By 1900 it had over 130 branches in Scotland and had opened its first branch in London. During the 1920s and 30s it established a significant presence in England through the acquisition of Glyn, Mills and Williams Deacon’s. By 1970, having merged with the National Commercial Bank of Scotland, it was the leading bank in Scotland, with over 700 branches.
During the 1980s RBS diversified its business, pioneering the direct distribution of motor insurance through the establishment of Direct Line in 1985, and entering US banking in 1988 with the acquisition of Citizens Bank of Rhode Island.
In the 1990s RBS re-engineered its retail banking business, removing processing activities from branches, and segmenting the Bank’s customers and associated service propositions. Over the same period RBS developed and implemented its multibrand, multiple channel strategy, launching Direct Banking in 1994, and the UK’s first comprehensive internet banking service in 1997, together with financial services operations in partnership with Virgin and Tesco in the same year.
In 2000 RBS successfully completed the £21 billion acquisition of NatWest, the biggest takeover in British banking history, creating a Group with over 20 million customers, £400 billion assets and 110,000 employees worldwide. The NatWest integration was completed successfully in February 2003, with the original targets for cost savings and revenue benefits exceeded.
In August 2005, RBS signed strategic investment and co-operation agreements with Bank of China, the second largest bank in China.
G ov er na nc e an d fin an ci al r ev ie w
Contents 02 Financial highlights 04 Chairman’s statement 06 Group Chief Executive’s review 08 Group profile 10 Divisional profile
The Group’s total income grew by 14% to £25,569 million in 2005.
Group operating profit increased by 16% to £8,251 million in 2005.
The directors have recommended a final dividend of 53.1p per ordinary share which, when added to the interim dividend of 19.4p, makes a total for 2005 of 72.5p, an increase of 25%.
The Group’s cost:income ratio, excluding acquisitions and at constant exchange rates, was 41.8%. The cost:income ratio is calculated excluding purchased intangibles amortisation, integration costs and net gain on sale of strategic investments and subsidiaries, and after netting operating lease depreciation against rental income.
The performance graph illustrates the performance of the company over the past five years in terms of total shareholder return compared with that of the companies comprising the FTSE 100 index. This index has been selected because it represents a cross-section of leading UK companies. The total shareholder return for the company and the FTSE 100 have been rebased to 100 for 2000.
Capital Our first use of additional capital is to invest in profitable business growth, and we see many opportunities to do so across the Group. Whilst having no plans for large acquisitions, we will continue to evaluate good opportunities to supplement organic growth, using strict investment criteria and leveraging our proven integration capabilities. In addition, it has always been our plan to be capital generative beyond the development needs of our businesses, and our 2005 results represent an important milestone in that ambition as we are able to return capital to shareholders in the form of an increased dividend and share buyback.
Staff profit sharing Reflecting the strong financial performance of the Group, we are delighted that our staff are once again sharing in our success with a profit share for the year at 10% of basic salaries.
I am delighted that Sir Tom McKillop agreed to join last year as our Deputy Chairman. Subject to his election, he will take over from me as Chairman at the Annual General Meeting on 28 April 2006. As chief executive of AstraZeneca PLC he enjoyed wide experience of operating successfully in different international markets and his comprehensive understanding of financial services from his previous directorship of a major bank will be of great value to us.
Over the same period we have welcomed the appointment of two new non-executive directors, Janis Kong and, with effect from 1 March 2006, Bill Friedrich. I am confident that, with their different backgrounds and experience across our key markets, both will greatly strengthen the Board as we embark on our next phase of growth.
Outlook Leaving an organisation which has been so important to me for the last 18 years will mark a milestone for me also, but I am pleased to be doing so at a time when the business is in such good shape. We have demonstrated our ability to generate capital consistently from a stable and diverse platform and I believe we are well placed to take advantage of the many opportunities that lie ahead, for the benefit of our shareholders, customers and staff.
We are particularly pleased with the geographic mix of our profits, 42% of which came from our international operations. Our profits in Europe, outside the UK, have grown to be equal to Citizens’ profits before the acquisition of Charter One. The majority of this growth is organic. Strong organic income growth has been a recurring theme of our results over recent years and provided over 70% of our increase in 2005.
During the course of the year we established Retail Markets in order to strengthen the co-ordination and delivery of our multi-brand retail strategy. At the beginning of 2006 the former Corporate Banking & Financial Markets division was renamed Corporate Markets and we reorganised our activities into two businesses, UK Corporate Banking and Global Banking & Markets, to enhance our ability to serve the needs of these distinct customer segments.
Our customers Customer numbers increased in all our divisions, with The Royal Bank of Scotland securing top position amongst the high street banks for personal customer satisfaction and NatWest moving into joint second position. This result reflects our investment in our branches and our people to support them, and improved access through a wide choice of channels.
Our people In the 2005 Employee Opinion Survey the Group improved its score in each of the 14 categories surveyed. At 86%, response to the 2005 Employee Opinion Survey was even higher than previously. We have launched new initiatives to encourage innovation and leadership. Our new Business School and programmes developed in conjunction with Harvard Business School are helping to develop the vision and quality of management that the Group will need in challenging markets in the future.
Sir George Mathewson George Mathewson will retire as the Group's Chairman at the Annual General Meeting. Under his leadership, initially as Group Chief Executive, RBS has enjoyed an unparalleled period of growth and success both at home and internationally. Very few can match his 18-year legacy of consistently increasing value generation. Personally and on behalf of his colleagues, I would like to thank George for his outstanding contribution.
Geographic analysis of income and operating profit determined by location of customer
�Largest provider of banking services to small and medium sized enterprises (SMEs) in the UK
Ulster Bank Group operates across the island of Ireland providing a full range of banking and financial products and services for personal customers and corporates via branches, telephone and the internet. Ulster Bank Group has the largest share of personal banking customers in Northern Ireland and is the third largest bank in the Republic of Ireland. In 2005 Ulster Bank Group launched market-leading mortgage and current account products and a new brand identity with the RBS logo.
�With credit cards and our partnership with Kroger our total retail and corporate presence stretches across 40 states
The Group’s property portfolio is managed, maintained and refurbished by Manufacturing, which also oversees the property investment programme.
�No.1 in the UK for Bank Automated Clearing System (BACS) transactions
�No.1 in the UK for Clearing House Automated Payment System (CHAPS) transactions
RBS Insurance is the second largest general insurer in the UK and a growing provider of general insurance in Spain, Italy and Germany. It sells and underwrites insurance via the telephone, the internet, partnerships and a network of brokers. Its brands, including Direct Line, Churchill, Privilege, Green Flag and NIG, are some of the best known in the UK.
Corporate Markets is focused on the provision of financial services to commercial and corporate customers in the UK and to large corporates and financial institutions around the world. In 2005 Corporate Markets increased income by 17% to £8,815 million.
��� The former Corporate Banking & Financial Markets division was renamed Corporate Markets on 1 January 2006, when we reorganised our activities into two businesses, UK Corporate Banking and Global Banking & Markets, in order to enhance our focus on the distinct needs of these two customer segments.
��� Our corporate and commercial banking business has 86,000 customers supported by 1,500 dedicated relationship and business development managers operating out of 170 corporate centres spread across the UK.
��� In addition to our core banking offering of lending, payments, deposits and international services, our specialist businesses offer a full range of financing solutions to UK customers. Lombard is the market-leading provider of asset financing and management services from traditional hire purchase, leasing and contract hire through to bespoke solutions. RBS Invoice Finance’s services include factoring, invoice discounting, asset-backed lending, trade cycle finance and bad debt protection. Lombard and RBS Invoice Finance have 400 sales staff working out of 53 offices, and over 100,000 customers.
Corporate Markets continued 2005 successes include: ��� RBS jointly underwrote and syndicated a £1.2 billion funding package to enable Travis Perkins to acquire Wickes, creating one of the largest building supply businesses in the UK. We then acted as sole adviser on the raising of $400 million of debt in the US Private Placement market, Travis Perkins’ first such transaction. As a lead banker to the enlarged group we also provide clearing services, interest rate hedging and Letters of Credit to support its international business.
��� Our relationship team, working with Financial Markets’ colleagues, provided South Yorkshire based Castings Technology International with funding for new flagship premises, allowing the company to grow its business and create 48 new jobs in the region.
��� A strong relationship with Icelandic readyprepared foods group Bakkavör resulted in RBS being mandated to structure and jointly arrange a £500 million facility to enable Bakkavör to acquire the entire share capital of Geest and refinance its debt.
��� As the leading UK clearing bank for TNT, we provide a comprehensive range of payment and cheque reconciliation services, including integrated IT systems and secure e-mail communication with our service centre. Our close relationship enables us to integrate product delivery and enhance our customer service.
��� Lombard provided a funding package to support the installation of a revolutionary new ‘G-Force’ rollercoaster ride at Drayton Manor Theme Park in Staffordshire.
��� RBS Invoice Finance delivered a committed £16.5 million stock and debtor funding package for Hargreaves Group, a leading bulk haulage and aggregates business. This allowed the customer to complete the acquisition of Monckton Coke & Chemical Co whilst refinancing existing credit lines.
��� We helped Joy Mining Machinery to manage the payment risks associated with exporting to the Far East, Russia and North Africa. Our Letter of Credit processing expertise enabled the company to trade safely in these countries.
��� A focus on long-term relationships backed by our strong balance sheet and suite of valueadded product capabilities is at the heart of our approach to our customers. This approach enabled excellent growth across the full range of products and markets that Global Banking & Markets serves. We have relationships with the overwhelming majority of the members of each of the FTSE 100 index, the Fortune 100 list and the Dow Jones Eurostoxx 50 index.
Our focus on long-term relationships backed by value-adding solutions has won Global Banking & Markets major corporate and institutional customers around the world. We have relationships with over 95% of the FTSE 100, over 80% of Fortune 100 companies in the US and over 90% of the Dow Jones Eurostoxx 50.
��� In the Asia Pacific region we have selectively built up our presence, particularly where we have identified opportunities to leverage our expertise in delivering financial markets products to financial institutions. We continue to achieve impressive results from the region, where we now employ 500 people. In Australia our wide range of products has been particularly successful with both corporate and institutional customers.
��� Our worldwide team of structured finance professionals provides specialised financing solutions for acquisitions, property, projects, infrastructure and commercial equipment including aircraft, ships and trains. In Europe we have a long-standing market-leading position in leveraged finance as a preferred partner to financial sponsors. Globally we are the No.1 project finance bank and No.3 commercial aircraft financier.
2005 successes include: ��� RBS arranged and underwrote £1.7 billion of debt facilities to finance Gala Group’s acquisition of Coral Eurobet in the UK. This transaction was one of the largest-ever sterling leveraged transactions (awarded Domestic Deal of the Year by Acquisitions Monthly).
��� We were awarded the role of Sole Lead Arranger on the €470 million debt refinancing of the api Energia Power Project in Italy due to our long-term relationship, structuring expertise and market-leading position. api Energia is one of three integrated gasification combined cycle plants in Europe showcasing an environmentally friendly gasification process which converts refinery residue to electrical power. This transaction and our ongoing support have enabled the api Group to continue with its development plans and long-term growth objectives.
��� RBS was instrumental in the largest Public Tender Offer ever made by a privately owned company in Germany, when it served as the exclusive financial arranger to Spohn Cement GmbH in its acquisition of Heidelberg Cement AG. RBS was mandated as Sole Bookrunner to underwrite and arrange the financing needs of the bid, including the provision of acquisition facilities totalling €3.1 billion.
We’ve been the fastest growing debt issuance bank globally over the last four years.
��� As Joint Mandated Lead Arranger and Underwriter, via our offices in France and Spain, RBS provided an innovative financing structure for €532 million of debt to fund the €1.1 billion high speed rail link concession to be built through the Pyrenees between Perpignan and Figueras (awarded EMEA Infrastructure Deal of the Year, PFI Awards, and EMEA Rail Transport Deal of the Year by Project Finance Magazine).
��� RBS Greenwich Capital acted as Joint Bookrunner for the US$750 million 10-year Global Notes offering for Harrah’s operating company, Harrah’s Entertainment Inc. Harrah’s is a leading entertainment and casino group and is the only investment grade gaming company in the world. By taking advantage of an attractive financing window the transaction was twice over-subscribed.
��� In Australia we completed our first leveraged finance transaction as Joint Mandated Lead Arranger and Bookrunner for the US$1.7 billion acquisition of Dyno Nobel, a leading global supplier of commercial explosives, by a consortium of investors.
The international hotel group, headquartered in Chicago, embarked on a significant hotel investment in 2005. RBS in New York was joint lead arranger for the US$1 billion loan facility.
� � Monro Muffler. RBS Securities and Charter One in Chicago joined forces as Lead Arranger and Sole Bookrunner for Monro Muffler, which runs a network for automotive repairs, showing the strength of the RBS platform in the US.
RBS – Child Trust Fund. RBS was one of the first banks to offer a Child Trust Fund in response to the Government’s commitment to give £250 to each child born after September 2002. RBS has matched the £250 with discounted retail vouchers and created a new stakeholder product to capitalise on the value the child will receive at 18.
� Profit contribution £4,207 million (2004 – £4,064 million) � Total income up 7% � Profit up 4%
Retail Markets was established in June 2005 to strengthen co-ordination and delivery of our full range of retail services through all our brands and channels. It has brought together the three businesses – Retail Banking, Retail Direct and Wealth Management – which focus on the interests of our personal and small business customers. In a challenging market, Retail Markets increased total income by 7% to £8,213 million.
��� In Retail Banking, average loans and advances to customers grew by 11%, with average mortgage balances up 12%, personal lending up 10% and small business lending up 9%. In Retail Direct, average loans to customers grew by 15%, personal loan balances grew by 11% and mortgage lending grew by 34%. In Wealth Management, average loans to clients grew by 20%, while average client deposits grew by 11%.
Retail Banking has the largest network of bank branches and ATMs in the UK and is the leading bank for small business customers. In 2005 Retail Banking increased its total income by 5% to £5,433 million.
��� In 2005 our measures to improve customer service were rewarded when The Royal Bank of Scotland secured top position amongst the high street banks, and NatWest moved into joint second position, for customers who rate themselves “extremely satisfied” with their main current account provider. Source: Gfk Financial Research Survey, 12 months to November 2005; high street banks defined as RBS, NatWest, Barclays, Lloyds TSB, HSBC and HBOS.
��� Our quality of service has also been enhanced by our new Customer Service Review/ Personal Service Review, which enables our people to run a comprehensive financial health check tailored to a customer’s individual circumstances. The Review offers recommendations to meet the customer’s immediate and future needs. Our revised Customer Account Opening system enables our customers to open additional accounts within minutes, whether they use our branches, telephone service or the internet.
��� Continued emphasis on long-term savings, assisted by excellent salesforce recruitment and retention, resulted in an increase of 25% in sales in our joint venture for life assurance and investments. The second half of 2005 saw record sales volumes, up 52% on the same period in 2004. Our team of Financial Planning Managers continues to grow, with more of them located in our branches to broaden the services we can offer through the network. The launch of new investment products enabled us to provide our customers with more choice and better value.
Retail Banking provides customers with a choice of when and how they do their banking through access to branches, a 24-hour telephone banking service, a network of ATMs and a full internet banking service.
��� The Royal Bank of Scotland launched First Home Saver, a new savings account designed to help customers get onto the property ladder by encouraging them to save regularly for the deposit, and by giving a tax-free bonus on taking out a Royal Bank of Scotland mortgage.
��� In September 2005, Royal Bank of Scotland Business was voted No.1 for service to small business customers in Scotland.
��� Mentor, our Business Advice Service for Employment Law, Health & Safety and Tax, reached more than 15,000 customers last year. It is the fastest-growing service of its type in the UK and increased income by 18% whilst delivering significant improvements to our proposition, including training in Health & Safety and Employment Law.
��� Loans to our small business customers were up 9% in 2005. Deposits by small business customers, taking advantage of our competitive range of products, grew by 4%.
��� 13,000 customers have opened a Flexible Business Loan, our market-leading product that enables business customers to customise their loan. They can choose from a range of options at the start of their loan, and can then update their choices if their circumstances alter. We also launched Client Money Services, a unique product that enables our business customers to manage their client funds simply and easily.
��� The personal cards issuing business issues personal credit cards to customers of The Royal Bank of Scotland and NatWest primarily through branches, and also to non-banked customers using the MINT brand through direct channels.
��� During 2005, we introduced an enhanced credit card offer for The Royal Bank of Scotland and NatWest brand cards, with preferential pricing for current account holders. In addition, the MINT brand continued to improve the quality and breadth of service it offers to customers by launching motor and home insurance.
Google. Retailer Card Services provides Google with a multi-currency capability, which enables the processing and settlement of credit card transactions in a wide choice of major international currencies.
Retail Direct offers a full range of financial services products through a number of brands and a variety of convenient channels in the UK and continental Europe.
Tesco Personal Finance in Hungary. Our joint venture with Tesco is developing its presence in Europe. Financial services products are now available through Tesco Personal Finance in Hungary.
��� Our merchant acquiring business is the fourth-largest merchant acquirer globally. The business enhanced its product range during 2005, enabling retailers to offer customers the ability to top up their mobile phones through point-of-sale terminals. The business is now European leader in online merchant acquiring.
��� During the year the number of customer accounts at Tesco Personal Finance exceeded five million. First Active supported the launch of two new TPF mortgage products, making TPF the only supermarket bank to offer mortgages. Retail Direct also continued to support the development of Tesco’s financial services operations in Central Europe and Asia.
��� Elsewhere in Europe our relationship with Tchibo, a major German retailer, has grown successfully, with the offer of consumer loans now extended across the store network in Germany and online.
Wealth Management provides private banking and investment services to its global clients through a number of leading UK and overseas private banking subsidiaries and offshore banking businesses. It has a network of more than 50 offices globally. In 2005 Wealth Management increased its total income by 10% to £814 million.
��� Investment assets under management increased by 18%. Investment programmes within Wealth Management have grown by 18% to US$27 billion and continue to perform competitively against industry benchmarks. Coutts is a significant investor in multi-manager hedge funds with more than US$7 billion invested.
��� Coutts continued to enhance its position as the leading private bank in the UK and increased its client base by 7%. A philanthropy service was launched in 2005, which won Coutts the title of Best Provider of Philanthropy Services. Coutts also launched its Family Business Service, offering specialist advice as well as education and networking forums for family business owners. In parallel, Coutts created its family prize and sponsored the Guide to Giving. Internationally, Coutts celebrated 10 years in Singapore in 2005.
Selected Awards ��� The Royal Bank of Scotland – Best for Overall Customer Service category 2005 Personal Finance and Savings Readership Awards
��� NatWest Mortgages – Best Bank, Best Large Loans and Highly Commended Remortgage Lender
��� MINT – Best Credit Card Direct Mail, Peoples Choice award
��� Coutts – Best Private Bank for high net worth individuals (US$1m to US$10m)
Stella McCartney is one of the most successful of Britain’s young fashion designers with a now well recognised luxury brand. Stella and Coutts have a fruitful commercial relationship including exclusive customer events for Coutts clients.
��� Ulster Bank Group ended 2005 with 1.6 million personal and business customers across the island of Ireland.
��� Ulster Bank also led as the first clearing bank to extend its 100% mortgage to first-time buyers across the island. The Switcher Mortgage package has made it easy for customers to switch to us.
��� Ulster Bank Group’s Corporate Banking and Financial Markets (CBFM) division continued to experience strong lending growth to its corporate customers. Average lending grew by 29% in 2005 – 26% in Northern Ireland and 30% in the Republic of Ireland.
��� Important transactions completed during the year included the banking business of United Dairy Farmers, a leading dairy producer; funding the construction of major shopping centres in Essex and Dundalk, and working with the RBS Specialist Healthcare team to win the mandate to fund development of Beacon Hospital, a major new private hospital in Dublin.
��� Aimhigher programme – Northern Ireland Big Tick Award for Business in the Community Excellence and Chambers of Commerce in Ireland President’s Awards Commendation
Citizens ranks as the eighth largest commercial banking organisation in the US by deposits. Last year was Citizens’ 13th consecutive year of record profits, achieved through the integration of Charter One and strong organic growth. In 2005 Citizens increased its income by 42% to US$5,940 million.
��� The systems and account integration for 3 million customer accounts and around 8,000 colleagues of the former Charter One Financial, Inc., the company’s largest US acquisition, was completed in July 2005, five months ahead of schedule.
��� In 2005, all Citizens Bank and Charter One branches and facilities were re-branded, with more than 70,000 new signs and ATM surrounds using the RBS logo, a new font for the bank name and the distinctive Citizens green.
��� Building on this momentum, in January 2006 Citizens announced the opening of 75 branches in Stop & Shop Supermarkets over the next three years, expanding its supermarket banking franchise into New York’s Hudson Valley, Rockland and Westchester Counties and Long Island. The partnership with Stop & Shop began in the New England franchise in 2001, where it has grown to 125 stores.
Ryerson, Inc., based in Chicago, is North America’s leading processor and distributor of metals. Our ability to meet the complex needs of large commercial customers is demonstrated in the partnership between RBS Corporate Markets, which provided Ryerson with credit facilities, and Charter One, which was able to offer treasury management services.
��� Kroger Personal Finance, a joint venture between Citizens’ cards division and Kroger Co., the second largest supermarket chain in the US, is offering KPF credit cards in nearly 2,200 stores and is branching out into other products.
We launched seven different branded card programmes in 2005 for Kroger customers, launched a MasterCard-branded gift card and started installing RBS Lynk-supported ATMs into a number of Kroger locations.
��� During 2005, RBS transferred to Citizens the operating control of the electronic processing provider RBS Lynk. RBS Lynk began cross-selling merchant services to small business customers through Citizens and Charter One branches and their business bankers.
��� Since it began in 2004, Citizens’ Job Bank offered US$144 million in loan funds at belowmarket rates to 11 companies that agreed to create an estimated 4,536 jobs. Citizens’ Housing Bank offered US$167 million in low-interest loan funds to non-profit housing developers to create 2,286 affordable housing units in New England and Ohio. Both programmes will be extended in 2006.
��� Citizens’ support for the community is extensive. Examples include a comprehensive, multi-million dollar investment plan to increase home ownership, strengthen commercial retail districts, and create an education district in Albany, New York; a new innovative product for low/moderate-income homebuyers introduced by CCO Mortgage Corp in traditionally under-served areas; a strong partnership with the Chicago Urban League on housing and financial literacy; US$700,000 of help with heating costs for more than 345 homeless shelters in eight states through the “Shelter Heating Assistance Campaign”; and assistance through our Champions in ActionSM
programme for close to 70 small, non-profit agencies dedicated to a range of housing, health and youth issues in New England, Pennsylvania and Ohio.
��� Citizens Financial Group received the 2005 Secretary of Defense Employer Support Freedom Award, the US government’s highest honour for support of the Guard and Reserve for policies and programmes that support colleagues on active duty well beyond US legal requirement.
Defender is one of the oldest newspapers in America serving the AfroAmerican community.
Charter One built on its SBA lending success offering capital to inner city businesses like The Chicago Defender.
� Profit contribution £926 million (2004 – £881 million) � Total income up 8% � Profit up 5%
Churchill Home Insurance. David and Catherine Barton switched to Churchill Home Insurance last year. They loved the brand, saved £200 and found the quality of service excellent.
��� RBS Insurance now has over 4.9 million car rescue policies sold through Direct Line, Churchill, Green Flag, Privilege and many partners under their brands.
��� RBS Insurance is the No.2 travel insurance provider with 2.3 million policies; its pet policies increased by 20% to 0.6 million.
RBS Insurance is the strength behind some of the UK’s biggest and best known insurance brands offering customers more choice and better products.
��� TRACKER, which specialises in recovering stolen vehicles, was acquired in 2005. TRACKER traced and recovered more than £36 million worth of stolen cars and plant equipment over the year. In one case, a vehicle was recovered in just 21 minutes.
��� NIG held six SME Business Academy roadshows throughout the country. The key objective of these events was to build NIG’s profile in the regions and forge close links with brokers and SME customers.
��� NIG joined imarket, the industry e-commerce initiative designed to make it easier for brokers to transact commercial business electronically.
��� Continuing their consumer champion roles, Direct Line and Green Flag were again the headline sponsors of Road Safety Week. Organised by road safety charity Brake each November to highlight road safety issues, the 2005 theme was child pedestrian safety.
��� Direct Line partnered Durham Police in a high profile campaign to tackle the problem of uninsured driving. By the end of 2005, more than 1,000 uninsured vehicles, which Direct Line estimates would have caused up to 2,000 accidents, had been removed from the streets of Durham County.
Awards ��� Direct Line – Car Insurer of the Year Personal Finance Magazine
��� Direct Line – Best Online Motor Insurance Provider Your Money Magazine
��� Green Flag – Best Online Breakdown Provider Your Money Magazine
��� Green Flag – UK Roadside Assistance Company of 2005 Institute of Transport Management Awards
��� NIG – Risk Management Product of the Year (for All Risk Management (ARM)) European Risk Management Awards
TRACKER has provided Balfour Beatty Power Networks with the ability to track its vehicles 24:7 via data on the internet. It has greatly improved vehicle management, efficiency, flexibility and driver safety and reduced insurance premiums.
NIG. For the broker market, quick and accurate online quotations are an important part of their competitive offering. NIG’s Commercial Quotes system is regularly accessed by brokers such as Saffron Insurance to provide commercial insurance for their customers.
Manufacturing is the backbone of RBS, supplying IT, processing, telephone, property and purchasing support for the Group’s customer-facing divisions.
Gogarburn. On 14 September 2005, Her Majesty The Queen and His Royal Highness The Duke of Edinburgh formally opened the new RBS headquarters in Edinburgh. It provides a superb working environment, together with fitness, nursery and conference facilities.
In 2005 Manufacturing redesigned its operations so that more customers’ queries are resolved by the first person they contact and errors are reduced. Good progress was made with the integration of Ulster Bank onto the Group’s platform. Manufacturing’s purchasing and property operations were benchmarked as “World Class” during the year.
��� Manufacturing processed 262,000 new mortgage applications and 61,000 extra borrowing mortgage applications for Group customers.
��� The Group’s ‘Fraud Ring Task Force’ tackles the growing threat of ‘fraud rings’ – fraud cases linked together which can fund terrorism and organised crime. This team is already creating considerable benefit for the Group in the early identification and closure of fraud ring activity.
��� In 2005 the key technology systems supporting branches and other parts of the Group were available 99.95% of the time.
Often referred to as “The Engine Room”, Manufacturing enables the Group to function 24 hours a day, 365 days a year.
��� Manufacturing completed the delivery of Gogarburn, the Group’s new headquarters, on budget and six months early.
��� Previously Royal Mail collected, sorted and delivered our mail to customers. We appointed UK Mail, a third party supplier, to collect and sort the mail bags, and track and deliver them to the Royal Mail for final delivery to the customer. By the year end, UK Mail had processed over 200 million envelopes through downstream access, generating savings of £5 million. On average, 20% of customers are now receiving their mail a day earlier than they did formerly by 2nd class mail.
��� Gogarburn campus – most significant contribution to the property industry in Scotland for 2005
89 branches such as this one at Dorset Street in Dublin were upgraded as part of our £50 million improvement to the Ulster Bank branch network, with work planned on a further
Our prime responsibility is to ensure our business is run successfully, sustainably and with integrity. In 2005 our Sustainability Dow Jones score improved by 12% to 76%, scoring 28% above the global average for the sector.
There is a strong business case for building the trust of stakeholders, and we can do this by demonstrating that we understand our responsibilities and operate with integrity.
��� We have more than one-third of the basic bank accounts accessible through Post Offices.
��� In 2005 the Group’s small business lending in the 5% most deprived wards in the UK stood at £659 million.
Equator Principles ��� During 2005, we contributed to the revision of the Equator Principles to take account of the International Finance Corporation’s (IFC) revised performance standards.
Our people ��� We were awarded the Gold standard in Race for Opportunity, positioning us sixth overall.
��� In 2005 we launched ‘The Leadership Journey’, a Group-wide approach to developing leadership skills.
��� In December 2005, the Group switched to recycled paper for office use in the UK and Ireland.
The Group continues to meet the socially responsible investment criteria required for inclusion in the FTSE4Good Index.
In the UK we are the sixth largest employer in the FTSE 100 paying £4.9 billion to our employees in salaries £2.7 billion paid to the UK Exchequer £2.0 billion paid to our shareholders in dividends £7.5 billion paid to suppliers 634 million free UK ATM transactions, dispensing £39.5 billion
The RBS group’s £56.2 million Community Investment programme goes beyond simple financial donation and aims to generate long term benefit through genuine partnerships with charities, community groups, employees and other stakeholders.
��� 7,000 Community Cashback Awards totalling £2.5 million were made to good causes, supported by our staff through fundraising or volunteering.
Money Matters ��� In 2005, Face 2 Face with Finance, the Group’s unique programme to provide financial education, helped 260,000 young people better understand personal finance. 550 members of staff worked with teachers to deliver lessons and interactive activities.
Moving On ��� The number of employees volunteering with The Prince’s Trust and Fairbridge has increased this year with more than 1,600 employees now involved with both charities.
��� 112 schools completed Year One of the Supergrounds programme, which transforms school grounds nominated through local retail branches into attractive and stimulating places to learn and play in safety. A further 183 schools are now taking part in Year Two of the programme.
Supergrounds. Communities across the UK have seen their playgrounds transformed into Supergrounds.
Youngsters like these on the Isle of Skye are amongst 250,000 who are now more active outdoors.
Contents 52 Presentation of information 53 Forward-looking statements 54 Description of business 56 Risk factors 57 Financial highlights 58 Summary consolidated income statement 61 Analysis of results 69 Divisional performance 82 Consolidated balance sheet 84 Cash flow 85 IFRS compared with US GAAP
International Financial Reporting Standards As required by the Companies Act 1985 and Article 4 of the European Union IAS Regulation, the consolidated financial statements of the Group have been prepared, for the first time, in accordance with International Financial Reporting Standards adopted by the International Accounting Standards Board (IASB) and interpretations issued by the International Financial Reporting Interpretations Committee of the IASB (together ‘IFRS’) as endorsed by the European Union. The Group, however, has taken advantage of the option in IFRS 1 ‘Firsttime Adoption of International Financial Reporting Standards’ to implement IAS 39 ‘Financial Instruments: Recognition and Measurement’ (IAS 39), IAS 32 ‘Financial Instruments: Disclosure and Presentation’ (IAS 32) and IFRS 4 ‘Insurance Contracts’ (IFRS 4) from 1 January 2005 without restating its 2004 income statement and balance sheet.
The Group’s 2004 financial statements were prepared in accordance with then current UK generally accepted accounting principles (“UK GAAP” or “previous GAAP”) comprising standards issued by the UK Accounting Standards Board, pronouncements of the Urgent Issues Task Force, relevant Statements of Recommended Accounting Practice and provisions of the Companies Act 1985. The Group also presents information under generally accepted accounting principles in the US (“US GAAP”).
O pe ra tin g an d fin an ci al r ev ie w Operating and financial review
Description of business Introduction The Royal Bank of Scotland Group plc is the holding company of one of the world’s largest banking and financial services groups, with a market capitalisation of £56 billion at the end of 2005. Headquartered in Edinburgh, the Group operates in the UK, US and internationally through its two principal subsidiaries, the Royal Bank and NatWest. Both the Royal Bank and NatWest are major UK clearing banks whose origins go back over 275 years. In the US, the Group’s subsidiary Citizens is ranked the eighth largest commercial banking organisation by deposits. The Group has a large and diversified customer base and provides a wide range of products and services to personal, commercial and large corporate and institutional customers.
The Group had total assets of £776.8 billion and shareholders’ equity of £35.4 billion at 31 December 2005. It is strongly capitalised with a total capital ratio of 11.7% and tier 1 capital ratio of 7.6% as at 31 December 2005.
Corporate Markets provides an integrated range of core banking, structured finance and financial markets products and services, including acquisition finance, trade finance, leasing, factoring, treasury services, money markets, foreign exchange, derivatives, bond origination and trading, sovereign debt trading, futures brokerage and interest rate risk management services.
Corporate Markets is the largest provider of banking, finance and risk management services to Mid-Corporate and Commercial customers in the UK. Through its network of relationship managers across the country it provides the full range of Corporate Markets products and services to small, medium and large companies.
Corporate Markets is a leading banking partner to major corporations and financial institutions around the world, specialising in providing a full range of debt financing, risk management and investment services to its Global Banking & Markets customers.
Retail Markets was established in June 2005 to strengthen co-ordination and delivery of our multi-brand retail strategy. Retail Markets comprises Retail Banking, Retail Direct and Wealth Management.
Customer choice and product flexibility are central to the Retail Banking proposition and customers are able to access services through a full range of channels: branches, ATMs, the internet and the telephone.
Ulster Bank brings together Ulster Bank and First Active to provide a highly effective challenger to the larger competitors in the Irish banking market. Serving personal and small business customers, Ulster Bank Retail Banking provides branch banking, wealth management and direct banking throughout the Republic of Ireland and Northern Ireland. With a continued focus on providing customer choice and value, First Active serves personal and small business customers through its separately branded product offerings and branch network throughout the Republic of Ireland. Both First Active and Ulster Bank retain their own brands, branch networks and distinctive customer propositions and benefits are achieved by selling more mortgage and savings products to Ulster Bank’s customers and a broader range of banking products to First Active’s customers.
RBS Insurance is the second largest general insurer in the UK, by gross earned premiums. Through the Direct Line, Churchill and Privilege brands it sells and underwrites personal insurance over the telephone and the internet in the UK. Through the Direct Line brand, RBS Insurance also sells and underwrites personal insurance in Spain, Italy and Germany. Through UKI Partnerships, our partnership business, we operate insurance schemes on behalf of third parties who in turn sell insurance products to their customers. NIG sells personal and commercial products through a network of intermediaries, while Inter Group acts as an insurance administrator and Devitt Insurance Services operates as a specialist broker administrator.
Manufacturing drives optimum efficiencies in high volume processing activities, leverages the Group’s purchasing power and has become a centre of excellence for managing large scale and complex change programmes such as integration.
In the UK credit card market large retailers and specialist card issuers, including major US operators, are active in addition to the UK banks. Competitive activity is across a number of dimensions including introductory and longer term pricing, loyalty and reward schemes, and packaged benefits. Whilst competition remains intense, pricing of introductory interest rate offers has become less aggressive. In addition to physical distribution channels, providers compete through direct marketing activity and the internet.
In Ireland, Ulster Bank and First Active compete in retail and commercial banking with the major Irish banks and building societies, and with other UK and international banks and building societies active in the market. Competition is intensifying as UK, Irish and other European institutions seek to expand their businesses.
In the United States, where competition is intense, Citizens competes in the New England, Mid-Atlantic and Mid-West retail and mid-corporate banking markets with local and regional banks and other financial institutions. The Group also competes in the US in large corporate lending and specialised finance markets, and in fixed-income trading and sales. Competition is principally with the large US commercial and investment banks and international banks active in the US.
Financial highlights Pro forma for the year ended 31 December £m £m £m
Profit before tax, purchased intangibles amortisation, integration costs and net gain on sale of strategic investments and subsidiaries 8,251 7,849 7,108 Profit before tax 7,936 7,284 6,543 Profit attributable to ordinary shareholders 5,392 4,856 4,620
Basic earnings per share (pence) 169.4 157.4 149.8 Adjusted earnings per share (pence) (3) 175.9 170.2 162.6 Adjusted after-tax return on equity (%) (4) 18.2% 18.9% 18.5%
(2) Cost:income ratio represents operating expenses excluding purchased intangibles amortisation, integration costs and loss on sale of subsidiaries, expressed as a percentage of total income excluding gain on sale of strategic investments and after netting operating lease depreciation against rental income, and excluding acquisitions.
Basis of preparation of pro forma results In preparing its annual results, the Group has taken advantage of the option in IFRS 1 ‘First-time Adoption of International Financial Reporting Standards’ to implement IAS 39 ‘Financial Instruments: Recognition and Measurement’ (“IAS 39”), IAS 32 ‘Financial Instruments: Disclosure and Presentation’ (“IAS 32”) and IFRS 4 ‘Insurance Contracts’ (“IFRS 4”) from 1 January 2005 without restating its 2004 income statement and balance sheet. However, given the importance of these standards, the Group has provided detailed pro forma information for the year ended 31 December 2004 reflecting the estimated effect of these standards to facilitate inter-period comparison. This pro forma information has been prepared on the following basis: (i) The requirements of IAS 32, IAS 39 and IFRS 4 have been applied from 1 January 2004 except for the requirements relating to hedge accounting; no hedge ineffectiveness has been recognised in profit or loss.
(iii) Classification of financial assets into held-to-maturity, held-for-trading, available-for-sale, loans and receivables or designated as at fair value through profit or loss at 1 January 2004 is consistent with the approach adopted on 1 January 2005 on implementation of IAS 39.
Net gain on sale of strategic investments and subsidiaries (5.4p) — — Adjusted earnings per ordinary share 175.9p 170.2p 162.6p
Total income Total income, excluding the gain on sale of strategic investment, was up 9% or £2,178 million to £25,569 million. This reflected growth in all divisions particularly Corporate Markets, Citizens and Ulster Bank. The effect of implementing the requirements of IAS 32, IAS 39 and IFRS 4 in 2004 would have been to reduce total income by £876 million for the year ended 31 December 2004.
Net interest income increased by 9% to £9,918 million. Average loans and advances to customers and average customer deposits grew by 24% and 17% respectively. The effect of implementing the requirements of IAS 32, IAS 39 and IFRS 4 in 2004 would have been to reduce net interest income by £68 million for the year ended 31 December 2004. Interest income is recognised on a constant yield basis under IFRS; under UK GAAP interest was recognised on an accrual basis.
Net insurance claims Bancassurance and general insurance claims, after reinsurance which under IFRS, include maturities and surrenders, increased by 1% to £4,313 million. The increase reflects volume growth and maturities of our guaranteed capital bonds. The effect of implementing the requirements of IFRS 4 in 2004 would have been to reduce net claims by £314 million for the year ended 31 December 2004.
A final dividend of 53.1p per ordinary share, up 29% is recommended, giving a total dividend for the year of 72.5p, an increase of 25%. If approved, the final dividend will be paid on 9 June 2006 to shareholders registered on 10 March 2006. The total dividend is covered 2.4 times by earnings before purchased intangibles amortisation, integration costs and net gain on sale of strategic investments and subsidiaries.
O pe ra tin g an d fin an ci al r ev ie w Operating and financial review continued 2005 compared with pro forma 2004 Profit Profit before tax, purchased intangibles amortisation, integration costs and net gain on sale of strategic investments and subsidiaries increased by 16% or £1,143 million, from £7,108 million to £8,251 million.
Balance sheet Total assets were £776.8 billion at 31 December 2005, 12% higher than total assets of £696.5 billion at 1 January 2005.
Lending to customers, excluding repurchase agreements and stock borrowing (“reverse repos”), increased in 2005 by 16% or £51.8 billion to £368.3 billion. Customer deposits, excluding repurchase agreements and stock lending (“repos”), grew by 13% or £33.5 billion to £294.1 billion over the same period.
Capital ratios at 31 December 2005 were 7.6% (Tier 1) and 11.7% (Total).
Yields, spreads and margins of the banking business % % % Gross yield (3)
(2) Interest income has been adjusted by £115 million (2004 – £49 million) and interest expense by £307 million (2004 – £99 million) to record interest on financial assets and liabilities designated as at fair value through profit or loss. Related interest-earning assets and interest-bearing liabilities have also been adjusted.
2005 compared with 2004 Group – The net interest margin at 2.55% was down 33 basis points from 2.88% in 2004. The effect of implementing IAS 32 and IAS 39 in 2004 would have been to decrease the 2004 margin by 7 basis points.
UK – The UK net interest margin, down 24 basis points at 2.66%, would have declined 20 basis points if IAS 32 and IAS 39 had been implemented in 2004.
2005 compared with pro forma 2004 The net interest margin at 2.55% was down 26 basis points from 2.81% in 2004. Product mix changes accounted for 17 basis points of the decline, driven by organic growth in lower margin mortgage lending and large corporate loans, and in rental assets as well as a change in deposit mix. The flattening of the US dollar yield curve accounted for 6 basis points of the reduction:the remainder was due to price re-positioning of some of our products.
Assets Treasury bills and other eligible bills – UK 3,160 138 4.37 835 34 4.07
Loans and advances to customers – UK 212,991 13,510 6.34 186,117 11,150 5.99
Total interest-earning assets 556,680 450,096 Non-interest-earning assets (2, 3) 180,368 72,711
Customer accounts: demand deposits – UK 73,653 2,056 2.79 67,519 1,568 2.32
Customer accounts: savings deposits – UK 26,727 778 2.91 23,149 625 2.70
Total interest-bearing liabilities – banking business (2, 3) 349,610 11,720 3.35 279,743 7,548 2.70
Total interest-bearing liabilities 522,354 411,486 Non-interest-bearing liabilities Demand deposits – UK 17,484 17,157
(2) Interest-earning assets and interest-bearing liabilities exclude the Retail bancassurance long-term assets and liabilities attributable to policyholders, in view of their distinct nature. As a result, net interest income has been adjusted by £59 million (2004 – £47 million).
Total interest-bearing liabilities – banking business (2, 3) 288,710 8,082 2.80
Total interest-bearing liabilities 435,481 Non-interest-bearing liabilities Demand deposits – UK 17,263
2005 compared with pro forma 2004 Non-interest income increased by £2,139 million, 16% to £15,651 million and represents 61% of total income (2004 – 60%). Excluding general insurance premium income, noninterest income rose by 24% or £1,883 million to £9,872 million reflecting strong performances in Corporate Markets, up 23% or £1,097 million and Citizens, up 73% or £483 million.
Within non-interest income, fees and commissions receivable increased by 11% or £679 million, to £6,750 million, while fees and commissions payable decreased by £79 million to £1,841 million.
Income from trading activities, which primarily arises from providing customers with debt and risk management products in interest rate, currency and credit, was up £387 million, 20%. The increase on 2004 reflected increased customer volumes.
Operating expenses (excluding purchased intangibles amortisation and integration costs) Pro forma £m £m £m
Administrative expenses: Premises and equipment 1,274 1,142 1,143 Other administrative expenses 2,592 2,174 2,221 Total administrative expenses 9,710 8,421 8,495 Depreciation and amortisation 1,588 1,376 1,376 2005 compared with 2004 Operating expenses, excluding purchased intangibles amortisation and integration costs, rose by 15% to £11,298 million. The effect of implementing the requirements of IAS 39 and IFRS 4 in 2004 would have been to increase operating expenses by £74 million for the year ended 31 December 2004.
Staff costs were up £713 million, 14% to £5,844 million reflecting business growth. The number of staff increased by 400 to 137,000.
Premises and equipment expenses increased by £131 million, 11% to £1,274 million reflecting our programme of investment both in the branch networks and in our major operational centres.
Other administrative expenses, up 17%, £371 million reflected business volume growth and ongoing expenditure on regulatory projects.
The Group’s ratio of operating expenses (excluding purchased intangibles amortisation and integration costs and after netting operating lease depreciation against rental income) to total income was 42.4% compared with 42.0% in 2004. Excluding acquisitions and at constant exchange rates, the ratio was unchanged at 41.8%.
Premises and equipment 39 35 35 Other administrative expenses 131 149 149 Depreciation and amortisation 140 253 253
At 31 December Currency translation Charge to Utilised during At 31 December 2004 adjustments income statement the year 2005 £m £m £m £m £m
UK corporation tax rate 30.0 30.0 30.0 Effective tax rate 30.0 27.4 28.4
The actual tax charge differs from the expected tax charge computed by applying the standard rate of UK corporation tax as follows: Pro forma £m £m £m
The ratio of total balance sheet provisions for impairment to total risk elements in lending and potential problem loans decreased to 65% compared with 70% at 1 January 2005. This reflects amounts written-off and the changing mix from unsecured to secured exposure.
New impairment losses 1,879 1,629 1,734 less: recoveries of amounts previously written-off (172) (144) (144) Charge to income statement 1,707 1,485 1,590
Comprising: Loan impairment losses 1,703 1,402 1,507 Other impairment losses 4 83 83 Charge to income statement 1,707 1,485 1,590
Divisional performance The contribution of each division before amortisation of purchased intangible assets, integration costs and net gain on sale of strategic investments and subsidiaries and, where appropriate, Manufacturing costs is detailed below.
Central items (1,468) (1,010) Profit before amortisation of purchased intangible assets, integration costs and net gain on sale of strategic investments and subsidiaries 8,251 7,108
The performance of each of the divisions is reviewed on pages 70 to 81.
Contribution before impairment losses 5,559 4,678 Impairment losses 335 482 31 December 1 January £bn £bn
Rental assets 13.2 11.5 Customer deposits* 111.1 100.8 Weighted risk assets 202.6 178.4 * excluding repos and reverse repos
Corporate Markets achieved excellent results in 2005, with total income up 17% to £8,815 million and contribution up 24% to £5,224 million, reflecting very good performances across our businesses. We maintained a stable cost:income ratio and the credit environment in all geographies remained benign.
Our businesses continue to deliver good returns. Weighted risk assets rose by 14% over the course of the year to £202.6 billion, with much slower growth in the second half following the above-trend spike in spot levels at mid-year.
Total assets* 70.4 61.6 Loans and advances to customers – gross* 67.9 59.4 Customer deposits* 60.0 51.8 Weighted risk assets 74.2 65.6 * excluding repos and reverse repos
Net interest income increased 10% to £1,760 million as a result of strong growth in average lending, up £7.7 billion, or 16% and in average customer deposits, up £5.1 billion, or 12%. Average interest-bearing deposits grew particularly strongly.
Expense growth, excluding operating lease depreciation, was 8% which included a further investment in customerfacing staff.
Corporate Markets – Global Banking & Markets Pro forma £m £m
Contribution before impairment losses 3,538 2,834 Impairment losses 117 205 31 December 1 January £bn £bn
Total assets* 338.8 297.8 Loans and advances to customers – gross*
An excellent performance from our Global Banking & Markets customer segment in 2005 shows the fruits of the global platform we have built over the last five years, with good growth in all major geographies and across-the-board success in income generation from our core banking, structured finance and financial markets activities.
Retail Markets Retail Markets was established in June 2005 to strengthen co-ordination and delivery of our multi-brand retail strategy across our product range, and comprises Retail Banking, Retail Direct and Wealth Management. The performance of each of these divisions is discussed on pages 74 to 76.
Net interest income 4,499 4,362 Non-interest income 3,714 3,322 Total income 8,213 7,684 Direct expenses 2,335 2,306 Insurance net claims 486 398 Contribution before impairment losses 5,392 4,980 Impairment losses 1,185 916 Contribution 4,207 4,064 1 January £bn £bn
At the end of 2004 we referred to the changes being seen in the retail markets with the consumer transitioning from an environment which had seen several years of very fast growth in consumer lending to an increased emphasis on savings and investment.
As a consequence, we planned to refocus our strategy to grow our sales of deposit and bancassurance products faster than the market, to exploit our potential for building profitable market share in the mortgage market and to concentrate more on the development of our branch franchise, building on our strong service proposition. During 2005 this transition has gathered momentum and we have achieved good progress in our strategies.
Branch deposit balances outgrew the market and our bancassurance sales accelerated strongly, with annual premium equivalent sales 25% higher than in 2004. Our share of net mortgage lending, assisted by the launch of the First Active brand, reached 8% in 2005. Our credit card business, meanwhile, made excellent headway in marketing through branch channels; we gained 60% more credit card customers in our core NatWest and RBS brands in the second half than in the same period of 2004.
Insurance net claims 486 398 Contribution before impairment losses 3,610 3,482 Impairment losses 601 490 31 December 1 January £bn £bn
Total banking assets 77.1 72.8 Loans and advances to customers – gross
Net interest income was stronger in the second half, recovering from a dip in the first half to reach £3,175 million for the full year. Net interest margin was lower in 2005 than in 2004 but second half margin was similar to the first half, with increased product margins offsetting mix effects. Spreads in mortgages and some savings products improved in the latter part of the year.
Non-interest income rose by 13% to £2,258 million. In bancassurance, Annualised Premium Equivalent income increased by 25% to £171 million, with good sales of Child Trust Funds and portfolio bonds. Excluding bancassurance premium and other income, non-interest income increased by 11% to £1,567 million, reflecting growth in income from core personal and small business banking services, and good progress in our private banking and investment businesses.
Direct expense growth was contained to 3%, despite some investment in future income initiatives in the second half. Staff costs increased by 7% to £1,026 million as a result of continued investment in customer-facing staff with over 500 additional customer advisors in branches, an increase in telephone banking advisors, and continued expansion of our bancassurance and investment businesses. We continue to make efficiency gains in other areas resulting in a 5% decrease in other costs to £311 million.
Impairment losses increased by 23% or £111 million to £601 million. The increased charge principally reflects the growth in lending over recent years, including 17% growth in 2004. We have taken further steps to refine our credit policy and improved our recoveries process. Mortgage arrears remain very low. The average loan-to-value ratio on new mortgages written in 2005 was 62% and on the stock of mortgages was 46%. Small business credit quality remains stable.
Net interest income 882 779 Non-interest income 1,084 995 Total income 1,966 1,774 Direct expenses
During the year, the number of customer accounts increased by 734,000 (4%). In the light of changing market conditions we have focussed our marketing efforts on existing customers, and this has resulted in very strong growth in our core NatWest and RBS brands. We gained 336,000 credit card accounts in these brands in the second half, 60% more than in the equivalent period of 2004.
Impairment losses rose by 39% to £571 million, reflecting higher lending volumes as well as the increase in personal arrears signalled at the end of 2004. There are some signs of a stabilisation of credit quality, assisted by the tightening of lending criteria. Mortgage arrears remain very low. The average loan-to-value ratio on new mortgages written in 2005 was 51% and on the stock of mortgages was 44%.
Loans and advances to customers – gross 7.8 7.1 Investment management assets – excluding deposits 25.4 21.6 Customer deposits 25.5 22.3 Weighted risk assets 6.1 6.0
Total income rose by 10% to £814 million, reflecting good growth across all our businesses, and contribution was 26% higher at £408 million. Coutts UK and Adam & Co both gained good numbers of customers, with Coutts up 7% and Adam up 11%. 2005 also saw the continuation of rapid growth in Asia, where the number of private bankers increased by 20%, with particular emphasis placed on recruitment for the Chinese and Indian markets.
Average lending increased by 20% and customer deposits by 11%. This resulted in an 8% increase in net interest income to £442 million, with net interest margin reduced by the mix of business.
Average exchange rate – €/£ 1.463 1.474 Spot exchange rate – €/£ 1.457 1.418
The number of personal and business customers increased by 68,000 in the year. Ulster Bank personal customer numbers rose by 9% in the Republic of Ireland, where our switcher mortgage product has helped us to gain market share. In Northern Ireland, Ulster Bank significantly enhanced its personal current account offering in the fourth quarter to provide free banking to all customers.
Net interest income rose by 17% to £655 million. Average loans and advances increased by 33% to £25.0 billion and average customer deposits by 21% to £14.4 billion. The continuing strong growth in lending, particularly in mortgages and business loans, led to a decline in net interest margin.
Impairment losses increased by £13 million to £58 million, reflecting the growth in lending.
Contribution before impairment losses 1,706 1,186 Impairment losses 131 117 31 December 1 January
Average exchange rate – US$/£ 1.820 1.832 Spot exchange rate – US$/£ 1.721 1.935
We have grown our customer numbers in both personal and business segments, with Charter One increasing its small business and corporate customer base by 10%. Co-operation between Citizens and RBS Corporate Markets is yielding good results. Citizens’ new international cash management service has already won nearly 300 new accounts with existing RBS customers, bringing in more than $80 million of new core deposits.
systems of over 750 branches and three million customer accounts spread over a wide geography. Despite the focus on the integration process, Charter One achieved good growth in business volumes, with loans and advances up 18% over the course of the year and customers deposits up 10%.
Expenses were up 42% to $2,834 million. Expense growth, excluding acquisitions, was contained to 5%.
Impairment losses, including acquisitions, were up $25 million to $239 million. Credit quality overall remained stable. More than 90% of our personal sector lending is secured, and as a result there was minimal impact from the change in US bankruptcy laws in 2005.
Earned premiums 5,641 5,561 Reinsurers’ share (246) (455) Insurance premium income 5,395 5,106 Net fees and commissions (449) (485) Other income 543 460 Total income 5,489 5,081 Expenses
Gross claims 3,903 3,815 Reinsurers’ share (76) (267) Net claims 3,827 3,548 31 December 31 December
RBS Insurance achieved 4% growth in UK motor policies in force. In achieving this against a background of very strong competition in UK motor insurance, we benefited from the strength of our brands and the diversity of our distribution channels. Growth came through our direct brands, through our partnership business, where we operate insurance schemes on behalf of third parties who in turn sell insurance products to their customers, and through NIG, our intermediary business acquired as part of Churchill. Our businesses in Spain, Germany and Italy together delivered 14% growth in motor policies in force. Linea Directa, our joint venture with Bankinter, increased its customer base by 17% and, with more than 1 million policies, is the largest direct motor insurer and sixth largest motor insurer in Spain.
In addition to expanding its intermediary business in motor and home insurance, NIG achieved 10% growth in commercial policies sold to SMEs.
Analysis: Group Technology 945 852 Group Purchasing and Property Operations 1,013 927 Customer Support and other operations 785 773 Total manufacturing costs 2,743 2,552
Group Purchasing and Property Operations costs increased by 9% to £1,013 million. We improved the efficiency of our property utilisation in 2005 while continuing our programme of investment both in the branch networks and in our major operational centres, including Birmingham, Manchester and our new headquarters in Edinburgh.
Funding costs at £810 million, were up £195 million largely because of the full year funding cost of the acquisition of Charter One in August 2004. The Group’s primary objective is to hedge its economic risks. So as not to distort divisional results, volatility attributable to derivatives in economic hedges that do not meet the criteria in IFRS for hedge accounting is transferred to the Group’s central treasury function. This resulted in a charge of £45 million, in addition to a charge for £14 million for hedge ineffectiveness under IFRS.
Central departmental costs and other corporate items at £658 million were £263 million higher than 2004. This was principally due to higher pension costs and the centralisation of certain functions, and includes ongoing expenditure on regulatory projects such as Basel II and Sarbanes-Oxley Section 404.
Consolidated balance sheet at 31 December 2005 31 December 1 January 31 December £m £m £m
Assets Cash and balances at central banks 4,759 4,293 4,293 Treasury bills and other eligible bills 5,538 6,109 6,110 Loans and advances to banks 70,587 65,691 61,073 Loans and advances to customers 417,226 381,162 347,251
Debt securities in issue 90,420 66,245 63,999 Settlement balances and short positions 43,988 33,339 32,990 Derivatives at fair value 96,438 91,277 18,876 Accruals, deferred income and other liabilities 14,247 14,720 17,648 Retirement benefit liabilities 3,735 2,940 2,940 Deferred taxation liabilities 1,695 1,826 2,061
31 December 2005 compared with 1 January 2005 Total assets of £776.8 billion at 31 December 2005 were up £80.3 billion, 12% compared with 1 January 2005, reflecting business growth.
Loans and advances to customers were up £36.1 billion, 9%, to £417.2 billion. Within this, reverse repos decreased by 24%, £15.7 billion to £48.9 billion. Excluding reverse repos, lending rose by £51.8 billion, 16% to £368.3 billion reflecting organic growth across all divisions.
Debt securities increased by £27.1 billion, 29%, to £121.0 billion and Equity shares rose by £4.1 billion, 78%, to £9.3 billion, principally due to increased holdings in Corporate Markets.
Customer accounts were up £27.8 billion, 9% at £342.9 billion. Within this, repos decreased £5.7 billion, 11% to £48.8 billion. Excluding repos, deposits rose by £33.5 billion, 13%, to £294.1 billion with good growth in all divisions.
Subordinated liabilities were up £0.7 billion, 3% to £28.3 billion. This reflected the issue of £1.2 billion dated loan capital and the effect of exchange rate movements, £1.3 billion, which was partially offset by the redemption of £1.6 billion non-cumulative preference shares and dated loan capital.
Shareholders’ equity increased by £5.4 billion, 18% to £35.4 billion. The profit for the year of £5.5 billion, issue of £1.6 billion non-cumulative fixed rate equity preference shares and £0.3 billion of ordinary shares in respect of scrip dividends and the exercise of share options, were partly offset by the payment of the 2004 final ordinary dividend, £1.3 billion, and the 2005 interim ordinary dividend, £0.6 billion and preference dividends, £0.1 billion.
The fair value of the assets of the Group’s post-retirement benefit schemes was £17.4 billion (2004 – £14.8 billion) and the present value of defined benefit obligations was £21.1 billion (2004 – £17.7 billion). The increase in net pension liability (after tax) to £2.7 billion from £2.1 billion is principally due to movements in interest rates. The mortality assumptions used in the valuation of liabilities were updated at the end of 2004 and have not been changed.
Net purchases of fixed assets of £2,662 million, including operating lease assets and computer and other equipment, and net investment in business interests and intangible assets of £7,968 million led to the net cash outflow from investing activities of £9,398 million.
IFRS compared with US GAAP The Group’s financial statements are prepared in accordance with IFRS, which differ in certain material respects from US GAAP as described on pages 221 to 229.
• higher pension costs under US GAAP compared with IFRS reflecting the deferral of actuarial gains and losses over the remaining service lives of current employees under US GAAP; such gains and losses are recognised in full under IFRS.
Capital resources The following table analyses the Group’s regulatory capital resources at 31 December: £m £m £m £m £m
Less: investments in insurance subsidiaries, associated undertakings and other supervisory deductions (7,282) (5,165) (4,618) (3,146) (2,698)
Weighted risk assets Banking book: Note: The comparative data in the table above are under UK GAAP as previously published and regulated. As from 1 January 2005, the Group was regulated on an IFRS basis.
UK banking sector, comparing a bank’s capital resources with its weighted risk 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%. At 31 December 2005, the Group’s total RAR was 11.7% (2004 – 11.7%) and the tier 1 RAR was 7.6% (2004 – 7.0%).
These Committees are supported by two dedicated group level functions, Group Risk Management (“GRM”), which has responsibility for credit, market, regulatory and enterprise risk and Group Treasury which is responsible for the management of the Group’s balance sheet, capital raising, intra group credit exposure, liquidity and hedging policies. Both functions report to GEMC and the Group Board through the Group Finance Director and play an active role in assessing and monitoring the effectiveness of the divisional risk management functions. Heads of Group Risk Mangement and Internal Audit have direct access to the Group Chief Executive and the Chairman of the Group Audit Committee.
• Enterprise risk: the Group separately defines operational and external risk. Operational risk is defined as the risk arising from the Group’s people, processes, systems and assets. External risk comprises business, political and environmental risk.
• Regularly reviewing and monitoring the Group’s performance in relation to risk through monthly Board Reports.
Risk appetite is usually defined in both quantitative and qualitative terms. Whilst different techniques are used to ensure that the Group’s risk appetite is achieved, generically they can be classified as follows: • Quantitative: encompassing stress testing, risk concentration, value at risk and credit related metrics, including the probability, loss and exposure at default.
• Qualitative: focuses on ensuring that the Group applies the correct principles, policies and procedures.
Risk organisation Divisional CEOs are specifically responsible for the management of risk within their divisions. As such, they are responsible for ensuring that they have appropriate risk management frameworks that are adequate in design, effective in operation and meet minimum Group standards.
Group Risk Management is responsible for setting standards for maintaining and developing credit risk management throughout the Group. This is achieved via a combination of governance structures, credit risk policies, control processes and credit systems collectively known as the Group’s Credit Risk Management Framework (“CRMF”).
The key principles for credit risk management as defined in the CRMF include: • Approval of all credit exposure must be granted prior to any advance or extension of credit.
• An appropriate credit risk assessment of the customer and related credit facilities must be undertaken prior to approval of credit exposure. This must include a review of, amongst other things, the purpose of the credit and sources of repayment, compliance with affordability tests, repayment history, capacity to repay, sensitivity to economic and market developments and risk-adjusted return.
• The Board delegates authority to Executive Advances Committee, Group Credit Committee and divisional credit committees.
• All credit exposures, once approved, must be effectively monitored and managed and reviewed periodically against approved limits. Lower quality exposures are subject to a greater frequency of analysis and assessment.
Each Division must establish its own CRMF consistent with the Group CRMF. Divisional credit departments are responsible for maintaining the CRMF and ensuring that asset quality is within specified parameters. Divisional credit departments are independent of business management and have no direct responsibility or accountability for revenue generation. This independence is supported by the divisional head of credit having dual reporting lines to the both the divisional CEO (via the divisional Chief Risk Officer) and to the Head of Group Credit Risk.
GRM undertakes regular assessment of the effectiveness of each divisional CRMF to ensure it complies with Group standards and is appropriate for the business being undertaken. GRC and the GEMC review reports on the Group’s portfolio of credit risks on a monthly basis.
Credit risk modelling governance The Group’s ‘Principles for Managing Credit Risk’ outline the governance structure under which all credit risk models must be developed, reviewed and approved. GRM is responsible for: • Establishing high level standards to which all credit risk models across the Group must adhere and thus ensuring a consistency of approach to credit risk modelling across the Group.
• Validating the models on at least an annual basis (every two years for credit risk exposure measurements models) and submitting documentation of these validations to GRM with appropriate recommendations on recalibration, where applicable.
Credit risk assets Credit risk assets measure the exposure to all products in the Group’s credit portfolios which consist of loans and advances (including overdraft facilities), instalment credit, finance lease receivables, debt securities and other traded instruments across all customer types.
Expressed as an annual probability of default, the upper and lower boundaries and the midpoint for each of these Group level asset quality grades are as follows: Asset Annual probability of default quality Minimum Midpoint Maximum S&P grade % % % equivalent AQ1 0.02 0.10 0.20 AAA to BBBAQ2 0.21 0.40 0.60 BB+ to BB AQ3 0.61 1.05 1.50 BB- to B+
Distribution of credit risk assets by asset quality Overall credit asset quality remained stable during 2005. As at 31 December 2005, exposure to investment grade counterparties (AQ1) accounted for 47% (2004 – 49%) of credit risk assets and 98% (2004 – 97%) of exposures were to counterparties rated AQ4 or higher. The exposure to the lowest asset quality (AQ5) reduced from 2.6% at 31 December 2004 to 2.2% at 31 December 2005.
Excluding reverse repurchase agreements, credit risk assets at 31 December 2005 were £498.2 billion (2004 – £427.6 billion), an increase of £70.6 billion (17%) during the year.
As at 31 December 2005, 30% of credit risk assets (2004 – 30%) relate to individuals (personal and retail customers) and include mortgage lending and other smaller loans that are intrinsically well-diversified. Corporate industry sectors, including public sector and quasi government, account for 48% (2004 – 46%) of credit risk assets, with banks and other financial institutions representing the remaining 22% (2004 – 24%) of credit risk assets.
The Group also uses scenario analysis and stress testing in order to monitor the risk to clusters of correlated industry sectors.
During 2005 there was further geographic diversification of credit risk assets away from the UK and into the rest of Europe and North America. As at 31 December 2005, 49.3% of credit risk assets were within the UK. North America and Europe account for 45.5% of credit risk assets with the remaining 5.2% in the rest of the world.
The Group also monitors the breakdown of the credit portfolio by customer type and product type. The Group’s largest exposure by credit risk assets is corporate customer lending products which represent 31% of credit risk assets as at 31 December 2005 (2004 – 30%). As illustrated in the industry analysis this exposure is well diversified across industry sectors.
Non-accrual loans(1) 5,926 5,836 4,733 Accrual loans past due 90 days(2) 9 52 713 Troubled debt restructurings(3) 2 — 24
(2) Loans where an impairment event has taken place but no impairment recognised. This category is used for over-collateralised non-revolving credit facilities.
(4) Loans for which an impairment event has occurred but no impairment provision is necessary. This category is used for over-collateralised advances and revolving credit facilities where identification as 90 days overdue is not feasible.
Loan impairment The Group classifies impaired assets as either Risk Elements in Lending (“REIL”) or Potential Problem Loans (“PPL”). REIL represents non-accrual loans, loans that are accruing but are past due 90 days and restructured loans. PPL represent impaired assets which are not included in REIL but where known information about possible credit problems causes management to have serious doubts about the future ability of the borrower to comply with loan repayment terms.
The table below sets out the Group’s loans that are classified as REIL and PPL:
Early and active management of problem exposures ensures that credit losses are minimised. Specialised units are used for different customer types to ensure that the appropriate risk mitigation is taken in a timely manner.
Latent loss provisions charge 14 75 Collectively assessed provisions charge 1,399 1,059 Individually assessed provisions charge 290 373 Specific provision charge 1,386 General provision charge 16 Total charge to income statement 1,703 1,507 1,402
Provisions for loan impairment charged to the income statement in 2005 were £1,703 million, up £196 million (13%) from pro forma 2004. As a percentage of customer lending, the impairment charge improved slightly from 0.47% to 0.46%.
The adoption of IAS 39 under IFRS at the start of 2005 resulted in changes to the methodology used to identify impaired assets and to calculate required provisions. The following table therefore shows 2004 on both a pro forma and statutory basis. Commentary is based on comparisons with the pro forma information which reflects the impact of IAS 32, IAS 39 and IFRS 4.
Movement in loan impairment provisions balance The movement in provisions balance during 2005 is shown in the table below.
Total provision expressed as a: % of REIL and PPL 65% 70% 72%
Notes: (1) Excludes provisions against loans and advances to banks of £3 million (1 January 2005 – £5 million; 31 December 2004 – £6 million).
The management of liquidity risk within the Group is undertaken within limits and other policy parameters set by GALCO, which reviews monthly, and receives on an exception basis, reports detailing compliance with those policy parameters. A weekly report is also provided to the Group’s executive management. Compliance is monitored and coordinated daily under the stewardship of the Group Treasury function, both in respect of internal policy and the regulatory requirements of the Financial Services Authority.
Detailed liquidity position reports are compiled each day by Group Treasury and reviewed daily and weekly with Financial Markets, who manage day-to-day and intra-day market execution within the policy parameters set.
In addition to their consolidation within the Group’s daily liquidity management process, it is also the responsibility of all Group subsidiaries and branches outside the UK to ensure compliance with any separate local regulatory liquidity requirements where applicable, subject to Group Treasury oversight.
Total customer accounts (excluding repos) 294,113 46 241,181 46 Debt securities over 1 year remaining maturity 22,293 3 9,931 2
Debt securities up to 1 year remaining maturity 68,127 11 54,068 10 Repo agreements with customers 48,754 7 42,134 8 Deposits by banks (excluding repos) 62,502 10 56,541 11 Repo agreements with banks 47,905 7 43,342 8
The level of large deposits taken from banks, corporate customers, non-bank financial institutions and other customers, and significant cash outflows therefrom, are also reviewed regularly to monitor concentration and identify any adverse trends. During 2005 the composition of the Group’s funding sources remained well diversified by counterparty, instrument, market and maturity.
Capital (shareholders’ equity and subordinated debt) increased by £9,438 million (17%) and provides around 10% of total funding excluding other liabilities.
Greenwich Capital in the US and by Financial Markets. Repo and short positions increased by £19,687 million (17%) to represent 21% of total funding excluding other liabilities at 31 December 2005.
The Group remains well placed to access various wholesale funding sources from a wide range of counterparties and markets. The changing mix evident between customer repo, deposits by banks, debt securities in issue, and shorts primarily reflects comparative pricing, maturity considerations and investor/counterparty demand rather than a material perceived trend.
Loans and advances to customers as a % of customer accounts (excluding repos) 126.6% 124.1%
In prevailing economic conditions and with interest rates at relatively low historical levels in the UK, US and Europe, it is anticipated that the growth in demand for further borrowing by customers is likely, in the medium term, to continue to exceed that for customer deposits received, thus increasing net customer lending further and increasing gradually over time the Group’s dependence on the wholesale market for funding.
The Group evaluates on a regular basis a range of balance sheet management and term funding strategies to address the consequent potential impact on its structural liquidity risk position and maintain that within its normal policy parameters.
Stress testing The maintenance of high quality credit ratings is recognised as an important component in the management of the Group’s liquidity risk. Credit ratings affect the Group’s ability to raise, and the cost of raising, funds from the wholesale market and the need to provide collateral in respect of, for example, changes in the mark-to-market value of derivative transactions.
Given its strong credit ratings, the impact of a single notch downgrade would, if it occurred, be expected to have a relatively small impact on the Group’s economic access to liquidity. More severe downgrades would have a progressively greater impact but have an increasingly lower probability of occurrence.
Contingency funding plans are maintained to anticipate and respond to any approaching or actual material deterioration in market conditions or in the Group’s credit ratings, and the Group remains confident of its ability to manage its liquidity requirements effectively in all such circumstances.
Net customer activity Net customer lending, excluding repos, rose by £20,056 million as the growth in loans and advances to customers continued to exceed the growth in customer accounts, thus increasing the degree of reliance on wholesale market funding to support loan growth.
Debt securities, treasury bills and other eligible bills 126,503 100,018 Reverse repo agreements with banks and customers 90,691 82,159 Less: repos with banks and customers (96,659) (85,476) Short positions (37,427) (28,923) Insurance Companies’ debt securities held (5,724) (5,029) Debt securities charged as security for liabilities (9,578) (4,852) Net marketable assets 67,806 57,897
The Group’s net surplus of marketable assets over net shortterm wholesale liabilities due within one month increased by £3,039 million to £28,457 million at 31 December 2005. Overall access to liquidity to meet all foreseen needs remains comfortably within the Group’s policy parameters.
Sterling liquidity Over 42% of the Group’s total assets are denominated in sterling. For its sterling activity the FSA requires the Group on a consolidated basis to maintain daily a minimum ratio of 100% between: 1. a stock of qualifying high quality liquid assets (primarily UK and EU government securities, treasury bills, and cash held in branches) and 2. the sum of : • sterling wholesale net outflows contractually due within five working days (offset up to a limit of 50%, by 85% of sterling certificates of deposit held which mature beyond five working days); and
The FSA also set an absolute minimum level for the stock of qualifying liquid assets that the Group is required to maintain each day. The Group has exceeded that minimum stock requirement at all times during 2005.
The Group has operated within its non-sterling liquidity policy mismatch limits at all times during 2005 and operational processes are actively managed to ensure that is the case going forward.
Developments in liquidity risk management regulation Following the Basel Committee’s publication of Sound Practices for Managing Liquidity in Banking Organisations in February 2000, a number of regulatory bodies internationally began reviewing their regulatory liquidity frameworks.
In the UK, the FSA published a discussion document – DP24 – in October 2003 setting out draft proposals for a new quantitative framework to operate in the UK. Comments made to the FSA, by the Group and other banks collectively, in response to these proposals, made clear the desirability of an internationally coordinated approach to the regulation of liquidity. An international forum of regulators, chaired jointly by the FSA and the US Federal Reserve Bank, was also established in 2004 to review regulation across the OECD. Their report is awaited. In 2005, the European Commission has also begun to consider the subject.
Trading The principal focus of the Group’s trading activities is client facilitation – providing products to the Group’s client base at competitive prices. The Group also undertakes: market making – quoting firm bid (buy) and offer (sell) prices with the intention of profiting from the spread between the quotes; arbitrage – entering into offsetting positions in different but closely related markets in order to profit from market imperfections; and proprietary activity – taking positions in financial instruments as principal in order to take advantage of anticipated market conditions. The main risk factors are interest rates, credit spreads and foreign exchange. Financial instruments held in the Group’s trading portfolios include, but are not limited to, debt securities, loans, deposits, securities sale and repurchase agreements and derivative financial instruments (futures, forwards, swaps and options). For a discussion of the Group’s accounting policies for, and information with respect to, its exposures to derivative financial instruments, see Accounting policies and Note 19 on the accounts.
Average Period end Maximum Minimum Average Period end Maximum Minimum Trading £m £m £m £m £m £m £m £m
The Group’s trading activities are carried out principally by Global Banking & Markets. The charts below depict the number of days on which Global Banking & Markets’ trading income fell within the stated ranges
(2) > <0 0 > <2 2 > <4 4 > <6
Non-trading The principal market risks arising from the Group’s non-trading activities are interest rate risk, currency risk and equity risk. Treasury activity and mismatches between the repricing of assets and liabilities in its retail and corporate banking operations account for most of the non-trading interest rate risk. Non-trading currency risk derives from the Group’s investments in overseas subsidiaries, associates and branches. The Group’s venture capital portfolio and investments held by its general insurance business are the principal sources of non-trading equity price risk. The Group’s portfolios of nontrading financial instruments mainly comprise loans (including finance leases), debt securities, equity shares, deposits, certificates of deposits and other debt securities issued, loan capital and derivatives. To reflect their distinct nature, the Group’s long-term assurance assets and liabilities attributable to policyholders have been excluded from these market risk disclosures.
� Interest rate risk Non-trading interest rate risk arises from the Group’s treasury activities and retail and corporate banking businesses.
Retail and corporate banking Structural interest rate risk arises in these activities where assets and liabilities have different repricing dates. It is the Group’s policy to minimise the sensitivity of net interest income to changes in interest rates and where interest rate risk is retained to ensure that appropriate resources, measures and limits are applied.
The limits applied to these measures are set to parallel movements of +/-1% and +/-2%. The EVE methodology captures deposit repricing strategies and the embedded option risks that exist within both the investment portfolio of mortgage-backed securities and the consumer loan portfolio. EVE is the present value of the cash flows generated by the current balance sheet. EVE sensitivity to a 2% parallel movement upwards and downwards in US interest rates is shown below.
The US dollar open structural foreign currency exposure reflects the action taken to mitigate the effect of the acquisition in 2004 of Charter One on the Group’s capital ratios. However, the increase in this position and the Euro structural exposure over 2004 is largely a result of the exclusion from the table of preference shares classified as equity under IFRS. These instruments continue to be considered part of the currency funding of foreign operations for asset and liability management purposes. The exposure in Chinese RMB arises from the Group’s strategic investment in Bank of China.
� Equity risk Non-trading equity risk arises principally from the Group’s strategic investments, its venture capital activities and its general insurance business. General insurance investment strategy is discussed below under insurance risk.
Insurance risk is the risk of fluctuations in the timing, frequency and severity of insured events, relative to the expectations of the Group at the time of underwriting. This risk is managed according to the following separate components: • Underwriting and pricing risk, • Claims management risk, • Reinsurance risk, • Reserving risk
Underwriting and pricing risk The Group manages underwriting and pricing risk through a wide range of processes and forums, which include: • Underwriting guidelines which exist for all business transacted restricting the types and classes of business that may be accepted; • Pricing policies which are set by pricing committees, by product line and by brand; • Centralised control of policy wordings and any subsequent changes
Reinsurance and insurance of Group assets are centrally controlled in the same department as insurance risk and both have a similar framework of robust controls and processes.
Claims management risk Claims management risk is the risk that claims are paid inappropriately. Claims are managed using a range of IT system controls and manual processes conducted by experienced staff, to ensure that claims are handled in a timely and accurate manner. Detailed policies and procedures exist to ensure that all claims are handled appropriately, with each member of staff having a specified handling authority. The processes include controls to avoid claims staff handling or paying claims beyond their authorities, as well as controls to avoid paying invalid claims. Loss adjustors are used to handle certain claims to conclusion.
Reinsurance risk Reinsurance is used to protect the insurance results against the impact of major catastrophic events or unforeseen volumes of, or adverse trends in, large individual claims and to transfer risk that is outside the Group’s current risk appetite.
• Excess of loss catastrophe ‘event’ reinsurance to protect against major events, for example, windstorms or floods.
The following paragraphs explain the frequency and severity of claims and the sources of uncertainty for the key classes that the Group is exposed to: a) Motor insurance contracts (private and commercial) Claims experience is quite variable, due to a wide number of factors, but the principal ones of these are age of driver, type of vehicle and use.
Annual Report and Accounts 2005 c) Commercial other 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 can be broken down between employers liability and public/products liability. The first is to indemnify employees for injury caused as a result of the insured’s negligence. Public/products liability is to indemnify a third party for injury and/or damage as a result of an act of the Insured’s negligence. As liability insurance is written on an occurrence basis, these covers are still subject to claims that manifest over a substantial period of time, but where loss was in existence during the life of the policy.
A recession could lead to an increased number and cost of unemployment, accident and sickness claims. Other sources of uncertainty include operational and reserving issues.
Life business The three regulated life companies of RBSG, NatWest Life Assurance Limited, Royal Scottish Assurance plc and Direct Line Life Limited, are required to meet minimum capital requirements at all times under the Financial Service Authority’s Prudential Sourcebook. The capital resources covering the regulatory requirement are not transferable to other areas of the Group. To ensure that the capital requirement is satisfied at all times, each company holds an additional voluntary buffer above the absolute minimum. Sufficient capital resources are held to ensure that the capital requirements are covered over a two year projection period. Life insurance results are inherently uncertain, due to actual experience being different to modelled assumptions. Such differences affect regulatory capital resources, as do varying levels of new business. Therefore, projections are formally reviewed twice a year. Where there is a shortfall of capital, various options are available to provide new capital.
Enterprise risk In order to adequately identify and manage the full range of Enterprise risk, the Group has separately defined operational and external risk: Operational risk is defined as the risk arising within the organisation from: • People – risks arising from an inappropriate level of staff, inadequately skilled or managed.
• Process – risk caused by inadequate or failed internal processes.
External risk is defined as the risk arising outside of the organisation in three main areas: • Business – risks arising from product performance, competitor activity, supplier unreliability or customer activity.
Operational risk exposures and loss events for each division are captured through monthly Risk and Control returns, which provide details on the change of risk exposures for each risk category in the light of trends and the risk profile of each division.
Regulatory risk Regulatory risk is the risk arising from failing to meet the requirements of our regulators. To mitigate this risk, the Group is active in various regulatory developments affecting risk, capital and liquidity management. This includes working with domestic and international trade associations, being active with various regulators, especially the FSA and the main regulatory groups, including the Basel Committee (see page 256), the Committee of European Banking Supervisors, the EU Commission and US regulators.
B oa rd o f di re ct or s an d se cr et ar y
Chairman Sir George Mathewson (age 65) CBE, DUniv, LLD, FRSE, FCIBS C (Chairman), N (Chairman) Appointed to the Board in September 1987 and as Chairman in April 2001, Sir George Mathewson has a wide background in finance, technology and management and spent some of his career in the United States. He became Group Chief Executive in January 1992 and, in March 2000, he was appointed Executive Deputy Chairman. He is a director of The Scottish Investment Trust PLC and the Institute of International Finance, Inc. He is also president of the International Monetary Conference, a member of the Advisory Committee of Bridgepoint Capital Limited and a member of the Financial Reporting Council. He was chief executive of the Scottish Development Agency from 1981 to 1987 and is a former president of the British Bankers’ Association.
Executive directors Sir Fred Goodwin (age 47) DUniv, FCIBS, FCIB, LLD Group Chief Executive C Appointed to the Board in August 1998, Sir Fred Goodwin is a Chartered Accountant. He was formerly chief executive and director, Clydesdale Bank PLC and Yorkshire Bank PLC. He is chairman of The Prince’s Trust, a non-executive director of Bank of China Limited and a former president of the Chartered Institute of Bankers in Scotland.
Gordon Pell (age 56) FCIBS, FCIB Chief Executive, Retail Markets Appointed to the Board in March 2000, Gordon Pell was formerly group director of Lloyds TSB UK Retail Banking before joining National Westminster Bank Plc as a director in February 2000 and then becoming chief executive, Retail Banking. He is also a director of Race for Opportunity and a member of the National Employment Panel and the FSA Practitioner Panel.
Guy Whittaker (age 49) Group Finance Director C Appointed to the Board in February 2006, Guy Whittaker was formerly group treasurer at Citigroup Inc., based in New York, having previously held a number of management positions within the financial markets business at Citigroup. He was elected a Lady Beaufort Fellow of Christ's College Cambridge in 2004.
Non-executive directors Colin Buchan* (age 51) A, C, R Appointed to the Board in June 2002, Colin Buchan was educated in South Africa and spent the early part of his career in South Africa and the Far East. He has considerable international investment banking experience, as well as experience in very large risk management in the equities business. He was formerly a member of the group management board of UBS AG and head of equities of UBS Warburg. He is chairman of UBS Securities Canada Inc. and vice-chairman of Standard Life Investments Limited. He is also a director of Merrill Lynch World Mining Trust Plc, Merrill
Lynch Gold Limited, Royal Scottish National Orchestra Society Limited and World Mining Investment Company Limited.
Archie Hunter* (age 62) A (Chairman), C Appointed to the Board in September 2004, Archie Hunter is a Chartered Accountant. He was Scottish senior partner of KPMG between 1992 and 1999 and President of The Institute of Chartered Accountants of Scotland in 1997/1998. He has extensive professional experience in the UK and North and South America. He is currently chairman of Macfarlane Group plc, a director of Edinburgh US Tracker Trust plc, Convenor of Court at the University of Strathclyde and a governor of the Beatson Cancer Research Institute.
Charles ‘Bud’ Koch (age 59) Appointed to the Board in September 2004, Bud Koch is an American national. He has extensive professional experience in the USA and is currently chairman of the board of the Federal Home Loan Bank of Cincinnati, chairman of the board of John Carroll University and a trustee of Case Western Reserve University. He was chairman, president and chief executive officer of Charter One Financial, Inc. and its wholly owned subsidiary, Charter One Bank, N.A between 1973 and 2004. He is also a director of Assurant, Inc.
Janis Kong* (age 55) OBE, DUniv Appointed to the Board in January 2006, Janis Kong is currently executive chairman of Heathrow Airport Limited, chairman of Heathrow Express Limited and a director of BAA plc and Portmeirion Group plc. She is also a member of the board of Visit Britain and previously served as a member of the board of the South East England Regional Development Agency.
Joe MacHale* (age 54) A Appointed to the Board in September 2004, Joe MacHale is currently a non-executive director and chairman of the audit committee of Morgan Crucible plc, a non-executive director of Brit Insurance Holdings plc, and a trustee of MacMillan Cancer Relief. He held a number of senior executive positions with J P Morgan between 1979 and 2001 and was latterly chief executive of J P Morgan Europe, Middle East and Africa Region.
The directors have pleasure in presenting their report together with the audited accounts for the year ended 31 December 2005.
Activities and business review The company is a holding company owning the entire issued ordinary share capital of the Royal Bank, the principal direct operating subsidiary undertaking of the company. The “Group” comprises the company and all its subsidiary and associated undertakings, including the Royal Bank and NatWest. The Group is engaged principally in providing a wide range of banking, insurance and other financial services. The financial risk management objectives and policies of the Group and information on the Group’s exposure to price, credit, liquidity and cash flow risk are contained in Note 34 on the financial statements. Details of the principal subsidiary undertakings of the company are shown in Note 15. A review of the business for the year to 31 December 2005, of recent events and of likely future developments is contained in the Operating and financial review.
Business developments In August 2005, the Group announced a strategic partnership with Bank of China (BoC). Subsequently, a Group-led consortium acquired a 10% shareholding in BoC through a majority-owned subsidiary for US$3.1 billion (£1.7 billion). The Group’s share of the investment (US$1.6 billion) was financed through the disposal of its 2.2% holding in the issued share capital of Banco Santander Central Hispano, S.A. Following receipt of all required regulatory approvals, the investment was completed in December 2005. The two banks will co-operate across a range of business activities in China including credit cards, wealth management, corporate banking and personal lines insurance. They will also closely co-operate in key operational areas including financial controls, risk management, human resources and corporate governance.
Going concern The directors are satisfied that the Group has adequate resources to continue in business for the foreseeable future. For this reason, they continue to adopt the ‘going concern’ basis for preparing the accounts.
Ordinary share capital During the year ended 31 December 2005, the ordinary share capital was increased by the following issues: (a) 13.5 million ordinary shares allotted as a result of the exercise of options under the company’s executive, sharesave and option 2000 schemes and a further 0.7 million ordinary shares allotted in respect of the exercise of options under the NatWest executive and sharesave schemes which had been exchanged for options over the company’s shares following the acquisition of NatWest in 2000; (b) 7.4 million ordinary shares allotted in lieu of cash dividends; and
(c) 2.3 million ordinary shares allotted under the company’s employee share ownership plan.
Details of the authorised and issued ordinary share capital at 31 December 2005 are shown in Note 30.
Preference share capital Details of issues of preference shares during the year and the authorised and issued share capital at 31 December 2005 are shown in Note 30.
Authority to repurchase shares At the Annual General Meeting in 2005, shareholders renewed the authority for the company to make market purchases of up to 317,495,924 ordinary shares. The directors have not exercised this authority to date. The Group has however announced its intention to repurchase up to £1 billion of ordinary shares over the course of the next 12 months, and shareholders will be asked to renew this authority at the Annual General Meeting in April.
R ep or t of th e d ire ct or s
• Sir Tom McKillop, who was appointed to the Board on 1 September 2005, Janis Kong, who was appointed to the Board on 1 January 2006, and Guy Whittaker, who was appointed to the Board on 1 February 2006, and
Details of the service agreement for Guy Whittaker are set out on page 125. Johnny Cameron has a service agreement with The Royal Bank of Scotland plc dated 29 March 1998 which may be terminated by Mr Cameron giving six months notice to the Royal Bank and by the Royal Bank giving 12 months notice to Mr Cameron. Mark Fisher has a service agreement with The Royal Bank of Scotland plc dated 3 May 2000 which may be terminated by either party giving six months notice to the other. No other director seeking election or re-election has a service agreement.
Directors’ interests The interests of the directors in the shares of the company at 31 December 2005 are shown on page 130. None of the directors held an interest in the loan capital of the company or in the shares and loan capital of any of the subsidiary undertakings of the company, during the period from 1 January
Employee recruitment Utilising a wide range of recruitment channels, including an open internal jobs market, talent forums and detailed succession planning, the Group ensures that the recruitment and development of employees is closely aligned to organisational requirements. A strong standing as an employer of choice prompts applications from hundreds of thousands of potential candidates each year. Similarly, all vacancies are displayed internally and RBS employees can apply for any role.
The Group retains a high profile as a graduate recruiter, providing a wide range of development programmes. In 2005, more than 14,000 graduates applied for over 230 places with the Group. The Group also received the Association of Graduate Recruiters Award for delivering the ‘Best Integrated Marketing Recruitment Campaign’ targeted at graduates.
Ordinary shares: 51⁄2% cumulative preference shares: Legal & General Group plc 98,761,695 3.40 Commercial Union Assurance plc 91,429 22.86 Barclays PLC 126,816,644 3.97 Mr P. S. and Mrs J. Allen 86,999 21.75 The Capital Group of Companies, Inc 95,578,555 3.01 Bassett-Patrick Securities Limited* 46,255 11.56 11% cumulative preference shares: E M Behrens Charitable Trust 20,000 5.00 Guardian Royal Exchange Mrs Gina Wild 19,800 4.95
Assurance plc 129,830 25.97 Trustees of The Stephen Cockburn Windsor Life Assurance Limited Pension Scheme 19,879 4.97
The Group’s remuneration and benefits package, Total Reward, (consisting of salary, bonus, share scheme and competitive pension benefits) is acknowledged as one of the most comprehensive and flexible packages in the financial services sector. Salary awards within the Group reflect individual performance, offering greater increases for high performers, as well as acknowledging market competitor movements.
Employees can also participate in bonus incentive plans specific to their business and share in the Group’s ongoing success through profit sharing, Buy As You Earn and Sharesave schemes, which align their interests with those of shareholders. UK employees participate in profit sharing that is directly related to the annual performance of the Group. For the last seven years this has amounted to a further 10 percent of basic salary.
The RBS group Charity Lottery was launched during 2005. Employees contributing to the prize fund through a small monthly entry fee have the chance to win up to 50% of the total funds collected each month. The remainder, after payment of a small lottery-operating fee, is donated to charity.
Employee learning and development The Group actively encourages learning and development and is committed to creating and providing opportunities both inside and outside the workplace. These experiences are provided through a variety of developmental initiatives, technological innovations and learning networks and forums. Creating and maintaining a talented network of people across the Group ensures not only a strong leadership capability, but also a high performing workforce.
In 2005 a new Group-wide approach to leadership development was launched. Called the “Leadership Journey”, it defines success at different leadership levels and the key developmental challenges that employees face as they progress within the Group. A suite of development programmes has been designed and implemented to ensure appropriate leadership development, supporting the challenges that individual leaders face whilst completing different stages of the Leadership Journey.
A core component of this ongoing activity is the Group’s Executive Leadership Programme (developed in conjunction with the Harvard Business School) and the establishment of an on-site business school at the Group Headquarters at Gogarburn, Edinburgh, which opened in January 2006. The Business School is central to the Group’s commitment to developing its leaders, and equipping them with the skills and confidence necessary to lead in complex and challenging environments.
The Group Chief Executive and other senior Group executives regularly communicate with employees through ‘Question Time’ style programmes, broadcast on the Group’s internal television network. An ‘Open Air’ debate chaired by the Group Chief Executive on Diversity and Inclusion, seeking to ensure equality of opportunity for employees and customers, typifies this approach.
The survey enables employees to maximise their contribution to the Group by expressing their views and opinions on a range of key issues.
The results from the 2005 survey, which 86% of Group employees completed, demonstrated significant improvements for the fifth successive year. This year, for the very first time, the Group scored above the ISR Global Financial Services Norm in every single category.
In addition to direct communication and consultation with employees, the Group recognises the trade union Amicus in the UK, and the Irish Bank Officials Association and the Services, Industrial, Professional and Technical Union in Ireland. These formal relationships are complemented by works council arrangements in many of the Group’s mainland Europe-based operations.
The Group has an European Employee Communication Council that provides elected employee representatives with an opportunity to better understand market conditions and strategic decisions with transnational impact on our European operations.
Diversity The Group’s “Managing Diversity” policy sets a framework and a minimum standard within which all employees can develop to their full potential irrespective of race, gender, marital status, age, disability, religious belief, political opinion or sexual orientation. Each division has developed and delivered an action plan incorporating both Group and division-specific priorities to promote diversity across all areas of the employee lifecycle.
The Board regularly considers corporate responsibility issues and receives a formal report twice each year. Further details of the Group’s corporate responsibility policies will be contained in the 2005 Corporate Responsibility Report.
Corporate governance The company is committed to high standards of Corporate governance. Details are given on pages 115 to 120.
At 31 December 2005, the Group’s trade creditors represented 27 days (2004 – 27 days) of amounts invoiced by suppliers. The company does not have any trade creditors.
Auditors The auditors, Deloitte & Touche LLP, have indicated their willingness to continue in office. A resolution to re-appoint Deloitte & Touche LLP as the company’s auditor will be proposed at the forthcoming Annual General Meeting.
The Board met nine times during 2005 and was supplied with comprehensive papers in advance of each Board meeting covering the Group’s principal business activities. Members of the executive management attend and make regular presentations at meetings of the Board.
The non-executive directors combine broad business and commercial experience with independent and objective judgement. The balance between non-executive and executive directors enables the Board to provide clear and effective leadership and maintain the highest standards of integrity across the company’s business activities. The names and biographies of all Board members are set out on page 109.
The Board comprises nine independent and five nonindependent directors (including executive directors), in addition to the Chairman. Sir Tom McKillop is Chairmandesignate and Bob Scott has been nominated as the senior independent director.
Performance evaluation The annual performance evaluation of the Board and its Committees was undertaken in the autumn of 2005. The evaluation, which covered the operation and effectiveness of the Board, the Remuneration Committee and the Nominations Committee, was conducted by the Group Secretary using a detailed questionnaire and meetings with each director. Amongst the areas reviewed were the composition of the Board, Board processes and performance against objectives.
A review of the effectiveness of the Audit Committee was undertaken during the year by PricewaterhouseCoopers and was the subject of a separate report to the Board. Amongst the areas reviewed were the composition and performance of the Committee and the Committee’s role in relation to internal and external audit, risk management and financial reporting.
Board Committees In order to provide effective oversight and leadership, the Board has established a number of Board Committees with particular responsibilities. The Committee chairmanship and membership are reviewed on a regular basis. The names and biographies of all Board Committee members are set out on page 109.
The Remuneration Committee is responsible for assisting the Board in discharging its responsibilities and making all relevant disclosures in relation to the formulation and review of the Group’s executive remuneration policy. The Remuneration Committee makes recommendations to the Board on the remuneration arrangements for its executive directors and the Chairman. The Directors’ Remuneration Report is contained on pages 121 to 129.
Responsibility for determining the remuneration of executive directors has not been delegated to the Remuneration Committee, and in that sense the provisions of the Code have not been complied with. The Board as a whole reserves the authority to make the final determination of the remuneration of directors as it considers that this two stage process allows greater consideration and evaluation and is consistent with the unitary nature of the Board. No director is involved in decisions regarding his or her own remuneration.
Relations with shareholders The company communicates with shareholders through the annual report and by providing information in advance of the Annual General Meeting. Individual shareholders can raise matters relating to their shareholdings and the business of the Group at any time throughout the year. Shareholders are given the opportunity to ask questions at the Annual General Meeting or submit written questions in advance. The chairmen of the Audit, Remuneration and Nominations Committees are available to answer questions at the Annual General Meeting.
In 2005, a survey of investor perceptions was undertaken on behalf of the Board by independent advisers, and the findings were considered by the Board.
Disclosure controls and procedures As required by US regulations, the Group Chief Executive and the Group Finance Director have evaluated the effectiveness of the company’s disclosure controls and procedures (as defined in the rules under the US Securities Exchange Act of 1934). This evaluation has been considered and approved by the Board which has authorised the Group Chief Executive and the Group Finance Director to certify that as at 31 December 2005, the company’s disclosure controls and procedures were adequate and effective and designed to ensure that material information relating to the company and its consolidated subsidiaries would be made known to them by others within those entities.
Changes in internal controls There was no change in the company’s internal control over financial reporting that occurred during the period covered by this report that has materially affected, or is reasonably likely to materially affect, the company’s internal control over financial reporting.
Annual audit services also include statutory or non-statutory audits required by any Group companies that are not incorporated in the United Kingdom. Terms of engagement for these audits are agreed separately with management, and are consistent with those set out in the audit engagement letter, as local regulations permit.
C or p or at e g ov er na nc e
In 2004 KPMG conducted a review of the effectiveness of Group Internal Audit. It is intended that there will be an external review of the effectiveness of Group Internal Audit every three years, with internal reviews continuing in the intervening years. In 2005 the Audit Committee conducted a review of Group Internal Audit that involved cross Group participation and the external auditors.
In 2005 the Audit Committee reviewed the audit committee structure throughout the Group and as a result proposed to the Board a reorganisation and strengthening of the structure to ensure that audit committees would cover each separate Group business appropriately. That recommendation was accepted by the Board and is now being implemented.
The Remuneration Committee The members of the Remuneration Committee are Bob Scott (Chairman), Colin Buchan, Jim Currie and Eileen Mackay, until her retirement on 31 December 2005. All members of the Remuneration Committee are independent non-executive directors.
In addition to advising the Remuneration Committee, Watson Wyatt provided professional services in the ordinary course of business, including actuarial advice and benefits administration services to subsidiaries of the Group and investment consulting advice to The Royal Bank of Scotland Pension Trustees Limited. Mercer Human Resource Consulting provided advice and support in connection with a range of benefits, pension actuarial and investment matters. Ernst & Young provided professional services in the ordinary course of business, including actuarial and corporate recovery advice.
• Remuneration arrangements will strike an appropriate balance between fixed and performance-related rewards. Performancerelated elements will comprise the major part of executive remuneration packages. See illustrative charts below.
Benefits UK-based executive directors are eligible to participate in The Royal Bank of Scotland Group Pension Fund (“the RBS Fund”).
All Employee Profit Share (annual) Mediam Term EPS growth and Share Price
Executive directors are eligible to receive a choice of various employee benefits or a cash equivalent, on a similar basis to other employees. In addition, as employees, executive directors are eligible also to participate in Sharesave, Buy As You Earn and the Group profit sharing scheme, which currently pays up to 10 per cent of salaries, depending on the Group’s performance. These schemes are not subject to performance conditions since they are operated on an all-employee basis. Executive directors also receive death-in-service benefits.
The award in 2005 is subject to two performance measures. First, the annual growth in the company’s earnings per share (“EPS”) must exceed the annualised growth of the Retail Prices Index (”RPI”) plus three per cent. If this condition is satisfied, the company’s total shareholder return (“TSR”) is compared with the TSR of a comparator group of companies. The companies are Aviva plc; Banco Santander Central Hispano S.A. (“BSCH”); Barclays PLC; Citigroup inc.; HBOS plc; HSBC Holdings PLC; Legal & General Group plc; Lloyds TSB Group plc; Prudential plc and Standard Chartered PLC. Awards made under the plan will not vest if the company’s TSR is below the median of the comparator group. Achievement of the EPS target and median TSR performance against the comparator companies will result in vesting of 25% of the award, increasing to 200% if the company achieves a TSR ranking at first position in the comparator group and exceeds the TSR of the second placed comparator company by at least 34%.
The introduction of the EPS element is designed to ensure that the plan includes a performance measure which is in the clear line of sight for the participants and which reflects the business strategy for the next few years.
Following the Remuneration Committee’s review of the plan, the comparator group was amended to comprise UK and international banking groups, which the Remuneration Committee considers more appropriate in the context of the Group’s business and performance. For awards made from 2006, the companies in the comparator group will be ABN Amro Holdings N.V.; BSCH; Barclays PLC; Citigroup Inc; HBOS plc; HSBC Holdings plc; Lloyds TSB Group plc and Standard Chartered PLC.
For the EPS element, the level of EPS growth over the three year period will be calculated by comparing the adjusted EPS in the year prior to the year of grant with that in the final year of the performance period. Each year the vesting schedule for the EPS growth measure will be agreed by the Remuneration Committee at the time of grant, having regard to the business plan, performance relative to comparators and analysts’ forecasts.
Short term performance rewards take the form of an annual incentive plan which rewards the achievement of Group, business unit and individual financial and non-financial targets. The normal maximum annual bonus potential is two times salary, although additional amounts to a maximum of a further two times salary may be awarded, at the discretion of the Board, for exceptional performance as measured by the achievement of significant objectives.
Long term incentives consist of the following components: • The two grants made under the Citizens Phantom 2000 Plan vested on 1 January 2005 and 1 January 2006, respectively. The value of units at the time of vesting is performancelinked and is based on the cumulative economic profit generated by Citizens, the trend in economic profit and on the external market trends in the US banking sector, using price/earnings ratios of comparator US banks. This measure was chosen to establish a clear link between the potential incentive and the performance of Citizens. No other grants will be made under this plan.
Sir Fred Goodwin 1 August 1998 60 12 months 6 months The Royal Bank of Scotland plc
Mr Pell 20 February 2006 60 12 months 6 months The Royal Bank of Scotland plc
Mr Watt* 28 September 2000 60 12 months 6 months The Royal Bank of Scotland plc
Service contracts The company’s policy in relation to the duration of contracts with directors is that executive directors’ contracts generally continue until termination by either party, subject to the required notice, or until retirement date. The notice period under the service contracts of executive directors will not normally exceed 12 months. In relation to newly recruited executive directors, subject to the prior approval of the Remuneration Committee, the notice period from the employing company required to terminate the contract will not normally exceed 12 months unless there is a clear case for this. Where a longer period of notice is initially approved on appointment, it will normally be structured such that it will automatically reduce to 12 months in due course.
Sir George Mathewson 1 September 1987 retires 28 April 2006 Sir Tom McKillop 1 September 2005 2006 Mr Buchan 1 June 2002 2006 Dr Currie 28 November 2001 2008 Mr Hunter 1 September 2004 2008 Mr Koch 29 September 2004 2008 Mrs Kong 1 January 2006 2006 Mr MacHale 1 September 2004 2008 Sir Steve Robson 25 July 2001 2008 Mr Scott 31 January 2001 2006 Mr Sutherland 31 January 2001 2006
If Mr Fish’s contract is terminated without cause, or if he terminates the contract for good reason (as defined in the contract), he is entitled to a lump sum payment to compensate him for the loss of 12 months salary plus annual bonus. Mr Fish would also be entitled to receive for this period health, life insurance and long term disability coverage and any other benefits determined in accordance with the plans, policies and practices of Citizens at the time of termination. The Remuneration Committee has been advised that these termination provisions are less generous than the current market practice in the US.
Group Finance Director – Guy Whittaker Guy Whittaker was appointed Group Finance Director on 1 February 2006 and has a service contract with The Royal Bank of Scotland plc dated 19 December 2005. This service contract provides for a normal retirement age of 60 and may be terminated by either party giving 12 months notice to the other.
As Group Finance Director, Mr Whittaker will be eligible to receive short-term annual incentives and long-term incentives on the same basis as other UK-based executive directors.
Executive directors * includes 10% profit sharing ** Mr Fish is a non-executive director of Textron Inc. and retains the fees paid to him in this respect. For 2005, he received a remuneration package from Textron Inc. equivalent to approximately US$75,400.
Options held at Options Market price at 1 January granted in date of exercise Option price Options held at 31 December 2005 2005 2005 Number £ £ Number Exercise period * Options held under the sharesave and option 2000 schemes, which are not subject to performance conditions.
*** Mr Watt resigned from the Board on 31 January 2006.
No options had their terms and conditions varied during the accounting period to 31 December 2005. No payment is required on the award of an option.
In the ten year period to 31 December 2005, awards made using new issue shares under the company’s share plans represented 4.62% of the company’s issued ordinary share capital, leaving an available dilution headroom of 5.38%.
Medium Term Performance Plan Market Market Share interest End of period Scheme interests Awards price on Awards Awards price on (share for qualifying
(share equivalents) at granted award vested in exercised exercise equivalents) at conditions to 1 January 2005 in 2005 £ 2005* in 2005 £ 31 December 2005 be fulfilled
** The exercise of awards for Mr Robertson occurred after his retirement from the Group Board on 20 April 2005.
No variation was made to any of the terms of the plan during the year. The performance measures are detailed on page pages 122 and 123.
Directors’ pension arrangements During the year, Sir Fred Goodwin, Gordon Pell, Iain Robertson and Fred Watt participated in The Royal Bank of Scotland Group Pension Fund (“the RBS Fund”). The RBS Fund is a defined benefit fund which provides pensions and other benefits within Inland Revenue limits.
The pension entitlements of Sir Fred Goodwin, Mr Pell, Mr Robertson and Mr Watt within the RBS Fund are restricted by Inland Revenue limits as set out in the Finance Act 1989. Additional life assurance cover in excess of these limits is provided by a separate arrangement. Arrangements have been made to provide Sir Fred Goodwin and Mr Pell 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. Mr Watt was provided with additional pension benefits on a defined contribution basis and contributions made in the year are shown below.
Of the total transfer value as at 31 December 2005 shown, 25% relates to benefits in funded pension schemes. Sir George Mathewson receives life insurance cover under an individual arrangement. The non-executive directors do not accrue pension benefits, other than Mr Robertson who continued to accrue benefits in the RBS Fund after his appointment as a non-executive director.
(5) The proportion of benefits represented by funded pension schemes for Sir Fred Goodwin, Gordon Pell and Lawrence Fish is 3%, 69% and 3% respectively. All benefits for Iain Robertson and Fred Watt are in funded pension schemes.
(6) Following Mr Pell’s appointment as Executive Chairman, Retail Markets, he was awarded enhanced pension benefits.
(7) In accordance with US market practice, Mr Fish’s pensionable remuneration is limited to $4 million per annum.
Contributions and allowances paid in the year ended 31 December 2005 under defined contribution arrangements were: Mr Watt £144 £128 Mr Fish $139 $91
The company’s Register of Directors’ Interests, which is open to inspection, contains full details of directors’ shareholdings and options to subscribe.
Non-executive directors Sir Tom McKillop — 30,000 Mr Buchan 5,000 5,000 Dr Currie — 556 Mr Hunter 1,500 3,500 Mr Koch 20,000 20,000 Mr MacHale 10,000 10,000 Mr Scott 2,448 4,448 Mr Sutherland — 5,590
(2) The value is based on the share price at 31 December 2005, which was £17.55. During the year ended 31 December 2005 the share price ranged from £15.22 to £18.33.
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 company and the Group and hence for taking reasonable steps for the prevention and detection of fraud and other irregularities.
’r ep or t to t he m em be rs o f T
Respective responsibilities of directors and auditors As described in the ‘Statement of directors’ responsibilities’, the company’s directors are responsible for the preparation of the financial statements in accordance with applicable United Kingdom law and International Financial Reporting Standards (“IFRS”) as adopted for use in the European Union. They are also responsible for the preparation of the other information contained in the 2005 Annual Report including the directors’ remuneration report. Our responsibility is to audit the financial statements and the part of the directors’ remuneration report described as having been audited in accordance with relevant United Kingdom legal and regulatory requirements and International Standards on Auditing (UK and Ireland).
We report to you our opinion as to whether the financial statements give a true and fair view in accordance with the relevant framework and whether the financial statements and the part of the directors’ remuneration report described as having been audited have been properly prepared in accordance with the Companies Act 1985 and Article 4 of the IAS Regulation. We also report to you if, in our opinion, the directors’ report is not consistent with the financial statements, if the company has not kept proper accounting records, if we have not received all the information and explanations we require for our audit, or if information specified by law regarding directors’ remuneration and transactions with the company and other members of the Group is not disclosed.
We also report to you if, in our opinion, the company has not complied with any of the four directors’ remuneration disclosure requirements specified for our review by the Listing Rules of the Financial Services Authority. These comprise the amount of each element in the remuneration package and information on share options, details of long term incentive schemes, and money purchase and defined benefit schemes. We give a statement, to the extent possible, of details of any non-compliance.
We review whether the corporate governance statement reflects the company’s compliance with the nine provisions of the Combined Code specified for our review by the Listing Rules of the Financial Services Authority, and we report if it does not. We are not required to consider whether the Board’s statements on internal control cover all risks and controls, or form an opinion on the effectiveness of the Group’s corporate governance procedures or its risk and control procedures.
US opinion In our opinion, the financial statements present fairly, in all material respects, the financial position of the Group as at 31 December 2005 and 2004 and the results of its operations and its cash flows for each of the two years in the period ended 31 December 2005 in conformity with IFRS.
IFRS vary in certain significant respects from accounting principles generally accepted in the United States of America. Information relating to the nature and effect of such differences is presented in Note 46 to the financial statements.
Deloitte & Touche LLP Chartered Accountants and Registered Auditors Edinburgh, United Kingdom
On initial adoption of IFRS, the Group (and the company where relevant) applied the following exemptions from the requirements of IFRS and from their retrospective application as permitted by IFRS 1 ‘First-time Adoption of International Financial Reporting Standards’: Business combinations – the Group has applied IFRS 3 ‘Business Combinations’ to business combinations that occurred on or after 1 January 2004. Business combinations before that date have not been restated. Under UK GAAP, goodwill arising on acquisitions after 1 October 1998 was capitalised and amortised over its estimated useful economic life. Goodwill arising on acquisitions before 1 October 1998 was deducted from equity. The carrying amount of goodwill in the Group’s opening IFRS balance sheet was £13,131 million, its carrying value under UK GAAP as at 31 December 2003.
Derecognition – the Group has applied the derecognition requirements of IAS 39 to transactions occurring on or after 1 January 1992.
Implementation of IAS 32, IAS 39 and IFRS 4 ‘Insurance Contracts’ (incorporating the adoption of FRS 27 ‘Life Assurance’) – as allowed by IFRS 1, the Group and the company implemented IAS 32, IAS 39 and IFRS 4 with effect from 1 January 2005 without restating the income statement, balance sheet and notes for 2004. The Group has adopted the Amendment to IAS 39 ‘The Fair Value Option’ issued by the IASB in June 2005 also from 1 January 2005. The effect of implementing IAS 32, IAS 39 and IFRS 4 on the Group and company balance sheets and shareholders’ funds as at 1 January 2005 is set out on pages 219 to 220. In preparing the 2004 comparatives, UK GAAP principles then current have been applied to financial instruments. The main differences between UK GAAP and IFRS on financial instruments are summarised on pages 212 to 214.
Discontinued operations and assets classified as held for sale – the Group has applied IFRS 5 ‘Non-current Assets Held for Sale and Discontinued Operations’ from 1 January 2005.
The results of subsidiaries acquired are included in the consolidated income statement from the date control passes to the Group. The results of subsidiaries sold are included up until the Group ceases to control them.
An annual fee payable by a credit card holder is deferred and taken to profit or loss over the period of the service i.e. 12 months.
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.
For defined benefit schemes, scheme liabilities are measured on an actuarial basis using the projected unit credit method and discounted at a rate that reflects the current rate of return on a high quality corporate bond of equivalent term and currency to the scheme liabilities. Scheme assets are measured at their fair value. Any surplus or deficit of scheme assets over liabilities is recognised in the balance sheet as an asset (surplus) or liability (deficit). The current service cost and any past service costs together with the expected return on scheme assets less the unwinding of the discount on the scheme liabilities is charged to operating expenses. Actuarial gains and losses are recognised in full in the period in which they occur outside profit or loss and presented in the statement of recognised income and expense. Contributions to defined contribution pension schemes are recognised in the income statement when payable.
6. Intangible assets and goodwill Intangible assets that are acquired by the Group are stated at cost less accumulated amortisation and impairment losses. Amortisation is charged to profit or loss using methods that best reflect the economic benefits over their estimated useful
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 foreign operations are recognised directly in equity.
Rental income from operating leases is credited to the income statement on a receivable basis over the term of the lease. Operating lease assets are included within Property, plant and equipment and depreciated over their useful lives (see note 7 above).
13. Financial assets Financial assets are classified into held-to-maturity investments; available-for-sale financial assets; held-for-trading; designated as at fair value through profit or loss; or loans and receivables.
Financial assets may be designated as at fair value through profit or loss only if such designation (a) eliminates or significantly reduces a measurement or recognition inconsistency; or (b) applies to a group of financial assets, financial liabilities or both that the Group manages and
A cc ou nt in g po lic ie s evaluates on a fair value basis; or (c) relates to an instrument that contains an embedded derivative which is not evidently closely related to the host contract.
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-fortrading, or designated as at fair value through profit or loss. Loans and receivables are initially recognised at fair value plus directly related transaction costs. They are subsequently measured at adjusted cost using the effective interest method (see note 4 above) less any impairment losses.
Regular way purchases of financial assets classified as loans and receivables are recognised on settlement date; all other regular way purchases are recognised on trade date.
Financial assets carried at amortised cost – if there is objective evidence that an impairment loss on a financial asset or group of financial assets classified as loans and receivables or as heldto -maturity investments has been incurred, the Group measures the amount of the loss as the difference between the carrying amount of the asset or group of assets and the present value of estimated future cash flows from the asset or group of assets discounted at the effective interest rate of the instrument at initial recognition. Impairment losses are assessed individually for financial assets that are individually significant and individually or collectively for assets that are not individually significant. In making collective assessment of impairment, financial assets are grouped into portfolios on the basis of similar risk characteristics. Future cash flows from these portfolios are estimated on the basis of the contractual cash flows and historical loss experience for assets with similar credit risk characteristics. Historical loss experience is adjusted, on the basis of current observable data, to reflect the effects of current conditions not affecting the period of historical experience.
16. Derecognition A financial asset is derecognised when it has been transferred and the transfer qualifies for derecognition. A transfer requires that the Group either: (a) transfers the contractual rights to receive the asset’s cash flows; or (b) retains the right to the asset’s cash flows but assumes a contractual obligation to pay those cash flows to a third party. After a transfer, the Group assesses the extent to which it has retained the risks and rewards of ownership of the transferred asset. If substantially all the risks and rewards have been retained, the asset remains on the balance sheet. If substantially all of the risks and rewards have been transferred, the asset is derecognised. If substantially all the risks and rewards have been neither retained nor transferred, the Group assesses whether or not it has retained control of the asset. If it has not retained control, the asset is derecognised. Where the Group has retained control of the asset, it continues to recognise the asset to the extent of its continuing involvement.
17. 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.
18. Derivatives and hedging Derivative financial instruments are recognised initially, and subsequently measured, at fair value. Derivative fair values are determined from quoted prices in active markets where available. Where there is no active market for an instrument, fair value is derived from prices for the derivative’s components using appropriate pricing or valuation models.
A derivative embedded in a contract is accounted for as standalone derivative if its economic characteristics are not closely related to the economic characteristics of the host contract; unless the entire contract is carried at fair value through profit or loss.
22. Shares in Group entities The company’s investments in its subsidiaries are stated at cost less any impairment.
Critical accounting policies and key sources of estimation uncertainty The reported results of the Group are sensitive to the accounting policies, assumptions and estimates that underlie the preparation of its financial statements. UK company law and IFRS require the directors, in preparing the Group's financial statements, to select suitable accounting policies, apply them consistently and make judgements and estimates that are reasonable and prudent. In the absence of an applicable standard or interpretation, IAS 8 ‘Accounting Policies, Changes in Accounting Estimates and Errors’, requires management to develop and apply an accounting policy that results in relevant and reliable information in the light of the requirements and guidance in IFRS dealing with similar and related issues and the IASB’s Framework for the Preparation and Presentation of Financial Statements.
At 31 December 2005, gross loans and advances to customers totalled £421,110 million (2004 – £351,419 million) and customer loan impairment provisions amounted to £3,884 million (2004 – £4,168 million).
Individual component – all impaired loans that exceed specific thresholds are individually assessed for impairment. Individually assessed loans principally comprise the Group's portfolio of commercial loans to medium and large businesses. Impairment losses are recognised as the difference between the carrying value of the loan and the discounted value of management’s best estimate of future cash repayments and proceeds from any security held. These estimates take into account the customer’s debt capacity and financial flexibility; the level and quality of its earnings; the amount and sources of cash flows; the industry in which the counterparty operates; and the realisable value of any security held. Estimating the quantum and timing of future recoveries involves significant judgement. The size of receipts will depend on the future performance of the borrower and the value of security, both of which will be affected by future economic conditions; additionally, collateral may not be readily marketable. The actual amount of future cash flows and the date they are received may differ from these
Annual Report and Accounts 2005 estimates and consequently actual losses incurred may differ from those recognised in these financial statements.
Pensions The Group operates a number of defined benefit pension schemes as described in Note 3 on the financial statements. The assets of the schemes are measured at their fair value at the balance sheet date. Scheme liabilities are measured using the projected unit method, which takes account of projected earnings increases, using actuarial assumptions that give the best estimate of the future cash flows that will arise under the scheme liabilities. These cash flows are discounted at the interest rate applicable to high-quality corporate bonds of the same currency and term as the liabilities. Any surplus or deficit of scheme assets over liabilities is recognised in the balance sheet as an asset (surplus) or liability (deficit). In determining the value of scheme liabilities, assumptions are made as to price inflation, dividend growth, pension increases, earnings growth and employees. There is a range of assumptions that could be adopted in valuing the schemes’ liabilities. Different assumptions could significantly alter the amount of the deficit recognised in the balance sheet and the pension cost charged to the income statement. The assumptions adopted for the Group’s pension schemes are set out in Note 3 on the financial statements. The pension deficit recognised in the balance sheet at 31 December 2005 was £3,735 million (2004 – £2,940 million).
Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction. Fair values are determined by reference to observable market prices where available and reliable. Where representative market prices for an instrument are not available or are unreliable because of poor liquidity, the fair value is derived from prices for its components using appropriate pricing or valuation models that are based on independently sourced market parameters, including interest rate yield curves, option volatilities and currency rates.
Financial assets carried at fair value include government, asset backed and corporate debt securities, reverse repos, loans, corporate equity shares and derivatives. Financial liabilities carried at fair value include deposits, repos, short positions in securities and debt securities issued. Fair value for a substantial proportion of these instruments is based on observable market prices or derived from observable market parameters. Where observable prices are not available, fair value is based on appropriate valuation techniques or management estimates.
The Group’s derivative products include swaps, forwards, futures and options. Exchange traded instruments are valued using quoted prices. The fair value of over-the-counter instruments is derived from pricing models which take account of contract terms, including maturity, as well as quoted market parameters such as interest rates and volatilities. Most of the Group’s pricing models do not entail material subjectivity because the methodologies utilised do not incorporate significant judgement and the parameters included in the models can be calibrated to actively quoted market prices. Values established from pricing models are adjusted for credit risk, liquidity risk and future operational costs.
Provisions are determined by management based on experience of claims settled and on statistical models which require certain assumptions to be made regarding the
A cc ou nt in g po lic ie s incidence, timing and amount of claims and any specific factors such as adverse weather conditions. In order to calculate the total provision required, the historical development of claims is analysed using statistical methodology to extrapolate, within acceptable probability parameters, the value of outstanding claims at the balance sheet date. Also included in the estimation of outstanding claims are other assumptions such as the inflationary factor used for bodily injury claims which is based on historical trends and, therefore, allows for some increase due to changes in common law and statute. Costs for both direct and indirect claims handling expenses are also included. Outward reinsurance recoveries are accounted for in the same accounting period as the direct claims to which they relate. The outstanding claims provision is based on information available to management and the eventual outcome may vary from the original assessment. Actual claims experience may differ from the historical pattern on which the estimate is based and the cost of settling individual claims may exceed that assumed.
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.
Accounting developments International Financial Reporting Standards The International Accounting Standards Board (“IASB”) issued
IFRS 7 ‘Financial Instruments: Disclosures’ in August 2005. The standard replaces IAS 30 ‘Disclosures in the Financial Statements of Banks and Similar Financial Institutions’ and the disclosure provisions in IAS 32 ‘Financial Instruments: Disclosure and Presentation’. IFRS 7 requires disclosure of the significance of financial instruments for an entity’s financial position and performance and of qualitative and quantitative information about exposure to risks arising from financial instruments. The standard is effective for annual periods beginning on or after 1 January 2007. Earlier application is encouraged.
At the same time the IASB issued an amendment ‘Capital Disclosures’ to IAS 1 ‘Presentation of Financial Statements’. It requires disclosures about an entity's capital and the way it is managed. This amendment is also effective for annual periods beginning on or after 1 January 2007. Earlier application is encouraged.
The second, ‘The Fair Value Option’, published in June 2005, places conditions on the option in IAS 39 to designate on initial recognition a financial asset or financial liability as at fair value through profit or loss. The amendment is effective for annual periods beginning on or after 1 January 2006. Earlier application is encouraged. The Group has adopted this amendment from 1 January 2005 (see accounting policies on page 136).
The third, ‘Financial Guarantee Contracts’, published in August 2005, amends IAS 39 and IFRS 4 ‘Insurance Contracts’. The amendments define a financial guarantee contract. They require such contracts to be recorded initially at fair value and subsequently at higher of the provision determined in accordance with IAS 37 ‘Provisions, Contingent Liabilities and Contingent Assets’ and the amount initially recognised less amortisation. The amendments are effective for annual periods beginning on or after 1 January 2006.
C on so lid at ed in co m e st at em en t
Interest receivable 21,331 16,632 Interest payable (11,413) (7,561) Net interest income 9,918 9,071 Fees and commissions receivable 6,750 6,473 Fees and commissions payable (1,841) (1,926) Income from trading activities 1 2,343 1,988 Other operating income (excluding insurance premium income) 2,953 2,138 Insurance premium income 6,076 6,146 Reinsurers’ share (297) (499) Non-interest income 15,984 14,320 Total income 25,902 23,391 Staff costs 5,992 5,188 Premises and equipment 1,313 1,177 Other administrative expenses 2,816 2,323 Depreciation and amortisation 1,825 1,674
Profit before other operating charges 13,956 13,029 Insurance claims 4,413 4,565 Reinsurers’ share (100) (305) Operating profit before impairment losses 9,643 8,769 Impairment losses 1,707 1,485 Operating profit before tax 4 7,936 7,284
Per 25p ordinary share: Consolidated income statement for the year ended 31 December 2005
Property, plant and equipment 18 18,053 16,428 — — Settlement balances 6,005 5,682 — — Derivatives at fair value 19 95,663 17,800 55 — Prepayments, accrued income and other assets 20 8,798 11,612 147 318
S ta te m en ts o f re co g ni se d in co m e an d e xp en se
Cash flow hedges Net (losses)/gains taken direct to equity (67) 6
Effect of changes in accounting policies on the implementation of IFRS Equity holders of the parent (1,843) 1,243 (16,759) (15,798) Minority interests (2,878) (321) — —
Adjustments for: Depreciation and amortisation 1,825 1,674 — — Interest on subordinated liabilities 1,271 681 583 318 Charge for defined benefit pension schemes 462 397 — — Cash contribution to defined benefit pension schemes (452) (1,146) — — Other non-cash items 338 (767) (16) 1 Net cash inflow from trading activities 11,380 8,123 2,499 3,209 Changes in operating assets and liabilities (519) (4,264) 2,050 (148) Net cash flows from operating activities before tax 10,861 3,859 4,549 3,061 Income taxes (paid)/received (1,911) (1,366) (18) 36 Net cash flows from operating activities 36 8,950 2,493 4,531 3,097
Investing activities Sale and maturity of securities 39,472 43,022 — — Purchase of securities (39,196) (41,790) — — Investment in subsidiaries — — (2,961) (6,342) Sale of property, plant and equipment 2,220 1,921 — — Purchase of property, plant and equipment (4,812) (4,583) — — Net investment in business interests and intangible assets 37 (296) (7,968) — — Loans to subsidiaries — — (337) (350) Repayments to subsidiaries — — 1,183 40 Net cash flows from investing activities (2,612) (9,398) (2,115) (6,652)
Financing activities Issue of ordinary shares 163 2,845 163 2,845 Issue of equity preference shares 1,649 1,358 1,649 1,358 Issue of subordinated liabilities 1,234 4,624 337 1,424 Proceeds of minority interests acquired 1,264 1,260 — — Costs of minority interests redeemed (121) (2) — — Repayments of subordinated liabilities (1,553) (718) (1,183) (40)
Net increase in cash and cash equivalents 2,528 1,900 817 226 Cash and cash equivalents 1 January 50,021 48,121 309 83 Cash and cash equivalents 31 December 52,549 50,021 1,126 309
Introduction IAS 32 ‘Financial Instruments: Disclosure and Presentation’, IAS 39 ‘Financial Instruments: Recognition and Measurement’ and IFRS 4 ‘Insurance Contracts’ were implemented by the Group on 1 January 2005 and applied prospectively from that date and, as permitted by IFRS, without restating comparatives. Consequently, in the notes on the accounts affected by these standards, comparative data for 2004 in accordance with previous GAAP have been presented.
Notes: (1) Includes spot and forward foreign exchange contracts and currency swaps, futures and options and related hedges and funding.
Depreciation and amortisation Property plant and equipment (see note 18) 1,326 1,155 Intangible assets (see note 17) 499 519
N ot es o n th e ac co un ts 3 Pension costs The Group operates a number of pension schemes which are predominantly defined benefit schemes whose assets are independent of the Group’s finances. In addition to The Royal Bank of Scotland Group Pension Fund (‘Main Scheme’), the Group operates a number of other UK and overseas pension schemes.
It also provides other post-retirement benefits, principally through subscriptions to private healthcare schemes in the UK and the US and unfunded post-retirement benefit plans. Provision for the costs of these benefits is charged to the income statement over the average remaining future service lives of the eligible employees. The amounts are not material.
Expected return on plan assets 6.5% 6.7% 6.5% 6.8% Rate of increase in salaries 4.0% 4.0% 3.9% 3.9% Rate of increase in pensions in payment 2.7% 2.7% 2.6% 2.7%
The expected return on plan assets at 31 December is based upon the weighted average of the following assumptions of the returns on the major classes of plan assets: Main Scheme All Schemes
The expected return on Main Scheme plan assets at 31 December 2004 has been adjusted to reflect the investment, in early January 2005, of payments made to the fund on 31 December and included as cash and other assets at that date.
Fair value defined Net Fair value defined Net of plan benefit pension of plan benefit pension assets obligations liability assets obligations liability
Currency translation and other adjustments — — — (18) (9) 9 Income statement: Past service cost — — 11 11
The Group expects to contribute £444 million to its defined benefit pension schemes in 2006 (Main Scheme – £384 million). Of the net pension liability, £104 million (2004 – £95 million) relates to unfunded schemes.
N ot es o n th e ac co un ts Notes on the accounts continued 4 Operating profit before tax Operating profit before tax is stated after taking account of the following: Group £m £m
Income Sales of available-for-sale securities – Gross gains 683 – Gross losses (16) – Net profit 667
Major plan assets as a percentage of total plan assets 2005 2004 2005 2004
Government fixed interest bonds 1.8% 2.1% 2.6% 2.8% Corporate and other bonds 14.6% 12.5% 14.6% 12.7%
Experience losses on plan liabilities (41) (624) (68) (631) Experience gains on plan assets 1,556 392 1,660 408 Actual return on pension schemes assets 2,486 1,230 2,677 1,328
Audit services – Statutory audit 9.9 8.2 – Audit related including regulatory reporting* 7.0 1.1
The auditors’ remuneration for statutory audit of the company was £0.1 million (2004 – £0.1 million). Non–audit fees paid to the auditors and their associates in the UK was £12.4 million (2004 – £6.4 million).
Deferred taxation: Current year charge 477 333 Over provision in respect of prior periods (107) (49) Tax charge for the year 2,378 1,995
N ot es o n th e ac co un ts Notes on the accounts continued 6 Profit attributable to preference shareholders Group
Dividends paid Finance cost Finance to equity included in cost of preference interest preference shareholders payable shares £m £m £m
Non-cumulative preference shares of US$0.01 58 115 105 Non-cumulative convertible preference shares of US$0.01 — 73 90 Non-cumulative convertible preference shares of €0.01 — 9 33 Non-cumulative preference shares of €0.01 51 — 4 Non-cumulative convertible preference shares of £0.01 — 15 15 Appropriation for premium payable on redemption and issue costs — 8 9
(2) Following the implementation of IAS 32 on 1 January 2005, several of the Group’s preference share issues are now included in subordinated liabilities and the finance cost thereon is included in interest payable.
(3) Between 1 January 2006 and the date of approval of these accounts, dividends amounting to US$39 million have been declared in respect of equity preference shareholders for payment on 31 March 2006.
Final dividend for previous year declared during the current year 41.2 35.7 1,308 1,059
Total dividends paid on ordinary equity shares 60.6 52.5 1,927 1,588
Number of ordinary shares: Weighted average number of ordinary shares in issue during the year 3,183 3,085 Effect of dilutive share options and convertible non-equity shares 60 73 Diluted weighted average number of ordinary shares during the year 3,243 3,158
All convertible preference shares have a dilutive effect in the current year and as such have been 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.
Treasury bills and similar securities 5,402 5,538 Other eligible bills 136 572
Amounts above include: Items in the course of collection from other banks 2,901 2,629 Due from subsidiaries 9,122 4,106 12 Loans and advances to customers Group Company £m £m £m £m
Securitisations The Group engages in securitisation transactions of its financial assets including commercial and residential mortgage loans, commercial and residential mortgage related securities, US Government agency collateralised mortgage obligations, and other types of financial assets. In such transactions, the assets, or interests in the assets, are transferred generally to a special purpose entity which then issues liabilities to third party investors.
Continued recognition The table below sets out the asset categories together the carrying amounts of the assets and associated liabilities.
(1) At 31 December 2004, in accordance with previous GAAP, the financial assets in these categories were derecognised to the extent of non-recourse finance as the arrangements qualified for the linked presentation.
(3) Certain finance lease receivables (leveraged leases) involve the Group as lessor obtaining non-recourse funding from third parties. This financing is secured on the underlying leases and the provider of the finance has no recourse whatsoever to the other assets of the Group. In 2004, the Group recognised net income of £13 million.
(5) Credit card receivables in the UK have been securitised. Notes have been issued by a special purpose vehicle. The note holders have a proportionate interest in a pool of credit card receivables that have been equitably assigned by the Group to a receivables trust. The Group continues to be exposed to the risks and rewards of the transferred receivables through its right to excess spread (after charge offs).
(6) The Group sponsors commercial paper conduits. Customer assets are transferred into an SPE which issues notes in the commercial paper market. The Group supplies certain services and contingent liquidity support to these vehicles on an arm’s length basis as well as programme credit enhancement.
Disclosures are given below about those securitisations of financial assets undertaken by the Group that resulted in derecognition or recognition to the extent of continuing involvement. The Group has classified these securitisations into three broad categories: US Agency, consumer, and commercial securitisations. During 2005, the Group received proceeds of approximately £46.3 billion from securitisation trusts in connection with new securitisations of Group assets and £9.6 billion in connection with securitisation of third-party assets.
At 31 December 2005, the fair value of the Group’s retained interests was approximately £2.1 billion (2004 – £1.4 billion). These retained interests comprise approximately £1,179 million in US Agency based retained interests, £764 million in consumer based retained interests and £128 million in commercial based retained interests. These retained interests primarily relate to mortgage loans and securities and arose from securitisations that have taken place in current and prior years. Cash flows received in 2005 from retained interests held at 31 December 2005 in connection with securitisations that took place in current and prior years amounted to approximately £481 million (2004 – £383 million).
Key economic assumptions used in measuring the value of retained interests at the date of securitisation resulting from securitisations completed during the year were as follows: U.S. Agency Consumer Commercial retained retained retained
Weighted average life 1 – 20 years 1 – 10 years 1 – 20 years
Impact on fair value of 10% adverse change £33.5 million £23.8 million £4.7 million Impact on fair value of 20% adverse change £65.1 million £46.0 million £9.1 million
(3) Population consists of securities whose collateral is guaranteed by US Government sponsored entities and therefore, no credit loss has been assumed.
(5) Population consists of only investment grade senior tranches; therefore, no credit losses are included in the assumptions.
(6) Prepayment speed has been stressed on an overall portfolio basis for US Agency retained interests due to the overall homogeneous nature of the collateral. Consumer and commercial retained interests have been stressed on a security level basis.
The sensitivities depicted in the preceding table are hypothetical and should be used with caution. The likelihood of those percent variations selected for sensitivity testing is not necessarily indicative of expected market movements because the relationship of the change in the assumptions to the change in fair value may not be linear. Also, the effect of a variation in a particular assumption on the fair value of a retained interest is calculated without changing any other assumptions. This might not be the case in actual market conditions since changes in one factor might result in changes to other factors. Further, the sensitivities depicted above do not consider any corrective actions that the Group might take to mitigate the effect of any adverse changes in one or more key assumptions.
Agencies have agreed to seek repayment only from the cash from the mortgage loans. Once the securities exchanged for the loans have been sold the Group’s exposure is restricted to the amount of the recourse. At 31 December 2005 mortgages amounting to £385 million (2004 - £472 million) had been sold with recourse and the related securities sold. These loans have been derecognised; they qualified for the linked presentation under previous GAAP.
Investment securities: (1) Amounts above include subordinated debt securities of £644 million at 31 December 2004.
Amount Yield Amount Yield Amount Yield Amount Yield Amount Yield £m % £m % £m % £m % £m %
US government, federal agencies and states 52 2.2 292 2.3 829 1.9 14,976 3.6 16,149 3.5
The table below shows the number and fair value of available-for-sale debt-securities that were in an unrealised loss position at 31 December 2005.
US government, federal agencies and states 511 13,390 228 1,475 35 14,865 263
Held-for-trading 2,937 4 2,941 Designated as at fair value through profit or loss 2,113 428 2,541 Available-for-sale 704 3,115 3,819
Available-for-sale Gross unrealised gains 168 54 222 Gross unrealised losses (5) (8) (13)
At 31 December 2005 the £13 million gross unrealised losses represented 23 equity issues with fair value of £30 million which were in an unrealised loss position for less than 12 months.
The Royal Bank of Scotland plc Banking Great Britain National Westminster Bank Plc(1) Banking Great Britain Citizens Financial Group, Inc. Banking US Coutts & Co(2) Private banking Great Britain Greenwich Capital Markets, Inc. Broker dealer US RBS Insurance Group Limited Insurance Great Britain Ulster Bank Limited(3) Banking Northern Ireland
(3) Ulster Bank Limited and its subsidiary undertakings also operate in the Republic of Ireland.
N ot es o n th e ac co un ts Notes on the accounts continued 16 Impaired and past-due financial assets Group
Impaired financial assets Loans and receivables and finance leases 5,926 3,344 2,582 Available-for-sale 316 132 184
The following table shows impairment losses for loans and receivables and finance leases (2004 – loans and advances).
Implementation of IAS 39 (29) — — — Currency translation and other adjustments 51 (22) (76) (98)
Recoveries of amounts previously written-off 172 144 — 144 Charged to the income statement 1,703 1,386 16 1,402 Unwind of discount (144) — — —
Accumulated amortisation and impairment: Currency translation and other adjustments — 5 3 — 8 Disposals and write-off of fully amortised assets — — — (106) (106) Charge for the year — 58 39 402 499
Net book value at 31 December 2004 18,032 246 239 725 19,242
The weighted average amortisation period of purchased intangible assets, other than goodwill, subject to amortisation are: Years
Corporate Markets NatWest* Core corporate banking 1,888 1,888 (2) Earnings Corporate Markets NatWest* Financial markets 1,563 1,563 (2) Earnings Retail Banking NatWest* NatWest Retail 3,095 2,721(2) Earnings Citizens Mellon Mid-Atlantic 1,209 1,197(1)
Citizens Charter One Charter One 4,471 Value-in-use: (acquired 2004) cash flow
* Of the overall goodwill arising from the acquisition of NatWest in 2000, £2.7 billion (2004 – £3.1 billion) has been allocated to cash generating units other than those shown above.
Mellon business typical of recent transactions in the same region Terminal growth rate after year 7**
Disposals and write-off of fully depreciated assets (80) (493) (21) (51) (360) (1,234) (2,239)
Disposals and write-off of fully depreciated assets — (19) (2) (4) (130) (232) (387) Depreciation charge for the year — 30 3 9 425 688 1,155
Net book value at 31 December 2004 4,162 2,461 266 562 1,312 7,665 16,428 £m £m
Contractual obligations to purchase, construct or develop investment properties or to repair, maintain or enhance investment property 4 155
The fair value of investment properties includes £100 million (2004 – £74 million) of appreciation since purchase. This increase would normally be realised on disposal of the properties. Premises include £84 million (2004 – £570 million) assets in the course of construction.
The company held derivative assets at fair value amounting to £55 million (notional amounts £1 billion).
Forwards include forward foreign exchange contracts and forward rate agreements. A forward contract is a contract to buy (or sell) a specified amount of a physical or financial commodity, at agreed price, on an agreed future date. Forward foreign exchange contracts are contracts for the delayed delivery of currency on a specified future date. Forward rate agreements are contracts under which two counterparties agree on the interest to be paid on a notional deposit of a specified maturity at a specific future date; there is no exchange of principal.
Interest rate contracts Interest rate swaps 4,939 54,964 55,360 Options purchased 296 3,168 — Options written 287 — 3,274 Futures and forwards 1,091 475 479
Non-trading derivatives Under previous GAAP, hedging derivatives were accounted for in accordance with the treatment of the hedged transaction. As a result any gains or losses on the hedging instrument arising from changes in fair values were not recognised in the profit and loss account immediately but accounted for in the same manner as the hedged item. The Group established such non-trading derivative positions externally with third parties and also internally. The tables below include the components of the internal hedging programme that transferred risks to the trading portfolio or to external third party participants in the derivatives market.
Recognised gains that arose in previous periods (781) (65) Recognised losses that arose in previous periods 537 4 Unrecognised gains and losses arising in the year 224 — Unrecognised gains and losses deferred in the year 61 (61) Unrecognised gains and losses deferred and taken to profit or loss in the year — (30)
(1) The amounts include insurance linked liabilities with a carrying value of £2,296 million. The carrying amount of other customer accounts designated as at fair value through profit or loss is £114 million greater than amortised cost. No amounts have been recognised in profit or loss for changes in credit risk associated with these liabilities as the changes are immaterial measured as the change in fair value from movements in the period in the credit risk premium payable by the Group.
(1) No amounts have been recognised in profit or loss for changes in credit risk associated with these liabilities as the changes are immaterial measured as the change in fair value from movements in the period in the credit risk premium payable by the Group. The carrying amount is £365 million less than amortised cost.
N ot es o n th e ac co un ts Notes on the accounts continued 25 Accruals, deferred income and other liabilities Group Company £m £m £m £m
Deferred income 3,333 3,095 — — Provisions for liabilities and charges (see table below) 162 198 — —
(1) Other liabilities include £10 million (2004 – £20 million) in respect of share-based compensation.
Deferred tax liability 1,695 2,061 — — Deferred tax asset (included in Prepayments, accrued income and other assets, Note 20) (156) (47) (3) — Net deferred tax 1,539 2,014 (3) —
Fair Accelerated value of capital Deferred Other financial Pension allowances Provisions gains transition instruments Intangibles Hedging Other Total £m £m £m £m £m £m £m £m £m £m
At 1 January 2004 and 1 January 2005 — Implementation of IAS 32 and IAS 39 (5) At 1 January 2005 restated (5) Charge to equity directly 2 *All relates to hedging.
Opening net assets 772 New business contribution 34 Profit from existing business: Expected return 16 Experience variances (13)
Investment return variances 7 Economic assumption changes (15) Other 23 Closing net assets 824
New business contribution represents the present value of future profits on new insurance contract business written during the year.
Movement in provision for liabilities under life contracts and investment contracts (net of reinsurance)
Debt securities 1,497 1,491 Equity securities 2,217 1,887 Other investments 8 14 Cash and cash equivalents 49 65
The associated liabilities are: Unit-linked contracts classified as insurance contracts 1,640 1,514 Unit-linked contracts classified as investment contracts (within customer deposits) 2,131 1,943
On implementation of IAS 32, certain preference shares were re-classified as liabilities; these securities remain subject to the capital maintenance rules of the Companies Act 1985.
Group 2004 – final redemption £m £m £m £m £m £m £m
N ot es o n th e ac co un ts Notes on the accounts continued 28 Subordinated liabilities (continued) Company 2005 – final redemption £m £m £m £m £m £m £m
Company 2005 – call date £m £m £m £m £m £m £m £m
Company 2004 – final redemption £m £m £m £m £m £m £m
Undated loan capital – US$ — — — — — 1,085 1,085
Currently 2005 2006 2007– 2009 2010– 2014 thereafter Perpetual Total 2004 – call date £m £m £m £m £m £m £m £m
(2) At 31 December 2004 the principle amounts payable to dated and undated loan note holders would not have been materially different from the carrying amount.
(3) On 30 November 2005, the company gave notice of redemption of 8 million Exchangeble Capital Securities, Series A, of US$25 each on 31 December 2005. This occurred on the next banking day, 3 January 2006. On 15 December 2005, NatWest gave notice of redemption of 20 million Exchangeble Capital Securities, Series A, of US$25 each on 17 January 2006.
Annual Report and Accounts 2005 29 Minority interests Group £m £m
Implementation of IAS 32 and IAS 39 on 1 January 2005 (2,541) — Currency translation adjustments and other movements 53 (188) Profit attributable to minority interests 57 177 Dividends paid (95) (147) Equity raised 1,264 1,260 Equity withdrawn (121) (2)
30 Share capital Allotted, called up and fully paid Authorised 1 January Issued during 31 December 31 December 31 December £m £m £m £m £m
Consideration of £163 million was received on the issue of ordinary shares for cash and dividends of £124 million were satisfied by the issue of shares.
During the year to 31 December 2005, options were granted over 17.3 million ordinary shares under the company’s executive, sharesave and option 2000 schemes. At 31 December 2005, options granted under the company’s various schemes, exercisable up to 2015 at prices ranging from 496p to 1841p per share, were outstanding in respect of 70.8 million ordinary shares.
Preference shares In March 2005, the company redeemed 750,000 Series 1 noncumulative convertible preference shares of €0.01 each at €1,000 per share and 500,000 Series 2 non-cumulative convertible preference shares of US$0.01 each at US1,000 per share.
In June 2005, the company issued 1.25 million Series 2 noncumulative preference shares of €0.01 each at €1,000 per share, the net proceeds being €1,226 million.
In November 2005, the company issued 22 million Series P non-cumulative preference shares of US$0.01 each at US$25 per share, the net proceeds being US$533 million and redeemed 9 million Series J non-cumulative preference shares of US$0.01 each at US$25 per share.
Non-cumulative preference shares of US$0.01 1,951 35 499 1,487 Non-cumulative convertible preference shares of US$0.01 978 — — 978 Non-cumulative preference shares of €0.01 864 (4) 860 — Non-cumulative convertible preference shares of €0.01 529 — — 529 Non-cumulative convertible preference shares of £0.01 197 — — 197 Cumulative preference shares of £1 1 — — 1 30 Share capital (continued)
Class of preference share Series in issue or after per share
N ot es o n th e ac co un ts Notes on the accounts continued 31 Reserves Group Company £m £m £m £m
Merger reserve At 1 January and 31 December 10,881 10,881 — —
Retranslation of net assets 1,588 (830) — — Foreign currency (losses)/gains on hedges of net assets (799) 420 — —
Implementation of IAS 32 and IAS 39 on 1 January 2005 (1,078) — 81 — Currency translation adjustments and other movements — (8) — (1) Profit attributable to ordinary and equity preference shareholders 5,501 5,112 2,074 2,874
Equity preference dividends paid (109) — (109) — Preference dividends – non-equity — (256) — (256) Share-based payments, net of tax 112 15 — — Actuarial losses recognised in post-retirement benefit schemes, net of tax (561) (1,136) — —
UK law prescribes that only reserves of the company are taken into account for the purpose of making distributions and the permissible applications of the share premium account. The merger reserve arose on the acquisition of NatWest under UK GAAP accounting.
At 31 December 2005, 680,966 (2004 – 707,247) ordinary shares of 25p each of the company were held by the 1992 Employee Share Trust and 91,951 (2004 – 63,098) ordinary shares of 25p each were held by the 2001 Employee Share Trust in respect of options under the executive option scheme and awards under the medium term performance plan.
32 Leases Minimum amounts receivable and payable under non-cancellable leases Group
Finance lease assets: Present value amounts receivable 809 2,740 7,745 11,294
Amounts recognised as income and expense Finance lease receivables – contingent rental income (34) (51) Operating lease payables – minimum payments 332 319
Contracts for future capital expenditure not provided for at the year end Operating leases 594 423
Residual value exposures The tables below give details of the unguaranteed residual values included in the carrying value of finance lease receivables (see page 181) and operating lease assets (see note 18).
Securities transferred under repurchase transactions included within securities on the balance sheet were as follows: £m £m
All of the above securities could be sold or repledged by the holder. Securities received as collateral under reverse repurchase agreements amounted to £105.6 billion (2004 – £91.4 billion), of which £85.6 billion (2004 – £85.1 billion) had been resold or repledged as collateral for the Group's own transactions.
The Board establishes the overall governance framework for risk management and sets the risk appetite and philosophy for the Group.
The principal financial risks that the Group manages are as follows: • Credit risk: credit risk is the risk arising from the possibility that the Group will incur losses from the failure of customers to meet their obligations.
• Liquidity risk: the risk that the Group is unable to meet its’ obligations as they fall due.
• Insurance underwriting risk: the Group is exposed to insurance risk, either directly through its businesses or through using insurance as a tool to mitigate other risk exposures.
Credit risk The objective of credit risk management is to enable the Group to achieve sustainable and superior risk versus reward performance whilst maintaining credit risk exposure in line with approved risk appetite.
• An appropriate credit risk assessment of the customer and related credit facilities must be undertaken prior to approval of credit exposure. This must include an assessment of, amongst others, the purpose of the credit and sources of repayment, compliance with affordability tests, repayment history, capacity to repay, sensitivity to economic and market developments and risk-adjusted return.
• The Board delegates authority to Executive Advances Committee, Group Credit Committee and divisional credit committees. A divisional CEO may delegate a subset of the divisional credit risk authority to sub-committees or to individuals.
• Where credit authority is exercised personally, the individual must not have any responsibility or accountability for business revenue origination.
• All credit exposures, once approved, must be effectively monitored and managed and reviewed periodically against approved limits. Review occurs at least annually, with lower quality exposures being subject to a greater frequency of analysis and assessment.
• Customers with emerging credit problems must be identified early and classified accordingly. Remedial actions must be implemented promptly to minimise the potential loss to the Group and consideration should be given whether to transfer customers with credit problems to a specialised problem management or recovery unit.
• Portfolio analysis and reporting must be used to identify and manage credit risk concentrations and credit risk quality migration.
Credit grading models In order to support the analytical elements of the credit risk management framework, in particular the risk assessment part of the credit approval process, ongoing monitoring and portfolio analysis, the Group employs a range of credit risk models. These models can be broadly grouped into four categories.
Risk assets The Group’s portfolio consists of loans (including overdraft facilities), instalment credit, finance lease receivables, debt securities and other traded instruments. In order to encompass the entire range of products in the Group’s credit portfolios exposure is monitored using risk assets, which cover exposures to all these asset and customer types.
The degree of maturity mismatch within the overall long-term structure of the Group’s assets and liabilities is also managed within internal policy limits, to ensure that term asset commitments may be funded on an economic basis over their life. In managing its overall term structure, the Group analyses and takes into account the effect of retail and corporate customer behaviour on actual asset and liability maturities where they differ materially from the underlying contractual maturities. The short-term maturity structure of the Group’s assets and liabilities is managed on a daily basis to ensure that contractual cash flow obligations, and potential cash flows arising from undrawn commitments and other contingent obligations, can be met as they arise from day to day, either from cash inflows from maturing assets, new borrowing or the sale or repurchase of debt securities held.
The level of large deposits taken from banks, corporate customers, non-bank financial institutions and other customers and significant cash outflows therefrom are also reviewed to monitor concentrations and identify any adverse trends.
Value-at-risk (“VaR”) VaR is a technique that produces estimates of the potential negative change in the market value of a portfolio over a specified time horizon at given confidence levels. For internal risk management purposes, the Group’s VaR assumes a time horizon of one day and a confidence level of 95%. The Group uses historical simulation models in computing VaR. This approach, in common with many other VaR models, assumes that risk factor changes observed in the past are a good estimate of those likely to occur in the future and is, therefore, limited by the relevance of the historical data used. The Group’s method, however, does not make any assumption about the nature or type of underlying loss distribution. The Group typically uses the previous two years of market data. The Group’s VaR should be interpreted in light of the limitations of the methodology used. These limitations include: • Historical data may not provide the best estimate of the joint distribution of risk factor changes in the future and may fail to capture the risk of possible extreme adverse market movements which have not occurred in the historical window used in the calculations.
Treasury The Group’s treasury activities include its money market business and the management of internal funds flow within the Group’s businesses. Money market portfolios include cash instruments (principally debt securities, loans and deposits) and related hedging derivatives.
Structural interest rate risk is calculated in each division on the basis of establishing the repricing behaviour of each asset and liability product. For many products, the actual interest rate repricing characteristics differ from the contractual repricing. In most cases, the repricing maturity is determined by the market interest rate that most closely fits the historical behaviour of the product interest rate. For non-interest bearing current accounts, the repricing maturity is determined by the stability of the portfolio. The repricing maturities used are approved by Group Treasury and divisional asset and liability committees at least annually. Key conventions are reviewed annually by GALCO.
The US dollar open structural foreign currency exposure reflects the action taken to mitigate the effect of the acquisition in 2004 of Charter One on the Group’s capital ratios. However, the increase in this position and the Euro structural exposure over 2004 is largely the result of the exclusion from the table of preference shares classified as equity under IFRS. These instruments continue to be considered part of the currency funding of foreign operations for asset and liability management purposes. The exposure in Chinese RMB arises from the Group’s strategic investment in Bank of China.
� Equity risk Non-trading equity risk arises principally from the Group’s strategic investments, its venture capital activities and its general insurance business.
Insurance risk The Group is exposed to insurance risk, either directly through its businesses or through using insurance as a tool to reduce other risk exposures.
Estimate of ultimate claims costs: At end of accident year 2,395 3,013 3,658 3,705 4,247 17,018
Current estimate of cumulative claims 2,317 3,093 3,412 3,519 4,247 16,588
Liability recognised on the balance sheet 198 413 775 998 2,212 4,596
Liability in respect of prior years 208 Claims handling costs 109
Insurance claims – net of reinsurance £m £m £m £m £m £m
Estimate of ultimate claims costs: At end of accident year 2,011 2,584 3,215 3,508 4,150 15,468
Three years later 13 (3) — — — 10 Four years later (41) — — — — (41)
Earned Claims Loss Earned Claims Loss premiums incurred ratio premiums incurred ratio
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, the social, economic and legislative environment and reinsurance failure risks.
Fluctuations in the social and economic climate are a source of uncertainty in the Group’s general liability account. Other sources of uncertainty are changes in the law, or its interpretation, and changes in the actuarial estimates underlying long-term claims. Other uncertainties are significant events (for example terrorist attacks) and any emerging new heads of damage, types of claim that are not envisaged when the policy is written.
The main source of uncertainty affecting the Group's creditor accounts is the economic environment.
The Group is not exposed to price, currency, credit, or interest risk on unit linked life contracts but it is exposed to variation in management fees. A decrease of 10% in the value of the assets would reduce the asset management fees by £5 million per annum (2004 – £5 million). The Group also writes insurance contracts with minimum guaranteed death benefits that expose it to the risk that declines in the value of underlying investments may increase the Group’s net exposure to death risk.
Pre-2000 products – NatWest Life Term assurances 65% TM80 ultimate + 33% AIDS R6A Unit-linked assurances 60% AM80 ult. Rates above are for male, non-smokers.
Post-2000 products Term assurances 60% TM80 ult + 33% AIDS R6A
Pre-2000 products – NatWest Life Term assurances £26.79 £25.13 Single premium unit-linked bonds £23.86 £22.38
Frequency and severity of claims – for contracts where death is the insured risk, the most significant factors that could increase the overall frequency of claims are epidemics or wide spread changes in lifestyle, resulting in earlier or more claims than expected.
Interest rates +1% (16) Interest rates –1% 20 Expenses +10% (5) Assurance mortality/morbidity +5% (7) Annuitant mortality – 5% —
Remaining maturity 1 month Within 3-12 1-5 Over 5 Equity or less 3 months months years years shares Total 2005 £m £m £m £m £m £m £m
Assets Cash and balances at central banks 4,759 — — — — — 4,759 Treasury bills and other eligible bills 779 1,252 3,507 — — — 5,538 Loans and advances to banks 46,276 14,959 8,749 265 338 — 70,587 Loans and advances to customers 139,732 48,881 42,485 66,488 119,640 — 417,226
Equity shares — — — — — 4,723 4,723 Settlement balances 5,682 — — — — — 5,682
Settlement balances and short positions 4,738 577 282 19,486 7,907 — 32,990
Company or less months months years years Total 2005 £m £m £m £m £m £m
Liabilities Deposits by banks 32 919 — — — 951 Customer accounts — 55 — — — 55 Debt securities in issue 909 2,033 — — — 2,942
Assets Loans and advances to banks 196 664 351 680 2,215 4,106 Loans and advances to customers — — — — 305 305
After 3 After 6 After 1 months months year but less but less but less 3 months than than than Over 5 or less 6 months 1 year 5 years years Total 2005 £’000 £’000 £’000 £’000 £’000 £’000
(Loss)/gain per basis point increase (487) (40) 180 (1,631) 1,146 (832)
Assets Loans and advances to banks 14,829 5,140 1,367 77 482 3,272 25,167 35,906 61,073 Loans and advances to customers 191,796 16,632 11,177 34,687 28,419 2,304 285,015 62,236 347,251 Debt securities and treasury bills 12,530 4,088 3,656 6,133 13,548 2,416 42,371 57,647 100,018
Internal funding of trading business (42,516) (313) (1,088) (9) — — (43,926) 43,926 —
Cumulative interest rate sensitivity gap (36,238) (31,971) (28,426) 591 36,443 34 Financial instruments (continued)
After 3 After 6 After 1 months months year Total Non but less but less but less interest interest Banking 3 months than than than Over 5 earning/ earning/ Book or less 6 months 1 year 5 years years bearing Yield bearing Total
Assets Loans and advances to banks 1,803 554 119 1,585 5,061 9,122 6.05 — 9,122 Loans and advances to customers 305 — — 262 — 567 2.82 — 567 Investment in subsidiaries — — — — — — — 20,851 20,851 Other assets — — — — — — — 202 202
Treasury bills and other eligible bills — — Held-for-trading 3,004 3,004 — — Available-for-sale 2,534 2,534 — —
Debt securities Held-for-trading 80,653 80,653 — — Designated as at fair value through profit or loss 3,991 3,991 — — Available-for-sale 35,533 35,533 — — Loans and receivables 788 788 — —
Equity shares Held-for-trading 2,941 2,941 — — Designated as at fair value through profit or loss 2,541 2,541 — — Available-for-sale 3,819 3,819 — —
Banking business 4,237 4,679 — — Trading business 486 486 — —
Debt securities in issue Held-for-trading 1,469 1,469 — — Designated as at fair value through profit or loss 11,068 11,068 — —
Subordinated liabilities Designated as at fair value through profit or loss 150 150 — —
Assets: denominated in sterling 279,433 denominated in currencies other than sterling 308,689
Finance leases and instalment credit 2,973 — — — 2,973 —
(2) This column shows the amount by which exposures to counterparties are reduced by the existence of a legal right of set off (on the basis that the financial asset will be collected in accordance with its terms) and under master netting arrangements. The credit risk of financial assets subject to a master netting arrangement is eliminated only to the extent that financial liabilities due to the same counterparty will be settled after the assets are realised. The extent to which the Group's credit risk is reduced through a master netting arrangement may change substantially within a short period following the balance sheet date because the exposure is affected by each transaction subject to the arrangement.
Contingent liabilities and commitments The amounts shown in the table below are intended only to provide an indication of the volume of business outstanding at 31 December. Although the Group is exposed to credit risk in the event of non-performance of the obligations undertaken by customers, the amounts shown do not, and are not intended to, provide any indication of the Group’s expectation of future losses.
– less than one year 121,911 109,653 — — – one year and over 81,110 69,577 — —
Banking commitments and contingent obligations, which have been entered into on behalf of customers and for which there are corresponding obligations from customers, are not included in assets and liabilities. The Group’s maximum exposure to credit loss, in the event of non-performance by the other party and where all counterclaims, collateral or security proves valueless, is represented by the contractual nominal amount of these instruments included in the table. These commitments and contingent obligations are subject to the Group’s normal credit approval processes and any potential loss is taken into account in assessing provisions for bad and doubtful debts in accordance with the Group’s provisioning policy.
Operating profit before tax 7,936 7,284 1,932 2,890 Decrease/(increase) in prepayments and accrued income 1,064 (333) 4 (17) Interest on subordinated liabilities 1,271 681 583 318 (Decrease)/increase in accruals and deferred income (1,200) 1,750 8 (7) Provisions for impairment losses 1,707 1,402 — — Loans and advances written-off net of recoveries (1,870) (1,305) — — Unwind of discount on impairment losses (144) — — — Profit on sale of property, plant and equipment (91) (69) — — Loss/(profit) on sale of subsidiaries and associates 80 (4) — — Profit on sale of securities (667) (167) — — Charge for defined benefit pensions 462 397 — — Cash contribution to defined benefit pension schemes (452) (1,146) — — Other provisions utilised (34) (47) — — Depreciation and amortisation 1,825 1,674 — — Other non-cash items 1,493 (1,994) (28) 25 Net cash inflow from trading activities 11,380 8,123 2,499 3,209 (Increase)/decrease in loans and advances to banks and customers (36,778) (72,955) (14) 77 Increase in securities (28,842) (11,883) — — (Increase)/decrease in other assets (2,390) (2,208) 5 33 (Increase)/decrease in derivative assets (5,758) (3,753) 50 21 Changes in operating assets (73,768) (90,799) 41 131 Increase in deposits by banks and customers 32,424 53,073 832 18 Increase in insurance liabilities 620 866 — — Increase/(decrease) in debt securities in issue 24,147 19,073 1,328 (269) Increase/(decrease) in other liabilities 571 919 (55) (19) Increase/(decrease) in derivative liabilities 5,161 3,808 (96) (9) Increase in settlement balances and short positions 10,326 8,796 — — Changes in operating liabilities 73,249 86,535 2,009 (279) Total income taxes paid (1,911) (1,366) (18) 36 Net cash inflow from operating activities 8,950 2,493 4,531 3,097 37 Analysis of the net investment in business interests and intangible assets Group £m £m
Fair value given for businesses acquired (85) (8,157) Cash and cash equivalents acquired — 457 Non-cash consideration 10 4 Net outflow of cash in respect of purchases (75) (7,696)
Cash and cash equivalents in businesses sold 10 — Other assets sold 208 18 Non-cash consideration (30) — (Loss)/profit on disposal (80) 4 Net inflow of cash in respect of disposals 108 22 Dividends received from joint ventures 16 9 Cash expenditure on intangible assets (345) (303) Net outflow (296) (7,968)
N ot es o n th e ac co un ts 38 Interest received and paid Group Company £m £m £m £m 39 Analysis of changes in financing during the year Group Company
Share capital Subordinated liabilities Share capital Subordinated liabilities £m £m £m £m £m £m £m £m
Repayment of subordinated liabilities (1,553) (718) (1,183) (40) Net cash inflow/(outflow) from financing 1,812 4,203 (319) 3,906 1,812 4,203 (846) 1,384 Acquisitions of subsidiaries — — — 397 — — — —