Adds context in paragraphs 6 and 8, details in paragraphs 11 and 12

By Lawrence White

LONDON, Jan 29 (Reuters) - Lloyds Banking Group LLOY.L reported a better-than-expected 12% rise in annual profit on Thursday, and it raised a key performance forecast as increased income offset nearly 1 billion pounds ($1.38 billion) in charges for compensating customers mis-sold motor finance.

The British bank reported profit before tax for 2025 of 6.7 billion pounds, up from 5.97 billion pounds the year before and better than the 6.4 billion pounds average of analysts' forecasts.

The bank also lifted its profitability target, saying it now expects to make a return on tangible equity greater than 16% in 2026, having forecast just 12% for 2025.

"Looking ahead to 2026 and the culmination of the five-year strategy we set out in 2022, our continued business momentum and strategic delivery enable us to upgrade guidance," CEO Charlie Nunn said.

The stronger-than-expected numbers from the first of the big British lenders to report annual earnings this year show how the sector has nonetheless thrived even as interest rates have fallen back, thanks to growth in fee income and a more favourable political climate.

Britain's Labour government has so far avoided increasing taxes on banks, as some had expected, and instead urged financial regulators to cut red tape in a bid to boost growth.

RIVALS EXPECTED TO FOLLOW WITH PROFIT TARGET UPGRADE

The upgraded profit target also sets the stage for rival lenders to follow suit, after Reuters reported on January 26 such upgrades were likely for rivals including HSBC, Barclays and NatWest.

The bank said it would also buy back 1.75 billion pounds of its own shares, bringing total capital returned to shareholders in 2025 to 3.9 billion pounds.

Lloyds will update investors on the next phase of its strategy in July, Nunn added.

That is likely to include an even bigger focus on using artificial intelligence to serve customers and reduce costs, with Nunn one of the most outspoken of big British bank chiefs on the possibilities of the technology.

Lloyds said it was now targeting more than 100 million pounds in incremental profit benefit from generative AI in 2026, as it scales usage across the business.

Britain's biggest mortgage lender had already flagged earlier this year that the cost of dealing with the motor finance scandal, in which customers were sometimes not told about hidden commissions, would drag down its overall results for 2025.

($1 = 0.7224 pounds)