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Edited Transcript of PAG.L earnings conference call or presentation 26-Nov-19 9:30am GMT

Full Year 2019 Paragon Banking Group PLC Earnings Presentation

London Dec 2, 2019 (Thomson StreetEvents) -- Edited Transcript of Paragon Banking Group PLC earnings conference call or presentation Tuesday, November 26, 2019 at 9:30:00am GMT

TEXT version of Transcript

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Corporate Participants

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* Nigel S. Terrington

Paragon Banking Group PLC - Chief Executive & Director

* Richard J. Woodman

Paragon Banking Group PLC - CFO & Director

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Conference Call Participants

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* Edward Hugo Anson Firth

Keefe, Bruyette & Woods Limited, Research Division - Analyst

* Gary Greenwood

Shore Capital Group Ltd., Research Division - Research Analyst

* Ian White

Autonomous Research LLP - Research Analyst

* Ian David Gordon

Investec Bank plc, Research Division - Head of Banks Research

* Nicholas Herman

Citigroup Inc, Research Division - Assistant VP and Analyst

* Portia Anjuli Patel

Canaccord Genuity Corp., Research Division - Analyst

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Presentation

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Nigel S. Terrington, Paragon Banking Group PLC - Chief Executive & Director [1]

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Okay. Good morning, everyone. Welcome to Paragon's full year results. Today, Richard is going to run through the financial performance. I'll come back a little later, give you more color around some of the performance aspects for the year and a bit more on outlook. And then finally, we'll leave plenty of time for your Q&As.

Let me start, though, by just touching on a few of the highlights. Clearly, as you would expect, we're delighted with these results. Operating profits, up 5%; earnings, up 6%; dividends per share, up over 9%. All marching towards that ROE target of over 15%.

Alongside the financial performance, we're delighted with the operating performance as well. What we have seen is continued progress towards our strategy of increasing the level of diversification and increasing the focus on specialist lending.

On the liability side, that's also been a very pleasing performance. We have seen a significant increase in the deposit flows, up over 20%. Importantly though, when we start to look at some of the strategic developments, what we have been able to do is increase the deposit capacity, increase our addressable market. And the importance for that, we'll come back and touch on later.

Not only though were we able to make good inroads into the deposit market, but revisit our old stomping ground, the securitization market, where we were able to do yet another mortgage-backed security. In addition to that, we showed great flexibility in capital management by doing our first residual sale and employing a good part of that in a further buyback program. So overall, we can see great progress being achieved financially, operationally and I think most importantly, strategically.

So I'll hand over to Richard now, and I'll pick up with you a little later.

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Richard J. Woodman, Paragon Banking Group PLC - CFO & Director [2]

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Thank you, Nigel. Good morning. With 3 divisions now at very different stages of maturity, there's quite a lot going on within the P&L in 2019. We've also had an accounting change with IFRS 9 and also a few one-off items, so I'll pick those up in a while. Overall, operating income was up just under 8% for the year. It would have been a little higher, but we sold that residual that Nigel was talking about back in June, which would have taken some income out of the last part of the year, but some of that's being fed into the exceptional gain below the line.

One of the things I'll keep coming back to is the -- is rather the change in the mix between the 3 divisions. We've seen very, very strong progress on our Commercial Lending after the acquisition that we made in 2018, Titlestone. That has been -- that has generated a step change in earnings and scale for that part of the business, and that's been maintained throughout the year. The mortgage business continues to develop very strong volumes. But because we see much stronger opportunities to deploy capital in those areas, we've put it there rather than putting it into Idem where at the moment, our pricing would deliver a sub hurdle rate RoTE.

Overall, operating expenses were up. We've seen the full year effects of the Titlestone deal. We've got -- it also spent more money on projects. And one that's very dear to my heart this year has been the IRB process, and that has been quite an expensive beast and continues to deliver great fun for us over the next period.

In terms of impairments. We've moved to IFRS 9 during the year. This is done now on an expected loss basis rather than incurred, so it accelerates bad debt charges. And again, I'll come onto that in a little bit more detail.

Overall, underlying profits were up 5%, which we're very pleased with. And in terms of the below-the-line items, there are a few, and I'll come on to each of those a little bit later.

When we look at the balance sheet, we've got probably 3 main areas to look at. Firstly, in terms of net loan growth, only growing at the 0.5% in terms of the year-end to year-end figure, probably disguises a lot of activity that's been going on within the business. If we had readjusted for the residual sale, which took GBP 700 million of assets out of the balance sheet, the underlying growth would have been 7%. And so that shows more of that progress with an underlying growth then in Mortgages of around 6%. Commercial Lending, up 28%, but then that run-off of the Idem portfolio.

In terms of the liability side, we've seen over 20% increase in the -- in our deposits and a further reduction in our asset-backed notes, the securitizations where we've continued to repackage old deals. We've sold the residual. But as Nigel said, we've actually done our first SONIA-based securitization during the year as well.

Segmentally, I think this shows a very clear picture in terms of where that growth is coming from. Mortgages, we saw a strong increase, its net interest margin was up. This is where we have a stronger margin on the new business we're writing compared to the legacy portfolio. And so that position is maintained. One of the key things that caused a little bit of a drag in the progress on earnings in 2018 was we saw higher levels of redemption on the new portfolio. Actually, we've much improved our customer retention process this year. We've also had a smaller number of product maturities where there's been more of a switch towards 5-year lending. So the combination has supported a higher average balance within the new book, which supports that -- part of that NIM progression.

In terms of Commercial Lending. Again, up very, very strongly, I'd say, the full year effects of the Titlestone deal. For Idem, the overall impact was down GBP 30 million. If you remember, we sold the portfolio right at the end of last year, which was going to take out around GBP 7 million or GBP 8 million of profits for this year. And then on top of that, without doing any new deals, the underlying amortization rate has been around 30%.

In terms of the business activity, you can see Mortgages was relatively flat in the year. We did less in the way of owner-occupied residential lending. And within the buy-to-let piece, we've increased the mix towards specialist landlords and reduced the proportion of simple or amateur business. Commercial Lending was up strongly. Although the £710.0 million last year, that includes the business that we'd actually written in terms of development finance.

In terms of what goes on to our balance sheet, development finance was up around 160% year-on-year. But if you did that on a pro forma basis, only about 13% if you take account of the volumes that the guys at Titlestone did prior to our acquisition.

In terms of the loans and advances, you can see how the legacy book has been running off. The hatched line there is PM12. So you can see how that's impacted that runoff rate. And then on the funding side, you can also see then very clear the progress we've made on the deposit growth as that's gradually refinanced a lot of those older securitizations.

Now I talked a little bit about net interest margin already. Underlying NIM altogether was up to 229 basis points. That's helped in part by the removal of the PM12 assets, which -- so these are old loans that carry a rather a lower net interest margin than the new book.

But looking at the segments individually. So if we look at Mortgages, we see a very stable pricing on our new buy-to-let lending. The pipeline actually today is priced at exactly the same level as it was 2 years ago. In terms of our front-book pricing, as I say, the NIM is wider than legacy. And that higher volume effect, you can see in the tables below. You've got a combination -- you still got positive volume variances even with the sale of the residual, but then that strong margin benefit.

In terms of Commercial Lending, we've seen strong volumes and margins. So the portfolio has got bigger, and the average spread has got stronger. We've focused all of our new areas on margin stability and enhancement. So we've actually taken the view this year that we've taken some of the volume back in our motor division to make sure that, that delivers the right yield performance. So that's worked well. And also, if you recall, last year, we'd been talking in the asset finance business. So that -- as we'd moved to that mid-market focus, yields had fallen. They've actually come back this year. So we're seeing growth, say, across those different elements within Commercial Lending.

For Idem, as I mentioned earlier, we've had a run-off of the portfolio. We've also had, as you'd imagine, the highest-yielding parts of the portfolio run off first, as that has an impact on the margin as well.

In terms of operating expenses, we've seen an increase in the year. You see that's also come through in terms of an increase in cost-income ratio. We've had the addition of the Titlestone costs. We've had project costs, as I mentioned earlier. In total, between incremental project costs, IRB and Titlestone, that's over half of the increase in costs within the year, so it's just over GBP 7 million between them. And we expect those project costs to continue into the next years at least.

We have a lot of areas where we're enhancing our technology capability. We still capitalize very little. Our capitalized software at the end of the year was only GBP 2.4 million, which is small compared to almost every one of our peers. And as a consequence, we expense a lot, and that's coming through that line, which we think is a more prudent way of financing -- of accounting for those spends.

We've also, though, undertaken a number of transactions, which have been positive for both EPS and RoTE that have hurt cost-income ratio. So the sale of the residual took income out, but we returned money to shareholders through the buyback. That goes straight against the delivery on cost income. We have the same with the Idem portfolio sale at the end of last year. So we very much focus our decisions around RoTE and EPS, with cost income being a secondary measure. As a consequence, we still expect to be able to generate a lot of operational leverage from the business, but we think that's now more towards the longer term than the shorter term.

In terms of credit. The credit performance remains very strong. You'll see this is the first year that we've operated under IFRS. When we did the transition back in March, we gave quite a detailed paper. And one of the key areas that we saw there was a change in the treatment for our longer-term receivership portfolio, where that was effectively provided on a faster basis now than we had seen it previously where you would only actually provide under IAS 39 when those loans actually, when they -- you had a problem or a void or there was going to be some sale activity. And so as a consequence, the provisions we've seen in the mortgage book are now lower than they were previously, because we've effectively made the provisions already that we would have been seeing on a typical year-on-year basis.

In terms of the Commercial Lending book, we expect higher losses throughout the lives there than on the mortgage portfolios. And that's reflected in the Stage 1 provisioning that we hold. So for the whole group, around 12% of our Stage 1 assets are in Commercial, 90% of our Stage 1 provisions are in the Commercial book as well. So you should expect with your modeling that as the portfolio grows, the provision levels will grow accordingly.

One thing on the piece. We have had a bit of a reduction in the coverage ratio on our Stage 3 assets. This is just because we've written off some fully provided accounts. So the underlying basis for the non-fully provided accounts are still strong -- or stronger than we had earlier in the year.

And we've also enhanced the weightings that we have towards the downside in terms of our economic assumptions. So previously, on transition and then at the interim, we were pretty well balanced. We have 30% as an upside scenario, 40% as our base case, 30% is down; and that 30% was split between a downside and a severe downside. We've effectively now moved 10% from our upside case to the downside, just reflecting that prolonged political and economic uncertainty that we've seen over the period. So it's just strengthened that position coming into the year-end.

In terms of the below-the-line items, there's one positive, which is the gain that we made on the disposal of the legacy portfolio in PM12. We were very pleased with this in the end because one of the areas is that, that legacy book does deliver a substandard RoTE. It's been one of the drags that we've seen in the portfolio over the last number of years. And the ability to actually dispose of that at a gain, so above carrying value, I think was a very strong performance.

In terms of the negative movements. In terms of fair values, we reported this at the half year. The main element of impact there is that we hedge our pipeline. And with the point you put your hedge in place, it doesn't count for hedge accounting until you actually can match it to the actual asset at the end. So the period between putting the swap in place and actually putting those swaps into your hedge, you have to fair value the difference. And in a declining rate environment, you end up with a fair value charge. In very simple terms, that will come back to 0 over the coming years. So it's a noncash item that will reverse over time.

The other thing though, with an absolute lower level of interest rates and, therefore, the discount rate that we apply to our -- the liabilities in our pension fund, we have an increase in the pension deficit. Underlying, it would have been a little bit bigger than this, but actually, we had a very strong performance from the scheme assets during the year. So from that perspective, I think we've -- you're never happy with a larger deficit, but actually, it's not been as painful as it potentially could have been given the movements in discount rates.

Now the size of those, in particular the fair value adjustment and the noncash item meant that we decided in the end that we would go for a 2.33x dividend cover ratio rather than the 2.5 that we would normally be aiming at. So our expectation is policy goes back to 2.5x going forward. But clearly, if there were some big one-off items, we will look at that at the time.

In terms of the capital bridge, we started the year with a 13.8% CET1. These are reported, not fully loaded, I'll lay in the fully loaded figure in a moment. So during the year, our post-tax earnings added 2% to that capital capacity. That's after taking account of that fair value impact. Then of that, we distributed 2/3 of our -- of that through both dividends and the share buyback. We used about 0.6% of CET1 to carry on growing the balance sheet.

The -- going back to that chart in terms of the new origination flows with very, very strong flows now coming from the Commercial division, that carries a high-risk weight. So on a fully standardized basis, I think if we go back to 2017, our average risk weight was around 39.5%. It's just under 45% now. And that reflects that movement towards the Commercial book, and in particular, development finance loans.

The other movement at the end was the movement on the pension deficit, which says -- across the year sees us at 13.7% in terms of our CET1, 13.4% on a fully loaded basis. And then we have our Tier 2 bond as well.

So overall, our capital position remains strong. The requirements that we have increased through the year as they did for all banks as the CRD IV buffers increased, that added around GBP 75 million to our capital requirements. Our next capital SREP is due for the summer of next year, so we'll have a good idea then in terms of what our requirements are going to change to. We still operate on a standardized basis. And again, at the half year, I reported that we had done a full review of our risk weightings in the approach, and we were happy we were operating that property.

We've also been talking, as I mentioned earlier about the cost side of it, in terms of the IRB process. There have been a lot of updates from the EBA in terms of future regulation requirements. In September, the PRA pulled all that together in the consultation paper, which effectively said for both all -- for existing IRB banks and aspirant banks, that they need to make sure that all of those future regulations are embedded in any -- into their models by the end of 2020. Now we'd already made the big changes. So the most notable ones are the hybrid approach, where you look at both a point-in-time and a through-the-cycle approach to your modeling. And that's probably one of the bigger areas that the larger banks are having to change through their models in 2020.

And also the LGD floors. So regardless of the LTV of a loan, if there's a PD, there will be an LGD of at least 5%. So those things will, for most people, be inflationary. I think most of the banks have point -- pointed out that, that will be the case. For us to say, we've taken account of that already in our numbers. But there's documentation and then some other analysis that we need to do around the piece. And we want to make sure that we're fully compliant before we put our application in. So as soon as we've done that, we will be back in touch with the PRA to take things forward.

So overall, we're very pleased with the results. We think we've delivered a strong set of financials, and we've got a good capital position to take ourselves into next year.

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Nigel S. Terrington, Paragon Banking Group PLC - Chief Executive & Director [3]

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Okay. Thank you, Richard. So now I'm going to pick up more -- a little bit more color and then also look at some of the plans for the future.

Now one thing that's not changed is our strategic priorities. We are increasingly focused on being a specialist lender. We are increasingly diversifying our business. And the areas in which we are seeking to develop and grow are those that are displaying the greatest growth opportunities. We continue to apply appropriate capital management as and when we think it's there. And importantly, we have a long-term mindset in the way in which we seek to deliver these results and performances to ensure that there is a strong adherence to the sustainability. And that's not just the sustainability of the financial performance, but also the returns and the requirements of all of our stakeholders.

Now the way in which we deliver that is got to be through a clear and dedicated focus towards our customers and their requirements. Now importantly, we have a role for technology. You've heard about some of the investments we've undertaken and more that we will do. But that has to sit alongside the very strong and long-term experience that a specialist organization needs to have, and that we clearly can display in quite some detail.

The way in which that, that then has to come through in terms of the outcomes is the delivery of fair and appropriate products to our customers; the need to deliver those benefits to the wider group of stakeholders, not just shareholders; and, but a very clear financial metric of driving up our return on tangible equity. You've seen we are at 14.6%. We remain completely committed to delivering a greater than 15% return on equity. And that has to be on a sustainable basis. It's no good having a 1-year wonder. You've seen our performance over the long term, therefore, that is something we will always maintain and that adherence to the long-term mindset.

Here, you can see the fact that we have undertaken a material transformation of our business. That is still under way. Since this started 5 years ago, we've: launched a bank; we then subsequently restructured it; we've undertaken 4 acquisitions; 5 business start-ups; technology investments; capital management, of which we have returned either through dividends or share buybacks, a 1/3 of our current market cap; and as Richard highlighted earlier, substantial efforts in order to implement IRB. And despite all of that transformation, we've maintained strong momentum in our earnings. EPS has achieved a compound growth of 10%; dividends, nearly 19%; and as we highlighted, our return on tangible equity, up from 10.9% to 14.6%.

This focus on being a specialist lender and seeking diversification is an unwavering objective. As you can see on the right-hand side, this has been achieved quite -- has seen quite significant steps in the last 3 years. Our specialist buy-to-let lending has gone up from just above 1/3 to over 1/2 of all originations. Our more commoditized, particularly amateur buy-to-let, has come down from 37% to under 10% of all originations. And Commercial is up from 14% to 38%. The way we have to do that is not because we have the cheapest funding in the U.K. It's because we have to know more than our competitors, and we have to know more, as much as we possibly can know, about the markets in which we operate, the customers we serve, the products we offer, the services we provide and importantly, the risks we incur. It has to be a competitive advantage of our organization to excel at these.

So turning to each of the product lines individually. The death of buy-to-let has been greatly exaggerated. As you can see at the top there, the market volume figures have hovered around GBP 40 billion of new origination over the last 4 years, including the year in which we saw the great fiscal changes. Remortgage activity has continued to dominate that. But importantly, a lot more of the purchase activity is being undertaken by landlords. Our underlying performance, whilst flat and stable at GBP 1.5 billion worth of new originations, masks a material change of the underlying dynamics. We've seen an increase in our specialist buy-to-let of up 11%, whilst our amateur is off 46%, and that was what we intended.

We've undertaken quite a lot of technology investment during the course of this year, boosting the intermediary platform and significantly enhancing the customer service proposition that runs with it.

Importantly, as Richard highlighted, the margins have remained robust. Not just stable, but we've been able to, against a backdrop of what is a competitive environment, is to maintain those margins. And that has also been done whilst achieving a 17% increase in the pipeline, which clearly will bode well for the current financial year.

There's no good originating loans, only to see your customers heading for the back door. So therefore, one of the things that we've undertaken is an increased effort and focus towards retaining customers for the longer term. Now the importance of that is that if you keep customers for longer, it enhances its embedded value or its lifetime value for those relationships. So a significant amount of time has been spent in improving the technology, in extending broker and customer retention initiatives and also extending the maturity profile through longer-duration products. We therefore expect those lower levels of redemptions to continue for the future.

Turning to Commercial now. I'll only focus on the 2 key product lines in the time we have this morning. So first of all, development finance. During the year, we completed the integration of Titlestone within the business and rebranded it development finance. We have enabled -- despite that, we've been able to boost the origination levels, up 13%. And as Richard highlighted, that's on a pro forma basis. The real numbers are significantly higher than that. And we have ended the year with a strong pipeline and undrawn committed facilities of over -- of approaching GBP 300 million. I think those numbers would have been higher, but for some uncertainty caused by the Brexit process. A lot of customer interest actually is -- people were just actually monitoring the situation and periods of people waiting to determine whether they are going to draw down, and if so, when.

The important bit is that we see significant opportunities for growth. There is an obvious and clear need for substantial house building across the U.K. And we are trying to add that -- add to that growth, underlying growth, by broadening our geographical footprint and by also enhancing the management capacity within the business. Importantly, and this is a more cyclical product, we accept, but we will not chase volumes at the expense of risk or pricing.

Turning to the SME or asset finance as it used to be called. This, I think, was an outstanding year for the development of this particular division. It is the product of 3 acquisitions and where we repositioned this from a Tier 3 lender to a Tier 2 lender over recent years, which saw margin compression happening until this last 12 months. During the last 12 months, we were able to increase new lending by 14.6%, whilst also seeing improvements in both yields and margins. That has been achieved by further developments in the customer service proposition, some improvements in the technology, but where we have also been able to deepen and broaden our addressable market.

Our market share is still only 1%. So over the long term, we do believe that there is significant upside opportunities. The technology investments that we've made in the mortgage side in this last year will now be turning their attention to the SME side, where we expect over the next 18 to 24 months to undertake quite a transformation of the way in which we engage with the broker market and the distributors in that space. Again, there is a clear and strong focus to underwriting risk and control, and we are not going to loosen the standards on either of those.

Idem Capital has clearly had a difficult couple of years. However, its portfolio has performed well, with cash flows standing at 109% of the originally underwritten numbers. The market remains highly competitive, although there has been some softening, but it is not at a level that we regard as acceptable. That approach -- that disciplined approach to capital allocation is something that we hold clear -- hold close to our -- the way in which we run the business. That discipline towards pricing and risk is something that means that we will focus our capital to where we believe we will get the best returns relative to the risks incurred.

Now we will retain an opportunistic approach here. We believe opportunities will emerge over time, but what we have done is we have managed the cost base accordingly. The 2 key areas that support Idem, the centralized servicing function, which had 399 people, today has 214. There was no redundancy program. There was no forced changes. This is where natural attrition and the normal recycling of people, we were able to manage that cost base accordingly. Equally, the deal team have been engaged where they're not looking at Idem deals on other opportunities.

Turning to the deposit side. Over the last 5 years, we think we've built a strong franchise. The balance is now over GBP 6.4 billion. We have a pretty broad product range and an outstanding customer service proposition. The key strategy here is that we have, and are, and will continue to try and expand our addressable market and the capability. That means enhancing the product range, the customer reach and also the channels in order to access the market. During the course of this year, we've engaged with 3 platforms: Hargreaves Lansdown, Monzo and Flagstone, all of which are giving us access to customers we would not have been able to get to otherwise. There will be more to come. We've also extended the product range: postal accounts, balances -- the larger balance sizes and also lifetime ISAs, which is the latest launch. Again, there will be more to come.

During this period, we've also invested in the capability of all of our people, data and knowledge and technology. The building of those technology links between the platforms and ourselves was crucially important in broadening that distribution. However, we believe that there will be a new disruptive market that will emerge in the years to come. Importantly, the wealth managers and the asset managers that we have already engaged with, we believe, are the precursor to that change. There is GBP 800 billion of deposits on the balance sheets of the clearers, earning interest rates substantially below the rates -- the lowest rate we have on offer. And it's that inert level of deposits stay there because it's just too much hassle to move it.

We all know how easy it is now to make mobile payments. We all know how easy it is to transact through our phones. One day, Open Banking will enable you to do that with your deposit accounts. And so you can do it already through Hargreaves Lansdown's accounts. You can move your money between Paragon and another bank or vice versa really easily, really simply. It will inevitably extend to broader product ranges within the banking sector, including deposits.

The shape of the deposit curve is massively geared towards the bigger banks. And with GBP 800 billion as an opportunity, we won't get all of it. We don't need all of it. But small amounts of it will make material differences, will expand addressable markets and improve our pricing capability. And you can already see the pricing evidence on -- as we have expanded our addressable market. The back book rate in the darker dotted line at the top is being beaten time and time again by the front book rate as we continue to expand the addressable market.

So NIM is a crucial driver for our strategy. If you look at the pie chart on the right-hand side, you can see 38% in the green segment. 38% of our loan book today still represented by the legacy book where there's a yield of 2.58%. The new mortgages are growing and representing 46% but where their yield is just over 4%. So there's virtually a 1.5% pickup between the old and the new.

Add to that the growing Commercial segment, at the moment, only representing 12% of the whole but where the yield there sits at 7.4%. And it is fairly obvious that there is an inexorable drive towards wider asset yields as a consequence. The one factor that draws back against that, the headwind, is caused by the runoff of Idem, which clearly, Richard highlighted earlier. There is a natural runoff in that. It's a very wide margin business, so it has a disproportionate effect. But by 2021, that will be materially reduced, and its effect on the NIM will have a significantly lower consequence.

So to conclude. Again, as you would expect, we were delighted with these results today. Not just to deliver a strong financial performance, but also the very strong operational dynamics that are happening in the business as we move increasingly towards specialist products, increasingly towards a more diversified platform. The deposit franchise has shown great progress. And we believe the technology changes that we are making and are being made across the marketplace as a whole presents a significant opportunity for the future.

The -- we do sit in an unusual and somewhat uncertain environment. We have prepared well for Brexit. We have done all of our stress testing and all of our contingency planning. And to be quite honest, if some things don't go the way we would all like them to do, we are incredibly well prepared to pick up opportunities if they arise.

As I said, NIM is an important focus. There is a natural structural NIM improvement that we should expect to see across our business across the long term. It won't be in a linear relationship. They will -- it will ebb and flow, but there is inexorable rise in that NIM. We expect further drives and further opportunities in the specialist lending markets in the years ahead. They will operate at higher NIMs. Additionally, we think that there will be a longer-term opportunity to improve deposit liability margins as well, as those markets restructure and change.

So our transformation is not complete. There is significant operational leverage within the business. It will take a bit of time to deliver, but inevitably, it will happen. And therefore, we do remain confident, and we look forward to continuing to develop the business and to drive to our 15% and greater return on tangible equity target.

So thank you very much for that, and we will now be happy to take questions. Now when you should have a microphone and pick it up, I think you have to hold it in order to keep it working. Okay. All right.

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Questions and Answers

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Ian David Gordon, Investec Bank plc, Research Division - Head of Banks Research [1]

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Ian Gordon from Investec. Just 2, please. Cost income, I hear your guidance today in terms of the long term being your time scale for improvement. And you've previously reminded us that some of your new businesses are higher cost income businesses. What is the Promised Land in the long term? Is it sort of still mid-30s or a different number?

And then secondly, on tax. Just a couple of points really. I'm assuming that Boris Johnson's proposed tax rate on corporates is a headwind relative to your prior expectations, but I'd appreciate your comments there. And then secondly, can you just help me out in terms of understanding your expectations for how effective tax rate will play out vis-à-vis corporation tax plus surcharge where maybe you enjoy a wide differential at the moment?

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Nigel S. Terrington, Paragon Banking Group PLC - Chief Executive & Director [2]

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Okay. I'll do the tax. I'll just deal with the cost income ratio. I think you managed to sneak in 3 there, by the way. But so in terms of the cost income ratio, we still believe there is significant operational leverage. I think when we had those initial targets, some of the things that we've done that Richard highlighted, that I highlighted in the transformation stage, has meant that you constantly have done things that are going to incur costs and then push back that inevitable date. So unfortunately, the world doesn't stand still, and we are a dynamic business. So we still believe that there is a strong potential for significant delivery of operational leverage over time. As to when that exact date is going to be. I'm not going to get held to that. But we still believe that's there.

One thing to help you is this year, the current financial year 2020, the consensus, my learned friend will then confirm me on costs is...

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Richard J. Woodman, Paragon Banking Group PLC - CFO & Director [3]

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GBP 136.5 million.

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Nigel S. Terrington, Paragon Banking Group PLC - Chief Executive & Director [4]

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GBP 136.5 million. We're happy with that. So if that helps you in terms of trying to sort of manage the numbers with a bit of clarity, we appreciate it's not that easy sometimes. Do you want to do the tax?

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Richard J. Woodman, Paragon Banking Group PLC - CFO & Director [5]

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Yes, sure. Actually, not many of you include any benefit for tax reductions going forward. So most forecasts, I think, have got the consensus tax rates of 20% or more over the coming years. So I think any reversal of policy, I don't think will be that material for the forecast. As we have more earnings that go through Paragon Bank, clearly, the level of the surcharge will increase.

I think if you were looking at your increase for next year, it's probably 1.5% to 2% of the total underlying tax charge. And it probably nudges up a little bit more than that over the coming years. It's quite important, though, that -- to bear in mind that the acquisitions that we've made don't actually form part of Paragon Bank, the entity. And it's the entity that pays the surcharge.

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Nigel S. Terrington, Paragon Banking Group PLC - Chief Executive & Director [6]

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We have been lobbying the treasury for -- to -- for them to reduce the surcharge or to raise the threshold. All part of trying to increase competition, we'd like to think anyway. Obviously, we don't have a vested interest. There was a question there first.

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Ian White, Autonomous Research LLP - Research Analyst [7]

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It's Ian White from Autonomous. Just a couple from my side, please. So first of all, on asset quality around specialist buy-to-let. Obviously, as you pointed out, how the front book lending mix has changed over the past few years, obviously, it also has an impact on the back book. So I was just wondering what evidence you would point to that would suggest that the credit quality in the specialist lines is likely to be similarly robust to how your book has performed historically. And if there's any color you can give us around that in terms of whether those loans are treated differently from an ICAP or regulatory stress testing perspective, then that would be much appreciated, please.

And then just secondly, in terms of the picture post IRB, obviously, you'll then see a material uplift in your capital ratio. At that point, do you think there could be opportunities to deploy capital inorganically within the Commercial business? Or will it really just be a case of the portfolio market, the debt purchase market through Idem at that point, please?

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Nigel S. Terrington, Paragon Banking Group PLC - Chief Executive & Director [8]

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Okay, dealing with the last one first. I mean we're not going to get drawn on should IRB deliver a capital uplift, what we're going to do with it at the time. Because the options are many and varied, whether it be organic developments, acquisitive opportunities or share buybacks or any combination of the above. It is in the future. And as and when we get to it, we will hopefully provide you with a bit more guidance then. But it's not -- I don't think it's one for today.

In terms of the asset quality, an easy one. Correct me if I'm wrong, Richard, to the exact percentage point. But if you look at the loan book that we have originated today, the new book, if you call it -- will, on buy-to-let compared to the old book, it's around 15% lower LTV. And the higher LTV back book didn't do too bad during the crisis either.

The -- and if you also then look to the new book as well, one of the things that you'll see is the stress testing. Well, you won't see, actually, because -- there is general stress testing that lenders apply. We have a secondary level of stress testing that is behind the scenes, which results in only 55% of all of the applications that pass our day 1 market-wide tests. Only 55% of them actually go through to complete. So when you look at the incredibly low delinquency relative to our track record by comparison to where those numbers sit in the marketplace, I think we can comfortably and justifiably think we have a very strong asset quality book on the buy-to-let side. Gary? Then we'll come across.

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Gary Greenwood, Shore Capital Group Ltd., Research Division - Research Analyst [9]

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It's Gary, Shore Capital. Just 2. Just following up on Ian's question on costs. I mean is it realistic, do you think you can get down to that sort of low to mid-30s cost-income ratio as the business sort of structurally change with writing more complex business? It's just a higher cost business now.

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Nigel S. Terrington, Paragon Banking Group PLC - Chief Executive & Director [10]

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Yes. So let me just deal with that one first. So what we tried to do is -- with the cost income ratio is to say, our primary focus is return on tangible equity. The cost-income ratio target is a secondary ratio. And we are going to prioritize return on tangible equity. And we believe there is operational leverage. And I think that for the purposes of this, I think the operational leverage will be delivered, but it's going to take a few years to achieve that. And I don't want to sort of get to the point of saying, "It's going to be mid- 30s, low 30s. It's going to be 33.7%." Because I think it is too far and too narrow a restriction. But in one sense, I'm less concerned about the cost-income ratio if I'm driving up my return on tangible equity. And if I have to trade one for the other, I know which one I'll pick.

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Gary Greenwood, Shore Capital Group Ltd., Research Division - Research Analyst [11]

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That's a nice segue into my second question, which was on return on tangible equity. You're nearly there on the sort of 15%, I think you were 14.6% in the year just reported. So I mean do you think you can get over the line in the current financial year? And as and when you do get over that line in terms of managing the business going forward, if you're on a trajectory whereby that return was continuing to nudge up, would you prefer to see that happen? Or would you put your foot down on the gas and grow a bit faster and sort of keep the return sort of very stable? What's your preference?

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Nigel S. Terrington, Paragon Banking Group PLC - Chief Executive & Director [12]

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So I don't care for size too much, to be quite honest. I think our focus should be on the quality of the earnings and their sustainability. And so ensuring that we are optimizing the balance, the various mixtures, whether they be the return on tangible equity, cannot be achieved if we're compromising the good outcomes for our customers or they can't be compromising the other -- the interests of our other stakeholders within the organization. So that sustainability point is important to ensure that we achieve that as well.

But whether that -- if we provide opportunities to continue to grow, we will just balance that off at the time to decide what is the best outcome -- sustainable outcome for shareholders. But if I wanted to just focus on size, I'd compress the margin and blow the balance sheet on the size. We could do that, but it doesn't seem to us like a sensible strategy.

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Gary Greenwood, Shore Capital Group Ltd., Research Division - Research Analyst [13]

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But do you think you can get over the line this year?

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Nigel S. Terrington, Paragon Banking Group PLC - Chief Executive & Director [14]

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What we're going to just do is we'll -- when we get over the line, which we will do at some point into the future, we'll come back and talk to you about that then. [Alistair?]

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Unidentified Analyst, [15]

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Two, please, myself. So on the risk-weighted assets, I mean, you had a significantly better performance in the crisis on your buy-to-let book than peers. So IRB should give you a material advantage versus other people who are dropping out. But -- was never quite clear whether the Bank of England have added stuff in to make that not the case. But is that a reasonable way of thinking that you should come out of this with an advantage versus other people in the same market because you did better than them in the model period?

The second thing is the comment on the savings market. I mean it sounds like you're increasingly comfortable with your sort of feel for that market. But equally, it's more about taking pricing out of the book rather than putting volume through. Is that the best way of thinking about it? Or are there opportunities for you to rethink the scale of the deposit franchise as well?

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Nigel S. Terrington, Paragon Banking Group PLC - Chief Executive & Director [16]

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Okay. You'll do the IRB one.

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Richard J. Woodman, Paragon Banking Group PLC - CFO & Director [17]

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Yes, sure. So absolutely, in terms of the like-for-like products, we would expect that the history we've got ought to give an improved position. But clearly, if somebody is doing 60% LTV simple buy-to-lets, that will carry a lower risk weight than the 72% complex. So I think you have to look at the makeup within people's portfolios, but we do have the data. And we have a lot of granularity.

And coming back to the earlier question about credit quality of that complex book. The detailed IRB modeling that we're doing around our current complex portfolio gives us a better result than we saw historically from the legacy portfolio. So that the IRB models would give you a lower risk weight, but that's driven by the LTV position that Nigel mentioned, you're starting at 72%, not 85%.

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Nigel S. Terrington, Paragon Banking Group PLC - Chief Executive & Director [18]

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Okay. In terms of the savings side, as you can see, from 0 to GBP 6.4 billion is great progress, but we've got more to do there because if we want to expand our lending, that requires funding. But we'll also be looking to refinance some of the older securitizations, and that's those are ones that will come up for their natural call dates. We also retain the optionality to issue new mortgage-backed securities as well. But one of the key points of that is, go back in time: when we needed to fund, we had to issue a mortgage-backed security. And whatever the price was, you had to do it. Today, the optionality gives us the ability to access the deposit markets, which are vast, or go to the capital markets.

So we pick and choose our moments now. And the 2 last deals we've done is, if you look at the way markets inevitably have their cycles and the pricing goes up and down, we've hit the 2 low points over the last 2 years because that gives us that capability, and particularly with our track record on securitization. We've done more mortgage-backed securities than any other bank in the U.K. So it's -- I wouldn't describe it, I've got some of my colleagues up there, they'll hate me for saying it, but they're so expert at this it's a production line for them to be able to do. I know there's -- the guys, there's a lot of hard work involved.

But the key bit for us is expanding that addressable market. So it might be a GBP 1.8 trillion market. But not all of it is accessible immediately for us. So gradually, either through products, channels, customer targeting, we're expanding that addressable market. And for us, the important bit is price control because if you've only got a narrow bit, you just have to take what the price of the market is. So if you look at our pricing today, some of our products are not remotely near top of the best buy tables, and yet we're still getting pretty substantial flows.

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Nicholas Herman, Citigroup Inc, Research Division - Assistant VP and Analyst [19]

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It's Nicholas Herman from Citi. Just 3 quick questions, if I may. Just follow-up -- one follow-up on the previous question, which was on deposits. Could you just provide just a bit more detail on the products that drove that growth this year? And particularly, how much of the new relationships, new products contributed to that deposit growth that we saw?

On Commercial, a material step-up in net interest margin, even half-on-half. So I'm interested on the driver for that expansion. And this is something that you continue to expect to go forward? Or would you expect that now to now be a bit more flat-like but very resilient at a high level?

And then finally, just on buy-to-let. Thank you for the disclosure on new lending on amateur versus specialist. I think you said your specialist went up about 11%, amateur down almost 50%. Would you also have some -- would you be able to provide us with some equivalent figures for the broader market, please? If you have those equivalent figures for the broader market? If you have them to hand?

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Nigel S. Terrington, Paragon Banking Group PLC - Chief Executive & Director [20]

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Yes. Well, not to hand, but we can probably -- we can get them for you. So again, on the NIM front, we are, I think as we said earlier, I said in my presentation, we see the dynamics of our business, the change in mix of the assets, the combination and focus towards specialist areas that it will be driving up NIM over the duration of either your plan or our longer plan. What it won't be is it won't be a nice linear straight line, and so that makes it's harder for you to model. But we're not going to give you, "It's going to be x basis points in the next 12 months," because there are too many moving parts. You've got the speed with which loans come off, the speed with which loans go off, the change -- some of the changing dynamics, the pricing in the deposit market. All of those factors. There's so many moving parts, they can have an effect. So -- but I think the general message is that we expect to see, notwithstanding the competitive environment, we expect to see continued further improvements in our NIM over the duration of the plan.

Turning to the deposit side of the market. I think the opportunities that exist there are of quite some scale, but they are less easy to predict. And so any comments that are made about the improvements in the NIM are made excluding the opportunities that could exist on the deposit side, just because I think those are of some significant scale and of probably significant duration. It's just that much harder to predict the timing of, and the scale of what that will likely be.

There was a...

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Richard J. Woodman, Paragon Banking Group PLC - CFO & Director [21]

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Yes. Within Commercial, the widest spread is on development finance. And so in terms of the net growth of the individual portfolios, that was strongest in H2 rather than H1. But also, sorry, that goes to the same risk-weighted point as well. You have more asset, more at 150%.

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Nigel S. Terrington, Paragon Banking Group PLC - Chief Executive & Director [22]

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Portia, you had a question?

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Portia Anjuli Patel, Canaccord Genuity Corp., Research Division - Analyst [23]

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Just on IRB again. Would you set out a broad time line from now of key events, so when you expect to submit and roughly when we might expect to see a result?

And secondly, the EBA regulations that you mentioned. Did they change materially your expectations of the benefit you would be able to receive, either just thinking about Paragon itself or relatively to others?

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Nigel S. Terrington, Paragon Banking Group PLC - Chief Executive & Director [24]

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Okay. Richard, deal with the specifics of the EBA. But the answer to the first question is no. Once the documents leave our building, you're then in the hands of the regulatory timetable, and it's impossible for us to dictate the timing of when that submission will convert to a fully completed application. But it's not going to be 6 months. I would suspect it's more in the couple of years category. But as to an exact date, no.

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Portia Anjuli Patel, Canaccord Genuity Corp., Research Division - Analyst [25]

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But the submission is planned for this calendar year or next calendar year?

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Nigel S. Terrington, Paragon Banking Group PLC - Chief Executive & Director [26]

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Let's say probably more on this point here, which is to do with the changes coming from EBA -- results from the PRA.

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Richard J. Woodman, Paragon Banking Group PLC - CFO & Director [27]

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Yes. So our plan is -- all the advice we've had from both very good pre-engagement with the PRA and our advisers is you want to have your best application in that delivers everything the regulator is after rather than have to do something that's half-baked and you remediate as you go through. That could create quite an extensive elapsed time to get the overall application through. So to give yourself the best bet in terms of that piece, you want have you your fully compliant application on the way in.

And so in terms of the EBA rules, we've been aware of how these have been developing over the last 12 or 18 months. What hadn't been specific is that they needed to be embedded in your models in 2020. So we knew that it was future regulation that was to come. So when we were building our models for the material things, as I mentioned, LGD floors, a hybrid approach, they're the big things that will be affecting the largest banks. And where they, I'd say, I think they've given reasonable guidance in terms of the risk weight inflation that will come as a consequence of that. We built our initial models reflecting those points. So in terms of the CP that came along in September, no surprises in terms of our figures. It does mean more documentation, more analysis, more proofs, a little bit more governance. You need to make sure that all of that analysis and all that testing has gone through your internal governance processes. I could say we can get our application in, in month x. But actually, if, when we go through our model risk committees, there's a question asked, that goes back, is a miss by a month. So it would be foolish of me to say it's imminent, but we're very well progressed on it.

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Nigel S. Terrington, Paragon Banking Group PLC - Chief Executive & Director [28]

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Probably got time for about another one question after this. Push it up.

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Unidentified Analyst, [29]

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It's [Amen Rachmel] from Barclays. Just a follow-on question on IRB. So I mean, Basel 3.1, Basel IV, whatever the [number] is, is scheduled to come in first of January 2022, under the standardized rules, when we look at it, it looks like there's some risk weight inflation to come for precisely the kind of specialist buys that you guys do, and you're able to [beef-up the sale] prices. Does that mean that there's bit of a cliff edge if you guys don't get IRB in advance of that because you potentially see risk weight inflation on January 2022? So is that the kind of -- I know you don't want to give a certain timing too much about the IRB application, but is that kind of ultimate aim to try and get that in and approved ahead of that to offset that headwind?

And then, sorry, the second question I was just going to ask was just on MREL. I know there was a discussion on the last results call, just as to whether you still consider yourself not to be an MREL bank. I don't know if that is a result of ongoing negotiation and discussion with the Bank of England. And I'm asking specifically because, obviously, your, one of your most direct competitors is -- there's clearly a big focus is their potentially seeing themselves as an MREL bank. And when I assess and appraise your liability base, it looks pretty similar to me, so I'm trying to reconcile those 2 bits.

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Nigel S. Terrington, Paragon Banking Group PLC - Chief Executive & Director [30]

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Okay. So dealing with MREL. So we were very explicit in our views at the half year that we've done a lot of work ourselves. We had engaged with advisers, lawyers, accountants, and we had also engaged with the Bank of England. And it was very clear to us that MREL will not apply for the duration of your plans, your forecasts in the market. So we also have -- we're aware that the Bank of England is reviewing MREL in 2020. We don't know what the outcome of that will be. But for us, there is no expectation of MREL applying for the duration of plans that didn't apply at the half year, and they don't apply from now onwards as well.

So the second point, the cliff edge on our IRB. We're aware, we're very conscious that the 1st of January 2022 is the Basel IV trigger date. We understand that. We know that. We have assessed that. And in all of our plans, we still have excess management buffers over and above the regulatory requirements, even with the risk-weighted inflation. So again, we are not concerned by the cliff edge event that will happen. I think it will be something that others in the marketplace will have to be attentive to because I think it's more significant an event for some others than for us. But that's not for us to comment on.

Right. Last question.

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Edward Hugo Anson Firth, Keefe, Bruyette & Woods Limited, Research Division - Analyst [31]

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Ed Firth from KBW. I just had 2 quick questions actually, just detail ones. In terms of the core Tier 1, I saw your chart for the year-on-year, but if I look -- I think your core Tier 1 was pretty much flat in the second half, but you did the residual interest disposal then, which was [about] 1% to core Tier 1. So I just wondered, is there something else that was going the other way? I mean, obviously, you had the share buyback, but that was only half of it. So is there something else there that was going the other way that I'm missing? So that was my first question.

And then the second one was just in terms of your margin chart, showing your front book versus back book, just to be clear, is that a cash margin or a behavioral margin? And in terms of behaviors, a lot of the other banks are talking about having seen behavioral life on mortgages coming in. Are you seeing any of that or not for your client base?

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Nigel S. Terrington, Paragon Banking Group PLC - Chief Executive & Director [32]

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So do with the NIM, I'll do the...

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Richard J. Woodman, Paragon Banking Group PLC - CFO & Director [33]

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You always do -- okay. So the 2 other changes were the pension deficit, which is 0.2%. And we had a further fair value charge in H2. So H1 was GBP 7.8 million and H2 would have been GBP 7.3 million. So that will be your Basel fig for the year for the capital movement. So the -- unfortunately, the fair value, although it's a noncash item, it does go to capital.

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Nigel S. Terrington, Paragon Banking Group PLC - Chief Executive & Director [34]

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Sorry, I meant CET1. In terms of the NIM, I'm not quite sure what a behavioral margin is. But -- well, the figures that you have up there is accounting margins. The accounting margins will take into account behaviors like redemption rates and amortization, all front end costs and front end income as well. So it's one and the same thing then -- that's what that number shows. We're not seeing any change in redemption profiles other than what the figures that I put up on the mortgage side, which showed the way in which redemption rates have come down, but that's a mix effect because professional landlords tend to stick around for longer. So -- but all of that will depend on the factors we build in, in order to get to the margin and expected redemption curve that creates the EIR in itself. We're not seeing any change in behavior in any of those curves that would cause us to change the NIM as a consequence.

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Richard J. Woodman, Paragon Banking Group PLC - CFO & Director [35]

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Sorry, just in terms of color, I mentioned that we saw more of a drag in 2017, '18, that was that behavioral shift that we saw at that point with a faster level of product churn, particularly for the simple or amateur buy-to-let.

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Nigel S. Terrington, Paragon Banking Group PLC - Chief Executive & Director [36]

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Okay. I think, probably, we need to wrap up on that. We'll be around. So if anyone's got any questions that they want to ask us now, that's fine. Alternatively, Richard has cleared his diary for you if you want to have a chat with him. We're very happy to help and very happy to try and answer any specific questions in order for you to get your numbers together. Okay. Thank you very much.