Directors' remuneration report

Statement from Wolfgang Berndt

Chairman of the remuneration committee

It is my privilege once again to introduce the board’s report on remuneration policy and practice.

Introduction

2008 was a year of unprecedented change and turmoil in financial services, in reality probably one of the most dramatic years that the sector has ever been through. The erosion of trust in the financial system, triggered by high profile failures both here and abroad, led to a change in business circumstances that no bank could escape. The problems in the financial sector have fed into the real economy and we now face a severe recession. This has understandably led to public anger and to questions being raised about the role of banks in the financial crisis.

Deciding how executives should be paid in these extraordinary circumstances has been an immensely difficult task. We know that many of our stakeholders will want to understand how we came to our decisions. For this reason, we have adopted a different approach to this year’s remuneration report. In addition to the normal information provided, much of which is required by regulations, we have decided to set out the principles underlying our remuneration philosophy. We have also decided to describe how the committee came to the decisions it did during the year in more detail than would be normal. Given the current environment, we believe that our shareholders, customers, employees, and regulators are entitled to this information. We hope that in whatever capacity you are reading this report, you find it helpful.

A PRUDENT REMUNERATION POLICY

For some years now we have adopted a strategy based on building long-term relationships with our customers and through managing our business decisions based on our assessment of how they will perform through an entire economic cycle. This strategy is inherently long-term and requires a prudent approach to managing risk. It resulted in Lloyds TSB avoiding many of the more high-risk lending areas and funding strategies, even though this could have led to higher profits in the short-term during the boom years.

Like many other banks, we have been unable to avoid the problems created by the sharp decline in the willingness of banks to lend to each other and by the recession in the UK and many other countries around the world. In addition we recognise that while the acquisition of HBOS creates significant opportunities for Lloyds Banking Group, in the short term it has created a number of challenges and the need to participate in the Government recapitalisation programme. However, we remain an inherently prudent and well-managed bank, and will be in a very strong position to continue to serve our customers and shareholders in the future.

Historically our prudent business strategy has also been reflected in our approach to remuneration. Overall, we have taken a conservative approach to remuneration levels. We have typically positioned our base salaries and incentive levels at or below the levels offered by our direct competitors or by other UK companies of a similar size. The termination provisions within our contracts are among the toughest in the FTSE 100, ensuring no payment for failure.

We have used targets in our incentive plans that encourage the prudent management of risk. The economic profit measure that we use takes account of the capital we need to generate our profits, and the risk of the business we are undertaking. For a given level of profit, higher risk will result in lower levels of annual incentive payout for our executives. Economic profit is measured on the performance of our business (and in particular default rates on loans) through an entire economic cycle. This discourages management from taking short-term risks that will have adverse long-term consequences. As a result we have been able to avoid the riskier types of lending or the less prudent funding strategies that were the downfall of some other UK banks.

Our annual incentive plan also reflects the fact that you cannot run a successful bank by entirely focusing on financial performance. The plan includes measures relating to how well we serve our customers, how committed and engaged our employees are, the success with which we are growing our franchise, and how we are managing risk. These are factors that have a direct and measurable impact on the future success of our business.

This combination of financial and non-financial annual incentive targets encapsulated in a balanced scorecard reinforces to all of our executives the importance of doing business for the long-term in a way that is sustainable. This reflects our commitment to basing our business on building long-term relationships.

GOVERNMENT RECAPITALISATION

In October last year Lloyds TSB participated in a recapitalisation programme launched by the UK Government to ensure the stability of the UK banking system. Details of this arrangement are included in the Chairman’s statement.

Participation in this programme has clearly impacted on our remuneration approach as well as our commitment to comply with the Financial Service Authority’s (FSA) principles on remuneration. In light of a review of the Group’s remuneration polices earlier in 2008 and following consultation with the FSA in October, we developed an approach which is aligned to these principles. Our approach is currently under further detailed review and any subsequent changes will be made as required to ensure our compliance with the FSA’s draft Code of Practice.

Although we believe that our approach to remuneration has served the business well, we recognise that we are now operating in an entirely different environment for banks. This will be reflected in the changes we are making to our remuneration approach.

In line with our prudent approach to remuneration we had already announced that for 2009 there would be no salary increases for the board and at their own request the executive directors would not be awarded any bonus for 2008. In addition long-term incentive awards for 2009 have been reduced by 175 per cent of salary.

FUTURE REMUNERATION DESIGN

During 2009 we will be undertaking a further review of our remuneration policy and practices. The committee intends to undertake this review mindful of the requirements of our shareholders and regulators whilst doing the utmost to ensure that we are not competitively disadvantaged against the market with respect to our approach to remuneration going forward; particularly our ability to attract and retain the best talent for the future of the Group.

There are clearly many things to be learned by all banks from the current crisis. One of the areas receiving a lot of attention is the whole area of remuneration and risk management. During the year the committee reviewed an analysis of Lloyds TSB incentive schemes and the extent to which they support sound risk-management, and are aligned with customer and shareholder interests. This was started in the first half of the year, pre-dating the HBOS acquisition and the Financial Services Authority’s project looking at remuneration in the banking sector.

The committee believes that we have an approach to remuneration aligned with our business strategy that remains sound in its fundamental principles. We do not believe that remuneration led to adverse behaviour at Lloyds TSB. Indeed we believe that our prudent approach to remuneration helped us to avoid many of the problems experienced by a number of our competitors. However, we are not complacent. We recognise that there are areas where our remuneration arrangements can be improved. We have studied the developments in the industry and the recommendations put forward by regulators and industry commentators. We are adopting many of these recommendations in our remuneration for 2009 and beyond. We are committed to rolling out these remuneration practices across the Lloyds Banking Group.

CONCLUSION

Our past approach to remuneration has been well received by shareholders and a key focus for the committee and the management team is to maintain that positive relationship. We have therefore consulted extensively with shareholders in relation to all of our 2008 and 2009 remuneration decisions.

One key challenge that the committee has been grappling with has been how best to motivate and incentivise the management team of the Lloyds Banking Group to undertake the huge task ahead, while recognising that we are operating in a very difficult environment for banks generally. We recognise the extreme scrutiny that remuneration in the financial services sector is attracting and the current sentiment of shareholders. At the same time, the Board strongly believes that we have the executive management team required to take on the complexity of issues that the integration of HBOS will bring. The retention of this team is central to the future success of the bank and it is important that they are paid in a fair and responsible way.

The remuneration committee unanimously recommends that you vote to approve the remuneration report at the 2009 Annual General Meeting.

Dr Wolfgang Berndt
Chairman, remuneration committee