NatWest Group plc (NYSE:NWG) Q3 2023 Earnings Call Transcript

NatWest Group plc (NYSE:NWG) Q3 2023 Earnings Call Transcript October 27, 2023

Paul Thwaite: Good morning and thank you for joining us for the first set of results since becoming CEO. I’m going to start with the financial headlines and my near-term priorities for the business. Then, Katie, will run you through the quarter three results in greater detail, and after that we’ll open it up for questions. Our customers and communities are central to our strategy. So I’d like to begin by putting the financial headlines in the context of recent customer activity. During the first nine months of this year, we have lent over £8 billion into the UK economy, opened over 80,000 new business startup accounts, helped 312,000 customers buy or refinance their homes, and opened over 1 million savings accounts alongside around 800,000 current accounts.

In addition, we have delivered over £53 billion of climate and sustainable funding and financing since July 2021. Turning now to the financial headlines. We delivered operating profit of £4.9 billion for the first nine months, which is up 33% on the prior year, with attributable profit of £3.2 billion. Income was £10.9 billion and costs were £5.6 billion. Our cost income ratio was just under 50%, with some benefit from foreign exchange gains, and we are on track to meet our cost target of £7.6 billion for the year. Our balance sheet remains strong and our funding is well diversified with £424 billion in deposits, £358 billion of customer loans, and a loan to deposit ratio of 83%. We remain committed to a 40% payout ratio with capacity for buybacks and have paid or accrued £1.1 billion in dividend payments in the first nine months.

A smiling customer, holding a debit card issued by the bank.

In addition to the directed buyback of £1.3 billion in May, we have also carried out almost half of the £500 million on market buyback announced in July. Taken together, this represents distributions of £2.9 billion, more than 90% of our nine-month attributable profit, and brings our CET1 ratio to 13.5%. Our return on tangible equity was 17.1%, and we expect to be at the top end of our 14% to 16% target range by the year-end. Despite this strong set of results, I recognize net income and net interest margin came in below expectations, reflecting an accelerated change in customer behavior during the quarter. Customers are more actively searching for yield and moving balances from noninterest-bearing accounts to lower margin saving and fixed term products.

And in a competitive market environment, we have taken the decision to compete. Whilst this comes at a cost in the near-term, we are balancing income and margin with the long-term value of deepening customer relationships and maintaining a strong funding and liquidity profile. As a result of changes in customer behavior relating to both assets and liabilities, as well as assumptions on interest rates, we are revising our income and net interest margin guidance for the full-year, which Katie will cover in more detail. So let me turn now to my near-term priorities for the business. I’ve been very focused on running the business, ensuring we continue to serve and support our customers and our communities. At a time of macroeconomic uncertainty and evolving behavior, it is essential that we continue to be a strong, stable, and trustworthy partner for our 19 million customers.

It is important to me that we are the very best bank we can be, and I would like to thank all of my colleagues for their continued hard work and dedication. There is more to be done as we continue to make it easier for our customers to engage with us, either via our digital channels or our extensive presence across the country. We remain focused on driving and delivering the outcomes we set out earlier this year, simplification, digitization, and using data and technology to better serve our customers. I’ve already made several decisions to improve efficiency and strengthen our focus on simplification and productivity. This is very much in line with the agenda I drove in my previous roles here at the bank and as I continued to spend time with our businesses during the quarter, it has only confirmed my view that there is more value and growth we can deliver.

We are also in the midst of the planning cycle, and as you’d expect, I’ve spent a lot of time with Katie and the team going over the plan, stress testing it, and challenging ourselves to look at a range of scenarios. We have worked hard to absorb the recent inflationary pressures, but given the macroeconomic environment, it will come as no surprise that we continue to tighten our approach to cost in order to deliver attractive returns and capital generation consistent with our medium-term target of 14% to 16% royalty. An important strength of the bank in recent years has been the robustness of its balance sheet, which positions us well both for the upside and the downside. Our customers remain resilient and impairments are low. But I’m very alive to the ongoing risks associated with higher rates, inflation, and supply chain shocks.

I am also clear that these impacts may still be working their way through the system, so we are closely monitoring a wide range of indicators and testing our balance sheet for a wide range of economic scenarios. Our strong common equity Tier 1 and liquidity ratios position us well to navigate the macro environment, changing customer behavior and remaining uncertainty on the impact and timing of upcoming regulatory change. We therefore need to be dynamic and disciplined in the way we manage and allocate our liquidity and capital. We have made good progress over the year to diversify our deposit product offering, better leveraging our data, and using a broader range of tools on both sides of the balance sheet. That said, I still see opportunities to be smarter and quicker.

Our recent track record of capital generation is strong and allows us both to invest in the business and provide shareholders with attractive returns. I fully appreciate that stability and predictability of our capital distributions together with their timing through the cycle is central to our value and investment case. Finally, the recent appointments to my leadership team have settled well and I am pleased with the team’s ability to focus on delivering for our customers and driving the execution of our plan. We have a strong business and are making good progress, but I’m keenly aware that we’ll be judged on our ability to deliver. With that, I will hand over now to Katie to go through the results in more detail.

Katie Murray: Thank you, Paul. I’m going to talk about performance in the third quarter using the second quarter as a comparator on Slide 6. Total income of £3.5 billion was down 9.4%, as foreign currency gains in the second quarter were not repeated in the third. Income excluding all notable items was also around £3.5 billion, down 1.4%. Within this, net interest income was 4.9% lower at £2.7 billion, while non-interest income grew 12.2% to £829 million. Operating expenses were stable at £1.9 billion. The impairment charge increased to £229 million or 24 basis points of loans, reflecting normalization and the non-repeat of releases in the second quarter when we updated our economic assumptions. Taking all of this together, we delivered operating profit before tax of £1.3 billion and profit attributable to ordinary shareholders of £866 million, which is equal to a return on tangible equity of 14.7% in the quarter.

We are pleased to have delivered further net lending growth. This was driven by our corporate customers while net mortgage lending moderated following a strong first half. Gross loans to customers across the three businesses increased by £2 billion to £358 billion. Taking retail banking together with private banking, mortgage balances grew by £200 million, representing stock share of 12.6%. Gross new mortgage lending was £7.9 billion, representing flow share of around 13%. Unsecured balances increased by £500 million to £15.5 billion, driven by continuing customer demand and share gains within cards. In commercial and institutional, gross customer loans were up by £1.3 billion. At the mid to large end, we saw demand for term credit facilities and private financing.

At the smaller end, demand remains muted and customers with surplus liquidity continue to deleverage, including repayment of government scheme lending. So let me now turn to deposits on Slide 8. Customer deposits across our three businesses were up in the quarter at £424 billion. Across retail and private deposits grew by £2.1 billion, reflecting market share gains in term deposits. In commercial and institutional, deposits increased by £300 million. Our stable loan to deposit ratio of 83% allows us to manage our deposit base for value as well as support customers and grow our lending share in target markets. The UK base rate has increased by 25 basis points to 5.25% since we presented our first half results. And customers continue to move balances from noninterest-bearing to term accounts.

Noninterest-bearing balances have reduced from 37% of the total to 35%, and as you can see on the slide, the absolute reduction in noninterest-bearing balances, which is the main transaction accounts for our customers, has continued in line with the second quarter across each of the businesses. Within interest bearing balances, we have seen an accelerated change of mix and term accounts are now around 15% of the total, up from 11% at the end of the second quarter. There were high levels of deposit migration amongst our existing customers, in particular to lower margin term accounts. We also launched a new fixed rate savings product for retail customers to the entire market at the end of the second quarter. This attracted new term balances from customers that are new to the bank, helping to grow our share and contributing to the change in deposit mix.

This launch has enabled us to grow our customer franchise, strengthen our liquidity position and grow income, albeit at tighter margins. Going forward, we expect the pace of migration to reduce, given a slowdown in late September and October and our expectation that UK base rates will remain at 5.25% through to the second half of 2024. Turning now to how this impacts our deposit margin on Slide 9. The top left of the slide shows the average third-party customer deposit rates across all three businesses on both interest bearing balances and total deposit balances over the last four quarters. The cost of our total customer deposit base has increased from 0.5% in the fourth quarter last year to 1.8% in the third quarter this year. As a result, interest payable to customers grew from £588 million to £1.9 billion.

The rise in interest payable has outpaced the rise of interest receivable since the second quarter this year, which is why Group net interest income has fallen since then. The average UK base rate in the third quarter was 5.2%, up around 80 basis points on the second. This compares to 60 basis point increase in the cost of deposits, yet our deposit margin fell. This is because a significant proportion of our deposits are hedged and did not yet benefit from the rise in interest rates. The bar chart on the right-hand side of the slide shows them that £195 billion or 45% of our customer deposits form part of the product structural hedge. This has a weighted average life of 2.5 years, meaning it takes five years to fully re-price. We also hedge our term deposits separately, and this income is not included in our structural hedge disclosures.

As a result, less than half of our deposits are unhedged and benefit immediately from the increase in SONIA. As you consider the outlook for our deposit income, you should think about the margins we earn on each of the component parts, how the margin will develop going forward, and the balance in mix. Starting with the product structural hedge. Given the ongoing reduction in 12 months average eligible balances, we expect the size of the hedge to reduce during the fourth quarter and into 2024. However, we expect the reinvestment uplift to offset this balance reduction, so that structural hedge income increases year-on-year in 2024 and more meaningfully in 2025. Turning to hedged term deposits, this remains a competitive market with tight margins where we are seeing the fastest growth in balances.

Finally, unhedged instant access deposits as you know, our cumulative pass-through on instant access accounts has been around 50% to-date. This means that unhedged margins are currently around 2.5%. The margin outlook will depend on competition, customer behavior, and of course, the UK base rate. Let me explain how deposit margins impacted income on Slide 10. Income excluding all notable items was £3.5 billion, down 1.4% on the second quarter. Net interest income was 4.9% lower at £2.7 billion, driven by lower margins and broadly stable average interest earning assets. Bank net interest margin reduced by 19 basis points to 2.94% as a result of lower lending margins, which accounted for 12 basis points driven by mortgages and lower deposit margins accounting for 14 basis points reflecting additional interest expense, which more than offset the structural hedge reinvestment this quarter.

These two movements were partly offset by a 6 basis point benefit from funding and other movement as a result of one-off reallocations from non-interest income, which we do not expect to repeat. Non-interest income, excluding notable items grew £90 million to £829 million. Corporate activity improved in the quarter, resulting in higher lending fees. We are pleased that non-interest income for the first nine months of the year is up 7% on the same period last year. Turning to the full-year. We now expect income excluding notable items of around £14.3 billion and bank net interest margin greater than 3%. This guidance is the result of changes in customer behavior on both the asset and liability side, as well as revised assumptions on interest rates.

On liabilities, as I just mentioned, we expect the future pace of migration to slow and noninterest-bearing accounts to represent 34% of the total at the year-end with term at around 17%. This means that we do not expect deposit margin pressure to continue at the same pace into the fourth quarter. On the asset side, our mortgage customers are refinancing onto rates that are higher but at a tighter margin for us. We expect this headwind to moderate over the coming quarters. Finally, the interest rate outlook has changed. As you know, our income guidance assumed a 50 basis point increase in August to 5.5%. We now expect the UK base rate to remain at 5.25% for the rest of the year. We expect both lending margin and deposit margin pressures to ease into the fourth quarter.

And therefore, we do not expect bank NIM to reduce by a similar 19 basis points as we saw in the third quarter. Moving on to costs on Slide 11. Other operating expenses were £1.8 billion for the third quarter, down £82 million or 4.4% on the second. This was driven by lower staff costs due to our ongoing exit from Ulster Bank, where we have incurred £206 million of direct costs in the first nine months and continue to guide to around £300 million for the full-year. We expect other operating costs of around £7.6 billion for the full-year in line with our guidance. This delivers a cost income ratio of 49.9% for the first nine months benefiting from foreign exchange gains. Excluding these, the cost income ratio is 51.4%. I’d like to turn now to impairments on Slide 12.

We booked a net impairment charge of £229 million in the third quarter, equivalent to 24 basis points of loans on an annualized basis. This reflects a normalization of trends and the absence of releases made in the second quarter when we revised our economic assumptions. These assumptions remain appropriate and are unchanged. Our impairment loss rate for the first nine months is 16 basis points, and we now expect to be below our through the cycle range of 20 basis points to 30 basis points for the full-year. Our balance sheet provision for expected credit loss is broadly stable at £3.6 billion, equivalent to coverage of 94 basis points of loans. This includes £453 million of post-model adjustments for economic uncertainty, which are also broadly stable in the quarter.

We remain comfortable with coverage of the book, which continues to perform well. I’ll talk a little more about the composition and quality of our loan book on Slide 12. We have a well-diversified prime loan book. Over 50% of our Group lending consists of mortgages where the average loan to value is 55% or 69% on new business. 92% of our book is fixed and the majority at five years. 5% are trackers and 3% is on a standard variable rate. Our customers continue to refinance early to take advantage of lower rates in the six-month window before roll off, and we monitor the impact of higher rates on customers closely after they refinance. We are seeing a return to a more normalized level of arrears in our mortgage book, but these remain a little below 2019 levels and we are not seeing any material increase in the request for forbearance.

Our personal unsecured exposure is less than 4% of Group lending and is performing in line with expectations. Our corporate book is well diversified and is performing well. We have seen some sectors rebuild cash buffers over the past quarters, and we continue to hold PMAs for those sectors where liquidity pressures may be more acute. Turning now to look at capital and return generation on Slide 13. We are pleased to have delivered 14.7% return on tangible equity this quarter, driving good capital generation. We ended the quarter with a common equity Tier 1 ratio of 13.5% in line with the second quarter. Earnings delivered an uplift of 49 basis points, which was partly offset by RWA growth of £4.1 billion absorbing 30 basis points. This led to a net capital generation of 21 basis points in the quarter and 118 basis points for the first nine months, excluding non-recurring impacts such as our acquisition of Cushon.

We accrued the equivalent of 20 basis points in the third quarter towards the final dividend in line with our 40% payout ratio. Looking to the fourth quarter, we expect RWAs to increase by around £3 billion as a result of CRD IV model updates, which remain subject to further development and final approval by the PRA. We expect net RWA growth to be broadly in line with this £3 billion increase, given our current expectations for credit growth and typical market risk seasonality. We now expect RWAs to be around £200 billion at the end of 2025, including the impact of Basel 3.1 and the further CRD IV model development. At this point, we view around £200 billion as an appropriate basis for planning, but this guidance is clearly subject to final rules on credit and output floors, which will not be published until the middle of 2024, as well, of course, as an equity approval.

We note recent comments from the PRA and its intention to evolve some of the credit risk proposals, and we will seek to mitigate these changes and optimize our balance sheet as much as we can through to 2025. Earnings have generated 180 basis points of capital in the first nine months before RWA growth, and we are comfortable with our ongoing capacity to generate and distribute capital over this period. In December, Paul and I will discuss our capital return plans for 2024 with the Board, including both directed and on market buybacks and we will update you at the full-year results in February. Turning now to our balance sheet strength on Slide 14. Our CET1 ratio of 13.5% was within our target range of 13% to 14%, which includes a buffer above our minimum requirements.

Our UK leverage ratio of 5.1% was stable on the second quarter and remains well above the Bank of England minimum requirement. Our liquidity coverage ratio was 145% at the end of the third quarter on a spot basis and 142% on a 12-month average basis. This is well above our minimum requirement. Turning to 2023 guidance. We now expect income excluding notable items to be around £14.3 billion at a UK base rate of 5.25% with net interest margin above 3%, and Group operating costs excluding litigation and conduct of around £7.6 billion, delivering a cost income ratio below 52%. We anticipate a loan impairment rate below the range of 20 basis points to 30 basis points, and together, we expect this to lead to a return on tangible equity at the upper end of our 14% to 16% range.

And with that, I’ll hand back to Paul.

Paul Thwaite: Thank you, Katie. As you can see, we have performed well in the first nine months as our customers continued to adapt in an uncertain economic environment, and I remain optimistic about our ability to deliver good performance. My focus remains on consistently serving our customers’ needs whilst continuing to drive the execution of our strategic plan with an emphasis on further digitization and simplification. We are able to do this supported by a strong balance sheet, which allows us to grow in attractive parts of the market whilst maintaining strong originating discipline. As we continue to generate capital, we are committed to continuing to drive returns and shareholder distributions with a 40% payout ratio for ordinary dividends and with capacity for further buybacks. I expect to provide you with more detail in February. Thank you very much. We’re happy to open it up for questions now.

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Q&A Session

Operator: [Operator Instructions]. Our first question comes from Rahul Sinha from J.P. Morgan. Please go ahead.

Katie Murray: Hi, Rahul.

Paul Thwaite: Hey, Rahul.

Rahul Sinha: Hi, good morning. Hi, Paul. Hi, Katie. A couple of questions to start with I guess. The first one, I think you’ve been reasonably clear on the direction of NIM travel in the second half this year coming into these results, but I guess the magnitude of some of the moves has surprised most people. So I guess the question that I wanted you to address is how should we think about the direction of travel in Q4? And if you can give us a little bit more color around the exit run rate. And related to that, I guess the broader question is that some of the external factors that are impacting your NIM and the industry NIM, such as competition, migration, deposit levels in the industry are all quite difficult to predict and external to you.

So what sort of gives you the confidence around the slightly better outlook for NIM decline next quarter? That’s the first one. The second one just maybe staying on deposits. You’ve taken the decision, as you said, Paul to compete in deposits and I was just wondering if you might elaborate a little bit around your thinking just given the very low loans to deposit ratio at NatWest. What does that really mean in terms of what are you looking to do with your deposits? Are you expecting to grow your deposits on an absolute basis? And are you — how do you look at sort of the returns dynamic within that? Thank you.

Paul Thwaite: Great. Thanks, Rahul. Why don’t I take the deposit question, the second question first then, Katie you can cover the NIM piece. So, as you rightly said, Rahul, we made a very conscious and deliberate decision around competition in deposits. You can see that we’ve stabilized the book quarter two, quarter three that’s allowed us to retain deposits and in certain parts of the market gain some share. As you rightly point out, there’s a trade-off there. It has a cost. And the judgment I’ve made really is balancing that cost versus retaining and acquiring the customer relationships, but also the liquidity value. That’s the kind of strategic judgment that we’ve made, and we stand behind that. We think that’s the right move for us.

The link to the loan deposit ratio you reference is a good one, and you’re right. Our LDR is different from some of our peers. As you can see from the growth in some of our products on the asset side, we still want to grow parts of our asset balance sheet and some of our customer segments there. So we’ll be looking to deploy that where we see good opportunities. We’ll be very disciplined around the returns that we want to get for the deployment of that capital on the asset side. But I do see various areas to deploy, so we’re very focused on getting those. I think it’s your final part of your question. Those dynamics between what we pay for deposits versus then how we pass those pricing on to the asset side. And you can see some of that in the C&I asset book as well.

Katie, NIM?

Katie Murray: Sure. Thanks so much, Paul. And so full-year guidance for total income ex-notable items of around £14.3 billion. We don’t give you specific NII guidance. This implies that income for the fourth quarter starts to stabilize relative to the third. Our current view is NIM is greater than 3% for the full-year, which means that you would expect that the Q4 reduction is less than the Q3 reduction. When we look at the current view there’s a couple of factors you need to be keep in mind. Base rates remaining at 5.25% until the end of the year. Broadly stable deposit balances through to the end of the year as we’ve delivered this quarter and customer behavior, we do assume a slowdown in deposit migration with NIBBs at 34% and term at 17% at the year-end.

I guess, Rahul, your second part of your question is the confidence in that slowdown is very much what we’ve seen really through the last seven weeks, where you have started to see it slowing down. We do expect there to be some short-term movements as you see. People and other banks do kind of special offers at any one-time, but we’re comfortable with that kind of slowdown. So we would expect to end 34% and 17%. Thanks, Rahul.

Operator: Our next question comes from Aman Rakkar from Barclays. Aman, please unmute and go ahead.

Katie Murray: Good morning, Aman.

Aman Rakkar: Hey, good morning, Katie. Good morning, Paul. Hopefully you can hear me, okay? Could I probe on two things, please? One was around your hedge commentary. So I just wondering if you could tighten up some of the — some of your expectations around the hedge. I think you talked about hedge national being down in Q4 and into 2024. You’ve obviously given us some kind of deposit mixed expectations into year-end, which is actually really helpful. So thank you very much for that. So presumably you’ve got a pretty decent view on where you expect the kind of hedge in terms of notional to go from here. But I guess also I mean it sounded like you’re looking for it to be a tailwind into 2024 and 2025. I mean I would definitely hope that to be the case right, given the re-pricing tailwind.

So can you help us kind of quantify that? Yes. It should be a material headwind going forward. So do you see that? And then the second one was just around your medium-term aspirations. So I kind of note around the outlook statement, you continue to target medium-term royalty of 14% to 16%, but particularly around the sub 50% cost income ratio in 2025. I guess there’s two parts to that. One is, is that a proper reiteration of that medium-term aspiration? So do you continue to target a sub 50% cost income ratio or not? Do you remain confident in achieving that in 2025 or should we expect to kind of refresh to that update at full-year? And I’m kind of interested in the implied recovery in the revenue performance that inherently assumes and implies, which I think is quite important.

So if you do believe that, where is that coming from and what does it mean for NIM kind of — do you expect NIM to recover in coming quarters? Thank you very much.

Paul Thwaite: Thanks, Aman. Very clear. So let me take the kind of royalty and the guidance point, and then Katie, you can take us through the hedge. So from a royalty perspective, let’s do the guidance first for this year. We’re still very clear; we’ll be at the upper end of the range. We’re also in terms of the outlook medium to target royalty 14% to 16% that’s unchanged. We do expect to operate in that range. So very clear on that. You also correctly highlighted that the target is 2025 cost income ratio of 50%. Obviously there’s two parts to that. I think you would agree, and I hope you’d agree. We’ve got a very strong track record on cost reduction, very focused on managing costs. In my prepared statements, hopefully you heard that given the change in macro, I’ve been very focused on getting a grip on both the cost outlook and the capital outlook.

So really trying to take control on the things that we can’t control, some of the customer behaviors we can’t, obviously the economics we can’t. But I’m determined to mitigate some of those external impacts with the actions we take on costs and capital. So that’s where the guidance is for the medium-term. Obviously, it links to the first part of your question, how does the hedge flow through to that? Katie?