Audit Committee Report The current members of the Audit Committee are Archie Hunter (Chairman), Colin Buchan and Joe MacHale. All served throughout 2008 as did former members of the committee, Bill Friedrich and Sir Steve Robson, until their retirement as directors on 6 February 2009. All members of the Audit Committee are independent non-executive directors. The Audit Committee holds at least five scheduled meetings each year, two of which are held immediately prior to submission of the interim and annual financial statements to the Board. This core programme is supplemented by additional meetings as required. A total of ten meetings were held in 2008. Audit Committee meetings are attended by relevant executive directors, the internal and external auditors and finance and risk management executives. At least twice per annum the Audit Committee meets privately with the external auditors. Since 2000, the Audit Committee has undertaken an annual programme of visits to the Group's business divisions and control functions. The object of the programme is to allow the Audit Committee to gain a better understanding of the Group and an invitation to attend is extended to all non-executive directors. The programme of future visits is considered annually and the norm is for two to three visits to be undertaken each year. The Committee undertook three visits in 2008.
The terms of reference of the Audit Committee are available at www.rbs.com and these are considered annually by the Audit Committee and approved by the Board.
Annual audit services include all services detailed in the annual engagement letter including the annual audit and interim reviews (including US reporting requirements), periodic profit verifications and reports to regulators including skilled persons reports commissioned by the Financial Services Authority (e.g. Reporting Accountants Reports).
Annual audit services also include statutory or non-statutory audits required by any Group companies that are not incorporated in the UK. Terms of engagement for these audits are agreed separately with management, and are consistent with those set out in the audit engagement letter insofar as local regulations permit.
For all other permitted non-audit services, Audit Committee approval must be sought, on a case by case basis, before the provision of the service commences. In addition, the Audit Committee reviews and monitors the independence and objectivity of the external auditors when it approves non-audit work to be carried out by them, taking into consideration relevant legislation and ethical guidance. Information on the audit and non-audit services carried out by the external auditors is detailed in Note 5 to the Group’s accounts.
An issue of key interest to the Audit Committee, given the current economic environment, was management's going concern assessment. In particular, the Committee's attention was directed to understanding the way in which management had satisfied itself that the Group has access to sufficient funding and capital over the next 12 months. The Committee reviewed and challenged the assumptions underlying management's analysis and discussed with the external auditors its review of management's analysis and conclusions.
As far as it can determine, the Committee received all the information and material it required to allow it to meet its obligations in respect of the 2008 financial statements.
The Audit Committee approves the terms of engagement of the external auditors.
It is intended that there will be an external review of the effectiveness of Group Internal Audit every three to five years, in line with best practice, with internal reviews continuing in the intervening years. In 2007, KPMG conducted a review of the effectiveness of Group Internal Audit and concluded that the function operated effectively and the Board agreed with these findings. In 2008, the Audit Committee conducted an internal review of Group Internal Audit that involved participants throughout the Group as well as the external auditors. The Audit Committee concluded that the function operated effectively and the Board agreed with the Audit Committee’s findings.
Since 2005, divisional audit committees have been responsible for reviewing each division’s business. During 2008, the divisional audit committee structure was revised to take account of the acquisition of ABN AMRO, the significant international growth of the Group’s businesses and best practice requirements. The divisional audit committees report to the Audit Committee and the Audit Committee is satisfied that these committees continue to discharge their terms of reference.
As we embark on a process of change, our approach has sought to balance the reality of our current situation with the need to offer a competitive remuneration package for teams and individuals that are performing well and in a manner that is sustainable in the long-term. Achieving this balance is essential to our task of rebuilding the Group's standalone strength as well as repaying the support of the UK taxpayers.
• Where there has been exceptional performance by key individuals and teams, employees have been given deferred bonus awards. These awards will be released in three instalments in 2010, 2011 and 2012, in the form of RBS Group subordinated debt, by which time we hope the Group will be well on its way to standalone financial strength.
If the performance on which these deferred bonus awards was based later turns out to have been materially different or if there is subsequent material loss or reputational damage as a result of activity in the deferral period, or otherwise at the discretion of the Remuneration Committee, then part of these awards may be reduced or cancelled without payment (‘clawback’).
• No profit share payment has been made for financial year 2008 and the scheme has been withdrawn going forward. We have made changes to benefits for some employees below manager level as part of the transitional arrangements to end the annual entitlement to profit share bonuses.
• Annual base salary increases in 2009 will be made to a limited number of employees and salary increases will be below inflation for all businesses across the Group.
No bonuses have been paid to executive directors in relation to 2008 performance, and no deferred awards have been made. Over the past four years, the long term incentive awards granted under the Medium Term Performance Plan have lapsed due to the performance criteria not being met.
• Long term incentive awards will continue to be made under the Medium-term Performance Plan and the Executive Share Option Plan but the level of awards will be lowered compared to 2008. All awards will only vest if stretching performance conditions are met in three years’ time.
The Remuneration Committee recognises that the Group’s performance has not only impacted its shareholders and customers, but also its employees who have worked so very hard over many years to build an organisation of which they were proud and which provided a secure livelihood for them and their families. The Board deeply regrets that our employees’ trust has been eroded and their welfare affected during the last year. While it is both necessary and appropriate that we adopt stringent measures for employee compensation, we are more mindful than ever of the need for the Group to continue to develop the best employment practices in our industry to enable us to retain and recruit outstanding talent. This is critical to the delivery of our strategic plan and to build a sustainable and successful Group for the future.
The Remuneration Committee also approves the remuneration arrangements of senior executives below Board level who are members of the Group Executive Management Committee, on the recommendation of the Group Chief Executive, and maintains high level oversight of the application of remuneration policy below this level. The Committee oversees annual incentive plans and reviews all long-term incentive arrangements operated by the Group.
During the year, the Remuneration Committee received advice from Watson Wyatt and Mercer on matters relating to directors’ remuneration in the UK and US respectively, together with advice from the Group Director, Human Resources and the Group General Counsel and Group Secretary on general remuneration matters. In addition, the Remuneration Committee has taken account of the views of the Group Chief Executive on performance assessment of the executive directors and members of the Group Executive Management Committee.
Watson Wyatt also provided professional services in the ordinary course of business, including actuarial advice and benefits administration services to subsidiaries of the Group and investment consulting and actuarial advice to the trustees of some of the Group’s pension funds. Mercer provided advice and support in connection with a range of compensation benefits, pension actuarial and investment matters. The advisers to the Remuneration Committee are appointed independently by the Committee, which reviews its selection of advisers annually. The Committee is satisfied that the consultants from Watson Wyatt and Mercer who advise the Committee operate independently of the consulting teams undertaking other work with the Group.
Remuneration policy It has been agreed with HM Treasury that, in addition to complying with the Association of British Insurer's best practice code on remuneration, the Remuneration Committee will continue to work to ensure that future remuneration arrangements are linked to long-term value creation in line with the Group’s business strategy, with appropriate account taken of risk and avoiding a bias towards short-term indicators such as profit or revenues. The company is also actively engaged in discussions with the Financial Services Authority (FSA) in relation to remuneration policies and practices across the banking sector and intends that any remuneration policies should take account of the FSA’s remuneration design criteria.
Components of executive remuneration 2009 UK based directors Salary Base salaries of executive directors have been reviewed and it has been agreed that no increases in base salaries will be made as part of the annual 2009 review.
Benefits Executive directors are eligible to receive various employee benefits or a cash equivalent from a flexible benefits account, on a similar basis to other employees.
Details of pension arrangements of directors are shown on page 168. Where cash allowances are paid in place of pension accrual (or of pension accrual on salary over the pension earnings cap), they are shown on page 164. Executive directors also receive cover for death-inservice benefits.
UK-based executive directors have a normal maximum annual incentive opportunity of between 160% and 200% of salary (with an exceptional maximum opportunity of 200-250% of salary). The on-target opportunity is 107% to 133% of salary.
Any incentive payments to executive directors in 2009 will reflect performance across five performance categories: Strategic Direction, Finance and Operations, Stakeholders, Efficiency and Control and Capability and Development. Group business unit and functional performance will be considered as appropriate.
Medium-term Performance Plan The Medium-term Performance Plan was approved by shareholders in April 2001. Each executive director is eligible for an annual award under the plan in the form of share or share equivalent awards. Whilst the rules of the plan allow awards over shares worth up to one and a half times earnings, the Remuneration Committee has adopted a policy of granting awards based on a multiple of salary. No changes will be made to this policy without prior consultation with shareholders.
The award levels for 2009 will be reduced from the policy applied for awards in 2008.
Options The Executive Share Option Plan was approved by shareholders at the company’s 2007 Annual General Meeting.
In 2008, options were granted to executive directors under the Executive Share Option Plan approved by shareholders in 2007, over shares worth between one and a half times salary and three times salary. For 2009, the award levels will be reduced from the policy applied in 2008.
Any compensation payment made in connection with the departure of an executive director will be subject to approval by the Remuneration Committee, having regard to the terms of the service contract and the reasons for termination. Any Board members who leave the company in the future will receive a severance package which is reasonable and perceived as fair.
Information regarding directors’ service contracts is shown below: Date of Notice period – Notice period – current contract from company from executive
Former executive directors Sir Fred Goodwin 1 August 1998 see page 161 see page 161 Mr Cameron 29 March 1998 12 months 6 months Mr Fisher 27 February 2007 12 months 12 months
In the event that Stephen Hester’s employment is terminated by the company (other than by reason of his personal underperformance), the following will apply. First Mr Hester will be entitled to receive a payment in lieu of notice to the value of base salary, bonus and benefits (including pension contributions). Secondly, any share awards granted to him to replace bonus and share awards he forfeited on leaving The British Land Company PLC will vest immediately on such termination.
If Mr Hester’s employment is terminated by reason of his personal underperformance, the company is entitled to terminate by giving written notice with immediate effect and without making any payment in lieu thereof and Mr Hester will forfeit any unvested stock awards. If he resigns voluntarily and the company does not require him to work out his notice period, Mr Hester may receive a payment in lieu of notice based on salary only (i.e. no bonus or benefits) and he will also forfeit any unvested stock awards.
The non-executive directors do not have service contracts or notice periods although they have letters of engagement reflecting their responsibilities and commitments. No compensation would be paid to any non-executive director in the event of termination.
The Chairman, Philip Hampton, will be entitled to receive a payment in lieu of notice if his appointment is terminated by the Group other than by reason of his personal underperformance. This payment will be based on a notice period of 24 months initially, reducing on a daily basis so that from the first anniversary of his appointment his notice period is 12 months.
Notes: (1) Mr Hester was appointed Group Chief Executive on 21 November 2008. He was previously a non-executive director from 1 October 2008.
(2) Sir Tom McKillop ceased to be Chairman and a director on 3 February 2009.
Share options Options to subscribe for ordinary shares of 25p each in the company granted to, and exercised by, directors during the year ended 31 December 2008 are shown in the table below. Options held at 1 January 2008 and all subsequent figures have been restated to reflect the rights issue in June 2008 and the capitalisation issue in September 2008.
Options held at Options at date of Options 1 January granted in exercise lapsed in Option price Options held at 31 December 2008
(2) Options held at 21 November 2008 when he ceased to be a director. Unvested awards were waived on cessation and lapsed on 31 January 2009. In respect of his vested options under The Royal Bank of Scotland Group plc 1999 Executive Share Option Scheme, any options exercisable at 31 January 2009 remain exercisable subject to and in accordance with the rules of that plan for 12 months from that date, but not after the 10th anniversary of their grant.
(3) Options held at 13 October 2008 when he ceased to be a director. All outstanding awards will lapse when his employment with the company ends on 28 February 2009, which is reflected in the table above.
(4) Options held at 21 November 2008 when he ceased to be a director. All outstanding awards will lapse when his employment with the company ends on 6 March 2009.
For executive share options granted in 2007 and 2008, the performance condition is based on the average annual growth in the company’s adjusted EPS over the three-year performance period commencing with the year of grant. The calibration of the EPS growth measure is agreed by the Remuneration Committee at the time of each grant having regard to the business plan, prevailing economic conditions and analysts’ forecasts.
Medium Term Performance Plan Scheme interests at 1 January 2008 and the related market price on award in the table below have been restated to reflect the rights issue in June 2008 and the capitalisation issue in September 2008.
(share equivalents) at granted award vested in exercised equivalents) at conditions to 1 January 2008 in 2008 £ 2008 in 2008 31 December 2008 be fulfilled
Notes: (1) Awards held at 21 November 2008 when he ceased to be a director. Unvested awards were waived on cessation and lapsed on 31 January 2009.
(2) Awards held at 13 October 2008 when he ceased to be a director. Subsequently Mr Cameron exercised his vested awards on 5 December 2008. All outstanding awards will lapse when his employment with the company ends on 28 February 2009.
(3) Awards held at 21 November 2008 when he ceased to be a director. All unvested awards and any vested, but unexercised, awards will lapse when his employment with the company ends on
Restricted Share Award Interests at 1 January 2008 and the related prices on award and vesting in the table below have been restated to reflect the rights issue in June 2008 and the capitalisation issue in September 2008.
End of the Awards Market Market Value of Awards period for held at Awards price on Awards price on awards held at qualifying 1 January granted in award vested in vesting vested 31 December conditions to
(2) These awards vest as to 1/3 on each of the first, second and third anniversary of award, subject to their terms.
(4) The end period for qualifying conditions is subject to any restrictions on dealing in the Group’s shares which may be in place and to which Mr Whittaker may be subject. As a result of the close period prior to the announcement of the Group’s results, the end of the period for qualifying conditions to be fulfilled in 2009 is 26 February 2009.
Benefits received from awards Interests at 1 January 2008 vesting during the year Interests at 31 December 2008
Mr Fish LTIP awards for the 3 year periods: Notes: (1) This cash LTIP was approved by shareholders at the company’s Annual General Meeting in April 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.
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 2007, the companies in the comparator group were 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. Following the acquisition of ABN
During 2008, Johnny Cameron, Sir Fred Goodwin and Gordon Pell accrued pensionable service in The Royal Bank of Scotland Group Pension Fund (the “RBS Fund”). The RBS Fund is a defined benefit fund registered with HM Revenue & Customs under the Finance Act 2004.
Sir Fred Goodwin was, and Gordon Pell is, provided with additional pension benefits on a defined benefit basis outwith the RBS Fund. The figures shown below include the accrual in respect of these arrangements. A funded, non-registered arrangement provides Sir Fred Goodwin’s benefits to the extent they are not provided by the RBS Fund.
The cash allowances for Johnny Cameron and Mark Fisher are shown on page 164.
Larry Fish accrued pension benefits under a number of arrangements in the US. Defined benefits were built up under the Citizens’ Qualified Plan, Excess Plan and Supplemental Executive Retirement Arrangement. In addition, he was a member of two defined contribution arrangements: a Qualified 401(k) Plan and an Excess 401(k) Plan until he became a non-executive director on 1 May 2008.
Of the total transfer value shown as at 31 December 2008, 54% relates to benefits in funded pension schemes.
Note: (1) Sir Fred Goodwin retired from employment with effect from 31 January 2009 and Johnny Cameron will retire from employment with effect from 28 February 2009. They were contractually entitled to an immediate pension based on their accrued service, including any service transferred in, with no discount for early payment. The valuation of their pensions as at 31 December 2008 in the table above takes account of the payment dates of these pensions. Employees in the RBS Fund, including directors, who retire early at the request of their employer, are entitled to an immediate pension with no discount for early payment. The provision for an early undiscounted pension on early retirement at employer request will not apply to any executive director appointed in the future. Except as noted above for Sir Fred Goodwin and Johnny Cameron, the valuations in the table above make no allowance for early retirement.
In accordance with US market practice, Larry Fish’s pensionable remuneration was limited to US$4 million per annum.
Contributions and allowances paid in the year ended 31 December 2008 under defined contribution arrangements were: Mr Fish 6 60
Preference shares Mr Koch held 20,000 non-cumulative preference shares of US$0.01 each at 31 December 2008 (2007 – 20,000). No other director shown above had an interest in the preference shares during the year.
Shares beneficially owned at 1 January 2008 in the tables below have been restated to reflect the capitalisation issue of ordinary shares in September 2008.
Notes: (1) The value is based on the share price at 31 December 2008, which was 49.4p. During the year ended 31 December 2008 the share price ranged from 41.4p to 370.5p.
As at 31 December 2008, the executive directors held a technical interest as potential beneficiaries in The Royal Bank of Scotland Group plc 2001 Employee Share Trust (51,680,795 shares), The Royal Bank of Scotland plc 1992 Employee Share Trust (1,028,914 shares) and The Royal Bank of Scotland Group plc 2007 US Employee Share Trust (8,455,545 shares), being trusts operated for the benefit of employees of the company and its subsidiaries.
The directors are responsible for keeping proper accounting records which disclose with reasonable accuracy at any time the financial position of the Group and to enable them to ensure that the Annual Report and Accounts complies with the Companies Act 1985. They are also responsible for safeguarding the assets of the Group and hence for taking reasonable steps for the prevention and detection of fraud and other irregularities.
We, the directors listed below, confirm that to the best of our knowledge: • the financial statements, prepared in accordance with International Financial Reporting Standards, give a true and fair view of the assets, liabilities, financial position and profit or loss of the company and the undertakings included in the consolidation taken as a whole; and
Philip Hampton Stephen Hester Guy Whittaker Chairman Group Chief Executive Group Finance Director
Financial statements 172 Independent auditors’ report 174 Consolidated income statement 175 Balance sheets 176 Statements of recognised income and expense 177 Cash flow statements 178 Accounting policies 189 Notes on the accounts 1 Net interest income 189 2 Non-interest income 189
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 2008 which comprise the accounting policies, the balance sheets as at 31 December 2008 and 2007, 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 2008, the related Notes 1 to 42 and the information identified as ‘audited’ in the Risk, capital and liquidity management section of the Business review. 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.
Basis of audit opinion We conducted our audit in accordance with International Standards on Auditing (UK and Ireland) issued by the Auditing Practices Board and with the standards of the Public Company Accounting Oversight Board (United States). An audit includes examination, on a test basis, of evidence relevant to the amounts and disclosures in the financial statements and the part of the directors’ remuneration report described as having been audited. It also includes an assessment of the significant estimates and judgements made by the directors in the preparation of the financial statements, and of whether the accounting policies are appropriate to the circumstances of the company and the Group, consistently applied and adequately disclosed.
We planned and performed our audit so as to obtain all the information and explanations which we considered necessary in order to provide us with sufficient evidence to give reasonable assurance that the financial statements and the part of the directors’ remuneration report described as having been audited are free from material misstatement, whether caused by fraud or other irregularity or error. In forming our opinion, we also evaluated the overall adequacy of the presentation of information in the financial statements and the part of the directors’ remuneration report described as having been audited.
US opinion In our opinion, the financial statements present fairly, in all material respects, the financial position of the Group as at 31 December 2008 and 2007 and the results of its operations and its cash flows for each of the three years in the period ended 31 December 2008, in conformity with IFRS as adopted for use in the European Union and IFRS as issued by the IASB.
The financial statements for the year ended 31 December 2007 were restated for the matters disclosed in Note 1 of the Accounting Polices.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Group’s internal control over financial reporting as at 31 December 2008, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organisations of the Treadway Commission.
Fees and commissions receivable 2 9,831 8,278 7,116 Fees and commissions payable 2 (2,386) (2,193) (1,922) (Loss)/income from trading activities 2 (8,477) 1,292 2,675 Other operating income (excluding insurance premium income) 2 1,899 4,833 3,564 Insurance net premium income 24 6,326 6,087 5,973 Non-interest income 7,193 18,297 17,406
(Loss)/profit attributable to: Per 25p ordinary share: The accompanying notes on pages 189 to 266, the accounting policies on pages 178 to 188 and the audited sections of ‘The Business Review: Risk, Capital and Liquidity Management’ on pages 78 to 144 form an integral part of these financial statements.
Accruals, deferred income and other liabilities 22 31,482 34,208 47 8 Retirement benefit liabilities 4 2,032 460 — —
The accounts were approved by the Board of directors on 25 February 2009 and signed on its behalf by: Philip Hampton Stephen Hester Guy Whittaker Chairman Group Chief Executive Group Finance Director
Exchange differences on translation of foreign operations 15,425 2,210 (1,681) — — — Actuarial (losses)/gains on defined benefit plans (2,287) 2,189 1,781 — — — Income before tax on items recognised direct in equity 4,276 2,546 4,330 2 3 3 Tax on items recognised direct in equity 2,786 (170) (1,173) (1) (1) (1) Net income recognised direct in equity 7,062 2,376 3,157 1 2 2 (Loss)/profit for the period (34,373) 7,712 6,497 (9,602) 2,499 3,499 Total recognised income and expense for the year (27,311) 10,088 9,654 (9,601) 2,501 3,501
Attributable to: The accompanying notes on pages 189 to 266, the accounting policies on pages 178 to 188 and the audited sections of ‘The Business Review: Risk, Capital and Liquidity Management’ on pages 78 to 144 form an integral part of these financial statements.
Adjustments for: Depreciation and amortisation 3,154 1,932 1,678 — — — Write-down of goodwill and other intangible assets 32,581 — — — — — Write-down of investment in subsidiaries 14,321 — —
Charge for defined benefit pension schemes 490 489 580 — — — Cash contribution to defined benefit pension schemes (810) (599) (536) — — — Elimination of non-cash items on discontinued activities 592 62 — — — — Elimination of foreign exchange differences (41,874) (10,282) 4,516 1,778 (58) (22)
Net cash (outflow)/inflow from trading activities (31,579) (215) 15,690 6,103 2,785 4,002 Changes in operating assets and liabilities (42,219) 28,261 3,980 (22,254) 15,562 (508) Net cash flows from operating activities before tax (73,798) 28,046 19,670 (16,151) 18,347 3,494
Placing and open offer 19,741 — — 19,741 — — Rights issue 12,000 — — 12,000 — — Issue of other equity interests — 3,600 671 3,600 671 Issue of paid up equity — 1,073 — — 1,073 — Issue of subordinated liabilities 2,413 1,018 3,027 — — 399 Proceeds of minority interests issued 1,427 31,095 1,354 — — — Redemption of minority interests (13,579) (545) (81) — — — Repurchase of ordinary shares — — (991) — — (991) Shares purchased by employee trusts (64) (65) (254) — — — Shares issued under employee share schemes 2 79 108 — — 7
The accompanying notes on pages 189 to 266, the accounting policies on pages 178 to 188 and the audited sections of ‘The Business Review: Risk, Capital and Liquidity Management’ on pages 78 to 144 form an integral part of these financial statements.
RBS Group Annual Report and Accounts 2008178 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 Group’s financial statements are prepared in accordance with IFRS 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.
The Group has reclassified certain loans and debt securities out of the held-for-trading and available-for-sale categories into the loans and receivables category. It has also reclassified certain debt securities out of the held-for-trading category into the available-for-sale category. The balance sheet values of these assets, the effect of the reclassification on the income statement and the impairment losses relating to these assets are shown in Note 11 Financial instruments on page 208.
The 2007 comparative amounts have been restated for the netting of certain derivative asset and derivative liability balances with the London Clearing House as described in Note 13; the finalisation of the ABN AMRO acquisition accounting as set out in Note 34; and for the classification of Banco Real as a discontinued operation as described in Note 20.
The Group is not required to include reconciliations of shareholders’ equity and net income under IFRS and US GAAP in its filings with the Securities and Exchange Commission in the US.
2. Basis of consolidation The consolidated financial statements incorporate the financial statements of the company and entities (including certain special purpose entities) that continue to be 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.
3. Revenue recognition Interest income on financial assets that are classified as loans and receivables, available-for-sale or held-to-maturity and interest expense on financial liabilities other than those at fair value through profit or loss are determined using the effective interest method. The effective interest method is a method of calculating the amortised cost of a financial asset or financial liability (or group of financial assets or liabilities) and of allocating the interest income or interest expense over the expected life of the asset or liability. The effective interest rate is the rate that exactly discounts estimated future cash flows to the instrument’s initial carrying amount. Calculation of the effective interest rate takes into account fees payable or receivable, that are an integral part of the instrument’s yield, premiums or discounts on acquisition or issue, early redemption fees and transaction costs. All contractual terms of a financial instrument are considered when estimating future cash flows.
Payment services: this comprises income received for payment services including cheques cashed, direct debits, Clearing House Automated Payments (the UK electronic settlement system) and CHAPs payments (the automated clearing house that processes direct debits and direct credits). These are generally charged on a per transaction basis. The income is earned when the payment or transaction occurs. Charges for payment services are usually debited to the customer’s account monthly or quarterly in arrears. Accruals are raised for services provided but not charged at period end.
Insurance brokerage: this is made up of fees and commissions received from the agency sale of insurance. Commission on the sale of an insurance contract is earned at the inception of the policy, as the insurance has been arranged and placed. However, provision is made where commission is refundable in the event of policy cancellation in line with estimated cancellations.
4. Assets held for sale and discontinued operations A non-current asset (or disposal group) is classified as held for sale if the Group will recover the carrying amount principally through a sale transaction rather than through continuing use. A non-current asset (or disposal group) classified as held for sale is measured at the lower of its carrying amount and fair value less costs to sell. If the asset (or disposal group) is acquired as part of a business combination it is initially measured at fair value less costs to sell. Assets and liabilities of disposal groups classified as held for sale and non-current assets classified as held for sale are shown separately on the face of the balance sheet.
5. Pensions and other post-retirement benefits The Group provides post-retirement benefits in the form of pensions and healthcare plans to eligible employees.
7. Property, plant and equipment Items of property, plant and equipment are stated at cost less accumulated depreciation and impairment losses. Where an item of property, plant and equipment comprises major components having different useful lives, they are accounted for separately. 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.
Depreciation is charged to profit or loss on a straight-line basis so as to write-off the depreciable amount of property, plant and equipment (including assets owned and let on operating leases (except investment property – see accounting policy 9)) over their estimated useful lives. The depreciable amount is the cost of an asset less its residual value. Land is not depreciated. Estimated useful lives are as follows: Freehold and long leasehold buildings 50 years Short leaseholds unexpired period of the lease Property adaptation costs 10 to 15 years Computer equipment up to 5 years Other equipment 4 to 15 years
9. 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.
10. Foreign currencies The Group’s consolidated financial statements are presented in sterling which is the functional currency of the company.
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 are recognised directly in equity and included in profit or loss on its disposal.
RBS Group Annual Report and Accounts 2008182 14. Taxation Provision is made for taxation at current enacted rates on taxable profits, arising in income or in equity, taking into account relief for overseas taxation where appropriate. Deferred taxation is accounted for in full for all temporary differences between the carrying amount of an asset or liability for accounting purposes and its carrying amount for tax purposes, except in relation to overseas earnings where remittance is controlled by the Group, and goodwill.
Held-for-trading – a financial asset is classified as held-for-trading if it is acquired principally for sale 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.
Loans and receivables – non-derivative financial assets with fixed or determinable repayments that are not quoted in an active market are classified as loans and receivables, except those that are classified as available-for-sale or as held-for-trading, or designated as at fair value through profit or loss. Loans and receivables are initially recognised at fair value plus directly related transaction costs. They are subsequently measured at amortised cost using the effective interest method (see accounting policy 3) less any impairment losses.
Available-for-sale – financial assets that are not classified as held-tomaturity; held-for-trading; designated as at fair value through profit or loss; or loans and receivables, are classified as available-for-sale. Financial assets can be designated as available-for-sale on initial recognition. Available-for-sale financial assets are initially recognised at fair value plus directly related transaction costs. They are subsequently measured at fair value. Unquoted equity investments whose fair value cannot be measured reliably are carried at cost and classified as available-for-sale financial assets. Impairment losses and exchange differences resulting from retranslating the amortised cost of foreign currency monetary available-for-sale financial assets are recognised in profit or loss together with interest calculated using the effective interest method (see accounting policy 3). Other changes in the fair value of available-for-sale financial assets are reported in a separate component of shareholders’ equity until disposal, when the cumulative gain or loss is recognised in profit or loss.
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 held-tomaturity 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.
Financial assets carried at fair value – when a decline in the fair value of a financial asset classified as available-for-sale has been recognised directly in equity and there is objective evidence that the asset is impaired, the cumulative loss is removed from equity and recognised in profit or loss. The loss is measured as the difference between the amortised cost of the financial asset and its current fair value. Impairment losses on available-for-sale equity instruments are not reversed through profit or loss, but those on available-for-sale debt instruments are reversed, if there is an increase in fair value that is objectively related to a subsequent event.
17. Financial liabilities On initial recognition financial liabilities are classified into held-fortrading; designated as at fair value through profit or loss; or amortised cost.
All other financial liabilities are measured at amortised cost using the effective interest method (see accounting policy 3).
RBS Group Annual Report and Accounts 2008184 18. Loan commitments Provision is made for loan commitments, other than those classified as held-for-trading, if it is probable that the facility will be drawn and the resulting loan will be recognised at a value less than the cash advanced. Syndicated loan commitments in excess of the level of lending under the commitment approved for retention by the Group are classified as held-for-trading and measured at fair value.
20. Sale and repurchase transactions Securities subject to a sale and repurchase agreement under which substantially all the risks and rewards of ownership are retained by the Group continue to be shown on the balance sheet and the sale proceeds recorded as a deposit. Securities acquired in a reverse sale and repurchase transaction under which the Group is not exposed to substantially all the risks and rewards of ownership are not recognised on the balance sheet and the consideration is recorded in Loans and advances to banks or Loans and advances to customers as appropriate.
Securities borrowing and lending transactions are usually secured by cash or securities advanced by the borrower. Borrowed securities are not recognised on the balance sheet or lent securities derecognised. Cash collateral received or given is treated as a loan or deposit; collateral in the form of securities is not recognised. However, where securities borrowed are transferred to third parties, a liability for the obligation to return the securities to the stock lending counterparty is recorded.
22. Capital instruments The Group classifies a financial instrument that it issues as a financial asset, financial liability or an equity instrument in accordance with the substance of the contractual arrangement. An instrument is classified as a liability if it is a contractual obligation to deliver cash or another financial asset, or to exchange financial assets or financial liabilities on potentially unfavourable terms. An instrument is classified as equity if it evidences a residual interest in the assets of the Group after the deduction of liabilities. The components of a compound financial instrument issued by the Group are classified and accounted for separately as financial assets, financial liabilities or equity as appropriate.
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 transaction is no longer expected to occur), the cumulative unrealised gain or loss recognised in equity is recognised in profit or loss when the hedged cash flow occurs or, if the forecast transaction results in the recognition of a financial asset or financial liability, in the same periods during which the asset or liability affects profit or loss. Where a forecast transaction is no longer expected to occur, the cumulative unrealised gain or loss is recognised in profit or loss immediately.
25. 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 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 4 on the accounts. The assets of the schemes are measured at their fair value at the balance sheet date. Scheme liabilities are measured using the projected unit method, which takes account of projected earnings increases, using actuarial assumptions that give the best estimate of the future cash flows that will arise under the scheme liabilities. These cash flows are discounted at the interest rate applicable to high-quality corporate bonds of the same currency and term as the liabilities. Any recognisable surplus or deficit of scheme assets over liabilities is recognised in the balance sheet as an asset (surplus) or liability (deficit). In determining the value of scheme liabilities, assumptions are made as to price inflation, dividend growth, pension increases, earnings growth and employees. There is a range of assumptions that could be adopted in valuing the schemes’ liabilities. Different assumptions could significantly alter the amount of the surplus or deficit recognised in the balance sheet and the pension cost charged to the income statement. The assumptions adopted for the Group’s pension schemes are set out in Note 4 on the accounts together with the sensitivity of reported amounts to changes in those assumptions. A pension asset of £36 million and a liability of £2,032 million were recognised in the balance sheet at 31 December 2008 (2007 asset – £575 million; liability – £460 million).
Financial instruments measured at fair value include: Loans and advances (held-for-trading and designated as at fair value though profit or loss) – principally comprise reverse repurchase agreements (reverse repos) and syndicated loans. In repurchase agreements one party agrees to sell securities to another and simultaneously agrees to repurchase the securities at a future date for a specified price. The repurchase price is fixed at the outset, usually being the original sale price plus an amount representing interest for the period from the sale to the repurchase. Syndicated loans measured at fair value are amounts retained, from syndications where the Group was lead manager or underwriter, in excess of the Group’s intended long term participation.
Deposits by banks and customer accounts (held-for-trading and designated as at fair value though profit or loss) – deposits measured at fair value principally include repurchase agreements (repos) discussed above and investment contracts issued by the Group’s life assurance businesses.
Derivatives – these include swaps, forwards, futures and options. They may be traded on an organised exchange (exchange-traded) or overthe -counter (OTC). Holders of exchange traded derivatives are generally required to provide margin daily in the form of cash or other collateral.
General insurance claims The Group makes provision for the full cost of settling outstanding claims arising from its general insurance business at the balance sheet date, including claims estimated to have been incurred but not yet reported at that date and claims handling expenses. General insurance claims provisions amounted to £5,478 million at 31 December 2008
For the purposes of impairment testing, goodwill acquired in a business combination is allocated to each of the Group’s cash-generating units or groups of cash-generating units expected to benefit from the combination. Goodwill impairment testing involves the comparison of the carrying value of a cash-generating unit or group of cashgenerating units with its recoverable amount. The recoverable amount is the higher of the unit’s fair value and its value in use. Value in use is the present value of expected future cash flows from the cash-generating unit or group of cash-generating units. Fair value is the amount obtainable for the sale of the cash-generating unit in an arm’s length transaction between knowledgeable, willing parties.
Impairment testing inherently involves a number of judgmental areas: the preparation of cash flow forecasts for periods that are beyond the normal requirements of management reporting; the assessment of the discount rate appropriate to the business; estimation of the fair value of cash-generating units; and the valuation of the separable assets of each business whose goodwill is being reviewed. Sensitivity to changes in assumptions is discussed in Note 17 on page 220.
Deferred tax The Group makes provision for deferred tax on short-term and other temporary differences where tax recognition occurs at a different time from accounting recognition.
The IASB issued a revised IAS 1 ‘Presentation of Financial Statements’ in September 2007 effective for accounting periods beginning on or after 1 January 2009. The amendments to the presentation requirements for financial statements are not expected to have a material effect on the Group or company.
The IASB published revisions to IAS 32 ‘Financial Instruments: Presentation’ and consequential revisions to other standards in February 2008 to improve the accounting for and disclosure of puttable financial instruments. The revisions are effective for accounting periods beginning on or after 1 January 2009 but together they may be adopted earlier. They are not expected to have a material affect on the Group or the company.
The IASB issued an amendment, 'Vesting Conditions and Cancellations', to IFRS 2 'Share-based Payment' in January 2008 that will change the accounting for share awards that have non-vesting conditions. The fair value of these awards does not currently take account of the effect of non-vesting conditions and where such conditions are not subsequently met, costs recognised up to the date of cancellation are reversed. The amendment requires costs not recognised up to the date of cancellation to be recognised immediately. The amendment is effective for accounting periods beginning on or after 1 January 2009. The Group estimates that adoption will cause a restatement of 2008 results, reducing profit by £110 million with no material affect on earlier periods. There is not expected to be a material effect on the company.
Also in May 2008, the IASB issued amendments to IFRS 1 ‘First-time Adoption of International Financial Reporting Standards’ and IAS 27 ‘Consolidated and Separate Financial Statements’ that change the investor's accounting for the cost of an investment in a subsidiary, jointly controlled entity or associate. It does not affect the consolidated accounts but may prospectively affect the company’s accounting and presentation of receipts of dividends from such entities.
The IASB issued an amendment to IAS 39 in July 2008 to clarify the IFRS stance on eligible hedged items. The amendment is effective for accounting periods beginning on or after 1 January 2009 and is not expected to have a material effect on the Group or the Bank.
The IFRIC issued interpretation IFRIC 16 ‘Hedges of a Net Investment in a Foreign Operation’ in July 2008. The interpretation addresses the nature of the hedged risk and the amount of the hedged item; where in a group the hedging item could be held; and what amounts should be reclassified from equity on the disposal of a foreign operation that had been subject to hedging. The interpretation is effective for accounting periods beginning on or after 1 October 2008 and is not expected to have a material effect on the Group or company.
The IFRIC issued interpretation IFRIC 17 ‘Distributions of Non-Cash Assets to Owners’ and the IASB made consequential amendments to IFRS 5 'Non-Current Assets Held for Sale and Discontinued Operations' in December 2008. The interpretation requires distributions to be presented at fair value with any surplus or deficit to be recognised in income. The amendment to IFRS 5 extends the definition of disposal groups and discontinued operations to disposals by way of distribution. The interpretation is effective for accounting periods beginning on or after 1 July 2009, to be adopted at the same time as IFRS 3 (revised 2008), and is not expected to have a material effect on the Group or company.
Loans and advances to customers 41,812 28,568 22,195 Loans and advances to banks 2,356 1,570 843
Share of profits less losses of associated entities 69 25 36
Wages, salaries and other staff costs 8,907 6,230 5,652 Social security costs 696 471 389 Share-based compensation — 65 65 Pension costs – defined benefit schemes (see Note 4) 490 489 580 – defined contribution schemes 148 83 37
Property, plant and equipment (see Note 18) 1,584 1,297 1,293 Intangible assets (see Note 17) 1,570 635 385 Depreciation and amortisation 3,154 1,932 1,678
Staff costs 251 Premises and equipment 15 Other administrative expenses 41
Global Banking & Markets 18,700 17,600 7,600 Global Transaction Services 4,200 3,900 2,500 UK Retail & Commercial Banking 46,100 45,700 46,300 US Retail & Commercial Banking 18,700 19,000 19,800 Europe & Middle East Retail & Commercial Banking 7,900 8,700 5,700 Asia Retail & Commercial Banking 11,600 12,500 4,600
Principal actuarial assumptions at 31 December 2008 2007 2006 2008 2007 2006
Expected return on plan assets (weighted average) 7.1% 6.9% 6.9% 6.3% 6.8% 6.9% Rate of increase in salaries* 4.0% 4.5% 4.2% 3.4% 4.0% 4.1% Rate of increase in pensions in payment 2.7% 3.2% 2.9% 2.4% 2.8% 2.8%
Ordinary shares of the company with a fair value of £15 million (2007 – £69 million; 2006 – £89 million) are held by the Group’s pension schemes; £15 million (2007 – £65 million; 2006 – £87 million) in the Main scheme which also holds other financial instruments issued by the Group with a value
Longevity at age 60 for current pensioners (years): Longevity at age 60 for future pensioners (years):
Expenses included in service cost (39) (39) — (40) (40) —
Transfers to disposal groups — — — (1) (49) (48) Currency translation and other adjustments — — — 2,497 2,692 195 Income statement: Statement of recognised income and expense: Disposal of subsidiaries — — — (31) (34) (3)
Net assets of schemes in surplus (included in Prepayments, accrued income and other assets, Note 19) (36) Net liabilities of schemes in deficit 2,032
The Group expects to contribute £807 million to its defined benefit pension schemes in 2009 (Main scheme – £385 million). Of the net liabilities of schemes in deficit, £201 million (2007 – £212 million) relates to unfunded schemes.
Cumulative net actuarial losses of £717 million (2007 – £1,570 million gains; 2006 – £619 million losses) have been recognised in the statement of recognised income and expense, of which £184 million gains (2007 – £1,579 million gains; 2006 – £521 million losses) relate to the Main scheme.
Experience losses on plan liabilities (55) (256) (4) (41) (624) (65) (210) (19) (68) (631) Experience gains on plan assets (4,784) 163 552 1,556 392 (6,051) 19 587 1,661 408 Actual return on pension
The table below sets out the sensitivities of the pension cost for the year and the present value of detailed benefit obligations at the balance sheet dates to a change in the principal actuarial assumptions: Main scheme All schemes
Current taxation: Charge for the year 1,230 2,514 2,626 Over provision in respect of prior periods (254) (39) (253) Relief for overseas taxation (34) (198) (147)
Note: (1) Prior period tax adjustments principally comprise releases of tax provisions in respect of structured transactions and investment disposals, and adjustments to reflect submitted tax computations in the UK and overseas.
Notes: (1) In accordance with IAS 32, certain preference share issued by the company are included in subordinated liabilities and the related finance cost in interest payable.
Dividends received from banking subsidiary 4,639 2,330 3,502 Dividends received from other subsidiaries 163 415 229
RBS Group Annual Report and Accounts 2008196 10 Earnings per ordinary share The earnings per share are based on the following: Group £m £m £m
Earnings: (Loss)/profit attributable to ordinary shareholders (24,137) 7,303 6,202 Add back finance cost on dilutive convertible securities — 60 64 Diluted earnings attributable to ordinary shareholders (24,137) 7,363 6,266
Number of ordinary shares: Weighted average number of ordinary shares in issue during the year 16,563 11,413 11,411 Effect of dilutive share options and convertible securities — 198 208 Diluted weighted average number of ordinary shares during the year 16,563 11,611 11,619
The effect of discontinued operations on earnings per share is not material.
11 Financial instruments Classification The following tables analyse the Group’s financial assets and financial liabilities in accordance with the categories of financial instruments in IAS 39. Assets and liabilities outside the scope of IAS 39 are shown separately.
Designated as at fair Non value Other financial Held-for- through Hedging Available- Loans and (amortised Finance assets/ trading profit or loss derivatives for-sale receivables cost) leases liabilities Total 2008 £m £m £m £m £m £m £m £m £m
Intangible assets — — — — 20,049 20,049 Property, plant and equipment — — — 18,949 18,949 Deferred taxation — — — — — 7,082 7,082 Prepayments, accrued income and other assets — — — 1,326 23,076 24,402
Retirement benefit liabilities 460 460 Deferred taxation 5,400 5,400 Insurance liabilities 10,162 10,162
(2) Includes reverse repurchase agreements of £39,313 million (2007 – £142,357 million).
(3) The change in fair value of loans and advances to customers designated as at fair value through profit and loss attributable to changes in credit risk was £328 million for the year and £440 million cumulatively. The amounts for 2007 were not material.
(4) Includes treasury bills and similar securities of £31,509 million (2007 – £16,315 million) and other eligible bills of £25,028 million (2007 – £1,914 million).
(10) During 2008 the Group reclassified financial assets from the held-for-trading and available-for-sale categories into the loans and receivables category and from the held-for-trading category into the available-for-sale category (see page 208).
RBS Group Annual Report and Accounts 2008198 11 Financial instruments (continued) The following tables analyse the company’s financial assets and financial liabilities in accordance with the categories of financial instruments in IAS 39. Assets and liabilities outside the scope of IAS 39 are shown separately.
Assets Loans and advances to banks (1) — 27,031 — 27,031 Investments in Group undertakings — — 42,196 42,196
Assets Loans and advances to banks (1) — — 7,686 — 7,686 Loans and advances to customers (3) — — 307 — 307 Investments in Group undertakings — — — 43,542 43,542
Prepayments, accrued income and other assets — — — 127 127
Liabilities Deposits by banks (2) — — 5,572 — 5,572 Debt securities in issue — — 13,453 — 13,453
Notes: (1) Includes amounts due from subsidiaries of £27,031 million (2007 – £7,130 million).
Valuation of financial instruments Control environment The Group’s control environment for the determination of the fair value of financial instruments has been designed to ensure there are formalised review protocols for independent review and validation of fair values separate from those businesses entering into the transactions. This includes specific controls to ensure consistent pricing policies and procedures, incorporating disciplined price verification for both proprietary and counterparty risk trades. The Group ensures special attention is given to bespoke transactions, structured products, illiquid products, and other assets which are difficult to price.
In GBM, when models are used to value products, those models are subject to a review process which requires different levels of model documentation, testing and review, depending on the complexity of the model and the size of the Group’s exposure. A key element of the control environment over model use in GBM is a review committee which comprises of valuations experts from several functions within GBM. The committee sets the policy for model documentation, testing and review, and prioritises models with significant exposure for review by the Group’s quantitative research centre. This centre, which is independent of the trading businesses, assesses the appropriateness of the application of the model to the product, the mathematical robustness of the model, and (where appropriate), considers alternative modelling approaches.
GBM also maintains a valuation control committee that meets formally on a monthly basis to discuss and review escalated items and to consider highly complex and subjective valuation matters. The committee includes valuation specialists representing several independent review functions (including market risk, quantitative research and finance) and senior members of the Group’s front office trading businesses.
Certain financial instruments have become more difficult and subjective to value and have therefore been transferred to a centrally managed asset unit, to separate them from business as usual activities and to allow dedicated focus on the management and valuation of the exposures. The unit has a valuation committee comprising senior representatives of the trading function, risk management and GBM Global Pricing Unit which meets regularly and is responsible for monitoring, assessing and enhancing the adequacy of the valuation techniques being adopted for these instruments.
• Bond prices – quoted prices are generally available for government bonds, certain corporate securities and some mortgage-related products.
• Recovery rates / loss given default - these are used as an input to valuation models and reserves for ABS and other credit products as an indicator of severity of losses on default. Recovery rates are primarily sourced from market data providers or inferred from observable credit spreads.
In order to determine a reliable fair value, where appropriate, the Group applies valuation adjustments to the pricing information derived from the above sources. These adjustments reflect the Group’s assessment of factors that market participants would consider in setting a price, to the extent that these factors have not already been included in the information from the above sources. Furthermore, on an ongoing basis, the Group assesses the appropriateness of any model used. To the extent that the price provided by internal models does not represent the fair value of the instrument, for instance in highly stressed market conditions, the Group makes adjustments to the model valuation to calibrate to other available pricing sources. Where unobservable inputs are used, the Group may determine a range of possible valuations based upon differing and stress scenarios to determine the sensitivity associated with the valuation. When establishing the fair value of a financial instrument using a valuation technique, the Group considers certain adjustments to the modelled price which market participants would make when pricing that instrument. Such adjustments include the credit quality of the counterparty and adjustments to correct model valuations for any known limitations. In addition, the Group makes adjustments to defer income for financial instruments valued at inception where the valuation of that financial instrument materially depends on one or more unobservable model inputs.
Valuation hierarchy The table below shows the financial instruments carried at fair value by valuation method.
Available-for-sale: Liabilities Deposits by banks and customers — 144.8 0.3 145.1 — 132.0 1.4 133.4
(2) Valued using techniques based significantly on observable market data. Instruments in this category are valued using: (a) quoted prices for similar instruments or identical instruments in markets which are not considered to be active; or
(3) Instruments in this category have been valued using a valuation technique where at least one input (which could have a significant effect on the instrument’s valuation) is not based on observable market data. Where inputs can be observed from market data without undue cost and effort, the observed input is used. Otherwise, the Group determines a reasonable level for the input.
Financial instruments included within level 3 of the fair value hierarchy primarily consist of cash instruments which trade infrequently, certain syndicated and commercial mortgage loans, unlisted equity shares, certain residual interests in securitisations, super senior tranches of high grade and mezzanine collateralised debt obligations (CDOs), and other mortgage-based products and less liquid debt securities, certain structured debt securities in issue and OTC derivatives where valuation depends upon unobservable inputs such as certain credit and exotic derivatives. No gain or loss is recognised on the initial recognition of a financial instrument valued using a technique incorporating significant unobservable data.
Carrying Increase in Decrease in Valuation basis/ Main value fair value fair value
Loans and advances Proprietary model Credit spreads, indices 3.1 70 50 Debt securities: – RMBS (1) Industry standard model Prepayment rates, probability of default, loss severity and yield 0.5 40 90 – CMBS (2) Industry standard model Prepayment rates, probability of default, loss severity and yield 0.6 30 30 – CDOs Proprietary model Implied collateral valuation, defaults rates, housing prices, correlation 1.7 410 440
– CLOs (3) Industry standard simulation model Credit spreads, recovery rates, correlation 1.0 40 40
– Other Proprietary model Credit spreads 3.1 50 50 Derivatives – credit Proprietary CVA model, industry Counterparty credit risk, option models, correlation model correlation, volatility 8.0 1,030 1,200 – equity Proprietary model Volatility, correlation, dividends 0.1 — 10 – interest rate and commodity Proprietary model Volatility, correlation 2.2 130 130 Equity shares – private equity Valuation statements Fund valuations 1.1 80 160
11 Financial instruments (continued) Level 3 portfolios Level 3 loans and advances decreased by £10 billion, primarily reflecting reclassification of certain loans (leveraged finance and other corporate loans) to loans and receivables (LAR) and fair value adjustments on the remaining portfolio at the end of the year.
Debt securities in issue, categorised as level 3, were structured medium term notes and the decrease in the year primarily reflects the termination of a deal in the first half of 2008.
Debt securities in issue Proprietary model Credit spreads 4.4 170 190 Derivatives Credit derivatives Proprietary CVA model, Counterparty credit risk, industry option models, correlation model correlation, volatility 2.6 160 180 Other derivatives Proprietary model Volatility, correlation 1.4 120 120
Syndicated lending The Group’s syndicated lending activities are conducted by the syndicate business in conjunction with the various product lines covering corporate, leveraged, real estate and project finance activities. When a commitment to lend is entered into, the Group estimates the proportion of the loan that is intended to be held for trading on draw down, and the proportion it anticipates to retain on its balance sheet as a loan and receivable. Where the commitment is intended to be syndicated, the commitment to lend is fair valued through profit or loss. On drawdown, the portion of the loan expected to be syndicated is recorded at fair value as a held-for-trading asset, and the expected hold portion is measured at amortised cost less, where appropriate, impairment.
The Group values the portion of the loan expected to be syndicated held at fair value by using market observable syndication prices in the same or similar assets. Where these prices are not available, a discounted cash flow model is used. The model incorporates observable assumptions such as current interest rates and yield curves, the notional and tender amount of the loan, and counterparty credit quality where it is derived from credit default swap spreads using market indices. The model also incorporates unobservable assumptions, including expected refinancing periods, and counterparty credit quality where it is derived from the Group’s internal risk assessments. Derivatives arising from commitments to lend are measured using the same model, based on proxy notional amounts.
Debt securities Residential mortgage backed securities (RMBS) RMBS where the underlying assets are US agency-backed mortgages and there is regular trading are generally classified as level 2 in the fair value hierarchy. RMBS are also classified as level 2 when regular trading is not prevalent in the market, but similar executed trades or third-party data including indices, broker quotes and pricing services can be used to substantiate the fair value. RMBS are classified as level 3 when trading activity is not available and a model is utilised which uses significant unobservable data.
RBS Group Annual Report and Accounts 2008204 11 Financial instruments (continued) tenor and nature of the trades that have been observed. This method is most frequently used for US and UK RMBS. The RMBS of Dutch and Spanish originated mortgages guaranteed by those governments are valued using the credit spreads of the respective government debt and certain assumptions made by the Group, or based on observable prices from Bloomberg or consensus pricing services.
The weighted average of the key significant inputs utilised in valuing US level 3 RMBS positions are shown in the table below.
The fair value of securities within each class of asset changes on a broadly consistent basis in response to changes in given market factors. However, the extent of the change, and therefore the range of reasonably possible alternative assumptions, may be either more or less pronounced, depending on the particular terms and circumstances of the individual security. Through most of 2008, while default rates on sub-prime mortgages were on the rise, there was less transparency and historical data to predict future defaults on both Alt-A and prime securities. As such, the Group felt that probability of default was the least transparent input into Alt-A and prime RMBS modelled valuations throughout 2008 (and most sensitive to variations). The Group believes that a range of 500 basis points greater than and 500 basis points less than the weighted average constant default rate, and a range of 200 basis points greater than and 200 basis points less than the weighted average constant default rate represents a reasonably possible set of acceptable pricing alternatives for Alt-A and prime RMBS, respectively. These assumptions consider the inherently risky nature of Alt-A over prime securities, as well as declining economic conditions leading to an increased likelihood of default at year-end. While other key inputs may possess characteristics of unobservability in both Alt-A and prime modelled valuations, the effect of utilising reasonably possible alternatives for these respective inputs would have an immaterial effect on the overall valuation. Using these reasonably possible alternative assumptions the fair value of RMBS of £0.5 billion would be £90 million lower or £40 million higher.
Commercial mortgage backed securities CMBS is valued using an industry standard model and the inputs, where possible, are corroborated using observable market data.
For senior CMBS and subordinated tranches, the Group determined that the most sensitive input to reasonably possible alternatives valuation is probability of default and yield respectively. Using reasonably possible alternative assumptions for these inputs, the fair value of CMBS of £0.6 billion would be £30 million lower or £30 million higher.
Probability of default 3.00 CDR(1) 40.00 CDR(1) Loss severity 45.00%(2) 52.25%(2)
Due to the subjectivity of the inputs to the pricing model, alternative valuation points are constructed to benchmark the output of the model. These valuation points include determining an ABS index implied collateral valuation, which provides a market calibrated valuation data point. A collateral net asset value methodology is also considered which uses dealer buy side marks to determine an upper bound for super senior CDO valuations. Both the ABS index implied valuation and the collateral net asset value methodology apply an assumed immediate liquidation approach.
Collateralised loan obligations To determine the fair value of CLOs purchased from third parties, the Group use third-party broker or lead manager quotes as the primary pricing source. These quotes are benchmarked to consensus pricing sources where they are available.
For CLOs originated and still held by the Group, the fair value is determined using a correlation model based on a Monte Carlo simulation framework. The main model inputs are credit spreads and recovery rates of the underlying assets and their correlation. A credit curve is assigned to each underlying asset based on prices, from thirdparty dealer quotes, and cash flow profiles, sourced from an industry standard model. Losses are calculated taking into account the attachment and detachment point of the exposure. As the correlation inputs to this model are not observable CLOs are deemed to be level 3. Using reasonably possible alternative assumptions the fair value of CLOs of £1.0 billion would be £40 million lower or £40 million higher.
Derivatives are priced using quoted prices for the same or similar instruments where these are available. However, the majority of derivatives are valued using pricing models. Inputs for these models are usually observed directly in the market, or derived from observed prices. However, it is not always possible to observe or corroborate all model inputs. Unobservable inputs used are based on estimates taking into account a range of available information including historic analysis, historic traded levels, market practice, comparison to other relevant benchmark observable data and consensus pricing data.
Gap risk products are leveraged trades, with the counterparty’s potential loss capped at the amount of the initial principal invested. Gap risk is the probability that the market will move discontinuously too quickly to exit a portfolio and return the principal to the counterparty without incurring losses, should an unwind event be triggered. This optionality is embedded within these portfolio structures and is very rarely traded outright in the market. Gap risk is not observable in the markets and, as such, these structures are deemed to be level 3 instruments.
Other derivatives Exotic equity, interest rate and commodity options provide a payout (or series of payouts) linked to the performance of one or more underlying, including equities, interest rates, foreign exchange rates and commodities. Included in commodities derivatives are energy contracts entered into by RBS Sempra Commodities. Most of these contracts are valued using models that incorporate observable data. A small number are more complex, structured derivatives which incorporate in their valuation assumptions regarding power price volatilities and correlation between inputs, which are not market observable. These include certain tolling agreements, where power is purchased in return for a given quantity of fuel, and load deals, where a seller agrees to deliver a fixed proportion of power used by a client’s utility customers.
Reasonably possible alternative assumptions In determining the effect of reasonably possible alternative assumptions for unobservable inputs, the Group has considered credit derivative trades with CDPCs separately from all other level 3 derivatives due to the significant element of subjectivity in determining the counterparty credit risk.
The fair value of credit derivative trades with CDPCs as at 31 December 2008 was £4.8 billion before applying a CVA of £1.3 billion. The Group’s credit derivative exposures to CDPCs are valued using pricing models with inputs observed directly in the market. An adjustment is made to the model valuation as the creditworthiness of CDPC counterparties differs from that of the credit risk assumptions used in the model. The adjustment reflects the estimated cost of hedging the counterparty risk arising from each trade. In the absence of market observable credit spreads of CDPCs, the cost of hedging the counterparty risk is estimated from an analysis of the underlying trades and the cost of hedging expected default losses in excess of the capital available in each vehicle. A reasonably possible alternative approach would be to estimate the cost of hedging the counterparty risk from market observable credit spreads of entities considered similar to CDPCs (for example monoline insurers with similar business or similarly rated entities). These reasonably possible alternative approaches would reduce the fair value credit derivatives with CDPCs by up to £740 million or increase the fair value by up to £600 million.
For all other level 3 derivatives, unobservable inputs are principally comprised of correlations and volatilities. Where a derivative valuation relies significantly on an unobservable input, the valuation is shown in level 3. It is usual for such derivative valuations to depend on several observable, and one or few unobservable model inputs. In determining reasonably possible alternative assumptions, the relative impact of unobservable inputs as compared to those which may be observed was considered. Using reasonably possible alternative assumptions the fair value of all other level 3 derivative assets (excluding CDPCs) would be reduced by up to £600 million or increased by up to £560 million and derivative liabilities of £4.0 billion, would be reduced by up to £300 million or increased by upto £280 million.
Although such valuations are provided from third parties, the Group recognises that such valuations may rely significantly on the judgements and estimates made by those fund managers, particularly in assessing private equity components. Following the decline in liquidity in world markets, the Group believes that there is sufficient subjectivity in such valuations to report them in level 3.
Reasonably possible alternative valuations have been determined based on the historic trends in valuations received, and by considering the possible impact of market movements towards the end of the reporting period, which may not be fully reflected in valuations received. Using these reasonably possible alternate assumptions would reduce the fair value of externally managed funds of £1.1 billion by up to £160 million or increase the fair value by up to £80 million.
Held-for- fair value through trading profit and loss Total Derivatives Total £m £m £m £m £m
Effect of changes to credit spreads 376 583 959 450 1,409 Benefit of foreign exchange hedges 392 195 587 — 587
RBS Group Annual Report and Accounts 2008208 11 Financial instruments (continued) Reclassification of financial instruments As discussed in accounting policies on page 178, during 2008 the Group reclassified financial assets from the held-for-trading and available-for-sale categories into the loans and receivables category (as permitted by paragraph 50D of IAS 39 as amended) and from the heldfor -trading category into the available-for-sale category (as permitted by paragraph 50B of IAS 39 as amended).
The balance sheet values of these assets, the effect of the reclassification on the income statement for the period from the date of reclassification to 31 December 2008 and the gains and losses relating to these assets recorded in the income statement for the years ended 31 December 2008, 2007 and 2006 were as follows: 2008 – on reclassification 31 December 2008 After reclassification Gains/(losses)
Reclassified from HFT to LAR: Loans: Debt securities: Reclassified from HFT to AFS: Debt securities: Reclassified from AFS to LAR: Note: (1) Gains/(losses) recognised in the available-for-sale reserve.
Amounts included in the consolidated income statement: Group £m £m £m
(3) The fair value of deposits repayable on demand is equal to their carrying value. The fair value of other deposits by banks and customer accounts is estimated by discounting expected future cash flows at current rates and adjusting, where appropriate, for the Group’s own credit spread. The fair value of many of these instruments approximates to their carrying value because they are of short maturity or reprice frequently.
(5) The fair value of subordinated liabilities in issue is based on quoted prices; where these are unavailable fair value is estimated using other valuation techniques.
Assets Cash and balances at central banks 12,364 36 12,400 17,866 — 17,866 Loans and advances to banks 133,565 4,632 138,197 187,969 31,491 219,460 Loans and advances to customers 338,751 535,971 874,722 395,753 432,785 828,538
The following tables show the contractual undiscounted cash flows payable up to a period of twenty years including future payments of interest.
Settlement balances and other liabilities 13,351 5 12 6 10 6
Settlement balances and other liabilities 17,998 5 14 6 12 7
Company 0-3 months 3-12 months 1-3 years 3-5 years 5-10 years 10-20 years 2008 £m £m £m £m £m £m
Deposits by banks 116 5,544 — — — — Debt securities in issue 824 8,477 3,447 1,372 — — Derivatives held for hedging 52 1 — 2 — —
The tables above show the timing of cash outflows to settle financial liabilities. They have been prepared on the following basis: Financial liabilities are included at the earliest date on which the counterparty can require repayment regardless of whether or not such early repayment results in a penalty. If repayment is triggered by, or is subject to, specific criteria such as market price hurdles being reached, the liability is included at the earliest possible date that the conditions could be fulfilled without considering the probability of the conditions being met. For example, if a structured note is automatically prepaid when an equity index exceeds a certain level, the cash outflow will be included in the less than three months period whatever the level of the index at the year end. The settlement date of debt securities in issue issued by certain securitisation vehicles consolidated by the Group depends on when cash flows are received from the securitised assets. Where these assets are prepayable, the timing of the cash outflow relating to securities assumes that each asset will be prepaid at the earliest possible date.
Notes on the accounts continued 12 Past due and impaired financial assets The following table shows the movement in the provision for impairment losses for loans and advances.
Notes: (1) The provision for impairment losses at 31 December 2008 includes £127 million relating to loans and advances to banks (2007 – £3 million; 2006 – £2 million).
(2) There is no provision for impairment losses in the company.
Loans and advances to customers 6,973 1,946 1,877 Loans and advances to banks 118 — —
Impaired financial assets Loans and advances to banks (1) 129 127 2 25 3 22 Loans and advances to customers (2) 19,350 8,945 10,405 10,337 5,399 4,938
(2) Impairment provisions individually assessed on balances of £11.313 million (2007 – £3,178 million).
Loans that have been renegotiated in the past 12 months that would otherwise have been past due or impaired amounted to £2,637 million as at
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, EURIBOR or the Bank of England Official Bank Rate. The financial assets are customer loans and the financial liabilities are customer deposits and LIBOR linked medium-term notes and other issued securities. As at 31 December 2008, variable rate financial assets of £34.6 billion and variable rate financial liabilities of £56.4 billion were hedged in such cash flow hedge relationships.
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 or by comparing the respective changes in the price value of a basis point. 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.
Certain derivative asset and liability balances with the London Clearing House, which meet the offset criteria in IAS 32 ‘Financial Instruments Presentation’, are now shown net. Comparative figures have been restated, reducing derivative assets and liabilities at 31 December 2007 by £60,008 million.
Fair value hedging: (Losses)/gains on the hedged items attributable to the hedged risk (965) 81 219 Gains/(losses) on the hedging instruments 884 (87) (215)
Notional Notional amounts Assets Liabilities amounts Assets Liabilities £bn £m £m £bn £m £m
UK US Other Mortgage and central central central Bank and other asset and local and local and local building backed government government government society securities(1) Corporate Other(2) Total 2008 £m £m £m £m £m £m £m £m
UK US Other Mortgage and central central central Bank and other asset and local and local and local building backed government government government society securities(1) Corporate Other(2) Total 2007 £m £m £m £m £m £m £m £m
US central and local government 260 3 10,777 163 11,037 166 Other central and local government 17,939 3,450 39 7 17,978 3,457
(2) Includes non asset-backed securities issued by US federal agencies and government sponsored entities.
RBS Group Annual Report and Accounts 2008218 15 Equity shares Group
Cost: Currency translation and other adjustments 8,905 680 961 214 10,760 Acquisition of subsidiaries 524 — — — 524
Disposal of subsidiaries (3,066) — — (7) (3,073) Disposals and write-off of fully amortised assets — (4) (1) (21) (26)
Cost: Currency translation and other adjustments 1,187 105 177 52 1,521
Net book value at 31 December 2007 42,953 2,106 3,266 1,591 49,916
Impairment review The Group’s goodwill acquired in business combinations is reviewed annually at 30 September for impairment by comparing the recoverable amount of each cash generating unit (CGU) to which goodwill has been allocated with its carrying value. In light of the unprecedented market conditions the review has been updated to reflect the latest position as at 31 December 2008.
The Group recognised goodwill of £23.3 billion (€33.5 billion) following the preliminary allocation of fair values since acquiring ABN AMRO on 17 October 2007. On final allocation of fair values, goodwill of £23.9 billion (€34.2 billion) was recognised (see Note 34), of which £17.6 billion (€25.3 billion) was attributable to minority interests. Of the minority interests goodwill, £5.4 billion (€5.7 billion) was in respect of Santander acquired businesses which were subsequently sold during 2008. The remaining goodwill in respect of the State of the Netherlands minority interest of £18.8 billion (€19.6 billion) was reduced in part by £2.7 billion (€2.9 billion) following the sale of the Asset Management business with £14.6 billion (€15.2 billion) of the remainder subsequently impaired following the acquisition by the State of the Netherlands for £6.2 billion (€6.5 billion). In addition, a further £1.1 billion (€1.2 billion) impairment was recognised on other intangible assets attributable to the State of the Netherlands acquired businesses.
On the finalisation of the allocation of fair values, goodwill arising on the acquisition of ABN AMRO attributable to the Group has been allocated to those CGUs which are expected to benefit from the synergies of the combination based on their relative values. In addition, following the reorganisation of the Group reporting structure, NatWest and Citizens goodwill was reallocated to the appropriate CGUs.
RBS Insurance Fair value less costs to sell 1,064 Global Banking & Markets Fair value less costs to sell 2,346 UK Corporate Banking Fair value less costs to sell 1,630 Retail Fair value less costs to sell 4,278 Wealth Management Fair value less costs to sell 1,100 Citizens – Retail Banking Value in use 2,067 Citizens – Commercial Banking Value in use 2,274 Citizens – Consumer Financial Services Value in use 1,701
UK Retail and Commercial Banking was formed at the beginning of 2008 when the Group brought together the businesses that use its UK branch network. It primarily comprised the UK Retail and Corporate banks but excluded their transaction services business. The recoverable amount was equal to the carrying amount including goodwill arising from the NatWest acquisition. This is based on a 4% terminal growth rate and 15.9% pre tax risk discount rate. A 1% change in discount rate or the terminal growth rate would change the recoverable amount by over £2 billion and £1 billion respectively. In addition, a 5% change in forecast pre-tax earnings would change the recoverable amount by approximately £1 billion.
The Asia Retail and Commercial Banking business comprises much of the Group’s Wealth management business and retail operations in Asia. The outlook in the Asian economies has deteriorated and falling investment values have reduced the yield from managed portfolios. The allocated goodwill principally arising on the acquisition of ABN AMRO was impaired by £862 million based on a 5% terminal growth rate and 14% pre-tax risk discount rate. A 1% change in the discount rate or similar change in the terminal growth rate would change the recoverable amount by approximately £200 million and £100 million respectively. In addition, a 5% change in forecast pre-tax earnings would change the recoverable amount by approximately £50 million.
The goodwill allocated to RBS Insurance principally arose from the acquisition of Churchill in 2003. The recoverable amount based on a 3% terminal growth rate and 14.6% pre tax risk discount rate exceeded the carrying amount by over £3 billion, and was insensitive to reasonably possible changes in key assumptions.
Cost or valuation: Transfers to disposal groups — (262) — (188) (349) — (799) Currency translation and other adjustments 320 452 5 149 436 1,313 2,675 Acquisition of subsidiaries — — — 30 31 — 61
Accumulated impairment, depreciation and amortisation: Transfers to disposal groups — (60) — (91) (243) — (394) Currency translation and other adjustments — (9) 1 9 148 202 351
Net book value at 31 December 2007 3,431 3,254 141 1,252 1,977 8,690 18,745
Notes on the accounts continued 18 Property, plant and equipment (continued)
Valuations are carried out by management with the support of qualified surveyors who are members of the Royal Institution of Chartered Surveyors, or an equivalent overseas body. The valuation as at 31 December 2008 for a significant majority of the Group’s investment properties was undertaken by external valuers.
The fair value of investment properties includes £172 million (2007 – £234 million) of appreciation since purchase.
Freehold and long leasehold properties with a net book value of nil (2007 – £451 million; 2006 – £164 million) were sold subject to operating leases.
20 Discontinued operations and assets and liabilities of disposal groups (a) Profit/(loss) from discontinued operations, net of tax £m £m
Discontinued operations: Total income 2,571 749 Operating expenses (1,407) (493) Insurance net claims — (28) Impairment losses (564) (160) Profit before tax 600 68 Gain on disposal 3,859 — Operating profit before tax 4,459 68 Tax on profit (204) (8) Tax on gain on disposal (33) — Profit after tax 4,222 60
Businesses acquired exclusively with a view to disposal Loss after tax (251) (136) Profit/(loss) from discontinued operations, net of tax 3,971 (76)
Discontinued operations reflect the results of Banco Real sold to Santander on 24 July 2008. There were no discontinued operations during 2006.
Net cash flows from operating activities (124) (1,304) Net cash flows from investing activities (368) 4,341 Net cash flows from financing activities 339 (25) Net increase in cash and cash equivalents 287 3,172
Assets of disposal groups Disposal groups and other disposals 66 395 Assets acquired exclusively with a view to disposal 1,515 45,455
Liabilities of disposal groups Liabilities acquired exclusively with a view to disposal 859 29,228
Notes on the accounts continued 21 Settlement balances and short positions Group £m £m
– Other issuers 6,374 25,310 Equity shares 3,643 7,143 22 Accruals, deferred income and other liabilities Group Company £m £m £m £m
Currency translation and other movements 12 Charge to income statement 116 Releases to income statement (42) Provisions utilised (32)
23 Deferred taxation Provision for deferred taxation has been made as follows: Group Company £m £m £m £m
Deferred tax liability 4,165 5,400 — 3 Deferred tax asset (7,082) (3,119) (3) —
Life assurance business: Unit linked insurance contracts 260 364 Other linked insurance contracts 3,929 4,034 Other insurance contracts 309 298
Cash paid for claims settled in the year (3,969) 97 (3,872) Increase/(decrease) in liabilities – arising from current year claims 4,079 (45) 4,034 – arising from prior year claims (241) (66) (307)
Increase in the year 175 — 175 Release in the year (280) (38) (318) Net exchange differences 64 — 64
Opening net assets 604 579 Profit from existing business: Expected return 41 35 Experience variances (15) (23)
Debt securities 4,500 2,899 Equity securities 4,816 6,863 Cash and cash equivalents 81 68
The associated liabilities are: Linked contracts classified as insurance contracts 4,189 4,398 Linked contracts classified as investment contracts 5,208 5,432
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.
Estimate of ultimate claims costs: At end of accident year 2,395 3,013 3,658 3,710 4,265 4,269 4,621 4,080 30,011
Current estimate of cumulative claims 2,313 3,046 3,289 3,320 3,966 3,917 4,550 4,080 28,481
Liability in respect of prior years 91 Claims handling costs 118 Gross general insurance claims liability 5,478
Insurance claims – net of reinsurance £m £m £m £m £m £m £m £m £m
The frequency and severity of claims and the sources of uncertainty for the key classes that the Group is exposed to are as follows: Motor insurance contracts (private and commercial) Claims experience is quite variable, due to a wide range of factors, but the principal ones are age, sex and driving experience of the driver, type and nature of vehicle, use of vehicle and area.
There are many sources of uncertainty that will affect the Group’s experience under motor insurance, including operational risk, reserving risk, premium rates not matching claims inflation rates, weather, the social, economic and legislative environment and reinsurance failure risk.
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.
Lifestyle protection plan £29.30 £25.18 £28.96 Mortgage savings plan £65.92 £56.67 £65.15
Estimations (assumptions) including future mortality, morbidity, persistency and levels of expenses are made in calculating actuarial reserves. Key metrics for the UK include:
For contracts where survival is the insured risk, the most significant factor is continued improvement in medical science and social conditions that would increase longevity.
Certain preference shares issued by the company are classified as liabilities; these securities remain subject to the capital maintenance rules of the Companies Act 1985.
Company 2008 – final redemption £m £m £m £m £m £m £m
Currently 2009 2010 2011-2013 2014-2018 Thereafter Perpetual Total 2008 – call date £m £m £m £m £m £m £m £m
US$50 million floating rate subordinated notes 2013 36 26 €1,000 million floating rate subordinated notes 2013 (redeemed October 2008) — 744
CHF200 million 2.75% subordinated notes 2017 (callable December 2012) 129 89 €100 million floating rate subordinated notes 2017 97 73 €500 million floating rate subordinated notes 2017 (callable June 2012) 482 371 €750 million 4.35% subordinated notes 2017 (callable January 2017) 770 548 AUD450 million 6.5% subordinated notes 2017 (callable February 2012) 217 202 AUD450 million floating rate subordinated notes 2017 (callable February 2012) 214 199 US$1,500 million floating rate subordinated callable step up €2,000 million 6.93% subordinated notes 2018 (issued April 2008; callable April 2018) 2,136 — US$125.6 million floating rate subordinated notes 2020 87 64 €1,000 million 4.625% subordinated notes 2021 (callable September 2016) 1,019 724 €300 million CMS linked floating rate subordinated notes 2022 303 228 €144.4 million floating rate subordinated notes 2022 (issued June 2008; callable June 2022) 152 —
Charter One Financial, Inc US$400 million 6.375% subordinated notes 2012 287 212
The company US$350 million undated floating rate primary capital notes (callable on any interest payment date) (1) 240 175 US$1,200 million 7.648% perpetual regulatory tier one securities (callable September 2031) (1, 2) 831 606
First Active plc £20 million 11.75% perpetual tier two capital 26 23 €38 million 11.375% perpetual tier two capital 52 39 £1.3 million floating rate perpetual tier two capital 2 2
Series 1 US$1,000 million 9.118% (redeemable March 2010) 698 510 Non-cumulative convertible preference shares of £0.01 (1)
Cumulative preference shares of £1 £0.5 million 11% and £0.4 million 5.5% (non-redeemable) 1 1
National Westminster Bank Plc Non-cumulative preference shares of £1 Series A £140 million 9% (non-redeemable) 145 143
ABN AMRO and subsidiaries US$1,285 million 6.03% Trust Preferred V 760 464 US$200 million 6.25% Trust Preferred VI 121 82 US$1,800 million 6.08% Trust Preferred VII 1,064 762
Note: (1) The trust preferred securities issued by subsidiaries have no maturity date and are not redeemable at the option of the holders at any time. These securities may, with the consent of the UK Financial Services Authority, be redeemed, by the issuer on the dates specified above or on any interest payment date thereafter. They may also be redeemed in whole, but not in part, upon the occurrence of certain tax and regulatory events. The company classifies its obligations to these subsidiaries as dated loan capital.
ABN AMRO represents the other consortium members’ interests in RFS Holdings B.V. The capital and income rights of shares issued by RFS Holdings B.V. are linked to the net assets and income of the ABN AMRO business units which the individual consortium members have agreed to acquire. Other minority interests include trust preferred securities of £1,821 million (2007 – £1,821 million) and RBS China Sarl of £1,898 million (2007 – £2,438 million). Equity withdrawn in respect of ABN AMRO relates to distributions to consortium members.
Notes on the accounts continued 27 Share capital Allotted, called up and fully paid Authorised 1 January Issued 31 December 31 December 31 December £m £m £m £m £m
Movement in ordinary shares in issue during the year: Number of shares
In September 2008, the company issued 403 million ordinary shares of 25p each by way of a capitalisation issue. The capitalisation was on the basis of one new share for every 40 shares held by shareholders on 12 September 2008.
In December 2008, the company issued 22,910 million ordinary shares of 25p each at 65.5p per share through a placing and open offer. This placing and open offer, which was fully underwritten by HM Treasury, was made available to shareholders on 31 October 2008. The net proceeds were £14.7 billion.
Total consideration, including the rights issue and placing and open offer identified above, of £27.3 billion was received on the issue of ordinary shares for cash.
On 16 January 2009, further options were granted over 1,176.1 million ordinary shares under the company’s sharesave scheme.
The employee share trusts incurred costs of £0.3 million in purchasing the company’s ordinary shares.
Preference shares In December 2008, the company issued 5 million Series 2 noncumulative preference shares of £1 at £1,000 each, the net proceeds being £5 billion.
In the event that the non-cumulative convertible preference shares are not redeemed on or before the redemption date, the holder may convert them into ordinary shares in the company.
The series 2 non-cumulative preference shares of £1 each were issued to HM Treasury. The company, subject to shareholder approval, intends to issue new ordinary shares by way of an open offer, the proceeds will be used to repay the preference shares, issued to HM Treasury, together with the accrued dividend.
Class of preference share in issue rate or after per share equity(1)
Ordinary shares issued in respect of capitalisation issue (101) — — (101) — — Expenses of placing and open offer (265) — — (265) — —
Bonus issue of ordinary shares — (1,576) — — (1,576) — Redemption of preference shares classified as debt — 159 271 — 159 271 Shares repurchased — — (381) — — (381)
Placing and open offer 14,273 — — 14,273 — — Transfer to retained earnings (14,273) — — (14,273) — —
Amount recognised in equity during the year (603) (460) (109) — — — Amount transferred from equity to earnings in the year (1) 198 (138) (140) 2 3 3
Retranslation of net assets 11,970 1,339 (2,159) — — — Foreign currency (losses)/gains on hedges of net assets (2) (5,801) (963) 818 — — —
Shares repurchased during the year — — 13 — — 13
(2) The hedging instruments in the majority of the Group’s net investment hedges are foreign currency borrowings, the effectiveness of these hedges is assessed prospectively (and on an ongoing basis) by comparing expected (actual) changes in the fair value of the currency net investments in foreign operations and expected (actual) changes in the fair value of the external currency liabilities (excluding accrued interest) attributable to changes in the spot exchange rate between the currency of the investment and sterling.
Paid-in equity dividends paid, net of tax (60) — — (60) — — Shares repurchased during the year — — (624) — — (624) Redemption of preference shares classified as debt — (159) (271) — (159) (271) Transfer from merger reserve 14,273 — — 14,273 — — Actuarial (losses)/gains recognised in retirement benefit schemes, net of tax (1,335) 1,517 1,262 — — —
Net cost of shares bought and used to satisfy share-based payments (19) (40) (38) — — Share-based payments, net of tax — 8 80 — — —
Paid-in equity represents notes issued under the company’s euro medium term note programme with par value of US$1,600 million and CAD600 million that are classified as equity under IFRS. The notes attract coupons of 6.99% and 6.666% respectively until October 2017 when they change to 2.67% above the London interbank offered rate for 3-month US dollar deposits and 2.76% above the Canadian dollar offered rate respectively.
Under the arrangements for the placing and open offer in December 2008, the company issued shares in exchange for shares in Encuentro Limited. No share premium was recorded in the company financial statements through the operation of the merger relief provisions of the Companies Act 1985. The subsequent redemption of these shares gave rise to distributable profits of £14,273 million which have been transferred from merger reserve to retained earnings.
Finance lease assets: Present value amounts receivable 848 3,980 9,132 13,960
Operating lease assets: Future minimum lease receivables 918 2,479 1,141 4,538
Amounts recognised as income and expense Finance lease receivables – contingent rental income (37) (23) Operating lease payables – minimum payments 566 322
Residual value exposures The tables below give details of the unguaranteed residual values included in the carrying value of finance lease receivables (see page 209) and operating lease assets (see page 223).
After 1 year After 2 years Within 1 but within but within After 5 year 2 years 5 years years Total 2008 £m £m £m £m £m
Under standard terms for repurchase transactions in the UK and US markets, the recipient of collateral has an unrestricted right to sell or repledge it, subject to returning equivalent securities on settlement of the transaction.
The fair value (and carrying value) of securities transferred under repurchase transactions included within debt securities on the balance sheet were £80,576 million (2007 – £107,651 million). All of these securities could be sold or repledged by the holder. Securities received as collateral under reverse repurchase agreements amounted to £89.3 billion (2007 – £373.7 billion), of which £49.0 billion (2007 – £337.8 billion) had been resold or repledged as collateral for the Group’s own transactions.
Loans and advances to banks 13 753 Loans and advances to customers 118,933 80,719 Debt securities 15,490 29,709 Property, plant and equipment — 935
Tier 2: Reserves arising on revaluation of property and unrealised gains on available-for-sale equities 984 3,321 Collective impairment allowances 666 2,582 Perpetual subordinated debt 9,829 9,042 Term subordinated debt 23,162 18,639 Minority and other interests in Tier 2 capital 11 109 Tier 2 deductions (2,429) n/a Total Tier 2 capital 32,223 33,693
It is the Group’s policy to maintain a strong capital base, to expand it as appropriate and to utilise it efficiently throughout its activities to optimise the return to shareholders while maintaining a prudent relationship between the capital base and the underlying risks of the business. In carrying out this policy, the Group has regard to the supervisory requirements of the FSA. The FSA uses Risk Asset Ratio (RAR) as a measure of capital adequacy for UK banks, comparing a bank’s capital resources with its risk-weighted assets (the assets and off-balance sheet exposures are ‘weighted’ to reflect the inherent credit and other risks); by international agreement, the RAR should be not less than 8% with a Tier 1 component of not less than 4%. The Group has complied with the FSAs capital requirements throughout the year.
Trustee and other fiduciary activities In its capacity as trustee or other fiduciary role, the Group may hold or place assets on behalf of individuals, trusts, companies, pension schemes and others. The assets and their income are not included in the Group’s financial statements. The Group earned fee income of £1,442 million (2007 – £695 million; 2006 – £472 million) from these activities.
Contingent liabilities: Guarantees and assets pledged as collateral security 29,350 7,738 2,898 9,276 49,262 46,441
The Group has accrued £150 million for its share of FSCS management expenses levies for the 2008/9 and 2009/10 scheme years.
Investigations The Group’s businesses and financial condition can be affected by the fiscal or other policies and other actions of various governmental and regulatory authorities in the United Kingdom, the European Union, the United States and elsewhere.
There is continuing political and regulatory scrutiny of the operation of the retail banking and consumer credit industries in the United Kingdom and elsewhere. The nature and impact of future changes in policies and regulatory action are not predictable and are beyond the Group’s control but could have an adverse impact on the Group’s businesses and earnings.
European Union In the European Union, regulatory actions included an inquiry into retail banking in all of the then 25 member states by the European Commission’s Directorate General for Competition. The inquiry examined retail banking in Europe generally. On 31 January 2007, the European Commission announced that barriers to competition in certain areas of retail banking, payment cards and payment systems in the European Union had been identified. The European Commission indicated that it will consider using its powers to address these barriers and will encourage national competition authorities to enforce European and national competition laws where appropriate.
United Kingdom In the United Kingdom, in September 2005, the Office of Fair Trading (OFT) received a super-complaint from the Citizens Advice Bureau relating to payment protection insurance (PPI). As a result, the OFT commenced a market study on PPI in April 2006. In October 2006, the OFT announced the outcome of the market study and, on 7 February 2007, following a period of consultation, the OFT referred the PPI market to the Competition Commission (CC) for an in-depth inquiry. The CC published its final report on 29 January 2009. It found a lack of competition in the PPI market as a result of various factors, including a lack of transparency and barriers to entry for standalone providers. The CC will therefore impose by Order a range of remedies, including a prohibition on actively selling PPI at point of sale of the credit product (and for 7 days thereafter), a ban on single premium policies and other measures to increase transparency (in order to improve customers’ ability to search and improve price competition). The deadline for implementation will be 2010.
United States In July 2004, ABN AMRO signed a written agreement with the US regulatory authorities concerning ABN AMRO’s dollar clearing activities in the New York branch. In addition, in December 2005, ABN AMRO agreed to a Cease and Desist Order with the Dutch Central Bank and various US federal and state regulators. This involved an agreement to pay an aggregate civil penalty of US$75 million and a voluntary endowment of US$5 million in connection with deficiencies in the US dollar clearing operations at ABN AMRO’s New York branch and OFAC compliance procedures regarding transactions originating at its Dubai branch. ABN AMRO and members of ABN AMRO’s management continue to provide information to law enforcement authorities in connection with ongoing criminal investigations relating to ABN AMRO’s dollar clearing activities, OFAC compliance procedures and other Bank Secrecy Act compliance matters. The Cease and Desist Order with the Dutch Central Bank was lifted on 26 July 2007 and the Cease and Desist Order agreed with the US authorities was lifted on 9 September 2008. Although no written agreement has yet been reached and negotiations are ongoing, ABN AMRO has reached an agreement in principle with the US Department of Justice that would resolve all presently known aspects of the ongoing investigation. Under the terms of the agreement in principle, ABN AMRO and the United States would enter into a deferred prosecution agreement in which ABN AMRO would waive indictment and agree to the filing of information in the United States District Court charging it with certain violations of federal law based on information disclosed in an agreed factual statement. ABN AMRO would also agree to continue co-operating in the United States’ ongoing investigation and to settle all known civil and criminal claims currently held by the United States for the sum of US$500 million. The precise terms of the deferred prosecution agreement are still under negotiation.
These compliance issues and the related sanctions and investigations have had, and will continue to have, an impact on ABN AMRO’s operations in the United States, including limitations on expansion. ABN AMRO is actively exploring all possible options to resolve these issues. The ultimate resolution of these compliance issues and related investigations and the nature and severity of possible additional sanctions cannot be predicted.
On 27 July 2007, the OFT issued proceedings in a test case against the banks which was intended to determine certain preliminary issues concerning the legal status and enforceability of contractual terms relating to the Charges. Because of the test case, most existing and new claims in the County Courts are currently stayed, the FSA temporarily waived the customer complaints-handling process and there is a standstill of Financial Ombudsman Service decisions.
Notes on the accounts continuedNotes on the accounts continued 32 Memorandum items (continued)
High Court judgments on further preliminary issues were handed down in October 2008 and January 2009. These judgments primarily addressed the question of whether certain Historic Terms were capable of being unenforceable penalties. The Judge decided that all of the Royal Bank’s and most of NatWest’s Historic Terms were not penalties, but that a term contained in a set of NatWest 2001 terms and conditions was a contractual prohibition against using a card to obtain an unarranged overdraft. The Judge did not decide whether any charge payable upon a breach of this prohibition was a penalty. The Group has not appealed that decision.
The company and a number of its subsidiaries and certain individual officers and directors have been named as defendants in a number of class action complaints filed in the United States District Court for the Southern District of New York. The complaints allege that public filings in connection with the issuance of non-cumulative dollar preference shares, ADS, including Series Q, Series R, Series S and Series T, contained false and misleading statements, and variously assert claims under Sections 11, 12 and 15 of the Securities Act 1933, Section 10 of the Securities Exchange Act of 1934 and SEC Rule 10b-5. Plaintiffs seek unquantified damages on behalf of purchasers of these shares. The proceedings are in their initial stages. The Group considers that it has substantial and credible legal and factual defences to these claims and will defend them vigorously. The Group is unable reliably to estimate the liability, if any, that might arise or its effect on the Group’s consolidated net assets, operating results or cash flows in any particular period.
Increase/(decrease) in accruals and deferred income 3,961 (818) 515 7 — (27) Provisions for impairment losses 8,072 1,968 1,877 — — — Loans and advances written-off net of recoveries (2,829) (1,669) (1,626) — — — Unwind of discount on impairment losses (194) (164) (142) — — — Profit on sale of property, plant and equipment (167) (741) (216) — — — Profit on sale of subsidiaries and associates (943) (67) (44) (487) — — Profit on sale of securities (342) (544) (369) — — — Charge for defined benefit pension schemes 490 489 580 — — — Cash contribution to defined benefit pension schemes (810) (599) (536) — — — Other provisions utilised (32) (211) (42) — — — Depreciation and amortisation 3,154 1,932 1,678 — — — Write down of goodwill and other intangible assets 32,581 — — — — — Write down of investment in subsidiaries — — — 14,321 — — Elimination of foreign exchange differences (41,874) (10,282) 4,516 1,778 (58) (22) Elimination of non-cash items on discontinued activities 592 62 — — — —
Net cash (outflow)/inflow from trading activities (31,579) (215) 15,690 6,103 2,785 4,002 (Increase)/decrease in loans and advances to banks and customers (5,469) (90,829) (44,525) (15,542) (8) 346 Decrease/(increase) in securities 75,964 (26,167) (16,703) — — — (Increase)/decrease in other assets (5,845) (384) 671 (73) — 2 (Increase)/decrease in derivative assets (708,607) (88,948) (18,616) (995) (173) 55
(Decrease)/increase in deposits by banks and customers (78,166) 81,645 63,091 (4,064) 4,677 (164) (Decrease)/increase in insurance liabilities (186) 2,706 244 — — — Increase/(decrease) in debt securities in issue 27,222 59,735 (4,457) (1,794) 10,936 (803) (Decrease)/increase in other liabilities (8,869) (1,036) 935 32 (7) 14
Amendments Pre-acquisition Provisional to provisional Recognised carrying Disposal fair value fair value acquisition amounts groups(1) adjustments (2) adjustments values(2)
Cash and balances at central banks 7,263 (186) — — 7,077 Loans and advances to banks 120,120 (3,646) — — 116,474 Loans and advances to customers 314,287 (26,158) (1,843) (699) 285,587 Treasury and other eligible bills and debt and equity securities 166,018 (3,804) — — 162,214
Notes: (1) Banca Antonveneta SpA. and ABN AMRO’s asset management business were identified as disposal groups on the acquisition of ABN AMRO and sold during 2008. In addition, under the terms of the Consortium and Shareholders’ Agreement, consortium members other than the Group agreed to acquire, in due course, various ABN AMRO businesses including operations in Brazil (sold 1 July 2008), the commercial and retail businesses in the Netherlands, the private clients business and Interbanca.
(2) The initial accounting for the acquisition was determined provisionally at 31 December 2007 because of its complexity and the limited time available between the acquisition and the preparation of the 2007 financial statements. The principal adjustments, excluding reclassifications, on finalising fair values were: (a) The Group’s methodology for calculating the fair value of trading financial instruments produced values lower by £524 million than those recorded by ABN AMRO; (b) Following further work on identifying intangible assets, additional customer relationship assets and core deposit intangibles of £724 million have been recognised; (c) Net assets of the Netherlands pension scheme have been reduced by £250 million.
(d) The fair value of private equity investments was reduced by £98 million based on additional evidence provided by disposals in 2008; (e) The liability for instruments issued by conduits should be increased by £366 million; No material change was required to the deferred tax effect of fair value adjustments.
It is estimated that the Group would have reported total income of £37.2 billion and profit after tax of £7.7 billion from continuing operations for the year ended 31 December 2007 had all acquisitions occurred on 1 January 2007. These results would not have been materially affected by the finalisation of fair values.
The Group’s reported result from continuing operations for the year would not have been materially affected had all acquisitions occurred on 1 January 2008. The profit on disposal arises on the sales of Angel Trains, Tesco Personal Finance and the European Consumer Finance business during the year.
Acquisition of subsidiaries — 60,098 — — — — Disposal of subsidiaries (3,171) — — — — —
Comprising: Cash and balances at central banks 12,007 17,428 5,752 — — — Treasury bills and debt securities 15,623 6,818 1,596 — — — Loans and advances to banks 107,295 124,709 64,303 5,069 1,573 657
Certain subsidiary undertakings are required to maintain balances with the Bank of England which, at 31 December 2008, amounted to £393 million (2007 – £439 million). Certain subsidiary undertakings are required by law to maintain reserve balances with the Federal Reserve Bank in the US. Such reserve balances were nil at 31 December 2008 (2007 – US$1 million). ABN AMRO had mandatory reserve deposits of €3 million at
GBM is a leading banking partner to major corporations and financial institutions around the world, providing an extensive range of debt and equity financing, risk management and investment services to its customers.
Citizens Financial Group provides financial services through the Citizens and Charter One brands.
RBS Insurance sells and underwrites retail and SME insurance over the telephone and internet, as well as through brokers and partnerships. Its brands include Direct Line, Churchill, Privilege, Green Flag and NIG. Direct Line, Churchill and Privilege sell general insurance products direct to the customer. Through its international division, RBS Insurance sells general insurance, mainly motor, in Spain, Germany and Italy. The Intermediary and Broker division sells general insurance products through independent brokers.
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 resources and Group-wide regulatory projects and provides services to the operating divisions.
Share of shared assets comprises the Group’s share of the unallocated assets of ABN AMRO.
Notes on the accounts continuedNotes on the accounts continued 38 Segmental analysis (continued) Group
Amortisation of intangibles — — — — (443) — (443) Integration and restructuring costs — — — (1,321) (36) — (1,357) Goodwill and other intangibles write-downs — — — (32,581) — — (32,581)
– Europe & Middle East Retail & Commercial Banking 958 388 1,346 (453) (6) (118) 769
Global Markets – Global Banking & Markets 17,100 9,076 – Global Transaction Services 1,202 567 Regional Markets – UK Retail & Commercial Banking 9,928 8,696 – US Retail & Commercial Banking 10,035 10,865 – Europe & Middle East Retail & Commercial Banking 1,894 1,652 – Asia Retail & Commercial Banking 396 149 RBS Insurance 3,048 2,646 Group Manufacturing 257 149 Central Items 15,019 19,238
Note: (1) Segmental results for 2007 have been restated to reflect transfers of businesses between segments in 2008.
Middle East Asia RFS Global Global UK Retail & US Retail & Retail & Retail & Holdings
Banking & Transaction Commercial Commercial Commercial Commercial RBS minority Markets Services Banking Banking Banking Banking Insurance interest Total £m £m £m £m £m £m £m £m £m
Currency translation and other adjustments 227 24 — (103) 48 34 — 957 1,187
Transfers to disposal groups — — — — — — — (3,692) (3,692) Currency translation and other adjustments 1,475 678 (2) 2,013 173 225 7 4,336 8,905
(b) Geographical segments The geographical analyses in the tables below have been compiled on the basis of location of office where the transactions are recorded.
Rest of minority UK USA Europe the World Total interest Group 2008 £m £m £m £m £m £m £m
Insurance premium income (net of reinsurers’ share) 5,190 — 1,136 — 6,326 617 5,709
Operating (loss)/profit before tax (7,989) (5,809) (26,883) 14 (40,667) (15,629) (25,038)
Insurance premium income (net of reinsurers’ share) 5,562 — 525 — 6,087 106 5,981
Non-executive directors – emoluments 1,408 1,081 Chairman and executive directors – emoluments 7,132 16,461
The executive directors may also participate in the company’s executive share option and sharesave schemes and details of their interests in the company’s shares arising from their participation are given on page 165. Details of the remuneration received by each director during the year and each director’s pension arrangements are given on pages 164 to 168.
Short-term benefits 16,813 37,763 Post-employment benefits 13,174 10,051 Other long-term 496 708 Termination benefits 345 — Share-based payments 2,078 5,165
Loans and advances to customers 4,217 2,023 Customer accounts 9,572 13,309
(b) For the purposes of IAS 24 ‘Related Party Disclosures’, key management comprise directors of the company and members of the Group Executive Management Committee. The captions in the Group’s primary financial statements include the following amounts attributable, in aggregate, to key management: 41 Related parties (a) In their roles as providers of finance, Group companies provide development and other types of capital support to businesses. These investments are made in the normal course of business and on arm’s-length terms. In some instances, the investment may extend to ownership or control over 20% or more of the voting rights of the investee company. However, these investments are not considered to give rise to transactions of a materiality requiring disclosure under IAS 24.
As at 31 December 2008 balances with the UK Government and UK Government controlled bodies were: Central Banks, financial government corporations
Assets Balances at central banks 393 — — 393 Loans and advances to banks — — 1,081 1,081 Loans and advances to customers 5 721 468 1,194
Notes on the accounts continuedNotes on the accounts continued 41 Related parties (continued)
The Group participates in a number of schemes operated by the Bank of England and the UK Government and made available to eligible banks and building societies.
As at 31 December 2008, the Group’s utilisation of these facilities amounted to £41.8 billion.
As at 31 December 2008, the Group had obtained funding from the Bank of England and issued debt guaranteed by the government totalling £32.2 billion.
Additional information 268 Financial summary 268 Amounts in accordance with IFRS
(Loss)/profit attributable to: Notes: (1) Includes gain on sale of strategic investment of £333 million in 2005.
(3) Includes integration expenditure of £1,050 million in 2008 (2007 – £108 million; 2006 – £134 million; 2005 – £458 million; 2004 – £520 million).
(6) Includes write-down of goodwill and other intangibles assets of £32,581 million in 2008.
Debt securities and equity shares 429,622 293,879 347,682 146,246 135,804 104,741
Derivatives, settlement balances and short positions (2) 1,499,385 1,025,641 363,073 152,988 128,228 43,577
Notes: (1) 2007 comparative data have been restated following finalisation of the ABN AMRO acquisition accounting.
The dollar financial information included below has been converted from sterling at a rate of £1.00 to US$1.4619, being the Noon Buying Rate on
Other financial data based upon IFRS 2008 2007 2006 2005 2004
Earnings per ordinary share – pence (145.7) 64.0 54.4 47.3 43.9 Diluted earnings per ordinary share – pence (1) (145.7) 63.4 53.9 47.0 43.5 Adjusted earnings per ordinary share – pence (12.9) 63.3 55.8 49.1 47.5 Dividends per ordinary share – pence 19.3 27.0 21.6 17.0 14.7
Notes: (1) None of the convertible preference shares had a dilutive effect in 2008. All the convertible preference shares had a dilutive effect in 2007, 2006 and 2005 and as such were included in the computation of diluted earnings per share. In 2004, $1,500 million of convertible preference shares was not included in the computation of diluted earnings per share as their effect was anti-dilutive.
Norway * * 7,768 Switzerland * * 7,262 China * * 6,574 * Less than 0.75% of Group total assets.
Service industries and business activities 25,763 13,076 19,799 58,638 53,965 43,887 40,687 30,867
Loan impairment provisions For a discussion of the factors considered in determining the amount of the provisions, see ‘Impairment’ on page 99 and ‘Critical accounting policies – Loan impairment provisions’ on pages 185 and 186.
As a % of average loans and advances to customers during the year: Total customer provisions charged to income statement 0.81% 0.34% 0.42% 0.42% 0.47%
Gross income not recognised but which would have been recognised under the original terms of non-accrual and restructured loans: Interest on non-accrual and restructured loans included in net interest income: Amounts in accordance with IFRS (continued)
IFRS require interest to be recognised on a financial asset (or a group of financial assets) after impairment at the rate of interest used to discount recoveries when measuring the impairment loss. Thus, interest on impaired financial assets is credited to profit or loss as the discount on expected recoveries unwinds. Despite this, such assets are not considered performing. All loans that have an impairment provision are classified as non-accrual. This is a change from practice in 2004 and earlier years where certain loans with provisions were classified as past due 90 days or potential problem loans (and interest accrued on them).
Held-for-trading 137,080 125,917 104,249 Designated as at fair value through profit or loss 8,054 7,505 3,922
Rest of the World 287,950 315,087 40,636 Total overseas offices 441,113 467,411 155,757
Commercial paper Outstanding at year end 78,581 78,612 12,675 Maximum outstanding at any month end during the year 111,108 81,187 14,402 Approximate average amount during the year 98,150 32,498 13,225 Approximate weighted average interest rate during the year 3.3% 4.8% 4.9% Approximate weighted average interest rate at year end 3.0% 5.5% 5.0%
Other short term borrowings Outstanding at year end 194,346 280,526 122,576 Maximum outstanding at any month end during the year 395,132 312,557 130,867 Approximate average amount during the year 299,513 188,326 112,008 Approximate weighted average interest rate during the year 3.2% 4.6% 4.5% Approximate weighted average interest rate at year end 2.5% 4.1% 4.5%
Average interest rates during the year are computed by dividing total interest expense by the average amount borrowed. Average interest rates at year end are average rates for a single day and as such may reflect one-day market distortions which may not be indicative of generally prevailing rates. Original maturities of commercial paper are not in excess of one year. ‘Other short-term borrowings’ consist principally of borrowings in the money markets included within ‘Deposits by banks’ and ‘Customer accounts’ in the financial statements, and generally have original maturities of one year or less.
Over 3 months Over 6 months Within but within but within Over 2008 3 months 6 months 12 months 12 months Total £m £m £m £m £m
Contractual obligations to purchase goods or services 237 892 486 208 303 1
Average rate for the period (1) 1.8424 2.0073 1.8582 1.8147 1.8356
Economic and monetary environment The world economy entered its most difficult period in a generation in the second half of 2008. The failure of a large financial institution in September coincided with the near-seizure of already fragile interbank funding markets. Heightened risk aversion among investors led to unprecedented volatility across global financial markets including equities, fixed income and foreign exchange. Many asset prices tumbled, with global real estate and equity markets the worst hit, while a ‘flight to quality’ prompted an historic rally in government bond markets that pushed long-term risk free interest rates towards all time lows in many developed economies.
The pronounced increase in commodity prices in the first half of 2008, together with the intensifying financial crisis led to a further sharp deterioration in private sector confidence in all major economies. Private spending weakened significantly. Softer demand conditions adversely affected prospects for profitability and employment. Policymakers responded aggressively. Since September, governments have either proposed or implemented measures that include the recapitalisation of the banking sector, tax cuts and/or new infrastructure spending. Central banks provided support through rate cuts and increased liquidity provision. Despite these supportive actions, the global economy remained on a downward trajectory at the beginning of 2009, with many industrialised economies in recession.
In the UK, the Bank Rate fell from 5.5% at the beginning of 2008 to 1.0% in February 2009. The Bank of England remained cautious in the first half of 2008, lowering policy rates a modest 25bps twice. Mounting inflationary pressures were a major constraint, with the annual inflation rate climbing as high as 5.2% in September, the highest reading since the Bank of England’s operational independence in 1997, and some way above the official target of 2%. Before October, the Bank focused on liquidity measures to support the financial system. When it became clear in the final quarter of 2008 that the confidence in the wider economy had fallen to levels consistent with a deep contraction, policy became more aggressive. The government assisted the recapitalisation of the banking sector, while the Bank of England reduced rates rapidly, from 5.0% in October to 1.0% in February 2009.
However, the economy had already gathered too much negative momentum to stop an official recession – GDP declined by 2.1% in the second half of 2008, and is widely expected to fall further in 2009. One reason is lower policy rates have failed to translate effectively into looser monetary conditions for the private sector. Three-month sterling LIBOR, a key determinant of borrowing costs for households and firms, remained on average almost 100bps above the prevailing Bank Rate, well above its long-term average of 20bps. Sterling’s 17% depreciation on a trade-weighted basis did not deliver a significant offset to weakening domestic demand due to the difficult economic conditions prevailing in the UK’s main trading partners.
The US officially entered recession in December 2007 and, in spite of a fiscal stimulus in the first half of the year, activity continued to fall through 2008 and is forecast to decline markedly in 2009. The effects were acutely felt in employment, with US non-farm businesses shedding 2.6 million jobs in the twelve months to December. The dollar’s 11% depreciation in 2007 helped to boost net exports, making trade the single biggest contributor to GDP growth in 2008. However, this support was fading in early 2009, due to slumping overseas demand.
Policy in the Eurozone was on average less supportive than in the UK or the US, with the Repo Rate on hold at 4% in the first half of 2008. In July 2008, the ECB raised rates by 25bps to fend off the dangers of spiralling inflation. Official rates finally started to fall in October, when the ECB participated in a globally co-ordinated rate cut to calm investors’ fears amid intensifying strains in the global financial system. The euro’s strong appreciation against the dollar also reduced the competitiveness of the region’s exporters.
Supervision United Kingdom The UK Financial Services Authority (FSA) is the consolidated supervisor of the Group. As at 31 December 2008, 31 companies in the Group (excluding subsidiaries of ABN AMRO), spanning a range of financial services sectors (banking, insurance and investment business), were authorised to conduct financial activities regulated by the FSA.
The UK authorised banks in the Group include the Royal Bank, NatWest, Coutts & Co and Ulster Bank Limited. Wholesale activities, other than Group Treasury activities, are concentrated in the Group’s Global Markets division and are undertaken under the names of the Royal Bank and NatWest. UK retail banking activities are managed by Regional Markets, RBS UK. The exception is Ulster Bank Limited, which is run as a separate division within the Group. Ulster Bank Group will move to a single brand in the Republic of Ireland, with First Active merging with Ulster Bank. Ulster Bank Limited provides banking services in Northern Ireland while the banking service in the Republic of Ireland is provided by Ulster Bank Ireland Limited which is primarily supervised by the Irish Financial Services Regulatory Authority.
The Group’s US bank and non-bank subsidiaries and the Royal Bank’s US branches are also subject to supervision and regulation by a variety of other US regulatory agencies. RBS Citizens, NA is supervised by the Office of the Comptroller of the Currency, which is charged with the regulation and supervision of nationally chartered banks. Citizens Financial Group is under the supervision of the Federal Reserve as a bank holding company. Citizens Bank of Pennsylvania is subject to the regulation and supervision of the Pennsylvania Department of Banking and the US Federal Deposit Insurance Corporation. The Royal Bank’s New York branch is supervised by the New York State Banking Department, and its Connecticut branch is supervised by the Connecticut Department of Banking. Both branches are also subject to supervisory oversight by the Federal Reserve, through the Federal Reserve Bank of Boston.
The Group is subject to extensive regulations that impose obligations on financial institutions to maintain appropriate policies, procedures and controls to insure compliance with the rules and regulations to which they are subject, in particular to detect, prevent and report money laundering and terrorist financing and to ensure compliance with economic sanctions against designated foreign countries, nationals and others. Anti-money laundering, anti-terrorism and economic sanctions regulations have become a major focus of US government policy relating to financial institutions and are rigorously enforced by US government agencies.
Netherlands The consolidated supervisor of ABN AMRO is the Dutch Central Bank, De Nederlandsche Bank (DNB). The DNB operates as prudential supervisor of banks and insurance companies and also as part of the European System of Central Banks.
Regulatory reviews and developments The Group works with domestic and international trade associations and proactively engages with regulators and other authorities such as the Basel Committee, the Committee of European Banking Supervisors and the EU Commission in order to understand the implications of proposed regulatory change and to contribute to the development of regulatory policy.
A review by the Competition Commission and the FSA into Payment Protection Insurance is ongoing, with the Competition Commission drafting the implementation order following finalisation of its remedies.
UK regulated firms within the Group are members of the Financial Services Compensation Scheme (FSCS), which provides compensation to eligible customers of authorised financial services firms that are unable to meet their obligations. The FSCS is funded through annual levies charged to UK regulated firms. These levies are apportioned between firms on the basis of their shares of the FSCS tariff base: in the case of deposit takers, this means that levies are determined by their share of protected deposits. As a result of FSCS involvement in a number of bank failures in 2008, there will be a significant impact on levies charged to deposit takers, starting with those for 2008-09. These impacts are reflected in the accounts.
Department of Justice investigation As previously disclosed by ABN AMRO, the United States Department of Justice has been conducting a criminal investigation into ABN AMRO’s dollar clearing activities, Office of Foreign Assets Control compliance procedures and other Bank Secrecy Act compliance matters. ABN AMRO has cooperated and continues to cooperate fully with the investigation. Prior to the acquisition by the Group, ABN AMRO had reached an agreement in principle with the Department of Justice that would resolve all presently known aspects of the ongoing investigation by way of a Deferred Prosecution Agreement in return for a settlement payment by ABN AMRO of US$500 million (accrued by ABN AMRO in its interim financial statements for the six months ended 30 June 2007). Negotiations are continuing to enable a written agreement to be concluded.
The outcome of these reviews is outside the Group’s control and it is not possible to predict the effect, if any, on the Group’s operations of future regulatory actions or policy changes.
Description of property and equipment The Group operates from a number of locations worldwide, principally in the UK. At 31 December 2008, the Royal Bank and NatWest had 651 and 1,628 retail branches, respectively, in the UK. Ulster Bank and First Active had a network of 295 branches and business centres in Northern Ireland and the Republic of Ireland. Citizens had 1,606 retail banking offices (including in-store branches) covering Connecticut, Delaware, Illinois, Indiana, Massachusetts, Michigan, New Hampshire, New Jersey, New York, Ohio, Pennsylvania, Rhode Island and Vermont. A substantial majority of the UK branches are owned by the Royal Bank, NatWest and their subsidiaries or are held under leases with unexpired terms of over 50 years. The Group’s principal properties include its headquarters at Gogarburn, Edinburgh, its principal offices in London at 135 and 280 Bishopsgate and the Drummond House administration centre located at South Gyle, Edinburgh.
As at 31 December 2008, almost all of the company’s US$ denominated preference shares and American Depositary Shares representing ordinary shares were held by shareholders registered in the US. All other shares were predominantly held by shareholders registered outside the US.
Standby underwriting commitment letter On 28 May 2007, the company and Merrill Lynch International entered into a standby underwriting commitment letter, pursuant to which Merrill Lynch International undertook to underwrite one or more issues by the company of securities eligible to be treated as part of its innovative or non-innovative Tier 1 capital and/or convertible securities convertible into Ordinary Shares, the proceeds of which would be used to finance part of the cash portion of consideration payable to ABN AMRO shareholders upon settlement of the offers for shares in ABN AMRO. The aggregate amount of Merrill Lynch International’s standby underwriting commitment was €6.2 billion. Pursuant to the letter, the company agreed to pay certain fees and expenses to Merrill Lynch International in consideration for its standby commitment.
Agreement with Bank of America for the sale of LaSalle On 22 April 2007, ABN AMRO Bank and Bank of America entered into an agreement for the sale by ABN AMRO Bank to Bank of America of all of the outstanding shares of common stock of ABN AMRO North America Holding Company (ABN AMRO North America), a Delaware corporation whose subsidiaries include LaSalle. The consideration for the shares was US$21 billion, subject to a potential purchase price adjustment if ABN AMRO Bank’s estimate of the net income of ABN AMRO North America for the pre-closing period was less than a specified income threshold. The agreement also provided for approximately US$6 billion owed by ABN AMRO North America to other members of the ABN AMRO group to be converted into common stock of ABN AMRO North America. ABN AMRO Bank gave certain representations and warranties to Bank of America, including, inter alia, as to title to the shares, authority and capacity to enter into the agreement, financial statements, tax and employee benefits. The warranties given by ABN AMRO Bank were repeated on closing of the agreement. ABN AMRO Bank is liable to indemnify and hold harmless Bank of America for damages arising out of certain specified events, including breach of any covenant that survives closing.
The company also bore all costs and expenses relating to the First Placing and Open Offer and the Preference Share Issue, including (but not limited to) the fees and expenses of its professional advisers, the cost of preparation, advertising, printing and distribution of the First Placing and Open Offer prospectus and all other documents connected with the First Placing and Open Offer and the Preference Share Issue, the listing fees of the FSA, any charges by CREST and the fees of the London Stock Exchange and Euronext.
The company gave certain undertakings to HM Treasury in relation to such matters as mortgage lending, lending to SMEs and Board remuneration. These undertakings were aimed at ensuring that any state aid involved in the potential acquisition of new Shares and the company’s potential participation in the guarantee scheme to be promoted by HM Treasury as part of its support for the UK banking industry was compatible with the common market under EU law. These constraints will cease to apply when, broadly, it is determined that the company is no longer in receipt of state aid.
• to publish an annual report, for each year until 2011, on its lending to SMEs and establish transparent public reporting on both SME and mortgage lending as agreed with HM Treasury.
Sale of Bank of China investment On 14 January 2009, pursuant to (i) a placing agreement entered into between the company, RBS China Investments Sarl (a Luxembourg incorporated subsidiary of the company) and ABN AMRO Bank N.V., Hong Kong Branch, (ii) a placing agreement entered into between the company, RBS China Investments Sarl, ABN AMRO Bank N.V., Hong Kong Branch and Morgan Stanley & Co. International plc, and (iii) a share purchase agreement entered into between RBS China Investments Sarl., Primestar Resource Holdings Limited and Orientmax Capital Limited, the company (through RBS China Investments Sarl.) sold its entire 4.26 per cent. stake in Bank of China for HKD18.4 billion.
Treasury at not less than the Issue Price on the basis that the New Shares placed will be subject to clawback to the extent they are taken up under the Open Offer and (iii) HM Treasury agreed that, to the extent not placed or taken up under the Open Offer and subject to the terms and conditions set out in the Placing and Open Offer Agreement, HM Treasury will subscribe for such New Shares itself at the Issue Price.
In consideration of the provision of its services under the Second Placing and Open Offer Agreement, the company shall pay to HM Treasury (i) a commission of 0.5 per cent. of the aggregate value of the New Shares at the Issue Price per New Share payable on the earlier of Admission and the second Business Day after the day on which the Second Placing and Open Offer Agreement is terminated and (ii) a further commission of 1 per cent. of the aggregate value of the New Shares subscribed for by Placees at the Issue Price per New Share payable on the date of Admission.
• Admission becoming effective by not later than 8.00 a.m. on 15 April 2009 (or such later time and date as HM Treasury may agree).
The company also gave HM Treasury the following undertakings: • to extend the lending commitments made to HM Treasury in the First Placing and Open Offer Agreement in respect of the UK mortgage and SME lending markets. These commitments will now also apply to the company’s lending to larger commercial and industrial companies in the United Kingdom; and
The Preference Share Subscription Agreement was conditional on the First Placing and Open Offer Agreement becoming unconditional in accordance with its terms.
Annual General Meeting 3 April 2009 at 1pm Edinburgh International Conference Centre, The Exchange, Morrison Street, Edinburgh
Shareholders may also download an instruction form via our website (www.rbs.com/shareholder). Completed instruction forms must be returned to the registrar no later than 15 working days before the relevant dividend payment date.
Braille and audio Annual Review and Summary Financial Statement Shareholders requiring a Braille or audio version of the Annual Review and Summary Financial Statement should contact the Registrar on 0870
Capital gains tax For shareholders who held RBS ordinary shares at 31 March 1982, the market value of one ordinary share held was 103p. After adjusting for the following: • the 1 March 1985 rights issue; • the 1 September 1989 capitalisation issue; • the 12 July 2000 bonus issue of Additional Value Shares; • the 8 May 2007 bonus issue; • the 6 June 2008 rights issue; • the 15 September 2008 capitalisation issue; and
The information set out above is intended as a general guide only and is based on current United Kingdom legislation and HM Revenue & Customs practice as at this date. This information deals only with the position of individual shareholders who are resident in the United Kingdom for tax purposes, who are the beneficial owners of their shares and who hold their shares as an investment. It does not deal with the position of shareholders other than individual shareholders, shareholders who are resident outside the United Kingdom for tax purposes or certain types of shareholders, such as dealers in securities.
Analyses of ordinary shareholders at 31 December 2008 Number of shares
Banks and nominee companies 28,242 37,496.0 95.0 Investment trusts 179 7.0 — Insurance companies 283 7.8 —
ADSs representing ordinary shares In October 2007, the company listed ADSs, each representing one ordinary share, nominal value 25p each (or a right to receive one ordinary share), and evidenced by an ADR or uncertificated securities, on the NYSE. With effect from 7 November 2008, the ratio of one ADS representing one ordinary share changed to one ADS representing 20 ordinary shares. As of 31 December 2008, 12.9 million ADSs were outstanding. The ADSs were issued in connection with the company’s bid for the outstanding share capital of ABN AMRO Holding N.V.
Ordinary shares The following table shows, for the periods indicated, the high and low sales prices for the company’s ordinary shares on the London Stock Exchange, as derived from the Daily Official List of the UK Listing Authority and restated for the effect of the rights issue in June 2008 and the capitalisation issue in September 2008.
Subordinated Subordinated Subordinated Subordinated liabilities Equity liabilities Equity liabilities Equity liabilities Equity 2004
– Series J (redeemed November 2005) — — — — 1.06 1.15
(2) Final dividends for each year were proposed in the indicated year and paid in the following year.
In December 2008, the company issued Series 2 non-cumulative preference shares of £1 each to HM Treasury, with an attached condition that no dividend is paid to ordinary shareholders until those preference shares are no longer in issue, unless otherwise agreed by HM Treasury. The company has reached agreement with HM Treasury to replace the Series 2 non-cumulative preference shares held by HM Treasury with new ordinary shares. Following redemption, the dividend restriction on ordinary shares will be removed. However, it is currently the Board’s intention not to pay any ordinary dividends for 2009.
For further information, see Notes 7 and 8 on the accounts.
Taxation for US Holders The following discussion summarises certain US federal and UK tax consequences of the acquisition, ownership and disposition of ordinary shares, non-cumulative dollar preference shares, ADSs representing ordinary shares (ordinary ADSs), ADSs representing non-cumulative dollar preference shares (preference ADSs) or PROs by a beneficial owner that is a citizen or resident of the United States or that otherwise will be subject to US federal income tax on a net income basis in respect of the ordinary shares, non-cumulative dollar preference shares, ordinary ADSs, preference ADSs or PROs (a US Holder). This summary assumes that a US Holder is holding ordinary shares, non-cumulative dollar preference shares, ordinary ADSs, preference ADSs or PROs, as applicable, as capital assets. This summary does not address the tax consequences to a US Holder (i) that is resident (or, in the case of an individual, ordinarily resident) in the UK for UK tax purposes or (ii) generally, that is a corporation which alone or together with one or more associated companies, controls, directly or indirectly, 10% or more of the voting stock of the company.
The US Treasury has expressed concerns that parties to whom depositary receipts are released before shares are delivered to the depositary, or intermediaries, in the chain of ownership between US holders and the issuer of the security underlying the depositary receipts may be taking actions that are inconsistent with the claiming of foreign tax credits for US holders of depositary receipts. Such actions in connection with pre-release activity would also be inconsistent with the claiming of the reduced rate of US tax applicable to dividends received by certain non-corporate US holders. Accordingly, availability of the reduced tax rate for dividends received by certain non-corporate US holders of ordinary ADSs could be affected by actions taken by such parties or intermediaries.
Distributions by the company will constitute foreign source dividend income for US federal income tax purposes to the extent paid out of the current or accumulated earnings and profits of the company, as determined for US federal income tax purposes. Because the company does not maintain calculations of its earnings and profits under US federal income tax principles, it is expected that distributions will be reported to US Holders as dividends. Payments will not be eligible for the dividends-received deduction generally allowed to corporate US holders.
Dividends will be included in a US Holder’s income on the date of the US Holder’s (or in the case of ADSs, the Depositary’s) receipt of the dividend. The amount of any dividend income paid in pounds sterling or euros will be a US dollar amount calculated by reference to the relevant exchange rate in effect on the date of such receipt regardless of whether the payment is in fact converted into US dollars. If the dividend is converted into US dollars on the date of receipt, the US Holder generally should not be required to recognise foreign currency gain or loss in respect of the dividend income. If the amount of such dividend is not converted into US dollars on the date of receipt, the US Holder may have foreign currency gain or loss.
A US Holder will, upon the sale or other disposition of an ordinary share, a non-cumulative dollar preference share, an ordinary ADS or a preference ADS, or upon the redemption of a non-cumulative dollar
preference share or preference ADS, generally recognise capital gain or loss for US federal income tax purposes (assuming that in the case of a redemption of a non-cumulative dollar preference share or a preference ADS, such US Holder does not own, and is not deemed to own, any ordinary shares or ordinary ADSs of the company) in an amount equal to the difference between the amount realised (excluding in the case of a redemption any amount treated as a dividend for US federal income tax purposes, which will be taxed accordingly) and the US Holder’s tax basis in such share or ADS. This capital gain or loss will be long-term capital gain or loss if the US Holder held the share or ADS so sold, disposed or redeemed for more than one year.
If a corporate US Holder is subject to UK corporation tax by reason of carrying on a trade in the UK through a permanent establishment and its non-cumulative dollar preference share or preference ADS is, or has been, used, held or acquired for the purposes of that permanent establishment, certain provisions introduced by the Finance (No. 2) Act 2005 will apply if the US Holder holds its non-cumulative dollar preference share or preference ADS for a ‘tax avoidance purpose’. If these provisions apply, dividends on the non-cumulative dollar preference share or preference ADS, as well as certain fair value credits and debits arising in respect of such share or ADS, will be brought within the charge to UK corporation tax on income and the UK tax position outlined in the preceding paragraphs will not apply in relation to such US Holder.
Estate and gift tax Subject to the discussion of the Estate Tax Treaty in the next paragraph, ordinary shares, non-cumulative dollar preference shares, ordinary ADSs or preference ADSs beneficially owned by an individual may be subject to UK inheritance tax (subject to exemptions and reliefs) on the death of the individual or in certain circumstances, if such shares or ADSs are the subject of a gift (including a transfer at less than market value) by such individual. (Inheritance tax is not generally chargeable on gifts to individuals made more than seven years before the death of the donor). Ordinary shares, non-cumulative dollar preference shares, ordinary ADSs or preference ADSs held by the trustees of a settlement will also be subject to UK inheritance tax. Special rules apply to such settlements.
PROs United States Payments of interest on a PRO (including any UK withholding tax, as to which see below) will constitute foreign source dividend income for US federal income tax purposes to the extent paid out of the current or accumulated earnings and profits of the company, as determined for US federal income tax purposes. Payments will not be eligible for the dividends-received deduction generally allowed to corporate US holders. A US Holder who is entitled under the Treaty to a refund of UK tax, if any, withheld on a payment will not be entitled to claim a foreign tax credit with respect to such tax.
In addition, bills have been introduced in both the US House and the US Senate which would have denied the favourable tax rates described in the preceding paragraph for dividends paid in respect of certain securities, including securities such as PROs, where the issuer of the securities is allowed a deduction under the tax laws of a foreign country with respect to such dividend. The proposed legislation would have applied to dividends received after the date of its enactment. It is not possible to predict whether similar legislation might be reintroduced and enacted in the future. Non-corporate US Holders should consult their tax advisers with respect to the potential enactment of currently proposed legislation and its application in their particular circumstances.
United Kingdom Taxation of payments on the PROs Payments on the PROs will constitute interest rather than dividends for UK withholding tax purposes. However, the PROs will constitute ‘quoted eurobonds’ within the meaning of section 987 of the Income Tax Act 2007 and therefore payments of interest will not be subject to withholding or deduction for or on account of UK taxation as long as the PROs remain at all times listed on a ‘recognised stock exchange’ within the meaning of section 1005 of the Income Tax Act 2007. In all other cases, an amount must be withheld on account of UK income tax at the basic rate (currently 20%) subject to any direction to the contrary by HM Revenue & Customs under the Treaty and except that the withholding obligation is disapplied in respect of payments to persons who the company reasonably believes are within the charge to corporation tax or fall within various categories enjoying a special tax status (including charities and pension funds), or are partnerships consisting of such persons (unless HM Revenue & Customs directs otherwise). Where interest has been paid under deduction of UK withholding tax, US Holders may be able to recover the tax deducted under the Treaty.
Passive Foreign Investment Company considerations A foreign corporation will be a PFIC in any taxable year in which, after taking into account the income and assets of the corporation and certain subsidiaries pursuant to applicable ‘look-through rules’, either (i) at least 75% of its gross income is ‘passive income’ or (ii) at least 50% of the average value of its assets is attributable to assets which produce passive income or are held for the production of passive income. The company does not believe that it was as a PFIC for its 2008 taxable year. Although interest income is generally passive income, a special rule allows banks to treat their banking business income as nonpassive. To qualify for this rule, a bank must satisfy certain requirements regarding its licensing and activities. The company believes that it currently meets these requirements. The company’s possible status as a PFIC must be determined annually, however, and may be subject to change if the company fails to qualify under this special rule for any year in which a US Holder holds ordinary shares, non-cumulative dollar preference shares, ordinary ADSs, preference ADSs or PROs. If the company were to be treated as a PFIC in any year during which a US Holder holds ordinary shares, non-cumulative dollar preference shares, ordinary ADSs, preference ADSs or PROs, US Holders would generally be subject to adverse US federal income tax consequences. Holders should consult their own tax advisers as to the potential application of the PFIC rules to the ownership and disposition of the company’s ordinary shares, non-cumulative dollar preference shares, ordinary ADSs, preference ADSs or PROs.
Memorandum and Articles of Association The company’s Memorandum of Association and Articles of Association as in effect at the date of this annual report are registered with the Registrar of Companies of Scotland. The Articles of Association were last amended on 23 April 2008 and have been filed with the SEC.
Incorporation and registration The company was incorporated and registered in Scotland under the Companies Act 1948 as a limited company on 25 March 1968 under the name National and Commercial Banking Group Limited. On 10 March 1982, it changed its name to its present name and was registered under the Companies Acts 1948 to 1980 as a public company with limited liability. The company is registered under Company No. SC 45551.
Shareholder enquiries Registrar Computershare Investor Services PLC The Pavilions Bridgwater Road Bristol BS99 6ZZ
The Royal Bank of Scotland Group plc PO Box 1000 Gogarburn Edinburgh EH12 1HQ