Natwest Group PLC

LSE:NWG

Earnings Call Transcript 2021-Q3

[Operator]

Welcome, everyone. Today's presentation will be hosted by CEO, Alison Rose; and CFO, Katie Murray. [Operator Instructions]

[Alison Marie Rose-Slade]

Good morning, and thank you for joining us today. As usual, I'll start with a brief update before handing over to Katie to take you through the Q3 results. We'll then take your questions. So starting with the headlines. We're reporting operating profit of GBP 1.1 billion, up from GBP 400 million for the same quarter last year. This includes an impairment release of GBP 242 million as underlying credit metrics improved and defaults remained low, resulting in an attributable profit of GBP 674 million. We continue to make good progress on our targets. Net lending was up 3.1% on an annualized basis, driven primarily by growth in mortgage lending. Costs were down 4.3% for the first 9 months compared to the same period in 2020 and we're reporting a CET1 ratio of 18.7%. As you know, this capital strength has enabled us to increase our annual dividend distribution to a minimum of GBP 1 billion for 2021, '22 and '23. It has also allowed us to make an initial on-market buyback of up to GBP 750 million this year, of which GBP 402 million has been executed to date. Taking into account the GBP 1.1 billion directed buyback in March, this brings total distributions for 2021 to around GBP 2.9 billion, of which we have already booked GBP 2.6 billion. As you'd expect, our focus is very much on executing our strategic priorities in order to drive shareholder returns and deliver on our 2023 targets. These priorities are all about generating income growth, reducing operating costs, investing to make our business more customer-friendly and efficient through digitization and allocating our capital wisely in order to maximize returns. I won't dwell on this slide, but I would like to underline our commitment to play a leading role in relation to climate change. We have already exceeded our initial target of delivering GBP 20 billion of climate and sustainable funding and financing. So we have recently announced a new target to deliver a further GBP 100 billion by the end of 2025. Turning to Slide 5, I'd like to talk in more detail about how we are supporting our customers to drive growth. Net lending across our retail and commercial businesses is up 3.1% on an annualized basis to GBP 305 million, GBP 7 billion up since the year-end, excluding government lending schemes. This growth has been driven by mortgage lending, whilst commercial demand continues to be relatively muted as the economy reopens. I've spoken in the past that we see an opportunity to grow our share of mortgage and unsecured lending. And during the year, we have launched a range of initiatives to achieve this. We're making good progress in buy-to-let mortgages, where application volumes in the third quarter more than doubled compared to the second as a result of simplifying our policy and aligning our lending criteria more closely to the market, whilst maintaining firm pricing discipline. We're also seeing good momentum in unsecured lending. The issuance of new credit cards has almost doubled year-on-year, and we have brought new products to the market. Around 1/3 of this growth has been in the last 4 months following the launch of a new purchase and balance transfer card in June. Spending on credit cards is up 20% on last September to pre-COVID levels. And whilst credit card balances remain slightly down, this trend is gradually reversing. As you would expect, we are growing unsecured lending in a thoughtful and disciplined manner. We have made our new purchase and balance transfer card available only for existing customers, just as we did with the government lending schemes, and our mobile app helps customers both to track and set limits on their card spending. Turning to Commercial Banking. Demand remains relatively muted from smaller businesses, but we are seeing more activity in our corporate and specialized businesses. Revolving credit facility utilization remains broadly stable at 19% compared to a peak of 40% in April last year. Looking at government lending and particular Bounce Back loans. Since the first anniversary of the scheme when repayment started, about 7% of these loans have been repaid in full and around 90% of customers due to start repayments are repaying on or ahead of schedule. In NatWest Markets, our currency and capital markets businesses are performing in line with expectations, whilst we continue to reshape our Rates business to better serve corporate and institutional clients. And finally, we are benefiting from having brought all our Wealth Management businesses together in Private Banking in order to make better use of our asset management expertise right across the group. Year-to-date, we have delivered strong growth of around 11% in assets under management and administration. This includes growth of GBP 1 billion in the third quarter bringing assets under management and administration to GBP 35.7 billion. Just over half our growth in the first 9 months was net to new inflows, of which about 30% was via our digital platforms. Whilst all these trends are positive, we continue to monitor customer behavior closely in the light of recent supply chain challenges and inflationary cost pressures. At the same time as expanding our products and services to meet customer needs, we continue to accelerate our digital transformation, as you'll see on Slide 6. About 7 million of our retail current account customers now use digital means only to interact with us, allowing them to access our services at any time of the day from any place they want. We are using data and analytics to deepen customer engagement in retail banking through increasingly personalized messaging. Tailored messages have grown from GBP 72 million in the first 9 months last year to GBP 318 million in the first 9 months this year, and they have resulted in a significant improvement in customer engagement. Meanwhile, branch transactions remain below pre-COVID levels whilst mobile payments and video banking have grown year-on-year. We have also been investing in technology-led payment solutions for commercial banking customers through our merchant acquiring platform, Tyl, and online payment service, Payit. Tyl has processed over GBP 1.5 billion worth of transactions since inception, of which around GBP 500 million took place during the third quarter. I want to turn now to capital management on Slide 7. Let me start with our multiyear withdrawal from Ulster Bank. We continue to work through our agreements to accelerate our withdrawal. We have now reclassified EUR 3.7 billion of commercial loans, the vast majority of those we are selling to Allied Irish Bank as assets held for sale. And we're working with Permanent TSB on the sale of EUR 7.6 billion of performing retail and small business loans, along with the transfer of associated colleagues. If completed, we expect these 2 transactions to be capital accretive. We are also reviewing options for other elements of the portfolio, and we'll continue to keep you updated on our progress. Actively managing our capital in commercial banking has contributed to the GBP 700 million reduction in RWAs during the quarter. We expect the impact of this capital management in Commercial Banking, together with disposal costs in NatWest Markets, to amount to GBP 150 million in 2021, down from our estimate of GBP 300 million of which GBP 70 million has been realized to date. As you know, our focus on capital allocation is about maximizing returns to shareholders. This is a capital generative business and our CET1 ratio at 18.7% is well above our target ratio of 13% to 14%. As I said earlier, this has enabled us to commit to an annual distribution of at least GBP 1 billion for 2021, '22 and '23. We expect to complete our initial on-market share buyback program of up to GBP 750 million in the first quarter of 2022 and have already executed on GBP 402 million. Taking into account the directed buyback of GBP 1.1 billion last March, this brings total distributions for 2021 to around GBP 2.9 billion. With that, I'll hand over to Katie to take you through our financial performance in more detail.

[Katie Murray, Group CFO & Executive Director]

Thank you, Alison, and good morning, everyone. I will start with the Group income statement. We reported total income of GBP 2.8 billion for the third quarter, up 4.3% from the second quarter. Within this, net interest income was down 2% at GBP 2 billion and noninterest income was up 21% to GBP 820 million. This increase reflects a number of notable items, including a GBP 79 million share of gains from our collaboration with the Business Growth Fund and gains of GBP 45 million on the liquid asset bond sales in the quarter. Excluding all notable items, income was in line with the second quarter. Operating expenses increased 14% to GBP 1.9 billion, driven by litigation and conduct costs. This means we are reporting an operating profit before impairments of GBP 832 million, down 13% on the second quarter. The net impairment release of GBP 242 million represents 26 basis points of gross customer loans and compares to a release of GBP 605 million or 66 basis points in the second quarter. This reflects improvements in underlying credit metrics and a low level of defaults. Taking all of this together, we reported operating profit before tax of GBP 1.1 billion. Attributable profit to ordinary shareholders was GBP 674 million, equivalent to a return on tangible equity of 8.5%. I'll move on now to net interest income on Slide 10. Banking net interest income for the third quarter was GBP 6 million higher than the second, excluding the one-off tax adjustment in the second quarter. This increase reflects continued mortgage growth, a return to net growth in unsecured balances and 1 extra day in the quarter. It was partly offset by the reclassification of AT1 from equity to subordinated debt for the period before redemption in August. This accounted for a GBP 14 million decrease. Turning to bank net interest margin, excluding the liquid asset buffer, this reduced by 3 basis points to 234 basis points after adjusting for the one-off tax adjustment in the second quarter. This reduction was driven by AT1 classification and a full quarter of debt costs following new issuance in Q2. Business trends were broadly stable in the quarter, which you can see in our yield and cost data Slide 11. On the asset or lending side, gross yield for the Group fell by 3 basis points to 178, reflecting further growth in lower-yielding liquid assets. There was moderate pressure on the retail banking loan yields due to lower mortgage rates, while commercial banking yield broadly stable excluding the one-off tax adjustment. On the liability or deposit side, group funding costs at 34 basis points were impacted by the AT1 reclassification. There was a small reduction in both retail and commercial deposit costs due to mix. There are 2 key factors to consider in relation to net interest margin in 2022, excluding the liquid asset buffer, First, the yield curve; and second, price and mix. I will talk more about these factors on Slide 12.Mortgage margins are returning to pre-COVID levels. Average application margins in the third quarter reduced by 37 basis points to 115 basis points and then continued to reduce towards the end of the quarter to around 105 basis points, reflecting the higher spot rates. This is broadly in line with January 2020. Front book margins on mortgages that completed in the third quarter decreased from 165 to 143 basis points below the back book. Lower margin roll-offs resulted in the back book margin improving by 1 basis point to 164. The increase in swap rates in Q3 was followed by a further sharp rise in October and like other lenders, we have taken action to increase customer rates across a selection of our products. Of course, the other side of the equation is the benefit we derive from higher spot rates through our structural hedge. We have said that the majority of the GBP 250 million year-on-year decline in our hedge income was in the first half, and the hedge impact in the third quarter relative to the second quarter was negligible. We also expect the hedge impact on net interest margin to be broadly neutral in Q4 and in 2022. Turning to our interest rate sensitivity, which we updated at the first half. We revised our economic assumptions at the half year, and they will not be updated until the year-end, in line with our usual practice, but we welcome the improved consensus rate outlook. At the half year, the yield curve suggested that U.K. base rates would remain at 10 basis points until Q4 '22 before rising to 25 basis points and a further hike to 50 basis points was expected in Q4 '23. You will see that the majority of our sensitivity comes from our managed margin or the unhedged balance sheet. This shows a benefit of GBP 414 million for an upward shift in the yield curve, from 10 basis points to 35 basis points. This reduces in year 2 and 3, reflecting higher pass-through assumptions as base rate increases. The overall benefit from a 100 basis point increase would be GBP 1.3 billion in year 1, which shows you the sensitivity is not linear. Moving on now to look at volumes on Slide 13. Gross banking loans decreased by GBP 2.9 billion or 0.8% in the quarter to GBP 358 billion. This includes growth of GBP 2.7 billion in our U.K. and RBSI Retail and Commercial businesses, excluding government schemes, which was more than offset by the reclassification of Ulster Bank loans that we have agreed to sell to Allied Irish Bank as assets held for sale. U.K. mortgage growth of GBP 2.5 billion or 1.4% reflects continued robust demand following the first deadline for stamp duty relief at the end of June. U.K. unsecured balances grew by GBP 300 million, the first increase since the fourth quarter in 2019. We were pleased to see growth in personal loans of GBP 200 million or 2% and continued growth of credit card balances up a further 3% in the quarter. In Commercial Banking, gross customer loans fell by GBP 1.3 billion, reflecting continued repayments on government schemes and targeted sector reductions mainly across real estate and retail. And this was partially offset by growth in specialized business. Average interest-earning banking assets, excluding the liquid asset buffer, increased by GBP 1 billion to GBP 331 billion. I'd like to now turn to noninterest income on Slide 14. Noninterest income, excluding notable items, was in line with the second quarter at GBP 667 million. Within this, income from trading and other activities decreased by 7% to GBP 137 million. Our currencies and capital markets business in NatWest Markets performed in line with expectations, but there was continued weakness in fixed income as a result of subdued customer activity and ongoing reshaping of the business. We are taking action to address this performance and expect an improvement into 2022. Fees and commissions in the Retail and Commercial businesses grew by GBP 20 million to GBP 504 million. This was driven by higher payments due to increased corporate activity as well as card and lending fees as consumer activity increased. I will move on now to look at costs on Slide 15. Other expenses, excluding operating lease depreciation and the direct cost base of Ulster, were GBP 1.5 billion for the third quarter. That's down GBP 13 million on the third quarter last year and reflects ongoing cost reduction, partly offset by higher investment spend as expected. This takes our year-to-date cost savings to 4.3%, and we continue to expect to deliver savings of around 4% for the full year. Strategic costs in Q3 were GBP 77 million, bringing the total for the first 9 months to GBP 409 million. Turning now to impairments on Slide 16. We're reporting a third quarter net impairment release of GBP 242 million or 26 basis points of gross customer loans. This brings the overall release for the first 9 months to GBP 949 million. The Q3 release was driven by improved underlying risk metrics in our performing book and a continued low level of defaults. We still expect a net release for the full year, and the outcome will be affected by 3 key variables. First and foremost is the economic performance versus the weighted economic outlook we use in our scenarios. As you know, we update these each half. So the consensus economic outlook as we approach the end of the year will be critical. Second, credit performance. While we see a low level of default and no [ tall trees ] at the moment, we will monitor credit conditions carefully as COVID support continues to roll off. And third, our post-model adjustments. Our ECL provision at the end of Q3 was GBP 4.5 billion, down from GBP 4.9 billion at Q2. This includes GBP 1.1 billion of post model adjustments, of which GBP 729 million relates to economic uncertainty. This is down by GBP 105 million in the quarter, reflecting a GBP 54 million reclassification of the PMA held against the Ulster portfolio, we have agreed to sell to Allied Irish Bank. And at the end of the payment holiday support for a number of our customers. If the economic and credit conditions continue to trend in line with the third quarter, there could be some further unwind of this PMA later this year and into 2022. We are comfortable with our ECL coverage of 1.19%. Turning now to look at capital and risk-weighted assets on Slide 17. We ended the quarter with a common equity Tier 1 ratio of 18.7% on a transitional basis under IFRS 9, up 50 basis points over the second quarter. This increase reflects a 28 basis point increase from attributable profit net of changes to IFRS 9 transitional relief and a 37 basis point benefit due to lower RWAs. This was partially offset by the updated dividend accrual and linked pension contribution, which together reduced the ratio by 26 basis points. Our IFRS 9 transitional relief reduced by 13 basis points in the quarter to 60 basis points. This reflects the release of Stage 1 and Stage 2 expected credit loss which would previously have been added back to our capital position. RWAs fell by GBP 3.2 billion in the quarter to GBP 160 billion. This was driven by lower market risk, which decreased by GBP 2.9 million, reflecting the GBP 2.4 billion impact of our updated model following the transition from LIBOR to SONIA. There was a small decrease in RWAs of GBP 100 million from positive pro-cyclicality, which reflects a positive GBP 600 million in Commercial Banking, offset by a negative in Retail banking. As we look to the year-end, in NatWest Markets, we no longer expect to achieve the majority of the remaining RWA reduction towards the medium-term target of GBP 20 billion this year. However, we now expect group RWAs to be below our previously guided range of GBP 185 billion to GBP 195 billion on 1 January 2022. You will find more details of the various regulatory impacts in our appendix. Turning to my final slide, which shows the strength of our balance sheet. Our CET1 ratio of 18.7% is now between 470 and 570 basis points above our 13% to 14% target range and is more than double our maximum distributable amount. We continue to expect to operate within a range of 13% to 14% CET1 by full year '23. And you will find more details of the CET1 ratio drivers in our appendix. Our U.K. leverage ratio of 5.9% is down from 6.2% in the prior quarter and 265 basis points above the Bank of England minimum requirement. The reduction was driven by the redemption of one of our most expensive U.S. dollar AT1s following issuance during the first half, for which we recognized a gain of GBP 150 million through reserves in the quarter. We have also maintained strong liquidity levels with a high-quality liquid asset pool and a stable, diverse funding base. Our liquidity coverage ratio increased in the quarter to 166% due to ongoing deposit inflows and headroom above our minimum requirement is now GBP 79 billion. So to conclude, we have delivered a strong operating performance in the third quarter and we are pleased to see the growth in unsecured balances and fee income. We're also making good progress on cost reduction and capital optimization. And with that, I'll hand back to Alison.

[Alison Marie Rose-Slade]

Thank you, Katie. So to sum up before we open up for questions. We are reporting operating profit of GBP 1.1 billion, which includes an impairment release of GBP 242 million as a result of low levels of default, though we are mindful of the current operating environment and are monitoring customer activity closely. We're continuing to make progress in the execution of our strategy and delivery of our 3-year targets. Lending is up 3.1% on an annualized basis. We are on track to reduce costs by around 4% per annum and we continue to work towards a CET1 ratio of 13% to 14% with the aim of delivering return on equity of 9% to 10% by 2023. We're pleased that our capital strength enables us to continue investing in our digital transformation and to consider other options for creating shareholder value at the same time as committing to total distributions of around GBP 2.9 billion for 2021. Thank you very much, and we're happy to take your questions.

[Operator]

[Operator Instructions] We will take our first question from the line of Omar Keenan from Crédit Suisse.

[Omar Keenan, Research Analyst]

I've got 2 questions, please. One on rate sensitivity. And then just one on mortgages and mortgage margins. So firstly, on rate sensitivity. On the GBP 450 million for 25 basis points, is there any color that you could add around what deposit beta assumptions are behind that number? And then secondly, on mortgage margins. So the application margins were 105 basis points in September versus a back book of 1.64. I think kind of historically, the level of around 100 bps received in 2019 is quite low, and a few peers like mentioned why at the time made comments that similar levels didn't meet their hurdles. So my questions on mortgage margins are, firstly, how do you get comfort that your internal ROE metrics that drive the business really reflect economic reality? And then secondly, how do you get comfort that mortgage margins and volumes are being balanced in the most optimal way considering price elasticities, for example?

[Alison Marie Rose-Slade]

Thank you. Katie, do you want to pick up the question on the rate pass-through in mortgages?

[Katie Murray, Group CFO & Executive Director]

Yes, sure, absolutely. Thanks very much. So good to hear you. So let me try to give you a little bit of color on this one. So our economic assumptions, they're based off H1. They're not updated in Q3, in line with our usual process. So just to remind you, at H1, the yield curve suggested that base rates would remain at 10 basis points until Q4 2022 before rising to 15 basis points and rising -- sorry, by 15 basis points to 25 with a further hike to 50 basis points was expected in Q4 '23. Clearly, consensus rate expectations have increased significantly since then. So on the managed margin slide, as you look at it in terms of the Q3, the GBP 414 million for a 25 basis point shift in the base rate. Within there, that's around 90% of that number is sterling-based. This sensitivity is built bottom-up, incorporating different pass-through assumptions for products across all franchises. The actual pass-through rates will be reviewed and adjusted, subject to prevailing market conditions and upcoming capital charges, et cetera, including expectations of the pace and the number of rate increases that we might see. Omar, you'll be a bit disappointed to hear that I'm not going to get into the finer details of the pass-through rates today. But this is a built up from the bottom, the number that we're giving you. You can see from the interest rate sensitivity disclosure that the managed margin benefit decreases in year 2 and 3. This reflects the higher pass-through assumptions that come as we get to those higher base rates. You can also see from our disclosure that 100 basis point shift in the sterling GBP yield curve would be GBP 1.3 billion income benefit. So the sensitivity incorporates higher pass-through rates, and it is not as simple as a multiplication of the 25 basis point level. But clearly, from this, you can see that any rate rise is very positive for us. And then if I go to the mortgage margin question. So you're right, again on that Slide 12, September at 105 bps, the back book at 164 bps. What I would say is that we continue to meet hurdle. But clearly, what's happened in that level. And then with the rate increases that you saw coming through from swaps into October. And then we've accompanied those with some rate rises as well from our own side. So that gets us comfortable. We're still okay on internal ROE. We do, do a lot of analysis internally to make sure that we are clear on the elasticity of pricing and that we're comfortable in terms of how we do all the extra charging over of costs into this business. So very comfortable that it makes sense. And I think it's important also to look at the whole book. And I think that's what I was really trying to demonstrate to you on Slide 12 is actually the movement we've seen in pricing. Obviously, one helps compensate for the other. But overall, we're very comfortable on this book, and that's seen in the very strong ROE that you see for the retail business as a whole.

[Operator]

Next question comes from the line of Fahed Kunwar from Redburn.

[Fahed Irshad Kunwar, Research Analyst]

I have a couple of questions and they're kind of related. If I think about the kind of revenue and cost in isolation, they do make sense. But when I look at the jaws coming through for the next few years given the cost reductions, they're one of the most ambitious in Europe. And I guess, given the cost inflation we're seeing across the market right now, how confident are you that you can see revenue growth while cutting costs 4% per annum? And then just specifically on -- it feels like NatWest Markets is a real kind of microcosm of that point. When you look at the kind of annualized quarterly number, it's kind of annualizing at around GBP 400 million in the guidance, I think you talked about being 800 million to 1 billion in the medium term. How much of that is actual growth expected in kind of rates improvement, currency improvement, capital market improvement? And how much is just mechanically, if you've got any negative funding drag still running in the business from the old non-core and that just kind of rolling off would just move that kind of GBP 400 million up towards GBP 800 million? I was interested to know how much do we need to kind of make an assumption on growth and how much is mechanical? That would be very helpful. And then just a final question on NatWest Markets. The kind of GBP 25 billion or the kind of -- the little day in cutting the risk-weighted assets, I think that was to do with the particular position that you have on your balance sheet, you want to keep on. When that rolls off next year, what would be the revenue loss that you would see when that little bit of balance sheet comes off?

[Alison Marie Rose-Slade]

Let me start and see if I can help you with some of that. So on costs, you can see we've got a very good trajectory on our costs. As Katie and I both said, it won't be linear, but we're very confident about the 4%, and we see opportunities to continue to reduce costs within the business as we continue to invest in digitization and technology and our customer journeys. And we also see continued revenue opportunities across different parts of our business. You can see the strong performance in mortgages. You can see our unsecured growth is very strong and coming back. We've doubled the number of new credit card issues as we've launched new products. And you can see the strong growth in our AUMA in our private bank with GBP 1 billion of assets under management and almost 11% year-to-date growth. So we see continuing growth trajectory from the strength of our franchises and with our continued investment in technology and digitization, which is where 80% of our investment is going, opportunities across there. So I think probably that's all I'll say there. On NatWest Markets specifically and just to sort of talk through that and give you some help on that. I mean, let's put -- looking at the Q3 performance, I think the capital markets and currency businesses, which are serving our core client base are performing well and remain in line with our expectations. Obviously, a disappointing performance in our Rates business as we continue to reshape that. But what we expect is that as we continue to grow in our capital markets and currency business, and you can see the strong performance in ESG. That will continue to perform very well on the back of our strong franchise. We'll have the benefit from improved funding costs, which will come through. And I think we'll see a stabilization of fixed income revenues into 2022 from the improved trading, the lower funding costs and the completion of the refocus, which is largely on the Rates business. So in the medium term, we're comfortable that this business is GBP 0.8 billion to GBP 1 billion revenue business, and we would expect that to stay the same and as that restructuring continues. So I think that's where we remain. On your specific point on the RWAs, the reshaping of the business is going well. We are running a strong syndicated loan pipeline as a result of strong activity across our corporate business and our specialized business. And so that's giving us a little bit more RWA, but we'll continue to restructure that business in the right way on the RWA. So again, trajectory, we're comfortable with.

[Fahad Usman Changazi, Equity Analyst]

Can I just ask 1 quick follow-up? I guess I understand isolation how the costs can come down and obviously NatWest has done a great job over the years of doing that. But the issue has always been the revenues have followed. I guess where I struggle a bit is if you're cutting capital and costs in a wholesale business without any kind of mechanical benefit, what really is going to be driving the growth when you are kind of cutting costs and capital, which is a big part of the story on NatWest Markets?

[Alison Marie Rose-Slade]

So on the -- you're talking about growth in NatWest Markets specifically is your question?

[Fahed Irshad Kunwar, Research Analyst]

Yes.

[Alison Marie Rose-Slade]

So on NatWest Markets, again, if I remind you where we started with NatWest Markets, too much of the capital was deployed into our Rates business. And therefore -- and not focused around our key strategic priorities, where that capital is focused, and you can see that through the strong performance in the capital markets business and also currency, in effect, that business is growing very well. So the capital is being deployed to the areas that are growing, and we're shrinking it in our Rates business, which was outside. So overall, we're very comfortable that the size of the capital deployed to our Markets business will be delivered, we'll deliver the sort of GBP [ 0.82 ] billion revenue business. And we're also investing in the underlying business as well, so more digitization, more technology, which drives some more efficiency in terms of our productivity and also our revenue growth. So I think we're very happy with that balance between investment and where the capital is deployed for growth.

[Operator]

Our next question comes from the line of Alvaro Serrano from Morgan Stanley.

[Alvaro Serrano Saenz de Tejada, Lead Analyst]

Katie, Alison. I've got, I think, a question one for each, and they are both follow-ups. First, on the managed margin, the rate sensitivity. I know you don't want to be drawn into the exact deposit beta. But the way I'm thinking about it, and the question is I'm thinking is -- if I'm thinking about it correctly. If I take your product hedge, GBP 146 billion disclosed in the first half and deduct it from your deposits, from your total deposits, that you get to GBP 320 billion or so remaining, sort of unhedged deposits, which is basically if I -- 25 basis points and 0.50 beta gets you to GBP 400 million, which sounds very, very familiar, very similar to the figure you've got in that slide in Page 12. Am I missing that some of those deposits might be [ back in ] base rate? Or is it roughly the very sort of -- is it not that simple? That's the first question. And the other follow-up is on the costs and inflation, Alison, I hear your reply, but -- maybe you can give a bit more color as to why you're so confident around the 4% in subsequent years? Because presumably, when you laid out the plan sort of inflation, you wouldn't have expected this kind of inflation. Is it more about the fact that you're reducing the headcount [ the year nought ]? The inflation pressures are less intense given the reduction of headcount. Is it the fact that you -- as a good manager, you were building a buffer, you've got other sort of efficiency plans to offset here? Or you didn't have Ireland in there? Just a bit more color that can help us gain confidence or reassure us on that target.

[Alison Marie Rose-Slade]

Well, look, on the costs and then Katie can pick up the managed margin. As you can see in our quarterly results, this quarter, the continuing strong trajectory on costs, and we're -- that's very much focused on largely our customer journeys as we create benefits from the investment that we're making in our customer journeys. And as we simplify those and more use of automation and digitization and the subsequent impacts on that, I think as we roll forward, obviously, we're mindful of the inflationary situation that we may be looking at. But as I look at our customer journeys, as I look at the return on the investment that we're making, we still think there is efficiency that can be delivered across the business from that. And if I look at the benefits that we get from our customer journeys, the reduced throughput and the use of automation, that does help us. I'm not going to comment as I never do on FTE and headcount going forward. But clearly, that is an element of how we'll drive cost out going forward through the benefit of the investment that we're making. Katie, managed margin.

[Katie Murray, Group CFO & Executive Director]

Yes, Alvaro. Look, it's not a bad proxy. It's probably not quite as simple as you would expect. You need to consider the asset and the liability side. So if I think a little bit in terms of one, deposits, almost all of our retail and corporate deposits are managed rates. We do not have an automatic price change due to the external reference rate change. So if you look at retail, $186 billion at Q3, around 40% of that is current accounts, 60% is [ fixed ] accounts with an average cost of 5 basis points and no explicit link to that external base rate. So what I said in that assumption we've given you is we've obviously gone through product by product and saying we'd move this, we move that. The exact moves will depend a little bit on the environment in that moment. And then you see the same sort of dynamic in the commercial book where there's minimal balance that's linked to that external reference rate. So you have a bit of flexibility. But then consider what will happen on the asset side in terms of the lending. So Retail Bank, 90% fixed book. So you have an impact because of the SVR immediately, and that's less than 10% of the book. In Commercial Bank, there was a bit more linking to reference rate, so you'd see that come through much more quickly. But look, I'd say your proxy is not a bad one. But inevitably, as you can imagine, the devil on this one is in the detail.

[Operator]

Your next question comes from the line of Andrew Coombs from Citi.

[Andrew Philip Coombs, Director]

I'm going to flog a dead horse, I'm afraid. So if we come to the rate sensitivity. I guess what intrigues me when you look at your sensitivity and you compare it to peers, is that the peers has a much bigger multiplier effect in year 2 and year 3. But you in your sensitivity it's almost relatively static over that time period. Now one of the things you do provide, which your peers don't, which is quite helpful is the split between structural hedge and the managed margin and what's quite [ nice able ] here is the decline in the managed margin over time, whereas when you gave this guidance for the full year in the end 2020 sensitivity, you didn't see that same decline. So I'd love a bit more color on what's driving the decline in the managed margin from year 1, year 2 to year 3. It's clearly the pass-through and the churn presumably on the time deposit book. But -- are you also not assuming static balances? Are you assuming dynamic balances within your sensitivity? So just a bit more color there on the sensitivity and assets. My other one on NatWest Markets as well. You still reiterated the GBP 0.8 million to GBP 1 billion revenue guidance, I think. Can you just confirm that the breakeven guidance of that business is still in force as well in the medium term?

[Katie Murray, Group CFO & Executive Director]

I plunge myself in there, Andrew. Look, it's interesting. I smiled when you said it's relatively static. And I guess that the headline level of the 4 50, 4 92 and 5 02, it's relatively static, though I smile sometimes at the pain you give me when I moved by GBP 50 million on one line. So I'm delighted to get the feedback that, that is seen as a static movement. The details -- the devil is absolutely in there. The managed margin, this is the disclosure we gave you at H1. What we talked about at H1, and you've got to remember where your base sensitivity was. It was 10 basis points going through, and this is a 25 basis point increase on that. And then in the outer year, it was then a further -- so the 15, sorry, and then a further 25 basis points. So you get the change in that movement. So what you can see from there is that clearly, the beta -- the pass-through is lower in the earlier years and higher in the later years. Obviously, the structural hedge continues to strengthen. If you cast your mind back to year-end when we had this slide here, what we were all talking about actually was going into negative territory. So therefore, you had a market curve that was assuming a negative journey. And so therefore, the increase in the later years was in relation to coming out of negative. So therefore, the pass-through assumption was probably lower if you could assume in that case. So that's why you see this kind of convert. So it's rather going -- we're now going into a rising rate, whereas there we were actually going into a falling rate. And you'll remember that we also floored some of them at 0 because they would be flooring happening at that point. So you've got to look at the disclosure and think what was the -- in their assumptions at that time? And what does -- how does the shape change? So that's what's kind of driving you there. Probably won't comment on how others have done their sensitivity. We've done our bottom-up, product by product to try to give you the kind of the best view that if this was to happen now, this is what would happen in terms of the movement going forward on that.

[Alison Marie Rose-Slade]

And on NatWest Markets questions, yes, we remain comfortable with the medium-term guidance we've given you on that. And we're pleased with the refocusing and the restructure with that business. And obviously, we're making good progress. In October, NatWest Markets made a further GBP 250 million dividend, bringing the total year-to-date to GBP 1 billion, but our guidance remains the same in terms of our confidence on the medium-term outlook.

[Katie Murray, Group CFO & Executive Director]

Sorry, Andrew, I didn't answer your question on static balances. They are static. So we kind of leave them flat from this point, whereas, obviously, movements in balances will have movements as well, sorry, I missed off.

[Operator]

Our next question comes from the line of Jonathan Pierce from Numis.

[Jonathan Richard Kuczynski Pierce, Research Analyst]

A couple of questions on the hedge, I'm afraid. First question is, could you just clarify what you've done on the scale of the hedge in the third quarter and what the remaining capacity is? Build the hedge any further from here? Maybe we'll deal with that one first before I come onto the second one on the hedge, if that's okay?

[Katie Murray, Group CFO & Executive Director]

Yes, sure. Absolutely, that's one for me. So if I look at the hedge, we added on GBP 7 billion in the first quarter, so it's now GBP 197 billion and that we believe that we've got over the next 12 months. Assuming balances do not grow, and I think that's important, it would be a GBP 15 billion growth that we would do over the next 12 months. I'm very conscious that's the same thing as I said at Q1, and then I added on GBP 7 billion in the next quarter and that is [ when those ] balances grew.

[Jonathan Richard Kuczynski Pierce, Research Analyst]

Okay. That's very clear. Second question is, I think I heard you correctly in your comments, Katie, where you said that the contribution from the hedge in 2022 would be broadly neutral in 2021? Is that correct? Did I hear that right?

[Katie Murray, Group CFO & Executive Director]

I think broadly neutral may even slip into slight positive, but I would think about it in that level. I think it really depends on what kind of happens on rates in the next -- where this movement kind of settles in terms of that. But yes, we'd expect it to be broadly neutral.

[Jonathan Richard Kuczynski Pierce, Research Analyst]

I mean I suppose coming into 2021, the hedge revenue was higher than where it's ending. So that leaves scope maybe for some incremental quarter-on-quarter growth in hedge income as we move through 2022. But I'm still just slightly surprised that you're not more positive on the potential outlook for the hedge. Because if I go back 5 years, the 5-year swap rate in 2017 was 65 basis points on average, and we're now at 100. So all those hedges you have pre pandemic or presumably -- well, certainly the 5-year part of it are rolling on to high yields through 2022. But maybe more importantly than that, you've loaded on a huge amount of net new hedge over the course of the last 12 to 18 months. And a lot of it was done, I think, at the sort of 1-year part of the curve because you [ severed it ]. And early this year, that the 1-year part of the curve was next to nothing. And those will be rolling out onto the 5-year pass of the curve, which is now around about 1 percentage point. Just slightly surprised that the comments on the outlook for hedge income are not more positive than you seem to be pointing to, interested in your view on that?

[Katie Murray, Group CFO & Executive Director]

And so Jonathan, we'll talk as ever more about '22 in February. So let's see what happens in the next little while. But I think the important thing is to remember, it's an average life of 2.8 years. So we roll about GBP 9 billion a quarter in terms of what's kind of coming off. We added about GBP 7 billion on there. The impact in '21 was circa GBP 250 million, which was down from early in the year. We expected it to be GBP 300 million down. So it's definitely improved quite a bit. And we've gone from that down compared to prior year to flattened -- flat, sorry, neutral to slightly positive in 2022. I think what I'm really interested in seeing is this movement that we've seen in the last -- literally only in the last sort of 6, 7 weeks in terms of the particular spike. Let's see how that balances out, and we'll take it from there. But I think neutral to slightly positive feels the right balance sitting here today.

[Jonathan Richard Kuczynski Pierce, Research Analyst]

But I am right, just -- sorry, just to finish on this point. I am right in saying that, for instance, the sort of GBP 32 billion in net new hedges that were put on in the 12 months to June, a lot of those were put on at shorter duration to ensure that there's no cliff edge in 5 years. As I say, back then the short duration yields were very, very low. But directionally, that's correct, isn't it? That's how you've done this.

[Katie Murray, Group CFO & Executive Director]

That is correct, yes.

[Operator]

Next question comes from the line of Guy Stebbings from Exane.

[Guy Stebbings, Analyst of Banks]

The first one was on Commercial, both from a sort of volume and margin perspective, a bit more color. So NIM fell in the Commercial division, I think about 11 basis points this quarter. I think you said taxes having a distortion there. So I don't know if you can show that sort of fully explains it. And then as we look forward, excluding anything from rates, how we think about the dynamics of government guaranteed lending rolling off to new lending in terms of whether that's margin accretive or not? And then also, whether this derisking that you're doing within Commercial, does that have a negative NIM impact at all? So any comments there? And then more broadly, how you're thinking about growth in the Commercial division as you still have those headwinds, but then hopefully, areas like invoice finance, et cetera, start to come through. And then the second question was just a point of clarification really on strategic costs. So you're tracking quite a bit below the full year guidance. So I just want to see, should we expect quite a big step-up in the fourth quarter there?

[Alison Marie Rose-Slade]

Great. Thank you. Well, on Commercial, let me talk a little bit about that and particularly on what we're seeing in the government guarantee lending. So you can see -- we gave you some detail on how those loans are performing. So we've had GBP 1.1 billion of those Bounce Back Loans repaid. The environment continues to remain benign. We think around 30% of the balances from the Bounce Back Loans are still sitting in current accounts of businesses and around 90% of them are repaying on time or ahead of schedule. Clearly, at the moment, demand for new lending, particularly at the small end, it's a different story in the mid- and larger end and specialized end of our businesses. But at the small end demand is relatively muted. And we would expect that growth to -- and lending to come back over the coming quarters as the economy continues to recover and particularly as all the support schemes taper. Any new lending that comes on will be more accretive than the Bounce Back Loans, which obviously are at lower rates because they benefit from the government guarantee. So I think as you look forward, the degree of commercial lending growth is going to depend on a number of things. Firstly, the degree and speed of the economic recovery and the result in increasing working capital requirements. We are seeing good signs of that with invoice financing and working capital lines are increasingly being used, and we would expect that to continue. I think business confidence is obviously a key driver, and that will be a driver of investment spend. And then this continuing behavior of customers paying down the government scheme. So I think that's the dynamic between the government lending and the margin accretive. I think at the larger end of Commercial, we're seeing much higher levels of activity, particularly in specialized finance, infrastructure and [ larger ] mid-corporates. Those tend to be lower RWAs, so returns again remain sort of positive on that side. So I think that's how I would think about it from that perspective. Strategic costs, Katie?

[Katie Murray, Group CFO & Executive Director]

Can I just finish off on the NIM point, to remember on the tax point of that. So if I can cast your mind back to a Q2 guide, when we had the enactment of the corporation tax change that came through. And so that required us to change the tax treatment in our operating lease, and with leases that we do with the customer base. So we had a benefit that came through on that. And what you've seen is the reversal of that as it's come into this quarter. So NIM looks down. When you take that tax out, it's flat. So there's nothing in there that we're concerned about.

[Alison Marie Rose-Slade]

Will you take strategic costs?

[Katie Murray, Group CFO & Executive Director]

Alison, I can't remember the strategic cost question. Could you remind me of what that was. I'm terribly sorry.

[Alison Marie Rose-Slade]

What are we expecting for [indiscernible]...

[Katie Murray, Group CFO & Executive Director]

Thank you very much. If you look back over strategic costs for the last number of years, I've got the team actually to run it for me the other day, just to completely confirm that I was comfortable in this, is that Q4 is always a bigger strategic cost number that comes through as we kind of push towards the end of the year to get decisions made on property and things like that. So what you can see is there's always a little bit of a bump up in there. So not changing our guidance on strat costs as we know that Q4 is often -- it's a month where you get the last things done and then put through, so it's often a higher month and that's looking over the last number of years, that's exactly what's happened. So I think just stick with the guidance as we've got just now. Thanks, Alison.

[Guy Stebbings, Analyst of Banks]

If I could just quickly push out on perhaps on -- I appreciate really difficult -- there's lots of puts and takes there. But in terms of Commercial, whether you expect to see balanced growth from here? Or is it still probably a bit too soon for that?

[Alison Marie Rose-Slade]

Yes. No, happy to cover. I mean, look, I think we really expect the demand to start coming back. I think one of the dynamics, and we can see the signs of that demand businesses are trading, and we can see those indicators in working capital and invoice financing. There is still a lot of liquidity, so average revolving credit facilities are -- drawings are around 19%. So there's still a lot of liquidity, but we are seeing demand coming back. I think the big question, which is the one you're pushing on is business confidence, that's a big, big dynamic. And I think at the smaller end, the SME end, they're the ones who've absorbed a lot of the lending on the government scheme. So they're more indebted and business confidence is certainly affected by some of the short-term issues. But we are expecting commercial lending demand to come back. At the moment, it's a demand issue. We've got the capacity to lend, and we are lending at the upper end and then in specialized areas and across the business. So I would expect that demand to come back, subject to confidence levels remaining not too much knocked things like supply chain issues.

[Operator]

Our next question comes from the line of Chris Cant from Autonomous.

[Christopher Cant, Senior Analyst of UK & Irish Banks]

One on targets and then one on Ulster, please. So on your targets, if I think back to your 2023 guidance that you gave at full year '20 results, you were saying [ up ] 9% to 10% ROTE 2023, and that was on a 0% base rate. And if we look at the curve now, it's probably going to be 100 bips base rate, accepting that, that might change again. But that's where the rates market is. So if I take your sensitivity post tax, into that GBP 900 million. And I think your guidance back in February implied a net income of GBP 2.6 billion, GBP 2.7 billion. So it's quite a big uplift that we're talking about here proportionately for you in terms of where the rates market is. That would be implying a ROTE of maybe 12% to 13%. So what is it that offsetting that, do you think? Are you going to be revisiting that target? Should we be thinking about something in low double digits now, given where the curve is? I mean, NatWest Markets has obviously been a problem area in recent quarters, but I know you're reiterating that medium-term revenue guidance, it doesn't feel like that's a big change in your thinking. What is it, if anything, that's offsetting that big change in the rates outlook, please, when we're thinking about your medium-term ROTE target? And then on Ulster Bank, I understand you don't necessarily want to comment too much on ongoing transactions. But given that you've moved the AIB book to held for sale now and that's fair value or where you think you're going to clear that transaction, including any cost to sell. Could you please guide on the expected capital impact of that transaction? I know you said capital accretive, but I presume you now have a number for that transaction, given you've reclassified it. And on a related point, given the progress you're making with the Ulster Bank transactions, looking at your current consensus, Ulster Bank direct costs of 200-plus million in 2023. How should we be thinking about that number? I would have thought that the direct costs would have dropped away rather more sharply than that given the transactions are likely to close, but maybe I'm misunderstanding the dynamics there.

[Alison Marie Rose-Slade]

Thanks, Chris. I think I'm going to disappoint you on my answer on Ulster, I'm afraid. Just from the perspective of -- I mean, clearly, we're happy with the progress we're making. I've always said it's going to be a phased withdrawal over a number of years, but progress is being made. And yes, absolutely moving those assets gives you comfort in terms of how we're doing. And as we complete those transactions, we will look to update you and we'll probably update you on our full year results in February around the costs and the disposals. We do expect it to be capital accretive over the multiyear period that we've always talked about. On your specific point on costs, I mean, clearly, costs are going to -- cost reduction will lag because we need to support the exit of our customers as we migrate those and we complete the sales, but we'll update you in February. But I guess I would just reaffirm we're positive about the progress. We're pleased with the direction of travel on the transactions. We remain confident this is capital accretive and it will be phased and we'll give you some more specific guidance in February as we conclude some of these elements. And obviously, we'll keep you updated on other transactions as and when they happen. Katie, do you want to take...

[Katie Murray, Group CFO & Executive Director]

[ The rates outlook ] Yes. No, absolutely. So I mean, Chris, probably a bit of a frustrating set answers for you. Look, as I look at 2023 guidance, clearly, rates are very helpful to us. You can see where that is and let's all see where the excitement of consensus lands. I think for the time we get to February, we'll certainly -- we'll look at it at that state. But in terms of that with our cautious optimism, I think that, that's good. If there were offsets, I think the mortgage completion which we've talked about, you can see where those rates are just now and a little bit about some of the muted commercial loan growth. So we feel we're at the pivot point of that coming kind of back on. But certainly -- sorry, optimistic as we move forward from here, and this rates increase is a very different picture from when we announce them. So that will certainly be helpful. And we'll talk more about it in 2023. Sorry, not in 2023, we'll talk more about it in February, Chris, forgive me.

[Operator]

The next question comes from the line of Aman Rakkar from Barclays.

[Amandeep Singh Rakkar, European Banks Analyst]

A couple of questions, if I might. Can I come back to net interest margin, please? So thanks very much for the disclosure around the application spread. It looks like you've got about 60 basis points of refinancing pressure to digest on a book that's GBP 180-odd billion. If I have to run the math on that, that does look like that could offset quite a significant chunk of your deposit beta rate hike benefit, I guess, coupled with the comment that the structural hedge is not necessarily a tailwind. Can I trouble you for your view on -- do you think net interest margin can actually rise from here given the various moving parts that you can see on the horizon? And second would be on NatWest Markets. Just interested for a trading update actually. How a condition through October, how is that performing relative to Q3? That would be really helpful. And then I guess just a final one. I guess we've kind of probed costs a fair amount. I do note that your current cost target at the moment is to reduce the cost base 4% per annum ex-Ulster. Should we wait until February for you to kind of merge those kind of 2 comments together? I mean, is it a case that given the inflationary pressure that we're expecting, 4% is probably the best that we can expect? Or do you think Ulster can be incremental to your cost reduction target?

[Alison Marie Rose-Slade]

Thank you. So on cost, yes, I suggest you wait till February to address that in terms of the Ulster position. On NatWest Markets, I mean in terms of how it's performing. I think we're still seeing a very strong performance in our currencies and capital markets business. I think we've -- in terms of October, there's no real change to the trends we're seeing in Q3. So continued weakness in the fixed income performance in Q4 as we finish the reshaping of that business. I think that's what I'd say. But both our currencies, capital markets are performing well. Our sort of pipeline in terms of syndicated lending and corporate remains very strong. So that is continuing to Q4, but you'll still see weakness in the fixed income business. NIM, Katie?

[Katie Murray, Group CFO & Executive Director]

Sure, absolutely. So as we look at it, I think -- well, you've got to look at it's not just the point in time. But obviously, on that graph, as you've got -- on Page 12 is you've got the higher rates that we wrote. They will continue to kind of flow through as well. But certainly, look, this recent go down -- the fall down to the 105 bps is significant. And the way that we can offset that, a couple of things. And one is obviously continued focus on volume, which we've been good in the past of volume and margin kind of offsetting. We've had nice progress in the buy-to-let, which will help. But I do think, as I look at mortgage income, that the level of rate where that is, is hard, which is why you've seen us and others do a number of price increases in the last couple of weeks. We did another one yesterday to look to offset it. Clearly, the strategic hedge also will provide some offset, particularly you can see that it does grow into year 2 and year 3. And obviously, the volume will go into that will help as we go forward as well. Other things as I look at margin for the whole group. We're pleased to see the growth that we've seen in the unsecured space in both across personal loans in this quarter and now for the second quarter on the row in terms of commercial. And then obviously, in Commercial -- sorry, the second one quarter, forgive me in terms of credit cards. And then in Commercial, as we start to see the kind of the growth coming back there, we hope that there would be some benefit as we move forward as well. And then you heard me talk about the kind of the AT1 reclassification from debt in Q3 that won't repeat. But look, I do think, Aman, the mortgage spread, clearly, that does have an impact as we go through and we need to focus on the offset of that through the price rise and to make sure that we add volume. And as I say every call, the NIM is really important. They work -- the NII is generating and the ROE for the business, which continues to be strong is also very important as well. So don't get too focused on that one metric. Thanks, Aman. Sorry, you also asked on February cost reduction. We will talk about it more in February as we do that. Thank you. Alison has obviously covered that already. She's nodding at me across the table. Forgive me. Thank you, Aman.

[Operator]

We have time for 1 last question. The question comes from the line of Martin Leitgeb from Goldman Sachs.

[Martin Leitgeb, Analyst]

Just 1 question on capital, please. I mean the capital print today is better than expected in terms of Quarter 1. And also, I believe some of the headwinds you have previously guided for seem to have shrunk a little bit, I guess, partly due to, obviously, the strong impairment print today. I was just wondering how should we interpret the stronger capital print today. Does this mean there is increased scope for capital return? Or do you see some of these changes and drivers here as more temporary in terms of nature. And just in terms of next key dates, I think in the presentation, back you state that the old market program is expected to complete early in 1Q '22? Could there be a scenario that there is an update on this potentially ahead of full year results? Is that an interval you frequently assess/scope? Or should we really wait here for FY '21 for any update?

[Alison Marie Rose-Slade]

Great. Thank you. Well, look, I mean, obviously, we're very pleased with the capital build. We've shaped a capital-generative business. So 50 basis points up, you've got very clear guidance around our -- and very clear that my intention is to return capital to shareholders. We're investing in the businesses, growing in the areas that we have targeted to strategically grow. So we're pleased with performance and continuing to generate capital. So I think that should be very positive, obviously. We've given you guidance on the GBP 1 billion that we want to distribute as a minimum as well as any other opportunities that may arise. So I think we're pleased with the capital generative nature of our business, and that's positive. In terms of share buyback, we'll talk about that in February, and we see it as an important tool that we have at our disposal.

[Operator]

I would now like to hand the call back to Alison for any closing comments.

[Alison Marie Rose-Slade]

Great, thank you very much. Well, thank you for your questions and time today. I mean, obviously, we think this is a good performance, a strong delivery, operating profit, GBP 1.1 billion, capital-generative business and growing in the key areas that we've targeted in mortgages, in unsecured, strong performance in our AUMA and strong commitment in terms of the targets that we've set out. So pleased with the performance and good to see the resilience in the underlying customer base as we move forward. So thank you, again, for your time and look forward to catching up with all of you soon.

[Katie Murray, Group CFO & Executive Director]

Thanks very much.

[Operator]

Ladies and gentlemen, that concludes today's call. Thank you for your participation, and you may now disconnect.