assets had a contractual residual maturity of greater than one year. Deferred acquisition costs: At 1 January Acquisition costs deferred, net of amounts amortised to the income statement Disposal of businesses and other adjustments At 31 December 28 deposiTs from banks The breakdown of deposits from banks between the domestic and international offices of the Group is set out below: Domestic: Non-interest bearing Interest bearing International: Non-interest bearing Interest bearing Deposits from banks 2008 £m 212 (16) – 196 2008 £m 131 58,471 58,602 32,335 32,436 23 7,889 7,912 66,514 46 6,609 6,655 39,091 2007 £m 350 212 205 4,296 5,063 2007 £m 443 (22) (209) 212 2007 £m 101 At 31 December 2008 £1,956 million (2007: £25 million) of deposits from banks had a contractual residual maturity of greater than one year. Included in deposits from banks were deposits of £2,574 million (2007: £1,509 million) held as collateral, principally in relation to derivative contracts. The fair value of those deposits approximates the carrying amount. 29 cusTomer accounTs Non-interest bearing current accounts Interest bearing current accounts Savings and investment accounts Other customer deposits Customer accounts 2008 £m 4,176 47,109 76,144 43,509 2007 £m 3,807 45,726 71,905 35,117 170,938 156,555 136 Lloyds Banking Group Annual Report and Accounts 2008 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued 29 cusTomer accounTs continued The breakdown of customer accounts between the domestic and international offices of the Group is set out below: Domestic: Non-interest bearing Interest bearing International: Non-interest bearing Interest bearing Customer accounts 2008 £m 2007 £m 3,530 3,407 162,804 149,412 166,334 152,819 646 3,958 4,604 400 3,336 3,736 170,938 156,555 At 31 December 2008 £2,499 million (2007: £1,949 million) of customer accounts had a contractual residual maturity of greater than one year. Included in customer accounts were deposits of £1,002 million (2007: £777 million) held as collateral, principally in relation to derivative contracts. The fair value of those deposits approximates the carrying amount. 30 Trading and oTher LiabiLiTies aT fair vaLue Through profiT or Loss Liabilities held at fair value through profit or loss (debt securities) Trading liabilities Trading and other liabilities at fair value through profit or loss 2008 £m 6,748 6 6,754 2007 £m 3,107 99 3,206 At 31 December 2008 £6,525 million (2007: £2,032 million) of trading and other liabilities at fair value through profit or loss had a contractual residual maturity of greater than one year. The amount contractually payable on maturity of the debt securities held at fair value through profit or loss at 31 December 2008 was £6,517 million, which was £231 million lower than the balance sheet carrying value (2007: £3,131 million, which was £24 million higher than the balance sheet carrying value). At 31 December 2008 there was a cumulative £44 million decrease in the fair value of these liabilities attributable to changes in credit spread risk; this is determined by reference to the quoted credit spreads of Lloyds TSB Bank plc, the issuing entity within the Group. Of the £44 million, £36 million arose in 2008 and £8 million arose in 2007. Liabilities designated at fair value through profit or loss represent debt securities in issue which either contain substantive embedded derivatives which would otherwise need to be recognised and measured at fair value separately from the related debt securities, or which are accounted for at fair value to significantly reduce an accounting mismatch. 31 debT securiTies in issue Euro medium-term note programme Other bonds and medium-term notes Certificates of deposit issued Commercial paper Total debt securities in issue 2008 £m 9,178 12,695 33,207 20,630 75,710 2007 £m 4,692 14,497 14,995 17,388 51,572 At 31 December 2008 £16,120 million (2007: £18,604 million) of debt securities in issue had a contractual residual maturity of greater than one year. Debt securities in issue at 31 December 2008 included £9,824 million (2007: £12,403 million) in respect of the securitisation of mortgages and £226 million (2007: £98 million) in respect of the securitisation of corporate and commercial banking loans (see note 19). overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 financiaL sTaTemenTs sharehoLder informaTion Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 137 Lloyds Banking Group Annual Report and Accounts 2008 32 LiabiLiTies arising from insurance conTracTs and parTicipaTing invesTmenT conTracTs Insurance contract liabilities Participating investment contract liabilities 2008 £m 22,173 11,619 33,792 2007 £m 23,189 14,874 38,063 At 31 December 2008 £29,967 million (2007: £35,603 million) of liabilities arising from insurance contracts and participating investment contracts had a contractual residual maturity of greater than one year. insurance conTracT LiabiLiTies Insurance contract liabilities, substantially all of which relate to business written in the United Kingdom, are comprised as follows: Life insurance (see (1) below) Non-life insurance (see (2) below): Unearned premiums Claims outstanding gross £m 21,518 472 183 655 2008 reinsurance* £m net £m (380) 21,138 – (5) (5) 472 178 650 Gross £m 22,526 456 207 663 22,173 (385) 21,788 23,189 * Reinsurance balances receivable are reported within other assets (note 27). (1) Life insurance The movement in life insurance contract liabilities over the year can be analysed as follows: At 1 January 2007 New business Changes in existing business Disposal of businesses At 31 December 2007 New business Changes in existing business At 31 December 2008 The movement in liabilities arising from participating investment contracts may be analysed as follows: Gross £m 25,763 2,428 (1,316) (4,349) 22,526 2,915 (3,923) 21,518 At 1 January 2007 New business Changes in existing business At 31 December 2007 New business Changes in existing business At 31 December 2008 2007 Reinsurance* £m (340) – (10) (10) (350) Reinsurance £m (425) (18) 15 88 (340) (32) (8) (380) Net £m 22,186 456 197 653 22,839 Net £m 25,338 2,410 (1,301) (4,261) 22,186 2,883 (3,931) 21,138 £m 15,095 491 (712) 14,874 208 (3,463) 11,619 138 Lloyds Banking Group Annual Report and Accounts 2008 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued 32 LiabiLiTies arising from insurance conTracTs and parTicipaTing invesTmenT conTracTs continued PROCESS FOR DETERMINING KEy ASSUMPTIONS The process for determining the key assumptions for insurance contracts and participating investment contracts is set out below. These policy liabilities can be split into With Profit Fund liabilities, accounted for using the FSA’s realistic capital regime (realistic liabilities) and Non-Profit Fund liabilities, accounted for using a traditional prospective actuarial discounted cash flow methodology as described in the accounting policies. WITH PROFIT FUND REALISTIC LIABILITIES The Group’s With Profit Fund contains life insurance contracts and participating investment contracts. The calculation of With Profit Fund realistic liabilities uses best estimate assumptions for mortality, persistency rates and expenses. These are calculated in a similar manner to those used for the value of in-force business as discussed in note 24. The persistency rates used for the realistic valuation of the With Profit Fund liabilities make an allowance for potential changes in future experience as the guarantees and options within with-profits contracts become more valuable under adverse market conditions. Other key assumptions are: INVESTMENT RETURNS AND DISCOUNT RATES The realistic capital regime dictates that With Profit Fund liabilities are valued on a market-consistent basis. This is achieved by the use of a valuation model which values liabilities on a basis calibrated to tradable market option contracts and other observable market data. The With Profit Fund financial options and guarantees are valued using a stochastic simulation model where all assets are assumed to earn, on average, the risk-free yield and all cash flows are discounted using the risk-free yield. The risk-free yield is defined as the spot yield derived from the UK gilt yield curve. GUARANTEED ANNUITy OPTION TAKE-UP RATES The guaranteed annuity option take-up rates are set with regard to the Group’s actual experience and make allowance for potential increases in take- up rates when the Guaranteed Annuity Options become more valuable to the policyholder. INVESTMENT VOLATILITy The calibration of the stochastic simulation model uses implied volatilities of derivatives where possible, or historical volatility where it is not possible to observe meaningful prices. For example, as at 31 December 2008, the 10 year equity-implied at-the -money assumption was set at 34.6 per cent (31 December 2007: 25.5 per cent). The assumption for property volatility was 15 per cent (31 December 2007: 15 per cent), with swaption volatility of broadly 16 per cent (31 December 2007: broadly 11 per cent). MORTALITy The mortality assumptions, including allowances for improvements in longevity for annuitants, are set with regard to the Group’s actual experience where this is significant, and relevant industry data otherwise. LAPSE RATES Lapse rates refer to the rate of policy termination and the rate at which policyholders stop paying regular premiums. These rates are based on a combination of historical experience and management’s views on future experience taking into consideration potential changes in future experience that may result from guarantees and options becoming more valuable under adverse market conditions. NON-PROFIT FUND LIABILITIES Generally, assumptions used to value Non-Profit Fund liabilities are prudent in nature and therefore contain a margin for adverse deviation. This margin for adverse deviation is based on management’s judgement and reflects management’s views on the inherent level of uncertainty. The key assumptions used in the measurement of Non-Profit Fund liabilities are: INTEREST RATES The rates used are derived in accordance with the FSA Rules. These limit the rates of interest that can be used by reference to a number of factors including the redemption yields on fixed interest assets at the valuation date. Margins for risk are allowed for in the assumed interest rates. These are derived from the limits in the FSA Rules, including reductions made to the available yields to allow for default risk based upon the credit rating of each stock. MORTALITy AND MORBIDITy The mortality and morbidity assumptions, including allowances for improvements in longevity for annuitants, are set with regard to the Group’s actual experience where this provides a reliable basis, and relevant industry data otherwise, and include a margin for adverse deviation. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 financiaL sTaTemenTs sharehoLder informaTion Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 139 Lloyds Banking Group Annual Report and Accounts 2008 32 LiabiLiTies arising from insurance conTracTs and parTicipaTing invesTmenT conTracTs continued LAPSE RATES Lapse rates, set with regard to the Group’s actual experience and with a margin for adverse deviation, are allowed for on some Non-Profit Fund contracts. MAINTENANCE ExPENSES Allowance is made for future policy costs explicitly. Expenses are determined by reference to an internal analysis of current and expected future costs plus a margin for adverse deviation. Explicit allowance is made for future expense inflation. KEy CHANGES IN ASSUMPTIONS During 2008, following a detailed review of the Group’s current and expected experience, there has been a change in the key assumption in respect of lapse and paid-up rates. The impact of this change has been to decrease profit before tax by £143 million; this amount includes movements in liabilities and value of the in-force business in respect of insurance contracts and participating investment contracts. (2) non-Life insurance Gross non-life insurance contract liabilities are analysed by line of business as follows: Credit protection Home Health 2008 £m 293 359 3 655 2007 £m 274 385 4 663 For non-life insurance contracts, the methodology and assumptions used in relation to determining the bases of the earned premium and claims provisioning levels are derived for each individual underwritten product. Assumptions are intended to be neutral estimates of the most likely or expected outcome. There has been no significant change in the assumptions and methodologies used for setting reserves. The reserving methodology and associated assumptions are set out below: The unearned premium reserve is determined on a basis that reflects the length of time for which contracts have been in force and the projected incidence of risk over the term of each contract. Claims outstanding comprise those claims that have been notified and those that have been incurred but not reported. Claims incurred but not reported are determined based on the historical emergence of claims and their average cost. The notified claims element represents the best estimate of the cost of claims reported using projections and estimates based on historical experience. The movements in non-life insurance contract liabilities and reinsurance assets over the year have been as follows: provisions for unearned premiums At 1 January 2007 Increase in the year Release in the year At 31 December 2007 Increase in the year Release in the year At 31 December 2008 Gross £m Reinsurance £m 438 632 (614) 456 651 (635) 472 – (23) 23 – (23) 23 – Net £m 438 609 (591) 456 628 (612) 472 140 Lloyds Banking Group Annual Report and Accounts 2008 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued 32 LiabiLiTies arising from insurance conTracTs and parTicipaTing invesTmenT conTracTs continued These provisions represent the liability for short-term insurance contracts for which the Group’s obligations are not expired at the year end. Gross £m Reinsurance £m claims and loss adjustment expenses Notified claims Incurred but not reported At 1 January 2007 Cash paid for claims settled in the year Increase (decrease) in liabilities: Arising from current year claims Arising from prior year claims At 31 December 2007 Cash paid for claims settled in the year Increase (decrease) in liabilities: Arising from current year claims Arising from prior year claims At 31 December 2008 Notified claims Incurred but not reported At 31 December 2008 Notified claims Incurred but not reported At 31 December 2007 127 22 149 (275) 341 (8) 207 (245) 221 – 183 160 23 183 188 19 207 (4) – (4) – (9) 3 (10) 7 – (2) (5) (5) – (5) (10) – (10) Net £m 123 22 145 (275) 332 (5) 197 (238) 221 (2) 178 155 23 178 178 19 197 non-Life insurance cLaims deveLopmenT TabLe The development of insurance liabilities provides a measure of the Group’s ability to estimate the ultimate value of claims. The top half of the table below illustrates how the Group’s estimate of total claims outstanding for each accident year has changed at successive year ends. The bottom half of the table reconciles the cumulative claims to the amount appearing in the balance sheet. The accident year basis is considered the most appropriate for the business written by the Group. non-Life insurance aLL risks – gross accident year Estimate of ultimate claims costs: At end of accident year One year later Two years later Three years later Four years later Current estimate of cumulative claims Cumulative payments to date Liability recognised in the balance sheet Liability in respect of earlier years Total liability included in the balance sheet 2004 £m 227 209 207 206 206 206 (204) 2 2005 £m 211 207 204 202 202 (197) 5 2006 £m 208 206 204 204 (195) 9 2007 £m 317 311 311 (265) 46 2008 £m Total £m 205 1,168 205 (99) 106 1,128 (960) 168 8 176 The liability of £176 million shown in the above table excludes £7 million of unallocated claims handling expenses. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 financiaL sTaTemenTs sharehoLder informaTion Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 141 Lloyds Banking Group Annual Report and Accounts 2008 33 Life insurance sensiTiviTy anaLysis The following table demonstrates the effect of changes in key assumptions on profit before tax and equity disclosed in these financial statements assuming that the other assumptions remain unchanged. In practice this is unlikely to occur, and changes in some assumptions may be correlated. These amounts include movements in assets, liabilities and the value of the in-force business in respect of insurance contracts and participating investment contracts. The impact is shown in one direction but can be assumed to be reasonably symmetrical. Non-annuitant mortality1 Annuitant mortality 2 Lapse rates 3 Future maintenance and investment expenses 4 Risk-free rate 5 Guaranteed annuity option take up 6 Equity investment volatility 7 Widening of credit default spreads on corporate bonds 8 Decrease in illiquidity premia9 change in variable 5% reduction 5% reduction 10% reduction 10% reduction 0.25% deduction 5% addition 1% addition 0.25% addition increase (reduction) in profit before tax £m increase (reduction) in equity £m 31 (77) 38 70 47 (22) (7) (82) 22 (55) 28 50 34 (15) (5) (59) (97) 0.25% deduction (134) Assumptions have been flexed on the basis used to calculate the value of in-force business and the realistic and statutory reserving bases. 1 2 3 4 5 6 7 8 9 This sensitivity shows the impact of reducing mortality and morbidity rates on non-annuity business to 95 per cent of the expected rate. This sensitivity shows the impact on the annuity and deferred annuity business of reducing mortality rates to 95 per cent of the expected rate. This sensitivity shows the impact of reducing lapse and surrender rates to 90 per cent of the expected rate. This sensitivity shows the impact of reducing maintenance expenses and investment expenses to 90 per cent of the expected rate. This sensitivity shows the impact on the value of in-force business, financial options and guarantee costs, statutory reserves and asset values of reducing the risk-free rate by 25 basis points. This sensitivity shows the impact of a flat 5 per cent addition to the expected rate. This sensitivity shows the impact of a flat 1 per cent addition to the expected rate. This sensitivity shows the impact of a 25 basis point increase in credit default spreads on corporate bonds and the corresponding reduction in market values. Government bond yields, the risk-free rate and illiquidity premia are all assumed to be unchanged. This sensitivity shows the impact of a 25 basis point reduction in the allowance for illiquidity premia. It assumes the overall corporate bond spreads are unchanged and hence market values are unchanged. Government bond yields and the risk-free rate are both assumed to be unchanged. 142 Lloyds Banking Group Annual Report and Accounts 2008 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued 34 LiabiLiTies arising from non-parTicipaTing invesTmenT conTracTs The movement in liabilities arising from non-participating investment contracts may be analysed as follows: At 1 January 2007 New business Changes in existing business Disposal of businesses At 31 December 2007 New business Changes in existing business At 31 December 2008 Gross £m 24,370 2,413 (1,303) (7,283) 18,197 660 (4,614) 14,243 35 unaLLocaTed surpLus wiThin insurance businesses The movement in the unallocated surplus within long-term insurance business over the year can be analysed as follows: At 1 January Change in unallocated surplus recognised in the income statement (note 10) Disposal of businesses At 31 December 36 oTher LiabiLiTies Settlement balances Unitholders’ interest in Open Ended Investment Companies Other creditors and accruals Other liabilities Reinsurance £m (22) – 22 – – – – – 2008 £m 554 (284) – 270 2008 £m 891 4,336 6,229 11,456 At 31 December 2008 £5,454 million (2007: £4,427 million) of other liabilities had a contractual residual maturity of greater than one year. 37 reTiremenT benefiT obLigaTions charge to the income statement Defined benefit pension schemes Other post-retirement benefit schemes Total defined benefit schemes Defined contribution pension schemes amounts recognised in the balance sheet Defined benefit pension schemes Other post-retirement benefit schemes 2008 £m 157 7 164 71 235 2008 £m 1,657 114 1,771 Net £m 24,348 2,413 (1,281) (7,283) 18,197 660 (4,614) 14,243 2007 £m 683 (114) (15) 554 2007 £m 445 3,441 5,804 9,690 2007 £m 158 17 175 63 238 2007 £m 2,033 111 2,144 overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 financiaL sTaTemenTs sharehoLder informaTion Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 143 Lloyds Banking Group Annual Report and Accounts 2008 37 reTiremenT benefiT obLigaTions continued pension schemes DEFINED BENEFIT SCHEMES The Group has established a number of defined benefit pension schemes in the UK and overseas. The majority of the Group’s employees are members of the defined benefit sections of the Lloyds TSB Group Pension Schemes No’s 1 and 2. These schemes provide retirement benefits calculated as a percentage of final salary depending upon the length of service; the minimum retirement age under the rules of the schemes is 50. The latest full valuations of the two main schemes are being carried out as at 30 June 2008. The provisional results have been updated to 31 December 2008 by qualified independent actuaries. The last full valuations of other Group schemes were carried out on a number of different dates; these have been updated to 31 December 2008 by qualified independent actuaries or, in the case of the Scottish Widows Retirement Benefits Scheme, by a qualified actuary employed by Scottish Widows. The Group’s obligations in respect of its defined benefit schemes are funded. The Group currently expects to pay contributions of at least £525 million to its defined benefit schemes in 2009. amount included in the balance sheet Present value of funded obligations Fair value of scheme assets Unrecognised actuarial (losses) gains Liability in the balance sheet movements in the defined benefit obligation At 1 January Current service cost Interest cost Actuarial gains Benefits paid Past service cost Curtailments Disposal of businesses Exchange and other adjustments At 31 December changes in the fair value of scheme assets At 1 January Expected return Employer contributions Actuarial (losses) gains Benefits paid Disposal of businesses Exchange and other adjustments At 31 December Actual return on scheme assets 2008 £m 2007 £m 15,617 (13,693) 1,924 (267) 1,657 2008 £m 16,795 (16,112) 683 1,350 2,033 2007 £m 16,795 17,378 258 957 (1,928) (597) 21 6 – 105 15,617 2008 £m 16,112 1,085 541 (3,520) (597) – 72 13,693 (2,435) 302 866 (971) (555) 25 – (262) 12 16,795 2007 £m 15,279 1,035 446 139 (555) (244) 12 16,112 1,174 144 Lloyds Banking Group Annual Report and Accounts 2008 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued 37 reTiremenT benefiT obLigaTions continued ASSUMPTIONS The principal actuarial and financial assumptions used in valuations of the defined benefit pension schemes were as follows: Discount rate Rate of inflation Rate of salary increases Rate of increase for pensions in payment Life expectancy for member aged 60, on the valuation date: Men Women Life expectancy for member aged 60, 15 years after the valuation date: Men Women 2008 % 6.30 3.00 3.75 2.80 years 26.4 27.2 27.3 28.1 2007 % 5.80 3.30 4.00 3.10 years 25.9 27.9 27.1 29.0 The mortality assumptions used in the scheme valuations are based on standard tables published by the Institute and Faculty of Actuaries which were adjusted in line with the actual experience of the relevant schemes. The table shows that a member retiring at age 60 as at 31 December 2008 is assumed to live for, on average, 26.4 years for a male and 27.2 years for a female. In practice there will be much variation between individual members but these assumptions are expected to be appropriate across all members. It is assumed that younger members will live longer in retirement than those retiring now. This reflects the expectation that mortality rates will continue to fall over time as medical science and standards of living improve. To illustrate the degree of improvement assumed the table also shows the life expectancy for members aged 45 now, when they retire in 15 years time at age 60. An analysis of the impact of a reasonable change in these assumptions is provided in note 3. The expected return on scheme assets has been calculated using the following assumptions: Equities Fixed interest gilts Index linked gilts Non-Government bonds Property Money market instruments and cash The expected return on scheme assets in 2009 will be calculated using the following assumptions: Equities and alternative assets Fixed interest gilts Index linked gilts Non-Government bonds Property Money market instruments and cash 2008 % 8.2 4.5 4.4 6.0 6.7 4.8 2007 % 8.0 4.6 4.2 5.1 6.5 3.9 2009 % 8.4 3.7 4.0 6.7 6.4 3.8 overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 37 reTiremenT benefiT obLigaTions continued Composition of scheme assets: Equities Fixed interest gilts Index linked gilts Non-Government bonds Property Money market instruments, cash and other assets and liabilities At 31 December financiaL sTaTemenTs sharehoLder informaTion Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 145 Lloyds Banking Group Annual Report and Accounts 2008 2008 £m 7,040 1,452 1,326 1,721 1,485 669 2007 £m 8,537 2,041 1,433 1,990 1,666 445 13,693 16,112 The assets of all the funded plans are held independently of the Group’s assets in separate trustee administered funds. The expected return on plan assets was determined by considering the expected returns available on the assets underlying the current investment policy. Expected yields on fixed interest investments are based on gross redemption yields at the balance sheet date at a term and credit rating broadly appropriate for the bonds held. Expected returns on equity and property investment are long-term rates based on the views of the plan’s independent investment consultants. The expected return on equities allows for the different expected returns from the private equity, infrastructure and hedge fund investments held by some of the funded plans. Some of the funded plans also invest in certain money market instruments and the expected return on these investments has been assumed to be the same as cash. Experience adjustments history (since the date of adoption of IAS 19): Present value of defined benefit obligation Fair value of scheme assets Experience losses on scheme liabilities Experience (losses) gains on scheme assets 2008 £m 15,617 (13,693) 1,924 (39) (3,520) 2007 £m 16,795 (16,112) 683 (185) 139 2006 £m 17,378 (15,279) 2,099 (50) 314 The expense recognised in the income statement for the year ended 31 December comprises: Current service cost Interest cost Expected return on scheme assets Curtailments Past service cost Total defined benefit pension expense DEFINED CONTRIBUTION SCHEMES 2005 £m 17,320 (14,026) 3,294 (69) 1,538 2008 £m 258 957 2004 £m 14,866 (11,648) 3,218 (126) 361 2007 £m 302 866 (1,085) (1,035) 6 21 157 – 25 158 The Group operates a number of defined contribution pension schemes in the UK and overseas, principally the defined contribution sections of the Lloyds TSB Group Pension Schemes No’s 1 and 2. During the year ended 31 December 2008 the charge to the income statement in respect of these schemes was £71 million (2007: £63 million), representing the contributions payable by the employer in accordance with each scheme’s rules. oTher posT-reTiremenT benefiT schemes The Group operates a number of schemes which provide post-retirement healthcare benefits to certain employees, retired employees and their dependants. The principal scheme relates to former Lloyds Bank staff and under this scheme the Group has undertaken to meet the cost of post- retirement healthcare for all eligible former employees (and their dependants) who retired prior to 1 January 1996. The Group has entered into an insurance contract to provide these benefits and a provision has been made for the estimated cost of future insurance premiums payable. For the principal post-retirement healthcare scheme, the latest actuarial valuation of the liability was carried out at 30 June 2007; this valuation has been updated to 31 December 2008 by qualified independent actuaries. The principal assumptions used were as set out above, except that the rate of increase in healthcare premiums has been assumed at 7.50 per cent (2007: 7.43 per cent). 146 Lloyds Banking Group Annual Report and Accounts 2008 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued 37 reTiremenT benefiT obLigaTions continued Amount included in the balance sheet: Present value of unfunded obligations Unrecognised actuarial losses Liability in the balance sheet Movements in the other post-retirement benefits obligation: At 1 January Exchange and other adjustments Actuarial (gain) loss Insurance premiums paid Charge for the year At 31 December 38 deferred Tax The movement in the net deferred tax balance is as follows: Liability at 1 January Exchange and other adjustments Disposals Income statement (credit) charge: Due to change in UK corporation tax rate Other Amount charged (credited) to equity: Available-for-sale financial assets (note 43) Net investment hedge (note 43) Cash flow hedges (note 43) Share based compensation (Asset) liability at 31 December The deferred tax (credit) charge in the income statement comprises the following temporary differences: Accelerated capital allowances Pensions and other post-retirement benefits Investment reserve Allowances for impairment losses Unrealised gains Tax on value of in-force business Other temporary differences 2008 £m 118 (4) 114 2008 £m 123 2 (8) (6) 7 118 2008 £m 948 4 (98) – (773) (773) (566) (358) (5) 15 (914) (833) 2008 £m (318) 104 32 (2) (297) (193) (99) (773) 2007 £m 123 (12) 111 2007 £m 110 – 2 (6) 17 123 2007 £m 1,416 – (389) (110) 21 (89) (1) – (6) 17 10 948 2007 £m (32) 134 (30) 42 (91) (108) (4) (89) overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility Our people Risk management Five year financial summary 10 18 36 40 42 65 governance The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 38 deferred Tax continued Deferred tax assets and liabilities are comprised as follows: Deferred tax assets: Pensions and other post-retirement benefits Allowances for impairment losses Other provisions Derivatives Available-for-sale asset revaluation Tax losses carried forward Other temporary differences Deferred tax liabilities: Accelerated capital allowances Investment reserve Unrealised gains Tax on value of in-force business Other temporary differences deferred Tax asseTs financiaL sTaTemenTs sharehoLder informaTion Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 Notes to the parent company financial statements 186 Shareholder information Index to annual report Financial calendar 2009 191 192 195 147 Lloyds Banking Group Annual Report and Accounts 2008 2008 £m (496) (103) (51) (114) (567) (856) (121) (2,308) 2008 £m 561 151 45 459 259 2007 £m (600) (101) (15) (178) (1) (409) (168) (1,472) 2007 £m 979 119 342 652 328 1,475 2,420 Deferred tax assets are recognised for tax losses and foreign tax credit carry forwards to the extent that the realisation of the related tax benefit through future taxable profits is probable. Scottish Widows plc has recognised a deferred tax asset of £388 million and other Group companies have recognised deferred tax assets totalling £468 million in relation to tax losses carried forward. For all of these losses, after reviewing medium term profit forecasts, the Group considers that there will be sufficient profits in the future against which these losses will be offset. Deferred tax assets of £252 million (2007: £33 million) have not been recognised in respect of capital losses carried forward as there are no predicted future capital profits. Capital losses can be carried forward indefinitely. In addition, deferred tax assets have not been recognised in respect of Eligible Unrelieved Foreign Tax (EUFT) and other foreign tax credits carried forward as at 31 December 2008 of £60 million (2007: £104 million), as there are no predicted future taxable profits against which the unrelieved foreign tax credits can be utilised. EUFT can be carried forward indefinitely. deferred Tax LiabiLiTies Deferred tax liabilities have not been recognised for tax that may be payable if earnings of certain subsidiaries were remitted to the UK. Such amounts are either reinvested for the foreseeable future or can be remitted free of tax. Unremitted earnings totalled £1,196 million (2007: £928 million). Future transfers from Scottish Widows plc’s long-term business funds to its Shareholder Fund will be subject to a shareholder tax charge. Under IAS 12, no provision is required to be made to the extent that the timing of such transfers is under Scottish Widows plc’s control. Accordingly, deferred tax liabilities of £90 million (2007: £90 million) have not been recognised. 148 Lloyds Banking Group Annual Report and Accounts 2008 noTES To THE ConSoLIDATED fInAnCIAL STATEmEnTS continued 39 other provisions At 1 January 2008 Exchange and other adjustments Provisions applied Amortisation of discount Charge for the year At 31 December 2008 provisions for contingent liabilities and commitments £m Customer remediation provisions £m vacant leasehold property and other £m 29 1 (6) – 6 30 43 – (9) – – 34 137 13 (21) 2 35 166 total £m 209 14 (36) 2 41 230 provisions for Contingent liabilities and Commitments Provisions are held in cases where the Group is irrevocably committed to advance additional funds, but where there is doubt as to the customer’s ability to meet its repayment obligations. Customer remediation provisions The Group establishes provisions for the estimated cost of making redress payments to customers in respect of past product sales, in those cases where the original sales processes have been found to be deficient. During 2008 management has reviewed the adequacy of the provisions held having regard to current complaint volumes and the level of payments being made and are satisfied that no additional charge is required. At 31 December 2008 the remaining provisions held relate to past sales of a number of products, including mortgage endowment policies, sold through the branch networks of Lloyds TSB Bank, Lloyds TSB Scotland and Cheltenham & Gloucester and underwritten by life assurance companies within the Group and also by third parties. The principal assumptions that are made in the assessment of the adequacy of the provision relate to the number of cases that are likely to require redress, taking into account any time barring, and the estimated average cost per case. The ultimate cost and timing of the payments remains highly uncertain and will be influenced by external factors beyond the control of management, such as regulatory actions, media interest and the performance of the financial markets. However, it is expected that the majority of the remaining expenditure will be incurred within the next five years. vaCant leasehold property and other Vacant leasehold property provisions are made by reference to a prudent estimate of expected sub-let income, compared to the head rent, and the possibility of disposing of the Group’s interest in the lease, taking into account conditions in the property market. These provisions are reassessed on a biennial basis and will normally run off over the period of under-recovery of the leases concerned, currently averaging five years; where a property is disposed of earlier than anticipated, any remaining balance in the provision relating to that property is released. The Group also carries provisions in respect of its obligations relating to UIC Insurance Company Limited (UIC), which is in provisional liquidation. The Group has indemnified a third party against losses in the event that UIC does not honour its obligations under a reinsurance contract, which is subject to asbestosis and pollution claims in the US. The ultimate cost of settling the Group’s exposure in respect of the insurance business of UIC and the timing remains uncertain. The provision held represents management’s current best estimate of the cost after having regard to the financial condition of UIC and actuarial estimates of future claims. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility our people Risk management five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 notes to the parent company financial statements 186 40 subordinated liabilities preferred securities 6.90% Perpetual Capital Securities (US$1,000 million) fixed/floating Rate non-Cumulative Callable Preference Shares callable 2015 (£600 million) fixed/floating Rate non-Cumulative Callable Preference Shares callable 2016 (US$1,000 million) 6% non-cumulative Redeemable Preference Shares Euro Step-up non-Voting non-Cumulative Preferred Securities callable 2012 (€430 million) 7.875% Perpetual Capital Securities (€500 million) 7.875% Perpetual Capital Securities (US$1,250 million) 6.35% Step-up Perpetual Capital Securities callable 2013 (€500 million) Sterling Step-up non-Voting non-Cumulative Preferred Securities callable 2015 (£250 million) 4.385% Step-up Perpetual Capital Securities callable 2017 (€750 million) undated subordinated liabilities Primary Capital Undated floating Rate notes: Series 1 (US$750 million) Series 2 (US$500 million) Series 3 (US$600 million) 11¾% Perpetual Subordinated Bonds (£100 million) 55/8% Undated Subordinated Step-up notes callable 2009 (€1,250 million) Undated Step-up floating Rate notes callable 2009 (€150 million) 65/8% Undated Subordinated Step-up notes callable 2010 (£410 million) 5.125% Step-up Perpetual Subordinated notes callable 2015 (£560 million) 5.57% Undated Subordinated Step-up Coupon notes callable 2015 (¥20,000 million) 5.125% Undated Subordinated Step-up notes callable 2016 (£500 million) 6½% Undated Subordinated Step-up notes callable 2019 (£270 million) 8% Undated Subordinated Step-up notes callable 2023 (£200 million) 6½% Undated Subordinated Step-up notes callable 2029 (£450 million) 6% Undated Subordinated Step-up Guaranteed Bonds callable 2032 (£500 million) Shareholder information Index to annual report financial calendar 2009 191 192 195 149 Lloyds Banking Group Annual Report and Accounts 2008 2008 £m 756 584 824 – 459 472 921 512 248 2007 £m 471 593 515 – 335 – – 365 248 720 5,496 504 3,031 515 343 412 100 1,212 144 409 536 189 455 241 186 444 374 249 299 100 915 110 408 534 111 449 238 188 444 452 5,638 450 4,869 note d, g a, b a, c o d, m d, f, p d, f, p d, f, k d, n d, f, k d, e d, k d, e d, j d, h d, l d, j d, j d, j d, j d, j 150 Lloyds Banking Group Annual Report and Accounts 2008 noTES To THE ConSoLIDATED fInAnCIAL STATEmEnTS continued 40 subordinated liabilities continued dated subordinated liabilities 5 1/4% Subordinated notes 2008 (Dm 750 million) 10 5/8% Guaranteed Subordinated Loan Stock 2008 (£100 million) 9 1/2% Subordinated Bonds 2009 (£100 million) 61/4% Subordinated notes 2010 (€400 million) 12% Guaranteed Subordinated Bonds 2011 (£100 million) 9 1/8% Subordinated Bonds 2011 (£150 million) 43/4% Subordinated notes 2011 (€850 million) 5 7/8% Subordinated Guaranteed Bonds 2014 (€750 million) 5 7/8% Subordinated notes 2014 (£150 million) 6 5/8% Subordinated notes 2015 (£350 million) Subordinated Step-up floating Rate notes 2016 callable 2011 (£300 million) Subordinated Step-up floating Rate notes 2016 callable 2011 (€500 million) Subordinated fixed to floating Rate notes due 2018 callable 2013 (€1,000 million) Subordinated fixed to floating Rate notes due 2020 callable 2015 (£750 million) Subordinated floating Rate notes 2020 (€100 million) 5.75% Subordinated Step-up notes 2025 callable 2020 (£350 million) 9 5/8% Subordinated Bonds 2023 (£300 million) Total subordinated liabilities note i i e e k, p k, p e 2008 £m – – 100 404 100 149 836 821 149 320 300 480 992 754 96 309 2007 £m 281 100 100 302 100 149 609 591 149 316 300 371 – – 73 305 312 6,122 17,256 312 4,058 11,958 These liabilities will, in the event of the winding-up of the issuer, be subordinated to the claims of depositors and all other creditors of the issuer. The Group has not had any defaults of principal, interest or other breaches with respect to its subordinated liabilities during the period (2007: nil). At 31 December 2008 £17,156 million (2007: £11,577 million) of subordinated liabilities had a contractual residual maturity of greater than one year. a) b) c) d) Any repayment of preference shares would require prior notification to the financial Services Authority. In certain circumstances, the shares may be mandatorily exchanged for qualifying non-innovative tier 1 securities. The Company may declare no dividend or a partial dividend on these preference shares. Dividends may be reduced if the distributable profits of the Company are insufficient to cover the payment in full of the dividends and also the payment in full of all other dividends on shares issued by the Company. Dividends will accrue at a rate of 6.369 per cent per annum up to 24 August 2015, and, unless redeemed, at a rate reset quarterly equal to 1.28 per cent per annum above the London interbank offered rate for three-month sterling deposits thereafter. These preference shares can be redeemed at the option of the Company on 25 August 2015 or quarterly thereafter. Dividends will accrue at a rate of 6.267 per cent per annum up to 13 november 2016 and, unless redeemed, at a rate reset quarterly equal to 1.035 per cent per annum above the London interbank offered rate for three-month sterling deposits thereafter. These preference shares can be redeemed at the option of the Company on 14 november 2016 or every 10 years thereafter. In certain circumstances, these notes, bonds and securities would acquire the characteristics of preference share capital. Any repayments of undated subordinated liabilities would require prior notification to the financial Services Authority. They are accounted for as liabilities since coupon payments are mandatory as a consequence of the terms of the 6 per cent non-cumulative Redeemable Preference Shares. e) These notes bear interest at rates fixed periodically in advance based on London interbank rates. f) g) In certain circumstances the interest payments on these securities can be deferred although in this case neither Lloyds TSB Bank plc nor Lloyds Banking Group plc can declare or pay a dividend until payments have been resumed. In the event of a winding up of Lloyds TSB Bank plc, these securities will acquire the characteristics of preference shares. In certain circumstances the interest payments on these securities can be deferred although in this case neither Lloyds TSB Bank plc nor Lloyds Banking Group plc can declare or pay a dividend until payments are resumed. Any deferred payments will be made good on redemption of the securities. The securities can be redeemed at par at the option of Lloyds TSB Bank plc on any coupon date. h) In certain circumstances the interest payments on these securities can be deferred although in this case Scottish Widows plc cannot declare or pay a dividend until any deferred payments have been made. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility our people Risk management five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 notes to the parent company financial statements 186 Shareholder information Index to annual report financial calendar 2009 191 192 195 151 Lloyds Banking Group Annual Report and Accounts 2008 40 subordinated liabilities continued i) Issued by a group undertaking under the Company’s subordinated guarantee. j) At the callable date the coupon on these notes will be reset by reference to the applicable five year benchmark gilt rate. k) In the event that these notes are not redeemed at the callable date, the coupon will be reset to a floating rate. l) In the event that these notes are not redeemed at the callable date, the coupon will be reset to a margin of 1.60 per cent over the five year Yen swap rate. m) These securities constitute limited partnership interests in Lloyds TSB Capital 1 L.P., a Jersey limited partnership in which Lloyds TSB (General Partner) Limited, a wholly owned subsidiary, is the general partner. non-cumulative income distributions accrue at a fixed rate of 7.375 per cent per annum up to 7 february 2012; thereafter they will accrue at a margin of 2.33 per cent over EURIBoR. This issue was made under the limited subordinated guarantee of Lloyds TSB Bank plc. In certain circumstances these preferred securities will be mandatorily exchanged for preference shares in Lloyds Banking Group plc. Lloyds Banking Group plc has entered into an agreement whereby dividends may only be paid on its ordinary shares if sufficient distributable profits are available for distributions due in the financial year on these preferred securities. n) These securities constitute limited partnership interests in Lloyds TSB Capital 2 L.P., a Jersey limited partnership in which Lloyds TSB (General Partner) Limited, a wholly owned subsidiary, is the general partner. non-cumulative income distributions accrue at a fixed rate of 7.834 per cent per annum up to 7 february 2015; thereafter they will accrue at a margin of 3.50 per cent over a rate based on the yield of specified UK Government stock. This issue was made under the limited subordinated guarantee of Lloyds TSB Bank plc. In certain circumstances these preferred securities will be mandatorily exchanged for preference shares in Lloyds Banking Group plc. Lloyds Banking Group plc has entered into an agreement whereby dividends may only be paid on its ordinary shares if sufficient distributable profits are available for distributions due in the financial year on these preferred securities. o) Since 2004, the Company has had in issue 400 6 per cent non-cumulative preference shares of 25p each. The shares, which are redeemable at the option of the Company at any time, carry the rights to a fixed rate non-cumulative preferential dividend of 6 per cent per annum; no dividend shall be payable in the event that the directors determine that prudent capital ratios would not be maintained if the dividend were paid. Upon winding up, the shares rank equally with any other preference shares issued by the Company. p) Issued during 2008 to finance the general business of the Group. Changes in the issued preference share capital of the Group during January 2009 are discussed in note 52. 152 Lloyds Banking Group Annual Report and Accounts 2008 noTES To THE ConSoLIDATED fInAnCIAL STATEmEnTS continued 41 share Capital authorised share capital Sterling: 6,911 million ordinary shares of 25p each 79 million Limited voting ordinary shares of 25p each 175 million Preference shares of 25p each US dollars: 160 million Preference shares of 25 cents each Euro: 160 million Preference shares of 25 cents each Japanese yen: 50 million Preference shares of ¥25 each issued and fully paid ordinary shares ordinary shares of 25p each At 1 January Private placement of ordinary shares Issued under employee share schemes At 31 December Limited voting ordinary shares of 25p each At 1 January and 31 December share Capital and Control 2008 2007 £m 1,728 20 44 1,792 us$m 40 em 40 ¥m 1,250 2008 £m £m 1,728 20 44 1,792 US$m 40 em 40 ¥m 1,250 2007 £m 2008 number of shares 2007 number of shares 5,647,703,945 5,637,964,437 1,412 1,409 284,400,000 – 40,751,724 9,739,508 71 10 – 3 5,972,855,669 5,647,703,945 1,493 1,412 78,947,368 78,947,368 20 1,513 20 1,432 There are no restrictions on the transfer of shares in the Company other than as set out in the articles of association and: – certain restrictions which may from time to time be imposed by law and regulations (for example, insider trading laws); – pursuant to the UK Listing Authority’s listing rules where directors and certain employees of the Company require the approval of the Company to deal in the Company’s shares; and – pursuant to the rules of some of the Company’s employee share plans where certain restrictions may apply while the shares are subject to the plans. Where, under an employee share plan operated by the Company, participants are the beneficial owners of shares but not the registered owners, the voting rights are normally exercised by the registered owner at the direction of the participant. All of the Company’s share plans contain provisions relating to a change of control. outstanding awards and options would normally vest and become exercisable on a change of control, subject to the satisfaction of any performance conditions at that time. In addition, the Company is not aware of any agreements between shareholders that may result in restrictions on the transfer of securities and/or voting rights. Information regarding significant direct or indirect holdings of shares in the Company can be found on page 191. The directors have authority to allot and issue ordinary and preference shares and to make market purchases of ordinary shares in accordance with the articles of association. The authority for the Company to purchase, in the market, 572,712,063 of its shares, representing some 10 per cent of the issued share capital, expires at the annual general meeting. Shareholders will be asked, at the annual general meeting, to give similar authorities. In addition, the Company has authority to purchase, in the market, (i) the £1,000,000,000 fixed to floating non-cumulative callable preference shares issued by the Company to Hm Treasury on 15 January 2009 pursuant to the preference share subscription agreement entered into with effect from 13 october 2008 by the Company and Hm Treasury and (ii) the preference shares issued by the Company in exchange for the £3,000,000,000 fixed to floating non-cumulative callable preference shares issued by HBoS plc to Hm Treasury on 15 January 2009 pursuant to the preference share subscription agreement entered into with effect from 13 october 2008 by HBoS plc and Hm Treasury (together with the £1,000,000,000 Hm Treasury preference shares, the Preference Shares) provided that (a) the maximum number of Preference Shares which may be purchased is 4,000,000 (b) the minimum price which may be paid for each Preference Share is 25 pence (exclusive of expenses) (c) the maximum price which may be paid for each Preference Share is an amount equal to 120 per cent of the liquidation preference of the Preference Share and (d) the authority expires 18 months after 19 november 2008 (except in relation to the purchase of Preference Shares the contracts for which are concluded before such expiry and which are executed wholly or partly after such expiry) unless such authority is renewed prior to that time. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility our people Risk management five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 notes to the parent company financial statements 186 Shareholder information Index to annual report financial calendar 2009 191 192 195 153 Lloyds Banking Group Annual Report and Accounts 2008 41 share Capital continued Subject to any rights or restrictions attached to any shares, on a show of hands at a general meeting of the Company every holder of shares present in person or by proxy and entitled to vote has one vote and on a poll every member present and entitled to vote has one vote for every share held. further details regarding voting at the annual general meeting can be found in the notes to the notice of the annual general meeting. ordinary shares The holders of ordinary shares (excluding the limited voting ordinary shares), who held 98.7 per cent of the total share capital as at 31 December 2008, are entitled to receive the Company’s report and accounts, attend, speak and vote at general meetings and appoint proxies to exercise voting rights. Holders of ordinary shares (excluding the limited voting ordinary shares) may also receive a dividend (subject to the provisions of the Company’s articles of association) and on a winding up may share in the assets of the Company. limited voting ordinary shares The limited voting ordinary shares are held by the Lloyds TSB foundations (the foundations). The holders of the limited voting ordinary shares, who held 1.3 per cent of the total share capital as at 31 December 2008, are entitled to receive copies of every circular or other document sent out by the Company to the holders of other ordinary shares. These shares carry no rights to dividends but rank pari passu with the ordinary shares in respect of other distributions and in the event of winding up. These shares do not have any right to vote at general meetings other than on resolutions concerning acquisitions or disposals of such importance that they require shareholder consent, or for the winding up of the Company, or for a variation in the class rights of the limited voting ordinary shares. In the event of an offer for more than 50 per cent of the issued ordinary share capital of the Company, each limited voting ordinary share will convert into an ordinary share and shall rank equally with the ordinary shares in all respects from the date of conversion. Lloyds Banking Group plc has entered into deeds of covenant with the foundations, under the terms of which the Company makes annual donations to the foundations equal, in total, to 1 per cent of the Group’s pre-tax profits (after certain adjustments) averaged over three years. The deeds of covenant can be cancelled by the Company at nine years’ notice. This donation is payable on or before the last day of february in each year (the payment date). In the event of conversion of the limited voting ordinary shares, the foundations shall be entitled to receive a donation, on the same basis as set out above, on the payment date following conversion. private plaCement of ordinary shares during 2008 on 19 September 2008, the Company entered into a placing agreement whereby a total of 284,400,000 new ordinary shares of 25 pence each with an aggregate nominal value of £71,100,000 were placed with institutional investors at a price of 270 pence per share. The proceeds of the placing, after costs, were £760 million. The issue represented an increase of approximately 5 per cent in the issued share capital at the time. The capital was raised to allow Lloyds Banking Group to strengthen its capital and support the development of business strategies. issued and fully paid preferenCe shares Since 2004, the Company has had in issue 400 6 per cent non-cumulative redeemable preference shares of 25 pence each. The shares, which are redeemable at the option of the Company at any time, carry the rights to a fixed rate non-cumulative preferential dividend at a rate of 6 per cent per annum; no dividend shall be payable in the event that the directors determine that prudent capital ratios would not be maintained if the dividend were paid. Upon winding up, the shares rank equally with any other preference shares issued by the Company. The holders of the 6 per cent non-cumulative redeemable preference shares held less than 0.1 per cent of the total share capital as at 31 December 2008. In accordance with IfRS, these shares are reported within liabilities. In addition, during 2006 the Company issued 600,000 fixed/floating Rate non-Cumulative Callable Preference Shares of 25 pence each with a liquidation preference of £1,000 per share and 1,000,000 fixed/floating Rate non-Cumulative Callable Preference Shares of 25 cents each with a liquidation preference of US$1,000 per share. Both issues of preference shares are perpetual, although the two issues can be redeemed at the option of the Company on or after 25 August 2015 and 14 november 2016 respectively and carry the right to non-cumulative dividends which are fixed until those first redemption dates. The terms of these two issues of preference shares are such that the Company cannot declare and pay a dividend on any other junior class of share (including the mandatory dividend on the 400 6 per cent non-cumulative redeemable preference shares mentioned above) until the coupon has been paid on these preference shares. As the Company is effectively committed to the payment of a coupon on these shares they are classified as liabilities on the balance sheet in accordance with IfRS (see note 40). The holders of the fixed/floating rate non-cumulative callable preference shares, who held less than 0.1 per cent of the total share capital as at 31 December 2008, do not have the right to receive notice of, attend, speak or vote at any general meetings other than on resolutions relating to the variation or abrogation of any of the rights or restrictions attached to the preference shares or the winding up or dissolution of the Company or if, at the date of the notice of meeting, the dividend payable at the immediately preceding dividend payment date has failed to be declared and paid in full. Upon winding up, the fixed/floating rate non-cumulative callable preference shares shall rank equally with the most senior class of preference shares and any other class of shares which are expressed to rank equally. Any repayment of the fixed/floating rate non-cumulative callable preference shares would require prior notification to the fSA. The sterling fixed/floating rate non-cumulative callable preference shares can be redeemed at the option of the Company on or after 25 August 2015; at this call date, dividends will be reset at a margin of 1.28 per cent over 3 month LIBoR. The US dollar fixed/floating rate non-cumulative callable preference shares can be redeemed at the option of the Company on or after 14 november 2016; at this call date, dividends will be reset at a margin of 1.035 per cent over 3 month LIBoR. In certain circumstances, the fixed/floating rate non-cumulative callable preference shares may be mandatorily exchanged for qualifying non-innovative tier 1 securities and in certain circumstances and subject to compliance with certain requirements, the fixed/floating rate non-cumulative callable preference shares may be redeemed by the Company at certain times in the event that the fSA makes a decision that the preference shares can no longer qualify as non-innovative tier 1 capital. The Company may declare no dividend or a partial dividend on these preference shares; notwithstanding this discretion, in certain circumstances, the dividends on the fixed/floating rate non-cumulative callable preference shares will be mandatorily payable if the preference shares cease to be eligible to qualify as regulatory capital and the Company is in 154 Lloyds Banking Group Annual Report and Accounts 2008 noTES To THE ConSoLIDATED fInAnCIAL STATEmEnTS continued 41 share Capital continued compliance with relevant fSA regulations regarding capital adequacy. Dividends may be reduced if the distributable profits of the Company are insufficient to cover the payment in full of the dividends and also the payment in full of all other dividends on shares issued by the Company. These securities were issued during 2006 primarily to finance the development and expansion of the business of the Group. Changes in authorised and issued share Capital sinCe the end of the year Increases in the authorised and issued share capital of the Company during January 2009 are discussed in note 52. 42 share premium aCCount At 1 January Premium arising on private placement of ordinary shares (note 41) Premium arising on issue of shares under share option schemes At 31 December 43 other reserves other reserves comprise: merger reserve Revaluation reserve in respect of available-for-sale financial assets Cash flow hedging reserve foreign currency translation reserve movements in other reserves were as follows: merger reserve At 1 January and 31 December revaluation reserve in respect of available-for-sale financial assets At 1 January Exchange and other adjustments Change in fair value of available-for-sale financial assets Change in fair value attributable to minority interests Deferred tax Current tax Income statement transfers: Disposals (note 9) Impairment Current tax other transfers Current tax Disposal of businesses At 31 December 2008 £m 1,298 689 109 2,096 2008 £m 343 (2,982) (15) 178 (2,476) 2008 £m 343 2008 £m (399) (541) (2,721) 2 566 94 (2,059) (19) 130 (28) 102 (91) 25 (66) – 2007 £m 1,266 – 32 1,298 2007 £m 343 (399) (3) (1) (60) 2007 £m 343 2007 £m – (1) (483) – 1 46 (436) (5) 70 (21) 49 – – – (6) (2,982) (399) overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility our people Risk management five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 notes to the parent company financial statements 186 Shareholder information Index to annual report financial calendar 2009 191 192 195 155 Lloyds Banking Group Annual Report and Accounts 2008 43 other reserves continued Cash flow hedging reserve At 1 January Change in fair value of hedging derivatives Deferred tax Income statement transfer (note 5) Deferred tax At 31 December foreign currency translation reserve At 1 January Currency translation differences arising in the year foreign currency losses on net investment hedges Amounts transferred to income statement in respect of hedge ineffectiveness Current tax Deferred tax At 31 December 44 retained profits At 1 January Profit for the year Dividends Purchase/sale of treasury shares Employee share option schemes – value of employee services At 31 December 2008 £m (3) (33) 9 (24) 16 (4) 12 (15) 2008 £m (1) 2,533 (3,310) 14 584 358 (2,354) 178 2008 £m 9,471 819 (2,042) 16 (4) 2007 £m 12 (20) 6 (14) (1) – (1) (3) 2007 £m (19) 257 (342) – 103 – (239) (1) 2007 £m 8,124 3,289 (1,957) (1) 16 8,260 9,471 Retained profits are stated after deducting £40 million (2007: £75 million) representing 15 million (2007: 15 million) treasury shares held. Value of employee services includes a credit of £12 million (2007: £30 million) reflecting the income statement charge in respect of SAYE and executive options, together with a related tax charge of £16 million (2007: tax charge £14 million). Purchase/sale of treasury shares includes a credit of £31 million (2007: £29 million) relating to the cost of other share scheme awards. 45 ordinary dividends final dividend for previous year paid during the current year Interim dividend 2008 pence per share 2007 Pence per share 24.7 11.4 36.1 23.5 11.2 34.7 2008 £m 1,394 648 2,042 2007 £m 1,325 632 1,957 The directors do not propose to pay a final dividend (2007: 24.7 pence per share, which represented a total cost of £1,394 million). Bank of new York nominees Limited have waived the right to all dividends on Lloyds Banking Group plc shares that they hold (holding at 31 December 2008 and at 31 December 2007: 10 shares). 156 Lloyds Banking Group Annual Report and Accounts 2008 noTES To THE ConSoLIDATED fInAnCIAL STATEmEnTS continued 45 ordinary dividends continued In addition, the trustees of the following holdings of Lloyds Banking Group plc shares in relation to employee share schemes retain the right to receive dividends but chose to waive their entitlement to the dividends on those shares as indicated: the Lloyds TSB Group Shareplan (holding at 31 December 2008: 972,151 shares, at 31 December 2007: 931,478 shares, waived right to all dividends), the Lloyds TSB Group Employee Share ownership Trust (holding at 31 December 2008: 1,442,116 shares, at 31 December 2007: 1,935,141 shares, waived right to all dividends), Lloyds TSB Group Holdings (Jersey) Limited (holding at 31 December 2008 and 31 December 2007: 41,801 shares, waived right to all but a nominal amount of 1 penny in total) and the Lloyds TSB Qualifying Employee Share ownership Trust (holding at 31 December 2008 and 31 December 2007: 1,364 shares, waived right to all but a nominal amount of 1 penny in total). 46 share based payments Charge to the inCome statement The charge to the income statement is set out below: Executive and SAYE schemes: options granted in the year options granted in prior years Share incentive plan: Shares granted in the year Shares granted in prior years 2008 £m 8 4 12 10 21 31 43 2007 £m 6 24 30 12 17 29 59 share based payment sCheme details During the year ended 31 December 2008 the Group operated the following share based payment schemes, all of which are equity settled. ExECUTIVE SCHEmES The executive share option schemes were long-term incentive schemes available to certain senior executives of the Group, with grants usually made annually. options were granted within limits set by the rules of the schemes relating to the number of shares under option and the price payable on the exercise of options. The last grant of executive options was made in August 2005. These options were granted without a performance multiplier and the maximum limit for the grant of options in normal circumstances was three times annual salary. Between April 2001 and August 2004, the aggregate value of the award based upon the market price at the date of grant could not exceed four times the executive’s annual remuneration and, normally, the limit for the grant of options to an executive in any one year would be equal to 1.5 times annual salary with a maximum performance multiplier of 3.5. Prior to 18 April 2001, the normal limit was equal to one year’s remuneration and no performance multiplier was applied. performanCe Conditions for exeCutive options foR oPTIonS GRAnTED UP To mARCH 2001 options granted Performance conditions march 1998 – August 1999 Growth in earnings per share which is equal to the aggregate percentage change in the Retail Price Index plus two percentage points for each complete year of the relevant period together with a further condition that Lloyds Banking Group plc’s ranking based on total shareholder return (calculated by reference to both dividends and growth in share price) over the relevant period should be in the top fifty companies of the fTSE 100. march 2000 – march 2001 As for march 1998 – August 1999 except that there must have been growth in the earnings per share equal to the change in the Retail Price Index plus three percentage points for each complete year of the relevant period. In respect of options granted between march 1998 and march 2001, the relevant period for the performance conditions begins at the end of the financial year preceding the date of grant and will continue until the end of the third subsequent year following commencement or, if not met, the end of such later year in which the conditions are met. once the conditions have been satisfied the options will remain exercisable without further conditions. If they are not satisfied by the tenth anniversary of the grant the option will lapse. foR oPTIonS GRAnTED fRom AUGUST 2001 To AUGUST 2004 The performance condition is linked to the performance of Lloyds Banking Group plc’s total shareholder return (calculated by reference to both dividends and growth in share price) against a comparator group of 17 companies including Lloyds Banking Group plc. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility our people Risk management five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 notes to the parent company financial statements 186 Shareholder information Index to annual report financial calendar 2009 191 192 195 157 Lloyds Banking Group Annual Report and Accounts 2008 46 share based payments continued The performance condition is measured over a three year period commencing at the end of the financial year preceding the grant of the option and continuing until the end of the third subsequent year. If the performance condition is not then met, it will be measured at the end of the fourth financial year. If the condition has not then been met, the options will lapse. To meet the performance conditions, the Group’s ranking against the comparator group must be at least ninth. The full grant of options will only become exercisable if the Group is ranked first. A performance multiplier (of between nil and 100 per cent) will be applied below this level to calculate the number of shares in respect of which options granted to executive directors will become exercisable, and will be calculated on a sliding scale. If Lloyds Banking Group plc is ranked below median the options will not be exercisable. options granted to senior executives other than executive directors are not so highly leveraged and, as a result, different performance multipliers are applied to their options. for the majority of executives, options are granted with the performance condition but no performance multiplier. options granted in 2004 became exercisable as the performance condition was met on the re-test. The performance condition vested at 14 per cent for executive directors, 24 per cent for managing directors, and 100 per cent for all other executives. foR oPTIonS GRAnTED In 2005 The same conditions apply as for grants made up to August 2004, except that: – the performance condition is linked to the performance of Lloyds Banking Group plc’s total shareholder return (calculated by reference to both dividends and growth in share price) against a comparator group of 15 companies including Lloyds Banking Group plc; – if the performance condition has not been met at the end of the third subsequent year, the options will lapse; and – the full grant of options becomes exercisable only if the Group is ranked in the top four places of the comparator group. A sliding scale applies between fourth and eighth positions. If Lloyds Banking Group is ranked below the median (ninth or below) the options will not be exercisable and will lapse. options granted in 2005 became exercisable as the performance condition was met when tested. The performance condition vested at 82.5 per cent for all options granted. movements in the number of share options outstanding under the Executive share option schemes during 2007 and 2008 are set out below: outstanding at 1 January Exercised forfeited outstanding at 31 December Exercisable at 31 December 2008 2007 number of options weighted average exercise price (pence) number of options Weighted average exercise price (pence) 20,621,774 (137,431) (9,280,715) 11,203,628 9,132,197 480.57 419.25 470.02 490.05 453.77 32,459,593 (267,650) (11,570,169) 20,621,774 423,300 459.84 509.10 421.76 480.57 876.37 The weighted average share price at the time that the options were exercised during 2008 was 453.42 pence (2007: 574.39 pence). The weighted average remaining contractual life of options outstanding at the end of the year was 5.1 years (2006: 6.2 years). SAVE-AS-YoU-EARn SCHEmES Eligible employees may enter into contracts through the Save-As-You-Earn (SAYE) schemes to save up to £250 per month and, at the expiry of a fixed term of three or five years, have the option to use these savings within six months of the expiry of the fixed term to acquire shares in the Group at a price equal to 80 per cent of the market price at the date the options were granted. Grants in periods up to 31 December 2001 also had options exercising after seven years. movements in the number of share options outstanding under the SAYE schemes are set out below: outstanding at 1 January Granted Exercised forfeited Cancelled Expired outstanding at 31 December Exercisable at 31 December 2008 number of options weighted average exercise price (pence) 85,673,227 215,737,733 (40,612,608) (2,394,415) (62,963,491) (4,961,997) 190,478,449 3,157,524 342.49 173.80 290.77 388.11 373.21 311.47 152.54 332.12 2007 Weighted average exercise price (pence) 335.94 432.00 351.28 363.45 397.98 547.46 342.49 459.01 number of options 90,220,144 10,759,688 (9,473,792) (3,447,524) (1,822,417) (562,872) 85,673,227 1,560,472 158 Lloyds Banking Group Annual Report and Accounts 2008 noTES To THE ConSoLIDATED fInAnCIAL STATEmEnTS continued 46 share based payments continued The weighted average share price at the time that the options were exercised during 2008 was 370.29 pence (2007: 552.20 pence). The weighted average remaining contractual life of options outstanding at the end of the year was 3.4 years (2007: 1.7 years). The weighted average fair value of SAYE options granted during the year was £0.61 (2007: £1.07). The values for the SAYE options have been determined using a standard Black-Scholes model. oTHER SHARE oPTIon PLAnS lloyds tsb group exeCutive share plan 2003 The plan was adopted in December 2003 and under the plan share options may be granted to senior employees. options granted to date under this scheme were granted specifically to facilitate recruitment. options granted under this plan are not subject to any performance conditions. outstanding at 1 January Granted Exercised forfeited outstanding at 31 December 2008 2007 number of options 308,718 681,931 (117,236) (15,802) 857,611 weighted average exercise price (pence) nil nil nil nil nil number of options 357,123 214,444 (203,170) (59,679) 308,718 Weighted average exercise price (pence) nil nil nil nil nil The weighted average fair value of options granted in the year was £2.92 (2007: £5.27). The weighted average share price at the time that the options were exercised during 2008 was 291.04 pence (2007: 539.77 pence). no options outstanding at 31 December were exercisable. The weighted average remaining contractual life of options outstanding at the end of the year was 2.5 years (2007: 1.8 years). lloyds tsb group exeCutive share plan 2005 This plan was adopted by the Group in 2005, specifically to facilitate the recruitment of ms Dial. ms Dial was the only participant in the plan. options granted under this plan were not subject to any performance conditions and would have normally become exercisable if ms Dial remained as an employee, and had not given notice of resignation, on 31 may 2008. on 28 march 2008, the Group announced that ms Dial had decided to leave the Group and, in accordance with the terms of the plan, the options lapsed. outstanding at 1 January Lapsed outstanding at 31 December 2008 2007 number of options 242,825 (242,825) – weighted average exercise price (pence) nil nil – number of options 242,825 – 242,825 Weighted average exercise price (pence) nil – nil The weighted average remaining contractual life of options outstanding at the end of 2007 was 0.9 years. oTHER SHARE PLAnS long-term inCentive plan The Long-Term Incentive Plan introduced in 2006 is a long-term incentive scheme aimed at delivering shareholder value by linking the receipt of shares to an improvement in the performance of the Group over a three year period. Awards are made within limits set by the rules of the plan, with the limits determining the maximum number of shares that can be awarded equating to three times annual salary, in exceptional circumstances this may increase up to four times annual salary. The performance conditions for awards made in may and August 2006 are as follows: (i) (ii) for 50 per cent of the award (the ‘EPS Award’) – the percentage increase in earnings per share of the Group (on a compound annualised basis) over the relevant period must be at least an average of 6 percentage points per annum greater than the percentage increase (if any) in the Retail Price Index over the same period. If it is less than 3 per cent per annum the EPS Award will lapse. If the increase is more than 3 per cent but less than 6 per cent per annum then the proportion of shares released will be on a straight line basis between 17.5 per cent and 100 per cent. The relevant period commenced on 1 January 2006 and ended on 31 December 2008. for the other 50 per cent of the award (the ‘TSR Award’) – it will be necessary for the Group’s total shareholder return (calculated by reference to both dividends and growth in share price) to exceed the median of a comparator group (14 companies) over the relevant period by an average of 7.5 per cent per annum for the TSR Award to vest in full. 17.5 per cent of the TSR Award will vest where the Group’s total shareholder return is equal to median and vesting will occur on a straight line basis in between these points. Where the Group’s total shareholder return is below the median of the comparator group, the TSR Award will lapse. The relevant period commenced on 1 January 2006 and ended on 31 December 2008. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility our people Risk management five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 notes to the parent company financial statements 186 Shareholder information Index to annual report financial calendar 2009 191 192 195 159 Lloyds Banking Group Annual Report and Accounts 2008 46 share based payments continued The performance conditions for awards made in march and August 2007 are as follows: (i) (ii) for 50 per cent of the award (the ‘EPS Award’) – the performance condition is as described for may 2006 with the relevant performance period commencing on 1 January 2007 and ending on 31 December 2009. for the other 50 per cent of the award (the ‘TSR Award’) – the performance condition is as described for may 2006 with the relevant performance period commencing on 8 march 2007 (the date of the first award) and ending on 7 march 2010. The performance conditions for awards made in march, April, August and September 2008 are as follows: (i) (ii) for 50 per cent of the award (the EPS Award) – the performance condition is as described for may 2006 with the relevant performance period commencing on 1 January 2008 and ending on 31 December 2010. for the other 50 per cent of the award (the TSR Award) – the performance condition is as described for may 2006, except that the comparator group comprises of 13 companies, with the relevant performance period commencing on 6 march 2008 (the date of the first award) and ending on 5 march 2011. outstanding at 1 January Granted forfeited outstanding at 31 December 2008 number of shares 2007 number of shares 13,209,081 10,519,609 5,788,108 7,884,787 (1,491,408) (463,814) 22,237,282 13,209,081 The fair value of the share awards granted in 2008 was £2.28 (2007: £3.13). performanCe share plan Under the performance share plan, introduced during 2005, participating executives will be eligible for an award of free shares, known as performance shares, to match the bonus shares awarded as part of their 2004 and 2005 bonus. The maximum match will be two performance shares for each bonus share, awarded at the end of a three year period. The actual number of shares awarded will depend on the Group’s total shareholder return performance measured over a three year period, compared to other companies in the comparator group. The maximum of two performance shares for each bonus share will be awarded only if the Group’s total shareholder return performance places it first in the comparator group; one performance share for each bonus share will be granted if the Group is placed fifth; and one performance share for every two bonus shares if the Group is placed eighth (median). Between first and fifth position, and fifth and eighth position, sliding scales will apply. If the total shareholder return performance is below median, no performance shares will be awarded. There will be no retest. Whilst income tax is deducted from the bonus before deferral into the plan, where a match of performance shares is justified, these shares will be awarded as if income tax had not been deducted. The performance condition attached to the march 2005 award was met, with the Group ranked in fifth place. Bonus shares were released on 18 march 2008, with one performance share granted for each bonus share. Performance shares were released on 10 April 2008. outstanding at 1 January forfeited Lapsed Released outstanding at 31 December The weighted average share price at the date the shares were released during 2008 was 446.13 pence. 2008 number of shares 2007 number of shares 1,767,594 1,849,102 (74,691) (375,790) (375,789) (81,508) – – 941,324 1,767,594 160 Lloyds Banking Group Annual Report and Accounts 2008 noTES To THE ConSoLIDATED fInAnCIAL STATEmEnTS continued 46 share based payments continued The ranges of exercise prices, weighted average exercise prices, weighted average remaining contractual life and number of options outstanding for the option schemes were as follows: executive schemes saye schemes other share option plans weighted average weighted average exercise price remaining life (years) (pence) weighted average weighted average exercise price remaining life (years) (pence) number of options number of options weighted average weighted average exercise price remaining life (years) (pence) number of options 31 december 2008 Exercise price range £0 to £1 £1 to £2 £2 to £3 £3 to £4 £4 to £5 £5 to £6 £6 to £7 £7 to £8 £8 to £9 31 december 2007 Exercise price range £0 to £2 £2 to £3 £3 to £4 £4 to £5 £5 to £6 £6 to £7 £7 to £8 £8 to £9 – nil 2.5 857,611 – – – – 453.77 551.25 652.30 – – – – – – – – – 5.9 9,132,197 1.2 2.1 – 741,905 997,326 – 863.63 0.3 332,200 – 139.00 284.00 344.75 423.49 588.50 – – – – 3.5 0.4 1.9 2.0 0.3 – – – 178,932,603 941,414 7,366,320 3,200,532 37,580 – – – – – – – – – – – – – – – – – – – Executive schemes SAYE schemes other share option plans Weighted average Weighted average exercise price remaining life (years) (pence) number of options Weighted average Weighted average exercise price remaining life (years) (pence) Weighted average Weighted average exercise price remaining life (years) (pence) number of options – – – – – – – – number of options – – – 449.34 551.09 652.47 – 871.54 – – – – – – 6.8 17,898,897 2.2 3.1 – 0.7 815,965 1,114,912 – 792,000 – 284.00 353.10 424.23 563.65 – – – – 0.9 1.9 2.9 0.1 – – – – nil 1.4 551,543 42,651,925 15,775,539 26,525,262 720,501 – – – – – – – – – – – – – – – – – – – – – – – – The fair value calculations at 31 December 2008 for grants made in the year are based on the following assumptions: Risk-free interest rate Expected life Expected volatility Expected dividend yield Weighted average share price Weighted average exercise price Expected forfeitures saye 3.14% other option schemes 3.90% other share plans 4.04% 3.2 years 2.9 years 3.0 years 40% 3.5% £2.17 £1.74 6% 29% 7.3% £3.67 nil 4% 23% 8.9% £4.24 nil 4% Expected volatility is a measure of the amount by which the Group’s shares are expected to fluctuate during the life of an option. The expected volatility is estimated based on the historical volatility of the closing daily share price over the most recent period that is commensurate with the expected life of the option. The historical volatility is compared to the implied volatility generated from market traded options in the Group’s shares to assess the reasonableness of the historical volatility and adjustments made where appropriate. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility our people Risk management five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 notes to the parent company financial statements 186 Shareholder information Index to annual report financial calendar 2009 191 192 195 161 Lloyds Banking Group Annual Report and Accounts 2008 46 share based payments continued SHARE InCEnTIVE PLAn free shares An award of shares may be made annually to employees based on a percentage of each employee’s salary in the preceding year up to a maximum of £3,000. The percentage is normally announced concurrently with the Group’s annual results and the price of the shares awarded is announced at the time of award. The shares awarded are held in trust for a mandatory period of three years on the employee’s behalf. The award is subject to a non-market based condition: if an employee leaves the Group within this three year period for other than a ‘good’ reason, all of the shares awarded will be forfeited (for awards made up to April 2005, only a portion of the shares would be forfeited: 75 per cent within one year of the award, 50 per cent within two years and 25 per cent within three years). The number of shares awarded relating to free shares in 2008 was 8,862,823 (2007: 6,784,201), with an average fair value of £4.38 (2007: £5.82), based on the market price at the date of award. matChing shares The Group undertakes to match shares purchased by employees up to the value of £30 per month; these shares are held in trust for a mandatory period of three years on the employees’ behalf. The award is subject to a non-market based condition: if an employee leaves within this three year period for other than a ‘good’ reason or the accompanying partnership shares are sold within that time, 100 per cent of the matching shares are forfeited (or the portion relating to the shares sold). The number of shares awarded relating to matching shares in 2008 was 4,475,264 (2007: 2,073,018), with an average fair value of £2.56 (2007: £5.49), based on market prices at the date of award. 47 related party transaCtions Key management personnel Key management personnel are those persons having authority and responsibility for planning, directing and controlling the activities of an entity; the Group’s key management personnel are the members of Lloyds Banking Group plc group executive committee together with its non-executive directors. The table below details, on an aggregated basis, key management personnel compensation: Compensation Salaries and other short-term benefits Post-employment benefits Termination benefits Share based payments 2008 £m 8 1 – 4 13 2007 £m 15 4 – 4 23 In addition, mr fairey retired as at 30 June 2008 and received his non approved benefit entitlement in the form of a lump sum in accordance with the scheme rules. A tax free amount of £4,523,000 was paid from the fURBS, with a further taxable amount of £2,446,000 made by the Group from provisions set aside. The total amount of £6,969,000 covered the Group’s liability to provide benefits in respect of salary in excess of the earnings cap. share options At 1 January Granted (including options of appointed directors) Exercised/lapsed (including options of former directors) At 31 December share incentive plans At 1 January Granted (including entitlements of appointed directors) Exercised/lapsed (including entitlements of former directors) At 31 December 2008 million 2007 million 7 – (5) 2 11 – (4) 7 2008 million 2007 million 6 3 (2) 7 4 2 – 6 162 Lloyds Banking Group Annual Report and Accounts 2008 noTES To THE ConSoLIDATED fInAnCIAL STATEmEnTS continued 47 related party transaCtions continued The tables below detail, on an aggregated basis, balances outstanding at the year end and related income and expense, together with information relating to other transactions between the Group and its key management personnel: 2008 £m 2007 £m loans At 1 January Advanced Repayments At 31 December 2 2 (1) 3 The loans are on both a secured and unsecured basis and are expected to be settled in cash. The loans attracted interest rates of between 2.14 per cent and 34.01 per cent in 2008 (2007: 4.95 per cent and 30.0 per cent). no provisions have been recognised in respect of loans given to key management personnel (2007: £nil). deposits At 1 January Placed Withdrawn At 31 December 2008 £m 5 27 (26) 6 2 1 (1) 2 2007 £m 5 21 (21) 5 Deposits placed by key management personnel attracted interest rates of up to 6.0 per cent (2007: 8.0 per cent). At 31 December 2008, the Group did not provide any guarantees in respect of key management personnel (2007: £6,154 in respect of one director). At 31 December 2008, transactions, arrangements and agreements entered into by the Group’s banking subsidiaries with directors and connected persons included amounts outstanding in respect of loans and credit card transactions of £3 million with eight directors and six connected persons (2007: £2 million with five directors and three connected persons). subsidiaries Details of the principal subsidiaries are given in note 8 to the parent company financial statements. In accordance with IAS 27, transactions and balances with subsidiaries have been eliminated on consolidation. other related party disClosures At 31 December 2008, the Group’s pension funds had call deposits with Lloyds TSB Bank plc amounting to £23 million (2007: £23 million). The Group manages 105 (2007: 107) open Ended Investment Companies (oEICs), and of these 47 (2007: 40) are consolidated. The Group invested £455 million (2007: £1,961 million) and redeemed £343 million (2007: £1,526 million) in the unconsolidated oEICs during the year and had investments, at fair value, of £2,661 million (2007: £2,233 million) at 31 December. The Group earned fees of £206 million from the unconsolidated oEICs (2007: £200 million). The Company held no investments in oEICs at any time during 2007 or 2008. The Group has a number of associates held by its venture capital business that it accounts for at fair value through profit or loss. At 31 December 2008, these companies had total assets of approximately £5,838 million (2007: £3,184 million ), total liabilities of approximately £5,780 million (2007: £3,182 million) and for the year ended 31 December 2008 had turnover of £2,088 million (2007: £2,136 million) and made a net loss of approximately £80 million (2007: net profit of £9 million). In addition, the Group has provided £825 million (2007: £609 million) of financing to these companies on which it received £46 million (2007: £23 million) of interest income in the year. 48 Contingent liabilities and Commitments legal proCeedings The Group has provided information relating to its review of historic US dollar payments involving countries, persons or entities subject to US economic sanctions administered by the office of foreign Assets Control (ofAC) to a number of authorities including ofAC, the US Department of Justice and the new York County District Attorney’s office which, along with other authorities, have been reported to be conducting a broader review of sanctions compliance by non-US financial institutions. At 31 December 2008, the discussions with those authorities had advanced towards resolution of their investigations and the Group held an accrual of £180 million in respect of this matter. on 9 January 2009, the Group announced that it had reached a settlement with both the US Department of Justice and the new York County District Attorney’s office in relation to their investigations. The settlement documentation contains details of the results of the investigations including the identification of certain activities overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility our people Risk management five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 notes to the parent company financial statements 186 Shareholder information Index to annual report financial calendar 2009 191 192 195 163 Lloyds Banking Group Annual Report and Accounts 2008 48 Contingent liabilities and Commitments continued relating to Iran, Sudan and Libya which the Group conducted during the relevant period. The provision made by the Group in respect of this matter during 2008 was hedged into US dollars at the time and fully covers the settlement amount. The Group is continuing discussions with ofAC regarding the terms of the resolution of its investigation. ofAC has confirmed to the Group that the amount paid to the US Department of Justice and the new York County District Attorney’s office will be credited towards satisfying any penalty it imposes. The Group does not currently believe that any additional liability requiring provision will arise following the conclusion of the discussions with ofAC. The Group does not anticipate any further enforcement actions as to these issues. on 27 July 2007, following agreement between the ofT and a number of UK financial institutions, the ofT issued High Court legal proceedings against those institutions, including Lloyds TSB Bank plc, to determine the legal status and enforceability of certain of the charges applied to their personal customers in relation to requests for unplanned overdrafts. on 24 April 2008, the High Court determined, in relation to the current terms and conditions of those financial institutions (including Lloyds TSB Bank plc), that the relevant charges are not capable of amounting to penalties but that they are assessable for fairness under the Unfair Terms in Consumer Contracts Regulations 1999. on 23 may 2008, Lloyds TSB Bank plc, along with the other relevant financial institutions, was given permission to appeal the finding that unplanned overdraft charges are assessable for fairness. The appeal hearing commenced on 28 october 2008 and concluded on 5 november 2008. on 26 february 2009, the Court of Appeal dismissed the banks’ appeal and held that the charges are assessable for fairness. The banks will now be applying to the House of Lords for permission to appeal this judgment. A further hearing was held on 7 to 9 July 2008 to consider whether those financial institutions’ historic terms and conditions are capable of being penalties, and to consider whether their historic terms are assessable for fairness. on 21 January 2009, the court confirmed that the relevant charges under Lloyds TSB Bank plc’s historic terms and conditions are not capable of being penalties but are assessable for fairness, to the extent that the bank’s contracts with customers included the applicable charging terms. The issue of whether the charges are actually fair will be determined at subsequent hearings. If various appeals are pursued, the proceedings may take a number of years to conclude. Cases before the financial ombudsman Service and the County Courts are currently stayed pending the outcome of the legal proceedings initiated by the ofT. Lloyds Banking Group intends to continue to defend its position strongly. Accordingly, no provision in relation to the outcome of this litigation has been made. Depending on the High Court’s determinations, a range of outcomes is possible, some of which could have a significant financial impact on the Group. The ultimate impact of the litigation on the Group can only be known at its conclusion. In addition, during the ordinary course of business the Group is subject to threatened or actual legal proceedings. All such material cases are periodically reassessed, with the assistance of external professional advisers where appropriate, to determine the likelihood of the Group incurring a liability. In those instances where it is concluded that it is more likely than not that a payment will be made, a provision is established to management’s best estimate of the amount required to settle the obligation at the relevant balance sheet date. In some cases it will not be possible to form a view, either because the facts are unclear or because further time is needed properly to assess the merits of the case. no provisions are held against such cases; however the Group does not currently expect the final outcome of these cases to have a material adverse effect on its financial position. the finanCial serviCes Compensation sCheme The financial Services Compensation Scheme (fSCS) is the UK’s statutory fund of last resort for customers of authorised financial services firms and pays compensation if a firm is unable to pay claims against it. The fSCS has borrowings from Hm Treasury to fund the compensation costs associated with the institutions that have failed in 2008 and will receive the receipts from asset sales, surplus cash flow and other recoveries from these institutions in the future. The fSCS fulfils its obligations by raising management expenses levies, which include amounts to cover the interest on its borrowings, and compensation levies on the industry, each deposit-taking institution contributing in proportion to its share of total protected deposits. In 2008, the Group has accrued £122 million in respect of its current obligation to meet management expenses levies. If the fSCS does not receive sufficient funds from the failed institutions to repay Hm Treasury in full, it will raise compensation levies. At this time, it is not possible to estimate the quantum or timing of any shortfall resulting from the cash flows received from the failed institutions and, accordingly, no provision for compensation levies, which could be significant, has been made in these financial statements. Contingent liabilities and Commitments arising from the banKing business Acceptances and endorsements arise where Lloyds Banking Group agrees to guarantee payment on a negotiable instrument drawn up by a customer. other items serving as direct credit substitutes include standby letters of credit, or other irrevocable obligations, where Lloyds Banking Group has an irrevocable obligation to pay a third party beneficiary if the customer fails to repay an outstanding commitment; they also include acceptances drawn under letters of credit or similar facilities where the acceptor does not have specific title to an identifiable underlying shipment of goods. Performance bonds and other transaction-related contingencies (which include bid or tender bonds, advance payment guarantees, VAT Customs & Excise bonds and standby letters of credit relating to a particular contract or non-financial transaction) are undertakings where the requirement to make payment under the guarantee depends on the outcome of a future event. Lloyds Banking Group’s maximum exposure to loss is represented by the contractual nominal amount detailed in the table below. Consideration has not been taken of any possible recoveries from customers for payments made in respect of such guarantees under recourse provisions or from collateral held. 164 Lloyds Banking Group Annual Report and Accounts 2008 noTES To THE ConSoLIDATED fInAnCIAL STATEmEnTS continued 48 Contingent liabilities and Commitments continued Contingent liabilities Acceptances and endorsements other: other items serving as direct credit substitutes Performance bonds and other transaction-related contingencies 2008 £m 49 1,870 2,850 4,720 4,769 2007 £m 40 1,095 2,429 3,524 3,564 The contingent liabilities of the Group, as detailed above, arise in the normal course of its banking business and it is not practicable to quantify their future financial effect. Commitments Documentary credits and other short-term trade-related transactions forward asset purchases and forward deposits placed Undrawn formal standby facilities, credit lines and other commitments to lend: Less than 1 year original maturity: mortgage offers made other commitments 1 year or over original maturity 2008 £m 319 613 3,056 46,006 49,062 31,761 81,755 2007 £m 306 463 4,639 52,791 57,430 32,165 90,364 of the amounts shown above in respect of undrawn formal standby facilities, credit lines and other commitments to lend, £46,890 million (2007: £53,036 million) was irrevocable. Included in commitments to lend above are not-yet-syndicated leveraged loan underwriting commitments which amounted to £931 million (2007: £1,158 million). All of the underlying assets are performing satisfactorily. operating lease Commitments Where a Group company is the lessee the future minimum lease payments under non-cancellable premises operating leases are as follows: not later than 1 year Later than 1 year and not later than 5 years Later than 5 years 2008 £m 216 647 774 2007 £m 212 677 764 1,637 1,653 operating lease payments represent rental payable by the Group for certain of its properties. Some of these operating lease arrangements have renewal options and rent escalation clauses, although the effect of these is not material. no arrangements have been entered into for contingent rental payments. Capital Commitments Excluding commitments in respect of investment property (see note 22), capital expenditure contracted but not provided for at 31 December 2008 amounted to £92 million (2007: £102 million). of this amount, £85 million (2007: £96 million) related to assets to be leased to customers under operating leases. The Group’s management is confident that future net revenues and funding will be sufficient to cover these commitments. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility our people Risk management five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 notes to the parent company financial statements 186 Shareholder information Index to annual report financial calendar 2009 191 192 195 165 Lloyds Banking Group Annual Report and Accounts 2008 49 finanCial risK management As a bancassurer, financial instruments are fundamental to the Group’s activities and, as a consequence, the risks associated with financial instruments represent a significant component of the risks faced by the Group. The primary risks affecting the Group through its use of financial instruments are: credit risk; market risk, which includes interest rate risk and foreign exchange risk; and liquidity risk. Information about the Group’s exposure to each of the above risks, the Group’s objectives, policies and processes for measuring and managing risk and the Group’s management of capital can be found on pages 42 to 64. The following additional disclosures, which provide quantitative information about the risks within financial instruments held or issued by the Group, should be read in conjunction with that earlier information. measurement basis of finanCial assets and liabilities The accounting policies in note 2 describe how different classes of financial instruments are measured, and how income and expenses, including fair value gains and losses, are recognised. The following table analyses the carrying amounts of the financial assets and liabilities by category and by balance sheet heading. derivatives designated as hedging instruments £m at fair value through profit or loss held for trading £m designated upon initial recognition £m available- for-sale £m loans and receivables £m held at amortised cost £m insurance contracts £m total £m as at 31 december 2008 financial assets Cash and balances at central banks Items in the course of collection from banks Trading and other financial assets at fair value through profit or loss Derivative financial instruments Loans and advances to banks Loans and advances to customers Available-for-sale financial assets Total financial assets financial liabilities Deposits from banks Customer accounts Items in course of transmission to banks Trading and other liabilities at fair value through profit or loss Derivative financial instruments Debt securities in issue Liabilities arising from insurance contracts and participating investment contracts Liabilities arising from non-participating investment contracts Unallocated surplus within insurance businesses Subordinated liabilities Total financial liabilities – – – – – – – – – – – – – – 5,008 946 45,064 28,884 40,758 242,735 55,707 419,102 66,514 170,938 508 6,754 26,892 75,710 – – – – – – – 857 44,207 435 28,449 – – – – – – – – – – – – – – – – – – – – 40,758 242,735 55,707 – 5,008 946 – – – – – 435 29,306 44,207 55,707 283,493 5,954 66,514 170,938 508 – – 75,710 – – – – – – – 6 – – – 6,748 4,169 22,723 – – – – – – – – – – – – – – – – 4,169 22,729 6,748 – – – – – – – – – – – – – – – – – – – – – – – – – 33,792 33,792 14,243 14,243 270 270 17,256 – 17,256 330,926 48,305 412,877 166 Lloyds Banking Group Annual Report and Accounts 2008 noTES To THE ConSoLIDATED fInAnCIAL STATEmEnTS continued 49 finanCial risK management continued as at 31 december 2007 financial assets Cash and balances at central banks Items in the course of collection from banks Trading and other financial assets at fair value through profit or loss Derivative financial instruments Loans and advances to banks Loans and advances to customers Available-for-sale financial assets Total financial assets financial liabilities Deposits from banks Customer accounts Items in course of transmission to banks Trading and other liabilities at fair value through profit or loss Derivative financial instruments Debt securities in issue Liabilities arising from insurance contracts and participating investment contracts Liabilities arising from non-participating investment contracts Unallocated surplus within insurance businesses Subordinated liabilities Total financial liabilities reClassifiCation of finanCial assets Derivatives designated as hedging instruments £m At fair value through profit or loss Held for trading £m Designated upon initial recognition £m Available- for-sale £m Loans and receivables £m Held at amortised cost £m Insurance contracts £m Total £m – – – 264 – – – – – 4,663 8,395 – – – – – 53,248 – – – – – – – – – – – – – – 34,845 209,814 20,196 – 4,330 1,242 – – – – – 264 13,058 53,248 20,196 244,659 5,572 – – – – 800 – – – – – – – – 99 6,782 – – – – – – – – 3,107 – – – – – – 800 6,881 3,107 – – – – – – – – – – – – – – – – – – – – – – 39,091 156,555 668 – – 51,572 – – – 11,958 – – – – – – – – – – – – – – 4,330 1,242 57,911 8,659 34,845 209,814 20,196 336,997 39,091 156,555 668 3,206 7,582 51,572 38,063 38,063 18,197 18,197 554 – 554 11,958 259,844 56,814 327,446 In accordance with the amendment to lAS 39 as disclosed in note 2, the Group reviewed the categorisation of its assets classified as held for trading and available-for-sale financial assets. on the basis that there was no longer an active market for some of those assets, which are therefore more appropriately managed as loans, the Group reclassified £2,993 million of assets classified as held for trading (measured at fair value through profit or loss immediately prior to reclassification) to loans and receivables with effect from 1 July 2008 and £437 million of assets classified as available-for-sale financial assets (measured at fair value through equity) to loans and receivables with effect from 1 november 2008. At the time of these transfers, the Group had the intention and ability to hold them for the foreseeable future or until maturity. HELD foR TRADInG To LoAnS AnD RECEIVABLES In respect of the £2,993 million of assets transferred with effect from 1 July 2008, a loss of £172 million was recognised in the income statement for the six months to 30 June 2008 (year to 31 December 2007: £132 million) while they were classified as held for trading. If the assets had not been transferred and had been kept as held for trading, a loss of £347 million would have been recognised in the income statement for the six months to 31 December 2008 within net trading income. Since their reclassification to loans and receivables, a net credit of £31 million has been recognised in the income statement for the six months to 31 December 2008 within net interest income and a charge of £158 million within impairment. The weighted average effective interest rate of the assets transferred was 6.3 per cent with expected recoverable cash flows of £3,524 million. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility our people Risk management five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 notes to the parent company financial statements 186 Shareholder information Index to annual report financial calendar 2009 191 192 195 167 Lloyds Banking Group Annual Report and Accounts 2008 49 finanCial risK management continued AVAILABLE-foR-SALE fInAnCIAL ASSETS To LoAnS AnD RECEIVABLES In respect of the £437 million of assets transferred with effect from 1 november 2008, a negative valuation movement of £261 million, including exchange movements, was recognised in the revaluation reserve in respect of available-for-sale financial assets for the ten months to 31 october 2008 while they were classified as available-for-sale financial assets. If the assets had not been transferred and had been kept as available-for-sale financial assets £3 million would have been recognised in interest income and £209 million would have been recognised in impairment in the income statement for the two months to 31 December 2008. Since their reclassification to loans and receivables, an amount of £3 million has been recognised in the income statement for the two months to 31 December 2008 within interest income and a further £23 million within impairment. The weighted average effective interest rate of the assets transferred was 10.9 per cent with expected recoverable cash flows of £837 million. for the year ended 31 December 2007, a negative valuation movement of £34 million, including exchange movements, was recognised in the revaluation reserve in respect of available-for-sale financial assets and £32 million was recognised in interest income. interest rate risK In the Group’s retail banking business interest rate risk arises from the different repricing characteristics of the assets and liabilities. Liabilities are either insensitive to interest rate movements, for example interest free or very low interest customer deposits, or are sensitive to interest rate changes but bear rates which may be varied at the Group’s discretion and that for competitive reasons generally reflect changes in the Bank of England’s base rate. There are a relatively small volume of deposits whose rate is contractually fixed for their term to maturity. many banking assets are sensitive to interest rate movements; there is a large volume of managed rate assets such as variable rate mortgages which may be considered as a natural offset to the interest rate risk arising from the managed rate liabilities. However a significant proportion of the Group’s lending assets, for example personal loans and mortgages, bear interest rates which are contractually fixed for periods of up to five years or longer. The Group establishes two types of hedge accounting relationships for interest rate risk: fair value hedges and cash flow hedges. The Group is exposed to fair value interest rate risk on its fixed rate customer loans, its fixed rate customer deposits and the majority of its subordinated debt, and to cash flow interest rate risk on its variable rate loans and deposits together with its floating rate subordinated debt. The majority of the Group’s hedge accounting relationships are fair value hedges where interest rate swaps are used to hedge the interest rate risk inherent in the fixed rate mortgage portfolio. At 31 December 2008 the aggregate notional principal of interest rate swaps designated as fair value hedges was £37,243 million (2007: £50,734 million) with a net fair value liability of £1,231 million (2007: £197 million) (see note 17). The losses on the hedging instruments were £584 million (2007: losses of £233 million). The gains on the hedged items attributable to the hedged risk were £426 million (2007: gains of £211 million). In addition the Group has a small number of cash flow hedges which are primarily used to hedge the variability in the cost of funding within the wholesale business. These cash flows are expected to occur over the next six years and the hedge accounting adjustments will be reported in the income statement as the cash flows arise. The notional principal of the interest rate swaps designated as cash flow hedges at 31 December 2008 was £867 million (2007: £630 million) with a net fair value liability of £90 million (2007: £23 million) (see note 17). In 2008, there is no ineffectiveness recognised in the income statement that arises from cash flow hedges (2007: nil). There were no transactions for which cash flow hedge accounting had to be ceased in 2008 or 2007 as a result of the highly probable cash flows no longer being expected to occur. CurrenCy risK foreign exchange exposures comprise those originating in treasury trading activities and structural foreign exchange exposures, which arise from investment in the Group’s overseas operations. The corporate and retail businesses incur foreign exchange risk in the course of providing services to their customers. All non-structural foreign exchange exposures in the non-trading book are transferred to the trading area where they are monitored and controlled. These risks reside in the authorised trading centres who are allocated exposure limits. The limits are monitored daily by the local centres and reported to Wholesale and International Banking market and Liquidity Risk. Associated VaR and the closing, average, maximum and minimum for 2007 and 2008 are disclosed on page 51. Risk arises from the Group’s investments in its overseas operations. The Group’s structural foreign currency exposure is represented by the net asset value of the foreign currency equity and subordinated debt investments in its subsidiaries and branches. Gains or losses on structural foreign currency exposures are taken to reserves. The Group hedges part of the currency translation risk of the net investment in certain foreign operations using cross currency swaps. At 31 December 2008 the aggregate notional principal of these cross currency swaps was £6,318 million (2007: £5,302 million) with a net fair value liability of £2,413 million (2007: liability of £316 million) (see note 17) and they were designated on an after-tax basis as hedges of net investments in foreign operations. In 2008, ineffectiveness of £14 million before tax and £10 million after tax (2007: nil) was recognised in the income statement arising from net investment hedges. The Group’s main overseas operations are in the Americas, Asia and Europe. Details of the Group’s structural foreign currency exposures, after net investment hedges, are as follows: 168 Lloyds Banking Group Annual Report and Accounts 2008 noTES To THE ConSoLIDATED fInAnCIAL STATEmEnTS continued 49 finanCial risK management continued functional currency of Group operations Euro US dollar Swiss franc: Gross exposure net investment hedge Japanese yen: Gross exposure net investment hedge other non-sterling Credit risK 2008 £m 133 (907) 2,784 (2,663) 121 3,667 (3,645) 22 296 (335) 2007 £m 95 7 1,945 (1,875) 70 2,148 (2,136) 12 196 380 The Group’s credit risk exposure arises predominantly in the United Kingdom and the European Union. The maximum credit risk exposure of the Group in the event of other parties failing to perform their obligations is detailed below. no account is taken of any collateral held and the maximum exposure to loss is considered to be the balance sheet carrying amount or, for non-derivative off- balance sheet transactions and financial guarantees, their contractual nominal amounts. Loans and advances to banks Loans and advances to customers Deposit amounts available for offset1 Impairment losses Available-for-sale debt securities and treasury and other bills Trading and other financial assets at fair value through profit or loss Derivative assets, before netting 2008 £m 40,916 246,304 (4,837) (3,727) 278,656 55,666 21,790 28,884 2007 £m 34,845 212,222 (6,206) (2,408) 238,453 20,167 26,165 8,659 Amounts available for offset under master netting arrangements1 (10,598) (3,287) Assets arising from reinsurance contracts held financial guarantees Irrevocable loan commitments and other credit-related contingencies2 maximum credit risk exposure maximum credit risk exposure before offset items 18,286 385 10,382 51,659 436,824 452,259 5,372 350 9,753 56,600 356,860 366,353 1 Deposit amounts available for offset and amounts available for offset under master netting arrangements do not meet the criteria under IAS 32 to enable loans and advances and derivative assets respectively to be presented net of these balances in the financial statements. 2 See note 48 – Contingent liabilities and commitments for further information. A general description of collateral held in respect of financial instruments is disclosed on page 50. loans and advances to banks – the Group may require collateral before entering into a credit commitment with another bank, depending on the type of the financial product and the counterparty involved, and netting agreements are obtained whenever possible and to the extent that such agreements are legally enforceable. available-for-sale debt securities, treasury and other bills, and trading and other financial assets at fair value through profit or loss – the credit quality of the Group’s available-for-sale debt securities, treasury and other bills, and the majority of the Group’s trading and other financial assets at fair value through profit or loss held is set out below. An analysis of trading and other financial assets at fair value through profit or loss overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility our people Risk management five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 notes to the parent company financial statements 186 Shareholder information Index to annual report financial calendar 2009 191 192 195 169 Lloyds Banking Group Annual Report and Accounts 2008 49 finanCial risK management continued is included in note 16 and a similar analysis for available-for-sale financial assets is included in note 21. The Group’s non-participating investment contracts are all unit-linked. movements in the fair values of trading and other financial assets at fair value through profit or loss which back those investment contracts, including movements arising from credit risk, are borne by the contract holders. derivative assets – the Group reduces exposure to credit risk by using master netting agreements and by obtaining cash collateral. An analysis of derivative assets is given in note 17. of the net derivative assets of £18,286 million (2007 £5,372 million), cash collateral of £2,970 million (2007: £2,004 million) was held and a further £5,840 million was due from oECD banks (2007: £1,459 million). assets arising from reinsurance contracts held – of the assets arising from reinsurance contracts held at 31 December 2008 of £385 million (2007: £350 million), £380 million (2007: £341 million) were due from insurers with a credit rating of AA or above. financial guarantees – these represent undertakings that the Group will meet a customer’s obligation to third parties if the customer fails to do so. Commitments to extend credit represent unused portions of authorisations to extend credit in the form of loans, guarantees or letters of credit. The Group is theoretically exposed to loss in an amount equal to the total guarantees or unused commitments, however, the likely amount of loss is expected to be significantly less; most commitments to extend credit are contingent upon customers maintaining specific credit standards. reverse repo and repo transactions – for reverse repo transactions which are accounted for as collateralised loans, it is the Group’s policy to seek collateral which is at least equal to the amount loaned. At 31 December 2008, the fair value of collateral accepted under reverse repo transactions that the Group is permitted by contract or custom to sell or repledge was £5,858 million (2007: £10,300 million). of this, £5,855 million (2007: £10,299 million) was sold or repledged as at 31 December 2008. The fair value of collateral pledged in respect of repo transactions, accounted for as secured borrowings, where the secured party is permitted by contract or custom to repledge was £5,734 million (2007: £768 million). LoAnS AnD ADVAnCES 31 december 2008 neither past due nor impaired Past due but not impaired Impaired – no provision required – provision held Gross loans and advances to customers retail – mortgages £m retail – other £m wholesale £m loans and advances designated at fair value through total profit or loss £m £m loans and advances to banks £m 110,148 33,571 89,208 232,927 608 40,741 3,134 479 882 1,146 150 4,327 555 1,253 1,451 4,835 1,882 6,660 – – – 17 – 158 114,643 39,194 92,467 246,304 608 40,916 Allowance for impairment losses (note 20) (186) (2,345) (1,038) (3,569) – (158) net 31 december 2007 neither past due nor impaired Past due but not impaired Impaired – no provision required – provision held Gross Allowance for impairment losses (note 20) net 114,457 36,849 91,429 242,735 608 40,758 99,828 2,153 415 343 102,739 (37) 102,702 29,850 73,475 203,153 1,189 34,845 966 100 3,600 34,516 (2,029) 32,487 639 293 560 3,758 808 4,503 – – – – – – 74,967 212,222 1,189 34,845 (342) (2,408) – – 74,625 209,814 1,189 34,845 The analysis of lending between retail and wholesale has been prepared based upon the type of exposure and not the business segment in which the exposure is recorded. Included within retail are exposures to personal customers and small businesses, whilst included within wholesale are exposures to corporate customers and other large institutions. 170 Lloyds Banking Group Annual Report and Accounts 2008 noTES To THE ConSoLIDATED fInAnCIAL STATEmEnTS continued 49 finanCial risK management continued LoAnS AnD ADVAnCES WHICH ARE nEITHER PAST DUE noR ImPAIRED 31 december 2008 Good quality Satisfactory quality Lower quality Below standard, but not impaired Total 31 december 2007 Good quality Satisfactory quality Lower quality Below standard, but not impaired Total loans and advances to customers retail – mortgages £m retail – other £m wholesale £m 109,437 21,251 643 – 68 9,305 900 2,115 50,718 34,559 3,444 487 loans and advances designated at fair value through total profit or loss £m £m 129 411 56 12 loans and advances to banks £m 40,295 192 240 14 110,148 33,571 89,208 232,927 608 40,741 99,407 18,157 378 1 42 8,964 665 2,064 46,240 25,013 2,034 188 191 670 327 1 34,647 190 7 1 99,828 29,850 73,475 203,153 1,189 34,845 The definitions of good quality, satisfactory quality, lower quality and below standard, but not impaired applying to retail and wholesale are not the same, reflecting the different characteristics of these exposures and the way they are managed internally, and consequently totals are not provided. Wholesale lending has been classified using internal probability of default rating models mapped so that they are comparable to external credit ratings. Good quality lending comprises the lower assessed default probabilities, with other classifications reflecting progressively higher default risk. Classifications of retail lending incorporate expected recovery levels for mortgages, as well as probabilities of default assessed using internal rating models. Good quality lending includes the lower assessed default probabilities and all loans with low expected losses in the event of default, with other categories reflecting progressively higher risks and lower expected recoveries. LoAnS AnD ADVAnCES WHICH ARE PAST DUE BUT noT ImPAIRED 31 december 2008 0-30 days 30-60 days 60-90 days 90-180 days over 180 days Total fair value of collateral held 31 december 2007 0-30 days 30-60 days 60-90 days 90-180 days over 180 days Total fair value of collateral held loans and advances to customers retail – mortgages £m retail – other £m wholesale £m loans and advances designated at fair value through total profit or loss £m £m loans and advances to banks £m 1,527 633 424 549 1 3,134 2,637 1,123 445 260 325 – 2,153 2,111 853 259 32 2 – 1,146 n/a 781 155 29 1 – 966 n/a 289 2,669 90 70 77 29 555 n/a 266 107 129 67 70 639 n/a 982 526 628 30 4,835 n/a 2,170 707 418 393 70 3,758 n/a – – – – – – – – – – – – – – 17 – – 17 – – – – – – A financial asset is ‘past due’ if a counterparty has failed to make a payment when contractually due. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility our people Risk management five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 notes to the parent company financial statements 186 Shareholder information Index to annual report financial calendar 2009 191 192 195 171 Lloyds Banking Group Annual Report and Accounts 2008 49 finanCial risK management continued Collateral held against retail mortgage lending is principally comprised of residential properties; their fair value has been estimated based upon the last actual valuation, adjusted to take into account subsequent movements in house prices, after making allowance for indexation error and dilapidations. The resulting valuation has been limited to the principal amount of the outstanding advance in order to provide a clearer representation of the Group’s credit exposure. Lending decisions are based on an obligor’s ability to repay from normal business operations rather than reliance on the disposal of any security provided. Collateral values for non-mortgage lending are assessed more rigorously at the time of loan origination or when taking enforcement action and may fluctuate, as in the case of floating charges, according to the level of assets held by the customer. Whilst collateral is reviewed on a regular basis in accordance with business unit credit policy, this varies according to the type of lending and collateral involved. It is therefore not practicable to estimate and aggregate current fair values of collateral for non-mortgage lending. REnEGoTIATED LoAnS AnD ADVAnCES Loans and advances that were renegotiated during the year and that would otherwise have been past due or impaired at 31 December 2008 totalled £144 million (2007: £579 million). REPoSSESSED CoLLATERAL Residential property other Total 2008 £m 221 26 247 2007 £m 73 9 82 The Group does not take physical possession of properties or other assets held as collateral and uses external agents to realise the value as soon as practicable, generally at auction, to settle indebtedness. Any surplus funds are returned to the borrower or are otherwise dealt with in accordance with appropriate insolvency regulations. LoAn To VALUE RATIo of moRTGAGE LEnDInG Analysis by loan to value ratio of the Group’s residential mortgage lending which is neither past due nor impaired: Less than 70 per cent 70 per cent to 80 per cent 80 per cent to 90 per cent Greater than 90 per cent Total 2008 £m 55,040 15,812 15,954 23,342 110,148 2007 £m 66,716 15,690 12,102 5,320 99,828 172 Lloyds Banking Group Annual Report and Accounts 2008 noTES To THE ConSoLIDATED fInAnCIAL STATEmEnTS continued 49 finanCial risK management continued Debt securities, treasury and other bills – analysis by credit rating: as at 31 december 2008 debt securities held at fair value through profit or loss Trading assets: Government securities Corporate and other debt securities Total held as trading assets other assets held at fair value through profit or loss: Government securities other public sector securities Bank and building society certificates of deposit mortgage backed securities other asset backed securities Corporate and other debt securities Total held at fair value through profit or loss available-for-sale financial assets Debt securities: Government securities other public sector securities Bank and building society certificates of deposit mortgage backed securities other asset backed securities Corporate and other debt securities Total debt securities Treasury bills and other bills Total held as available-for-sale assets aaa £m aa £m a £m bbb £m rated bb or lower £m not rated £m total £m 38 76 114 7,025 – 96 207 206 3,194 10,842 851 – – 4,388 4,604 4,111 13,954 26,858 40,812 – 187 187 45 – 337 108 362 864 1,903 – – 9,418 6 121 1,424 10,969 2,351 13,320 – 38 38 138 – – 23 391 2,911 3,501 1 – 166 21 60 304 552 – 552 – 68 68 1 – – 16 277 2,142 2,504 – – – – 20 71 91 – 91 – 87 87 – – – – 105 599 791 – – 18 14 98 113 243 – 243 – 80 80 38 536 574 117 7,326 18 – 15 1 1,410 1,641 16 12 – – 53 567 648 – 648 18 433 369 1,342 11,120 21,182 868 12 9,602 4,429 4,956 6,590 26,457 29,209 55,666 overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility our people Risk management five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 notes to the parent company financial statements 186 Shareholder information Index to annual report financial calendar 2009 191 192 195 173 Lloyds Banking Group Annual Report and Accounts 2008 49 finanCial risK management continued as at 31 december 2007 debt securities held at fair value through profit or loss Trading assets: Government securities mortgage backed securities other asset backed securities Corporate and other debt securities Total held as trading assets other assets held at fair value through profit or loss: Government securities Bank and building society certificates of deposit mortgage backed securities other asset backed securities Corporate and other debt securities Total held at fair value through profit or loss available-for-sale financial assets Debt securities: Government securities other public sector securities Bank and building society certificates of deposit mortgage backed securities other asset backed securities Corporate and other debt securities Total debt securities Treasury bills and other bills Total held as available-for-sale assets AAA £m 62 – – 268 330 4,808 42 61 1,367 5,118 11,726 310 – – 5,880 3,895 3,822 13,907 31 13,938 AA £m – 28 15 1,268 1,311 6 548 – 214 1,606 3,685 – – 1,683 14 37 1,170 2,904 1,596 4,500 A £m – 51 61 1,390 1,502 15 53 – 153 2,868 4,591 – – 125 10 27 186 348 – 348 BBB £m Rated BB or lower £m not rated £m Total £m – 8 38 103 149 1 – – 71 2,528 2,749 – – – – – – – – – – – 3 59 62 – – – – – – 5 519 524 18 168 9 – 340 402 1,104 1,823 – – 15 – – – 15 – 15 9 5 2 146 112 1,092 1,366 – 1,366 62 87 122 3,607 3,878 4,848 811 70 1,805 13,564 24,976 319 5 1,825 6,050 4,071 6,270 18,540 1,627 20,167 There are no material amounts for debt securities, treasury and other bills which are past due but not impaired. 174 Lloyds Banking Group Annual Report and Accounts 2008 noTES To THE ConSoLIDATED fInAnCIAL STATEmEnTS continued 49 finanCial risK management continued liquidity risK The table below analyses financial instrument liabilities of the Group, excluding those arising from insurance and participating investment contracts, on an undiscounted future cash flow basis according to contractual maturity, into relevant maturity groupings based on the remaining period at the balance sheet date; balances with no fixed maturity are included in the over 5 years category. Up to 1 month £m 1-3 months £m 3-12 months £m 1-5 years £m over 5 years £m Total £m as at 31 december 2008 Deposits from banks Customer accounts Derivative financial instruments, trading and other liabilities at fair value through profit or loss Debt securities in issue Liabilities arising from non-participating investment contracts Subordinated liabilities Total as at 31 december 2007 Deposits from banks Customer accounts Derivative financial instruments, trading and other liabilities at fair value through profit or loss Debt securities in issue Liabilities arising from non-participating investment contracts Subordinated liabilities Total 49,620 13,617 151,164 8,258 29,479 24,381 14,243 34 1,077 26,944 – 130 1,480 9,675 5,295 9,192 – 563 1,986 2,303 7,203 13,643 – 5 66,708 697 172,097 3,818 3,489 – 46,872 77,649 14,243 26,625 5,382 20,516 268,921 50,026 26,205 30,517 28,525 404,194 35,466 144,213 10,286 20,307 18,197 27 2,218 4,800 2,176 6,047 – 210 228,496 15,451 1,480 7,578 3,607 9,529 – 1,067 23,261 26 2,002 1,589 13,202 – 6,371 23,190 – 447 39,190 159,040 1,851 6,197 – 14,292 22,787 19,509 55,282 18,197 21,967 313,185 Trading derivatives (other than those in the insurance companies) and trading liabilities are included in the up to 1 month column at their fair value. Liquidity risk on these items is not managed on the basis of contractual maturity as they are frequently settled on demand at fair value and therefore this is considered a better presentation of the Group’s liquidity risk. Derivatives used in a hedging relationship are included according to their contractual maturity. Cash flows for undated subordinated liabilities whose terms give the Group the option to redeem at a future date are included within the table on the basis that the Group will exercise its option to redeem. The principal amount for undated subordinated liabilities with no redemption option is included within the over 5 years column; interest of approximately £412 million (2007: £223 million) per annum which is payable in respect of those instruments for as long as they remain in issue is not included beyond 5 years. further information on the Group’s liquidity exposures is provided on pages 55 and 56. Liabilities arising from insurance and participating investment contracts are analysed on a behavioural basis, as permitted by IfRS 4, as follows: as at 31 december 2008 As at 31 December 2007 up to 1 month £m 340 238 1-3 months £m 927 651 3-12 months £m 2,626 1,570 1-5 years £m over 5 years £m total £m 7,030 22,869 33,792 9,548 26,056 38,063 The following tables set out the amounts and residual maturities of Lloyds Banking Group’s off balance sheet contingent liabilities and commitments. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility our people Risk management five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 notes to the parent company financial statements 186 Shareholder information Index to annual report financial calendar 2009 191 192 195 175 Lloyds Banking Group Annual Report and Accounts 2008 49 finanCial risK management continued 31 december 2008 Acceptances other contingent liabilities Total contingent liabilities Lending commitments other commitments Total commitments Total contingents and commitments 31 december 2007 Acceptances other contingent liabilities Total contingent liabilities Lending commitments other commitments Total commitments Total contingents and commitments within 1 year £m 1-3 years £m 3-5 years £m over 5 years £m total £m 49 – 1,722 1,525 1,771 1,525 54,155 15,029 572 54,727 56,498 Within 1 year £m 39 1,441 1,480 60,981 466 61,447 62,927 181 15,210 16,735 1-3 years £m 1 1,032 1,033 13,759 78 13,837 14,870 – 402 402 8,014 80 8,094 8,496 3-5 years £m – 255 255 10,634 108 10,742 10,997 – 49 1,071 4,720 1,071 3,625 99 3,724 4,795 over 5 years £m – 796 796 4,221 117 4,338 5,134 4,769 80,823 932 81,755 86,524 Total £m 40 3,524 3,564 89,595 769 90,364 93,928 fair values of finanCial assets and liabilities financial instruments include financial assets, financial liabilities and derivatives. The fair value of a financial instrument is the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. Wherever possible, fair values have been estimated using market prices for instruments held by the Group. Where market prices are not available, or are unreliable because of poor liquidity, fair values have been determined using valuation techniques which, to the extent possible, use market observable inputs. Valuation techniques used include discounted cash flow analysis and pricing models and, where appropriate, comparison to instruments with characteristics either identical or similar to those of the instruments held by the Group. These estimation techniques are necessarily subjective in nature and involve several assumptions. The fair values presented in the following table are at a specific date and may be significantly different from the amounts which will actually be paid or received on the maturity or settlement date. Because a variety of estimation techniques are employed and significant estimates made, comparisons of fair values between financial institutions may not be meaningful. Readers of these financial statements are thus advised to use caution when using this data to evaluate the Group’s financial position. fair value information is not provided for items that do not meet the definition of a financial instrument. These items include intangible assets, such as the value of the Group’s branch network, the long-term relationships with depositors and credit card relationships; premises and equipment; and shareholders’ equity. These items are material and accordingly the Group believes that the fair value information presented does not represent the underlying value of the Group. The valuation technique for each major category of financial instrument and, where valuation models are used, significant inputs into valuation models, are discussed below. Where referred to within the major categories listed, the Group’s use of lead manager quotes and market standard consensus pricing services are as described below: Lead manager quotes for illiquid assets in the current markets do not represent binding levels and are validated for consistency across the same asset class and by reference to discounted cash flow models that use expected loss and discount assumptions. market standard consensus pricing services aggregate price and other market data inputs from leading participants in the relevant markets and provide average mid-level outputs adjusted to exclude prices that are clearly out of line with other prices observed; these levels do not represent binding quotes. TRADInG AnD oTHER fInAnCIAL ASSETS AT fAIR VALUE THRoUGH PRofIT oR LoSS The fair values of financial instruments quoted in active markets are based on quoted prices. The fair values of financial instruments that are not quoted in active markets are determined using valuation techniques including cash flow models which, to the extent practicable, use observable market inputs such as interest rate yield curves, equities and commodities prices, option volatilities and currency rates that are either directly 176 Lloyds Banking Group Annual Report and Accounts 2008 noTES To THE ConSoLIDATED fInAnCIAL STATEmEnTS continued 49 finanCial risK management continued observable or are implied from instrument prices. The fair values of bonds classified as trading assets are determined predominantly from lead manager quotes and, where these are not available, by reference to market standard consensus pricing services, broker quotes and other research data. Certain corporate bonds were valued using credit default swap (CDS) spreads and assumptions around the bond/CDS spread. The fair values of the Group’s venture capital investments are determined using techniques which follow British Venture Capital Association (BVCA) guidelines. The fair value movement on assets and liabilities held at fair value through profit or loss and gains in respect of instruments held for trading are disclosed in note 7. At 31 December 2008, the Group had a portfolio of corporate bonds hedged by CDS. Prior to october 2008, the markets for both corporate bonds and CDS were relatively liquid and both sides of the above position were valued using market observable inputs. During october 2008 bid/offer spreads widened severely and, consequently, the cash market for corporate bonds became inactive. The above position is valued in part using assumptions around the bond/CDS spread. The effect of using reasonably possible alternative adverse assumptions for this valuation would reduce net trading income by up to £105 million. DERIVATIVE fInAnCIAL InSTRUmEnTS All derivatives are recognised at their fair value. fair values are obtained from quoted market prices in active markets, including recent market transactions, and using valuation techniques, including discounted cash flow and options pricing models, as appropriate. Derivatives are carried in the balance sheet as assets when their fair value is positive and as liabilities when their fair value is negative. Interest rate swaps are valued using discounted cash flow models; the most significant inputs into those models are interest rate yield curves which are developed from publicly quoted rates. foreign exchange derivatives that do not contain options are priced using rates available from publicly quoted sources. Credit derivatives, except for the items noted below, are valued using publicly available yield and CDS curves; the Group uses standard models with observable inputs. Less complex interest rate and foreign exchange option products are valued using volatility surfaces developed from publicly available interest rate cap, interest rate swaption and other option volatilities; option volatility skew information is derived from a market standard consensus pricing service. for more complex option products, the Group calibrates its models using observable at-the- money data; where necessary, the Group adjusts for out-of-the-money positions using a market standard consensus pricing service. An analysis of derivatives including fair values by contract type is given in note 17. At 31 December 2008, the Group had a senior synthetic position in a structured corporate collateralised debt obligation (CDo) that is valued in part using assumptions around recovery levels. The effect of using reasonably possible alternative favourable or adverse assumptions for recovery levels would increase or reduce net trading income by up to £80 million respectively. At 31 December 2008, the Group had a credit valuation reserve on its derivative positions that is valued in part using assumptions around credit spreads and recovery risks. The effect of using reasonably possible alternative adverse combinations of assumptions for these risks would reduce net trading income by up to £70 million. LoAnS AnD ADVAnCES To BAnKS AnD CUSTomERS The Group provides loans and advances to commercial, corporate and personal customers at both fixed and variable rates. The carrying value of the variable rate loans and those relating to lease financing is assumed to be their fair value. for fixed rate lending, several different techniques are used to estimate fair value, as considered appropriate. for commercial and personal customers, fair value is principally estimated by discounting anticipated cash flows (including interest at contractual rates) at market rates for similar loans offered by the Group and other financial institutions. The fair value for corporate loans is estimated by discounting anticipated cash flows at a rate which reflects the effects of interest rate changes, adjusted for changes in credit risk. Certain loans secured on residential properties are made at a fixed rate for a limited period, typically two to five years, after which the loans revert to the relevant variable rate. The fair value of such loans is estimated by reference to the market rates for similar loans of maturity equal to the remaining fixed interest rate period. The fair values of asset backed securities (ABS) and secondary loans, which were previously within assets held for trading and were reclassified to loans and receivables (see page 166), are determined predominantly from lead manager quotes and, where these are not available, by alternative techniques including reference to credit spreads on similar assets with the same obligor, market standard consensus pricing services, broker quotes and other research data. AVAILABLE-foR-SALE fInAnCIAL ASSETS Listed securities are valued at current bid prices. Unlisted securities and other financial assets are valued based on discounted cash flows, market prices of similar instruments and other appropriate valuation techniques. The fair values of bonds classified as available-for-sale financial assets, including ABS, are determined predominantly from lead manager quotes and, where these are not available, by alternative techniques including reference to credit spreads on similar assets with the same obligor, market standard consensus pricing services, broker quotes and other research data. At 31 December 2008, the Group’s available-for-sale financial assets included ABS of £13,938 million. In respect of these assets, the effect of a 100 basis point shift in credit spreads would result in a pre-tax movement of £590 million which would be recognised, net of tax, in the revaluation reserve in respect of available-for-sale assets. DEPoSITS fRom BAnKS AnD CUSTomER ACCoUnTS The fair value of deposits repayable on demand is considered to be equal to their carrying value. The fair value for all other deposits and customer accounts is estimated using discounted cash flows applying either market rates, where applicable, or current rates for deposits of similar remaining maturities. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility our people Risk management five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 notes to the parent company financial statements 186 Shareholder information Index to annual report financial calendar 2009 191 192 195 177 Lloyds Banking Group Annual Report and Accounts 2008 49 finanCial risK management continued DEBT SECURITIES In ISSUE AnD SUBoRDInATED LIABILITIES The fair value of short-term debt securities in issue is approximately equal to their carrying value. fair value for other debt securities and for subordinated liabilities is estimated using quoted market prices. TRADInG AnD oTHER LIABILITIES AT fAIR VALUE THRoUGH PRofIT oR LoSS The fair values of financial instruments quoted in active markets are based on quoted prices. The fair values of financial instruments that are not quoted in active markets are determined using valuation techniques including cash flow models which, to the extent practicable, use observable market inputs such as interest rate yield curves, equities and commodities prices, option volatilities and currency rates that are either directly observable or are implied from instrument prices. LIABILITIES ARISInG fRom non-PARTICIPATInG InVESTmEnT ConTRACTS The value of the Group’s non-participating investment contracts, all of which are unit-linked, is contractually linked to the fair values of financial assets within the Group’s unitised investment funds and is determined using current unit prices multiplied by the number of units attributed to the contract holders at the balance sheet date. Their value is never less than the amount payable on surrender, discounted for the required notice period where applicable. fInAnCIAL CommITmEnTS AnD ConTInGEnT LIABILITIES financial guarantees are valued on the basis of cash premiums receivable. The Group considers that it is not meaningful or practical to provide an estimate of the fair value of other contingent liabilities and financial commitments, given the lack of an established market, the diversity of fee structures and the difficulty of separating the value of the instruments from the value of the overall transaction. Therefore only financial guarantees are included in the following table. Carrying value 2008 £m Carrying value 2007 £m fair value 2008 £m fair value 2007 £m financial assets Trading and other financial assets at fair value through profit or loss Derivative financial instruments Loans and advances to banks Loans and advances to customers Available-for-sale financial assets financial liabilities Deposits from banks Customer accounts Trading and other liabilities at fair value through profit or loss Derivative financial instruments Debt securities in issue Liabilities arising from non-participating investment contracts financial guarantees Subordinated liabilities 50 Consolidated Cash flow statement (a) Change in operating assets Change in loans and advances to banks Change in loans and advances to customers Change in derivative financial instruments, trading and other financial assets at fair value through profit or loss Change in other operating assets Change in operating assets 45,064 28,884 40,758 242,735 55,707 66,514 170,938 6,754 26,892 75,710 14,243 35 17,256 57,911 8,659 34,845 209,814 20,196 39,091 156,555 3,206 7,582 51,572 18,197 26 11,958 45,064 28,884 40,425 237,079 55,707 66,504 171,119 6,754 26,892 76,291 14,243 35 11,199 2008 £m (3,360) (30,357) (8,990) (318) (43,025) 57,911 8,659 34,832 209,066 20,196 39,063 156,608 3,206 7,582 51,312 18,197 26 12,128 2007 £m 8,673 (20,796) (4,348) (511) (16,982) 178 Lloyds Banking Group Annual Report and Accounts 2008 noTES To THE ConSoLIDATED fInAnCIAL STATEmEnTS continued 50 Consolidated Cash flow statement continued (b) Change in operating liabilities Change in deposits from banks Change in customer accounts Change in debt securities in issue Change in derivative financial instruments, trading and other liabilities at fair value through profit or loss Change in investment contract liabilities Change in other operating liabilities Change in operating liabilities (C) non-Cash and other items Depreciation and amortisation Revaluation of investment property Allowance for loan losses Write-off of allowance for loan losses Impairment of available-for-sale securities Impairment of goodwill Change in insurance contract liabilities Customer remediation paid other provision movements net charge in respect of defined benefit schemes Contributions to defined benefit schemes other non-cash items Total non-cash items Interest expense on subordinated liabilities Profit on disposal of businesses other Total other items non-cash and other items (d) analysis of Cash and Cash equivalents as shown in the balanCe sheet Cash and balances with central banks Less: mandatory reserve deposits1 Loans and advances to banks Less: amounts with a maturity of three months or more Total cash and cash equivalents 2008 £m 25,279 13,088 22,401 22,565 (3,061) 661 80,933 2008 £m 686 1,058 2,876 (1,498) 130 100 (4,555) (9) 16 164 (547) (3,371) (4,950) 896 – (10) 886 2007 £m 2,136 17,172 (2,450) 3,840 (58) 901 21,541 2007 £m 630 321 1,721 (1,405) 70 – 853 (54) 2 175 (452) 870 2,731 741 (657) (31) 53 (4,064) 2,784 2008 £m 5,008 (545) 4,463 40,758 (12,461) 28,297 32,760 2007 £m 4,330 (338) 3,992 34,845 (6,946) 27,899 31,891 1 mandatory reserve deposits are held with local central banks in accordance with statutory requirements; these deposits are not available to finance the Group’s day-to-day operations. Included within cash and cash equivalents at 31 December 2008 is £8,255 million (2007: £7,426 million) held within the Group’s life funds, which is not immediately available for use in the business. finanCial statements shareholder information Shareholder information Index to annual report financial calendar 2009 191 192 195 Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 notes to the parent company financial statements 186 overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility our people Risk management five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 50 Consolidated Cash flow statement continued (e) analysis of Changes in finanCing during the year Share capital (including share premium account): At 1 January Issue of share capital: Private placement other At 31 December minority interests: At 1 January Exchange and other adjustments Repayment of capital to minority shareholders minority share of profit after tax Dividends to minority shareholders At 31 December Subordinated liabilities: At 1 January Exchange and other adjustments Issue of subordinated liabilities Repayments of subordinated liabilities At 31 December (f) aCquisition of group undertaKings and businesses Payments to former members of Scottish Widows fund and Life Assurance Society acquired during 2000 (g) disposal and Closure of group undertaKings and businesses Cash and balances at central banks Trading and other financial assets at fair value through profit or loss Loans and advances to banks Value of in-force business Liabilities arising from insurance contracts and participating investment contracts Liabilities arising from non-participating investment contracts Unallocated surplus within insurance businesses other net assets and liabilities Profit on sale of businesses Cash and cash equivalents disposed of net cash inflow from disposals 179 Lloyds Banking Group Annual Report and Accounts 2008 2008 £m 2007 £m 2,730 2,695 760 119 3,609 2008 £m 284 28 (3) 26 (29) 306 2008 £m – 35 2,730 2007 £m 352 (1) (80) 32 (19) 284 2007 £m 11,958 12,072 2,658 3,021 (381) 186 – (300) 17,256 11,958 2008 £m 19 2008 £m – – – – – – – – – – – – 2007 £m 8 2007 £m 37 10,999 1,150 412 (4,349) (7,283) (15) (95) 856 657 (37) 1,476 180 Lloyds Banking Group Annual Report and Accounts 2008 noTES To THE ConSoLIDATED fInAnCIAL STATEmEnTS continued 51 future aCCounting developments The following pronouncements will be relevant to the Group but were not effective at 31 December 2008 and have not been applied in preparing these financial statements. The full impact of these accounting changes is being assessed by the Group, however, the initial view is that none of these pronouncements are expected to cause any material adjustments to reported numbers in the financial statements. Pronouncement nature of change IfRIC 13 Customer Loyalty Programmes Addresses accounting by entities who grant customer loyalty award credits to customers as part of sales transactions and which can be redeemed in the future for free or discounted goods or services. Effective date Annual periods beginning on or after 1 July 2008. IfRIC 16 Hedges of a net Investment in a foreign operation1 Provides guidance on accounting for hedges of net investments in foreign operations in an entity’s consolidated financial statements. Annual periods beginning on or after 1 october 2008. IAS 1 Presentation of financial Statements IAS 23 Borrowing Costs IfRS 8 operating Segments IfRS 2 Share-based Payment – Vesting Conditions and Cancellations Amendments to IAS 32 financial Instruments: Presentation and IAS 1 Presentation of financial Statements – Puttable financial Instruments and obligations Arising on Liquidation Improvements to IfRSs Amendment to IAS 27 Consolidated and Separate financial Statements – Cost of an Investment in a Subsidiary, Jointly Controlled Entity or Associate IfRS 3 Business Combinations1, 2 IAS 27 Consolidated and Separate financial Statements1, 2 Revises the overall requirements for the presentation of financial statements, guidance for their structure and minimum content requirements. The revised standard requires the presentation of all non- owner changes in equity within a statement of comprehensive income. Requires interest and other costs incurred in connection with the borrowing of funds to be recognised as an expense except for those which are directly attributable to the acquisition, construction or production of assets that take a substantial period of time to get ready for their intended use or sale which must be capitalised as part of the cost of those assets. Annual periods beginning on or after 1 January 2009. Annual periods beginning on or after 1 January 2009. Replaces IAS 14 Segment Reporting and requires reporting of financial and descriptive information about operating segments which are based on how financial information is reported and evaluated internally. Annual periods beginning on or after 1 January 2009. The amendment restricts the definition of vesting conditions to include only service conditions and performance conditions and deals with the accounting consequences of a failure to meet a condition other than a vesting condition including how to deal with cancellations by the counterparty and circumstances where neither the entity nor the counterparty is in a position to choose whether or not to meet a vesting condition. The amendment requires some puttable financial instruments (being those which give the holder the right to put the instrument back to the issuer for cash or another financial asset) and some financial instruments that impose on the entity an obligation to deliver to another party a pro rata share of the net assets of the entity only on liquidation to be classified as equity. Sets out minor amendments to IfRS standards as part of annual improvements process. Annual periods beginning on or after 1 January 2009. Annual periods beginning on or after 1 January 2009. Dealt with on a standard by standard basis but not earlier than annual periods beginning on or after 1 January 2009. Removes the definition of the cost method and requires the presentation of dividends as income in the separate financial statements of the investor. Annual periods beginning on or after 1 January 2009. The revised standard continues to apply the acquisition method to business combinations, however, all payments to purchase a business are to be recorded at fair value at the acquisition date, some contingent payments are subsequently remeasured at fair value through income, goodwill may be calculated based on the parent’s share of net assets or it may include goodwill related to the minority interest, and all transaction costs are expensed. Requires the effects of all transactions with non-controlling interests to be recorded in equity if there is no change in control; any remaining interest in an investee is re-measured to fair value in determining the gain or loss recognised in profit or loss where control over the investee is lost. Annual periods beginning on or after 1 July 2009. Annual periods beginning on or after 1 July 2009. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility our people Risk management five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements 96 97 notes to the consolidated financial statements 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 notes to the parent company financial statements 186 Shareholder information Index to annual report financial calendar 2009 191 192 195 181 Lloyds Banking Group Annual Report and Accounts 2008 51 future aCCounting developments continued Pronouncement nature of change IfRIC 17 Distributions of non-cash Assets to owners1, 2 Provides accounting guidance for non-reciprocal distributions of non-cash assets to owners (and those in which owners may elect to receive a cash alternative). Effective date Annual periods beginning on or after 1 July 2009. Amendment to IAS 39 financial Instruments: Recognition and measurement – Eligible Hedged Items1, 2 Clarifies how the principles underlying hedge accounting should be applied in particular situations. Annual periods beginning on or after 1 July 2009. 1 2 At the date of this report, these pronouncements are awaiting EU endorsement. Subject to EU endorsement, the Group has not yet made a final decision as to whether it will apply these pronouncements in the 2009 financial statements. 52 post balanCe sheet events share Capital on 19 november 2008, Lloyds Banking Group plc shareholders approved, subject to certain conditions, an increase in the Company’s share capital by creating 14,911,908,221 new ordinary shares of 25 pence each, and creating 625,000,000 new preference shares of 25 pence each. These conditions were met in January 2009. on 13 January 2009, the Group issued 2,596,653,203 ordinary shares at 173.3p, largely subscribed for by Hm Treasury, raising a total of £4,500 million. on 15 January 2009, the Company issued £1,000,000,000 12 per cent fixed to floating non-cumulative callable preference shares to Hm Treasury pursuant to the preference share subscription agreement entered into with effect from 13 october 2008 by the Company and Hm Treasury. These preference shares became fungible with the £3,000,000,000 12 per cent fixed to floating non-cumulative callable preference shares issued by the Company on 16 January 2009 (see below); under the terms of these preference shares, the payment of cash dividends to ordinary shareholders is not permitted until the preference shares are repaid. So as to improve the position of HBoS preference shareholders following the acquisition of HBoS (see below), on 16 January 2009 the Group cancelled a number of HBoS preference share issuances in exchange for preference shares issued by Lloyds Banking Group plc. In this regard, the Company issued £299,987,729 9.25 per cent fixed rate non-cumulative preference shares, £99,999,942 9.75 per cent fixed rate non-cumulative preference shares, £186,190,532 6.475 per cent fixed rate non-cumulative preference shares, £745,431,000 6.0884 per cent fixed to floating rate non-cumulative callable preference shares, £334,951,000 6.3673 per cent fixed to floating non-cumulative callable preference shares, US$750,000,000 6.413 per cent fixed to floating rate non-cumulative callable preference shares, US$750,000,000 5.92 per cent fixed to floating rate non-cumulative callable preference shares, US$750,000,000 6.657 per cent fixed to floating rate non-cumulative callable preference shares and £3,000,000,000 12 per cent fixed to floating non-cumulative callable preference shares. on 19 January 2009, the Company issued US$1,250,000,000 7.875 per cent non-cumulative callable preference shares and e500,000,000 7.875 per cent non-cumulative callable preference shares. aCquisition on 16 January 2009, the Group acquired 100 per cent of the ordinary share capital of HBoS plc, which together with its subsidiaries undertakes banking, insurance and other financial services related activities. Under the terms of the acquisition, HBoS shareholders received 0.605 Lloyds Banking Group shares for every 1 HBoS share. The total fair value of the purchase consideration was £7,751 million, comprising 7,775,694,993 Lloyds Banking Group ordinary shares with a fair value of £7,651 million based on the closing price of 98.4p per ordinary share on 15 January 2009, the trading day immediately prior to completion, and directly attributable transaction costs of approximately £100 million. Because of the limited time available between the acquisition and the approval of these financial statements, the Group is still in the process of establishing the fair value of the assets and liabilities acquired. The audited net assets of HBoS at 31 December 2008 as shown in the accounts were £13,499 million. Capitalisation issue on 19 november 2008, the Company’s shareholders approved, subject to certain conditions, a resolution authorising the board to capitalise an amount out of the Company’s reserves and to apply such amount in paying up new Company shares. on 26 february 2009, the board approved a capitalisation issue of one for forty ordinary shares held. name Change on 19 november 2008, the Company’s shareholders approved, subject to certain conditions, a resolution changing the name of the Company to Lloyds Banking Group plc. These conditions were met and the Company changed its name on 16 January 2009. 53 approval of finanCial statements The consolidated financial statements were approved by the directors of Lloyds Banking Group plc on 26 february 2009. 182 Lloyds Banking Group Annual Report and Accounts 2008 REPoRT of THE InDEPEnDEnT AUDIToRS on THE PAREnT ComPAnY fInAnCIAL STATEmEnTS to the members of lloyds banKing group plC We have audited the parent company financial statements of Lloyds Banking Group plc for the year ended 31 December 2008 which comprise the parent company balance sheet, the parent company statement of changes in equity, the parent company cash flow statement and the related notes. These parent company financial statements have been prepared under the accounting policies set out therein. We have also audited the information in the directors’ remuneration report on pages 74 to 95 that is described as having been audited. We have reported separately on the consolidated financial statements of Lloyds Banking Group plc for the year ended 31 December 2008. respeCtive responsibilities of direCtors and auditors The directors’ responsibilities for preparing the annual report, the directors’ remuneration report and the parent company financial statements in accordance with applicable law and International financial Reporting Standards (‘IfRSs’) as adopted by the European Union are set out in the statement of directors’ responsibilities on page 73. our responsibility is to audit the parent company financial statements and the part of the directors’ remuneration report to be audited in accordance with relevant legal and regulatory requirements and International Standards on Auditing (UK and Ireland). This report, including the opinion, has been prepared for and only for the Company’s members as a body in accordance with section 235 of the Companies Act 1985 and for no other purpose. We do not, in giving this opinion, accept or assume responsibility for any other purpose or to any other person to whom this report is shown or into whose hands it may come save where expressly agreed by our prior consent in writing. We report to you our opinion as to whether the parent company financial statements give a true and fair view and whether the parent company financial statements and the part of the directors’ remuneration report to be audited have been properly prepared in accordance with the Companies Act 1985. We also report to you whether, in our opinion, the information given in the directors’ report is consistent with the parent company financial statements. The information given in the directors’ report includes that specific information presented in the overview and the Business Review that is cross referred from the principal activities, business review, future developments and financial risk management objectives and policies section of the directors’ report. In addition we report to you if, in our opinion, the Company has not kept proper accounting records, if we have not received all the information and explanations we require for our audit, or if information specified by law regarding directors’ remuneration and other transactions is not disclosed. We read other information contained in the annual report and consider whether it is consistent with the audited parent company financial statements. The other information comprises only the chairman’s statement, the group chief executive’s review, the Business Review, the directors’ report, the corporate governance disclosures, the unaudited part of the directors’ remuneration report, the shareholder information and all other information listed on the contents page . We consider the implications for our report if we become aware of any apparent misstatements or material inconsistencies with the parent company financial statements. our responsibilities do not extend to any other information. basis of audit opinion We conducted our audit in accordance with International Standards on Auditing (UK and Ireland) issued by the Auditing Practices Board. An audit includes examination, on a test basis, of evidence relevant to the amounts and disclosures in the parent company financial statements and the part of the directors’ remuneration report to be audited. It also includes an assessment of the significant estimates and judgments made by the directors in the preparation of the parent company financial statements, and of whether the accounting policies are appropriate to the Company’s circumstances, consistently applied and adequately disclosed. We planned and performed our audit so as to obtain all the information and explanations which we considered necessary in order to provide us with sufficient evidence to give reasonable assurance that the parent company financial statements and the part of the directors’ remuneration report to be audited are free from material misstatement, whether caused by fraud or other irregularity or error. In forming our opinion we also evaluated the overall adequacy of the presentation of information in the parent company financial statements and the part of the directors’ remuneration report to be audited. opinion In our opinion: – the parent company financial statements give a true and fair view, in accordance with IfRSs as adopted by the European Union as applied in accordance with the provisions of the Companies Act 1985, of the state of the parent company’s affairs as at 31 December 2008 and cash flows for the year then ended; – the parent company financial statements and the part of the directors’ remuneration report to be audited have been properly prepared in accordance with the Companies Act 1985; and – the information given in the directors’ report is consistent with the parent company financial statements. pricewaterhouseCoopers llp Chartered Accountants and Registered Auditors Southampton, England 26 february 2009 overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility our people Risk management five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 parent company financial statements 183 notes to the parent company financial statements 186 Shareholder information Index to annual report financial calendar 2009 191 192 195 183 Lloyds Banking Group Annual Report and Accounts 2008 PAREnT ComPAnY BALAnCE SHEET at 31 december 2008 assets non-current assets: Investment in subsidiaries Loans to subsidiaries Deferred tax assets Current assets: Derivative financial instruments other assets Amounts due from subsidiaries Cash and cash equivalents total assets equity and liabilities Capital and reserves: Share capital Share premium account Retained profits total equity non-current liabilities: Subordinated liabilities Debt securities in issue Debt securities in issue Current tax liabilities Derivative financial instruments other liabilities total liabilities total equity and liabilities The accompanying notes are an integral part of the parent company financial statements. The directors approved the parent company financial statements on 26 february 2009. sir victor blank Chairman J eric daniels Group Chief Executive tim J w tookey Group finance Director note 2008 £ million 2007 £ million 8 8 2 3 4 4 5 6 7 7 5,589 3,009 – 8,598 1,297 205 216 1,201 2,919 11,517 1,513 2,096 2,147 5,756 2,875 – 2,875 2,644 116 – 126 2,886 5,761 11,517 5,589 2,820 2 8,411 169 165 92 58 484 8,895 1,432 1,298 1,935 4,665 2,345 50 2,395 1,694 28 29 84 1,835 4,230 8,895 184 Lloyds Banking Group Annual Report and Accounts 2008 PAREnT ComPAnY STATEmEnT of CHAnGES In EQUITY balance at 1 January 2007 Profit for the year* Dividends Purchase/sale of treasury shares Employee share option schemes: Value of employee services Proceeds from shares issued balance at 31 december 2007 Profit for the year* Dividends Shares issued via private placement Purchase/sale of treasury shares Employee share option schemes: Value of employee services Proceeds from shares issued balance at 31 december 2008 * no income statement has been shown for the parent company, as permitted by section 230 of the Companies Act 1985. Share capital and premium £ million 2,695 – – – – 35 2,730 – – 760 – – 119 3,609 Retained profits £ million 2,026 1,855 (1,957) (19) 30 – 1,935 2,256 (2,042) – (14) 12 – 2,147 Total £ million 4,721 1,855 (1,957) (19) 30 35 4,665 2,256 (2,042) 760 (14) 12 119 5,756 overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility our people Risk management five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 parent company financial statements 183 notes to the parent company financial statements 186 PAREnT ComPAnY CASH fLoW STATEmEnT for the year ended 31 december 2008 Profit before tax Dividend income fair value and exchange adjustments Change in other assets Change in other liabilities Tax received (paid) net cash used in operating activities Cash flows from investing activities Capital lending to subsidiaries Cash flows from financing activities Dividends received from subsidiaries Dividends paid to equity shareholders Proceeds from issue of debt securities Repayment of debt securities in issue Proceeds from issue of ordinary shares via private placement Proceeds from issue of other ordinary shares Repayment of amounts due to subsidiaries net cash generated by financing activities Change in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year The accompanying notes are an integral part of the parent company financial statements. Shareholder information Index to annual report financial calendar 2009 191 192 195 185 Lloyds Banking Group Annual Report and Accounts 2008 2008 £ million 2,269 (2,294) (68) (166) 42 77 (140) 2007 £ million 1,870 (1,957) 10 103 (128) (32) (134) – (1,111) 2,294 (2,042) 1,896 (1,744) 760 119 – 1,283 1,143 58 1,201 1,957 (1,957) 1,770 – – 35 (1,715) 90 (1,155) 1,213 58 186 Lloyds Banking Group Annual Report and Accounts 2008 noTES To THE PAREnT ComPAnY fInAnCIAL STATEmEnTS 1 aCCounting poliCies The parent company has applied International financial Reporting Standards (IfRS) as adopted by the European Union (EU) in its financial statements for the year ended 31 December 2008. IfRS comprises accounting standards prefixed IfRS issued by the International Accounting Standards Board (IASB) and those prefixed IAS issued by the IASB’s predecessor body as well as interpretations issued by the International financial Reporting Interpretations Committee and its predecessor body. The EU endorsed version of IAS 39 ‘financial Instruments: Recognition and measurement’ relaxes some of the hedge accounting requirements; the Company has not taken advantage of this relaxation, and therefore there is no difference in application to the Company between IfRS as adopted by the EU and IfRS as issued by the IASB. The financial information has been prepared under the historical cost convention, as modified by the revaluation of all derivative contracts. The accounting policies of the parent company are the same as those of the Group which are set out in note 2 to the consolidated financial statements, except that it has no policy in respect of consolidation and investments in subsidiaries are carried at historical cost, less any provisions for impairment. 2 deferred tax assets The movement in the net deferred tax assets is as follows: At 1 January Income statement (charge) credit At 31 December The deferred tax assets relate to temporary differences. 2008 £m 2 (2) – 2007 £m – 2 2 3 amounts due from subsidiaries These comprise short-term lending to subsidiaries, repayable on demand. The fair values of amounts owed by subsidiaries are equal to their carrying amounts. no provisions have been recognised in respect of amounts owed by subsidiaries. 4 share Capital and share premium Details of the Company’s share capital and share premium account are as set out in notes 41 and 42 to the consolidated financial statements. 5 retained profits At 1 January 2007 Profit for the year Dividends Purchase/sale of treasury shares Employee share option schemes: value of employee services At 31 December 2007 Profit for the year Dividends Purchase/sale of treasury shares Employee share option schemes: value of employee services At 31 December 2008 Details of the Company’s dividends are as set out in note 45 to the consolidated financial statements. £m 2,026 1,855 (1,957) (19) 30 1,935 2,256 (2,042) (14) 12 2,147 overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility our people Risk management five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 notes to the parent company financial statements 186 Shareholder information Index to annual report financial calendar 2009 191 192 195 187 Lloyds Banking Group Annual Report and Accounts 2008 2008 £m 584 824 – 497 149 821 970 2,875 2007 £m 593 515 – 497 149 591 740 2,345 6 subordinated liabilities preferred securities fixed/floating Rate non-Cumulative Callable Preference Shares callable 2015 (£600 million)† fixed/floating Rate non-Cumulative Callable Preference Shares callable 2016 (US$ 1,000 million)† 6% non-Cumulative Redeemable Preference Shares undated subordinated liabilities 6% Undated Subordinated Step-up Guaranteed Bonds callable 2032 (£500 million)* dated subordinated liabilities 91/8% Subordinated Bonds 2011 (£150 million) 57/8% Subordinated Guaranteed Bonds 2014 (€750 million) Total subordinated liabilities These liabilities will, in the event of the winding-up of the issuer, be subordinated to the claims of depositors and all other creditors of the issuer. † * further information regarding the fixed/floating rate non-cumulative callable preference shares can be found in note 40 to the consolidated financial statements. In certain circumstances, these bonds would acquire the characteristics of preference share capital. Any repayments of undated loan capital would require the prior consent of the financial Services Authority. They are accounted for as liabilities as coupon payments are mandatory as a consequence of the terms of certain preference shares. At the callable date the coupon on these bonds will be reset by reference to the applicable five year benchmark gilt rate. 7 debt seCurities in issue These comprise the US$100 million Thirteen-month Extendible Short-Term notes issued by the Company in may 2007 and the US$3,750 million Thirteen-month Extendible Short-Term notes issued by the Company in July 2008. 8 related party transaCtions Key management personnel The key management personnel of the Group and parent company are the same. The relevant disclosures are given in note 47 to the consolidated financial statements. The Company has no employees (2007: nil). As discussed in note 46 to the consolidated financial statements, the Group provides share based compensation to employees through a number of schemes; these are all in relation to shares in the Company and the cost of providing those benefits is recharged to the employing companies in the Group on a cash basis. investment in subsidiaries The Company’s investment in subsidiaries is carried at cost: there has been no movement in the carrying value during the year and there has been no impairment of the Company’s investment in subsidiaries. 188 Lloyds Banking Group Annual Report and Accounts 2008 noTES To THE PAREnT ComPAnY fInAnCIAL STATEmEnTS continued 8 related party transaCtions continued The principal subsidiaries, all of which have prepared accounts to 31 December and whose results are included in the consolidated accounts of Lloyds Banking Group plc, are: Lloyds TSB Bank plc Lloyds TSB Commercial finance Limited Lloyds TSB Leasing Limited Lloyds TSB Private Banking Limited The Agricultural mortgage Corporation PLC Lloyds TSB offshore Limited Lloyds TSB Scotland plc Lloyds TSB General Insurance Limited Scottish Widows Investment Partnership Group Limited Lloyds TSB Insurance Services Limited Lloyds TSB Asset finance Division Limited Black Horse Limited Scottish Widows plc Scottish Widows Annuities Limited † Indirect interest. Country of registration/ incorporation England England England England England Jersey Scotland England England England England England Scotland Scotland Percentage of equity share capital and voting rights held 100% 100%† 100%† 100%† 100%† 100%† 100%† 100%† 100%† 100%† 100%† 100%† 100%† 100%† nature of business Banking and financial services Credit factoring financial leasing Private banking Long-term agricultural finance Banking and financial services Banking and financial services General insurance Investment management Insurance broking Consumer credit, leasing and related services Consumer credit, leasing and related services Life assurance Life assurance The principal area of operation for each of the above subsidiaries is the United Kingdom and the Channel Islands, except as follows: Lloyds TSB Bank plc operates principally in the UK but also through branches in Belgium, Dubai, Ecuador, france, Germany, Gibraltar, Hong Kong, Japan, Jersey, Luxembourg, malaysia, monaco, netherlands, Singapore, Spain, Switzerland, Uruguay and the USA, and representative offices in China, Colombia, Guatemala and Paraguay. none of the parent company’s subsidiaries has experienced any significant restrictions in paying dividends or repaying loans and advances. All regulated banking and insurance subsidiaries are required to maintain capital at levels agreed with the regulators; this may impact those subsidiaries’ ability to make distributions. Loans to subsidiaries: At 1 January Exchange and other adjustments Amounts advanced At 31 December 2008 £m 2,820 189 – 3,009 2007 £m 1,723 (14) 1,111 2,820 In addition the parent company carried out all of its banking activities through its subsidiary, Lloyds TSB Bank plc (the Bank). At 31 December 2008, the parent company held deposits of £1,201 million with the Bank (2007: £58 million). Given the volume of transactions flowing through the account, it is not meaningful to provide gross inflow and outflow information. In addition, at 31 December 2008 the parent company had interest rate and currency swaps with the Bank with an aggregate notional principal amount of £4,567 million and a net positive fair value of £1,297 million (2007: notional principal amount of £4,032 million and a net positive fair value of £140 million), of which contracts with an aggregate notional principal amount of £1,870 million and a net positive fair value of £501 million (2007: notional principal amount of £4,032 million and a net positive fair value of £140 million) were designated as fair value hedges to manage the Company’s issuance of subordinated liabilities and debt securities in issue. Related party information in respect of other related party transactions is given in note 47 to the consolidated financial statements. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility our people Risk management five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 notes to the parent company financial statements 186 Shareholder information Index to annual report financial calendar 2009 191 192 195 189 Lloyds Banking Group Annual Report and Accounts 2008 9 finanCial instruments measurement basis of finanCial assets and liabilities The accounting policies in note 2 to the consolidated financial statements describe how different classes of financial instruments are measured, and how income and expenses, including fair value gains and losses, are recognised. The following table analyses the carrying amounts of the financial assets and liabilities by category and by balance sheet heading. as at 31 december 2008 financial assets: Cash and cash equivalents Derivative financial instruments Loans to subsidiaries Amounts due from subsidiaries Total financial assets financial liabilities: Debt securities in issue Subordinated liabilities Total financial liabilities as at 31 december 2007 financial assets: Cash and cash equivalents Derivative financial instruments Loans to subsidiaries Amounts due from subsidiaries Total financial assets financial liabilities: Derivative financial instruments Debt securities in issue Subordinated liabilities Total financial liabilities derivatives designated as hedging instruments, held at fair value through profit or loss £m held for trading at fair value through profit or loss £m loans and receivables £m held at amortised cost £m – 501 – – 501 – – – – 796 – – 796 – – – – – 3,009 216 3,225 – – – 1,201 – – – 1,201 2,644 2,875 5,519 Derivatives designated as hedging instruments, held at fair value through profit or loss £m Held for trading at fair value through profit or loss £m Loans and receivables £m Held at amortised cost £m – 169 – – 169 29 – – 29 – – – – – – – – – – – 2,820 92 2,912 – – – – 58 – – – 58 – 1,744 2,345 4,089 total £m 1,201 1,297 3,009 216 5,723 2,644 2,875 5,519 Total £m 58 169 2,820 92 3,139 29 1,744 2,345 4,118 interest rate risK and CurrenCy risK The Company is exposed to interest rate risk and currency risk on its debt securities in issue and its subordinated debt. As discussed in note 8, the Company has entered into interest rate and currency swaps with its subsidiary, Lloyds TSB Bank plc, to manage these risks. Credit risK The majority of the Company’s credit risk arises from amounts due from its wholly owned subsidiary, Lloyds TSB Bank plc, and subsidiaries of that company. 190 Lloyds Banking Group Annual Report and Accounts 2008 noTES To THE PAREnT ComPAnY fInAnCIAL STATEmEnTS continued 9 finanCial instruments continued liquidity risK The table below analyses financial instrument liabilities of the Company, on an undiscounted future cash flow basis according to contractual maturity, into relevant maturity groupings based on the remaining period at the balance sheet date, balances with no fixed maturity are included in the over 5 years category. as at 31 december 2008 Debt securities in issue Subordinated liabilities Total as at 31 december 2007 Derivative financial instruments Debt securities in issue Subordinated liabilities Total up to 1 month £m 1-3 months £m 75 14 89 10 8 11 29 12 28 40 20 15 21 56 3-12 months £m 2,601 125 2,726 1,791 1,740 97 3,628 1-5 years £m – 789 789 – 50 516 566 over 5 years £m – 2,529 2,529 – – 3,195 3,195 total £m 2,688 3,485 6,173 1,821 1,813 3,840 7,474 The principal amount for undated subordinated liabilities with no redemption option is included within the over 5 years column; interest of approximately £111 million (2007: £97 million) per annum which is payable in respect of those instruments for as long as they remain in issue is not included beyond 5 years. fair values of finanCial assets and liabilities The valuation techniques for the Company’s financial instruments are as discussed in note 49 to the consolidated financial statements. financial assets: Cash and cash equivalents Derivative financial instruments Loans to subsidiaries Amounts due from subsidiaries financial liabilities: Derivative financial instruments Debt securities in issue Subordinated liabilities Carrying value 2008 £m 1,201 1,297 3,009 216 – 2,644 2,875 Carrying value 2007 £m 58 169 2,820 92 29 1,744 2,345 fair value 2008 £m 1,201 1,297 2,139 216 – 2,644 1,563 fair value 2007 £m 58 169 2,856 92 29 1,744 2,134 10 post balanCe sheet events Details of the Company’s post balance sheet events are set out in note 52 to the consolidated financial statements. 11 approval of the finanCial statements and other information The parent company financial statements were approved by the directors of Lloyds Banking Group plc on 26 february 2009. Lloyds Banking Group plc was incorporated as a public limited company and registered in Scotland under the UK Companies Act 1985 on 21 october 1985 with the registered number 95000. Lloyds Banking Group plc’s registered office is Henry Duncan House, 120 George Street, Edinburgh EH2 4LH, Scotland, and its principal executive offices in the UK are located at 25 Gresham Street, London EC2V 7Hn. overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility our people Risk management five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 notes to the parent company financial statements 186 shareholder information 191 Index to annual report financial calendar 2009 192 195 191 Lloyds Banking Group Annual Report and Accounts 2008 SHAREHoLDER InfoRmATIon analysis of shareholders at 31 december 2008 Size of shareholding 1 – 99 100 – 499 500 – 999 1,000 – 4,999 5,000 – 9,999 10,000 – 49,999 50,000 – 99,999 100,000 – 999,999 1,000,000 and over shareholders number of ordinary shares number 61,777 317,901 232,719 169,621 24,486 15,053 735 887 493 % 7.50 38.60 28.25 20.59 2.97 1.83 0.09 0.11 0.06 823,672 100.00 millions 2.2 105.3 155.0 322.8 165.3 267.6 48.8 305.0 % 0.04 1.76 2.59 5.40 2.77 4.48 0.82 5.11 4,600.9 5,972.9 77.03 100.00 substantial shareholdings At the date of this report, notifications had been received that: – AxA Investment managers Limited had a direct interest of 0.79 per cent and an indirect interest of 2.7 per cent; – Barclays PLC had an interest of 3.84 per cent; – The Capital Group Companies, Inc had an interest of 4.86 per cent; and – The Solicitor for the Affairs of Her majesty’s Treasury had a direct interest of 43.38 per cent in the issued share capital with rights to vote in all circumstances at general meetings. no other notification has been received that anyone has an interest of 3 per cent or more in the issued ordinary share capital. share priCe information individual savings aCCounts (isas) The Company provides a facility for investing in Lloyds Banking Group shares through an ISA. for details contact: Retail Investor operations, Equiniti Limited, Aspect House, Spencer Road, Lancing, West Sussex Bn99 6DA. Telephone 0871 384 2244. Corporate responsibility A copy of the Group’s corporate responsibility report may be obtained by writing to Corporate Responsibility, Lloyds Banking Group plc, 25 Gresham Street, London EC2V 7Hn. This information together with the Group’s code of business conduct is also available on the Group’s website www.lloydsbankinggroup.com In addition to listings in the financial pages of the press, the latest price of Lloyds Banking Group shares on the London Stock Exchange can be obtained by telephoning 09058 890 190. Visit www.londonstockexchange.com for details. the better payment praCtiCe Code A copy of the code and information about it may be obtained from the BERR Publications orderline 0845 015 0010, quoting ref URn 04/606. Alternatively, visit www.payontime.co.uk for details. share dealing faCilities A full range of dealing services is available as follows: – Internet dealing. Log on to www.lloydstsbsharedealing.com – Telephone dealing. Call 0845 606 0560 – Internet and telephone dealing services are available between 8.00am and 4.30pm, monday to friday. Details of any dealing costs are available when you log on to the share dealing website or when you call the above number. ameriCan depositary reCeipts (adrs) Lloyds Banking Group shares are traded in the USA through an nYSE-listed sponsored ADR facility, with The Bank of new York mellon as the depositary. The ADRs are traded on the new York Stock Exchange under the symbol LYG. The CUSIP number is 539439109 and the ratio of ADRs to ordinary shares is 1:4. for details contact: The Bank of new York mellon Shareowner Services, Po Box 358516, Pittsburgh, Pennsylvania 15252-8516. Telephone: 877-353-1154 (US toll free), international callers: +1 201-680-6825. Alternatively visit www.bnymellon.com or email shrrelations@bnymellon.com shareholder enquiries The Company’s share register is maintained by Equiniti Limited. Contact them if you have enquiries about your Lloyds Banking Group shareholding, including those concerning the following matters: – change of name or address – loss of share certificate – dividend information, including loss of dividend warrant or tax voucher. Contact details for Equiniti Limited can be found on page 195. Equiniti operates a web based enquiry and portfolio management service for you to receive shareholder communications electronically. In addition, you can change your address or bank details and register proxy appointments and voting instructions on your shareholding online. Visit www.shareview.co.uk for details. Computershare Investor Services continue to maintain the register of Lloyds Banking Group shareholder account holders (formerly the HBoS shareholder account). If you have any queries please either write to Computershare Investor Services PLC, Po Box 1910, Bristol BS99 7DS or call 0870 702 0102 or visit www.computershare.com Daytime calls monday to friday from BT landlines to 0870 numbers will cost no more than 6p a minute plus an 8p connection fee. Calls to 09058, 0871 and 0845 numbers are charged at 55p, 8p and 5p per minute, respectively, from a BT landline. The price of calls from mobiles and other networks may vary. The call prices we have quoted were correct in february 2009. 192 Lloyds Banking Group Annual Report and Accounts 2008 InDEx To AnnUAL REPoRT aCCounting Accounting policies Critical accounting estimates and judgements future accounting developments aCquisition Chairman’s statement Group chief executive’s review Group chief executive’s Q&A Post balance sheet events approval of finanCial statements Consolidated Parent company auditors Report on the consolidated financial statements Report on the parent company financial statements fees available-for-sale finanCial assets Accounting policies Critical accounting estimates and judgements notes to the consolidated financial statements Valuation balanCe sheet Consolidated Parent company Capital adequaCy Capital ratios Cash flow statement Consolidated notes to the consolidated financial statements Parent company Chairman’s statement Change of name Post balance sheet events Charitable donations Contingent liabilities and Commitments Corporate responsibility Credit marKet positions debt seCurities in issue Consolidated Parent company Valuation 102 111 180 2 4 6 181 181 190 96 182 121 deposits Customer accounts Deposits from banks Valuation derivative finanCial instruments Accounting policy notes to the consolidated financial statements Valuation direCtors Attendance at board and committee meetings Biographies Directors’ report Emoluments Interests Remuneration policy Service agreements dividends ordinary dividends 103, 106 Post balance sheet events 111 130 176 earnings per share employees Equality and diversity 98, 99 our people 183 finanCial risK management Credit risk 58 Currency risk fair values of financial assets and liabilities Insurance risk Interest rate risk Liquidity and funding risk market risk measurement basis of financial assets and liabilities five year finanCial summary forward looKing statements contents page 101 177 185 2 181 38 162 36 going ConCern Basis of preparation Directors’ report goodwill 32 Accounting policy Critical accounting estimates and judgements notes to the consolidated financial statements 136 187 177 135 135 176 105 125 176 72 66 68 86 89 78 85 155 181 123 41 40 48, 168, 189 167, 189 175, 190 52 167, 189 55, 174, 190 50 165, 189 65 102 73 103 112 131 overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility our people Risk management five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 notes to the parent company financial statements 186 Shareholder information index to annual report financial calendar 2009 191 192 195 193 Lloyds Banking Group Annual Report and Accounts 2008 127 128 176 8 116 116 117 120 118 107 112 84, 87 142 181 188 governanCe Compliance with the combined code Risk governance structures The board and its committees group Chief exeCutive’s q&a group Chief exeCutive’s review loans and advanCes Loans and advances to banks Loans and advances to customers Valuation marKetplaCe trends net fee and Commission inCome 70 43 70 6 4 held at fair value through profit or loss net interest inCome Accounting policy notes to the consolidated financial statements Valuation impairment Accounting policy Critical accounting estimates and judgements notes to the consolidated financial statements inCome statement Consolidated information for shareholders Analysis of shareholders financial calendar 2009 Shareholder enquiries insuranCe premium inCome insuranCe Claims investment property Accounting policy notes to the consolidated financial statements Key performanCe indiCators insuranCe businesses Accounting policy Basis of determining regulatory capital Capital sensitivities Capital statement Critical accounting estimates and judgements financial information calculated on a ‘realistic’ basis Liabilities arising from insurance contracts and participating investment contracts Liabilities arising from non-participating investment contracts Life insurance sensitivity analysis options and guarantees Unallocated surplus within insurance businesses Valuation Value of in-force business 103 124, 136 175, 177 net trading inCome operating expenses other operating inCome pensions Accounting policy Critical accounting estimates and judgements Directors’ pensions notes to the consolidated financial statements post balanCe sheet events prinCipal subsidiaries 105 111 122 97 191 195 191 118 presentation of information contents page provisions 119 Accounting policy notes to the group accounts 106 131 11 regulation related party transaCtions risK management frameworK Business risk 108 Credit risk financial soundness Insurance risk market risk Principal risks operational risk Risk drivers Risk governance structures risK-weighted assets seCuritisations 59 64 60 113 62 137 142 141 64 142 177 132 110 148 35 161 48 48 55 52 50 46 53 46 43 58 129 194 Lloyds Banking Group Annual Report and Accounts 2008 InDEx To AnnUAL REPoRT continued segmental reporting Central group items Insurance and Investments notes to the consolidated financial statements Summarised segmental analysis UK Retail Banking Wholesale and International Banking share-based payments Accounting policy notes to the consolidated financial statements share Capital Share capital Post balance sheet events statement of Changes in equity Consolidated Parent company subordinated liabilities Consolidated Parent company Valuation summary of group results tangible fixed assets Accounting policy notes to the consolidated financial statements taxation Accounting policy Critical accounting estimates and judgements 34 22 114 16 18 30 108 156 152 181 100 184 149 187 177 10 107 134 108 113 notes to the consolidated financial statements 122, 146 value at risK (var) volatility Insurance Policyholder interests Summary of Group results 51 34 34 13 overview Group profile Chairman’s statement Group chief executive’s review Group chief executive’s Q&A marketplace trends 1 2 4 6 8 business review Summary of Group results Divisional results Corporate responsibility our people Risk management five year financial summary 10 18 36 40 42 65 governanCe The board Directors’ report Corporate governance 66 68 70 Directors’ remuneration report 74 finanCial statements shareholder information Report of the independent auditors on the consolidated financial statements Consolidated financial statements notes to the consolidated financial statements 96 97 102 Report of the independent auditors on the parent company financial statements 182 Parent company financial statements 183 notes to the parent company financial statements 186 Shareholder information Index to annual report financial calendar 2009 191 192 195 195 Lloyds Banking Group Annual Report and Accounts 2008 fInAnCIAL CALEnDAR 2009 27 february Results for 2008 announced 8 may 11 may 22 may Record date for the capitalisation issue Ex-date for the capitalisation issue and shares admitted to trading. CREST accounts credited Latest date for the despatch of share certificates and Lloyds Banking Group shareholder account statements in respect of the capitalisation issue 5 august Results for the half-year to 30 June 2009 announced head offiCe 25 Gresham Street London EC2V 7Hn Telephone +44 (0)20 7626 1500 registered offiCe Henry Duncan House 120 George Street Edinburgh EH2 4LH Registered in Scotland no 95000 internet www.lloydsbankinggroup.com registrar Equiniti Limited Aspect House Spencer Road Lancing West Sussex Bn99 6DA Telephone 0871 384 2990 Textphone 0871 384 2255 overseas +44 (0)121 415 7066 www.equiniti.com Mixed Sources Product group from well-managed forests, controlled sources and recycled wood or fiber WWW.fsc.org Cert_No._TT-COC-002228 © 1996 Forest Stewardship Council Designed and produced by Radley Yeldar www.ry.com Executive producer Lora Starling Front cover photography Mark Horn/gettyimages Printed in the UK by Royle Print, a Carbon Neutral printing company, on material which contains a minimum of 50% post consumer waste, using soya based inks and water based sealants; the printer and paper manufacturing mill are both accredited with ISO 140001 Environmental Management systems standards and both are Forest Stewardship Council certified. 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