Lloyds Banking Group admitted it was facing a bill of more than £3 billion today after conceding defeat in its legal battle over the mis-selling of controversial payment protection insurance (PPI).
The taxpayer-backed bank will now begin the process of compensating thousands of customers, having previously put any redress on hold while the banking industry thrashed out the issue in the courts.
In a shock move, it set aside up to £3.2 billion to cover the cost of compensating people mis-sold the policies after deciding to withdraw from any further legal action on the issue.
The scale of the provision surprised the City and caused its shares to slump 9% after the banking giant recorded a loss of £3.47 billion for the first three months of the year, compared with a £721 million profit last year.
The huge amount set aside also suggests that the final PPI compensation bill for the whole industry could be far higher than the £4.5 billion that was originally estimated by the Financial Services Authority, with speculation that between £7 billion and £8 billion could eventually be paid out.
The move comes after the High Court ruled last month against the British Bankers' Association, which was acting on behalf of the banking industry, and said new FSA rules on mis-selling PPI could be applied retrospectively.
The BBA still has until next Tuesday to decide if it wants to appeal against the ruling, while other banks have not yet said whether they plan to follow Lloyds' lead and pay out compensation.
Lloyds, in which taxpayers hold a 41% stake, said today that it had decided to withdraw from any action the BBA may take, in order to provide certainty for its customers.
It is thought that its new chief executive Antonio Horta-Osorio, who took over in March, is keen to draw a line under the saga as he clears the decks ahead of the publication of his strategy update next month.
The group, which sold the policies under its Lloyds TSB, Halifax and Bank of Scotland brands, said people who had already made a complaint did not need to do anything.
But other customers who think they may have been mis-sold one of the policies should get in touch either by telephone or through a dedicated area on its website.
The group said it did not have any plans to proactively contact customers who had bought a PPI policy and alert them to the fact that they may be eligible for compensation, as the FSA has called for.
Lloyds' decision was welcomed by consumer groups, which called on other banks to follow its lead and pay compensation to their customers.
Dan Plant, web editor of MoneySavingExpert.com, which has long campaigned on the issue, said: "This is a massive victory and vindication of what consumers, and now the court, have been yelling loudly.
"Lloyds has finally seen sense, yet as millions of PPI policies have been mis-sold over years, the other massive institutions involved must now follow suit, admit that customers were badly treated, and give the billions of pounds back."
Richard Lloyd, executive director of Which?, said: "This is great news for the millions of Lloyds customers who have been mis-sold PPI. It's refreshing to see a bank break ranks from its peers and do the right thing by its customers.
"The rest of the UK's banks must now follow suit and draw a line under the great PPI mis-selling scandal by withdrawing their legal challenge of the FSA and proactively reimbursing the millions of customers who were mis-sold PPI."
News of the compensation overshadowed the rest of Lloyds' first-quarter results, which showed that bad debt losses at the bank had increased to £2.6 billion, up from £2.4 billion in the same period last year, as a result of the Irish debt crisis.
Underlying income was also down, dipping to £5.2 billion from £5.9 billion, as higher funding costs hit margins.
Stripping out the PPI provision, the lender made a £284 million pre-tax profit in the first quarter, compared to a profit of £1.1 billion the previous year.
Customers who think they were mis-sold a PPI policy by Lloyds Banking Group should contact it on the following numbers, depending on which brand sold them the policy: Lloyds TSB 08453 005599, Halifax 08457 253519 and Bank of Scotland 08457 253519.