The average price of the tier 2 securities is around 6570% of par. We assume that Lloyds
exchanges the securities at an average price of 75% and that it restricts the offer size to £2.5bn
of new innovative tier 1 securities. Therefore in our model £3.3bn or 40% of the tier 2 securities
are redeemed.

Using the 14% coupon on the restricted capital instruments recently issued by Barclays as the
benchmark, the exchange reduces earnings by c. £100m posttax or a reduction in EPS of 0.6p
per share. Given the greater need for tier 1 capital, we regard the impact on earnings as
immaterial.

On our assumptions purchasing £3.3bn of tier 2 notes at a 25% discount generates a pre tax gain
of £0.8bn. Post tax, £0.6bn, adds 11bp to equity tier 1. We understand that there is no need to
amortise the gain and that for both accounting and regulatory purposes, the gain is recognised in
the first year.

Ahead of the exchange, we estimate a pro forma equity tier 1 of 5.8% and tier 1 of 8.8%.
Technically neither the open offers, the acquisition nor tier 2 exchange will complete until the third
week of January. We expect, at the time of the preliminary results announcement, Lloyds will
provide guidance on the capital position as at the start of 2009 on a pro forma basis.

In December Lloyds exchanged some existing innovative tier 1 notes for preference shares. The
$1.25bn (£0.82bn) and €0.5bn (£0.45bn) 7.875% perpetual capital securities issued in May were
exchanged for 7.875% preference shares. This created headroom for additional innovative tier 1
capital as on our original estimates the enlarged group was at the limit. The FSA limits innovative
capital to a maximum of 15% of total tier 1.

We expect Lloyds will want to have some excess innovative tier 1 notes. Hence we assume
Lloyds issues £2.5bn of innovative tier 1 securities, of which £1.7bn qualify within tier 1 and
£0.8bn is allotted to tier 2.

The reduction in equity reduces the amount of innovative capital that is eligible for tier 1. By
December 2010E we estimate that innovative notes within tier 1 will decline by £0.7bn or
11bp.

The debt element within tier 1 rises from 36% to 38% as total tier 1 falls from 9.3% to 7.0%.

To count towards tier 1 capital, instruments must have loss absorbency qualities equivalent to equity. Depending on their design and the arrangements surrounding their issue, instruments that are in legal form debt can nevertheless be accepted by the FSA as counting towards tier 1 capital. These instruments are referred to as ‘innovative’ tier 1 capital.

The FSA sets a limit (15%) on how much of a bank or insurance company’s tier 1 capital can be ‘innovative’. For tax purposes, the legal form of innovative tier 1 capital is followed: the instruments are treated as loan relationships and any coupons payable are allowed as deductions in computing taxable profits.

The reason why bad debts may not peak at such a high multiple of ‘normal’ as in the early 1990s, is that interest rates are rather lower today (and still falling) compared to the levels endured then. Lower interest rates mean that, for those of us who are luckyenough to keep our jobs, affordability will be good, while in the early 1990s, even those who remained in gainful employment struggled to meet the interest burden. The following chart illustrates that, heading into the early 1990s recession, consumers and corporates alike faced a rising interest rate environment in 1998, and then elevated interest rates that remained at or above 10% from July 1988 all the way through to May 1992. Interest rates then fell rapidly – to 6% by January 1993.

In our core scenario, while we do expect unempoyment to reach similar levels to the early 1990s, in large part driven by sharply weakening consumer spending, given the low interest rate environment, we expect that affordability and debt service capability will remain comfortable for a wide section of the UK population. Therefore in our core scenario, we model the impairment charge for Lloyds Banking Group rising to 2-2.5x ‘normal’.

On this basis, we would conclude that Lloyds Banking Group is quite well positioned to withstand a deep recession, hence our Outperform recommendation.

StanChart and HSBC have dividend floors
As the ban comes off, we hope to see improved liquidity but also feel that previous outperformers may come under shorting pressure. In the near term, we are approaching UK bank ex-dividend dates only an issue for HSBC and StanChart. Shorting across a dividend date is expensive: these two will both show 3-3.5% final dividend yields, going ex-dividend in March.

We retain our cautious stance on the sector.

Key risk is further recapitalisations being needed
UK banks should show materially stronger equity Tier 1 ratios by end-09 than they did in 2007, we estimate. However, this is massively contingent on the extent of further write-downs reported for 2H08 (or even 1H09). We believe accurately measuring these write-downs from inside the banks to bea very difficult task and these numbers are broadly unknowable from outside. The new CEO of RBS, Stephen Hester, has a track record of large, upfront provisions in restructuring situations (Abbey in 2002-3) and this could well be repeated here, irrespective of the massive differences between RBS and Abbey.

Pressure on HSBC to raise capital persists
We feel recent stock price falls are due to pressure on the bank to raise capital. Whilst we believe its capital levels are adequate by normal analysis, these are clearly abnormal times and other banks have been rewarded for raising capital from positions of relative strength (SAN and StanChart). We are therefore more cautious on HSBC in the near term.

As a result, the lower volume of seasonal post-holiday layoffs is likely to be
smaller, as well—thereby distorting the claims tally. We are inclined to believe the
improvement in initial claims is not accurate, because most other labor indicators we
follow continue to deteriorate, including continuing claims. At 3.4%, the insured rate
of unemployment is consistent with our estimate of a 7% national unemployment
rate. We are bracing for net payroll losses of roughly 600k in December.

Scenario 2. The world is saved

Scenario 3. An extinction-level event, where the world economy takes a turn for the worst, with a dramatic drop in GDP and employment and the downturn lasts longer than expected and possibly for several years.

We confirm that grants of security over shares (by the creation of a security interest such as a pledge, mortgage or charge) are covered by the disclosure requirement in our Rules and consider that this is consistent with the statements we made in 2005. However, we recognise that we are implementing a European regime and it has become clear that there are differing approaches in some other Member States, based in part on local practices and structures or procedures for granting security over shares, including the circumstances in which legal title to shares transfers. We are therefore seeking to reach a common understanding on the detail of the MAD requirements in this area with the European Commission and our counterparts in the Committee of European Securities Regulators.

We consider that those PDMRs who have granted security over their shares should disclose this to the market as soon as possible and certainly no later than 23 January 2009. However, given the circumstances, we are not intending to take enforcement action in respect of prior failures to notify the market of grants of security.

Model Code

Looking ahead, we expect drilling to start on the D9 prospect during the first half of 2009 and for production to start at the Oza field in Nigeria in H109. We believe that Hardy has sufficient cash in hand to see itself through most of 2009. Next result due are the FY08 figures, which we expect in mid-March 2009.

The key issue has been a disappointing sales performance from Tomb
Raider in the US. 1.5m units have been sold in total, which is below the
company’s internal forecasts, and pricing is being dropped to clear
inventory. Sales overall have been slightly weak but are not the key source of
disappointment.

We retain our Hold/ High Risk rating on the stock. We think the shares will
react badly to this statement but Time Warner is the wild card given their
c20% shareholding. They are free to buy shares.