Lloyds, 41-percent owned by Britain after a credit crisis bailout, made the provision against payment protection insurance (PPI) complaints after banks lost a British court case on how policies were sold to millions of customers.
Investec analyst Gareth Hunt said the PPI charge was double what the market expected and could be bad news for other lenders embroiled in the saga.
At least it is clear, we now know what the charge is and the bank can move forward, but it is definitely bigger than expected. It does suggest everyone else will share some of the same pain, said Hunt.
Lloyds shares were down 8.7 percent at 53 pence in mid-morning trade, making the stock the worst-performer on the blue-chip FTSE 100 index <.FTSE>, which was down by 0.1 percent.
Losses from bad loans at Lloyds rose to 2.6 billion pounds in the first quarter, up from 2.4 billion a year ago but down from 3.8 billion in the previous quarter. It said the first quarter hit was 500 million pounds more than it expected, mainly due to Ireland, where its impairment charge reached 1.1 billion.
The double blow from the insurance mis-selling provision and Ireland pushed Lloyds into a statutory loss of 3.5 billion pounds in the first quarter, down from a 721 million profit a year ago.
Lloyds's net interest margin -- the difference between what a bank charges for loans and what it pays to borrow -- also fell to 2.07 percent from 2.12 percent at the end of last year.
Lloyds had been expected to swing to a 5 billion pound pretax profit this year, and analysts said making an 8 billion pound profit in the final 9 months of the year looked a tall order.
HOPING TO DRAW LINE UNDER INSURANCE MIS-SELLING ISSUE
Last month, banks lost an appeal at the High Court aimed at thwarting new rules on how they should sell PPI.
The competition watchdog has for years been probing possible mis-selling of PPI, which typically covers purchases paid for by installments in the event of the buyer becoming sick or unemployed.
There are about 12 million outstanding policies, and one analyst estimated Lloyds was exposed to about a third of this -- implying the banking industry as a whole could face 9 billion pounds of provisions from the PPI debacle.
Following talks with the financial watchdog, Lloyds said there were certain circumstances where customer contact and/or redress will be appropriate. It did not give more details on the scale of the possible compensation.
It will affect other banks and some overseas firms. Up to now the most conservative stance had come from Bank of America
RBS reports results on Friday and it too may be affected. RBS shares were down by 4 percent while Barclays fell 1 percent.
Morgan Stanley analysts last year estimated banks could have to pay out 5.1 billion pounds in compensation to customers.
The British Bankers Association (BBA) has been considering whether or not to mount a new legal challenge against the PPI ruling but Lloyds said it would not take part in any fresh challenge as it wanted to draw a line under the episode.
We will no longer be participating in the BBA's judicial review. We do not want to continue a long-standing debate of this with the regulator, chief executive Antonio Horta-Osorio told reporters.
Britain also has an 83 percent holding in Royal Bank of Scotland
Due to the bailout Lloyds and RBS were ordered by European regulators to sell off a host of assets.
Lloyds is looking to sell 600 retail bank branches, but last month the Independent Commission on Banking (ICB) - set up to propose reforming the industry, said Lloyds may have to sell more to improve competition.
Lloyds reiterated its surprise at that proposal, which could delay the sale of branches agreed with the EU, adding it was contacting potential buyers.
National Australia Bank UK
Analysts also expected Lloyds will sell its Scottish Widows and St James's Place
(Editing by Hans Peters and Greg Mahlich)
($1 = 0.6052 pounds)