Report and accounts 43 Operating and financial review 101 Governance 127 Financial statements 225 Additional information 251 Shareholder information
Corporate Responsibility 38 Corporate Responsibility 40 Key Achievements 41 Community Investment
� Total dividend for the year of 90.6p per share, up 25%
The Group’s total income grew by 10% to £28,002 million in 2006.
The directors have recommended a final dividend of 66.4p per ordinary share which, when added to the interim dividend of 24.2p, makes a total for 2006 of 90.6p, an increase of 25%.
The Group’s cost:income ratio was 42.1%. 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.
Group operating profit increased by 14% to £9,414 million in 2006.
The 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
Financial performance and use of capital In 2006 the Group operating profit increased by 14% to £9,414 million (2005 – £8,251 million). Total income grew by 10% to £28,002 million (2005 – £25,569 million), while operating expenses grew by just 8% to £12,252 million
Board of directors I would also like to thank my Board colleagues for their commitment and support during 2006.
The economy and environment In general, we have enjoyed benign economic conditions which have proved favourable to our businesses, though there have been and will continue to be challenges. The Group is well positioned for growth in all its geographies and invested £2.8 billion in infrastructure in 2006 to support our growth ambitions.
The environment has appropriately become the focus of much attention. I am pleased to say that with our adoption of the revised Equator Principles and our approach to sustainability in all we do, RBS has established a fine reputation as a responsibly managed company.
C h ai rm an ’s s ta te m en t
The Group maintained strength and momentum in 2006 with higher earnings growth and an improved return on equity. All our growth was organic and all our divisions contributed to it. We increased our total income by 10% and held our cost growth to 8%. Group operating profit increased by 14% to £9,414 million.
Our shareholders The capital generated by our businesses during 2006 has enabled us to invest in profitable organic growth across the Group, carry out a £1 billion share buyback and we propose to raise our payout ratio to 45% through a final dividend of 66.4p, making a total of 90.6p for the year, an increase of 25%.
Outlook Our proven business model delivered strong results in 2006. We are expanding our reach and making progress in all the major economies we operate in. We believe that the strategic choices we have made, together with the prospects for continued growth in the world economy, position us well for 2007. We remain confident in the Group’s ability to take advantage of the many opportunities to invest profitably in sustainable growth.
– No 1 for Global Asset Backed Securities and Mortgage Backed Securities
Ulster Bank provides a broad range of banking and other financial services for personal and corporate customers across the island of Ireland, through branches, the telephone and the internet. It has the largest share of personal and business customers in Northern Ireland and is the third-largest bank in the Republic of Ireland.
Manufacturing is the ‘engine room’ of the RBS Group, supplying processing, telephony, IT, property, purchasing and security expertise to the Group’s business divisions.
Manufacturing’s support and services enable the Group to operate continuously 365 days a year and 24 hours a day, whilst providing a strong, stable and scalable platform for future growth.
UK and is growing its direct business in Spain, Italy and
– No 1 UK direct insurer by both phone and internet
– UK Corporate Banking UK Corporate Banking is the largest provider of banking, finance and risk management services to UK corporate customers. Through its network of relationship managers across the country it distributes the full range of Corporate Markets’ products and services to companies.
Global Banking & Markets (GBM) � GBM has a strong client franchise across our chosen markets. We have relationships with the great majority of the largest UK, US and European corporations and institutions, including over 95% of the FTSE 100, 80% of the Fortune 100, and over 95% of the Dow Jones Eurostoxx 50.
� RBS helped Arsenal Football Club sell £260 million secured long-dated bonds to refinance the shorter-term construction loans used to fund their new Emirates Stadium. The deal was described by Euroweek as arguably the most comprehensive application of structured finance techniques in an asset-backed securitisation deal yet in Europe.
� RBS was selected by German industrial conglomerate Siemens as one of six banks arranging $4 billion acquisition finance facilities and one of four joint lead managers for Europe’s largest-ever hybrid bond issue of £900 million and €750 million.
� We arranged acquisition financing for the newly built Kamppi Shopping Centre in central Helsinki. The owners agreed to sell the company to a new company established by Boultbee, a specialist shopping centre manager, and RBS, for €345 million. The shopping centre opened in March 2006 and was visited by more than three million people in its first month.
Renewable energy Last year RBS was the largest provider of funding for renewable energy projects and is the market leader internationally for wind farm financing, with over £1 billion of funding for projects globally.
� UKCB works closely with GBM to provide specialist products and distribution for larger clients.
� Corporate Banking is the UK’s No 1 bank for businesses with turnover in excess of £25 million, and operates in the UK and offshore. It offers a combination of dedicated relationship directors and specialist sector teams. Corporate Banking continues to be a market leader in the provision of funding and risk management products to mid-market corporate customers in the UK.
� RBS Invoice Finance is a leading invoice finance provider in Europe with over 8,000 clients. It operates from 25 locations across the UK and continental Europe. Both the French and German businesses now trade under the RBS Group brand.
Examples of UKCB client transactions � RBS was instrumental in assisting Mitchells & Butlers, the pub and restaurant operator, to relever its asset portfolio, involving transactions totalling more than £2 billion. This allowed it to refinance existing debt, fund a strategically important acquisition and make a substantial cash payment to its shareholders.
� RBS Corporate Banking in Birmingham led and co-arranged a £750 million syndicated facility for Pendragon, the UK’s leading motor retailer group.
WA Developments Group WA Developments Group includes the UK’s largest haulage company, Eddie Stobart. RBS Corporate Banking, RBS Invoice Finance and Lombard provided a refinance package to assist the company’s future growth and development.
� RBS provided a trade cycle finance facility of £2.3 million to Shubiz, designers and importers of ladies shoes from the Far East.
� RBS Commercial Banking in Cardiff provided £1.5 million debt funding for Freshwater UK, which enabled this Welshbased communications agency to make a further acquisition that will help grow turnover by 50% to around £6 million in 2006/07.
� RBS Corporate Banking in Southampton provided a debt package to support Graphite Capital in the purchase of the largest UK independent tyre wholesaler, distributor and retailer, Micheldever Tyre Services.
� RBS Corporate Banking in Scotland provided Wolfson MicroElectronics with a revolving credit facility complemented by international cash management, corporate treasury and trade finance solutions to help the firm focus on building its business and expanding into new markets.
� RBS Corporate Banking has provided the Haymarket Group with a long-dated finance package to support growth aspirations.
Best Global Project Finance House of the Year – Project Finance Sector Euromoney
Best Use of IT in Wholesale Banking Financial Sector Technology Awards 2006
Alder Sportswear Distributors of watersports equipment Alder Sportswear recently moved to NatWest Commercial Banking in Exeter believing that our products and services would help them move their business forward. RBS financial products included international trade finance, invoice finance and foreign exchange hedging, allowing the company to concentrate on product design, development and distribution.
Savings products 2006 saw strong growth in our savings and investment products with a 56% increase in bancassurance sales. We increased the number of financial planning managers in our branch network by 25%.
� Contribution £4,364 million (2005 – £4,191 million) � Total income up 5% � Operating profit up 5%
Retail Markets focuses on serving our personal and small business customers. It was established in June 2005 to strengthen the co-ordination of our full range of retail banking services across our brands and channels in the UK. In December 2006 we created four distinct business areas: Consumer Banking, Business Banking and Cards & Direct Finance operate in the UK; and Wealth Management serves customers in the UK, continental Europe and the Asia Pacific region.
Consumer Banking � Consumer Banking is joint first in the UK current account market and the leading provider in the UK student current account market.
� We continue to grow our share of the UK savings market. The number of savings accounts taken out with NatWest in 2006 grew by 11%, and balances grew by 14%, helped by significant improvements to the speed and ease of opening an account either in a branch, by telephone or via the internet.
� With over 2,250 branches, the Royal Bank of Scotland and NatWest have the UK’s largest branch network. We also have the largest free-to-use ATM network, with over 6,600 under the Royal Bank of Scotland, NatWest and Tesco Personal Finance brands.
� The Royal Bank of Scotland and NatWest maintained our commitment to development of the branch network, opening new branches, refurbishing or upgrading dozens of branches, increasing the number of branches open on Saturdays, and adding mobile bank routes in South Wales and Aberdeenshire.
� We have one million new active telephone and internet users, with an annual growth in active usage of more than 25%. Since May 2006, customers have been automatically enrolled for telephone and internet banking when opening a new account. 5.4 million customers use our telephone banking service every month.
� Our Customer Account Opening system enables our customers to open additional accounts within minutes, whether they use branches, telephone or the internet.
� We launched RBS Intermediary Partners, providing intermediaries with one point of contact for the Group’s main mortgage brands: Royal Bank of Scotland, NatWest, First Active and the One account.
� We launched Royal Bank of Scotland and NatWest ‘Lifetime Mortgages’, offering existing customers a no negative equity guarantee and an option of either a monthly income, lump sum or combination of both; and an interest rate fixed for life.
� Retail Markets was the fastest-growing UK Bancassurer in 2006, with sales increasing by 56% to £267 million annualised premium equivalent in 2006 and 116,000 customers taking out £8.9 billion worth of life assurance cover.
� We have introduced significant changes to our Bancassurance administration processes and systems. These help to process our customers’ applications faster, and include a new telephone support team and a new, shorter application form.
� We piloted Shariah Commercial Property Finance in Leeds and Bradford to provide Muslim customers with compliant finance options.
� Mentor, our business advice service for employment law, health & safety, and tax, assisted more than 22,000 customers last year.
� The relationship with Bank of China gives us access to one of the fastest-growing cards markets in the world, and our joint business has issued 1.2 million cards in China.
Private Banking RBS and NatWest have the largest market share of affluent current account holders and in the past three years have seen a 30% increase in the number of customers who earn over £100,000. Private Banking has been re-launched to meet the needs of this customer group with dedicated relationship managers, and 24 hour telephone support.
Mint Mobile In 2006 Mint customers were given the option of managing their credit card payments via their mobile phone.
� The number of transactions processed by our payment acquiring business topped three billion for the first time, an increase of 6% on 2005.
� By combining our card issuing and acquiring capabilities, we were the first in Europe to develop and trial a ‘contactless card’, for making payments of under £10 without the need for cash.
� Hanco is the largest supplier of third-party ATMs in the UK. Although Hanco offers a range of internal and external ATM options, it predominately operates ATMs on a ‘merchant replenishment basis’. Hanco has continued to grow market share successfully ahead of competition.
� Our direct brand MINT has continued to grow and as well as credit cards also offers gift cards, loans and motor insurance. Over two thirds of MINT credit card applications come via the internet. MINT card customers can set email and text alerts to help them manage their accounts quickly and simply, and can receive statements and balances by text message.
� With five million customer accounts and 22 products and services, our joint venture Tesco Personal Finance is the UK’s largest and most successful supermarket bank. Tesco Personal Finance operates in the UK, Ireland, Hungary and Poland.
� Tesco Personal Finance is the third-largest issuer of car insurance policies in the UK. In 2006 we introduced Value Car Insurance, offering modified comprehensive cover to motorists who currently have only third party insurance.
Free Access to Cash for Deprived Communities In July 2006 RBS committed to providing 300 free-to-use cash machines for deprived and rural areas. We have worked with community groups, local authorities and the National Federation of Sub-Postmasters to find host sites for these machines.
Best On Line Business Banking Provider – Royal Bank and NatWest Business Your Money Direct
The Editor’s Award: The race for China’s High Net Worth Individuals – Coutts Asia Private Banker International Awards 2006
Best Current Account of 2006 – RBS International for Advantage and Royalties International Portfolio International
The Sunday Times Best Big Companies To Work For – 4th – RBS Retail Banking The Sunday Times
� Coutts International has a network of offices in Switzerland and a presence in selected jurisdictions around the world. In 2006 the headquarters for this business was moved from Switzerland to Singapore.
� Sustained investment in Asia has seen Coutts grow its client base by 13% and revenues in the region by 24%.
� Working with GBM we have enhanced our derivatives and FX capacity which is proving attractive with ultra high net worth clients elsewhere in the world.
� RBS International launched a new internet banking service, i-banking, providing an online personal multicurrency, multi-jurisdiction service with access to international and same-day UK payments.
Ulster Bank Ulster Bank paid tribute to footballing legend George Best with a commemorative five pound note this year. The response from fans around the globe was overwhelming and the limited edition of one million notes sold out in ten days. Barbara McNarry, his sister, is pictured with one of the notes in the family home.
� Contribution £602 million (2005 – £530 million) � Total income up 15% � Operating profit up 20%
Ulster Bank, including First Active, provides an extensive range of retail and wholesale financial services for personal and corporate customers across the island of Ireland, through branches, business centres, the telephone and the internet.
� We acquired 18,000 new student customers (9,000 in Northern Ireland and 9,000 in the Republic of Ireland), representing a 50% increase on 2005. Additional relationships were established with the two major universities in Northern Ireland.
� We have increased staff numbers by 9% to provide additional service in our branches and Business Centres. We have grown our Corporate Markets sales force by 15% in the last 18 months, with 200 new recruits.
� We continued our £50 million branch improvement and maintenance programme, transforming an additional 66 branches in 2006. The programme is now 70% complete and scheduled to finish in 2007.
� We increased the number of our Business Centres, opened a new bank branch in Midleton, Co. Cork, and relocated our Donegal and Dundrum branches to larger premises.
� First Active introduced an offset flexible mortgage that allows customers to link savings accounts and a current account to reduce the cost and duration of their mortgage.
� We have successfully integrated our banking systems with the RBS Group IT platform giving us a unique competitive advantage in Ireland, as well as access to a wider range of products.
� Ulster Bank Structured Finance together with the RBS Power Sector Team successfully structured the funding of a 59.5 Megawatt windfarm involving 70 wind turbines situated in a large bogland site in Gort, Co. Galway, for Gort Windfarms Limited, a subsidiary of ESB.
� We provided £360 million financing for a group of Irish investors to buy Fosse Park, a shopping centre outside Leicester, in the largest single retail property acquisition in the UK since the late 1990s.
� We have diversified our funding base through securitisations, issuing Ireland’s largest residential mortgage securitisation of €3.9 billion and confirming Ulster Bank’s status as the largest issuer of securitisation bonds to date in the Irish market.
YouthBank Ulster Bank has launched a network of 30 YouthBanks in partnership with three national community youth foundations. This initiative encourages youngsters to take decisions on which youth-led community projects to support, underlining Ulster Bank’s commitment to its community investment programme across the island of Ireland.
� Contribution US$2,917 million (2005 – US$2,867 million) � Total income up 3% � Operating profit up 2%
Citizens Financial Group is engaged in retail and corporate banking activities through its branch network in 13 states in the US and through nonbranch offices in 30 other states. Citizens was ranked the eighth largest commercial banking organisation in the US based on deposits as at 30 September 2006. Citizens Financial Group includes the seven Citizens Banks; Charter One; RBS National Bank, our US credit card business; RBS Lynk, our merchant acquiring business; and Kroger Personal Finance, our joint venture with the second-largest US supermarket group.
� Citizens is a major player in US banking. Among commercial banking organisations it ranks 9th in assets, 7th in personal loans, 8th in deposits, 16th in mortgages, 6th in home equity loans, 9th in credit cards, and 14th in business lending.
� Last year was Citizens’ 14th consecutive year of record profits, and in 2006 profit increased by 2% to US$2,917 million. Citizens has been building its customer franchise in commercial banking and in card issuing and acquiring. Business and home equity lending also showed good growth.
� Citizens’ Debit Rewards debit card programme, through which customers earn redeemable points, was well received by customers and led to an average 3,800 new enrollments per day.
� More than 1.8 million credit cards were issued under the RBS, Citizens and Kroger brands. Citizens’ partnership with Kroger, the second-largest US supermarket group, was extended to include pre-payment cards, mortgages and other financial products.
� RBS Lynk, our merchant acquiring business, achieved significant growth, processing 40% more transactions than in 2005 and expanding its merchant base by 11%. RBS Lynk became only the second processor in the US to offer its merchants full end-to-end acquiring, processing and settlement for transactions.
� Citizens’ commercial business has grown significantly since December 2005, with average commercial loans up 15% excluding financed leases. In foreign exchange, interest rate derivatives and cash management we benefited from the product strength of RBS Corporate Markets.
� The Government Banking division recorded a 14% increase in total funds under management during 2006, rising to US$14 billion.
� Citizens’ purchase of GreatBanc, Inc., announced in October 2006 and completed on 1 February 2007, continues the Charter One Bank expansion in Illinois and makes it the fourth-largest bank in the greater Chicago marketplace.
� Since it began in 2002, Citizens’ Community Champions in Action programme has assisted 94 small, non-profit agencies dedicated to significant social service issues.
� Charter One is making available US$150 million in loans over three years for economic and community development in and around Cleveland’s University Circle in Ohio.
� More than 140 colleagues have benefited from our military leave policy, which was extended above and beyond legal requirements, to bridge pay and benefits to cover the duration of military leave.
Innovator of the Year – large company category Boston Business Journal’s Corporate Philanthropy Summit 2006
Governor’s Outstanding Volunteer Award Citizens Bank, Delaware Governor’s Commission on Volunteerism and Service
Chicago Music Exchange Citizens has maintained its No 1 Small Business Administration rating in all its local markets. Charter One provides business banking for Chicago Music Exchange, which supplies guitars for world-renowned performers.
� RBS Insurance is the UK’s No1 direct insurer, by both phone and internet, and No1 in partnerships.
� RBS Insurance has over 1.3 million car rescue policies sold through Direct Line, Churchill and Privilege and a further 3.7 million through partner brands.
� RBS Insurance is the No 2 travel insurance provider with 2.4 million policies and the No 2 pet insurance provider with 25% of the market.
� Total income of £5.7 billion in 2006 was achieved through a range of channels, with customers offered the choice of direct brands (Direct Line, Churchill, Privilege) and access through the bank branches (Royal Bank of Scotland and NatWest), as well as through a range of partners.
� Over 50% of own-brand car business is sold over the internet, and RBS Insurance hosts car insurance websites for over 23 partner brands.
� Churchill’s advertising campaign, Challenge Churchill, urged people to challenge Churchill to get them a better deal on their car and home insurance.
� Direct Line’s Good Deal Better marketing campaign highlighted enhancements to its No Claims Discount on car insurance.
� RBS Insurance’s partnership business, UKI Partnerships, introduced a seven-day free car insurance offer scheme for new car purchases across all its motor manufacturer partners. It also introduced a car insurance policy for Tesco Personal Finance, consistent with the Tesco Value range.
� After agreeing a new deal with Saab, UKI Partnerships now provides car insurance in the UK for seven of the top ten car manufacturers.
� UKI Partnerships signed a new contract with Nationwide to provide household insurance, extending the relationship, which already provides car insurance.
� RBS Insurance handles more than 35 million calls for its own brands and partnership brands every year through its UK call centres.
� RBS Insurance has the largest motor claims operation in the UK, providing scale and efficiency benefits.
� RBS Insurance has played an important role in helping the Insurance Fraud Bureau disrupt organised crossindustry fraud, and a number of successful investigations have resulted in many arrests.
RBS Insurance HR – People Management Award Chartered Institute of Personnel and Development
RBS Insurance IT Application Development – Business Achievement in Financial, Insurance and Professional Services 2006 British Computer Society Awards
� Manufacturing is the ‘engine room’ of the RBS group, supplying processing and telephone services, IT, property, purchasing and security expertise to the Group’s customer-facing divisions.
� We manage and maintain over 3,200 buildings around the world, covering 2.1 million square metres and providing workplaces for 135,000 people.
� Our e-sourcing programme continues to be one of the largest of any company in the world, with 2006 throughput of over £1 billion. We use a common purchasing approach across all divisions to make the most of our scale.
� Manufacturing’s Lean programme – which uses techniques to remove waste, improve the flow of work and ultimately improve customer service – has created the capacity for Manufacturing to provide more support to all divisions.
Highlights of 2006 � Ulster Bank integration was the Group’s biggest integration project since NatWest, involving nearly 2,000 business and technology staff across the Group. It was a complex programme involving the integration of three banks and two currencies in two jurisdictions. The Ulster Bank integration successfully migrated systems and processes from Ulster Bank Retail and First Active onto the RBS group Manufacturing model. This involved moving 2.5 million customer accounts and £30 billion of balances to the RBS group platform in a single weekend.
� Recently the Group launched the Welcome Account, which provides the increasing number of Polish speakers in the UK with a current account, a money transmission account and a debit card. The service also offers a duallanguage website and an option to talk to a Polish-speaking customer service adviser.
� We created a telephone service for Private Banking customers allowing them to make transactions and speak to an adviser round the clock. We have supported the significant business growth of Coutts with a 20% increase in the number of new accounts opened and an increase of 22% of payments processed.
� The Group collaborates with two charities, ‘GreenWorks ’ and ‘Recycle Scotland’, to recycle surplus office furniture for re-use by non-profit organisations, donating over 1,700 tonnes of office furniture in 2006 for use in schools, hospitals and community groups.
World-class real estate organisation – Group Property University College London (UCL)
Our priorities in 2006 were promoting financial inclusion and capability; protecting our customers and shareholders against crime and fraud; managing our people to a global benchmark; adopting the revised Equator Principles and improving the environmental impact of our operations. Moreover we continue to invest heavily in the communities in which we serve around the world through our charitable engagement and through supporting the causes our staff care about.
Financial Inclusion � We are committed to maintaining our branch network, and now have the largest number of branches and the largest network of free-to-use ATMs in the UK. We also increased our fleet of mobile branches in 2006 to 17, which visit 334 rural communities each week.
� We joined a working party with Treasury Select Committee Chairman John McFall to review financial inclusion and the availability of free-to-use ATMs in low-income areas. In 2006 we offered 300 more free-to-use ATMs in both rural and deprived areas. A further 200 are planned for 2007.
� In 2006, over 200,400 Step and Key accounts were opened, bringing the total number of basic bank accounts to over 930,800. This makes RBS the leading provider of basic bank accounts that are accessible at Post Offices.
Financial Capability � Our Face2Face with Finance™ (F2F) programme is the largest financial education programme for schools in the UK. RBS provides curriculum-related teaching resources accredited by pfeg, the FSA’s educational charity. In 2006, 450,000 pupils from 1,400 schools took part in lessons led by 550 RBS and NatWest employees.
� We launched School Money, the school bank, from the Royal Bank of Scotland and NatWest, and committed to opening 100 school banks in inner city schools in 2007. These school banks are set up and run by pupils for pupils and aim to establish a savings habit.
� In May 2006 we launched our Managing Your Money websites providing consumers with free access to skills, tools and advice to help them understand and manage their money.
� In 2006 we installed a system called 3D Secure, which provides greater security for internet purchases. We also introduced our industry-leading real-time profiling capability, which is an early fraud detection process, providing greater protection for our customers.
Employee Practices � The 2006 ISR Employee Opinion Survey was completed by 87% of our 135,000-plus workforce, a new record. We outperformed our global peers in all 15 categories measured, for the second successive year.
� Over the course of the year, more than 800 senior managers were trained at our Business School.
� The Group received the Gold Award from Opportunity Now, recognising the excellence of our practices and performance in ensuring inclusion for women in the workplace. Online diversity training was launched across the UK.
� RBS received the Remploy ‘Leading the Way’ award for excellence in disability management.
The revised Equator Principles (EP) � In 2006, RBS adopted the revised Equator Principles which lowered the threshold for EP projects from US$50 million to US$10 million. Technical training for all relevant teams in implementing the revised Equator Principles will be complete by early 2007.
� £58.6 million invested across the UK in our Community Investment programme.
C o rp o ra te r es p o n si b ili ty
Community Investment � In 2006, over 25,000 employees took part in our employee giving programmes (Give As You Earn and Community Cashback Awards), generating £12.7 million for over 8,500 charities and good causes across the UK and Ireland.
� Our Supergrounds programme entered its third year, with 450 primary schools from across the UK, nominated by RBS employees, benefiting from a playground improvement project.
� Charter One is making available $150 million in loans over three years for economic and community development through its Charter One Uptown Initiative. The Initiative includes $100 million set aside for economic development investments to encourage businesses to invest in the Cleveland area.
RBS Supergrounds As the international reach of RBS continues, so does the extension of its Community Programme. A team of over 60 from our Global Banking & Markets business across the Asia Pacific region gave up a day of their time to refurbish the Lin Tian Migrant School in Shanghai. Undertaken in partnership with Save the Children, it was our first international Supergrounds project.
Chairman’s Award This year’s winner of the Chairman’s Award for Community Excellence was Jim Smith, a branch manager from Glasgow. Over the past 20 years he has dedicated his time to supporting and coaching the junior football team at Paisley United Boy’s Club. He has raised over £125,000 for the Club in the last five years.
Operating and financial review 44 Presentation of information 45 Forward-looking statements 46 Description of business 48 Risk factors 49 Financial highlights 50 Summary consolidated income statement 52 Analysis of results 60 Divisional performance 75 Consolidated balance sheet 77 Cash flow 78 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 are prepared in accordance with International Financial Reporting Standards issued by the International Accounting Standards Board (“IASB”) and interpretations issued by the International Financial Reporting Interpretations Committee of the IASB (together “IFRS’) as adopted by the European Union. On implementation of IFRS on 1 January 2005, the Group took 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 32 ‘Financial Instruments: Disclosure and Presentation’ and IFRS 4 ‘Insurance Contracts’ from 1 January 2005 without restating its 2004 income statement and balance sheet. The date of transition to IFRS for the Group and the company and the date of their opening IFRS balance sheets was 1 January 2004.
Organisational structure and business overview The Group’s activities are organised in the following business divisions: Corporate Markets (comprising Global Banking & Markets and UK Corporate Banking), Retail Markets (comprising Retail and Wealth Management), Ulster Bank, Citizens, RBS Insurance and Manufacturing. A description of each of the divisions is given below.
UK Corporate Banking is the largest provider of banking, finance and risk management services to UK corporate customers. Through its network of relationship managers across the country it distributes the full range of Corporate Markets’ products and services to companies.
Retail Markets was established in June 2005 to lead coordination and delivery of our multi-brand retail strategy across our product range and comprises Retail (including our direct channels businesses) and Wealth Management.
In core retail banking, Retail offers a comprehensive product range across the personal and small business market: money transmission, savings, loans, mortgages and insurance. 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, including the largest network of branches and ATMs in the UK, the internet and the telephone.
Retail also includes the Group’s non-branch based retail businesses that issue a comprehensive range of credit and charge cards to personal and corporate customers and provides card processing services for retail businesses. Retail is the leading merchant acquirer in Europe and ranks fourth globally.
It also includes Tesco Personal Finance, The One account, First Active UK, Direct Line Financial Services and Lombard Direct, all of which offer products to customers through direct channels principally in the UK. In continental Europe, Retail offers a similar range of products through the RBS and Comfort Card brands.
Wealth Management provides private banking and investment services to its clients through a number of leading UK and overseas private banking subsidiaries and offshore banking businesses. Coutts is one of the world's leading international wealth managers with offices in Switzerland, Dubai, Monaco, Hong Kong and Singapore, as well as its premier position in the UK. Adam & Company is the major private bank in Scotland. The offshore banking businesses – The Royal Bank of Scotland International and NatWest Offshore – deliver retail banking services to local and expatriate customers, principally in the Channel Islands, the Isle of Man and Gibraltar.
Ulster Bank Group brings together the Ulster Bank and First Active businesses to provide a comprehensive range of products and services to retail and corporate customers in the island of Ireland.
Citizens is the second largest commercial banking organisation in New England and the eighth largest commercial banking organisation in the US measured by deposits. Citizens provides retail and corporate banking services under the Citizens brand in Connecticut, Delaware, Massachusetts, New Hampshire, New Jersey, New York state, Pennsylvania, Rhode Island and Vermont and the Charter One brand in Illinois, Indiana, Michigan and
Ohio. Through its branch network Citizens provides a full range of retail and corporate banking services, including personal banking, residential mortgages and cash management.
Competition The Group faces intense competition in all the markets it serves. In the UK, the Group’s principal competitors are the other UK retail and commercial banks, building societies and the other major international banks represented in London.
In the small business banking market, the Group competes with other UK clearing banks, specialist finance providers and building societies.
In the personal banking segment the Group competes with UK banks and building societies, major retailers, life assurance companies and internet-only players. In the mortgage market the Group competes with UK banks and building societies. National Westminster Life Assurance Limited and Royal Scottish Assurance compete with Independent Financial Advisors and life assurance companies.
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. In addition to physical distribution channels, providers compete through direct marketing activity and the internet. The market remains very competitive, both between issuers and with other payment methods.
In the United States, where competition is intense, Citizens competes in the New England, Mid-Atlantic and Midstates 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.
Changes in interest rates, foreign exchange rates, equity prices and other market factors affect the Group’s business The most significant market risks the Group faces are interest rate, foreign exchange and bond and equity price risks. Changes in interest rate levels, yield curves and spreads may affect the interest rate margin realised between lending and borrowing costs. Changes in currency rates, particularly in the sterling-dollar and sterling-euro exchange rates, affect the value of assets and liabilities denominated in foreign currencies and affect earnings reported by the Group’s nonUK subsidiaries, mainly Citizens, RBS Greenwich Capital and Ulster Bank, and may affect income from foreign exchange dealing. The performance of financial markets may cause changes in the value of the Group’s investment and trading portfolios. The Group has implemented risk management methods to mitigate and control these and other market risks to which the Group is exposed. However, it is difficult to predict with accuracy changes in economic or market conditions and to anticipate the effects that such changes could have on the Group’s financial performance and business operations.
Profit before tax, purchased intangibles amortisation, integration costs and net gain on sale of strategic investments and subsidiaries 9,414 8,251 Profit before tax 9,186 7,936 Profit attributable to ordinary shareholders 6,202 5,392 Cost:income ratio (2) 42.1% 42.4% Basic earnings per share (pence) 194.7 169.4 Adjusted earnings per share (pence) (3) 200.0 175.9 Adjusted after-tax return on equity (4) 19.0% 18.2%
Total assets 871,432 776,827 Loans and advances to customers 466,893 417,226
Notes: (1) Total income for the year ended 31 December 2005 excludes gains on sale of strategic investments and subsidiaries. In the statutory consolidated income statement on page 139, these items are included in total income.
Profit for the year 6,497 5,558 Minority interests 104 57 Preference dividends 191 109 Profit attributable to ordinary shareholders 6,202 5,392
O p er at in g a n d f in an ci al r ev ie w 2006 compared with 2005 Profit Profit before tax, purchased intangibles amortisation, integration costs and net gain on sale of strategic investments and subsidiaries increased by 14% or £1,163 million, from £8,251 million to £9,414 million.
Profit before tax was up 16%, from £7,936 million to £9,186 million, reflecting strong organic income growth in all divisions.
Net interest income increased by 7% to £10,596 million and represents 38% of total income (2005 – 39%). Average loans and advances to customers and average customer deposits grew by 14% and 11% respectively.
Operating expenses Operating expenses, excluding purchased intangibles amortisation and integration costs, rose by 8% to £12,252 million.
Net insurance claims Bancassurance and general insurance claims, after reinsurance, increased by 3% to £4,458 million reflecting volume growth.
Impairment losses Impairment losses were £1,878 million compared with £1,707 million in 2005, an increase of 10%.
Integration Integration costs were £134 million compared with £458 million in 2005. Included are costs relating to the integration of First Active and Charter One, as well as the amortisation of software costs relating to the integration of Churchill. Integration costs in 2005 included software costs relating to the acquisition of NatWest which were previously written-off as incurred under UK GAAP but under IFRS were capitalised and amortised. All such software was fully amortised by the end of 2005.
A final dividend of 66.4p per ordinary share is recommended, giving a total dividend for the year of 90.6p, an increase of 25%. If approved, the final dividend will be paid on 8 June 2007 to shareholders registered on 9 March 2007. The total dividend is covered 2.2 times by earnings before purchased intangibles amortisation and integration costs.
Balance sheet Total assets were £871.4 billion at 31 December 2006, 12% higher than total assets of £776.8 billion at 31 December 2005.
Lending to customers, excluding repurchase agreements and stock borrowing (“reverse repos”), increased in 2006 by 10% or £35.7 billion to £404.0 billion. Customer deposits, excluding repurchase agreements and stock lending (“repos”), grew by 9% or £26.1 billion to £320.2 billion.
Profitability The adjusted after-tax return on ordinary equity, which is based on profit attributable to ordinary shareholders before purchased intangibles amortisation, integration costs and net gain on sale of strategic investments and subsidiaries, and average ordinary equity, was 19.0% compared with 18.2% in 2005.
Yields, spreads and margins of the banking business % % Gross yield (3)
The Royal Bank of Scotland plc base rate (average) 4.64 4.65 London inter-bank three month offered rates (average): Notes: (1) Interest-earning assets and interest-bearing liabilities exclude the Retail bancassurance assets and liabilities attributable to policyholders, in view of their distinct nature. As a result, net interest income has been adjusted by £63 million (2005 – £59 million).
(2) Interest income has been adjusted by £215 million (2005 – £115 million) and interest expense by £465 million (2005 – £307 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.
(4) Interest spread is the difference between the gross yield and the interest rate paid on average interest-bearing liabilities of the banking business.
(5) Net interest margin is net interest income of the banking business as a percentage of average interest-earning assets of the banking business.
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.
Assets Treasury bills and other eligible bills – UK 2,059 90 4.37 3,160 138 4.37
Loans and advances to banks – UK 15,850 697 4.40 15,338 649 4.23
Total interest-earning assets – banking business (2,3) 421,136 24,966 5.93 383,690 21,505 5.60
Customer accounts: savings deposits – UK 30,933 1,058 3.42 26,727 778 2.91
Customer accounts: other time deposits – UK 67,806 2,807 4.14 60,454 2,328 3.85
Debt securities in issue – UK 55,912 2,670 4.78 52,672 2,071 3.93
Internal funding of trading business – UK (44,475) (1,893) 4.26 (37,628) (1,125) 2.99
(3) Interest income has been adjusted by £215 million (2005 – £115 million) and interest expense by £465 million (2005 – £307 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.
Increase/(decrease) due to changes in: Average Average Net volume rate change £m £m £m
O p er at in g a n d f in an ci al r ev ie w 2006 compared with 2005 Non-interest income increased by £1,755 million, 11% to £17,406 million reflecting strong organic growth in all divisions especially Global Banking & Markets, up 27% and Wealth Management, up 17%. Non-interest income represents 62% of total income (2005 – 61%). Excluding general insurance premium income, non-interest income rose by 16% or £1,561 million to £11,433 million.
Within non-interest income, fees and commissions receivable increased by 5% or £366 million, to £7,116 million, while fees and commissions payable increased by 4%, £81 million to £1,922 million.
Other operating income increased by 36%, £944 million to £3,564 million. This was principally due to growth in income from rental and asset-backed activities and principal investments in Corporate Markets.
Premises and equipment expenses increased by £137 million, 11% to £1,411 million reflecting the continuation of our branch network improvement programme and ongoing investment in our major operational centres.
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 42.1% compared with 42.4% in 2005.
O p er at in g a n d f in an ci al r ev ie w 2006 compared with 2005 Impairment losses were £1,878 million compared with £1,707 million in 2005. New impairment losses were up 11%, £214 million to £2,093 million. Recoveries of amounts previously written-off were up £43 million, 25% to £215 million. Consequently the net charge to the income statement was up £171 million, 10% to £1,878 million. Improvements in Corporate Markets reflecting a benign credit environment partly offset higher impairment losses in Retail Markets and Citizens.
UK corporation tax rate 30.0 30.0 Effective tax rate 29.3 30.0
The actual tax charge differs from the expected tax charge computed by applying the standard rate of UK corporation tax as follows: £m £m
Expected tax charge 2,756 2,381 Interest on subordinated debt not allowable for tax 58 79 Non-deductible items 230 230 Non-taxable items (251) (166) Taxable foreign exchange movements 5 (10) Foreign profits taxed at other rates 63 77 Unutilised losses – brought forward and carried forward 14 (5) Adjustments in respect of prior periods (186) (208) Actual tax charge 2,689 2,378
The performance of each of the divisions is reviewed on pages 61 to 74.
O p er at in g a n d f in an ci al r ev ie w £m £m
Allocation of Manufacturing costs 570 552 Operating profit 5,552 4,613 £bn £bn
Rental assets 13.9 13.2 Customer deposits* 132.5 111.1 Risk-weighted assets 231.2 202.6 * excluding repos and reverse repos
Net interest income from banking activities 1,629 1,486 Net fees and commissions receivable 998 790 Trading activities 2,242 1,949 Net income from rental assets (net of related funding costs) 677 622 Other operating income (net of related funding costs) 1,280 744 Non-interest income 5,197 4,105 Total income 6,826 5,591 Direct expenses
Global Banking & Markets performed strongly in 2006, delivering excellent growth in income while continuing to build our strong international franchise. Total income rose by 22% to £6,826 million, contribution by 24% to £3,933 million and operating profit by 25% to £3,790 million.
In 2006 we have further invested in extending our product capabilities and our worldwide reach. Income in North America rose by 18% in local currency, despite flat revenues in our US residential mortgage-backed securities business, as the investments we have made in our debt capital markets, loan markets, rates and credit trading businesses have borne fruit.
Net interest income from banking activities rose by 10% to £1,629 million, representing 24% of total GBM income. Average loans and advances to customers increased by 20% as we further expanded our customer base outside the UK.
Our rental and other asset-based activities have achieved continuing success in originating, structuring, financing and managing physical assets such as aircraft, trains, ships and real estate for our customers. This success has driven good growth in net income from rental assets, which increased (net of related funding costs and operating lease depreciation) to £271 million from £224 million.
Net interest income from banking activities 2,169 1,953 Non-interest income 1,284 1,216 Total income 3,453 3,169 Direct expenses
Allocation of Manufacturing costs 427 414 Operating profit 1,762 1,572 £bn £bn
UK Corporate Banking had a successful year across all its businesses, strengthening its market leading positions in corporate and commercial banking and building good momentum in the provision of a broadening range of financing and risk management services to its customer base. As a result UKCB increased its total income by 9% to £3,453 million and contribution by 10% to £2,189 million. Operating profit rose by 12% to £1,762 million.
Total expenses rose by 7% to £1,502 million. The increase in direct expenses, excluding operating lease depreciation, reflected the recruitment of additional relationship managers and other staff to strengthen the quality of service provided to our expanding customer base, as well as further investment in our electronic banking proposition.
Impairment losses were 4% lower than in 2005 at £189 million. Portfolio risk remained stable and the credit environment benign.
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 and Wealth Management.
Customer deposits* 115.6 105.3 Investment management assets – excluding deposits 34.9 31.4 Risk-weighted assets 78.4 80.6 * customer deposits exclude bancassurance
Retail Markets achieved a good performance in 2006, with total income rising by 5% to £8,637 million. Contribution before impairment losses increased by 6% to £5,708 million, contribution by 4% to £4,364 million and operating profit by 5% to £2,653 million.
Average risk-weighted assets fell by 1%, reflecting a change in business mix toward mortgage lending as well as careful balance sheet management, including increased use of securitisations.
Retail has delivered a good performance in 2006, achieving 4% growth in total income to £7,703 million. Contribution before impairment losses was up by 5% to £5,210 million, contribution by 2% to £3,867 million, and operating profit by 2% to £2,299 million.
We have continued to expand our customer franchise, growing our personal current account base by 232,000 in 2006 as a result of our sustained focus on quality and customer service. We continue to have the highest share of customers switching current accounts from other banks, and are now joint leader in the personal current account market. RBS is first and NatWest is joint second among major high street banks in Great Britain for the percentage of main current account customers that are "extremely satisfied" overall.
Net interest income increased by 4% to £4,211 million, with faster growth in deposits helping to mitigate lower unsecured lending volumes. Net interest margin improved slightly in the second half.
Customer deposits* 87.1 79.8 Risk-weighted assets 71.9 74.5 * customer deposits exclude bancassurance
Bancassurance Bancassurance has had an excellent year with sales increasing by 56% to £267 million annual premium equivalent. The growth reflects the continued increase in focus on the recruitment of Financial Planning Managers, up 25% and productivity levels, up 43%. Increased sales of collective investments on the back of a successful ISA season and strong individual pensions growth, boosted by A-Day, helped underpin the outturn. Sales of guaranteed bonds were also particularly strong, and helped support a new business margin which improved significantly over the period. The product proposition was strengthened across all lines. Latest market share data shows an increase from 6.6% to 9.0%. On a UK GAAP embedded value basis for life assurance, investment contracts and open ended investment companies, adjusted for investment market volatility, pre tax profit was £78 million compared with £42 million in 2005.
Loans and advances to customers – gross 8.8 7.8 Investment management assets – excluding deposits 28.2 25.4 Customer deposits 28.5 25.5 Risk-weighted assets 6.5 6.1
Wealth Management’s offering of private banking and investment services delivered robust organic income growth in 2006. Our continuing investment in Coutts UK, Adam & Company and our offshore businesses helped us to achieve an overall increase in client numbers of 5%. Coutts UK customers rose by 9%. Outside the UK, Coutts International moved its headquarters to Singapore and was successful in the Asia-Pacific region in recruiting additional experienced private bankers. We grew customer numbers in the region by 13% and income by 24%.
Total expenses rose by 9% to £579 million. In a highly competitive recruitment market, headcount was successfully increased by 7%, reflecting our continued investment in the UK and further expansion in Asia.
Total assets 43.1 35.9 Loans and advances to customers – gross
Average exchange rate – €/£ 1.467 1.463 Spot exchange rate – €/£ 1.490 1.457
Net interest income increased by 18% to £773 million, reflecting good growth in both loans and customer deposits. Average loans and advances to customers increased by 28%, and average customer deposits by 15%. A principal focus during 2006 was the expansion of our corporate banking franchise, and we succeeded in increasing corporate customer numbers by 7% in the Republic of Ireland and by 4% in Northern Ireland. This contributed to strong growth in both corporate lending, where average loans and advances increased by 32%, and deposits, with Ulster Bank winning a share of new business current accounts well in excess of its historic market share, particularly in the Republic of Ireland. Average mortgage balances grew by 26%, although the rate of growth was slower in the second half when there was some evidence of a more subdued pace of expansion in the mortgage market. The change in business mix resulting from strong growth in corporate lending and mortgages, together with some competitive pressures, led to a modest reduction in net interest margin in the first half, with margin stabilising in the second half.
Non-interest income rose by 6% to £215 million. Ulster Bank achieved good growth in fees from credit cards and ATMs as well as in sales of investment products, which was only partially offset by the introduction of Ulster Bank’s new range of current accounts, which are free of transaction fees.
During 2006 we successfully completed the migration of our core systems to the RBS Group manufacturing model and, as a result, we now have access to the complete RBS product range.
The credit environment remains benign. Impairment losses rose by £13 million to £71 million, consistent with growth in lending.
– home equity 34.5 31.8 – other consumer 23.2 24.8 – corporate and commercial 32.7 29.2
Citizens grew its total income by 3% to $6,115 million and its operating profit by 2% to $2,917 million. In sterling terms, Citizens total income increased by 2% to £3,317 million, while its operating profit rose slightly to £1,582 million.
We have achieved good growth in lending volumes, with average loans and advances to customers increasing by 10%. In business lending, average loans excluding finance leases increased by 15%, reflecting Citizens’ success in adding new mid-corporate customers and increasing its total number of business customers by 4% to 467,000. In personal lending, Citizens increased average mortgage and home equity lending by 14%, though the mortgage market slowed in the second half. Average credit card receivables, while still relatively small, increased by 19%.
Markets. There was good progress in debit cards, where issuance has been boosted by the launch in September of our "Everyday Rewards" programme. Citizens has also become the US’s leading issuer of Paypass™ contactless debit cards, with 3.65 million cards issued. Our credit card customers increased by 20%, whilst RBS Lynk, our merchant acquiring business, also achieved significant growth, processing 40% more transactions than it did in 2005 and expanding its merchant base by 11%.
Earned premiums 5,713 5,641 Reinsurers’ share (212) (246) Insurance premium income 5,501 5,395 Net fees and commissions (486) (449) Other income 664 543 Total income 5,679 5,489 Direct expenses
– Core motor: UK 7,490 7,439 – Core motor: Continental Europe 2,114 1,862 – Core non-motor (including home, rescue, SMEs, pet, HR24): UK 4,920 4,799 – Partnerships (including motor, home, rescue, SMEs, pet, HR24) 7,267 7,559
In the UK we have grown our core motor book by 1% whilst focusing on more profitable customers acquired through our direct brands, with good results achieved through the internet channel, which accounted for half of all new own-brand motor policies last year.
Total expenses rose by 3% to £959 million. Good cost discipline held direct expenses to £745 million, up 2%. Staff costs rose by 1%, reflecting improved efficiency despite continued investment in service standards. A 4% rise in nonstaff costs included increased marketing expenditure to support growth in continental Europe.
Net claims rose by 4% to £3,970 million. The environment for home claims remained benign, whilst underlying increases in average motor claims costs were partially offset by purchasing efficiencies and improvements in risk management.
Group Property costs increased by 9% to £910 million, reflecting the continuation of our branch improvement programme and ongoing investment in major operational centres, including Manchester, Birmingham and Glasgow.
Customer Support and other operations held costs virtually flat at £976 million and, like Group Technology, achieved significant improvements in productivity. At the same time we maintained our focus on service quality, and our UK-based telephony centres continued to record market-leading customer satisfaction scores. Our investment in ‘lean manufacturing’ approaches across our operational centres is expected to deliver further improvements in efficiency.
Allocation of Manufacturing costs 143 137 Total central Items 1,511 1,524
Central funding costs were 3% lower at £780 million, largely reflecting a year on year reduction of £41 million in IFRS-related volatility. The Group hedges its economic risks, and 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.
Departmental and corporate costs at £588 million were similar to 2005.
Prepayments, accrued income and other assets 8,136 8,798 Total assets 871,432 776,827
Liabilities Deposits by banks 132,143 110,407 Customer accounts 384,222 342,867 Debt securities in issue 85,963 90,420 Settlement balances and short positions 49,476 43,988
Reverse repurchase agreements and stock borrowing Loans and advances to banks 54,152 41,804 Loans and advances to customers 62,908 48,887
Repurchase agreements and stock lending Deposits by banks 76,376 47,905 Customer accounts 63,984 48,754
Overview of consolidated balance sheet Total assets of £871.4 billion at 31 December 2006 were up £94.6 billion, 12%, compared with 31 December 2005, reflecting business growth.
Property, plant and equipment were up £0.4 billion, 2%, to £18.4 billion, mainly due to growth in investment properties and operating lease assets.
Settlement balances rose £1.4 billion, 24%, to £7.4 billion as a result of increased customer activity.
Prepayments, accrued income and other assets were down £0.7 billion, 8%, to £8.1 billion.
Debt securities in issue decreased by £4.5 billion, 5%, to £86.0 billion.
Deferred taxation liabilities rose by £1.6 billion to £3.3 billion largely reflecting the provision for tax on the uplift in the value of available-for-sale equity shares.
Equity minority interests increased by £3.2 billion to £5.3 billion. Of the increase, £2.1 billion related to the uplift in the value of the investment in Bank of China attributable to minority shareholders. The remaining increase primarily arose from the issue of £400 million trust preferred securities and a restructuring of the life assurance joint venture with Aviva, following the repayment of an existing loan replaced by an equity investment. This restructuring has no effect on the Group’s regulatory capital position.
Shareholders’ equity increased by £4.8 billion, 14%, to £40.2 billion. The profit for the year of £6.4 billion, issue of £0.7 billion non-cumulative fixed rate equity preference shares and £0.1 billion of ordinary shares in respect of the exercise of share options, £1.6 billion increase in available-for-sale reserves, mainly reflecting the Group’s share in the investment in Bank of China and a £1.3 billion net decrease after tax in the Group’s pension liability, were partly offset by the payment of the 2005 final ordinary dividend and the 2006 interim dividend, £2.5 billion and preference dividends of £0.2 billion, together with £1.0 billion ordinary share buybacks and £1.6 billion resulting from the effect of exchange rates and other movements.
• higher pension costs of £387 million under US GAAP reflecting the deferral of actuarial losses over the remaining service lives of current employees.
• tax of £410 million on the above and other adjustments.
Risk-weighted assets Banking book: Note: The comparative data for 2002 to 2004 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.
It is the Group’s policy to maintain a strong capital base, to expand it as appropriate and to utilise it efficiently throughout its activities to optimise the return to shareholders while maintaining a prudent relationship between the capital base and the underlying risks of the business. In carrying out this policy, the Group has regard to the supervisory requirements of the Financial Services Authority (“FSA”). The FSA uses Risk Asset Ratio (“RAR”) as a measure of capital adequacy in the
• Advances Committee is a board committee that deals with all transactions that exceed the Group Credit Committee’s delegated authority.
• Group Asset and Liability Management Committee (“GALCO”), is an executive committee which is responsible for reviewing the balance sheet, funding, liquidity, structural foreign exchange, capital adequacy and capital raising across the Group as well as interest rate risk in the banking book. In addition, GALCO monitors and reviews external, economic and environmental changes affecting such risks.
Risk management The principal risks that the Group manages are as follows: • Credit risk: is the risk arising from the possibility that the Group will incur losses from the failure of customers to meet their obligations.
• Contributing to, and ultimately approving annual plans for the Group and each division.
The Board delegates the articulation of risk appetite to GEMC and ensures that this is in line with the strategy and the desired risk reward trade off for the Group. Risk appetite is an expression of the maximum level of residual risk that the Group is prepared to accept in order to deliver its business objectives and is assessed against regular (often daily) controls and stress testing to ensure that the limits are not compromised in abnormal circumstances.
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 of default, loss given default and exposure at default.
Risk organisation Divisional Chief Executive Officers (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.
Divisional CEOs are supported by divisional Chief Risk Officers (CROs) and Chief Financial Officers (CFOs). An important element that underpins the Group’s approach to the management of all risk is independence. In the case of CROs, it is enforced by joint reporting lines, both operationally to the divisional CEO and functionally to the Group Chief Risk Officer.
Credit risk Key principles of credit risk management The objective of credit risk management is to enable the Group to achieve appropriate risk versus reward performance whilst maintaining credit risk exposure in line with approved risk appetite.
Group Risk Management is responsible for setting standards for 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 framework is defined in detail in the Group’s ‘Principles for Managing Credit Risk’.
Each Division has established 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 both the divisional CEO (via the divisional Chief Risk Officer) and to the Head of Group Credit Risk.
GRM undertakes regular assessments 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.
• Financial Markets counterparties are subject to similar modelling techniques but are approved by a dedicated credit function which specialises in traded market product risk.
Consumer lending and personal businesses employ best practice credit scoring techniques to process small scale, large volume credit decisions. Scores from such systems are combined with management judgement to ensure an effective ongoing process of approval, review and enhancement. Credit decisions for loans above specified thresholds are individually assessed.
Credit risk models Credit risk models are used throughout the Group to support the analytical elements of the credit risk management framework, in particular the quantitative risk assessment part of the credit approval process, ongoing credit monitoring as well as portfolio level analysis and reporting.
Divisional credit risk departments own the particular models and are responsible for: • Developing credit risk models appropriate for the types of borrower and facilities in their credit portfolios and obtaining approval from GRM for their implementation.
Every customer credit grade across all grading scales in the Group can be mapped to a Group level credit grade (see page 83).
In addition, the Group calculates the potential impact of a range of macroeconomic scenarios on both the Group’s income statement and balance sheet. This analysis is discussed by GEMC and reported to the Board.
Credit risk assets Credit risk assets are an internal risk measure of the Group’s exposure to customers. These consist of loans and advances (including overdraft facilities), instalment credit, finance lease receivables, debt securities and other traded instruments across all customer types.
Distribution of credit risk assets by asset quality Asset quality remained broadly stable throughout 2006. As at 31 December 2006, exposure to investment grade counterparties (AQ1) accounted for 46% (2005 – 47%) of credit risk assets and 97% (2005 – 97%) of exposures were to counterparties rated AQ4 or higher. The exposure to the lowest asset quality (AQ5) remained at 3%.
An analysis of reverse repurchase agreements is shown below. 1 January
As at 31 December 2006, 28% of credit risk assets (2005 – 30%) related to individuals and include mortgage lending and other smaller loans that are intrinsically well-diversified. Corporate industry exposure comprised 36% of credit risk assets (2005 – 35%), which are well diversified across a range of sectors. Banks and financial sevices account for 20% of credit risk assets (2005 – 22%) and public sector and quasi government credit risk assets make up the remaining 16% (2005 – 13%).
Distribution of credit risk assets by industry sector Industry analysis plays an important part in assessing potential concentration risk from within the loan portfolio. Particular attention is given to industry sectors where the Group believes there is a high degree of risk or potential for volatility in the future.
Business growth resulted in the proportion of credit risk assets in Europe and the Rest of the World increasing to 26% from 23%, while exchange rate movements led to a reduction in the proportion in North America from 27% to 25%.
The Group also monitors its credit portfolio by customer type and product type. The largest category is lending to corporate customers, which represented 35% of credit risk assets as at 31 December 2006 (2005 – 31%). Debt securities issued by banks, sovereigns and quasi government bodies and mortgage lending to individuals accounted for 19% (2005 – 15%) and 20% (2005 – 21%) respectively.
Accrual loans past due 90 days (2) 105 9 52 713 Troubled debt restructurings (3) — 2 — 24
REIL and PPL as % of customer loans and advances – gross (5) 1.57% 1.60% 1.84% 1.92%
Following the implementation of IAS 39 in 2005, the sub-categories of REIL and PPL are calculated as per notes 1 to 4 below.
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 represents impaired assets which are not included in REIL but where known information about possible credit problems cause management to have serious doubts about the future ability of the borrower to comply with loan repayment terms.
Impairment loss provision methodology Provisions for impairment losses are assessed under three categories as described below: Individually assessed provisions are the provisions required for individually significant impaired assets which are assessed on a case by case basis, taking into account the financial condition of the counterparty and any guarantor. This incorporates an estimate of the discounted value of any recoveries and realisation of security or collateral. The asset continues to be assessed on an individual basis until it is repaid in full, transferred to the performing portfolio or written-off.
Portfolio provisions are reassessed regularly as part of the Group’s ongoing monitoring process.
Latent loss provisions charge 87 14 Collectively assessed provisions charge 1,573 1,399 Individually assessed provisions charge 217 290 Specific provision charge 1,386 General provision charge 16 Total charge to income statement 1,877 1,703 1,402
Summary of loan impairment provisions A summary of the total customer provisions balance is shown in the table below.
Notes: (1) Excludes provisions against loans and advances to banks of £2 million (2005 – £3 million; 1 January 2005 – £5 million, 31 December 2004 – £6 million).
Provisions coverage The Group’s provision coverage ratios are shown in the table below.
Movement in loan impairment provisions balance The movement in provisions balance during 2006 is shown in the table below.
Notes: (1) The impact of discounting inherent within the provisions balance is unwound as the time to receiving the expected recovery cash flows draws nearer.
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 concentration and identify any adverse trends. During 2006 the Group’s funding sources remained well diversified by counterparty, instrument and maturity.
Customer accounts (excluding repos), term debt securities of over one year remaining maturity and capital continue to represent the core of the Group’s funding. These core funds in total increased by £52.0 billion (14%) over the course of 2006 and represent 61% of total funding excluding other liabilities at
Customer accounts continue to provide a substantial proportion of the Group’s funding and comprise a well diversified and stable source of funds from a wide range of retail, corporate and non-bank institutional customers. Excluding repo agreements, customer accounts grew by £26.1 billion (9%), and represent 45% of total funding excluding other liabilities at 31 December 2006.
Capital (shareholders’ equity and subordinated debt) increased by £4.2 billion (7%) and provides 10% of total funding excluding other liabilities.
Short term wholesale deposits are taken from a wide range of counterparties, with the largest single depositor continuing to represent less than 1% of the Group’s total funding. The level of funding from short term unsecured debt issuance and bank deposits, excluding repos and short positions, has decreased by £32.9 billion (25%) and now represents 13% of total funding excluding other liabilities at 31 December 2006. This reflects the increased use of secured and unsecured term issuance to fund the higher rate of growth in customer loans and advances (see ‘net customer activity’ below) and increased repo activity.
Short positions and repos with corporate, institutional customers and banks are undertaken primarily by RBS Greenwich Capital in the US and by Global Banking & Markets. Repos and short positions increased by £50.1 billion (37%) to represent 26% of total funding excluding other liabilities at 31 December 2006.
The Group remains well placed to access various wholesale funding sources from a wide range of counterparties and markets.
Loans and advances to customers (gross, excluding reverse repos) 407,918 372,223 299,235 Customer accounts (excluding repos) 320,238 294,113 241,181 Customer lending less customer accounts 87,680 78,110 58,054
The Group evaluates on a regular basis its structural liquidity risk and applies a variety of balance sheet management and term funding strategies to maintain this risk within its normal policy parameters.
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 could have a progressively greater impact but have an increasingly lower probability of occurrence.
Debt securities, treasury and other eligible bills 132,742 126,503 100,018 Reverse repo agreements with banks and customers 117,060 90,691 82,159 Less: repos with banks and customers (140,360) (96,659) (85,476)
Insurance Companies’ debt securities held (6,149) (5,724) (5,029) Debt securities charged as security for liabilities (8,560) (9,578) (4,852)
Net surplus of marketable assets over wholesale liabilities due within one month 16,047 28,457 25,418
Sterling liquidity Over 43% 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 sets 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 2006.
Liquidity in non-sterling currencies For non-sterling currencies, no specific regulatory liquidity requirement is currently set for the Group by the FSA. However, the importance of managing prudently the liquidity risk in its non-sterling activities is recognised and the Group manages its non-sterling liquidity risk daily within net mismatch limits set for the 0-8 calendar day and 0-1 month periods as a percentage of the Group’s total deposit and debt liabilities.
The level of contingent risk from the potential drawing of undrawn or partially drawn commitments, back-up lines, standby lines and other similar facilities is also actively monitored and reflected in the measures of the Group’s nonsterling liquidity risk. Particular attention is given to the US$ commercial paper market and the propensity of the Group’s corporate counterparties who are active in raising funds from that market to switch to utilising facilities offered by the Group in the event of either counterparty specific difficulties or a significant widening of interest spreads generally in the commercial paper market.
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 co-ordinated approach to the regulation of liquidity. An international forum of regulators, chaired jointly by the FSA and the US Federal Reserve Bank, published their findings in 2006 but no specific recommendations were made. During 2007 it is expected that further work by international regulators will be undertaken.
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 500 trading days of market data.
The Group largely computes the VaR of trading portfolios at the close of business and positions may change substantially during the course of the trading day. Further controls are in place to limit the Group’s intra-day exposure, such as the calculation of the VaR for selected portfolios. These limitations and the nature of the VaR measure mean that the Group cannot guarantee that losses will not exceed the VaR amounts indicated. The Group undertakes stress testing to identify the potential for losses in excess of the VaR.
(2) > <0 0 > <2 2 > <4 4 > <6 > 48
Backtesting The Group undertakes a programme of daily backtesting, which compares the actual profit or loss realised in trading activity to the VaR estimation. The results of the backtesting process are one of the methods by which the Group monitors the ongoing suitability of its VaR model. Backtesting exceptions are those instances when a realised loss exceeds the predicted VaR. At the 99% confidence level, no more than one backtesting exception is expected every 100 trading days. The Group experienced no backtesting exceptions at legal entity level during 2006.
Market risk methodology: non-trading Non-trading interest rate risk arises from the Group’s treasury activities and retail and commercial banking businesses. It is the Group’s policy to minimise the sensitivity of net accrual earnings to changes in interest rates and where interest rate risk is retained, to ensure that appropriate resources, measures and limits are applied.
Retail and commercial banking Non-trading interest rate risk can arise in these activities from a variety of sources, including where assets, liabilities and offbalance sheet instruments have different repricing dates.
Non-trading interest rate risk is calculated in each business on the basis of establishing the repricing behaviour of each asset, liability and off-balance sheet 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 noninterest 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.
Citizens was the main contributor to the Group’s non-trading interest rate VaR. It invests in a portfolio of highly rated and liquid investments, principally mortgage-backed securities. This balance sheet management approach is common for US retail banks where mortgages are originated and then sold to Federal agencies for funding through the capital markets. VaR, like all interest rate risk measures, has its limitations when applied to retail banking books and the management of Citizens’ interest rate exposures involves a number of other interest rate risk measures and related limits. Two measures that are reported both to Citizens ALCO and the Board are: • the sensitivity of net accrual earnings to a series of parallel movements in interest rates; and
The increase in the US dollar open structural foreign currency exposure over 2005 was created in order to minimise the impact of movements in the US dollar exchange rate against sterling on the Group’s capital ratios. The increase in the Chinese RMB position reflects the uplift in the value of the Group’s strategic investment in Bank of China.
VaR is not an appropriate risk measure for the Group’s venture capital investments, which comprise a mix of quoted and unquoted investments, or its portfolio of strategic investments. These investments are carried at fair value with changes in fair value recorded in profit or loss, or in equity.
Insurance risk is predictable, especially with the analysis of large volumes of data over time. There is, however, uncertainty around the predictions from various sources, for example, volatility of the weather. However, the Group has documented risk policies, coupled with governance frameworks to oversee and control and hence minimise the risks.
Underwriting and pricing risk The Group manages underwriting and pricing risk through a wide range of processes which include: • Underwriting guidelines that detail the class, nature and type of business that may be accepted; • Pricing policies which are set by senior management through pricing committees; • Centralised control of policy wordings and any subsequent changes.
Claims management risk Claims management risk is the risk that claims are handled or paid inappropriately. Claims are managed using a range of IT system controls and manual processes conducted by experienced staff. These, together with a range of detailed policies and procedures ensure that claims are handled in a timely, appropriate and accurate manner. 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.
• Quota share reinsurance to protect against unforeseen adverse trends, where the reinsurer takes an agreed percentage of premiums and claims.
a) Premium reserves In respect of premium reserves, it is the Group’s policy to ensure that the net unearned premium reserves are adequate to meet the expected cost of claims and associated expenses in relation to the exposure after the balance sheet date. To the extent that the unearned premium reserves, net of reinsurance and deferred acquisition costs are inadequate, a liability adequacy provision will be held.
The Group’s focus is on high volume and relatively straightforward products, for example home and motor. This facilitates the generation of comprehensive underwriting and claims data, which are used to accurately price and monitor the risks accepted. This attention to data analysis is reinforced by tight controls on costs and claims handling procedures.
Frequency and severity of specific risks and sources of uncertainty Most general insurance contracts written by the Group are issued on an annual basis, which means that the Group’s liability extends for a 12 month period, after which the Group is entitled to decline or renew or can impose renewal terms by amending the premium, terms and conditions, or both.
O p er at in g a n d f in an ci al r ev ie w b) Property insurance contracts (residential and commercial) The major source of uncertainty in the Group’s property accounts is the volatility of weather. Over a longer period, the strength of the economy is also a factor. There are many other sources of uncertainty which include operational and reinsurance issues.
Operational risk Operational risks are inherent in the Group’s business. Operational risk losses occur as the result of fraud, human error, missing or inadequately designed processes, failed systems, damage to physical assets, improper behaviour or from external events.
The Group’s Operational Risk Management Framework (“ORMF”) provides the direction for delivering effective operational risk management. The ORMF comprises the policy, principles and procedures that enable the consistent identification, assessment, mitigation, monitoring and reporting of operational risk across the Group in a cost-effective manner.
The Group’s central Operational Risk function is responsible for the ORMF. It is the responsibility of the businesses to implement the framework. The businesses are required to identify where and how the business is exposed to the risk of loss; assess the extent of the risk exposure; control and mitigate the risk and monitor and report the operational risk exposure and highlight any action required.
The Group’s risk management processes are designed to ensure that enterprise risk issues are identified quickly, escalated and managed. Operational risk exposures for each division are reported through the monthly risk and control reports, which provide details of the risk exposures and action plans for each significant business process.
This includes working with domestic and international trade associations, proactively engaging with various regulators, especially the FSA and the main regulatory groups, including the Basel Committee (see page 249), the Committee of European Banking Supervisors, the EU Commission and US regulators.
Governance 102 Board of directors and secretary 104 Report of the directors 108 Corporate governance 114 Directors’ remuneration report 125 Directors’ interests in shares 126 Statement of directors’ responsibilities
Chairman 1. Sir Tom McKillop (age 63) C, N, R Appointed to the Board as Deputy Chairman in September 2005, Sir Tom is a non-executive director of BP p.l.c., and president of the Science Council. He was formerly chief executive of AstraZeneca PLC, and was previously president of the European Federation of Pharmaceutical Industries and Associations and chairman of the British Pharma Group. He is Pro-Chancellor of the University of Leicester and a trustee of the Council for Industry and Higher Education.
Chief Executive, Corporate Markets 4. Johnny Cameron (age 52) FCIBS Appointed to the Board in March 2006, Johnny Cameron joined RBS from Dresdner Kleinwort Benson in 1998. In 2000, he was appointed Deputy Chief Executive of Corporate Banking & Financial Markets (CBFM) with responsibility for the integration of the NatWest and RBS Corporate Banking businesses. In October 2001 he was appointed Chief Executive CBFM, subsequently renamed Corporate Markets in January 2006.
Chief Executive, Manufacturing 6. Mark Fisher (age 46) FCIBS Appointed to the Board in March 2006, Mark Fisher is a career banker having joined National Westminster Bank Plc in 1981. In 2000, he was appointed Chief Executive, Manufacturing with various responsibilities including the integration of RBS and NatWest systems platforms. He is chairman of APACS Administration Limited.
12. Charles ‘Bud’ Koch (age 60) 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 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.
15. Sir Steve Robson* (age 63) A Appointed to the Board in July 2001, Sir Steve is a former senior UK civil servant, who had responsibility for a wide variety of Treasury matters. His early career included the post of private secretary to the Chancellor of the Exchequer and secondment to ICFC (now 3i). He was also a second permanent secretary of HM Treasury, where he was managing director of the Finance and Regulation Directorate. He is a non-executive director of JP Morgan Cazenove Holdings, Xstrata Plc and Partnerships UK plc, and a member of the Chairman’s Advisory Committee of KPMG.
An interim dividend of 24.2p per ordinary share was paid on 6 October 2006 totalling £771 million (2005 – £619 million). The directors now recommend that, subject to approval at the Annual General Meeting, a final dividend of 66.4p per ordinary share totalling £2,093 million (2005 – £1,699 million) be paid on 8 June 2007 to members on the register at the close of business on 9 March 2007.
The Group is engaged principally in providing a wide range of banking, insurance and other financial services. Further details of the organisational structure and business overview of the Group, including the products and services provided by each of its divisions and the competitive markets in which they operate, is contained on pages 46 and 47 of the Operating and financial review.
Risk factors The Group’s future performance and results could be materially different from expected results depending on the outcome of certain potential risks and uncertainties. Details of the principal risk factors the Group faces are given on page 48 of the Operating and financial review.
The reported results of the Group are also sensitive to the accounting policies, assumptions and estimates that underlie the preparation of its financial statements. Details of the Group’s critical accounting policies and key sources of accounting judgements are included in the Accounting policies on pages
The Group’s approach to risk management, including its financial risk management objectives and policies and information on the Group’s exposure to price, credit, liquidity and cash flow risk is discussed in Note 34 on the accounts.
Financial performance A review of the Group’s performance during the year ended 31 December 2006, including details of each division, and the Group’s financial position as at that date is contained in the Operating and financial review on pages 49 to 78.
Employee recruitment Across the Group, over 20,000 employees are recruited at different levels every year. The Group utilises a wide range of recruitment channels including executive search, general advertising, an open internal jobs market, talent fora and detailed succession planning to ensure that the recruitment and development of its employees are fully aligned to its organisational requirements.
Within this package, RBSelect, the Group’s benefit choice programme, provides for UK staff in the Group a flexible way of tailoring their reward to reflect their own individual lifestyles. During 2006, the Group brought retirement savings provision within RBSelect in order to provide more choice for the receipt of retirement benefits. 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.
Many of the Group’s development programmes are delivered at the RBS Business School, based on the Gogarburn Campus.
Employee communication Employee engagement is encouraged through a variety of means including the corporate intranet, Group and divisional magazines, team meetings led by line managers, briefings held by senior managers and regular dialogue with employees and employee representatives. 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.
The Group recognises trade unions in the UK and Ireland. These formal relationships are complemented by works council arrangements in many of the Group’s mainland Europe-based operations. The Group has a European Employee Communication Council that provides elected employee representatives with an opportunity to better understand the impact on its European operations.
Health, safety, wellbeing and security The health, safety, wellbeing and security of employees and customers continues to be a priority for the Group. Regular reviews are undertaken of both policies and processes to ensure compliance with current legislation and best practice. The Group focus is on ensuring that these policies are closely linked to the operational needs of the business.
Corporate governance The company is committed to high standards of corporate governance. Details are given on pages 108 to 113.
Ordinary share capital During the year ended 31 December 2006, the company purchased for cancellation 54.4 million of its ordinary shares at a total cost of £1 billion. These repurchases represented 1.7% of the issued ordinary share capital of the company at
During the year, the ordinary share capital was increased by 7.5 million ordinary shares allotted as a result of the exercise of options under the company’s executive and sharesave schemes, 0.3 million ordinary shares allotted in respect of the exercise of options under the NatWest executive scheme which had been exchanged for options over the company’s ordinary shares following the acquisition of NatWest in 2000 and 2.2 million ordinary shares allotted under the company’s employee share ownership plan.
Details of the authorised and issued ordinary share capital at 31 December 2006 are shown in Note 30 on the accounts.
Preference share capital Details of issues and redemptions of preference shares during the year and the authorised and issued preference share capital at 31 December 2006 are shown in Note 30 on the accounts.
• Guy Whittaker, who was appointed to the Board on 1 February 2006,
• Sir George Mathewson, who retired from the Board on 28 April 2006, served throughout the year and to the date of signing of the financial statements.
At 31 December 2006, the Group’s trade creditors represented 28 days (2005 – 27 days) of amounts invoiced by suppliers. The company does not have any trade creditors.
Shareholdings As at 28 February 2007, the company had been notified of the following interests in its shares.
Under the US Sarbanes-Oxley Act of 2002 (the “Act”), specific standards of corporate governance and business and financial disclosures apply to companies, including the company, with securities registered in the US. Section 404 of the Act concerns internal control over financial reporting and the Group is required to comply with it for the first time for the financial year ended 31 December 2006. The company complies with section 404 and all other applicable sections of the Act.
The roles of the Chairman and Group Chief Executive are distinct and separate, with a clear division of responsibilities. The Chairman leads the Board and ensures the effective engagement and contribution of all non-executive and executive directors. The Group Chief Executive has responsibility for all Group businesses and acts in accordance with the authority delegated by the Board. Responsibility for the development of policy and strategy and operational management is delegated to the Group Chief Executive and other executive directors.
The Board is aware of the other commitments of its directors and is satisfied that these do not conflict with their duties as non-executive directors of the company.
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 pages 102 and 103.
The Board comprises nine independent and seven nonindependent directors (including executive directors), in addition to the Chairman. Bob Scott has been nominated as the senior independent director.
The names of directors standing for re-election at the 2007 Annual General Meeting are contained on page 106 and further information will be given in the Chairman’s letter to shareholders in relation to the company’s Annual General Meeting.
Information, induction and professional development All directors receive accurate, timely and clear information on all relevant matters. All directors have access to the advice and services of the Group Secretary who is responsible to the Board for ensuring that Board procedures are followed and that applicable rules and regulations are complied with. In addition, all directors are able, if necessary, to obtain independent professional advice at the company’s expense.
The performance evaluation of the operation and effectiveness of the Board, the Remuneration Committee and the Nominations Committee was undertaken in the autumn of 2006. This was conducted internally using a detailed questionnaire and individual meetings with each director. Amongst the areas reviewed were the role of the Board, Board composition, Board meetings and processes, Board performance and reporting, external relationships and Board Committees. A separate performance evaluation of the Audit Committee was also undertaken internally in late 2006 using a detailed questionnaire and meetings with Audit Committee members and attendees.
In addition, each director discussed his or her own performance as a director and their Board evaluation with the Chairman. The senior independent director canvassed the views of the executive directors and met with the non-executive directors as a group without the Chairman present to consider the Chairman’s performance. The Board is satisfied that each director continues to contribute effectively to the Board and the Group and demonstrates commitment to his or her role as a director.
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 pages 102 and 103.
Nominations Committee The Nominations Committee comprises independent nonexecutive directors, under the chairmanship of the Chairman of the Board. The Nominations Committee meets as required.
The Nominations Committee is responsible for assisting the Board in the formal selection and appointment of directors. It considers potential candidates and recommends appointments of new directors to the Board. The appointments are based on merit and against objective criteria, including the time available to, and the commitment which will be required of, the potential director.
Meetings The number of meetings of the Board and the Audit, Remuneration and Nominations Committees and individual attendance by members is shown below.
(3) Mr Cameron and Mr Fisher were appointed to the Board on
(4) Mr Friedrich was appointed to the Board on 1 March 2006 and to the Audit Committee on 1 July 2006.
(6) Mrs Kong and Mr Sutherland were appointed to the Remuneration Committee on 1 July 2006.
Management’s report on the Group’s internal control over financial reporting will be filed with the US Securities and Exchange Commission (‘SEC’) at the same time as the Annual Report on Form 20-F.
Disclosure controls and procedures As required by US regulations, the effectiveness of the company’s disclosure controls and procedures (as defined in the rules under the US Securities Exchange Act of 1934) have been evaluated. This evaluation has been considered and approved by the Board which has instructed the Group Chief Executive and the Group Finance Director to certify that as at 31 December 2006, 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.
The Audit Committee, in advance of the commencement of any such service, approves all other permitted non-audit services on a case by case basis. In addition, the Audit Committee reviews and monitors the independence and objectivity of the external auditors when it approves non-audit work to be carried out by them, taking into consideration relevant legislation and ethical guidance. Information on the audit and non-audit services carried out by the external auditors is detailed in Note 4 to the Group’s accounts.
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 to five years in line with best practice, with internal reviews continuing in the intervening years. In 2006 the Audit Committee conducted a review of Group Internal Audit that involved cross Group participation and the external auditors and concluded that the function operated effectively. The Board also concluded, following the 2006 internal review, that the Group Internal Audit function was effective. During 2005 PricewaterhouseCoopers conducted an external review of the effectiveness of the Audit Committee, the results of which were reported to the Board. It is intended that there will be an external review of the effectiveness of the Audit Committee every three years, with internal reviews by the Board continuing in the intervening years. An internal review of the Audit Committee’s performance was undertaken in 2006 and a separate report on the outcome was considered and discussed by the Board.
During the year, the Remuneration Committee received advice from Watson Wyatt and Mercer Human Resource Consulting on matters relating to directors’ remuneration in the UK (Watson Wyatt) and US (Mercer), together with advice from the Group Director, Human Resources and the Group Secretary and General Counsel on general remuneration matters. In addition, the Remuneration Committee has taken account of the views of the Chairman of the Board (who was appointed as a member of the Remuneration Committee in September 2006) and the Group Chief Executive on performance assessment of the 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 and actuarial advice to the trustees of some of the Group’s pension funds. Mercer Human Resource Consulting provided advice and support in connection with a range of benefits, pension actuarial and investment matters.
The objective of the executive remuneration policy is to provide, in the context of the company’s business strategy, remuneration in form and amount which will attract, motivate and retain high-calibre executives. In order to achieve this objective, the policy is framed around the following core principles: • Total rewards will be set at levels that are competitive within the relevant market, taking each executive director’s remuneration package as a whole. The relevant market is FTSE top 20 companies and major UK banks for the UKbased executives and US retail banks for US-based executives.
• Total potential rewards will be earned through achievement of demanding performance targets based on measures consistent with shareholder interests over the short, medium and longer term.
• 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 opposite.
The non-executive directors’ fees are reviewed annually by the Board, on the recommendation of its Chairman. The level of remuneration reflects the responsibility and time commitment of directors and the level of fees paid to non-executive directors of comparable major UK companies. Non-executive directors do not participate in any incentive or performance plan.
Benefits UK-based executive directors, with the exception of Guy Whittaker, are members of The Royal Bank of Scotland Group Pension Fund (“the RBS Fund”). Any new executive directors will not be eligible to participate in the RBS Fund unless they were already a member prior to 1 October 2006.
From April 2006, new tax legislation applies to UK pensions. The Remuneration Committee reviewed the pension provision for all executives and determined that the cost of any additional tax that individuals may incur as a result of their benefits exceeding the new lifetime allowances and annual allowances would not be met by the Group. The Committee believes that pension is an effective element in the retention of directors and decided that no changes should be made to existing arrangements other than to allow directors to opt out of future tax-registered pension provision. For those directors who have opted out of the pension provision, the cash allowances are shown on page 119.
Group operating profit and other Group financial metrics were fully met or exceeded, while most divisional and individual performance objectives were also met or exceeded. As a result, the Remuneration Committee proposed and the Board (excluding executive directors) agreed annual incentive payments ranging from 75% to 125% of normal maximum level. The payments made to Mr Cameron (125% of normal maximum) and Sir Fred Goodwin (110% of normal maximum) reflected the outstanding performance achieved by Corporate Markets and the Group overall respectively and were within the exceptional maximum level.
Long-term incentives The company provides long-term incentives in the form of share options and share or share equivalent awards. Their objective is to encourage the creation of value over the long term and to align the rewards of the executive directors with the returns to shareholders.
Medium-term Performance Plan The Medium-term Performance Plan (“MPP”) was approved by shareholders in April 2001. Each executive director is eligible for an annual award under the plan in the form of share or share equivalent awards. Whilst the rules of the plan allow awards over shares worth up to one and a half times earnings, the Remuneration Committee has adopted a policy of granting awards based on a multiple of salary. Normally awards are made at one times salary to executive directors, with one and a half times salary being granted in the case of the Group Chief Executive. No changes will be made to this policy without prior consultation with shareholders. All awards under the plan are subject to three-year performance targets.
Awards made from 2006 are subject to two performance measures; 50% of the award vests on a relative Total Shareholder Return (“TSR”) measure and 50% vests on growth in adjusted earnings per share (“EPS”) over the three year performance period.
The EPS element ensures a clear line of sight for executives to improve long-term financial performance. For this 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.
For the awards made in 2006, the awards will not vest if EPS growth is below 5% per annum over the three year period. Where EPS growth is between 5% per annum and 10% per annum vesting will occur on a straight-line basis from 25% to 100%. Vesting at 100% will occur if EPS growth is at least 10% per annum.
Shareholding guidelines In 2006, the Remuneration Committee reviewed the policy on shareholding requirements and the Group has now adopted shareholding guidelines for executive directors.
• A grant under the Group’s Medium-term Performance Plan within the levels, and on the same terms, available to UK based executives.
• A grant under the executive share option scheme within the levels, and on the same terms, available to UK based executives. In 2007, Mr Fish will be eligible for a grant under the new executive share option plan if approved by shareholders at the company’s Annual General Meeting.
Sir Fred Goodwin 1 August 1998 12 months 6 months The Royal Bank of Scotland plc
Mr Fisher 27 February 2007 12 months 12 months The Royal Bank of Scotland plc
Mr Pell 20 February 2006 12 months 6 months The Royal Bank of Scotland plc
Mr Whittaker 19 December 2005 12 months 12 months The Royal Bank of Scotland plc
Sir Tom McKillop 1 September 2005 2009 Mr Buchan 1 June 2002 2009 Dr Currie 28 November 2001 2008 Mr Friedrich 1 March 2006 2009 Mr Hunter 1 September 2004 2008 Mr Koch 29 September 2004 2008 Mrs Kong 1 January 2006 2009 Mr MacHale 1 September 2004 2008 Sir Steve Robson 25 July 2001 2008 Mr Scott 31 January 2001 2009 Mr Sutherland 31 January 2001 2009
The tables and explanatory notes on pages 119 to 124 report the remuneration of each director for the year ended 31 December 2006 and have been audited by the company’s auditors, Deloitte & Touche LLP.
Salary/ Performance Pension 2006 2005 fees bonus(1) allowance Benefits Other Total Total
Notes: (1) Includes 10% profit sharing. The performance bonus for Mr Cameron and Mr Fisher reflects their performance for the full year.
(3) The above figures include remuneration paid to Mr Cameron and Mr Fisher prior to their appointment as directors. For this period, Mr Cameron and Mr Fisher received salary and benefits of £141,000 and £105,000 respectively.
(4) Mr Fish is a non-executive director of Textron Inc. and retains the fees paid to him in this respect. For 2006, he received a remuneration package from Textron Inc. equivalent to approximately US$84,974.
The market price of the company’s ordinary shares at 31 December 2006 was £19.93 and the range during the year to 31 December 2006 was £16.69 to £19.99.
Notes: (1) Options held under the sharesave and option 2000 schemes, which are not subject to performance conditions.
(2) Sir George Mathewson retired from the Board on 28 April 2006. The figures quoted above are as at cessation. Subsequently, Sir George exercised his option over 150 shares on
(3) Options held at 1 January 2006 by Mr Cameron and Mr Fisher were granted prior to their appointment to the Board on 1 March 2006.
(share equivalents) at granted award vested in exercised exercise equivalents) at conditions to 1 January 2006 in 2006 £ 2006(1) in 2006 £ 31 December 2006 be fulfilled
Notes: (1) Awards were granted on 9 April 2004 and these awards have now lapsed.
(3) Mr Watt resigned from the Board on 31 January 2006. Mr Watt subsequently exercised his 2002 award (which vested on 31 December 2004) on 7 March 2006. All remaining awards lapsed at cessation of employment.
No variation was made to any of the terms of the plan during the year. The performance measures are detailed on pages 115 and 116.
Restricted Stock Award Awards granted End of the in 2006 Market period for and held at price on qualifying 31 December award conditions to
Notes: (1) Awards were granted to Mr Whittaker in lieu of unvested share awards from his previous employer. Further information on these awards is set out on page 116.
(2) Award has now vested and shares will be released to Mr Whittaker on 1 March 2007.
(3) The end period for qualifying conditions is subject to any restrictions on dealing in the Group’s shares which may be in place and to which Mr Whittaker may be subject. As a result of the close period prior to the announcement of the Group’s results on 1 March 2007, the end of the period for qualifying conditions to be fulfilled in 2007 is 1 March 2007.
Directors’ pension arrangements During the year, Johnny Cameron, Mark Fisher, Sir Fred Goodwin, Gordon Pell and Fred Watt participated in The Royal Bank of Scotland Group Pension Fund (“the RBS Fund”). The RBS Fund is a defined benefit fund registered with HM Revenue & Customs under the Finance Act 2004.
The legislation governing the taxation of pensions in the UK changed with effect from April 2006. No changes have been made to the level of pension benefits of any of the directors as a result of this legislation, however the arrangements for providing some benefits have changed as follows.
Lawrence Fish accrues pension benefits under a number of arrangements in the US. Defined benefits are built up under the Citizens’ Qualified Plan, Excess Plan and Supplemental Executive Retirement Arrangement. In addition, he is a member of two defined contribution arrangements: a Qualified 401(k) Plan and an Excess 401(k) Plan.
Contributions and allowances paid in the year ended 31 December 2006 under defined contribution arrangements were: Mr Cameron £46 — Mr Watt £25 £144 Mr Fish $56 $139
Shares beneficially owned at 31 December 2006 1 January 2006 Vested or date of Shares MPP shares Vested Value as at appointment owned or share share 31 December Executive directors if later beneficially equivalents options Total 2006 (2,3)
Shares beneficially owned at Shares 1 January 2006 beneficially or date of owned at appointment 31 December
Mr Buchan 5,000 5,000 Dr Currie 556 556 Mr Friedrich (appointed 1 March 2006) — 20,256 Mr Hunter 3,500 3,500 Mrs Kong 1,120 7,000 Mr Koch 20,000 20,000 Mr MacHale 10,000 10,000 Mr Scott 4,448 4,448 Mr Sutherland 5,590 5,590
On 18 January 2007, Mr Cameron acquired 1,466 ordinary shares of 25p each from the late Sir Donald and Lady Cameron Marriage Settlement Trust.
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 law and International Financial Reporting Standards (“IFRS”) as adopted by the European Union. They are also responsible for the preparation of the other information contained in the 2006 Annual Report including the directors’ remuneration report.
We report to you our opinion as to whether the financial statements give a true and fair view 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 as regards the financial statements, Article 4 of the IAS Regulation. We also report to you whether in our opinion, the information given in the directors’ report is consistent with the financial statements. The information given in the director’s report includes that specific information presented in the Operating and Financial Review that is cross referred from the business review section of the directors’ report.
We review whether the corporate governance statement reflects the company’s compliance with the nine provisions of the 2003 Combined Code specified for our review by the Listing Rules of the Financial Services Authority, and we report if it does not.
The Listing Rules do not require us to consider whether the Board or management’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.
UK opinion In our opinion: • the Group financial statements give a true and fair view, in accordance with IFRS as adopted by the European Union, of the state of the Group’s affairs as at 31 December 2006 and of its profit and cash flows for the year then ended; • the company financial statements give a true and fair view, in accordance with IFRS as adopted by the European Union as applied in accordance with the requirements of the Companies Act 1985, of the state of affairs of the company as at 31 December 2006; • 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, as regards the financial statements, Article 4 of the IAS Regulation; and
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Group’s internal control over financial reporting as at 31 December 2006, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Our report dated 28 February 2007 which will be included in the Annual Report on Form 20-F for the year ended 31 December 2006 to be filed with the Securities and Exchange Commission expressed an unqualified opinion on management’s assessment of the effectiveness of the Group’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Group’s internal control over financial reporting.
The company is incorporated in the UK and registered in Scotland. The accounts are prepared on the historical cost basis except that the following assets and liabilities are stated at their fair value: derivative financial instruments, held-for-trading financial assets and financial liabilities, financial assets and financial liabilities that are designated as at fair value through profit or loss, available-forsale financial assets and investment property. Recognised financial assets and financial liabilities in fair value hedges are adjusted for changes in fair value in respect of the risk that is hedged.
3. Revenue recognition Interest income on financial assets that are classified as loans and receivables, available-for-sale or held-to-maturity and interest expense on financial liabilities other than those at fair value through profit or loss are determined using the effective interest method. The effective interest method is a method of calculating the amortised cost of a financial asset or financial liability (or group of financial assets or liabilities) and of allocating the interest income or interest expense over the expected life of the asset or liability. The effective interest rate is the rate that exactly discounts estimated future cash flows to the instrument’s initial carrying amount. Calculation of the effective interest rate takes into account fees receivable, that are an integral part of the instrument’s yield, premiums or discounts on acquisition or issue, early redemption fees and transaction costs. All contractual terms of a financial instrument are considered when estimating future cash flows.
4. Pensions and other post-retirement benefits The Group provides post-retirement benefits in the form of pensions and healthcare plans to eligible employees.
Contributions to defined contribution pension schemes are recognised in the income statement when payable.
5. 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 economic lives and is included in depreciation and amortisation. The estimated useful economic lives are as follows: Core deposit intangibles 6 to 10 years Other acquired intangibles 5 to 10 years Computer software 3 to 5 years
Expenditure on internally generated goodwill and brands is written-off as incurred. Direct costs relating to the development of internal-use computer software are capitalised once technical feasibility and economic viability have been established. These costs include payroll, the costs of materials and services, and directly attributable overhead. Capitalisation of costs ceases when the software is capable of operating as intended. During and after development, accumulated costs are reviewed for impairment against the projected benefits that the software is expected to generate. Costs incurred prior to the establishment of technical feasibility and economic viability are expensed as incurred as are all training costs and general overhead. The costs of licences to use computer software that are expected to generate economic benefits beyond one year are also capitalised.
Under previous GAAP, the Group’s freehold and long leasehold property occupied for its own use was recorded at valuation on the basis of existing use value. The Group elected to use this valuation as at 31 December 2003 (£2,391 million) as deemed cost for its opening IFRS balance sheet (1 January 2004).
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 accounting policy 6 above).
F in an ci al s ta te m en ts 10. Insurance General insurance General insurance comprises short-duration contracts, principally property and liability insurance contracts. Due to the nature of the products sold – retail-based property and casualty, motor, home and personal health insurance contracts – the insurance protection is provided on an even basis throughout the term of the policy.
Life assurance The Group’s long-term assurance contracts include whole-life term assurance, endowment assurance, flexible whole-life, pension and annuity contracts that are expected to remain in force for an extended period of time. Long-term assurance contracts under which the Group does not accept significant insurance risk are classified as financial instruments. The Group recognises the value of in-force long-term assurance contracts as an asset. Cash flows associated with in-force contracts and related assets, including reinsurance cash flows, are projected, using appropriate assumptions as to future mortality, persistency and levels of expenses and excluding the value of future investment margins, to estimate future surpluses attributable to the Group. These surpluses, discounted at a risk-adjusted rate, are recognised as a separate asset. Changes in the value of this asset are included in operating profit.
12. Financial assets On initial recognition financial assets are classified into heldto -maturity investments; available-for-sale financial assets; heldfor -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 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 amortised cost using the effective interest method (see accounting policy 3 above) less any impairment losses.
Available-for-sale – financial assets that are not classified as held-to-maturity; held-for-trading; designated as at fair value through profit or loss; or loans and receivables are classified as available-for-sale. Financial assets can be designated as available-for-sale on initial recognition. Available-for-sale financial assets are initially recognised at fair value plus directly related transaction costs. They are subsequently measured at fair value. Unquoted equity investments whose fair value cannot be measured reliably are carried at cost and classified as available-for-sale financial assets. Impairment losses and exchange differences resulting from retranslating the amortised cost of currency monetary available-for-sale financial assets are recognised in profit or loss together with interest calculated using the effective interest method (see accounting policy 3 above). Other changes in the fair value of available-for-sale financial assets are reported in a separate component of shareholders’ equity until disposal, when the cumulative gain or loss is recognised in profit or loss.
13. Impairment of financial assets The Group assesses at each balance sheet date whether there is any objective evidence that a financial asset or group of financial assets classified as held-to-maturity, available-for-sale or loans and receivables is impaired. A financial asset or portfolio of financial assets is impaired and an impairment loss incurred if there is objective evidence that an event or events since initial recognition of the asset have adversely affected the amount or timing of future cash flows from the asset.
All other financial liabilities are measured at amortised cost using the effective interest method (see accounting policy 3 above).
15. 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.
16. 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.
Fair value hedge – in a fair value hedge, the gain or loss on the hedging instrument is recognised in profit or loss. The gain or loss on the hedged item attributable to the hedged risk is recognised in profit or loss and adjusts the carrying amount of the hedged item. Hedge accounting is discontinued if the hedge no longer meets the criteria for hedge accounting or if the hedging instrument expires or is sold, terminated or exercised or if hedge designation is revoked. If the hedged item is one for which the effective interest rate method is used, any cumulative adjustment is amortised to profit or loss over the life of the hedged item using a recalculated effective interest rate.
F in an ci al s ta te m en ts transaction is no longer expected to occur), the cumulative unrealised gain or loss recognised in equity is recognised in profit or loss when the hedged cash flow occurs or, if the forecast transaction results in the recognition of a financial asset or financial liability, in the same periods during which the asset or liability affects profit or loss. Where a forecast transaction is no longer expected to occur, the cumulative unrealised gain or loss is recognised in profit or loss immediately.
18. Share-based payments The Group grants options over shares in The Royal Bank of Scotland Group plc to its employees under various share option schemes. The Group has applied IFRS 2 ‘Share-based Payment’ to grants under these schemes after 7 November 2002 that had not vested on 1 January 2005. The expense for these transactions is measured based on the fair value on the date the options are granted. The fair value is estimated using valuation techniques which take into account the option’s exercise price, its term, the risk-free interest rate and the expected volatility of the market price of The Royal Bank of Scotland Group plc’s shares. Vesting conditions are not taken into account when measuring fair value, but are reflected by adjusting the number of options included in the measurement of the transaction such that the amount recognised reflects the number that actually vest. The fair value is expensed on a straight-line basis over the vesting period.
At 31 December 2006, gross loans and advances to customers totalled £470,826 million (2005 – £421,110 million) and customer loan impairment provisions amounted to £3,933 million (2005 – £3,884 million).
Provisions are determined by management based on experience of claims settled and on statistical models which require certain assumptions to be made regarding the 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
For the purposes of impairment testing, goodwill acquired in a business combination is allocated to each of the Group’s cashgenerating units or groups of cash-generating units expected to benefit from the combination. Goodwill impairment testing involves the comparison of the carrying value of a cashgenerating unit or group of cash generating units with its recoverable amount. The recoverable amount is the higher of the unit’s fair value and its value in use. Value in use is the present value of expected future cash flows from the cash-generating unit or group of cash-generating units. Fair value is the amount obtainable for the sale of the cash-generating unit in an arm’s length transaction between knowledgeable, willing parties.
The Group is reviewing IFRS 7 and the amendment to IAS 1 to determine their effect on its financial reporting.
The International Financial Reporting Interpretations Committee (‘IFRIC’) issued interpretation IFRIC 9 ‘Reassessment of Embedded Derivatives’ in March 2006. Entities are required to assess financial instruments for the existence of embedded derivatives; this interpretation prohibits subsequent reassessment unless there is a change of terms that significantly changes the terms of the financial instrument. The interpretation is effective for accounting periods starting on or after 1 June 2006 and is not expected to have a material effect on the Group or company.
The IFRIC issued interpretation IFRIC 11 ‘Group and Treasury Share Transactions’ in November 2006. Entities which buy their own shares, or whose shareholders buy shares in the reporting entity, in order to provide incentives to employees shall account for those incentives on an equity-settled basis. This principle applies also to the accounting by subsidiaries. The interpretation is effective for annual accounting periods beginning on or after 1 March 2007 and is not expected to have a material effect on the Group or company.
The IFRIC issued interpretation IFRIC 12 ‘Service Concession Arrangements’ in December 2006. Entities providing infrastructure and services to governments under concession arrangements shall account for each component of the arrangement separately. Infrastructure provided under these arrangements may be recognised as either a financial asset or an intangible asset. The interpretation is effective for accounting periods beginning on or after 1 January 2008 and is not expected to have a material effect on the Group or company.
The IASB issued IFRS 8 ‘Operating Segments’ in December 2006. This will replace IAS 14 ‘Segment Reporting’ for accounting periods beginning on or after 1 January 2009. IFRS 8 is very similar to US Statement of Financial Accounting Standards No. 131 ‘Disclosures about Segments of an Enterprise and Related Information’ and requires entities to report segment information as reported to management and reconcile it to the financial statements. Disclosures required by SFAS 131 are included on pages 203 to 207.
Net interest income 10,596 9,918 9,071 Fees and commissions receivable 7,116 6,750 6,473 Fees and commissions payable (1,922) (1,841) (1,926) Income from trading activities 1 2,675 2,343 1,988 Other operating income (excluding insurance premium income) 3,564 2,953 2,138 Insurance premium income 6,243 6,076 6,146
Premises and equipment 1,421 1,313 1,177 Other administrative expenses 2,658 2,816 2,323 Depreciation and amortisation 1,678 1,825 1,674
Assets Cash and balances at central banks 6,121 4,759 — — Treasury and other eligible bills subject to repurchase agreements 33 1,426 896 — — Other treasury and other eligible bills 4,065 4,642 — — Treasury and other eligible bills 10 5,491 5,538 — — Loans and advances to banks 11 82,606 70,587 7,252 9,122 Loans and advances to customers 12 466,893 417,226 286 567 Debt securities subject to repurchase agreements 33 58,874 53,485 — — Other debt securities 68,377 67,480 — —
Property, plant and equipment 18 18,420 18,053 — — Settlement balances 7,425 6,005 — —
The accounts were approved by the Board of directors on 28 February 2007 and signed on its behalf by: Sir Tom McKillop Sir Fred Goodwin Guy Whittaker Chairman Group Chief Executive Group Finance Director
Statements of recognised income and expense for the year ended 31 December 2006
Available-for-sale investments Net valuation gains taken direct to equity 4,792 35 — — Net profit taken to income on sales (313) (582) — —
Cash flow hedges Net (losses)/gains taken direct to equity (109) 18 — — Net (gains)/losses taken to earnings (140) (85) 3 6
Exchange differences on translation of foreign operations (1,681) 842 (606) — — — Actuarial gains/(losses) on defined benefit plans 1,781 (799) (1,601) — — — Other movements — — — — — (1) Income/(expense) before tax on items recognised direct in equity 4,330 (571) (2,207) 3 6 (1) Tax on items recognised direct in equity (1,173) 478 465 (1) (2) — Net income/(expense) recognised direct in equity 3,157 (93) (1,742) 2 4 (1)
Adjustments for: Depreciation and amortisation 1,678 1,825 1,674 — — —
Charge for defined benefit pension schemes 580 462 397 — — — Cash contribution to defined benefit pension schemes (536) (452) (1,146) — — — Elimination of foreign exchange differences 4,516 (3,060) 1,864 (22) (30) —
Net cash flows from operating activities 37 17,441 4,140 5,099 3,648 4,413 3,097
Proceeds of minority interests issued 1,354 1,264 1,260 — — — Redemption of minority interests (81) (121) (2) — — — Repurchase of ordinary shares (991) — — (991) — — Shares purchased by employee trusts (254) — — — — — Shares issued under employee share schemes 108 — — 7 — —
The analysis of trading income is based on how the business is organised and the underlying risks managed; 2005 and 2004 have been restated to reflect this. The total income from trading activities is unchanged.
(2) Interest rates: interest rate swaps, forward foreign exchange contracts, forward rate agreements, interest rate options, interest rate futures and related hedges and funding.
Premises and equipment 1,421 1,313 1,177 Other administrative expenses 2,658 2,816 2,323
The average number of persons employed by the Group during the year, excluding temporary staff, was 142,600 (2005 – 144,900; 2004 – 133,300). The average number of temporary employees during 2006 was 4,800. The number of persons employed by the Group at 31 December, excluding temporary staff, was as follows: Group
Expected return on plan assets (weighted average) 6.9% 6.5% 6.7% 6.9% 6.5% 6.8% Rate of increase in salaries 4.2% 4.0% 4.0% 4.1% 3.9% 3.9% Rate of increase in pensions in payment 2.9% 2.7% 2.7% 2.8% 2.6% 2.7%
Major classes of plan assets as a percentage of total plan assets 2006 2005 2004 2006 2005 2004
Currency translation and other adjustments — — — (59) (65) (6) Income statement: Statement of recognised income and expense: Expenses included in service cost (26) (26) — (28) (28) —
Experience losses on plan liabilities (4) (41) (624) (19) (68) (631) Experience gains on plan assets 552 1,556 392 587 1,660 408 Actual return on pension schemes assets 1,574 2,486 1,230 1,660 2,677 1,328
F in an ci al s ta te m en ts 4 Auditors’ remuneration Amounts paid to the auditors for statutory audit and other services were as follows: Group £m £m
Fees payable to the Group’s auditors for the audit of the Group’s annual accounts 0.8 0.6 Fees payable to the Group’s auditors and their associates for other services to the Group: – The audit of the company’s subsidiaries pursuant to legislation 10.8 9.3 Total audit fees 11.6 9.9
Expected tax charge 2,756 2,381 2,185 Interest on subordinated debt not allowable for tax 58 79 — Non-deductible items 230 230 110 Non-taxable items (251) (166) (128) Taxable foreign exchange movements 5 (10) (10) Foreign profits taxed at other rates 63 77 49 Unutilised losses brought forward and carried forward 14 (5) 6 Adjustments in respect of prior periods (186) (208) (217) Actual tax charge for the year 2,689 2,378 1,995
F in an ci al s ta te m en ts 6 Profit attributable to preference shareholders Group
Dividends Finance cost Dividends Finance cost Finance paid to equity included in paid to equity included in cost of preference interest preference interest preference shareholders payable shareholders payable shares £m £m £m £m £m
Non-cumulative preference shares of US$0.01 92 86 58 115 105 Non-cumulative convertible preference shares of US$0.01 — 50 — 73 90 Non-cumulative convertible preference shares of €0.01 — — — 9 33 Non-cumulative preference shares of €0.01 99 — 51 — 4 Non-cumulative convertible preference shares of £0.01 — 15 — 15 15 Appropriation for premium payable on redemption and issue costs — 6 — 8 9
Notes: (1) In the year ended 31 December 2006, dividends of £55,000 (2005 and 2004 – £55,000) were paid on the 11% cumulative preference shares of £1 and dividends of £22,000 (2005 and 2004 – £22,000) were paid on the 5.5% cumulative preference shares of £1.
(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 related finance cost in interest payable.
(3) Between 1 January 2007 and the date of approval of these accounts, dividends amounting to US$61 million have been declared in respect of equity preference shareholders for payment on 30 March 2007.
Final dividend for previous year declared during the current year 53.1 41.2 35.7 1,699 1,308 1,059
All convertible preference shares have a dilutive effect in 2006 and 2005 and have been included in the computation of diluted earnings per share. In 2004, US$1,500 million of convertible preference shares were not included in the computation of diluted earnings per share as their effect was anti-dilutive.
Securitisations and other asset transfers 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 (“SPE”) which then issues liabilities to third party investors.
Securitisations may, depending on the individual arrangement, result in continued recognition of the securitised assets; continued recognition of the assets to the extent of the Group’s continuing involvement in those assets; or derecognition of the assets and the separate recognition, as assets or liabilities, of any rights and obligations created or retained in the transfer (see Accounting policy on page 135). The Group has securitisations in each of these categories.
Notes: (1) Mortgages have been transferred to special purpose vehicles, held ultimately by charitable trusts, funded principally through the issue of floating rate notes. The Group has entered into arm’s length fixed/floating interest rate swaps and cross-currency swaps with the securitisation vehicles and provides mortgage management and agency services to the vehicles. On repayment of the financing, any further amounts generated by the mortgages will be paid to the Group.
(2) 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.
(3) Other loans originated by the Group have been transferred to special purpose vehicles funded through the issue of notes. Any proceeds from the loans in excess of the amounts required to service and repay the notes are payable to the Group after deduction of expenses.
Continuing involvement In certain US securitisations of residential mortgages, substantially all the risks and rewards have been neither transferred nor retained, but the Group has retained control, as defined by IFRS, of the assets and continues to recognise the assets to the extent of its continuing involvement which takes the form of retaining certain subordinated bonds issued by the securitisation vehicles. These bonds have differing rights and, depending on their terms, they may expose the Group to interest rate risk where they carry a fixed coupon or to credit risk depending on the extent of their subordination. Certain bonds entitle the Group to additional interest if the portfolio performs better than expected and others give the Group the right to prepayment penalties received on the securitised mortgages. At 31 December 2006, securitised assets were £37.3 billion (2005 – £39.8 billion); retained interests £930 million (2005 – £863 million); subordination assets £694 million (2005 – £609 million) and related liabilities £694 million (2005 – £609 million).
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 2006, the Group received proceeds of approximately £45.6 billion (2005 – £46.3 billion; 2004 – £30.1 billion) from securitisation trusts in connection with new securitisations of Group assets and £10.7 billion (2005 – £9.6 billion; 2004 – £1.3 billion) in connection with securitisation of third-party assets.
The Group recognised net pre-tax gains of approximately £192 million (2005 – £182 million; 2004 – £111 million) relating to these securitisations. Net pre-tax gains are based on the difference between the sales prices and previous carrying values of assets prior to date of sale, are net of transaction costs, and exclude any results attributable to hedging activities, interest income, funding costs, and changes in asset values prior to, and in retained interest values subsequent to, the securitisation date.
Weighted average life 2 – 18 years 0 – 13 years 1 – 10 years
Fair value of retained interests at 31 December 2006 (£m) 1,148 818 113 Prepayment speed(5) 10 – 32% CPR (1) 0 – 40% CPR (1) 0 – 100% CPY (2)
Impact on fair value of 10% adverse change (£m) 23.8 23.7 3.3 Impact on fair value of 20% adverse change (£m) 46.5 46.0 6.4
Impact on fair value of 10% adverse change (£m) N/A 36.2 0.1 Impact on fair value of 20% adverse change (£m) N/A 50.8 0.1
(2) CPR with yield maintenance provision and thus prepayment risk is limited.
(3) US Agency retained interests are securities whose principal and interest have been guaranteed by various United States government sponsored enterprises (‘GSEs’). These GSEs include the Federal National Mortgage Association (‘Fannie Mae’), the Federal Home Loan Mortgage Corporation (‘Freddie Mac’), and the Government National Mortgage Association (‘Ginnie Mae’). Fannie Mae and Freddie Mac are federally regulated but are privately owned. These GSEs guarantee that the holders of their mortgage-backed securities will receive payments of interest and principal. Securities guaranteed by either of these two GSEs, although not formally rated, are regarded as having a credit rating equivalent to AAA. Ginnie Mae guarantees the timely payment of principal and interest on all of its mortgage-backed securities, and its guarantee is backed by the full faith and credit of the United States Government.
state and government Bank and MortgageUK federal Other sponsored building backed government agency government entity society securities(1) Corporate Other Total 2006 £m £m £m £m £m £m £m £m £m
Loans and receivables — — — — — — 21 540 561
The following table shows the Group’s available-for-sale debt securities by remaining maturity and the related yield (based on weighted averages) as at 31 December 2006.
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 2006.
Interest receivable includes £1,559 million (2005 – £1,624 million; 2004 – £1,487 million) in respect of debt securities.
The Group considers that unrealised losses on available-for-sale debt securities are temporary, principally because they reflect changes in benchmark interest rates.
Designated as at fair value through profit or loss 2,051 559 2,610 2,113 428 2,541
F in an ci al s ta te m en ts 15 Investments in Group undertakings Investments in Group undertakings are carried at cost less impairment. Movements during the year were as follows: Company £m £m
Implementation of IAS 32 and IAS 39 on 1 January 2005 — (4,004) Currency translation and other adjustments (164) (6)
The above information is provided in relation to the principal related undertakings as permitted by Section 231(5) of the Companies Act 1985. Full information on all related undertakings will be included in the Annual Return delivered to the Registrar of Companies for Scotland.
F in an ci al s ta te m en ts £m £m £m
Individually Collectively Total assessed assessed Latent 2006 2005 2004 £m £m £m £m £m £m
Implementation of IAS 39 on 1 January 2005 — — — — (29) — Currency translation and other adjustments (19) (5) (37) (61) 51 (98) Acquisitions — — — — — 290
(2) Impairment losses at 31 December 2006 include £2 million relating to loans and advances to banks (2005 – £3 million).
Loan impairment At 31 December 2006, the Group’s non-accrual loans, loans past due 90 days and troubled debt restructurings amounted to £6,337 million (2005 – £5,937 million). Loan impairment provisions of £3,342 million (2005 – £3,344 million) were held against these loans. Average non-accrual loans, loans past due 90 days and troubled debt restructurings for the year ended 31 December 2006 were £6,163 million (2005 – £5,923 million;
Accumulated amortisation and impairment: Currency translation and other adjustments — (12) (7) — (19) Disposals and write-off of fully amortised assets — — — (8) (8) Charge for the year — 54 40 291 385
Net book value at 31 December 2005 18,823 214 261 634 19,932
The amortisation expense in respect of core deposit intangibles and other purchased intangibles for each of the next five years is currently estimated to be: £m
Impairment review The Group’s goodwill acquired in business combinations is reviewed annually at 30 September for impairment by comparing the recoverable amount of each cash generating unit to which goodwill has been allocated with its carrying value. There was no impairment recognised in 2006 or 2005.
Cash generating units where goodwill is significant were as follows: On 1 January 2006 the Corporate Markets division was reorganised into Global Banking & Markets and UK Corporate Banking; Retail Markets was reorganised during the second half of 2006 into Retail and Wealth Management; goodwill was reallocated using relative fair values calculated as a weighted average of headcount, risk-weighted assets and profitability.
The recoverable amounts for all CGU’s, except for Citizens – Midstates were based on fair value less costs to sell. Fair value was based upon a price-earnings methodology using current earnings for each unit. Approximate price earnings multiples, validated against independent analyst information were applied to each CGU. The multiples used for both 2006 and 2005 were in the range 7.0 – 13.0 times earnings after charging manufacturing costs.
Developments in Citizens, including the integration of Charter One, acquired in 2004, have led to changes in its management structure during 2006 resulting in the new Citizens Midstates cash-generating unit. The recoverable amount was based on a value in use methodology using management forecasts to 2014 (2005 – 2012). A projection period of greater than five years was used reflecting Citizens’ sustained historical growth rates, independently projected industry growth rates and the execution of Citizens’ commercial banking strategy in the Midstates operating area. A terminal growth rate of 5% (2005 – 4%) and a discount rate of 10% (2005 – 10.7%) was used. The recoverable amount of Citizens Midstates exceeds its carrying value by over $4 billion. The profit growth rate would have to be approximately half the projected rate to cause the value in use of the unit to equal its carrying amount.
Long Short Computers Operating Investment Freehold leasehold leasehold and other lease properties premises premises premises equipment assets Total 2006 £m £m £m £m £m £m £m
Net book value at 31 December 2006 4,885 2,133 214 880 1,399 8,909 18,420
Expenditure on investment properties 53 — — — — — 53 Change in fair value of investment properties 26 — — — — — 26 Disposals and write-off of fully depreciated assets (176) (560) (71) (127) (466) (1,372) (2,772)
Depreciation charge for the year — 60 7 64 390 805 1,326
Net book value at 31 December 2005 4,347 2,291 217 726 1,419 9,053 18,053
Valuations are carried out by qualified surveyors who are members of the Royal Institution of Chartered Surveyors, or an equivalent overseas body. The 31 December 2006 valuation for a significant majority of the Group’s investment properties was undertaken by external valuers.
Companies in the Group enter into derivatives as principal either as a trading activity or to manage balance sheet foreign exchange, interest rate and credit risk. Derivatives include swaps, forwards, futures and options. They may be traded on an organised exchange (exchange-traded) or over-the-counter (OTC). Holders of exchange traded derivatives are generally required to provide margin daily in the form of cash or other collateral.
Included in the above are fair value hedging derivatives as follows: Hedge ineffectiveness recognised in other operating income comprised fair value hedges – gain of £4 million (2005 – loss of £24 million) and cash flow hedges – gain of £4 million (2005 – gain of £12 million).
The company held derivative liabilities with a fair value of £42 million (2005 – £55 million derivative assets) and notional amount of
F in an ci al s ta te m en ts 20 Prepayments, accrued income and other assets Group Company £m £m £m £m
Accrued income 668 857 — — Deferred expenses 367 372 — —
Held-for-trading 46,797 34,645 — — Designated as at fair value through profit or loss (1) 3,922 3,683 — —
Amounts above include: Repurchase agreements 63,984 48,754 — — Due to subsidiaries — 55
Held-for-trading 2,141 1,469 — — Designated as at fair value through profit or loss (1) 10,499 11,068 — —
F in an ci al s ta te m en ts 24 Settlement balances and short positions Group £m £m
Settlement balances – amortised cost 5,667 6,561 Short positions – held-for-trading: Debt securities – Government 36,901 30,749 Debt securities – Other issuers 5,843 5,355 Treasury and other eligible bills 654 1,178 Equity shares 411 145 25 Accruals, deferred income and other liabilities Group Company £m £m £m £m
Currency translation and other movements (1) Charge to income statement 101 Releases to income statement (20) Provisions utilised (42)
Notes: (1) Comprises property provisions and other provisions arising in the normal course of business.
F in an ci al s ta te m en ts 26 Deferred taxation Provision for deferred taxation has been made as follows: Group Company £m £m £m £m
Fair Accelerated value of capital Deferred IAS financial Cash flow Pension allowances Provisions gains transition instruments Intangibles hedging Other Total £m £m £m £m £m £m £m £m £m £m
(2) Deferred tax liabilities of £649 million (2005 – £830 million) have not been recognised in respect of retained earnings of overseas subsidiaries and held-over gains on the incorporation of overseas branches. Retained earnings of overseas subsidiaries are expected to be reinvested indefinitely or remitted to the UK free from further taxation. No taxation is expected to arise in the foreseeable future in respect of held-over gains.
Cash paid for claims settled in the year (3,474) 147 (3,327) Increase/(decrease) in liabilities
– arising from current year claims 4,220 (96) 4,124 – arising from prior year claims (344) 29 (315)
Cash paid for claims settled in the year (3,687) 106 (3,581) Increase/(decrease) in liabilities
New business contribution (2) 12 (4) Operating assumption changes 5 1 Investment return variances 1 7 Economic assumption changes (1) 1
(2) New business contribution represents the present value of future profits on new insurance contract business written during the year.
Implementation of IAS 32, IAS 39 and IFRS 4 on 1 January 2005 47 — Premiums received 429 86 Fees and expenses (11) (21) Investment return 252 333 Actuarial adjustments (91) — Account balances paid on surrender and other terminations in the year (368) (204)
Premiums received 588 83 Fees and expenses (30) (19) Investment return 235 182 Actuarial adjustments (454) — Account balances paid on surrender and other terminations in the year (429) (296)
The associated liabilities are: Linked contracts classified as insurance contracts 1,713 1,640 Linked contracts classified as investment contracts (within customer deposits) 2,146 2,189
F in an ci al s ta te m en ts 28 Subordinated liabilities Group Company £m £m £m £m
Designated as at fair value through profit or loss 124 150 — —
Group 2006 – final redemption £m £m £m £m £m £m £m
Currently 2007 2008 2009– 2011 2012– 2016 Thereafter Perpetual Total 2006 – call date £m £m £m £m £m £m £m £m
Company 2006 – final redemption £m £m £m £m £m £m £m
Company 2005 – final redemption £m £m £m £m £m £m £m
US$750 million floating rate subordinated notes 2015 (callable September 2010) 381 435 €750 million floating rate subordinated notes 2015 531 574 CHF400 million 2.375% subordinated notes 2015 160 174 CHF100 million 2.375% subordinated notes 2015 43 44 CHF200 million 2.375% subordinated notes 2015 (issued April 2006) 81 — US$500 million floating rate subordinated notes 2016 (callable October 2011) 257 293 US$1,500 million floating rate subordinated notes 2016 (issued April 2006; callable April 2011) 773 —
CHF200 million 2.75% subordinated notes 2017 (issued December 2006; callable December 2012) 84 — €100 million floating rate subordinated notes 2017 67 69 €500 million floating rate subordinated notes 2017 (issued June 2006; callable June 2012) 337 — €750 million 4.35% subordinated notes 2017 (issued October 2006; callable October 2017) 502 — AUD450 million 6.5% subordinated notes 2017 (issued November 2006; callable February 2012) 184 — AUD450 million floating rate subordinated notes 2017 (issued November 2006; callable February 2012) 182 — US$125.6 million floating rate subordinated notes 2020 65 74 €1,000 million 4.625% subordinated notes 2021 (callable September 2016) 687 747
Greenwich Capital Holdings, Inc US$105 million subordinated loan capital 2006 floating rate notes (redeemed October 2006) — 61 US$500 million subordinated loan capital 2010 floating rate notes (callable December 2007) 256 291 US$170 million subordinated loan capital floating rate notes 2008 (issued October 2006) 87 —
Other minority interest subordinated issues 24 24 * In addition the company has issued 0.5 million subordinated loan notes of €1,000 each, 1.95 million subordinated loan notes of US$1,000 each and 0.4 million subordinated loan notes of £1,000 each. These loan notes are included in the company balance sheet as loan capital but are reclassified as minority interest Trust Preferred Securities on consolidation (see Note 29).
(2) Unconditionally guaranteed by the company. (3) In the event of certain changes in tax laws, dated loan capital issues may be redeemed in whole, but not in part, at the option of the issuer, at the principal amount thereof plus accrued interest, subject to prior regulatory approval.
(4) Except as stated above, claims in respect of the Group’s dated loan capital are subordinated to the claims of other creditors. None of the Group’s dated loan capital is secured. (5) Interest on all floating rate subordinated notes is calculated by reference to market rates.
The company US$200 million 8.5% exchangeable capital securities, Series A (redeemed January 2006) (1) — 117 US$50 million undated 7.993% capital securities (redeemed January 2006) (1) — 30 US$35 million undated 7.755% capital securities (redeemed January 2006) (1) — 20 US$350 million undated floating rate primary capital notes (callable on any interest payment date) (1) 178 203 US$200 million undated 7.375% reset capital securities (redeemed April 2006) (1) — 119 US$75 million floating rate perpetual capital securities (callable September 2007) (1) 38 44 US$1,200 million 7.648% perpetual regulatory tier one securities (callable September 2031) (1,2) 618 711
First Active plc £20 million 11.75% perpetual tier two capital 23 23 €38 million 11.375% perpetual tier two capital 36 37 £1.3 million floating rate perpetual tier two capital 2 2
(6) In the event of certain changes in tax laws, undated loan capital issues may be redeemed in whole, but not in part, at the option of the Group, at the principal amount thereof plus accrued interest, subject to prior regulatory approval.
Series 1 US$1,000 million 9.118% (redeemable March 2010) 515 607 Non-cumulative convertible preference shares of £0.01 (1)
Series A £140 million 9% (non-redeemable) 142 140 Non-cumulative preference shares of US$25
US$750 million 6.8% (redeemable March 2008) 382 436 US$850 million 4.709% (redeemable July 2013) 409 494 US$650 million 6.425% (redeemable January 2034) 341 378
Note: (1) The trust preferred securities have no maturity date and are not redeemable at the option of the holders at any time. These securities may with the consent of the UK Financial Services Authority be redeemed, by the issuer on the dates specified above or on any interest payment date thereafter. They may also be redeemed in whole, but not in part, upon the occurrence of certain tax and regulatory events. These securities are included in the company balance sheet as dated loan capital.
F in an ci al s ta te m en ts 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 (297) 53 Profit attributable to minority interests 104 57 Dividends paid (66) (95) Unrealised gains on available-for-sale securities 2,140 — Equity raised 1,354 1,264 Equity withdrawn (81) (121)
Note: (1) The trust preferred securities have no maturity date and are not redeemable at the option of the holders at any time. These securities may, with the consent of the UK Financial Services Authority, be redeemed, in whole or in part, by the issuer on the dates specified above or on any interest payment date thereafter. They may also be redeemed in whole, but not in part, upon the occurrence of certain tax and regulatory events. These securities are included in the company balance sheet as dated loan capital.
F in an ci al s ta te m en ts 30 Share capital Allotted, called up and fully paid Authorised 1 January Issued Cancelled 31 December 31 December 31 December 2006 during the year during the year 2006 2006 2005 £m £m £m £m £m £m
Non-voting deferred shares of £0.01 27 — — 27 323 323
Non-voting deferred shares of £0.01 2,660,556 2,660,556 2,660,556 32,300,000 32,300,000 32,300,000 Additional Value Shares of £0.01 — — — 2,700,000 2,700,000 2,700,000 Non-cumulative preference shares of US$0.01 240,000 206,000 153,000 419,500 419,500 348,500 Non-cumulative convertible preference shares of US$0.01 1,000 1,000 1,900 3,900 3,900 3,900 Non-cumulative preference shares of €0.01 2,500 2,500 1,250 66,000 66,000 66,000 Non-cumulative convertible preference shares of €0.01 — — 750 3,000 3,000 3,000 Non-cumulative convertible preference shares of £0.25 — — — 900,000 900,000 900,000 Non-cumulative convertible preference shares of £0.01 200 200 200 1,000 1,000 1,000
Non-cumulative preference shares of £1 — — — 300,000 300,000 300,000
Movement in ordinary shares in issue during the year Number of shares
During the year ended 31 December 2006, options were granted over 13.6 million ordinary shares under the company’s executive and sharesave schemes. At 31 December 2006, options granted under the company’s various schemes, exercisable up to 2016 at prices ranging from 558p to 1852p per share, were outstanding in respect of 65 million ordinary shares.
Transaction costs of £5 million were incurred by the company in purchasing its ordinary shares. The employee share trusts incurred costs of £1.9 million in purchasing the company’s ordinary shares.
In May 2006, the company issued 27 million Series Q noncumulative preference shares of US$0.01 each at US$25 per share, the net proceeds being US$655 million.
In December 2006, the company issued 26 million Series R non-cumulative preference shares of US$0.01 at US$25 each, the net proceeds being US$631 million.
The costs of issue and discounts allowed on preference shares issued during the year were £20 million.
Number Redemption Redemption of shares Interest date on price Debt or
Non-cumulative preference shares of US$0.01 Series E (2) 8 million 8.1% 17 October 2006 US$25 Debt Series F 8 million 7.65% 31 March 2007 US$25 Debt Series G(2) 10 million 7.4% 31 March 2003 US$25 Debt Series H 12 million 7.25% 31 March 2004 US$25 Debt Series K (2) 16 million 7.875% 30 June 2006 US$25 Debt Series L 34 million 5.75% 30 September 2009 US$25 Debt Series M 37 million 6.4% 30 September 2009 US$25 Equity Series N 40 million 6.35% 30 June 2010 US$25 Equity Series P 22 million 6.25% 31 December 2010 US$25 Equity Series Q 27 million 6.75% 30 June 2011 US$25 Equity Series R 26 million 6.125% 30 December 2011 US$25 Equity
Notes: (1) Those preference shares where the Group has an obligation to pay dividends are classified as debt; those where distributions are discretionary are classified as equity. The conversion rights attaching to the convertible preference shares may result in the Group delivering a variable number of equity shares to preference shareholders; these convertible preference shares are treated as debt.
Holders of the non-cumulative preference shares are not entitled to receive notice of or attend general meetings of the company except if any resolution is proposed for adoption by the shareholders of the company to vary or abrogate any of the rights attaching to the non-cumulative preference shares or proposing the winding-up or liquidation of the company. In any such case, they are entitled to receive notice of and to attend the general meeting of shareholders at which such resolution is to be proposed and are entitled to speak and vote on such resolution (but not on any other resolution). In addition, in the event that, prior to any general meeting of shareholders, the company has failed to pay in full the three most recent quarterly dividend payments due on the non-cumulative dollar preference shares, the two most recent semi-annual dividend payments due on the non-cumulative convertible dollar preference shares and the most recent annual dividend payments due on the non-cumulative euro preference shares and on the non-cumulative convertible sterling preference shares, the holders shall be entitled to receive notice of, attend, speak and vote at such meeting on all matters together with the holders of the ordinary shares, and in these circumstances only, the rights of the holders of the non-cumulative preference shares so to vote shall continue until the company shall have resumed the payment in full of the dividends in arrears.
Notes on the accounts continued 31 Shareholders’ equity Group Company £m £m £m £m £m £m
Implementation of IAS 32 and IAS 39 on 1 January 2005 — 67 — (13) Amount recognised in equity during the year (109) 18 — — Amount transferred from equity to earnings in the year (140) (85) 3 6
Retranslation of net assets (2,159) 1,588 (830) — — — Foreign currency gains/(losses) on hedges of net assets 818 (799) 420 — — —
The Group optimises capital efficiency by maintaining reserves in subsidiaries, including regulated entities. Certain preference shares and subordinated debt are also included within regulatory capital. The remittance of reserves to the parent or the redemption of shares or subordinated capital by regulated entities may be subject to maintaining the capital resources required by the relevant regulator.
shares of 25p each of the company were held by Employee Share Trusts in respect of share awards and options granted to employees.
Finance lease assets: Present value amounts receivable 760 2,603 7,761 11,124
After 1 year Within 1 but within After 5 year 5 years years Total 2005 £m £m £m £m
Operating lease assets: Future minimum lease receivables 954 2,757 2,241 5,952
Finance lease receivables Unearned finance income 5,211 5,947 Accumulated allowance for uncollectable minimum lease receivables 67 72
Note: (1) In the year ended 31 December 2004 contingent rental income amounted to £51 million and minimum operating lease payments amounted to £319 million.
Deposits by banks 11,680 11,407 Customer accounts 7,095 6,761 Debt securities in issue 27,607 11,347 Other liabilities 45 20 33 Collateral Securities repurchase agreements and lending transactions The Group enters into securities repurchase agreements and securities lending transactions under which it receives or transfers collateral in accordance with normal market practice. Generally, the agreements require additional collateral to be provided if the value of the securities fall below a predetermined level.
Securities transferred under repurchase transactions included within securities on the balance sheet were as follows: All of the above securities could be sold or repledged by the holder. Securities received as collateral under reverse repurchase agreements amounted to £124.7 billion (2005 –
Notes on the accounts continued 34 Risk management Financial risk management policies and objectives 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: is the risk arising from the possibility that the Group will incur losses from the failure of customers to meet their obligations.
Credit risk The objective of credit risk management is to enable the Group to achieve appropriate risk versus reward performance whilst maintaining credit risk exposure in line with approved risk appetite.
The key principles for credit risk management as defined in the Group’s Credit Risk Management Framework are set out below.
• The Board delegates authority to Advances Committee, Group Credit Committee and divisional credit committees.
• Credit risk authority must be specifically granted in writing to all individuals involved in the granting of credit approval, whether this is exercised personally or collectively as part of a credit committee. In exercising credit authority, the individuals act independently.
• Customers with emerging credit problems are identified early and classified accordingly. Remedial actions are implemented promptly to minimise the potential loss to the Group.
• Portfolio analysis and reporting is used to identify and manage credit risk concentrations and credit risk quality migration.
Credit approval process Different credit approval processes exist for each customer type in order to ensure appropriate skills and resources are employed in credit assessment and approval. Credit authority is not extended to relationship management.
F in an ci al s ta te m en ts
Credit risk assets Credit risk assets are an internal risk measure of the Group’s exposure to customers. These consist of loans and advances (including overdraft facilities), instalment credit, finance lease receivables, debt securities and other traded instruments.
Early and active management of problem exposures ensures that credit losses are minimised. Specialised units are used for different customer types to ensure that appropriate risk mitigation is taken in a timely manner.
Provisions methodology Provisions for impairment losses are assessed under three categories as described below: Individually assessed provisions are the provisions required for individually significant impaired assets which are assessed on a case-by-case basis, taking into account the financial condition of the counterparty and any guarantor. This incorporates an estimate of the discounted value of any recoveries and realisation of security or collateral. The asset continues to be assessed on an individual basis until it is repaid in full, transferred to the performing portfolio or written-off.
The structure of the Group’s balance sheet is managed to maintain substantial diversification, to minimise concentration across its various deposit sources, and to contain the level of reliance on total short-term wholesale sources of funds within prudent levels.
The degree of maturity mismatch within the overall long-term structure of the Group’s assets and liabilities is managed within internal policy guidelines, to ensure that term asset commitments may be funded on an economic basis over their life. In managing its overall term structure, the Group analyses and takes into account the effect of retail and corporate customer behaviour on actual asset and liability maturities where they differ materially from the underlying contractual maturities. The short-term maturity structure of the Group’s liabilities and assets is managed on a daily basis to ensure that all material 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 concentration 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 500 trading days market data.
• VaR using a 95% confidence level does not reflect the extent of potential losses beyond that percentile.
Non-trading The principal market risks arising from the Group’s non-trading activities are interest rate risk, currency risk and equity risk. Treasury activity and mismatches between the repricing of assets and liabilities in its retail and commercial banking operations account for most of the non-trading interest rate risk. Nontrading 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 non-trading financial instruments mainly comprise loans (including finance leases), debt securities, equity shares, deposits, certificates of deposit and other debt securities issued, loan capital and derivatives. To reflect their distinct nature, the Group’s long-term assurance assets and liabilities attributable to policyholders have been excluded from these market risk disclosures.
Retail and commercial banking Non-trading interest rate risk is calculated in each business on the basis of establishing the repricing behaviour of each asset, liability and off-balance sheet 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.
Net investments borrowings foreign in foreign hedging net currency operations investments exposures
VaR is not an appropriate risk measure for the Group’s venture capital investments, which comprise a mix of quoted and unquoted investments, or its portfolio of strategic investments. These investments are carried at fair value with changes in fair value recorded in profit or loss, or equity.
Estimate of ultimate claims costs: At end of accident year 2,011 2,584 3,215 3,514 4,168 4,215 19,707
Current estimate of cumulative claims 1,945 2,607 2,953 3,256 4,101 4,215 19,077
The following table indicates the diversity of risks underwritten and the corresponding loss ratios for each major class of business, gross and net of reinsurance.
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 (personal and commercial) Claims experience is quite variable, due to a wide range of factors, but the principal ones are age, sex and driving experience of the driver, type and nature of vehicle, use of vehicle and area.
There are many sources of uncertainty that will affect the Group’s experience under motor insurance, including operational risk, reserving risk, premium rates not matching claims inflation rates, the weather, the social, economic and legislative environment and reinsurance failure risk.
The major source of uncertainty in the Group’s property accounts is the volatility of weather. Weather in the UK can affect most of the above perils. Over a longer period, the strength of the economy is also a factor.
Limitations of sensitivity analysis: the above tables demonstrate the effect of a change in a key assumption whilst other assumptions remain unaffected. In reality, such an occurrence is unlikely, due to correlation between the assumptions and other factors. It should also be noted that these sensitivities are non-linear, and larger or smaller impacts should not be interpolated or extrapolated from these results. The sensitivity analyses do not take into consideration that assets and liabilities are actively managed and may vary at the time that any actual market movement occurs.
Expenses Increase in maintenance expenses of 10% Assurance mortality/morbidity Increase in mortality/morbidity rates for assurance contracts of 5% Annuitant mortality Reduction in mortality rates for annuity contracts of 5%
The above sensitivity factors are applied via actuarial and statistical models, with the following impact on the financial statements.
Assets Cash and balances at central banks 6,121 — — — — — 6,121 Treasury and other eligible bills 739 1,179 3,573 — — — 5,491 Loans and advances to banks 63,779 10,813 7,601 121 292 — 82,606 Loans and advances to customers 166,701 47,573 49,230 61,655 141,734 — 466,893
Interest rate sensitivity The following tables summarise the interest rate sensitivity gap for the Group and the company at 31 December 2006 and 31 December 2005. The tables show the contractual repricing for each category of asset, liability and off-balance sheet items in the banking book. A liability (or negative) gap position exists when liabilities reprice more quickly or in greater proportion than assets during a given period and tends to benefit net interest income in a declining interest rate environment. An asset (or positive) gap position exists when assets reprice more quickly or in greater proportion than liabilities during a given period and tends to benefit net interest income in a rising interest rate environment. The actual interest rate sensitivity of the Group’s earnings will be determined by the currency and contractual or behavioural profile of assets and liabilities, in addition to the size and timing of interest rate movements. Contractual repricing terms do not reflect the potential impact of early repayment or withdrawal. Positions may not be reflective of those in subsequent periods. Major changes in positions can be made promptly as market outlooks change. In addition, significant variations in interest rate sensitivity may exist within the re-pricing periods presented and among the currencies in which the Group has interest rate positions.
Debt securities in issue 2,139 — — — — 2,139 5.24 — 2,139 Other liabilities — — — — — — — 57 57
Debt securities in issue 2,942 — — — — 2,942 4.55 — 2,942 Other liabilities — — — — — — — 14 14
Gain/(loss) per basis point increase 187 102 110 (2,033) 763 (871)
Net gain in year recognised in other operating income 573 364
Financial assets Cash and balances at central banks 6,121 6,121 4,759 4,759 — — — —
Designated as at fair value through profit or loss 376 376 282 282 — — — —
Designated as at fair value through profit or loss 5,989 5,989 3,991 3,991 — — — —
Designated as at fair value through profit or loss 2,610 2,610 2,541 2,541 — — — —
Designated as at fair value through profit or loss 3,922 3,922 3,683 3,683 — — — —
Finance leases and instalment credit 14,218 5 — — 14,223 189
Finance leases and instalment credit 2,282 — — — 2,282 —
Finance leases and instalment credit 1,325 — — — 1,325 — Interest accruals 221 — — — 221 —
Service industries and business activities 2,664 2 27 2 2,695 2 Agriculture, forestry and fishing 13 — — — 13 —
Loans and Treasury bills, advances to banks debt securities Netting and and customers and equity shares Derivatives Other (1) Total offset (2) 2006 £m £m £m £m £m £m
Loans and Treasury bills, advances to banks debt securities Netting and and customers and equity shares Derivatives Other (1) Total offset (2) 2005 £m £m £m £m £m £m
Finance leases and instalment credit 13,909 4 — — 13,913 158
Service industries and business activities 9,908 10 11 — 9,929 — Agriculture, forestry and fishing 514 — — — 514 —
Contingent liabilities: Guarantees and assets pledged as collateral security 13,013 12,253 397 448 Other contingent liabilities 6,833 6,394 — —
– less than one year 133,673 121,911 — — – one year and over 101,913 81,110 — —
Members of the Group are engaged in other litigation in the United Kingdom and a number of overseas jurisdictions, including the United States, involving claims by and against them arising in the ordinary course of business. The Group has reviewed these other actual, threatened and known potential claims and proceedings and, after consulting with its legal advisers, is satisfied that the outcome of these other claims and proceedings will not have a material adverse effect on its consolidated net assets, operating results or cash flows in any particular period.
Decrease/(increase) in prepayments and accrued income 322 1,064 (333) — 4 (17)
Increase/(decrease) in accruals and deferred income 515 (1,200) 1,750 (27) 8 (7) Provisions for impairment losses 1,877 1,707 1,402 — — — Loans and advances written-off net of recoveries (1,626) (1,870) (1,305) — — — Unwind of discount on impairment losses (142) (144) — — — — Profit on sale of property, plant and equipment (216) (91) (69) — — — (Profit)/loss on sale of subsidiaries and associates (44) 80 (4) — — — Profit on sale of securities (369) (667) (167) — — — Charge for defined benefit pension schemes 580 462 397 — — — Cash contribution to defined benefit pension schemes (536) (452) (1,146) — — — Other provisions utilised (42) (34) (47) — — — Depreciation and amortisation 1,678 1,825 1,674 — — — Elimination of foreign exchange differences 4,516 (3,060) 1,864 (22) (30) —
Net cash inflow from operating activities 17,441 4,140 5,099 3,648 4,413 3,097 *restated (see Note 48).
38 Analysis of the net investment in business interests and intangible assets Group £m £m £m
Fair value given for businesses acquired (21) (85) (8,157) Cash and cash equivalents acquired — — 457 Non-cash consideration — 10 4 Net outflow of cash in respect of purchases (21) (75) (7,696)
Cash and cash equivalents in businesses sold 229 10 — Other assets sold 36 208 18 Non-cash consideration (1) (30) — Profit/(loss) on disposal 44 (80) 4 Net inflow of cash in respect of disposals 308 108 22 Dividends received from joint ventures 29 16 9 Cash expenditure on intangible assets (379) (345) (303)
Notes on the accounts continued 39 Interest received and paid Group Company £m £m £m £m £m £m 40 Analysis of changes in financing during the year
Repayment of subordinated liabilities (1,318) (1,553) (547) (1,183) Net cash inflow/(outflow) from financing 381 1,812 1,709 (319) 381 1,812 (148) (846) Currency translation and other adjustments 313 166 (2,329) 1,067 313 166 (900) 845 41 Analysis of cash and cash equivalents Group Company £m £m £m £m £m £m
• Wealth Management provides private banking and investment services to its global clients through Coutts Group, Adam & Company, The Royal Bank of Scotland International and NatWest Offshore.
• Citizens is engaged in retail and corporate banking activities through its branch network in 13 states in the United States and through non-branch offices in other states. Citizens includes the seven Citizens Banks, Charter One, RBS National Bank, US credit card business, RBS Lynk, merchant acquiring business, and Kroger Personal Finance, the credit card joint venture with the second largest US supermarket group.
• RBS Insurance sells and underwrites retail, SME and wholesale insurance over the telephone and internet, as well as through brokers and partnerships. The Retail Divisions of Direct Line, Churchill and Privilege sell general insurance products direct to the customer. Through its International Division, RBS Insurance sells general insurance, mainly motor, in Spain, Germany and Italy. The Intermediary and Broker Division sells general insurance products through its network of 2,500 independent brokers.
Net and Depreciation Allocation of Operating interest Non-interest insurance and Impairment Manufacturing profit income income Total claims amortisation losses Contribution costs before tax 2006 £m £m £m £m £m £m £m £m £m
Amortisation of intangibles — — — — (94) — (94) — (94)
Amortisation of intangibles — — — — (97) — (97) — (97)
Amortisation of intangibles — — — — (45) — (45) — (45)
Note: (1) Segmental results for 2005 and 2004 have been restated to reflect transfers of businesses between segments in 2006.
Global Banking & Markets 10,745 9,449 UK Corporate Banking 6,987 6,281
Markets Banking Retail Management Bank Citizens Insurance items Total £m £m £m £m £m £m £m £m £m
Currency translation and other adjustments (5) — (3) (4) (11) 809 — — 786 Arising on acquisitions during the year — 1 9 — — — 103 — 113
Insurance premium income (net of reinsurers’ share) 5,604 — 369 — 5,973
Insurance premium income (net of reinsurers’ share) 5,462 — 317 — 5,779
Cost to acquire property, plant and equipment and intangible assets 3,353 337 1,581 17 5,288 42 Segmental analysis (continued)
Non-executive directors – emoluments 998 924 Chairman and executive directors – emoluments 19,448 8,994 Chairman and executive directors – contributions and allowances in respect of defined contribution pension schemes 101 220
Chairman and executive directors – amounts receivable under long-term incentive plans 3,997 4,778 Chairman and executive directors – gains on exercise of share options 2 11
The figures for 2006 include remuneration paid to Mr Cameron and Mr Fisher prior to their appointment as directors on 1 March 2006. For this period, Mr Cameron and Mr Fisher received salary and benefits of £141,000 and £105,000 respectively. The figures above also include the full year performance bonus for Mr Cameron and Mr Fisher.
Retirement benefits are accruing to five directors (2005 – four) under defined benefit schemes, two (2005 – two) of whom also accrued benefits under defined contribution schemes.
Short-term benefits 41,003 26,180 Post-employment benefits 11,264 9,383 Other long-term 3,309 4,215 Share-based payments 2,787 1,568
(b) For the purposes of IAS 24 ‘Related Party Disclosures’, key management comprise directors of the company and members of the Group Executive Management Committee. The captions in the Group’s primary financial statements include the following amounts attributable, in aggregate, to key management: 44 Transactions with directors, officers and others
Loans and advances to customers 2,188 3,090 Customer accounts 18,575 12,604
Key management have banking relationships with Group entities which are entered into in the normal course of business.
(b) Financial instruments: financial liabilities Under UK GAAP, short positions in securities and trading derivatives are carried at fair value; all other financial liabilities are recorded at amortised cost.
Implementation of IAS 32, IAS 39 and IFRS 4 on 1 January 2005 (continued)
(d) Effective interest rate and lending fees Under UK GAAP, loan origination fees are recognised when received unless they are charged in lieu of interest.
(f) Loan impairment Under UK GAAP provisions for bad and doubtful debts are made so as to record impaired loans at their ultimate net realisable value. Specific provisions are established against individual advances or portfolios of smaller balance homogeneous advances and the general provision covers advances impaired at the balance sheet date but which have not been identified as such. Interest receivable from loans and advances is credited to the income statement as it accrues unless there is significant doubt that it can be collected.
(g) Offset Under UK GAAP an intention to settle net is not a requirement for set off; the entity must have the ability to insist on net settlement and that ability is assured beyond doubt.
For a financial asset and a financial liability to be offset, IFRS require that an entity must intend to settle on a net basis or to realise the asset and settle the liability simultaneously.
On implementation of IAS 32, the balance sheet value of financial assets and financial liabilities increased by £104 billion.
IFRS Provisioning Fair IFRS 31 December Other Debt/ Classification/ Embedded and Hedging/ Revenue Insurance value Total 1 January 2004 Offset IAS 39 equity measurement derivatives impairment measurement Derecognition recognition contracts option Other adjustments 2005 £m £m £m £m £m £m £m £m £m £m £m £m £m £m £m
Balance sheet at 1 January 2005 – Company IFRS Fair IFRS
Assets Loans and advances to banks 4,106 3,959 91 — — 4,050 8,156 Loans and advances to customers 305 153 95 — — 248 553 Investment in Group undertakings 21,900 (4,004) — — — (4,004) 17,896 Derivatives at fair value — — 101 4 — 105 105 Prepayments, accrued income and other assets 318 — (287) (17) — (304) 14
Liabilities Deposits by banks 174 — — — — — 174 Debt securities in issue 1,608 — 6 — — 6 1,614 Derivatives at fair value — — 96 — — 96 96 Accruals, deferred income and other liabilities 301 (31) (146) — (45) (222) 79
Tax effect on adjustments 235 5 Shareholders’ funds under IFRS at 1 January 2005 30,022 15,518 Equity – minority interests 951 — Equity under IFRS at 1 January 2005 30,973 15,518
Notes on the accounts continued 47 Significant differences between IFRS and US GAAP The consolidated accounts of the Group have been prepared in accordance with IFRS issued and extant at 31 December 2006 which differ in certain significant respects from US GAAP. The significant differences which affect the Group are summarised below in three separate sections: Section (1) covers ongoing significant differences between IFRS and US GAAP.
Section (3) sets out significant differences between US GAAP and IFRS for 2004.
Under US GAAP, revaluations of property are not permitted. Depreciation is charged, and gains or losses on disposal are based on the depreciated cost for own-use and investment properties.
Under US GAAP, the full surplus was recognised as a fair value adjustment in 2000. As a result goodwill recognised under US GAAP on the acquisition of NatWest was lower than under IFRS.
(b) the seller retains more than a minor part but less than substantially all of the use of the property through the leaseback in which case the profit on sale in excess of the present value of minimum lease payments is recognised at the date of sale.
US GAAP also requires contracts to be classified either as insurance or investment contracts; however US GAAP does not permit embedded value reporting.
(g) Sale and leaseback transactions If a sale and leaseback transaction results in an operating lease and it is clear that the transaction is established at fair value, the seller recognises any profit immediately.
(i) Financial instruments Financial assets at fair value through profit or loss Under IFRS, financial assets held for trading are measured at fair value. A financial asset may be designated as at fair value through profit or loss on initial recognition.
Available-for-sale financial assets Under IAS 39 financial assets classified as available-for-sale may take any legal form.
Equity shares, the sale of which is restricted by contractual requirements (restricted stock) are carried at fair value.
(l) Consolidation All entities controlled by the Group are consolidated including those special purpose entities (SPEs) where the substance of the relationship between the reporting entity and the SPE indicates that it is controlled by the Group.
Only financial liabilities that are derivatives and short positions are carried at fair value with changes in fair value recognised in net income.
Under US GAAP, preference shares issued by the company are classified as equity, as they are perpetual and redeemable only at the option of the company.
This GAAP difference has no effect on net income or shareholders’ equity.
(2) Implementation timing differences This section sets out those adjustments that, although the applicable IFRS and US GAAP standards are substantially the same, arise because their effective dates for the Group differ.
Intangible assets Purchased goodwill Purchased goodwill is recorded at cost less any accumulated impairment losses. Goodwill is tested annually (at 30 September) for impairment or more frequently if events or changes in circumstances indicate that it might be impaired.
Other adjustments in the reconciliation of net income from IFRS to US GAAP for the year ended 31 December 2005 include refinements to estimates arising from the implementation of IFRS.
(d) Loan origination Certain loan origination fees, together with related costs, are recognised in the income statement as received or incurred.
(f) Long-term assurance business The shareholders’ interest in the long-term assurance fund is valued as the discounted value of the cash flows expected to be generated from in-force policies together with net assets in excess of the statutory liabilities.
Provisions are recognised on leasehold properties at the time the property is vacated.
Loan origination fees and certain direct costs are deferred and recognised over the period of the related loan or facility.
(i) Derivatives and hedging Non-trading derivatives are entered into by the Group to hedge exposures arising from transactions entered into in the normal course of banking activities. They are recognised in the accounts in accordance with the accounting treatment of the underlying transaction or transactions being hedged. To be classified as non-trading, a derivative must match or eliminate the risk inherent in the hedged item from potential movements in interest rates, exchange rates and market values. In addition, there must be a demonstrable link to an underlying transaction, pool of transactions or specified future transaction or transactions. Specified future transactions must be reasonably certain to arise for the derivative to be accounted for as a hedge. In the event that a non-trading derivative transaction is terminated or ceases to be an effective hedge, the derivative is remeasured at fair value and any resulting profit or loss amortised over the remaining life of the underlying transaction or transactions being hedged. If a hedged item is derecognised, or a specified future transaction is no longer likely to occur, the related non-trading derivative is remeasured at fair value and the resulting profit or loss taken to the income statement.
Monetary assets denominated in a foreign currency are retranslated at closing rates with exchange differences taken to profit or loss. Equity shares financed by foreign currency borrowings are retranslated at closing rates with exchange differences taken to reserves along with differences on the related borrowings.
The Group has not made changes in its use of non-trading derivatives to meet the hedge criteria in SFAS 133 ‘Accounting for Derivative Instruments and Hedging Activities’. For US GAAP purposes, its portfolio of non-trading derivatives is remeasured to fair value and changes in fair value reflected in net income.
In September 2006, the FASB issued SFAS 157 ‘Fair Value Measurements’. This statement establishes a framework for fair value measurement and prescribes extended disclosures. SFAS 157 does not extend the scope of fair value measurement in financial statements. The statement will be effective from 1 January 2008 for the Group and will be applied prospectively except for: trades in an active market held by a broker-dealer or investment company where blockage factors were used in determining fair value, instruments recognised at fair value using transaction price in accordance with EITF 02-03, and hybrid instruments measured at fair value at initial recognition.
In February 2007, the FASB issued SFAS 159 ‘Fair Value Option for Financial Assets and Financial Liabilities, Including an amendment of FASB Statement No. 115’ which allows companies to report certain financial assets and liabilities at fair value. The statement’s objective is to reduce complexity in accounting for financial instruments and volatility in earnings caused by measuring related assets and liabilities differently.
The FASB issued SFAS 156 ‘Accounting for Servicing of Financial assets – an amendment of FASB Statement No. 140’ in March 2006. This statement simplifies the accounting for servicing rights and related financial instruments used to economically hedge risks associated with those rights. The Group applied SFAS 156 to servicing rights recognised on or after 1 January 2006.
In September 2006, the FASB issued SFAS 158 ‘Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB Statements No. 87, 88, 106 and 132(R)’. SFAS 158 requires an employer to (i) recognise the overfunded or underfunded status of a defined benefit plan as an asset or liability with changes in that funded status recognised through comprehensive income; and (ii) measure the funded status of a plan as of the year-end date. It also specifies additional disclosures. It is effective for the Group’s 2006 US GAAP reporting.
Sale and leaseback transactions (84) — — Long-term assurance business (12) 10 (17) Extinguishment of liabilities — — (94)