NatWest Group plc (NYSE:NWG) Q4 2022 Earnings Call Transcript

NatWest Group plc (NYSE:NWG) Q4 2022 Earnings Call Transcript February 17, 2023

Operator: Good morning and welcome to the NatWest Group Annual Results 2022 Management Presentation. Today’s presentation will be hosted by Chairman, Howard Davis; CEO, Alison Rose; and CFO, Katie Murray. After the presentation, we will open up for questions. Howard, please go ahead.

Howard Davies: Good morning, everyone. And thank you for joining Alison and Katie and me for our full year 2022 results presentation. Against a difficult and uncertain backdrop with at times turbulent financial markets, NatWest Group delivered a strong financial performance in the year. We achieved continued growth in our lending and further progressed against our strategy. In addition, the government shareholding fell below 50% for the first time since the financial crisis. They have continued to sell in the market and their stake is now well below 44%. While the majority stake in itself had no material effect on the way the bank operates, and the government did not and does not interfere in our commercial decisions. It was an important milestone, underlining the progress we have made in recent years.

The outlook for this year remains challenging, with a decline in economic activity expected and a further tightening of real incomes, which will inevitably affect spending and borrowing. But our strong financial performance continued capital generation and robust balance sheet mean that we nonetheless look forward with confidence. Our strong capital position also allowed us to continue lending through the pandemic, while investing to create a simpler and better banking experience for our customers. And delivering on our purpose about which Alison will say more shortly. I’m confident that the bank strategy will ensure we can continue to support all of our stakeholders and to deliver sustainable growth and returns in the years to come. With that, I’ll hand over to Alison, who will take you through our results and our future priorities in more detail.

Alison Rose: Thank you, Howard, and good morning. I will start with a business overview and our priorities going forward before Katie takes you through the bank’s performance for 2022. We will then open it up for questions. You can see the strength and resilience of our business and the results we are announcing today. In a difficult macroeconomic environment, we remain well-positioned as a result of our strong customer franchise, disciplined risk management, and robust balance sheet as we continue to support customers in order to generate growth. So let’s start with the highlights. We delivered operating profit for the full year of 5.1 billion up 34% on the prior year, with attributable profit of 3.3 billion. Our return on tangible equity was 12.3% up from 9.4% in 2021.

We are reporting income of 13.1 billion and we have continued our tight cost discipline, reducing expenses by 2.9% in line with our target. This resulted in a much-improved cost income ratio of 55.5% down from 70% for 2021. During the year, we distributed or accrued a total of 5.1 billion for shareholders, which comprised 1.3 billion in ordinary dividends above our committed distribution of at least £1 billion. A special dividend of 1.75 billion announced at the half year. The directed buyback of 1.2 billion completed last March and our third on market buyback announced today of 800 million. As a result, our common equity Tier-1 ratio at the year-end was 14.2% in line with our target. We have made excellent progress on the strategic priorities we set out three years ago.

Despite the disruption caused by a global pandemic and the Russian invasion of Ukraine, we have remained focused on supporting our customers and delivering on our commitments. We have delivered organic growth as we improve both our offering and service for customers. We have maintained tight cost discipline yet continued to invest for the future in our digital transformation. We have refocused our markets business and made significant progress on our phased withdrawal from Ulster Bank Republic of Ireland. So we are now much more capital efficient. This has delivered an excellent outcome for shareholders with very significant distributions and a return on tangible equity of 12.3% well above our initial target. In an uncertain economic environment, our strong balance sheet, high-quality deposit base and disciplined risk management continued to give us a competitive edge.

Whilst arrears are currently broadly stable, we are very aware of the pressures that customers face as a result of high inflation, a steep increase in energy prices and a challenging macroeconomic environment. The strength of our balance sheet evidenced here by our capital leverage and liquidity ratios, together with the quality of our loan book, which is almost all secured in personal lending with prudent loan to value ratios make it possible for us to continue supporting customers and the U.K. economy through difficult times. Given the uncertain economic outlook, our purpose led strategy has never been more relevant. We have continued to support customers by lending responsibly and helping them save for the future with lending across our three business segments up 6.7% year-on- year.

We have also proactively contacted customers with advice on managing the cost of living, carrying out free financial health checks, delivered hardship funding through charities and offered targeted support such as forbearance for those in need. Our colleagues face the same challenges as our customers. So we have supported them with targeted pay rises for the lowest paid, as well as enhanced parental leave, and ongoing training and development. Three years ago, I outlined four strategic priorities designed to achieve sustainable returns for shareholders. So I’d like to update you on our progress since then. By supporting our customers across every stage of their lives, we have continued to grow organically and built on our strong franchise. Customers want a bank that is easier to deal with.

So we have invested in digital transformation to simplify our processes and improve customer journeys at the same time as reducing costs and increasing efficiency. For example, 72% of new retail accounts were opened with straight through processing in 2022 compared to just 14% in 2019. 88% of retail customer needs were met digitally and over 60% of our retail customers are now digital only. We’re also using data analytics more effectively. So around 12 million personalized messages were acted on by customers last year, up nearly 40% on 2021. All of this has significantly improved customer satisfaction. Since 2019, our retail net promoter score has increased from 4 to 22. Our affluent net promoter score has gone from minus 2 to 25. And we have the leading Net Promoter Score for commercial banking in the U.K. at 22.

We also set out to deploy capital more effectively within a culture of strong risk management. We have reduced our RWA density from 53% to 47%. And by refocusing NatWest markets and making significant progress on our phased withdrawal from Ulster Bank Republic of Ireland. We have decreased RWA’s by 20.8 billion within these entities. We actively manage risks by maintaining a well-diversified loan book where we monitor at risk sectors closely. Our focus on driving innovation and developing strategic partnerships is enabling us to offer customers a wider range of services. As the leading commercial bank in the U.K., we are proud of our digital only business bank Mettle, which now serves 44,000 customers. And we’re building out a comprehensive payments proposition for our commercial customers, which includes our payment provider Tyl and a platform using the U.K.’s open banking infrastructure called Payit.

Our new strategic partnership with Vodeno Group is just one example of how we’re accessing the expertise of others, and combining it with our own to deliver innovation by putting Vodeno’s technological capabilities and cloud platform together with banking technology developed by Mettle, we aim to create a leading U.K, banking-as-a-service business. In short, we are now serving existing customers better and gaining new ones as a result of our focus on deepening relationships, digital transformation, and the provision of a wider range of innovative services. I’d like to move on now to our plans moving forward. Over the past three years, we have successfully delivered our transformation. This is now a simpler organization that is more focused, more capital efficient and easier for our customers to interact with.

The purpose and priorities we set out three years ago will not change. We will continue to be a purpose-led helping our customers to thrive, to focus on becoming a simpler organization that is highly cost efficient, to allocate our capital and resources on areas that generates the best returns for shareholders, and to advanced digitization, as well as foster innovation through strategic partnerships to better serve our customers. But we are shifting our investment over the next three years more towards growth. And we are now focused on further acceleration. First, by increasing our personalized engagement with customers at every stage of their lives, we’ve shown that we can generate value for both customers and shareholders by deepening relationships.

Second, by leveraging our competitive edge as a leading U.K. provider of renewable financing, to support customers in their transition to a net zero economy. And third, by further embedding our services into customers digital lives, our customers spent more time online than ever before, and we have to be where they are. We are doing all this to deliver sustainable growth and diversification of income as we participate in areas which are set to outgrow traditional banking revenue pools. So let me give you some examples in each of our businesses. In retail banking, we start from a strong position with 17 million customers, strong net promoter scores, and a growing share in mortgages and credit cards. We have capacity to grow further by driving higher levels of engagement and enhancing our customer proposition.

For example, we are strengthening our youth and family offering to build on the success of our RoosterMoney acquisition, which helps young children manage money. Last year, we connected Rooster with our own app, which resulted in 90,000 new card openings during the year. We know that customers who join us in childhood have greater lifetime value than those who join us as adults, and that when we serve a full family, parents become more valuable. Supporting households to act on energy efficiency is not just an essential part of making a transition to a net zero economy, but also commercially valuable. That’s why we are funding a green home retrofit pilot helping customers to decide what improvements they need to make. And then financing solutions such as insulation upgrades, heat pumps and solar panels.

Our green mortgages offer a discounted interest rate to customers who buy a property with an energy efficiency rating of A or B. As part of our ambition to provide £100 billion of climate and sustainable funding and financing, we aim to make at least £10 billion of lending available for homes with these ratings by the end of 2025. Helping homeowners to improve energy efficiency and reduce emissions. Further embedding our services in our customers digital lives, allows us to improve both customer experience and our own efficiency. A good example of this is our digital-only mortgages. We were the first U.K. bank to offer a paperless mortgage, so that the offer can be made within 24 hours. This has completely transformed the process of buying a property as well as increased our market share and we are building on this success to grow our share further.

We will also support financial well-being by extending our free credit score service which is currently available just for our own customers to everyone in the U.K. One of the major changes we have made in our private bank is making better use of our asset management expertise to serve our customers more effectively across the Group. This has enabled us to grow assets under management to 33.4 billion since 2019, delivering a strong performance despite significant macroeconomic challenges, with 6.5 billion of net new money and a 60% increase in digital net new money. We saw new customer inflows of 5% into our private bank in 2022 of which a fifth were referrals from other parts of the Group. And we see a significant opportunity to grow assets under management further by increasing the number of referrals.

We also plan to scale our wealth offering which includes not just investing but also saving, lending and financial planning. We want to help more people invest sustainably and have set a target for our own discretionary funds to achieve net zero by 2050. And as we continue to embed our services and customers digital lives, we’re enhancing and expanding our digital investment platform, NatWest Invest. This week, we have also announced our intention to acquire a majority stake in FinTech Cushion. This allows us to enter the workplace savings and pension market, which is expected to double in size to well over a £1 trillion by 2031. After a successful pilot last year, we plan to extend their offering to our commercial customers in order to improve financial well-being as well as drive long-term fee income.

Last year, we created a new business segment bringing together commercial and institutional banking. This is now a less capital intensive business, helping to extend our expertise in foreign exchange, interest rate management and capital markets to more commercial customers. As we look to the future, we plan to continue growing our share in startups and high growth businesses. We are the number one U.K. high street bank for startups with a share of 16.4%. Last year, we opened 99,000 new startup accounts, almost 40% of which were via Mettle. This is supported by our regional network of free accelerator hubs, which offers a program specifically tailored to high growth businesses. And we also plan to launch a new enhanced trade finance platform to meet more customers international needs.

We have an important role to play in helping our business customers transition to a net zero economy. We are already a leading underwriter and provider of renewable financing in the U.K., and we have delivered over £27 billion of climate and sustainable funding and financing towards our £100 billion target. We have led a collaboration with other banks to launch carbon place, the world’s first marketplace for carbon offsets. And we are rolling out the NatWest carbon planner launched last summer, which is a free platform to help SMEs reduce their carbon footprint. Good examples of embedding our services in customers digital lives included building out our comprehensive payments proposition delivered through Tyl and Payit as well as extending our foreign exchange offering via digital channels.

At the same time as focusing on targeted growth, we will continue our strong track record of discipline cost management and investment. Since 2020, we have made an 18-percentage point improvement in our cost income ratio. We are targeting a ratio below 52% this year, and less than 50% on a sustainable basis by 2025. We are now two years through our 3 billion investment program with a significant proportion going into our digital transformation. We expect to invest in the region of 3.5 billion over the next three years. But you can see the mix of spend change as our digital transformation advances. We will also continue to deploy capital effectively across the business. You can see here how our allocation of capital has changed since 2019, with a reduction of RWA’s in commercial and institutional and Ulster Bank, Republic of Ireland and an increase in the retail bank.

This more effective deployment of capital, combined with our strong capital generation has enabled us to support our customers in difficult times, as well as invest for growth, consider other strategic options and make shareholder distributions of almost £11 billion since 2019. By continuing to deliver targeted growth, to manage cost in a disciplined manner and to deploy our capital effectively, we plan to operate with a CET1 ratio of 13% to 14% over the medium term and deliver a sustainable return on tangible equity of 14% to 16%. We expect to generate and return significant capital to shareholders in 2023. And intend to maintain our payout ratio of 40% with the capacity to deploy any excess capital by making additional buybacks. Thank you very much.

And I’ll now hand over to Katie to take you through our full year performance in detail.

Photo by Clay Banks on Unsplash

Katie Murray: Thank you, Alison. I’ll start with performance in the fourth quarter using the third quarter as a comparator. Total income increased 14.8% to £3.7 billion. Income excluding all notable items was 3.8 billion up 10.9%. Within this net interest income was up 10.2% at £2.9 billion, a non-interest income was up 13.2% at 857 million. Operating expenses rose 12.8% to 2.1 billion including Ulster exit costs, and the annual U.K. bank levy. The impairment charge decreased to 144 million or 16 basis points of loans. This brings the full year charge to 9 basis points in line with our guidance of less than 10. Taking all of this together, we delivered operating profit before tax of 1.4 billion. Profits attributable to ordinary shareholders was 1.3 billion after the benefit of differed and other tax credits.

And return on tangible equity was 20.6%, including six percentage point benefit from tax credits. Before I take you through our performance in more detail, I’d like to share some of our assumptions about the economic outlook on my next slide. We will show you here our current expectations for interest rates and economic activity. Clearly, the backdrop of low economic growth and high inflation makes us a challenging time for our customers. There are some signs that inflation peaked in October last year, though it remains high at around 10%. Our base case assumption is that inflation will fall to the Bank of England 2% target by mid-2024, resulting in interest rates reducing from the second quarter of that year to 3.25% by the year end. We have not modeled any further rise in interest rates beyond the Bank of England’s decision earlier this month to increase them to 4%.

It is also worth noting that we assume the five-year swap rate will steadily decline from 3.6%, averaging 3.3% over 2023. This is important for the rollover of our hedge positions, which I will talk about later. All in, our outlook is aligned to the consensus of forecasts from economists with both upside and downside risks. We will monitor and react to market conditions as they develop during the year. However, we are pleased that the macroeconomic environment has stabilized since we spoke at Q3 and we note the improved outlook from the Bank of England this month. I’d like to move on now to net interest income on Slide 19. Strong momentum continued as net interest income increased 10.2% to 2.9 billion. This was the result of higher lending volumes with growth across all three businesses and higher margin.

We also incurred a one-off £41 million impact from the redemption of legacy debt in line with our disclosure in December. Net interest margin excluding notable items increased 26 basis points to 325. Wider deposit margins added 44 basis points reflecting the benefits of higher U.K. base rates, which increased by 125 basis points in the quarter, net of pass-through to our customers and higher swap rates on our structural hedge. This was partly offset by a 10-basis point reduction as a result of lower mortgage margins on the front book and a 2-basis point reduction from commercial and institutional fixed rate lending. Net interest margin for the full year of 285 basis points is in line with our guidance of more than 280. If the current U.K. base rate remains at 4% throughout 2023, we expect NIM to average around 320 basis points for the full year.

This takes into account the run rate benefit of recent base rate increases net of further pass-through to customers. The reinvestment of the hedge into higher swap rates, lower front book mortgage margins, the reduction in deposits towards the end of 2022 and further mix changes in deposits. Average interest earning assets increased by 1.5% in the quarter to 355.8 billion driven by higher lending. The future impact of these assets on NIM is dependent on lending volumes, since they do not include the liquid asset buffer. Turning to loans on the next slide. We’re pleased to have delivered a strong year of balanced growth across the Group. Gross loans to customers across our three businesses increased by 6.7% or 21.9 billion to 350 billion year-on-year, of which 3 billion was in the fourth quarter.

Taking retail banking together with private banking, mortgage balances grew by 4.7 billion or 2.4% in the quarter. Gross new mortgage lending for the full year was a record £45 billion, representing flow share of 14%. Combined with good retention this resulted in our stock share growing from 11.8% at the end of 2021 to 12.3% at the end of 2022. Unsecured balances increased by a further 200 million in the quarter to 14.2 billion, driven by higher spending on credit cards. In commercial and institutional, gross customer loans decreased by £2 billion. This was driven by continued repayment of government lending schemes, which reduced by 1.4 billion in the quarter and 3.4 billion over the year. Within this, mid-sized corporates increased borrowing by £1 billion, driven by working capital demands and asset financing.

This was offset by net repayments from large corporate and institutional customers, reflecting usual year-end balance sheet management. I’d like to turn now to deposits on Slide 21. Customer deposits across the Group were 450 billion at the end of 2022 down 4.8% in the quarter. This includes a reduction of 5.1 billion in Ulster Bank, as customers moved to other banks as planned. Across our three businesses, deposits amount to 433 billion, over 80 billion more than loans, resulting in a loan to deposit ratio of 80%. During the fourth quarter deposits reduced by £15 billion of which 12 billion was in commercial and institutional. When I look at this 12 billion one-third was the result of typical year end movement, including a reduction in system liquidity.

Another third was caused by lower foreign currency balances as a result of market volatility. And the final third was balanced attrition, where we took the decision not to compete aggressively on price for balances with low margin and low liquidity value, given our strong funding and liquidity position. Across retail banking, and private banking deposits were down £3.5 billion as a result of lower current account balances in line with trends across the U.K. banking sector. Around 60% of our deposits are interest bearing and 40% are non-interest bearing in line with the third quarter and prior years. Within interest bearing balances, there is some migration from instant access to term accounts, which is positive from a relationship perspective, but clearly has an impact on deposit margins.

We launched a new fixed term savings product for retail customers in January to meet rising demand and this is going well. We remain competitive across our customer savings rates and continue to pass-through higher interest rates, including recent pricing decisions after the base rate increased to 4%. Our cumulative pass-through is now around 35% across interest bearing deposits, up from 25% to 30% in Q3. As I said earlier in our current modeling, there are no further base rate increases from here, and we expect rates to start coming down in the second quarter of 2024. Our disclosures show the third-party funding rate for all three businesses, which reflects the average cost of all deposits, including those that are non-interest bearing. Here you will see that the rise in customer deposit rates as lagged the increase in base rates.

The outlook for customer deposit rates will be a function of customer behavior as well as competition. We expect the average cost of customer deposits to continue trending higher in the coming quarters as a result of recent pass-through decisions as well as a change in mix as customers move to term and higher yielding accounts though the pace of this change is clearly uncertain. Turning now to our structural hedge on Slide 22. As you know, we hedged the majority of our current accounts and a smaller proportion of our instant access savings. From deposit balances totaling 450 billion, 184 billion are included in the product structural hedge. The notional amount was stable during the quarter. Given the reduction and mix change of deposits in Q4, we do not expect to reinvest all the balances maturing during 2023, which is approximately 40 billion.

As we show in the chart before we consider reinvestment, product hedges already written will deliver income of £2 billion in 2023. In addition to this, you should consider the reinvestment yield available with five-year swaps. We model an average reinvestment yield of 3.3% for 2023 compared to a rate of 3.75% today and relative to an average redemption yield of around 1.1%. The volume of hedges that are reinvested will be a function of both the flow and the mix of deposits. If there are no change to year-end deposit volumes or mix, we would expect the product hedge notional to reduce by 5 billion over the course of the next 12 months. I’d like to turn now to non-interest income on Slide 23. Non-interest income excluding notable items was 857 million, up 100 million on the third quarter.

This was driven by fees and commissions, which increased 62 million, 650 million due to higher lending fees. Increased investment fee income and the end of our no fee foreign exchange offer for retail customers. Looking back over the full year, we are pleased that non-interest income increased 19% year-on-year to 3.2 billion. There was a more stable trading performance following the completion of our markets restructuring and net fees and commissions grew 8% as a result of increased customer activity, combined with the impact of inflation on nominal spending. Going forward non-interest income will be influenced by economic activity and customer confidence as you would expect. I’ll summarize our income performance and outlook on the next slide.

2022 income excluding notable items was 13.1 billion, up 3 billion or 30% year-on-year. This exceeded our expectations largely due to our strong lending performance and the pace of interest rate increases, which resulted in net interest margin of 285 basis points. In 2023, we expect Group income excluding notable items to grow about 13% to around 14.8 billion with net interest margin of about 320 basis points. This is modeled on the assumption of a stable U.K. base rate of 4% throughout the year, with full run rate benefits into the second quarter. Income will also be driven by the positive impact of our hedge reinvestment, the negative role on mortgage refinancing, volume and mix development across the balance sheet, as well as consumer and market activities.

Turning over to costs on Slide 25. Other operating expenses for the Go-forward Group was 6.6 billion for 2022. That’s down 201 million or 2.9% on the prior year, in line with our guidance. This was driven by continued automation of customer journeys. I’m going to break down our cost guidance to give you full transparency on this and our ongoing tight management of expenses. Now that Ulster is in sent items, we start with 6.6 billion for 2022. We incur 221 million of Ulster indirect costs, which we expect to reduce over time but as these costs are shared, they will not disappear entirely. This takes us to 6.9 billion. Ulster direct costs of 433 million include 195 million of exit costs, most of which was booked in the fourth quarter. This brings us to Group other operating expenses of 7.3 billion as per the income statement.

Turning now to 2023 costs on the next slide. We start with 6.9 billion of operating expenses for 2022 excluding Ulster direct costs. Acquisitions include the impact of both Vodeno and Cushion which we announced this week. So pro forma for acquisitions 2022 costs are around 7 billion, which I view as the business-as-usual cost base of the Group. In 2023, we expect this to grow by around 5% to 7.3 billion, and with another 300 million of Ulster direct costs, this takes us to an expected Group, other operating expenses of £7.6 billion. We also expect a further improvement in operational leverage with a reduction in the cost income ratio from 56 to below 52% for the year. Litigation and conduct costs totaled 385 million for 2022. And we expect them to be broadly in line with this in 2023.

So as you know these costs can fluctuate. So let me tell you more about the drivers of costs in 2023 on Slide 27. Staff costs represent around half our operating expenses, a further 23% are admin costs with the remainder being property and depreciation. In 2023, we expect other operating expenses to increase 4% on a reported basis to around 7.6 billion, including reduced Ulster direct costs. This increase is driven by staff and admin costs. We manage salary costs carefully and will continue to do so. Staff costs were broadly stable in 2022, as the impact of a 3.6 pay award, and the cost-of-living support was offset by lower average headcount. In 2023, the average pay award is 6.4% effective from April. And in addition, we made one-off payments of around £60 million to staff in January to support ongoing cost of living pressures.

Admin costs increased 8% in 2022, as a result of strategic investment in data and financial crime prevention. We are now seeing higher inflation feed through into supplier contract renewals, which is the main driver of growth in 2023. We expect premises and equipment costs to be broadly stable this year, and for depreciation and amortization to increase slightly as a result of higher investments. I’d like to turn now to talk to credit risk on Slide 28. We have a well-diversified prime loan book. Over 50% of our Group lending consists of mortgages where the average loan to value is 53%, or 69% on new business. Overall, we have low levels of arrears and forbearance in our mortgage book. 92% of our book is at a fixed rate, 4% of trackers, and 4% is on standard variable rates.

Two-thirds of mortgage balances are on five-year fixed rates and a quarter or two year, 17% of the book is interest-only, most of which is our buy to let book with the rest concentrated in our private bank. 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 we have brought down concentration risk over the past decade. For example, our commercial real estate exposure represents less than 5% of Group loans with an average loan to value of 47%. Whilst, we have a well-diversified high quality loan book, with low level of defaults, we are mindful of the economic uncertainty. So let me tell you how we have addressed this on Slide 29. We have four economic scenarios where we have updated our forecasts and relative weightings.

For 2023, this has driven a slight improvement in our weighted average expectations for GDP, but a deterioration in levels of employment, which are the two key drivers of expected loss. In terms of sensitivity 100% waiting to the extreme downside scenario would increase Stage 1 and 2 expected credit loss by a further £1.6 billion, or around 40 basis points of loans. In this scenario, Stage 3 expected credit loss would also increase. Though this is not modeled here. The net effect of changes to economic forecasts in the fourth quarter is an increase of 171 million in the Good Book expected credit loss provisions. Overall, expected credit loss reduced during 2022, reflecting the face withdrawal of Ulster Bank, stable trends in portfolio performance and a related net release of post model adjustments and write-offs.

The post model adjustment for economic uncertainty decreased by 193 million in the fourth quarter to 352 million. We continue to be cautious on the release of these provisions, as we have yet to see the full impact of economic and cost of living challenges play out. Turning now to look at impairments on Slide 30. We reported a net impairment charge of 144 million in the fourth quarter, equivalent to 16 basis points of loans on an annualized basis. This took our charge for the full year to 337 million equivalent to 9 basis points of loans. You can see that our impairment charge has largely been driven by unsecured lending and commercial property where we have relatively small exposures. You will also see that our ECL coverage of unsecured and property exposures compares favorably with pre-COVID levels.

As you know our through the cycle impairment guidance is 20 to 30 basis points. And I continue to see this as an appropriate level for 2023. Given both the economic outlook and relatively benign trends in our book, Turning now to look at capital and risk weighted assets on Slide 31. We ended the fourth quarter with a common equity Tier-1 ratio of 14.2% down 10 basis points on the third quarter. We generated 59 basis points of capital from earnings. This was a net of deferred tax credits, which are not recognized in CET1 capital and changes to IFRS 9 transitional relief. This was offset by accruals for shareholder distributions of 79 basis points, which includes the impact of the 800 million in market buyback that we have announced the day before 45 basis points and final pension accrual of 5 basis points.

Given the strong funding position of the pension fund, we have reached agreement not to make a final 500 million cash payment in 2023. But have set it aside in case of future needs, which we view as a low probability. We do not expect any further capital deductions for pension contributions going forward. RWA’s decreased by 2.4 billion due to lower counterparty credit risk and market risk, partly offset by 0.4 billion increase in credit risk. Our phased withdrawal from the Republic of Ireland delivered a further reduction of 2.6 billion as the majority of the residential mortgage portfolio was transferred to permanent TSB. Procyclicality has remained positive throughout 2022, leading to a total RWA reduction of 4 billion, of which 0.5 billion was in the fourth quarter.

Changes in risk weightings are typically driven by events that increase the probability of default. So we would need to see an increase in defaults and Stage 3 charges before RWA’s are meaningfully impacted. We expect a normalization of risk parameters in our medium term RWA guidance. And we anticipate an increase in RWA’s of 5% to 10% between the end of 2022 and 2025, which includes possible procyclicality and the day one impact of Basel 3.1. Turning now to our balance sheet strength on Slide 32. Our CET1 ratio of 14.2% is moving towards a range of 13% to 14% as planned. Our U.K. leverage ratio of 5.4% increased from 5.2% at Q3 and remains well above the Bank of England minimum requirements. Our liquidity coverage ratio of 145% is down from Q3 due to higher lending across our three businesses, and the reduction in surplus deposits.

And we maintained strong liquidity levels with a high-quality liquid asset pool and stable diverse funding base. Headroom above our minimum is 52 billion. Turning to guidance on my final slide. In 2023, we expect income excluding notable items to be around 14.8 billion. Net interest margin of about 3.2% and Group operating costs excluding litigation and conduct to be around 7.6 billion, delivering an improvement in the cost income ratio to below 52%. We anticipate a loan impairment rate in the range of 20 to 30 basis points. And together we expect this to lead to a return on tangible equity of 14% to 16% and to be the upper end of this range. As Alison said earlier, we expect to return significant capital to shareholders in 2023. And we also have permission from the PRE to participate in a directed buyback from the U.K. Government of up to 4.99% of issued share capital.

And with that, I will hand back to Alison.

Alison Rose: Thank you, Katie. As I look back over the past three years, I think it’s fair to say that we have dealt with the shock of a global pandemic, the invasion of Ukraine and economic uncertainty by remaining focused on supporting our customers and delivering our strategic objectives. We now have a simpler, more capital efficient organization, which is benefiting from digital transformation and growing customer franchises. We have met our targets by growing income, reducing costs and making significant shareholder distributions which has helped us to achieve our 2022 target CET1 ratio of 14.2%. As we continue to focus on delivering long-term sustainable value for shareholders, we are investing in growth in three ways; by accelerating our engagement with customers at every stage of their lives; by supporting customers in their transition to a low carbon economy; and by further embedding our services into customers digital lives.

We expect to operate with a CET1 ratio of 13% to 14% over the medium term, and to return significant capital to shareholders in 2023 with a payout ratio of 40% and with capacity for additional buybacks. By building on our strong customer franchise, and continuing to deliver targeted growth, to manage cost in a disciplined manner, and to deploy our capital effectively, we plan to deliver a sustainable return on tangible equity of 14% to 16% over the medium term. Thank you very much. And we’ll now open it up for questions.

See also 12 Countries that Make the Best Whiskey and 16 Largest Photography Companies in the World.

Q&A Session

Operator: We will take our first question from Raul Sinha of JPMorgan.

Raul Sinha: The first one is on NII and kind of your NIM assumptions. Thank you very much for the long list of assumptions that you’ve made. They do look very conservative. I guess the one question I have related to your assumptions is around the deposit pass-through. I think you’ve talked about 35% so far on interest bearing balances. Can I ask what you might have assumed on that going forward? And I guess related to that, perhaps Alison, if I can ask you, at the Treasury Select Committee meeting, you talked about how 80% of your depositors had less than £5000 in their accounts? Can I ask about the customer behavior for the remaining 20%? Are you seeing elevated levels of switching amongst people with higher deposits? And do you expect that to be a driver?

Then related to that, if I can ask on the NII medium term. Just to try and understand given your rate assumptions, you obviously expect rate cuts from 2024? Should we assume that NII follows the direction of interest rates medium term? Or do you think that some of the positive drivers like the structure hedge, the growth in your loan book and unsecured could offset and you end up with a more flat outcome more medium term on NII? Thanks.

Alison Rose: Great. Thank you very much. So I’ll let Katie pick up some of those. Let me pick up the points around customer deposits and what we’re seeing. Look, I think we’ve got strong capital and funding levels, what we’ve focused on, particularly on consumers, is helping build the savings habits so that 80% of customers with less than £5000 in their deposit accounts, we’ve really targeted something called our digital regular saver on that. And building sort of saving habits that the balance between our NIBs and NIBs remained broadly stable, which is what we’re seeing from a behavioral perspective. And then, in terms of competitive products, we’ve offered some fixed term products out to our consumers around the 3% to 4%.

And we’ve seen good uptake on that which remain competitive. So broadly, we’ve seen customers engage a little bit more in their financial capability and management of their deposits. But NIBs and NIBs broadly stable, we’ve got competitive products, and were targeting regular savings. We’re not seeing any shift in customer relationships, and the liquidity value of outflows have been very low. Katie, do you want to pick up the NIM assumption on pass-through?

Katie Murray: Yes, sure. Absolutely. So as we look at the pass-through MPC, obviously, we’re at 35%. Just now we give you the structural hedge sensitivity in terms of that, that works, as you know, on a static balance sheet, but that — it worked on a 50% pass-through. I think that’s probably a good kind of proxy to go through. As we go into 2024 and that kind of drivers that you’re thinking of there. I think we would expect similar kind of drivers. You can see in our economics, that the rate does start to fall off at the end of Q1. So hit kind of from Q2. I would say, it’s clearly some uncertainty of how rates do evolve in that time, but we do see benefits coming through on this structural hedge. In our assumptions, I talked about — in my speech about 3.3, 3% is the average.

If you look at your five-year swap rate, today, it’s a little bit higher. that will give you a little bit of a benefit as you move through from year-to-date. And then obviously, mortgage headwinds and what happens to them as we move from ’23 and into 2024 will be a bit of a movement as well. Hope that helps a little bit, Raul.

Operator: Our next question comes from Alvaro Serrano of Morgan Stanley.