Highlights of 2006 02 Financial highlights 04 Chairman’s statement 06 Group Chief Executive’s review 08 Group profile 10 Divisional profile
Group profit before tax rose by 16% to £9,186 million in 2006.
F in an ci al h ig h lig h ts
Group operating profit – profit before tax, purchased intangibles amortisation, integration costs, and net gain on sale of strategic investments and subsidiaries in 2005 (£m)
Earnings per share increased by 14% to 200.0p for 2006, adjusted for purchased intangibles amortisation, integration costs, and net gain on sale of strategic investments and subsidiaries in 2005, and in 2002–2003 for the AVS dividend.
Note: The accounts are prepared in accordance with International Financial Reporting Standards. Certain standards relating to financial instruments were not adopted until January 2005. The Group has provided comparative information on a pro forma basis that includes the estimated effect of these standards for the year ended 31 December 2004.
The Group’s market capitalisation at 31 December 2006 was £62.8 billion compared with £56.1 billion a year earlier.
Index has been selected because it represents a cross-section of leading UK companies. The total shareholder return for the company and the FTSE
In 2006, the Group once again demonstrated its inherent strength and breadth, achieving impressive growth and capital generation enabling us to increase the dividend by 25% and raise our payout ratio to 45%.
At last year’s AGM, Sir George Mathewson stood down as Chairman and the Board appointed me as his successor. George’s 18 years at the helm of RBS, as Group Chief Executive and latterly Chairman, marked an extraordinary period of growth and success. I thank him for the fine legacy he provided and for all the help he gave me in ensuring a smooth and easy transition.
Impressive profit growth in 2006 coupled with increased distribution, which helped minimise the capital required to support origination, enabled us to be strongly capital generative. As a consequence, the Board is recommending raising the total dividend by 25%, which raises the payout ratio to 45%. In addition, we completed the repurchase of £1 billion of shares announced last year. Our adjusted return on equity increased to 19.0% from 18.2% in 2005, and our total shareholder return in 2006 was 18%, in line with the average over the last decade.
Bonus share issue The company’s shares traded at an average price of £18.09 over the course of 2006 and have moved higher since. This is significantly above the average share price of companies trading on the London Stock Exchange and we believe that many shareholders prefer to deal in shares with a lower price per share, more in line with the average. We therefore propose to adjust the price per share by a bonus issue of two new ordinary shares of 25p for each ordinary share held.
In the UK there has been much debate about the retail banking model. Studies have shown that the UK has one of the most efficient and competitive banking services in the world, offering excellent value to customers overall. With the largest branch network and the highest customer satisfaction scores amongst our peers we are confident that we will be able to respond effectively to any changes which may occur in the marketplace.
I have been proud to serve as your Chairman in 2006 and look forward to the continuing progress of The Royal Bank of Scotland Group.
We are building a group whose diversity, scale, distribution capacity and operational excellence can deliver superior, sustainable income growth, controlled risk and strong returns. Our 2006 results demonstrate once again the success of this model with particularly strong performances from Global Banking & Markets (“GBM”), UK Corporate Banking, Wealth Management and Ulster Bank. UK Retail banking, Citizens and RBS Insurance made good progress in the face of headwinds in their markets.
Our customers The Group continues to hold the highest market share in UK corporate banking and we are now the joint leader in the personal current account market. RBS has once again secured top position and NatWest is joint second among major High Street banks for extremely satisfied customers, and we continued to invest in the expansion of our branch network in the UK. Through Ulster Bank we expanded across the island of Ireland, and in the US, Citizens continued to broaden its customer base through the expansion of its credit card, merchant acquiring, small business and midcorporate activities. Our GBM and Wealth Management businesses are growing rapidly in Asia.
Our people Our performance is the result of the hard work, energy and dedication of our 135,000 employees. We have made significant progress in recent years in the development of our people, by seeking and then acting upon feedback from them. A record 87% of our employees participated in the 2006 Employee Opinion Survey and we outperformed the Global Financial Services norm in every category.
Our people told us, and our results demonstrate, that the Group provides a rewarding and stimulating working environment for personal and professional development.
We continue to listen to them and invest to maintain our market-leading position.
Bank of China We have made good progress in developing our partnership with Bank of China. Our joint credit card business has already issued 1.2 million cards, we are establishing a joint private banking business and have together completed a number of significant transactions in shipping, aviation and trade finance.
Retail Markets provides a broad range of retail services across different brands and channels to our personal and small business customers. It has four distinct business areas: Consumer
UK; and Wealth Management in the UK, continental Europe and the Asia Pacific region.
Citizens provides retail and corporate banking services through the Citizens and Charter One brands across 13 states in the northeastern and midwestern US, with a retail and commercial presence in more than 30 other states. Activities include personal banking, residential mortgages, cash management, credit card products, merchant servicing and a wide variety of commercial banking services.
� Contribution £6,122 million (2005 – £5,165 million) � Total income up 17% � Operating profit up 20%
– Global Banking & Markets Global Banking & Markets is a leading banking partner to major corporations and financial and governmental institutions around the world, providing an extensive range of debt financing, risk management and investment services to its customers.
� GBM’s employees serve the diverse needs of major corporates and financial institutions from offices in 21 countries around the world. GBM continues to invest significantly in people, infrastructure and technology to support growth and develop new product capabilities.
� GBM made significant progress in building its business internationally in 2006. Income grew by 18% in the US, 26% in Europe and 35% in the Asia Pacific region.
� To support international expansion we made significant investments in new offices and locations. Construction work started on new premises, which will bring together our people from RBS Greenwich Capital and RBS New York; a new office in Helsinki opened on 1 September 2006; and we moved to larger premises in Tokyo, Hong Kong and Singapore.
Examples of GBM client transactions � RBS teams in Spain and the UK successfully arranged the financing of the £15 billion acquisition of BAA, the world’s leading airport operator, by a consortium led by Ferrovial. This complex transaction benefited from our knowledge of the Spanish and UK markets as well as our global distribution capabilities.
� In North America, RBS financed the energy sector’s largest acquisition to date, that of Burlington Resources by ConocoPhillips, for $35 billion. We played the lead role as administrative agent on $22.5 billion of credit facilities, including $15 billion of bridge facilities to finance the cash portion of the acquisition and $7.5 billion of permanent debt facilities. RBS Greenwich Capital was also joint Bookrunner on $3 billion of related debt capital markets issuances.
� RBS Structured Ship Finance successfully completed a financing programme in China for three ships for Shanghai Time Shipping for $60 million. We enabled the company to secure the ships offshore at attractive prices, and charter them in a strong international market. We also obtained Chinese government approvals to import, flag and register the vessels. This was the first joint ship financing by RBS working with Bank of China as its strategic partner in the Chinese market.
� RBS acted for Leighton Holdings Limited, Australia’s largest construction and contract mining group, as Bookrunner, Mandated Lead Arranger, Residual Value Guarantor and joint Lead Manager for an AU$750 million leveraged operating lease facility and associated senior debt and bond financing. The purpose was to enable Leighton to fund their equipment requirements in a flexible and capital efficient maner.
� We were one of two joint Bookrunners and joint Lead Arrangers on Hutchison Whampoa Ltd’s inaugural £700 million sterling debt capital issue. The company took advantage of attractive sterling market conditions, benefiting from a strong appetite for corporate names in longer-dated maturities, to launch and price an 11 and 20-year dual-tranche issue successfully. To date this is the largest ever sterling issue by a non-Japanese Asia Pacific corporate.
UK Corporate Banking (UKCB) � UKCB has over 90,000 customers and over 8,500 employees. UKCB’s approach to relationship management provides customers with access to the resources of one of the world’s largest financial groups through a local point of contact.
� We have made significant investment in additional international trade services and specialists to help our UK customers to trade in international markets.
� 2006 has seen strong growth in both lending and deposits across UKCB, reflecting the successful growth of our customers’ businesses.
� Commercial Banking serves customers with turnover between £1 million and £25 million. It operates under the Royal Bank of Scotland and NatWest brands and is the No 1 commercial relationship bank in the UK, with just under 1,000 relationship managers.
� Lombard is the UK’s leading provider of finance and leasing facilities for business assets. It has a comprehensive network of business centres across the UK and Ireland as well as specialist units for the aviation, corporate, marine, technology services and vehicle management markets.
� RBS Corporate Banking organised an innovative £1 billion debt structure for Barchester Healthcare.
� RBS Corporate Banking in Yorkshire was the joint underwriter and provider of £450 million senior debt and revolving credit facilities to support Croda with its acquisition of Uniqema.
� RBS Commercial Banking in Scotland provided SBS Marine with a £30 million funding package that enabled both a buy-out and an expansion of the fleet from three to six vessels.
� In a transaction worth £8.5 million, Lombard financed Asda’s 2006 refrigerated trailer replacement programme of over 200 trailers on a five year lease.
� As well as supplying the AA’s iconic yellow patrol vans and company cars, Lombard is funding over 12,000 AA Driving School vehicles over a three year period.
Asia Shipping Debt Deal of the Year 2006 – Shanghai Time Shipping Jane’s Transport Finance
� NatWest was again the No 1 choice for student accounts, with 42% of first-year students in England and Wales opening their current account with us.
� Amongst high street bank customers who rate themselves ‘extremely satisfied’ with their main current account provider, the Royal Bank of Scotland retained top position and NatWest was again joint second.
� We launched the new NatWest and RBS Private Banking services, which are tailored to the needs of customers who typically earn more than £100,000 a year, or with £50,000 or more to save or invest. We offer the choice of a local relationship manager or advice by phone through the new Private Banking Direct service. A dedicated range of products and services, including flexible borrowing facilities, guaranteed deposits and an enhanced mortgage service have enabled us to build on the Group’s position as the UK’s No1 provider of current accounts amongst this high income group.
� In response to simplified pension legislation in the UK, Bancassurance modified and re-launched our Stakeholder Pension Plan and introduced a new Self-Invested Personal Pension Plan. We also launched a website providing customers with detailed information on the new legislation and an interactive tool to help them assess its impact and decide on their best course of action.
� In 2006, over 53,000 business customers reviewed their banking needs with one of our 200 Financial Planning Managers.
� NatWest Business Banking provides an extended hours, telephone-based, full banking service with access to a dedicated business relationship team for over 44,000 customers. The number of NatWest business customers using internet banking regularly has increased by 28% in 2006.
� The Royal Bank of Scotland provided facilities for farmers to accept their support payments in euros.
� In merchant aquiring, through our brands including Streamline and RBS Worldpay, we are the largest in traditional and internet payments in the UK and continental Europe, and No 4 globally for traditional payments. We are the largest facilitator of e-commerce payments in Europe and processed 360 million transactions via the internet in 2006.
New branches The Royal Bank of Scotland and NatWest have continued to extend their branch networks. When Clydesdale Bank closed its branch in New Deer, Aberdeenshire, we worked with the local community to open a Royal Bank of Scotland branch in its place.
� Tesco Personal Finance continues to expand its range of products, and in 2006 introduced the Bonus Credit Card, which gives customers back one month’s interest every year – a first in the UK. Tesco Personal Finance has also entered the business market with the new Tesco Business Credit Card.
Best Banking Provider – Royal Bank of Scotland Your Money Direct
The Innovators 2006 awards – The Royal Bank of Scotland Contactless Card Scottish Financial Enterprise.
Business to Business award – RBS International Chartered Institute of Marketing, Guernsey
Best Customer Retention Programme 2006 – RBS International for packaged accounts Chartered Institute of Marketing
Wealth Management � Coutts & Co is the leading private bank in the UK and strengthened its position with income growth of 20% and a 9% increase in customer numbers. Coutts has continued its regional expansion and now has 23 offices in the UK.
� RBS International is one of the largest UK offshore banks with 39 offices across the world in nine jurisdictions and achieved double-digit income and profit growth in 2006.
� Adam & Company have five offices in the UK and one in Guernsey, and achieved a 14% growth in income, its twelth successive year of double-digit income growth.
� We opened 80,000 new current accounts in 2006, following the introduction of transaction fee-free banking for all retail customers.
� In 2006 we became the No1 financial institution for business in Northern Ireland, with 32% of all businesses classifying Ulster Bank as their main bank.
� We won the financing of Belfast’s Titanic Quarter, one of the largest urban waterfront regeneration projects in Europe, with a first phase that includes 475 apartments, a 120-bed hotel and a large office complex.
� In conjunction with RBS Private Placement Group, Ulster Bank arranged a $150 million Private Placement providing Bord Na Móna, the Irish state-owned energy company, with long term funding for the roll-out of its energy, environmental and waste management business strategy.
� Citizens has the eighth-largest retail branch network in the US, and has more than 5.1 million personal and business customers.
� A continued emphasis on customer service helped raise retail customer satisfaction levels by 3.5% in 2006.
� Retail Banking in the Charter One footprint has opened more than 276,000 new checking accounts and has seen a 6% increase in cross-selling of other bank products.
� Citizens added PayPass™ embedded-chip technology to its customer debit cards, issuing 3.5 million new cards to its customers to become Mastercard’s largest PayPass™ issuer in the US.
� Supermarket and other non-traditional branches now account for approximately one-third of Citizens’ retail branch distribution, with more than 520 branches. Citizens is the second-largest supermarket bank in the US, taking advantage of busy store locations with key partners.
� Citizens was the No 1 US Small Business Administration (SBA) lender in every market it served during 2006, with nearly 7,000 SBA-backed loans totalling more than US$320 million.
� By the end of 2006, Citizens had opened 390 new company cash management relationships with RBS corporate clients, bringing in over US$200 million of new deposits.
� Launched in early 2002, the Asset Finance group has grown to more than US$5 billion in assets and funded more than US$1.7 billion in 2006, providing asset financing to mid-sized and large corporate customers nationally.
Boston Scientific A world-leading developer and manufacturer of medical devices, including coronary stents, Boston Scientific, found funding support for its acquisition of Guidant from a combination of Citizens, RBS and Ulster Bank.
� In 2006 Citizens Financial Group expanded its community initiatives for job creation and affordable housing. Two different programmes offered over $120 million in loans at low interest rates to companies that agreed to create an estimated 4,000 jobs. The Citizens Housing Bank and Charter One Housing Bank offered US$82 million in lowinterest funds to non-profit housing developers to create 1,070 affordable housing units.
� Our Home Buyer Assistance Programme has helped more than 3,000 Citizens colleagues purchase their homes – often their first.
Direct Line Innovation is integral to Direct Line’s personal insurance products. Additional drivers named on a Direct Line car insurance policy now build up their own no claims discount, one of the most successful new product features highlighted in the “Good Deal Better” marketing campaign in 2006.
� Contribution £964 million (2005 – £935 million) � Total income up 3% � Operating profit up 3%
� RBS Insurance is the No1 car insurance provider in the UK, and the No 2 home insurance provider in the UK.
� Following its acquisition in 2005, RBS insurance completed the integration of Tracker, the UK leader in stolen vehicle tracking.
� NIG now has 1.9 million policyholders including 1.4 million motor policyholders. It became the first insurer to offer a motor product for brokers on imarket, the e-commerce portal.
� RBS Insurance’s international business is growing successfully. Sales of motor and related insurance in Spain, Italy and Germany have now reached more than 2 million policies.
Green Flag An annual campaign sponsored by Green Flag, Beep Beep! Day is a nationwide scheme led by road safety charity Brake, designed to teach under fives important lessons about road safety. Nurseries and preschool groups hold road safety days to teach young children the vital skills for staying safe on the roads. The sponsorship also helps raise funds for Brake’s crucial work supporting families bereaved or affected by a serious injury in a road traffic accident.
� Direct Line has the highest spontaneous customer brand awareness in both car and home, and Churchill has the second-highest awareness for car.
� In May, Direct Line announced the launch of enhanced home insurance, offering a 50% discount on contents insurance and free European annual family travel cover to new customers.
� Direct Line in Spain introduced faster claims management and improved customer communication.
� Direct Line Italy pays its insurance claims on average six days faster than the market, according to Italy’s Insurance regulator. An annual price comparison produced by Quattro Route motoring magazine reported Direct Line to be the most competitive insurer in Italy.
� Direct Line in Germany continued to expand its product range, launching general legal protection and private third party liability insurance.
� As a result of development in 2006, our UK Assistance Accident Repair Centre in Heywood became one of the first bodyshops in the industry to achieve the Thatcham BSI (British Standards Industry) Kitemark accreditation, a new industry quality standard.
Direct Line – Best Corporate Social Responsibility Programme ifs/Capgemini Financial Innovations Awards 2006
Direct Line – Winner of the Judges Special Award for Consumer Insight The Financial Services Forum Awards for Marketing Effectiveness 2006
Churchill Challenge In July 2006 Churchill – the famous nodding dog – took to the road with the “Challenge Churchill” campaign, urging people to challenge him to save money on their car and home insurance. The initiative has significantly increased unprompted awareness of the brand.
Our support and services enable the Group to operate around the clock, and provide a strong, stable and scalable platform for future growth.
Manufacturing employs more than 25,000 people across the UK, Republic of Ireland and continental Europe and manages the UK’s largest free-to-use ATM network. During 2006 our retail customer service centres received just under 70 million customer calls.
� We operate one of the world’s largest and most advanced mainframe computer environments, delivering extremely high levels of service availability. This supports over 122,000 desktop PCs, and the servers, mainframe and storage for these all to run efficiently and securely, as well as more than 7,500 ATMs and 475,350 merchant terminals.
� In 2006 over 100 key technology systems supporting customer transactions and employee systems were available an average 99.9% of the time, even though we make many upgrades and changes to systems daily. We have been able to reduce the delivery time of new IT developments by creating a scalable production environment.
� We have applied a number of improved fraud detection tools, focusing on ‘real-time’ fraud detection. We reduced fraud throughout the Group by 24% in 2006 and 50% since 2004.
� We have streamlined the way we produce and handle statements, cheque books and debit cards, generating seven million fewer sheets of paper.
� Printed documents are stored as an image that can be called up and processed at any location. This eliminates the risk of ‘lost paper’ and improves the management of queries.
� Ulster Bank Group is now well positioned to take advantage of existing RBS products and services and future developments on the Group’s platform. As a result of this integration, our core retail systems now support euro processing, and will be able to support any future euro-based brands.
� On our busiest payment processing day in 2006 we processed over 100,000 outward CHAPS payments, worth over £118 billion. We are among the top 10 senders of SWIFT payments globally.
� In 2006, the Royal Bank of Scotland and NatWest brands had 2.3 million customers banking online, an increase of 33% from 2005.
� Our customer contact centres generated more than 1.57 million sales leads during 2006, compared with 1.17 million in 2005.
� Corporate Service Centres opened 123,000 new accounts in 2006, a 13.8% rise over 2005.
� Lombard Operations supported 17% growth in UK new business deals for Lombard Asset Finance.
� We successfully won and implemented the handling of Tesco’s England and Wales cash, coin and clearing business, equalling a total cash and coin business of £9.6 billion, and processing of eight million cheques per year.
� By training people in multiple skills and adopting flexible working hours we are able to redeploy staff to areas of peak demand. This increased flexibility resulted in call centre staff handling 11% more calls per person than in 2005.
Ulster Bank Integration In 2006 we successfully completed the integration of Ulster Bank and First Active onto the RBS technology platform. This was a complex programme involving the integration of three banks and two currencies in two jurisdictions. 2.5 million customer accounts and £30 billion of customer balances were transferred.Manufacturing continued
World-class Management System for Hub and Spoke Operations – Manufacturing Operations University of Warwick
Project of the Year, Private Sector – Group Enterprise Platform Techworld Network Awards
Polish bank account With over 300,000 Polish speakers now resident in the UK, NatWest has launched the first dedicated Polish bank account in Britain. Special features which meet the needs of the Polish community include a second account to allow the transfer of money to family members in Poland, a dedicated Polish call centre and all Polish material available both in print and online.
Ards Peninsula Ulster Bank has provided funding for a small-scale hydro project in the Ards Peninsula. Generating 56kW at peak output it can generate 88,000 units of renewable electricity every year. Ian McMurray is the Conservation Officer at the project.
In 2006 we have strengthened the extent, rigour and reporting of our consultation with our stakeholders. The issues that matter most to them provide the focus of our Corporate Responsibility strategy.
� RBS is the largest corporate sponsor of the Money Advice Trust, through a six-year commitment to a £3.68 million partnership. During 2006 we extended our support for a further three years, providing an additional £2.15 million. This allows the Trust to improve the quality of face-to-face money advice delivered through organisations such as the Citizens Advice Bureau, and has provided training for 5,000 advisers each year.
Financial Crime � The Group’s global fraud losses fell by 24% in 2006. In the UK, total industry fraud attacks grew by 8%, while attacks against RBS increased by just 2%. Plastic fraud losses for RBS declined by 5% while industry losses declined by 2%. Internet fraud losses declined by 14% compared with an industry-wide increase of 46%. As a leader in ‘Phishing’ prevention, RBS experienced only 1% of industry losses.
Environment � In 2006, we reduced our carbon footprint in the UK and Ireland by 216,000 tonnes of CO2, by purchasing green electricity. We switched to recycled paper for office use in the UK and Ireland. A number of RBS facilities, including the Group’s headquarters at RBS Gogarburn, achieved ISO14001 certification for environmental excellence.
Key Achievements � 300 free-to-use ATMs offered to rural and deprived areas and a further 200 planned for 2007.
� 930,800 basic bank accounts opened since the launch in 1999, with over 200,400 in 2006 alone.
� £677 million loaned to small businesses in the 5% most deprived wards in the UK.
� One million schoolchildren have attended a Face2Face with Finance (F2F) lesson since the programme’s re-launch in 2004.
� Over £150 million of attempted fraud attacks thwarted as a result of new customer profiling capability.
Further information about Corporate Responsibility at RBS is available on our website at www.rbs.com/cr
Corporate Responsibility continued Madrid Run Women from Global Banking & Market’s Madrid office joined in one of Madrid’s best supported charity fun runs. Asociación Española Contra el Cancer’s annual run has become one of the most popular fund raising events in the city.
� In 2006 our people spent a total of 202,800 hours on community activities during working hours, representing an investment of £3.6 million and involving 26,460 employees. The Group’s main charity partners are The Prince’s Trust, Fairbridge, Supergrounds and F2F, but in addition each of our businesses has a list of approved community and charity partners that employees can work with at a local level.
� The work of our people is recognised annually through our Chairman’s Awards. 754 nominations were received and 42 finalists were honoured at the awards presentation in February 2007.
� In partnership with The Daily Mail, we made a £1 million Christmas donation to 91 Children’s Charities, nominated by 18,000 RBS employees and Daily Mail readers.
The Group’s published 2004 financial statements were prepared in accordance with then current UK generally accepted accounting principles (“UK GAAP” or “previous GAAP”) comprising standards issued by the UK Accounting Standards Board, pronouncements of the Urgent Issues Task Force, relevant Statements of Recommended Accounting Practice and provisions of the Companies Act 1985. The Group also presents information under generally accepted accounting principles in the US (“US GAAP”).
For a further discussion of certain risks faced by the Group, see Risk factors on page 48.
Description of business Introduction The Royal Bank of Scotland Group plc is the holding company of one of the world’s largest banking and financial services groups, with a market capitalisation of £62.8 billion at the end of 2006. Headquartered in Edinburgh, the Group operates in the UK, US and internationally through its two principal subsidiaries, the Royal Bank and NatWest. Both the Royal Bank and NatWest are major UK clearing banks whose origins go back over 275 years. In the US, the Group’s subsidiary Citizens is ranked the eighth largest commercial banking organisation by deposits. The Group has a large and diversified customer base and provides a wide range of products and services to personal, commercial and large corporate and institutional customers.
The Group had total assets of £871.4 billion and shareholders’ equity of £40.2 billion at 31 December 2006. It is strongly capitalised with a total capital ratio of 11.7% and tier 1 capital ratio of 7.5% as at 31 December 2006.
Corporate Markets is focused on the provision of banking, investment and risk management services to medium and large businesses and financial institutions in the UK and around the world. Corporate Banking and Financial Markets was renamed Corporate Markets on 1 January 2006 when we reorganised our activities into two businesses, Global Banking & Markets and UK Corporate Banking, in order to enhance the service provided to these two customer segments.
Global Banking & Markets (“GBM”) is a leading banking partner to major corporations and financial institutions around the world, providing an extensive range of debt financing, risk management and investment services to its customers. GBM has a wide range of clients across its chosen markets. It has relationships with an overwhelming majority of the largest UK, European and US corporations and institutions. GBM’s principal activity in the US is conducted through RBS Greenwich Capital.
Ulster Bank Retail Markets serves personal customers through both the Ulster Bank and First Active brands. Ulster Bank provides branch banking and direct banking services throughout the island of Ireland. First Active, through its branch network, serves personal customers in the Republic of Ireland with its separately branded product offerings, including mortgages and savings.
Ulster Bank Corporate Markets caters for the banking needs of business and corporate customers, including treasury and money market activities, asset finance, e-banking, wealth management and international services. Business and corporate banking services are provided via centrally-based relationship management teams and dedicated Business Centres located across both Northern Ireland and the Republic of Ireland.
RBS Insurance is the second largest general insurer in the UK, by gross written premiums. It sells and underwrites retail, SME and wholesale insurance over the telephone and internet, as well as through brokers and partnerships. The Retail Divisions of Direct Line, Churchill and Privilege sell general insurance products direct to the customer. Through its International Division, RBS Insurance sells motor insurance in Spain, Germany and Italy. The Intermediary and Broker Division sells general insurance products through its network of independent brokers.
The expenditure incurred by Manufacturing relates to costs principally in respect of the Group’s banking and insurance operations in the UK and Ireland. These costs reflect activities that are shared between the various customer-facing divisions and consequently cannot be directly attributed to individual divisions. Instead, the Group monitors and controls each of its customer-facing divisions on revenue generation and direct costs whilst in Manufacturing such control is exercised through appropriate efficiency measures and targets. For financial reporting purposes the Manufacturing costs have been allocated to the relevant customer-facing divisions on a basis management considers to be reasonable.
The Centre comprises group and corporate functions, such as capital raising, finance, risk management, legal, communications and human resources. The Centre manages the Group’s capital requirements and Group-wide regulatory projects and provides services to the operating divisions.
RBS Insurance competes in personal lines insurance and, to a limited extent, in commercial insurance. There is strong competition from a range of insurance companies which now operate telephone and internet direct sales businesses. Competition in the UK motor market remains particularly intense. RBS Insurance also competes with local insurance companies in the direct motor insurance markets in Spain, Italy and Germany.
The Group's business and earnings are affected by general business and geopolitical conditions The performance of the Group is influenced by economic conditions particularly in the UK, US and Europe. Downturns in these economies could result in a general reduction in business activity and a consequent loss of income for the Group. It could also cause a higher incidence of credit losses and losses in the Group’s trading portfolios. Geopolitical conditions can also affect the Groups earnings. Terrorist acts and threats and the response of governments in the UK, US and elsewhere to them could affect the level of economic activity. The Group’s business is also exposed to the risk of business interruption and economic slowdown following the outbreak of a pandemic.
The financial performance of the Group is affected by borrower credit quality Risks arising from changes in credit quality and the recoverability of loans and amounts due from counterparties are inherent in a wide range of the Group’s businesses. Adverse changes in the credit quality of the Group’s borrowers and counterparties or a general deterioration in UK, US, European or global economic conditions, or arising from systemic risks in the financial systems, could affect the recoverability and value of the Group’s assets and require an increase in the provision for impairment losses and other provisions.
Operational risks are inherent in the Group’s business The Group’s businesses are dependent on the ability to process a very large number of transactions efficiently and accurately. Operational losses can result from fraud, errors by employees, failure to document transactions properly or to obtain proper authorisation, failure to comply with regulatory requirements and Conduct of Business rules, equipment failures, natural disasters or the failure of external systems, for example, the Group’s suppliers or counterparties. Although the Group has implemented risk controls and loss mitigation actions, and substantial resources are devoted to developing efficient procedures and to staff training, it is only possible to be reasonably, but not absolutely, certain that such procedures will be effective in controlling each of the operational risks faced by the Group.
Future growth in the Group’s earnings and shareholder value depends on strategic decisions regarding organic growth and potential acquisitions The Group devotes substantial management and planning resources to the development of strategic plans for organic growth and identification of possible acquisitions, supported by substantial expenditure to generate growth in customer business. If these strategic plans do not meet with success, the Group’s earnings could grow more slowly or decline.
The Group is exposed to the risk of changes in tax legislation and its interpretation and to increases in the rate of corporate and other taxes in the jurisdictions in which it operates The Group’s activities are subject to tax at various rates around the world computed in accordance with local legislation and practice. Action by governments to increase tax rates or to impose additional taxes would reduce the profitability of the Group. Revisions to tax legislation or to its interpretation might also affect the Group's results in the future.
Shareholders’ equity 40,227 35,435 Risk asset ratio – tier 1 7.5% 7.6%
(4) Adjusted after-tax return on equity is based on profit attributable to ordinary shareholders adjusted for purchased intangibles amortisation, integration costs and net gain on sale of strategic investments and subsidiaries, and average ordinary equity shareholders’ funds.
Summary consolidated income statement for the year ended 31 December 2006 The income statement set out below shows purchased intangibles amortisation, integration costs and net gain on sale of strategic investments and subsidiaries separately. In the statutory consolidated income statement on page 139, these items are included in non-interest income and operating expenses as appropriate.
Net interest income 10,596 9,918 Fees and commissions receivable 7,116 6,750 Fees and commissions payable (1,922) (1,841) Other non-interest income 6,239 4,963 Insurance premium income 6,243 6,076 Reinsurers’ share (270) (297) Non-interest income 17,406 15,651 Total income 28,002 25,569 Operating expenses 12,252 11,298 Profit before other operating charges 15,750 14,271 Insurance claims 4,550 4,413 Reinsurers’ share (92) (100) Operating profit before impairment losses 11,292 9,958 Impairment losses 1,878 1,707 Profit before tax, purchased intangibles amortisation, integration costs and net gain on sale of strategic investments and subsidiaries 9,414 8,251 Amortisation of purchased intangible assets 94 97 Integration costs 134 458 Net gain on sale of strategic investments and subsidiaries — 240 Profit before tax 9,186 7,936
Basic earnings per ordinary share 194.7p 169.4p Intangibles amortisation 2.0p 2.0p Integration costs 3.3p 9.9p Net gain on sale of strategic investments and subsidiaries — (5.4p) Adjusted earnings per ordinary share 200.0p 175.9p
Total income The Group achieved strong growth in income during 2006. Total income was up 10% or £2,433 million to £28,002 million.
Non-interest income increased by 11% to £17,406 million and represents 62% of total income (2005 – 61%).
Net interest margin The Group’s net interest margin at 2.47% was down from 2.55% in 2005, due mainly to the business mix effect of growth in corporate and mortgage lending and the impact of the flatter US dollar yield curve.
Capital ratios at 31 December 2006 were 7.5% (Tier 1) and 11.7% (Total).
(3) Gross yield is the interest rate earned on average interest-earning assets of the banking business.
2.66%, would have declined 20 basis points if IAS 32 and IAS 39 had been implemented in 2004.
Loans and advances to customers – UK 239,469 15,204 6.35 212,991 13,510 6.34
Customer accounts: demand deposits – UK 86,207 2,428 2.82 73,653 2,056 2.79
Total interest-bearing liabilities – banking business (2,3) 377,892 14,557 3.85 349,610 11,720 3.35
Total interest-bearing liabilities 582,702 522,354 Non-interest-bearing liabilities Demand deposits – UK 17,909 17,484
(2) Interest-earning assets and interest-bearing liabilities exclude the Retail bancassurance assets and liabilities attributable to policyholders, in view of their distinct nature. As a result, net interest income has been adjusted by £63 million (2005 – £59 million).
Fees and commissions receivable 7,116 6,750 Fees and commissions payable (1,922) (1,841) Income from trading activities 2,675 2,343 Other operating income 3,564 2,620
Administrative expenses: Staff costs 6,647 5,844 Premises and equipment 1,411 1,274 Other administrative expenses 2,626 2,592 Total administrative expenses 10,684 9,710 Depreciation and amortisation 1,568 1,588 2006 compared with 2005 Operating expenses, excluding purchased intangibles amortisation and integration costs, rose by 8% to £12,252 million to support the strong growth in business volumes.
Staff costs were up £803 million, 14% to £6,647 million reflecting growth and expansion of activities in Corporate Markets, where the number of staff increased by 1,700.
Other administrative expenses, up 1%, £34 million to £2,626 million reflected efficiency improvements whilst supporting higher business volumes.
O p er at in g a n d f in an ci al r ev ie w
Staff costs 76 148 Premises and equipment 10 39 Other administrative expenses 32 131 Depreciation and amortisation 16 140
At 31 December Currency translation Charge to Utilised during At 31 December 2005 adjustments income statement the year 2006 £m £m £m £m £m
Integration costs were £134 million compared with £458 million in 2005 comprising amortisation of internally developed software and other expenditure. Software costs were previously written-off as incurred under UK GAAP but under IFRS are now amortised over 3-5 years. All software relating to the
Total provision coverage (the ratio of total balance sheet provisions for impairment to total risk elements in lending) decreased from 65% to 62%. The ratio of total balance sheet provisions for impairment to total risk elements in lending and potential problem loans also decreased to 62% compared with 65% in 2005. This reflects amounts written-off and the changing mix from unsecured to secured exposure.
New impairment losses 2,093 1,879 less: recoveries of amounts previously written-off (215) (172) Charge to income statement 1,878 1,707
Divisional performance The profit before amortisation of purchased intangible assets, integration costs and net gain on sale of strategic investments and subsidiaries and after allocation of Manufacturing costs where appropriate, of each division is detailed below, and is described as ‘operating profit’ in the divisional analyses that follow.
Corporate Markets Global Banking & Markets 3,790 3,041 UK Corporate Banking 1,762 1,572
RBS Insurance 750 728 Manufacturing — — Central items (1,511) (1,524) Profit before amortisation of purchased intangible assets, integration costs and net gain on sale of strategic investments and subsidiaries 9,414 8,251
Corporate Markets achieved a strong performance in 2006, with excellent results across many of our businesses. Total income, after deducting operating lease depreciation, rose by 19% to £9,543 million with contribution growing by 19% to £6,122 million. Operating profit rose by 20% to £5,552 million.
Corporate Markets Corporate Banking and Financial Markets was renamed Corporate Markets on 1 January 2006 when we reorganised our activities into two businesses, Global Banking & Markets and UK Corporate Banking, in order to enhance our focus on the distinct needs of these two customer segments.
Allocation of Manufacturing costs 143 138 Operating profit 3,790 3,041 £bn £bn
Total assets* 383.6 330.9 Loans and advances to customers – gross*
Rental assets 12.2 11.9 Customer deposits* 54.1 44.7 Risk-weighted assets 138.1 120.0 * excluding repos and reverse repos
Net fee income rose by 26% to £998 million, reflecting our top tier position in arranging, structuring and distributing large scale private and public financings. We have increased our customer penetration, and in 2006 were the third most active underwriter of bonds for European, including UK, corporates.
Income from trading activities continued to grow steadily, rising by 15% to £2,242 million as a result of good volumes of debt and risk management products provided to our customers. A strong performance in credit products was supplemented by growth in our broadening product range, including equity derivatives and structured credit, partially offset by the impact of a slower US mortgage-backed securities market. Average trading book value at risk remained modest at £14.2 million.
These businesses also generate value through the ownership of a portfolio of assets which we manage actively. Good results from these activities, as well as from principal investments where we work with our corporate customers and with financial sponsors, leveraging our financial capability to structure and participate in a wide variety of investment opportunities, were reflected in other operating income, which increased to £1,280 million (net of related funding costs) from £744 million in 2005.
We have maintained good cost discipline while continuing to invest in extending our geographical footprint, our infrastructure and our product range. Net of operating lease depreciation our cost:income ratio was 39.6%. Total expenses grew by 22% to £2,951 million. Variable performance-related compensation increased and now accounts for 41% of total costs.
Portfolio risk remained stable and the corporate credit environment remained benign. Impairment losses fell to £85 million, with the distribution of impairments over the course of the year reflecting recoveries in the first half.
Average risk-weighted assets grew by 11% and the ratio of operating profit to average risk-weighted assets improved from
Total assets* 88.7 78.3 Loans and advances to customers – gross* 86.8 76.7 Customer deposits* 78.4 66.4 Risk-weighted assets 93.1 82.6 * excluding repos and reverse repos
Net interest income from banking activities grew by 11% to £2,169 million. We achieved an 18% increase in average loans and advances to customers, with good growth across all customer segments. We increased average customer deposits by 21%, demonstrating the attractiveness of our range of deposit products for commercial and corporate customers. Changes in the deposit mix and some narrowing of lending margins, principally in the first half of the year, led to a modest decline in UKCB’s net interest margin.
Non-interest income rose by 6% to £1,284 million, reflecting good growth in origination fees and improved distribution of trade and invoice finance and interest rate and foreign exchange products.
– staff costs 1,648 1,565 2,441 2,394 Insurance net claims 488 486 Contribution before impairment losses 5,708 5,376 Impairment losses 1,344 1,185 Contribution 4,364 4,191 Allocation of Manufacturing costs 1,711 1,655 Operating profit 2,653 2,536 £bn £bn
Responding to evolving demand from its customers, Retail Markets has added to its capabilities in deposits and investment products and has been rewarded by strong growth in these areas. Lending growth has been centred on high quality residential mortgages and small business loans, while personal unsecured lending was flat, as we limited our activity in the direct loans market and customer demand remained subdued. We have used our full range of brands to address markets flexibly, focusing on the most appropriate products and channels in the light of prevailing market conditions.
Expenses have been kept under tight control, with additional investment in our business offset by efficiency gains and the benefits of combining Retail Banking and Direct Channels into a unified business.
Customer recruitment has been centred on our branch channels, where we have achieved good growth in savings accounts and are joint market leader for personal current accounts. Our commitment to customer service, through the largest network of branches and ATMs in the UK, is reflected in our industry-leading customer satisfaction ratings.
We have advanced in personal banking, with good growth in savings and investment products combined with effective cost control and improvements in the quality of our lending book. Credit card recruitment and unsecured personal lending continues to be focused on lower risk segments, with reduced emphasis on acquisition through direct marketing.
Net interest income 4,211 4,068 Non-interest income 3,492 3,374 Total income 7,703 7,442 Direct expenses
Insurance net claims 488 486 Contribution before impairment losses 5,210 4,953 Impairment losses 1,343 1,172
Allocation of Manufacturing costs 1,568 1,517 Operating profit 2,299 2,264 £bn £bn
Total banking assets 108.8 104.3 Loans and advances to customers – gross
Average customer deposit balances were 9% higher, driven by personal savings balances up 12% and accelerating growth in business deposits, up 7%. Average mortgage lending was up 8%, with stronger volumes in the second half leading to a 7% market share of net lending in that period. Our offset mortgage product continues to perform well. For the year as a whole, average personal unsecured and credit card lending was flat, reflecting the slower UK consumer demand and our concentration on quality business with existing customers. In the second half we further reduced our activity in the direct loans market, but unsecured balances from our RBS and NatWest customers are broadly in line with the first half. Average business lending rose 5%, reflecting our cautious credit stance.
Despite investments for future growth, total expenses rose by just 2%, to £3,573 million, whilst direct expenses were held flat at £2,005 million. Staff costs increased by 3% to £1,349 million, reflecting sustained investment in customer service and the expansion of our bancassurance and investment businesses. We continue to make efficiency gains as a result of the consolidation of our retail businesses. Other costs, such as marketing expenses, fell by 6% to £656 million, also benefiting from consolidation.
Impairment losses increased by 15% to £1,343 million, but were lower in the second half of the year than in the first. The year-on-year change in impairment losses slowed from 18% in the first half to 11% in the second half. Credit card arrears have stabilised, while the rate of increase in arrears on unsecured personal loans continued to slow. Mortgage arrears remain very low – the average loan-to-value ratio of Retail’s mortgages was 46% overall and 64% on new mortgages written in 2006. Small business credit quality remains steady.
Net claims, which include maturities, surrenders and liabilities to policyholders, were stable at £488 million compared with £486 million in 2005.
Net interest income 500 442 Non-interest income 434 372 Total income 934 814 Direct expenses
Wealth Management delivered strong growth, with total income rising by 15% to £934 million. Contribution grew by 21% to £497 million and operating profit by 30% to £354 million.
Non-interest income grew by 17% to £434 million, reflecting higher investment management fees and performance fees, as well as strong growth in new business volumes, particularly in the UK. Assets under management rose by 11%, to £28.2 billion at the year-end.
Impairment losses returned to historic levels, following a number of specific items in prior years.
Net interest income 773 655 Non-interest income 215 203 Total income 988 858 Direct expenses
Total expenses increased by 11% to £529 million, as we continued our investment programme to support the future growth of the business. We recruited additional customerfacing staff, particularly in corporate banking, opened three new business centres and continued with our branch improvement programme. By the end of 2006, 70% of Ulster Bank branches had been upgraded.
Net interest income 2,085 2,122 Non-interest income 1,232 1,142 Total income 3,317 3,264 Direct expenses
Contribution before impairment losses 1,763 1,706 Impairment losses 181 131 Operating profit 1,582 1,575
Total assets 162.2 158.8 Loans and advances to customers – gross
Average exchange rate – US$/£ 1.844 1.820 Spot exchange rate – US$/£ 1.965 1.721
Citizens continued to expand its branch network. Our partnership with Stop & Shop Supermarkets has helped us to expand our supermarket banking franchise into New York, while in October we announced the purchase of GreatBanc, Inc., strengthening our position in the Chicago market and making us the 4th largest bank in the Chicago area, based on deposits. The acquisition was completed in February 2007.
RBS Insurance increased total income by 3% to £5,679 million, with contribution also rising by 3% to £964 million and operating profit by the same percentage to £750 million.
We achieved good overall policy growth of 3% in our core businesses including excellent progress in our European businesses. Our joint venture in Spain grew policy numbers by 14% to 1.34 million.
Our core non-motor personal lines policies grew by 3%, with particularly good progress in Tesco Personal Finance. SME has also performed well with policies sold through our intermediary business growing by 10%.
However, some of our partnership books continue to age and we did not renew a number of other partnerships. As a result, the number of partnership policies in force fell by 8% in motor and by 9% in home.
Insurance premium income was up 2% to £5,501 million, reflecting a modest overall increase in the total number of in-force policies.
The UK combined operating ratio for 2006, including Manufacturing costs, was 94.6%, compared with 93.4% in 2005, reflecting a higher loss ratio and the discontinuation of some partnerships.
— — Analysis of Manufacturing costs: Group Technology 966 953 Group Property 910 834 Customer Support and other operations 976 971 Total Manufacturing costs 2,852 2,758
Manufacturing costs increased by 3% to £2,852 million, benefiting from investment in efficiency programmes while supporting business growth and maintaining high levels of customer satisfaction. Staff costs rose by 5%, with increases in Group Technology partially offset by reduced headcount in Operations.
Group total 135,000 137,000 2006 compared with 2005 The number of employees at 31 December 2006 was 135,000, a decrease of 2,000 compared with the prior year.
Accruals, deferred income and other liabilities 15,660 14,247 Retirement benefit liabilities 1,992 3,735 Deferred taxation 3,264 1,695 Insurance liabilities 7,456 7,212
Loans and advances to banks increased by £12.0 billion, 17%, to £82.6 billion. Reverse repurchase agreements and stock borrowing (“reverse repos”) increased by £12.3 billion, 30% to £54.2 billion, offset by a reduction in bank placings of £0.3 billion, 1% to £28.4 billion.
Loans and advances to customers were up £49.7 billion, 12%, to £466.9 billion. Within this, reverse repos increased by 29%, £14.0 billion to £62.9 billion. Excluding reverse repos, lending rose by £35.7 billion, 10%, to £404.0 billion reflecting organic growth across all divisions.
Debt securities increased by £6.3 billion, 5%, to £127.3 billion, principally due to increased trading book holdings in Corporate Markets.
Equity shares rose by £4.2 billion, 45%, to £13.5 billion, reflecting the increase in the fair value of available-for-sale securities, principally the investment in Bank of China.
Intangible assets decreased by £1.0 billion, 5%, to £18.9 billion, principally due to exchange rate movements.
Derivatives, assets and liabilities, increased reflecting growth in trading volumes and the effects of interest and exchange rates.
Deposits by banks rose by £21.7 billion, 20%, to £132.1 billion to fund business growth. Increased repurchase agreements and stock lending (“repos”), up £28.5 billion, 59%, to £76.4 billion were partially offset by lower inter-bank deposits, down £6.8 billion, 11%, at £55.7 billion.
Customer accounts were up £41.4 billion, 12%, at £384.2 billion. Within this, repos increased £15.3 billion, 31%, to £64.0 billion. Excluding repos, deposits rose by £26.1 billion, 9%, to £320.2 billion with good growth in all divisions.
Subordinated liabilities were down £0.6 billion, 2%, to £27.7 billion. The issue of £2.3 billion dated and £0.7 billion undated loan capital was offset by the redemption of £0.3 billion dated loan capital, £0.7 billion undated loan capital and £0.3 billion non-cumulative preference shares and the effect of exchange rates, £1.7 billion and other movements, £0.6 billion.
Net cash flows from operating activities 17,441 4,140 Net cash flows from investing activities 6,645 (2,612) Net cash flows from financing activities (1,516) (703) Effects of exchange rate changes on cash and cash equivalents (3,468) 1,703 Net increase in cash and cash equivalents 19,102 2,528 * restated (see Note 48)
The major factors contributing to the net cash inflow from operating activities of £17,441 million were the profit before tax of £9,186 million adjusted for the elimination of foreign exchange differences of £4,516 million and depreciation and amortisation of £1,678 million, together with an increase of £3,980 million in operating liabilities less operating assets.
• reduction of £454 million from eliminating IFRS hedge accounting adjustments partially offset by an increase of £196 million relating to financial instruments, principally net foreign exchange losses on available-for-sale securities.
US GAAP shareholders’ equity at £40,077 million is £150 million lower than IFRS shareholders’ equity of £40,227 million mainly attributable to the reversal of revaluation gains: £2,558 million on financial instruments, principally the Group’s investment in Bank of China and £873 million on investment and own-use properties, offset by the inclusion of £1,491 million of preference shares classified as debt under IFRS, an increase of £520 million from the deferral and amortisation of loan origination costs, net difference of £692 million on acquisition accounting and intangibles and tax on these and other adjustments of £784 million.
Less: investments in insurance subsidiaries, associated undertakings and other supervisory deductions (10,583) (7,282) (5,165) (4,618) (3,146)
Risk management Governance framework The Board sets the overall risk appetite and philosophy for the Group. Various Board and executive sub-committees support these goals, as follows: • Group Audit Committee (“GAC”) is a committee comprising independent non-executive directors that supports the Board in carrying out its responsibilities for financial reporting including accounting policies and in respect of internal control and risk assessment. The Group Audit Committee monitors the ongoing process of the identification, evaluation and management of all significant risks throughout the Group. The Committee is supported by Group Internal Audit which provides an independent assessment of the design, adequacy and effectiveness of the Group’s internal controls.
In addition to the responsibilities at Board level, operational authority and oversight is delegated to the Group Executive Management Committee (“GEMC”), which is responsible for implementing a risk management framework consistent with the Board’s risk appetite. The GEMC, in turn, is supported by the following committees: • Group Risk Committee (“GRC”) is an executive risk governance committee which recommends and approves limits, processes and policies in respect of the effective management of all material non-balance sheet risks across the Group.
• Group Credit Committee (“GCC”) is responsible for approving credit proposals under authority delegated to it by the Board. Credit proposals exceeding the authority of GCC are referred to the Advances Committee. The GCC in turn delegates authority to divisional credit committees.
Heads of Group Risk Management and Internal Audit have direct access to the Group Chief Executive and the Chairman of the Group Audit Committee.
• Liquidity risk: is the risk that the Group is unable to meet its obligations as they fall due.
• Regulatory risk: is the risk arising from failing to meet the requirements and expectations of our many regulators, or from a failure to address or implement any change in these requirements or expectations.
The key principles for credit risk management as defined in the CRMF are set out below.
• Credit risk authority is specifically granted in writing to all individuals involved in the granting of credit approval, whether this is exercised personally or collectively as part of a credit committee. In exercising credit authority, the individuals act independently.
• Where credit authority is exercised personally, the individual has no responsibility or accountability for related business revenue generation.
• All credit exposures, once approved, are effectively monitored and managed and reviewed periodically against approved limits. Lower quality exposures are subject to a greater frequency of analysis and assessment.
Credit authority is not extended to relationship managers: • Assessments of corporate borrower and transaction risk are undertaken using a range of credit risk models supplemented, where appropriate, by management judgement. Specialist internal credit risk departments independently oversee the credit process and make credit decisions or recommendations to the appropriate credit committee.
• Validating the models and submitting documentation of these validations to GRM with appropriate recommendations on recalibration, where applicable.
• Probability of default (“PD”)/customer credit grade – these models assess the probability that the customer will fail to make full and timely repayment of credit obligations over a one year time horizon. Each customer is assigned an internal credit grade which corresponds to probability of default. There are a number of different credit grading models in use across the Group, each of which considers particular customer characteristics in that portfolio. The credit grading models use a combination of quantitative inputs, such as recent financial performance and customer behaviour, and qualitative inputs, such as company management performance or sector outlook.
• Loss given default (“LGD”) – these models estimate the economic loss that may be suffered by the Group on a credit facility in the event of default. The LGD of a facility represents the amount of debt which cannot be recovered and is typically expressed as a percentage of the EAD. The Group’s LGD models take into account the type of borrower, facility and any risk mitigation such as security or collateral held. The LGD may also be affected by the industry sector of the borrower, the legal jurisdiction in which the borrower operates as well as general economic conditions which may impact the value of any assets held as security.
• Credit risk exposure measurement – these models calculate the credit risk exposure for products where the exposure is not 100% of the gross nominal amount of the credit obligation. These models are most commonly used for derivative and other traded instruments where the amount of credit risk exposure may be dependent on external variables such as interest rates or foreign exchange rates.
Credit risk stress testing Credit risk stress testing measures the potential vulnerability to exceptional but plausible economic and geopolitical events, and seeks to quantify the impact of an adverse change in factors which drive the performance and profitability of a portfolio. Stress testing is used within the Group’s CRMF to estimate and manage potential loss in the portfolio and to support the Board’s internal assessment of adequacy of regulatory capital.
At the Group level, a series of stress events are monitored on a regular basis to assess the potential impact on the Group’s income statement, through the credit impairment charge. The primary objective of this analysis is to support the Group’s framework for managing industry and geographical sector concentrations. This is done through the identification of scenarios which are likely to affect groups of inter-related sectors. These stress tests are discussed with senior divisional management and are reported to GRC, GEMC and the GAC. The Group manages to a trigger limit on the stressed impairment charge for an individual scenario.
Expressed as an annual probability of default, the upper and lower boundaries and the midpoint for each of these Group level asset quality grades are as follows: Asset Annual probability of default quality Minimum Midpoint Maximum S&P grade % % % equivalent AQ1 0.00 0.10 0.20 AAA to BBBAQ2 0.21 0.40 0.60 BB+ to BB AQ3 0.61 1.05 1.50 BB- to B+
Corporate Markets – Global Banking & Markets 233.4 206.5 185.5 – UK Corporate Banking 76.0 66.5 49.7
Excluding reverse repurchase agreements, credit risk assets at 31 December 2006 were £539.2 billion (2005 – £498.2 billion), an increase of £41 billion (8%) during the year.
The table below sets out the Group’s loans that are classified as REIL and PPL: 1 January 31 December
REIL as at 31 December 2006 was £6,337 million (2005 – £5,937 million), an increase of £400 million (7%) during the year. As a percentage of customer lending, REIL and PPL in aggregate show an improving trend, amounting to 1.57% of customer loans and advances at 31 December 2006 (2005 – 1.60%).
During 2006, REIL in Corporate Markets rose by £61 million but remained at historically low levels reflecting continued favourable conditions in the corporate environment in the UK, Europe and the US. In addition, REIL increased in Retail by £266 million (7%) due to ongoing challenging conditions in the UK consumer environment.
The adoption of IAS 39 under IFRS at the beginning of 2005 resulted in changes to the methodology used to identify impaired assets and therefore the way that REIL is calculated. Comparative financial information is given in the following tables for both 1 January 2005 and 31 December 2004.
Provision analysis The Group’s consumer portfolios, which consist of small value, high volume 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.
Provisions for loan impairment charged to the income statement in 2006 were £1,877 million, up £174 million (10%) from 2005. As a percentage of customer lending, the impairment charge remained flat at 0.46%.
The adoption of IAS 39 at the beginning of 2005 resulted in changes to the methodology used to identify impaired assets and to calculate required provisions.
Latent loss provisions 593 543 570 Collectively assessed provisions 2,645 2,587 2,484 Individually assessed provisions 695 754 1,086 Specific provisions 3,607 General provision 561
Total provision as a % of customer loans and advances – gross (2) 1.0% 1.0% 1.3% 1.4%
As at 31 December 2006 total customer provisions were £3,933 million, up £49 million (1%) from 31 December 2005. The movement in the provisions balance is shown at the bottom of the page.
Total provision expressed as a: The coverage ratio of closing provisions to REIL and PPL decreased from 65% to 62% during 2006. The lower coverage ratio reflects amounts written-off and the changing mix from unsecured to secured exposures.
Balance as at 1 January 3,887 4,145 Currency translation and other adjustments (61) 51 Amounts written-off (1,841) (2,040) Recoveries of amounts previously written-off 215 172 Charge to income statement 1,877 1,703 Discount unwind(1) (142) (144) Balance as at 31 December (2) 3,935 3,887
(2) Includes provisions against loans and advances to banks of £2 million (2005 – £3 million).
Diversification of funding sources The structure of the Group’s balance sheet is managed to maintain substantial diversification, to minimise concentration across its various deposit sources, and to contain the level of reliance on total short-term wholesale sources of funds (gross and net of repos) within prudent levels. As part of the Group’s planning process, the forecast structure of the balance sheet is regularly reviewed over the plan horizon and funding strategies and options are developed by Group Treasury and implemented after review and approval by GALCO.
Total customer accounts (excluding repos) 320,238 45 294,113 46 241,181 46 Debt securities over one year remaining maturity 44,006 6 22,293 3 9,931 2
Deposits by banks (excluding repos) 55,767 8 62,502 10 56,541 11
Term debt securities with an outstanding term of over one year increased £21.7 billion (97%) to represent 6% of the Group’s funding at 31 December 2006, reflecting the activity of the Group in raising term funds through its securitisation and Euro and US Medium Term Note programmes.
Net customer activity Net customer lending, excluding repos, rose by £9.6 billion (as the growth in loans and advances to customers continued to exceed the growth in customer accounts, albeit to a lesser degree than in previous years), thus increasing the degree of reliance on wholesale market funding to support loan growth.
Management of term structure The degree of maturity mismatch within the overall long-term structure of the Group’s assets and liabilities is managed within internal policy guidelines, to ensure that term asset commitments may be funded on an economic basis over their life. In managing its overall term structure, the Group analyses and takes into account the effect of retail and corporate customer behaviour on actual asset and liability maturities where they differ materially from the underlying contractual maturities.
Daily management The primary focus of the Group’s daily management activity is to ensure access to sufficient liquidity to meet its cashflow obligations within key time horizons out to one month ahead. The short-term maturity structure of the Group’s liabilities and assets is managed on a daily basis to ensure that all material cashflow obligations, and potential cashflows arising from undrawn commitments and other contingent obligations, can be met as they arise from day to day, either from cash inflows, from maturing assets, new borrowing or the sale or repurchase of various debt securities held (after allowing for appropriate haircuts). Short-term liquidity risk is managed on a consolidated basis for the whole Group including the Greenwich companies but excluding the activities of Citizens and insurance businesses, which are subject to regulatory regimes that necessitate local management of liquidity.
Citizens and the insurance companies have their own liquidity policies which comply with their respective regulatory regimes. The policies are also reviewed and monitored by Group Treasury.
Whilst the Group’s net surplus of marketable assets over net short-term wholesale liabilities due within one month decreased by £12.4 billion (44%), access to liquidity to meet all foreseen needs remains comfortably within the Group’s policy parameters. The Group has increased its reliance on medium term funding, both unsecured (via medium term notes) and secured (via residential mortgage securitisation). In the banking book, this has reduced the relative reliance on short term unsecured funding and consequently the level of short-term liquidity risk. In the trading book, an increased proportion of the higher overall level of marketable assets held has been used as collateral for repo borrowing.
Recognising that there are some gaps in the scope of the liquidity risk parameters covered by the FSA’s sterling regime, the Group is actively developing an all-currency mismatch approach for the management of its liquidity risk, in line with its current approach for non-sterling currencies (see below) whilst continuing to ensure compliance with the FSA’s separate requirements for its sterling activity.
The Group has operated within its non-sterling liquidity policy mismatch limits at all times during 2006 and operational processes are actively managed to ensure that is the case going forward.
New quantitative liquidity regulation is being developed by a number of local regulators and will impact the Group’s overseas subsidiaries and branches, notably in the Republic of Ireland. We do not foresee any difficulty in meeting the new requirements.
Taking account of the indicative future regulatory requirements published to date, the Group continues to develop its liquidity risk reporting, management and stress testing capabilities.
Market risk Market risk is defined as the risk of loss as a result of adverse changes in risk factors including interest rates, foreign currency and equity prices together with related parameters such as market volatilities.
The delegation of market risk authority to the Group’s trading businesses is set out in the Group’s Market Risk Policy Statement (“MRPS”), which also sets out standards by which trading market risk must be managed throughout the Group.
The Group Market Risk function, which is independent of the Group’s trading businesses, is responsible for setting and monitoring the adequacy and effectiveness of the Group’s market risk management processes. This includes overseeing the effective application and compliance with the Group’s MRPS. The businesses are responsible for the market risks that they assume and for remaining within their defined limits.
Sources of market risk Trading The principal trading book market risk factors for the Group are interest rates, credit spreads and foreign exchange.
The primary focus of the Group’s trading activities is client facilitation – providing products to the Group’s client base at competitive prices. The Group also undertakes: market making – quoting firm bid (buy) and offer (sell) prices with the intention of profiting from the spread between the quotes; arbitrage – entering into offsetting positions in different but closely related markets in order to profit from market imperfections; and proprietary activity – taking positions in financial instruments as principal in order to take advantage of anticipated market conditions.
Financial instruments held in the Group’s trading portfolios include, but are not limited to: debt securities, loans, deposits, securities sale and repurchase agreements and derivative financial instruments (futures, forwards, swaps and options). For a discussion of the Group’s accounting policies for, and information with respect to, its exposures to derivative financial instruments, see Accounting policies and Note 19 on the accounts.
Non-trading The principal market risks arising from the Group’s non-trading activities are interest rate risk, currency risk and equity risk. Treasury activity and mismatches between the repricing of assets and liabilities in its retail and commercial banking operations account for most of the non-trading interest rate risk. Non-trading currency risk derives from the Group’s investments in overseas subsidiaries, associates and branches. The Group’s venture capital portfolio and investments held by its general insurance business are the principal sources of non-trading equity price risk. The Group’s portfolios of nontrading financial instruments mainly comprise loans (including finance leases), debt securities, equity shares, deposits, certificates of deposit and other debt securities issued, loan capital and derivatives. To reflect their distinct nature, the Group’s long-term assurance assets and liabilities attributable to policyholders have been excluded from these market risk disclosures.
Market risk methodology: trading The Group manages the market risk in its trading and treasury portfolios through its market risk management framework. This expresses limits based on, but not limited to: (i) VaR (ii) Stress testing and scenario analysis (iii) Position and sensitivity analyses
(i) VaR VaR is a technique that produces estimates of the potential negative change in the market value of a portfolio over a specified time horizon at given confidence levels. For internal risk management purposes, the Group’s VaR assumes a time horizon of one trading day and a confidence level of 95%. The Group also calculates VaR at a confidence interval of 99% and a time horizon of ten trading days for the purposes of calculating trading book market risk capital.
(ii) Stress testing Stress testing measures the impact of abnormal changes in market rates and prices on the fair value of the Group’s trading portfolios. GEMC approves the high-level market risk stress test limit for the Group.
The Group calculates a range of market risk stress tests each day. The objective of stress testing is to identify the loss that the Group’s current portfolio of trading book exposures would generate in plausible but adverse market events. The Group calculates historical stress tests and hypothetical stress tests. Historical stress tests calculate the loss that would be generated if the market movements that occurred during a historical market event were to be repeated. Hypothetical stress tests calculate the loss that would be generated if a specific set of adverse market movements were to occur.
In addition to the Group-level consolidated market risk stress tests, stress testing is also undertaken at key trading strategy level. Additional stress tests are undertaken for those strategies where the associated market risks are not adequately captured by VaR.
Stress test exposures are discussed with senior management and are reported to GRC, GEMC and the Board. Breaches in the Group’s market risk stress testing limit are reported to GEMC.
(iii) Position risk and sensitivity analyses In addition to the VaR and stress testing measures discussed above, the Group calculates a wide range of sensitivity and position risk measures, for example interest rate ladders or option revaluation matrices. These measures provide valuable additional controls, often at individual desk or strategy level.
Treasury The Group’s treasury activities include its money market business and the management of internal funds flow within the Group’s businesses. Money market portfolios include cash instruments (principally debt securities, loans and deposits) and related hedging derivatives. VaR for the Group’s treasury portfolios, which relates mainly to interest rate risk including credit spreads, was £1.5 million at 31 December 2006 (2005 – £3.5 million). During the year the maximum VaR was £4.4 million (2005 – £5.8 million), the minimum £0.6 million (2005 – £2.8 million) and the average £2.4 million (2005 – £4.0 million).
A static maturity gap report is produced as at the month-end for each business, in each functional currency based on the behaviouralised repricing for each product. It is Group policy to include in the gap report, non-financial assets and liabilities, mainly property, plant and equipment and the Group’s capital and reserves, spread over medium and longer term maturities. This report also includes hedge transactions, principally derivatives.
Any residual non-trading interest rate exposures are controlled by limiting repricing mismatches in the individual business balance sheets. Potential exposures to interest rate movements in the medium to long term are measured and controlled using a version of the same VaR methodology that is used for the Group’s trading portfolios but without discount factors. Net accrual income exposures are measured and controlled in terms of sensitivity over time to movements in interest rates.
Risk is managed, within VaR limits approved by GALCO, through the execution of cash and derivative instruments. Execution of the hedging is carried out by the relevant division through the Group’s treasury functions. The residual risk position is reported to divisional asset and liability committees, GALCO and the Board.
Non-trading interest rate VaR Non-trading interest rate VaR for the Group’s treasury and retail and commercial banking activities was £40.2 million at 31 December 2006 (2005 – £81.5 million) with the major exposure being to changes in longer term US dollar interest rates. During the year, the maximum VaR was £98.7 million (2005 – £104.2 million), the minimum £40.2 million (2005 – £10.8 million) and the average £76.6 million (2005 – £65.5 million).
Note 35 on the accounts includes, on pages 191 and 192, tables that summarise the Group’s interest rate sensitivity gap for its non-trading book at 31 December 2006 and 31 December 2005. The tables show the contractual re-pricing for each category of asset, liability and for off-balance sheet items and do not reflect the behaviouralised repricing used in the Group’s asset and liability management methodology and the nontrading interest rate VaR presented above.
Insurance risk is the risk of fluctuations in the timing, frequency or severity of insured events, relative to the expectations of the Group at the time of underwriting. This risk is managed according to the following separate components: • Underwriting and pricing risk, • Claims management risk, • Reinsurance risk, • Reserving risk
• Excess of loss catastrophic ‘event’ reinsurance to protect against major events, for example, windstorms or floods.
It is the risk that reserves are assessed incorrectly such that insufficient funds have been retained to pay or handle claims as the amounts fall due, both in relation to those claims which have already occurred in relation to the claims reserves (including claims handling expense reserves) or will occur in future periods of insurance (in relation to the premium reserves).
b) Claims reserves It is the Group’s policy to hold undiscounted claims reserves (including reserves to cover claims which have been incurred but not reported (IBNR reserves)) for all classes at a sufficient level to meet all liabilities as they fall due, having regard to actuarial estimates and the volatility observed and expected in the claims in each class.
There are many sources of uncertainty that affect the Group’s experience under motor insurance, including operational risk, reserving risk, premium rates not matching claims inflation rates, the weather, the social, economic and legislative environment and reinsurance failure risks.
c) Other commercial insurance contracts Other commercial claims come mainly from business interruption and loss arising from the negligence of the insured (liability insurance). Business interruption losses come from the loss of income, revenue and/or profit as a result of property damage claims. Liability insurance includes employers liability and public/products liability. As liability insurance is written on an occurrence basis, these covers are still subject to claims that are identified over a substantial period of time, but where the loss event occurred during the life of the policy.
Fluctuations in the social, economic and legislative climate are a source of uncertainty in the Group’s general liability account, and in particular court judgements and legislation, significant events (for example terrorist attacks), any emerging new heads of damage and types of claim that are not envisaged when the policy is written.
Life business The three regulated life companies of the Group, National Westminster Life Assurance Limited, Royal Scottish Assurance plc and Direct Line Life Insurance Company Limited, are required to meet minimum capital requirements at all times under the Financial Service Authority’s Prudential Sourcebook. The capital resources covering the regulatory requirement are not transferable to other areas of the Group. To ensure that the capital requirement is satisfied at all times, each company holds an additional voluntary buffer above the regulatory minimum.
The objectives of the framework are to protect the Group from financial loss or damage to its reputation and to ensure that it meets all necessary regulatory and legal requirements.
Regulatory risk and supervision Regulatory risk is the risk arising from failing to meet the requirements of our regulators in the conduct of our business. To mitigate this risk, the Group is active in various regulatory developments affecting risk, capital and liquidity management.
In the normal course of business the Group and its subsidiaries co-operate with regulatory authorities in various jurisdictions in their enquiries or investigations into alleged or possible breaches of regulations.
These include the reviews by the Competition Commission and the FSA into payment protection insurance, the OFT’s reviews of undertakings given following the Competition Commission inquiry in 2002 into the provision of banking services to SMEs. The OFT is also inquiring into credit and debit card interchange fees and has decided to undertake a fact find into unauthorised overdraft fees. In the EU, the European Commission is inquiring into MasterCard cross border interchange fees and has announced that its inquiry into retail banking has identified barriers to competition in certain areas of retail banking, payment systems and cards.
The outcome of these reviews is outside the Group’s control and it is not possible to predict the effect, if any, on the Group’s operations of future changes in regulatory actions and policies.
Executive directors Group Chief Executive 2. Sir Fred Goodwin (age 48) DUniv, FCIBS, FCIB, LLD C Appointed to the Board in August 1998, Sir Fred is a Chartered Accountant. He was formerly chief executive and director, Clydesdale Bank PLC and Yorkshire Bank PLC. He is chairman of The Prince’s Trust, a non-executive director of Bank of China Limited and a former president of the Chartered Institute of Bankers in Scotland.
Non-executive directors 8. Colin Buchan* (age 52) A, C, R Appointed to the Board in June 2002, Colin Buchan was educated in South Africa and spent the early part of his career in South Africa and the Far East. He has considerable international investment banking experience, as well as experience in very large risk management in the equities business. He was formerly a member of the group management board of UBS AG and head of equities of UBS Warburg. He is chairman of UBS Securities Canada Inc. and vice-chairman of Standard Life Investments (Holdings) Ltd. He is also a director of Merrill Lynch World Mining Trust Plc, Merrill Lynch Gold Limited, Royal Scottish National Orchestra Society Limited and World Mining Investment Company Limited.
G o ve rn an ce 10. Bill Friedrich* (age 58) A Appointed to the Board in March 2006, Bill Friedrich is currently deputy chief executive of BG Group plc. He previously served as general counsel for British Gas plc and is a former partner of Shearman & Sterling where he practised as a general corporate lawyer working for several of the world's leading financial institutions.
13. Janis Kong* (age 56) OBE, DUniv R Appointed to the Board in January 2006, Janis Kong was formerly executive chairman of Heathrow Airport Limited, chairman of Heathrow Express Limited and a director of BAA plc. She is currently a non-executive director of Kingfisher plc and Portmeirion Group plc. She is also chairman of Forum for the Future and a member of the board of Visit Britain.
16. Bob Scott* (age 65) CBE, FCIBS C, N, R (Chairman) Appointed to the Board in January 2001, Bob Scott is an Australian national. He is the senior independent director. He has many years’ experience in the international insurance business and played a leading role in the consolidation of the UK insurance industry. He is a former group chief executive of CGNU plc (now Aviva plc) and former chairman of the board of the Association of British Insurers. He is chairman of Yell Group plc and a non-executive director of Swiss Reinsurance Company (Zurich) and Jardine Lloyd Thompson Group plc. He is also a trustee of the Crimestoppers Trust, an adviser to Duke Street Capital Private Equity and a board member of Pension Insurance Corporation Holdings LLP.
11. Archie Hunter* (age 63) A (Chairman), C, N Appointed to the Board in September 2004, Archie Hunter is a Chartered Accountant. He was Scottish senior partner of KPMG between 1992 and 1999 and President of The Institute of Chartered Accountants of Scotland in 1997/1998. He has extensive professional experience in the UK and North and South America. He is currently chairman of Macfarlane Group plc, a director of Edinburgh US Tracker Trust plc, Convenor of Court at the University of Strathclyde and a governor of the Beatson Cancer Research Institute.
17. Peter Sutherland* (age 60) KCMG C, N, R Appointed to the Board in January 2001, Peter Sutherland is an Irish national. He is a former attorney general of Ireland and from 1985 to 1989 was the European Commissioner responsible for competition policy. He is chairman of BP p.l.c. and Goldman Sachs International. He was formerly chairman of Allied Irish Bank and director general of GATT and its successor, the World Trade Organisation.
The directors have pleasure in presenting their report together with the audited accounts for the year ended 31 December 2006.
Profit and dividends The profit attributable to the ordinary shareholders of the company for the year ended 31 December 2006 amounted to £6,202 million compared with £5,392 million for the year ended 31 December 2005, as set out in the consolidated income statement on page 139.
Business review Activities The company is a holding company owning the entire issued ordinary share capital of The Royal Bank of Scotland, the principal direct operating subsidiary undertaking of the company. The “Group” comprises the company and all its subsidiary and associated undertakings, including The Royal Bank of Scotland and NatWest. Details of the principal subsidiary undertakings of the company are shown in Note 15 on the accounts.
Business developments The Group led a consortium which acquired a 10% stake in Bank of China for US$3.1 billion in 2005. The Group itself invested US$1.6 billion. Bank of China listed on the Hong Kong Stock Exchange in June 2006 and on the Shanghai Stock Exchange in July 2006, issuing new shares equivalent to 14.14% of its enlarged share capital and raising US$13.7 billion. The Group did not take up its rights in the listings and the consortiums’ shareholding in Bank of China is now 8.25%.
Employees As at 31 December 2006, the Group employed 135,000 employees (full-time equivalent basis) throughout the world. Details of employee related costs are included in Note 2 on the accounts on page 143.
Employee reward The Group’s continuing success is closely linked to the performance, skills and individual commitment of its employees. In order to attract, motivate and retain the best available talent at every level, the Group offers a comprehensive remuneration and benefits package, Total Reward, to all employees.
Employee consultation The Group’s confidential global employee opinion survey is externally designed, undertaken and analysed annually on behalf of the Group by International Survey Research (ISR). The survey enables employees to maximise their contribution to the Group by expressing their views and opinions on a range of key issues.
A record-breaking 87% of Group employees in over 30 countries completed the 2006 survey. For the second year in a row, the Group scored significantly above the ISR Global Financial Services Norm in all categories. The survey results are presented to the Board and at divisional and team levels. Action plans are developed to address any issues identified.
Diversity The Group’s Managing Diversity policy sets a framework for broadening the Group’s talent base, achieving the highest levels of performance, and enabling all employees to reach their full potential irrespective of age, disability, gender, marital status, political opinion, race, religious belief or sexual orientation.
Services were extended under HelpDirect, the Group’s Employee Assistance Programme, to provide support to all employees in the event of a critical incident. The service provides telephone access to qualified clinicians and a global network of counselling affiliates to enable the Group to provide a consistent level of support to individuals and the business wherever they are located.
Code of ethics The Group has adopted a code of ethics that is applicable to all of the Group’s employees and a copy is available upon request.
Further details of the Group’s corporate responsibility policies will be contained in the 2006 Corporate Responsibility Report.
Authority to repurchase shares At the Annual General Meeting in 2006, shareholders renewed the authority for the company to make market purchases of up to 319,778,520 ordinary shares. As at 28 February 2007 (the latest practical date prior to printing of this report) the company had an unexpired authority to repurchase further shares up to a maximum of 265,384,899 ordinary shares of 25p. Shareholders will be asked to renew this authority at the Annual General Meeting in April 2007.
Bonus issue Shareholders will be asked to vote at the Annual General Meeting on a proposal for the capitalisation of part of the company’s share premium account, resulting in the issue of up to 6.4 billion new ordinary shares of 25p each, details of which are set out in the letter to shareholders.
Directors The names and brief biographical details of the directors are shown on pages 102 and 103. All directors, except: • Fred Watt, who resigned from the Board on 31 January 2006,
• Johnny Cameron, Mark Fisher and Bill Friedrich, who were appointed to the Board on 1 March 2006, and
Details of the service agreements for Lawrence Fish, Sir Fred Goodwin and Gordon Pell are set out on pages 117 and 118. No other director seeking election or re-election has a service agreement.
Directors’ interests The interests of the directors in the shares of the company at 31 December 2006 are shown on page 125. None of the directors held an interest in the loan capital of the company or in the shares and loan capital of any of the subsidiary undertakings of the company, during the period from 1 January
This confirmation is given and should be interpreted in accordance with the provisions of section 234ZA of the Companies Act 1985.
Charitable contributions In 2006 the contribution to the Group’s Community Investment programmes increased to £58.6 million (2005 – £56.2 million). The total amount given for charitable purposes by the company and its subsidiary undertakings during the year ended 31 December 2006 was £25.4 million (2005 – £24.3 million).
Ordinary shares: 51⁄2% cumulative preference shares: Legal & General Group plc 127,207,908 4.01 Commercial Union Assurance plc 91,429 22.86 Barclays PLC 126,836,868 4.01 Mr P. S. and Mrs J. Allen 86,999 21.75 The Capital Group of Companies, Inc 95,578,555 3.01 Bassett-Patrick Securities Limited* 46,255 11.56 11% cumulative preference shares: E M Behrens Charitable Trust 20,000 5.00 Guardian Royal Exchange Mrs Gina Wild 19,800 4.95
Company Limited 51,510 10.30 Miss Elizabeth Hill 16,124 4.03 Mr S. J. and Mrs J. A. Cockburn 30,810 6.16 Mr W. T. Hardison Jr. 13,532 3.38 Cleaning Tokens Limited 25,500 5.10 Ms C. L. Allen 13,200 3.30
Ms J. C. Allen 12,750 3.18 * Notification has been received on behalf of Mr A. W. R. Medlock and Mrs H. M. Medlock that they each have an interest in the holding of 51⁄2% cumulative preference shares registered in the name of Bassett-Patrick Securities Limited noted above and that there are further holdings of 5,300 and 5,000 shares, respectively, of that class registered in each of their names.
Throughout the year ended 31 December 2006, the company has complied with all of the provisions of the Combined Code issued by the Financial Reporting Council (the “FRC”) in July 2003 (the “Code”) except in relation to the authority reserved to the Board to make the final determination of the remuneration of the executive directors and in relation to the appointment of the Chairman of the Board to the Remuneration Committee, which are explained in the paragraph headed ‘Remuneration Committee’.
Board of directors The Board is the principal decision-making forum for the company. It has overall responsibility for leading and controlling the company and is accountable to shareholders for financial and operational performance. The Board approves Group strategy and monitors performance. The Board has adopted a formal schedule of matters detailing key aspects of the company’s affairs reserved to it for its decision. This schedule is reviewed annually.
Board balance and independence The Board currently comprises the Chairman, six executive directors and ten non-executive directors. The Board functions effectively and efficiently, and is considered to be of an appropriate size in view of the scale of the company and the diversity of its businesses. The directors provide the Group with the knowledge, mix of skills, experience and networks of contacts required. The Board Committees contain directors with a variety of relevant skills and experience so that no undue reliance is placed on any individual.
Re-election of directors At each Annual General Meeting, one third of the directors retire and offer themselves for re-election and each director must stand for re-election at least once every three years. Any non-executive directors who have served for more than nine years will also stand for annual re-election and the Board will consider their independence at that time. The proposed reelection of directors is subject to prior review by the Board.
Each new director receives a formal induction on joining the Board, including visits to the Group’s major businesses and meetings with directors and senior management. The induction is tailored to the director’s specific requirements. Directors are advised of appropriate training and professional development opportunities and undertake training and professional development they consider necessary in assisting them to carry out their duties as a director.
Performance evaluation The Board has undertaken a formal and rigorous annual evaluation of its own performance and that of its committees and individual directors.
Taking into account their review and deliberations the directors have concluded that the Board is effective in meeting its objectives and fulfilling its duties and obligations. The directors are also satisfied that each of the Board’s Committees (Audit, Remuneration and Nominations) carries out its delegated duties effectively.
Audit Committee All members of the Audit Committee are independent nonexecutive directors. The Audit Committee holds at least five meetings each year. The Audit Committee’s report is set out on pages 112 and 113.
Remuneration Committee The members of the Remuneration Committee comprise independent non-executive directors together with the Chairman of the Board. In June 2006, the FRC issued a revised Combined Code (the “revised Code”) which applies to reporting years beginning on or after 1 November 2006. The company has adopted provision B.2.1. of the revised Code early and appointed the Chairman of the Board as a member of the Remuneration Committee as the company considers him to have been independent on appointment as Chairman. In that regard the provisions of the Code have not been complied with. The Remuneration Committee holds at least three meetings each year.
The Remuneration Committee is responsible for assisting the Board in discharging its responsibilities and making all relevant disclosures in relation to the formulation and review of the Group’s executive remuneration policy. The Remuneration Committee makes recommendations to the Board on the remuneration arrangements for the executive directors and the Chairman. The Directors’ Remuneration Report is contained on pages 114 to 124.
(2) Sir Tom McKillop was appointed to the Remuneration Committee on 27 September 2006.
(7) Mr Watt resigned from the Board on 31 January 2006.
(8) Mr Whittaker was appointed to the Board on 1 February 2006.
Relations with shareholders The company communicates with shareholders through the Annual Report 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. Shareholders are given the opportunity to ask questions at the Annual General Meeting or submit written questions in advance. The chairmen of the Audit, Remuneration and Nominations Committees are available to answer questions at the Annual General Meeting.
Communication with the company’s largest institutional shareholders is undertaken as part of the company’s investor relations programme. During the year, the directors received copies of analysts’ reports and a monthly report from the Group’s investor relations department which includes an analysis of share price movements, the Group’s performance against the sector, and key broker comments. In addition, information on major investor relations activities and changes to external ratings is provided. The senior independent director would be available to shareholders if concerns could not be addressed through the normal channels. The arrangements used to ensure that directors develop an understanding of the views of major shareholders are considered as part of the annual Board performance evaluation.
The Board commissions a survey of investor perceptions annually. The survey is undertaken on behalf of the Board by independent consultants and the outcomes of the study are considered by the Board.
The Board has established a process for the identification, evaluation and management of the significant risks faced by the Group, which operated throughout the year ended 31 December 2006 and to 28 February 2007, the date the directors approved the Report and Accounts. This process is regularly reviewed by the Board and meets the requirements of the guidance ‘Internal Control: Revised Guidance for Directors on the Combined Code’ issued by the Financial Reporting Council in October 2005.
The effectiveness of the Group’s internal control system is reviewed regularly by the Board and the Audit Committee. Executive management committees or boards of directors in each of the Group’s businesses receive quarterly reports on significant risks facing their business and how they are being controlled. These reports are combined and submitted to the Board as quarterly risk and control assessments. Additional details of the Group’s approach to risk management are given in the ‘Risk management’ section of the ‘Operating and financial review’ on pages 79 to 100. The Audit Committee also receives regular reports from Group Risk Management and Group Internal Audit. In addition, the Group’s independent auditors report to the Audit Committee details of any significant internal control matters which they have identified. The system of internal controls of the authorised institutions and other regulated entities in the Group is also subject to regulatory oversight in the UK and overseas. Additional details of the Group’s regulatory oversight are given in the Supervision and regulation section on pages 246 to 249.
The process employed by the Group to undertake its assessment and the conclusion regarding effectiveness have been audited by the Group’s auditors who have given an unqualified opinion.
The Audit Committee also fixes the remuneration of the external auditors as authorised by shareholders at the Annual General Meeting.
The Remuneration Committee The members of the Remuneration Committee are Bob Scott (Chairman), Colin Buchan, Jim Currie, Janis Kong, Sir Tom McKillop and Peter Sutherland. The members of the Remuneration Committee comprise independent non-executive directors, together with the Chairman of the Board.
Remuneration policy The Remuneration Committee conducted a comprehensive review of all aspects of the remuneration package in 2005, and the executive remuneration policy outcome was approved by shareholders at the company’s Annual General Meeting in 2006. During the year, the Remuneration Committee continued to review policy in light of market changes and shareholder comments. As a result, a new executive share option plan is being submitted to shareholders for approval at the company’s 2007 Annual General Meeting.
The RBS Fund is a non-contributory defined benefit fund. Details of pension arrangements of directors are shown on page 124.
Executive directors are eligible to receive a choice of various employee benefits or a cash equivalent, on a similar basis to other employees. In addition, as employees, executive directors are eligible also to participate in Sharesave, Buy As You Earn and the Profit Sharing scheme, which currently pays up to 10 per cent of salaries, depending on the Group’s performance. These schemes are not subject to performance conditions since they are operated on an all-employee basis. Executive directors also receive death-in-service benefits.
For the Group Chief Executive, the annual incentive is primarily based on specific Group financial performance measures such as operating profit, earnings per share growth and return on equity. The remainder of the Group Chief Executive’s annual incentive is based on a range of non-financial measures which may include measures relating to shareholders, customers and staff.
For the other executive directors a proportion of the annual incentive is based on Group financial performance and a proportion on division financial performance. The remainder of each individual’s annual incentive opportunity is dependent on achievement of a range of non-financial measures, specific objectives and key result areas. Divisional performance includes measures such as operating income, costs, loan impairments or operating profit. Non-financial measures include customer measures (e.g. customer numbers, customer satisfaction), staff measures (e.g. employee engagement) and efficiency and change objectives.
For the TSR element, vesting is based on the level of outperformance by the Group of the median of the comparator group TSR over the performance period. Awards made under the plan will not vest if the company’s TSR is below the median of the comparator group. Achievement of median TSR performance against comparator companies will result in vesting of 25% of the award. Outperformance of median TSR performance by up to 9% will result in vesting on a straight-line basis from 25% to 125%, outperformance by 9% to 18% will result in vesting on a straight-line basis from 125% to 200%. Vesting at 200% will occur if the company outperforms the median TSR performance of the comparator group by at least 18%. For awards made in 2006, the companies in the comparator group are ABN Amro Holdings N.V.; Banco Santander Central Hispano, S.A.; Barclays PLC; Citigroup Inc; HBOS plc; HSBC Holdings plc; Lloyds TSB Group plc and Standard Chartered PLC. The Remuneration Committee considers this group to be appropriate in the context of the Group’s business.
Options In 2006, awards were made under the executive share option scheme approved by shareholders in January 1999. Options granted to executive directors were over shares worth between one and a quarter times salary and two and a half times salary, based on the market value at the date of grant. These options are exercisable only if, over a three year period from the date of grant, the growth in the company’s EPS has exceeded the growth in the RPI plus 9%.
A new executive share option plan is being submitted for approval at the company’s Annual General Meeting in 2007. It is proposed that, subject to approval at the Annual General Meeting, the first grants under this plan will be made following the Annual General Meeting. Grants to executive directors will be made over shares worth up to 300% of salary with an EPS performance condition. The performance condition will be based on the average annual growth in the Group’s adjusted EPS over the three year performance period commencing with the year of grant. The calibration of the EPS growth measure will be agreed by the Remuneration Committee at the time of each grant having regard to the business plan, prevailing economic conditions and analysts’ forecasts.
The target shareholding level is 200% of gross annual salary for the Group Chief Executive and 100% of gross annual salary for executive directors. Target shareholding levels are determined by reference to ordinary shares held, together with any vested awards under the Group’s Medium-term Performance Plan. Executive directors have a period of five years in which to build up their shareholdings to meet the guideline levels.
US based director – Lawrence Fish The remuneration policy for Mr Fish is as follows: Base salary is set having regard to the levels of base salary in other US banks and the appropriate balance of fixed and variable remuneration for US based executives of UK listed companies operating within the corporate governance frameworks of the UK.
Benefits Mr Fish accrues pension benefits under a number of arrangements in the US. Details are provided on page 124. In addition he is entitled to receive other benefits on a similar basis to other Citizens employees.
Short-term performance rewards take the form of an annual incentive plan which rewards the achievement of Group, business unit and individual financial and non-financial targets. The normal maximum annual bonus potential is two times salary, although additional amounts to a maximum of a further two times salary may be awarded, at the discretion of the Board, for exceptional performance as measured by the achievement of significant objectives.
Long-term incentives consist of the following components: • The last grant made under the Citizens Phantom 2000 Plan vested on 1 January 2006. The value of units at the time of vesting was based on the cumulative economic profit generated by Citizens, the trend in economic profit and on the external market trends in the US banking sector, using price/earnings ratios of comparator US banks.
• A grant under the new Citizens Long Term Incentive Plan approved by shareholders at the company’s Annual General Meeting in 2005. Performance is measured on a combination of Growth in Profit before Tax and Relative Return on Equity based on a comparison of Citizens with comparator US banks. The targets for this plan are set on an annual basis over the three year term of the grant. The target value of the award made under the plan in 2005 was 33% of salary and in 2006 was 75% of salary. Each award may deliver up to a maximum of twice the target value.
Date of current contract/ Notice period – Notice period – Name Employing company from company from executive
Total shareholder return performance The undernoted performance graph illustrates the performance of the company over the past five years in terms of total shareholder return compared with that of the companies comprising the FTSE 100 Index. This Index has been selected because it represents a cross-section of leading UK companies. The total shareholder return for the company and the FTSE 100 have been rebased to 100 for 2001.
Service contracts The company’s policy in relation to the duration of contracts with directors is that executive directors’ contracts generally continue until termination by either party, subject to the required notice, or until retirement. The notice period under the service contracts of executive directors will not normally exceed 12 months. In relation to newly recruited executive directors, subject to the prior approval of the Remuneration Committee, the notice period from the employing company required to terminate the contract will not normally exceed 12 months unless there is a clear case for this. Where a longer period of notice is initially approved on appointment, it will normally be structured such that it will automatically reduce to 12 months in due course.
Chairman and non-executive directors The original date of appointment as a director of the company and the latest date for the next re-election are as follows: Latest date for Date first appointed next re-election
Except as noted below, in the event of severance of contract where any contractual notice period is not worked, the employing company may pay a sum to the executive in lieu of this period of notice. Any such payment would, at maximum, comprise base salary and a cash value in respect of fixed benefits (including pension plan contributions). In the event of situations involving breach of the employing company’s policies resulting in dismissal, reduced or no payments may be made to the executive. Depending on the circumstances of the termination of employment, the executive may be entitled, or the Remuneration Committee may exercise its discretion to allow, the executive to exercise outstanding awards under longterm incentive arrangements subject to the rules of the relevant plan. All UK based directors, with the exception of Guy Whittaker, are members of The Royal Bank of Scotland Group Pension Fund (‘the RBS Fund’) and are contractually entitled to receive all pension benefits in accordance with its terms. The RBS Fund rules allow all members who retire early at the request of their employer to receive a pension based on accrued service with no discount applied for early retirement.
The Remuneration Committee has reviewed this provision of the RBS Fund, which applies equally to executive directors and other employees. The Remuneration Committee concluded that a change to the terms of the RBS Fund in respect of early retirement at the company’s request would not be a cost effective route to take at this time. The RBS Fund is closed to employees, including any executive directors, joining the Group after 30 September 2006.
The exception to these severance arrangements relates only to Mr Fish. If Mr Fish’s contract is terminated without cause, or if he terminates the contract for good reason (as defined in the contract), he is entitled to a lump sum payment to compensate him for the loss of 12 months salary plus annual bonus. Mr Fish would also be entitled to receive for this period health, life insurance and long term disability coverage and any other benefits determined in accordance with the plans, policies and practices of Citizens at the time of termination. The Remuneration Committee has been advised that these termination provisions are less generous than the current market practice in the US.
Chairman Sir Tom McKillop (appointed Chairman on 28 April 2006) 471 — — — — 471 67 Sir George Mathewson (retired 28 April 2006) (2) 199 — — 1 — 200 607
(5) Following his resignation as a director on 31 January 2006, Mr Watt remained employed by the Group until 28 February 2006 in order to facilitate a handover of duties to his successor. For this period, Mr Watt received remuneration of £112,000, comprising £57,000 in respect of salary and benefits, and £55,000 in respect of performance bonus.
(6) Included in other remuneration for Mr Whittaker is an award of ordinary shares in the company of £1,000,000, a cash payment of £1,195,181 and relocation expenses of £197,211.
Notes: (1) In addition to his role as a non-executive director, Mr Koch has an agreement with Citizens Financial Group, Inc. to provide consulting services for a period of three years following the acquisition by Citizens of Charter One Financial, Inc. For these services Mr Koch receives $402,500 per annum.
Share options Options to subscribe for ordinary shares of 25p each in the company granted to, and exercised by, directors during the year to 31 December 2006 are included in the table below: Options exercised in 2006
No options had their terms and conditions varied during the accounting period to 31 December 2006. No payment is required on the award of an option.
In the ten year period to 31 December 2006, awards made that could require new issue shares under the company’s share plans represented 4.8% of the company’s issued ordinary share capital, leaving an available dilution headroom of 5.2%.
Options held at Options Market price at 1 January granted in date of exercise Option price Options held at 31 December 2006 2006 2006 Number £ £ Number Exercise period
(4) Mr Watt resigned from the Board on 31 January 2006. The figures quoted above are as at cessation. Subsequently, Mr Watt exercised all of his options on 10 October 2006.
(5) Mr Whittaker was appointed to the Board on 1 February 2006.
The performance conditions for options granted in 2006 are detailed on page 116.
Market Market Share interest End of period Scheme interests Awards price on Awards Awards price on (share for qualifying
(2) Scheme interests at 1 January 2006 of Mr Cameron and Mr Fisher were awarded prior to their appointment to the Board on 1 March 2006.
(4) Mr Whittaker was appointed to the Board on 1 February 2006.
Benefits received Interests at 1 January 2006 Awards granted during year during year Interests at 31 December 2006
Mr Fish LTIP awards for the LTIP award for the LTIP award for the LTIP awards for the 3 year periods: 3 year period: 3 year period: 3 year periods: Note: (1) A new cash LTIP was approved by shareholders at the company’s Annual General Meeting in April 2005. Details are given on page 116. This replaced the previous LTIP which provided for a target payment of 60% of average salary over the three year period and a maximum payment of 105% of average salary.
No variation was made to any of the terms of the plan during the year. The performance measures are detailed on page 116.
Arrangements had previously been made to provide Sir Fred Goodwin and Gordon Pell with additional pension benefits on a defined benefit basis outwith the RBS Fund. No changes have been made to the overall level of benefits to be provided, but the amount which can be provided from within the RBS Fund may be different than previously envisaged. The figures shown below include the accrual in respect of these arrangements.
Johnny Cameron and Fred Watt were provided with additional pension benefits on a defined contribution basis and the contributions made in the year are shown below. These contributions ceased with effect from April 2006 and were replaced by a salary supplement which is shown in the table on page 119.
Mark Fisher opted to cease future accrual of pension benefit within the RBS Fund with effect from 6 April 2006 and to receive instead a salary supplement. Guy Whittaker has been provided with a salary supplement in place of pension benefits since his employment started. These cash allowances are shown in the table on page 119.
Of the total transfer value shown as at 31 December 2006, 34% relates to benefits in funded pension schemes.
Age at 31 December 31 December 31 December 31 December 31 December 31 December 31 December 31 December 2006 2006 2006* 2006 2005 2006 2006*
(5) In accordance with US market practice, Mr Fish’s pensionable remuneration is limited to US$4 million per annum.
(6) The above figures include pension accrued for Mr Watt for the period until cessation of employment on 28 February 2006.
No director held a non-beneficial interest in the shares of the company at 31 December 2006, at 1 January 2006 or date of appointment if later.
(2) The value is based on the share price at 29 December 2006, which was £19.93. During the year ended 31 December 2006 the share price ranged from £16.69 to £19.99.
(4) As at 31 December 2006, the executive directors held a technical interest as potential beneficiaries in The Royal Bank of Scotland Group plc 2001 Employee Share Trust (5,987,597 shares) and The Royal Bank of Scotland plc 1992 Employee Share Trust (509,905 shares), being trusts operated for the benefit of employees of the company and its subsidiaries.
No other director had an interest in the company’s ordinary shares during the year.
On both 8 January 2007 and 7 February 2007, six ordinary shares of 25p each were acquired by Sir Fred Goodwin and Mr Fisher under the Group’s Buy As You Earn share scheme.
Financial statements 128 Independent auditors’ report 130 Accounting policies 139 Consolidated income statement 140 Balance sheets 141 Statements of recognised income and expense 142 Cash flow statements 143 Notes on the accounts
We have audited the financial statements of The Royal Bank of Scotland Group plc (“the company”) and its subsidiaries (together “the Group”) for the year ended 31 December 2006 which comprise the accounting policies, the balance sheets as at 31 December 2006 and 2005, the consolidated income statements, the cash flow statements, the statements of recognised income and expense for each of the three years in the period ended 31 December 2006 and the related Notes 1 to 49. These financial statements have been prepared under the accounting policies set out therein. We have also audited the information in the part of the directors’ remuneration report that is described as having been audited.
Our responsibility is to audit the financial statements and the part of the directors’ remuneration report described as having been audited in accordance with relevant legal and regulatory requirements and International Standards on Auditing (UK and Ireland).
We read the other information contained in the 2006 Annual Report as described in the contents section including the unaudited part of the directors’ remuneration report and consider whether it is consistent with the audited financial statements. We consider the implications for our report if we become aware of any apparent misstatements or material inconsistencies with the financial statements. Our responsibilities do not extend to any further information outside the 2006 Annual Report.
• the information given in the directors’ report is consistent with the financial statements.
Separate opinion in relation to IFRS As explained in the accounting policies, the Group, in addition to complying with its legal obligation to comply with IFRS as adopted by the European Union, has also complied with the IFRS as issued by the International Accounting Standards Board.
In our opinion the financial statements give a true and fair view, in accordance with IFRS, of the state of the Group’s affairs as at 31 December 2006 and of its profit and cash flows for the year then ended.
IFRS vary in certain significant respects from accounting principles generally accepted in the United States of America. Information relating to the nature and the effect of such differences is presented in Note 47 to the financial statements.
F in an ci al s ta te m en ts 1. Presentation of accounts The accounts are prepared in accordance with International Financial Reporting Standards issued by the International Accounting Standards Board (“IASB”) and interpretations issued by the International Financial Reporting Interpretations Committee of the IASB (together “IFRS”) as adopted by the European Union (“EU”). The EU has not adopted the complete text of IAS 39 ‘Financial Instruments: Recognition and Measurement’; it has relaxed some of the standard’s hedging requirements. The Group has not taken advantage of this relaxation and has adopted IAS 39 as issued by the IASB. The date of transition to IFRS for the Group and the company (The Royal Bank of Scotland Group plc) and the date of their opening IFRS balance sheets was 1 January 2004.
Change of accounting policy As permitted by IFRS 1, the Group and the company implemented IAS 32 ’Financial Instruments: Disclosure and Presentation’, IAS 39 ‘Financial Instruments: Recognition and Measurement’ and IFRS 4 ‘Insurance Contracts’ with effect from 1 January 2005 without restating the income statement, balance sheet and notes for 2004. The Group adopted the second amendment to IAS 39 ‘The Fair Value Option’ issued by the IASB in June 2005 also from 1 January 2005. The effect of implementing IAS 32, IAS 39 and IFRS 4 on the Group and company balance sheets and shareholders’ funds as at 1 January 2005 is set out in Note 46. In preparing the 2004 comparatives, UK GAAP principles then current have been applied to financial instruments. The main differences between UK GAAP and IFRS on financial instruments are summarised in Note 46 on the accounts.
The IASB’s amendment to IAS 39, ‘Cash Flow Hedge Accounting of Forecast Intragroup Transactions’, published in April 2005, amended IAS 39 to permit the foreign currency risk of a highly probable forecast intragroup transaction to qualify as a hedged item in consolidated financial statements. The amendment, effective for annual periods beginning on or after 1 January 2006, had no material effect on the financial statements of the Group or the company.
The IASB’s amendment to IAS 39, ‘Financial Guarantee Contracts’, published in August 2005, amended IAS 39 and IFRS 4. The amendment defines a financial guarantee contract and requires such contracts to be recorded initially at fair value and subsequently at higher of the provision determined in accordance with IAS 37 ‘Provisions, Contingent Liabilities and Contingent Assets’ and the amount initially recognised less amortisation. The amendment, effective for annual periods beginning on or after 1 January 2006, had no material effect on the Group or the company.
In December 2005, the IASB issued an amendment to IAS 21 ‘The Effects of Changes in Foreign Exchange Rates’ to clarify that a monetary item can form part of the net investment in overseas operations regardless of the currency in which it is denominated and that the net investment in a foreign operation can include a loan from a fellow subsidiary. The amendment, adopted by the EU in May 2006, had no material effect on the Group or the company.
2. Basis of consolidation The consolidated financial statements incorporate the financial statements of the company and entities (including certain special purpose entities) controlled by the Group (its subsidiaries). Control exists where the Group has the power to govern the financial and operating policies of the entity; generally conferred by holding a majority of voting rights. On acquisition of a subsidiary, its identifiable assets, liabilities and contingent liabilities are included in the consolidated accounts at their fair value. Any excess of the cost (the fair value of assets given, liabilities incurred or assumed and equity instruments issued by the Group plus any directly attributable costs) of an acquisition over the fair value of the net assets acquired is recognised as goodwill. The interest of minority shareholders is stated at their share of the fair value of the subsidiary’s net assets.
For defined benefit schemes, scheme liabilities are measured on an actuarial basis using the projected unit credit method and discounted at a rate that reflects the current rate of return on a high quality corporate bond of equivalent term and currency to the scheme liabilities. Scheme assets are measured at their fair value. Any surplus or deficit of scheme assets over liabilities is recognised in the balance sheet as an asset (surplus) or liability (deficit). The current service cost and any past service costs together with the expected return on scheme assets less the unwinding of the discount on the scheme liabilities is charged to operating expenses. Actuarial gains and losses are recognised in full in the period in which they occur outside profit or loss and presented in the statement of recognised income and expense.
6. Property, plant and equipment Items of property, plant and equipment are stated at cost less accumulated depreciation (see below) and impairment losses. Where an item of property, plant and equipment comprises major components having different useful lives, they are accounted for separately. Property that is being constructed or developed for future use as investment property is classified as property, plant and equipment and stated at cost until construction or development is complete, at which time it is reclassified as investment property.
7. Impairment of intangible assets and property, plant and equipment At each reporting date, the Group assesses whether there is any indication that its intangible assets, or property, plant and equipment are impaired. If any such indication exists, the Group estimates the recoverable amount of the asset and the impairment loss if any. Goodwill is tested for impairment annually or more frequently if events or changes in circumstances indicate that it might be impaired. If an asset does not generate cash flows that are independent from those of other assets or groups of assets, recoverable amount is determined for the cash-generating unit to which the asset belongs. The recoverable amount of an asset is the higher of its fair value less cost to sell and its value in use. Value in use is the present value of future cash flows from the asset or cash-generating unit discounted at a rate that reflects market interest rates adjusted for risks specific to the asset or cash generating unit that have not been reflected in the estimation of future cash flows. If the recoverable amount of an intangible or tangible asset is less than its carrying value, an impairment loss is recognised immediately in profit or loss and the carrying value of the asset reduced by the amount of the loss. A reversal of an impairment loss on intangible assets (excluding goodwill) or property, plant and equipment is recognised as it arises provided the increased carrying value does not exceed that which it would have been had no impairment loss been recognised. Impairment losses on goodwill are not reversed.
8. Foreign currencies The Group’s consolidated financial statements are presented in sterling which is the functional currency of the company.
Transactions in foreign currencies are translated into sterling at the foreign exchange rate ruling at the date of the transaction. Monetary assets and liabilities denominated in foreign currencies are translated into sterling at the rates of exchange ruling at the balance sheet date. Foreign exchange differences arising on translation are reported in income from trading activities except for differences arising on cash flow hedges and hedges of net investments in foreign operations. Nonmonetary items denominated in foreign currencies that are stated at fair value are translated into sterling at foreign exchange rates ruling at the dates the values were determined. Translation differences arising on non-monetary items measured at fair value are recognised in profit or loss except for differences arising on available-for-sale non-monetary financial assets, for example equity shares, which are included in the available-for-sale reserve in equity unless the asset is the hedged item in a fair value hedge.
The assets and liabilities of foreign operations, including goodwill and fair value adjustments arising on acquisition, are translated into sterling at foreign exchange rates ruling at the balance sheet date. The revenues and expenses of foreign operations are translated into sterling at average exchange rates unless these do not approximate to the foreign exchange rates ruling at the dates of the transactions. Foreign exchange differences arising on the translation of a foreign operation is recognised directly in equity and included in profit or loss on its disposal.
9. Leases Contracts to lease assets are classified as finance leases if they transfer substantially all the risks and rewards of ownership of the asset to the customer. Other contracts to lease assets are classified as operating leases.
Premiums from general insurance contracts are recognised in the accounting period in which they begin. Unearned premiums represent the proportion of the net premiums that relate to periods of insurance after the balance sheet date and are calculated over the period of exposure under the policy, on a daily basis, 24th’s basis or allowing for the estimated incidence of exposure under policies which are longer than twelve months. Provision is made where necessary for the estimated amount of claims over and above unearned premiums including that in respect of future written business on discontinued lines under the run-off of delegated underwriting authority arrangements. It is designed to meet future claims and related expenses and is calculated across related classes of business on the basis of a separate carry forward of deferred acquisition expenses after making allowance for investment income.
Acquisition expenses relating to new and renewed business for all classes are expensed over the period during which the premiums are earned. The principal acquisition costs so deferred are commissions payable, costs associated with the telesales and underwriting staff and prepaid claims handling costs in respect of delegated claims handling arrangements for claims which are expected to occur after the balance sheet date. Claims and the related reinsurance are recognised in the accounting period in which the loss occurs. Provision is made for the full cost of settling outstanding claims at the balance sheet date, including claims estimated to have been incurred but not yet reported at that date, and claims handling expenses. The related reinsurance receivable is recognised at the same time.
11. Taxation Provision is made for taxation at current enacted rates on taxable profits, arising in income or in equity, taking into account relief for overseas taxation where appropriate. Deferred taxation is accounted for in full for all temporary differences between the carrying amount of an asset or liability for accounting purposes and its carrying amount for tax purposes, except in relation to overseas earnings where remittance is controlled by the Group, and goodwill.
Held-to-maturity investments – a financial asset is classified as a held-to-maturity investment only if it has fixed or determinable payments, a fixed maturity and the Group has the positive intention and ability to hold to maturity. Held-to-maturity investments are initially recognised at fair value plus directly related transaction costs. They are subsequently measured at amortised cost using the effective interest method (see accounting policy 3 above) less any impairment losses.
Held-for-trading – a financial asset is classified as held-fortrading if it is acquired principally for the purpose of selling in the near term, or forms part of a portfolio of financial instruments that are managed together and for which there is evidence of short-term profit taking, or it is a derivative (not in a qualifying hedge relationship). Held-for-trading financial assets are recognised at fair value with transaction costs being recognised in profit or loss. Subsequently they are measured at fair value. Gains and losses on held-for-trading financial assets are recognised in profit or loss as they arise.
Financial assets carried at amortised cost – if there is objective evidence that an impairment loss on a financial asset or group of financial assets classified as loans and receivables or as heldto -maturity investments has been incurred, the Group measures the amount of the loss as the difference between the carrying amount of the asset or group of assets and the present value of estimated future cash flows from the asset or group of assets discounted at the effective interest rate of the instrument at initial recognition. Impairment losses are assessed individually for financial assets that are individually significant and individually or collectively for assets that are not individually significant. In making collective assessment of impairment, financial assets are grouped into portfolios on the basis of similar risk characteristics. Future cash flows from these portfolios are estimated on the basis of the contractual cash flows and historical loss experience for assets with similar credit risk characteristics. Historical loss experience is adjusted, on the basis of current observable data, to reflect the effects of current conditions not affecting the period of historical experience. Impairment losses are recognised in profit or loss and the carrying amount of the financial asset or group of financial assets reduced by establishing an allowance for impairment losses. If in a subsequent period the amount of the impairment loss reduces and the reduction can be ascribed to an event after the impairment was recognised, the previously recognised loss is reversed by adjusting the allowance. Once an impairment loss has been recognised on a financial asset or group of financial assets, interest income is recognised on the carrying amount using the rate of interest at which estimated future cash flows were discounted in measuring impairment.
14. Financial liabilities On initial recognition a financial liability is classified as held-fortrading if it is incurred principally for the purpose of selling in the near term, or forms part of a portfolio of financial instruments that are managed together and for which there is evidence of short-term profit taking, or it is a derivative (not in a qualifying hedge relationship). Held-for-trading financial liabilities are recognised at fair value with transaction costs being recognised in profit or loss. Subsequently they are measured at fair value. Gains and losses are recognised in profit or loss as they arise.
Financial liabilities that the Group designates on initial recognition as being at fair value through profit or loss are recognised at fair value, with transaction costs being recognised in profit or loss and are subsequently measured at fair value. Gains and losses on financial liabilities that are designated as at fair value through profit or loss are recognised in profit or loss as they arise.
Financial liabilities may be designated as at fair value through profit or loss only if such designation (a) eliminates or significantly reduces a measurement or recognition inconsistency; or (b) applies to a group of financial assets, financial liabilities or both that the Group manages and evaluates on a fair value basis; or (c) relates to an instrument
F in an ci al s ta te m en ts that contains an embedded derivative which is not evidently closely related to the host contract.
The principal categories of financial liabilities designated as at fair value through profit or loss are (a) structured liabilities issued by the Group: designation significantly reduces the measurement inconsistency between these liabilities and the related derivatives carried at fair value; and (b) investment contracts issued by the Group's life assurance businesses: fair value designation significantly reduces the measurement inconsistency that would arise if these liabilities were measured at amortised cost.
17. Derivatives and hedging Derivative financial instruments are recognised initially, and subsequently measured, at fair value. Derivative fair values are determined from quoted prices in active markets where available. Where there is no active market for an instrument, fair value is derived from prices for the derivative’s components using appropriate pricing or valuation models.
Cash flow hedge – where a derivative financial instrument is designated as a hedge of the variability in cash flows of a recognised asset or liability or a highly probable forecast transaction, the effective portion of the gain or loss on the hedging instrument is recognised directly in equity. The ineffective portion is recognised in profit or loss. When the forecast transaction results in the recognition of a financial asset or financial liability, the cumulative gain or loss is reclassified from equity in the same periods in which the asset or liability affects profit or loss. Otherwise the cumulative gain or loss is removed from equity and recognised in profit or loss at the same time as the hedged transaction. Hedge accounting is discontinued if the hedge no longer meets the criteria for hedge accounting; if the hedging instrument expires or is sold, terminated or exercised; if the forecast transaction is no longer expected to occur; or if hedge designation is revoked. On the discontinuance of hedge accounting (except where a forecast
19. Investment property Investment property comprises freehold and leasehold properties that are held to earn rentals or for capital appreciation or both. It is not depreciated but is stated at fair value based on valuations by independent registered valuers. Fair value is based on current prices for similar properties in the same location and condition. Any gain or loss arising from a change in fair value is recognised in profit or loss. Rental income from investment property is recognised on a straight-line basis over the term of the lease. Lease incentives granted are recognised as an integral part of the total rental income.
20. Cash and cash equivalents Cash and cash equivalents comprises cash and demand deposits with banks together with short-term highly liquid investments that are readily convertible to known amounts of cash and subject to insignificant risk of change in value.
Collective component – this is made up of two elements: loan impairment provisions for impaired loans that are below individual assessment thresholds (collective impaired loan provisions) and for loan losses that have been incurred but have not been separately identified at the balance sheet date (latent loss provisions). These are established on a portfolio basis using a
F in an ci al s ta te m en ts present value methodology taking into account the level of arrears, security, past loss experience, credit scores and defaults based on portfolio trends. The most significant factors in establishing these provisions are the expected loss rates and the related average life. These portfolios include credit card receivables and other personal advances including mortgages. The future credit quality of these portfolios is subject to uncertainties that could cause actual credit losses to differ materially from reported loan impairment provisions. These uncertainties include the economic environment, notably interest rates and their effect on customer spending, the unemployment level, payment behaviour and bankruptcy trends.
Pensions The Group operates a number of defined benefit pension schemes as described in Note 3 on the accounts. The assets of the schemes are measured at their fair value at the balance sheet date. Scheme liabilities are measured using the projected unit method, which takes account of projected earnings increases, using actuarial assumptions that give the best estimate of the future cash flows that will arise under the scheme liabilities. These cash flows are discounted at the interest rate applicable to high-quality corporate bonds of the same currency and term as the liabilities. Any surplus or deficit of scheme assets over liabilities is recognised in the balance sheet as an asset (surplus) or liability (deficit). In determining the value of scheme liabilities, assumptions are made as to price inflation, dividend growth, pension increases, earnings growth and employees. There is a range of assumptions that could be adopted in valuing the schemes’ liabilities. Different assumptions could significantly alter the amount of the deficit recognised in the balance sheet and the pension cost charged to the income statement. The assumptions adopted for the Group’s pension schemes are set out in Note 3 on the accounts. The pension deficit recognised in the balance sheet at 31 December 2006 was £1,992 million (2005 – £3,735 million).
Fair value Financial instruments classified as held-for-trading or designated as at fair value through profit or loss and financial assets classified as available-for-sale are recognised in the financial statements at fair value. All derivatives are measured at fair value. In the balance sheet, financial assets carried at fair value are included within Treasury and other eligible bills, Loans and advances to banks, Loans and advances to customers, Debt securities and Equity shares as appropriate. Financial liabilities carried at fair value are included within the captions Deposits by banks, Customer accounts, Debt securities in issue and Subordinated liabilities. Derivative assets and Derivative liabilities are shown separately on the face of the balance sheets. Gains or losses arising from changes in fair value of financial instruments classified as held-for-trading or designated as at fair value through profit or loss are included in the income statement. Unrealised gains and losses on available-for-sale financial assets are recognised directly in equity unless an impairment loss is recognised. The carrying value of a financial asset or a financial liability carried at cost or amortised cost that is the hedged item in a qualifying hedge relationship is adjusted by the gain or loss attributable to the hedged risk.
Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction. Fair values are determined by reference to observable market prices where available and reliable. Where representative market prices for an instrument are not available or are unreliable because of poor liquidity, the fair value is derived from prices for its components using appropriate pricing or valuation models that are based on independently sourced market parameters, including interest rate yield curves, option volatilities and currency rates. Financial assets carried at fair value include government, asset backed and corporate debt securities, reverse repos, loans, corporate equity shares and derivatives. Financial liabilities carried at fair value include deposits, repos, short positions in securities and debt securities issued. Fair value for a substantial proportion of these instruments is based on observable market prices or derived from observable market parameters. Where observable prices are not available, fair value is based on appropriate valuation techniques or management estimates.
The Group’s derivative products include swaps, forwards, futures and options. Exchange traded instruments are valued using quoted prices. The fair value of over-the-counter instruments is derived from pricing models which take account of contract terms, including maturity, as well as quoted market parameters such as interest rates and volatilities. Most of the Group’s pricing models do not entail material subjectivity because the methodologies utilised do not incorporate significant judgement and the parameters included in the models can be calibrated to actively quoted market prices. Values established from pricing models are adjusted for credit risk, liquidity risk and future servicing costs.
A negligible proportion of the Group’s trading derivatives are valued directly from quoted prices, the majority being valued using appropriate valuation techniques. The fair value of substantially all securities positions carried at fair value is determined directly from quoted prices.
Details of financial instruments carried at fair value are given in Note 35 on the accounts.
Goodwill The Group capitalises goodwill arising on the acquisition of businesses, as discussed in accounting policy 5. The carrying value of goodwill as at 31 December 2006 was £17,889 million
Accounting developments International Financial Reporting Standards The IASB issued IFRS 7 ‘Financial Instruments: Disclosures’ in August 2005. The standard replaces IAS 30 ‘Disclosures in the Financial Statements of Banks and Similar Financial Institutions’ and the disclosure provisions in IAS 32. IFRS 7 requires disclosure of the significance of financial instruments for an entity’s financial position and performance and of qualitative and quantitative information about exposure to risks arising from financial instruments. The standard is effective for annual periods beginning on or after 1 January 2007.
The IFRIC issued interpretation IFRIC 10 ‘Interim Financial Reporting and Impairment’ in July 2006. Entities recognising an impairment of an intangible asset, goodwill or a financial asset in their interim financial statements are not allowed to reverse that impairment if the asset had recovered its value at the next reporting date. The interpretation is effective for accounting periods beginning on or after 1 November 2006 and is not expected to have a material effect on the Group or company.
US GAAP For a discussion of recent developments in US GAAP relevant to the Group, see Note 47 on the accounts.
Accruals, deferred income and other liabilities 25 15,660 14,247 15 14 Retirement benefit liabilities 3 1,992 3,735 — —
Total recognised income and expense for the year 9,654 5,465 3,547 3,501 2,078 2,873
Attributable to: Effect of changes in accounting policies on implementation of IFRS
Net cash inflow from trading activities 15,690 6,570 10,729 4,002 2,381 3,209 Changes in operating assets and liabilities 3,980 (519) (4,264) (508) 2,050 (148) Net cash flows from operating activities before tax 19,670 6,051 6,465 3,494 4,431 3,061
Investing activities Sale and maturity of securities 27,126 39,472 43,022 — — — Purchase of securities (19,126) (39,196) (41,790) — — — Investment in subsidiaries — — — (1,097) (2,961) (6,342) Sale of property, plant and equipment 2,990 2,220 1,921 — — — Purchase of property, plant and equipment (4,282) (4,812) (4,583) — — — Net investment in business interests and intangible assets 38 (63) (296) (7,968) — — — Loans to subsidiaries — — — — (337) (350) Repayments from subsidiaries — — — 547 1,183 40 Net cash flows from investing activities 6,645 (2,612) (9,398) (550) (2,115) (6,652)
Issue of equity preference shares 671 1,649 1,358 671 1,649 1,358
Net cash flows from financing activities (1,516) (703) 7,119 (3,515) (1,523) 3,781 Effects of exchange rate changes on cash and cash equivalents (3,468) 1,703 (920) (52) 42 —
Net increase in cash and cash equivalents 19,102 2,528 1,900 (469) 817 226 Cash and cash equivalents 1 January 52,549 50,021 48,121 1,126 309 83 Cash and cash equivalents 31 December 71,651 52,549 50,021 657 1,126 309 *restated (see Note 48).
Notes on the accounts 1 Income from trading activities Group £m £m £m
Property, plant and equipment (see Note 18) 1,293 1,326 1,155 Intangible assets (see Note 17) 385 499 519 Depreciation and amortisation 1,678 1,825 1,674
Integration costs included in operating expenses comprise expenditure incurred in respect of cost reduction and revenue enhancement targets set in connection with the various acquisitions made by the Group: Group £m £m £m
Premises and equipment 10 39 35 Other administrative expenses 32 131 149 Depreciation and amortisation 16 140 253
Global Banking & Markets 7,800 6,900 8,600 UK Corporate Banking 8,800 8,200 7,800
Principal actuarial assumptions at 31 December 2006 2005 2004 2006 2005 2004 weighted average
3 Pension costs Members of the Group sponsor a number of pension schemes in the UK and overseas, predominantly of the defined benefit type, whose assets are independent of the Group’s finances. Defined benefit pensions generally provide a pension of onesixtieth of final pensionable salary for each year of service prior to retirement. Employees do not make contributions for basic pensions but may make voluntary contributions to secure additional benefits on a money-purchase basis. Since October 2006 The Royal Bank of Scotland Group Pension Fund (‘Main scheme’) has been closed to new entrants.
Changes in value of net pension liability £m £m £m £m £m £m
Currency translation and other adjustments — — — 26 26 — Income statement: Statement of recognised income and expense: Disposal of subsidiaries — — — — (14) (14)
The Group expects to contribute £464 million to its defined benefit pension schemes in 2007 (Main scheme – £408 million). Of the net pension liability, £106 million (2005 – £104 million) relates to unfunded schemes.
Cumulative net actuarial losses of £619 million (2005 – £2,400 million; 2004 – £1,601 million) have been recognised in the statement of recognised income and expense, of which £521 million (2005 – £2,150 million; 2004 – £1,433 million) relate to the Main scheme.
Present value of defined benefit obligations 19,004 19,118 16,051 13,594 20,951 21,123 17,738 14,898 Fair value of plan assets 17,374 15,914 13,569 11,797 18,959 17,388 14,798 12,862
– Other services pursuant to legislation (1) 5.9 3.3 – Other services relating to taxation 0.2 0.2 – Services relating to corporate finance transactions, including securitisations, entered into by the Group 2.4 4.9 – All other services (2) 2.6 6.0
Fees payable to the Group’s auditors and their associates in respect of pension schemes: Notes: (1) Includes fees for work relating to Section 404 of the US Sarbanes-Oxley Act.
(2) Includes fees relating to the transition to IFRS in 2005.
Current taxation: Charge for the year 2,626 2,280 2,091 Over provision in respect of prior periods (253) (101) (168) Relief for overseas taxation (147) (171) (212)
Deferred taxation: Charge for the year 396 477 333 Under/(over) provision in respect of prior periods 67 (107) (49) Tax charge for the year 2,689 2,378 1,995
The actual tax charge differs from the expected tax charge computed by applying the standard rate of UK corporation tax of 30% as follows: £m £m £m
7 Ordinary dividends Group p per share p per share p per share £m £m £m
Total dividends paid on ordinary equity shares 77.3 60.6 52.5 2,470 1,927 1,588
Final dividends are not accounted for until they have been ratified by members in a general meeting. At the Annual General Meeting on 25 April 2007, a final dividend in respect of 2006 of 66.4 pence per share (2005 – 53.1 pence per share) amounting to a total of £2.1 billion (2005 – £1.7 billion) is to be proposed. The financial statements for the year ended 31 December 2006 do not reflect this dividend which, if approved, will be accounted for in shareholders’ equity as an appropriation of retained profits in the year ending 8 Profit dealt with in the accounts of the company As permitted by section 230(3) of the Companies Act 1985, the primary financial statements of the company do not include an income statement. Condensed information is set out below: Company £m £m £m
Dividends received from banking subsidiary 3,502 2,082 3,000 Dividends received from other subsidiaries 229 100 —
F in an ci al s ta te m en ts 9 Earnings per ordinary share The earnings per share are based on the following: Group £m £m £m
Earnings: Profit attributable to ordinary shareholders 6,202 5,392 4,856 Add back dividends on dilutive convertible non-equity shares 64 65 66 Diluted earnings attributable to ordinary shareholders 6,266 5,457 4,922
Number of ordinary shares: Weighted average number of ordinary shares in issue during the year 3,185 3,183 3,085 Effect of dilutive share options and convertible non-equity shares 58 60 73 Diluted weighted average number of ordinary shares during the year 3,243 3,243 3,158
Treasury bills and similar securities 5,407 5,402 Other eligible bills 84 136
Held-for-trading 4,516 3,004 Available-for-sale 975 2,534 11 Loans and advances to banks Group Company £m £m £m £m
Held-for-trading 52,736 44,965 — — Designated as at fair value through profit or loss 376 282 — —
Held-for-trading 72,462 53,963 — — Designated as at fair value through profit or loss 1,327 616 — —
Amounts above include: Reverse repurchase agreements 62,908 48,887 — — Due from subsidiaries 286 567
Continued recognition The table below sets out the asset categories together with the carrying amounts of the assets and associated liabilities.
(4) Credit card receivables in the UK have been securitised. Notes have been issued by a special purpose vehicle. The note holders have a proportionate interest in a pool of credit card receivables that have been equitably assigned by the Group to a receivables trust. The Group continues to be exposed to the risks and rewards of the transferred receivables through its right to excess spread (after charge-offs).
(5) The Group sponsors commercial paper conduits. Customer assets are transferred into an SPE which issues notes in the commercial paper market. The Group supplies certain services and contingent liquidity support to these vehicles on an arm’s length basis as well as programme credit enhancement.
At 31 December 2006, the fair value of the Group’s retained interests, which are classified as held-for-trading, was approximately £2.1 billion (2005 – £2.1 billion). These retained interests comprise approximately £1,148 million (2005 – £1,179 million) in US Agency based retained interests, £818 million (2005 – £764 million) in consumer based retained interests and £113 million (2005 – £128 million) in commercial based retained interests. These retained interests primarily relate to mortgage loans and securities and arose from securitisations that have taken place in current and prior years. Cash flows received in 2006 from retained interests held at 31 December 2006 in connection with securitisations that took place in current and prior years amounted to £544 million (2005 – £481 million; 2004 – £383 million).
Key economic assumptions used in measuring the value of retained interests at the date of securitisation resulting from securitisations completed during the year were as follows: US Agency Consumer Commercial retained retained retained
Prepayment speed 100 – 500 PSA 0 – 40% CPR (1) 0 – 50 CPY (2)
Key economic assumptions and the sensitivity of the current fair value of retained interests at 31 December 2006 to immediate adverse changes, as indicated below, in those assumptions are as follows: US Agency Consumer Commercial retained retained retained
Impact on fair value of 10% adverse change (£m) 2.1 15.3 0.1 Impact on fair value of 20% adverse change (£m) 3.7 29.3 0.1 Weighted average life 1 – 18 years 0 – 13 years 1 – 18 years
Notes: (1) Constant prepayment rate (“CPR”) – the CPR range represents the low and high points of a dynamic CPR curve.
(5) Prepayment speed has been stressed on an overall portfolio basis for US Agency retained interests due to the overall homogeneous nature of the collateral. Consumer and commercial retained interests have been stressed on a security level basis.
Mortgage-backed securities The Group sells originated mortgage loans to US government sponsored enterprises in return for securities backed by these loans and guaranteed by the Agency whilst retaining the rights to service the mortgages. These securities may be subsequently sold. The purchaser has recourse to the Group for losses up to pre-determined levels on certain designated mortgages. The Group is not obliged, and does not intend, to support losses that may be suffered by the Agencies. Under the terms of the sale agreements, the Agencies have agreed to seek repayment only from the cash from the mortgage loans. Once the securities exchanged for the loans have been sold the Group’s exposure is restricted to the amount of the recourse. At 31 December 2006 mortgages amounting to £144 million (2005 – £385 million) had been sold with recourse to US GSEs. These loans have been derecognised.
F in an ci al s ta te m en ts 13 Debt securities Group
Loans and receivables — — — — — — — 788 788
After 1 but After 5 but Within 1 year within 5 years within 10 years After 10 years Total
Amount Yield Amount Yield Amount Yield Amount Yield Amount Yield Issued by £m % £m % £m % £m % £m %
Number Fair value losses Fair value losses Fair value losses Issued by of issues £m £m £m £m £m £m
US government, state, and federal agency 249 829 10 4,215 78 5,044 88
Listed equity shares include the Group’s investment in Bank of China which, following its successful IPO in 2006, is carried at fair value and showed an uplift of £4 billion in the year.
Gross gains of £357 million (2005 – £618 million) and gross losses of £3 million (2005 – £4 million) were realised on the sale of available-for-sale equity shares. Gross gains of £96 million were realised on the sale of investment securities in 2004.
At 31 December 2006, gross unrealised losses of £6 million represented 22 equity issues with a fair value of £26 million. No securities were in an unrealised loss position for more than 12 months.
Unquoted equity investments whose fair value cannot be reliably measured are carried at cost and classified as available-for-sale financial assets. They include the Group’s investments in the Federal Home Loans Bank and Federal Reserve Bank that are redeemable at cost of £0.8 billion (2005 – £0.8 billion), and prior to listing in 2006, the Group’s investment in Bank of China, together with a number of individually small shareholdings including those received in trouble debt restructurings. Disposals in the year generated gains of £56 million (2005 – £85 million).
The Royal Bank of Scotland plc Banking Great Britain National Westminster Bank Plc (1) Banking Great Britain Citizens Financial Group, Inc. Banking US Coutts & Co(2) Private banking Great Britain Greenwich Capital Markets, Inc. Broker dealer US RBS Insurance Group Limited Insurance Great Britain Ulster Bank Limited (3) Banking Northern Ireland
(2) Coutts & Co is incorporated with unlimited liability. Its registered office is 440 Strand, London WC2R 0QS.
The principal subsidiary undertakings of the company are shown below. Their capital consists of ordinary and preference shares which are unlisted with the exception of certain preference shares issued by NatWest. The Royal Bank of Scotland plc and RBS Insurance Group Limited are directly owned by the company, and all of the other subsidiary undertakings are wholly owned directly, or indirectly through intermediate holding companies, by these companies. All of these subsidiaries are included in the Group’s consolidated financial statements and have an accounting reference date of 31 December.
Impaired financial assets Loans and receivables and finance leases 6,232 3,342 2,890 5,926 3,344 2,582
Impairment losses charged to the income statement Loans and receivables and finance leases (see table below) 1,877 1,703 Available-for-sale 1 4 Loans and advances 1,402 Amounts written-off fixed asset investments 83
The following table shows the movement in the provision for impairment losses for loans and receivables and finance leases.
Recoveries of amounts previously written-off 24 191 — 215 172 144 Charged to the income statement 217 1,573 87 1,877 1,703 1,402
F in an ci al s ta te m en ts 17 Intangible assets Group
Disposal of subsidiaries (10) — (1) — (11) Disposals and write-off of fully amortised assets — — (21) (33) (54)
Net book value at 31 December 2006 17,889 138 178 699 18,904
Cost: Currency translation and other adjustments 786 31 30 — 847 Acquisition of subsidiaries 113 — — — 113
Global Banking & Markets Fair value less costs to sell 2,341 — UK Corporate Banking Fair value less costs to sell 1,630 — Corporate Markets Fair value less costs to sell — 3,966 Retail Fair value less costs to sell 4,365 4,365 Wealth Management Fair value less costs to sell 1,105 1,123 RBS Insurance Fair value less costs to sell 1,069 1,063 Citizens – Midstates Value in use 5,598 — Charter One Value in use — 4,471 Mid-Atlantic Value in use — 1,450
The goodwill allocated to Global Banking & Markets, UK Corporate Banking, Retail and Wealth Management arose from the acquisition of NatWest in 2000. The recoverable amount of these cash generating units exceeds their carrying value by over £15 billion. The goodwill allocated to RBS Insurance principally arose from the acquisition of Churchill in 2003. The recoverable amount for RBS Insurance exceeds the carrying value by over £2 billion. The multiples or earnings would have to be less than half those used to cause the value in use of the units to equal their carrying value.
F in an ci al s ta te m en ts 18 Property, plant and equipment Group
Expenditure on investment properties 16 — — — — — 16 Change in fair value of investment properties 486 — — — — — 486 Disposals and write-off of fully depreciated assets (610) (353) (44) (40) (693) (1,947) (3,687) Disposals of subsidiaries — — — — (3) — (3)
Disposals and write-off of fully depreciated assets — (5) (26) (15) (539) (528) (1,113) Disposals of subsidiaries — — — — (2) — (2) Depreciation charge for the year — 59 8 78 361 787 1,293
Accumulated depreciation and amortisation: Currency translation and other adjustments — 4 — 6 31 141 182 Disposals and write-off of fully depreciated assets — (91) (24) (29) (340) (159) (643)
Contracts for future capital expenditure not provided for in the accounts at the year end (excluding investment properties and operating lease assets) 117 38
The fair value of investment properties includes £451 million (2005 – £100 million) of appreciation since purchase.
Rental income from investment properties was £278 million (2005 – £250 million; 2004 – £241 million). Direct operating expenses of investment properties were £54 million (2005 –
Property, plant and equipment, excluding investment properties, include £607 million (2005 – £84 million) assets in the course of construction.
Forwards include forward foreign exchange contracts and forward rate agreements. A forward contract is a contract to buy (or sell) a specified amount of a physical or financial commodity, at an agreed price, on an agreed future date. Forward foreign exchange contracts are contracts for the delayed delivery of currency on a specified future date. Forward rate agreements are contracts under which two counterparties agree on the interest to be paid on a notional deposit of a specified maturity at a specific future date; there is no exchange of principal.
Futures are exchange-traded forward contracts to buy (or sell) standardised amounts of underlying physical or financial commodities. The Group buys and sells currency, interest rate and equity futures.
Options include exchange-traded options on currencies, interest rates and equities and equity indices and OTC currency and equity options, interest rate caps and floors and swaptions. They are contracts that give the holder the right but not the obligation to buy (or sell) a specified amount of the underlying physical or financial commodity at an agreed price on an agreed date or over an agreed period.
The Group enters into fair value and cash flow hedges and hedges of net investments in foreign operations. Fair value hedges principally involve interest rate swaps hedging the interest rate risk in recognised financial assets and financial liabilities. Similarly, the majority of the Group’s cash flow hedges relate to exposure to variability in future interest payments and receipts on forecast transactions and on recognised financial assets and financial liabilities and hedged by interest rate swaps for periods of up to 26 years. The Group hedges its net investments in foreign operations with currency borrowings.
For cash flow hedge relationships of interest rate risk the hedged items are actual and forecast variable interest rate cash flows arising from financial assets and financial liabilities with interest rates linked to LIBOR or the Bank of England Official Bank Rate. The financial assets are customer loans and the financial liabilities are customer deposits and LIBOR linked mediumterm notes and other issued securities.
For fair value hedge relationships of interest rate risk the hedged items are typically large corporate fixed-rate loans, fixed-rate finance leases, fixed-rate medium-term notes or preference shares classified as debt. The initial and ongoing prospective effectiveness of fair value hedge relationships is assessed on a cumulative basis by comparing movements in the fair value of the hedged item attributable to the hedged risk with changes in the fair value of the hedging interest rate swap. Retrospective effectiveness is assessed by comparing the actual movements in the fair value of the hedged items attributable to the hedged risk with actual movements in the fair value of the hedging derivative over the life to date of the hedging relationship.
Notional amounts Assets Liabilities Notional amounts Assets Liabilities £bn £m £m £bn £m £m
Included in the above are cash flow hedging derivatives as follows: Spot, forwards and futures 41 — 5 25
Amounts above include: Repurchase agreements 76,376 47,905 — — Items in the course of transmission to other banks 799 722 Due to subsidiaries 738 944 22 Customer accounts Group Company £m £m £m £m
Note: (1) The amounts include investment contracts with a carrying value of £2,246 million (2005 – £2,296 million). The carrying amount of other customer accounts designated as at fair value through profit or loss is £140 million (2005 – £114 million) greater than the principal amount. No amounts have been recognised in profit or loss for changes in credit risk associated with these liabilities as the changes are immaterial measured as the change in fair value from movements in the period in the credit risk premium payable by the Group.
Note: (1) No amounts have been recognised in profit or loss for changes in credit risk associated with these liabilities as the changes are immaterial measured as the change in fair value from movements in the period in the credit risk premium payable by the Group. The carrying amount is £383 million (2005 – £365 million) lower than the principal amount.
Notes in circulation 1,453 1,365 — — Current taxation 789 952 — —
Note: (1) Other liabilities include £10 million (2005 – £10 million) in respect of share-based compensation.
Included in other liabilities are provisions for liabilities and charges as follows: Group £m
Note: (1) Deferred tax assets of £86 million (2005 – £51 million) have not been recognised in respect of tax losses carried forward of £254 million (2005 – £150 million) as it is not considered probable that taxable profits will arise against which they could be utilised. Of these losses, £44 million will expire within one year and a further £92 million within five years. The balance of tax losses carried forward has no time limit.
F in an ci al s ta te m en ts 27 Insurance liabilities
(ii) Provisions for unearned premiums and unexpired short-term insurance risks Group
Increase in the year — (16) (16) Release in the year (33) — (33)
F in an ci al s ta te m en ts 27 Insurance liabilities (continued)
Profit from existing business: Expected return 26 30 Experience variances (3) (2)
Notes: (1) Prior year comparatives have been reanalysed to be consistent with 2006 presentation.
Debt securities 1,540 1,514 Equity securities 2,243 2,255 Other investments 3 8 Cash and cash equivalents 73 52
Certain preference shares are classified as liabilities; these securities remain subject to the capital maintenance rules of the Companies Act 1985.
Group 2005 – final redemption £m £m £m £m £m £m £m
US$350 million floating rate subordinated notes 2012 (callable July 2007) 184 205 US$500 million floating rate subordinated notes 2012 (callable July 2007) 254 293 €130 million floating rate subordinated notes 2012 (callable July 2007) 88 90 €1,000 million floating rate subordinated notes 2013 (callable October 2008) 677 690 US$50 million floating rate subordinated notes 2013 25 29
National Westminster Bank Plc US$1,000 million 7.375% rate subordinated notes 2009 516 589 £300 million 8.125% step-up subordinated notes 2011 (redeemed December 2006) — 309
Charter One Financial, Inc US$400 million 6.375% subordinated notes 2012 218 252
First Active Plc US$35 million 7.24% subordinated bonds 2012 (callable December 2007) 22 22 £60 million 6.375% subordinated bonds 2018 (callable April 2013) 65 65
The Royal Bank of Scotland plc £150 million 5.625% undated subordinated notes (callable June 2032) 144 149 £175 million 7.375% undated subordinated notes (callable August 2010) 183 191 €152 million 5.875% undated subordinated notes (callable October 2008) 105 111 £350 million 6.25% undated subordinated notes (callable December 2012) 350 366 £500 million 6% undated subordinated notes (callable September 2014) 512 540 €500 million 5.125% undated subordinated notes (callable July 2014) 350 378 €1,000 million floating rate undated subordinated notes (callable July 2014) 675 688 £500 million 5.125% undated subordinated notes (callable March 2016) 493 516 £200 million 5.625% subordinated upper tier 2 notes (callable September 2026) 210 213 £125 million 9.25% undated subordinated step-up notes (redeemed April 2006) — 136 £600 million 5.5% undated subordinated notes (callable December 2019) 594 628 £500 million 6.2% undated subordinated notes (callable March 2022) 546 570 £200 million 9.5% undated subordinated bonds (callable August 2018) (3) 229 243 £400 million 5.625% subordinated upper tier 2 notes (callable September 2026) 397 404 £300 million 5.625% undated subordinated notes (callable September 2026) 326 359 £350 million 5.625% undated subordinated notes (callable June 2032) 362 358 £150 million undated subordinated floating rate step-up notes (callable March 2007) 150 150 £400 million 5% undated subordinated notes (issued March 2006; callable March 2011) 395 — JPY25 billion 2.605% undated subordinates notes (callable November 2034) 99 123 CAD700 million 5.37% fixed rate undated subordinated notes (issued May 2006; callable May 2016) 317 —
(4) Exchangeable at the option of the issuer into 200 million 8.392% (gross) non-cumulative preference shares of £1 each of National Westminster Bank Plc at any time.
Notes: (1) Further details of the contractual terms of the preference shares are given in Note 30 on page 175.
(3) Series B preference shares each carry a gross dividend of 8.75% inclusive of associated tax credit. These preference shares were redeemed in January 2007.
(4) Series C preference shares each carry a gross dividend of 8.625% inclusive of associated tax credit. Redeemable at the option of the issuer at a premium of US$0.30 reducing to nil if the date of redemption falls after 8 April 2007.
Included in minority interests are the following trust preferred securities: (1)
Non-equity shares Additional Value Shares of £0.01 — — — — 27 27 Non-cumulative preference shares of US$0.01 1 — — 1 2 2 Non-cumulative convertible preference shares of US$0.01 — — — — — — Non-cumulative preference shares of €0.01 — — — — — — Non-cumulative convertible preference shares of €0.01 — — — — — — Non-cumulative convertible preference shares of £0.25 — — — — 225 225 Non-cumulative convertible preference shares of £0.01 — — — — — —
Non-cumulative preference shares of £1 — — — — 300 300 Total non-equity share capital 2 — — 2 555 555
Shares issued during the year 9,999 Shares repurchased and cancelled during the year (53,699)
Ordinary shares The following issues of ordinary shares were made during the year ended 31 December 2006: (a) 7.5 million ordinary shares following the exercise of options under the company’s executive, sharesave and option 2000 schemes and a further 0.3 million ordinary shares in respect of the exercise of options under the NatWest executive scheme which had been exchanged for options over the company’s shares following the acquisition of NatWest in 2000; and
(b) 2.2 million ordinary shares under the company’s employee share ownership plan.
Consideration of £104 million was received on the issue of ordinary shares for cash.
In addition, options granted under the NatWest executive scheme were outstanding in respect of 0.6 million ordinary shares exercisable up to 2009 at prices ranging from 500p to 924p per share.
During the year the company purchased in the market 54.4 million of its ordinary shares at a total cost of £1,005 million. A total of 695,000 shares repurchased on 28 and 29 December 2006 were not cancelled until 3 and 4 January 2007. These shares are therefore included in issued ordinary share capital as at 31 December 2006.
Employee share trusts purchased 13.8 million ordinary shares at a cost of £252.5 million and awarded 7.8 million ordinary shares on receipt of £108 million on the exercise of awards under employee share schemes.
Non-cumulative convertible preference shares of US$0.01 Series 1 1 million 9.118% 31 March 2010 US$1,000 Debt
On a winding-up or liquidation of the company, the holders of the non-cumulative preference shares will be entitled to receive, out of any surplus assets available for distribution to the company’s shareholders (after payment of arrears of dividends on the cumulative preference shares up to the date of repayment) pari passu with the cumulative preference shares, the non-cumulative sterling preference shares and all other shares of the company ranking pari passu with the noncumulative preference shares as regards participation in the surplus assets of the company, a liquidation distribution of US$25 per non-cumulative preference share of US$0.01, US$1,000 per non-cumulative convertible preference share of US$0.01, €1,000 per non-cumulative preference share of €0.01 and £1,000 per non-cumulative convertible preference share of £0.01, together with an amount equal to dividends for the then current dividend period accrued to the date of payment, before any distribution or payment may be made to holders of the ordinary shares as regards participation in the surplus assets of the company.
Except as described above, the holders of the non-cumulative preference shares have no right to participate in the surplus assets of the company.
Available-for-sale reserve At 1 January (73) — Implementation of IAS 32 and IAS 39 on 1 January 2005 — 289 — — Currency translation adjustments (43) 4 — — Unrealised gains in the year 2,652 35 — — Realised gains in the year (313) (582) — —
Shares repurchased during the year 13 — — 13 — —
Implementation of IAS 32 and IAS 39 on 1 January 2005 — (1,078) — — 81 — Currency translation adjustments and other movements — — (8) — — (1) Profit attributable to ordinary and equity preference shareholders 6,393 5,501 5,112 3,499 2,074 2,874
Equity preference dividends paid (191) (109) — (191) (109) — Preference dividends – non-equity — — (256) — — (256) Shares repurchased during the year (624) — — (624) — — Redemption of preference shares classified as debt (271) — — (271) — — Actuarial gains/(losses) recognised in retirement benefit schemes, net of tax 1,262 (561) (1,136) — — — Net cost of shares bought and used to satisfy share-based payments (38) — — — — — Share-based payments, net of tax 80 112 15 — — —
Shares purchased during the year (254) — (7) — — (7) Shares issued under employee share schemes 146 — — 7 — —
The merger reserve comprises the premium on shares issued to acquire NatWest less goodwill amortisation charged under previous GAAP. No share premium was recorded in the company financial statements through the operation of the merger relief provisions of the Companies Act 1985.
UK law prescribes that only reserves of the company are taken into account for the purpose of making distributions and the permissible applications of the share premium account.
Notes on the accounts continued 32 Leases Minimum amounts receivable and payable under non-cancellable leases Group
Operating lease assets: Future minimum lease receivables 444 2,391 2,640 5,475
Finance lease receivables – contingent rental income (37) (34) Operating lease payables – minimum payments 366 332
Contracts for future capital expenditure not provided for at the year end Operating leases 1,437 594
F in an ci al s ta te m en ts £m £m
Treasury and other eligible bills 1,426 896 Debt securities 58,874 53,485
Loans and advances to customers 44,966 27,092 Debt securities 8,560 9,578 Property, plant and equipment 1,222 1,274 Loans to banks 469 60
£105.6 billion), of which £107.2 billion (2005 – £85.6 billion) had been resold or repledged as collateral for the Group’s own transactions.
Included in the above balances are loans and advances to customers of £15.8 billion (2005 – £16.2 billion) and debt securities of £1.5 billion (2005 – £ 2.5 billion) charged as security against Federal Home Loan Bank deposits of £10.5 billion (2005 – £11.1 billion).
Residual value exposures The tables below give details of the unguaranteed residual values included in the carrying value of finance lease receivables (see page 178) and operating lease assets (see Note 18). Year in which residual value will be recovered
• Approval of all credit exposure is granted prior to any advance or extension of credit.
• An appropriate credit risk assessment of the customer and credit facilities is undertaken prior to approval of credit exposure. This includes a review of, amongst other things, the purpose of the credit and sources of repayment, compliance with affordability tests, repayment history, capacity to repay, sensitivity to economic and market developments and risk-adjusted return.
• Where credit authority is exercised personally, the individual has no responsibility or accountability for related business revenue origination.
Credit risk models Credit risk models are used throughout the Group to support the analytical elements of the credit risk management framework, in particular the risk assessment part of the credit approval process, ongoing monitoring as well as portfolio analysis and reporting. Credit risk models used by the Group can be broadly grouped into four categories.
• Probability of default (“PD”)/customer credit grade – these models assess the probability that the customer will fail to make full and timely repayment of credit obligations over a one year time horizon. Each customer is assigned an internal credit grade which corresponds to a probability of default. There are a number of different credit grading models in use across the Group, each of which considers particular characteristics of customer types in that portfolio. The credit grading models use a combination of quantitative inputs, such as recent financial performance and customer behaviour, and qualitative inputs, such as company management performance or sector outlook.
Every customer credit grade across all grading scales in the Group can be mapped to a Group level credit grade which uses a five band scale from AQ1 to AQ5.
• Exposure at default (“EAD”) – these models estimate the expected level of utilisation of a credit facility at the time of a borrower’s default. The EAD will typically be higher than the current utilisation (e.g. in the case where further drawings are made on a revolving credit facility prior to default) but will not normally exceed the total facility limit. The methodologies used in EAD modelling recognise that customers may make more use of their existing credit facilities in the run up to a default.
Provision analysis The Group’s consumer portfolios, which consist of small value, high volume 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. Provisions are assessed on a case by case basis.
Collectively assessed provisions are the provisions on impaired credits below an agreed threshold which are assessed on a portfolio basis, to reflect the homogeneous nature of the assets, such as credit cards or personal loans. The provision is determined from a quantitative review of the relevant portfolio, taking account of the level of arrears, security and average loss experience over the recovery period.
Latent loss provisions are the provisions held against the estimated impairment in the performing portfolio which has yet to be identified as at the balance sheet date. To assess the latent loss within the portfolio, the Group has developed methodologies to estimate the time that an asset can remain impaired within a performing portfolio before it is identified and reported as such.
Liquidity risk Liquidity management within the Group focuses on both overall balance sheet structure and the control, within prudent limits, of risk arising from the mismatch of maturities across the balance sheet and from undrawn commitments and other contingent obligations. It is undertaken within limits and other policy parameters set by Group Asset and Liability Management Committee (GALCO).
Short-term liquidity risk is managed on a consolidated basis for the whole Group including the Greenwich companies but excluding the activities of Citizens and insurance businesses, which are subject to regulatory regimes that necessitate local management of liquidity.
Trading The principal focus of the Group’s trading activities is client facilitation – providing products to the Group’s client base at competitive prices. The Group also undertakes: market making – quoting firm bid (buy) and offer (sell) prices with the intention of profiting from the spread between the quotes; arbitrage – entering into offsetting positions in different but closely related markets in order to profit from market imperfections; and proprietary activity – taking positions in financial instruments as principal in order to take advantage of anticipated market conditions. The main risk factors are interest rates, credit spreads and foreign exchange. Financial instruments held in the Group’s trading portfolios include, but are not limited to, debt securities, loans, deposits, securities sale and repurchase agreements and derivative financial instruments (futures, forwards, swaps and options). For a discussion of the Group’s accounting policies for derivative financial instruments, see Accounting policies on pages 135 and 136.
The VaR for the Group’s trading portfolios segregated by type of market risk exposure, including idiosyncratic risk, is presented in the table below.
� Interest rate risk Non-trading interest rate risk arises from the Group’s treasury activities and retail and commercial banking businesses.
A static maturity gap report is produced as at the month-end for each division, in each functional currency based on the behaviouralised repricing for each product. It is Group policy to include in the gap report, non-financial assets and liabilities, mainly property, plant and equipment and the Group’s capital and reserves, spread over medium and longer term maturities. This report also includes hedge transactions, principally derivatives.
� Currency risk The Group does not maintain material non-trading open currency positions other than the structural foreign currency translation exposures arising from its investments in foreign subsidiaries and associated undertakings and their related currency funding. The Group’s policy in relation to structural positions is to match fund the structural foreign currency exposure arising from net asset value, including goodwill, in foreign subsidiaries, equity accounted investments and branches, except where doing so would materially increase the sensitivity of either the Group’s or the subsidiary’s regulatory capital ratios to currency movements. The policy requires structural foreign exchange positions to be reviewed regularly by GALCO. Foreign exchange differences arising on the translation of foreign operations are recognised directly in equity together with the effective portion of foreign exchange differences arising on hedging liabilities.
The tables below set out the Group’s structural foreign currency exposures. Foreign currency Structural
Reinsurance of risks above the Group’s risk appetite is only effective if the reinsurance premium makes economic sense and the counterparty is financially secure. Acceptable reinsurers are rated A- or better unless specifically authorised.
Insurance claims – gross £m £m £m £m £m £m £m
Current estimate of cumulative claims 2,316 3,076 3,357 3,436 4,173 4,269 20,627
Four years later (41) (21) — — — — (62) Five years later 1 — — — — — 1
Liability in respect of prior years 79 Claims handling costs 103
Earned Claims Loss Earned Loss Earned Loss premiums incurred ratio premiums ratio premiums ratio
b) Property insurance contracts (residential and commercial) The major causes of claims for property insurance are theft, flood, escape of water, fire, storm, subsidence and various types of accidental damage.
c) Other commercial insurance contracts Other commercial claims come mainly from business interruption and loss arising from the negligence of the insured (liability insurance). Business interruption losses come from the loss of income, revenue and/or profit as a result of property damage claims. Liability insurance includes employers liability and public/products liability. Liability insurance is written on an occurrence basis, and is subject to claims that are identified over a substantial period of time, but where the loss event occurred during the life of the policy.
Life business The Group’s three regulated life companies, National Westminster Life Assurance Limited, Royal Scottish Assurance plc (“RSA”) and Direct Line Life Insurance Company Limited, are required to meet minimum capital requirements at all times under the Financial Service Authority’s Prudential Sourcebook. The capital resources covering the regulatory requirement are not transferable to other areas of the Group. To ensure that the capital requirement is satisfied at all times, each company holds an additional voluntary buffer above the regulatory minimum.
The Group is not exposed to price, currency, credit, or interest risk on unit linked life contracts but it is exposed to variation in management fees. A decrease of 10% in the value of the assets would reduce the asset management fees by £5 million per annum (2005 – £5 million). The Group also writes insurance contracts with minimum guaranteed death benefits that expose it to the risk that declines in the value of underlying investments may increase the Group’s net exposure to death risk.
Sample mortality rates, expressed as deaths per million per annum, for term assurance products (age 40).
Expenses: Pre-2000 products – RSA per annum per annum per annum
Lifestyle protection plan £28.96 £29.81 £27.17 Mortgage savings plan £65.15 £67.05 £60.08
Sources of uncertainty in the estimation of future benefit payments and premium receipts – the Group uses base tables of standard mortality appropriate to the type of contract being written and the territory in which the insured person resides. These are adjusted to reflect the Group’s experience, mortality improvements and voluntary termination behaviour.
Sensitivity factor Description of sensitivity factor applied Interest rate and investment return Change in market interest rates of ±1%.
Assurance mortality/morbidity +5% (6) (7) Annuitant mortality – 5% — —
Remaining maturity 1 month 1-3 3-12 1-5 Over 5 Equity or less months months years years shares Total 2006 £m £m £m £m £m £m £m
Equity shares — — — — — 13,504 13,504 Settlement balances 7,425 — — — — — 7,425
Assets Cash and balances at central banks 4,759 — — — — — 4,759 Treasury and other eligible bills 779 1,252 3,507 — — — 5,538 Loans and advances to banks 46,276 14,959 8,749 265 338 — 70,587 Loans and advances to customers 139,732 48,881 42,485 66,488 119,640 — 417,226
Equity shares — — — — — 9,301 9,301 Settlement balances 6,005 — — — — — 6,005
Settlement balances and short positions 16,533 569 1,696 15,950 9,240 — 43,988 35 Financial instruments
Company or less months months years years Total 2006 £m £m £m £m £m £m
Assets Loans and advances to banks 1,090 81 — 355 5,726 7,252 Loans and advances to customers — — 286 — — 286
Liabilities Deposits by banks — — — 738 — 738 Debt securities in issue — 518 1,163 458 — 2,139
Assets Loans and advances to banks 435 1,476 780 1,510 4,921 9,122 Loans and advances to customers — — — 262 305 567
Liabilities Deposits by banks 32 919 — — — 951 Customer accounts — 55 — — — 55 Debt securities in issue 909 2,033 — — — 2,942 35 Financial instruments (continued)
Shareholders’ equity — — — — — — — 18,197 18,197
Cumulative interest rate sensitivity gap (2,446) (2,446) (2,446) (2,444) (3,537) (3,537) —
Cumulative interest rate sensitivity gap (3,157) (3,170) (3,167) (2,923) (3,501) (3,501) —
Trading book The table below sets out by time band the net effect on the Group’s profit or loss of a basis point (0.01%) increase in interest rates, assuming all trading positions remained unchanged.
After 3 After 6 After 1 months months year but less but less but less 3 months than than than Over 5 or less 6 months 1 year 5 years years Total
Financial assets and liabilities designated as at fair value through profit or loss £m £m
The following table shows the carrying values and the fair values of financial instruments on the balance sheets.
Designated as at fair value through profit or loss 1,327 1,327 616 616 — — — —
Settlement balances and short positions 49,476 49,476 43,988 43,988 — — — —
Subordinated liabilities Designated as at fair value through profit or loss 124 124 150 150 — — — —
Service industries and business activities 57,895 4,330 2,616 769 65,610 5,289
Service industries and business activities 80,844 5,699 2,818 778 90,139 5,313
Finance lease and instalment credit 17,835 5 — — 17,840 189
Service industries and business activities 53,504 3,404 2,148 162 59,218 5,211
Europe Central and local government 297 301 — — 598 —
Service industries and business activities 75,462 4,099 2,289 162 82,012 5,222
Finance lease and instalment credit 18,193 4 — — 18,197 158
(2) This column shows the amount by which exposures to counterparties are reduced by the existence of a legal right of set-off (on the basis that the financial asset will be collected in accordance with its terms) and under master netting arrangements. The credit risk of financial assets subject to a master netting arrangement is eliminated only to the extent that financial liabilities due to the same counterparty will be settled after the assets are realised. The extent to which the Group's credit risk is reduced through a master netting arrangement may change substantially within a short period following the balance sheet date because the exposure is affected by each transaction subject to the arrangement.
36 Memorandum items Contingent liabilities and commitments The amounts shown in the table below are intended only to provide an indication of the volume of business outstanding at 31 December. Although the Group is exposed to credit risk in the event of non-performance of the obligations undertaken by customers, the amounts shown do not, and are not intended to, provide any indication of the Group’s expectation of future losses.
Commitments: Undrawn formal standby facilities, credit lines and other commitments to lend
Litigation Proceedings, including a consolidated class action, have been brought in the United States against a large number of defendants, including the Group, following the collapse of Enron. The claims against the Group could be significant but are largely unquantified. The Group considers that it has substantial and credible legal and factual defences to these claims and it continues to defend them vigorously. A court ordered mediation commenced in September 2003 but no material progress has been made towards a resolution of the claims, although a number of other defendants have reached settlements in the principal class action. The Group is unable reliably to estimate the possible loss in relation to these matters or the effect that the possible loss might have on the Group’s consolidated net assets or its operating results or cash flows in any particular period. In addition, pursuant to requests received from the US Securities and Exchange Commission and the Department of Justice, the Group has provided copies of Enron-related materials to these authorities and has co-operated fully with them.
F in an ci al s ta te m en ts 37 Net cash inflow from operating activities Group Company £m £m £m £m £m £m
Net cash inflow from trading activities 15,690 6,570 10,729 4,002 2,381 3,209 (Increase)/decrease in loans and advances to banks and customers (44,525) (36,778) (72,955) 346 (14) 77 Increase in securities (16,703) (28,842) (11,883) — — — Decrease/(increase) in other assets 671 (2,390) (2,208) 2 5 33 (Increase)/decrease in derivative assets (21,018) (5,758) (3,753) 55 50 21
Increase/(decrease) in deposits by banks and customers 63,091 32,424 53,073 (164) 832 18 Increase in insurance liabilities 244 620 866 — — — (Decrease)/increase in debt securities in issue (4,457) 24,147 19,073 (803) 1,328 (269) Increase/(decrease) in other liabilities 935 571 919 14 (55) (19) Increase/(decrease) in derivative liabilities 21,674 5,161 3,808 42 (96) (9) Increase in settlement balances and short positions 4,068 10,326 8,796 — — —
Implementation of IAS 32 on 1 January 2005 (3,161) 7,160 (3,161) 3,308 Issue of ordinary shares 104 163 104 163 Issue of equity preference shares 671 1,649 671 1,649 Repurchase of ordinary shares (394) — (394) — Net proceeds from issue of
Comprising: Cash and balances at central banks 5,752 4,456 4,035 — — — Treasury bills and debt securities 1,596 998 3,016 — — — Loans and advances to banks 64,303 47,095 42,970 657 1,126 309
Certain subsidiary undertakings are required to maintain balances with the Bank of England which, at 31 December 2006, amounted to £369 million (2005 – £303 million). Certain subsidiary undertakings are required by law to maintain reserve balances with the Federal Reserve Bank in the US. Such reserve balances amounted to US$13 million at 31 December 2006 (2005 – US$156 million).
F in an ci al s ta te m en ts 42 Segmental analysis (a) Divisions The directors manage the Group primarily by class of business and present the segmental analysis on that basis. The Group’s activities are organised as follows: • Global Banking & Markets is a leading banking partner to major corporations and financial institutions around the world, providing a full range of debt financing, risk management and investment services to its customers.
• Retail comprises both the Royal Bank and NatWest retail brands, and a number of direct providers offering a full range of banking products and related financial services to the personal, premium and small business markets across several distribution channels. Retail also includes the Group’s nonbranch based retail business, such as Tesco Personal Finance, that issues a comprehensive range of credit and charge cards to personal and corporate customers and provides card processing services for retail businesses.
• Ulster Bank Group brings together the Ulster Bank and First Active businesses. Retail Markets serves personal customers through both brands and Corporate Markets caters for the banking needs of business and corporate customers.