Lloyds Regulatory News (LLOY)

Lloyds Banking Group plc

2023 Half-Year Results

26 July 2023

 Part 1 of 2

CONTENTS

Alternative performance measures

The Group uses a number of alternative performance measures, including underlying profit, in the description of its business performance and financial position. These measures are labelled with a superscript 'A' throughout this document. Further information on these measures is set out on page 27. Unless otherwise stated, commentary on pages 1 to 2 and on pages 7 to 8 is given on an underlying basis.

Forward looking statements

This news release contains forward looking statements. For further details, reference should be made to page 124.

RESULTS FOR THE HALF-YEAR

"We know that rising interest rates, cost of living pressures and an uncertain economic outlook are proving challenging for many people and businesses. Guided by our purpose of Helping Britain Prosper, we remain fully focused on proactively supporting our customers and helping them navigate the current environment.

The Group delivered a robust financial performance in the first half of 2023 with strong net income and capital generation alongside resilient asset quality.

We continue to make good progress on delivering our strategic initiatives. Combined with our franchise resilience, this better positions us to support our customers, both today and in the future."

 Charlie Nunn,

Group Chief Executive

Fully focused on proactively supporting customers

• Proactively contacting customers to offer cost of living support, including more than 200,000 mortgage customers, alongside committing to the Government's Mortgage Charter

• Contact with more than 550,000 business customers to offer guidance on building financial resilience

• Supporting customers to develop financial resilience; contacted over 10 million customers about savings options, with 1.9 million new savings accounts opened in the first half in response to the Group's higher rates and enhanced offering

Robust financial performance and consistent delivery supporting higher interim dividend

• Continuing to deliver on strategic ambitions and well positioned to deliver for all stakeholders

• Statutory profit after tax of £2.9 billion, with net income of £9.2 billion up 11 per cent (stable on the second half of 2022), partly offset by expected higher operating costs and impairment charge. Strong return on tangible equity of 16.6 per cent in the first half of 2023 and 13.6 per cent in the second quarter

• Statutory profit after tax in the second quarter of £1.2 billion, reflecting broadly stable income compared to the first quarter, offset by increases in operating lease depreciation, operating costs and impairment charges

• Underlying net interest income of £7.0 billion, with a net interest margin of 3.18 per cent. Net interest margin of 3.14 per cent in the second quarter, down 8 basis points compared to the first, given expected headwinds from mortgage and deposit pricing. Average interest-earning assets of £453.8 billion, stable compared to the fourth quarter of 2022

• Other income of £2.5 billion, 7 per cent higher, reflecting continued recovery of customer activity and ongoing investment in the business, building confidence in growth potential

• Operating lease depreciation of £356 million, up 67 per cent, given depreciation cost of higher value vehicles, the Tusker acquisition, lower gains on disposal and recent declines in electric vehicle used car prices

• Operating costs of £4.4 billion, up 6 per cent. The Group has maintained its cost discipline in the context of higher planned strategic investment, new business costs and continued inflationary pressure

• Remediation charge of £70 million remains low, largely in relation to pre-existing programmes

• Impairment charge of £0.7 billion and asset quality ratio of 29 basis points reflecting broadly stable credit trends. Asset quality remains resilient and the portfolio is well-positioned in the context of cost of living pressures

• Loans and advances to customers reduced by £4.2 billion (£1.6 billion in the second quarter) to £450.7 billion, impacted by the first quarter £2.5 billion legacy mortgage portfolio exit and net reductions in the open mortgage book

• Customer deposits of £469.8 billion down £5.5 billion (1.2 per cent), including £6.2 billion in Retail current accounts, partly offset by a £3.5 billion increase in Retail savings balances

• Customer deposits in the second quarter benefited from broadly stable Retail balances. Commercial Banking balances were slightly lower including the expected reversal of short term placements, leading to an overall £3.3 billion reduction

• Loan to deposit ratio of 96 per cent; large, high quality liquid asset portfolio with all assets hedged for interest rate risk

• Strong capital generation of 111 basis points includes the full £800 million fixed pension contributions for 2023; 75 basis points after CRD IV model changes and phased unwind of IFRS 9 relief

• Risk-weighted assets increased by £4.4 billion, including £3 billion anticipated impact of CRD IV model updates

• Tangible net assets per share of 45.7 pence, slightly down on the end of 2022 and down 3.9 pence per share in the second quarter, largely due to the impact of rising rates on the cash flow hedge reserve

• Interim ordinary dividend of 0.92 pence per share, up 15 per cent on the prior year and equivalent to £594 million

• CET1 ratio of 14.2 per cent after 44 basis points for ordinary dividend accrual and 21 basis points for the Tusker acquisition. Remains ahead of ongoing target of c.12.5 per cent, plus a management buffer of c.1 per cent

RESULTS FOR THE HALF-YEAR (continued)

Enhancing guidance for 2023, delivering higher, more sustainable returns

Based on our purpose-driven strategy, robust financial performance and the Group's revised macroeconomic forecasts, we are enhancing our 2023 guidance and now expect:

• Banking net interest margin to be greater than 310 basis points

• Operating costs to be c.£9.1 billion

• Asset quality ratio to be c.30 basis points

• Return on tangible equity to be greater than 14 per cent

• Capital generation to be c.175 basis points1

1 Excluding capital distributions and the impact of the Tusker acquisition. Inclusive of ordinary dividends received from the Insurance business.

INCOME STATEMENT - UNDERLYING BASISA AND KEY BALANCE SHEET METRICS

A See page 27.

1 2022 comparatives have been restated to reflect the impact of IFRS 17. See page 123.

1 30 June 2022 reflects the interim ordinary dividend received from the Insurance business in July 2022. 31 December 2022 reflects the interim ordinary dividend received from the Insurance business in February 2023 and the full impact of the announced share buyback, but excludes the impact of the phased unwind of IFRS 9 relief on 1 January 2023.

2 The liquidity coverage ratio is calculated as a monthly rolling simple average over the previous 12 months.

3 Net stable funding ratio is based on an average of the four previous quarters.

4 2022 comparatives have been restated to reflect the impact of IFRS 17. See page 123.

QUARTERLY INFORMATIONA

1 2022 comparatives have been restated to reflect the impact of IFRS 17. See page 123.

BALANCE SHEET ANALYSIS

1 The portfolios shown reflect the new organisation structure; comparatives have been presented on a consistent basis. See page 123.

2 Primarily Europe.

3 Central items includes central fair value hedge accounting adjustments. 30 June 2022 included a £200 million ECL central adjustment that was not allocated to specific portfolios. In the third quarter of 2022 this central adjustment was released.

GROUP RESULTS - STATUTORY BASIS

The results below are prepared in accordance with the recognition and measurement principles of International Financial Reporting Standards (IFRSs). The underlying results are shown on page 3.

1 Restated for presentational changes and for the adoption of IFRS 17; see notes 1 (page 72) and 24 (page 114).

GROUP CHIEF EXECUTIVE'S STATEMENT

We set out our ambitious new strategy last year and are making good progress. Since that time, the macroeconomic environment has changed significantly. We are seeing higher and more persistent inflation, driving a significant increase in interest rates and a slower economic recovery than we had anticipated. Our strategy remains the right one, but in this context and guided by our purpose of Helping Britain Prosper, we have increased our focus on proactively supporting our customers, helping them navigate the current environment.

The Group is performing well and has delivered a robust financial performance in the first half of the year with continued income growth. This performance, alongside continued business momentum, has enabled our enhanced customer support and positions the Group well for the future. It has also enabled the Board to announce an interim ordinary dividend of 0.92 pence per share, up 15 per cent on the first half of 2022.

We have made good progress on our strategic ambitions and we are on track to deliver our targets, with the aim of growing our business and deepening relationships with our customers, meeting more of their financial needs. We believe our purpose-driven strategy will deliver higher, more sustainable returns, whilst better positioning the Group to support customers now and in the future.

Supporting our customers

We know that many people and businesses are experiencing significant challenges given inflationary pressures and higher interest rates. Our purpose-driven business model and strong financial foundations enable us to provide enhanced support to our customers.

We are continuing to proactively contact our customers to offer support due to the rising cost of living, including over 200,000 mortgage customers most affected by rising interest rates. We have also offered c.260,000 customers a £500 interest free overdraft buffer since the start of 2023. We have committed to the Government's Mortgage Charter and product transfers are now available six months in advance for residential mortgage customers1. To enable our customers to build their financial resilience and develop a savings habit, we continue to launch competitive rated fixed products and have expanded our offering to include tiered rates and limited withdrawal accounts with attractive rates, as well as raising rates on instant access savings accounts. We have contacted over 10 million customers about their savings options and have seen 1.9 million new savings accounts opened in the first half of 2023.

Whilst our business customers continue to demonstrate resilience, we continue to proactively contact more than 550,000 customers with guidance on how to build financial resilience. We have launched a hub in partnership with Mental Health UK to support small business leaders and owners.

Robust financial performance

In the first six months, we delivered a robust financial performance with business trends developing in line with our expectations.

Statutory profit after tax of £2.9 billion was up 17 per cent on the first half of 2022, albeit the second quarter was down 25 per cent on the first quarter. Net income increased 11 per cent to £9.2 billion in the first half, supported by a strengthened banking net interest margin, broadly stable average interest-earning assets compared to year end and the continued recovery in other income. The banking net interest margin reduced 8 basis points in the second quarter compared to the first quarter, as a result of expected headwinds from mortgage and deposit pricing. Operating costs of £4.4 billion increased by 6 per cent with cost discipline maintained in the context of higher planned strategic investment, costs associated with new businesses and expected inflationary effects. Asset quality remains resilient and the impairment charge of £0.7 billion reflects our broadly stable credit metrics.

Loans and advances to customers decreased by £4.2 billion in the half to £450.7 billion. This was largely the result of the £2.5 billion exit of legacy retail mortgage loans in the first quarter and modest net reductions in the open mortgage book. Customer deposits were down 1.2 per cent in the first half of the year at £469.8 billion. Retail balances were broadly stable in the second quarter as current account balances have reduced but savings balances have grown.

Underpinned by this robust financial performance, the Group generated 111 basis points of CET1 capital in the first half of 2023, enabling the Board to announce an interim ordinary dividend of 0.92 pence per share, an increase of 15 per cent on prior year and in line with our progressive and sustainable ordinary dividend policy.

As usual, the Board will continue to give due consideration at each year end to the return of any surplus capital. In February this year, the Board decided to return surplus capital through a share buyback programme of up to £2.0 billion. As at 30 June 2023, the programme had completed £1.5 billion of the buyback, with c.3.3 billion ordinary shares purchased.

GROUP CHIEF EXECUTIVE'S STATEMENT (continued)

Focusing on serving all stakeholders, making progress on our strategic priorities

We have a purpose-driven strategy. Core to this is our focus on contributing to an inclusive society and supporting the transition to a low carbon economy, while creating new opportunities for our future growth. Our initiatives in building a more inclusive society include lending £5.6 billion to first time buyers and supporting c.£1 billion of funding to the social housing sector in the first half of the year. We have launched our new partnership with the homelessness charity Crisis and together we believe we can help end homelessness. Importantly, we remain on track to reach our gender and ethnic diversity ambitions by 2025 and have announced a new ambition to double the representation of colleagues with a disability in senior roles by 2025.

To help support the transition to a low carbon economy we have funded c.£20 billion of green and sustainable financing2 since January 2022 and made more than £20 billion of discretionary investments in climate-aware strategies3 through Scottish Widows since January 2021. In the first half of the year, we launched a new sustainability hub and training modules for mortgage brokers to promote sustainability in housing and agreed to partner with the Green Finance Institute to develop a blueprint for property-linked retrofit finance.

We are now in the second year of our five-year strategic transformation. Having laid the foundations in 2022, we are now building momentum across our strategic initiatives, as well as realising business and financial benefits. In the first half of 2023, we accelerated our deployment, investing a further £0.6 billion to reach c.£1.4 billion to date. We are now at the halfway stage for the 2024 targeted outcomes that we outlined last year and are on track to deliver against these, whilst surpassing our targets on some. For example, we now have 20.6 million digitally active customers, up c.13 per cent since the end of 2021 and are already ahead of our 2024 ambition. We have reduced our office footprint by c.20 per cent over the same period as we progress towards a reduction of more than 30 per cent by the end of 2024. Our progress is split across all of our strategic priority areas, alongside the strategic enablers of people, technology and data. It provides us with confidence that we are on track to deliver c.£0.7 billion of additional revenues from strategic initiatives and c.£1.2 billion of gross cost savings by the end of 2024. We continue to believe our strategy is the right one to position the Group for success over both the medium and long-term. We are encouraged by the progress we have made.

Enhancing guidance for 2023, delivering higher, more sustainable returns

Although the macroeconomic outlook remains uncertain, our people, business model and financial strength ensure that we can continue to support our customers and Help Britain Prosper. As we continue to make progress against our strategic ambitions we remain confident that successful delivery will create a more sustainable business and deliver increased shareholder returns in the medium to longer-term. Based on our purpose-driven strategy, robust financial performance and the Group's revised macroeconomic forecasts, we are enhancing our 2023 guidance and now expect:

• Banking net interest margin to be greater than 310 basis points

• Operating costs to be c.£9.1 billion

• Asset quality ratio to be c.30 basis points

• Return on tangible equity to be greater than 14 per cent

• Capital generation to be c.175 basis points4

1 Product transfers available for residential customers in arrears (Halifax, Lloyds Bank and the majority of Bank of Scotland customers). Advanced product transfers available to Halifax and Lloyds Bank customers.

2 Since 1 January 2022, c.£6bn green mortgage lending (at 31 March 2023), c.£4 billion financing for electric vehicles and plug-in hybrid electric vehicles, c.£11 billion sustainable finance for corporate and institutional clients (at 30 June 2023).

3 Since 1 January 2022, c.£20 billion discretionary investment in climate aware strategies through Scottish Widows.

4 Excluding capital distributions and the impact of the Tusker acquisition. Inclusive of ordinary dividends received from the Insurance business.

SUMMARY OF GROUP RESULTSA

Robust financial performance and consistent delivery supporting higher interim dividend

Statutory results

The Group's statutory profit before tax for the first half of 2023 was £3,870 million, 23 per cent higher than the same period in 2022, benefiting from higher net income, partly offset by operating expense and impairment charge increases. Statutory profit after tax was £2,864 million (half-year to 30 June 2022: £2,447 million). In the second quarter of the year, statutory profit before tax was £1,610 million and statutory profit after tax was £1,223 million, lower than the first quarter.

The Group's statutory income statement includes income and expenses attributable to the policyholders of the Group's long-term assurance funds. These items materially offset in arriving at profit before tax but can, depending on market movements, lead to significant variances on a statutory basis between total income and net finance income in respect of insurance and investment contracts from one period to the next. In the first half of 2023, due to market conditions, the Group recognised net gains on policyholder investments within total income, which were materially offset by the corresponding decrease in net finance income in respect of insurance and investment contracts.

Total income, after net finance income in respect of insurance and investment contracts for the first half of 2023 was £9,306 million, an increase of 17 per cent on the same period in 2022, primarily reflecting higher net interest income in the period. Net interest income of £6,798 million was up 13 per cent on the prior year, driven by stronger margins and higher average interest-earning banking assets, supported by growth in the open mortgage book, Retail unsecured and European retail business.

Other income amounted to a gain of £8,097 million in the half-year to 30 June 2023, compared to a loss of £18,030 million in the same period in 2022. Net finance income in respect of insurance and investment contracts was a loss of £5,589 million in the first half of 2023 compared to a gain of £19,941 million in the first half of 2022, reflecting improved global equity markets.

The Group maintained its focus on cost management, whilst increasing strategic investment as planned. Total operating expenses of £4,774 million were 8 per cent higher than in the prior year. This reflects higher planned strategic investment, new business costs and inflationary effects. In the first half of 2023 the Group recognised remediation costs of £70 million largely in relation to pre-existing programmes (half-year to 30 June 2022: £79 million). The higher operating lease depreciation charge reflected the depreciation cost of higher value vehicles, the Tusker acquisition, lower gains on disposal and recent declines in battery electric used car prices.

Impairment was a net charge of £662 million (half-year to 30 June 2022: £381 million). This reflects a charge of £657 million, pre-updated multiple economic scenarios (MES), in the period (half-year to 30 June 2022: £282 million) and a small net £5 million MES charge (half-year to 30 June 2022: £95 million charge).

The Group recognised a tax expense of £1,006 million in the period, compared to £702 million in the first half of 2022.

Loans and advances to customers fell by £4.2 billion in the first half of 2023 (£1.6 billion in the second quarter) to £450.7 billion, largely as a result of the exit of £2.5 billion of legacy Retail mortgage loans (including £2.1 billion in the closed mortgage book) during the first quarter. Excluding this, loans and advances to customers were down 0.4 per cent. £2.5 billion growth in other Retail lending, principally unsecured, was offset by a net reduction of £1.3 billion in the open mortgage book and net repayments in Small and Medium Businesses including government-backed lending.

Customer deposits at £469.8 billion have decreased by £5.5 billion (1.2 per cent) since the end of 2022. This included decreases in Retail current account balances of £6.2 billion as a result of tax payments, higher spend and a more competitive market, including the Group's own savings offers where balances increased by £3.5 billion, partly from transfers from the Group's current account customer base. Commercial Banking deposits were stable during the first half of 2023. Customer deposits in the second quarter reduced £3.3 billion including the expected reversal of short term placements in Commercial Banking, while Retail balances were broadly stable. In the first half of 2023, due to market conditions, an increase was seen in policyholder investments, primarily within financial assets at fair value through profit or loss. This was materially offset by a corresponding increase in the related insurance and investment contract liabilities.

Total equity of £44,482 million at 30 June 2023 increased from £43,911 million at 31 December 2022. The movement reflected attributable profit for the period and issuance of other equity instruments in the first quarter, partially offset by market movements impacting the cash flow hedge reserve and pensions, the dividend paid in May 2023 and the impact of the share buyback programme. As at 30 June 2023, the programme had completed £1.5 billion of the buyback, with c.3.3 billion ordinary shares purchased.

SUMMARY OF GROUP RESULTS (continued)

Underlying results

The Group's underlying profit for the first half of 2023 was £4,041 million, compared to £3,662 million in the prior year. Growth in net income was partly offset by higher operating costs and impairment charges. Underlying profit in the second quarter reduced 18 per cent compared to the first, reflecting broadly stable income offset by increases in operating lease depreciation, operating costs and underlying impairment charges.

Net incomeA

Net income of £9,186 million was up 11 per cent on the prior year, with higher net interest income and other income partially offset by an increased charge for operating lease depreciation.

1 2022 comparatives have been restated to reflect the impact of IFRS 17. See page 123.

Net interest income in the first half of £7,004 million was up 14 per cent, driven by a stronger banking net interest margin of 3.18 per cent (half-year to 30 June 2022: 2.77 per cent, half-year to 31 December 2022: 3.10 per cent) and higher average interest-earning banking assets. The net interest margin benefitted from UK Bank Rate increases and higher structural hedge earnings from the rising rate environment, partly offset by asset margin compression, particularly in the mortgage book and unsecured lending. Average interest-earning banking assets were up 1 per cent compared to the first half of 2022 at £453.8 billion, supported by growth in the open mortgage book, Retail unsecured and the European retail business. Net interest income in the first half of 2023 included a non-banking interest income charge of £155 million (half-year to 30 June 2022: £52 million), an increase on the prior year as a result of higher funding costs and growth in the Group's non-banking businesses. Net interest income in the second quarter of £3,469 million was 2 per cent lower than the first quarter, reflecting a lower net interest margin of 3.14 per cent (three months to 31 March 2023: 3.22 per cent) and stable average interest earning assets. The Group now expects the banking net interest margin for 2023 to be greater than 310 basis points. Average interest-earning assets over 2023 are expected to be down slightly compared to the fourth quarter of 2022.

The Group manages the risk to earnings and capital from movements in interest rates by hedging the net liabilities which are stable or less sensitive to movements in rates. As at 30 June 2023, the Group's structural hedge had an approved capacity of £255 billion (31 December 2022: £255 billion). The nominal balance of the structural hedge was £255 billion (31 December 2022: £255 billion) with a weighted-average duration of approximately three-and-a-half years (31 December 2022: approximately three-and-a-half years). The Group continues to review the stability and mix of underlying deposits and their eligibility for the structural hedge and expects a modest reduction in nominal balance in the second half given deposit mix changes. The Group generated £1.6 billion of total gross income from structural hedge balances in the first half of 2023, representing material growth over the prior year (half-year to 30 June 2022: £1.2 billion). The Group continues to expect hedge earnings in 2023 to be c.£0.8 billion higher than in 2022.

SUMMARY OF GROUP RESULTS (continued)

Underlying other income in the first half of £2,538 million was 7 per cent higher compared to £2,367 million in the prior year, with growth across Retail, Commercial Banking and Insurance, Pensions and Investments. Underlying other income was 2 per cent higher in the second quarter versus the first, reflecting progress in the underlying business. Retail other income was up 18 per cent on the prior year, including increased current account and credit card activity, improved Lex performance and the impact of the acquisition of Tusker. Retail other income was 13 per cent higher in the second quarter versus the first, benefiting from higher customer spending, the Tusker acquisition and Lex performance. Commercial Banking other income was up 17 per cent versus the prior year, reflecting improved trading and strong bond financing performance, down modestly in the second quarter given less favourable market conditions.

Insurance, Pensions and Investments other income was 16 per cent higher than the prior year, driven by balance sheet growth from both new business and the impact of adding a drawdown feature in 2022 to existing long-standing and workplace pension business. This resulted in higher contractual service margin and risk adjustment releases to income. Insurance, Pensions and Investments other income was 9 per cent higher in the second quarter versus the first, principally as a result of improved general insurance net income, with lower claims. The Group delivered good organic growth in Insurance, Pensions and Investments and Wealth (reported within Retail) assets under administration (AuA), with combined £4 billion net new money in open book AuA over the period. In total, open book AuA currently stand atc.£168 billion.

Other income from the Group's equity investments businesses, including Lloyds Development Capital, was lower than the prior year, reflecting more subdued market conditions in the first half of 2023.

Operating lease depreciation of £356 million increased by 67 per cent compared to the prior year, reflecting the depreciation cost of higher value vehicles, the Tusker acquisition, lower gains on disposal and recent declines in battery electric used car prices. Overall, operating lease depreciation is increasing towards more normalised levels as expected.

Total costsA

1 2022 comparatives have been restated to reflect the impact of IFRS 17. See page 123.

Total costs of £4,483 million were 5 per cent higher than in the prior year, and 5 per cent higher in the second quarter than the first. The Group has maintained its cost discipline. Operating costs were up 6 per cent to £4,413 million, given the higher planned strategic investment (expected to peak in 2023), new business costs and inflationary effects, partially mitigated by continued cost efficiency. The Group's cost:income ratio for the first half of 2023 was 48.8 per cent, compared to 51.3 per cent in the prior year. Consistent with guidance, operating costs are expected to be c.£9.1 billion in 2023 (2022: £8.7 billion).

The Group recognised remediation costs of £70 million in the first half of 2023, largely in relation to pre-existing programmes (half-year to 30 June 2022: £79 million), with £51 million in the second quarter. There have been no further charges relating to HBOS Reading and the provision held continues to reflect the Group's best estimate of its full liability, albeit uncertainties remain. Following the FCA's Motor Market review, the Group continues to receive complaints and is engaging with the Financial Ombudsman Service in respect of historical motor commission arrangements. Discussions are continuing, with the remediation and financial impact, if any, remaining uncertain.

SUMMARY OF GROUP RESULTS (continued)

Underlying impairmentA

1 Impairment charges for Retail, Commercial Banking and Other reflect the new organisation structure; comparatives have been presented on a consistent basis. See page 123.

2 Impairment charges excluding the impact from updated economic outlook taken each quarter.

Asset quality remains resilient with only modest deterioration to date from a low base, with credit performance similar, or favourable, to pre-pandemic experience. Underlying impairment was a net charge of £662 million (half-year to 30 June 2022: £377 million, half-year to 31 December 2022: £1,133 million), resulting in an asset quality ratio of 29 basis points. This included a small net £5 million multiple economic scenarios (MES) charge, with £84 million in the second quarter (half-year to 30 June 2022: £95 million charge), reflecting a stronger near-term GDP outlook relative to the view at year end, offset by increased losses assumed from a higher UK Bank Rate outlook. The pre-updated MES charge was £657 million in the period (half-year to 30 June 2022: £282 million, half-year to 31 December 2022: £633 million), equivalent to an asset quality ratio of 29 basis points. The increase compared to the first half of 2022 reflects increased flows to default primarily in legacy variable rate UK mortgage portfolios and higher charges on existing Stage 3 clients in Commercial Banking, the impact of higher discount rates on future recoveries, as well as the expected credit loss (ECL) allowance build from Stage 1 loans rolling forward into a more adverse economic outlook.

The ECL allowance of £5.4 billion (31 December 2022: £5.3 billion) continues to reflect a probability-weighted view of economic scenarios built out from the base case and its associated conditioning assumptions. A 30 per cent weighting is applied to the base case, upside and downside scenarios and a 10 per cent weighting to the severe downside. The base case outlook improved modestly in the first quarter of 2023, but then deteriorated in the second quarter to a similar overall position to the end of 2022. The updated base case no longer anticipates a mild GDP recession, however it anticipates a slower recovery and a UK Bank Rate peak of 5.5 per cent which, alongside inflation, remains higher for longer than previously assumed. Unemployment and asset price forecasts are not materially changed from those used at the year end, with unemployment still assumed to rise to 5.3 per cent and HPI to observe a peak to trough decline of 12 per cent. The probability-weighted ECL is impacted by higher UK Bank Rates increasing flows to default assumptions, partly offset by improvements in GDP and HPI levels in the downside scenarios. The Group continues to include an adjusted severe downside scenario to incorporate higher CPI inflation and UK Bank Rate profiles.

Management judgement adjustments have reduced in the first half of 2023. With all COVID-19 related judgements released by the end of 2022, the remaining judgements include c.£250 million at 30 June 2023 held in respect of the current high inflationary and interest rate pressures not deemed to be fully captured by models, with other judgements covering broader limitations in the Group's impairment models or data inputs largely netting off at a Group level.

Observed portfolio performance has seen slightly increased levels of new to arrears rates in UK mortgages. New to arrears remain broadly stable across unsecured portfolios, with only credit cards marginally above pre-pandemic levels. UK mortgages flow to default rates have seen an increase to above pre-pandemic levels, primarily due to legacy variable rate assets, with credit performance among more recent vintages remaining resilient. Unsecured flow to default rates remain broadly flat. The Commercial Banking portfolio's credit quality remains resilient with only a small number of credit metrics indicating very modest deterioration.

SUMMARY OF GROUP RESULTS (continued)

Stage 2 loans and advances to customers are flat at the half year at £65.7 billion including a reduction of £0.9 billion in respect of the exit of £2.5 billion of legacy Retail mortgage loans, against an offsetting increase largely as a result of the higher bank base rate outlook relative to year end. 92 per cent of Group Stage 2 loans are up to date (31 December 2022: 93 per cent). Stage 3 assets were £10.7 billion as at 30 June 2023 (31 December 2022: £10.8 billion) with £0.4 billion removed as a result of the legacy Retail mortgage loans exit. Excluding this, Stage 3 assets grew by £0.3 billion reflecting an increase in UK mortgages and low levels of write-offs in the period.

On the basis of the Group's revised macroeconomic forecast, the Group continues to expect the asset quality ratio to be c.30 basis points in 2023.

Restructuring, volatility and other items