March 6 (The following statement was released by the rating agency)
Fitch Ratings has assigned Lloyds Banking Group Plc's (LBG, A/Stable/F1/bbb+) potential issue of perpetual subordinated contingent convertible securities (the notes) an expected rating of 'BB-(EXP)'.
The final rating is contingent on receipt of final documentation conforming to information already received.
KEY RATING DRIVERS
The notes are additional Tier 1 (AT1) instruments with fully discretionary interest payments and are subject to conversion into equity on breach of a consolidated 7% CRD IV common equity Tier 1 (CET1) ratio, which is calculated on a 'fully loaded' basis.
The securities are rated five notches below LBG's 'bbb+' Viability Rating (VR), in accordance with Fitch's criteria for "Assessing and Rating Bank Subordinated and Hybrid Securities", dated 31 January 2014. The notes are notched twice for loss severity to reflect the conversion into equity on breach of the trigger, and three times for incremental non-performance risk.
The notching for non-performance risk reflects the instruments' fully discretionary interest payment, which Fitch considers the most easily activated form of loss absorption. The issuer will not make an interest payment if the payment exceeds the maximum distributable amount or if the issuer is insolvent. The issuer will also be subject to restrictions on interest payments if it fails to meet the combined buffer capital requirements that will be phased in from 2016.
LBG's pro-forma fully loaded Basel III (FLB3) CET1 ratio was 10.3% at end-2013. This provides it with a GBP8.9bn buffer for the 7% CET1 ratio trigger. However, non-performance in the form of non-payment of interest could be triggered before reaching the 7% CET1 ratio trigger, either by breaching the combined buffer requirement (or possibly though a breach of a minimum leverage ratio). These additional regulatory requirements reduce the buffer considerably.
The combined buffer requirements will be phased in at 25% per annum from 1 January 2016. The UK regulator has also clarified that 56% of Pillar 2 requirements should be covered by CET1 capital rather than by total regulatory capital. We estimate therefore that LBG will have to maintain a CET1 ratio of at least 10%-11% by 2019. LBG has indicated that it is targeting an FLB3 CET1 ratio of around 13% before dividend distribution by end-2015.
While we expect that LBG will meet its regulatory capital expectations, additional non-performance risk is introduced by the possibility that the combined buffer requirements for LBG could change over time, and additional buffers, for instance in the form of countercyclical buffers, and time adjusted leverage ratio could be required.
Fitch has assigned 100% equity credit to the securities. This reflects their full coupon flexibility, the ability to be converted into equity, which Fitch considers core capital well before the bank would become non-viable, the permanent nature and the subordination to all senior creditors.
As the securities are notched from LBG's VR, their rating is sensitive to any change in this rating. The securities' ratings are also sensitive to any change in their notching, which could arise if Fitch changed its assessment of the probability of their non-performance relative to the risk captured in LBG's VR. This could occur if there were a change in capital management or flexibility or an unexpected shift in regulatory buffers.