Operating Review
continued
Treasury & Asset Management
Underlying profit before tax increased by 33% to £350m (2005 £263m). Net interest income increased by 12% with the margin remaining broadly stable and underlying non-interest income increased by 27%. Underlying operating expenses increased by 18% as we continue to invest in the development of our overseas Treasury offices and our Asset Management capabilities.
Our Treasury team were active in executing the Group’s funding and capital plans in 2006, arranging four capital issues on behalf of HBOS plc and approximately £21bn of securitisations and covered bonds during the year.
In September 2006, we successfully listed our property investment company, Invista Real Estate, on the London AIM market, retaining a majority stake of 55% and recognising a profit of £22m at Initial Public Offering (‘IPO’). Property funds under management have subsequently increased by 35% to £9.2bn.
Total funds under management for our Asset Management businesses increased to £107.8bn in 2006 (2005 £88.7bn), helped by continued progress in the Liability Driven Investment market and above benchmark performance in most asset classes including fixed income and European equities.
Risks and uncertainties
The following section describes the key risks and uncertainties faced by the Group. Divisional risks and uncertainties are set out in the divisional sections that follow.
The risks to our overall planned operating and financial performance outcome in 2007 are firstly to our revenue prospects where a combination of margin reduction linked
to higher growth, additional competitor pressure and a potential reduction in existing fee revenues from regulatory intervention
are headwinds. Our planning has taken into account our assessment of the pressures we face and the mitigating actions we will take
to manage these factors in pursuit of the desired full year outcome. We are however alert to the potential of a downside to our plans in respect of these risks and will constantly review the adequacy of our risk assessment as the year develops.
Our demanding programme of cost reductions in pursuit of further improvements to our cost:income efficiency carries with it the usual implementation risks of large projects. With a strong track record of cost management, we remain confident in our ability to manage this risk and fully expect to achieve 20% of the planned cost reductions amounting to some £60m by the end of 2007.
As we enter 2007 we will increasingly embed the risk management practices developed as part of our preparation for the Basel II regulatory regime. We welcome the greater insight these practices have given us in our capital allocation choices across the Group. As the relative capital requirements become established amongst competitors, we may face additional risks of unpredictable competitor pricing and the consequences of a long, drawn out road to a new level of comparator capital stability. Capital strength and capital discipline will remain non-negotiable at HBOS notwithstanding the potential capital benefit arising under Basel II.
Finally, reputation risk is high on the alert list as we strive to ensure that in our policies and practices we, at all times, behave in an appropriate way, as a banker for our customers and an employer for our colleagues. The reputation of HBOS and its major brands is of paramount importance and we guard it jealously.
Banking at HBOS is about managing risks and uncertainties with the objective of delivering sustainable returns for our shareholders. 2007 presents us with the usual long lists of opportunities and risks to their achievement. Our strategy and the guiding principles of value creation will again be deployed to achieve the optimum result for our shareholders.
Outlook
In 2007 we expect positive continuing GDP growth in each of the major economies in which we operate. In the UK we remain optimistic about the UK economy with a generally benign business environment supporting growth in secured Retail products. We continue to be cautious, however, about unsecured lending given the cumulative impact of rising interest rates, utility prices and consumer indebtedness. In strong Corporate lending markets, we will continue to participate fully in originating assets but also continue our strategy of selective sell down to enhance returns.
In the UK savings and investments markets, we estimate that UK liquid savings will exceed, for the first time ever, £1 trillion by the end of 2007. Total household financial assets (savings, mutual funds, pensions and other collective investments), we forecast, are set to grow to £4 trillion by the end of 2007. As the UK’s largest savings institution, and the UK’s number one provider of new investment products, this growth presents HBOS with a major opportunity.
Internationally, we plan to take advantage of the stronger GDP growth available to us by continuing our investment in our chosen markets. In Ireland, this will see us complete the roll out of our retail branch network by the end of 2007. In Australia, we will continue to make additional investments in infrastructure and distribution which will inevitably slow profit growth in the near term, but will further strengthen our potential for both market share and profit growth over the coming years.
Lending growth for the Group as a whole in 2007 is expected to be at or slightly above the level achieved in 2006, with similar levels of UK growth again enhanced by stronger growth from our International businesses.
In addition to the disposal of Drive, which accounted for circa 6bps in the Group margin in 2006, we anticipate some further margin decline in 2007, reflecting continuing competitive pressures in Retail and changes in business mix in International.
2007 will see the first major initiatives designed to deliver a ‘mid-thirties’ cost:income ratio by 2010. Including the first year cost of this programme and the substantial investments in future growth outlined above, we are targeting overall Group cost growth of circa 7% in 2007, offering the prospect of a further improvement to our cost:income ratio.
Capital efficiency will also remain a key discipline at HBOS. As announced in December, we have established a share buyback programme for 2007 which has been set initially at up to £500m. During 2007 we will be transitioning to the use of Basel II capital measures in our businesses, where we continue to expect a benefit reflecting the relatively simpler, lower risk HBOS business model.
In summary, the attractive revenue growth across our businesses, coupled with our relentless focus on cost leadership and capital discipline, will deliver shareholders continued momentum in the coming year.
Andy Hornby
Chief Executive
