REVIEW OF PERFORMANCE

Income statement

In the three months to 31 March 2022, the Group recorded a profit before tax of £1,457 million compared to £1,768 million in the same period in 2021, representing a reduction of £311 million as higher total income was more than offset by the impact of a net impairment charge for the period compared to a net credit in the first quarter of 2021. Profit after tax was £1,050 million.

Total income increased by £166 million, or 5 per cent, to £3,810 million in the three months to 31 March 2022 compared to £3,644 million in the first three months of 2021; there was an increase of £266 million in net interest income offset by a decrease of £100 million in other income.

Net interest income was £2,922 million, an increase of £266 million compared to £2,656 million in the three months to 31 March 2021. The increased net interest income was driven by growth in average interest-earning assets and deposits as well as an improved margin; the net interest margin benefited from bank base rate increases and deposit growth, offsetting mortgage book margin impacts.

Other income was £100 million lower at £888 million in the three months to 31 March 2022 compared to £988 million in the same period last year. Net fee and commission income increased to £301 million, compared to £239 million in the first quarter of 2021 due to higher card and other transaction-based income streams, reflecting improved levels of customer activity compared to the first quarter of 2021. Net trading income was £89 million lower at £91 million in the three months to 31 March 2022, in part reflecting the change in fair value of interest rate derivatives and foreign exchange contracts in the banking book not mitigated through hedge accounting. Other operating income decreased to £496 million compared to £569 million in the three months to 31 March 2021 as a result of lower gains on the disposal of financial assets at fair value through other comprehensive income.

Total operating expenses decreased by £37 million to £2,175 million compared to £2,212 million in the first three months of 2021. There was a decrease of £6 million in operating costs; the impact of staff pay increases was offset by staff number reductions and an increase in IT-related costs, as a result of the Group's strategic investment, was in part offset by increased gains on disposal of operating lease assets as a result of strong used car prices. The charge in respect of regulatory provisions was £31 million lower at £33 million and largely related to pre-existing programmes. There have been no further charges relating to HBOS Reading since the end of 2021 and the provision held continues to reflect the Group's estimate of its full liability, albeit significant uncertainties remain.

There was a net impairment charge in the quarter of £178 million, compared to a net credit of £336 million in the first quarter of 2021, largely reflecting a low incurred charge and a charge in the first quarter of 2022 as a result of revisions to the Group's economic outlook, as an improvement from unemployment assumptions and house prices was offset by additional provisions taken to capture elevated inflation risk.

Overall the Group's loan portfolio continues to be well-positioned, reflecting a prudent through-the-cycle approach to credit risk with high levels of security. The Group's expected credit loss (ECL) allowance remained stable in the first three months of the year at £4,060 million (31 December 2021: £4,000 million). The Group continues to retain £0.7 billion of net management judgements in respect of coronavirus (31 December 2021: £0.8 billion); within this, the Group has maintained its central adjustment of £0.4 billion to recognise the downside risks outside of the base case conditioning assumptions. As noted above, additional judgements have been raised to capture the increased risk of inflation and impact on the cost of living, with a further £0.1 billion added in the quarter, largely within the segments of the Retail book that are considered less resilient to disposable income shocks.

REVIEW OF PERFORMANCE (continued)

Following changes in credit risk measurement and modelling associated with CRD IV regulatory requirements during the quarter, the Group has amended its definition of Stage 3 for UK mortgages to maintain alignment between IFRS 9 and regulatory definitions of default. Default continues to be considered to have occurred when there is evidence that the customer is experiencing financial difficulty which is likely to significantly affect their ability to repay the amount due. For UK mortgages, this was previously deemed to have occurred no later than when a payment was 180 days past due; in line with CRD IV this has now been reduced to 90 days, as well as including end-of-term payments on interest-only accounts and all non-performing loans. Overall ECL is not impacted as management judgements were previously held in lieu of these known changes, however they result in £0.1 billion of ECL moving from Stage 1 and 2 to Stage 3 with £1.5 billion of additional assets in Stage 3. These changes also lead to £7.4 billion of additional assets moving to Stage 2 given the consequential change in approach to the prediction and modelling of up to date accounts and their likelihood of reaching the new broader definition of default in the future. Given these are up to date accounts with low probability of default that are moving to Stage 2, there is no material ECL impact. Absent this definitional change, the sustained low levels of new to arrears observed means that mortgage accounts that are classified as Stage 2, due to being in early arrears, have reduced slightly in the quarter.

The Group recognised a tax expense of £407 million in the period compared to £485 million in the first three months of 2021. On 2 February 2022, the UK Government substantively enacted a change in banking surcharge from 8 per cent to 3 per cent with effect from 1 April 2023. As a result of rate changes, including the impact of the surcharge reduction, the Group recognised a £12 million deferred tax charge in the income statement and a £69 million credit within other comprehensive income, increasing the Group's net deferred tax asset by £57 million.

Balance sheet

Total assets were £28,131 million, or 5 per cent higher at £630,980 million at 31 March 2022 compared to £602,849 million at 31 December 2021. Cash and balances at central banks rose by £28,536 million to £82,815 million reflecting the placement of funds from increased available liquidity. Financial assets at amortised cost were £1,566 million higher at £491,882 million at 31 March 2022 compared to £490,316 million at 31 December 2021, as a result of a £2,041 million increase in loans and advances to customers, net of impairment allowances, and £1,455 million in debt securities, offset by a £1,740 million decrease in reverse repurchase agreement balances. The increase in loans and advances to customers, net of impairment allowances was driven by continued growth in the open mortgage book, partially offset by further reductions in the closed mortgage book. Other assets increased £2,657 million due to a £1,579 million increase in retirement benefit assets as a result of significant accelerated pension contributions in the period and a £509 million increase in current tax recoverable. Financial assets at fair value through other comprehensive income were £4,191 million lower at £23,595 million as a result of sales during the period.

Total liabilities were £28,297 million, or 5 per cent higher at £590,374 million compared to £562,077 million at 31 December 2021. Customer deposits increased by £4,586 million, or 1 per cent, to £453,959 million compared to £449,373 million at 31 December 2021, as a result of continued inflows to retail current and savings accounts and commercial deposits. Repurchase agreements at amortised cost increased £16,414 million to £46,520 million, as the Group took advantage of favourable funding opportunities and debt securities in issue increased by £6,415 million reflecting issuances of commercial paper and certificates of deposit. Subordinated liabilities decreased by £2,040 million following redemptions during the period.

Ordinary shareholders' equity decreased £155 million to £36,255 million at 31 March 2022 as retained profit for the period and positive actuarial remeasurements in respect of the Group's post-retirement defined benefit schemes were more than offset by negative movements in the cash flow hedging reserve.

REVIEW OF PERFORMANCE (continued)

The Group's operations are predominantly UK-based with no direct credit exposure to Russia or Ukraine. The Group does have credit exposure to businesses that are impacted, either directly or indirectly, by higher energy costs or commodity prices, or potential disruption within their supply chains. Such activity is monitored through prudent risk management. The Group continues to monitor and analyse carefully key internal and external indicators for signs of contagion risk and any second or third order risks that may arise from the war in Ukraine above and beyond those captured in the macroeconomic outlook. Investigations so far have not revealed any significant risks, although the Group remains vigilant and proactive risk mitigation is undertaken as appropriate to ensure that it supports clients, including those in financial difficulty, whilst protecting its portfolios.

Capital

The Group's common equity tier 1 (CET1) capital ratio reduced from 16.7 per cent at 31 December 2021 to 14.1 per cent on 1 January 2022, before increasing during the quarter to 14.5 per cent¹ at 31 March 2022. The reduction on 1 January 2022 reflected the impact of regulatory changes, including an increase in risk-weighted assets as well as other related modelled impacts, in addition to the reinstatement of the full deduction treatment for intangible software assets and phased unwind of IFRS 9 transitional relief. The subsequent increase during the quarter reflected profits for the period and a reduction in risk-weighted assets, partly offset by accelerated pension contributions.

The total capital ratio reduced from 23.5 per cent at 31 December 2021 to 20.0 per cent¹ at 31 March 2022.

Risk-weighted assets increased from £161.6 billion at 31 December 2021 to around £178 billion on 1 January 2022, before reducing during the quarter to £175.4 billion at 31 March 2022. The increase on 1 January 2022 reflected the impact of regulatory changes, including the implementation of new CRD IV models to meet revised regulatory standards for modelled outputs and a new standardised approach for measuring counterparty credit risk (SA-CCR) following the UK implementation of the remainder of Capital Requirements Regulation (CRR) 2. The subsequent reduction in risk-weighted assets during the quarter was largely driven by optimisation activities and model recalibrations, partially offset by the growth in balance sheet lending.

The UK leverage ratio reduced from 5.3 per cent at 31 December 2021 to 5.1 per cent¹ at 31 March 2022.

¹        Incorporating profits for the quarter that remain subject to formal verification in accordance with capital regulations.