Impairment charge The following table shows impairment losses charged to the income statement.
Group before RFS RFS Holdings Holdings minority minority 2008 2007 Core Non-Core interest interest Group Group Group £m £m £m £m £m £m £m less: recoveries of amounts previously written-off (189) (136) (325) (74) (399) (319) (342)
Global Banking & Markets 640 522 66 Global Transaction Services 39 54 14
• Impairment losses increased by £6.9 billion to £15.0 billion. Non-Core accounted for 62% (£4.3 billion) of the increase. Retail and commercial business in UK, Ireland and the US also recorded significant increases in loans impairments.
Core Non-Core interest interest Group interest Group interest Group £m £m £m £m £m £m £m £m £m
Movement in loan impairment provisions The following table shows the movement in the provision for impairment losses for loans and advances.
Individually assessed Collectively 2009 2008 2007 Banks Customers assessed Latent Total Total Total £m £m £m £m £m £m £m
Recoveries of amounts previously written-off — 38 287 — 325 261 275
(2) Includes closing provisions relating to loans and advances to banks of £157 million (2008 – £127 million; 2007 – £3 million).
Analysis of AFS impairment charge The following table analyses the AFS impairment charge.
The movement in provisions balance by division is shown in the table below.
Net increase in provisions of discontinued operations — — — — — — — — — — — 46
Risk, capital and liquidity management 149RBS Group Annual Report and Accounts 2009
Cash and balances Loans and Loans and Other at central advances advances to Settlement financial Contingent banks to banks (1) customers balances Derivatives instruments Commitments liabilities Total 2008 £m £m £m £m £m £m £m £m £m
Note: (1) Excluding items in the course of collection of £2,888 million in 2008 (2007 – £3,095 million).
Risk, capital and liquidity management 151RBS Group Annual Report and Accounts 2009
Group before RFS Holdings minority interest 49,820 84,262 13,993 87,602 12,382 1,036 249,095
• Securities issued by central and local governments comprised 54% of the portfolio at 31 December 2009.
• 63% of corporate debt securities are investment grade. Of £2.6 billion unrated corporate securities, £1.1 billion relates to US funds derivatives portfolio.
Past due analysis The following loans and advances to customers were past due at the balance sheet date but not considered impaired: Group before RFS RFS Holdings Holdings minority minority 2008 2007
Past due 90 days or more 1,358 1,820 3,178 46 3,224 1,782 369
Loans and advances to Netting banks and and customers Securities Derivatives Other (1) Total offset(2)
Service industries and business activities 154,657 15,403 12,025 795 182,880 5,824
Loans and advances Netting to banks and and customers Securities Derivatives Other (1) Total off-set(2)
Individuals: Finance lease and instalment credit 22,355 23 25 — 22,403 119
(2) This column shows the amount by which the Group’s credit risk exposure is reduced through arrangements, such as master netting agreements, which give the Group a legal right to set-off the financial asset against a financial liability due to the same counterparty. In addition, the Group holds collateral in respect of individual loans and advances to banks and customers. This collateral includes mortgages over property (both personal and commercial); charges over business assets such as plant, inventories and trade debtors; and guarantees of lending from parties other than the borrower. The Group obtains collateral in the form of securities in reverse repurchase agreements. Cash and securities are received as collateral in respect of derivative transactions.
Liquidity risk framework and governance The Group has an approved risk appetite supported by explicit targets and metrics to control the size and extent of both short-term and longterm liquidity risk. These metrics are reviewed by the Board and Group Asset and Liability Management Committee (GALCO) on a regular basis. The Group uses stress tests to refine and update the risk appetite in light of changing conditions.
The Group uses funds transfer pricing to ensure the costs of liquidity as well as funding are integrated into the business decision making process.
Structural management The Group regularly evaluates its structural liquidity risk and applies a variety of balance sheet management and term funding strategies to maintain this risk within its policy parameters. The degree of maturity mismatch within the overall long-term structure of the Group’s assets and liabilities is managed within internal policy guidelines, aimed at ensuring term asset commitments are funded on an economic basis over their life. In managing its overall term structure, the Group analyses and takes into account the effect of retail and corporate customer behaviour on actual asset and liability maturities where they differ materially from the underlying contractual maturities.
Stress testing The Group performs stress tests to simulate how events may impact its funding and liquidity capabilities. Such tests assist in the planning of the overall balance sheet structure, help define suitable limits for control of the risk arising from the mismatch of maturities across the balance sheet and from undrawn commitments and other contingent obligations, and feed into the risk appetite and contingency funding plan. The form and content of stress tests are updated where required as market conditions evolve. These stresses include the following scenarios: • Idiosyncratic stress: an unforeseen, name-specific, liquidity stress, with the initial short-term period of stress lasting for at least two weeks; • Market stress: an unforeseen, market-wide liquidity stress of three months duration; • Idiosyncratic and market stress: a combination of idiosyncratic and market stress; • Rating downgrade: one and two notch long-term credit rating downgrade scenarios; and
• Daily market lockout: no access to unsecured funding and no funding rollovers are possible.
Monitoring Liquidity risk is constantly monitored to evaluate the Group’s position having regard to its risk appetite and key metrics. Daily, weekly and monthly monitoring and control processes are in place, which allow management to take appropriate action. Actions taken to improve the liquidity risk include a focus on improving the loan to deposit ratio, issuing longer-term wholesale funding, both guaranteed and unguaranteed, and the size of the conduit commitments. Metrics include, but are not limited to; Wholesale funding > one year: As the wholesale funding markets have improved over the course of 2009 the Group has been better able to manage both its short and longer-term funding requirements and has significantly reduced its reliance on central bank funding. In 2009, the Group issued £21 billion of public, private and structured unguaranteed debt securities with a maturity greater than one year including issuances with maturities of ten years and five years of £3 billion and £2 billion respectively. To provide protection from liquidity risk in these markets the Group targets a ratio of wholesale funding greater than one year. The proportion of outstanding debt instruments issued with a remaining maturity of greater than 12 months has increased from 45% at 31 December 2008 to 50% at 31 December 2009, reflecting a lengthening of the maturity profile of debt issuance over the period. The Group is also targeting an absolute funding reliance (unsecured wholesale funding with a residual maturity of less than one year) of less than £150 billion by 2013. The 2013 target can also be segmented further into bank deposits of less than £65 billion and other unsecured wholesale funding of less than £85 billion. The reliance on wholesale funding has improved from £343 billion at 31 December 2008 to £249 billion at December 2009 (and this figure includes £109 billion of bank deposits).
In addition to available liquid assets, the Group has a pool of unencumbered assets that are available for securitisation to raise funds if and when required.
Government securities 57,407 27,303 Cash and central bank balances 51,500 11,830 Unencumbered collateral (1) 42,055 30,054 Other liquid assets 19,699 20,647 Total liquidity reserve 170,661 89,834
Funding profile The contractual maturity of on balance sheet assets and liabilities, shown in the tables overleaf, highlight the maturity transformation which underpins the role of banks to lend longer-term but funded predominantly by short-term liabilities such as customer deposits. This is achieved through the diversified funding franchise of the Group across an extensive retail, wealth and SME customer base, and across a wide geographic network. In practice, the behavioural profile of many assets and liabilities exhibit greater stability and longer maturity than the contractual maturity. The Group models the behavioural maturity of liabilities so that it can target a diversified and stable funding base.
Risk, capital and liquidity management 157RBS Group Annual Report and Accounts 2009
Liabilities by contractual maturity Deposits by banks 65,966 15,541 3,934 2,301 632 12 Debt securities in issue 100,220 49,300 56,869 25,915 27,326 3,819 Subordinated liabilities 1,929 1,892 3,654 4,963 20,157 6,105 Settlement balances and other liabilities 12,048 100 139 104 239 83 Total maturing liabilities 180,163 66,833 64,596 33,283 48,354 10,019 Customer accounts 521,400 15,619 5,944 4,221 8,490 4,392 Derivatives held for hedging 660 1,566 3,232 1,264 1,674 1,508 Total liabilities 702,223 84,018 73,772 38,768 58,518 15,919
Assets and liabilities with a contractual maturity of greater than twenty years – the principal amounts of financial assets and liabilities that are repayable after twenty years or where the counterparty has no right to repayment of the principal are excluded from the table, as are interest payments after twenty years.
Regulatory environment* The Group operates in multiple jurisdictions across the globe and is subject to a number of regulatory regimes. The Group’s lead regulator is the UK FSA, with other authorities such as the De Nederlandsche Bank and the US Federal Reserve Bank playing key roles. The liquidity framework applied by the FSA is the Sterling Stock regime. In line with the FSA policy statement PS09/16, the Group will be subject to a new liquidity risk regulatory framework in the future. The Group has been working towards this new framework and will meet the requirements as they come into force.
ASF (1) ASF (1) Weighting Structural term liabilities £bn £bn £bn £bn %
Others (deferred tax, insurance liabilities, etc) 106 — 94 — — Total liabilities and equity 1,522 577 2,219 602
Risk, capital and liquidity management 161RBS Group Annual Report and Accounts 2009
Market risk All the disclosures in this section (pages 161 to 166) are audited unless indicated otherwise with an asterisk (*).
Market risk arises from changes in interest rates, foreign currency, credit spread, equity prices and risk related factors such as market volatilities. The Group manages market risk centrally within its trading and nontrading portfolios through a comprehensive market risk management framework. This framework includes limits based on, but not limited to VaR, scenario analysis, position and sensitivity analyses.
The Group continued to update and enhance its market risk management framework during 2009. In addition to the move to a VaR based on a 99% confidence level, the Group has improved and strengthened its market risk limit framework increasing the transparency of market risk taken across the Group’s businesses in both the trading and non-trading portfolios.
The Group’s market risk appetite is defined within this limit framework which is cascaded down through legal entity, division, business and ultimately trader level market risk limits.
As part of the strategic review, the designation of assets between Core and Non-Core divisions was completed during 2009. As the Non-Core division was not established until conclusion of the strategic review in the first quarter of 2009, constitution of the average, maximum and minimum VaR for Core and Non-Core has been prepared on a best efforts basis as these measures require daily data.
• The Group computes the VaR of trading portfolios at the close of business. Positions may change substantially during the course of the trading day and intra-day profit and losses will be incurred.
A ‘Risks not in VaR’ framework has been developed to address those market risks not adequately captured by the market standard VaR methodology. Where risks are not included in the model, various nonVaR controls (for example, position monitoring, sensitivity limits, triggers or stress limits) are in place.
Traded portfolios The primary focus of the Group’s trading activities is client facilitation. The Group also undertakes activities within the Core division of the wholesale bank, built around clients in chosen markets, including: • Market making – quoting firm bid (buy) and offer (sell) prices with the intention of profiting from the spread between the quotes.
• Proprietary activity – taking positions in financial instruments as principal in order to take advantage of anticipated market conditions.
Assets and liabilities in the trading book are measured at their fair value. Fair value is the amount at which the instrument could be exchanged in a current transaction between willing parties. The fair values are determined following IAS 39 guidance, which requires banks to use quoted market prices or valuation techniques (models) that make the maximum use of observable inputs. When marking to market using a model, the valuation methodologies are reviewed and approved by the market risk function. Group Risk provides an independent evaluation of the model for transactions deemed by the Group Model Product Review Committee (GMPRC) to be large, complex and/or innovative. Any profits or losses on the revaluation of positions are recognised in the daily profit and loss.
• The average total VaR utilisation increased in 2009 compared with 2008 largely as a result of increased market volatility experienced since the credit crisis began in August 2007 being more fully incorporated into the two year time series used by the VaR model. This volatility had a marked impact on the credit spread VaR. This increase is partially off-set by a reduction in trading book exposure throughout the period, due to a reduction in the size of the inventory held on the balance sheet as a result of sales, reclassification of assets to the non-trading book and write-downs.
• The credit spread VaR decreased significantly at the end of August 2009 due to the positions relating to CDPCs being capitalised under the Pillar II approach and hence excluded from the VaR measure from that date.
Risk, capital and liquidity management 163RBS Group Annual Report and Accounts 2009 2009 (99%ile) 2008 (99%ile)
Average Period end Maximum Minimum Average Period end Maximum Minimum Non-trading VaR (2008 and 2009) £m £m £m £m £m £m £m £m 2007 (scaled to 99%ile) 2007 (95%ile)
Average Period end Maximum Minimum Average Period end Maximum Minimum Non-trading VaR (2007) £m £m £m £m £m £m £m £m
• The Counterparty Exposure Management (CEM) trading book exposure and the exposure of Core without CEM have been disclosed separately. CEM manages the OTC derivative counterparty credit risk in GBM, by actively controlling risk concentrations and reducing unwanted risk exposures. The hedging transactions CEM enters into are recorded in the trading book, and therefore contribute to the market risk VaR exposure of the Group.
The counterparty exposures themselves are not captured in VaR for regulatory capital. In the interest of transparency CEM trading book exposure is disclosed separately.
The 2008 and 2009 data on trading VaR in the tables on the previous page excludes exposures to super-senior tranches of asset backed CDOs, as VaR does not produce an appropriate measure of risk for these exposures due to the illiquidity and opaqueness of the pricing of these instruments over an extended period. For these exposures, the maximum potential loss is equal to the aggregate net exposure, which was £910 million as at 31 December 2009.
RBS Sempra Commodities LLP (Sempra), the commodities-marketing joint venture between RBS and Sempra Energy, was formed on 1 April 2008, and its trading risks were included in the disclosed VaR from that date. Sempra is designated as Non-Core in the 2009 data.
Stress testing is also undertaken at key trading strategy level, for those strategies where the associated market risks are not adequately captured by VaR. Stress test exposures are discussed with senior management and are reported to GRC, ERF and the Board. Breaches in the Group’s market risk stress testing limits are monitored and reported.
• A permanent increase in the limit can be granted if consistent with the strategy and supported by the business and Risk Management.
Risk is managed within VaR limits approved by GALCO, through the execution of cash and derivative instruments (see Note 13 on the accounts, on page 294). Execution of the hedging is carried out by the relevant division through the Group’s treasury functions. The residual risk position is reported to divisional asset and liability committees, GALCO and the Board.
Foreign Exchange Risk in the Banking Book (FXRBB) represents exposures to changes in the values of current holdings and future cash flows denominated in other currencies. Hedging instruments used to mitigate these risks include foreign currency options, currency swaps, futures, forwards and deposits. Foreign exchange risk results from the Group’s investments in overseas subsidiaries, associates and branches in three principal forms: • Structural foreign currency exposures that arise from net investment in overseas subsidiaries, associates and branches; • Transactional/commercial foreign currency exposures that arise from mismatches in the currency balance sheet; and
The commercial decision to invest in equity holdings, including customer restructurings, is taken by authorised persons with delegated authority under the Group credit approval framework. Investments or disposals of a strategic nature are referred to the Group Acquisitions and Disposal Committee (ADCo), Group Executive Committee (ExCo) and where appropriate the Board for approval; those involving the purchase or sale by the Group of subsidiary companies also require Board approval, after consideration by ExCo and ADCo.
Structural interest rate risk Non-trading interest rate VaR for the Group’s retail and commercial banking activities at a 99% confidence level was £101.3 million at 31 December 2009 (2008 – £76.7 million). During 2009, the maximum VaR was £123.2 million (2008 – £197.4 million), the minimum was £53.3 million (2008 – £76.7 million) and the average was £85.5 million (2008 – £130.0 million).
2% parallel 2% parallel upward downward movement movement in US in US
Citizens Economic Value of Equity (EVE)* Generally, Citizens is the main contributor to overall non-trading interest rate VaR. Citizens aims, through its management of market risk in nontrading portfolios, to mitigate the effect of prospective interest movements which could reduce future net interest income, whilst balancing the cost of such hedging activities on the current net revenue stream. To do so it uses a variety of income simulation and valuation risk measures that more effectively capture the risk to earnings due to mortgage prepayment and competitive deposit pricing behaviour than a VaR-based methodology. IRRBB is managed within approved limits on interest rate risk, liquidity and capitalisation, with a goal of optimising yield.
+ 100bp shift in yield curves 510 139 – 100bp shift in yield curves (687) (234)
The base case projected net interest income is based on the Group’s current balance sheet, forwards rate paths implied by the yield curve as at 31 December 2009 and using contractual repricing dates. Where contractual repricing dates are not held an estimate of the likely timing and extent of any rate change is used. The projection also includes the expected effects of behavioural options such as the prepayment of residential mortgages.
The scenarios used are simplified in that they assume all interest rates for all currencies and maturities move at the same time and by the same amount and therefore do not reflect the potential effect on net interest income of some rates changing whilst others remain the same. The scenarios also do not incorporate actions that would be taken by the business units to mitigate the effect of this interest rate risk.
Foreign exchange differences arising on the translation of foreign operations are recognised directly in equity, together with the effective portion of foreign exchange differences arising on hedging instruments.
Equity classification of foreign currency denominated preference share issuances means that these shares are recorded on the balance sheet at historical cost. Consequently, these share issuances have the effect of increasing the Group’s structural foreign currency position.
• These movements in equity would off-set retranslation effects on the Group's foreign currency denominated RWAs, reducing the sensitivity of the Group's Tier 1 capital ratio to movements in foreign currency exchange rates.
Equity risk Equity positions are measured at fair value. Fair value calculations are based on available market prices wherever possible. In the event that market prices are not available, fair value is based on appropriate valuation techniques or management estimates.
The table below sets out the Group’s banking book equity exposures at
Risk control* The prime risk control mechanism for non-traded market risk exposures is the completion of monthly or quarterly IRRBB and quarterly FXRBB returns by the Group’s business units, collated as part of month-end reporting by Group Treasury to GALCO.
Risk, capital and liquidity management 169RBS Group Annual Report and Accounts 2009
Overall, insurance risk is predictable over time, given the large volumes of data. However, uncertainty does exist, especially around predictions such as the variations in weather for example. Risk is minimised through the application of documented insurance risk policies, coupled with risk governance frameworks and the purchase of reinsurance.
General insurance business RBS Insurance underwrites retail and SME insurance with a focus on high volume, relatively straightforward products. The key insurance risks are as follows: • Motor insurance contracts (private and commercial): claims experience varies due to a range of factors, including age, gender and driving experience together with the type of vehicle and location; • Property insurance contracts (residential and commercial): the major causes of claims for property insurance are weather (flood, storm), theft, fire, subsidence and various types of accidental damage; and
Most general insurance contracts are written on an annual basis, which means that the Group’s liability extends for a twelve month period, after which the Group is entitled to decline to renew the policy or can impose renewal terms by amending the premium, terms and conditions.
An analysis of gross and net insurance claims can be found in the financial statements (see page 310).
Life assurance business The Group’s three regulated life companies, National Westminster Life Assurance Limited, Royal Scottish Assurance plc and Direct Line Life Insurance Company Limited underwrite life insurance products within the UK retail insurance market. The key assurance risks are as follows: • Term assurance contracts: mortality claims experience varies due to a range of factors, including age, gender and smoker status. The key factors that increase the level of claims are disease pandemics and adverse lifestyle changes; and
Estimations (assumptions) including future mortality, morbidity, persistency and levels of expenses are made in calculating reserves. The Group uses standard mortality and morbidity tables appropriate to the type of contract being written. These are adjusted as appropriate to reflect historical experience and future expectations. Sample mortality rates, expressed as deaths per million per annum, for term assurance products (age 40) are: Mortality (per million) per annum per annum
Male non-smoker 674 723 Male smoker 1,542 1,590 Female non-smoker 497 568 Female smoker 1,136 1,277 * unaudited
To ensure appropriate responsibility is allocated for the management, reporting and escalation of operational risk, the Group operates a three lines of defence model which outlines principles for the roles, responsibilities and accountabilities for operational risk management.
• Self Certification Process: this requires management to monitor and report regularly on the internal control framework for which they are responsible, confirming its adequacy and effectiveness. This includes certifying compliance with the requirements of Group policies.
The Group purchases insurance to provide the business with financial protection against specific losses and to comply with statutory or contractual requirements. Insurance is primarily used as an additional risk mitigation tool in controlling the Group’s exposures. However, insurance only provides protection against financial loss once a risk has crystallised.
Operational risk metrics Reporting forms an integral part of operational risk management. The Group’s risk management processes are designed to ensure that issues are identified, escalated and managed on a timely basis. Exposures for each division are reported through monthly risk and control reports, which provide detail on the risk exposures and action plans.
Operational risk events by risk category – % of total risk events by count The chart below shows that as at 31 December 2009 execution, delivery and process management, together with external fraud, accounted for circa 90% of losses by value during 2009.
Fraud prevention Fraud remains a big challenge to the Group, and the rest of the financial services industry. The Group continues to respond to this threat, continually investing in people and processes for both detective and preventative measures, especially in relation to the impact of organised crime against the Group. Key initiatives are focused on solutions for payment fraud, ATM security, identification of counterfeit documentation and online banking protection for our customers. This has resulted in multi-million pound savings and, through close working ties with law enforcement agencies, handing down of significant custodial sentences.
Physical security The Group has implemented strong measures to protect our customers, our staff and our assets from physical harm. These measures are kept under constant review in response to changing threats. In particular, in 2009 there has been a significant rise in demonstrations against the Group in relation to the increased media attention the Group has received. Robust processes are in place to ensure the safety of customers and staff during these demonstrations.
Business continuity The need to ensure the continuity of business across the Group and the management of crisis situations is a key activity within the risk function.
Risk, capital and liquidity management 173RBS Group Annual Report and Accounts 2009
Every three years the Group and Trustees meet to formally agree the appropriate basis for calculating the funding valuation. The most recent funding valuation was carried out as at 31 March 2007. This showed the fund to be in surplus, and therefore there was no need in 2008 or 2009 for additional payments over and above the regular contributions.
The Group has the right to terminate the Scheme at any time provided that the Financial Services Authority has confirmed in writing to HMT that it has no objection to the proposed termination. On termination, the Group is liable to pay HMT a termination fee. The termination fee would be the difference between £2.5 billion (or, if higher, a sum related to the economic benefit of regulatory capital relief obtained as a result of having entered the APS) and the aggregate fees paid. In addition, the Group would have to repay any amounts received from HMT under the terms of the APS (or as otherwise agreed with HMT). In consideration for the protection provided by the APS, the Group paid an initial premium of £1.4 billion on 31 December 2009 for the years 2009 and 2010. A further premium of £700 million is payable on 1 January 2011 and subsequently annual premiums of £500 million until the earlier of 31 December 2099 or the termination of the agreement.
The APS is a single contract providing credit protection in respect of a portfolio of financial assets: the unit of account is the contract as a whole. Under IFRS, credit protection is either treated as a financial guarantee contract (‘FGC’) or a derivative depending on the terms of the agreement and the nature of the protected assets and exposures. The portfolio contains more than an insignificant element of derivatives and limited recourse assets, and hence the contract does not meet the definition of an FGC. The APS contract is therefore treated as a derivative and is recognised at fair value, with changes in fair value recognised in profit or loss. The APS derivative did not have any effect on the Group’s 2009 income statement; however in future period’s changes in value of the APS derivative will have an effect on the Group’s profit or loss.
• restructuring: a covered asset which is individually impaired and is subject to a restructuring.
Covered assets at 31 December 2008 – at accession to the Scheme 282.0 Disposals (3.0) Non-contractual early repayments (8.9) Amortisations (9.4) Maturities (16.7) Rollovers and covered amount cap adjustments (1.7) Effect of foreign currency movements (11.8) Covered assets at 31 December 2009 230.5
Note: (1) The covered amount at 31 December 2009 above includes approximately £2.1 billion of assets in the derivatives and structured finance asset classes which, for technical reasons, do not currently satisfy, or are anticipated at some stage not to satisfy, the eligibility requirements of the Scheme. HMT and the Group continue to negotiate in good faith whether (and, if so, to what extent) coverage should extend to these assets. Also, the Group and HMT are in discussion over the HMT classifications of some structured credit assets and this may result in adjustments to amounts for some asset classes; however underlying risks will be unchanged.
Global Banking Banking book: selection by individual asset pool (corporate loans, real estate finance, and leveraged finance), Markets (GBM) (1) Global Restructuring Group work-out unit counterparties/assets and high risk counterparties/assets.
Additional counterparties/assets were selected through an individual risk review of the total portfolio.
Corporate: all defaulted assets in the work-out/restructuring unit. Corporate banking clients in high risk sectors or with high concentration risk.
Loans and overdrafts: higher risk customers based on internal bandings, and those assets in arrears (at 31 December 2008).
Ulster Bank (1) Mortgages: assets with greater than 85% LTV, broker mortgages and interest only with a higher probability of default. (Corporate & Retail)
Corporate: counterparties/assets in work-out/restructuring groups or in high risk bands, and other assets identified as part of an individual review of cases.
APS recoveries include any return of value on a triggered asset, although these are only recognised for Scheme reporting purposes when they are realised in cash. The net triggered amount at any point in time, only takes into account cash recoveries to date. The capturing of triggered amounts has required extensive new processes and controls to be put in place. These continue to be work in progress. Additionally, as with any bespoke and highly complex legal agreement there are various areas of interpretation which still need to be clarified and agreed between the Group and the Asset Protection Agency (‘APA’), some of which could have a material impact on the triggered amount identified to date. Also as part of the APS terms and conditions it was agreed to re-characterise certain assets and their closely related hedges under the scheme and the Group continues to negotiate with APA in good faith to finalise this.
Note: (1) The triggered amount on a covered asset is calculated when an asset is triggered (due to bankruptcy, failure to pay after a grace period, and restructuring with an impairment) and is the lower of the covered amount and the outstanding amount for each covered asset. Given the grace period for triggering assets, the Group expects additional assets to trigger based on the current risk rating and level of impairments on covered assets.
• APS recoveries include almost any return of value on a triggered asset but are only recognised when they are realised in cash, hence there will be a time lag for the realisation of recoveries.
• On this basis, expected loss on triggered assets at 31 December 2009 is approximately £15 billion (25%) of the £60 billion first loss threshold under the APS.
• In case the net triggered amount exceeds a specified threshold level for each covered asset class, HMT retains step-in rights as defined in the Scheme rules.
• Over the year RWAs covered by the APS declined overall due to the restructuring of certain exposures, including monoline related assets, and decrease in the covered amount partly off-set by credit downgrade and procyclicality.
Residential mortgages 10,280 — 128 2,837 2,182 15,427 Consumer finance 11,609 25,031 — 5,776 12,127 54,543 Commercial real estate finance — 12,436 — 1,268 26,146 39,850 Leveraged finance — 4,978 993 329 21,434 27,734 Lease finance — 594 — — 1,844 2,438 Project finance — — 425 — 1,818 2,243 Structured finance — — 6,897 - 12,294 19,191 Loans — 9,097 45,610 2,663 22,607 79,977 Bonds — — 455 — 1,108 1,563 Derivatives — — 16,349 229 22,415 38,993
Notes: (1) Per the Scheme rules, the definition of consumer finance includes personal loans, as well as business and commercial loans to SMEs
Risk, capital and liquidity management 179RBS Group Annual Report and Accounts 2009
Asset classes The following tables detail the balances by asset classes, as defined by the Scheme, with underlying product categories.
UK Retail 16,599 2,431 19,030 2,212 21,242 UK Corporate 37,710 1,007 38,717 10,510 49,227 Global Banking & Markets 26,141 1,628 27,769 16,248 44,017 Ulster Bank 10,152 486 10,638 1,231 11,869 Non-Core 63,557 23,338 86,895 17,280 104,175
Provisions and commitments Carrying adjustments and other Covered value (2) to par value (3) Par value (4) adjustments (5) amount £m £m £m £m £m 2008 (a) (b) (a)+(b)=(c) (d) (c)+(d)=(e)
(3) Provisions and adjustments to par value comprise: • impairments on LAR and AFS debt securities; • credit valuation adjustments relating to derivatives; • adjustment to par value on other FVTPL assets; • add-back of write-offs of £6,079 million, as these are covered by the Scheme rules; and
Risk, capital and liquidity management 181RBS Group Annual Report and Accounts 2009
UK UK Ulster Covered Covered Retail Corporate GBM Bank Non-Core amount amount 2008 £m £m £m £m £m £m £m
Residential Consumer Commercial Leveraged Lease Project Structured Covered mortgages finance real estate finance finance finance finance Loan Bonds Derivative amount 2009 £m £m £m £m £m £m £m £m £m £m £m
Financial institutions — — 818 1,620 18 — 13,769 9,741 337 22,447 48,750 Manufacturing — — — 5,906 120 6 6 9,782 48 1,011 16,879 Natural resources — — — 1,260 41 1,065 9 2,458 46 442 5,321 Property — — 30,636 1,810 564 298 486 9,058 53 4,915 47,820 Retail and leisure — — 616 3,510 40 142 369 7,819 74 1,599 14,169 Services — — 29 3,213 320 104 191 1,572 6 622 6,057 TMT — — — 5,490 9 — 3 3,908 11 1,287 10,708 Transport — — 35 465 273 202 342 10,171 123 1,164 12,775 Personal and SME 14,205 53,261 3 2 144 — — 433 — 3 68,051
Financial Institutions — — 638 4,196 28 138 17,288 15,478 514 25,747 64,027 Manufacturing — — — 4,895 196 14 7 13,233 60 1,648 20,053 Natural resources — — — 1,484 60 1,261 11 4,699 53 554 8,122 Property — — 38,467 2,188 876 388 550 12,289 128 5,331 60,217 Retail and leisure — — 679 4,067 63 151 443 10,417 165 1,990 17,975 Services — — 31 3,773 556 66 519 2,832 13 694 8,484 TMT — — — 6,591 13 — 3 5,918 406 1,604 14,535 Transport — — 35 537 369 225 370 12,619 149 1,422 15,726 Personal and SME 15,427 54,543 — 3 277 — — 2,492 75 3 72,820
Currency breakdown The table below shows the currency breakdown of covered assets.
The analysis by currency does not reflect hedges that the Group may have in place.
Risk, capital and liquidity management 183RBS Group Annual Report and Accounts 2009
Risk elements in lending (REIL) and potential problem loans (PPL) REIL and PPL for the Group and the amount relating to assets in the Scheme are set out below.
Credit quality of loans The table below analyses the credit quality of the Group’s credit risk assets by risk bands and the proportion relating to assets in the Scheme.
(2) Reverse repurchase agreements, carrying value relating to net derivative positions and debt securities are excluded from both Group numbers and APS covered assets above.
Asset-backed securities The Group structures, originates, distributes and trades debt in the form of loan, bond and derivative instruments in all major currencies and debt capital markets in North America, Western Europe, Asia and major emerging markets. The carrying value of the Group’s debt securities at 31 December 2009 was £249.1 billion (2008 – £253.2 billion). This comprised: Group Group before RFS before RFS
Securities issued by central and local governments 134.1 146.9 95.1 105.8 122.8
Risk, capital and liquidity management 185RBS Group Annual Report and Accounts 2009
RMBS: prime (4) 2,436 3,747 3,018 172 9,373 3,167 5,480 584 142 RMBS: non-conforming 948 1,957 128 — 3,033 379 1,180 1,474 — RMBS: sub-prime 565 305 137 290 1,297 529 427 324 17 CMBS 2,245 1,228 595 399 4,467 1,331 1,556 1,377 203 CDOs 743 124 382 26 1,275 521 550 203 1
(3) Net exposures represent the carrying value after taking account of hedge protection purchased from monoline insurers and other counterparties but exclude the effect of counterparty credit valuation adjustments. The hedges provide credit protection of principal and interest cash flows in the event of default by the counterparty. The value of this protection is based on the underlying instrument being protected.
Gross exposure (1): RMBS: G10 governments (2) 26,644 49 17 297 2,679 13,357 94 — 29,434 13,703 RMBS: prime 2,873 92 3,787 1,489 1,200 3,367 177 45 8,037 4,993
Net exposure (3): RMBS: G10 governments (2) 26,984 50 17 288 2,632 12,972 33 — 29,666 13,310 RMBS: prime 2,433 3 3,518 229 484 2,534 169 3 6,604 2,769 RMBS: non-conforming 946 2 1,928 29 — 128 — — 2,874 159 RMBS: sub-prime 450 115 236 69 92 45 6 284 784 513 CMBS 2,193 52 622 606 394 201 — 399 3,209 1,258
(2) RMBS: G10 government securities comprise securities that are: (a) Guaranteed or effectively guaranteed by the US government, by way of its support for US federal agencies and GSEs; (b) Guaranteed by the Dutch government; and
Notes: (1) RMBS: G10 government securities comprise securities that are: (a) Guaranteed or effectively guaranteed by the US government, by way of its support for US federal agencies and GSEs; (b) Guaranteed by the Dutch government; and
RMBS: G10 governments 43,005 550 — — 43,555 43,555 — 43,555 RMBS: prime 9,211 1,731 558 1 11,501 10,696 221 10,917 RMBS: non-conforming 1,980 467 594 2 3,043 1,549 21 1,570 RMBS: sub-prime 578 514 579 153 1,824 1,371 128 1,499 CMBS 3,440 1,920 147 2 5,509 4,000 134 4,134 CDOs 616 2,141 849 262 3,868 2,640 1,025 3,665 CLOs 2,718 5,232 636 730 9,316 7,978 818 8,796 Other ABS 4,099 4,516 152 799 9,566 5,177 946 6,123
RMBS: G10 governments 40,142 — — 125 40,267 40,267 — 40,267 RMBS: prime 15,242 575 27 131 15,975 15,975 — 15,975 RMBS: non-conforming 2,958 530 146 144 3,778 3,598 180 3,778 RMBS: sub-prime 1,929 2,478 637 191 5,235 5,171 59 5,230 CMBS 4,286 1,212 35 22 5,555 4,929 — 4,929 CDOs 10,069 823 989 119 12,000 10,334 1,666 12,000 CLOs 4,157 704 93 722 5,676 5,593 83 5,676 Other ABS 8,568 1,285 177 1,565 11,595 11,391 130 11,521
Notes: (1) Credit ratings are based on those from rating agency Standard & Poor’s (S&P). Moody’s and Fitch have been mapped onto the S&P scale.
Risk, capital and liquidity management 189RBS Group Annual Report and Accounts 2009
• Life-to-date net valuation losses on ABS held at 31 December 2009, including impairment provisions, were £20.1 billion comprising: – RMBS: £3.6 billion, of which £0.7 billion was in US sub-prime and £2.3 billion in European assets; – CMBS: £1.2 billion; – CDOs: £9.4 billion and CLOs: £3.3 billion, significantly all in NonCore; and
• The majority of the Group’s exposure to ABS is through governmentbacked RMBS, amounting to £43.6 billion at 31 December 2009 (2008 – £51.6 billion), and includes: – US government -backed securities, comprising mainly current year vintage positions, were £27.0 billion (2008 – £33.5 billion). Due to the US government backing, explicit or implicit, for these securities, the counterparty credit risk exposure is low. This is comprised of: – HFT securities of £13.4 billion (2008 – £18.6 billion). These securities are actively transacted and possess a high degree of liquidity. Trading in this portfolio has shifted to more recent vintages; – AFS securities of £13.6 billion (2008 – £14.9 billion) relating to liquidity portfolios held by US Retail & Commercial; and
• Subprime balances decreased across ratings, geographies and vintages, due to pay-downs, maturities and sales during the year, while non-conforming exposures fell mainly due to UK AAA-rated AFS redemptions. During the third quarter, improved prices off-set the effect of redemptions in some portfolios.
• Many of the assets, primarily CDOs and CLOs, in Non-Core Trading have market hedges in place which gives rise to a significant difference between the carrying value and the net exposure.
• AAA-rated assets decreased from £93.9 billion at 31 December 2008 to £65.6 billion at 31 December 2009 primarily as a result of the selldown activity of prime and government-backed securities.
• There were significant downgrades of AAA-rated CLOs to BBB during the year.
The main categories of mortgages that serve as collateral to RMBS held by the Group are described below. The US market has more established definitions of differing underlying mortgage quality and these are used as the basis for the Group’s RMBS categorisation.
RMBS: G10 government securities comprise securities that are: • Guaranteed or effectively guaranteed by the US government, by way of its support for US federal agencies and GSEs; • Guaranteed by the Dutch government; and
Guaranteed or effectively guaranteed mortgages are mortgages that form part of a mortgage-backed security issuance by a government agency, or in the US an entity that benefits from a guarantee (direct or indirect) provided by the US government. For US RMBS, this category includes RMBS issued by Ginnie Mae, Freddie Mac and Fannie Mae. European RMBS includes mortgages guaranteed by the Dutch Government.
Covered mortgage bonds are debt instruments that have recourse to a pool of mortgage assets, where investors have a preferred claim if a default occurs. These underlying assets are segregated from the other assets held by the issuing entity.
Sub-prime mortgages are loans to sub-prime borrowers typically having weakened credit histories that include payment delinquencies and potentially more severe problems such as court judgements and bankruptcies. They may also display reduced repayment capacity as measured by credit scores, high debt-to-income ratios, or other criteria indicating heightened risk of default.
• The change in vintage composition is a result of the balance sheet sell-down as well as the US Mortgage trading activity.
Risk, capital and liquidity management 191RBS Group Annual Report and Accounts 2009
Collateralised debt and loan obligations Collateralised debt obligations (CDO) are securities whose performance is dependent on a portfolio of referenced underlying securitised assets. The referenced assets generally consist of ABS, but may also include other classes of assets. Collateralised loan obligations (CLO) represent securities in special purpose entities, the assets of which are primarily cash flows from underlying leveraged loans. Some of the Group’s holdings of asset-backed securities were originated for CDO structures. These CDO structures include off-balance sheet ABS with hedges to provide net super senior CDO exposures.
The Group retained significant holdings of super senior positions in CDOs. These positions represent the most senior positions in the CDO and, at the time of structuring, were senior to tranches rated AAA by independent rating agencies. However, since the inception of these transactions, the subordinate tranches have diminished significantly in value such that, at 31 December 2009, there was no significant value in any of the subordinate positions related to the Group’s open super senior positions in ABS CDOs. The net exposure on the open positions at 31 December 2009 is £910 million (2008 – £1,182 million). Net exposure represents the value after taking account of hedge protection purchased from monolines and other counterparties but excludes the effect of credit valuation adjustments.
The Group has accumulated these assets from a range of trading and funding activities. The carrying value of the Group’s other asset-backed securities by underlying asset type and geographical region is shown below.
Risk, capital and liquidity management 193RBS Group Annual Report and Accounts 2009
Credit valuation adjustments (CVA) CVA represent an estimate of the adjustment to arrive at fair value that a market participant would make to incorporate the credit risk inherent in counterparty derivative exposures. The Group makes such credit adjustments to derivative exposures it has to counterparties, as well as debit valuation adjustments (DVA) to liabilities issued by the Group. The Group’s methodology used for deriving DVA is different to that used for
CVA and is discussed within Note 11 Financial instruments – own credit on page 281.
The Group has purchased protection from monoline insurers (‘monolines’), credit derivative product companies (CDPCs) and other counterparties. The Group makes CVAs to exposures it has to these counterparties. The CVAs at 31 December 2009 are set out below.
• During 2009, there was a significant reduction in the level of CVA held against exposures to monoline insurers and CDPCs, primarily driven by a reduction in the gross exposures to these counterparties due to a combination of restructuring certain trades and higher prices of underlying reference instruments.
• The exposure to monoline insurers has decreased considerably during 2009 due to a combination of restructuring certain exposures and higher prices of underlying reference instruments. The trades with monoline insurers are predominantly denominated in US dollars, and the strengthening of sterling against the US dollar during 2009 has further reduced the exposure.
RWAs* Counterparty and credit RWAs relating to risk structures incorporating gross monoline exposures increased from £7.3 billion to £13.7 billion over the year. The increase was driven by revised credit risk assessments of these counterparties in the first nine months of the year, partially off-set by reductions in the last quarter due to restructuring.
Monoline insurers The Group has purchased protection from monolines, mainly against specific asset-backed securities. Monolines specialise in providing credit protection against the principal and interest cash flows due to the holders of debt instruments in the event of default by the debt instrument counterparty. This protection is typically held in the form of derivatives such as credit default swaps (CDSs) referencing underlying exposures held directly or synthetically by the Group.
Risk, capital and liquidity management 195RBS Group Annual Report and Accounts 2009
Of which: Of which: BBB rated — — — — — —
Of which: Credit ratings are based on those from rating agencies Standard & Poor’s (S&P) and Moody’s. Where the ratings differ, the lower of the two is taken.
Notes: (1) Represents the fair value of the reclassified debt securities, adjusted for principal based cash flows between 1 July 2008 and 31 December 2009.
If the debt securities had not been reclassified, all changes in fair value would have been recognised in the income statement and would be offset by changes in the fair value of the related monoline CDS. The extent to which the level of impairments recorded differs from the fair value changes gives rise to a net profit or loss that, but for the reclassification, would have been recorded for accounting purposes.
The net income statement effect relating to monoline exposures is shown below.
• The net loss arising from the reclassification of debt securities is due to the difference between impairment losses on these available-for-sale securities and the gains that would have been reported in the income statement if these assets had continued to be accounted for as held-fortrading.
Credit derivative product companies (CDPC) A CDPC is a company that sells protection on credit derivatives. CDPCs are similar to monoline insurers, however, they are not regulated as insurers.
The Group has purchased credit protection from CDPCs through tranched and single name credit derivatives. The Group’s exposure to CDPCs is predominantly due to tranched credit derivatives (tranches). A tranche references a portfolio of loans and bonds and provides protection against total portfolio default losses exceeding a certain percentage of the portfolio notional (the attachment point) up to another percentage (the detachment point). The Group has predominantly traded senior tranches with CDPCs, the average attachment and detachment points are 15% and 51% respectively (2008 – 16% and 50% respectively), and the majority of the loans and bonds in the reference portfolios are investment grade.
The gross mark-to-market of the CDPC protection is determined using industry standard models. The methodology employed to calculate the CDPC CVA is different to that outlined above for monolines, as there are no market observable credit spreads and recovery levels for these entities. The level of expected loss on CDPC exposures is estimated by analysing the underlying trades and the cost of hedging expected default losses in excess of the capital available in each vehicle.
A summary of the Group’s exposure to CDPCs is detailed below: £m £m £m
Gross exposure to CDPCs 1,275 4,776 863 Credit valuation adjustment (499) (1,311) (44) Net exposure to CDPCs 776 3,465 819
• The exposure to CDPCs reduced significantly during the year mainly due to a combination of tighter credit spreads of the underlying reference loans and bonds, and a decrease in the relative value of senior tranches compared with the underlying reference portfolios. The trades with CDPCs are predominantly US and Canadian dollar denominated, and the strengthening of sterling against the US dollar has further reduced the exposure, partially off-set by the weakening of sterling against the Canadian dollar.
• The Group has additional hedges in place which effectively cap the exposure to CDPCs where the Group has significant risk. As the exposure to these CDPCs has reduced, losses have been incurred on the additional hedges.
• These losses, together with losses arising on trades hedging CVA, are the primary components of the £1.8 billion above.
Risk, capital and liquidity management 199RBS Group Annual Report and Accounts 2009
Correlation between exposure and counterparty risk is also incorporated within the CVA calculation where this risk is considered significant. The risk primarily arises on trades with emerging market counterparties where the gross mark-to-market value of the trade, and therefore the counterparty exposure, increases as the strength of the local currency declines.
CVA is held against exposures to all counterparties with the exception of the CDS protection that the Group has purchased from HMT, as part of its participation in the APS, due to the unique features of this derivative.
The net income statement effect arising from the change in level of CVA for all other counterparties and related trades is shown in the table below.
Credit valuation adjustment at 1 January 2009 (1,738) Credit valuation adjustment at 31 December 2009 (1,588) Decrease in credit valuation adjustment 150 Net debit relating to hedges, foreign exchange and other movements (841) Net debit to income statement (income from trading activities) (691)
• Losses arose on trades hedging the CVA held against other counterparties due to the tightening of credit spreads. These losses, together with realised losses from counterparty defaults, are the primary cause of the loss arising on foreign exchange, hedges, realisations and other movements.
• The net income statement effect was driven by updates to the CVA methodology, hedges and realised defaults off-setting CVA movements.
– The primary update applied to the CVA methodology reflected a market wide shift in the approach to pricing and managing counterparty risk. The methodology change related to the calculation of the probability of default. The basis for this calculation moved from a blended market implied and historic measure to the market implied methodology set out above. Other updates to the methodology were made to reflect the correlation between exposure and counterparty risk.
– Prior to the update to the CVA methodology, CVA moves driven by changes to the historic element of the blended measure were not hedged, resulting in losses during the year arising from related CVA increases.
The table below shows the Group’s global markets sponsor-led leveraged finance exposures by industry and geography. The gross exposure represents the total amount of leveraged finance committed by the Group (drawn and undrawn). The net exposure represents the balance sheet carrying values of drawn leveraged finance and the total undrawn amount. The difference between gross and net exposures is principally due to the cumulative effect of impairment provisions and historic write-downs on assets prior to reclassification.
Gross exposure: Net exposure: Of which: Notes: (1) All the above exposures are in Non-Core.
(3) There were no held-for-trading exposures at 31 December 2009 (2008 – £102 million).
Of this balance, £8,874 million was drawn and £5,708 million was undrawn.
Risk, capital and liquidity management 201RBS Group Annual Report and Accounts 2009
• During 2009 the Group’s sterling exposure has declined, largely as a result of the weakening of the US dollar and euro against sterling during the period.
Not included in the table above are: • UK Corporate leveraged finance net exposures of £7.1 billion at 31 December 2009 (2008 – £6.9 billion) related to debt and banking facilities provided to UK mid-corporates. Of this, £1.4 billion related to facilities provided to client in the retail sector and £2.1 billion to the industrial sector (2008 – £1.4 billion and £2.5 billion respectively).
The Group sponsors own-asset securitisations as a way of diversifying funding sources, managing specific risk concentrations, and achieving capital efficiency. The Group purchases the securities issued in ownasset securitisations. During 2008, the Group was able to pledge AAArated asset-backed securities as collateral for repurchase agreements with major central banks under schemes such as the Bank of England’s Special Liquidity Scheme, launched in April 2008, which allowed banks to temporarily swap high-quality mortgage-backed and other securities for liquid UK treasury bills. This practice has contributed to the Group’s sources of funding during 2008 and 2009 in the face of the contraction in the UK market for inter-bank lending and the investor base for securitisations.
Conduits The Group sponsors and administers a number of asset-backed commercial paper (ABCP) conduits. A conduit is an SPE that issues commercial paper and uses the proceeds to purchase or fund a pool of assets. The commercial paper is secured on the assets and is redeemed either by further commercial paper issuance, repayment of assets or funding from liquidity facilities. Commercial paper is typically short-dated, usually up to three months.
Group-sponsored conduits can be divided into multi-seller conduits and own-asset conduits. The Group consolidates both types of conduit where the substance of the relationship between the Group and the conduit vehicle is such that the vehicle is controlled by the Group. The total assets held by Group-sponsored conduits were £27.4 billion at 31 December 2009 (2008 – £49.9 billion). Liquidity commitments from the Group to the conduit exceed the nominal amount of assets funded by the conduit as liquidity commitments are sized to cover the funding cost of the related assets.
Group-sponsored multi-seller conduits The multi-seller conduits were established by the Group for the purpose of providing its clients with access to diversified and flexible funding sources. A multi-seller conduit typically purchases or funds assets originated by the banks’ clients. The multi-seller conduits account for 43% of the total liquidity and credit enhancements committed by the
The Group sponsors six multi-seller conduits which finance assets from Europe, North America and Asia-Pacific. Assets purchased or financed by the multi-seller conduits include auto loans, residential mortgages, credit card receivables, consumer loans and trade receivables.
• The increase in both residential mortgages and other loan assets in the year principally relates to assets securitised to facilitate access to central bank liquidity schemes.
• As all notes issued by own-asset securitisation SPEs are purchased by Group companies, assets are significantly greater than securitised liabilities.
Risk, capital and liquidity management 203RBS Group Annual Report and Accounts 2009
(2) Maximum exposure to loss is determined as the Group’s total liquidity commitments to the conduits and additionally programme-wide credit support which would absorb first loss on transactions where liquidity support is provided by a third party. Third party maximum exposure to loss is reduced by repo trades conducted with an external counterparty.
The third-party assets financed by the conduits receive credit enhancement from the originators of the assets. This credit enhancement, which is specific to each transaction can take the form of over-collateralisation, excess spread or subordinated loan, and typically ensures the asset acquired by the conduit has a rating equivalent to at least a single-A credit. In addition, in line with general market practice, the Group provides a small second-loss layer of programme-wide protection to the multi-seller conduits. Given the nature and investment grade equivalent quality of the first loss enhancement provided by the originators of the assets, the Group has only a minimal risk of loss on its programme-wide exposure. The issued ABCP is rated A-1/P-1 by Moody’s and Standard & Poor’s.
The Group provides liquidity back-up facilities to the conduits it sponsors. The conduits are able to draw funding under these facilities in the event of a disruption in the ABCP market, or when certain trigger events prevent the issue of ABCP.
• The Group’s maximum exposure to loss on its multi-seller conduits is £25.2 billion (2008 – £43.2 billion), being the total amount of the Group’s liquidity commitments plus the extent of programme-wide credit enhancements of conduit assets for which liquidity facilities were provided by third parties.
The Group holds three own-asset conduits which have assets that have previously been funded by the Group. These vehicles represent 56% (2008 – 25%) of the Group’s conduit business (as a percentage of the total liquidity and credit enhancements committed by the Group), with £7.7 billion of ABCP outstanding at 31 December 2009 (2008 – £14.8 billion). The Group’s maximum exposure to loss on its own-asset conduits is £34.2 billion (2008 – £15.9 billion), being the total drawn and undrawn amount of the Group’s liquidity commitments to these conduits. This comprises committed liquidity of $40.8 billion (£25.1 billion) to an own-asset conduit established to access the Bank of England’s open market operations and £9.1 billion to other own-asset conduits. As the first of these conduits was established for contingent funding and at 31 December 2009 it had no commercial paper outstanding, the Group’s liquidity commitment to this conduit is not included in the table below.
During the period both multi-seller and own asset conduit assets have been reduced in line with the wider Group balance sheet management.
Auto loans 4,293 356 4,649 2,526 — 7,175 Corporate loans 106 7,695 7,801 161 — 7,962 Credit card receivables 4,083 — 4,083 1,058 — 5,141 Trade receivables 806 — 806 1,351 — 2,157 Student loans 915 — 915 263 (132) 1,046 Consumer loans 1,686 — 1,686 222 — 1,908 Mortgages: Auto loans 9,924 383 10,307 1,871 — 12,178 Corporate loans 430 11,042 11,472 534 — 12,006 Credit card receivables 5,844 — 5,844 922 — 6,766 Trade receivables 2,745 — 2,745 1,432 (71) 4,106 Student loans 2,555 — 2,555 478 (132) 2,901
Auto loans 8,066 578 8,644 3,701 (102) 12,243 Corporate loans 36 8,927 8,963 1,390 — 10,353 Credit card receivables 5,104 90 5,194 1,206 — 6,400 Trade receivables 3,068 320 3,388 2,386 — 5,774 Student loans 335 262 597 1,082 (132) 1,547 Consumer loans 1,886 — 1,886 403 — 2,289 Mortgages: Prime 4,424 2,263 6,687 664 — 7,351 Non-conforming 2,343 234 2,577 740 — 3,317 Sub-prime 9 117 126 363 — 489 Commercial 799 1,094 1,893 168 (23) 2,038 Buy-to-let — 61 61 8 — 69
Mortgages: Sub-prime — — — — — — — — — — —
Third party sponsored conduits The Group also extends liquidity commitments to multi-seller conduits sponsored by other banks, but typically does not consolidate these entities as the Group does not retain the majority of risks and rewards.
Liquidity and credit enhancements: Deal specific liquidity: Programme-wide liquidity: Note: (1) Maximum exposure to loss is determined as the Group’s total liquidity commitments to the conduits and additionally programme-wide credit support which would absorb first loss on transactions where liquidity support is provided by a third party.
• £0.4 billion (2008 – £0.7 billion) in money market ‘Plus’ funds managed by the Group denominated in sterling, US dollars and euro. The funds invest in longer-dated, highly rated securities with the objective of providing enhanced returns over the average return on comparable cash deposits.
Non-money market funds The Group has also established a number of non-money market funds to enable investors to invest in a range of assets including bonds, equities, hedge funds, private equity and real estate. The Group’s nonmoney market funds had total assets of £14.9 billion at 31 December 2009 (2008 – £18.7 billion). The sub-categories of non-money market funds are: • £1.1 billion (2008 – £1.6 billion) in committed capital to generate returns from equity and equity-like investments in private companies.
On 19 January 2009 the company announced, in conjunction with HM Treasury and UKFI, that the £5 billion non-cumulative sterling preference shares held by HM Treasury would be replaced with new ordinary shares. Eligible shareholders were able to apply to subscribe for approximately £5 billion of new ordinary shares pro rata to their existing shareholdings at a fixed price of 31.75 pence per share by way of an open offer. Any shares not taken up by shareholders in the open offer (or otherwise placed on behalf of the company) were subscribed for by HM Treasury at a fixed price of 31.75 pence per share and the aggregate proceeds of the open offer were used to fund the redemption of the preference shares held by HM Treasury, together with the redemption premium on the preference shares, accrued dividend, and commissions payable to HM Treasury on the offer. The preference shares were redeemed on 14 April 2009 at 101% of their issue price. This resulted in HM Treasury’s shareholding increasing by 16,791,036,376 ordinary shares to 70.3% of the enlarged ordinary share capital of the company.
On 27 November 2009 the company announced, in conjunction with HM Treasury and UKFI, that it would issue £25.5 billion of new capital to HM Treasury. This new capital, issued on 22 December 2009, took the form of B shares, which do not generally carry voting rights at meetings of ordinary shareholders but which are convertible into ordinary shares and count as Core Tier 1 capital. Whilst the B shares themselves are entitled to the same dividends as ordinary shares, a Dividend Access Share was issued in conjunction with them. The combined effect is that HM Treasury will enjoy preferential but non-transferable dividend rights on the new capital it provides. Although the capital issue of £25.5 billion is expected to be sufficient to provide RBS with robust capital ratios according to the Group’s current base case forecasts, the FSA also requires banks to have enough capital to maintain a minimum Core Tier 1 ratio of at least 4 per cent. even in a severely stressed scenario in which economic conditions deteriorate well beyond consensus forecasts. To enable RBS to meet this test, HM Treasury has agreed to subscribe for up to an additional £8 billion of capital (in the form of additional B shares) if RBS’s Core Tier 1 ratio falls below 5 per cent. (the ‘‘Contingent Subscription”). This Contingent Subscription will enable RBS to maintain its capital resilience even if such a severely stressed scenario were to occur.
Following approval at the General Meeting held on 15 December 2009, RBS joined the Asset Protection Scheme, set up by HM Treasury, which provides additional protection to the Group’s capital ratio and financial position.
Employees As at 31 December 2009, the Group employed over 160,000 employees (full-time equivalent basis) throughout the world. Details of employee related costs are included in Note 3 on the accounts on page 261.
The Group offers an appropriate remuneration and benefits package to all employees which seeks to balance the interests of employees, shareholders and the long-term needs of the businesses and reflects banking bonus reforms.
The Group is committed to leading the way in implementing reforms to bank remuneration as agreed by the G20 in Pittsburgh and is implementing enhancements in disclosure, deferral and clawback of bonus awards with effect from 1 January 2010 for the performance year 2009. A large amount of focus has been placed on achieving compliance with the emerging regulatory developments on a global scale. This has had a large impact on the Group's culture, and changes have affected all levels of the organisation.
Employee communication Employee engagement is encouraged through a range of communication channels, at both a divisional and Group level. These channels provide access to news and information in a number of ways, including the intranet, magazines, video, team meetings led by line managers, briefings held by senior managers and regular dialogue with employees and employee representatives.
Employee consultation Each year, all employees are invited to complete the global employee opinion survey. The survey is confidential and independently managed by Towers Perrin-ISR (now Towers Watson). The survey provides a channel for employees to express their views and opinions about the Group on a range of key issues.
The Group recognises employee representative organisations such as trade unions and work councils in a number of businesses and countries. The Group has two European Employee Forums that provide elected representatives with an opportunity to understand better its European operations. Engagement with its employees and such bodies remains important to the Group.
Diversity and inclusion The Group renewed its commitment to the principles of diversity and inclusion during 2009. The Group recognises that the diversity of its workforce is a considerable asset to the business and believes that an inclusive environment will enable all employees to develop to their full potential and enable RBS to attract and retain the best talent.
During 2009, the Group continued to focus on compliance, governance and managing risk across all jurisdictions. Enhanced mechanisms were implemented to support the health and wellbeing of employees, particularly given the impact of the economic environment.
Corporate sustainability Sustainability sits at the heart of how the Group is being re-shaped and RBS maintains a strong commitment to meeting high standards of environmental, social and ethical responsibility.
Corporate sustainability issues are governed by the Group Corporate Sustainability Committee (GCSC), which was established in 2009. The GCSC is supported by the executive-led Environment Working Group which has representatives from across the Group and reports to the GCSC. The Environment Working Group monitors environmental risk, commercial opportunities, operational impacts and communications and engagement.
Throughout the development of ’MoneySense’, RBS has continuously sought independent counsel. This has now been formalised through the formation of the MoneySense Advisory Board which draws on the skills of independent, impartial experts, to provide strategic input to the MoneySense programme.
Further details of the Group’s Corporate Sustainability policies are available on www.rbs.com/sustainability and in the annual Corporate Sustainability Report.
BBA draft disclosure code In October 2009, the British Bankers’ Association (BBA) published a draft code for Financial Reporting Disclosure. The draft code sets out five disclosure principles together with supporting guidance. The principles are that the Group and other major UK banks will provide high quality, meaningful and decision-useful disclosures; review and enhance their financial instrument disclosures for key areas of interest to market participants; assess the applicability and relevance of good practice recommendations to their disclosures acknowledging the importance of such guidance; seek to enhance the comparability of financial statement disclosures across the UK banking sector and clearly differentiate in their annual reports between information that is audited and information that is unaudited.
Corporate governance The company is committed to high standards of corporate governance. Details are given on pages 214 to 222. The Corporate governance statement forms part of this Report of the directors.
Ordinary share capital In April 2009, the company issued 16,909,716,385 ordinary shares of 25p by way of a placing and open offer on the basis of three new shares for every seven existing shares, raising £5.37 billion.
In December 2009, the company issued 51 billion B shares of 1p to HM Treasury at 50p per share, raising £25.5 billion.
During 2009 any option exercises were satisfied using market purchase shares. Therefore there was no increase to the ordinary share capital in respect of any option exercises.
Details of the authorised and issued ordinary share capital at 31 December 2009 are shown in Note 27 on the accounts.
Preference share capital Following the placing and open offer in April 2009, the company redeemed the five million non-cumulative sterling preference shares of £1 issued at £1,000 each (£5 billion in total) held by HM Treasury at 101 per cent of their issue price, the dividend accrued on the preference shares from 1 December 2008 to the date of redemption and the commissions payable to HM Treasury under the Second Placing and Open Offer Agreement.
The rights and obligations attaching to the company’s ordinary shares and preference shares are set out in the company’s Articles of Association, copies of which can be obtained from Companies House in the UK or at www.rbs.com.
A change of control of the company following a takeover bid may cause a number of agreements to which the company is party to take effect, alter or terminate. In addition, a number of executive directors’ service agreements may be affected on a change of control. All of the company’s employee share plans contain provisions relating to a change of control. Outstanding awards and options may vest and become exercisable on change of control, subject where appropriate to the satisfaction of any performance conditions at that time and prorating of awards. In the context of the company as a whole, these agreements are not considered to be significant.
Directors The names and brief biographical details of the directors are shown on pages 8 and 9.
Philip Hampton was appointed as a director and Chairman-designate on 19 January 2009 and as Chairman on 3 February 2009.
Sandy Crombie was appointed as Senior Independent Director on 1 June 2009.
Guy Whittaker ceased to be a director on 30 September 2009.
Gordon Pell will retire from the Board on 31 March 2010.
Archie Hunter, who has served as a director since September 2004 and chairman of the Group Audit Committee since April 2005, will retire from the Board at the end of his existing term at the conclusion of the Group’s Annual General Meeting in April 2010.
Group General Counsel and Group Secretary Miller McLean will retire as Group General Counsel and Group Secretary on 30 April 2010, after 40 years with the Group.
• Secondly, during the period from 6 February 2009 to 1 June 2009, the company did not have a senior independent director and from 6 February 2009 to 4 August 2009, the Remuneration Committee comprised two independent non-executive directors and the Chairman of the Board, not the three independent non-executive directors required by the Code. Since the appointment of Sandy Crombie as Senior Independent Director on 1 June 2009 and as a member of the Remuneration Committee on 4 August 2009, at which time the Chairman of the Board stepped down from the Remuneration Committee, the company has been compliant with both of these provisions of the Code.
The company supports and has engaged fully with the review of governance in banks and financial institutions undertaken by Sir David Walker and has taken various steps, as described throughout this report to implement the recommendations of the Walker review, details of which can be found in the ‘Recent Publications’ section at www.hm-treasury.gov.uk.
The company has reviewed its corporate governance arrangements and is satisfied that these are consistent with the NYSE’s corporate governance listing practices, with the exception that the Chairman of the Board is Chairman of the Nominations Committee and was a member of the Remuneration Committee until 4 August 2009, both of which are permitted by the Code (since the Chairman was considered independent on appointment). The company’s Audit, Nominations, Risk and Remuneration Committees are otherwise composed solely of nonexecutive directors deemed by the Board to be independent. The NYSE corporate governance listing standards also require that a compensation committee has direct responsibility to review and approve Group Chief Executive remuneration. As disclosed already, in the case of the company, the Board, rather than the Remuneration Committee, reserves the authority to make the final determination of the remuneration of the Group Chief Executive.
At the beginning of the year, a number of Board meetings are scheduled. For 2009, ten Board meetings were scheduled. The directors were supplied with comprehensive papers in advance of each Board meeting covering the Group’s principal business activities. The Group Chief Executive provides a written report on business activities at each Board meeting. Members of executive management attend and make regular presentations at meetings of the Board. The Chairman and the non-executives meet at least once per year without executives present.
The Board is aware of the other commitments of its directors and has established procedures for ensuring that the Board’s powers for authorising directors’ conflicts of interest are being operated effectively. With effect from 1 October 2008, the Companies Act 2006 introduced a
Governance statutory duty on directors to avoid conflicts of interest. Since that date, the Board has considered, and where appropriate authorised, any actual or potential conflicts of interests that directors may have. The Walker review recommends that the Chairman should be expected to commit a proportion of his time, probably not less than two thirds, to the business. In November 2009, Philip Hampton joined the Board of Anglo American plc as a non-executive director. This appointment was fully disclosed to the Board and it was satisfied that there were no issues in relation to his time commitment to RBS. Philip Hampton has confirmed that RBS remains his priority.
The non-executive directors combine broad business and commercial experience with independent and objective judgement. The balance between non-executive and executive directors enables the Board to provide clear and effective leadership and maintain the highest standards of integrity across the company’s business activities. The names and biographies of all Board members are set out on pages 8 and 9.
The Board considers that the Chairman was independent on appointment and all non-executive directors are independent for the purposes of the Code. The standard terms and conditions of the appointment of non-executive directors are available on the Group website (www.rbs.com) and copies are available on request.
Information, induction and professional development All directors receive accurate, timely and clear information on all relevant matters, and have access to the advice and services of the Group General Counsel and Group Secretary who is responsible to the Board for ensuring that Board procedures are followed and that applicable rules and regulations are complied with. In addition, all directors are able, if necessary, to obtain independent professional advice at the company’s expense.
In line with recommendations of the Walker review, the company is currently undertaking a comprehensive review of its Board induction and continuing development programme for directors. As a result, the induction programme has recently been expanded to include sessions with external advisers as well as the heads of key business areas.
Performance evaluation Following the Board evaluation last year, a number of initiatives were implemented in 2009 aimed at improving the overall performance and effectiveness of the Board, including further Board appointments, restructuring Board agendas and papers and allowing more time at Board meetings to consider strategic issues. In addition, reporting to the Board on risk matters, capital, liquidity and funding was enhanced.
The Board has again undertaken a formal and rigorous evaluation of its own performance and that of its committees and individual directors.
In 2009, this process was independently facilitated by Spencer Stuart*, using a detailed framework of questions which was used to structure the individual meetings held with each director. Amongst the areas reviewed were the role and organisation of the Board and its Committees, Board composition and the staffing of Committees, Board processes, the structure and frequency of meetings, Board and Committee reporting, and external relationships including those with shareholders and regulators. The Board has considered and discussed reports on the outcomes of the evaluations and is satisfied with the way in which the evaluations have been conducted.
The evaluation concluded that the Board is operating effectively and has benefited from the reduction in size and changes in composition which have been successfully implemented during 2009. The composition of the Board and staffing of key Committees, along with the shape of Board agendas and meeting formats are under continual review to build on this and further increase effectiveness. The separation of responsibilities between the Audit Committee and the newly formed Board Risk Committee to meet the recommendations of the Walker review will assist the Group in focusing on risk management as a whole and continuing to improve on areas such as risk analysis and reporting.
In accordance with the recommendations of the Walker review, the company has established a Board Risk Committee to advise the Board on risk issues.
Audit Committee All members of the Audit Committee are independent non-executive directors. The Audit Committee holds six scheduled meetings each year. In 2009, the Audit Committee held four additional meetings. The Audit Committee’s report is set out on pages 219 to 221. The Audit Committee is responsible for assisting the Board in carrying out its responsibilities relating to accounting policies, internal control and financial reporting.
The Directors’ remuneration report is contained on pages 225 to 236.
Meetings The number of scheduled meetings of the Board and the Audit, Remuneration and Nominations Committees and individual attendance of these scheduled meetings by members in 2009 is shown below.
Number of meetings attended in 2009: Stephen Hester 10 — — —
Philip Scott (7) 1 — — — Bruce Van Saun (8) 3 — — —
(3) Appointed as a director on 1 June 2009. Became a member of the Remuneration Committee on 4 August 2009.
Shareholders are given the opportunity to ask questions at the Annual General Meeting or submit written questions in advance. The chairmen of the Audit, Remuneration, Nominations and Board Risk Committees are available to answer questions at the Annual General Meeting.
Communication with the company’s largest institutional shareholders is undertaken as part of the Investor Relations programme: • The Group Chief Executive meets regularly with UKFI, the organisation set up to manage the Government's investments in financial institutions, to discuss the strategy and financials of the Group. He also undertakes an annual programme of meetings with the company’s largest institutional shareholders, as does the Group Finance Director.
• The Chairman independently meets with the Group’s largest institutional shareholders annually to hear their feedback on management, strategy, business performance and corporate governance.
The arrangements used to ensure that directors develop an understanding of the views of major shareholders are considered as part of the annual Board performance evaluation.
The effectiveness of the Group’s internal control system is reviewed regularly by the Board, the Audit Committee and, since January 2010, the Board Risk Committee. Executive management committees or boards of directors in each of the Group’s businesses receive regular reports on significant risks facing their business and how they are being controlled. In addition, the Board receives monthly risk management reports. Details of the Group’s approach to risk management are given in the Risk, capital and liquidity management section of the Business review. The Audit Committee has received confirmation that management has taken, or is taking, the necessary action to remedy any failings or weaknesses identified through the operation of the RBS group framework of controls.
Based on its assessment, management has concluded that, as of 31 December 2009, the Group’s internal control over financial reporting is effective.
The Group’s auditors have audited the effectiveness of the Group’s internal control over financial reporting and have given an unqualified opinion.
Management’s report on the Group’s internal control over financial reporting will be filed with the SEC at the same time as the Annual Report on Form 20-F.
Disclosure controls and procedures As required by US regulations, the effectiveness of the company’s disclosure controls and procedures (as defined in the rules under the US Securities Exchange Act of 1934) have been evaluated. This evaluation has been considered and approved by the Board which has instructed the Group Chief Executive and the Group Finance Director to certify that, as at 31 December 2009, the company’s disclosure controls and procedures were adequate and effective and designed to ensure that material information relating to the company and its consolidated subsidiaries would be made known to them by others within those entities.
• monitoring the Group’s processes for internal audit and external audit.
Following publication of the Walker review initial recommendations in July 2009, the Group Board approved the creation of a Board Risk Committee. The Group Audit Committee will be informed of risk issues through appropriate representation at the Board Risk Committee. Revised terms of reference for the Group Audit Committee and terms of reference for the Board Risk Committee were approved by the Board on
The terms of reference of the Audit Committee are available at www.rbs.com and these are considered annually by the Group Audit Committee and approved by the Board.
• reports providing assurance to third parties over certain of the Group’s internal controls prepared under US Statement of Auditing Standards 70 or similar auditing standards in other jurisdictions.
For all other permitted non-audit services, Audit Committee approval must be sought, on a case by case basis, before the provision of the service commences. In addition, the Audit Committee reviews and monitors the independence and objectivity of the external auditors when it approves non-audit work to be carried out by them, taking into consideration relevant legislation, ethical guidance and the level of nonaudit services relative to audit services. The approval process is rigorously applied to prevent the auditors from functioning in the role of management, auditing their own work, or serving in an advocacy role. Information on the audit and non-audit services carried out by the external auditors is detailed in Note 5 to the Group’s accounts.
The Group Audit Committee was pleased to note progress towards meeting the Group’s strategic plan in 2009. However, ongoing economic uncertainty continued to affect the Group throughout the period and it has recorded significant asset write-downs in its 2009 financial statements.
In these circumstances, particular attention of the Audit Committee was focused on a number of salient judgments involved in the preparation of the accounts: • valuation methodologies and assumptions for financial instruments carried at fair value including the Group’s credit market exposures and the disclosures provided; • claims reserves in the Group’s general insurance business; • the accounting treatment of bonus tax; • accounting issues relating to the Asset Protection Scheme; • actuarial assumptions for the Group Pension Fund; • impairment losses in the Group’s portfolio of loans and advances and available-for-sale securities; • carrying value of the deferred tax asset; and
In its consideration of each of these issues, the aims of the Audit Committee have been to: • understand and challenge the valuation and other accounting judgments made by management; • review the conclusions of the external auditors and, where applicable, other experts and to understand how they came to their conclusions; and
In response to the economic crisis the Group Audit Committee formally commissioned an independent report on risk reporting within the organisation. As a result, the format and content of risk reporting has undergone significant development during 2009.
The Audit Committee undertakes an annual evaluation to assess the independence and objectivity of the external auditors and the effectiveness of the audit process, taking into consideration relevant professional and regulatory requirements. The outcomes of this evaluation are considered by the Board together with the Group Audit Committee’s recommendation on the re-appointment of the external auditors or whether to commence an audit tender process. The annual evaluation is carried out following completion of the annual accounts and audit.
Deloitte LLP have been the company’s auditors since March 2000. The external auditors are required to rotate the lead audit partner responsible for the audit every five years. The current lead audit partner has completed his fifth year and accordingly, a new audit partner will lead the audits for the year ending 31 December 2010. There are no contractual obligations restricting the company’s choice of external auditor.
The Audit Committee is responsible for making recommendations to the Board, for it to submit the Audit Committee’s recommendations to shareholders for their approval at the Annual General Meeting in relation to the appointment, reappointment and removal of the external auditors. The Board has endorsed the Audit Committee’s recommendation that shareholders be requested to approve the reappointment of Deloitte LLP as external auditors at the Annual General Meeting in April 2010.
It is also intended that there will be an external review of the effectiveness of the Audit Committee every three to five years, with internal reviews by the Board continuing in the intervening years.
Since 2005, divisional audit committees have been responsible for reviewing each division’s business. During 2009, the divisional audit committee structure was revised to reflect organisational changes including the creation of the Non-Core Division. The divisional audit committees report to the Audit Committee and the Audit Committee is satisfied that these committees continue to discharge their terms of reference.
The Board Risk Committee is responsible for: • providing oversight and advice to the Board in relation to current and potential future risk exposures of the Group and risk strategy, including determination of risk appetite and tolerance; • assisting the Board on such other matters as may be referred to it by the Board; • promoting a risk awareness culture within the Group; and
Qualitative and quantitative information regarding the risks arising from the Group’s financial instruments required under International Financial Reporting Standard (IFRS) 7, are incorporated within the financial statements and Business review.
The Board Risk Committee will play a key role in the review, design and implementation of risk management and measurement strategies and risk management policy across the Group.
The Group risk appetite framework remains under development and work continues on enhancing risk limits and key risk measures. Risk appetite will be regularly reviewed by the Committee and the Committee will make recommendations to the Board as to risk appetite and tolerance as part of this ongoing process.
The Committee will also consider the Group’s exposure to country, single name and sector concentration risk and will ensure rigorous stress and scenario testing of the Group’s business is undertaken. The output of this testing will be reviewed by the Committee with a view to ensuring appropriate actions are taken where necessary. In due course it will make recommendations to the Group Board regarding related authorities, limits and mandates.
As required under the Walker review, the Committee will meet as required to review the due diligence of any proposed strategic transaction (involving a merger, acquisition or disposal) prior to the Group Board approval of the transaction.
The Committee will consider the adequacy and effectiveness of the technology infrastructure supporting the finance and risk management framework.
The Committee will review the risk input to divisional bonus pools and will provide advice to the Remuneration Committee on risk weightings to be applied to performance objectives which are incorporated within the incentive structure for the Group’s senior executives.
The Committee will ensure that it has substantial oversight of the work being undertaken within the divisions through the existing Divisional Audit Committee structure, in conjunction with the Group Audit Committee.
The principles I outlined to you in my letter last year connected the longterm interests of shareholders and customers with the performance of staff. These principles were the beginning of a fundamental reform of remuneration within the Group. During 2009, a thorough review of remuneration policies, processes and governance at RBS was undertaken. We have committed to positioning the Group at the leading edge of the financial services sector reform of remuneration and the changes we are making will help us reach this position. The framework that the Remuneration Committee has established has strengthened both the performance management processes and the link between risk and reward. The basis of the framework is: • a performance management process which ensures all employees know what is expected of them and includes a rigorous review of their achievements; • pay for performance – all annual and longer term awards are subject to challenging and measurable performance criteria directly linked to the Group’s strategic plan; • deferral – a significant proportion of annual awards are deferred and longer term awards are subject to a three year performance period; • clawback – awards can be subject to clawback and may be withheld if the results later turn out not to reflect sustained longer term performance; and
• use of shares for bonuses to align interests of employees with shareholders.
The Remuneration Committee appreciates that this has been another difficult year for our staff and their families as we restructure the business. The reality is that it is the hard work of our staff over many years that has resulted in a core set of resilient and valuable businesses that will drive our recovery. The performance of the core business remains strong due to the incredible focus our employees have maintained on our customers. It is for that reason we continue to create an environment in which our staff can meet their ambitions as we work with them to restore and then transform the Group into one of the world’s most admired, valued and stable banks.
• reviewing the remuneration of employees who have a material impact on Group performance. This includes new processes for reviewing remuneration for newly recruited senior individuals, who are critical to the long-term success of RBS; and
• reviewing and providing a strategic overview of all bonus and longterm incentive plans operating in RBS to ensure their compliance with shareholder interests, best industry practice and the requirements of the FSA’s Code of Practice on Remuneration.
The outcome of the Remuneration Committee’s review has included: • a clear governance framework for incentive plans across the Group, involving the Risk and HR functions at all key decision points; • a structure of deferment for incentives for up to three years, with the ability to claw back any that are shown to have been based on misstated or misleading results; • agreement with the Group’s major shareholder, UKFI, on the overall level of bonuses in respect of 2009 performance and the arrangements for their deferment in stages to 2012; and
• a new long term incentive plan which is being submitted to shareholders for approval at the Annual General Meeting following a comprehensive consultation with major institutional shareholders. This plan includes a new approach to performance measures to ensure that awards vest only if the Remuneration Committee is satisfied that the performance achieved is in line with the Board’s risk policies and that a balanced performance has been achieved across a number of risk adjusted metrics.
During the year the terms of reference of the Remuneration Committee were broadened to include oversight of remuneration policies for all employees across the Group. To reflect its work, the report of the Remuneration Committee contains not only information on executive remuneration, but also a statement of the remuneration policies which will apply across the whole of the Group.
The remuneration environment is evolving and while I acknowledge there is still more work to be done, we have already made significant changes and continue to be one of the leaders in the sector in the reform of our remuneration policies. The Remuneration Committee has made significant progress in overseeing the development of policies, processes and practices that will ensure that employee remuneration at RBS is properly controlled and fully aligns sustainable performance with the long term interests of shareholders and customers.
Jim Currie, Janis Kong, Sir Tom McKillop, Bob Scott and Peter Sutherland were members of the Committee until February 2009 when they ceased to be directors.
Philip Hampton was a member of the Remuneration Committee until 4 August 2009, when he was replaced as a member by Sandy Crombie.
The Remuneration Committee is also responsible for setting the remuneration arrangements for members of the Group Executive Committee and Management Committee and any employees falling within the definition of principle 8 of the FSA Code. Details of the FSA Code can be found at www.fsa.gov.uk.
The terms of reference for the Remuneration Committee have been reviewed. The revised terms of reference extend the remit of the Committee to oversight of Group-wide remuneration policy to ensure that the Group’s remuneration arrangements are consistent with and promote effective risk management. The Committee will undertake a regular review of the adequacy and effectiveness of the remuneration policy to ensure it is fully aligned with the Group’s long-term objectives. The Committee receives a number of reports to assist it in its oversight of remuneration policy, such as on risk and management performance across the Group.
The key aspects of the remuneration policy are as set out below: Pay-for-performance
• The pay-for-performance systems should be underpinned by a robust performance management system.
• Reward offerings in the markets where the Group operates should be understood and reward programmes should be designed and developed that offer value for money.
• Total compensation (comprising base pay progression and variable pay), benefits and long-term incentives should generally target a market position consistent with ensuring competitiveness and which allows a higher positioning for the highest performers.
A new deferral plan was approved by shareholders on 15 December 2009. Under the new plan, short-term incentives will be deferred into bonus awards vesting over a three year period in the form of RBS shares for the outer years. Deferral into shares helps to align the reward of participants with the long-term interests of shareholders. The terms of the deferral plan provides for “clawback” which allows the Remuneration Committee retrospectively to limit any compensation at the time of vesting if it considers that the performance factors on which reward decisions were based have later turned out not to reflect the corresponding performance in the longer term. The intention is to allow the Group to adjust historic compensation for unforeseen issues arising during the deferral period, particularly those that do not easily lend themselves to quantitative measurement.
Shareholder approval will be sought at the Annual General Meeting on 28 April 2010 for a new long term incentive plan, which will replace the existing Medium Term Performance Plan and Executive Share Option Plan. The key design features of the new long term incentive plan are: • awards will be structured as performance-vesting deferred shares; • at the discretion of the Remuneration Committee recipients will be able to elect whether they receive their award in the form of shares, or convert a portion of their award into market-value share options with the same performance conditions. The conversion rate between shares and options will be set so as to be broadly cost neutral. It is not the intention of the Remuneration Committee to offer this choice to participants for the initial award; GRA_4_Governance_09_207-238.qxp:GRA_4_Governance_09 15/3/10 09:29 Page 226
• clawback will apply to all awards. This allows the Remuneration Committee to retrospectively limit any compensation at the time of vesting if it considers that the performance factors on which reward decisions were based have later turned out not to reflect the corresponding performance in the long-term.
Pension arrangements The Group provides competitive retirement benefits in a manner that does not create an unacceptable level of risk for the Group. New employees are eligible for a cash allowance in lieu of pension provision and the facility to choose to have part of their remuneration in the form of contributions to The Royal Bank of Scotland Group Retirement Savings Plan.
Some employees continue to participate in defined benefit arrangements. The following two changes have been made to the main defined benefit pension plans: • a yearly limit on the amount of any salary increase that will count for pension purposes; and
Executive remuneration policy Components of executive directors’ remuneration 2010 Salary Base salaries of executive directors are reviewed annually. It has been agreed that no increases in base salaries will be made as part of the 2010 review.
Details of pension arrangements of directors are shown on page 236. Executive directors also receive death-in-service cover.
For all executive directors joining on or after 1 October 2006, pension provision is in the form of a pension allowance which may be used to participate in The Royal Bank of Scotland Group Retirement Savings Plan which is open to all employees, or to invest in alternative pension arrangements, or to take all or some of the allowance in cash. In addition, as employees, executive directors are eligible to participate in Sharesave and Buy As You Earn Plans. These plans are not subject to performance conditions since they are operated on an all-employee basis.
The 2008 Report and Accounts reported on the pension paid to the former Group Chief Executive, Sir Fred Goodwin, on his retirement from the Group on 31 January 2009. Following discussions between Sir Fred and the Group, he volunteered to make a substantial reduction to his pension to the level of £342,500 a year.
Gordon Pell will retire from the Group and the Board on 31 March 2010, shortly after his normal pension age of 60. Details of his pension are shown in this report. As agreed by the Board in 2005 his pension is based on his 39 years of service with Lloyds TSB and the Group, part of which has been funded by a transfer payment from a Lloyds TSB pension plan.
Annual incentives Annual incentives awarded to executive directors in respect of 2009 performance will be granted under the terms of the new deferral plan which was approved by shareholders in December 2009. In respect of 2009, the Remuneration Committee reviewed the annual incentive payments for executive directors, taking into account performance against targets for the year and targets relating to the strategic plan. As a result, the Remuneration Committee proposed annual incentive payments for Stephen Hester, Gordon Pell and Bruce Van Saun.
The Group Chief Executive, Stephen Hester, has declined his annual performance bonus for 2009 in the light of the public controversy currently prevailing on pay and the potential impediment taking such an award might have on support for the RBS turnaround which he was hired 15 months ago to lead. The Remuneration Committee, considers that Stephen Hester significantly outperformed the targets he was set for 2009 and intended to award a bonus commensurate with that view. In the light of Stephen Hester’s request, but mindful of the importance of the turnaround plan delivery that he was hired to achieve, no bonus will be awarded to him in respect of 2009. However, it remains the Board’s intention over the course of the recovery period to reward the Group Chief Executive fairly, appropriately and at market levels for achievement against the targets we have published to make the bank safe, successful and valuable again.
Executive directors have a normal maximum annual incentive opportunity of between 160% and 200% of salary (with an exceptional maximum opportunity of 200-250% of salary). The on-target opportunity is 107% to 133% of salary.
Shareholder approval will be sought at the Annual General Meeting on 28 April 2010 for a new long-term incentive plan, to replace the above plans. The key design features of this plan are outlined on pages 226 and 227.
Shareholding guidelines The Group operates shareholding guidelines for executive directors. The target shareholding level is 200% of gross annual salary for the Group Chief Executive and 100% of gross annual salary for executive directors. Executive directors have a period of five years in which to build up their shareholdings to meet the guideline levels.
Group Chief Executive – Stephen Hester Stephen Hester received certain share awards on appointment as Group Chief Executive and share awards to replace bonus and share awards he forfeited on leaving The British Land Company PLC. He was granted conditional share awards over a total of 10,407,081 shares. Subject to their terms, the majority of these awards vest between February 2009 and the third anniversary of his appointment as Group Chief Executive.
The chart above shows the make up of remuneration opportunity for ontarget annual performance, and with long term incentive awards shown at their fair value at the date of grant. Short term incentive payments earned in relation to 2010 performance will be deferred and will vest, subject to satisfactory performance. The actual value of the long term incentive awards will depend on performance over the period 2010 to 2012 and the share price at the time the awards vest.
Non-executive directors The level of remuneration for non-executive directors reflects the responsibility and time commitment of directors and the level of fees paid to non-executive directors of comparable major UK companies. Non-executive directors do not participate in any incentive or performance plan. Non-executive director fees are reviewed regularly. There was no change in fees during 2009.
Former executive directors Guy Whittaker (2) 19 December 2005 12 months 12 months
If Stephen Hester’s employment is terminated by reason of his personal underperformance, the company is entitled to terminate by giving written notice with immediate effect and without making any payment in lieu thereof and Stephen Hester will forfeit any unvested stock awards. If he resigns voluntarily and the company does not require him to work out his notice period, Stephen Hester may receive a payment in lieu of notice based on salary only (i.e. no bonus or benefits) and he will also forfeit any unvested stock awards.
Bruce Van Saun In the event Bruce Van Saun’s employment is terminated by reason of his personal underperformance, the company is entitled to terminate by giving written notice with immediate effect and without making any payment in lieu of notice. Any payment in lieu of notice that may be made to Bruce Van Saun would be based on salary only (i.e. not bonus or benefits).
The company has agreed that, provided certain conditions are met, on leaving employment, Bruce Van Saun will not forfeit awards under the rules of the Deferral Plan, the MPP and the ESOP.
Colin Buchan 1 June 2002 2011 Sandy Crombie 1 June 2009 2010 Penny Hughes 1 January 2010 2010
Note: (1) In accordance with the Walker review recommendations and with effect from the 2010 Annual General Meeting the Chairman will propose himself for re-election annually.
Under the company’s Articles of Association, all directors must retire and seek re-election by shareholders at least every three years. The dates in the table above reflect the latest date for election or re-election.
The non-executive directors do not have service contracts or notice periods although they have letters of engagement reflecting their responsibilities and commitments. These letters make clear to nonexecutive directors the time commitment they are expected to give to their Board duties. Philip Scott’s and Penny Hughes’ letters clearly state that the time commitment should be in line with the Walker review. No compensation would be paid to any non-executive director in the event of termination.
Philip Hampton is entitled to receive a cash payment in lieu of notice if his appointment is terminated as result of the Group’s majority shareholder seeking to effect the termination of his appointment. The applicable notice period is 12 months. In the event that the company terminates Philip Hampton’s appointment without good reason, or his reelection is not approved by shareholders in General Meeting resulting in the termination of his appointment, he will be entitled to receive a cash payment in lieu of notice of 12 months’ fees.
The tables and explanatory notes on pages 232 to 236 report the remuneration of each director for the year ended 31 December 2009 and have been audited by the company’s auditors, Deloitte LLP.
(3) Appointed to the Board in September 2005 and retired as Chairman and as a director on 3 February 2009.
(5) No payment for loss of office was made to Sir Tom McKillop or Guy Whittaker.
(3) Retired as a director on 6 February 2009. No compensation for loss of office was made.
(4) Fee is inclusive and covered all Board and Board Committee work.
Share options The Executive Share Option Plan (ESOP) was approved by shareholders at the company’s 2007 Annual General Meeting. In 2009, options were granted to executive directors under the ESOP over shares worth between one and a half times salary and three times salary.
Options to subscribe for ordinary shares of 25p each in the company granted to, and exercised by, directors during the year ended 31 December 2009 are shown in the table below.
The intention is that no further awards will be made under the ESOP. Instead, awards will be made under the new long term incentive plan, if approved by shareholders. Details of the long-term incentive plan can be found on pages 226 and 227.
Options at date of Options Options held at granted in exercise lapsed in Option price Options held at 31 December 2009 1 January 2009 2009 Number £ 2009 £ Number Exercise period
Notes: (1) Options held under the sharesave schemes, which are not subject to performance conditions.
(2) Options held at 30 September 2009 when Guy Whittaker ceased to be a director. All outstanding awards lapsed following cessation of employment.
No options had their terms and conditions varied during the year ended 31 December 2009. No payment is required on the award of an option.
The market price of the company’s ordinary shares at 31 December 2009 was 29.2p and the range during the year ended 31 December
(share equivalents) at granted award vested in exercised equivalents) at conditions to 1 January 2009 in 2009 £ 2009 in 2009 31 December 2009 be fulfilled
(3) End of qualifying period 22 June 2012, however award unavailable for exercise until 8 September 2012, 3 years from date of award.
(3) Awards were granted to Guy Whittaker in lieu of unvested share awards from his previous employer. He ceased to be a director on 30 September 2009 and the outstanding award lapsed following cessation of employment.
(4) Details of the restricted share award to Philip Hampton are outlined on page 228. The Remuneration Committee can amend this award as it considers appropriate. However, shareholder approval will be required to amend certain provisions to Philip Hampton’s advantage. These provisions relate to the basis for determining his entitlement to, and the terms of shares or other benefits and for the adjustment thereof (if any) if there is a capitalisation issue, rights issue or open offer, sub-division or consolidation of shares or reduction of capital or any other variation of capital and the amendment power itself. The Remuneration Committee may, without shareholder approval, make minor amendments to facilitate the administration of the award, to comply with or take account of any proposed or existing legislation or to obtain or maintain favourable tax, exchange control or regulatory treatment for Philip Hampton or his employer. The benefit of the award is not pensionable.
To receive any of the shares and options subject to this performance measure, the Group’s performance must be at least as good as the median of the comparator companies, with vesting as follows: • To receive 100% of the shares and options, RBS would need to be in the top quartile of its relative TSR group.
• To receive 25% of the shares and options the share price would need to reach 40 pence.
In addition, if the Group’s Remuneration Committee consider that the vesting outcome calibrated in line with the performance conditions outlined above does not reflect the Group’s underlying financial results or if the Committee considers that the financial results have been achieved with excessive risk, then the terms of the awards allow for an underpin to be used to reduce vesting of an award, or to allow the award to lapse in its entirety.
Directors’ pension arrangements During 2009 Gordon Pell accrued pensionable service in The Royal Bank of Scotland Group Pension Fund (the “RBS Fund”). The RBS Fund is a defined benefit fund registered with HM Revenue & Customs under the Finance Act 2004.
Accrued during the during the Transfer Transfer value during during the entitlement at year ended year ended value as at value as at year ended year ended
Age at 31 December 31 December 31 December 31 December 31 December 31 December 31 December 31 December 2009 2009 2009* 2009 2008 2009 2009*
Executive directors Stephen Hester 420 52 Bruce Van Saun 80 —
Note: (1) The value is based on the share price at 31 December 2009, which was 29.2p. During the year ended 31 December 2009 the share price ranged from 10.3p to 57.7p.
Shares beneficially owned at 1 January or date of Shares appointment, beneficially Value(1)
As at 24 February 2010 there were no changes to the directors’ interests in shares shown in the tables above.
• the Business review, which is incorporated into the Directors’ report, includes a fair review of the development and performance of the business and the position of the company and the undertakings included in the consolidation taken as a whole, together with a description of the principal risks and uncertainties that they face.
Archie Hunter Joe MacHale John McFarlane Arthur ‘Art’ Ryan Philip Scott
240 Independent auditors’ report 241 Consolidated income statement 242 Consolidated statement of comprehensive income 243 Balance sheets 244 Statements of changes in equity 247 Cash flow statements 248 Accounting policies 259 Notes on the accounts 1 Net interest income 259 2 Non-interest income 260
This report is made solely to the company’s members, as a body, in accordance with Chapter 3 of Part 16 of the Companies Act 2006. Our audit work has been undertaken so that we might state to the company’s members those matters we are required to state to them in an auditors’ report and for no other purpose. To the fullest extent permitted by law, we do not accept or assume responsibility to anyone other than the company and the company’s members as a body, for our audit work, for this report, or for the opinions we have formed.
Scope of the audit on the financial statements An audit involves obtaining evidence about the amounts and disclosures in the financial statements sufficient to give reasonable assurance that the financial statements are free from material misstatement, whether caused by fraud or error. This includes an assessment of: the reasonableness of significant accounting estimates made by the directors in the preparation of the financial statements; whether the accounting policies are appropriate to the circumstances of the company and the Group and have been consistently applied and adequately disclosed; and the overall presentation of the financial statements.
• the financial statements and the part of the Directors' remuneration report described as having been audited have been prepared in accordance with the requirements of the Companies Act 2006 and, as regards the Group financial statements, Article 4 of the IAS Regulation.
• the parent company financial statements and the part of the Directors’ remuneration report described as having been audited are not in agreement with the accounting records and returns; or
Under the Listing Rules we are required to review: • the directors’ statement contained within the Directors’ report in relation to going concern; and
• the part of the corporate governance statement relating to the company’s compliance with the nine provisions of the June 2008 Combined Code specified for our review.
Profit/(loss) before other operating charges and impairment losses 17,212 (28,334) 16,424
(Loss)/profit from continuing operations (2,224) (38,513) 7,788 (Loss)/profit from discontinued operations, net of tax 20 (99) 3,971 (76) (Loss)/profit for the year (2,323) (34,542) 7,712
Per ordinary and B share (1) : Basic (loss)/earnings from continuing operations 10 (6.3p) (146.2p) 64.0p
Actuarial (losses)/gains on defined benefit plans 4 (3,665) (2,287) 2,189 Other comprehensive (loss)/income before tax (4,265) 4,276 2,546
Assets Cash and balances at central banks 11 52,261 12,400 17,866 — — — Loans and advances to banks 11 91,753 138,197 219,460 31,238 27,031 7,686 Loans and advances to customers 11 728,393 874,722 828,538 2,777 — 307 Debt securities subject to repurchase agreements 30 66,883 80,576 107,651 — — —
Liabilities of disposal groups 20 18,890 859 29,228 — — —
Called-up share capital At 1 January 9,898 2,530 815 9,898 2,530 815 Ordinary shares issued in respect of placing and open offers 4,227 5,728 — 4,227 5,728 — Ordinary shares issued in respect of rights issue — 1,531 — — 1,531 — Ordinary shares issued in respect of capitalisation issue — 101 — — 101 — B shares issued 510 — — 510 — — Preference shares issued in respect of placing and open offer — 5 — — 5 — Other shares issued during the year — 3 139 — 3 139 Bonus issue of ordinary shares — — 1,576 — — 1,576 Preference shares redeemed during the year (5) — — (5) — — At 31 December 14,630 9,898 2,530 14,630 9,898 2,530
Amount recognised in equity during the year 380 (603) (460) — — — Amount transferred from equity to earnings in the year 513 198 (138) 3 2 3
Capital redemption reserve At 1 January and 31 December 170 170 170 170 170 170
Contingent capital reserve At 1 January — — — — — — Contingent capital agreement – consideration payable (1,208) — — (1,208) — — At 31 December (1,208) — — (1,208) — —
– gross 629 — — — — — – taxation (176) — — — — —
Redemption of preference shares classified as debt — — (159) — — (159) Transfer from merger reserve 9,950 14,273 — 9,950 14,273 — Actuarial (losses)/gains recognised in retirement benefit schemes
Net cost of shares bought and used to satisfy share-based payments (16) (19) (40) — — — Share-based payments
Currency translation adjustments and other movements (1,434) 9,256 1,834 — — — Acquisition of ABN AMRO — 356 32,245 — — — Profit/(loss) attributable to minority interests 349 (10,832) 163 — — —
– unrealised gains/(losses) in the year 299 (1,288) — — — — – realised gains in the year (466) (152) (585) — — —
Cash flow hedging reserve – amount recognised in equity during the year (209) (1,015) — — — — – amount transferred from equity to earnings in the year — (36) 34 — — —
Net cash inflow/(outflow) from trading activities 15,691 (31,579) (215) 3,419 6,103 2,785 Changes in operating assets and liabilities (15,964) (42,219) 28,261 12,537 (22,254) 15,562 Net cash flows from operating activities before tax (273) (73,798) 28,046 15,956 (16,151) 18,347
Financing activities Issue of ordinary shares — 49 77 — 49 77 Placing and open offer 5,274 19,741 — 5,274 19,741 — Rights issue — 12,000 — — 12,000 — Issue of B shares 25,101 — — 12,801 — — Issue of other equity interests — — 3,600 — — 3,600 Issue of paid-in equity — — 1,073 — — 1,073 Issue of subordinated liabilities 2,309 2,413 1,018 — — — Proceeds of minority interests issued 9 1,427 31,095 — — — Redemption of paid-in equity (308) — — (308) — — Redemption of preference shares (5,000) — — (5,000) — — Redemption of minority interests (422) (13,579) (545) — — — Shares purchased by employee trusts (33) (64) (65) — — — Shares issued under employee share schemes — 2 79 — — —
IAS 1 (Revised 2007) ‘Presentation of Financial Statements’ has introduced a number of changes in the format and content of the Group’s financial statements including a statement of changes in equity (showing the components of changes in equity for the period) as a primary financial statement and a statement of comprehensive income immediately following the income statement. Additionally, the revised standard has required the Group to present a third balance sheet (31 December 2007) as a result of the restatement of the Group’s 2008 income statement following the amendment to IFRS 2 (see below).
The results of subsidiaries acquired are included in the consolidated income statement from the date control passes up until the Group ceases to control them through a sale or significant change in circumstances.
• An annual fee payable by a credit card holder is deferred and taken to profit or loss over the period of the service i.e. 12 months.
6. Intangible assets and goodwill Intangible assets that are acquired by the Group are stated at cost less accumulated amortisation and impairment losses. Amortisation is charged to profit or loss over the assets’ estimated economic lives using methods that best reflect the pattern of economic benefits and is included in depreciation and amortisation. The estimated useful economic lives are as follows: Core deposit intangibles 6 to 10 years Other acquired intangibles 5 to 10 years Computer software 3 to 5 years
7. Property, plant and equipment Items of property, plant and equipment (except investment property – see accounting policy 9) are stated at cost less accumulated depreciation and impairment losses. Where an item of property, plant and equipment comprises major components having different useful lives, they are accounted for separately.
Transactions in foreign currencies are translated into sterling at the foreign exchange rate ruling at the date of the transaction. Monetary assets and liabilities denominated in foreign currencies are translated into sterling at the rates of exchange ruling at the balance sheet date.
Foreign exchange differences arising on translation are reported in income from trading activities except for differences arising on cash flow hedges and hedges of net investments in foreign operations. Nonmonetary items denominated in foreign currencies that are stated at fair value are translated into sterling at foreign exchange rates ruling at the dates the values were determined. Translation differences arising on non-monetary items measured at fair value are recognised in profit or loss except for differences arising on available-for-sale non-monetary financial assets, for example equity shares, which are included in the available-for-sale reserve in equity unless the asset is the hedged item in a fair value hedge.
11. Leases Contracts to lease assets are classified as finance leases if they transfer substantially all the risk s and rewards of ownership of the asset to the customer. Other contracts to lease assets are classified as operating leases.
12. Insurance General insurance General insurance comprises short-duration contracts, principally property and liability insurance contracts. Due to the nature of the products sold – retail-based property and casualty, motor, home and personal health insurance contracts – the insurance protection is provided on an even basis throughout the term of the policy.
Acquisition expenses relating to new and renewed business for all classes are expensed over the period during which the premiums are earned. The principal acquisition costs so deferred are commissions payable, costs associated with the telesales and underwriting staff and prepaid claims handling costs in respect of delegated claims handling arrangements for claims which are expected to occur after the balance sheet date. Claims and the related reinsurance are recognised in the accounting period in which the loss occurs. Provision is made for the cost of settling outstanding claims at the balance sheet date, including claims estimated to have been incurred but not yet reported at that date, and claims handling expenses. Provision is only discounted where there is a contractual agreement to make periodic payments. Related reinsurance receivables are recognised on the same basis and at the same time.
Life assurance The Group’s long-term assurance contracts include whole-life term assurance, endowment assurance, flexible whole-life, pension and annuity contracts that are expected to remain in force for an extended period of time. Long-term assurance contracts under which the Group does not accept significant insurance risk are classified as financial instruments.
Reinsurance The Group has reinsurance treaties that transfer significant insurance risk. Liabilities for reinsured contracts are calculated gross of reinsurance and a separate reinsurance asset recorded.
14. Taxation Provision is made for taxation at current enacted rates on taxable profits, arising in income or in equity, taking into account relief for overseas taxation where appropriate. Deferred taxation is accounted for in full for all temporary differences between the carrying amount of an asset or liability for accounting purposes and its carrying amount for tax purposes, except in relation to overseas earnings where remittance is controlled by the Group, and goodwill.
Held-to-maturity investments – a financial asset may be classified as a held-to-maturity investment only if it has fixed or determinable payments, a fixed maturity and the Group has the positive intention and ability to hold to maturity. Held-to-maturity investments are initially recognised at fair value plus directly related transaction costs. They are subsequently measured at amortised cost using the effective interest method (see accounting policy 3) less any impairment losses.
Designated as at fair value through profit or loss – financial assets may be designated as at fair value through profit or loss only if such designation (a) eliminates or significantly reduces a measurement or recognition inconsistency; or (b) applies to a group of financial assets, financial liabilities or both, that the Group manages and evaluates on a fair value basis; or (c) relates to an instrument that contains an embedded derivative which is not evidently closely related to the host contract.
Impairment losses are assessed individually for financial assets that are individually significant and individually or collectively for assets that are not individually significant. In making collective assessment of impairment, financial assets are grouped into portfolios on the basis of similar risk characteristics. Future cash flows from these portfolios are estimated on the basis of the contractual cash flows and historical loss experience for assets with similar credit risk characteristics. Historical loss experience is adjusted, on the basis of observable data, to reflect current conditions not affecting the period of historical experience.
Impaired loans and receivables are written off, i.e. the impairment provision is applied in writing down the loan's carrying value partially or in full, when the Group concludes that there is no longer any realistic prospect of recovery of part or all of the loan. For portfolios that are collectively assessed for impairment, the timing of write off principally reflects historic recovery experience for each portfolio. For loans that are individually assessed for impairment, the timing of write off is determined on a case-by-case basis. Such loans are reviewed regularly and write offs will be prompted by bankruptcy, insolvency, restructuring and similar events. Amounts recovered after a loan has been written off are credited to the loan impairment charge for the period in which they are received.
Designated as at fair value through profit or loss – financial liabilities may be designated as at fair value through profit or loss only if such designation (a) eliminates or significantly reduces a measurement or recognition inconsistency; or (b) applies to a group of financial assets, financial liabilities or both that the Group manages and evaluates on a fair value basis; or (c) relates to an instrument that contains an embedded derivative which is not evidently closely related to the host contract.
A financial liability is removed from the balance sheet when the obligation is discharged, or cancelled, or expires. On the redemption or settlement of debt securities (including subordinated liabilities) issued by the Group, the Group derecognises the debt instrument and records a gain or loss being the difference between the debt’s carrying amount and the cost of redemption or settlement. The same treatment applies where the debt is exchanged for a new debt issue that has terms substantially different from those of the existing debt. The assessment of whether the terms of the new debt instrument are substantially different takes into account qualitative and quantitative characteristics including a comparison of the discounted present value of the cash flows under the new terms with the discounted present value of the remaining cash flows of the original debt issue.
23. Derivatives and hedging Derivative financial instruments are initially recognised, and subsequently measured, at fair value. Derivative fair values are determined from quoted prices in active markets where available. Where there is no active market for an instrument, fair value is derived from prices for the derivative’s components using appropriate pricing or valuation models.
Fair value hedge – in a fair value hedge, the gain or loss on the hedging instrument is recognised in profit or loss. The gain or loss on the hedged item attributable to the hedged risk is recognised in profit or loss and adjusts the carrying amount of the hedged item. Hedge accounting is discontinued if the hedge no longer meets the criteria for hedge accounting; or if the hedging instrument expires or is sold, terminated or exercised; or if hedge designation is revoked. If the hedged item is one for which the effective interest rate method is used, any cumulative adjustment is amortised to profit or loss over the life of the hedged item using a recalculated effective interest rate.
Hedge of net investment in a foreign operation – in the hedge of a net investment in a foreign operation, the portion of foreign exchange differences arising on the hedging instrument determined to be an effective hedge is recognised directly in equity. Any ineffective portion is recognised in profit or loss. Non-derivative financial liabilities as well as derivatives may be the hedging instrument in a net investment hedge.
24. Share-based payments The Group awards shares and options over shares in The Royal Bank of Scotland Group plc to its employees under various share option schemes. The expense for these transactions is measured based on the fair value on the date the awards are granted. The fair value of an option is estimated using valuation techniques which take into account its exercise price, its term, the risk-free interest rate and the expected volatility of the market price of The Royal Bank of Scotland Group plc’s shares. Vesting conditions are not taken into account when measuring fair value, but are reflected by adjusting the proportion of awards that actually vest. The fair value is expensed on a straight-line basis over the vesting period. Following an amendment to IFRS 2 for accounting periods starting after 1 January 2009, the cancellation of an award with non-vesting conditions triggers immediate recognition of an expense in respect of any unrecognised element of the fair value of the award.
Critical accounting policies and key sources of estimation uncertainty The reported results of the Group are sensitive to the accounting policies, assumptions and estimates that underlie the preparation of its financial statements. UK company law and IFRS require the directors, in preparing the Group’s financial statements, to select suitable accounting policies, apply them consistently and make judgements and estimates that are reasonable and prudent. In the absence of an applicable standard or interpretation, IAS 8 ‘Accounting Policies, Changes in Accounting Estimates and Errors’, requires management to develop and apply an accounting policy that results in relevant and reliable information in the light of the requirements and guidance in IFRS dealing with similar and related issues and the IASB’s Framework for the Preparation and Presentation of Financial Statements. The judgements and assumptions involved in the Group’s accounting policies that are considered by the Board to be the most important to the portrayal of its financial condition are discussed below. The use of estimates, assumptions or models that differ from those adopted by the Group would affect its reported results.
At 31 December 2009, gross loans and advances to customers totalled customer loan impairment provisions amounted to £17,126 million (2008
Pensions The Group operates a number of defined benefit pension schemes as described in Note 4 on the accounts. The assets of the schemes are measured at their fair value at the balance sheet date. Scheme liabilities are measured using the projected unit method, which takes account of projected earnings increases, using actuarial assumptions that give the best estimate of the future cash flows that will arise under the scheme liabilities. These cash flows are discounted at the interest rate applicable to high-quality corporate bonds of the same currency and term as the liabilities. Any recognisable surplus or deficit of scheme assets over liabilities is recognised in the balance sheet as an asset (surplus) or liability (deficit). In determining the value of scheme liabilities, assumptions are made as to price inflation, dividend growth, pension increases, earnings growth and employees. There is a range of assumptions that could be adopted in valuing the schemes’ liabilities. Different assumptions could significantly alter the amount of the surplus or deficit recognised in the balance sheet and the pension cost charged to the income statement. The assumptions adopted for the Group’s pension schemes are set out in Note 4 on the accounts together with the sensitivity of reported amounts to changes in those assumptions. A pension asset of £58 million and a liability of £2,963 million were recognised in the balance sheet at 31 December 2009 (2008: asset – £36 million, liability – £2,032 million; 2007 asset – £575 million, liability – £460 million).
Financial instruments measured at fair value include: Loans and advances (held-for-trading and designated as at fair value though profit or loss) – principally comprise reverse repurchase agreements (reverse repos) and cash collateral.
Deposits by banks and customer accounts (held-for-trading and designated as at fair value though profit or loss) – deposits measured at fair value principally include repurchase agreements (repos), cash collateral and investment contracts issued by the Group’s life assurance businesses.
Derivatives –these include swaps (currency swaps, interest rate swaps, credit default swaps, total return swaps and equity and equity index swaps), forward foreign exchange contracts, forward rate agreements, futures (currency, interest rate and equity) and options (exchange-traded options on currencies, interest rates and equities and equity indices and OTC currency and equity options, interest rate caps and floors and swaptions).
General insurance claims The Group makes provision for the full cost of settling outstanding claims arising from its general insurance business at the balance sheet date, including claims estimated to have been incurred but not yet reported at that date and claims handling expenses. General insurance claims provisions amounted to £5,802 million at 31 December 2009
Impairment testing inherently involves a number of judgmental areas: the preparation of cash flow forecasts for periods that are beyond the normal requirements of management reporting; the assessment of the discount rate appropriate to the business; estimation of the fair value of cash-generating units; and the valuation of the separable assets of each business whose goodwill is being reviewed. Sensitivity to changes in assumptions is discussed in Note 17 on page 303.
Deferred tax The Group makes provision for deferred tax on short-term and other temporary differences where tax recognition occurs at a different time from accounting recognition. Deferred tax assets of £7,039 million were recognised as at 31 December 2009 (2008 – £7,082 million; 2007 – £3,119 million).
Accounting developments International Financial Reporting Standards The International Accounting Standards Board (IASB) published a revised IFRS 3 ‘Business Combinations’ and related revisions to IAS 27 ‘Consolidated and Separate Financial Statements’ following the completion in January 2008 of its project on the acquisition and disposal of subsidiaries. The standards improve convergence with US GAAP and provide new guidance on accounting for changes in interests in subsidiaries. The cost of an acquisition will comprise only consideration paid to vendors for equity; other costs will be expensed immediately. Groups will only account for goodwill on acquisition of a subsidiary; subsequent changes in interest will be recognised in equity and only on a loss of control will there be a profit or loss on disposal to be recognised in income. The changes are effective for accounting periods beginning on or after 1 July 2009 but both standards may be adopted together for accounting periods beginning on or after 1 July 2007. These changes will affect the Group’s accounting for future acquisitions and disposals of subsidiaries.
The IASB issued amendments to a number of standards in April 2009 as part of its annual improvements project. The amendments are effective for annual periods beginning on or after 1 July 2009 and are not expected to have a material effect on the Group or the company.
The IASB issued IFRS 9 ‘Financial Instruments’ in November 2009 simplifying the classification and measurement requirements in IAS 39 ‘Financial Instruments: Recognition and Measurement’ in respect of financial assets. The standard reduces the measurement categories for financial assets to two: fair value and amortised cost. A financial asset is classified on the basis of the entity’s business model for managing the financial asset and the contractual cash flow characteristics of the financial asset. Only assets with contractual terms that give rise to cash flows on specified dates that are solely payments of principal and interest on the principal amount outstanding and which are held within a business model whose objective is to hold assets in order to collect contractual cash flows are classified as amortised cost. All other financial assets are measured at fair value. Changes in the value of financial assets measured at fair value are generally taken to profit or loss. The standard is effective for annual periods beginning on or after 1 January 2013; early application is permitted.
The IFRIC issued interpretation IFRIC 19 ‘Extinguishing Financial Liabilities with Equity Instruments’ in December 2009. The interpretation clarifies that the profit or loss on extinguishing liabilities by issuing equity instruments should be measured by reference to fair value, preferably of the equity instruments. The interpretation, effective for the Group for annual periods beginning on or after 1 January 2011, is not expected to have a material effect on the Group or the company.
Notes on the accounts 259RBS Group Annual Report and Accounts 2009 1 Net interest income Group £m £m £m
Customer accounts: demand deposits 1,899 4,341 4,327 Customer accounts: savings deposits 2,894 3,911 2,560 Customer accounts: other time deposits 3,187 8,108 6,301 Deposits by banks 3,041 6,576 3,406 Debt securities in issue 5,330 9,941 5,687
RBS Group Annual Report and Accounts 2009260 2 Non-interest income (excluding insurance premium income) Group £m £m £m
Other operating income Operating lease and other rental income 1,391 1,525 1,671 Changes in the fair value of own debt 51 977 152 Changes in the fair value of securities and other financial assets and liabilities 101 (1,730) 970 Changes in the fair value of investment properties (117) (86) 288 Profit on sale of available-for-sale financial assets 294 342 544 Profit on sale of property, plant and equipment 43 167 741 (Loss)/profit on sale of subsidiaries and associates (135) 943 67 Life business profits/(losses) 156 (52) 187
UK Retail 28,500 31,700 31,400 UK Corporate 12,600 13,600 13,200 Wealth 4,800 5,300 5,400 Global Banking & Markets 13,800 14,500 15,500 Global Transaction Services 3,200 3,600 3,700 Ulster Bank 4,600 5,600 6,100 US Retail & Commercial 16,400 17,300 17,400 RBS Insurance 14,600 15,300 16,400 Centre 3,800 4,300 3,800 Core 102,300 111,200 112,900 Non-Core 13,700 15,000 16,100 116,000 126,200 129,000 Business Services 42,900 45,700 45,900 Integration 500 900 - RFS Holdings minority interest 25,100 26,700 28,600 Total 184,500 199,500 203,500
There were no persons employed in discontinued operations as at 31 December 2009 (2008 – 2,600; 2007 – 53,200).
Principal actuarial assumptions at 31 December 2009 2008 2007 2009 2008 2007
Ordinary shares of the company with a fair value of £4 million (2008 – £15 million; 2007 – £69 million) are held by the Group’s pension schemes; £4 million (2008 – £15 million; 2007 – £65 million) in the Main scheme which also holds other financial instruments issued by the Group with a value of £192 million (2008 – £421 million; 2007 – £606 million).
The expected return on plan assets at 31 December is based upon the weighted average of the following assumed returns on the major classes of plan assets: Main scheme All schemes
Net assets of schemes in surplus (included in Prepayments, accrued income and other assets, Note 19) (58) (36) (575) Net liabilities of schemes in deficit 2,963 2,032 460
At 31 December 2009, ABN AMRO’s principal pension scheme in the Netherlands had fair value of plan assets of £8,118 million (2008 – £8,181 million; 2007 – £6,417 million) and present value of defined benefit obligations of £8,298 million (2008 – £8,589 million; 2007 – £6,189 million). The principal actuarial assumptions at 31 December 2009 were: discount rate 5.25% (2008 – 5.4%); expected return on plan assets (weighted average) 5.25% (2008 – 4.7%); rate of increase in salaries 2.5% (2008 – 2.5%); rate of increase in pensions in payment
The most recent funding valuation of the main UK scheme, as at 31 March 2007, showed a surplus of assets over liabilities of £0.7 billion. The next valuation is due as at 31 March 2010 and the Group expects this valuation to show that liabilities exceed the value of the assets. Following this valuation, the Group and scheme Trustees will agree the level of contributions to be paid to the scheme. This could result in the amount of contributions payable in 2010 and subsequent years being materially different from the current rates based on the previous valuation.
Cumulative net actuarial losses of £4,382 million (2008 – £717 million losses; 2007 – £1,570 million gains) have been recognised in the statement of comprehensive income, of which £3,296 million losses (2008 – £184 million gains; 2007 – £1,579 million gains) relate to the Main scheme.
Actual return/(loss) on pension schemes assets 2,022 (3,513) 1,345 1,574 2,486 2,897 (4,186) 1,413 1,660 2,677 Actual return/(loss) on pension schemes assets – % 13.8% (19.0%) 7.8% 9.9% 18.4% 11.4% (14.5%) 6.9% 9.6% 18.1%
Increase/(decrease) Increase/(decrease) in pension in obligation in pension in obligation cost for the year at 31 December cost for the year at 31 December £m £m £m £m £m £m £m £m 0.25% increase in the discount rate (21) (37) (790) (696) (41) (53) (1,261) (1,161)
RBS Group Annual Report and Accounts 2009266 5 Auditors’ remuneration Amounts paid to the Group’s auditors for statutory audit and other services are set out below. All audit related and other services are approved by the Group Audit Committee. The Committee recognise that for certain assignments the auditors are best placed to perform the work economically; for other work the Group selects the supplier best placed to meet its requirements; the Group’s auditors are free to tender for such work in competition with other firms.
Total audit and audit related services 44.6 47.2 Fees payable to the auditors and their associates for other services
(3) Includes fees of £2.1 million (2008 – £3.1 million) in respect of work performed by the auditors as reporting accountants on debt and equity issuances undertaken by the Group, including securitisations.
Notes on the accounts 267RBS Group Annual Report and Accounts 2009 6 Tax Group £m £m £m
Current taxation: Charge for the year 552 1,230 2,514 Over provision in respect of prior periods (191) (254) (39) Relief for overseas taxation — (34) (198)
(Credit)/charge for the year (1,041) (3,167) 95 Over/(under) provision in respect of prior periods 309 (98) (328) Tax (credit)/charge for the year (371) (2,323) 2,044
The actual tax (credit)/charge differs from the expected tax (credit)/charge computed by applying the standard rate of UK corporation tax of 28%
Taxable foreign exchange movements (1) 80 16 Foreign profits taxed at other rates 320 203 (25) Reduction in deferred tax liability following change in the rate of UK corporation tax — — (189) Losses in year not recognised 780 942 2 Losses brought forward and utilised (94) (11) (11) Adjustments in respect of prior periods (1) 118 (352) (367) Actual tax (credit)/charge (371) (2,323) 2,044
The effective tax rate for the year was 14.3% (2008 – 5.7%; 2007 – 20.8%).
Preference shareholders: Non-cumulative preference shares of US$0.01 342 293 152 Non-cumulative preference shares of €0.01 201 183 94 Non-cumulative preference shares of £1
(2) In accordance with IAS 32, certain preference share issued by the company are included in subordinated liabilities and the related finance cost in interest payable.
RBS Group Annual Report and Accounts 2009268 8 Ordinary dividends Prior year ordinary dividends per share in the table below were restated for the effect of the rights issue in June 2008 and the capitalisation issue in September 2008.
Final dividend for previous year declared during the current year — 19.3 18.5 — 2,312 2,091 Interim dividend — — 8.5 — — 953 Total dividends paid on ordinary equity shares — 19.3 27.0 — 2,312 3,044 9 Profit dealt with in the accounts of the company As permitted by section 408(3) of the Companies Act 2006, the primary financial statements of the company do not include an income statement or statement of comprehensive income. Condensed information is set out below: Company
Dividends received from banking subsidiary 2,523 4,639 2,330 Dividends received from other subsidiaries 408 163 415 Gain on redemption of own debt 238 — —
Weighted average number of shares (millions): Ordinary shares in issue during the year 51,494 16,563 11,413 B shares in issue during the year 1,397 — — Weighted average number of ordinary and B shares in issue during the year 52,891 16,563 11,413 Effect of dilutive share options and convertible securities 438 — 198 Diluted weighted average number of ordinary and B shares in issue during the year 53,329 16,563 11,611
The numbers of shares in issue in prior years were adjusted retrospectively for the bonus element of the rights issue completed in June 2008 and the capitalisation issue in September 2008. The contingent agreement with HM Treasury enabling it to place up to 16 billion new B shares at 50p each had a dilutive effect in 2009. None of the convertible securities had a dilutive effect in 2009 or 2008. All convertible securities had a dilutive effect in 2007 and have been included in the computation of diluted earnings per share.
trading profit or loss derivatives for-sale receivables cost) leases liabilities Total 2009 £m £m £m £m £m £m £m £m £m
Intangible assets 17,847 17,847 Property, plant and equipment 19,397 19,397 Deferred taxation 7,039 7,039 Prepayments, accrued income and other assets — — — 1,421 19,564 20,985 Assets of disposal groups 18,542 18,542
Intangible assets 49,916 49,916 Property, plant and equipment 18,745 18,745 Deferred taxation 3,119 3,119 Prepayments, accrued income and other assets — — — 877 14,785 15,662 Assets of disposal groups 45,850 45,850
Notes: (1) Includes reverse repurchase agreements of £35,097 million (2008 – £58,771 million; 2007 – £175,941 million) and items in the course of collection from other banks of £2,533 million (2008 –
(9) £155 million (2008 – £1,054 million; 2007 – £162 million) has been recognised in profit or loss for changes in credit risk associated with debt securities in issue designated as at fair value through profit or loss measured as the change in fair value from movements in the period in the credit risk premium payable by the Group. The carrying amount is £810 million (2008 – £1,145 million; 2007 – £317 million) lower than the principal amount.
(10) During 2009 and 2008 the Group reclassified financial assets from the held-for-trading and available-for-sale categories into the loans and receivables category and during 2008 from the held-for-trading category into the available-for-sale category (see pages 275 to 277).
Notes on the accounts 273RBS Group Annual Report and Accounts 2009
The following tables analyse the company’s financial assets and financial liabilities in accordance with the categories of financial instruments in IAS 39. Assets and liabilities outside the scope of IAS 39 are shown separately as non financial assets/liabilities.
Held-for- Hedging Loans and (amortised assets/ trading derivatives receivables cost) liabilities Total 2007 £m £m £m £m £m £m
Liabilities Deposits by banks (4) — 5,572 5,572 Debt securities in issue — 13,453 13,453
Accruals, deferred income and other liabilities — — 8 8 Deferred taxation — 3 3 Subordinated liabilities — 7,743 7,743
Gains/(losses) on financial assets/liabilities designated as at fair value through profit or loss 1,441 (901) 1,074 (Losses)/gains on disposal or settlement of loans and receivables (573) 4 3
Reclassification of financial instruments The Group reclassified financial assets from the held-for-trading (HFT) and available-for-sale (AFS) categories into the loans and receivables (LAR) category (as permitted by paragraph 50D of IAS 39 as amended) and from the held-for-trading category into the available-for-sale category (as permitted by paragraph 50B of IAS 39 as amended).
RBS Group Annual Report and Accounts 2009276 11 Financial instruments continued
2009 – on reclassification 31 December 2009 Gains/(losses) Reduction in recognised in up to the Amount profit or loss the income
Effective Expected date of that would as result of statement Carrying interest cash Carrying Fair reclassi- Impairment have been reclassi- in prior value rate flows value value fication Income losses recognised fication periods £m % £m £m £m £m £m £m £m £m £m £m
Notes on the accounts 277RBS Group Annual Report and Accounts 2009
2008 – on reclassification 31 December 2008 Gains/(losses) Increase in recognised in up to the Amount profit or loss the income
(2) The amount that would have been in AFS reserves if reclassification had not occurred is £(37) million.
Valuation of financial instruments carried at fair value Control environment The Group’s control environment for the determination of the fair value of financial instruments includes formalised protocols for the review and validation of fair values independent from the businesses entering into the transactions. There are specific controls to ensure consistent pricing policies and procedures, incorporating disciplined price verification. The Group ensures that appropriate attention is given to bespoke transactions, structured products, illiquid products and other instruments which are difficult to price.
Certain assets in the non-core business are comparably more difficult and subjective to value. The valuations of these portfolios are subject to a further level of review through an additional Non-Core valuation committee comprising senior representatives of the trading function, risk management and the Global Pricing Unit which meets regularly and are responsible for monitoring, assessing and enhancing the adequacy of the valuation techniques being adopted for these instruments.
Valuation models are subject to a review process which requires different levels of model documentation, testing and review, depending on the complexity of the model and the size of the Group’s exposure. A key element of the control environment over model use in the Group is a modelled product review committee, made up of valuations experts from several functions within the Group. This committee sets the policy for model documentation, testing and review, and prioritises models with significant exposure for review by the Group’s Quantitative Research Centre. Potential valuation uncertainty is a key input in determining model review priorities at these meetings. The Quantative Research Centre, which is independent of the trading businesses, assesses the appropriateness of the application of the model to the product, the mathematical robustness of the model, and (where appropriate), considers alternative modelling approaches.
Valuation techniques The Group uses a number of methodologies to determine the fair values of financial instruments for which observable prices in active markets for identical instruments are not available. These techniques include: relative value methodologies based on observable prices for similar instruments; present value approaches where future cash flows from the asset or liability are estimated and then discounted using a risk-adjusted interest rate; option pricing models (such as Black-Scholes or binomial option pricing models) and simulation models such as Monte-Carlo.
The principal inputs to these valuation techniques are listed below. Values between and beyond available data points are obtained by interpolation and extrapolation. When utilising valuation techniques, the fair value can be significantly affected by the choice of valuation model and by underlying assumptions concerning factors such as the amounts and timing of cash flows, discount rates and credit risk.
• Interest rates – these are principally benchmark interest rates such as the London Inter-Bank Offered Rate (LIBOR) and quoted interest rates in the swap, bond and futures markets.
• Equity and equity index prices – quoted prices are generally readily available for equity shares listed on the world’s major stock exchanges and for major indices on such shares.
• Prepayment rates – the fair value of a financial instrument that can be prepaid by the issuer or borrower differs from that of an instrument that cannot be prepaid. In valuing prepayable instruments that are not quoted in active markets, the Group considers the value of the prepayment option.
Vanilla risk on exotic products is typically reserved as part of the overall portfolio based calculation e.g. delta and vega risk is included within the delta and vega bid-offer calculations. Aggregation of risk arising from different models is in line with the Group’s risk management practices; the model review control process considers the appropriateness of model selection in this respect.
Product related risks such as correlation risk attract specific bid to offer reserves. Additional reserves are provided for exotic products to ensure overall reserves match market close-out costs. These market close-out costs inherently incorporate risk decay and cross-effects which are unlikely to be adequately reflected in the static hedge based on vanilla instruments.
Where there is limited bid-offer information for a product a conservative approach is taken, taking into account pricing approach and risk management strategy.
Market risk close-out costs excluding CVA were £2,814 million as at 31 11 Financial instruments continued
Notes on the accounts 281RBS Group Annual Report and Accounts 2009
Own credit When valuing financial liabilities recorded at fair value, the Group takes into account the effect of its own credit standing. The categories of financial liabilities on which own credit spread adjustments are made are issued debt held at fair value, including issued structured notes, and derivatives. An own credit adjustment is applied to positions where it is believed that counterparties would consider the Group’s creditworthiness when pricing trades.
For issued debt and structured notes, this adjustment is based on independent quotes from market participants for the debt issuance spreads above average inter-bank rates, (at a range of tenors) which the market would demand when purchasing new senior or sub-debt issuances from the Group. Where necessary, these quotes are interpolated using a curve shape derived from CDS prices.
The own credit adjustment: • does not alter cash flows; • is not used for performance management; and
The effect of change in credit spreads could be reversed in future periods.
Designated as at fair value Held-for- through profit trading (1) or loss Total Derivatives (2) Total Cumulative own credit adjustment £m £m £m £m £m
Notes: (1) The held-for-trading portfolio consists of wholesale and retail note issuances.
CDOs 3.6 — 2.6 1.0 130 (80) Proprietary model: implied collateral valuation, default rates, housing prices, correlation CLOs 8.8 — 8.0 0.8 80 (50) Industry standard simulation model: credit spreads, recovery rates, correlation Other ABS 6.1 — 5.2 0.9 120 (40) Proprietary model: credit spreads, Corporate 11.4 — 10.8 0.6 70 (20) Proprietary model: credit spreads Other (3) 18.9 0.2 18.5 0.2 10 (30) Proprietary model: credit spreads
Liabilities Deposits: – customers 61.4 — 61.3 0.1 — (10) Proprietary model: credit spreads correlation Debt securities in issue 45.5 — 43.2 2.3 50 (10) Proprietary model: volatility, correlation, Short positions 40.5 27.1 13.2 0.2 10 (20) Proprietary model: credit spreads, correlation Derivatives Foreign exchange 63.9 — 63.9 — — — n/a Interest rate 311.4 0.1 310.5 0.8 40 (60) Proprietary model: volatility, correlation, Equities 9.5 1.0 8.3 0.2 20 (70) Proprietary model: volatility, correlation dividends
Credit 39.1 — 38.1 1.0 80 (100) Proprietary CVA model, industry option and correlation models: counterparty credit risk, correlation, volatility
Valuation hierarchy The tables below show the financial instruments carried at fair value by hierarchy – level 1, level 2 and level 3. The valuation techniques, main assumptions used in the valuation of these instruments and reasonably possible increases or decreases in fair value based on reasonably possible alternative assumptions for level 3 financial instruments are set out below.
2008 £bn £bn £bn £bn £m £m Level 3 valuation technique and related assumptions
RMBS 72.8 — 72.3 0.5 40 (90) Industry standard model: prepayment rates, probability of default, loss severity and yield
CDOs 8.6 — 6.9 1.7 410 (440) Proprietary model: implied collateral valuation, default rates, housing prices, correlation CLOs 8.7 — 7.7 1.0 40 (40) Industry standard simulation model: credit spreads, recovery rates, correlation Other ABS 8.1 — 6.6 1.5 10 (10) Proprietary model: credit spreads Corporate 18.0 0.9 15.8 1.3 40 (40) Proprietary model: credit spreads Other (3) 28.6 4.1 24.2 0.3 — — Proprietary model: credit spreads 254.6 73.7 174.0 6.9 570 (650) Equity shares 26.3 15.4 9.8 1.1 80 (160) Valuation statements: fund valuation Derivatives Foreign exchange 173.3 2.2 171.0 0.1 — — Proprietary model: volatility, correlation Interest rate 654.8 0.4 652.9 1.5 80 (80) Proprietary model: volatility, correlation Equities 9.2 0.5 8.6 0.1 — (10) Proprietary model: volatility, correlation, dividends
Interest rate 641.0 0.4 639.7 0.9 90 (90) Proprietary model: volatility, correlation Equities 12.2 0.9 11.2 0.1 — — Proprietary model: volatility, correlation, correlation, dividends
Notes: (1) Level 1: valued using unadjusted quoted prices in active markets, examples include G10 government securities, listed equity shares, certain exchange-traded derivatives and certain US agency securities.
Level 2: includes most government agency securities, investment-grade corporate bonds, certain mortgage products, most bank and bridge loans, repos and reverse repos, less liquid listed equities, state and municipal obligations, most physical commodities, investment contracts issued by the Group’s life assurance businesses and certain money market securities and loan commitments and most OTC derivatives.
(2) Sensitivity represents the reasonably possible favourable and unfavourable effect respectively on the income statement or the statement of comprehensive income due to reasonably possible changes to valuations using reasonably possible alternative inputs to the Group’s valuation techniques or models. Totals for sensitivities are not indicative of the total potential effect on the income statement or the statement of comprehensive income.
Notes on the accounts 285RBS Group Annual Report and Accounts 2009
For each of the portfolio categories shown in the above table, set out below is a description of the types of products that comprise the portfolio and the valuation techniques that are applied in determining fair value, including a description of valuation techniques used for levels 2 and 3 and inputs to those models and techniques. Where reasonably possible alternative assumptions of unobservable inputs used in models would change the fair value of the portfolio significantly, the alternative inputs are indicated. Where there have been significant changes to valuation techniques during the year a discussion of the reasons for this are also included.
A collateral net asset value methodology using dealer buy side marks to determine an upper bound for super senior CDO valuations. An ABS index implied collateral valuation, is also used which provides a market calibrated valuation data point. Both the ABS index implied valuation and the collateral net asset value methodology apply an assumed immediate liquidation approach.
Other asset-backed and corporate debt securities Where observable market prices for a particular debt security are not available, the fair value will typically be determined with reference to observable market transactions in other related products, such as similar debt securities or credit derivatives. Assumptions are made about the relationship between the individual debt security and the available benchmark data. Where significant management judgement has been applied in identifying the most relevant related product, or in determining the relationship between the related product and the instrument itself, the valuation is shown in level 3.
Equity shares Private equity investments include unit holdings and limited partnership interests primarily in corporate private equity funds, debt funds and fund of hedges funds. Externally managed funds are valued using recent prices where available. Where not available, the fair value of investments in externally managed funds is generally determined using statements or other information provided by the fund managers.
Credit derivatives – APS The Group has purchased credit protection over a portfolio of specified assets and exposures (covered assets) from HMT with a par value of £282 billion. The protection is subject to a first loss of £60 billion and covers 90% of subsequent losses. Once a covered asset has experienced a trigger event, losses and recoveries in respect of that asset are included in the balance receivable under the APS. Receipts from HMT will, over time, amount to 90% of cumulative losses (net of cumulative recoveries) on the portfolio of covered assets less the first loss amount.
Where protection is provided on a particular seniority of exposure, as is the case with the APS, which requires initial losses to be taken by the Group, it is termed “tranched” protection. The model being used to value the APS – Gaussian Copula model with stochastic recoveries is used by the Group to value tranches traded by the exotic credit desk and is a model that is currently used within the wider market.
• expected losses on covered assets that have triggered: +/- £1 billion
Using the above reasonably possible alternative assumptions, the fair value of the APS derivative could be higher by approximately £1,370 million or lower by approximately £1,540 million.
Equity derivatives Equity derivative products are split into equity exotic derivatives and equity hybrids. Equity exotic derivatives have payouts based on the performance of one or more stocks, equity funds or indices. Most payouts are based on the performance of a single asset and are valued using observable market option data. Unobservable equity derivative trades are typically complex basket options on stocks. Such basket option payouts depend on the performance of more than one equity asset and require correlations for their valuation. Valuation is then performed using industry standard valuation models, with unobservable correlation inputs calculated by reference to correlations observed between similar underlyings.
Equity hybrids have payouts based on the performance of a basket of underlyings where the underlyings are from different asset classes. Correlations between these different underlyings are typically unobservable with no market information for closely related assets available. Where no market for the correlation input exists, these inputs are based on historical time series.
Exotic valuation inputs include correlation between interest rates, foreign exchange rates and commodity prices. Correlations for more liquid rate pairs are valued using independently sourced consensus pricing levels. Where a consensus pricing benchmark is unavailable, these instruments are categorised as level 3.
Debt securities in issue The carrying value of debt securities in issue is represented partly by underlying cash and partly through a derivative component. The classification of the amount in level 3 is driven by the derivative component and not by the cash element.
At in the income Transfers At 31 instruments 1 January statement or in/out of Reclass- Purchases Sales and Foreign December held at 2009 SOCI (1) Level 3 ification and issues settlements exchange 2009 year end £m £m £m £m £m £m £m £m £m
Note: (1) Net losses recognised in the income statement and statement of comprehensive income were £4,257 million and £60 million respectively. Net losses on FVTPL assets and liabilities of £3,800 million were included in income from trading activities. £457 million net losses relating to AFS assets were recorded within interest income, dividend income and impairment losses as appropriate.
Assets reduced in the year due to disposals, write downs, transfers and reclassifications. Decrease in loans and advances to customers of £2,089 million primarily reflected the reclassification of certain leveraged and real estate finance loans from held-for-trading to loans and receivables in first half of the year. The decrease in debt securities of £2,841 million reflects wind-down of the US fund derivative portfolio, £929 million of available-for-sale debt securities transferred to level 2 due to increased observability as well as liquidations and write-downs. Derivative assets included hedges with CDPCs, illiquid credit and interest rate derivatives.
Sales and settlements include £577 million of derivative assets and £437 million of derivative liabilities relating to Sempra included in disposal groups in 2009.
Notes on the accounts 289RBS Group Annual Report and Accounts 2009
RBS Group Annual Report and Accounts 2009290 11 Financial instruments continued
Remaining maturity The following table shows the residual maturity of financial instruments, based on contract date of maturity.
Loans and advances to banks 89,622 2,131 91,753 133,565 4,632 138,197 187,969 31,491 219,460 Loans and advances to customers 227,745 500,648 728,393 338,751 535,971 874,722 395,753 432,785 828,538
Settlement balances 11 — 11 — — — — — —
Notes on the accounts 291RBS Group Annual Report and Accounts 2009
On balance sheet liabilities Group 0-3 months 3-12 months 1-3 years 3-5 years 5-10 years 10-20 years 2009 £m £m £m £m £m £m
The tables above show the timing of cash outflows to settle financial liabilities. They have been prepared on the following basis: Financial liabilities are included at the earliest date on which the counterparty can require repayment regardless of whether or not such early repayment results in a penalty. If repayment is triggered by, or is subject to, specific criteria such as market price hurdles being reached, the liability is included at the earliest possible date that the conditions could be fulfilled without considering the probability of the conditions being met. For example, if a structured note is automatically prepaid when an equity index exceeds a certain level, the cash outflow will be included in the less than three months’ period whatever the level of the index at the year end. The settlement date of debt securities in issue issued by certain securitisation vehicles consolidated by the Group depends on when cash flows are received from the securitised assets. Where these assets are prepayable, the timing of the cash outflow relating to securities assumes that each asset will be prepaid at the earliest possible date.
Individually Collectively Total assessed assessed Latent 2009 2008 2007 £m £m £m £m £m £m
Notes: (1) The provision for impairment losses at 31 December 2009 includes £157 million relating to loans and advances to banks (2008 – £127 million; 2007 – £3 million).
Loans and advances to customers 14,100 6,973 1,946 Loans and advances to banks 34 118 —
Notes on the accounts 293RBS Group Annual Report and Accounts 2009
Loans and receivables Loans and advances to banks (1) 206 157 49 129 127 2 25 3 22 Loans and advances to customers (2) 34,801 14,050 20,751 19,350 8,945 10,405 10,337 5,399 4,938
(2) Impairment provisions individually assessed on balances of £24,540 million (2008 – £11,313 million; 2007 – £3,178 million).
In general, the Group seeks to dispose of property and other assets not readily convertible into cash obtained by taking possession of collateral as rapidly as the market for the individual asset permits.
The Group holds collateral in respect of certain loans and advances to banks and to customers that are past due or impaired. Such collateral includes mortgages over property (both personal and commercial); charges over business assets such as plant, inventories and trade debtors; and guarantees of lending from parties other than the borrower. The following table shows financial and non-financial assets, recognised on the Group's balance sheet, obtained during the year by taking possession of collateral or calling on other credit enhancements.
The Group enters into fair value hedges, cash flow hedges and hedges of net investments in foreign operations. The majority of the Group’s interest rate hedges relate to the management of the Group’s nontrading interest rate risk. The Group manages this risk to Value-at-Risk limits. The risk is assessed using gap reports that show maturity mismatches. To the extent that such mismatches exceed predetermined limits they are closed by executing derivatives principally interest rate swaps. Suitable larger ticket financial instruments are fair value hedged; the remaining exposure, where possible, is hedged by derivatives documented as cash flow hedges and qualifying for hedge accounting. The majority of the Group’s fair value hedges involve interest rate swaps hedging the interest rate risk in recognised financial assets and financial liabilities. Cash flow hedges relate to exposure to variability in future interest payments and receipts on forecast transactions and on recognised financial assets and financial liabilities. The Group hedges its net investments in foreign operations with currency borrowings and forward foreign exchange contracts.
For fair value hedge relationships of interest rate risk, the hedged items are typically large corporate fixed-rate loans, fixed-rate finance leases, fixed-rate medium-term notes or preference shares classified as debt. As at 31 December 2009 fixed rate financial assets of £53.7 billion and fixed rate financial liabilities of £52.9 billion were hedged by interest rate swaps in fair value hedge relationships.
Notes on the accounts 295RBS Group Annual Report and Accounts 2009
Fair value hedging: Cash flow hedging: Commodity contracts — — 39 14 — —
Fair value ineffectiveness 57 (81) (6) Cash flow hedging ineffectiveness 14 (16) 9
Included above are derivatives held for hedging purposes as follows: Assets Liabilities Assets Liabilities Assets Liabilities Fair value hedging £m £m £m £m £m £m
Exchange rate contracts — — — 225 — 54 Interest rate contracts 239 14 193 — — —
UK US Other Mortgage and central central central Bank and other asset and local and local and local building backed government government government society securities(1) Corporate Other(2) Total 2009 £m £m £m £m £m £m £m £m
Notes: (1) Includes securities issued by US federal agencies and government sponsored entities and covered bonds.
(3) During 2009 and 2008 the Group reclassified financial assets from the held-for-trading and available-for-sale categories into the loans and receivables category and during 2008 from the held-fortrading category into the available-for-sale category (see pages 275 to 277).
RBS Group Annual Report and Accounts 2009298 14 Debt securities continued
UK central and local government 2,824 60 26 — 2,850 60 US central and local government 5,526 88 7 1 5,533 89 Other central and local government 6,935 260 391 6 7,326 266
Impairment losses on available-for-sale debt securities are recognised when there is objective evidence of impairment. The Group reviews its portfolios of available-for-sale financial assets for such evidence which includes: default or delinquency in interest or principal payments; significant financial difficulty of the issuer or obligor; and it becoming probable that the issuer will enter bankruptcy or other financial reorganisation. However, the disappearance of an active market because an entity’s financial instruments are no longer publicly traded is not evidence of impairment. Furthermore, a downgrade of an entity’s credit rating is not, of itself, evidence of impairment, although it may be evidence of impairment when considered with other available information. A decline in the fair value of a financial asset below its cost or amortised cost is not necessarily evidence of impairment. The existence of stand alone credit protection of an available-for-sale debt security has no effect on the Group’s assessment of whether or not the security is impaired. If an available-for-sale debt security benefits from credit protection that is integral to the security, the creditworthiness of the provider of that protection is taken into account when determining whether there is objective evidence that the security is impaired. Determining whether objective evidence of impairment exists requires the exercise of management judgment. The unrealised losses on the Group’s available-for-sale debt securities are concentrated in its portfolios of mortgage-backed securities. The losses reflect the widening of credit spreads as a result of the reduced market liquidity in these securities and the current uncertain macro-economic outlook in US and Europe. The underlying securities remain unimpaired.
Currency translation and other adjustments (566) 2,839 535 Additional investments in Group undertakings 36,202 10,323 3,663
Impairment of investment in RFS Holdings B.V. (5,025) (14,321) — Other impairments (114) — —
The Royal Bank of Scotland plc Banking Great Britain 100% National Westminster Bank Plc (1) Banking Great Britain 100% Citizens Financial Group, Inc. Banking US 100% Coutts & Company (2) Private banking Great Britain 100% RBS Securities Inc. Broker dealer US 100% RBS Insurance Group Limited Insurance Great Britain 100% Ulster Bank Limited (3) Banking Northern Ireland 100% ABN AMRO Holding N.V. (4) Banking The Netherlands 38%
Notes: (1) The company does not hold any of the NatWest preference shares in issue.
(4) RFS Holdings B.V. (RFS) owns 100% of the outstanding shares of ABN AMRO Holding N.V. (ABN AMRO). The company owns 38% of RFS; the balance of shares is held by the State of the Netherlands, successor to Fortis N.V., Fortis SA/NV, and Banco Santander S.A. (the consortium members). Although the company does not control a majority of the voting rights in RFS, through the terms of the Consortium and Shareholders’ Agreement and RFS’s Articles of Association, it controls the board of RFS and RFS is a subsidiary of the company. The capital and income rights of shares issued by RFS are linked to the net assets and income of the ABN AMRO business units which the individual consortium members have agreed to acquire. In preparation for the divestment of the ABN AMRO businesses to be acquired by the Dutch State, on 6 February 2010, the businesses of ABN AMRO acquired by the Dutch State were legally demerged from the RBS acquired businesses. As a result, there are now two separate banks within ABN AMRO Holding N.V., The Royal Bank of Scotland N.V. and the new entity named ABN AMRO Bank N.V., each licensed separately by the Dutch Central Bank. Both banks will be governed by the current managing and supervisory boards of ABN AMRO Holding N.V. until the legal separation of the new ABN AMRO Bank N.V. from ABN AMRO Holding N.V., which is expected to take place within two months of the legal demerger and is subject to approval by the Dutch Central Bank. From that point RBS will cease to consolidate the Consortium Members’ interest in ABN AMRO in the RBS Group statutory results.
The principal subsidiary undertakings of the company are shown below. Their capital consists of ordinary and preference shares which are unlisted with the exception of certain preference shares issued by NatWest and ABN AMRO. The Royal Bank of Scotland plc, RBS Insurance Group Limited and RFS Holdings B.V. are directly owned by the company, and all of the other subsidiary undertakings are owned directly, or indirectly through intermediate holding companies, by these companies. All of these subsidiaries are included in the Group’s consolidated financial statements and have an accounting reference date of 31 December.
Disposal of subsidiaries — — — (16) (16) Disposals and write-off of fully amortised assets — (2) — (187) (189)
Accumulated amortisation and impairment: At 1 January 2009 30,062 1,407 2,369 3,408 37,246 Currency translation and other adjustments (2,046) (106) (137) (58) (2,347) Disposal of subsidiaries — — — (13) (13) Disposals and write-off of fully amortised assets — (1) — (138) (139) Charge for the year — 262 345 586 1,193 Write down of goodwill and other intangible assets 363 — — — 363
Accumulated amortisation and impairment: At 1 January 2008 — 238 223 2,291 2,752 Transfer to disposal groups — — — (37) (37) Currency translation and other adjustments — 150 210 69 429 Disposals and write-off of fully amortised assets — (3) (1) (19) (23) Charge for the year — 337 582 651 1,570 Write down of goodwill and other intangible assets 30,062 685 1,355 453 32,555
Currency translation and other adjustments — 1 3 3 7 Disposals and write-off of fully amortised assets — — (1) (80) (81) Charge for the year – continuing operations — 110 124 401 635 Charge for the year – discontinued operations — — — 24 24
UK Retail Value in use 2,697 UK Corporate Value in use 2,693 Wealth Value in use 611 Global Transaction Services Value in use 2,749 US Retail & Commercial Value in use 2,761 RBS Insurance Value in use 935
The recoverable amount of UK Retail, based on a 4% terminal growth rate and 14.6% pre tax discount rate, exceeded the carrying amount by £0.7 billion. A 1% change in the discount rate or the terminal growth rate would change the recoverable amount by approximately £0.9 billion and £0.5 billion respectively. In addition, a 5% change in the forecast pre tax earnings would change the recoverable amount by approximately £0.4 billion.
The recoverable amount of UK Corporate, based on a 4% terminal growth rate and a 15.1% pre tax discount rate, exceeded its carrying value by £6.1 billion. A 1% change in the discount rate or similar change in the terminal growth rate would change the recoverable amount by approximately £1.4 billion and £0.9 billion respectively. In addition, a 5% change in the forecast pre tax earnings would change the recoverable amount by approximately £0.8 billion.
The recoverable amount of Wealth, based on a 4% terminal growth rate and a 15.3% pre tax discount rate, exceeded its carrying value by £5.6 billion. A 1% change in the discount rate or similar change in the terminal growth rate would change the recoverable amount by approximately £0.6 billion and £0.5 billion respectively. In addition, a 5% change in the forecast pre tax earnings would change the recoverable amount by approximately £0.4 billion.
Cost or valuation: At 1 January 2009 3,868 4,032 224 1,867 4,168 9,334 23,493 Transfers to disposal groups — (32) — (62) (80) — (174) Currency translation and other adjustments (85) (134) — (65) (131) (561) (976) Disposal of subsidiaries — (15) — — (19) — (34)
Expenditure on investment properties 8 — — — — — 8 Change in fair value of investment properties (117) — — — — — (117) Disposals and write-off of fully depreciated assets (426) (75) (19) (56) (420) (1,456) (2,452)
Accumulated impairment, depreciation and amortisation: At 1 January 2008 — 391 74 436 1,952 2,747 5,600 Transfers to disposal groups — (60) — (91) (243) — (394) Currency translation and other adjustments — (9) 1 9 148 202 351
Transfers to disposal groups — (4) (13) — — (422) (439) Expenditure on investment properties 41 — — — — — 41 Change in fair value of investment properties 288 — — — — — 288 Disposals and write-off of fully depreciated assets (2,332) (533) (120) (44) (197) (2,713) (5,939)
Notes on the accounts continued 19 Prepayments, accrued income and other assets
Businesses acquired exclusively with a view to disposal Loss after tax (99) (251) (136) (Loss)/profit from discontinued operations, net of tax (99) 3,971 (76)
Discontinued operations in 2008 reflect the results of Banco Real sold to Santander on 24 July 2008.
Net cash flows from operating activities — (124) (1,304) Net cash flows from investing activities — (368) 4,341 Net cash flows from financing activities — 339 (25) Net increase in cash and cash equivalents — 287 3,172
Intangible assets 238 — 238 — — Settlement balances 1,579 — 1,579 — — Property, plant and equipment 92 44 136 66 395 Other assets 5,257 160 5,417 — — Discontinued operations and other disposal groups 14,203 4,165 18,368 66 395 Assets acquired exclusively with a view to disposal — 174 174 1,515 45,455
Note: (1) Comprises property provisions and other provisions arising in the normal course of business.
Notes on the accounts 23 Deferred taxation Provision for deferred taxation has been made as follows: Group Company £m £m £m £m £m £m
Fair Available- Tax Accelerated value of for-sale Cash losses capital Deferred IFRS financial financial flow Share carried Pension allowances Provisions gains transition instruments assets Intangibles hedging schemes forward Other Total £m £m £m £m £m £m £m £m £m £m £m £m £m
Currency translation and other adjustments — (104) 72 107 52 7 1 (63) 54 1 15 (76) 66 At 31 December 2009 (724) 2,815 (1,480) 136 (373) (184) (391) 1,108 (60) (8) (5,134) 67 (4,228)
Notes: (1) Deferred tax assets are recognised, as set out above, that depend on the availability of future taxable profits in excess of profits arising from the reversal of other temporary differences. Business projections prepared for impairment reviews (see Note 17) indicate it is probable that sufficient future taxable income will be available against which to offset these recognised deferred tax assets within eight years. UK losses do not expire and Netherlands losses expire after nine years. In jurisdictions where doubt exists over the availability of future taxable profits, deferred tax assets of £2,163 million (2008 – £1,748 million; 2007 – £687 million) have not been recognised in respect of tax losses carried forward of £7,759 million (2008 – £5,779 million; 2007 – £2,043 million). Of these losses, £27 million will expire within one year, £18 million within five years and £6,837 million thereafter. The balance of tax losses carried forward has no time limit.
(2) Deferred tax liabilities of £279 million (2008 – £980 million; 2007 – £977 million) have not been recognised in respect of retained earnings of overseas subsidiaries and held-over gains on the incorporation of overseas branches. Retained earnings of overseas subsidiaries are expected to be reinvested indefinitely or remitted to the UK free from further taxation. No taxation is expected to arise in the foreseeable future in respect of held-over gains. The temporary differences at the balance sheet date are significantly reduced from the previous year as a result of changes to UK tax legislation which largely exempts from UK tax, overseas dividends received on or after 1 July 2009.
Cash paid for claims settled in the year (3,969) 97 (3,872) Increase/(decrease) in liabilities
– arising from current year claims 4,079 (45) 4,034 – arising from prior year claims (241) (66) (307)
Disposal of subsidiary (124) 5 (119) Net exchange differences (44) 3 (41)
The unearned premium provision is included within Accruals, deferred income and other liabilities (Note 22).
Opening net assets 588 604 579 Profit from existing business: Operating assumption changes 10 2 6 Investment return variances 32 (46) (14) Economic assumption changes (4) (2) — Transfer to shareholders’ funds (106) — —
Movement in provision for liabilities under life contracts and under linked and other investment contracts £m £m
Underwriting and pricing risk The Group manages underwriting and pricing risk through the use of underwriting guidelines which detail the class, nature and type of business that may be accepted; pricing policies by product line and by brand; and centralised control of policy wordings and any subsequent changes.
Reinsurance risk Reinsurance is used to protect against the impact of major catastrophic events or unforeseen volumes of, or adverse trends in, large individual claims and to transfer risk that is outside the Group’s current risk appetite.
Reserving risk Reserving risk relates to both premiums and claims. It is the risk that reserves are assessed incorrectly such that insufficient funds have been retained to pay or handle claims as the amounts fall due. Claims development data provides information on the historical pattern of reserving risk.
Claims reserves It is the Group’s policy to hold undiscounted claims reserves (including reserves to cover claims which have been incurred but not reported (IBNR reserves)) for all classes at a sufficient level to meet all liabilities as they fall due.
The Group’s focus is on high volume and relatively straightforward products, for example home and motor. This facilitates the generation of comprehensive underwriting and claims data, which are used to accurately price and monitor the risks accepted.
Estimate of ultimate claims costs: At end of accident year 2,011 2,584 3,215 3,514 4,168 4,215 4,572 4,034 4,360 32,673
Seven years later — (11) (11) Eight years later 1 1 Current estimate of
Lifestyle protection plan £26.68 £29.30 £25.18 Mortgage savings plan £59.80 £65.92 £56.67
The Group is not exposed to price, currency, credit, or interest risk on unit linked life contracts but it is exposed to variation in management fees. A decrease of 10% in the value of the assets would reduce the asset management fees by £1 million per annum (2008 – £5 million). The Group writes insurance contracts with minimum guaranteed death benefits that expose it to the risk that declines in the value of underlying investments may increase the Group’s net exposure to death risk. The Group’s long-term assurance contracts include whole-life, term assurance, endowment assurances, flexible whole life, pension and annuity contracts that are expected to remain in force for an extended period of time.
Contracts under which the Group does not accept significant insurance risk are classified as investment contracts. As required by IFRS 4 ‘Insurance Contracts’ long-term business provisions are calculated in accordance with existing local GAAP (UK accounting standard FRS 27 ‘Life Assurance’).
Estimations (assumptions) including future mortality, morbidity, persistency and levels of expenses are made in calculating actuarial reserves. Key metrics for the UK include: GRA_5_FS_Part2_09_300-348.qxp:GRA_5_FS_part2_09 15/3/10 09:34 Page 316
The test allows consistently for similar changes to investment returns and movements in the market value of backing fixed interest securities.
The above sensitivity factors are applied via actuarial and statistical models, with the following effect on the financial statements.
Frequency and severity of claims – for contracts where death is the insured risk, the most significant factors that could increase the overall frequency of claims are epidemics or widespread changes in lifestyle, resulting in earlier or more claims than expected.
25 Subordinated liabilities Group Company £m £m £m £m £m £m
The following tables analyse the remaining maturity of subordinated liabilities by (1) the final redemption date; and (2) the next call date.
Currently 2009 2010 2011-2013 2014-2018 Thereafter Perpetual Total 2008 – call date £m £m £m £m £m £m £m £m 25 Subordinated liabilities continued
Company 2009 – final redemption £m £m £m £m £m £m £m
The Royal Bank of Scotland plc €300 million 4.875% subordinated notes 2009 (redeemed March 2009) — 298 228
US$750 million floating rate subordinated notes 2015 (callable September 2010) 462 513 374 €750 million floating rate subordinated notes 2015 741 783 564
National Westminster Bank Plc US$1,000 million 7.375% subordinated notes 2009 (redeemed October 2009) — 697 507
The company US$163 million (2008 and 2007 – US$350 million) undated floating rate primary capital notes
(callable on any interest payment date) (3) 205 343 251 US$312 million (2008 and 2007 – US$500 million) primary capital floating rate notes, Series B
(2) The company can satisfy interest payment obligations by issuing sufficient ordinary shares to appointed Trustees to enable them, on selling these shares, to settle the interest payment.
(3) Partially redeemed following the completion of the exchange and tender offers in April 2009.
(7) In the event of certain changes in tax laws, undated loan capital issues may be redeemed in whole, but not in part, at the option of the Group, at the principal amount thereof plus accrued interest, subject to prior regulatory approval.
(8) Interest on all floating rate subordinated notes is calculated by reference to market rates.
US$486m (2008 and 2007 – US$750) 6.8% (redeemable December 2049) (1, 2) 300 514 374 US$322m (2008 and 2007 – US$850) 4.709% (redeemable July 2013) (1, 2) 196 640 421 US$394m (2008 and 2007 – US$650) 6.425% (redeemable January 2034) (1, 2) 280 677 344
ABN AMRO and subsidiaries US$1,285 million 5.90% Trust Preferred V 696 760 464 US$200 million 6.25% Trust Preferred VI 107 121 82 US$1,800 million 6.08% Trust Preferred VII 950 1,064 762
Currency translation and other adjustments (1,282) (152) (1,434) (Loss)/profit attributable to minority interests (299) 648 349 Dividends paid — (313) (313) Gains/(losses) on available-for-sale financial assets, net of tax 133 (336) (203) Movements in cash flow hedging reserves, net of tax (150) — (150) Actuarial gains recognised in retirement benefit schemes, net of tax 92 — 92 Equity raised — 9 9
Included in minority interests are the following trust preferred securities (1): 2009 2008 2007 £m £m £m
US$357 million (2008 and 2007 – US$950 million) 5.512% (redeemable September 2014) 198 529 529 US$470 million (2008 and 2007 – US$1,000 million) 3 month US$ LIBOR plus 0.80% (redeemable September 2014) 261 555 555 €166 million (2008 and 2007 – €500 million) 4.243% (redeemable January 2016) 112 337 337 £93 million (2008 and 2007 – £400 million) 5.6457% (redeemable June 2017) 93 400 400
Note: (1) The trust preferred securities issued by subsidiaries have no maturity date and are not redeemable at the option of the holders at any time. These securities may, with the consent of the UK Financial Services Authority, be redeemed, in whole or in part, by the issuer on the dates specified above or on any interest payment date thereafter. They may also be redeemed in whole, but not in part, upon the occurrence of certain tax and regulatory events. The company classifies its obligations to these subsidiaries as dated loan capital.
The trust preferred securities above were also included in the series of exchange offers and tender offers concluded by the Group in April 2009 (see page 318).
Notes on the accounts 27 Share capital Allotted, called up and fully paid Authorised (1)
1 January Issued Redeemed 31 December 31 December 2009 during the year during the year 2009 2008 £m £m £m £m £m
Dividend access share of £0.01 — — — — — Non-voting deferred shares of £0.01 27 — — 27 323 Additional Value Shares of £0.01 — — — — 27 Non-cumulative preference shares of US$0.01 2 — — 2 3 Non-cumulative convertible preference shares of US$0.01 — — — — — Non-cumulative preference shares of €0.01 — — — — — Non-cumulative convertible preference shares of €0.01 — — — — — Non-cumulative convertible preference shares of £0.25 — — — — 225 Non-cumulative convertible preference shares of £0.01 — — — — — Cumulative preference shares of £1 1 — — 1 1 Non-cumulative preference shares of £1 6 — (5) 1 300
B shares of £0.01 51,000,000 — — — — Dividend access share of £0.01 — — — — — Non-voting deferred shares of £0.01 2,660,556 2,660,556 2,660,556 32,300,000 32,300,000 Additional Value Shares of £0.01 — — — 2,700,000 2,700,000 Non-cumulative preference shares of US$0.01 308,015 308,015 308,015 516,000 419,500 Non-cumulative convertible preference shares of US$0.01 1,000 1,000 1,000 3,900 3,900 Non-cumulative preference shares of €0.01 2,526 2,526 2,526 66,000 66,000 Non-cumulative convertible preference shares of €0.01 — — — 3,000 3,000 Non-cumulative convertible preference shares of £0.25 — — — 900,000 900,000 Non-cumulative convertible preference shares of £0.01 200 200 200 1,000 1,000
Movement in ordinary and B shares in issue – thousands Ordinary shares B shares of 25p of £0.01
Shares issued in respect of the placing and open offer 16,909,716 — B Shares issued — 51,000,000
Note: (1) Prior to the Companies Act 2006, the authorised share capital of UK companies was divided between issued share capital and unissued share capital whose allotment was determined by the Articles of Association of a company and specific authorities granted to directors. Since 15 December 2009 when the company changed its constitution to reflect the Companies Act 2006, there is no authorised share capital. The meeting approving the changes also resolved to grant the directors the power to issue a nominal amount of £1,610 million B shares of 1p each and £44,250 million ordinary shares of 25p each in connection with the company's participation in the UK Government’s Asset Protection Scheme.
Ordinary shares At the Annual General meeting in April 2009, the authorised ordinary share capital of the company was increased by £7.5 billion through the creation of 30 billion new ordinary shares of 25p each.
At a General meeting in April 2009, the authorised ordinary share capital of the company was increased by a further £4.2 billion through the creation of 16.9 billion new ordinary shares of 25p each.
During the year ended 31 December 2009, options were granted over 1.5 billion ordinary shares under the company’s executive and sharesave schemes. At 31 December 2009, options granted under the company’s various schemes, exercisable up to 2019 at prices ranging from 28.2p to 586p per share, were outstanding in respect of 1.4 billion ordinary shares.
No ordinary shares were issued during the year ended 31 December 2009 following the exercise of options under the company’s share schemes. Any options exercised were satisfied using market purchase shares held in the Trust.
No options granted under the NatWest executive scheme were outstanding as at 31 December 2009.
Employee share trusts purchased 86.2 million ordinary shares at a cost of £33 million and awarded 8.7 million ordinary shares on receipt of £0.06 million on the exercise of awards under employee share schemes.
The employee share trusts incurred costs of £0.2 million in purchasing the company’s ordinary shares.
The Dividend Access Share entitles the holder to dividends equal to the greater of 7% of the aggregate issue price of B shares issued to HM Treasury and 250% times the ordinary dividend rate multiplied by the number of B shares issued, less any dividends paid on the B shares and on ordinary shares issued on conversion. Dividends on the dividend access share are discretionary unless a dividend has been paid on the ordinary shares, in which case dividends became mandatory. The Dividend Access Share does not generally carry voting rights at general meetings of ordinary shareholders and is not convertible into ordinary shares.
Preference shares Under IFRS certain of the Group’s preference shares are classified as debt and are included in subordinated liabilities on the balance sheet.