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Rating Action:

Moody's downgrades Lloyds TSB and Bank of Scotland (senior to Aa3)

16 Feb 2009

London, 16 February 2009 -- Moody's Investors Service today downgraded the long-term bank deposit and senior debt ratings of Lloyds TSB Bank plc (LTSB) to Aa3 from Aaa and the senior debt rating of Lloyds Banking Group plc (Lloyds) to A1 from Aa1. The debt ratings have a stable outlook. The bank financial strength rating (BFSR) of LTSB was downgraded to C+ (mapping to a baseline credit assessment (BCA) of A2) from B+ (a BCA of Aa2), with a negative outlook. The Prime-1 ratings on the short-term obligations of all the group entities (including HBOS entities) were affirmed.

The long-term bank deposit and senior debt ratings of Bank of Scotland plc were downgraded from Aa1 to Aa3, the same level as LTSB, and the senior debt rating of HBOS plc (HBOS) was downgraded from Aa2 to A1, the same level as Lloyds Banking Group plc. The BFSR of Bank of Scotland was downgraded to C- (mapping to a BCA of Baa2) from B (BCA of Aa3), and remains under review for further possible downgrade.

The ratings assigned to LTSB and Bank of Scotland reflect Moody's view of the overall financial profile of Lloyds following its acquisition of HBOS which closed on 19 January 2009. "The downgrades reflect the high level of troubled and higher risk exposures within HBOS which Moody's considers will weaken the profitability and capital adequacy of the overall group, as well as the very significant operational challenge of integrating a larger and weaker bank into the group," explains Elisabeth Rudman, Vice President -- Senior Credit Officer in Moody's Financial Institutions Group.

The acquisition of HBOS by Lloyds means that the group is now the dominant retail bank in the UK, with market-leading positions in current accounts, savings accounts, residential mortgages, credit cards and unsecured lending. The combined entity will also have the second-largest market share in business banking, behind Royal Bank of Scotland. Although this expanded franchise should enable the group to continue to generate substantial pre-provision earnings, the acquisition brings with it significant challenges. Specifically, Moody's notes that integrating a group of the size of HBOS (total assets at end-June 2008 of GBP681 billion compared with the GBP368 billion of Lloyds) during a major market downturn may prove problematic and will be a substantial challenge for the management team.

In addition, given the difficult environment, we believe that the forecasted cost savings may take longer to generate than would otherwise have been the case. A positive factor for HBOS however is the introduction of Lloyds's lower risk appetite into the franchise of HBOS. However, given the size of HBOS's loan book, this will not be reflected in the group's asset quality indicators for some time.

DOWNGRADE OF LTSB BFSR TO C+ AND BANK OF SCOTLAND BFSR TO C-

The downgrade to C+ and negative outlook on LTSB's BFSR reflects the substantially higher risk taken on by the group as a result of the acquisition of HBOS, as well as the continuing difficult environment in the UK. And the downgrade to C- (under review for further possible downgrade) of Bank of Scotland's BFSR reflects the high proportion of troubled assets remaining within this entity.

Moody's recognises that the recent capital injections into the group from the UK government of GBP17 billion provide the combined entity with a substantially larger capital base. Lloyds has recently indicated that the group's pro-forma core Tier 1 capital ratio at the end of 2008 will be within the range of 6.0 -- 6.5% and Tier 1 ratio over 9%, taking into account the capital raisings and initial fair value analysis, as well as an expected GBP10bn pre-tax loss at HBOS in 2008.

However, Moody's expects further writedowns will still need to be taken on Bank of Scotland`s Alt-A portfolio, due to the ongoing deterioration in these securities, as well as further substantial impairment charges on the Bank of Scotland's commercial property and approximately GBP 30 billion book of self-certified residential mortgages. Morevoer, Moody's does not allow for any benefit for gains through the fair value of own debt of HBOS.

Moody's considers LTSB's loan books to be more conservatively positioned than HBOS', with relatively low loan-to-value ratios (LTVs) on residential mortgage and commercial property lending. However, impairments on the bank's approximately GBP20bn SME lending and GBP24bn retail unsecured lending, are likely to increase due to the depth of the recession in the UK and rapid growth in unemployment, which is reflected in Moody's negative outlook for credit conditions in the UK banking sector. Moody's central risk scenario for the UK economy is outright contraction followed by a mild rebound in 2010 and unemployment of 7% -- 8% on average.

"In Moody's opinion, all of the above charges will continue to have a negative impact on the profitability and capitalisation of Lloyds. At the bank's current BFSR of C+ we consider the tolerance for further impairment charges and losses to be around GBP16 billion (beyond what the bank has already indicated is expected to be reported by Lloyds and HBOS in 2008). Losses above this level would increase the downward rating pressure on the BFSR of Lloyds TSB and Bank of Scotland", says Ms. Rudman.

In addition, Moody`s notes that the government's announced Asset Protection Scheme could cap or reduce some losses, which could have a material impact on the financial profile of Bank of Scotland in particular. Therefore, the rating agency has left the Bank of Scotland's BFSR under review for further possible downgrade in order to assess the impact of this programme. Should the government's plan not have a material impact on limiting the bank's future losses, the BFSR is likely to be downgraded further.

DOWNGRADE OF SENIOR RATINGS TO Aa3 FROM Aaa

The downgrade of LTSB's long-term bank deposit and senior debt ratings to Aa3 reflects the weaker intrinsic financial strength of the group, as indicated by the C+ BFSR. However, given the combined group's position as the largest retail and commercial bank in the UK and the government's 43% stake, Moody's continues to assess the probability of systemic support for the group in the event of need as very high, which leads to a two-notch uplift for the deposit and debt ratings from the A2 BCA.

Moody's notes that, as a result of the acquisition, HBOS and its subsidiaries have become subsidiaries of Lloyds, rather than being merged into LTSB. Lloyds has also not guaranteed or assumed any outstanding debt of HBOS or any of its subsidiaries. However, the equalisation of the debt ratings reflects the strategic importance of HBOS to Lloyds, and the fact that the businesses will be managed as one. It also incorporates our expectation that government support would be available to the combined group without a differentiation of legacy structures.

Although Moody's base-case scenario is that the government's stake in Lloyds will not increase further, such a scenario cannot be ruled out. However, if this were to happen, it would be unlikely to lead to a substantial change in the long-term ratings.

RATING IMPACT ON SUBSIDIARIES AND OTHER DEBT CLASSES

The subordinated debt and hybrid instruments of LTSB and Bank of Scotland (the operating banks) were downgraded to A1 and A2, respectively, and the subordinated debt and hybrid instruments of Lloyds and HBOS were downgraded to A2 and A3, respectively. The government backed ratings assigned to the debt instruments of LTSB and BOS, benefiting from the UK government guarantee, remain rated Aaa.

The following rated banking subsidiaries of the group were also downgraded: Lloyds TSB Offshore to A1 from Aa2 and Bank of Scotland (Ireland) to A2 from Aa3.

A separate press release will be issued on rating actions related to Scottish Widows and Clerical Medical and their subsidiaries.

Moody's last rating action on Lloyds was implemented on 18 September 2008 when its ratings were put on review for possible downgrade.

The principal methodologies used in rating this issuer were "Bank Financial Strength Ratings: Global Methodology" (February 2007) and "Incorporation of Joint-Default Analysis into Moody's Bank Ratings: A Refined Methodology" (March 2007), which can be found at www.moodys.com in the Credit Policy & Methodologies directory, in the Ratings Methodologies sub-directory. Other methodologies and factors that may have been considered in the process of rating this issuer can also be found in the Credit Policy & Methodologies directory.

At the end of June 2008, Lloyds TSB Group (now renamed Lloyds Banking Group plc) had total assets of GBP368 billion and HBOS plc, the parent of Bank of Scotland plc, had total assets of GBP681 billion. Lloyds Banking Group is headquartered in London.

London
Elisabeth Rudman
VP - Senior Credit Officer
Financial Institutions Group
Moody's Investors Service Ltd.
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

London
Johannes Wassenberg
Managing Director
Financial Institutions Group
Moody's Investors Service Ltd.
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

Moody's downgrades Lloyds TSB and Bank of Scotland (senior to Aa3)
No Related Data.
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