Chief Executive’s Statement

In 2004, good volume growth, tight cost control and resilient margins enabled us to achieve 20% plus profits growth and a significant increase in return on equity (‘RoE’), just 0.2% short of our 20% target for 2004.

Profit before tax and exceptional items increased 23% to £4,770m. After charging £178m for exceptional items, profit before tax rose 22% to £4,592m.

Underlying earnings per share increased 23% to 84.3p while basic earnings per share also increased 23% to 78.1p. The Board is proposing a final dividend of 22.15p (up 8%) taking the full year dividend to 32.95p (up 7%). Underlying dividend cover has risen to 2.6 times (2.2 times in 2003). Having now reached our target of 2.5 times cover, dividend growth will match growth in earnings per share more closely.

Group RoE increased to 19.7% (17.7% 2003). Group Target RoE increased to 19.5% (17.7% 2003). Allowing for the reduction in profit in 2004 as a result of our move to underwrite household insurance, Group Adjusted Target RoE was just below our 20% target for 2004 at 19.8%.

In the short term, sales and market share ambitions must be adapted to economic conditions. As a result, in a number of markets in 2004 we adopted a steadily more cautious stance. Even so we delivered good volume growth. Total loans and advances to customers grew 12% to £316.4bn whilst total customer deposits grew 13% to £195.5bn. Investment product sales rose 13% to £1,381m of effective premium income and insurance sales increased 9% to £1,732m gross written premiums.

Underlying operating income, after charging for amounts written off fixed asset investments, general insurance claims and operating lease depreciation, rose 13% to £9,583m. Net interest income was 9% higher with non-interest income rising 23%.

Underlying operating expenses, excluding exceptional items, goodwill amortisation and operating lease depreciation, grew by less than 3% to £3,628m.

The ten point gap between income and cost growth pushed the Group’s cost:income ratio down to 37.9% from 41.6% in 2003.

We will continue to seek further reductions in our cost:income ratio. But such reductions will not be achieved at the expense of investment either in customer service or future growth. Last year we added around 2,000 new customer facing jobs. The prospects of certain parts of our business call for a significant investment in people and infrastructure. In Bank of Scotland (Ireland), HBOS Australia and HBOS Treasury Services costs will therefore rise by around £100m in 2005. Across the rest of the Group, which accounts for around 90% of costs, we continue to target year on year productivity gains by containing cost growth to retail price inflation regardless of volume growth.

The Group net interest margin fell 7bps to 170bps (177bps full year 2003) although it was slightly higher in the second half (172bps H2, 168bps H1). The decline principally reflects the impact of higher LIBOR related funding costs on the Retail margin as, for most of the year, money markets anticipated base rate increases.

As a percentage of closing customer advances non-performing assets increased to 1.85% (1.75% end 2003), an increase in Retail being only partially offset by reductions in Corporate and International. Closing provisions were 0.79% of closing customer advances (0.79% end 2003) with coverage of non-performing assets (‘NPAs’) by total closing provisions and interest in suspense at 45% (48% end 2003). The Group charge for provisions was £1,201m (2003 £1,025m) representing 0.40% of average customer advances (0.39% in 2003).

Despite good asset growth, the total capital ratio increased to 11.8% (11.1% end 2003) and the Tier 1 capital ratio rose to 8.1% (7.6% end 2003). Retained earnings, the key indicator of our capacity to finance growth, rose 41% to £1,734m.

At the interim stage we reported that the target run rate for merger synergies had been achieved. The exceptional costs arising from the merger amounted to £48m (2003 £119m).

Industry-wide, last year saw a significant increase in the volume of mortgage endowment complaints as the media, the Financial Services Authority and companies themselves were more successful in encouraging customers to come forward. As a consequence we have set aside an exceptional amount of £130m to provide compensation for customers with a valid complaint.

In December we presented our assessment of the anticipated impact for HBOS of the change in accounting from UK GAAP to IFRS. In May we will report comparative figures for 2004 on an IFRS basis. Since December we have not changed our view of the likely impact on capital or earnings of the change to IFRS.

Divisional Performance
Retail
Profit before tax and exceptional items in Retail increased 22% to £2,059m as the division’s consumer credentials and multi-brand strategy continue to be major drivers of value creation in HBOS. Our increasingly cautious approach to the mortgage market and the credit experience in parts of our unsecured lending book saw us tighten lending criteria appreciably. Even so, Retail achieved good growth in both customer lending (10%) and customer deposits (7%).

The Retail net interest margin for the year as a whole fell to 183bps (192bps 2003), just above the 182bps achieved in the first half. Product margins were stable and the decline was wholly attributable to higher LIBOR related wholesale funding costs.

Net interest income grew 8% and driven primarily by asset growth and related fee income, non-interest income rose 24%. Together they produced an 11% increase in total operating income. Total operating expenses were virtually unchanged compared to the previous year. The gap between revenue and cost growth widened to over 10%. As a result the Retail cost:income ratio fell to 44.1% (48.7% 2003).

Last year our market share of UK net mortgage lending was 17% (25% 2003). Throughout the year our pricing strategy was designed to target lower loan to value (‘LTV’) ratios. The average LTV for our entire book of mortgages fell again to 41% (43% end 2003) and the proportion of loans above 85% LTV fell to 7% (10% end 2003). In the current climate we will continue to manage down LTVs and target a market share of new lending between 15 and 20%.

The increasing maturity of our lending and a change in business mix largely account for the increase in non-performing assets which, as a percentage of closing customer advances, rose to 2.16% (1.81% end 2003). But the credit performance of parts of our unsecured lending book written in 2002 and 2003 was also a contributory factor. Through tightening lending criteria we have taken corrective action which we believe has been effective. The provisions charge as a percentage of average advances increased to 0.33% (0.30% 2003) with coverage of NPAs by total provisions (including interest in suspense) now standing at 37% (40% end 2003).

Taken together, savings balances and credit balances in bank accounts increased by £8.4bn (£10.8bn 2003) generating a small increase in HBOS’s estimated share of UK Household Sector Liquid Assets to 15.9% (15.7% 2003).

With 1 million new bank accounts (estimated 25% of the new and switchers market) and 1.2 million new credit cards (estimated 19% of new credit cards), we continued to gain market share in basic banking products. Bank account credit balances and credit card outstandings grew by 12% and 30% respectively.

Good progress is also being made in servicing the small business banking market where competitors’ pricing continues to present us with the opportunity to grow at their expense. In 2004 we acquired 29,000 new customers which enabled us to grow deposit balances by 21%.

Corporate and Treasury
In Corporate, profit before tax and exceptional items grew by 25% to £1,376m as Corporate converted controlled asset growth into improved credit quality and better returns for shareholders. The division’s franchise in its key markets continues to strengthen. Last year the integration of the Corporate and Business banking divisions also yielded early cost savings.

Increased competition in a better trading environment reinforced our determination not to compromise our lending criteria. This, together with greater success in sell down activity as we sought to drive up returns and higher repayments, resulted in net lending to customers rising 9%. The Corporate net interest margin was little changed at 198bps (196bps 2003) and net interest income therefore grew by 10%.

Our clear focus on growing fees and commissions together with increased investment gains saw non-interest income rise 23%. Despite such gains the embedded profit in our investment portfolio increased during the year.

Corporate continued to expand its resources and infrastructure at pace but operational efficiencies arising from the integration of our Corporate and Business banking divisions saw costs, excluding operating lease asset depreciation, just 6% higher than in 2003.

The ten point gap between the growth in underlying operating income (16%) and underlying operating expenses (6%) meant that the Corporate cost:income ratio fell to 27.2% (29.8% 2003).

Throughout the year we saw improvements in credit quality performance indicators and NPAs as a percentage of closing advances fell to 1.45% (1.81% 2003). The provisioning charge as a % of average advances of 0.69% (0.66% 2003) resulted in coverage of NPAs by total provisions (including interest in suspense) of 71% (65% end 2003).

In Treasury, profit before tax and exceptional items rose 8% to £262m, as Treasury’s clear focus on the development of Group customer revenues continued to generate high quality earnings for HBOS.

Despite a strong performance from our structured investment portfolio, net interest income reduced by 8% as we chose to lengthen the maturity profile of our wholesale funding liabilities. Conversely, as a result of increased sales of Treasury products to the Group and its customers, non-interest income grew by 32%. Overall, total operating income rose 11%.

Total operating expenses increased 20% as we continued to invest in the capability and infrastructure required to support our businesses internationally, address regulatory change and extend our ability to service our customers’ needs. The cost:income ratio therefore rose to 29.9% (27.8% 2003).

Credit quality was such that no provisions for bad debts were required.

Insurance & Investment
HBOS’s multi-brand multi-channel strategy enabled our Insurance & Investment businesses to deliver profits before tax and exceptional items 20% higher at £1,067m. After allowing for the reduction in profit due to the commencement of household insurance underwriting in January 2004, which defers profit recognition, the increase in profits was 29%.

Reported insurance profits fell 8% to £409m but profits rose 9% after allowing for the household insurance adjustment. Generally favourable underwriting experience and tight cost control allowed sales growth to feed directly through to profits.

Repayment insurance sales were 2% higher. Major new contracts enabled us to achieve an 18% increase in third party sales of repayment insurance which more than offset the 4% reduction in Group sales. Household insurance sales rose 8%, and for the first time, non-mortgage related sales exceeded mortgage related sales. With the successful launch of First Alternative, motor insurance sales rose 34% as esure itself moved into profit.

Benefiting from positive short term fluctuations in investment returns, investment profits rose 48% to £658m. Profits based on long term assumptions also increased by 48%. Increased new business volumes, efficiency gains and favourable experience were the key factors.

Strong growth in overseas sales (up 84%) and improved margins in the UK caused new business profitability in the intermediary channel to rise from 18% to 25% of effective premium income. This was largely responsible for the overall improvement in new business profitability to 28% of effective premium income (25% 2003).

All three investment product channels showed good sales growth with bancassurance up 12%, intermediary sales up 11% and St James’s Place up 19%. Overall, UK sales of investment products grew 8% to £1,240m effective premium income increasing our market share to 12.2%. And for the first time this made HBOS the UK’s No.1 provider of such products on this measure.

International
In both Australia and Ireland we have set about exporting HBOS strategies with a proven track record of success in the UK, designed to capture business from incumbents. Profit before tax and exceptional items grew by 21% to £312m from our combined operations in Australia and Ireland. Profit before tax and exceptional items in Australia rose 17% to A$506m and in Ireland rose 41% to €148m.

Competitively priced product offerings with aggressive advertising has seen encouraging new business growth in Australia where we achieved advances growth of 15% alongside 28% growth in customer deposits. As a consequence of the product mix and higher funding costs, margins declined by 10bps to 212bps (222bps 2003). Tight cost control necessary during a period of growth and integration saw underlying cost growth contained at 8% with the cost:income ratio at 50.0% (50.3% 2003). Credit quality remained good with the provisions charge as a percentage of average advances falling to 0.13% (0.24% 2003). NPAs reduced to 0.45% of closing advances (0.72% 2003).

In Ireland where we consciously adopted the consumer champion positioning that has served us well in the UK, we also saw good growth, with customer lending up 59% and deposits up 27%. The 21% increase in underlying operating expenses is inclusive of Retail investment initiatives and the re-engineering of the Venture Capital business. The cost:income ratio nevertheless improved to 37.2% (39.2% 2003). Credit quality improved with the total provisions charge as a percentage of average advances at 0.17% (0.29% 2003). NPAs fell to 1.53% (1.86% 2003).

Outlook and Prospects
In 2005 we expect the UK economy to return to its trend rate of growth. Whilst consumer spending has slowed the prospects for employment remain bright and the trends in business investment appear healthy. Against this background we anticipate little change in the overall credit performance of our lending.

The housing market has seen a healthy shift in sentiment. Housing transactions have come back from last year’s peak but prices remain underpinned by strong employment and interest rates that are at or close to a peak. In slower growth markets, Retail’s momentum and rigorous cost discipline will continue to be a key source of advantage to HBOS.

Good levels of activity in our Corporate lending markets coupled with our continued commitment to controlled asset growth provide an encouraging backdrop for value creation in Corporate. In Treasury, through further extending our capability to meet the needs of both the Group and its customers, we are continuing to invest in the generation of a quality earnings stream.

Sentiment in stock markets is better than for some time as is already reflected in the performance of our investment businesses. As a market leader with particularly strong multi-channel distribution we are well placed to exploit the opportunities presented by the new “Sandler” products and depolarisation.

We do not anticipate significant shifts in underwriting experience across our personal lines businesses and we plan further investment in extending our distribution reach in order to gain market share.

In Australia and Ireland we are set to make good progress as we invest in the people and infrastructure we need to mount a serious challenge to the incumbents in each market.

Since the capital raising in early 2002 underlying earnings per share have increased by 76% and dividend cover has risen just above our target of 2.5 times. This has resulted in a near fourfold increase in retained earnings transforming our capacity to finance our own growth. This year we expect asset growth to moderate further and we also intend to adjust the balance between equity and preference capital in our balance sheet. At the end of last year our Tier 1 and total capital ratios were above their targets. We are therefore instigating a share buy back programme and in 2005 this will amount to up to £750m.

In HBOS’s first three years, we have gained market share, achieved much improved efficiency and established higher shareholder returns. Our consumer credentials, our multi-brand strategy and the distinctive skills of our corporate team will ensure that we continue to deliver the growth necessary to achieve our 15 – 20% market share targets. Even with the merger behind us and recognising a slower growth environment, we can and will achieve further efficiency gains. But most important of all, we will also consolidate the gains we have made in shareholder returns. Central to this ambition are our cost discipline, dividend policy and capital management programme. Through them we will make growth work harder for shareholders.

James Crosby
Chief Executive