Segments charge market prices for services rendered to other parts of the Group with the exception of Manufacturing and central items. The expenditure incurred by Manufacturing relates to costs principally in respect of the Group’s banking and insurance operations in the UK and Ireland. These costs reflect activities that are shared between the various customerfacing divisions. These shared costs and related assets and liabilities are not allocated to divisions in the day-to-day management of the businesses but for the first time in 2006, with comparatives restated accordingly, they are allocated to customer-facing divisions for financial reporting purposes on a basis the directors consider to be reasonable. Funding charges between segments are determined by Group Treasury, having regard to commercial demands. The results of each division before amortisation of purchased intangible assets, integration costs and net gain on sale of strategic investments and subsidiaries, and where appropriate, allocation of Manufacturing costs (‘Contribution’) and after allocation of Manufacturing costs (‘Operating profit before tax’) are shown below.
Net and Depreciation Allocation of Operating interest Non-interest insurance and Impairment Manufacturing profit income income Total claims amortisation losses Contribution costs before tax 2005 £m £m £m £m £m £m £m £m £m
Total revenue £m £m £m £m £m £m £m £m £m
Inter Inter Inter External segment Total External segment Total External segment Total
Note: (1) Segmental results for 2005 have been restated to reflect transfers of businesses between segments in 2006.
Currency translation and other adjustments 4 — (8) (7) (9) (904) — — (924)
Net assets attributable to equity shareholders and minority interests 21,470 13,991 4,097 5,932 45,490
Insurance premium income (net of reinsurers’ share) 5,390 — 257 — 5,647
Cost to acquire property, plant and equipment and intangible assets 3,811 6,178 1,736 2 11,727 43 Directors’ and key management remuneration Group
The executive directors may also participate in the company’s executive share option, sharesave and option 2000 schemes and details of their interests in the company’s shares arising from their participation are given on pages 120 and 121. Details of the remuneration received by each director during the year and each director’s pension arrangements are given on pages 119 to 124.
(b) The Group recharges The Royal Bank of Scotland Group Pension Fund with the cost of administration services incurred by it. The amounts involved are not material to the Group.
(a) Financial instruments: financial assets Loans are measured at cost less provisions for bad and doubtful debts, derivatives held-for-trading are carried at fair value and hedging derivatives are accounted for in accordance with the treatment of the item being hedged (see Derivatives and hedging below).
Debt securities and equity shares intended for use on a continuing basis in the Group’s activities are classified as investment securities and are stated at cost less provision for any permanent diminution in value. The cost of dated investment securities is adjusted for the amortisation of premiums or discounts. Other debt securities and equity shares are carried at fair value.
(c) Liabilities and equity Under UK GAAP, all shares are classified as shareholders’ funds. An analysis of shareholders’ funds between equity and non-equity interests is given.
Under IAS 39, financial assets are classified into held-tomaturity; available-for-sale; held-for-trading; designated as at fair value through profit or loss; and loans and receivables. Financial assets classified as held-to-maturity or as loans and receivables are carried at amortised cost. Other financial assets are measured at fair value. Changes in the fair value of available-for-sale financial assets are reported in a separate component of shareholders’ equity. Changes in the fair value of financial assets held-for-trading or designated as at fair value are taken to profit or loss. Financial assets can be classified as held-to-maturity only if they have a fixed maturity and the reporting entity has the positive intention and ability to hold to maturity. Trading financial assets are held for the purpose of selling in the near term. IFRS allows any financial asset to be designated as at fair value through profit or loss on initial recognition. Unquoted debt financial assets that are not classified as held-to-maturity, held-for-trading or designated as at fair value through profit or loss are categorised as loans and receivables. All other financial assets are classified as available-for-sale.
IAS 39 requires all financial liabilities to be measured at amortised cost except those held-for-trading and those that were designated as at fair value through profit or loss on initial recognition.
46 Transition to IFRS Implementation of IAS 32, IAS 39 and IFRS 4 on 1 January 2005
(e) Derivatives and hedging Under UK GAAP non-trading derivatives are accounted for on an accruals basis in accordance with the accounting treatment of the underlying transaction or transactions being hedged. If a non-trading derivative transaction is terminated or ceases to be an effective hedge, it is remeasured at fair value and any gain or loss amortised over the remaining life of the underlying transaction or transactions being hedged. If a hedged item is derecognised the related non-trading derivative is remeasured at fair value and any gain or loss taken to the income statement.
Under IAS 39, all derivatives are measured at fair value. Hedge accounting is permitted for three types of hedge relationship: fair value hedge – the hedge of changes in the fair value of a recognised asset or liability or firm commitment; cash flow hedge – the hedge of variability in cash flows from a recognised asset or liability or a forecasted transaction; and the hedge of a net investment in a foreign entity. In a fair value hedge the gain or loss on the derivative is recognised in profit or loss as it arises offset by the corresponding gain or loss on the hedged item attributable to the risk hedged. In a cash flow hedge and in the hedge of a net investment in a foreign entity, the element of the derivative’s gain or loss that is an effective hedge is recognised directly in equity. The ineffective element is taken to the income statement. Certain conditions must be met for a relationship to qualify for hedge accounting. These include designation, documentation and prospective and actual hedge effectiveness. On implementation of IAS 39, non-trading derivatives were remeasured at fair value.
IFRS require impairment losses on financial assets carried at amortised cost to be measured as the difference between the asset's carrying amount and the present value of estimated future cash flows discounted at the asset's original effective interest rate. There is no concept of specific and general provision – under IFRS impairment is assessed individually for individually significant assets but can be assessed collectively for other assets. Once an impairment loss has been recognised on a financial asset or group of financial assets, interest income is recognised on the carrying amount using the rate of interest at which estimated future cash flows were discounted in measuring impairment.
(h) Insurance contracts All contracts within the life assurance business are accounted for as insurance contracts and the obligations to policyholders presented as Long-term assurance liabilities attributable to policyholders.
(i) Linked presentation FRS 5 ‘Reporting the Substance of Transactions’ allows qualifying transactions to be presented using the linked presentation.
(j) Extinguishment of liabilities Under UK GAAP, recognition of a financial liability ceases once any transfer of economic benefits to the creditor is no longer likely.
The value of in-force policies excludes any amounts that reflect future investment margins.
A financial liability is removed from the balance sheet when, and only when, it is extinguished i.e. when the obligation specified in the contract is discharged or cancelled or expires.
Shareholders’ funds under IFRS at 31 December 2004 33,905 18,611 Standards applicable from 1 January 2005: Non-equity shares reclassified to debt (3,192) (3,192) Revenue recognition (932) — Derecognition (170) — Securities 229 — Investments in Group undertakings adjusted to historic cost — 108
Fair value on Carrying value Fair value on Carrying value implementation of IAS 39 under UK GAAP implementation of IAS 39 under UK GAAP
Financial assets – designated as at fair value through profit or loss 2,579 2,728 — — – available-for-sale 40,161 39,718 — —
Financial liabilities – designated as at fair value through profit or loss 9,976 10,071 — —
Section (2) summarises those adjustments that, although the applicable IFRS and US GAAP standards are substantially the same, arise because their effective dates for the Group differ.
(b) Property revaluation and depreciation Prior to the implementation of IFRS the Group revalued annually freehold and leasehold properties occupied for its own use. On transition to IFRS, as permitted by IFRS 1 valuation of these properties at 31 December 2003 was deemed to be their cost.
Investment properties are carried at fair value; changes in fair value are included in profit or loss.
(c) Leasehold property provisions Provisions are recognised on leasehold properties when there is a commitment to vacate the property.
(f) Pension costs – acquisition accounting On the acquisition of NatWest, the fair value of the pension scheme surplus was restricted to the amount expected to be realised through reduced contributions or refunds.
US GAAP requires similar measurement of pension assets and liabilities. Any surplus or deficit is recognised on the balance sheet with effect from 31 December 2006 and changes in the funded status of the plan are recognised through comprehensive income. In the income statement, a certain portion of actuarial gains and losses are deferred over the average remaining service lives of active employees expected to receive benefits. Prior to 31 December 2006 an additional minimum liability was recognised in comprehensive income as the accumulated benefit obligation (the current value of accrued benefits without the allowance for future salary increases) exceeded the fair value of plan assets and a prepayment was recorded.
If a sale and leaseback transaction results in an operating lease, the seller recognises any profit on the sale in proportion to the related gross rental charged to expense over the lease term unless: (a) the seller relinquishes the right to substantially all the remaining use of the property sold in which case the sale and leaseback is accounted for as separate transactions; or
Trading securities and derivatives are carried at fair value. Designation on initial recognition is not allowed. Securities held by the Group’s private equity business are considered to be held by investment companies and carried at fair value with changes in fair value being reflected in net income.
Collateralised loans arising from reverse repurchase and stock borrowing agreements and cash collateral given are measured at cost. Other held-for-trading loans are measured at the lower of cost and fair value except those held by the Group’s brokerdealer and its affiliates which are recorded at fair value.
(h) Long-term assurance business IFRS requires contracts to be analysed between insurance and investment contracts. Investment contracts are accounted for as financial instruments. Insurance contracts are accounted for using an embedded value methodology: the shareholders’ interest in the long-term assurance fund is valued as the discounted value of the cash flows expected to be generated from in-force policies together with net assets in excess of the statutory liabilities.
Debt securities classified as loans and receivables Non-derivative financial assets with fixed or determinable repayments that are not quoted in an active market are classified as loans and receivables except those that are classified as held-to-maturity, held-for-trading, available-for-sale or designated as at fair value through profit or loss. Loans and receivables are initially recognised at fair value plus directly related transaction costs. They are subsequently measured at adjusted cost using the effective interest method less any impairment losses. The Group has classified some debt securities as loans and receivables.
Loans classified as held-for-trading Under IAS 39, loans classified as held-for-trading are carried at fair value.
Foreign exchange gains and losses on monetary available-forsale financial assets For the purposes of recognising foreign exchange gains and losses, a monetary available-for-sale debt security is treated as if it were carried at amortised cost in the foreign currency. Accordingly, for such financial assets, exchange differences resulting from retranslating amortised cost are recognised in profit or loss.
(j) Derivatives and hedging Gains and losses arising from changes in fair value of a derivative are recognised as they arise in profit or loss unless the derivative is the hedging instrument in a qualifying hedge. The Group enters into three types of hedge relationship: hedges of changes in the fair value of a recognised asset or liability or firm commitment (fair value hedges); hedges of the variability in cash flows from a recognised asset or liability or a forecast transaction (cash flow hedges); and hedges of the net investment in a foreign entity.
(k) Liabilities and equity Certain preference shares issued by the company where distributions are not discretionary are classified as debt.
(m) Offset arrangements A financial asset and a financial liability are offset and the net amount reported in the balance sheet when, and only when, the Group currently has a legally enforceable right to set off the recognised amounts; and intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously.
Arrangements such as master netting agreements do not generally provide a basis for offsetting.
Exchange differences are included with other unrealised gains and losses on available-for-sale securities and reported in a separate component of equity.
US GAAP principles are similar to IFRS. There are however differences in their detailed application. The Group has not recognised any hedge relationships for US GAAP purposes except hedges of net investments in overseas operations. All derivatives are measured at fair value with changes in fair value recognised in net income.
US GAAP requires consolidation by the primary beneficiary of a variable interest entity (VIE). An enterprise is the primary beneficiary of a VIE if it will absorb the majority of the VIE’s expected losses, receive a majority of expected residual returns, or both.
Under US GAAP, debit and credit balances with the same counterparty may be offset only where there is a legally enforceable right of set-off and the intention to settle on a net basis. However, fair value amounts for forward, interest rate swap, currency swap, option, and other conditional or exchange contracts executed with the same counterparty under a master netting agreement may be offset as may repurchase and reverse repurchase agreements that are executed under a master netting agreement with the same counterparty and have the same settlement date.
US GAAP requires the same treatment of purchased goodwill. This was adopted by the Group from 1 July 2001. Prior to this goodwill was recognised as an asset and amortised over periods of up to 25 years. No amortisation was written back on this change of policy.
For US GAAP purposes the Group recognised intangible assets separately from goodwill from 1 July 2001. This has resulted in the recognition of additional intangible assets and consequently a higher amortisation charge under US GAAP.
There was no restatement of previous acquisitions in 1998. In 2004 no amortisation was written back.
Other intangibles Until 2004 intangible assets acquired in a business combination were recognised separately from goodwill only if they were separable and reliably measurable. From 1 January 2004 intangible assets are recognised if they are separable or arise from contractual or other legal rights. All intangible assets are amortised over their useful economic lives.
(3) For 2004 As permitted by IFRS 1, in the preparation of the Group’s 2004 consolidated income statements and balance sheets, all IFRS have been applied except those relating to financial instruments and insurance contracts where UK GAAP principles then current have been applied.
(c) Leasehold property provisions Provisions are raised on leasehold properties when there is a commitment to vacate the property.
(g) Extinguishment of liabilities Recognition of a financial liability ceases once any transfer of economic benefits to the creditor is no longer likely.
Under US GAAP, revaluations of property are not permitted. Own-use and investment properties are depreciated and gains and losses on disposal based on depreciated cost.
US GAAP requires similar valuations but allows a certain portion of actuarial gains and losses to be deferred and allocated in equal amounts over the average remaining service lives of current employees. An additional minimum liability must be recognised if the accumulated benefit obligation (the current value of accrued benefits without allowance for future salary increases) exceeds the fair value of plan assets and the Group has recorded a prepaid pension cost or has an accrued liability that is less than the unfunded accumulated benefit obligation. Movements in the additional minimum liability are recognised in a separate component of equity.
A financial liability is derecognised only when the creditor is paid or the debtor is legally released from being the primary obligor under the liability, either judicially or by the creditor.
(h) Financial instruments The Group’s debt and equity securities are classified as being held as investment securities or for trading purposes. Investment securities are stated at cost less provision for any permanent diminution in value. Premiums and discounts on dated debt securities are amortised to interest income over the period to maturity. Securities held for trading purposes are carried at fair value with changes in fair value recognised in profit or loss.
A non-derivative financial instrument cannot be designated as the hedging instrument in a fair value hedge of the foreign exchange exposure of available-for-sale securities.
Derivatives embedded in other financial instruments are accounted for on a stand-alone basis if they have economic characteristics and risks that differ from those of the host instrument.
Notes on the accounts continued 47 Significant differences between IFRS and US GAAP (continued)
Recent developments in US GAAP In February 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS 155 ‘Accounting for Certain Hybrid Financial Instruments – an amendment of FASB Statement No 133 and 140’ which is effective for all financial instruments acquired or issued by the Group after 1 January 2007. This statement allows any hybrid financial instrument that contains an embedded derivative that would otherwise require bifurcation to be measured at fair value. The statement also eliminates the exemption from applying SFAS 133 to interests in securitised financial assets.
In July 2006, the FASB issued Interpretation No.48 ‘Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No.109’ which clarifies the accounting for uncertainty in taxes and addresses the recognition and measurement of tax positions taken or expected to be taken. This Interpretation is effective from 1 January 2007 for the Group.
SFAS 159 also establishes presentation and disclosure requirements. The statement is effective from 1 January 2008; early adoption is permitted from 1 January 2007 provided certain conditions are met.
The Group is evaluating the implications of the above standards and interpretation on its US GAAP reporting.
In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108 (‘SAB No. 108’) ‘Financial Statements – Considering the Effects of Prior Year Misstatements when Quantifying Misstatement in Current Year Financial Statements’. SAB 108 requires a company to consider the amount by which the current year income statement may be misstated (‘rollover approach’) and the cumulative amount by which the current year balance sheet may be misstated (‘iron-curtain approach’) when assessing prior year misstatements. SAB 108 is effective for the Group’s 2006 consolidated financial statements; its adoption did not have a material effect.
Profit attributable to ordinary shareholders – IFRS 6,202 5,392 4,856 Adjustments in respect of: Acquisition accounting — — 66 Property revaluation and depreciation (470) (90) (65) Leasehold property provisions 46 (26) (19)
Income statement presentation under US GAAP does not differ significantly from IFRS except that under US GAAP impairment losses are included in total income.
Shareholders’ equity – IFRS 40,227 35,435 Adjustments in respect of: Acquisition accounting 494 517 Property revaluation and depreciation (873) (403) Leasehold property provisions 84 38 Loan origination 520 614 Pension costs (168) 2,367 Pension costs – acquisition accounting (1,555) (1,555) Sale and leaseback transactions (84) — Long-term assurance business (59) (47) Financial instruments (2,558) (259) Derivatives and hedging 55 260 Liabilities and equity 1,491 2,298 Implementation timing difference – intangibles 1,753 1,919 Other (34) —
Total assets under US GAAP of £770.8 billion (2005 – £700.4 billion) compared with total assets under IFRS of £871.4 billion (2005 – £776.8 billion) primarily reflect the effect of certain arrangements that can be netted under US GAAP, together with the effects of adjustments made to shareholders’ equity.
Dilutive effect of share options and convertible preference shares 64 58 (1.1) 65 60 (0.6) 66 73 (0.8)
* US GAAP net income available to ordinary shareholders, see page 221.
The Group has convertible preference shares totalling £200 million (2005 and 2004 – £200 million), and $1,000 million (2005 – $1,000 million; 2004 – $1,900 million). All of the convertible preference shares have a dilutive effect in the current year and have been included in the computation of diluted earnings per share.
Cash flows The following pension payments, which reflect expected future service, as appropriate, are expected to be paid: Main Other scheme schemes Total
Group Elimination of foreign exchange differences and other non-cash items 338 (4,472) (767) 1,839 Net cash inflow from trading activities 11,380 6,570 8,123 10,729 Net cash flows from operating activities before tax 10,861 6,051 3,859 6,465 Net cash flows from operating activities 8,950 4,140 2,493 5,099 Effects of foreign exchange rate changes on cash and cash equivalents (3,107) 1,703 1,686 (920)
Group Elimination of foreign exchange differences and other non-cash items 1,493 (3,317) (1,994) 612 Net cash inflow from trading activities 11,380 6,570 8,123 10,729 Net cash flows from operating activities 8,950 4,140 2,493 5,099
243 Exchange rates 244 Off-balance sheet arrangements 246 Economic and monetary environment 246 Supervision and regulation 250 Description of property and equipment 250 Major shareholders
(3) Includes integration expenditure of £134 million for the year ended 31 December 2006 (2005 – £458 million; 2004 – £520 million).
Share price per ordinary share at year end – £ 19.93 17.55 17.52 Market capitalisation at year end – £bn 62.8 56.1 55.6 Net asset value per ordinary share – £ 11.59 10.14 9.26 Return on average total assets (3) 0.74% 0.73% 0.94% Return on average ordinary shareholders’ equity (4) 18.5% 17.5% 18.3% Adjusted return on average ordinary shareholders’ equity (5) 19.0% 18.2% 18.9% Average shareholders’ equity as a percentage of average total assets 4.4% 4.5% 5.9% Risk asset ratio – Tier 1 7.5% 7.6% 7.0% Risk asset ratio – Total 11.7% 11.7% 11.7% Ratio of earnings to combined fixed charges and preference share dividends (6)
– including interest on deposits 1.62 1.67 1.88 – excluding interest on deposits 6.12 6.05 7.43
Notes: (1) All the convertible preference shares have a dilutive effect in 2006 and 2005 and as such have been included in the computation of diluted earnings per share. In 2004 their effect was anti-dilutive.
Loans and advances to customers – gross 267,437 61,655 141,734 470,826 421,110 351,419
The table below sets out the Group’s cross border outstandings in excess of 0.75% of Group total assets (including acceptances), which totalled £871.4 billion at 31
A d d it io n al i n fo rm at io n
Acquisitions of businesses Domestic — — 2 Foreign — — 288
Customer charge to income statement as a % of gross loans and advances to customers Domestic 0.66% 0.59% 0.49%
Notes: (1) Includes closing provisions against loans and advances to banks of £2 million (2005 – £3 million; 2004 – £6 million).
Loan impairment provisions at end of year: Specific provisions – customers 3,607 Specific provisions – banks 6 General provision 561
Customer provision at end of year as % of loans and advances to customers at end of year: Specific provisions 1.03% General provision 0.16%
Service industries and business activities 647 9.3 647 9.7 516 8.8
Finance — — 2 Service industries and business activities 5 2 1
Total risk elements in lending 6,337 5,937 5,470 Potential problem loans (4)
Closing provisions for impairment as a % of total risk elements in lending 62% 65% 76%
Interest on non-accrual and restructured loans included in net interest income
Held-for-trading 104,249 66,712 Designated as at fair value through profit or loss 3,922 3,683 Amortised cost 408,194 382,879
Other short term borrowings Outstanding at year end 122,576 105,483 95,381 Maximum outstanding at any month end during the year 130,867 117,913 96,356 Approximate average amount during the year 112,008 100,681 85,496 Approximate weighted average interest rate during the year 4.5% 3.4% 2.9% Approximate weighted average interest rate at year end 4.5% 3.5% 3.1%
Average interest rates during the year are computed by dividing total interest expense by the average amount borrowed. Average interest rates at year end are average rates for a single day and as such may reflect one-day market distortions which may not be indicative of generally prevailing rates. Original maturities of commercial paper are not in excess of one year. ‘Other short-term borrowings’ consist principally of borrowings in the money markets included within ‘Deposits by banks’ and ‘Customer accounts’ in the accounts, and generally have original maturities of one year or less.
Net income available for ordinary shareholders 10,655 5,440 4,475 3,909 2,564 3,108
Basic earnings per ordinary share – pence 170.8 140.6 126.7 87.5 107.9 Diluted earnings per ordinary share – pence (2) 169.7 140.0 125.9 86.8 106.3 Dividends per ordinary share – pence 77.3 60.6 52.5 45.6 39.7
2004 2003 2002 Summary consolidated balance sheet – UK GAAP £m £m £m
– including interest on deposits 1.84 1.95 1.74 – excluding interest on deposits 7.09 7.08 5.20
(4) Adjusted return on average equity shareholders’ funds represents profit attributable to ordinary shareholders before integration costs, goodwill amortisation and the AVS dividend, in 2003 and 2002 expressed as a percentage of average equity shareholders’ funds.
Rest of the World 35,004 21,535 17,305 Total overseas offices 109,049 61,908 58,313 Loans and advances to customers – gross 349,691 256,453 227,244 Provisions for bad and doubtful debts (4,222) (3,922) (3,920) Loans and advances to customers – net 345,469 252,531 223,324
Provisions for bad and doubtful debts The following table shows the elements of provisions for bad and doubtful debts under UK GAAP.
Customer charge against profit as a % of gross loans and advances to customers Domestic 0.50% 0.56% 0.56%
Notes: (1) Includes closing provisions against loans and advances to banks of £6 million in 2004 (2003 – £7 million; 2002 – £7 million).
The following table shows additional information with respect to the provisions for bad and doubtful debts under UK GAAP.
Provisions at end of year: Specific provisions – customers 3,648 3,356 3,323 Specific provisions – banks 6 7 7
As a % of average loans and advances to customers during the year: Total customer provisions charged to profit and loss 0.48% 0.59% 0.61%
Finance leases and instalment credit 122 3.7 136 4.6 208 5.2
Note: (1) Includes amounts written-off in respect of loans and advances to banks of £1 million in 2002.
Loans accounted for on a non-accrual basis (3): Accruing loans which are contractually overdue 90 days or more as to principal or interest (4): Loans not included above which are classified as ‘troubled debt restructurings’ by the SEC: Total risk elements in lending 5,529 5,157 4,871 Potential problem loans (5)
(5) Loans that are current as to the payment of principal and interest but in respect of which management has serious doubts about the ability of the borrower to comply with contractual repayment terms. Substantial security is held in respect of these loans and appropriate provisions have already been made in accordance with the Group’s provisioning policy for bad and doubtful debts.
Exchange rates Except as stated, the following tables show, for the dates or periods indicated, the Noon Buying Rate in New York for cable transfers in sterling as certified for customs’ purposes by the Federal Reserve Bank of New York (the “Noon Buying Rate”): January December November October September August
Noon Buying Rate Period end rate 1.9586 1.7188 1.9160 1.7842 1.6095 Average rate for the period (1) 1.8582 1.8147 1.8356 1.6450 1.5043
US securitisations – RBS Greenwich Capital securitises commercial and residential mortgage loans, commercial and residential mortgage related securities, US Government agency collateralised mortgage obligations, and other types of financial assets. It also acts as an underwriter and depositor in securitisation transactions involving both client and proprietary transactions. The majority of proprietary securitisations undertaken by RBS Greenwich Capital result in sales treatment under IFRS and US GAAP. Certain transactions may not result in derecognition of the assets under IFRS or US GAAP: under US GAAP, transactions involving vehicles that are not qualifying special purpose entities and where the Group is the primary beneficiary; under IFRS, those where the Group has retained substantially all the risks and rewards of the assets.
Commercial paper conduits – the Group has established a number of SPEs that act as multi-seller commercial paper conduits. These allow customers to access liquidity in the commercial paper market by selling assets to the conduit which it finances by issuing commercial paper to third parties. The Group supplies certain services and contingent liquidity support to these vehicles on an arm’s length basis as well as programme credit enhancement. These vehicles with total assets of £8,360 million at 31 December 2006 are consolidated under IFRS and US GAAP.
Less than less than less than Over 1 year 3 years 5 years 5 years Total 2006 £m £m £m £m £m
Undrawn formal standby facilities, credit lines and other commitments to lend 132,126 15,077 33,466 22,352 203,021
Unconditional obligations to purchase goods or services 827 969 101 153 2,050
Unconditional obligations to purchase goods or services 659 458 148 20 1,285
Even after 17 interest rate rises over the past two-and-a-half years, to 5.25%, monetary conditions remain fairly supportive in the US. A weak dollar and low long-term interest rates have partially offset the effect of a higher fed funds rate on economic activity – though 5.25% is not high by historic standards. The US economy grew by a respectable 3.4% in 2006, though sluggish growth towards the end of the year – largely attributed to a sharp slowdown in the housing and auto sectors – led markets to price in rate cuts in 2007. This helped to exacerbate the yield curve inversion that prevailed for most of 2006.
Under the FSMA 2000, businesses require the FSA's permission to undertake specified types of activities including entering into and carrying out contracts of insurance; managing, dealing in or advising on, investments; mortgage business; accepting deposits; and issuing electronic money (‘regulated activities’). The FSA has published detailed regulatory requirements contained in a Handbook of Rules and Guidance.
General insurance business is principally undertaken by companies in the RBS Insurance division, whilst life assurance business is undertaken by Royal Scottish Assurance plc and National Westminster Life Assurance Limited (with the Group’s partner, the AVIVA Group) and Direct Line Life Insurance Company Limited. Investment management business is principally undertaken by companies in the Retail Markets division, including Adam & Company Investment Management Limited and Coutts & Co Investment Management Limited, and in the Corporate Markets division, RBS Asset Management Limited.
A d d it io n al i n fo rm at io n 1.3 The FSA’s regulatory approach and supervisory standards The regulatory regime uses the full range of regulatory tools (including the authorisation of firms, rule-making, supervision, investigation and enforcement) available to the FSA. It is founded on a risk based, integrated approach to regulation.
The FSA can request information from and give directions to, authorised firms. It may also require authorised firms to provide independent reports prepared by experts. The FSA can exercise indirect control over the holding companies of authorised firms via its statutory powers to object to persons who are, or will become, ‘controllers’ of these firms.
As part of its regulatory approach the FSA carries out regular risk assessments of the Group which is also subject generally to direct and on-going FSA supervision.
The FSA carries out the prudential supervision and conduct of business regulation of all authorised firms and also regulates the conduct of their business in the UK. Currently, the application of its conduct of business rules to banking business is limited, but detailed conduct of business requirements apply to general insurance intermediary activities, mortgage business and investment business activities.
Prudential supervision includes monitoring the adequacy of a firm's management, its financial resources and internal systems and controls. Firms are required to submit regular returns to the FSA which provide material for supervisory assessment. Following the official adoption in the UK of the EU Capital Requirements Directive, new prudential sourcebooks were issued to take effect from 1 January 2007.
A d d it io n al i n fo rm at io n 1.5 Fraud During 2006, the FSA reviewed and reported on several fraud related topics across the financial services industry. These have been designed to raise awareness and understanding of their expectations in managing fraud risks at a general level such as ‘Firm’s High Level Management of Fraud Risk,’ and have also been issued to cover recommendations on specific topics such as ‘Online Fraud’, ‘Mortgage Fraud’ and ‘Commercial Property Fraud’.
The Group conducts business in several European countries. Notable European operations include business in the Republic of Ireland through the Ulster Bank Group (regulated by the Irish Financial Regulator); and Retail and Insurance business through the Retail Markets and RBS Insurance divisions in Germany, Italy, Spain and the Netherlands (regulated by those countries’ respective regulatory authorities). In all of these operations the Group recognises the importance of meeting the respective regulatory requirements.
Bank holding companies (including bank holding companies that are also financial holding companies, such as the company) are required to obtain the prior approval of the Federal Reserve Board before acquiring, directly or indirectly, the ownership or control of more than 5% of any class of the voting shares of any US bank or bank holding company.
The company’s US bank and non-bank subsidiaries and The Royal Bank of Scotland’s US offices, are subject to direct supervision and regulation by various other federal and state authorities. Citizens’ state-chartered bank subsidiaries are subject to regulation and supervision by state banking authorities and the US Federal Deposit Insurance Corporation, and The Royal Bank of Scotland’s New York branch is supervised by the New York State Banking Department. The company’s US insurance agencies are regulated by state insurance authorities. The company’s US securities affiliates, including Greenwich Capital Markets, Inc., are subject to regulation and supervision by the US Securities and Exchange Commission and various self-regulating organisations. The futures activities of Greenwich Capital Markets, Inc. are also subject to oversight by the US Commodity Futures Trading Commission and the Chicago Board of Trade. Charter One Bank, N.A., Citizens Bank, N.A., and RBS National Bank are regulated and supervised primarily by the US Office of the Comptroller of the Currency.
On 26 October 2001, the President of the United States signed into law the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “Patriot Act”). The Patriot Act was renewed on 2 March 2006 and signed into law by the President of the United States on 9 March 2006. The Patriot Act significantly expanded the responsibilities of financial institutions in preventing the use of the US financial system to fund terrorist activities. Title III of the Patriot Act (officially, the “International Money Laundering Abatement and Anti-Terrorist Financing Act of 2001”) is the anti-money laundering portion of the Patriot Act. Title III provided for a sweeping overhaul of the US anti-money laundering regime. Among other provisions, it requires financial institutions operating in the United States to (i) give special attention to correspondent and payablethrough bank accounts, (ii) implement enhanced reporting, due diligence and “know your customer” standards for private banking and correspondent banking relationships, (iii) scrutinise the beneficial ownership and activity of certain non-US and private banking customers and (iv) develop new anti-money laundering programmes, due diligence policies and controls to ensure the detection and reporting of money laundering. The Patriot Act requires all US financial institutions to develop anti-money laundering programmes. Such required compliance programmes are intended to supplement any existing compliance programmes for purposes of requirements under the Bank Secrecy Act and the Office of Foreign Assets Control Regulations.
5 Regulatory developments for capital and risk management The Basel Committee on Banking Supervision issued new requirements for firms’ risk weighted asset (“RWA”) calculations in June 2004. These rules are generally referred to as Basel 2.
In the EU, this new framework became law through the Capital Requirements Directive and associated changes to national laws or regulatory guidelines (e.g. the FSA’s GENPRU and BIPRU). Within the US, regulators have the flexibility to implement Basel 2 directly, after their final Notice of Proposed Rulemaking. Full adoption of these rules comes into force across the EU on 1 January 2008 and the US from 1 January 2009.
Application of Basel 2 differs between jurisdictions. The EU is applying Basel 2 to all banks and investment firms. The US is taking a different approach, mandating that the largest internationally active US banks use the ‘Advanced’ approaches for credit and operational risk calculations; other US banks will remain on the pre-existing standards or a modified version thereof (Basel 1 or Basel 1a) or decide to ‘opt-into’ Basel 2. Our US subsidiary, Citizens Financial Group, is an ‘opt-in’ firm for these purposes.
The implications of the new rules are becoming clearer. Assuming average risk profiles, banks will require less capital to support lending to residential mortgages and other retail and small and medium enterprises. Good quality corporate lending should also see a reduction in capital requirements. Conversely banks, on average, will be required to hold more regulatory capital for some specialised lending and equity exposures, sovereigns and poorer quality bank and corporate credits, although the actual capital requirements under Basel 2 depend on a number of factors, including collateral.
Basel 2 introduces, for the first time, an explicit requirement to hold capital for operational risk. Of the available options, the Group is adopting ‘The Standardised Approach’ initially, with the objective of migrating to the more sophisticated ‘Advanced Measurement Approach’, in line with the US implementation. In addition, Basel 2 also introduces two new elements – a formal supervisory review process (Pillar 2) and more extensive market disclosures (Pillar 3). The Group is making good progress in both areas, in advance of formal implementation in 2008.
Description of property and equipment The Group operates from a number of locations worldwide, principally in the UK. At 31 December 2006, the Royal Bank and NatWest had 647 and 1,629 retail branches, respectively, in the UK. Ulster Bank and First Active had a network of 272 branches in Northern Ireland and the Republic of Ireland. Citizens had 1,608 retail banking offices (including in-store branches) covering Connecticut, Delaware, Illinois, Indiana, Massachusetts, Michigan, New Hampshire, New Jersey, New York, Ohio, Pennsylvania, Rhode Island and Vermont. A substantial majority of the UK branches are owned by the Royal Bank, NatWest and their subsidiaries or are held under leases with unexpired terms of over 50 years. The Group’s principal properties include its headquarters at Gogarburn, Edinburgh, its principal offices in London at 135 and 280 Bishopsgate and the Drummond House administration centre located at South Gyle, Edinburgh.
With the exception of Banco Santander Central Hispano S.A. which sold (i) 79 million shares representing 2.5% of the company’s ordinary share capital on 9 September 2004 and (ii) 82 million shares representing 2.5% of the company’s ordinary share capital on 27 January 2005, there have been no significant changes in the percentage ownership of major shareholders of the company’s ordinary and preference shares during the three years ended 28 February 2007. All shareholders within a class of the company’s shares have the same voting rights. The company is not directly or indirectly owned or controlled by another corporation or any foreign government.
At 28 February 2007, the directors of the company had options to purchase a total of 2,286,733 ordinary shares of the company.
Record dates: Ordinary shares (2006 Final) 9 March 2007 Cumulative preference shares 4 May 2007
ShareGift The company is aware that shareholders who hold a small number of shares may be retaining these shares because dealing costs make it uneconomical to dispose of them. ShareGift, the charity share donation scheme is a free service operated by The Orr Mackintosh Foundation (registered charity 1052686) to enable shareholders to donate shares to charity.
Trading market On 16 October 1996, 26 March 1997, 12 February 1998, 8 February 1999, 12 June 2001, 30 September 2004, 26 August 2004, 19 May 2005, 9 November 2005, 25 May 2006 and 27 December 2006 the company issued the following American Depositary Shares (“ADSs”) in the United States, which were outstanding at 31 December 2006: 8,000,000 Series E (“Series E ADSs”) representing 8,000,000 non-cumulative dollar preference shares, Series E; 8,000,000 Series F (“Series F ADSs”) representing 8,000,000 non-cumulative dollar preference shares, Series F; 10,000,000 Series G (“Series G ADSs”) representing 10,000,000 non-cumulative dollar preference shares, Series G; 12,000,000 Series H (“Series H ADSs”) representing 12,000,000 non-cumulative dollar preference shares, Series H; 16,000,000 Series K (“Series K ADSs”) representing 16,000,000 non-cumulative dollar preference shares, Series K; 34,000,000 Series L (“Series L ADSs”) representing 34,000,000 non-cumulative dollar preference shares, Series L; 37,000,000 Series M (“Series M ADSs”) representing 37,000,000 non-cumulative dollar preference shares, Series M; 40,000,000 Series N (“Series N ADSs”) representing 40,000,000 non-cumulative dollar preference shares, Series N; 22,000,000 Series P (“Series P ADSs”) representing 22,000,000 non-cumulative dollar preference shares, Series P; 27,000,000 Series Q (“Series Q ADSs”) representing 27,000,000 non-cumulative dollar preference shares, Series Q; and 26,000,000 Series R (“Series R ADSs”) representing 26,000,000 non-cumulative dollar preference shares, Series R.
Each of the respective ADSs represents the right to receive one corresponding preference share, and is evidenced by an American Depositary Receipt (“ADR”) and is listed on the New York Stock Exchange (“NYSE”).
At 31 December 2006, there were 99 registered shareholders of Series E ADSs, 112 registered shareholders of Series F ADSs, 74 registered shareholders of Series G ADSs, 73 registered shareholders of Series H ADSs, 55 registered shareholders of Series K ADSs, 26 registered shareholders of Series L ADSs, 1 registered shareholder of Series M ADSs, 49 registered shareholders of Series N ADSs, 54 registered shareholders of Series P ADSs, 20 registered shareholders of Series Q ADSs and 1 registered shareholder of Series R ADSs.
On 20 August 2001, the company issued US$1.2 billion of perpetual regulatory tier one securities (‘PROs’) in connection with a public offering in the United States.
The following table shows the high and low sales prices for each of the outstanding ADSs and PROs for the periods indicated, as reported on the NYSE composite tape: Series E (1) Series F Series G (1) Series H Series K (1) Series L Series M Series N Series P Series Q Series R Figures in US$ ADSs (1) ADSs ADSs (1) ADSs ADSs (1) ADSs ADSs ADSs ADSs ADSs ADSs PROs (2)
Non-cumulative preference shares of US$0.01 – Series B (redeemed January 2003) — — — — 0.13 1.65 – Series C (redeemed January 2003) — — — — 0.11 1.40
– Series Q (issued May 2006) 1.01 0.53 — — — — – Series R (issued December 2006) — — — — — —
Additional Value Shares of £0.01 — — — — 0.55 0.30
UK stamp duty and stamp duty reserve tax (“SDRT”) The following is a summary of the UK stamp duty and SDRT consequences of transferring an ADS or ADR in registered form (otherwise than to the custodian on cancellation of the ADS) or of transferring a non-cumulative dollar preference share. A transfer of a registered ADS or ADR executed and retained in the United States will not give rise to stamp duty and an agreement to transfer a registered ADS or ADR will not give rise to SDRT. Stamp duty or SDRT will normally be payable on or in respect of transfers of non-cumulative dollar preference shares and accordingly any holder who acquires or intends to acquire non-cumulative dollar preference shares is advised to consult its own tax advisers in relation to stamp duty and SDRT.
Subject to applicable limitations that may vary depending upon a holder’s individual circumstances, dividends paid to certain non-corporate US Holders in taxable years beginning before 1 January 2011 will be taxable at a maximum tax rate of 15%. Non-corporate US Holders should consult their own tax advisers to determine whether they are subject to any special rules that limit their ability to be taxed at this favourable rate.
A US Holder will, upon the sale, exchange or redemption of a PRO, generally recognise capital gain or loss for US federal income tax purposes (assuming that in the case of a redemption, such US Holder does not own, and is not deemed to own, any ordinary shares of the company) in an amount equal to the difference between the amount realised (excluding any amount in respect of mandatory interest and any missed payments which are to be satisfied on a missed payment satisfaction date, which would be treated as ordinary income) and the US Holder’s tax basis in the PRO.
United Kingdom Taxation of payments on the PROs Payments on the PROs will constitute interest rather than dividends for UK withholding tax purposes. However, the PROs will constitute ‘quoted eurobonds’ within the meaning of section 349 of the Income and Corporation Taxes Act 1988 and therefore payments of interest will not be subject to withholding or deduction for or on account of UK taxation as long as the PROs remain at all times listed on a ‘recognised stock exchange’ within the meaning of section 841 of the Income and Corporation Taxes Act 1988. In all other cases, an amount must be withheld on account of UK income tax at the lower rate (currently 20%) subject to any direction to the contrary by HM Revenue & Customs under the Treaty and except that the withholding obligation is disapplied in respect of payments to persons who the company reasonably believes are within the charge to corporation tax or fall within various categories enjoying a special tax status (including charities and pension funds), or are partnerships consisting of such persons (unless HM Revenue & Customs directs otherwise). Where interest has been paid under deduction of UK withholding tax, US Holders may be able to recover the tax deducted under the Treaty.
EU Directive on taxation of savings income The European Union has adopted a directive regarding the taxation of savings income. The Directive requires member states of the European Union to provide to the tax authorities of other member states details of payments of interest and other similar income paid by a person to an individual resident in another member state, except that Belgium, Luxembourg and Austria are instead imposing a withholding system for a transitional period unless during such period they elect otherwise.
Disposal (including redemption) A disposal (including redemption) of PROs by a non-corporate US Holder will not give rise to any liability to UK taxation on capital gains unless the US Holder carries on a trade (which for this purpose includes a profession or a vocation) in the UK through a branch or agency and the PROs are, or have been, held or acquired for the purposes of that trade, branch or agency.
PROs beneficially owned by an individual, whose domicile is determined to be the United States for the purposes of the Estate Tax Treaty and who is not a national of the UK, will not be subject to UK inheritance tax on the individual’s death or on a lifetime transfer of the PRO, except in certain cases where the PRO (i) is comprised in a settlement (unless, at the time of the settlement, the settlor was domiciled in the United States and was not a national of the UK); (ii) is part of the business property of a UK permanent establishment of an enterprise; or (iii) pertains to a UK fixed base of an individual used for the performance of independent personal services. The Estate Tax Treaty generally provides a credit against US federal estate or gift tax liability for the amount of any tax paid in the UK in a case where the PRO is subject to both UK inheritance tax and US federal estate or gift tax.
S h ar eh o ld er i n fo rm at io n
Group Secretariat The Royal Bank of Scotland Group plc PO Box 1000 Business House F Gogarburn Edinburgh EH12 1HQ
The Royal Bank of Scotland plc PO Box 1000 Gogarburn Edinburgh EH12 1HQ 280 Bishopsgate London EC2M 4RB