Liquidity and funding risk

Definition (audited)

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.

• Risk appetite (audited)

  Liquidity and funding risk appetite for the banking businesses is set by the Board and reviewed on an annual basis. This statement of the Group’s overall appetite for liquidity 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. It is reported through various metrics that enable the Group to manage liquidity and funding constraints. The Group 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.

• Exposure (audited)

  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 (audited)

  A series of measures are used across the Group to monitor both short and long term liquidity including: ratios, cash outflow triggers, wholesale funding maturity profile, early warning indicators and stress test survival period triggers. The Board approved liquidity risk appetite links a number of these measures to balance sheet progression set out in the group funding plan, with regular reporting to the Board. Strict criteria and limits are in place to ensure highly liquid marketable securities are available as part of the portfolio of liquid assets.

  Details of contractual maturities for assets and liabilities form an important source of information for the management of liquidity risk. Note 56(4) to the financial statements sets out an analysis of assets and liabilities by relevant maturity grouping. In order to reflect more accurately the expected behaviour of the Group’s assets and liabilities, measurement and modelling of the behavioural aspects of each is constructed. This forms the foundation of the Group’s liquidity controls.

• Mitigation (audited)

  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 liquidity under stressed conditions, 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 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 customer deposit base, and has been supported by stable funding from the wholesale markets with a reduced dependence on short-term funding. 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 interbank 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 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 as set out in Table 1.21 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 (European Central Bank, Federal Reserve, Bank of England and Reserve Bank of Australia).

• Monitoring (audited)

  Liquidity is actively monitored at business unit and Group level. 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, the 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.
  • Secondly, the Group has a contingency funding plan embedded within the Group Liquidity Policy 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 Group has invested considerable resource to ensure that it satisfies the governance, reporting and stress testing requirements of the FSA’s new ILAS liquidity regime. The Group has noted the industry move towards strategic balance sheet measures of the funding profile and has started to monitor and forecast the Group’s Net Stable Funding Ratio (NSFR) and Liquidity Coverage Ratio (LCR). The Group is aware that the regulatory liquidity landscape is subject to potential change. Specifically, in relation to the papers issued by the Basel Committee on Banking Supervision (‘Strengthening the resilience of the banking sector’ and ‘International framework for liquidity risk measurement, standards and monitoring’) the Group has actively participated in the industry‑wide consultation and calibration exercises which took place through 2010.

  During the year, the individual entities within the Group, and the Group, complied with all of the externally imposed liquidity and funding requirements to which they are subject.

• Liquidity and funding management in 2010(unaudited)

  During 2010 liquidity and funding remained a key area of focus for the Group and the industry as a whole. 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 liquidity where necessary, its ability to fund its financial obligations could be affected.

  The Group is reliant on both wholesale funding markets and the legacy Government and central bank facilities to support its balance sheet. The liquidity and funding challenges facing the Group over the medium term continue to be ensuring sustainable access to wholesale funding markets, and the repayment of Government and central bank facilities. The combination of a clear focus on right-sizing the balance sheet, continued development of the Group’s customer deposit base, and strategic access to the capital markets will enable the Group to strengthen its funding base while reducing its overall wholesale funding requirement.

  The key dependencies on successfully funding the Group’s balance sheet include the continued functioning of the money and capital markets; successful right-sizing of the Group’s balance sheet; the repayment of Government and central bank facilities in accordance with the agreed terms; no more than limited further deterioration in the UK’s and the Group’s credit rating; and no significant or sudden withdrawal of deposits resulting in increased reliance on wholesale funding markets. Additionally, the Group has entered into a number of EU state aid related obligations to achieve reductions in certain parts of its balance sheet by the end of 2014. The requirement to meet this deadline may result in the Group having to provide funding to support these asset reductions and/or disposals and may also result in a lower price being achieved.

  During 2010, the Group further improved the diversification of funding supporting its balance sheet. Wholesale funding reduced by £27.5 billion whilst customer deposits increased by £11.3 billion, resulting in a more stable liability base. The customer loan to deposit ratio improved to 154 per cent compared with 169 per cent at 31 December 2009.

  At 31 December 2010, the Group’s further overall support from legacy Government and central bank facilities totalled £96.6 billion, a reduction of £60.6 billion compared with 31 December 2009. These facilities have various maturity dates, the last of which is in the fourth quarter of 2012. The Group’s plan to right size the balance sheet is expected to avoid the necessity to refinance much of this. Repayment of the remaining amount will be achieved by a combination of customer deposit growth and term wholesale issuance.

  TABLE 1.19: analysis of government and central bank FACILITIES (audited)

  As at 31 December	2010 £bn	2009 £bn
  Credit Guarantee scheme	45.4	50.0
  Other	51.2	107.2
  Total Government and central bank facilities	96.6	157.2

  The Group’s wholesale term funding ratio (wholesale funding with a remaining life of over one year as a percentage of total funding) at 31 December 2010 has been maintained at 50 per cent.

  Despite the market disruption as a result of European sovereign risk concerns during 2010, the Group outperformed its term wholesale issuance plans, allowing an accelerated repayment of Government and central bank facilities and thus reducing the on-going reliance on short term funding. The Group continued to fund itself successfully in the short term money markets, extending the maturity profile of this source of funding. The Group anticipates that wholesale markets will remain vulnerable to periods of disruption during 2011. To mitigate the impact of such events, the Group has been actively diversifying its funding sources and investor base.

  In June 2010, the FSA introduced a new liquidity framework (Individual Liquidity Adequacy Standards – ILAS) bringing in enhanced systems and controls, quantitative requirements, reporting requirements and stress testing. As part of the ILAS framework, the FSA has issued an Individual Liquidity Guidance (ILG) to the Group, representing a new regulatory requirement, which was effective from 1 June 2010. The Group has maintained its liquidity levels above the ILG regulatory minimum since inception.

  Late in 2010, the Basel Committee on Banking Supervision refined the details of the Basel III reforms to ensure the strengthening of global liquidity standards. This supplemented the 2008 published Principles of Sound Liquidity Risk Management and Supervision (‘Sound Principles’). These principles have been strengthened by the development of two principal liquidity measures.

  The first measure promotes short term resilience of the liquidity profile by ensuring that banks have sufficient high quality liquid assets to meet potential funding outflows in a stressed environment within a one month period. This is measured by the LCR. The second promotes resilience over a longer time horizon by requiring banks to fund their activities with a more stable source of funding on a going concern basis. This is measured by NSFR which has a time horizon of one year and has been developed to ensure a sustainable maturity structure of assets and liabilities.

  The Group welcomes the Basel Committee’s Sound Principles. The introduction of the LCR (January 2015) and NSFR (January 2018) will raise the resilience of banks to potential liquidity shocks and provide the basis for a harmonised approach to liquidity risk management. At 31 December 2010, the Group’s internal calculation of the LCR was 71 per cent and the NSFR was 88 per cent; the guidance issued by the Basel Committee is still subject to final ratification by the EU and the methodology is likely to be refined on the basis of feedback from banks and regulators during the observation period. The actions already announced to right size the balance sheet are expected to ensure compliance with the future minimum standards, which are expected to be 100 per cent for both ratios by their respective effective dates.

  TABLE 1.20: GROUP funding position (audited)

  As at 31 December	2010 £bn		2009 £bn	Change %
  Funding Requirement
  Loans and advances to customers1	589.5		625.9	(6)
  Loans and advances to banks2	10.5		16.1	(35)
  Debt securities	25.7		32.7	(21)
  Available-for-sale financial assets – secondary3	25.7		37.7	(32)
  Cash balances4	3.6		2.7	33
  Funded assets	655.0		715.1	(8)
  On balance sheet primary liquidity assets5
  Reverse repurchase agreements	7.3		5.3	38
  Balances at central banks – primary4	34.5		36.3	(5)
  Available-for-sale financial assets – primary	17.3		8.9	94
  Held to maturity	7.9		–
  	67.0		50.5	33
  Other assets6	269.6		261.7	3
  Total Group assets	991.6		1,027.3	(3)
  Less: Other liabilities6	(229.1)		(223.4)	3
  Funding requirement	762.5		803.9	(5)
  Funded by
  Customer deposits7	382.5		371.2	3
  Wholesale funding	298.0		325.5	(8)
  Repurchase agreements	35.1		63.1	(44)
  Total equity	46.9		44.1	6
  Total funding	762.5		803.9	(5)

  ¹ Excludes £3.1 billion (31 December 2009: £1.1 billion) of reverse repurchase agreements.

  ² Excludes £15.6 billion (31 December 2009: £15.1 billion) of loans and advances to banks within the insurance businesses and £4.2 billion (31 December 2009: £4.2 billion) of reverse repurchase agreements.

  ³ Secondary liquidity assets comprise a diversified pool of highly rated unencumbered collateral (including retained issuance).

  ⁴ Cash balances and Balances at central banks – primary are combined in the Group’s balance sheet.

  ⁵ Primary liquidity assets are FSA eligible liquid assets including UK Gilts, US Treasuries, Euro AAA government debt and unencumbered cash balances held at central banks.

  ⁶ Other assets and other liabilities primarily include balances in the Group’s insurance businesses and the fair value of derivative assets and liabilities.

  ⁷ Excluding repurchase agreements of £11.1 billion (31 December 2009: £35.5 billion).

  Table 1.21: group funding by type (audited)

  As at 31 December	2010 £bn		2010 %		2009 £bn		2009 %
  Deposits from banks1	26.4		3.9		48.6		7.0
  Debt securities in issue1:
  Certificates of deposit	42.4		6.2		50.9		7.3
  Commercial paper	32.5		4.8		35.0		5.0
  Medium-term notes2	87.7		12.9		89.7		12.9
  Covered bonds	32.1		4.7		28.1		4.0
  Securitisation	39.0		5.7		35.8		5.1
  	233.7		34.3		239.5		34.3
  Subordinated liabilities1	37.9		5.6		37.4		5.4
  Total wholesale funding3	298.0		43.8		325.5		46.7
  Customer deposits	382.5		56.2		371.2		53.3
  Total Group funding 4	680.5		100.0		696.7		100.0

  ¹ A reconciliation to the Group’s balance sheet is provided in table 1.25 in the liquidity portfolio part below.

  ² Medium-term notes include £45.4 billion of funding from the Credit Guarantee scheme.

  ³ The Group’s definition of wholesale funding aligns with that used by other international market participants; including interbank deposits, debt securities in issue and subordinated liabilities.

  ⁴ Excluding repos and total equity.

  Total wholesale funding is analysed by residual maturity as follows:

  TABLE 1.22: WHOLESALE FUNDING BY RESIDUAL MATURITY (audited)

  As at 31 December	2010 £bn	2010 %	2009 £bn	2009 %
  Less than one year	148.6	49.9	161.8	49.7
  One to two years	46.8	15.7	48.8	15.0
  Two to five years	52.3	17.6	68.7	21.1
  More than five years	50.3	16.8	46.2	14.2
  Total wholesale funding	298.0	100.0	325.5	100.0

• Term issuance (audited)

  The stabilisation of the term wholesale markets observed in the first quarter of 2010 and the continued functioning of these markets throughout the year, despite the European Sovereign credit concerns, enabled the Group to outperform its term issuance plan for 2010. The Group has taken advantage of the improved market sentiment by successfully accessing a number of markets, both secured and unsecured. The table below summarises the Group’s term issuance during 2010. Exceeding term funding plans in 2010 contributed to the acceleration in repaying Government and central bank facilities during the year.

  TABLE 1.23: analysis of 2010 term issuance (audited)

  	Sterling £bn	US Dollar £bn	Euro £bn	Other currencies £bn	Total £bn
  Securitisation	3.5	5.2	2.1	0.7	11.5
  Medium-term notes	1.1	3.7	2.7	2.2	9.7
  Covered bonds	–	–	3.7	–	3.7
  Subordinated liabilities	0.7	2.5	1.3	–	4.5
  Private placements¹	4.6	4.6	10.6	0.8	20.6
  Total Issuance	9.9	16.0	20.4	3.7	50.0

  ¹ Private placements include structured bonds and term repurchase agreements (repos).

• Liquidity portfolio (audited)

  The table below illustrates the Group’s holding of highly liquid unencumbered assets. This liquidity is available for deployment at immediate notice, subject to complying with regulatory requirements, and is a key component of the Group’s liquidity management process.

  TABLE 1.24: Liquidity portfolio (audited)

  As at 31 December	2010 £bn	2009 £bn
  Primary liquidity1	97.5	88.4
  Secondary liquidity2	62.4	62.4
  Total	159.9	150.8

  ¹ Primary liquidity is defined as FSA eligible liquid assets (UK Gilts, US Treasuries, Euro AAA government debt; unencumbered cash balances held at central banks).

  ² Secondary liquidity comprises a diversified pool of highly rated unencumbered collateral (including retained issuance).

  Following the introduction of the FSA’s Individual Liquidity Guidance under ILAS, the Group now manages its liquidity position as a coverage ratio (proportion of stressed outflows covered by primary liquid assets) rather than by reference to a quantum of liquid assets; the liquidity position reflects a buffer over the regulatory minimum. The Group receives no recognition under ILAS for assets held for secondary liquidity purposes.

  The following tables reconcile figures reported in table 1.21 in the Liquidity and funding management in 2010 part.

  TABLE 1.25: RECONCILIATION OF group FUNDING FIGURE FROM TABLE 1.21 TO THE BALANCE SHEET (audited)

  As at 31 December 2010	Included in funding analysis (above) £bn		Repos £bn		Fair value and other accounting methods £bn		Balance Sheet £bn
  Deposits from banks	26.4		24.0		–		50.4
  Debt securities in issue	233.7		–		(4.8)		228.9
  Subordinated liabilities	37.9		–		(1.7)		36.2
  Total wholesale funding	298.0		24.0
  Customer deposits	382.5		11.1		–		393.6
  Total	680.5		35.1
  As at 31 December 2009	Included in funding analysis (above) £bn		Repos £bn		Fair value and other accounting methods £bn		Balance Sheet £bn
  Deposits from banks	48.6		27.6		6.3		82.5
  Debt securities in issue	239.5		–		(6.0)		233.5
  Subordinated liabilities	37.4		–		(2.7)		34.7
  Total wholesale funding	325.5		27.6
  Customer deposits	371.2		35.5				406.7
  Total	696.7		63.1