Personal 129,431 19,256 30,664 1,351 39 926 181,667 177,880 3,787 Banks 5,023 36,573 6,421 8,837 1,435 2,711 61,000 60,609 391 Other financial institutions 20,997 13,398 10,189 2,924 4,660 789 52,957 47,425 5,532 Sovereign (2) 38,870 26,002 14,265 2,887 64 1,195 83,283 81,636 1,647 Property 54,831 23,220 7,051 1,149 2,979 1,280 90,510 56,566 33,944 Natural resources 6,103 5,911 6,758 4,129 690 1,500 25,091 21,877 3,214 Manufacturing 9,656 5,587 6,246 2,369 572 1,213 25,643 24,315 1,328 Transport (3) 12,298 5,394 4,722 5,065 2,278 4,798 34,555 26,973 7,582 Retail and leisure 17,229 5,200 4,998 1,103 270 658 29,458 26,203 3,255 Telecoms, media and technology 4,787 3,572 3,188 1,739 127 346 13,759 10,815 2,944 Business services 17,089 3,183 5,999 581 780 154 27,786 26,190 1,596 316,314 147,296 100,501 32,134 13,894 15,570 625,709 560,489 65,220
Personal 124,594 21,973 34,970 1,864 126 1,531 185,058 174,287 10,771 Banks 6,819 35,619 5,097 11,072 1,394 6,713 66,714 65,494 1,220 Other financial institutions 17,550 14,782 14,773 4,200 8,732 1,762 61,799 47,227 14,572 Sovereign (2) 20,209 24,826 18,088 3,243 125 1,789 68,280 66,556 1,724 Property 65,622 30,925 9,573 1,980 3,090 1,750 112,940 60,590 52,350 Natural resources 6,696 7,863 9,771 3,655 1,396 4,143 33,524 24,427 9,097 Manufacturing 10,599 8,532 6,744 2,673 917 2,059 31,524 28,088 3,436 Transport (3) 13,842 8,726 5,389 6,161 2,658 6,347 43,123 27,899 15,224 Retail and leisure 24,716 6,690 5,316 1,438 1,174 918 40,252 34,100 6,152 Telecoms, media and technology 5,495 5,764 3,283 2,187 328 786 17,843 12,076 5,767 Business services 19,757 5,116 6,521 985 1,086 385 33,850 28,780 5,070 315,899 170,816 119,525 39,458 21,026 28,183 694,907 569,524 125,383
Notes: (1) Includes Central and Eastern Europe, the Middle East, Central Asia and Africa, and supranationals such as the World Bank. (2) Includes central bank exposures. (3) Excludes net investment in operating leases in shipping and aviation portfolios as they are accounted for as property, plant and equipment. However, operating leases are included in the monitoring and management of these portfolios. (4) Enhancements to Wealth credit systems in the second quarter of 2012 resulted in refinements to sector classifications. The most significant impact has been a reallocation of £2.6 billion from the retail and leisure sector across a number of other sectors. Prior year data has not been revised.
Key points Financial markets and the Group’s focus on risk appetite and sector concentration had a direct impact on the portfolio during the year with the following key trends observed: Total credit risk assets fell 7%, with reductions in all wholesale sectors. Exposure to the personal sector remained broadly flat.
Credit risk assets fell in all geographic regions, except the UK. This was driven by the Group’s continued focus on reducing exposures to the peripheral eurozone countries and appropriate management of liquidity requirements reflected in the reduced exposures to Western European and US central banks.
UK exposure, as a proportion of the total portfolio, increased during the year and now comprises 51% of credit risk assets, driven by continued growth in UK personal sector assets and increased UK sovereign risk exposure.
Exposure to other financial institutions comprising traded and nontraded products is spread across a range of financial companies including insurance, securitisation vehicles, financial intermediaries including broker dealers and CCPs, financial guarantors - monolines and CDPCs - and funds comprising unleveraged, hedge and leveraged funds. The size and asset quality of the Core portfolio have not changed materially since 2011. However, entities in this sector remain vulnerable to market shocks or contagion from the banking sector. Credit risk is managed through the single name concentration, sector concentration and asset and product class frameworks, with specific sector and product caps in place where there is a perception of heightened credit risk. The Group is also actively managing down its exposures to monolines and CDPCs with a view to exiting these portfolios. Exposures to CDPCs and monolines have decreased materially during 2012 as trades are commuted and exposures reduce due to tightening credit spread of the assets protected by CDPCs and monolines.
Credit risk assets*: Sector and geographical regional analysis continued The Group’s transport sector portfolio includes £10.6 billion of assetbacked exposure to ocean-going vessels. Conditions remained poor across the major shipping market segments in 2012, with low charter rates and vessel values. A key protection for the Group is the minimum security covenant. This covenant is tested each quarter on an individual vessel basis to ensure prompt remedial action is taken if values fall significantly below agreed loan coverage ratios. There was an increase in the number of clients suffering liquidity issues or failing to meet their minimum security covenant and a commensurate rise in referrals to the Watchlist and the Global Restructuring Group (GRG). At 31 December 2012, 20% of the Group’s exposure to this sector was in Watchlist Red and the amount of loans in default were £687 million. The impairment charge for the year was c.£0.1 billion and the provision balance as at 31 December 2012 stood at c.£0.2 billion. The Group’s exposure to the shipping sector (including shipping related infrastructure) declined by 3.5% in 2012 as a result of amortisation and foreign exchange movements.
Exposure to healthcare of £10.0 billion at year end is included in the business services sector. It is heavily biased towards the UK health sector which represents 68% of the exposure. There was no significant change in the asset quality or size of this portfolio in 2012. Challenging market conditions persist in the nursing home subsector and as a result the Group has tightened its risk appetite and further strengthened its transactional controls and policies during the year.
Exposures are allocated to asset quality bands on the basis of statistically driven models which produce an estimate of default rate. The variables included in the models vary by product and geography. For portfolios secured on residential property these models typically include measures of delinquency and loan to value as well as other differentiating characteristics such as bureau score, product features or associated account performance information.
Note: (1) Largely comprises certain of the Group’s portfolios covered by the standardised approach, for which a probability of default equivalent to those assigned to assets covered by the internal ratings based approach is not available.
UK Retail 4,998 4.4 5,097 4.6 5,017 4.6 UK Corporate 6,310 6.2 5,484 5.2 5,198 4.8 International Banking 612 0.9 1,736 2.4 2,227 2.8 Ulster Bank 8,236 24.1 6,305 16.7 4,348 10.7 US Retail & Commercial 633 1.2 646 1.1 599 1.2 Retail & Commercial 20,789 5.3 19,268 4.8 17,389 4.3 Markets 773 0.7 749 0.7 605 0.5 Core 21,562 3.8 20,017 3.4 17,994 3.2 Non-Core 22,845 35.0 25,020 27.0 25,005 19.9 44,407 7.1 45,037 6.7 42,999 6.2
The increase in AQ4 is partly driven by the change to the bank and sovereign PD models noted above, and partly due to the improvement in the UK Retail mortgage asset quality band distribution. This followed updates to the Group’s models which were delayed whilst long term recalibrations were made to the capital rating system. These PD recalibrations reflect improvements in the underlying credit quality of the UK mortgage portfolio.
In UK Retail non-performing assets (AQ10) reduced slightly during the year predominantly as a result of lower flows of unsecured assets into non-performing. Recovery activity on non-performing assets is pursued over a number of years during which time the assets remain on balance sheet along with the appropriate impairment provision.
Credit risk mitigation Approaches and methodologies* The Group employs a number of structures and techniques to mitigate credit risk. Netting of debtor and creditor balances is undertaken in accordance with relevant regulatory and internal policies. Exposure on OTC derivative and secured financing transactions is further mitigated by the exchange of financial collateral and the use of market standard documentation. Further mitigation may occur in a range of transactions, from retail mortgage lending to large wholesale financing. This can include: structuring a security interest in a physical or financial asset; use of credit derivatives, including credit default swaps, credit-linked debt instruments and securitisation structures; and use of guarantees and similar instruments (for example, credit insurance) from related and third parties. Such techniques are used in the management of credit portfolios, typically to mitigate credit concentrations in relation to an individual obligor, a borrower group or a collection of related borrowers.
The use and approach to credit risk mitigation varies by product type, customer and business strategy. Minimum standards applied across the Group cover: The suitability of qualifying credit risk mitigation types and any conditions or restrictions applicable to those mitigants; The means by which legal certainty is to be established, including required documentation, supportive independent legal opinions and all necessary steps required to establish legal rights; Acceptable methodologies for initial and any subsequent valuations of collateral and the frequency with which collateral is to be revalued and the use of collateral haircuts; Actions to be taken in the event that the value of mitigation falls below required levels; Management of the risk of correlation between changes in the credit risk of the customer and the value of credit risk mitigation; Management of concentration risks, for example, by setting thresholds and controls on the acceptability of credit risk mitigants and on lines of business that are characterised by a specific collateral type or structure; and
Secured portfolios Within its secured portfolios, the Group has recourse to various types of collateral and other credit enhancements to mitigate credit risk and reduce the loss to the Group arising from the failure of a customer to meet its obligations. These include: cash deposits; charges over residential and commercial property, debt securities and equity shares; and third-party guarantees. The existence of collateral may affect the pricing of a facility and its regulatory capital requirement. When a collateralised financial asset becomes impaired, the impairment charge directly reflects the realisable value of collateral and any other credit enhancements.
Physical assets - These include business assets such as stock, plant and machinery, vehicles, ships and aircraft. In general, physical assets qualify as collateral only if they can be unambiguously identified, located or traced, and segregated from uncharged assets. Assets are valued on a number of bases according to the type of security that is granted.
Receivables - When taking a charge over receivables, the Group assesses their nature and quality and the borrower’s management and collection processes. The value of the receivables offered as collateral will typically be adjusted to exclude receivables that are past their due dates.
The security charges may be floating or fixed, with the type of security likely to impact: (i) the credit decision; and (ii) the potential loss upon default. In the case of a general charge such as a mortgage debenture, balance sheet information may be used as a proxy for market value if the information is deemed reliable.
Commercial real estate The table below analyses commercial real estate (Core and Non-Core) lending by loan-to-value (LTV) which represents loan value before provisions. Due to market conditions in Ireland and to a lesser extent in the UK, there is a shortage of market-based data. In the absence of external valuations, the Group deploys a range of alternative approaches to assess property values, including internal expert judgement and indexation.
Loan-to-value Performing £m Non-performing £m Total £m Performing £m Non-performing £m Total £m Performing £m Non-performing £m Total
<= 50% 183 24 207 7,210 281 7,491 7,393 305 7,698 > 50% and <= 70% 326 102 428 12,161 996 13,157 12,487 1,098 13,585 > 70% and <= 90% 462 250 712 6,438 1,042 7,480 6,900 1,292 8,192 > 90% and <= 100% 466 141 607 1,542 2,145 3,687 2,008 2,286 4,294 > 100% and <= 110% 103 596 699 1,019 1,449 2,468 1,122 2,045 3,167 > 110% and <= 130% 326 630 956 901 1,069 1,970 1,227 1,699 2,926 > 130% and <= 150% 274 878 1,152 322 913 1,235 596 1,791 2,387 > 150% 963 7,290 8,253 595 1,962 2,557 1,558 9,252 10,810 Total with LTVs 3,103 9,911 13,014 30,188 9,857 40,045 33,291 19,768 53,059 Minimal security (1) 7 1,461 1,468 3 13 16 10 1,474 1,484 Other (2) 97 715 812 6,494 1,191 7,685 6,591 1,906 8,497 Total 3,207 12,087 15,294 36,685 11,061 47,746 39,892 23,148 63,040
<= 50% 272 32 304 7,091 332 7,423 7,363 364 7,727 > 50% and <= 70% 479 127 606 14,105 984 15,089 14,584 1,111 15,695 > 70% and <= 90% 808 332 1,140 10,042 1,191 11,233 10,850 1,523 12,373 > 90% and <= 100% 438 201 639 2,616 1,679 4,295 3,054 1,880 4,934 > 100% and <= 110% 474 390 864 1,524 1,928 3,452 1,998 2,318 4,316 > 110% and <= 130% 527 1,101 1,628 698 1,039 1,737 1,225 2,140 3,365 > 130% and <= 150% 506 1,066 1,572 239 912 1,151 745 1,978 2,723 > 150% 912 7,472 8,384 433 2,082 2,515 1,345 9,554 10,899 Total with LTVs 4,416 10,721 15,137 36,748 10,147 46,895 41,164 20,868 62,032 Minimal security (1) 72 1,086 1,158 — — — 72 1,086 1,158 Other (2) 193 625 818 8,994 1,844 10,838 9,187 2,469 11,656 Total 4,681 12,432 17,113 45,742 11,991 57,733 50,423 24,423 74,846
Credit risk mitigation continued Wholesale market exposures As set out in the table below, the Group receives collateral for reverse repurchase transactions and for derivatives, typically in the form of cash, quoted debt securities or equities. The risks inherent in both types of transaction are further mitigated through master bilateral netting arrangements. Industry standard documentation such as master repurchase agreements and credit support annexes accompanied by legal opinion, is used for financial collateral taken as part of trading activities.
Note: (1) In accordance with normal market practice, at 31 December 2012 £100.7 billion (2011 - £95.4 billion; 2010 - £93.5 billion) had been resold or re-pledged as collateral for the Group’s own transactions.
Residential mortgages The table below shows LTVs for the Group’s residential mortgage portfolio split between performing (AQ1-AQ9) and non-performing (AQ10), with the average calculated on a weighted value basis. Loan balances are as at the end of the year whereas property values are calculated using the appropriate index.
£m Non-performing £m Total £m Performing £m Non-performing £m Total £m Performing £m Non-performing £m Total £m
Early problem identification and problem debt management While the principles of identifying, managing and providing for problem debts are broadly similar for wholesale and retail customers, the procedures differ based on the nature of the assets, as discussed below.
Customers identified through either the EWIs or annual review are assessed by portfolio management and/or credit officers within the division to determine whether or not the customer’s circumstances warrant placing the exposure on the Watchlist (detailed below).
Once on the Watchlist process, customers come under heightened scrutiny. The relationship strategy is reassessed by a forum of experienced credit, portfolio management and remedial management professionals within the division. In accordance with Group-wide policies, a number of mandatory actions are taken, including a review of the customer’s credit grade and facility security documentation. Other appropriate corrective action is taken when circumstances emerge that may affect the customer’s ability to service its debt. Such circumstances include deteriorating trading performance, an imminent breach of covenant, challenging macroeconomic conditions, a late payment or the expectation of a missed payment.
At 31 December 2012, exposures to customers reported as Watchlist Red and managed within the divisions totalled £4.3 billion (2011 - £4.9 billion).
Strategies that are available within divisions include granting a customer various types of concessions. Any decision to approve a concession will be a function of the division’s specific country and sector appetite, the key credit metrics of the customer, the market environment and the loan structure/security. Refer to the section below on Wholesale renegotiations.
Other potential outcomes of the review of the relationship are to: take the customer off the Watchlist and return them to the mainstream loan book; offer further lending and maintain ongoing reviews; transfer the relationship to GRG for those customers requiring such stewardship; or exit the relationship altogether.
The following table shows a sector breakdown of credit risk assets of Watchlist Red counterparties under GRG management: Watchlist Red credit risk assets under GRG management Core £m Non-Core £m Total £m Core £m Non-Core £m Total £m
Wholesale renegotiations involve the following types of concessions: Variation in margin - The contractual margin may be amended to bolster the customer’s day-to-day liquidity, with the aim of helping to sustain the customer’s business as a going concern. This would normally be seen as a short-term solution and is typically accompanied by the Group receiving an exit payment, a payment in kind or a deferred fee.
Payment concessions and loan rescheduling - payment concessions or changes to the contracted amortisation profile including extensions in contracted maturity may be granted to improve the customer’s liquidity. Such concessions often depend on the expectation that the customer’s liquidity will recover when market conditions improve or will benefit from access to alternative sources of liquidity, such as an issue of equity capital. These types of concessions are common in commercial real estate transactions, particularly where a shortage of market liquidity rules out immediate refinancing and makes short-term forced collateral sales unattractive.
Forgiveness of all or part of the outstanding debt - debt may be forgiven or exchanged for equity in cases where a fundamental shift in the customer’s business or economic environment means that the customer is incapable of servicing current debt obligations and other forms of renegotiations are unlikely to succeed in isolation. Debt forgiveness is often an element in leveraged finance transactions, which are typically structured on the basis of projected cash flows from operational activities, rather than underlying tangible asset values. Provided that the underlying business model and strategy are considered viable, maintaining the business as a going concern with a sustainable level of debt is the preferred option, rather than realising the value of the underlying assets.
The impact on the credit quality of any change in terms and conditions of a loan is assessed at the time of granting such changes, and the appropriateness of the credit metrics reviewed at such time. For performing counterparties, credit metrics are an integral part of the latent provision methodology and therefore the impact of covenant concessions will be reflected in the latent provision. For non-performing counterparties, covenant concessions will be considered in the overall provision adequacy for these loans.
Covenant waivers and amendments are predominantly undertaken prior to transfer to GRG. The vast majority of the other types of renegotiations undertaken by the Group take place within GRG. Forgiveness of debt and exchange for equity is only available to customers in GRG.
Note: (1) SME business within Wealth is now reported within Wholesale forbearance.
Renegotiation agreements The table below analyses the incidence of the main types of renegotiation by loan value: Loans by value
Additional provisions charged in 2012 relating to loans renegotiated during 2011 totalled £0.2 billion and provision coverage of those loans at 31 December 2012 was 25%.
Renegotiated loans disclosed in the table above may have been the subject of one or more covenant waivers or modifications. In addition loans totalling £3.5 billion granted financial covenant concessions only during the year are not included in the table above as these concessions do not affect a loan’s contractual cash flows.
Year-on-year analysis of renegotiated loans may be skewed by individual material cases reaching legal completion during a given year. This is particularly relevant when comparing the value of renegotiations completed in the property and transport sectors in 2012 with previous years.
Key points continued In 2012 renegotiations were more prevalent in the Group’s most significant corporate sectors and in those industries experiencing difficult markets, notably property and transport as the Group seeks to support viable customers. The majority of renegotiations granted to borrowers in the property sector were payment concessions and loan rescheduling. During 2012 there has been an increase in the number of renegotiations in the shipping sector as poor economic conditions persist.
84% of ‘completed’ and 93% of ‘in progress’ renegotiated cases were managed by GRG.
Provisions for the non-performing loans disclosed above are individually assessed and renegotiations are taken into account when determining the level of provision. The provision coverage is affected by the timing of write-offs and provisions. In some cases loans are fully or partially written off on the completion of a renegotiation. Non-performing renegotiated loans also include loans against which no provision is held and where these cases are large they can have a significant impact on the provision coverage within a specific sector.
Provisioning for wholesale renegotiated customers Wholesale renegotiations are predominantly individually assessed and are not therefore segregated into a separate risk pool.
The customer’s financial position, anticipated prospects and the likely effect of the renegotiation, including any concessions granted, are considered in order to establish whether an impairment provision is required.
The transfer of renegotiated wholesale loans from impaired to performing status follows assessment by relationship managers in GRG. When no further losses are anticipated and the customer is expected to meet the loan’s revised terms, any provision is written off and the balance of the loan returned to performing status.
Recoveries and active insolvency management The ultimate outcome of a renegotiation strategy is unknown at the time of execution. It is highly dependent on the cooperation of the borrower and the continued existence of a viable business. The following are generally considered to be options of last resort: Enforcement of security or otherwise taking control of assets -
Early problem identification and problem debt management: Wholesale renegotiations continued Retail customers Collections and recoveries There are collections functions in each of the retail businesses. Their role is to provide support and assistance to customers who are experiencing difficulties in meeting their financial obligations to the Group. Evidence of such difficulties includes, for example, a missed payment on their loan, or a balance that is in excess of the agreed credit limit. Additionally, in UK Retail and Ulster Bank, a dedicated support team aims to identify and help customers who may be facing financial difficulty but who are current with their payments.
Within collections, a range of tools is deployed to initiate contact with the customer, establish the cause of their financial difficulty and, aim to support them where possible including the use of a range of forbearance options. If these strategies are unsuccessful, the customer is transferred to the recoveries team.
The goal of the recoveries function is to collect the total amount outstanding and reduce the loss to the Group by maximising the level of cash recovery while treating customers fairly. A range of treatment options are available within recoveries, including litigation. In UK Retail and Ulster Bank, no repossession procedures are initiated until at least six months following the emergence of arrears. In Ulster Bank, new regulations further prohibit taking legal action for an extended period. Additionally, certain forbearance options are made available to customers within recoveries.
Identification of forbearance Customers are identified for forbearance treatment following initial contact from the customer, in the event of payment arrears or when the customer is transferred to collections or recoveries.
For UK Retail, interest only conversions have not been used as a tool to support customers in financial stress since 2009. Following a change to policy in 2012, switching to interest only is no longer permitted for residential mortgage customers who are up to date on payments. For Ulster Bank, interest only conversions are only offered to customers in financial stress on a temporary basis.
Arrears status and provisions Mortgage arrears information for retail accounts in forbearance and related provision are shown in the tables below.
UK Retail (1,2) 4,006 20 388 16 450 64 4,844 100 4.9 Ulster Bank (1,2) 915 100 546 60 527 194 1,988 354 10.4 RBS Citizens (3) — — 179 25 160 10 339 35 1.6 Wealth (4) 38 — — — 7 — 45 — 0.5 4,959 120 1,113 101 1,144 268 7,216 489 4.9
UK Retail (1,2) 3,677 16 351 13 407 59 4,435 88 4.7 Ulster Bank (1,2) 893 78 516 45 421 124 1,830 247 9.1 RBS Citizens (3) — — 91 10 89 10 180 20 0.8 Wealth 121 — — — 2 — 123 — 1.3 4,691 94 958 68 919 193 6,568 355 4.4
Forbearance arrangements The incidence of the main types of retail forbearance as at 31 December 2012 and 31 December 2011 are analysed below. For a small proportion of mortgages, more than one forbearance type applies.
Interest only conversions - temporary and permanent 1,220 924 — 6 2,150 Term extensions - capital repayment and interest only 2,271 183 — 27 2,481 Payment concessions 215 762 339 9 1,325 Capitalisation of arrears 932 119 — — 1,051 Other 452 — — 3 455 5,090 1,988 339 45 7,462
Interest only conversions - temporary and permanent 1,269 795 — 3 2,067 Term extensions - capital repayment and interest only 1,805 58 — 97 1,960 Payment concessions 198 876 180 — 1,254 Capitalisation of arrears 864 101 — — 965 Other 517 — — 23 540 4,653 1,830 180 123 6,786
Early problem identification and problem debt management: Retail customers continued Key points UK Retail The reported numbers for forbearance in UK Retail capture all instances where a change has been made to the contractual payment terms including those where the customer is up-to-date on payments and there is no obvious evidence of financial stress. The reported figures include stock dating back to 1 January 2008.
The most frequently occurring forbearance types were term extensions (47% of assets subject to forbearance at 31 December 2012), interest only conversions (25%) and capitalisations of arrears (19%). The stock of cases subject to interest only conversions reflects legacy policy. In 2009, UK Retail ceased providing this type of forbearance treatment for customers in financial difficulty and no longer permits interest only conversions on residential mortgages where the customer is current on payments.
Ulster Bank The reported numbers for forbearance in Ulster Bank Group capture all instances where a change has been made to the contractual payment terms including those where the customer is up-to-date on payments and there is no obvious evidence of financial stress. The reported figures include stock dating back to early 2009.
Ulster Bank Group continues to assist customers in the difficult economic environment. Mortgage forbearance treatments have been in place since 2009 and are aimed at assisting customers in financial difficulty. At 31 December 2012, 10.4% of total mortgage assets (£1.9 billion) were subject to a forbearance arrangement, an increase from 9.1% (£1.8 billion) at 31 December 2011. The majority of these forbearance arrangements were in the performing book (73%).
The majority of forbearance arrangements offered by Ulster Bank currently are temporary concessions, accounting for 85% of assets subject to forbearance at 31 December 2012. These are offered for periods of one to three years and incorporate different levels of repayment based on the customer’s ability to pay. The additional treatment options developed by Ulster Retail will lead to a shift to more long term arrangements over time.
The majority of retail forbearance takes place in the performing book and, for the purposes of the latent loss provisions, these constitute a separate risk pool. They are subject to higher provisioning rates than the remainder of the performing book. These rates are reviewed regularly in both divisions. Once forbearance is granted, the account continues to be assessed separately for latent provisioning for 24 months (UK Retail only) or until the forbearance period expires. After that point, the account is no longer separately identified for latent provisioning. In the non-performing portfolio, assets are grouped into homogeneous portfolios sharing similar credit characteristics according to the asset type. Further characteristics such as LTVs, arrears status and default vintage are also considered when assessing recoverable amount and calculating the related provision requirement. Whilst nonperforming forbearance retail loans do not form a separate risk pool, the LGD models used to calculate the collective impairment provision will be affected by agreements made under forbearance arrangements.
In RBS Citizens, consumer loans subject to forbearance are segmented from the rest of the non-forborne population and assessed individually for impairment loan throughout their lives until the accounts are repaid or fully written-off. The amount of recorded impairment depends upon whether the loan is collateral dependent. If the loans are considered collateral dependent, the excess of the loan’s carrying amount over the fair value of the collateral is the impairment amount. If the loan is not deemed collateral dependent, the excess of the loans’ carrying amount over the present value of expected future cash flows is the impairment amount. Any confirmed losses are charged off immediately.
Impairment loss provision methodology A financial asset or portfolio of financial assets is impaired and an impairment loss incurred if there is objective evidence that an event or events since initial recognition of the asset has adversely affected the amount or timing of future cash flows from the asset.
This assessment takes into account the benefit of any guarantees or other collateral held. The value and timing of cash flow receipts are based on available estimates in conjunction with facts available at that time. Timings and amounts of cash flows are reviewed on subsequent assessment dates, as new information becomes available. The asset continues to be assessed on an individual basis until it is repaid in full, transferred to the performing portfolio or written-off.
Collectively assessed provisions - Provisions on impaired credits below an agreed threshold are assessed on a portfolio basis to reflect the homogeneous nature of the assets. The Group segments impaired credits in its collectively assessed portfolios according to asset type, such as credit cards, personal loans, mortgages and smaller homogenous wholesale portfolios, such as business or commercial banking. A further distinction is made between those impaired assets in collections and those in recoveries (refer to Problem debt management on page 176 for a discussion of the collections and recoveries functions).
The provision is determined based on a quantitative review of the relevant portfolio, taking account of the level of arrears, the value of any security, historical and projected cash recovery trends over the recovery period. The provision also incorporates any adjustments that may be deemed appropriate given current economic and credit conditions. Such adjustments may be determined based on: a review of the current cash collections profile performance against historical trends; updates to metric inputs, including model recalibrations; and monitoring of operational processes used in managing exposures, including the time taken to process nonperforming exposures.
Latent loss provisions - A separate approach is taken for provisions held against impairments in the performing portfolio that have been incurred as a result of events occurring before the balance sheet date but which have not been identified at the balance sheet date.
The Group’s methodologies to estimate latent loss provisions reflect: the probability that the performing customer will default - historical loss experience, adjusted, where appropriate, to take into account current economic and credit conditions; and the emergence period, defined as the period between an impairment event occurring and a loan being identified and reported as impaired.
Key credit portfolios* Commercial real estate The commercial real estate lending portfolio totalled £63.0 billion at 31 December 2012, an £11.8 billion or 16% decrease over the year and £24.4 billion or 28% decrease in the last two years. The commercial real estate sector comprises exposures to entities involved in the development of, or investment in, commercial and residential properties (including housebuilders). The analysis of lending utilisations below excludes rate risk management and contingent obligations.
By division (1) Investment £m Development £m Total £m Investment £m Development £m Total £m Investment £m Development £m Total £m
UK (excluding NI) (2) 28,653 6,359 1,198 6,511 42,721 25,904 9,108 5,118 2,591 42,721 Ireland (ROI and NI) (2) 5,146 1,132 2,591 6,317 15,186 3,157 3,121 793 8,115 15,186 Western Europe (other) 7,649 1,048 9 52 8,758 422 8,275 20 41 8,758 US 5,552 1,279 59 46 6,936 4,521 2,310 71 34 6,936 RoW 785 35 141 284 1,245 227 593 332 93 1,245 47,785 9,853 3,998 13,210 74,846 34,231 23,407 6,334 10,874 74,846
UK (excluding NI) (2) 32,334 7,255 1,520 8,288 49,397 26,168 13,421 5,997 3,811 49,397 Ireland (ROI and NI) (2) 5,056 1,148 2,785 6,578 15,567 3,160 3,044 962 8,401 15,567 Western Europe (other) 10,568 643 25 42 11,278 409 10,802 25 42 11,278 US 7,345 1,296 69 175 8,885 4,636 4,005 173 71 8,885 RoW 1,622 25 138 498 2,283 243 1,404 489 147 2,283 56,925 10,367 4,537 15,581 87,410 34,616 32,676 7,646 12,472 87,410
Residential 10,344 6,701 403 996 242 18,686 Office 6,112 1,132 1,851 99 176 9,370 Retail 7,529 1,492 1,450 117 129 10,717 Industrial 3,550 476 143 4 39 4,212 Mixed/other 9,512 3,785 2,573 4,010 175 20,055 37,047 13,586 6,420 5,226 761 63,040
Residential 12,870 7,449 1,100 1,325 319 23,063 Office 7,155 1,354 2,246 404 352 11,511 Retail 8,709 1,641 1,891 285 275 12,801 Industrial 4,317 507 520 24 105 5,473 Mixed/other 9,670 4,235 3,001 4,898 194 21,998 42,721 15,186 8,758 6,936 1,245 74,846
Residential 15,543 7,726 685 1,471 523 25,948 Office 8,539 1,178 2,878 663 891 14,149 Retail 10,607 1,668 1,888 1,025 479 15,667 Industrial 4,912 515 711 80 106 6,324 Mixed/other 9,796 4,480 5,116 5,646 284 25,322 49,397 15,567 11,278 8,885 2,283 87,410
The UK portfolio is focused on London and the South East at approximately 43% in 2012 (2011 - 44%) with the remainder spread across other UK Regions.
The commercial real estate sector is expected to remain challenging in key markets and new business will be accommodated from run-off of existing Core exposure. Over £5.5 billion of loans in UK Corporate (Core and Non-Core) have been repaid over the last 12 months whilst the risk profile of the remaining performing book has remained relatively unchanged.
Non-Core < 1 year (1) 4,829 10,809 501 3,887 — 20,026 1-2 years 1,727 983 109 6,178 — 8,997 2-3 years 831 128 218 3,967 — 5,144 > 3 years 2,904 694 567 6,253 — 10,418 Not classified (2) 563 — — — — 563 Total 10,854 12,614 1,395 20,285 — 45,148
Non-Core exposure maturing in under 1 year has reduced from £21.7 billion in 2011 to £16.3 billion in 2012.
The majority of Ulster Bank’s commercial real estate portfolio was categorised as under 1 year, owing to the high level of nonperforming assets in the portfolio as Ulster Bank includes most renegotiated facilities as on demand.
Key points There has been an overall decrease in AQ10 during the year with reductions in Non-Core partially offset by increases in Ulster Bank and UK Corporate. The increase in defaulted exposure in UK Corporate is a result of a small number of significant individual cases. The high proportion of the portfolio in the AQ10 band was driven by exposures in Non-Core (Ulster Bank and International Banking) and Core (Ulster Bank).
Key points 81% of the commercial real estate portfolio categorised as LTV >
100% was in Ulster Bank Group (Core - 15%; Non-Core - 43%) and International Banking (Non-Core - 23%). A majority of the portfolios are managed within GRG and are subject to review at least quarterly. Significant levels of provisions have been taken against these portfolios. Provisions as a percentage of REIL for the Ulster Bank Group commercial real estate portfolio were 58% at 31 December 2012 (2011 - 53%).
Non-Core) and International Banking (Non-Core) were 2.96x and 1.30x respectively, at 31 December 2012 (2011 - 2.71x and 1.25x, respectively). The US Retail & Commercial portfolio is managed on the basis of debt service coverage, which includes scheduled principal amortisation. The average debt service coverage for this portfolio was 1.34x at 31 December 2012 (2011 - 1.24x). As a number of different approaches are used within the Group and across geographies to calculate interest coverage ratios, they may not be comparable for different portfolio types and organisations.
Key credit portfolios* continued Residential mortgages The majority of the Group’s secured lending exposures were in the UK, Ireland and the US. The analysis below includes both Core and Non-Core.
The table below shows LTVs for the Group’s residential mortgage portfolio split between performing (AQ1-AQ9) and non-performing (AQ10), with the average calculated on a weighted value basis. Loan balances are as at the end of the year whereas property values are calculated using property index movements since the last formal valuation (refer to page 170 for details).
<= 50% 22,306 327 22,633 2,182 274 2,456 4,167 51 4,218 > 50% and <= 70% 27,408 457 27,865 1,635 197 1,832 4,806 76 4,882 > 70% and <= 90% 34,002 767 34,769 2,019 294 2,313 6,461 114 6,575 > 90% and <= 100% 7,073 366 7,439 1,119 156 1,275 2,011 57 2,068 > 100% and <= 110% 3,301 290 3,591 1,239 174 1,413 1,280 43 1,323 > 110% and <= 130% 1,919 239 2,158 2,412 397 2,809 1,263 42 1,305 > 130% and <= 150% 83 26 109 2,144 474 2,618 463 14 477 > 150% — — — 3,156 1,290 4,446 365 14 379 Total with LTVs 96,092 2,472 98,564 15,906 3,256 19,162 20,816 411 21,227 Other (2) 486 12 498 — — — 292 19 311 Total 96,578 2,484 99,062 15,906 3,256 19,162 21,108 430 21,538
Average LTV on new originations during the year 65% 74% 64%
Average LTV on new originations during the year 68% 79% 66%
Key points UK Retail The UK Retail mortgage portfolio totalled approximately £99.1 billion at 31 December 2012, an increase of 2.8% from 31 December 2011.
The assets are prime mortgages and include £7.9 billion, 8% (2011 - £6.9 billion) of residential buy-to-let lending. There is a small legacy portfolio of self-certified mortgages (0.2% of the total mortgage portfolio). Self-certified mortgages were withdrawn in 2004. The interest rate product mix is approximately one third fixed rate with the remainder on variable rate products including those on managed rates.
UK Retail’s mortgage business is subject to prudent underwriting standards. These include an affordability test using a stressed interest rate, credit scoring with different pass marks depending on LTV as well as a range of specific criteria, for example, LTV thresholds. Changes over the last few years include: a reduction in maximum LTV for prime residential mortgage lending from 100% to 95% in the first quarter of 2008 and from 95% to 90% in the third quarter of 2008 and a tightening of credit scoring pass marks: credit score thresholds were increased in the third quarter of 2009 and again in the third quarter of 2010. In the first quarter of 2011, new scorecards were introduced alongside a further tightening of thresholds, these were tightened still further in the second quarter of 2012.
The maximum LTV available to new customers remains at 90%, except for those buying properties under the government-sponsored, and indemnity backed, new build schemes that were launched during the year, where the maximum LTV is 95%. These schemes aim to support the mortgage market, particularly first time buyers, and completions under the scheme totalled £35 million during the year.
The arrears rate (more than three payments in arrears, excluding repossessions and shortfalls post property sale) improved marginally to 1.5% at 31 December 2012 from 1.6% at 31 December 2011. The number of properties repossessed in 2012 was 1,426 compared with 1,671 in 2011. Arrears rates remain sensitive to economic developments and are currently benefiting from the low interest rate environment.
Refer to the Ulster Bank Group (Core and Non-Core) section on page 192 for commentary on mortgage REIL and repossessions.
RBS Citizens RBS Citizens’ mortgage portfolio totalled £21.5 billion at 31
December 2012, a reduction of 11% from 2011 (£24.2 billion). The Core business comprises 89% of the portfolio.
RBS Citizens’ lending originates predominantly in the ‘footprint states’ of New England, Mid Atlantic and Mid West regions. At 31 December 2012, £17.9 billion (83% of the total portfolio) was within footprint.
The current weighted average LTV of the mortgage portfolio decreased from 77% at 31 December 2011 to 75% at 31 December 2012, driven by increases in the Case-Shiller home price index from the third quarter of 2011 to the third quarter of 2012. The current weighted average LTV of the mortgage portfolio, excluding SBO, is 71%.
Personal lending The Group’s personal lending portfolio includes credit cards, unsecured loans, auto finance and overdrafts. The majority of personal lending exposures exist in the UK and the US. Impairment charge as a proportion of average loans and receivables are shown in the following table.
Notes: (1) The ratio for UK Retail assets refers to the impairment charge for the year. (2) The ratio for RBS Citizens refers to the impairment charge in the year, net of recoveries realised in the year.
The impairment charge on unsecured lending was £440 million for the year, down 24% on 2011, reflecting the continued benefit of risk appetite tightening in prior years, lower unsecured balances and also the investment in collections and recoveries capability. UK Retail continues to support customers experiencing financial difficulties including the provision of ‘breathing space’, refer to the disclosures on forbearance on page 178 for more information. Impairments remain sensitive to the external environment, including unemployment levels and interest rates.
Industry benchmarks for cards arrears remain stable, with the Group continuing to perform favourably.
December 2012 (2011 - £968 million). RBS Citizens' credit card business lends predominantly within the Bank's 12 state footprint and has traditionally adopted conservative risk strategies. Given the external climate, tighter lending criteria has been introduced leading to an improvement in credit quality. The portfolio's quarterly annualised loss performance in the third quarter of 2012 was 3.4% and ranked seventh out of 20 large and regional banks tracked.
Key credit portfolios* continued Ulster Bank Group (Core and Non-Core) Overview At 31 December 2012, Ulster Bank Group accounted for 10% of the Group’s total gross loans to customers (2011 and 2010 - 10%) and 8% of the Group’s Core gross loans to customers (2011 - 8%; 2010 - 9%). Ulster Bank’s financial performance continues to be overshadowed by the challenging economic climate in Ireland, with impairments remaining elevated as high unemployment, coupled with higher taxation and limited liquidity in the economy, continues to depress the property market and domestic spending.
The impairment charge of £2,340 million for 2012 (2011 - £3,717 million; 2010 - £3,843 million) was driven by a combination of new defaulting customers and higher provisions on existing defaulted cases due primarily to deteriorating security values. Provisions as a percentage of risk elements in lending increased from 53% in 2011, to 57% in 2012, predominantly as a result of the deterioration in the value of the Non-Core commercial real estate development portfolio. Ulster Bank impairment provisions take into account recovery strategies for its commercial real estate portfolio, as currently there is very limited liquidity in Irish commercial and development property.
Core The impairment charge for the year of £1,364 million (2011 - £1,384 million; 2010 - £1,161 million) reflects the difficult economic climate in Ireland, with elevated default levels across both mortgage and other corporate portfolios. The mortgage sector accounted for £646 million (47%) of the total 2012 impairment charge.
Core Mortgages 20,020 2,184 945 10.9 43 4.7 570 11 Commercial real estate - investment 3,882 1,014 413 26.1 41 10.6 225 — - development 881 290 145 32.9 50 16.5 99 16 Other corporate 7,736 1,834 1,062 23.7 58 13.7 434 72 Other lending 1,533 201 184 13.1 92 12.0 56 25 34,052 5,523 2,749 16.2 50 8.1 1,384 124
Non-Core Commercial real estate - investment 3,860 2,916 1,364 75.5 47 35.3 609 1 - development 8,490 7,536 4,295 88.8 57 50.6 1,551 32 Other corporate 1,630 1,159 642 71.1 55 39.4 173 16
Ulster Bank Group Mortgages 20,020 2,184 945 10.9 43 4.7 570 11 Commercial real estate - investment 7,742 3,930 1,777 50.8 45 23.0 834 1 - development 9,371 7,826 4,440 83.5 57 47.4 1,650 48 Other corporate 9,366 2,993 1,704 32.0 57 18.2 607 88 Other lending 1,533 201 184 13.1 92 12.0 56 25 48,032 17,134 9,050 35.7 53 18.8 3,717 173
Core Mortgages 21,162 1,566 439 7.4 28 2.1 294 7 Commercial real estate - investment 4,284 598 332 14.0 56 7.7 259 — - development 1,090 65 37 6.0 57 3.4 116 — Other corporate 9,039 1,205 667 13.3 55 7.4 444 11 Other lending 1,282 185 158 14.4 85 12.3 48 30 36,857 3,619 1,633 9.8 45 4.4 1,161 48
Core corporate REIL accounted for £1.0 billion of the overall increase, the movement driven by a small number of renegotiated arrangements for higher value real estate customers.
Core coverage increased from 50% to 52% as a result of additional impairment charges on the non-performing book due to further deterioration in collateral values. Core coverage is diluted due to the increased REIL relating to corporate renegotiations with lower provision requirements. Adjusting for these cases Core coverage would be 56%.
Non-Core REIL decreased by £0.3 billion reflecting lower defaults as well as recoveries and write-offs of £0.2 billion.
Key points Commercial real estate continues to be the primary sector driving the Ulster Bank Group non-performing loan book. A reduction over the year of £1.8 billion primarily reflects Ulster Bank’s continuing strategy to reduce concentration risk to this sector.
Credit derivatives 221 Monoline insurers 222 Credit derivative product companies (CDPCs) 223
REIL, provisions and AFS reserves 224 Divisional analysis 224 Sector and geographical regional analyses 226 Provisions and AFS reserves methodology 235 REIL flow statement 235 REIL and PPLs summary 236 Past due analysis 236 Impairment provisions flow statement 236 Impairment charge analysis 239 AFS reserves 240 AFS gross unrealised losses 241
Balance sheet analysis Credit risk assets analysed on the pages 163 to 167 are reported internally to senior management. However, they exclude certain exposures, primarily securities and reverse repurchase agreements, and take account of legal netting agreements, that provide a right of legal set-off but do not meet the criteria for offset in IFRS. The table below is therefore provided to supplement the credit risk assets analysis and other analysis to reconcile to the balance sheet grossed up for disposal groups.
Financial assets Exposure summary The table below analyses the Group’s financial asset exposures, both gross and net of offset arrangements.
Cash and balances at central banks 79,308 — 79,308 — 79,308 Reverse repos 143,207 (38,377) 104,830 (17,439) 87,391 Lending (3) 464,691 (1,460) 463,231 (34,941) 428,290 Debt securities 164,624 — 164,624 — 164,624 Equity shares 15,237 — 15,237 — 15,237 Derivatives (4) 815,394 (373,476) 441,918 (408,004) 33,914 Settlement balances 8,197 (2,456) 5,741 (1,760) 3,981 Other financial assets 924 — 924 — 924 Total 1,691,582 (415,769) 1,275,813 (462,144) 813,669 Short positions (27,591) — (27,591) — (27,591)
Cash and balances at central banks 79,396 — 79,396 — 79,396 Reverse repos 138,539 (37,605) 100,934 (15,246) 85,688 Lending (3) 517,474 — 517,474 (41,129) 476,345 Debt securities 209,080 — 209,080 — 209,080 Equity shares 15,188 — 15,188 — 15,188 Derivatives (4) 1,074,548 (544,491) 530,057 (478,848) 51,209 Settlement balances 9,144 (1,359) 7,785 (2,221) 5,564 Other financial assets 1,309 — 1,309 — 1,309 Total 2,044,678 (583,455) 1,461,223 (537,444) 923,779 Short positions (41,039) — (41,039) — (41,039)
Cash and balances at central banks 57,198 — 57,198 — 57,198 Reverse repos 135,105 (39,986) 95,119 (10,712) 84,407 Lending (3) 566,323 — 566,323 (44,801) 521,522 Debt securities 217,480 — 217,480 — 217,480 Equity shares 22,218 — 22,218 — 22,218 Derivatives (4) 882,803 (450,578) 432,225 (361,493) 70,732 Settlement balances 14,182 (2,022) 12,160 (1,539) 10,621 Other financial assets 1,306 — 1,306 — 1,306 Total 1,896,615 (492,586) 1,404,029 (418,545) 985,484 Short positions (43,118) — (43,118) — (43,118)
Securities Clearing Corporation. (2) This reflects 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 relating to reverse repurchase agreements. Cash and securities are received as collateral in respect of derivative transactions..
(3) Lending non-IFRS offset includes cash collateral posted against derivative liabilities of £24.6 billion, (2011 - £31.4 billion; 2010 - £31.0 billion) and cash management pooling of £10.3 billion, (2011 - £9.7 billion; 2010 - £13.8 billion).
(4) Derivative non-IFRS offset includes cash collateral received against derivative assets of £34.1 billion (2011 - £37.2 billion; 2010 - £31.1 billion). Refer to page 220.
Lending Securities Reverse repos Core Non-Core Total Debt Equity Derivatives Other
Government (2) 441 8,485 1,368 9,853 97,339 — 5,791 591 114,015 (5,151) 108,864 Financial institutions - banks (3) 34,783 30,917 477 31,394 11,555 1,643 335,521 79,308 494,204 (341,103) 153,101 - other (4) 69,256 39,658 2,540 42,198 50,104 2,672 80,817 5,591 250,638 (97,589) 153,049 Personal - mortgages — 146,770 2,855 149,625 — — — — 149,625 — 149,625 - unsecured — 31,247 965 32,212 — — — 4 32,216 — 32,216 Property — 43,602 28,617 72,219 774 318 4,118 — 77,429 (1,333) 76,096 Construction — 6,020 2,029 8,049 17 264 820 — 9,150 (1,687) 7,463 Manufacturing 326 22,234 1,553 23,787 836 1,639 1,759 144 28,491 (3,775) 24,716 Finance leases (5) — 9,201 4,408 13,609 82 1 13 — 13,705 — 13,705 Retail, wholesale and repairs — 20,842 1,094 21,936 461 1,807 914 41 25,159 (1,785) 23,374 Transport and storage — 14,590 3,751 18,341 659 382 3,397 2 22,781 (3,240) 19,541 Health, education and leisure — 15,770 935 16,705 314 554 904 59 18,536 (964) 17,572 Hotels and restaurants — 6,891 986 7,877 144 51 493 11 8,576 (348) 8,228 Utilities — 5,131 1,500 6,631 1,311 638 3,170 50 11,800 (2,766) 9,034 Other 24 26,315 3,742 30,057 1,886 5,380 4,201 172 41,720 (2,403) 39,317 Total gross of provisions 104,830 427,673 56,820 484,493 165,482 15,349 441,918 85,973 1,298,045 (462,144) 835,901 Provisions — (10,062) (11,200) (21,262) (858) (112) — — (22,232) n/a (22,232)
Government (2) 645 6,781 1,671 8,452 130,123 — 7,560 291 147,071 (3,916) 143,155 Financial institutions - banks (3) 42,571 57,033 1,654 58,687 22,474 3,259 315,297 57,198 499,486 (312,327) 187,159 - other (4) 51,297 47,161 7,791 54,952 54,726 4,366 84,042 12,740 262,123 (91,059) 171,064 Personal - mortgages — 140,359 6,142 146,501 — — — — 146,501 (19) 146,482 - unsecured — 33,581 3,891 37,472 — — — 48 37,520 (11) 37,509 Property — 42,455 47,948 90,403 2,700 237 3,830 28 97,198 (1,046) 96,152 Construction — 8,680 3,425 12,105 56 31 780 — 12,972 (1,406) 11,566 Manufacturing 389 25,797 7,688 33,485 784 113 3,229 — 38,000 (2,156) 35,844 Finance leases (5) — 8,321 8,529 16,850 13 2 14 — 16,879 (134) 16,745 Retail, wholesale and repairs — 21,974 3,191 25,165 520 41 1,124 — 26,850 (2,468) 24,382 Transport and storage — 15,946 8,195 24,141 879 54 2,703 — 27,777 (224) 27,553 Health, education and leisure — 17,456 1,975 19,431 1,495 42 1,198 — 22,166 (1,047) 21,119 Hotels and restaurants — 8,189 1,492 9,681 276 123 525 — 10,605 (253) 10,352 Utilities — 7,098 2,948 10,046 1,714 229 2,491 2 14,482 (985) 13,497 Other 217 29,053 8,115 37,168 3,021 13,897 9,432 386 64,121 (1,494) 62,627 Total gross of provisions 95,119 469,884 114,655 584,539 218,781 22,394 432,225 70,693 1,423,751 (418,545)1,005,206 Provisions — (7,866) (10,352) (18,218) (1,301) (176) — (29) (19,724) n/a (19,724) Total including disposal groups before RFS MI 95,119 462,018 104,303 566,321 217,480 22,218 432,225 70,664 1,404,027 (418,545) 985,482 RFS minority interests — — 2 2 — — — — 2 — 2 Total 95,119 462,018 104,305 566,323 217,480 22,218 432,225 70,664 1,404,029 (418,545) 985,484
Exposures to central and local governments decreased by £34 billion principally in debt securities. This was driven by Markets de-risking its balance sheet, management of the Group Treasury liquidity portfolio as well as overall risk reduction in respect of eurozone exposures. The Group’s portfolio comprises exposures to central governments and sub-sovereigns such as local authorities, primarily in the Group’s key markets in the UK, Western Europe and the US.
Exposure to financial institutions was £28 billion lower, across securities, loans and derivatives, driven by economy-wide subdued activity.
Exposure to other financial institutions comprising traded and non traded products is spread across a wide range of financial companies including insurance, securitisation vehicles, financial intermediaries including broker dealers and central counterparties (CCPs), financial guarantors - monolines and credit derivative product companies (CDPCs) - and funds comprising unleveraged, hedge and leveraged funds. The size of the Core portfolio has decreased marginally since 2011. Entities in this sector remain vulnerable to market shocks or contagion from the banking sector. Credit risk in these sectors is managed through the single name concentration, sector concentration and asset and product class frameworks, with specific sector and product caps in place where there is a perception of heightened credit risk, such as committed lending to banks, leveraged funds and insurance holding companies. The Group continues to develop its risk appetite framework for CCPs to reflect increased activity with these entities driven by regulatory requirements. The Group is also managing down its exposures to monolines and CDPCs with the aim of exiting these portfolios.
Key points continued The Group’s exposure to property and construction sector decreased by £11 billion, principally in commercial real estate lending. The majority of the Group’s Core property exposure is within UK Corporate (73%). In relation to property exposure, the UK Corporate and Ulster Bank divisions saw further deterioration in asset quality during the year.
Within lending: UK Retail increased its lending to homeowners by £4.1 billion, including first-time buyers, reflecting the impact of the UK Government’s Funding for Lending Scheme (FLS); unsecured lending balances fell.
Non-Core continued to make significant progress on its balance sheet strategy by reducing lending by £24 billion across all sectors, principally property and construction, where commercial real estate lending decreased by £9.4 billion, reflecting repayments and asset sales.
For further discussion on debt securities and derivatives, refer to pages 209 to 217 and 220 respectively.
The tables on pages 199 to 204 analyse financial assets by geographical region (based on location of transaction office) and sector.
US Government (2) — 151 — 151 22,084 — 23 500 22,758 (17) 22,741 Financial institutions - banks (3) 5,024 1,295 47 1,342 468 349 116,935 14,066 138,184 (115,459) 22,725 - other (4) 22,807 4,023 234 4,257 25,483 210 13,397 2,086 68,240 (14,720) 53,520 Personal - mortgages — 19,483 2,446 21,929 — — — — 21,929 — 21,929 - unsecured — 8,209 539 8,748 — — — — 8,748 — 8,748 Property — 2,847 496 3,343 8 26 34 — 3,411 — 3,411 Construction — 384 4 388 3 2 9 — 402 — 402 Manufacturing — 6,004 17 6,021 156 15 265 — 6,457 (215) 6,242 Finance leases (5) — 2,471 — 2,471 — — — — 2,471 — 2,471 Retail, wholesale and repairs — 4,852 53 4,905 58 1 66 — 5,030 (52) 4,978 Transport and storage — 1,522 406 1,928 37 — 855 — 2,820 (800) 2,020 Health, education and leisure — 2,822 26 2,848 170 — 73 — 3,091 (70) 3,021 Hotels and restaurants — 474 16 490 23 — — — 513 — 513 Utilities — 929 37 966 100 15 273 — 1,354 (251) 1,103 Other 4 5,019 298 5,317 674 324 1,094 — 7,413 (277) 7,136 Total gross of provisions 27,835 60,485 4,619 65,104 49,264 942 133,024 16,652 292,821 (131,861) 160,960 Provisions — (581) (335) (916) — — — — (916) n/a (916)
Europe Government (2) — 224 667 891 5,684 — 54 2 6,631 (15) 6,616 Financial institutions - banks (3) 375 2,961 190 3,151 4,016 8 55 23,181 30,786 (2) 30,784 - other (4) 20 1,390 300 1,690 7,222 309 95 134 9,470 — 9,470 Personal - mortgages — 17,446 390 17,836 — — — — 17,836 — 17,836 - unsecured — 1,540 365 1,905 — — — — 1,905 — 1,905 Property — 4,896 9,738 14,634 — 2 77 — 14,713 (5) 14,708 Construction — 513 619 1,132 — 6 — — 1,138 (21) 1,117 Manufacturing — 4,771 660 5,431 94 26 25 1 5,577 (9) 5,568 Finance leases (5) — 292 172 464 — — — — 464 — 464 Retail, wholesale and repairs — 3,142 607 3,749 — 109 10 — 3,868 (22) 3,846 Transport and storage — 4,851 599 5,450 1 10 12 — 5,473 (5) 5,468 Health, education and leisure — 1,170 399 1,569 — 2 — — 1,571 (6) 1,565 Hotels and restaurants — 893 486 1,379 — — — — 1,379 (4) 1,375 Utilities — 993 499 1,492 6 112 65 20 1,695 — 1,695 Other — 4,492 817 5,309 39 201 44 32 5,625 (53) 5,572 Total gross of provisions 395 49,574 16,508 66,082 17,062 785 437 23,370 108,131 (142) 107,989 Provisions — (3,697) (6,570) (10,267) (438) — — — (10,705) n/a (10,705)
UK Government (2) 2,130 8,012 25 8,037 77,831 — 5,282 548 93,828 (1,098) 92,730 Financial institutions - banks (3) 25,204 29,575 218 29,793 1,950 1,562 258,321 40,396 357,226 (271,500) 85,726 - other (4) 39,154 33,020 2,361 35,381 25,954 1,676 43,327 3,259 148,751 (59,160) 89,591 Personal - mortgages — 104,965 1,423 106,388 — — — — 106,388 — 106,388 - unsecured — 21,881 127 22,008 — — — 24 22,032 (7) 22,025 Property — 35,431 24,610 60,041 278 137 4,332 — 64,788 (1,265) 63,523 Construction — 5,707 1,882 7,589 20 26 895 — 8,530 (1,115) 7,415 Manufacturing 254 10,148 835 10,983 499 1,908 2,259 — 15,903 (2,205) 13,698 Finance leases (5) — 5,618 5,598 11,216 1 2 73 — 11,292 (16) 11,276 Retail, wholesale and repairs — 11,796 1,441 13,237 574 2,616 952 18 17,397 (1,647) 15,750 Transport and storage 436 8,716 3,439 12,155 145 67 2,217 — 15,020 (200) 14,820 Health, education and leisure — 11,534 757 12,291 72 8 756 — 13,127 (965) 12,162 Hotels and restaurants — 6,165 569 6,734 23 — 664 — 7,421 (178) 7,243 Utilities — 2,476 922 3,398 1,150 513 3,207 30 8,298 (450) 7,848 Other 126 17,393 1,723 19,116 2,395 4,704 4,105 593 31,039 (947) 30,092 Total gross of provisions 67,304 312,437 45,930 358,367 110,892 13,219 326,390 44,868 921,040 (340,753) 580,287 Provisions — (5,349) (4,754) (10,103) (1,170) (141) — — (11,414) n/a (11,414)
Europe Government (2) — 116 715 831 13,362 — 60 — 14,253 — 14,253 Financial institutions - banks (3) 247 8,361 250 8,611 10,859 78 — 6,725 26,520 — 26,520 - other (4) — 2,534 474 3,008 4,521 165 289 90 8,073 (1) 8,072 Personal - mortgages — 18,393 553 18,946 — — — — 18,946 — 18,946 - unsecured — 1,972 492 2,464 — — — 28 2,492 — 2,492 Property — 4,846 11,538 16,384 — — 168 — 16,552 (9) 16,543 Construction — 1,019 735 1,754 — 22 18 — 1,794 (24) 1,770 Manufacturing — 4,383 3,732 8,115 57 5 23 — 8,200 (9) 8,191 Finance leases (5) — 260 435 695 — — — — 695 — 695 Retail, wholesale and repairs — 3,992 772 4,764 16 2 23 — 4,805 (24) 4,781 Transport and storage — 5,667 862 6,529 143 — 15 — 6,687 (6) 6,681 Health, education and leisure — 1,235 349 1,584 164 5 2 — 1,755 (8) 1,747 Hotels and restaurants — 892 535 1,427 — — 6 — 1,433 (6) 1,427 Utilities — 1,569 530 2,099 124 3 85 — 2,311 — 2,311 Other 7 3,766 1,679 5,445 568 70 35 — 6,125 (56) 6,069 Total gross of provisions 254 59,005 23,651 82,656 29,814 350 724 6,843 120,641 (143) 120,498 Provisions — (3,003) (5,895) (8,898) (1,218) — — — (10,116) n/a (10,116)
RoW Government (2) 117 54 629 683 11,414 — 190 92 12,496 — 12,496 Financial institutions - banks (3) 6,605 4,767 198 4,965 2,886 135 30,700 2,849 48,140 (27,897) 20,243 - other (4) 1,956 4,051 96 4,147 268 100 — 592 7,063 — 7,063 Personal - mortgages — 502 200 702 — — — — 702 — 702 - unsecured — 1,510 1 1,511 — — — — 1,511 — 1,511 Property — 304 546 850 269 15 61 1 1,196 — 1,196 Construction — 59 10 69 9 2 22 — 102 — 102 Manufacturing — 2,395 322 2,717 7 13 1,052 306 4,095 — 4,095 Finance leases (5) — 91 26 117 127 — 2 — 246 — 246 Retail, wholesale and repairs — 1,276 28 1,304 3 34 96 — 1,437 — 1,437 Transport and storage — 366 239 605 225 6 443 — 1,279 (35) 1,244 Health, education and leisure — 358 225 583 — 4 34 — 621 — 621 Hotels and restaurants — 25 — 25 — 2 — — 27 — 27 Utilities — 1,479 369 1,848 13 22 94 — 1,977 — 1,977 Other 12 2,475 880 3,355 127 259 861 2 4,616 — 4,616 Total gross of provisions 8,690 19,712 3,769 23,481 15,348 592 33,555 3,842 85,508 (27,932) 57,576 Provisions — (48) (322) (370) — — — — (370) n/a (370)
UK Government (2) 611 5,728 173 5,901 72,427 — 7,300 173 86,412 (3,916) 82,496 Financial institutions - banks (3) 28,370 41,541 481 42,022 5,381 1,828 203,487 28,128 309,216 (210,136) 99,080 - other (4) 33,186 28,246 6,023 34,269 27,737 3,617 45,852 5,390 150,051 (46,812) 103,239 Personal - mortgages — 99,928 1,665 101,593 — — — — 101,593 (14) 101,579 - unsecured — 23,035 585 23,620 — — — 23 23,643 (11) 23,632 Property — 34,970 30,789 65,759 2,302 175 3,739 28 72,003 (1,041) 70,962 Construction — 7,041 2,383 9,424 39 — 741 — 10,204 (1,392) 8,812 Manufacturing 389 12,300 2,353 14,653 354 — 2,159 — 17,555 (2,150) 15,405 Finance leases (5) — 5,589 7,785 13,374 13 2 14 — 13,403 (134) 13,269 Retail, wholesale and repairs — 12,554 1,853 14,407 343 11 874 — 15,635 (2,452) 13,183 Transport and storage — 8,105 5,015 13,120 241 3 1,573 — 14,937 (219) 14,718 Health, education and leisure — 13,502 1,149 14,651 160 22 877 — 15,710 (1,047) 14,663 Hotels and restaurants — 6,558 808 7,366 172 — 518 — 8,056 (249) 7,807 Utilities — 3,101 1,459 4,560 1,040 5 2,112 2 7,719 (985) 6,734 Other 57 17,732 2,618 20,350 1,051 13,648 2,401 335 37,842 (1,448) 36,394 Total gross of provisions 62,613 319,930 65,139 385,069 111,260 19,311 271,647 34,079 883,979 (272,006) 611,973 Provisions — (4,937) (3,741) (8,678) (1,301) (176) — (29) (10,184) n/a (10,184)
US Government (2) — 263 53 316 24,975 — 5 112 25,408 — 25,408 Financial institutions - banks (3) 8,978 820 641 1,461 1,951 561 87,627 19,455 120,033 (80,128) 39,905 - other (4) 16,023 9,522 656 10,178 21,958 525 34,090 5,505 88,279 (43,734) 44,545 Personal - mortgages — 20,548 3,653 24,201 — — — — 24,201 — 24,201 - unsecured — 6,816 2,704 9,520 — — — — 9,520 — 9,520 Property — 1,611 3,318 4,929 95 4 23 — 5,051 — 5,051 Construction — 442 78 520 5 — 16 — 541 — 541 Manufacturing — 5,459 209 5,668 412 22 583 — 6,685 — 6,685 Finance leases (5) — 2,315 — 2,315 — — — — 2,315 — 2,315 Retail, wholesale and repairs — 4,264 237 4,501 132 — 68 — 4,701 — 4,701 Transport and storage — 1,786 1,408 3,194 99 2 929 — 4,224 — 4,224 Health, education and leisure — 2,380 313 2,693 1,308 3 292 — 4,296 — 4,296 Hotels and restaurants — 486 136 622 104 — 3 — 729 — 729 Utilities — 1,117 326 1,443 567 2 272 — 2,284 — 2,284 Other 131 4,256 682 4,938 1,057 105 5,971 42 12,244 — 12,244 Total gross of provisions 25,132 62,085 14,414 76,499 52,663 1,224 129,879 25,114 310,511 (123,862) 186,649 Provisions — (824) (819) (1,643) — — — — (1,643) n/a (1,643)
(2) Includes central and local government. (3) Includes £79.3 billion (2011 - £79.4 billion; 2010 - £57.2 billion) relating to cash and balances at central banks. (4) Loans made by the Group's consolidated conduits to asset owning companies are included within Financal institutions - other. (5) Includes instalment credit.
Asset quality The asset quality analysis presented below is based on the Group’s internal asset quality ratings which have ranges for the probability of default, as set out below. Customers are assigned credit grades, based on various credit grading models that reflect the key drivers of default for the customer type. All credit grades across the Group map to both a Group level asset quality scale, used for external financial reporting, and a master grading scale for wholesale exposures used for internal management reporting across portfolios. Debt securities are analysed by external ratings and are therefore excluded from the following table and are set out on pages 210 to 212.
Total AQ1 78,039 17,806 3,713 10,913 32,432 42,963 15,022 39,734 97,719 2,671 100,652 63,785 8,113 383,411 AQ2 12 3,556 4,566 526 8,648 710 704 13,101 14,515 185 108,733 20,333 2,810 155,236 AQ3 1,156 5,703 2,241 2,757 10,701 2,886 3,917 25,252 32,055 539 152,810 23,727 7,431 228,419 AQ4 100 6,251 1,761 2,734 10,746 14,079 2,144 104,060 120,283 1,202 58,705 40,196 5,736 236,968 AQ5 — 1,183 469 787 2,439 8,163 679 92,147 100,989 659 13,244 28,165 2,598 148,094 AQ6 — 282 39 357 678 86 50 40,096 40,232 73 2,175 13,854 1,380 58,392 AQ7 — 2 — 236 238 1,133 12 36,223 37,368 191 3,205 19,219 1,275 61,496 AQ8 — — — 68 68 4 2 12,812 12,818 8 262 5,688 185 19,029 AQ9 1 — — 93 93 23 7 17,431 17,461 137 1,360 1,363 95 20,510 AQ10 — — — — — — — 807 807 1 772 1,454 238 3,272 Past due — — — — — — 249 10,285 10,534 999 — — — 11,533 Impaired — — — 134 134 — — 38,365 38,365 — — — — 38,499 Impairment provision — — — (114) (114) — — (21,148) (21,148) — — — — (21,262)
Core AQ1 78,003 17,806 3,713 10,519 32,038 42,963 15,022 32,268 90,253 2,671 99,882 62,440 7,822 373,109 AQ2 12 3,556 4,566 521 8,643 710 704 10,551 11,965 185 108,107 20,207 2,792 151,911 AQ3 1,046 5,703 2,241 2,738 10,682 2,886 3,917 21,688 28,491 539 152,462 23,392 7,419 224,031 AQ4 100 6,251 1,761 2,729 10,741 14,079 2,144 99,771 115,994 1,202 57,650 39,832 5,648 231,167 AQ5 — 1,183 469 785 2,437 8,163 679 87,429 96,271 659 12,082 27,501 2,508 141,458 AQ6 — 282 39 356 677 86 50 36,891 37,027 73 1,476 13,140 1,353 53,746 AQ7 — 2 — 186 188 1,133 12 32,032 33,177 191 2,536 17,824 949 54,865 AQ8 — — — 68 68 4 2 10,731 10,737 8 247 5,607 146 16,813 AQ9 1 — — 93 93 — 7 14,979 14,986 137 979 1,088 93 17,377 AQ10 — — — — — — — 684 684 1 448 832 149 2,114 Past due — — — — — — 249 9,528 9,777 991 — — — 10,768 Impaired — — — 133 133 — — 17,418 17,418 — — — — 17,551 Impairment provision — — — (113) (113) — — (9,949) (9,949) — — — — (10,062)
Non-Core AQ1 36 — — 394 394 — — 7,466 7,466 — 770 1,345 291 10,302 AQ2 — — — 5 5 — — 2,550 2,550 — 626 126 18 3,325 AQ3 110 — — 19 19 — — 3,564 3,564 — 348 335 12 4,388 AQ4 — — — 5 5 — — 4,289 4,289 — 1,055 364 88 5,801 AQ5 — — — 2 2 — — 4,718 4,718 — 1,162 664 90 6,636 AQ6 — — — 1 1 — — 3,205 3,205 — 699 714 27 4,646 AQ7 — — — 50 50 — — 4,191 4,191 — 669 1,395 326 6,631 AQ8 — — — — — — — 2,081 2,081 — 15 81 39 2,216 AQ9 — — — — — 23 — 2,452 2,475 — 381 275 2 3,133 AQ10 — — — — — — — 123 123 — 324 622 89 1,158 Past due — — — — — — — 757 757 8 — — — 765 Impaired — — — 1 1 — — 20,947 20,947 — — — — 20,948 Impairment provision — — — (1) (1) — — (11,199) (11,199) — — — — (11,200)
Total AQ1 78,692 74,279 114,424 5,152 482,053 75,356 14,076 844,032 AQ2 342 1,881 15,810 93 8,177 24,269 3,154 53,726 AQ3 223 1,981 34,017 546 10,827 23,471 4,427 75,492 AQ4 19 1,612 108,262 760 14,421 40,071 5,847 170,992 AQ5 90 1,261 118,056 124 6,516 34,593 4,301 164,941 AQ6 9 188 50,428 46 2,221 17,153 1,662 71,707 AQ7 8 432 33,218 13 2,393 19,163 1,037 56,264 AQ8 7 30 12,622 19 1,252 4,159 276 18,365 AQ9 5 83 16,429 324 1,150 2,286 943 21,220 AQ10 1 164 784 6 1,047 2,354 221 4,577 Past due — 2 11,591 1,623 — — — 13,216 Impaired — 137 39,921 414 — — — 40,472 Impairment provision — (123) (20,551) (26) — — — (20,700)
Core AQ1 78,634 73,689 95,691 5,034 478,177 69,220 13,249 813,694 AQ2 342 1,877 14,158 91 7,500 23,404 3,122 50,494 AQ3 56 1,967 30,546 546 10,360 22,319 4,354 70,148 AQ4 18 1,557 101,646 759 13,475 38,808 5,655 161,918 AQ5 90 1,256 110,911 124 5,087 33,226 4,092 154,786 AQ6 9 140 44,012 46 1,987 16,118 1,634 63,946 AQ7 8 432 28,953 13 796 17,514 949 48,665 AQ8 7 20 10,608 19 666 4,068 236 15,624 AQ9 5 83 11,938 276 592 1,769 898 15,561 AQ10 1 164 478 6 339 1,274 180 2,442 Past due — 2 10,047 1,623 — — — 11,672 Impaired — 136 16,457 413 — — — 17,006 Impairment provision — (122) (9,065) (25) — — — (9,212)
Non-Core AQ1 58 590 18,733 118 3,876 6,136 827 30,338 AQ2 — 4 1,652 2 677 865 32 3,232 AQ3 167 14 3,471 — 467 1,152 73 5,344 AQ4 1 55 6,616 1 946 1,263 192 9,074 AQ5 — 5 7,145 — 1,429 1,367 209 10,155 AQ6 — 48 6,416 — 234 1,035 28 7,761 AQ7 — — 4,265 — 1,597 1,649 88 7,599 AQ8 — 10 2,014 — 586 91 40 2,741 AQ9 — — 4,491 48 558 517 45 5,659 AQ10 — — 306 — 708 1,080 41 2,135 Past due — — 1,544 — — — — 1,544 Impaired — 1 23,464 1 — — — 23,466 Impairment provision — (1) (11,486) (1) — — — (11,488)
Non-Core AQ1 18 1,196 25,172 577 14,956 7,637 94 49,650 AQ2 — 48 2,748 137 1,461 1,205 252 5,851 AQ3 — 32 3,130 1 185 2,185 69 5,602 AQ4 362 209 9,998 — 374 4,118 1,452 16,513 AQ5 — 75 15,931 180 1,411 3,310 245 21,152 AQ6 — 21 13,185 — 265 1,941 90 15,502 AQ7 — 24 7,634 80 869 1,147 147 9,901 AQ8 — — 3,283 — 146 672 111 4,212 AQ9 — 8 4,365 33 284 447 46 5,183 AQ10 — 55 2,867 — 1,213 1,329 157 5,621 Past due — 7 2,686 46 — — — 2,739 Impaired — 1 22,242 — — — — 22,243 Impairment provision — (1) (10,351) — — — — (10,352) Group before RFS MI 380 1,675 102,890 1,054 21,164 23,991 2,663 153,817 RFS MI — 2 — — — — 32 34 Group 380 1,677 102,890 1,054 21,164 23,991 2,695 153,851
Key points In 2012, the Group implemented updates to certain models, including those used for sovereign and financial institution counterparties, to incorporate more recent data and reflect new regulatory requirements applicable to wholesale internal ratings based modelling. This has resulted in ratings migration from AQ1, primarily to AQ2-AQ5. However, it is not practicable to quantify the impact of model updates on individual asset quality bands. The Group had modified various risk frameworks, including risk appetite framework and latent loss assessment in anticipation of these changes. Further updates, primarily of models used for the corporate counterparties, are planned for 2013. The AQ composition of the corporate portfolio has not changed materially during the year.
Derivatives: Balance sheet reductions in Markets and model updates resulted in decrease in AQ1 balances. Increase in AQ2AQ4 balances reflects the re-grading of counterparties previously included in AQ1.
Impaired and past due assets, net of impairment provisions, comprise 37% of Non-Core balances. Continued weakness in commercial real estate market overall and difficult conditions in Ireland are significant contributors to this.
Debt securities IFRS measurement classification and issuer The table below analyses debt securities by issuer and IFRS measurement classifications. US central and local government includes US federal agencies; financial institutions includes US government sponsored agencies and securitisation entities.
Available-for-sale Gross unrealised gains 1,007 1,092 1,187 110 660 120 4,176 764 Gross unrealised losses — (1) (14) (509) (1,319) (4) (1,847) (1,817)
Held-for-trading 9,004 19,636 36,928 3,400 23,160 2,948 95,076 20,816 Designated as at fair value 1 — 127 53 457 9 647 558 Available-for-sale 13,436 20,848 25,552 13,175 31,752 2,535 107,298 40,735 Loans and receivables 10 — 1 312 5,259 477 6,059 5,200 Long positions 22,451 40,484 62,608 16,940 60,628 5,969 209,080 67,309
Held-for-trading 5,097 15,648 42,828 5,486 23,711 6,099 98,869 21,988 Designated as at fair value 1 117 262 4 8 10 402 119 Available-for-sale 8,377 22,244 32,865 16,982 29,148 1,514 111,130 42,515 Loans and receivables 11 — — 1 6,686 381 7,079 6,203 Long positions 13,486 38,009 75,955 22,473 59,553 8,004 217,480 70,825
AFS Decreased by £26.4 billion, comprising £14.9 billion of central and local government, other financial institutions £7.9 billion, banks £4.3 billion offset by an increase in Corporate of £0.6 billion: UK and US government bonds fell by £3.7 billion and £1.8 billion respectively, primarily due to disposals.
Group Treasury reduced its liquidity portfolio, reflecting smaller balance sheet resulting in lower government bonds primarily German and French (£6.0 billion)
Reduction in ABS: US agency decrease reflected maturities and disposals in light of favourable market conditions in the US, Markets, and US Retail & Commercial; and Non-Core strategic reductions also contributed to the decrease in bonds issued by financial institutions.
Bank bonds decreased by £4.3 billion of which £1.7 billion related to Spanish covered bonds reflecting disposals by Group Treasury, and lower positions in Australian and German securities reflected the close out of positions and maturities, respectively.
Non-Core AAA 376 311 22 172 3,793 39 4,713 30 3,794 AA to AA+ — — — 26 2,781 4 2,811 18 2,679 A to AA- — — — 506 1,051 66 1,623 11 1,365 BBB- to A- — — — 274 2,000 102 2,376 15 2,277 Non-investment grade — — 306 84 1,864 411 2,665 17 1,871 Unrated — — 1 60 1,177 157 1,395 9 725 376 311 329 1,122 12,666 779 15,583 100 12,711
Notes: (1) Asset-backed securities. (2) Percentage calculated on Group before RFS MI.
The decrease in A to AA- debt securities related to downgrades of
Italy and Spain to BBB+ and BBB- respectively, in the first half of 2012, along with a downgrade of selected banks.
Non-investment grade and unrated debt securities decreased by £2.2 billion and accounted for 4% of the portfolio.
The Group’s credit market activities gave rise to risk concentrations in asset-backed securities (ABS). The Group has exposures to ABS, which are predominantly debt securities, but can also be held in derivative form. ABS have an interest in an underlying pool of referenced assets. The risks and rewards of the referenced pool are passed onto investors by the issue of securities with varying seniority by a special purpose entity.
The following tables summarise the gross and net exposures and carrying values of these securities by the location of the underlying assets at 31 December 2012, 2011 and 2010 and by IFRS measurement classification of held-for-trading (HFT), designated at fair value (DFV), available-for-sale (AFS) and loans and receivables (LAR). Gross exposures represent the principal amounts relating to ABS. Government sponsored or similar RMBS comprises securities that are: (a) guaranteed or effectively guaranteed by the US government, by way of its support for US federal agencies and government sponsored enterprises or (b) guaranteed by the Dutch government. Net exposures represent the carrying value after taking account of protection purchased from monoline insurers and other counterparties, but exclude the effect of counterparty credit valuation adjustments. The hedge provides credit protection of both 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.
The main categories of mortgages that serve as collateral to RMBS held by the Group with related vintages are set out below and described in the Glossary on pages 528 to 535. 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.
US UK Europe RoW Total HFT DFV AFS LAR 2012 £m £m £m £m £m £m £m £m £m
Gross exposure RMBS: government sponsored or similar 22,162 — 5,366 18 27,546 13,961 — 13,585 — RMBS: prime 819 2,821 1,181 403 5,224 753 509 3,876 86 RMBS: non-conforming 595 2,077 58 — 2,730 202 — 1,235 1,293 RMBS: sub-prime 968 99 66 5 1,138 1,027 — 5 106 MBS: covered bond 46 172 6,129 — 6,347 — — 6,347 — CMBS 3,352 1,121 671 3 5,147 1,992 — 2,327 828 CDOs 4,002 42 404 — 4,448 3,111 — 1,307 30 CLOs 2,705 44 787 — 3,536 1,049 — 2,422 65 ABS covered bond — 132 374 16 522 — — 522 — Other ABS 1,632 1,873 1,111 306 4,922 1,667 7 1,774 1,474 36,281 8,381 16,147 751 61,560 23,762 516 33,400 3,882
AAA 28,835 4,355 1,754 317 7,107 2,789 444 2,490 988 2,156 51,235 AA to AA+ 1,529 147 144 116 357 392 567 1,786 681 616 6,335 A to AA- — 67 60 212 408 973 296 343 192 693 3,244 BBB- to A- — 82 316 39 — 500 203 527 — 1,718 3,385 Non-investment grade (2) — 900 809 458 — 296 1,863 332 — 265 4,923 Unrated (3) — 196 52 76 — — 85 596 — 698 1,703 30,364 5,747 3,135 1,218 7,872 4,950 3,458 6,074 1,861 6,146 70,825
Hong Kong 2 81 97 180 — — 4 4 184 2 — Romania 16 4 158 178 — — — — 178 — — Russia — 123 — 123 — — — — 123 — — MDB and supranationals (3) — — 156 156 — — — — 156 — — Other 74 50 567 691 — 37 18 55 746 28 (16)
Romania 1 45 — 46 — — — — 46 — — MDB and supranationals (3) — — 233 233 — — — — 233 — — Other 86 381 600 1,067 — 3 31 34 1,101 26 (158)
Notes: (1) Designated as at fair value through profit or loss (DFV) balances are £533 million (2011 - £774 million) of which nil banks (2011 - nil), £61 million other financial institutions (2011 - £81 million) and £472 million corporate (2011 - £693 million). (2) Includes government sponsored entities (GSEs). (3) MDB - Multilateral Development Banks.
Balance sheet analysis continued Derivatives Summary The table below analyses the fair value of the Group’s derivatives by type of contract. Master netting arrangements in respect of mark-to-market (mtm) positions and collateral shown below do not result in a net presentation on the Group’s balance sheet under IFRS.
Interest rate (2) 5,144 10,395 11,343 6,601 33,483 363,454 345,565 38,727 422,553 406,784 39,764 312,111 299,209 Exchange rate 370 1,987 716 1,625 4,698 63,067 70,481 4,482 74,526 81,022 4,854 83,253 89,396 Credit 4 320 202 27 553 11,005 10,353 1,054 26,836 26,743 1,357 26,872 25,344 Other (3) 18 50 27 16 111 4,392 7,941 123 6,142 9,560 384 9,989 15,060 441,918 434,340 530,057 524,109 432,225 429,009 Counterparty mtm netting (373,906)(373,906) (441,626)(441,626) (330,397)(330,397)
Key points Net exposure, after taking account of position and collateral netting arrangements, decreased by 38% (liabilities decreased by 35%) due to lower derivative fair values, driven by market movements, including foreign exchange rates and increased use of compression cycles.
Interest rate contracts decreased due to the increased use of compression cycles reflecting a greater number of market participants and hence trade-matching and the effect of exchange rate movements. This was partially offset by downward shifts in interest rate yields.
The decrease in exchange rate contracts reflected the impact of exchange rate movements and trade maturities. This was partially offset by higher trade volumes, reflecting hedge funds taking advantage of market uncertainty.
Credit derivatives decreased due to a managed risk reduction and an increase in trades compressed through compression cycles.
2012 2011 2010 Notional Fair value Notional Fair value Notional Fair value
Client-led trading and residual risk 250.7 240.7 3.4 3.1 401.0 390.5 17.0 16.5 386.7 362.5 8.4 6.7 Credit hedging - banking book (1) 5.4 0.4 0.1 — 15.6 4.7 0.1 0.1 16.3 21.8 — 0.1 Credit hedging - trading book - rates 9.4 5.8 0.1 0.1 21.2 17.1 0.9 1.7 21.9 10.4 (0.9) 0.2 - credit and mortgage markets 22.4 16.0 0.9 0.7 42.9 28.4 2.3 1.7 168.1 172.7 3.5 3.1 - other 1.4 0.6 — — 0.9 0.1 — — 0.7 0.1 — — Total excluding APS 289.3 263.5 4.5 3.9 481.6 440.8 20.3 20.0 593.7 567.5 11.0 10.1 APS — — — — 131.8 — (0.2) — 195.8 — 0.6 —
Core Client-led trading 231.4 228.4 3.0 2.7 371.0 369.4 14.6 14.0 347.5 343.0 5.2 4.4 Credit hedging - banking book 1.7 — — — 2.2 1.0 — 0.1 1.1 1.0 (0.2) — Credit hedging - trading book - rates 7.8 4.6 0.1 0.1 19.9 16.2 0.9 1.7 21.7 10.3 (0.8) 0.2 - credit and mortgage markets 13.9 13.6 0.2 0.2 4.6 4.0 0.3 0.2 4.4 4.3 0.2 0.3 - other 1.3 0.5 — — 0.7 0.1 — — 0.6 0.1 — —
Balance sheet analysis: Derivatives continued Monoline insurers The table below summarises the Group's exposure to monolines, all of which are in Non-Core.
A to AA- 4,939 4,243 696 252 — 444 Non-investment grade 3,623 2,431 1,192 946 71 175 8,562 6,674 1,888 1,198 71 619
A to AA- 6,336 5,503 833 272 — 561 Non-investment grade 8,555 5,365 3,190 2,171 71 948 14,891 10,868 4,023 2,443 71 1,509
Of which: CMBS 4,149 2,424 1,725 1,253 CDOs 1,133 256 877 593 CLOs 6,724 6,121 603 210 Other ABS 2,393 1,779 614 294 Other 492 288 204 93 14,891 10,868 4,023 2,443
Key points The exposure to monolines declined during the year primarily due to restructuring of certain exposures and an increase in underlying asset prices.
AAA 213 212 1 — 1 A to AA- 646 632 14 3 11 Non-investment grade 19,671 18,151 1,520 788 732 Unrated 3,974 3,613 361 243 118 24,504 22,608 1,896 1,034 862
Balance sheet analysis: continued REIL, provisions and AFS reserves Risk elements in lending (REIL) comprises impaired loans and accruing loans past due 90 days or more as to principal or interest. Impaired loans are all loans (including renegotiated loans) for which an impairment provision has been established; for collectively assessed loans, impairment loss provisions are not allocated to individual loans and the entire portfolio is included in impaired loans. Accruing loans past due 90 days or more comprise loans past due 90 days where no impairment loss is expected and those awaiting individual assessment. A latent provision is established for the latter.
Divisional analysis The following tables analyse gross loans and advances to banks and customers (excluding reverse repos) and the related debt management measures and ratios by division.
UK Retail 695 113,599 4,569 2,629 4.0 58 529 599 UK Corporate 746 107,025 5,452 2,432 5.1 45 836 514 Wealth 1,545 17,074 248 109 1.5 44 46 15 International Banking 4,827 42,342 422 391 1.0 93 111 445 Ulster Bank 632 32,652 7,533 3,910 23.1 52 1,364 72 US Retail & Commercial 435 51,271 1,146 285 2.2 25 83 391 Retail & Commercial 8,880 363,963 19,370 9,756 5.3 50 2,969 2,036 Markets 16,805 29,787 396 305 1.3 77 25 109 Direct Line Group and other 5,232 3,006 — 1 — — 1 — Core 30,917 396,756 19,766 10,062 5.0 51 2,995 2,145 Non-Core 477 56,343 21,374 11,200 37.9 52 2,320 2,121 Group 31,394 453,099 41,140 21,262 9.1 52 5,315 4,266
December 2011 as improvements in International Banking and in Non-Core were partially offset by the continued increase in REIL in UK Corporate and Ulster Bank Core mortgage and corporate portfolios.
Balance sheet analysis: REIL, provisions and AFS reserves continued Sector and geographical regional analyses: Group The following tables analyse gross loans and advances to banks and customers (excluding reverse repos) and the related debt management measures and ratios by sector and geography (by location of lending office) for the Group, Core and Non-Core.
Government (1) 9,853 — — — — — — — Finance 42,198 592 317 1.4 54 0.8 145 380 Personal - mortgages 149,625 6,549 1,824 4.4 28 1.2 948 461 - unsecured 32,212 2,903 2,409 9.0 83 7.5 631 793 Property 72,219 21,223 9,859 29.4 46 13.7 2,212 1,080 Construction 8,049 1,483 640 18.4 43 8.0 94 182 Manufacturing 23,787 755 357 3.2 47 1.5 134 203 Finance leases (2) 13,609 442 294 3.2 67 2.2 44 263 Retail, wholesale and repairs 21,936 1,143 644 5.2 56 2.9 230 176 Transport and storage 18,341 834 336 4.5 40 1.8 289 102 Health, education and leisure 16,705 1,190 521 7.1 44 3.1 144 100 Hotels and restaurants 7,877 1,597 726 20.3 45 9.2 176 102 Utilities 6,631 118 21 1.8 18 0.3 (4) — Other 30,057 2,177 1,240 7.2 57 4.1 322 395 Latent — — 1,960 — — — (73) — 453,099 41,006 21,148 9.1 52 4.7 5,292 4,237 of which: UK - residential mortgages 109,530 2,440 457 2.2 19 0.4 122 32 - personal lending 20,498 2,477 2,152 12.1 87 10.5 479 610 - property 53,730 10,521 3,944 19.6 37 7.3 964 490 - construction 6,507 1,165 483 17.9 41 7.4 100 158 - other 122,029 3,729 2,611 3.1 70 2.1 674 823 Europe - residential mortgages 17,836 3,092 1,151 17.3 37 6.5 526 50 - personal lending 1,905 226 208 11.9 92 10.9 38 13 - property 14,634 10,347 5,766 70.7 56 39.4 1,264 441 - construction 1,132 289 146 25.5 51 12.9 (11) 12 - other 27,424 4,451 2,996 16.2 67 10.9 817 539 US - residential mortgages 21,929 990 208 4.5 21 0.9 298 377 - personal lending 8,748 199 48 2.3 24 0.5 109 162 - property 3,343 170 29 5.1 17 0.9 (11) 83 - construction 388 8 1 2.1 13 0.3 — 12 - other 29,354 352 630 1.2 179 2.1 (86) 149 RoW - residential mortgages 330 27 8 8.2 30 2.4 2 2 - personal lending 1,061 1 1 0.1 100 0.1 5 8 - property 512 185 120 36.1 65 23.4 (5) 66 - construction 22 21 10 95.5 48 45.5 5 — - other 12,187 316 179 2.6 57 1.5 2 210 Group 453,099 41,006 21,148 9.1 52 4.7 5,292 4,237
Government (1) 9,742 — — — — — — — Finance 51,870 1,062 726 2.0 68 1.4 89 87 Personal - mortgages 149,273 5,270 1,396 3.5 26 0.9 1,076 516 - unsecured 34,424 3,070 2,456 8.9 80 7.1 782 1,286 Property 81,058 22,101 8,994 27.3 41 11.1 3,669 1,171 Construction 9,869 1,943 761 19.7 39 7.7 140 244 Manufacturing 28,639 913 525 3.2 58 1.8 227 215 Finance leases (2) 14,499 794 508 5.5 64 3.5 112 170 Retail, wholesale and repairs 24,378 1,067 549 4.4 51 2.3 180 172 Transport and storage 22,058 606 154 2.7 25 0.7 78 43 Health, education and leisure 17,492 1,192 502 6.8 42 2.9 304 98 Hotels and restaurants 8,870 1,490 675 16.8 45 7.6 334 131 Utilities 8,406 88 23 1.0 26 0.3 3 3 Other 33,490 2,661 1,217 7.9 46 3.6 792 391 Latent — — 2,065 — — — (545) — 494,068 42,257 20,551 8.6 49 4.2 7,241 4,527 of which: UK - residential mortgages 106,388 2,262 431 2.1 19 0.4 180 25 - personal lending 22,008 2,717 2,209 12.3 81 10.0 645 1,007 - property 60,041 11,147 3,837 18.6 34 6.4 1,411 493 - construction 7,589 1,427 560 18.8 39 7.4 187 228 - other 132,548 4,635 2,943 3.5 63 2.2 514 655 Europe - residential mortgages 18,946 2,205 713 11.6 32 3.8 467 10 - personal lending 2,464 209 180 8.5 86 7.3 25 126 - property 16,384 10,314 4,947 63.0 48 30.2 2,296 504 - construction 1,754 362 185 20.6 51 10.5 (62) — - other 34,497 4,261 2,873 12.4 67 8.3 1,267 293 US - residential mortgages 23,237 770 240 3.3 31 1.0 426 481 - personal lending 8,441 143 66 1.7 46 0.8 112 153 - property 3,783 329 92 8.7 28 2.4 (2) 139 - construction 457 121 10 26.5 8 2.2 9 16 - other 37,015 517 895 1.4 173 2.4 (175) 180 RoW - residential mortgages 702 33 12 4.7 36 1.7 3 — - personal lending 1,511 1 1 0.1 100 0.1 — — - property 850 311 118 36.6 38 13.9 (36) 35 - construction 69 33 6 47.8 18 8.7 6 — - other 15,384 460 233 3.0 51 1.5 (32) 182 Group 494,068 42,257 20,551 8.6 49 4.2 7,241 4,527
Government (1) 8,452 — — — — — — — Finance 54,952 1,129 595 2.1 53 1.1 198 141 Personal - mortgages 146,501 4,276 877 2.9 21 0.6 1,014 669 - unsecured 37,472 3,544 2,894 9.5 82 7.7 1,370 1,577 Property 90,403 19,584 6,736 21.7 34 7.5 4,682 1,009 Construction 12,105 2,464 875 20.4 36 7.2 530 146 Manufacturing 33,485 1,199 503 3.6 42 1.5 (92) 1,547 Finance leases (2) 16,850 847 554 5.0 65 3.3 252 113 Retail, wholesale and repairs 25,165 1,157 572 4.6 49 2.3 334 161 Transport and storage 24,141 248 118 1.0 48 0.5 87 39 Health, education and leisure 19,431 1,055 319 5.4 30 1.6 159 199 Hotels and restaurants 9,681 1,269 504 13.1 40 5.2 321 106 Utilities 10,046 91 23 0.9 25 0.2 14 7 Other 37,168 1,643 863 4.4 53 2.3 409 316 Latent — — 2,658 — — — (121) — 525,852 38,506 18,091 7.3 47 3.4 9,157 6,030 of which: UK - residential mortgages 101,593 2,062 314 2.0 15 0.3 169 17 - personal lending 23,620 3,083 2,518 13.1 82 10.7 1,046 1,153 - property 65,759 7,986 2,219 12.1 28 3.4 1,546 397 - construction 9,424 1,747 605 18.5 35 6.4 371 110 - other 142,651 3,815 2,895 2.7 76 2.0 826 594 Europe - residential mortgages 20,094 1,551 301 7.7 19 1.5 221 6 - personal lending 2,870 401 316 14.0 79 11.0 66 24 - property 17,775 10,534 4,199 59.3 40 23.6 2,828 210 - construction 1,887 667 255 35.3 38 13.5 138 2 - other 41,280 3,229 2,156 7.8 67 5.2 633 1,414 US - residential mortgages 24,201 640 253 2.6 40 1.0 615 645 - personal lending 9,520 55 55 0.6 100 0.6 160 271 - property 4,929 765 202 15.5 26 4.1 321 220 - construction 520 50 15 9.6 30 2.9 26 34 - other 35,868 820 1,118 2.3 136 3.1 (102) 490 RoW - residential mortgages 613 23 9 3.8 39 1.5 9 1 - personal lending 1,462 5 5 0.3 100 0.3 98 129 - property 1,940 299 116 15.4 39 6.0 (13) 182 - construction 274 — — — — — (5) — - other 19,572 774 540 4.0 70 2.8 204 131 Group 525,852 38,506 18,091 7.3 47 3.4 9,157 6,030
Government (1) 8,485 — — — — — — — Finance 39,658 185 149 0.5 81 0.4 54 338 Personal - mortgages 146,770 6,229 1,691 4.2 27 1.2 786 234 - unsecured 31,247 2,717 2,306 8.7 85 7.4 568 718 Property 43,602 4,672 1,674 10.7 36 3.8 748 214 Construction 6,020 757 350 12.6 46 5.8 119 60 Manufacturing 22,234 496 225 2.2 45 1.0 118 63 Finance leases (2) 9,201 159 107 1.7 67 1.2 35 41 Retail, wholesale and repairs 20,842 791 439 3.8 55 2.1 181 129 Transport and storage 14,590 440 112 3.0 25 0.8 72 21 Health, education and leisure 15,770 761 299 4.8 39 1.9 109 67 Hotels and restaurants 6,891 1,042 473 15.1 45 6.9 138 56 Utilities 5,131 10 5 0.2 50 0.1 — — Other 26,315 1,374 794 5.2 58 3.0 189 175 Latent — — 1,325 — — — (145) — 396,756 19,633 9,949 4.9 51 2.5 2,972 2,116 of which: UK - residential mortgages 109,511 2,440 457 2.2 19 0.4 122 32 - personal lending 20,443 2,454 2,133 12.0 87 10.4 474 594 - property 35,532 2,777 896 7.8 32 2.5 395 181 - construction 5,101 671 301 13.2 45 5.9 109 47 - other 108,713 2,662 1,737 2.4 65 1.6 499 379 Europe - residential mortgages 17,446 3,060 1,124 17.5 37 6.4 521 24 - personal lending 1,540 143 138 9.3 97 9.0 29 11 - property 4,896 1,652 685 33.7 41 14.0 350 6 - construction 513 60 39 11.7 65 7.6 4 10 - other 22,218 2,280 1,711 10.3 75 7.7 362 267 US - residential mortgages 19,483 702 102 3.6 15 0.5 141 176 - personal lending 8,209 119 34 1.4 29 0.4 65 112 - property 2,847 112 13 3.9 12 0.5 3 27 - construction 384 5 — 1.3 — — 1 3 - other 28,267 252 432 0.9 171 1.5 (111) 90 RoW - residential mortgages 330 27 8 8.2 30 2.4 2 2 - personal lending 1,055 1 1 0.1 100 0.1 — 1 - property 327 131 80 40.1 61 24.5 — — - construction 22 21 10 95.5 48 45.5 5 — - other 9,919 64 48 0.6 75 0.5 1 154 Group 396,756 19,633 9,949 4.9 51 2.5 2,972 2,116
Balance sheet analysis: REIL, provisions and AFS reserves continued Sector and geographical regional analyses: Core continued
Government (1) 6,781 — — — — — — — Finance 47,161 567 402 1.2 71 0.9 191 53 Personal - mortgages 140,359 3,999 693 2.8 17 0.5 578 243 - unsecured 33,581 3,131 2,545 9.3 81 7.6 1,157 1,271 Property 42,455 3,287 818 7.7 25 1.9 739 98 Construction 8,680 610 222 7.0 36 2.6 189 38 Manufacturing 25,797 555 266 2.2 48 1.0 119 124 Finance leases (2) 8,321 244 140 2.9 57 1.7 63 42 Retail, wholesale and repairs 21,974 611 259 2.8 42 1.2 199 103 Transport and storage 15,946 112 40 0.7 36 0.3 40 35 Health, education and leisure 17,456 507 134 2.9 26 0.8 145 64 Hotels and restaurants 8,189 741 236 9.0 32 2.9 165 49 Utilities 7,098 22 3 0.3 14 — 1 — Other 29,053 677 329 2.3 49 1.1 161 103 Latent — — 1,653 — — — (5) — 412,851 15,063 7,740 3.6 51 1.9 3,742 2,223 of which: UK - residential mortgages 99,928 2,010 307 2.0 15 0.3 164 16 - personal lending 23,035 2,888 2,341 12.5 81 10.2 1,033 1,142 - property 34,970 2,454 500 7.0 20 1.4 394 43 - construction 7,041 536 183 7.6 34 2.6 148 29 - other 113,415 2,031 1,480 1.8 73 1.3 541 289 Europe - residential mortgages 19,473 1,506 280 7.7 19 1.4 184 6 - personal lending 2,270 203 164 8.9 81 7.2 43 19 - property 5,139 631 240 12.3 38 4.7 241 1 - construction 1,014 67 32 6.6 48 3.2 35 (1) - other 27,759 1,444 1,268 5.2 88 4.6 438 85 US - residential mortgages 20,548 460 97 2.2 21 0.5 225 221 - personal lending 6,816 35 35 0.5 100 0.5 81 110 - property 1,611 144 43 8.9 30 2.7 84 54 - construction 442 7 7 1.6 100 1.6 6 10 - other 31,848 381 642 1.2 169 2.0 29 161 RoW - residential mortgages 410 23 9 5.6 39 2.2 5 — - personal lending 1,460 5 5 0.3 100 0.3 — — - property 735 58 35 7.9 60 4.8 20 — - construction 183 — — — — — — — - other 14,754 180 72 1.2 40 0.5 71 38 Group 412,851 15,063 7,740 3.6 51 1.9 3,742 2,223
Government (1) 1,368 — — — — — — — Finance 2,540 407 168 16.0 41 6.6 91 42 Personal - mortgages 2,855 320 133 11.2 42 4.7 162 227 - unsecured 965 186 103 19.3 55 10.7 63 75 Property 28,617 16,551 8,185 57.8 49 28.6 1,464 866 Construction 2,029 726 290 35.8 40 14.3 (25) 122 Manufacturing 1,553 259 132 16.7 51 8.5 16 140 Finance leases (2) 4,408 283 187 6.4 66 4.2 9 222 Retail, wholesale and repairs 1,094 352 205 32.2 58 18.7 49 47 Transport and storage 3,751 394 224 10.5 57 6.0 217 81 Health, education and leisure 935 429 222 45.9 52 23.7 35 33 Hotels and restaurants 986 555 253 56.3 46 25.7 38 46 Utilities 1,500 108 16 7.2 15 1.1 (4) — Other 3,742 803 446 21.5 56 11.9 133 220 Latent — — 635 — — — 72 — 56,343 21,373 11,199 37.9 52 19.9 2,320 2,121 of which: UK - residential mortgages 19 — — — — — — — - personal lending 55 23 19 41.8 83 34.5 5 16 - property 18,198 7,744 3,048 42.6 39 16.7 569 309 - construction 1,406 494 182 35.1 37 12.9 (9) 111 - other 13,316 1,067 874 8.0 82 6.6 175 444 Europe - residential mortgages 390 32 27 8.2 84 6.9 5 26 - personal lending 365 83 70 22.7 84 19.2 9 2 - property 9,738 8,695 5,081 89.3 58 52.2 914 435 - construction 619 229 107 37.0 47 17.3 (15) 2 - other 5,206 2,171 1,285 41.7 59 24.7 455 272 US - residential mortgages 2,446 288 106 11.8 37 4.3 157 201 - personal lending 539 80 14 14.8 18 2.6 44 50 - property 496 58 16 11.7 28 3.2 (14) 56 - construction 4 3 1 75.0 33 25.0 (1) 9 - other 1,087 100 198 9.2 198 18.2 25 59 RoW - personal lending 6 — — — — — 5 7 - property 185 54 40 29.2 74 21.6 (5) 66 - other 2,268 252 131 11.1 52 5.8 1 56 Group 56,343 21,373 11,199 37.9 52 19.9 2,320 2,121
Government (1) 1,383 — — — — — — — Finance 3,272 317 147 9.7 46 4.5 (118) 43 Personal - mortgages 5,102 380 180 7.4 47 3.5 300 318 - unsecured 1,556 110 92 7.1 84 5.9 67 351 Property 38,064 17,969 7,861 47.2 44 20.7 3,200 1,004 Construction 2,672 1,102 475 41.2 43 17.8 (39) 101 Manufacturing 4,931 423 283 8.6 67 5.7 121 90 Finance leases (2) 6,059 622 398 10.3 64 6.6 81 102 Retail, wholesale and repairs 2,339 388 204 16.6 53 8.7 (28) 53 Transport and storage 5,477 264 94 4.8 36 1.7 31 14 Health, education and leisure 1,419 501 245 35.3 49 17.3 134 43 Hotels and restaurants 1,161 485 289 41.8 60 24.9 125 71 Utilities 1,849 66 22 3.6 33 1.2 3 3 Other 4,721 1,379 549 29.2 40 11.6 254 197 Latent — — 647 — — — (293) — 80,005 24,006 11,486 30.0 48 14.4 3,838 2,390 of which: UK - residential mortgages 1,423 52 11 3.7 21 0.8 6 1 - personal lending 127 37 30 29.1 81 23.6 (12) 179 - property 24,610 8,163 3,093 33.2 38 12.6 1,033 379 - construction 1,882 772 324 41.0 42 17.2 27 90 - other 17,670 2,064 1,295 11.7 63 7.3 148 257 Europe - residential mortgages 553 84 49 15.2 58 8.9 30 — - personal lending 492 66 55 13.4 83 11.2 33 104 - property 11,538 9,277 4,582 80.4 49 39.7 2,134 494 - construction 735 290 142 39.5 49 19.3 (75) — - other 10,083 1,831 1,067 18.2 58 10.5 352 110 US - residential mortgages 2,926 244 120 8.3 49 4.1 264 317 - personal lending 936 7 7 0.7 100 0.7 46 68 - property 1,370 218 68 15.9 31 5.0 (18) 96 - construction 45 23 9 51.1 39 20.0 9 11 - other 2,044 172 312 8.4 181 15.3 (201) 84 RoW - residential mortgages 200 — — — — — — — - personal lending 1 — — — — — — — - property 546 311 118 57.0 38 21.6 51 35 - construction 10 17 — 170.0 — — — — - other 2,814 378 204 13.4 54 7.2 11 165 Group 80,005 24,006 11,486 30.0 48 14.4 3,838 2,390
Notes: (1) Includes central and local government. (2) Includes instalment credit.
Provisions and AFS reserves methodology The Group's consumer portfolios, which consist of high volume, small value credits, have highly efficient largely automated processes for identifying problem credits and very short timescales, typically three months, before resolution or adoption of various recovery methods. Corporate portfolios consist of higher value, lower volume credits, which tend to be structured to meet individual customer requirements.
Analyses of AFS debt securities and related AFS reserves are set out on page 240.
REIL flow statement REIL are stated without giving effect to any security held that could reduce the eventual loss should it occur or to any provisions marked.
REIL as a % of gross loans and advances (1) 4.9% 38.2% 9.1% 4.4% 30.1% 8.6% 3.7% 20.8% 7.3% Provisions as a % of REIL 51% 52% 52% 50% 48% 49% 52% 44% 47%
Total Core Non-Core RFS MI Group £m £m £m £m £m £m £m £m £m £m £m £m £m
At 1 January 2012 2,679 2,061 81 851 2,749 455 8,876 311 — 9,187 11,487 — 20,674 Currency translation and other adjustments 12 87 — (131) (54) 53 (33) 77 — 44 (369) — (325) Disposal of subsidiaries — — — — — — — — — — (1) (4) (5)
Recoveries of amounts previously written-off 21 38 4 63 4 130 Charged to income statement - continuing operations 241 913 983 177 6 2,320 Unwind of discount (2) (38) (38) (170) — — (246)
Individually assessed - banks — 1 — — — 1 - customers 688 2,604 6,481 24 8 9,805 Collectively assessed 422 — 225 92 18 757 Latent 57 210 227 141 2 637 1,167 2,815 6,933 257 28 11,200
At 1 January 2010 2,677 1,287 55 1,139 962 482 6,602 319 6,921 8,553 2,110 17,584 Transfers to disposal groups — — — — — — — — — (72) — (72) Intra-group transfers — — — (217) (351) — (568) — (568) 568 — — Currency translation and other adjustments — 71 4 (98) (22) 20 (25) 9 (16) (206) — (222) Disposal of subsidiaries — — — — — — — — — (20) (2,152) (2,172)
Impairment provisions The table below analyses impairment provisions in respect of loans and advances to banks and customers.
Individually assessed 2,839 9,805 12,644 2,833 9,965 12,798 1,948 8,176 10,124 Collectively assessed 5,785 757 6,542 4,814 874 5,688 4,139 1,170 5,309 Latent loss 1,325 637 1,962 1,418 647 2,065 1,653 1,005 2,658 Loans and advances to customers 9,949 11,199 21,148 9,065 11,486 20,551 7,740 10,351 18,091 Loans and advances to banks 113 1 114 122 1 123 126 1 127 Total provisions 10,062 11,200 21,262 9,187 11,487 20,674 7,866 10,352 18,218
Individually assessed — 554 42 136 457 15 1,205 28 1 1,233 1,936 3,169 Collectively assessed 544 317 — (1) 787 237 1,884 — — 1,884 312 2,196 Latent loss (15) (35) 4 (47) 120 (169) (143) (3) — (145) 72 (73) Loans to customers 529 836 46 88 1,364 83 2,946 25 1 2,972 2,320 5,292 Loans to banks — — — 23 — — 23 — — 23 — 23 Securities - other — 2 — — — 8 10 12 39 61 (97) (36)
Individually assessed 206 913 842 (25) — 1,936 Collectively assessed 71 — 25 208 8 312 Latent loss (37) 1 116 (6) (2) 72 Loans to customers 240 914 983 177 6 2,320 Securities — (97) — — — (97)
Individually assessed 512 679 2,426 (3) 1 3,615 Collectively assessed 129 — 29 372 (14) 516 Latent loss (113) — (106) (66) (8) (293) Loans to customers 528 679 2,349 303 (21) 3,838 Securities — 78 — — 5 83 Charge to income statement 528 757 2,349 303 (16) 3,921
Balance sheet analysis: REIL, provisions and AFS reserves continued The tables below analyses the impairment charge for loans and securities.
Notes: (1) Includes related interest rate hedge adjustments. (2) Customer loan impairment charge as a percentage of gross loans and advances to customers including assets of disposal groups and excluding reverse repurchase agreements.
Loan impairment losses - customers 2,972 2,320 5,292 3,403 3,838 7,241 3,742 5,415 9,157 - banks 23 — 23 — — — (5) (8) (13)
Impairment losses on securities - debt securities 47 (114) (67) 1,381 52 1,433 40 41 81 - equity securities 14 17 31 4 31 35 4 27 31 61 (97) (36) 1,385 83 1,468 44 68 112
Central and local government 9,774 19,046 16,155 44,975 13,436 20,848 25,552 59,836 8,377 22,244 32,865 63,486 Banks 1,085 357 7,419 8,861 1,391 376 11,408 13,175 4,297 704 11,981 16,982 Other financial institutions 2,861 10,613 10,416 23,890 3,100 17,453 11,199 31,752 1,662 15,973 11,513 29,148 Corporate 1,318 719 1,130 3,167 1,105 131 1,299 2,535 438 65 1,011 1,514 Total 15,038 30,735 35,120 80,893 19,032 38,808 49,458 107,298 14,774 38,986 57,370 111,130
Central and local government - UK 716 10 — — 716 10 - US 74 1 163 1 237 2 - Other 4,328 6 1,738 612 6,066 618 Banks 1,655 16 6,202 770 7,857 786 Other financial institutions 2,993 73 6,972 2,553 9,965 2,626 Corporate 163 32 114 23 277 55 Total 9,929 138 15,189 3,959 25,118 4,097
Market risk analyses 247 Trading revenues 247 Daily VaR graph 248 Trading book 248
Market risk capital 250 Minimum capital requirements 250 IRC by rating and product category 251 Securitisation positions in the trading book 251
Market risk Introduction Market risk arises from fluctuations in interest rates, foreign currency, credit spreads, equity prices, commodity prices and risk related factors such as market volatilities. The Group manages market risk within its trading and non-trading portfolios through a comprehensive market risk management framework. This control framework includes qualitative and quantitative guidance in the form of comprehensive policy statements, dealing authorities, limits based on, but not limited to, value-at-risk (VaR), stressed VaR (SVaR), stress testing and sensitivity analyses.
Governance Business structure The primary focus of the Group’s trading activities is to provide an extensive range of financing, risk management and investment services to its customers, including major corporations and financial institutions around the world. The Group undertakes these activities organised within the principal business lines: money markets; rates flow trading; currencies and commodities; equities; credit markets; and portfolio management and origination.
Financial instruments held in the Group’s trading portfolios include, but are not limited to: debt securities; loans; deposits; equities; securities sale and repurchase agreements and derivative financial instruments.
The Group also undertakes transactions in financial instruments that are traded over-the-counter rather than on a recognised exchange. These instruments range from commoditised transactions in derivative markets, to trades where the specific terms are tailored to meet customer requirements.
Organisation structure Independent oversight and support is provided to the divisions by the Global Head of Market & Insurance Risk, assisted by the Group and divisional market risk teams. The head of each division, assisted by a divisional market risk management team, is accountable for all market risks associated with its activities. The Global Market Risk Committee reviews and makes recommendations concerning the market risk profile across the Group, including risk appetite, risk policy, models, methodology and market risk development issues. The committee meets quarterly and is chaired by the Global Head of Market & Insurance Risk. Attendees include respective divisional market risk managers and Group Market Risk.
Regulatory Risk Trading activities will indirectly be impacted by regulatory proposals that will change market participants behaviours. These are discussed in more detail in the Regulatory risk section (refer to page 285). Developments specific to market risk include the Fundamental Review of the Trading Book (FRTB) and the Fundamental Review of the Securitisation Treatments. The FRTB remains at a conceptual stage and there is currently insufficient practical detail available to provide a meaningful assessment of what may eventually be implemented. The Basel Committee's review of the treatment of securitisation positions is further advanced and the Group is currently reviewing how it can participate to assess the impact on trading book activities.
Risk measurement Key principles The Group’s qualitative market risk appetite is set out in policy statements, which outline the governance, responsibilities and requirements surrounding the identification, measurement, analysis, management and communication of market risk arising from the trading and non-trading investment activities of the Group. All teams involved in the management and control of market risk are required to fully comply with the policy statements to ensure the Group is not exposed to market risk beyond the qualitative and quantitative risk appetite. The control framework covers the following principles: Clearly defined responsibilities and authorities for the primary groups involved in market risk management in the Group; An independent market risk management process; Daily monitoring, analysis and reporting of market risk exposures against market risk limits; Clearly defined limit structure and escalation process in the event of a market risk limit excess; A market risk measurement methodology that captures correlation effects and allows aggregation of market risk across risk types, markets and business lines; Use of VaR as a measure of the one-day and SVaR as a measure of the ten-day market risk exposure of all trading positions; Use of non-VaR based limits and other controls; Use of stress testing and scenario analysis to support the market risk measurement and risk management process by assessing how portfolios and global business lines perform under extreme market conditions; Use of back-testing as a diagnostic tool to assess the accuracy of the VaR model and other risk management techniques; Adherence to the risks not in VaR framework to identify, quantify and capitalise risks not captured within the VaR model; and
The specific market risk metrics that are appropriate for controlling the positions of a desk will be more granular than the Group level limits and tailored to the particular division and business.
In 2012, a market risk economic capital model was developed. It is planned to use this model for performance measurement within Markets and to assess the risks of the group from a consolidated economic perspective. The results of the model will be consolidated with other risk types and reported during 2013. The model calculates the market and default risk in the trading book using an extended historic simulation approach with multiple liquidity horizons (differentiated by portfolio and asset class). The results are annualised to be consistent with the other Group economic capital models.
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, if so, intra-day profit and losses will be incurred.
SVaR - is applied to the trading portfolio and utilises data from a specific one year period of stress. As with VaR, the technique produces estimates of the potential change in the market value of a portfolio over a specified time horizon at given confidence level. For the purposes of calculating regulatory SVaR, a time horizon of ten trading days is assumed and a confidence level of 99%.
In December 2012, the FSA confirmed the European Banking Authority guidelines relating to SVaR. The FSA now requires the use of ‘Dynamic’ SVaR, where the worst one year period of stress is determined on a daily basis.
Some RNIVs are quantified using a stress scenario approach. For these RNIVs, an assessment of ten-day extreme, but plausible, market moves is used in combination with position sensitivities to give a stress-type loss number - the stressed RNIV value.
Incremental risk charge (IRC) - The IRC model aims to quantify the impact of defaults and rating changes on the market value of bonds, credit derivatives, and other related positions held in the trading book. It is calculated over a one year horizon to a 99.9% confidence level, and therefore represents a 1-in-1,000 loss over the following year. The modelling framework differentiates between the liquidity of different underlying instruments, with a minimum liquidity horizon of three months. It also captures basis risks between different products referencing the same underlying credit (e.g. bonds and credit default swaps (CDS)), and between similar products with different contractual terms (e.g. CDS in different currencies). The portfolio impact of correlated defaults and rating changes is assessed with reference to the resulting market value change of positions, which is determined using stressed recovery rates and modelled credit spread changes. The average liquidity horizon at the year end was 4.6 months.
Model validation - A model assessment is performed before a new or changed model element is implemented, and before a change is made to a market data mapping. Depending on the results, it may be necessary to notify the FSA before implementation. The form of internal validation depends on the type of model and the materiality of the change.
In the case of VaR models, the following steps are considered. In some cases, for example a minor change to a market data mapping, it will not be necessary to perform all of the steps. However, in all cases there will be an independent review and validation.
Back-test the approach using hypothetical portfolio(s) where this is helpful for isolating the performance of specific areas of the model.
Identify any model weaknesses or scope limitations, their effect and how they have been addressed.
Identify ongoing model testing designed to give early warning of market or portfolio weakness becoming significant.
Stress testing* The Group undertakes daily stress testing to identify the potential losses in excess of VaR. Stress testing is used to calculate a range of trading book exposures which result from severe and extreme market events. Stress testing measures the impact of exceptional changes in market rates and prices on the fair value of the Group’s trading and available-forsale portfolios. The Group calculates sensitivity analysis, historical stress tests and bottom-up stress testing.
Historical stress tests calculate the changes in the portfolio valuations that would be generated if the extreme market movements that occurred during significant historical market events were repeated. Historical stress tests also form part of the Group Market Risk limit framework.
The Global Market Risk Stress Testing Committee reviews and discusses all matters relating to market risk stress testing. Stress test exposures are discussed with senior management and relevant information is reported to the Group Risk Committee, the ERF and the Board. Breaches in the Group’s market risk stress testing limits are monitored and reported.
Marking-to-market To ensure that the risks associated with trading activity are reflected in the financial and management statements, assets and liabilities in the trading book are measured at their fair value. Any profits or losses on the revaluation of positions are recognised in the income statement on a daily basis.
Compliance statements - business unit control is required to prepare and maintain compliance statements that benchmark price verification procedures against the independent pricing policy. Each compliance statement requires review and sign-off from the relevant financial controller, market risk manager and front office management every six months at least.
For more information on independent price verification, refer to Valuation of financial instruments carried at fair value on page 393.
Key points Both 2011 and 2012 benefited from market rallies, albeit weaker but more sustained during 2012 than 2011, primarily due to the supportive actions of the Federal Reserve and European Central Bank in the third quarter of 2012. By way of contrast, in the third quarter of 2011, heightened uncertainty in the Eurozone saw a sudden deterioration in credit markets. Hence a wider range of results in 2011 than 2012.
The average daily revenue earned by Markets’ trading activities in 2012 was £16 million, compared with £18 million in 2011. The standard deviation of the daily revenues decreased from £20 million to £15 million. The number of days with negative revenue decreased to 34 from 45. The most frequent daily revenue was between £5 million and £10 million, which occurred 36 times. In 2011, the most frequent daily revenue was between £25 million and £30 million, which occurred 31 times.
CEM manages the over-the-counter derivative counterparty credit and funding risk on behalf of Markets and Non-Core, by actively controlling risk concentrations and reducing unwanted risk exposures. The hedging transactions CEM enters into are booked 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 and to more properly represent the exposure, CEM trading book exposure and total trading VaR excluding CEM are disclosed separately.
Key points The Group’s average and maximum credit spread VaR for 2012 was lower than for 2011. This reflected the credit spread volatility experienced during the financial crisis dropping out of the time series window, combined with a reduction in the asset-backed securities trading inventory in Core and the sale of unencumbered asset-backed securities assets following the prior restructuring of some monoline hedges in the Non-Core banking book.
The Non-Core VaR was significantly lower in 2012, as Non-Core continued its de-risking strategy through the disposal of assets and unwinding of trades.
Since late 2011, CEM started to centrally manage the funding risk on over-the-counter derivatives contracts, causing the VaR to be considerably higher in 2012 than 2011.
VaR is not always the most appropriate measure of risk for assets in the banking book and particularly for those in Non-Core, which will diminish over time as the asset inventory is sold down or run-off.
Core 11.3 7.5 19.0 7.1 19.3 15.1 38.9 13.5 30.5 15.6 98.1 12.8 Non-Core 2.5 3.4 3.6 1.6 3.4 2.5 4.3 2.2 1.3 2.8 4.1 0.2 CEM 1.0 1.0 1.1 0.9 0.4 0.9 0.9 0.3 Total (excluding CEM) 11.5 9.4 17.8 8.2 19.7 15.5 41.4 13.7
The Non-Core period end VaR was higher in 2012 than in 2011, due to improvements in the time series mapping on certain Australian bonds and the purchase of additional hedges.
Market risk capital* Minimum capital requirements The following table analyses the market risk minimum capital requirement, calculated in accordance with Basel 2.5.
Key points The FSA approved the inclusion of the Group’s US trading subsidiary RBS Securities Inc. in the regulatory models in March 2012. This resulted in the model-based charges for VaR, SVaR and IRC increasing at that time and the standardised interest rate PRR decreasing significantly.
SVaR decreased during the remainder of 2012, due to the disposal of assets in Non-Core and general de-risking in sovereign and agency positions in Markets.
External environment* Country risk, notably in the eurozone, remained elevated in 2012, particularly in the first half of the year. Economic growth projections were lowered, predominantly for Europe, but also for a number of major emerging markets. However, important first steps towards achieving longer-term stabilisation in the eurozone led to some notable easing of crisis risks. Growth data from major non-European economies, such as China, were more encouraging towards the end of the year. The ability of policymakers to tackle fiscal challenges and restore confidence and growth in both the US and Europe will be a key factor in determining the pace of recovery.
In the second half of the year, the ESM became fully operational and the European Central Bank (ECB) announced a major new facility, Outright Monetary Transactions. This facility allows secondary market purchases by the ECB of bonds issued by eurozone sovereigns that are subject to a European Union (EU)/International Monetary Fund (IMF) support programme. Following these steps, sovereign bond yields fell markedly.
Emerging markets Emerging markets performed better on the whole. In developing Asia, the economies of China and India both continued to slow from a strong base, but risks remained held in check by healthy external balance sheets.
General political instability seen in the Middle East and North Africa in 2011 moderated in 2012 in most countries except Syria, although transition to democratic rule was only partial in some cases. Excluding Bahrain, Gulf Cooperation Council countries were generally more stable, underpinned by high oil prices.
Latin America continued to be characterised by greater stability, due to generally healthier sovereign balance sheets. However, growth prospects deteriorated because of weaker external demand, notably in the region’s largest economy, Brazil.
Country risk continued Governance, monitoring and management* The Group’s country risk framework is set by the Executive Risk Forum (ERF), which has delegated authority to the Group Country Risk Committee (GCRC) to manage exposures within the framework and deal with any limit breaches, with escalation where needed to ERF. Under this framework, exposures to all countries are monitored. Countries with material exposures are included in the Group’s country risk Watchlist process to identify emerging issues and facilitate the development of mitigation strategies. Detailed portfolio reviews are undertaken on a regular basis to ensure that country portfolio compositions remain aligned to the Group’s country risk appetite in light of evolving economic and political developments.
Limits on total exposure are set for individual countries based on a risk assessment taking into account the country’s economic and political situation and outlook, as well as the Group’s portfolio composition in that country. Sub-limits are set on medium-term (greater than one year) exposure since this exposure can, by nature, not be reduced as rapidly as short-term exposure in the event of deterioration of a country’s creditworthiness.
Country risk: Country risk exposure All the data tables and related definitions in this section are audited.
Definitions Lending - Comprises gross loans and advances to: central and local government (Govt); central banks, including cash balances; other banks and financial institutions (FI), incorporating overdraft and other short-term facilities; corporates, in large part loans and leases; and individuals, comprising mortgages, personal loans and credit card balances. Lending includes risk elements in lending.
In addition and as a memorandum item, the mtm value of derivatives and repos gross of netting referred to above are disclosed.
Balance sheet - Comprises lending, debt securities, derivatives (net) and repo (net) exposures, as defined above.
Credit default swaps (CDSs) - Under a CDS contract, the credit risk on the reference entity is transferred from the buyer to the seller. The fair value, or mtm value, represents the balance sheet carrying value. The mtm value of CDSs is included within derivatives against the counterparty of the trade, as opposed to the reference entity. The notional is the par value of the credit protection bought or sold and is included against the reference entity of the CDS contract.
Asset quality (AQ) - For the probability of default range relating to each internal asset quality band, refer to page 205.
CDS notional less fair value Derivatives Repos 2012 £m £m £m £m £m £m £m £m £m £m £m £m £m £m £m £m £m
CDS notional less fair value Derivatives Repos 2011 £m £m £m £m £m £m £m £m £m £m £m £m £m £m £m £m £m
Total eurozone - Balance sheet exposure declined by £27.5 billion or 14% during 2012 to £165.8 billion, with reductions seen primarily in periphery countries but also in the Netherlands, Germany, France and Luxembourg. This reflected exchange rate movements, sales of Greek, Spanish and Portuguese AFS bonds, write-offs, active exposure management and debt reduction efforts by bank clients.
Eurozone periphery - Balance sheet exposure decreased across all countries to a combined £59.1 billion, a reduction of £8.8 billion or 13%, caused in part by reductions in AFS bonds in Spain, Italy and Greece. Most of the Group’s exposure arises from the activities of Markets, International Banking, Group Treasury and Ulster Bank (with respect to Ireland). Group Treasury has a portfolio of Spanish bank and financial institution securities. International Banking provides trade finance facilities to clients across Europe, including the eurozone periphery. Balance sheet exposure to Cyprus amounted to £0.3 billion at 31 December 2012, comprising mainly lending exposure to special purpose vehicles incorporated in Cyprus, but with assets and cash flows largely elsewhere.
CDS protection bought and sold The Group uses CDS contracts to service customer activity as well as manage counterparty and country exposure. During 2012, eurozone gross notional CDS contracts, bought and sold, decreased significantly. This was caused by maturing contracts and by efforts to reduce counterparty credit exposures and risk-weighted assets mainly through derivative compression trades. The fair value of bought and sold CDS contracts also decreased due to the reduction in gross notional CDS positions and a narrowing of CDS spreads over the year for a number of eurozone countries, including Portugal and Ireland. All in all, net bought CDS protection referencing entities in eurozone countries taken by the Group in terms of CDS notional less fair value, decreased to £6.8 billion, from £8.4 billion at 31 December 2011.
During 2012 the credit quality of CDS bought protection counterparties shown in the individual country tables, deteriorated primarily reflecting rating model changes in the fourth quarter of the year resulting in more conservative internal ratings (refer to Changes to wholesale credit risk models on page 162). There was also a downgrading of some of these counterparties during the year.
For more specific analysis and commentary on the Group’s exposure to Ireland, Spain, Italy, Portugal and Greece, refer to pages 262 to 271. For commentary on the Group’s exposure to eurozone non-periphery countries, refer to page 280.
Government 678 — — 11,487 267 17,430 8,469 20,448 1,797 — 22,923 783 23,706 5,307 — Central bank 21,969 — — — — — — — 35 — 22,004 — 22,004 36 4,648 Other banks 4,257 — — 5,588 (509) 1,021 611 5,998 25,956 1,161 37,372 4,400 41,772 148,534 28,679 Other FI 4,237 — — 9,367 (1,081) 1,261 142 10,486 7,595 727 23,045 5,537 28,582 15,055 16,124 Corporate 37,351 14,253 7,451 794 33 311 115 990 3,594 24 41,959 29,061 71,020 4,945 732 Personal 18,512 3,351 1,733 — — — — — 1 — 18,513 743 19,256 1 — 87,004 17,604 9,184 27,236 (1,290) 20,023 9,337 37,922 38,978 1,912 165,816 40,524 206,340 173,878 50,183
Government 671 — — 18,406 81 19,597 15,049 22,954 1,924 — 25,549 1,056 26,605 4,979 791 Central bank 27,282 — — 20 — 6 — 26 35 — 27,343 — 27,343 38 15,103 Other banks 3,474 — — 8,423 (752) 1,272 1,502 8,193 28,595 1,090 41,352 4,493 45,845 175,187 31,157 Other FI 4,355 — — 10,494 (1,129) 1,138 471 11,161 9,854 1,102 26,472 8,199 34,671 18,204 20,436 Corporate 47,522 14,152 7,267 964 24 528 59 1,433 4,116 3 53,074 30,551 83,625 6,659 713 Personal 19,564 2,280 1,069 — — — — — 1 — 19,565 765 20,330 1 — 102,868 16,432 8,336 38,307 (1,776) 22,541 17,081 43,767 44,525 2,195 193,355 45,064 238,419 205,068 68,200
Government 1,876 — — 23,201 (893) 25,041 14,256 33,986 1,537 — 37,399 313 37,712 4,712 18 Central bank 19,659 — — — — 7 — 7 13 6,369 26,048 1 26,049 25 30,283 Other banks 4,320 — — 9,192 (916) 1,719 1,187 9,724 24,193 1,447 39,684 5,463 45,147 142,668 25,111 Other FI 4,932 — — 10,583 (737) 908 83 11,408 7,648 1,377 25,365 10,189 35,554 13,842 11,384 Corporate 53,128 12,404 5,393 813 45 831 260 1,384 4,136 4 58,652 39,997 98,649 6,319 395 Personal 21,383 1,642 537 — — — — — — — 21,383 775 22,158 1 — 105,298 14,046 5,930 43,789 (2,501) 28,506 15,786 56,509 37,527 9,197 208,531 56,738 265,269 167,567 67,191
Government 61 — — 1,207 (339) 4,854 5,652 409 236 — 706 118 824 380 — Central bank 1,549 — — — — — — — — — 1,549 — 1,549 — — Other banks 509 — — 5,279 (956) 436 318 5,397 4,350 480 10,736 67 10,803 34,296 4,085 Other FI 855 — — 2,331 (654) 228 56 2,503 1,783 73 5,214 1,862 7,076 3,635 4,638 Corporate 28,385 12,272 6,567 274 4 240 — 514 1,538 — 30,437 6,412 36,849 2,103 — Personal 19,276 2,258 1,048 — — — — — 1 — 19,277 637 19,914 1 — 50,635 14,530 7,615 9,091 (1,945) 5,758 6,026 8,823 7,908 553 67,919 9,096 77,015 40,415 8,723
CDS by reference entity 2012 2011 2010 Notional Fair value Notional Fair value Notional Fair value Bought Sold Bought Sold Bought Sold Bought Sold Bought Sold Bought Sold £m £m £m £m £m £m £m £m £m £m £m £m
Government 42 — — 127 (23) 79 56 150 2 — 194 2 196 6 — Central bank 73 — — — — — — — — — 73 — 73 — — Other banks 98 — — 191 (6) 18 1 208 695 476 1,477 — 1,477 15,258 3,547 Other FI 532 — — 46 — 325 2 369 583 103 1,587 601 2,188 1,365 4,121 Corporate 17,921 11,058 6,226 60 — — — 60 411 — 18,392 1,840 20,232 436 326 Personal 17,893 3,286 1,686 — — — — — 1 — 17,894 515 18,409 1 — 36,559 14,344 7,912 424 (29) 422 59 787 1,692 579 39,617 2,958 42,575 17,066 7,994 2011 Government 45 — — 102 (46) 20 19 103 92 — 240 2 242 102 — Central bank 1,467 — — — — — — — — — 1,467 — 1,467 — — Other banks 136 — — 177 (39) 195 14 358 981 478 1,953 — 1,953 19,090 3,441 Other FI 333 — — 61 — 116 35 142 782 73 1,330 546 1,876 1,831 3,968 Corporate 18,994 10,269 5,689 148 3 135 — 283 417 — 19,694 1,841 21,535 438 — Personal 18,858 2,258 1,048 — — — — — 1 — 18,859 539 19,398 1 — 39,833 12,527 6,737 488 (82) 466 68 886 2,273 551 43,543 2,928 46,471 21,462 7,409 2010 Government 61 — — 104 (45) 93 88 109 20 — 190 1 191 20 — Central bank 2,119 — — — — 7 — 7 1 125 2,252 — 2,252 1 1,160 Other banks 87 — — 435 (51) 96 45 486 1,265 258 2,096 83 2,179 15,892 2,702 Other FI 813 — — 291 (1) 205 — 496 826 11 2,146 1,050 3,196 2,084 3,258 Corporate 19,886 8,291 4,072 91 (2) 140 6 225 430 4 20,545 2,638 23,183 446 4 Personal 20,228 1,638 534 — — — — — — — 20,228 544 20,772 1 — 43,194 9,929 4,606 921 (99) 541 139 1,323 2,542 398 47,457 4,316 51,773 18,444 7,124
Government and central bank Exposure to the central bank fluctuates, driven by regulatory requirements and deposits of excess liquidity. It was reduced as part of asset and liability management.
Financial institutions Markets, International Banking and UBG account for the large majority of the Group’s exposure to financial institutions, the main categories being derivatives and repos, where exposure is affected predominantly by market movements and much of it is collateralised.
Key points* The Group maintains good relationships with multinational banks, other financial institutions and large corporate clients.
Exposure to Spain is driven by corporate lending and a sizeable mortgage-backed securities covered bond portfolio. Exposure fell further in most categories during 2012, driven by the sale of part of the covered bond portfolio and a decline in corporate lending, as a result of steps taken to de-risk the portfolio.
Government The Group has an active portfolio of Spanish government debt and
Financial institutions The Group’s largest exposure was AFS debt securities (mainly the covered bond portfolio) of £4.8 billion at 31 December 2012, which decreased by £1.6 billion during 2012, largely as a result of sales in the first half of the year. The portfolio continued to perform satisfactorily. However, the Group is monitoring the situation closely, including undertaking stress analyses.
Derivative exposure, mostly to Spanish international banks and a few of the large regional banks, declined to £1.3 billion at 31 December 2012 from £1.9 billion at 31 December 2011. The majority of this exposure was collateralised.
Non-Core (included above) At 31 December 2012, Non-Core had lending exposure to Spain of £2.8 billion, a reduction of £1.0 billion or 26% since 31 December 2011. Commercial real estate (63%), construction (14%) and electricity (9%) sectors accounted for the majority of the lending exposure.
Government 9 — — 408 (81) 2,781 2,224 965 80 — 1,054 — 1,054 131 — Central bank 21 — — — — — — — — — 21 — 21 — — Other banks 200 — — 125 (8) 42 54 113 1,454 — 1,767 33 1,800 8,428 3 Other FI 218 — — 357 (1) 23 1 379 99 — 696 671 1,367 100 — Corporate 1,392 34 5 87 2 85 22 150 664 — 2,206 1,900 4,106 938 — Personal 23 — — — — — — — — — 23 12 35 — — 1,863 34 5 977 (88) 2,931 2,301 1,607 2,297 — 5,767 2,616 8,383 9,597 3 2011 Government — — — 704 (220) 4,336 4,725 315 90 — 405 — 405 142 — Central bank 73 — — — — — — — — — 73 — 73 — — Other banks 233 — — 119 (14) 67 88 98 1,064 — 1,395 23 1,418 9,117 305 Other FI 299 — — 685 (15) 40 13 712 686 — 1,697 1,146 2,843 687 — Corporate 2,444 361 113 75 — 58 — 133 474 — 3,051 1,968 5,019 1,001 — Personal 23 — — — — — — — — — 23 13 36 — — 3,072 361 113 1,583 (249) 4,501 4,826 1,258 2,314 — 6,644 3,150 9,794 10,947 305 2010 Government 45 — — 906 (99) 5,113 3,175 2,844 71 — 2,960 6 2,966 156 — Central bank 78 — — — — — — — — — 78 — 78 — — Other banks 668 — — 198 (11) 67 16 249 781 1 1,699 161 1,860 7,724 58 Other FI 418 — — 646 (5) 49 — 695 759 — 1,872 1,218 3,090 763 — Corporate 2,483 314 141 20 — 36 8 48 420 — 2,951 2,456 5,407 831 — Personal 27 — — — — — — — — — 27 12 39 — — 3,719 314 141 1,770 (115) 5,265 3,199 3,836 2,031 1 9,587 3,853 13,440 9,474 58
Key points* The Group maintains good relationships with Italian government entities, banks, other financial institutions and large corporate clients. Since the start of 2011, the Group has taken steps to reduce and mitigate its risk through strategic exits where appropriate and through increased collateral requirements, in line with its evolving appetite for Italian risk. Lending exposure to Italian counterparties was reduced by a further £1.2 billion during 2012, to £1.9 billion.
Financial institutions The majority of the Group’s exposure relates to the top five banks.
Government — — — 72 (18) 28 15 85 17 — 102 — 102 17 — Other banks — — — 66 (12) 5 — 71 380 — 451 — 451 481 26 Other FI — — — 1 — 21 11 11 38 — 49 3 52 38 — Corporate 336 253 188 41 — 7 — 48 79 — 463 247 710 82 — Personal 7 — — — — — — — — — 7 8 15 — — 343 253 188 180 (30) 61 26 215 514 — 1,072 258 1,330 618 26 2011 Government — — — 56 (58) 36 152 (60) 19 — (41) — (41) 25 — Other banks 10 — — 91 (36) 12 2 101 389 — 500 2 502 497 217 Other FI — — — 5 — 7 — 12 30 — 42 — 42 30 3 Corporate 495 27 27 42 1 18 — 60 81 — 636 258 894 81 — Personal 5 — — — — — — — — — 5 8 13 — — 510 27 27 194 (93) 73 154 113 519 — 1,142 268 1,410 633 220 2010 Government 86 — — 92 (26) 68 122 38 29 — 153 211 364 45 — Other banks 63 — — 106 (24) 46 2 150 307 — 520 2 522 452 782 Other FI — — — 47 — 7 — 54 7 — 61 1 62 7 — Corporate 611 27 21 — 1 — — — 51 — 662 512 1,174 51 — Personal 6 — — — — — — — — — 6 8 14 — — 766 27 21 245 (49) 121 124 242 394 — 1,402 734 2,136 555 782
Key points* The Portuguese portfolio, which is managed out of Spain, mainly consists of corporate lending and derivative trading with the largest local banks. Medium-term activity has ceased with the exception of collateralised business.
Financial institutions The remaining exposure is largely focused on the top four systemically important banks. Exposures generally consist of collateralised trading products.
Corporate The largest exposure is to the land transport and logistics, electricity and telecommunications sectors, concentrated on a few large, highly creditworthy clients.
2011 Government 7 — — 312 — 102 5 409 — — 416 — 416 71 — Central bank 6 — — — — — — — — — 6 — 6 — — Other banks — — — — — — — — 290 — 290 — 290 405 — Other FI 31 — — — — — — — 2 — 33 — 33 2 — Corporate 427 256 256 — — — — — 63 — 490 42 532 63 — Personal 14 — — — — — — — — — 14 10 24 — — 485 256 256 312 — 102 5 409 355 — 1,249 52 1,301 541 —
Financial institutions Activity with Greek financial institutions is largely collateralised derivative and repo exposure, and remains under close scrutiny.
The Group’s focus is on short-term trade facilities to the domestic subsidiaries of international clients, increasingly supported by parental guarantees.
Government — — — — — 3 — 3 — — 3 — 3 — — Other banks — — — — — — — — 11 — 11 — 11 12 — Other FI 2 — — — — 1 — 1 — — 3 — 3 4 15 Corporate 274 162 54 — — — — — 24 — 298 36 334 38 — Personal 15 — — — — — — — — — 15 11 26 — — 291 162 54 — — 4 — 4 35 — 330 47 377 54 15 2011 Other banks — — — — — — — — 6 — 6 1 7 7 — Other FI 38 — — — — — — — 1 — 39 1 40 1 200 Corporate 250 169 40 — — 2 — 2 49 — 301 56 357 49 — Personal 14 — — — — — — — — — 14 10 24 — — 302 169 40 — — 2 — 2 56 — 360 68 428 57 200 2010 Central bank — — — — — — — — — — — 1 1 — — Other banks 1 — — — — — — — 13 — 14 5 19 19 — Other FI 38 — — — — — — — 1 14 53 1 54 4 218 Corporate 285 175 45 — — — — — 41 — 326 20 346 59 — Personal 13 — — — — — — — — — 13 11 24 — — 337 175 45 — — — — — 55 14 406 38 444 82 218
Government 627 — — 10,843 399 13,744 5,771 18,816 1,663 — 21,106 767 21,873 4,946 — Central bank 21,862 — — — — — — — 35 — 21,897 — 21,897 36 4,648 Other banks 3,958 — — 2,037 151 856 480 2,413 21,863 685 28,919 4,325 33,244 118,828 24,493 Other FI 3,425 — — 7,302 (540) 795 102 7,995 6,849 624 18,893 4,123 23,016 13,498 11,988 Corporate 12,989 2,107 694 602 31 183 75 710 1,916 24 15,639 23,647 39,286 2,918 406 Personal 220 4 20 — — — — — — — 220 132 352 — — 43,081 2,111 714 20,784 41 15,578 6,428 29,934 32,326 1,333 106,674 32,994 139,668 140,226 41,535
Government 610 — — 17,199 420 14,743 9,397 22,545 1,688 — 24,843 938 25,781 4,599 791 Central bank 25,733 — — 20 — 6 — 26 35 — 25,794 — 25,794 38 15,103 Other banks 2,965 — — 3,144 204 836 1,184 2,796 24,245 610 30,616 4,426 35,042 140,891 27,072 Other FI 3,500 — — 8,163 (475) 910 415 8,658 8,071 1,029 21,258 6,337 27,595 14,569 15,798 Corporate 19,137 1,880 700 690 20 288 59 919 2,578 3 22,637 24,139 46,776 4,556 713 Personal 288 22 21 — — — — — — — 288 128 416 — — 52,233 1,902 721 29,216 169 16,783 11,055 34,944 36,617 1,642 125,436 35,968 161,404 164,653 59,477 2010 Government 1,651 — — 21,116 (22) 18,477 9,584 30,009 1,357 — 33,017 87 33,104 4,408 18 Central bank 17,421 — — — — — — — 12 6,244 23,677 — 23,677 24 29,123 Other banks 3,317 — — 3,189 4 1,363 1,006 3,546 20,180 1,186 28,229 5,170 33,399 113,199 20,873 Other FI 3,540 — — 7,875 (257) 613 76 8,412 6,030 1,352 19,334 7,631 26,965 10,836 7,908 Corporate 22,681 1,678 494 693 8 605 238 1,060 2,654 — 26,395 31,556 57,951 4,315 391 Personal 686 3 3 — — — — — — — 686 128 814 — — 49,296 1,681 497 32,873 (267) 21,058 10,904 43,027 30,233 8,782 131,338 44,572 175,910 132,782 58,313
Government — — — 828 (44) 1,269 711 1,386 103 — 1,489 — 1,489 404 — Other banks 186 — — 2 — 2 2 2 2,618 50 2,856 7 2,863 4,035 1,256 Other FI 249 — — — — — — — 239 — 488 30 518 252 — Corporate 414 50 15 14 — 6 — 20 180 — 614 1,263 1,877 270 — Personal 22 3 20 — — — — — — — 22 8 30 — — 871 53 35 844 (44) 1,277 713 1,408 3,140 50 5,469 1,308 6,777 4,961 1,256 2011 Government — — — 742 (116) 608 722 628 89 — 717 — 717 492 — Central bank 8 — — — — — — — 3 — 11 — 11 3 — Other banks 287 — — 4 — — — 4 2,399 51 2,741 8 2,749 7,868 1,694 Other FI 354 — — — — 1 4 (3) 191 — 542 64 606 260 — Corporate 588 31 21 3 — 20 — 23 277 — 888 1,279 2,167 375 255 Personal 20 — — — — — — — — — 20 8 28 — — 1,257 31 21 749 (116) 629 726 652 2,959 51 4,919 1,359 6,278 8,998 1,949 2010 Government 102 — — 763 (54) 529 602 690 92 — 884 — 884 745 — Central bank 14 — — — — — — — 7 — 21 — 21 7 — Other banks 441 — — 39 1 66 2 103 1,822 — 2,366 3 2,369 6,051 961 Other FI 32 — — — — — — — 126 — 158 81 239 201 — Corporate 893 27 27 1 — 11 2 10 191 — 1,094 1,400 2,494 387 391 Personal 327 — — — — — — — — — 327 8 335 — — 1,809 27 27 803 (53) 606 606 803 2,238 — 4,850 1,492 6,342 7,391 1,352
Central bank 13 — — — — — — — — — 13 — 13 — — Other banks 99 — — 8 — 8 6 10 485 77 671 — 671 650 2,215 Other FI 717 — — 51 (1) 198 4 245 821 68 1,851 719 2,570 2,343 2,951 Corporate 1,817 940 287 — — 19 23 (4) 156 — 1,969 1,469 3,438 164 — Personal 4 — — — — — — — — — 4 2 6 — — 2,650 940 287 59 (1) 225 33 251 1,462 145 4,508 2,190 6,698 3,157 5,166 2011 Other banks 101 — — 10 — 7 — 17 530 16 664 — 664 664 447 Other FI 925 — — 54 (7) 82 80 56 2,174 789 3,944 711 4,655 3,676 3,529 Corporate 2,228 897 301 5 — 58 6 57 180 — 2,465 1,294 3,759 195 — Personal 2 — — — — — — — — — 2 2 4 — — 3,256 897 301 69 (7) 147 86 130 2,884 805 7,075 2,007 9,082 4,535 3,976 2010 Government — — — — — 24 — 24 — — 24 — 24 — — Central bank 25 — — — — — — — — — 25 — 25 — — Other banks 26 — — 30 (1) 45 — 75 492 7 600 1 601 610 7 Other FI 734 — — 99 (3) 32 19 112 731 1,069 2,646 696 3,342 1,740 2,325 Corporate 2,503 807 206 5 1 183 21 167 246 — 2,916 1,684 4,600 258 — Personal 3 — — — — — — — — — 3 2 5 — — 3,291 807 206 134 (3) 284 40 378 1,469 1,076 6,214 2,383 8,597 2,608 2,332
Government 126 — — 323 (26) 971 411 883 734 — 1,743 — 1,743 954 — Central bank — — — — — — — — 33 — 33 — 33 34 — Other banks 19 — — 54 — 130 27 157 927 8 1,111 117 1,228 4,805 1,432 Other FI 90 — — 102 (4) 8 — 110 2 3 205 24 229 184 893 Corporate 856 33 13 97 (1) 2 7 92 41 — 989 1,118 2,107 52 — Personal 14 — — — — — — — — — 14 10 24 — — 1,105 33 13 576 (31) 1,111 445 1,242 1,737 11 4,095 1,269 5,364 6,029 2,325 2011 Government 121 — — 327 (47) 445 331 441 779 — 1,341 25 1,366 930 627 Central bank — — — — — — — — 23 — 23 — 23 23 — Other banks 28 — — 63 (1) 13 70 6 1,011 — 1,045 94 1,139 9,268 350 Other FI 77 — — 100 (9) 25 2 123 36 — 236 130 366 131 277 Corporate 1,125 12 15 134 (4) 11 7 138 45 — 1,308 1,038 2,346 55 — Personal 12 — — — — — — — — — 12 10 22 — — 1,363 12 15 624 (61) 494 410 708 1,894 — 3,965 1,297 5,262 10,407 1,254 2010 Government 124 — — 324 (25) 268 283 309 697 — 1,130 26 1,156 777 — Central bank 1 — — — — — — — 1 — 2 — 2 1 — Other banks 141 — — 71 (1) 52 44 79 550 2 772 149 921 5,828 212 Other FI 81 — — 4 — — 5 (1) 8 6 94 70 164 47 238 Corporate 1,220 63 22 133 (1) 30 15 148 37 — 1,405 1,745 3,150 50 — Personal 11 — — — — — — — — — 11 9 20 — — 1,578 63 22 532 (27) 350 347 535 1,293 8 3,414 1,999 5,413 6,703 450
Key points* The Group holds a major and diversified portfolio in eurozone nonperiphery countries with significant exposures to financial institutions and corporates, notably in Germany, the Netherlands and France, and a sizeable liquidity portfolio with the German central bank.
Exposure decreased in most product categories and to most client groups during 2012, particularly in lending to corporates, contingent liabilities and commitments, as a result of currency movements and de-risking of the portfolio.
Belgium - Net HFT government debt exposure increased by £0.7 billion on balance over 2012, as part of regular fluctuations in the Markets business. AFS debt securities exposures increased by £0.1 billion and the negative AFS reserve declined by the same amount as a result of recovery in bond prices.
Corporate Germany - Lending to corporate clients fell by £2.9 billion, largely as a result of reductions in Non-Core exposure to the transport, commercial real estate, electricity and media sectors.
The Netherlands - Lending to corporate clients decreased by £1.1 billion due to reductions in the commercial real estate and telecommunications sectors, with half of this reduction in the NonCore portfolio.
France - Lending to corporate clients decreased by £1.3 billion due to reductions in the telecommunications, commercial real estate and construction sectors, half of this reduction is in the Non-Core portfolio.
December 2012, down £2.6 billion since 31 December 2011. Most of the lending was in the commercial real estate (64%) and natural resources (12%) sectors.
Operational risk cycle and key management tools The operational risk cycle comprises four stages: identification of risks; assessment or measurement of the scale of risks; management or control of risks to prevent their recurrence or minimise the potential impact; and monitoring and reporting of risks.
Risk assessments are often conducted in a workshop environment, bringing together subject matter experts and key stakeholders from across the division and key functions. This approach has led to a more complete view of the risk profile and more informed decisions.
During 2013, the focus will be on the continued implementation and embedding of risk assessments across the Group. This includes the strengthening of links between risk assessments and other elements of the Group operational risk framework. In addition, risk assessments will increasingly be utilised to identify single points of failure.
Several process enhancements were made during 2012, which strengthened the interaction between business, risk and specialist areas. Reporting has been established and work has started to enhance the inventory of products provided by the Group.
Scenarios are run in a workshop environment, bringing business, risk and control experts together, thereby ensuring that risk management is approached holistically. They include Group-wide themes, which are led by Group Operational Risk and allow the Group to assess the impacts of pan-divisional risks and macroeconomic stresses (e.g. eurozone distress).
Stress testing The Group further refined its approach to assessing the impact of the economic cycle on its operational risk losses by specifically assessing the impact of the FSA's published Anchor II scenario, which describes a series of country-specific shocks around the world on: expected levels of operational risk losses; and capital adequacy requirements for operational risk.
Capital model development The Group has continued with the development of its statistical modelling capability for operational risk based on the requirements set out under the Basel II advanced measurement approach. The model considers internal and external loss data as well as scenarios and business environment and internal control factors. The primary use of the model will be to contribute to the economic capital calculation and to help test the Group’s capital adequacy requirement. Embedding of the model outputs is continuing in 2013.
Other risks: Operational risk* continued Control environment certification Control Environment Certification (CEC) is used by the Group Executive management to review and assess its internal control framework. Senior management are required to provide a twice-yearly assessment of the robustness of the Group’s internal control environment including: compliance with the Group Policy Framework and key divisional/functional policy standards; compliance with the requirements of the UK Corporate Governance
The CEC outcomes are reported at both the divisional risk and audit committees and Group Audit Committee.
Value of losses At 31 December 2012, three categories continue to account for 98% of the losses, however technology and infrastructure failures have replaced fraud as one of the primary loss categories. This reflects the value of losses and provisions associated with a major systems incident during 2012 (referred to as the Group technology incident). The majority of the increase in losses associated with the clients, products and business practices event category are the result of increased Payment Protection Insurance provisions, and new provisions in respect of Interest Rate Hedging Products and LIBOR.
A small number of operational risk events contribute a high percentage of the total losses. This is evidenced by the fact that in 2012 only 4% of operational risk events had a value of £1 million or greater (2011 - 3%) but accounted for 97% of the overall losses (2011 - 91%).
Capital The Group calculates the capital requirement for operational risk using the standardised approach. The capital requirements are as follows: £m
Regulatory risk* Regulatory risk is the risk of material loss or liability, legal or regulatory sanctions, or reputational damage, arising from the failure to comply with (or adequately plan for changes to) relevant official sector policy, laws, regulations, or major industry standards, in any location in which the Group operates. The Group believes that maintaining a strong regulatory risk framework is fundamental to protecting sustainable growth, rebuilding its reputation and maintaining stakeholder confidence.
Global regulatory developments The global agenda continues to be guided by the G20, drawing on the original action plan for strengthening financial stability agreed by G20 leaders at the November 2008 Washington summit. Although policy initiation at the G20 level is drawing to an end, a substantial pipeline of policy development remains in train and the Group does not anticipate any easing of this for some time. During 2012, G20 countries continued to implement various elements of this action plan, and further endorsed it at the G20 leaders’ summit held in Los Cabos, Mexico in June 2012 and the finance ministers’ and central bank governors’ meetings, most recently in Mexico City in November 2012.
Key developments during 2012 included the following: Basel III Following publication by the Basel Committee on Banking Supervision in December 2010 of rules for the new Basel III capital and liquidity framework, work during 2012 focused on finalising the remaining elements of policy and preparing for implementation. Highlights were: Publication of results of the Basel III monitoring exercise at 30 June 2011 (published April 2012) and at 31 December 2011 (published September 2012). The latest results (which ignore the transitional provisions which apply) showed good progress, with an average Common Equity Tier 1 ratio of 7.7% across 102 banks with Tier 1 capital above €3 billion. This compares to an effective target of 7%. However, individual bank shortfalls, including surcharges for systemically important banks where applicable, still totalled €374 billion; The finalisation of rules for composition of capital disclosure requirements (June 2012); Proposals for monitoring indicators for intra-day liquidity management (July 2012); Interim rules for the capitalisation of bank exposures to central counterparties (July 2012); Final rules for the regulatory treatment of valuation adjustments to derivative liabilities (July 2012); and
Other risks: Regulatory risk* continued Shadow banking Work in this area, which broadly refers to entities and financial transactions that fall outside the scope of existing financial (banking) regulation, such as hedge funds, money market funds and structured investment vehicles, intensified during 2012.
The European Commission began the first stage in its own regulatory process on shadow banking in March 2012, with the release of a Green Paper. A summary of responses published in September 2012 was broadly aligned with industry views.
Other Other papers issued during the year covered subjects including risk data aggregation and reporting; margin requirements for uncleared derivatives; foreign exchange settlement risk; supervision; financial conglomerates; and revisions to the securitisation framework.
The Expert Group’s proposals in October 2012 contained five recommendations: a ring-fence of trading book activities where they form a significant part of a bank’s activity; effective recovery and resolution plans (with authorities empowered to require further structural reform if that improves resolvability); specific ‘bail-in’ instruments (rather than a general bail-in power applied to existing liabilities); stricter capital treatment of trading book and real estate exposures; and a number of corporate governance, risk management and remuneration proposals.
In September, the Commission published its proposal for a Single Supervisory Mechanism, designating the European Central Bank (ECB) as primary prudential supervisor for all euro-area banks, with opt-ins available for EU member states outside the euro-area. The Council of the EU agreed to these proposals, with the proviso that the ECB would directly supervise only larger banks and those in receipt of state aid, while retaining some oversight of smaller banks that fall under the remit of national supervisors.
Prudential and related reforms A key focus during 2012 was work on agreeing the EU’s Capital Requirements Directive (CRD) following the publication of draft legislative text in 2011 for the CRD IV package to implement Basel III in the EU.
Market and structural reforms Key developments included: European Markets Infrastructure Regulation - the regulation came into force on 16 August 2012. In many areas, the European Securities and Markets Authority (ESMA) is yet to finalise draft technical standards. Full implementation is likely to be in the third quarter of 2013, when the final technical standards are due to be released by the ESMA.
Financial Transaction Tax - the EU Commission has previously published proposals, which would see trades in bonds and shares taxed at 0.1% and complex derivatives taxed at 0.01%. While the original EU-wide proposal was rejected due to opposition from several member states, including the UK, a subset of eleven EU member states has agreed to proceed via the Enhanced Cooperation Mechanism. The Commission set out detailed proposals for this in February 2013.
Protection Directive, further changes to the market abuse regime and prospectus requirements, further legislative developments impacting credit rating agencies and changes to depositor and investor protection.
The future of banking The Group has actively engaged with, and contributed to, a number of inquiries regarding the future of banking. These included the Government’s White Paper on the implementation of the Independent Commission on Banking recommendations, a Parliamentary inquiry into banking standards and various inquiries (in Europe as well as the UK) looking more specifically at LIBOR and other benchmarks. The Group is represented on, and is working closely with, the British Bankers’ Association Taskforce on Banking Standards, and the Group have specifically welcomed the developing role of the Chartered Banker: Professional Standards Board. In addition, work continued on the finalisation of recovery and resolution planning frameworks.
Furthermore, the Government proposed a transfer of consumer credit regulation from the Office of Fair Trading to the FCA and it may also replace current Consumer Credit Act legislation with an FCA rulebook, changing rules in the process.
Supervisory developments In line with other regulatory authorities, the FSA’s supervisory scrutiny has continued to intensify in response to the financial crisis and ongoing market stresses.
In addition, the FSA moved to a “twin peaks” organisational structure in April 2012, with the creation of new conduct and prudential business units which form separate teams supervising systemically important firms from a conduct and prudential perspective. The FSA has continued to develop new supervisory approaches to align to the new regulatory structure. The prudential framework includes the Core Prudential Programme for those major financial institutions it oversees, which includes in-depth rolling thematic assessments on governance, business models, risk management, capital and liquidity. The conduct framework includes a greater focus on business models and strategic analysis.
Proposed rules issued in December 2012 included important changes to the Federal Reserve Board’s approach to supervisory and prudential requirements for foreign banking organizations (FBOs). These proposals would require the Group and other FBOs to establish a single USincorporated intermediate holding company for all the Group’s US subsidiaries (although not the US branches of RBS plc or RBS N.V.). Enhanced prudential standards would also be required, including for the US branches.
Regulatory risk management The Group manages its regulatory risk through a regulatory affairs framework covering over 120 different regulatory bodies and central banks, wherever the Group operates. This framework is managed by the Group’s Regulatory Affairs function and includes: the tracking and management of regulatory developments and regulatory relationship management, together with ownership of the connected regulatory risk policies; assurance and monitoring; and training and awareness.
Against the backdrop of intensified regulatory pressure, Group Regulatory Affairs has managed the increased levels of scrutiny and legislation by increasing the capacity of its team, as well as improving and refining its operating model, tools, systems and processes.
Management of regulatory change The early identification and effective management of changes in legislative, regulatory and other requirements that may impact the Group is critical to the successful mitigation of prudential and conduct risk.
Regulatory relationship management The Regulatory Relations Forum, chaired by Group Regulatory Affairs, meets fortnightly and now has global coverage with representatives from all divisions and regions. It facilitates the sharing of key regulatory engagements.
Recovery and resolution planning As advocates of effective recovery and resolution planning, the Group continues to work towards the implementation of effective plans. In order to be able to deal effectively with any future severe stress events, the Group has developed a range of recovery options in the form of a detailed recovery plan.
Individual country regulators are developing and implementing their rules according to their own timescales. This emphasises the need for consistency of approach, both by the regulatory bodies and internally within the Group, to ensure effective management of financial stability across jurisdictions, and to avoid duplication and inefficiency for crossborder banks. The Group has worked with trade associations to provide feedback on the FSB’s consultative document on operationalising recovery and resolution planning, published in November 2012.
The Group has established a defined and measurable appetite for conduct risk to ensure commercial decisions take into account any conduct risk implications. During 2012, the foundations of the Group’s conduct risk framework were delivered. Key milestones were: Agreeing and establishing the Group’s conduct risk policies under four pillars: employee conduct; corporate conduct; market conduct; and conduct towards the Group’s customers. Each is designed to provide high-level direction to the Group and is supported by the Group’s Code of Conduct; Launching a phased roll-out of these policies, in order of materiality and scheduled to complete in June 2013; Developing and delivering awareness initiatives and targeted conduct risk training for each policy, aligned to the phased roll-out, to assist businesses and executives in embedding the understanding of conduct risk and provide the necessary clarity for staff on their conduct risk requirements; Establishing effective leadership and a supporting governance framework, with the participation of all divisions, to oversee the Group’s conduct agenda, notably the new Conduct Risk Committee; and
Training and awareness Maintaining compliance with existing rules and regulations requires continued investment in professional training, as well as maintaining risk awareness. During 2012, the Group continued to focus on strengthening the capabilities of its compliance functions, at both Group and divisional level. In addition, it facilitated training on conduct risk through Executive education, including master classes and workshops, and computer-based Group Policy Learning modules. Each module addresses the specific regulatory content of relevant Group Policy Standards.
Assurance and monitoring Assurance and monitoring activities are essential to ensure that the Group can: demonstrate compliance with existing rules and regulations; assess whether it is managing its conduct risks appropriately; and determine whether key controls are fit for purpose and effective.
Reputational risk* Reputational risk is the risk of brand damage and/or financial loss due to a failure to meet stakeholders’ expectations of the Group’s conduct and performance.
Restoring the reputation of the Group and the wider banking sector is built upon the role of banks as good companies that perform well for their owners, regulators, employees and communities and, above all else, serve their customers well.
The Group has put the focus on serving customers well at the heart of its strategic objectives that, combined with a safe and sound bank, will build a culture and reputation in line with our stakeholder expectations. There are still legacy issues to work through, but dealing with them in an open and direct manner is a necessary part of the ability to move forward.
Business risk is impacted by other risks the Group faces that may contribute to the adverse changes in the Group's revenues and/or costs, were these risks to crystallise. Examples of such risks include funding risk (through volatility in cost of funding), interest rate risk in the banking book, operational risk, conduct risk and reputational risk.
The Group operates a rolling forecast process which identifies projected changes in, or risks to operating profit and ensures appropriate actions are taken.
The trustee is solely responsible for the investment of the Main scheme’s assets which are held separately from the assets of the Group. Significant changes to asset strategy are discussed with the Group’s Pension Risk Committee, which was established in 2011. The Group and the trustee must also agree on the Main scheme’s funding plan.
Risk appetite and investment policy are agreed by the trustee with quantitative and qualitative input from the scheme actuaries and investment advisers. The Investment Executive, which acts on behalf of the trustee of the Group’s largest pension schemes, also consults with the Group to obtain its view on the appropriate level of risk within the pension fund.
Reporting and monitoring The Group maintains an independent view of risk from a sponsor perspective within its pension funds. It achieves this through regular pension risk reporting and monitoring to the Group Board, Group Executive Committee and Group Board Risk Committee on the material pension schemes that the Group has an obligation to support.
At 31 December 2011 Fall in nominal swap yields of 0.25% at all durations with no change in credit spreads or real swap yields 106 200 (94) Fall in real swap yields of 0.25% at all durations with no change in credit spreads or nominal swap yields 557 911 (354) Fall in credit spreads of 0.25% at all durations with no change in nominal or real swap yields 104 1,118 (1,014) Fall in equity values of 10% (935) — (935)
At 31 December 2010 Fall in nominal swap yields of 0.25% at all durations with no change in credit spreads or real swap yields 67 193 (126) Fall in real swap yields of 0.25% at all durations with no change in credit spreads or nominal swap yields 355 799 (444) Fall in credit spreads of 0.25% at all durations with no change in nominal or real swap yields 98 1,005 (907) Fall in equity values of 10% (1,083) — (1,083)
I am pleased to present our Corporate governance report for the 2012 financial year.
Corporate Governance in RBS We remain committed to the highest standards of governance, integrity and professionalism throughout the Group. As a global financial organisation, our governance framework operates across both our divisional and functional operating structure and geographically in the regions in which we operate. During 2012, we have continued to monitor compliance with the Corporate Governance policy that we introduced in 2011 and key areas of focus have included risk governance and regional governance, both of which were reviewed by the Board Risk Committee on behalf of the Board.
Board and Committee Membership We have had a period of stability recently in terms of Board membership and this has provided valuable continuity during a very busy year. John McFarlane stepped down from the Board in March 2012 and the experience and knowledge that he brought to the Board and the Group Performance and Remuneration Committee were greatly appreciated.
Some changes were made during the year to the composition of Board committees. Baroness Noakes joined the Board Risk Committee, Art Ryan joined the Group Performance and Remuneration Committee and Alison Davis became a member of the Group Sustainability Committee. These committees have benefitted from the skills and experience of these directors.
Finally, I would like to thank both the executive and non-executive directors for their outstanding commitment and their contributions to the Board and committees in 2012.
Philip Hampton Chairman of the Board of directors 27 February 2013
Group Board is the main decision making forum at Group level, setting the strategic direction of the Group and ensuring that the Group manages risk effectively. The Board is accountable to shareholders for financial and operational performance.
Group Audit Committee assists the Board in discharging its responsibilities for the disclosure of the financial affairs of the Group. It reviews the accounting policies, financial reporting and regulatory compliance practices of the Group and the Group’s system and standards of internal controls, and monitors the Group’s processes for internal audit and external audit.
Board Risk Committee provides oversight and advice to the Board on current and potential future risk exposures of the Group and risk strategy. It reviews the Group’s performance on risk appetite and oversees the operation of the Group Policy Framework.
Previously chief executive of The British Land Company PLC, chief operating officer of Abbey National plc and prior to that held positions with Credit Suisse First Boston including chief financial officer, head of fixed income and co-head of European investment banking. After nationalisation in 2008, he served as non-executive Deputy Chairman of Northern Rock plc.
External appointments Trustee of The Foundation and Friends of the Royal Botanical Gardens, Kew
Group Finance Director Bruce Van Saun (age 55) Date of appointment: 1 October 2009
Extensive leadership experience with 30 years in the financial services industry. From 1997 to 2008 he held a number of senior positions with Bank of New York and later Bank of New York Mellon, most recently as vicechairman and chief financial officer and before that was responsible for Asset Management and Market Related businesses. Prior to that he held senior positions with Deutsche Bank, Wasserstein Perella Group and Kidder Peabody & Co. He has served on several corporate boards as a non-executive director and has been active in numerous community organisations.
Corporation Non-executive director, chair of compensation committee and member of audit committee of Diamond Foods Inc.
Penny Hughes, CBE (age 53) Date of appointment: 1 January 2010
Previously a director and chairman of the Remuneration Committee of Skandinaviska Enskilda Banken AB and a non-executive director of Home Retail Group plc and chairman of its Remuneration Committee. She spent the majority of her executive career at Coca-Cola where she held a number of leadership positions, latterly as President, Coca-Cola Great Britain and Ireland. Former non-executive directorships include Vodafone Group plc, Reuters Group PLC, Cable & Wireless Worldwide plc and The Gap Inc.
Held a number of senior executive positions with J.P. Morgan between 1979 and 2001 and was latterly chief executive of J P Morgan Europe, Middle East and Africa Region. Previously held non-executive roles at The Morgan Crucible Company plc and Brit Insurance Holdings plc and former Trustee of MacMillan Cancer Support. He is a Fellow of the Institute of Chartered Accountants.
Board Committee membership Group Audit Committee (Chair) Board Risk Committee Group Nominations Committee
Baroness Noakes, DBE (age 63) Date of appointment: 1 August 2011
External appointments Non-executive director and chairman of audit committee of Severn Trent plc Deputy chairman and senior independent director and chairman of the nominations committee of Carpetright plc
Former chairman, chief executive officer and president of Prudential Financial Inc. Previously he held senior positions with Chase Manhattan Bank N.A. and was a founding member of the Financial Services Forum. He is a non-executive director of RBS Citizens Financial Group, Inc.
Wide-ranging experience of financial services and risk management, including previous responsibility for Aviva’s continental European and International life and long-term savings businesses. He held a number of senior executive positions during his career at Aviva including his role as group finance director until January 2010. President of the Institute and Faculty of Actuaries and Fellow of the Association of Certified Public Accountants.
External appointments Non-executive director and chairman of the audit committee of Diageo plc
Stephen Hester, Group Chief Executive Bruce Van Saun, Group Finance Director For biographies see page 298
Ellen Alemany (age 57) Chief Executive, RBS Citizens and Head of Americas Ellen Alemany joined the RBS Group in June 2007 as Head of RBS Americas. She became Chief Executive Officer of RBS Citizens Financial Group, Inc. in March 2008 and Chairman in March 2009. Prior to these appointments, Ellen was the chief executive officer for Global Transaction Services at Citigroup, one of Citi’s 12 publicly reported product lines. Ellen joined Citibank in 1987 and held various positions including executive vice-president for Commercial Business Group, chairman and chief executive officer for Citibank International plc and Citibank’s European bank. She also served on the Citibank, N.A., Board of Directors. Ellen was elected to serve on the Board of Directors of Automatic Data Processing, Inc., beginning in January 2012.
Ross McEwan (age 55) Chief Executive, UK Retail Ross McEwan was appointed Chief Executive Officer for UK Retail in August 2012. Ross joined RBS from Commonwealth Bank of Australia where he was Group Executive for Retail Banking Services for 5 years and prior to that position Ross was Executive General Manager in charge of its branch network, contact centres and third party mortgage brokers. Ross has worked in the insurance and investment industries both in Australia and New Zealand for more than 25 years. He has extensive management experience having spent 18 years in senior executive roles including Managing Director of stockbroking business First NZ Capital Securities and Chief Executive of National Mutual Life Association of Australasia Ltd/AXA New Zealand Ltd. Ross holds a Bachelor of Business Studies, majoring in Industrial Relations & Personnel Management.
John Hourican (age 42) Chief Executive, Markets & International Banking John Hourican was appointed Chief Executive, Markets & International Banking in January 2012 having served as Chief Executive of its predecessor, Global Banking & Markets, since October 2008. Prior to this John held a variety of positions across the RBS Group. John is a fellow of the Institute of Chartered Accountants in Ireland and received a degree in Economics and Sociology from the National University of Ireland and a Postgraduate Diploma in Accounting from Dublin City University.
Management Committee The Management Committee, comprising our major business and functional leaders, meets as required to review strategy and business performance.
The Board’s terms of reference include key aspects of the company’s affairs reserved for the Board’s decision and are reviewed at least annually. The terms of reference are available on the Group’s website www.rbs.com.
The names and biographical details of the current members of the Board are shown on pages 298 to 301.
The non-executive directors combine broad business and commercial experience with independent and objective judgement. The nonexecutive directors provide independent challenge to the executive directors and the leadership team. The balance between non-executive and executive directors enables the Board to provide clear and effective leadership across the Group’s business activities.
Members of the executive management team attend and make regular presentations at meetings of the Board to give the directors greater insight into the business areas.
The Board committees are discussed in their individual reports: Group Audit Committee - pages 309 to 315. Board Risk Committee - pages 316 to 319. Group Performance and Remuneration Committee - pages 320 to 340.
Performance evaluation In accordance with the Code, an external evaluation of the Board takes place every three years. An internal evaluation takes place in the intervening years.
The 2011 evaluation was conducted internally by the Group Secretary and a number of initiatives were implemented aimed at improving the overall performance and effectiveness of the Board. These included additional improvements to the flow of information to the Board, appointment of additional Directors to Board committees and additional succession planning sessions. The 2012 evaluation concluded that the recommendations from the 2011 evaluation had been implemented in full.
Amongst the areas reviewed were Board structure, membership (including diversity) and processes, Board committees, Director competence, independence and behaviour.
Outcomes of the 2012 performance evaluation The 2012 performance evaluation has concluded that the Board and Board committees are operating effectively. The key findings were as follows:the Group has a highly capable Board which is well-balanced and diverse, with the skills required to respond to the very full agenda and key priorities of the Group; Board composition and executive succession planning should remain under review; the Board is headed by a strong and effective Chairman and Board meetings are open and transparent with constructive discussion, particularly around culture. The skills and contribution that the executive directors bring to the Board was recognised; as a result of the continued challenging external and regulatory environment, and the number of regulatory investigations, a substantial time commitment is required from the non-executive directors; whilst improvements in the quality and clarity of Board and Board Committee papers during 2012 was acknowledged, Board information flows should remain under review so that improvements can be made on a continuous basis; Board committees continue to play a key role supporting the work of the Board and the directors, individually and collectively, dedicate extensive time to the Group; and given the increased focus on culture, the role and responsibilities of the Group Sustainability Committee should be enhanced in respect of cultural and behavioural issues.
The composition of the Board and Board committees to remain under review to ensure the board has the appropriate balance of skills, experience, independence and knowledge.
The Board and Group Nominations Committee to review board and executive succession planning.
RBS Secretariat to establish a board-sponsored, multi-disciplinary project, to devise an optimal board information pack, with summaries and levels of depth to suit each reporting area or issue.
Individual director and Chairman effectiveness reviews The Chairman met with each director individually to discuss their own performance and ongoing professional development and also shared peer feedback that had been provided as part of the evaluation process. Separately, IDDAS Limited sought feedback on the Chairman’s performance and prepared the Chairman’s development report. The Senior Independent Director also canvassed the views on the Chairman’s performance from the non-executive directors collectively. The results of the Chairman’s effectiveness review were then discussed by the Chairman and the Senior Independent Director.
Group Nominations Committee Role of the Group Nominations Committee The Group Nominations Committee is responsible for: reviewing the structure, size and composition of the Board and making recommendations to the Board on any appropriate changes; assisting the Board in the formal selection and appointment of directors (executive and non-executive) having regard to the overall balance of skills, knowledge, experience and diversity on the Board; reviewing membership and chairmanship of Board committees; considering succession planning for the Chairman and the executive and non-executive directors, taking into account the skills and expertise which will be needed on the Board in the future. No director is involved in decisions regarding his or her own succession; and making recommendations to the Board concerning the re-election by shareholders of directors under the provisions of the Code. In so doing, they will have due regard to their performance and ability to continue to contribute to the Board in light of the knowledge, skills and experience required and the need for progressive refreshing of the Board.
The Group Nominations Committee engages with external consultants, considers potential candidates and recommends appointments of new directors to the Board. The terms of reference of the Group Nominations Committee are available on the Group’s website www.rbs.com
Membership of the Group Nominations Committee All non-executive directors are members of the Group Nominations Committee which is chaired by the Chairman of the Group. The Group Chief Executive is invited to attend meetings. The Group Nominations Committee holds at least two scheduled meetings per year, and also meets on an ad hoc basis as required. In 2012, four meetings of the Group Nominations Committee were held.
The Chairman and members of the Committee during 2012, together with their attendance at meetings in 2012, is shown below.
Notes: (1) Unable to attend one Committee meeting during 2012 due to family illness. (2) Retired from the Board on 31 March 2012.
The Chairman and Group Secretary developed a role profile and skills matrix and engaged Egon Zehnder International, specialist search consultants, to compile a list of candidates with relevant skills and experience. This was to ensure that the Group Nominations Committee had access to a wide pool of potentially suitable candidates and the search for potential candidates remains ongoing. Egon Zehnder International does not provide services to any other part of the Group.
0-2 years 2-4 years 4+ years 0-2 years 2-4 years 4+ years
Board and Committee membership At the request of the Board and taking into consideration feedback from the Board committee evaluations and John McFarlane’s departure, the Group Nominations Committee reviewed the membership of the Board committees. The Group Nominations Committee agreed to strengthen the Board Risk Committee with the appointment of Baroness Noakes, the Group Performance and Remuneration Committee with the appointment of Art Ryan, and the Group Sustainability Committee with the appointment of Alison Davis.
In addition, the Committee will be responsible for overseeing and challenging how management is addressing sustainability and reputation issues relating to all stakeholder groups, except where such issues have already been dealt with by other Board committees.
Relations with investors The Chairman is responsible for ensuring effective communication with shareholders. The company communicates with shareholders through the Annual Report and Accounts and by providing information in advance of the Annual General Meeting. Individual shareholders can raise matters relating to their shareholdings and the business of the Group at any time throughout the year by letter, telephone or email via the Group’s website www.rbs.com/ir
Shareholders are given the opportunity to ask questions at the Annual General Meeting or can submit written questions in advance. Directors including the chairs of the Group Audit, Board Risk, Group Performance and Remuneration and Group Nominations Committees are available to answer questions at the Annual General Meeting. The Senior Independent Director is also available.
the Senior Independent Director is available if any shareholder has concerns that they feel are not being addressed through the normal channels.
the Chair of the Group Performance and Remuneration Committee consults extensively with institutional shareholders in respect of the Group’s remuneration policy.
Throughout the year, the Chairman, Group Chief Executive, Group Finance Director and Chair of the Group Performance and Remuneration Committee communicate shareholder feedback to the Board and the directors receive independent analyst notes and reports reviewing share price movements and the Group’s performance against the sector. Detailed market and shareholder feedback is also provided to the Board after major public announcements such as results announcements. The arrangements used to ensure that directors develop an understanding of the views of major shareholders and other stakeholders are considered as part of the annual Board evaluation.
The implications for the Group’s culture and control environment were considered in light of this and other ongoing investigations. The Committee in particular, reviewed proposed enhancements to the culture and control framework in the Markets and International Banking divisions. It has monitored the implementation of remedial action in the Markets business and has overseen liaison with the Group’s regulators. Independent assurance has been obtained regarding the comprehensiveness and timeliness of plans. The Committee is confident that the change programme will result in genuine behavioural change across the business as well as robust and sustainable control remediation. It will closely monitor implementation of these plans in 2013.
Inevitably, the challenges that have arisen during the year have meant that members have had to dedicate some considerable time to the work of the Committee. I would like to extend my thanks to my fellow Committee members for their continued dedication and support throughout 2012.
Brendan Nelson Chairman of the Group Audit Committee 27 February 2013
Report of the Group Audit Committee Meetings and visits A total of seven scheduled meetings of the Group Audit Committee were held in 2012, including meetings held immediately before consideration of the annual and interim financial statements and the quarterly interim management statements by the Board. The Group Audit Committee also held five ad hoc meetings. Group Audit Committee meetings are attended by relevant executive directors, the Internal and External Auditors and Finance and Risk Management executives. Other executives, subject matter experts and external advisers are also invited to attend the Group Audit Committee, as required, to present and advise on reports commissioned by the Committee. At least twice a year the Group Audit Committee meets privately with the External Auditors. The Committee also meets privately with the Group Internal Audit management.
The annual programme of joint visits by the Group Audit and Board Risk Committees to the Group's business divisions and control functions continued in 2012. The object of the programme is for members of the Committee to gain a deeper understanding of the Group; invitations to attend are extended to all non-executive directors. During 2012, the Group Audit Committee and the Board Risk Committee undertook a total of six visits - to Risk Management (2), Internal Audit (2), Group Finance and Business Services to review the Group Change portfolio.
Membership of the Group Audit Committee The Group Audit Committee is made up of at least three independent non-executive directors. The Chairman and members of the Committee, together with their attendance at meetings, are shown below.
The members of the Group Audit Committee are selected with a view to the expertise and experience of the Group Audit Committee as a whole. The Board is satisfied that all Group Audit Committee members have recent and relevant financial experience, and that each member of the Group Audit Committee is an ‘Audit Committee Financial Expert' and is independent, each as defined in the SEC rules under the US Securities Exchange Act of 1934 (“Exchange Act”) and related guidance. Full biographical details of the Committee members are set out on pages 298 to 301.
Monitor the integrity of the financial statements of the Group, and any formal announcements relating to the Group’s actual and forecast financial performance; and Review significant financial and accounting judgements.
Monitor and review the scope, nature of the work and effectiveness of Internal Audit; and Receive and review its reports, findings and recommendations covering the management of key operating risks, the adequacy of any necessary follow up action and any relevant investigation work.
Oversight of the Group’s relationship with its regulators Monitor the relationship with the Financial Services Authority and other relevant regulatory bodies, including review of the scope and results of work conducted by the Skilled Persons approved by the Financial Services Authority.
• Monitor the integrity of the financial statements of the Group, and any formal announcements relating to the Group’s actual and forecast financial performance; and
Systems of internal control Implementation of a clear and effective three lines of defence model was a priority in 2012. The Committee received regular reports on the approach to its implementation across the Group. Focus is now on ensuring the model is fully operational and the Committee will exercise close oversight of progress during 2013.
Regulatory investigations highlighted deficiencies in the control environment in certain parts of the Group, most notably within the Markets and International Banking divisions. Cultural weaknesses were also identified. On behalf of the Board, the Group Audit Committee undertook a detailed review of the divisional remediation plans and sought independent external assurance regarding comprehensiveness and timeliness of those plans. The Committee will closely oversee remediation throughout 2013, receiving quarterly reports.
The Committee also reviewed the effectiveness of the Group New Product Approval Process and received quarterly reports from the Credit Quality Assurance function. It considered the Group’s compliance with the requirements of the Sarbanes-Oxley Act of 2002 and was regularly advised of whistle blowing disclosures which took place in the Group; complaints raised with members of the Group’s executive team; and significant and sensitive internal investigations.
Divisional Risk and Audit Committees have responsibility for individual divisions and report to the Group Audit Committee and Board Risk Committee. Given the size and complexity of the Group, these committees are essential components of the governance framework that supports the effective operation of the Group Audit Committee and Board Risk Committee. The Committee agreed improvements to the divisional risk reporting framework and these changes will be implemented during 2013. Quarterly reports were received by the Group Audit Committee and Board Risk Committee from each Divisional Risk and Audit Committee.
Internal audit The Group Audit Committee oversaw the work of Group Internal Audit throughout 2012, and received regular reports from the Head of Group Internal Audit. These included bi-annual opinion reports which rated both the quality of the control environment of all the Group’s divisions and of management’s level of awareness. The reports from Group Internal Audit enabled the Committee to monitor internal control within the Group by reporting on areas where improvements to the control environment were needed.
In response to Group Internal Audit findings during 2012, the Committee requested presentations from the International Banking business on improvements to its control environment. More generally, Group Internal Audit raised observations regarding the Group’s management of the conduct risk agenda. Following discussion at the Group Executive Committee, Stephen Hester presented management's action plan responding to these findings to the Committee.
In line with best practice, an external review of the effectiveness of Group Internal Audit takes place every three to five years, with internal reviews continuing in intervening years. In January 2013, the Group Audit Committee undertook an internal evaluation of Group Internal Audit. It concluded that Group Internal Audit had operated effectively throughout 2012. Minor observations and recommendations will be implemented.
Oversight of the Group’s relationship with its regulators The Group Audit Committee has a responsibility to monitor the Group’s relationship with the Financial Services Authority (FSA) and other regulatory bodies. During 2012, it received regular reports on the Group’s relationship with all its regulators and highlighting significant developments. It received reports on regulatory actions and investigations. Over the course of the year the chairmen of the Group’s senior Board committees met with the FSA on an individual basis and also participated in certain Regulatory College meetings with the Group’s primary regulators. The FSA attended a Group Audit Committee meeting in October 2012 as an observer.
During 2012, the Chairman of the Group Audit Committee also met with the FSA and with the External Auditors on a trilateral basis.
The Committee closely monitored the Group’s relationship with its international regulators and significant time continued to be dedicated in particular to understanding the regulatory requirements in the US and the implications on the Group’s US operations and structure.
Processes for external audit During 2012, the External Auditors provided the Group Audit Committee with reports summarising their main observations and conclusions arising from their year end audit, half year review and work in connection with the first and third quarters and their recommendations for enhancements to the Group’s reporting and controls. The External Auditors also presented for approval to the Committee their audit plan and audit fee proposal and engagement letter, as well as confirmation of their independence and a comprehensive report of all non-audit fees.
The Group 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 annual evaluation is carried out in two stages. An initial review was carried out in early 2013. In assessing the effectiveness of the Group’s External Auditors, the Group Audit Committee had regard to: the experience and expertise of the senior members of the engagement team; the proposed scope of the audit work; the quality of dialogue between the External Auditors, the
In particular, the Group does not engage the External Auditors to provide any of the following non-audit services: bookkeeping or other services related to the accounting records or financial statements; financial information systems design and implementation; appraisal or valuation services, fairness opinions or contribution-inkind reports; actuarial services; internal audit outsourcing services; management functions or human resources; broker or dealer, investment adviser, or investment banking services; legal services and expert services unrelated to the audit; or other services determined to be impermissible by the US Public
Annual audit services also include statutory or non-statutory audits required by any Group companies that are not incorporated in the UK. Terms of engagement for these audits are agreed separately with management, and are consistent with those set out in the audit engagement letter insofar as local regulations permit. During 2012, prospectively approved non-audit services included the following classes of service: capital raising, including consents, comfort letters and relevant reviews of registration statements; provision of accounting opinions relating to the financial statements of the Group and its subsidiaries; provision of reports that, according to law or regulation, must be rendered by the External Auditors; permissible services relating to companies that will remain outside the Group; reports providing assurance to third parties over certain of the
Group's internal controls prepared under Standards for Attestation Engagements (SSAE) No. 16 or similar auditing standards in other jurisdictions; and reports and letters providing assurance to the Group in relation to a third party company where the Group is acting as equity/ debt underwriter in a transaction, in the ordinary course of business.
For all other permitted non-audit services, Group Audit Committee approval must be sought, on a case by case basis, in advance. The Group Audit Committee reviews and monitors the independence and objectivity of the External Auditors when it approves non-audit work, taking into consideration relevant legislation, ethical guidance and the level of non-audit services relative to audit services. The approval process is rigorously applied to prevent the External Auditors from functioning as management, auditing their own work, or serving in an advocacy role.
The External Auditors’ knowledge of the Group and extensive experience in such work ensured time and cost savings were achieved in both instances.
In addition, the External Auditors are engaged from time to time by the Group to perform restructuring services. The Group is not liable for these fees, and often has a limited role in the selection process. As an additional governance control, these engagements are subject to the ad hoc approval process. Information on fees paid in respect of audit and non-audit services carried out by the External Auditors can be found in Note 5 to the consolidated accounts on page 385.
However, inevitably risk management tools and measures can only take the organisation so far. The future success of RBS depends upon the correct culture and approach that places the customer at the forefront of all decision making. The Board Risk Committee is fully supportive of the measures being developed to engender the correct behaviours at all levels within the RBS Group. The Committee has worked closely with the Group Performance and Remuneration Committee over the past 12 months to consider issues relating to individual accountability and responsibility for legacy and new issues. Where appropriate, recommendations have been made to the Group Performance and Remuneration Committee in relation to risk performance and reward. Culture, including the role of financial incentives and reward, will continue to be a priority of the Committee during 2013.
The members of the Committee have dedicated significant additional time to the consideration of risk issues during 2012 and I would like to thank them for their dedication and commitment. The business of the Committee is set to be no less demanding in 2013. The creation of the Prudential Regulatory Authority and the Financial Conduct Authority as part of the UK’s twin peaks regulatory framework will be a major influence and the Group will have to adapt to the new regulatory approach and work closely with regulators to implement changes to standards and reporting where required.
More detailed information on the business of the Committee during 2012 is set out in the Board Risk Committee Report that follows.
Membership The Board Risk Committee comprises at least three independent nonexecutive directors. The Chairman and members of the Committee, together with their attendance at meetings, are shown below.
Philip Scott (chairman) 7/7 Sandy Crombie 7/7 Tony Di Iorio (1) 6/7 Joe MacHale 5/7 Brendan Nelson 7/7 Baroness Noakes (2) 5/5
Role of the Board Risk Committee 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 future risk strategy, including determination of risk appetite and tolerance. The Committee reviews the performance of the Group relative to risk appetite and provides oversight of the effectiveness of key Group policies. The Board Risk Committee has responsibility for promoting a risk awareness culture within the Group.
• To consider the Group's risk profile relative to current and future Group strategy and Group risk appetite and identify any risk trends, concentrations or exposures and any requirement for policy change.
• To ensure rigorous stress and scenario testing of the Group’s business.
During 2012, the Board Risk Committee reviewed the implementation of the Group Policy Framework across the organisation and reviewed the output of assurance testing to assess how those standards were operating in practice. Governance arrangements were also reviewed during the year. In particular, the Committee considered regional governance arrangements in operation across the Group; local guidance; regulatory expectations; and considered the adequacy of the current Group structure against that backdrop. In conjunction with the Group Audit Committee, the members reviewed how the three lines of defence model was being implemented across the Group and the Committee reinforced with management the importance of ensuring the model operated effectively in practice. The Committee will continue to review governance arrangements and compliance with the Group Policy Framework during 2013.
The Committee regards conduct risk and the delivery of appropriate outcomes to customers to be fundamental to the future success of the RBS Group. As referenced above, in 2012 the Board Risk Committee oversaw the development of the Group conduct risk appetite statement and framework which is now in the process of being fully implemented across all lines of defence in the organisation. Focus of the Committee has now turned to consideration of what measures, standards, training and objectives are required to instil and evidence the correct behaviours in practice.
Risk profile Reporting The Committee received a detailed report on key risks and metrics at each meeting and the Chief Risk Officer provided an oral update on the key risks to the organisation. This enabled the Committee to identify the key risk areas where additional focus was required. Focus sessions were provided by the Heads of Risk disciplines at Board Risk Committee meetings on a rotational basis, to offer the Committee additional insights.
During the period, risk reporting was enhanced and the Committee oversaw the development of a report on the key headline and emerging risks. Likewise, at the request of the Committee, metric based risk reporting in dashboard format was developed and will be extended to cover each of the key risk disciplines during 2013.
The Committee reported to the Board following each meeting on its consideration of the risk profile of the Group and made recommendations as appropriate.
A number of other internal and regulatory investigations arose or continued throughout 2012. During the period, the Committee received reports on the investigation of the alleged mis-selling of interest rate hedging products to small and medium sized enterprises; it reviewed ongoing programmes of work, remediation and investigation relating to unauthorised trading events and Anti-Money Laundering; it received reports on required enhancements to the mortgage sales process; and it continued to play an important governance role in the oversight and remediation of known regulatory issues in the RBS Americas region. Where appropriate, the Committee oversaw liaison with regulators; made recommendations regarding required remediation, training and process controls and enhancements; and made recommendations to the Group Performance and Remuneration Committee in relation to accountability. Progress to address identified weaknesses will be closely monitored throughout 2013.
The Committee considered pension risk in the context of managing liability and investment strategy. It will continue to monitor these risks in 2013.
Risk appetite, framework and limits The risk appetite framework for the Group was approved in 2011. During 2012, focus was placed on ensuring that the framework was rolled out and embedded across the business divisions and legal entities within the Group. The Committee has committed to review the risk appetite framework on an annual basis to ensure it remains fit for purpose and will review capital adequacy risk, earnings volatility, and liquidity risk appetite targets in early 2013.
The Committee received reports on the new Country Risk Appetite Framework that was developed in 2012. The members reviewed the approach to assessment of the potential for losses due to country risk shocks and how the framework informed the setting of country risk limits within the Group’s Risk Appetite Framework.
Risk management operating model The Committee reviewed planned improvements to the risk management operating model and noted the proposed enhancements and the additional assurance that the revised model seeks to introduce. Members of the Committee reviewed the calibre of senior risk personnel and succession planning arrangements. Adequacy of resource was considered in the context of the scope and nature of work undertaken by the Risk Management function.