Default rates on both cards and loans in the UK increased in 2009, driven by the deterioration in the economic environment and, to a lesser extent, the reduction in total balances. Default rates are still sensitive to economic developments, notably unemployment rates.
Corporate sectors This section discusses the components of property, transport and storage (automotive, shipping, aviation) and retail sectors, given their significance in the current market environment.
Wholesale property The Group's exposure to the wholesale property sector totals £104 billion, of which £85 billion is commercial property financing and analysed in detail below. The remainder comprises lending to property related sectors, including housing associations, estate agents and management companies, and non-lending exposures on off balance sheet instruments and FX/derivatives.
Commercial property The commercial property finance portfolio totalled £85 billion at 31 December 2009, an £11 billion or 12% decrease during the year. The Non-Core portion of the portfolio totalled £38 billion, or 44% of the portfolio.
Speculative lending represents less than 1% of the portfolio. The Group’s appetite for originating speculative commercial property lending is limited and any such business requires exceptional approval under the credit approval framework.
Whilst asset valuations stabilised during the latter part of 2009, the outlook remains challenging, with liquidity to support refinancing still reduced and high levels of concern regarding tenant failures. Wherever feasible, the Group works closely with clients to restructure loans while achieving mutual benefits.
The global automotive industry continues to face long-term structural challenges of overcapacity, weakened consumer demand owing to economic conditions, reduced credit availability and high input costs. The global OEMs are experiencing changing demand patterns with a greater focus on developing markets versus their established markets. Shifting production capacity to lower cost overseas locations remains a priority but one that risks labour force issues. The industry is also challenged by increasingly stringent environmental legislation that is forcing a shift to smaller, lower emission vehicles. In 2009 the automotive industry benefited from considerable government support in the form of direct intervention (US manufacturers) and other forms (for example, car scrappage schemes). Whilst there are some emerging signs of recovery and stability, albeit with volumes at historically low levels, the outlook remains fragile as government support is withdrawn and underlying demand is likely to remain subdued.
The portfolio has been reduced in size by a third since 31 December 2008 and whilst average credit quality was impacted by the restructuring of the large US manufacturers at the start of 2009, this restructuring provided a degree of stability to the portfolio that was largely maintained for the remainder of the year. Impairment provisions to date have not been material.
Automotive Exposure to the automotive sector decreased from £13.3 billion at 31 December 2008 to £8.9 billion at 31 December 2009.
Risk, capital and liquidity management 139RBS Group Annual Report and Accounts 2009
The performance of the sector over the past twelve months has been materially impacted by both the global downturn and the high volume of new capacity that has been delivered and will continue to come on stream into 2011.
The Group’s strategy is to focus on cash flows relating to the ships financed and to work with long-term industry participants in Europe and North America where the Group has long-standing relationships and where the companies have demonstrated an ability to withstand cyclical down turns with a consistent track record through cyclical volatility. Asset selection has been to focus on modern tonnage (average vessel age is eight years).
The performance of the portfolio reflects a rising level of stress with a number of transactions restructured in response to asset price reductions and security covenant breaches. The value of the fleet is reviewed on a quarterly basis and a large majority of deals remain fully secured. There have been few instances of payment default and in the majority of cases owners have supported transactions via cash injections. Cases on the Group’s watch list that are more closely monitored and controlled have increased and now stand at £1 billion, or 7% of the total portfolio.
Note: (1) Figures shown relate to direct shipping financing exposure and do not include related operating lease and counterparty exposures of £1.1 billion in 2009 and £3.3 billion in 2008.
The Group’s exposure to the retail sector was £16.3 billion at 31 December 2009, down 11% on the prior year. The portfolio is well spread geographically and across sub-sectors.
Whilst there has been some flow of retail customers into the GRG, the total value of debt managed by that team remains low. Economic conditions are, however, increasingly bringing to light those in the sector with poor operating models and stretched balance sheets. The more successful operators continue to adapt their customer proposition, operating models and capital structure to the new environment whilst keeping tight control on working capital.
Retail The Group’s retail portfolio is a component of the wholesale and retail trade industry sector, for which credit risk assets totalled £32 billion at 31 December 2009. Retail comprises £16.3 billion or 51% of the total portfolio, with the remainder being exposure to wholesalers and serviceorientated customers.
Risk elements in lending and potential problem loans by division Total Total provision
REIL Total provision as as % of REIL PPL & PPL provision % of REIL REIL & PPL
Group before RFS Holdings minority interest 34,989 924 35,913 15,173 43 42
Group before RFS Holdings minority interest 18,791 226 19,017 9,451 50 50
Group before RFS Holdings minority interest 8,251 131 8,382 4,972 60 59
• Provision coverage fell during the year from 52% to 45% (REIL & PPL coverage fell from 51% to 44%) as a consequence of the growth in REIL being concentrated in secured, property-related loans. These loans require relatively lower provisions in view of their collateralised nature. With many of these being in Non-Core, the provision coverage ratio is lower in Non-Core than in Core.
• REIL in the Core businesses increased by £4.4 billion to £12.1 billion while REIL in Non-Core more than doubled to £22.9 billion.
Risk elements and impairments All the disclosures in this section (pages 142 to 148) are audited. 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 information about possible credit problems cause management to have serious doubts about the future ability of the borrower to comply with loan repayment terms.
Risk, capital and liquidity management 143RBS Group Annual Report and Accounts 2009
Risk elements in lending and potential problem loans 2009 2008 2007
Loans accounted for on a non-accrual basis(2): Accruing loans which are contractually overdue 90 days or more as to principal interest (3): Potential problem loans(4): REIL as a % of gross lending to customers excluding
• REIL growth slowed in the second half of the year (15%) compared with the first half (57%), reflecting the moderating asset quality trend observed as the year progressed. REIL levels in the fourth quarter were flat to the third quarter.
Impairment loss provision methodology Provisions for impairment losses are assessed under three categories: • Individually assessed provisions: 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 guarantee and other collateral held after being stressed for downside risk. 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; • Collectively assessed provisions: provisions on impaired credits below an agreed threshold which are assessed on a portfolio basis, to reflect the homogeneous nature of the assets, such as credit cards or personal loans. The provision is determined from a quantitative review of the relevant portfolio, taking account of the level of arrears, security and average loss experience over the recovery period; and
• Latent loss provisions: provisions held against impairments in the performing portfolio that have been incurred as a result of events occuring before the balance sheet date but which have not been identified at the balance sheet date. The Group has developed methodologies to estimate latent loss provisions that reflect: – Historical loss experience adjusted where appropriate, in the light of current economic and credit conditions; and
– The period (‘emergence period’) between an impairment event occurring and a loan being identified and reported as impaired.
Recoverable cash flows are estimated using two parameters: loss given default (LGD) – this is the estimated loss amount, expressed as a percentage, that will be incurred if the borrower defaults; and the probability that the borrower will default (PD).
Provision analysis The Group’s consumer portfolios, which consist of high volume, small value credits, have highly efficient largely automated processes for identifying problem credits and very short timescales, typically three months, before resolution or adoption of various recovery methods. Corporate portfolios consist of higher value, lower volume credits, which tend to be structured to meet individual customer requirements.
US Retail & Commercial 702 437 246 RBS Insurance 8 42 —
Group before RFS Holdings minority interest 13,899 7,432 1,930 RFS Holdings minority interest 1,051 640 38
(3) Gross of provisions and excluding reverse repurchase agreements. Includes gross loans relating to disposal groups.
Note: (1) Excludes provision of £157 million relating to loans and advances to banks (2008 – £127 million; 2007 – £3 million).
Risk, capital and liquidity management 147RBS Group Annual Report and Accounts 2009
Transfers to disposal groups — (152) (111) (58) (321) — — Currency translation and other adjustments (4) (263) (56) (105) (428) 1,007 72 Acquisition of subsidiaries — — — — — — 129
Currency translation and other adjustments (4) (326) (78) (122) (530) 1,441 183 Acquisition of subsidiaries — — — — — — 2,221
Recoveries of amounts previously written-off — 94 305 — 399 319 342
Notes: (1) Includes charge relating to loans and advances to banks of £34 million (2008 – £118 million; 2007 – nil).
UK Corporate Banking Transaction Ulster Retail & minority Retail Banking Wealth & Markets Services Bank Commercial Non-Core interest 2009 2008 2007 £m £m £m £m £m £m £m £m £m £m £m £m
Acquisition of subsidiaries — — — — — — — — — — — 2,221
• The provision charge for 2009 was approximately double the previous year.
• Wholesale portfolios continue to drive the trend in provisions, with a notable concentration in the property sector.
Balance sheet analysis All the disclosures in this section (pages 149 to 153) are audited. The following tables provide an analysis of the credit quality and distribution of financial assets by the Group’s internal credit quality gradings, geography and industry sector. Credit risk assets analysed on the preceding pages are reported internally to senior management, however they exclude certain exposures and take account of netting agreements including master netting arrangements that provide a right of legal set-off but do not meet the criteria for off-set in IFRS. The analysis below is therefore provided to supplement the credit risk assets analysis and to reconcile to the consolidated balance sheet.
Cash and balances Loans and Loans and Other at central advances advances to Settlement financial Contingent banks to banks (1) customers balances Derivatives instruments Commitments liabilities Total 2009 £m £m £m £m £m £m £m £m £m
The following tables show 2007 and 2008 based on the old AQ1-5 bands.
Debt securities The table below analyses debt securities by external ratings, mapped on to the Standard & Poor’s ratings scale.
Bank and UK and US Other Building Asset-backed government government Society securities Corporate Other Total 2009 £m £m £m £m £m £m £m
Group before RFS Holdings minority interest 35,301 59,710 22,711 111,143 20,901 3,393 253,159
• 66% of the portfolio is AAA rated; 95% is investment grade.
• See Market turmoil section on page 184 for further analysis of assetbacked securities.
Core Non-Core interest interest Group Group Group £m £m £m £m £m £m £m
Note: (1) These balances include loans and advances to customers that are past due through administrative and other delays in recording payments or in finalising documentation and other events unrelated to credit quality.
Industry risk – geographical analysis The table below analyses financial assets by location of office and by industry type.
Individuals: Finance lease and instalment credit 20,103 306 16 — 20,425 39
Risk, capital and liquidity management 153RBS Group Annual Report and Accounts 2009
Individuals: Finance lease and instalment credit 19,498 131 281 45 19,955 5
Notes: (1) Includes settlement balances of £12,033 million at 31 December 2009 (2008 – £17,832 million; 2007 – £16,589 million).
Funding and liquidity risk All the disclosures in this section (pages 154 to 160) are audited unless indicated otherwise with an asterisk (*).
The Group’s liquidity policy is designed to ensure that the Group can at all times meet its obligations as they fall due.
Following a difficult first quarter of 2009, most indicators of stress in financial markets are close to or better than in late 2008. Liquidity conditions in money and debt markets have improved significantly since the beginning of the second quarter of 2009. Contributing to the improvement has been a combination of ongoing central bank and other official liquidity support schemes, guarantee schemes and rate cuts. Signs of underlying macroeconomic trends such as stabilisation of the UK economy, also helped to sustain a recovery in debt markets.
The GALCO, chaired by the Group Finance Director, has the responsibility to set Group policy and ensure that it is cascaded and communicated to the business divisions. Group Treasury is the functional area with responsibility for monitoring and control of the Group's funding and liquidity positions.
Group Treasury is supported by a governance process that includes a Liquidity Risk Forum comprising functional areas across the organisation that are responsible for liquidity management, including monitoring through divisional and regional asset and liability committees.
The Group continues to improve and augment funding and liquidity risk management practices in light of experience of the market over the last two years and of emerging regulatory and industry standards such as the FSA policy statement on strengthening liquidity standards.
The Group targets diversification in its funding sources to reduce funding risk. A key source of funds for the Group is its core customer deposits gathered by its retail banking, private client, corporate and small and medium enterprises franchises. The Group’s multi-brand offering and strong client focus is a key part of the funding strategy and continues to benefit the Group’s funding position.
The Group also accesses the wholesale funding market to provide additional flexibility in funding sources. The Group has actively sought to manage its liquidity position through increasing the duration of shortterm wholesale funding, continued diversification of wholesale debt investors and depositors, supplemented by long-term issuance, government guaranteed debt, and a programme of ensuring that assets held are eligible as collateral to access central bank liquidity schemes.
Potential sources of liquidity include cash inflows from maturing assets, new borrowings or the sale of various debt securities held. Short-term liquidity risk is generally managed on a consolidated basis with liquidity mismatch limits in place for subsidiaries and non-UK branches which have material local treasury activities, thereby assuring that the daily maintenance of the Group’s overall liquidity risk position is not compromised.
Volume management The Group also actively monitors and manages future business volumes to assess funding and liquidity requirements and ensure that the Group operates within the risk appetite and metrics set by the Board. This includes management of undrawn commitments, conduits and liquidity facilities within acceptable levels.
Liquidity reserves The Group has built up a diversified stock of highly marketable liquid assets including highly rated central government debt that can be used as a buffer against unforeseen impacts on cash flow or in stressed environments. The make up of this portfolio of assets is sub-divided into tiers on the basis of asset liquidity, with haircuts applied to ensure that realistic liquidation values are used in key metrics. This portfolio includes a centrally held buffer against severe liquidity stresses and locally held buffers to meet self sufficiency needs.
Risk, capital and liquidity management 155RBS Group Annual Report and Accounts 2009
Contingency planning Contingency funding plans have been developed which incorporate early warning indicators to monitor market conditions. The Group reviews its contingency funding plans in the light of evolving market conditions and stress test results. The contingency funding plans cover: the available sources of contingent funding to supplement cash flow shortages; the lead times to obtain such funding; the roles and responsibilities of those involved in the contingency plans; the communication and escalation requirements when early warning indicators signal deteriorating market conditions; and the ability and circumstances within which the Group accesses central bank liquidity.
In common with other UK banks, the Group has benefited from the UK Government’s scheme to guarantee debt issuance. At 31 December 2009 the Group had debt securities in issue amounting to £52 billion (2008 – £32 billion), which is approximately 38% of the total UK Government guaranteed debt.
Loan to deposit ratio: The Group monitors the loan to deposit ratio as a key metric. This ratio has decreased from 118% at 31 December 2008 to 104% at 31 December 2009 for Core and from 151% at 31 December 2008 to 134% at 31 December 2009 for the Group. The Group has a target of 100% for 2013. The gap between customer loans and customer deposits (excluding repos) narrowed by £91 billion from £233 billion at 31 December 2008 to £142 billion at 31 December 2009.
Undrawn commitments: The Group has been actively managing down the amount of undrawn commitments that it is exposed to. Undrawn commitments decreased from £349 billion at 31 December 2008 to £289 billion at 31 December 2009.
Repo Agreements: At 31 December 2009 the Group had £68 billion of customer secured funding and £38 billion of bank secured funding, which includes borrowing using central bank funding schemes. With markets continuing to stabilise through the course of 2009, the Group has significantly reduced its reliance on secured funding from central bank liquidity schemes.
Liquidity reserves: The total stock of liquid assets has increased by £81 billion during 2009 from £90 billion at 31 December 2008 to £171 billion at 31 December 2009; this reflects the injection of £25.5 billion of B shares at the end of December 2009 provided as treasury bills and cash. The Group is targeting a liquidity pool of £150 billion by 2013. The table below shows the breakdown of these assets.
The types of assets which can be used in securitisation include lending assets, and the Group benefits from not having encumbered significant amounts of lending assets historically.
Conduit commitments: The Group has taken additional measures to improve the balance sheet structure. One area of focus has been reducing the size of the multi-seller conduits business, which relies upon funding assets through the issuance of short term asset-backed commercial paper. Total facilities have declined by £17.9 billion to £25.0 billion at 31 December 2009. This has reduced the liquidity risk to the Group through the commitments provided for this type of business.
Note: (1) Includes secured assets which are eligible for discounting at central banks.
The table below analyses the contractual undiscounted cash flows receivable and payable up to a period of twenty years including future receipts and payments of interest of the on balance sheet assets by contractual maturity.
0-3 months 3-12 months 1-3 years 3-5 years 5-10 years 10-20 years 2009 £m £m £m £m £m £m
Assets by contractual maturity Cash and balances at central banks 52,239 — — 1 25 — Loans and advances to banks 42,615 1,757 966 282 868 71 Debt securities 17,581 14,484 29,675 26,788 52,104 30,335 Settlement balances 12,020 6 1 — 8 1 Other financial assets 265 215 402 127 421 — Total maturing assets 124,720 16,462 31,044 27,198 53,426 30,407 Loans and advances to customers 126,238 65,946 130,323 101,984 180,595 202,809 Derivatives held for hedging 488 1,547 3,049 1,076 751 10 Total assets 251,446 83,955 164,416 130,258 234,772 233,226
Assets by contractual maturity Cash and balances at central banks 12,333 25 — — 2 29 Loans and advances to banks 61,630 19,369 2,673 921 111 70 Debt securities 26,006 12,895 24,629 23,927 57,846 24,535 Settlement balances 17,830 — — — 2 — Other financial assets 621 193 58 111 343 — Total maturing assets 118,420 32,482 27,360 24,959 58,304 24,634 Loans and advances to customers 195,553 81,054 138,378 125,621 160,271 152,084 Derivatives held for hedging 266 1,796 2,281 1,359 1,517 649 Total assets 314,239 115,332 168,019 151,939 220,092 177,367
Liabilities by contractual maturity Deposits by banks 154,614 14,347 3,345 2,754 2,048 34 Debt securities in issue 131,714 48,652 40,067 38,223 38,667 5,626 Subordinated liabilities 1,753 4,271 6,824 5,793 24,503 13,030 Settlement balances and other liabilities 13,351 5 12 6 10 6 Total maturing liabilities 301,432 67,275 50,248 46,776 65,228 18,696 Customer accounts 523,268 33,450 6,577 6,337 7,298 5,319 Derivatives held for hedging 394 2,216 2,543 1,334 2,682 1,373 Total liabilities 825,094 102,941 59,368 54,447 75,208 25,388
For example, if a structured note is automatically prepaid when an equity index exceeds a certain level, the cash outflow will be included in the less than three months period whatever the level of the index at the year end. The settlement date of debt securities in issue, issued by certain securitisation vehicles consolidated by the Group, depends on when cash-flows are received from the securitised assets. Where these assets are prepayable, the timing of the cash-outflow relating to securities assumes that each asset will be prepaid at the earliest possible date. As the repayment of assets and liabilities are linked, the repayment of assets in securitisations are shown on the earliest date that the asset can be prepaid as this is the basis used for liabilities.
Held-for-trading assets and liabilities – held-for-trading assets and liabilities amounting to £651 billion (assets) and £568 billion (liabilities) (2008 – £1,227 billion assets, £1,147 billion liabilities) have been excluded from the table in view of their short term nature.
Wholesale funding breakdown The table below shows the composition of the sources of wholesale funding of the Group before RFS minority interest. The Group has implemented its funding strategy of reducing its reliance on short-term wholesale funding. Deposits by banks have decreased by £63 billion to £116 billion; comprising 14.3% of total funding sources at 31 December 2009, down from 18.8% at 31 December 2008. Short-term debt securities such as commercial paper and certificates of deposits in issue have also reduced by £41 billion to £103 billion at 31 December
Debt securities in issue: – Medium term notes and other bonds 125,800 15.6 108,529 11.4
Outlook for 2010* Whilst there have been improvements in the state of the global economy over the course of 2009, the outlook for 2010 remains uncertain. In line with meeting the objectives of the strategic plan, the Group is actively focusing on closing the customer funding gap, continuing to exit NonCore businesses and focusing on reducing undrawn and contingent commitments. This will reduce the absolute need for wholesale funding with the Group targeting £150 billion by 2013. In addition, the Group will continue to make progress in terming out its remaining wholesale funding. The Group will continue to reduce reliance on government supported schemes and be governed by the state of the markets and economies in which it operates. These strategies will ensure that the Group will be more resilient to any further disruptions in the market and will be better placed to take advantage of favourable trading conditions as they return.
In the US the Group is required to meet the liquidity requirements set out by all relevant regulatory authorities, including the Federal Reserve Bank, Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation and Financial Industry Regulatory Authority. In the Netherlands, ABN AMRO is subject the De Nederlandsche Bank liquidity regulation regime.
The table below shows the maturity profile of the Group’s debt securities in issue and subordinated debt. The composition of the profile reflects the increased proportion of the Group’s debt securities in issue of greater than 1 year maturity. Debt securities with a remaining maturity of less than 1 year has reduced by £33 billion to £139 billion at 31 December 2009 (2008 – £172 billion). The proportion of debt securities in issue with remaining maturity greater than 1 year has increased from 45% at 31 December 2008 to 50% at 31 December 2009.
Others (prepayments, accrued income, deferred taxation) 103 103 103 103 100
Net stable funding ratio* The net stable funding ratio shown below is assessed using the proposed Basel measure. This measure seeks to show the proportion of structural term assets which are funded by stable funding including customer deposits, long-term wholesale funding, and equity. Through the course of 2009, the measure has improved from 79% at 31 December 2008 to 90% at 31 December 2009. Over time this will be reviewed as proposals are developed and industry standards implemented.
Measurement At the Group level, the risk appetite is expressed in the form of a combination of VaR, sensitivity and scenario limits. VaR is a technique that produces estimates of the potential change in the market value of a portfolio over a specified time horizon at given confidence levels. For internal risk management purposes, the Group’s VaR assumes a time horizon of one trading day and in June 2009 the Group changed its VaR confidence level from 95% to 99% as it considers this provides greater clarity in respect of more severe potential economic outcomes. The Group’s VAR model is based on a historical simulation model utilising data from the previous two years trading results.
The VaR disclosure is broken down into trading and non-trading, where trading VaR relates to the main trading activities of the Group and nontrading reflects the VaR associated with reclassified assets, money market business and the management of internal funds flow within the Group’s businesses.
The Group calculates VaR using historical simulation models but does not make any assumption about the nature or type of underlying loss distribution other than implied by history. The methodology uses the previous 500 trading days of market data and calculates both general market risk (the risk due to movement in general market benchmarks) and idiosyncratic market risk (the risk due to movements in the value of securities by reference to specific issuers). The Group VaR should be interpreted in light of the limitations of the methodology used as follows: • Historical simulation VaR may not provide the best estimate of future market movements. It can only provide a prediction of the future based on events that occurred in the time series horizon. Therefore, events that are more severe than those in the historical data series cannot be predicted; • VaR that uses a 99% confidence level does not reflect the extent of potential losses beyond that percentile; • VaR that uses a one-day time horizon will not fully capture the profit and loss implications of positions that cannot be liquidated or hedged within one day; and
• Arbitrage – entering into offsetting positions in different, but closely related markets in order to profit from market imperfections.
Financial instruments held in the Group’s trading portfolios include, but are not limited to: debt securities, loans, deposits, equities, securities sale and repurchase agreements and derivative financial instruments (futures, forwards, swaps and options).
The Group participates in exchange traded and over-the-counter (OTC) derivatives markets. The Group buys and sells financial instruments that are traded or cleared on an exchange, including interest rate swaps, futures and options. Holders of exchange traded instruments provide daily margins with cash or other security at the exchange, to which the holders look for ultimate settlement.
The Group also buys and sells financial instruments that are traded OTC, rather than on a recognised exchange. These instruments range from commoditised transactions in derivative markets, to trades where the specific terms are tailored to the requirements of the Group’s customers. In many cases, industry standard documentation is used, most commonly in the form of a master agreement, with individual transaction confirmations.
The VaR for the Group’s 2009 trading portfolios segregated by type of market risk exposure is shown below.
Note: (1) The traded market risk VaR excludes super senior tranches of asset backed CDOs and credit derivative product company exposures.
Average Period end Maximum Minimum Average Period end Maximum Minimum Trading VaR Summary (2008 and 2009) £m £m £m £m £m £m £m £m 2007 (scaled to 99%ile) 2007 (95%ile)
Average Period end Maximum Minimum Average Period end Maximum Minimum Trading VaR (2007) £m £m £m £m £m £m £m £m 2009 (99%ile) 2008 (99%ile)
• The average total non-trading VaR utilisation was higher in 2009 at £207 million, compared with £15 million in 2008. This is primarily due to assets from the Group's now dissolved securitisation arbitrage conduit, which transferred from ABN AMRO to RBS, being included in the Group’s VaR measure from January 2009 and the increased market volatility being incorporated into the two year time series as previously noted. If both of these factors are excluded, the nontrading VaR would decrease to reflect actions taken through the course of the year to dynamically reduce the underlying risk sensitivity.
The trading and non-trading VaR for 2007 is shown on the basis it was previously disclosed at a 95% confidence level and using a normalised scaling factor to convert to 99% confidence level.
Non trading VaR in the tables on the previous page does not include structural interest rate risk which is covered on page 165.
Model validation governance Pricing models are developed and owned by the front office. Where pricing models are used as the basis of books and records valuations, they are all subject to independent review and sign-off. Models are assessed by GMPRC as having either immaterial or material model risk (valuation uncertainty arising from choice of modelling assumptions), the assessment being made on the basis of expert judgement.
Those models assessed by the GMPRC as having material model risk are prioritised for independent quantitative review. Independent quantitative review aims to quantify model risk (i.e. the impact of missing risk factors in the front office model or the possibility that we may be mismarking these products relative to other market participants who may be using an alternative model) by comparing model outputs against alternative independently developed models. The results of independent quantitative reviews are used by market risk to inform risk limits and by finance to inform reserves. Governance over this process is provided by GMPRC, a forum which brings together front office quantative analysts, market risk, finance and QuaRC (Quantitative Research Centre, Group Risk’s independent quantitative model review function). Risk (market risk, incremental default risk, counterparty credit risk) models are developed both within business units and by Group functions. Risk models are also subject to independent review and sign-off. Meetings are held with the FSA every quarter to discuss the traded market risk, including changes in models, management, back testing results, other risks not included in the VaR framework and other model performance statistics.
Risk control All divisions that are exposed to market risk in the course of their business are required to comply with the Group’s Market Risk Policy Standards (MRPS). The main risk management tools are delegated authorities, hard limits and discussion triggers, independent model valuation, a robust and efficient risk system and timely and accurate management information.
Limits form part of the dealing authorities and constitute one of the cornerstones of the market risk management framework. Upon notification of a limit breach, the appropriate body must take one of the following actions: • Instructions can be given to reduce positions so as to bring the Group within the agreed limits; • A temporary increase in the limit can be granted to pursue an agreed short-term strategy; and
Risk, capital and liquidity management 165RBS Group Annual Report and Accounts 2009
Various banking regulators review non-trading market risks as part of their regulatory oversight. As home country regulator, the FSA has responsibility for reviewing non-trading market risk at a Group consolidated level.
The Group is exposed to the following non-traded risks: Interest Rate Risk in the Banking Book (IRRBB) represents exposures to instruments whose values vary with the level or volatility of interest rates. These instruments include, but are not limited to, loans, debt securities, equity shares, deposits, certificates of deposits, loan capital and derivatives. Hedging instruments used to mitigate these risks include related derivatives such as options, futures, forwards and swaps. Interest rate risk arises from the Group’s non-trading activities in four principal forms: • Re-pricing risk – arises from differences in the re-pricing terms of the Group’s assets and liabilities; • Optionality – arises where a customer has an option to exit a deal early; • Basis risk – arises, for example where liabilities, the interest on which is linked to LIBOR, is used to fund assets bearing interest linked to the base rate; and
Non-trading interest rate risk is calculated in each business on the basis of establishing the re-pricing behaviour of each asset, liability and offbalance sheet product. For many retail and commercial products, the actual interest rate re-pricing characteristics differ from the contractual re-pricing. In most cases, the re-pricing 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.
Non-trading interest rate exposures are controlled by limiting repricing mismatches in the individual business balance sheets. Potential exposures to interest rate movements in the medium to long- term are measured and controlled using a version of the same VaR methodology that is used for the Group’s trading portfolios. Net accrual income exposures are measured and controlled in terms of sensitivity over time to movements in interest rates.
Equity Risk in the Banking Book (ERBB) is defined as the potential variation in the Group’s non-trading income and reserves arising from changes in equity prices/income. This risk may crystallise during the course of normal business activities or in stressed market conditions. Equity positions in the Group’s banking book are retained to achieve strategic objectives, support venture capital transactions or in respect of customer restructuring arrangements.
A breakdown of the Group’s non-trading VaR (including RFS Holdings minority interests) by currency is shown below.
At year end the GBP VaR was increased by the impact of the B share issuance.
Notes: (1) Economic value of equity is the net present value (NPV) of assets and liabilities calculated by discounting expected cash flows of each instrument over its expected life. Risk to EVE is quantified by calculating the impact of interest rate changes on the net present value of equity and is expressed as a percentage of CFG regulatory capital.
Sensitivity of net interest income* There have been no material changes to the Group’s measurement of, and management philosophy towards, sensitivity of net interest income to movement in interest rates. The Group aims to be relatively neutral to directional shifts in interest rates. It seeks to mitigate the effect of prospective interest movements which could reduce future net interest income, whilst balancing the cost of such hedging activities on the current net revenue stream.
The following table shows the sensitivity of net interest income over the next twelve months to an immediate up and down 1% change to all interest rates.
In addition to net interest income sensitivity Citizens also measures the sensitivity of the value of the net interest margin to changes in interest rates on a monthly basis. This measure is called EVE sensitivity. The table below details this sensitivity at the end of 2009 and the maximum and minimum month-end figures.
The above sensitivities show how this projected net interest income would change in response to an immediate parallel shift to all market rates.
Currency risk The Group does not maintain material non-trading open currency positions other than the structural foreign currency translation exposures arising from its investments in foreign subsidiaries and associated undertakings and their related currency funding. The Group’s policy in relation to structural positions is to match fund the structural foreign currency exposure arising from net asset value, including goodwill in foreign subsidiaries, equity accounted investments and branches, except where doing so would materially increase the sensitivity of either the Group’s or the subsidiary’s regulatory capital ratios to currency movements. The policy requires structural foreign exchange positions to be reviewed regularly by the Group Asset and Liability Committee.
The tables below set out the Group’s structural foreign currency exposures: Key points
• Retranslation gains and losses on the Group’s net investment in operations together with those on instruments hedging these investments are recognised directly in equity.
• Changes in foreign currency exchange rates will affect equity in proportion to the structural foreign currency exposure. A 5% strengthening in foreign currencies against sterling would result in a gain of £980 million (2008 – £1,010 million) recognised in equity, while a 5% weakening in foreign currencies would result in a loss of £880 million (2008 – £960 million) recognised in equity.
Net Net Structural assets of investments Net foreign overseas Minority in foreign investment currency operations interests operations hedges exposures 2009 £m £m £m £m £m
The types, nature and amounts of exchange-traded exposures, private equity exposures, and other exposures vary significantly. Such exposures may take the form of listed and unlisted equity shares, linked equity fund investments, private equity and venture capital investments, preference shares classified as equity and Federal Home Loan Stock.
Monthly or quarterly returns by the Group’s business units, collated as part of regular reporting by Group Treasury to GALCO, are used to build a Group IRRBB VaR position and to ensure businesses comply with materiality limits on a pre and post hedge basis for interest rates, as stipulated by Group Treasury. For FXRBB, the Group policy states that any foreign currency exposure is managed to de-minimus limits. Group Treasury monitors adherence to this policy by way of a quarterly return.
For both IRRBB and FXRBB, information is included in regulatory and statutory returns.
Insurance risk* All the disclosures in this section are unaudited and indicated with an asterisk (*). The Group is exposed to insurance risk directly through its general insurance and life insurance businesses.
• Other commercial insurance contracts: risk arises from business interruption and loss arising from the negligence of the insured (liability insurance).
• Critical illness insurance contracts: morbidity claims experience varies due to a range of factors, including age, gender and past medical history. The key factors that can increase the level of claims are adverse lifestyle changes and improvements in medical diagnosis methods.
These are long-term contracts with long-term business provisions that are calculated in accordance with the UK accounting standard FRS 27 ‘Life Assurance’.
Operational risk* All the disclosures in this section (pages 170 to 172) are unaudited and indicated with an asterisk (*). Operational risk is the potential for financial loss, damage to reputation, or impact upon customers resulting from fraud; human error; ineffective or inadequately designed processes or systems; improper behaviour; or external events. Operational risk is an integral and unavoidable part of the Group’s business as it is inherent in the processes it operates to provide services to customers and generate profit for shareholders.
An objective of operational risk management is not to remove operational risk altogether, but to manage the risk to an acceptable level, taking into account the cost of minimising the risk as against the resultant reduction in exposure. Strategies to manage operational risk include avoidance, transfer, acceptance and mitigation by controls.
The three lines of defence model and the Operational Risk Policy Standards apply throughout the Group and are implemented taking into account the nature and scale of the underlying business. The standards provide the direction for delivering effective operational risk management. They comprise principles and processes that enable the consistent identification, assessment, management, monitoring and reporting of operational risk across the Group. The objectives of the standards are to protect the Group from financial loss or damage to its reputation, its customers or staff and to ensure that it meets all necessary regulatory and legal requirements.
• Key risk indicators: business units monitor key risk indicators against their material risks. These indicators are used to monitor the operational risk profile and exposure to losses against thresholds which trigger risk management actions; 1st line of defence
Group Internal Audit Responsible for providing independent assurance on the design, adequacy and effectiveness of the Group’s system of internal controls.
• New product approval process: this process ensures that all new products or significant variations to existing products are subject to a comprehensive risk assessment. Products are evaluated and approved by specialist areas and are subject to executive approval prior to launch; and
Additionally, the Group’s Information Security Policy is reviewed regularly and includes processes for managing and monitoring compliance with the policy. The same standards apply to information controlled by the Group or managed by authorised third parties. The Group continues to invest in programmes to enhance and maintain information security controls and systems. For example, during 2009, we completed security reviews on all of our high risk third parties as well as externally facing and hosted websites.
Key risks and threats that the Group is consistently monitoring from a business continuity perspective include pandemics, terrorism, environmental impacts and technology disruptions. Business continuity plans are in place to ensure that the Group can continue key products, services, and operations.
A consistent crisis management framework has been developed that includes a six step methodology and allows incidents to be managed and resolved through skilled divisional, country, regional and global teams.
Other risks* All the disclosures in this section (pages 172 to 173) are unaudited and indicated with an asterisk (*).
Regulatory risk Regulatory risk is managed by designing, maintaining and implementing policies and systems in order to ensure effective compliance with all regulatory and legal requirements in all the jurisdictions in which the Group operates.
The Group’s approach to regulatory risk has three distinct elements: • The review of potential changes in regulation to ensure that the Group addresses the risks arising from such changes and responds appropriately; • The monitoring of compliance with existing rules and regulations and the mitigation of the consequences of any inadvertent noncompliance; and
The scale and pace of regulatory change continues, focused across a range of topics, including Systemically Important Firms, Prudential (Basel Capital & Liquidity requirements) and Conduct issues. Of particular interest is the cumulative impact of proposals across the financial services industry. Globally, regulators have expanded their focus across a range of issues, notably strategic, governance, capital, liquidity, systems, people issues, remuneration, Anti Money Laundering/sanctions and terrorist financing and Treating Customers Fairly. This is particularly the case in the UK, where the FSA (as the Group’s lead regulator) has implemented an enhanced supervisory framework.
The Group has a well developed regulatory developments framework, which assigns Senior Executive responsibility for all material risks facing the Group on a global basis. The Group engages with standard setters, rule makers, regulators and trade bodies to deliver effective and proportionate rule making.
Reputation risk Reputation is the body of perceptions and opinions held by the stakeholders of an organisation; customers, suppliers, employees, investors, interest groups, regulators and government. Reputation determines how stakeholders are likely to behave towards an organisation. Reputation risk arises from any activity that could have an adverse impact on the reputation of the Group.
There are several important drivers of the reputation of a company (and reputation risk) including: financial performance; corporate governance and quality of management; ethical, social and environmental performance; marketing, innovation and customer relationships; and regulatory compliance and litigation.
The Group protects its reputation by understanding and managing reputation risks, including failure to meet the expectations of stakeholders. The Group will only enter into a commercial transaction or customer relationship which is legal and complies with regulatory requirements, has economic substance or business purpose and is not designed or used for inappropriate accounting or tax purposes. The Group takes care to understand the issues that matter most to stakeholders, balance the views of all stakeholders and address them coherently. Risks to the reputation of the Group are identified, assessed, managed, monitored and reported. The Group pays particular attention to the reputation risks associated with the introduction of new products or customer relationships.
The Board has ultimate responsibility for managing any impact on the reputation of the Group arising from its operations. The Group Corporate Sustainability Committee was established in January 2010, chaired by one of our Non-Executive Directors to enhance governance in this area. However, all parts of the Group take responsibility for reputation management.
The Group maintains an independent review of risk within the pension funds.
GALCO monitors pension obligation risk which is assessed by estimating the funding position of the scheme with a twelve month risk horizon, and with a number of different confidence levels. Monte Carlo simulations are used, based on assumptions of statistical distribution of future equity returns, future real and nominal interest rates, sensitivity of asset and liability values to changes in equity returns and real and nominal interest rates, the impact of an adverse change in longevity assumptions and mitigation available to the Group.
The next valuation is due as at 31 March 2010 and the Group expects this valuation to show that liabilities exceed the value of the assets. Following this valuation the Group and the Trustees will agree the level of contributions to be paid to the scheme. This could result in the amount of contributions payable in 2010 and subsequent years being materially different from the current estimate for 2010.
Asset Protection Scheme* All the disclosures in this section (pages 174 to 183) are unaudited and indicated with an asterisk (*). References to ‘Group’ in this section relate to ‘Group before RFS Holdings minority interest’.
• bankruptcy: the counterparty is subject to a specified insolvency or bankruptcy-related event.
Risk, capital and liquidity management 175RBS Group Annual Report and Accounts 2009
• The majority of the reduction (68%) in the covered assets reflects repayments by customers.
• Additionally the Group took advantage of market conditions and executed a number of loan sales.
Business Banking: portfolios in the work out/restructuring unit or in high risk bands.
Retail: portfolios of accounts in default, >1 month arrears, <2 years old and a higher probability of default.
First loss utilisation The triggered amount is equivalent to the aggregate outstanding principal amount on the trigger date excluding interest, fees, premium or any other non-principal sum that is accrued or payable, except where it was capitalised on or before 31 December 2008. At the trigger date, in economic terms, there is an exchange of assets, with the Group receiving a two year interest bearing government receivable in exchange for the asset.
Credit impairments and write downs The table below analyses the cumulative credit impairment losses and adjustments to par value (including AFS reserves) relating to covered assets: £m £m
By division: UK Retail 2,431 1,492 UK Corporate 1,007 285 Global Banking & Markets 1,628 1,640 Ulster Bank 486 234 Non-Core 23,338 18,571
Note: (1) Total available-for-sale reserves on debt securities of £1,113 million at 31 December 2009 (£1,315 million as at 31 December 2008 was previously included in undrawn commitments and other adjustments).
• Of the increase in cumulative losses of £6,668 million, the largest was loan impairments in Non-Core.
Risk, capital and liquidity management 177RBS Group Annual Report and Accounts 2009
The table below summarises the total triggered amount and related cash recoveries by division at 31 December 2009.
Cash Net Triggered recoveries triggered amount to date amount £m £m £m
• The Group expects recoveries on triggered amounts to be approximately 45% over the life of the relevant assets.
Divisional analysis The following table analyses covered assets by the asset classes defined by the Scheme conditions and by division: Global UK UK Banking Covered
Retail Corporate & Markets Ulster Bank Non-Core amount £m £m £m £m £m £m
Residential mortgages 9,646 — 113 2,512 1,934 14,205 Consumer finance 11,596 24,818 — 5,538 11,309 53,261 Commercial real estate finance — 9,143 — 1,073 21,921 32,137 Leveraged finance — 4,899 621 291 17,465 23,276 Lease finance — 449 — — 1,080 1,529 Project finance — — 255 — 1,562 1,817 Structured finance — — 4,114 — 11,061 15,175 Loans — 9,918 25,815 2,237 16,972 54,942 Bonds — — 153 — 545 698 Derivatives — — 12,946 218 20,326 33,490
(3) The net increase in UK Corporate loans reflects transfers of shipping assets from GBM.
(4) There have been some minor divisional refinements to 31 December 2008 data, primarily between Core businesses and Non-Core division.
Carrying adjustments and other Covered value (2) to par value (3) Par value (4) adjustments (5) amount £m £m £m £m £m 2009 (a) (b) (a)+(b)=(c) (d) (c)+(d)=(e)
Loans and advances 134,845 14,240 149,085 32,753 181,838 Debt securities 6,804 7,816 14,620 582 15,202 Derivatives 12,510 6,834 19,344 14,146 33,490
Further analysed: By division: Notes: (1) The balances at 31 December 2008 and 31 December 2009 within specific asset classes reflect the Group’s application of the asset class definitions in the Scheme rules, particularly in relation to consumer finance, commercial real estate finance and loans.
(2) Carrying value represents the amounts recorded on the balance sheet and includes assets classified as loans and receivables (LAR), fair value through profit or loss (FVTPL) and available-for-sale (AFS).
(4) Undrawn commitments and other adjustments include: • undrawn commitments and other contingent liabilities; • potential future exposures and other adjustments to covered amount relating to derivative contracts; and
• adjustments to covered amount in accordance with the Scheme rules (restriction of cover for rollovers (loans and commercial real estate), maintenance of covered amount as at 31 December 2008 for two years (consumer finance)
Financial institutions — 1,427 11,303 35 35,985 48,750 64,027 Manufacturing — 1,673 6,849 230 8,127 16,879 20,053 Natural resources — 629 2,530 45 2,117 5,321 8,122 Property — 9,990 8,349 1,550 27,931 47,820 60,217 Retail and leisure — 4,292 4,608 964 4,305 14,169 17,975 Services — 1,885 1,159 324 2,689 6,057 8,484 TMT — 608 3,985 263 5,852 10,708 14,535 Transport — 3,962 5,118 116 3,579 12,775 15,726 Personal and SME 21,242 24,761 116 8,342 13,590 68,051 72,820
Geographical breakdown The table below provides a geographical breakdown of covered assets, based on the country of domicile or incorporation of the obligor, and by HMT asset class.
UK 10,102 46,027 15,285 8,406 997 167 2,433 15,879 53 8,379 107,728 Western Europe 3,971 6,814 12,080 9,448 485 904 2,963 21,273 105 2,369 60,412 North America 118 46 1,702 4,039 2 228 3,406 8,019 25 17,325 34,910 Latin America 1 282 2,042 476 17 40 5,628 2,593 7 4,068 15,154 Other 13 92 1,028 907 28 478 745 7,178 508 1,349 12,326
% relating % relating Group to assets in Group to assets in
Notes: (1) ‘Other’ largely comprises assets covered by the standardised approach for which a probability of default (PD) equivalent to those assigned to assets covered by the internal ratings based approach is not available.
Explanatory note These disclosures provide information on certain elements of the Group’s business activities affected by the unprecedented market events of the second half of 2007 and through 2008 and 2009, the majority of which reside within Non-Core and, to a lesser extent, Global Banking & Markets (‘GBM’), US Retail & Commercial and Group Treasury. For certain disclosures the information presented has been analysed into the Group’s Core and Non-Core businesses.
Definitions of acronyms used in this section are explained in the Glossary of terms on page 383 to 387.
Holdings Holdings minority minority interest Group interest Group Group £bn £bn £bn £bn £bn
Securities issued by corporates, US federal agencies and other entities 13.4 14.4 24.3 26.2 43.5 Securities issued by banks and building societies 14.0 17.8 22.7 24.4 28.2
The following table summarises the gross and net exposures and carrying values of these securities by geography – US, UK, other Europe and rest of the world (RoW) and by the measurement classification – held-for-trading (HFT), available-for-sale (AFS), loans and receivables (LAR) and designated at fair value through profit or loss (DFV) – of the underlying assets at 31 December 2009.
Carrying value: RMBS: non-conforming 958 1,957 128 — 3,043 389 1,180 1,474 — RMBS: sub-prime 977 314 146 387 1,824 779 704 324 17
Notes: (1) Gross exposures represent the principal amounts relating to asset-backed securities.
(2) RMBS: G10 government securities comprise securities that are: (a) Guaranteed or effectively guaranteed by the US government, by way of its support for US federal agencies and government sponsored enterprises (GSEs); (b) Guaranteed by the Dutch government; and
(4) Includes prime RMBS in RFS Holdings minority interests at 31 December 2009 comprising gross exposure: £558 million, carrying value: £579 million, and net exposure: £579 million. There was no ABS in RFS Holdings minority interest at 31 December 2008 or 2007.
The table below summarises the gross and net exposures and balance sheet carrying values of asset-backed securities by the geography of the underlying assets and between Core and Non-Core, at 31 December 2009.
Non- Non- Non- Non- NonCore Core Core Core Core Core Core Core Core Core 2009 £m £m £m £m £m £m £m £m £m £m
The table below summarises ABS carrying values and net exposures by geography and measurement classification at 31 December 2008 and 2007.
Other US UK Europe (3) RoW Total HFT AFS LAR DFV
(2) Net exposures represent the carrying value after taking account of hedge protection purchased from monoline insurers and other counterparties but exclude the effect of counterparty credit valuation adjustments. The hedges provide credit protection of principal and interest cash flows in the event of default by the counterparty. The value of this protection is based on the underlying instrument being protected.
(3) Includes prime RMBS in RFS Holdings minority interests at 31 December 2009 comprising gross exposure: £558 million, carrying value: £579 million, and net exposure: £579 million. There was no ABS in RFS Holdings minority interest at 31 December 2008 or 2007.
BBB- Non- Not AAA rated and investment publicity rated (1) above (1) grade rated Total Level 2 Level 3 Total 2009 £m £m £m £m £m £m £m £m
RMBS: G10 governments 51,548 — — 9 51,557 51,322 235 51,557 RMBS: prime 15,252 1,417 106 2 16,777 16,061 146 16,207 RMBS: non-conforming 3,532 337 146 2 4,017 2,486 50 2,536 RMBS: sub-prime 1,362 936 790 1 3,089 2,459 64 2,523 CMBS 3,702 1,586 38 1 5,327 3,315 574 3,889 CDOs 4,510 2,041 2,088 381 9,020 6,922 1,748 8,670 CLOs 7,299 1,601 268 449 9,617 7,721 963 8,684 Other ABS 6,649 3,519 242 1,329 11,739 6,676 1,442 8,118
• Total asset-backed securities decreased from £111.1 billion at 31 December 2008 to £88.2 billion at 31 December 2009, due principally to exchange rate movements and the significant sell-down activity which took place in the first half of the year. In addition, credit spreads widened in the first half of the year, further reducing carrying values, although this was off-set to some extent by spreads tightening in the second half of the year. Sales have been limited in the second half of the year, however maturities have continued to reduce the balance sheet exposures.
– The decrease in exposure over the year was due to foreign exchange movements driven by the strengthening of sterling against the US dollar in the first half of the year and a decrease in the balances in the second half of the year.
– Other European government-backed exposures of £16.2 billion. This largely comprises liquidity portfolios of £15.6 billion held by Group Treasury (2008 – £17.7 billion) in European government-backed RMBS, referencing primarily Dutch and Spanish government-backed loans and covered mortgage bonds. The portfolio reduced during the year, driven primarily by exchange rate movements, partially offset by improved prices, mainly during the second half of the year.
• The Group has other portfolios of RMBS from secondary trading activities, warehoused positions previously acquired with the intention of securitisation, and a portfolio of assets from the unwinding of the Group’s securities arbitrage conduit in 2008.
• Material disposals of prime RMBS occurred in the first half of the year, in particular £1.5 billion of 2005 vintage US securities, £0.5 billion of Spanish and Portuguese mortgages and £0.6 billion of positions which were hedged.
• CDOs decreased from £9.0 billion at 31 December 2008 to £3.9 billion at 31 December 2009, driven primarily by significant declines in prices, together with foreign exchange movements, in the first half of the year.
• US Mortgage trading in GBM, US Retail and Commercial are in Core.
• There was no significant change in the percentage of asset-backed securities classified as level 2 and level 3 assets year-on-year (2009 –
The remainder of this section provides additional information and analysis of specific ABS portfolios.
Residential mortgage-backed securities (RMBS) RMBS are securities that represent an interest in a portfolio of residential mortgages. Repayments made on the underlying mortgages are used to make payments to holders of the RMBS. The risk of the RMBS will vary primarily depending on the quality and geographic region of the underlying mortgage assets and the credit enhancement of the securitisation structure. Several tranches of notes are issued, each secured against the same portfolio of mortgages, but providing differing levels of seniority to match the risk appetite of investors. The most junior (or equity) notes will suffer early capital and interest losses experienced by the referenced mortgage collateral, with each more senior note benefiting from the protection provided by the subordinated notes below. Additional credit enhancements may be provided to the holder of senior RMBS notes, including guarantees over the value of the exposures, often provided by monoline insurers.
Prime mortgages are those of a higher credit quality than nonconforming and sub-prime mortgages, and exclude guaranteed and covered bond mortgages.
Non-conforming mortgages (or ‘Alt-A’ used for US exposure) have a higher credit quality than sub-prime mortgages, but lower than prime borrowers. Within the US mortgage industry, non-conforming mortgages are those that do not meet the lending criteria for US agency mortgages (described below). For non-US mortgages, judgement is applied in identifying loans with similar characteristics to US non-conforming loans and also includes self-certified loans. Alt-A describes a category of mortgages in which lenders consider the risk to be greater than prime mortgages though less than sub-prime. The offered interest rate is usually representative of the associated risk level.
The table below analyses the vintage of the Group’s holdings of RMBS portfolios (carrying value) by geography.
Other G10 NonUS UK Europe RoW Total goverments Prime conforming Sub-prime 2009 £m £m £m £m £m £m £m £m £m
Commercial mortgage-backed securities (CMBS) CMBS are securities that are secured by mortgage loans on commercial land and buildings. The securities are structured in the same way as RMBS but typically the underlying assets referenced will be of greater individual value. The performance of the securities is highly dependent upon the sector of commercial property referenced and the geographical region.
The Group accumulated CMBS for the purpose of securitisation and secondary trading. The largest holding of CMBS arose as a result of the Group’s purchase of senior tranches in mezzanine and high grade CMBS structures from third parties. These securities are predominantly hedged with monoline insurers. As a result, the Group’s risk is limited to the counterparty credit risk exposure to the hedge. The Group also holds CMBS arising from securitisations of European commercial mortgages it originated.
• CMBS carrying values declined due to foreign exchange movements driven by the strengthening of sterling against the US dollar and the euro, as well as modest pay downs, sales and write-downs. This was more than off-set by revised asset classifications, including US federal agency issued ABS, previously classified as US government debt securities.
• There were no material acquisitions of CMBS by the Group in 2009. Where exposures within CMBS types have increased, this was due to a change of sector exposure from permitted substitutions, particularly within US structures, and revised sector classifications.
Other asset-backed securities Other asset-backed securities are securities issued from securitisation vehicles, similar to those in RMBS and CMBS structures, which reference cash flow generating assets other than mortgages. The wide variety of referenced underlying assets results in diverse asset performance levels.
Other Other US UK Europe RoW Total US UK Europe RoW Total £m £m £m £m £m £m £m £m £m £m
• The reduction in carrying value of the Group’s Other ABS exposures reflects asset disposals and foreign exchange movements. There were no material acquisitions of other ABS by the Group in the year. Where exposures within specific asset types have increased, this is due to a combination of permitted substitutions within structures and revised sector classifications, particularly in relation to consumer positions.
• The covered bonds comprise asset-backed securities issued primarily by Spanish financial institutions. These securities benefit from credit enhancement provided by the issuing institutions.
• The reduction in CVA held against exposures to other counterparties was primarily driven by a reduction in counterparty risk due to the tightening of credit spreads.
• The overall level of CVA has decreased, in line with the reduction in exposure to these counterparties. However, relative to the exposure to monoline counterparties, the CVA has increased from 52% to 62% due to a combination of wider credit spreads and lower recovery rates. These moves have been driven by deterioration in the credit quality of the monoline insurers as evidenced by rating downgrades (as shown in the table on the following page, together with the Group’s exposure to monoline insurers by asset category).
The gross mark-to-market of the monoline protection depends on the value of the instruments against which protection has been bought. A positive fair value, or a valuation gain, in the protection is recognised if the fair value of the instrument it references decreases. For the majority of trades the gross mark-to-market of the monoline protection is determined directly from the fair value price of the underlying reference instrument. For the remainder of the trades the gross mark-to-market is determined using industry standard models.
The methodology employed to calculate the monoline CVA uses CDS spreads and recovery levels to determine the market’s implied level of expected loss on monoline exposures of different maturities. CVA is calculated at a trade level by applying the expected loss corresponding to each trade’s expected maturity to the gross mark-to-market of the monoline protection. The expected maturity of each trade reflects the scheduled notional amortisation of the underlying reference instruments and whether payments due from the monoline insurer are received at the point of default or over the life of the underlying reference instruments.
The table below summarises the Group’s exposure to monolines; all of which are in the Non-Core division.
Notional amount: Fair value: Credit Net exposure protected protected Gross valuation to monoline assets assets exposure adjustment Hedges insurers 2009 £m £m £m £m £m £m
• CDO and CLO prices improved during the year, mostly in the last quarter, whilst CMBS deteriorated slightly overall during the year, with a slight improvement in Q4.
A number of debt instruments with monoline protection were reclassified from held-for-trading to available-for-sale with effect from 1 July 2008. Changes in the fair value since the reclassification are only recognised in the income statement to the extent that they are considered impairments. Changes in the fair value of the related monoline protection continues to be recorded in the income statement. Higher prices of these debt securities in 2009 gave rise to net losses from the corresponding decrease in the gross mark-to-market of the related monoline protection. The reclassification gave rise to profits in 2008. A summary of the reclassified debt securities held at 31 December 2009 are shown in the table below: £m
Fair value at 1 July 2008 (1) 6,248 Fair value at 31 December 2009 (2) 5,022
(2) Of the net change in fair value, fair value losses of £563 million have not been recognised in the income statement.
Note: (1) Comprises a loss of £2,387 million recorded as income from trading activities, £239 million of impairment losses and £60 million of other income relating to reclassified debt securities.
• Realised losses arising from restructuring certain exposures, together with the impact of the US dollar weakening against sterling, are the primary components of the £3.3 billion above.
Risk, capital and liquidity management 197RBS Group Annual Report and Accounts 2009
• The overall level of CVA decreased, in line with the reduction in exposure to these counterparties, however on a relative basis the CVA increased from 27% to 39%. This reflects the perceived deterioration of the credit quality of the CDPCs as reflected by ratings down-grades. Further analysis of the Group’s exposure to CDPCs by counterparty credit rating is shown in the following table.
RWAs* Counterparty and credit RWAs relating to gross CDPC exposures increased from £5.0 billion to £7.5 billion over the year. In addition regulatory capital deductions of £347 million were taken at the end of the year (2008 – nil).
The net income statement effect arising from CDPC exposures is shown in the table below.
The table below summarises CDPC exposures by rating. Notional Fair value: amount: protected Credit Net protected reference Gross valuation exposure to assets assets exposure adjustment CDPCs 2009 £m £m £m £m £m
• Nearly all of the current exposure is to CDPCs that are either sub-investment grade or have had their rating withdrawn in 2009. The majority of CDPC counterparties suffered rating downgrades during the year.
• £750 million of the net exposure at 31 December 2009 is in the Non-Core division, including all of the sub-investment grade exposure.
Expected losses are applied to estimated potential future exposures which are modelled to reflect the volatility of the market factors which drive the exposures and the correlation between those factors. Potential future exposures arising from vanilla products (including interest rate and foreign exchange derivatives) are modelled jointly using the Group’s core counterparty risk systems. At 31 December 2009, over 75% of the Group’s CVA held in relation to other counterparties arises on these vanilla products. The exposures arising from all other product types are modelled and assessed individually. The potential future exposure to each counterparty is the aggregate of the exposures arising on the underlying product types.
Leveraged finance Leveraged finance is commonly employed to facilitate corporate finance transactions, such as acquisitions or buy-outs, and is so called due to the high ratio of debt to equity (leverage) common in such transactions. A bank acting as a lead manager for a leveraged finance transaction will typically underwrite a loan, alone or with others, and then syndicate the loan to other participants. The Group typically held a portion of these loans as part of its long-term portfolio once primary syndication is completed (‘hold portfolio’). Most of the leveraged finance loans held as part of the syndicated lending portfolio were reclassified from held-fortrading to loans and receivables with effect from 1 July 2008.
Leveraged finance provided by the Group that has been drawn down by the counterparty is reported on the balance sheet in loans and advances. Undrawn amounts of the facility provided to the borrower are reported in memorandum items – commitments to lend.
Other Other Americas UK Europe RoW Total Americas UK Europe RoW Total £m £m £m £m £m £m £m £m £m £m
The table below analyses the movements in leveraged finance exposures for the year. Drawn Undrawn Total £m £m £m
Balance at 1 January 2009 12,619 3,150 15,769 Transfers in (from credit trading business) 563 41 604 Sales (247) (144) (391) Repayments and facility reductions (934) (392) (1,326) Funded deals 166 (166) — Lapsed/collapsed deals — (19) (19) Changes in fair value (31) — (31) Accretion of interest 100 — 100 Impairment provisions (1,041) — (1,041) Exchange and other movements (655) (190) (845)
• Since the beginning of the credit market dislocation in the second half of 2007, investor appetite for leveraged loans and similar risky assets has fallen dramatically, with higher perceived risk of default due to the leverage involved. Furthermore, secondary prices of leveraged loans traded fell due to selling pressure and margins increasing, as well as reduced activity in the primary market.
• There have also been a number of credit impairments and write-offs during 2009, including some names which the Group previously held as part of its syndicate portfolio.
• Early repayments as a result of re-financings have further reduced the exposure.
• Ulster Bank leveraged finance net exposures of £0.6 billion at 31 December 2009 (2008 – £0.7 billion).
Special purpose entities (SPEs) The Group arranges securitisations to facilitate client transactions and undertakes securitisations to sell financial assets or to fund specific portfolios of assets. The Group also acts as an underwriter and depositor in securitisation transactions involving both client and proprietary transactions. In a securitisation, assets, or interests in a pool of assets, are transferred generally to a special purpose entity (SPE) which then issues liabilities to third party investors. SPEs are vehicles established for a specific, limited purpose, usually do not carry out a business or trade and typically have no employees. They take a variety of legal forms – trusts, partnerships and companies – and fulfil many different functions. As well as being a key element of securitisations, SPEs are also used in fund management activities to segregate custodial duties from the fund management advice provided by the Group.
The Group typically does not retain the majority of risks and rewards of own-asset securitisations set up for the purposes of risk diversification and capital efficiency, where the majority of investors tend to be third parties. Therefore, the Group typically does not consolidate the related SPEs.
The Group has also established whole loan securitisation programmes in the US and UK where assets originated by third parties are warehoused by the Group for securitisation. The majority of these vehicles are not consolidated by the Group, as it is not exposed to the risks and rewards of ownership.
The table below sets out the asset categories together with the carrying amount of the assets and associated liabilities for those securitisations and other asset transfers, other than conduits (discussed below), where the assets continue to be recorded on the Group’s balance sheet.
Assets Liabilities Assets Liabilities Assets Liabilities £m £m £m £m £m £m * revised
Total assets held by the conduits 23,409 3,957 27,366 49,857 48,070
Liquidity and credit enhancements: Deal specific liquidity: Programme-wide liquidity: undrawn — — — — 75
• The maturity of commercial paper issued by the Group’s conduits is managed to mitigate the short-term contingent liquidity risk of providing back-up facilities. The Group’s limits sanctioned for such liquidity facilities at 31 December 2009 totalled approximately £25.0 billion (2008 – £42.9 billion). For a very small number of transactions within one multi-seller conduit the liquidity facilities have been provided by third-party banks. This typically occurs on transactions where the third-party bank does not use, or have, its own conduit vehicles.
• The Group’s multi-seller conduits have continued to fund the vast majority of their assets solely through ABCP issuance. There have been no significant systemic failures within the financial markets similar to that experienced in the second half of 2008 following Lehman Brothers bankruptcy filing in September 2008. The improvement in market conditions has allowed these conduits to move towards more normal ABCP funding and reduced the need for backstop funding from the Group.
Group-sponsored own-asset conduits The Group’s own-asset conduit programmes have been established to diversify the Group’s funding sources. The conduits allow the Group to access central government funding schemes and the ABCP market.
Group exposure to consolidated conduits The exposure to conduits which are consolidated by the Group is set out below.
Loan Securities Total Undrawn third parties exposure 2009 £m £m £m £m £m £m
Risk, capital and liquidity management 205RBS Group Annual Report and Accounts 2009
Other Weighted Below UK Europe US RoW Total average AAA AA A BBB BBB
2009 £m £m £m £m £m life years £m £m £m £m £m
Structured investment vehicles* The Group does not sponsor any structured investment vehicles.
Investment funds set up and managed by the Group* The Group has established and manages a number of money market funds for its customers. When a new money market fund is launched, the Group typically provides a limited amount of seed capital to the funds. The Group has investments in these funds of £776 million at 31 December 2009 (2008 – £107 million). The investors in both money market and non-money market funds have recourse to the assets of the funds only. These funds are not consolidated by the Group. At 31 December 2009 the Group had exposure to one fund amounting to £145 million (2008 – £144 million).
Money market funds The Group’s money market funds held assets of £9.6 billion at 31 December 2009 (2008 – £13.6 billion). The sub-categories of money market funds are: • £8.0 billion (2008 – £8.0 billion) in money market funds managed by the Group denominated in sterling, US dollars and euro. The funds invest in short-dated, highly rated money market securities with the objective of ensuring stability of capital and net asset value per share, appropriate levels of liquid assets, together with an income which is comparable to the short dated money market interest rate in the relevant currency.
• £1.2 billion (2008 – £4.9 billion) in third party multi-manager money market funds denominated in sterling, US dollars and euro. The funds invest in short dated, highly rated securities with the objective of maximising current income consistent with the preservation of capital and liquidity.
208 Report of the directors 214 Corporate governance 223 Letter from the Chairman of the Remuneration Committee 225 Directors’ remuneration report 237 Directors’ interests in shares 238 Statement of directors’ responsibilities
The directors present their report together with the audited accounts for the year ended 31 December 2009.
Capital restructuring In November 2008, HM Treasury announced the establishment of UK Financial Investments Limited (UKFI), a company wholly owned by the UK Government which will manage, on an arms-length basis, the UK Government’s shareholding in the company and other banks that subscribed to the government’s recapitalisation fund.
Results and dividends The loss attributable to the ordinary and B shareholders of the company for the year ended 31 December 2009 amounted to £3,607 million compared with a loss of £24,306 million for the year ended 31 December 2008, as set out in the consolidated income statement on page 241.
The company did not pay a dividend on ordinary shares in 2009.
Business review Activities The company is a holding company owning the entire issued ordinary share capital of The Royal Bank of Scotland plc, the principal direct operating subsidiary undertaking of the company. The “Group” comprises the company and all its subsidiary and associated undertakings, including the Royal Bank and NatWest. Details of the principal subsidiary undertakings of the company are shown in Note 16 on the accounts.
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 in the Business review on pages 53 and 54.
Following the conclusion of a strategic review, the Group has realigned its Core divisions, in particular the separation of RBS UK into UK Retail and UK Corporate. A Non-Core division has also been established to manage and run off or dispose of a number of assets and businesses that do not meet the Group’s target criteria.
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 in the Business review on pages 55 to 71.
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 the Risk, capital and liquidity management section of the Business review on pages 72 to 116.
Financial performance A review of the Group’s performance during the year ended 31 December 2009, including details of each division, and the Group’s financial position as at that date is contained in the Business review on pages 86 to 107.
Business developments RFS Holdings B.V., a company jointly owned by the company, the State of the Netherlands and Banco Santander and controlled by the company, is implementing an orderly separation of the business units of ABN AMRO with the company retaining the following ABN AMRO business units: • Continuing businesses of Business Unit North America; • Business Unit Global Clients and wholesale clients in the Netherlands (including former Dutch wholesale clients) and Latin America (excluding Brazil); • Business Unit Asia (excluding Saudi Hollandi); and
On 6 February 2010, the businesses of ABN AMRO acquired by the Dutch State were legally demerged from the RBS acquired businesses. As a result, there are now two separate banks within ABN AMRO Holding N.V., The Royal Bank of Scotland N.V. and the new entity named ABN AMRO Bank N.V., each licensed separately by the Dutch National Bank. Both banks will be governed by the current managing and supervisory boards of ABN AMRO Holding N.V. until the legal separation of the new ABN AMRO Bank N.V. from ABN AMRO Holding N.V., which is expected to take place within two months of the legal demerger and is subject to approval by the Dutch Central Bank. From that point RBS will cease to consolidate the Consortium Members’ interest in ABN AMRO in its statutory results.
Employee learning and development The Group maintains a strong commitment to creating and providing learning opportunities for all its employees through a variety of personal development and training programmes and learning networks. Employees are encouraged to do voluntary work with community partners.
The 2009 survey took place in September 2009 and the final response rate was 87%. This represents over 144,000 employees participating in the survey, from more than 50 countries.
Safety, health and wellbeing The Group recognises that performance in safety, health and wellbeing adds value to employees and to the Group’s businesses globally. Industry leading expertise, innovative tools, products and services and a practical approach to implementation are combined to ensure improved performance continues to be delivered.
Code of conduct The Code of conduct applies to all employees globally and to all those engaged by the Group, but who are not employees, such as contractors and those engaged through external agencies.
The Code exists to promote honest and ethical conduct, including the handling of actual or apparent conflicts of interest between personal and professional relationships. The Group recognises that personal conduct, business integrity and the Group's security are crucial, and the Code serves to inform employees of the Group's expectations of their behaviour and practices.
The Microfinance Advisory Board comprises senior members from a range of stakeholder groups and provides independent oversight and support for the Microfinance and Supporting Enterprise programmes across the Group’s international business.
The Group and other major UK banks have voluntarily adopted the draft code in their 2009 financial statements. The Group’s 2009 financial statements have therefore been prepared in compliance with the draft code’s principles.
Going concern The Group’s business activities and financial position, the factors likely to affect its future development and performance and its objectives and policies in managing the financial risks to which it is exposed and its capital are discussed in the Business review. The risk factors which could materially affect the Group’s future results are set out on pages 55 to 71. The Group’s regulatory capital resources and significant developments in 2009 and anticipated future developments are detailed on pages 120 to 126. Pages 154 to 160 describe the Group’s funding and liquidity profile, including changes in key metrics, the build up of liquidity reserves and the outlook for 2010.
Details of the authorised and issued preference share capital at 31 December 2009 are shown in Note 27 on the accounts.
Additional information Where not provided previously in the Report of the directors, the following provides the additional information required to be disclosed by Part 6 of Schedule 7 to the Report and Accounts Regulations 2008.
On a show of hands at a general meeting of the company every holder of ordinary shares and cumulative preference shares present in person or by proxy and entitled to vote shall have one vote. On a poll, every holder of ordinary shares present in person or by proxy and entitled to vote shall have one vote for every share held. On a poll, holders of cumulative preference shares present in person or by proxy and entitled to vote shall have four votes for every share held. The Notices of Annual General Meetings and General Meetings specify the deadlines for exercising voting rights and appointing a proxy or proxies to vote in relation to resolutions to be passed at the meeting.
The cumulative preference shares represent less than 0.01% of the total voting rights of the company, the remainder being represented by the ordinary shares.
A number of the company’s share plans include restrictions on transfers of shares while the shares are subject to the plans, in particular the Employee Share Ownership Plan.
The rights and obligations of holders of non-cumulative preference shares are set out in Note 27 on the accounts on pages 325 to 327.
The Royal Bank of Scotland plc 1992 Employee Share Trust, The Royal Bank of Scotland Group plc 2001 Employee Share Trust and The Royal Bank of Scotland Group plc 2007 US Employee Share Trust hold shares on behalf of the Group’s employee share plans. The voting rights are exercisable by the Trustees, however, in accordance with investor protection guidelines, the Trustees abstain from voting. The Trustees would take independent advice before accepting any offer in respect of their shareholdings for the company in a takeover bid situation.
The rules governing the appointment of directors are set out in the Corporate governance section on page 215. The company’s Articles of Association may only be amended by a special resolution at a general meeting of shareholders.
Colin Buchan, Stephen Hester, Archie Hunter, Joe MacHale and Gordon Pell served throughout the year and to the date of signing of the financial statements.
Jim Currie, Bill Friedrich, Bud Koch, Janis Kong, Sir Steve Robson, Bob Scott and Peter Sutherland all ceased to be directors on 6 February 2009.
Penny Hughes was appointed as a director on 1 January 2010.
Sandy Crombie, Penny Hughes, Philip Scott and Bruce Van Saun, all of whom have been appointed since the 2009 Annual General Meeting, will offer themselves for election at the forthcoming Annual General Meeting. In addition, Philip Hampton and Joe MacHale will retire and offer themselves for re-election at the Annual General Meeting.
The appointment of a successor to Archie Hunter as chairman of the Group Audit Committee is well advanced and is subject to final regulatory approval. An announcement will be made in due course.
Directors’ interests The interests of the directors in the shares of the company at 31 December 2009 are shown on page 237. None of the directors held an interest in the loan capital of the company or in the shares or loan capital of any of the subsidiary undertakings of the company, during the period from 1 January 2009 to 24 February 2010.
This confirmation is given and should be interpreted in accordance with the provisions of section 418 of the Companies Act 2006.
Charitable contributions In 2009 the Group’s overall community contribution was £63.9 million (2008 – £66.3 million). The total amount given for charitable purposes by the company and its subsidiary undertakings during the year ended 31 December 2009 was £34.7 million (2008 – £24.8 million).
Political donations At the Annual General Meeting in 2006, shareholders gave authority, for a period of four years, for the company to make political donations and incur political expenditure up to a maximum aggregate sum of £500,000 as a precautionary measure in light of the wide definitions in the Political Parties, Elections and Referendums Act 2000, the provisions of which are largely restated in the Companies Act 2006. This authority has not been used and will be refreshed at the forthcoming Annual General Meeting.
No EU political donations were made, nor EU political expenditure incurred, during the year and it is not proposed that the Group’s longstanding policy of not making contributions to any political party be changed.
Shareholdings The table below shows the shareholders that have notified the Group that they hold more than 3% of the voting rights in the undernoted classes of shares as at 31 December 2009.
Ordinary shares 51⁄2% cumulative preference shares Solicitor For The Affairs of Mr P S and Mrs J M Allen, Her Majesty’s Treasury Miss C L Allen and Miss J C Allen 112,949 28.23 As Nominee for Commercial Union Assurance plc 91,429 22.86 Her Majesty’s Treasury 39,644,835,194 70.33 Bassett-Patrick Securities Limited (1) 46,255 11.56 B shares E M Behrens Charitable Trust 20,000 5.00 Solicitor For The Affairs of Trustees of The Stephen Cockburn Her Majesty’s Treasury Limited Pension Scheme 19,879 4.97 As Nominee for Mrs Gina Wild 19,800 4.95 Her Majesty’s Treasury 51,000,000,000 100.00 Miss Elizabeth Hill 16,124 4.03 11% cumulative preference shares Mr W T Hardison Jr. 13,532 3.38 Guardian Royal Exchange Assurance plc 129,830 25.97 Windsor Life Assurance Company Limited 51,510 10.30 Cleaning Tokens Limited 25,500 5.10 Mr S J and Mrs J A Cockburn 15,520 3.10 Mr Stephen J Cockburn 15,290 3.06
Throughout the year ended 31 December 2009, the company has complied with all of the provisions of the Combined Code issued by the Financial Reporting Council in June 2008 (the “Code”) except in the following respects: • First, in relation to the provision that the Remuneration Committee should have delegated responsibility for setting remuneration for the Chairman and executive directors, the company considers that this is a matter which should rightly be reserved for the Board. No director is involved in decisions regarding his or her own remuneration.
The New York Stock Exchange As a foreign issuer with American Depositary Shares (ADS) representing ordinary shares, preference shares and debt securities listed on the New York Stock Exchange (NYSE), the company must disclose any significant ways in which its corporate governance practices differ from those followed by US companies under the NYSE corporate governance listing standards. In addition, the company must comply fully with the provisions of the listing standards that relate to the composition, responsibilities and operation of audit committees. These provisions incorporate the relevant rules concerning audit committees of the US Securities Exchange Act of 1934.
The Group Audit Committee complies with the provisions of the NYSE corporate governance listing standards that relate to the composition, responsibilities and operation of audit committees. In May 2009, the company submitted its required annual written affirmation to the NYSE confirming its full compliance with those and other applicable provisions. More detailed information about the Audit Committee and its work during 2009 is set out in the Audit Committee Report on pages 219 to 221.
Board of directors The Board is the main decision-making forum for the company. It has overall responsibility for management of the business and affairs of the Group, the establishment of Group strategy and capital raising and allocation, and is accountable to shareholders for financial and operational performance. The Board considers strategic issues and ensures the Group manages risk effectively through approving and monitoring the Group’s risk appetite, considering Group stress scenarios and agreed mitigants and identifying longer term strategic threats to the Group’s business operations. The Board has a formal schedule of matters detailing key aspects of the company’s affairs reserved to it for its decision. This schedule is reviewed annually.
The roles of 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 executive and non-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.
Board balance and independence The Board currently comprises the Chairman, three executive directors and eight independent non-executive directors. The Board functions effectively and efficiently and is considered to be of an appropriate size. The directors provide the Group with the knowledge, mix of skills, experience and networks of contacts required. The Board Committees comprise directors with a variety of relevant skills and experience so that no undue reliance is placed on any individual.
The names of directors standing for election at the 2010 Annual General Meeting are included on page 212 and further information is given in the Chairman’s letter to shareholders in relation to the company’s Annual General Meeting.
Separately, the Senior Independent Director canvassed the views of the executive directors and met with the non-executive directors individually and as a group, without the Chairman present, to consider his performance. The Senior Independent Director also canvassed views from UKFI, the FSA and the Association of British Insurers. The results of this were then shared with the Chairman.
* The Board is satisfied that no potential conflict of interest exists between conducting this board evaluation and the other executive search services which Spencer Stuart has provided for the Group in 2009 in its operating divisions.
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 8 to 11.
The terms of reference of the undernoted committees are available on the Group’s website (www.rbs.com) and copies are available on request.
Remuneration Committee The Remuneration Committee is comprised of independent nonexecutive directors. The Remuneration Committee holds at least four scheduled meetings each year. The Remuneration Committee held an additional 16 meetings in 2009. The Remuneration Committee is responsible for the overview of the Group’s policy on remuneration, as well as considering executive remuneration and, as required, making recommendations to the Group Board in respect of the remuneration arrangements of the executive directors. It is also responsible for setting the remuneration arrangements of the Executive Committee and Management Committee and any employees falling within the definition of principle 8 of the FSA Code on Remuneration.
Board Risk Committee The Board Risk Committee is comprised of at least three independent non-executive directors, one of whom is the Chairman of the Audit Committee. A minimum of six meetings will be held each year. The Board Risk Committee is responsible for providing oversight and advice to the Board in relation to current and potential future risk exposures of the Group and future risk strategy, promoting a risk awareness culture within the Group, reporting to the Board, as well as identifying any matters within its remit in respect of which it considers that action or improvement is needed and making recommendations as to the steps to be taken. The Board Risk Committee’s report is set out on page 222.
Nominations Committee The Nominations Committee comprises independent non-executive 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 having regard to the overall balance of skills, knowledge and experience on the Board. The committee engages with external consultants, considers potential candidates and recommends appointments of new directors to the Board. The appointments are based on merit against objective criteria, including the time available of the potential director and the commitment which will be required. In addition, the Nominations Committee considers succession planning for the Chairman, Group Chief Executive and non-executive directors. The Nominations Committee takes into account the knowledge, mix of skills, experience and networks of contacts which are anticipated to be needed on the Board in the future. The Chairman, Group Chief Executive and non-executive directors meet to consider executive succession planning. No director is involved in decisions regarding his or her own succession.
Group Corporate Sustainability Committee The Group Corporate Sustainability Committee is chaired by the Senior Independent Director and attended by the Group Chairman and members of the Group executive and senior management. It reports into the Board and is responsible for setting and reviewing the Group’s overall sustainability strategy, values and policies. It receives reports from the Environment Working Group and other relevant internal programmes.
In addition to scheduled meetings, 39 ad-hoc meetings of the Board and Committees of the Board were held during 2009, many of which related to the Second Placing and Open Offer, and the Group’s participation in the Asset Protection Scheme. There were also four additional meetings of the Group Audit Committee during the year held to consider the Group Interim Management Statements and accession to the Asset Protection Scheme. There were 16 additional meetings of the Remuneration Committee during 2009, reflecting the increased focus on remuneration, introduction of the FSA Code, senior recruitment and the development of the new deferral plan and long-term incentive plans.
(2) Ceased to be a member of the Remuneration Committee on 4 August 2009.
• The Senior Independent Director joined the Group in June 2009 and will be available if any shareholder has concerns that they feel are not being addressed through the normal channels.
Throughout the year, the Chairman, Group Chief Executive and Group Finance Director communicate shareholder feedback to the Board and the directors receive independent analyst notes and a monthly report reviewing share price movements and the Group’s performance against the sector. Detailed market and shareholder feedback is also provided to the Board after major public announcements such as earnings releases.
The Board has established a process for the identification, evaluation and management of the significant risks faced by the Group, which operated throughout the year ended 31 December 2009 and to 24 February 2010, the date the directors approved the Report and Accounts. This process is regularly reviewed by the Board and meets the requirements of the guidance ‘Internal Control: Revised Guidance for Directors on the Combined Code’ issued by the Financial Reporting Council in October 2005. Enhancements have been made to the Risk Management Framework during throughout 2009 and further improvements will be made in 2010.
The Group’s independent auditors present to the Audit Committee reports that include details of any significant internal control matters which they have identified. The system of internal controls of the authorised institutions and other regulated entities in the Group is also subject to regulatory oversight in the UK and overseas. Additional details of the Group’s regulatory oversight are given in the Supervision and Regulatory reviews and developments sections on pages 361 and 362.
Internal control over financial reporting The Group is required to comply with Section 404 of the US SarbanesOxley Act of 2002 and assess the effectiveness of internal control over financial reporting as of 31 December 2009.
The Group assessed the effectiveness of its internal control over financial reporting as of 31 December 2009 based on the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in ‘Internal Control – Integrated Framework’.
Changes in internal control There was no change in the company’s internal control over financial reporting that occurred during the period covered by this report that has materially affected, or is reasonably likely to materially affect, the company’s internal control over financial reporting.
Audit Committee Report The current members of the Group Audit Committee are Archie Hunter (Chairman), Colin Buchan, Joe MacHale and Philip Scott. All served throughout 2009 with the exception of Philip Scott who became a member of the Committee with effect from 19 January 2010. All members of the Group Audit Committee are independent non-executive directors. Art Ryan has been a regular attendee since August 2009 and has fully participated in the activity of the Committee.
In addition the Committee had responsibility for the consideration of risk issues throughout 2009.
The prospectively approved non-audit services include the following classes of service: • capital raising, including consents, comfort letters and relevant reviews of registration statements; • provision of accounting opinions relating to the financial statements of the Group; • provision of reports that, according to law or regulation, must be rendered by the external auditors; • tax compliance services; • corporate finance services relative to companies that will remain outside the Group; • restructuring services relating to the Group’s customers; and
Also addressed by the Audit Committee, given the current economic environment, was management's going concern assessment. In particular, the Committee reviewed the evidence to demonstrate that the Group had access to sufficient funding and capital over the next 12 months. The Committee reviewed and challenged the assumptions underlying the analysis and discussed with the external auditors its review of management's analysis and conclusions.
The Committee also dedicated a significant proportion of time and attention during 2009 to the consideration and approval of the Group’s accession to the Asset Protection Scheme (“the Scheme”). A specific meeting, which was attended by the majority of the Group Board, was held to consider the Scheme and its impact on the Group.
As far as it can determine, the Group Audit Committee received all the information and material it required to allow it to meet its obligations in respect of the 2009 financial statements.
During 2009, the Group Audit Committee regularly reviewed the work of the Group’s risk management and internal audit functions. Additional sessions of the Group Audit Committee were held in 2009 that focused solely on risk and audit issues.
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. Ernst and Young will conduct an external review of the 2009 performance of Group Internal Audit in 2010. Internal reviews were undertaken of 2008 and 2009 performance, both of which concluded that the function operated effectively and the Board agreed with the Audit Committee findings.
The current members of the Board Risk Committee are Philip Scott (Chairman), Colin Buchan, Sandy Crombie, Archie Hunter and Joe MacHale. All members of the Board Risk Committee are independent non-executive directors.
The Board Risk Committee will hold at least six scheduled meetings each year. The Board Risk Committee held its first meeting on 19 January 2010 and a second on 22 February 2010. Meetings are held as soon as practicable prior to Group Audit Committee meetings to ensure that the work of the two Committees is coordinated and consistent. A meeting will be held immediately prior to submission of the interim and annual financial statements to the Board and the quarterly Interim Management Statements. This core programme will be supplemented by additional meetings as required. Board Risk Committee meetings will be attended by relevant executive directors, risk management, finance executives and the internal auditors. External advice may be sought by the Board Risk Committee where considered appropriate. The Board Risk Committee has not sought external advice to date.
The Board Risk Committee will consider the Group’s risk profile relative to current and future Group Strategy. The Committee will report to the Board following each meeting on its consideration of the risk profile of the Group and any longer term macro or perceived strategic threats to the Group and will make recommendations as appropriate.
The Committee will approve the operational plan for RBS Risk Management. It will consider the adequacy and effectiveness of resource and the scope and nature of the work undertaken by the function.
Dear shareholder, Remuneration is one of the most challenging issues currently facing RBS. The Remuneration Committee has sought to reflect public sentiment on this issue and the Group’s results, balanced with the need to remain competitive and retain individuals that are central to the future success of the Group. We are especially conscious of the public hostility to some of the higher levels of banking pay and the special scrutiny in such cases as RBS which is reporting an overall loss. We are trying to react to this responsibly, but if the staff needed to restore the Group’s fortunes feel they will be treated worse than at competitors, we will fail to retain or recruit and thereby fail in our turnaround goals for RBS. Those responsible for the major failings have left. Our remaining staff are performing well in profitable businesses or engaged in the challenging task of turning around our more difficult legacy cases.
The Remuneration Committee is acutely aware of the additional responsibilities it carries as a consequence of the support RBS has received from the UK Government. RBS fully intends to be a responsible steward of this investment. The Board believes that pay must be both appropriately restrained but commercial and fair. Our plans take account of the need for a careful balance to be struck reflecting competitor positions, the UK bonus tax, the overall results of RBS and the capital support the Group has received.
The Remuneration Committee reviewed remuneration policies, processes and practices across the Group to ensure that they support the strategic goals of RBS which are to serve institutions well, to return to standalone strength, to return shareholder value, and to reflect best practice and regulatory requirements. We have taken into account the recommendations on remuneration made by the G20, the FSA and the Walker review and we are working towards implementation. The Remuneration Committee very much hopes that the implementation of these recommendations creates a level playing field for all banks internationally. We cannot set remuneration policy in isolation as to do so would neither reflect the competitive environment nor enable us to attract and retain employees of the calibre necessary to rebuild the Group and deliver long-term shareholder value.
During the year, the Remuneration Committee’s activities have focused on: • ensuring that the Group’s remuneration policies, procedures and practices are effective and promote the highest possible standards of risk management; • designing policies to ensure that remuneration is appropriately competitive in the markets, sectors and geographies in which RBS operates, and is related to individual, business unit and Group performance; • strengthening the link between remuneration and risk taken and taking advice from the newly-formed Board Risk Committee; • developing and implementing a rigorous approach to performance management, using appropriate risk-adjusted performance measures and taking into account the full costs and capital allocated to individual businesses; Governance
Colin A. M. Buchan Chairman of the Remuneration Committee 24 February 2010
The Remuneration Committee The current members of the Remuneration Committee are Colin Buchan (committee Chairman since February 2009), Sandy Crombie, Penny Hughes and John McFarlane. The members of the Remuneration Committee are all independent non-executive directors. Attendance of each member at meetings of the Remuneration Committee in 2009 is shown on page 217.
The Remuneration Committee is responsible for the overview of the Group’s Policy on Remuneration, as well as considering executive remuneration and, as required, making recommendations to the Group Board in respect of the remuneration arrangements of the executive directors of the Group. The Board as a whole reserves the authority to make the final determination of the remuneration of directors as it considers that this two-stage process allows greater consideration and evaluation and is consistent with the unitary nature of the Board. No director is included in decisions regarding his or her own remuneration.
During the year, the Remuneration Committee received advice from Watson Wyatt (now Towers Watson) on matters relating to directors’ remuneration in the UK, together with advice from the Group Director, Human Resources and the Group General Counsel and Group Secretary on general remuneration matters. In addition, the Remuneration Committee has taken account of the views of the Group Chief Executive on performance assessment of the executive directors and members of the Group Executive Committee and Management Committee.
Towers Watson are signatories to the voluntary Code of Conduct in relation to executive remuneration consulting in the UK. The relationship between the Remuneration Committee and Towers Watson takes account of this code.
Towers Watson also provided professional services in the ordinary course of business, including actuarial advice and benefits administration services to subsidiaries of the Group and investment consulting and actuarial advice to the trustees of some of the Group’s pension funds. The advisers to the Remuneration Committee are appointed independently by the Committee, which reviews its selection of advisers annually. The Committee is satisfied that the consultants from Towers Watson who advise the Committee operate independently of the consulting teams undertaking other work with the Group.
Group-wide remuneration policy The objective of the Group’s remuneration policy is to provide, in the context of the Group’s business strategy, remuneration in form and amount which will attract, retain, motivate and reward high calibre employees to deliver superior long-term business performance within acceptable risk parameters. The remuneration policy is designed to ensure that the Group’s metrics, reward structures and governance processes as a whole provide comprehensive coverage of the key risks in an appropriate way.
An overarching set of principles has been implemented which provides a framework for the design of reward programmes across the Group. Policy standards ensure reward, benefits and support packages are provided which are aligned to business objectives and which are market facing and appropriately aligned with shareholders’ long term interests. The aspirations of the Group must be supported by reward programmes that recognise the capabilities and achievements of individual employees and that reward significant and sustained individual and business unit performance.
• Reward should be linked to business performance and appropriate account should be taken of risk factors associated with that business.
• The composition of reward should allow for customisation through individual choice.
Compliance and governance Reward design and delivery should comply with appropriate policy, standards, be aligned to industry best practice, meet relevant regulators’ criteria and be consistent with effective risk management and the long term interests of shareholders.
The remuneration policy as regards individual elements of employees’ remuneration packages are as follows: Base salary Base salaries are generally set around market median competitiveness, in the context of competitive annual compensation and total compensation. Base salaries are appropriate in the specific market for the business in which an individual works and for the talents, skills and competencies that the individual brings to the Group. The level of fixed pay should be sufficient so that inappropriate risk-taking is not encouraged.
The way in which expenditure on short term incentives is linked to business performance has been significantly amended to take account of FSA principles in both design and delivery to individual employees. Expenditure will be reviewed by the Remuneration Committee, against the context of a range of performance metrics. The key metric that will be considered is risk-adjusted profit in excess of the cost of capital, with the cost of liquidity and all of the risks associated with the underlying business performance also taken into account. Where risk factors do not readily lend themselves to quantitative analysis then these may be factored in as adjustments, on the recommendation of Group Risk Management. The Board Risk Committee will also provide assurance, on an arms-length basis, as to the appropriateness of the proposed adjustments for these additional risk factors. Allocation of the expenditure will depend on individual performance and on each employees’ performance rating. Ratings are based on an assessment of performance during a single year, against a full range of measures including both financial and non-financial measures which take risk into account. The Group discourages the use of guaranteed bonuses and will not agree to any that span longer than a single financial year.
Performance awards for 2009 to those earning over £39,000 will be deferred and paid in three tranches over the period to June 2012.
Selected senior individuals in Global Banking & Markets will receive part of their awards for performance in 2009 in shares which require to be held by recipients until January 2015. Participants will be able to sell sufficient shares to cover their tax liabilities which are incurred on vesting, but conditions remain on any further sales before 2015. In order for any further sales to occur prior to 2015, participants would need to hold shares under Group Schemes to at least the gross value of their awards.
Deferred award The purpose of deferred awards is to support a performance culture where employees recognise the importance of sustainable Group, business and individual performance. A significant proportion when compared with the fixed component of selected individual awards will be deferred over a three year period.
Long-term incentive plans The Group provides employees in senior roles (executive level and senior managers by nomination) the opportunity to receive annual awards of long-term incentives. The objective is to encourage the creation of value over the long term and to align the rewards of the participants with the returns to shareholders.
• the primary requirement for awards to vest is that the Remuneration Committee should be satisfied that risk management during the performance period has been effective at a Group and division/ functional level. The Remuneration Committee’s determination will be informed by input from the Group’s Board Risk Committee and the Chief Risk Officer. Specifically, prior to vesting, the Remuneration Committee will have regard to risk and compliance across the Group and divisions and make an assessment of future risks as appropriate. It will also review whether there are any individual or more general cases where clawback should be operated; • for participants below Board level, vesting of share and option awards will be based on delivery of the strategic plan. Performance will be considered against metrics that reflect the five strategic tests in the strategic plan including: – risk measures – returns – efficiency – growth – customer franchise measure
• a reduction in the severance lump sum for those who take an immediate undiscounted pension for redundancy.
Following Gordon Pell’s retirement, no current director will be a member of one of the Group’s final salary pension plans. The RBS Group Pension Fund is closed to employees, including executive directors, joining the Group after 30 September 2006. Any new executive director would only be a member if he or she is already a current employee who is a member of the plan. The provision for an undiscounted pension on early retirement at employer request would not apply to any executive director appointed in the future.
Any incentive payments to executive directors in 2010 will reflect performance across five performance categories: Strategic Direction, Finance and Operations, Stakeholders, Risk, Efficiency and Control and Capability and Development. Group business unit and functional performance will be considered as appropriate. Clawback provisions will apply.
Long-term incentives The Group provides long-term incentives which are designed to link reward with the long-term success of the RBS Group. The awards are a significant investment in individuals by the RBS Group, and recognise the responsibility those participants have in driving its future success and for delivering share price growth.
It is anticipated that awards under the new long-term incentive plan will be made to executive directors following shareholder approval of the plan. Awards to executive directors will have a normal maximum limit of 400% of salary. In the event of exceptional circumstances and if the award policy for executive directors were to be increased from this level, shareholder consultation would be undertaken.
Chairman – Philip Hampton Following consultation with UKFI and other major shareholders, it was agreed that Philip Hampton would receive a one-off restricted stock award on his appointment as Chairman. This award is in the form of nil priced shares. The award was made on 27 February 2009 over 5,172,413 shares. These will vest, subject to the satisfaction of performance conditions, on the third anniversary of the date of grant. The performance conditions include measures on effective governance and stewardship of RBS, relationships with key stakeholders and delivery of value and return to shareholders.
In assessing performance to determine the vesting of this award, the Remuneration Committee will consider a number of factors which demonstrate whether Philip Hampton has led the successful and sustainable rebuilding of the Group. The Committee will also require to be satisfied that the vesting level is commensurate with the underlying financial performance of the Group.
In 2009, Stephen Hester received an award over 4,800,000 shares under the MPP and options over 9,550,000 shares under the ESOP. The performance conditions attached to the vesting of these awards are based on absolute and relative Total Shareholder Return metrics as described on page 235. Before the Remuneration Committee will permit any of Stephen Hester’s shares to vest, it will consider underlying financial performance of the Group and whether this performance is delivered in a way which is consistent with effective risk management.
Stephen Hester has voluntarily agreed to retain any shares that he receives under the MPP in 2009 for a further two years past the vesting date. This reflects his personal commitment to driving the Group’s performance over the longer term.
The ESOP and MPP awards made to Bruce Van Saun are subject to the same absolute and relative TSR targets that apply to Stephen Hester’s awards, including the performance underpin allowing the Remuneration Committee to adjust awards if the vesting outcome does not reflect the Group’s underlying performance and management of risk.
UK-based executive directors’ remuneration balance Executive director (including Chief Executive) pay mix
Total shareholder return performance The performance graphs below illustrate the performance of the company over the past five years in terms of total shareholder return compared with that of the companies comprising the FTSE 100 Index. This Index has been selected because it represents a cross-section of leading UK companies. The total shareholder return for FTSE banks for the same period has been added for comparison. The total shareholder return for the company and the indices have been rebased to 100 for 2004.
Date of Notice period – Notice period – current contract from company from executive
Executive directors Stephen Hester 4 November 2008 12 months 12 months Gordon Pell 20 February 2006 12 months 6 months Bruce Van Saun (1) 8 September 2009 12 months 12 months
All new service contracts for executive directors are subject to approval by the Remuneration Committee. Those contracts normally include standard clauses covering the performance review process, the company’s normal disciplinary procedure, and terms for dismissal in the event of failure to perform or in situations involving actions in breach of the Group’s policies and standards.
No compensation payment was made to Guy Whittaker in respect of his ceasing to be a director.
Information regarding directors’ service contracts is shown below: Except as noted below, in the event of severance where any contractual notice period is not worked, the employing company may pay a sum to the executive in lieu of the notice period. In the event of situations involving breach of the employing company’s policies resulting in dismissal, reduced or no payments may be made to the executive. Depending on the circumstances of the termination of employment, the executive may be entitled, or the Remuneration Committee may exercise its discretion to allow, the executive to exercise outstanding awards under long-term incentive arrangements subject to the rules of the relevant plan.
Gordon Pell Gordon Pell will retire from employment of the Group on 31 March 2010. In the event that Gordon Pell’s employment has been terminated by notice, any payment in lieu of notice would have been based on salary only i.e. not bonus or benefits. Gordon Pell is a member of The Royal Bank of Scotland Group Pension Fund (the RBS Fund) and is contractually entitled to receive all pension benefits in accordance with its terms which apply to all members. The RBS Fund rules allow all members, including executive directors, who retire early at the request of their employer to receive a pension based on accrued service with no discount applied for early retirement. Gordon Pell attained his normal pension age of 60, according to the rules of the Group Pension Fund, on 23 February 2010 and from that date, no discount applies on payment of his pension.
(2) Will not seek re-election at the 2010 Annual General Meeting.
(3) Awards granted on 8 September 2009 when Bruce Van Saun joined the Group. He was appointed as a director on 1 October 2009.
The plan was amended to introduce a clawback provisions for grants made in 2009.
In respect of the grant of options in 2009, the performance conditions for executive directors are based on a combination of relative and absolute Total Shareholder Return (TSR) measures. Further details can be found on page 235.
In the ten year period to 31 December 2009, awards made that could require new issue shares under the company’s share plans represented 4.1% of the company’s issued ordinary share capital, leaving an available dilution headroom of 5.9%. The company meets its employee share plan obligations through a combination of new issue shares and market purchase shares.
Medium Term Performance Plan (MPP) The MPP was approved by shareholders in April 2001. Key executives (Management Committee members and above) are eligible for an annual award under the plan in the form of share or share equivalent awards. Whilst the rules of the plan allow awards over shares worth up to one and a half times earnings, the Remuneration Committee has adopted a policy of granting awards based on a multiple of salary. No changes will be made to this policy without prior consultation with shareholders. The intention is that no further awards will be made under the MPP, instead awards will be made under the new long term incentive plan, if approved by shareholders. Details of the long-term incentive plan can be found on pages 226 and 227.
Market Sheme interests End of period Scheme interests Awards price on Awards Awards (share for qualifying
Notes: (1) Awards held at 30 September 2009 when Guy Whittaker ceased to be a director. All outstanding awards lapsed following cessation of employment.
(2) Awards granted on 8 September 2009 when Bruce Van Saun joined the Group. He was appointed as a director on 1 October 2009.
For any awards that have vested, participants holding option-based awards can exercise their right over the underlying share equivalents at any time up to ten years from the date of grant.
No variation was made to any of the terms of the plan during the year other than introducing a clawback provision for awards made in 2009.
Market Market Value of Awards period for Awards held Awards price on Awards price on awards held at qualifying at 1 January granted in award vested in vesting vested 31 December conditions to
Notes: (1) Awards to replace bonus and share awards Stephen Hester forfeited on leaving The British Land Company PLC, which reflect the vesting dates of the original awards. Initially he was awarded 10,407,081 restricted shares on joining the Group and 577,964 vested during 2008.
The relative TSR measure compares the Group’s performance against a basket of banks from the UK and overseas, weighted towards those companies most similar to the Group
• To receive 25% of the shares and options, RBS would need to be at the median of its relative TSR group.
The absolute TSR measure is based on the achievement of share price targets by the end of the performance period. In respect of this performance measure, vesting is determined as follows: • To receive 100% of the shares and options the share price would need to reach 70 pence or more.
• To receive 50% of the shares and options the share price would need to reach 55 pence or more.
Gordon Pell is provided with additional pension benefits on a defined benefit basis outwith the RBS Fund. The figures shown below include the accrual in respect of these arrangements.
There is a significant difference in the form of disclosure required by the Listing Rules and the Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008. The former requires disclosure of the additional pension earned during the year and the transfer value equivalent to this pension based on financial conditions at the end of the year. The latter requires the disclosure of the difference between the transfer value at the start and end of the year and is therefore dependent on the change in financial conditions over the course of the year. During 2009, the real discount rate used to calculate all transfer values fell from 2.8% to 1.5%. As a result, Gordon Pell’s transfer value increased to a greater extent than the amount of his pension. There has been no augmentation to his pension during 2009 or as a result of his retirement.
The proportion of benefits represented by funded pension schemes for Gordon Pell is 43%.
Stephen Hester and Bruce Van Saun are, and Guy Whittaker was, provided with a cash allowance in place of pension benefits as detailed below: Cash allowances in place of pension £000 £000
Shares beneficially owned at or date of Shares appointment, beneficially Value(1)
Notes: (1) The value is based on the share price at 31 December 2009, which was 29.2p. During the year ended 31 December 2009 the share price ranged from 10.3p to 57.7p.
No other director had an interest in the company’s ordinary shares during the year or held a non-beneficial interest in the shares of the company at 31 December 2009, at 1 January 2009 or date of appointment if later. The interests shown above include the connected persons of the directors.
The directors are required by Article 4 of the IAS Regulation (European Commission Regulation No 1606/2002) to prepare Group accounts, and as permitted by the Companies Act 2006 have elected to prepare company accounts, for each financial year in accordance with International Financial Reporting Standards as adopted by the European Union. They are responsible for preparing accounts that present fairly the financial position, financial performance and cash flows of the Group and the company. In preparing those accounts, the directors are required to: • select suitable accounting policies and then apply them consistently; • make judgements and estimates that are reasonable and prudent; and
We have audited the financial statements of The Royal Bank of Scotland Group plc (the “company”) and its subsidiaries (together the “Group”) for the year ended 31 December 2009 which comprise the accounting policies, the balance sheets as at 31 December 2009, the consolidated income statement, the consolidated statement of comprehensive income, the statements of changes in equity and the cash flow statements for the year ended 31 December 2009, the related Notes 1 to 42 and the information identified as ‘audited’ in the Risk, capital and liquidity management section of the Business review. The financial reporting framework that has been applied in their preparation is applicable law and International Financial Reporting Standards (IFRS) as adopted by the European Union.
Respective responsibilities of directors and auditors As explained more fully in the Statement of directors’ responsibilities, the directors are responsible for the preparation of the financial statements and for being satisfied that they give a true and fair view.
Our responsibility is to audit the financial statements and the part of the Directors' remuneration report described as having been audited in accordance with applicable law and International Standards on Auditing (UK and Ireland). Those standards require us to comply with the Auditing Practices Board’s Ethical Standards for Auditors.
Opinion In our opinion: • the financial statements give a true and fair view of the state of the Group's and of the company’s affairs as at 31 December 2009 and of the Group’s loss for the year then ended; • the Group and company’s financial statements have been properly prepared in accordance with IFRS as adopted by the European Union; and
In our opinion the Group financial statements comply with IFRS as issued by the IASB.
Opinion on other matters prescribed by the Companies Act 2006 In our opinion: • the part of the Directors’ remuneration report described as having been audited has been properly prepared in accordance with the Companies Act 2006; and
Stephen Almond (Senior Statutory Auditor) for and on behalf of Deloitte LLP Chartered Accountants and Statutory Auditors London, United Kingdom 24 February 2010
Fees and commissions receivable 2 9,831 9,831 8,278 Fees and commissions payable 2 (2,822) (2,386) (2,193) Income/(loss) from trading activities 2 3,881 (8,477) 1,292 Gain on redemption of own debt 2 3,790 — — Other operating income (excluding insurance premium income) 2 1,962 1,899 4,833 Insurance net premium income 24 5,544 6,326 6,087 Non-interest income 22,186 7,193 18,297
– pension schemes curtailment gains 2,148 — — Premises and equipment (3,087) (2,593) (1,703) Other administrative expenses (5,584) (5,464) (2,969) Depreciation and amortisation (2,809) (3,154) (1,932) Write-down of goodwill and other intangible assets (363) (32,581) —
(Loss)/profit attributable to: Paid-in equity holders 7 57 60 — Ordinary and B shareholders (3,607) (24,306) 7,303
Total comprehensive (loss)/income recognised in the statement of changes in equity is attributable as follows: Paid-in equity holders 57 60 — Ordinary and B shareholders (5,747) (23,744) 8,364
Property, plant and equipment 18 19,397 18,949 18,745 — — —
Prepayments, accrued income and other assets 19 20,985 24,402 15,662 43 489 127 Assets of disposal groups 20 18,542 1,581 45,850 — — —
Settlement balances and short positions 21 50,876 54,277 91,021 — — —
Accruals, deferred income and other liabilities 22 30,327 31,482 34,208 1,357 47 8
The accounts were approved by the Board of directors and authorised for issue on 24 February 2010 and signed on its behalf by: Philip Hampton Stephen Hester Bruce Van Saun Chairman Group Chief Executive Group Finance Director
Paid-in equity At 1 January 1,073 1,073 — 1,073 1,073 — Securities (redeemed)/issued during the year (308) — 1,073 (308) — 1,073 Transfer to retained earnings (200) — — (200) — —
Issue of B shares, net of £399 million expenses 24,591 — — 24,591 — — Placing and open offer — 14,273 — — 14,273 — Transfer to retained earnings (9,950) (14,273) — (9,950) (14,273) —
Unrealised gains/(losses) in the year 1,202 (6,808) (191) — — — Realised losses/(gains) in the year 981 842 (513) — — —
Retranslation of net assets (2,322) 11,970 1,339 — — — Foreign currency gains/(losses) on hedges of net assets 456 (5,801) (963) — — —
Paid-in equity dividends paid, net of tax (57) (60) — (57) (60) — Transfer from paid-in equity 200 — — 200 — — Equity owners gain on withdrawal of minority interest
Shares purchased during the year (33) (64) (65) — — — Shares issued under employee share schemes 16 21 119 — — —
Total comprehensive income recognised in the statement of changes in equity is attributable as follows: Minority interests (1,346) (4,332) 1,478 — — — Preference shareholders 878 536 246 878 536 246 Paid-in equity holders 57 60 — 57 60 — Ordinary and B shareholders (5,747) (23,744) 8,364 (2,435) (10,197) 2,255
Operating activities Operating (loss)/profit before tax (2,595) (40,836) 9,832 (1,286) (10,017) 2,372 Operating (loss)/profit before tax on discontinued activities (101) 4,208 68 — — —
Adjustments for: Depreciation and amortisation 2,809 3,154 1,932 — — — Write-down of goodwill and other intangible assets 363 32,581 — — — — Write-down of investment in subsidiaries — — — 5,139 14,321 —
Charge for defined benefit pension schemes 659 490 489 — — — Pension scheme curtailment gains (2,148) — — — — — Cash contribution to defined benefit pension schemes (1,153) (810) (599) — — — Gain on redemption of own debt (3,790) — — (238) — — Elimination of non-cash items on discontinued activities — 592 62 — — — Elimination of foreign exchange differences 12,217 (41,874) (10,282) (753) 1,778 (58)
Net cash flows from operating activities 33 (992) (75,338) 25,604 16,365 (16,032) 18,353
Investing activities Sale and maturity of securities 76,492 53,390 63,007 — — — Purchase of securities (73,593) (55,229) (61,020) — — — Investment in subsidiaries — — — (23,902) (10,349) (18,510) Disposal of subsidiaries — — — 7,908 700 6 Sale of property, plant and equipment 1,948 2,228 5,786 — — — Purchase of property, plant and equipment (4,898) (5,757) (5,080) — — — Proceeds on disposal of discontinued activities — 20,113 (334) — — — Net investment in business interests and intangible assets 34 105 2,252 13,640 — — — Repayments from subsidiaries — — — 274 — 469 Net cash flows from investing activities 54 16,997 15,999 (15,720) (9,649) (18,035)
Net cash flows from financing activities 18,791 15,102 29,691 10,817 28,416 536 Effects of exchange rate changes on cash and cash equivalents (8,592) 29,209 6,010 (83) 761 62
Net increase/(decrease) in cash and cash equivalents 9,261 (14,030) 77,304 11,379 3,496 916 Cash and cash equivalents at 1 January 134,925 148,955 71,651 5,069 1,573 657 Cash and cash equivalents at 31 December 144,186 134,925 148,955 16,448 5,069 1,573
The accompanying notes on pages 259 to 348, the accounting policies on pages 248 to 258 and the audited sections of the Business review: Risk, capital and liquidity management on pages 117 to 206 form an integral part of these financial statements.
RBS Group Annual Report and Accounts 2009248 1. Presentation of accounts The accounts are prepared on a going concern basis (see page 211 of the Report of the directors) and 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 as adopted by the European Union (EU) (together IFRS). The EU has not adopted the complete text of IAS 39 ‘Financial Instruments: Recognition and Measurement’; it has relaxed some of the Standard’s hedging requirements. The Group has not taken advantage of this relaxation and has adopted IAS 39 as issued by the IASB: the Group’s financial statements are prepared in accordance with IFRS as issued by the IASB.
The IASB issued an amendment, 'Vesting Conditions and Cancellations', to IFRS 2 'Share-based Payment' in January 2008 that changed the accounting for share awards that have non-vesting conditions. The fair value of these awards did not take account of the effect of non-vesting conditions and where such conditions were not subsequently met, costs recognised up to the date of cancellation were reversed. The amendment requires costs not recognised up to the date of cancellation to be recognised immediately. Retrospective application of the amendment caused a restatement of 2008 results for the Group, reducing profit by £169 million with no material effect on earlier periods; there was no effect on the balance sheet. There was no material effect on the company.
The Group has adopted ‘Improving Disclosures about Financial Instruments (Amendments to IFRS 7 Financial Instruments: Disclosures)’. These amendments expand the disclosures required about fair value measurement and liquidity risk.
2. Basis of consolidation The consolidated financial statements incorporate the financial statements of the company and entities (including certain special purpose entities) that are controlled by the Group. Control exists where the Group has the power to govern the financial and operating policies of the entity; generally conferred by holding a majority of voting rights. On acquisition of a subsidiary, its identifiable assets, liabilities and contingent liabilities are included in the consolidated accounts at their fair value. Any excess of the cost (the fair value of assets given, liabilities incurred or assumed and equity instruments issued by the Group plus any directly attributable costs) of an acquisition over the fair value of the net assets acquired is recognised as goodwill. The interest of minority shareholders is stated at their share of the fair value of the subsidiary’s net assets.
Payment services: this comprises income received for payment services including cheques cashed, direct debits, Clearing House Automated Payments (the UK electronic settlement system) and BACS payments (the automated clearing house that processes direct debits and direct credits). These are generally charged on a per transaction basis. The income is earned when the payment or transaction occurs. Charges for payment services are usually debited to the customer’s account monthly or quarterly in arrears. Accruals are raised for services provided but not charged at period end.
Card related services: fees from credit card business include: • Commission received from retailers for processing credit and debit card transactions: income is accrued to the income statement as the service is performed; • Interchange received: as issuer, the Group receives a fee (interchange) each time a cardholder purchases goods and services. The Group also receives interchange fees from other card issuers for providing cash advances through its branch and Automated Teller Machine networks. These fees are accrued once the transaction has taken place; and
The results of discontinued operations are shown as a single amount on the face of the income statement comprising the post-tax profit or loss of discontinued operations and the post-tax gain or loss recognised either on measurement to fair value less costs to sell or on the disposal of the discontinued operation. A discontinued operation is a cashgenerating unit or a group of cash-generating units that either has been disposed of, or is classified as held for sale, and (a) represents a separate major line of business or geographical area of operations, (b) is part of a single co-ordinated plan to dispose of a separate major line of business or geographical area of operations or (c) is a subsidiary acquired exclusively with a view to resale.
For defined benefit schemes, scheme liabilities are measured on an actuarial basis using the projected unit credit method and discounted at a rate that reflects the current rate of return on a high quality corporate bond of equivalent term and currency to the scheme liabilities. Scheme assets are measured at their fair value. Any surplus or deficit of scheme assets over liabilities is recognised in the balance sheet as an asset (surplus) or liability (deficit). The current service cost, curtailments and any past service costs together with the expected return on scheme assets less the unwinding of the discount on the scheme liabilities is charged to operating expenses. Actuarial gains and losses are recognised in full in the period in which they occur outside profit or loss and presented in the consolidated statement of comprehensive income. Contributions to defined contribution pension schemes are recognised in the income statement when payable.
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 overheads. 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 overheads. The costs of licences to use computer software that are expected to generate economic benefits beyond one year are also capitalised.
The depreciable amount is the cost of an asset less its residual value. Land is not depreciated. Estimated useful lives are as follows: Freehold and long leasehold buildings 50 years Short leaseholds unexpired period of the lease Property adaptation costs 10 to 15 years Computer equipment up to 5 years Other equipment 4 to 15 years 8. Impairment of intangible assets and property, plant and equipment At each reporting date, the Group assesses whether there is any indication that its intangible assets, or property, plant and equipment are impaired. If any such indication exists, the Group estimates the recoverable amount of the asset and the impairment loss if any. Goodwill is tested for impairment annually or more frequently if events or changes in circumstances indicate that it might be impaired. If an asset does not generate cash flows that are independent from those of other assets or groups of assets, recoverable amount is determined for the cash-generating unit to which the asset belongs. The recoverable amount of an asset is the higher of its fair value less cost to sell and its value in use. Value in use is the present value of future cash flows from the asset or cash-generating unit discounted at a rate that reflects market interest rates adjusted for risks specific to the asset or cashgenerating unit that have not been reflected in the estimation of future cash flows. If the recoverable amount of an intangible or tangible asset is less than its carrying value, an impairment loss is recognised immediately in profit or loss and the carrying value of the asset reduced by the amount of the loss. A reversal of an impairment loss on intangible assets (excluding goodwill) or property, plant and equipment is recognised as it arises provided the increased carrying value does not exceed that which it would have been had no impairment loss been recognised. Impairment losses on goodwill are not reversed.
General insurance and reinsurance premiums are recognised in the accounting period in which they begin. Unearned premiums represent the proportion of the net premiums that relate to periods of insurance after the balance sheet date and are calculated over the period of exposure under the policy, on a daily basis, 24th’s basis or allowing for the estimated incidence of exposure under policies which are longer than twelve months. Provision is made where necessary for the estimated amount of claims over and above unearned premiums including that in respect of future written business on discontinued lines under the run-off of delegated underwriting authority arrangements. The provision is designed to meet future claims and related expenses and is calculated across related classes of business on the basis of a separate carry forward of deferred acquisition expenses after making allowance for investment income.
If the Group has a contract that is onerous, it recognises the present obligation under the contract as a provision. An onerous contract is one where the unavoidable costs of meeting the obligations under it exceed the expected economic benefits. When the Group vacates a leasehold property, a provision is recognised for the costs under the lease less any expected economic benefits (such as rental income).
Contingent liabilities are possible obligations arising from past events whose existence will be confirmed only by uncertain future events or present obligations arising from past events that are not recognised because either an outflow of economic benefits is not probable or the amount of the obligation cannot be reliably measured. Contingent liabilities are not recognised but information about them is disclosed unless the possibility of any outflow of economic benefits in settlement is remote.
15. Financial assets On initial recognition, financial assets are classified into held-to-maturity investments; available-for-sale financial assets; held-for-trading; designated as at fair value through profit or loss; or loans and receivables.
Reclassifications – held-for-trading and available-for-sale financial assets that meet the definition of loans and receivables (non-derivative financial assets with fixed or determinable payments that are not quoted in an active market) may be reclassified to loans and receivables if the Group has the intention and ability to hold the financial asset for the foreseeable future or until maturity. The Group typically regards the foreseeable future as twelve months from the date of reclassification. Additionally, held-for-trading financial assets that do not meet the definition of loans and receivables may, in rare circumstances, be transferred to available-for-sale financial assets or to held-to-maturity investments. Reclassifications are made at fair value. This fair value becomes the asset’s new cost or amortised cost as appropriate. Gains and losses recognised up to the date of reclassification are not reversed.
Regular way purchases of financial assets classified as loans and receivables are recognised on settlement date; issues of equity or financial liabilities measured at amortised cost are recognised on settlement date; all other regular way transactions in financial instruments are recognised on trade date.
Fair value for a net open position in a financial asset that is quoted in an active market is the current bid price times the number of units of the instrument held. Fair values for financial assets not quoted in an active market are determined using appropriate valuation techniques including discounting future cash flows, option pricing models and other methods that are consistent with accepted economic methodologies for pricing financial assets.
16. 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.
Held for trading – a financial liability is classified as held-for-trading if it is incurred principally for repurchase in the near term, or forms part of a portfolio of financial instruments that are managed together and for which there is evidence of short-term profit taking, or it is a derivative (not in a qualifying hedge relationship). Held-for-trading financial liabilities are recognised at fair value with transaction costs being recognised in profit or loss. Subsequently they are measured at fair value. Gains and losses are recognised in profit or loss as they arise.
Amortised cost – all other financial liabilities are measured at amortised cost using the effective interest method (see accounting policy 3).
19. 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 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.
21. Netting Financial assets and financial liabilities are offset and the net amount presented in the balance sheet when, and only when, the Group currently has a legally enforceable right to set off the recognised amounts; and it intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously. The Group is party to a number of arrangements, including master netting agreements, that give it the right to offset financial assets and financial liabilities but where it does not intend to settle the amounts net or simultaneously and therefore the assets and liabilities concerned are presented gross.
A derivative embedded in a contract is accounted for as a stand-alone derivative if its economic characteristics are not closely related to the economic characteristics of the host contract; unless the entire contract is measured at fair value with changes in fair value recognised in profit or loss.
Hedge relationships are formally documented at inception. The documentation identifies the hedged item and the hedging instrument and details the risk that is being hedged and the way in which effectiveness will be assessed at inception and during the period of the hedge. If the hedge is not highly effective in offsetting changes in fair values or cash flows attributable to the hedged risk, consistent with the documented risk management strategy, hedge accounting is discontinued.
Cash flow hedge – in a cash flow hedge, the effective portion of the gain or loss on the hedging instrument is recognised directly in equity and the ineffective portion in profit or loss. When the forecast transaction results in the recognition of a financial asset or financial liability, the cumulative gain or loss is reclassified from equity in the same periods in which the asset or liability affects profit or loss. Otherwise the cumulative gain or loss is removed from equity and recognised in profit or loss at the same time as the hedged transaction. Hedge accounting is discontinued if the hedge no longer meets the criteria for hedge accounting; if the hedging instrument expires or is sold, terminated or exercised; if the forecast transaction is no longer expected to occur; or if hedge designation is revoked. On the discontinuance of hedge accounting (except where a forecast transaction is no longer expected to occur), the cumulative unrealised gain or loss 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 in equity is recognised in profit or loss immediately.
Loan impairment provisions The Group’s loan impairment provisions are established to recognise incurred impairment losses in its portfolio of loans classified as loans and receivables and carried at amortised cost. A loan is impaired when there is objective evidence that events since the loan was granted have affected expected cash flows from the loan. The impairment loss is the difference between the carrying value of the loan and the present value of estimated future cash flows at the loan’s original effective interest rate.
Individual component – all impaired loans that exceed specific thresholds are individually assessed for impairment. Individually assessed loans principally comprise the Group’s portfolio of commercial loans to medium and large businesses. Impairment losses are recognised as the difference between the carrying value of the loan and the discounted value of management’s best estimate of future cash repayments and proceeds from any security held. These estimates take into account the customer’s debt capacity and financial flexibility; the level and quality of its earnings; the amount and sources of cash flows; the industry in which the counterparty operates; and the realisable value of any security held. Estimating the quantum and timing of future recoveries involves significant judgement. The size of receipts will depend on the future performance of the borrower and the value of security, both of which will be affected by future economic conditions; additionally, collateral may not be readily marketable. The actual amount of future cash flows and the date they are received may differ from these estimates and consequently actual losses incurred may differ from those recognised in these financial statements.
Collective component – this is made up of two elements: loan impairment provisions for impaired loans that are below individual assessment thresholds (collectively assessed provisions) and for loan losses that have been incurred but have not been separately identified at the balance sheet date (latent loss provisions). Collectively assessed provisions are established on a portfolio basis using a present value methodology taking into account the level of arrears, security, past loss experience, credit scores and defaults based on portfolio trends. The most significant factors in establishing these provisions are the expected loss rates and the related average life. These portfolios include credit card receivables and other personal advances including mortgages. The future credit quality of these portfolios is subject to uncertainties that could cause actual credit losses to differ materially from reported loan impairment provisions. These uncertainties include the economic environment, notably interest rates and their effect on customer spending, the unemployment level, payment behaviour and bankruptcy trends. Latent loss provisions are held against estimated impairment losses in the performing portfolio that have yet to be identified as at the balance sheet date. To assess the latent loss within its portfolios, the Group has developed methodologies to estimate the time that an asset can remain impaired within a performing portfolio before it is identified and reported as such.
Fair value – financial instruments Financial instruments classified as held-for-trading or designated as at fair value through profit or loss and financial assets classified as available-for-sale are recognised in the financial statements at fair value. All derivatives are measured at fair value. Gains or losses arising from changes in the fair value of financial instruments classified as held-fortrading or designated as at fair value through profit or loss are included in the income statement. Unrealised gains and losses on available-forsale financial assets are recognised directly in equity unless an impairment loss is recognised.
Short positions (held-for-trading) – arise in dealing and market making activities where debt securities and equity shares are sold which the Group does not currently possess.
Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. Fair values are determined from quoted prices in active markets for identical financial assets or financial liabilities where these are available. Fair value for a net open position in a financial asset or financial liability in an active market is the current bid or offer price times the number of units of the instrument held. Where a trading portfolio contains both financial assets and financial liabilities which are derivatives of the same underlying instrument, fair value is determined by valuing the gross long and short positions at current mid market prices, with an adjustment at portfolio level to the net open long or short position to amend the valuation to bid or offer as appropriate. Where the market for a financial instrument is not active, fair value is established using a valuation technique. These valuation techniques involve a degree of estimation, the extent of which depends on the instrument’s complexity and the availability of market-based data. More details about the Group’s valuation methodologies and the sensitivity to reasonably possible alternative assumptions of the fair value of financial instruments valued using techniques where at least one significant input is unobservable are given in Note 11 on pages 270 to 291.
Goodwill The Group capitalises goodwill arising on the acquisition of businesses, as discussed in accounting policy 6. The carrying value of goodwill as at 31 December 2009 was £14,264 million (2008 – £15,562 million; 2007 – £42,953 million).
The Group has recognised deferred tax assets in respect of losses, principally in the UK, and short-term timing differences. Deferred tax assets are recognised in respect of unused tax losses to the extent that it is probable that there will be future taxable profits against which the losses can be utilised. Business projections prepared for impairment reviews (see Note 17) indicate that sufficient future taxable income will be available against which to offset these recognised deferred tax assets within eight years. The number of years into the future for which forecast profits should be considered when assessing the recoverability of a deferred tax asset is a matter of judgment. A period of eight years is underpinned by the Group’s business projections, its history of profitable operation and the continuing strength of its core business franchises. The Group’s cumulative losses are principally attributable to the recent unparalleled market conditions. Deferred tax assets of £2,163 million (2008 – £1,748 million; 2007 – £687 million) have not been recognised in respect of tax losses carried forward in jurisdictions where doubt exists over the availability of future taxable profits.
The IASB issued an amendment, ‘Group Cash-settled Share-based Payment Transactions‘, to IFRS 2 ‘Share-based Payment’ in June 2009 that will change the accounting for share awards by permitting accounting for equity settlement only by entities that either grant awards over their own equity or have no obligation to settle a share-based payment transaction. The amendment is effective for annual periods beginning on or after 1 January 2010 and is not expected to have a material effect on the Group or the company.
The IASB published an amendment ‘Classification of Rights Issues’ to IAS 32 ‘Financial Instruments: Presentation’ and consequential revisions to other standards in October 2009 to improve the accounting for issues of equity for consideration fixed other than in the reporting entity’s functional currency. The amendment is effective for annual periods beginning on or after 1 February 2010 but it may be adopted earlier. It is not expected to have a material affect on the Group or the company.
This standard makes major changes to the framework for the classification and measurement of financial assets and will have a significant effect on the Group’s financial statements. The Group is assessing this impact which is likely to depend on the outcome of the other phases of IASB’s IAS 39 replacement project.
The IFRIC issued interpretation IFRIC 18 ‘Transfers of Assets from Customers’ in January 2009. The interpretation addresses the accounting by suppliers for assets received from customers, requiring such assets to be measured at fair value. The interpretation is effective for assets from customers received on or after 1 July 2009 and is not expected to have a material effect on the Group or the company.
Loans and advances to customers 28,279 41,812 28,568 Loans and advances to banks 923 2,356 1,570
Notes: (1) The analysis of trading income is based on how the business is organised and the underlying risks managed. Trading income comprises gains and losses on financial instruments held for trading, both realised and unrealised, interest income and dividends and the related funding costs.
– Interest rate: interest rate swaps, forward foreign exchange contracts, forward rate agreements, interest rate options, interest rate futures and related hedges and funding.
– Credit: asset-backed securities, corporate bonds, credit derivatives and related hedges and funding.
– Equities and commodities: equities, commodities, equity derivatives, commodity contracts and related hedges and funding.
(2) In April 2009, the Group concluded a series of exchange offers and tender offers with the holders of a number of Tier 1 and Upper Tier 2 securities. The exchanges involving instruments classified as liabilities all met the criteria in IFRS for treatment as the extinguishment of the original liability and the recognition of a new financial liability. Gains on these exchanges, and on the redemption of securities classified as liabilities for cash, totalling £3,790 million were credited to income. No amounts have been recognised in income in relation to the redemption of securities classified as equity or minority interest in the Group financial statements. The difference between the consideration and the carrying value for these securities amounting to £829 million has been recorded in equity.
(3) Other income includes contributions attributable to the Group from activities other than banking and insurance.
Wages, salaries and other staff costs 10,142 8,907 6,230 Social security costs 727 696 471 Share-based compensation 129 169 65 Pension costs – defined benefit schemes (see Note 4) 659 490 489 – curtailment gains (see Note 4) (2,148) — — – defined contribution schemes 126 148 83
Property, plant and equipment (see Note 18) 1,616 1,584 1,297 Intangible assets (see Note 17) 1,193 1,570 635 Depreciation and amortisation 2,809 3,154 1,932
Premises and equipment 78 25 4 Other administrative expenses 398 486 26 Depreciation and amortisation 18 36 60
Staff costs 328 251 — Premises and equipment 48 15 — Other administrative expenses 51 41 —
RBS Group Annual Report and Accounts 2009262 3 Operating expenses continued
The average number of persons employed, rounded to the nearest hundred, in the continuing operations of the Group during the year, excluding temporary staff, was 192,000 (2008 – 197,100; 2007 – 157,200); on the same basis discontinued operations employed 2,500 employees (2008 – 32,200; 2007 – 13,300). The average number of temporary employees during 2009 was 9,700 (2008 – 7,000; 2007 – 4,900). The number of persons employed in the continuing operations of the Group at 31 December, excluding temporary staff, was as follows: Group
UK 98,500 105,800 108,000 USA 25,600 27,100 26,500 Europe 36,800 40,200 40,500 Rest of the World 23,600 26,400 28,500 Total 184,500 199,500 203,500
Notes on the accounts 263RBS Group Annual Report and Accounts 2009 4 Pension costs The Group sponsors a number of pension schemes in the UK and overseas, predominantly defined benefit schemes, whose assets are independent of the Group’s finances. The Group’s defined benefit schemes generally provide a pension of one-sixtieth of final pensionable salary for each year of service prior to retirement up to a maximum of 40 years. Employees do not make contributions for basic pensions but may make voluntary contributions to secure additional benefits on a money-purchase basis. Since October 2006 The Royal Bank of Scotland Group Pension Fund (‘Main scheme’) has been closed to new entrants.
Expected return on plan assets (weighted average) 6.2% 7.1% 6.9% 5.9% 6.3% 6.8% Rate of increase in salaries 1.8% 4.0% 4.5% 2.0% 3.4% 4.0% Rate of increase in pensions in payment 3.5% 2.7% 3.2% 3.0% 2.4% 2.8%
Major classes of plan assets as a percentage of total plan assets 2009 2008 2007 2009 2008 2007
Longevity at age 60 for current pensioners (years): Longevity at age 60 for future pensioners (years): The allowance for post-retirement mortality has been updated following an analysis of recent experience of pensioners in the Main scheme.
RBS Group Annual Report and Accounts 2009264 4 Pension costs continued Main scheme All schemes
Transfers to disposal groups — — — (1) (49) (48) Currency translation and other adjustments — — — 2,497 2,692 195 Income statement: Statement of comprehensive income: Disposal of subsidiaries — — — (31) (34) (3)
Currency translation and other adjustments — — — (699) (813) (114) Income statement
Contributions by plan participants and other scheme members 2 2 — 15 15 —
Expenses included in service cost (20) (20) — (22) (22) —
Curtailment gains of £2,148 million have been recognised in 2009 arising from changes to pension benefits in the Main scheme and certain other subsidiaries schemes due to the capping of future salary increases that will count for pension purposes to the lower of 2% or the rate of inflation in any year.
The Group expects to contribute £746 million to its defined benefit pension schemes in 2010 (Main scheme – £414 million). Of the net liabilities of schemes in deficit, £198 million (2008 – £201 million; 2007 – £212 million) relates to unfunded schemes.
Fair value of plan assets 16,603 14,804 18,575 17,374 15,914 27,925 25,756 27,662 18,959 17,388 Present value of defined
The table below sets out the sensitivities of the pension cost for the year and the present value of defined benefit obligations at the balance sheet dates to a change in the principal actuarial assumptions: Main scheme All schemes
0.25% additional rate of increase in pensions in payment 33 41 442 383 47 63 596 695 0.25% additional rate of increase in deferred pensions 16 8 214 94 25 15 366 227 0.25% additional rate of increase in salaries 8 28 66 168 17 35 125 219
Fees payable for the audit of the Group’s annual accounts 4.4 4.8 Fees payable to the auditors and their associates for other services to the Group pursuant to legislation: – The audit of the company’s subsidiaries pursuant to legislation (1) 36.9 39.3 – Other services pursuant to legislation (2) 3.3 3.1
– Services relating to taxation 1.4 0.6 – Services relating to corporate finance transactions, including securitisations, entered into by the Group (3) 2.5 7.4
All other services – Accounting advice 0.6 1.0 – Review of internal controls 1.1 0.6 – Other assurance services 2.4 1.8 – Consulting services 0.9 0.1
Fees payable to the auditors and their associates in respect of pension schemes: Notes: (1) Includes fees of £21.9 million (2008 – £23.1 million) in respect of the audit of ABN AMRO Holding N.V., of which £8.8 million (2008 – £10.5 million) relates to the interests of the State of the Netherlands and Santander.
(2) Includes fees of £1.7 million (2008 – £2.0 million) in relation to reviews of interim financial information and £1.6 million (2008 – £1.1 million) in respect of reports to the Group’s regulators in the UK and overseas.
Expected tax (credit)/charge (727) (11,638) 2,950 Non-deductible goodwill impairment 102 8,292 12 Unrecognised timing differences (274) 274 29 Other non-deductible items 508 378 222 Non-taxable items – gain on redemption of own debt (693) — —
Note: (1) The 2008 and 2007 prior period tax adjustments principally comprise releases of tax provisions in respect of structured transactions and investment disposals, and adjustments to reflect submitted tax computations in the UK and overseas.
7 Profit attributable to preference shareholders and paid-in equity holders Group £m £m £m
Paid-in equity holders: Interest on securities classified as equity, net of tax 57 60 —
Notes: (1) Includes £50 million redemption premium on repayment of preference shares.
(3) Between 1 January 2010 and the date of approval of these accounts, dividends amounting to US$163 million have been declared in respect of equity preference shares for payment on 31 March 2010.
Interest receivable from subsidiaries 997 793 460 Interest payable to subsidiaries (251) (495) (307) Other net interest payable and operating expenses (62) (796) (526) Write-down of investments in subsidiaries (5,139) (14,321) — Operating (loss)/profit before tax (1,286) (10,017) 2,372
(Loss)/profit attributable to: Paid-in equity holders 57 60 — Ordinary and B shareholders (2,438) (10,198) 2,253
(Loss)/profit for the year (1,503) (9,602) 2,499 Other comprehensive income: Cash flow hedges 3 2 3 Tax on comprehensive income — (1) (1) Other comprehensive income for the year, net of tax 3 1 2
Attributable to: Paid-in equity holders 57 60 — Ordinary and B shareholders (2,435) (10,197) 2,255 Total comprehensive income for the year (1,500) (9,601) 2,501
Notes on the accounts 269RBS Group Annual Report and Accounts 2009 10 Earnings per ordinary and B share Earnings per ordinary and B share have been calculated based on the following: Group £m £m £m
Earnings: (Loss)/earnings attributable to ordinary and B shareholders (3,607) (24,306) 7,303 Add back loss from discontinued operations attributable to ordinary and B shareholders 72 86 — Gain on redemption of paid-in equity 200 — — (Loss)/earnings from continuing operations attributable to ordinary and B shareholders (3,335) (24,220) 7,303 Add back finance cost on dilutive convertible securities — — 60 Diluted (loss)/earnings from continuing operations attributable to ordinary and B shareholders (3,335) (24,220) 7,363
RBS Group Annual Report and Accounts 2009270 11 Financial instruments Classification The following tables analyse the Group’s financial assets and financial liabilities in accordance with the categories of financial instruments in IAS 39. Assets and liabilities outside the scope of IAS 39 are shown separately.
Retirement benefit liabilities 2,963 2,963 Deferred taxation 2,811 2,811 Insurance liabilities 10,281 10,281
Notes on the accounts 271RBS Group Annual Report and Accounts 2009
trading profit or loss derivatives for-sale receivables cost) leases liabilities Total 2008 £m £m £m £m £m £m £m £m £m
Assets Cash and balances at central banks — — — 12,400 12,400 Loans and advances to banks (1) 56,234 — — 81,963 138,197 Loans and advances to customers (2, 3) 51,501 2,141 — 806,627 14,453 874,722
Intangible assets 20,049 20,049 Property, plant and equipment 18,949 18,949 Deferred taxation 7,082 7,082 Prepayments, accrued income and other assets — — — 1,326 23,076 24,402 Assets of disposal groups 1,581 1,581
RBS Group Annual Report and Accounts 2009272 11 Financial instruments continued Group
Designated Other as at fair financial Non value instruments financial Held-for- through Hedging Available- Loans and (amortised Finance assets/
trading profit or loss derivatives for-sale receivables cost) leases liabilities Total 2007 £m £m £m £m £m £m £m £m £m
Assets Cash and balances at central banks — — — 17,866 17,866 Loans and advances to banks (1) 71,639 — — 147,821 219,460 Loans and advances to customers (2, 3) 103,811 3,067 — 709,090 12,570 828,538
(2) Includes reverse repurchase agreements of £41,040 million (2008 – £39,313 million; 2007 – £142,357 million).
(3) The change in fair value of loans and advances to customers designated as at fair value through profit and loss attributable to changes in credit risk was £157 million income for the year and cumulatively a credit of £140 million (2008 – charge £328 million; cumulative £440 million credit; 2007 – not material).
(4) Includes treasury bills and similar securities of £45,617 million (2008 – £31,509 million; 2007 – £16,315 million) and other eligible bills of £34,794 million (2008 – £25,028 million; 2007 – £1,914 million).
(5) Includes repurchase agreements of £38,006 million (2008 – £83,666 million; 2007 – £163,038 million) and items in the course of transmission to other banks of £770 million (2008 – £542 million; (6) Includes repurchase agreements of £68,353 million (2008 – £58,143 million; 2007 – £134,916 million).
(7) The carrying amount of other customer accounts designated as at fair value through profit or loss is £101 million higher (2008 – £47 million lower; 2007 – £77 million higher) than the principal amount. No amounts have been recognised in profit or loss for changes in credit risk associated with these liabilities as the changes are immaterial measured as the change in fair value from movements in the period in the credit risk premium payable. The amounts include investment contracts with a carrying value of £5,170 million (2008 – £5,364 million; 2007 – £5,555 million).
(8) Comprises bonds and medium term notes of £164,900 million (2008 – £156,841 million; 2007 – £119,578 million) and certificates of deposit and other commercial paper of £102,668 million (2008
Held-for- Hedging Loans and (amortised assets/ trading derivatives receivables cost) liabilities Total 2009 £m £m £m £m £m £m
Assets Loans and advances to banks (1) — 31,238 31,238 Loans and advances to customers (3) — 2,777 2,777
Deferred taxation 2 2 Prepayments, accrued income and other assets — — 43 43
Accruals, deferred income and other liabilities — — 1,357 1,357 Subordinated liabilities — 8,762 8,762
RBS Group Annual Report and Accounts 2009274 11 Financial instruments continued Company
Assets Loans and advances to banks (1) — 7,686 7,686 Loans and advances to customers (3) — 307 307 Investments in Group undertakings 43,542 43,542
Notes: (1) Includes amounts due from subsidiaries of £31,238 million (2008 – £27,031 million; 2007 – £7,130 million).
(4) Includes amounts due to subsidiaries of £4 million (2008 – £1,706 million; 2007 – £5,572 million).
Notes on the accounts 275RBS Group Annual Report and Accounts 2009
Reduction in 31 December 2009 After reclassification Amount profit or loss that would as result of
Carrying Fair Impairment have been reclassivalue value Income losses recognised fication £m £m £m £m £m £m
Notes: (1) The amount taken to AFS reserves was £1,067 million.
The following table is for reclassifications in 2009. The balance sheet values of these assets, the effect of the reclassification on the income statement for the period from the date of reclassification to 31 December 2009 and the gains and losses relating to these assets recorded in the income statement for the years ended 31 December 2009, 2008 and 2007 were as follows: After reclassification Gains/(losses)
The following table is for reclassifications in 2008. The balance sheet values of these assets, the effect of the reclassification on the income statement for the period from the date of reclassification to 31 December 2008 and the gains and losses relating to these assets recorded in the income statement for the years ended 31 December 2008, 2007 and 2006 were as follows: After reclassification Gains/(losses)
Reclassified from HFT to LAR: Loans Leveraged finance 3,602 10.14% 6,091 4,304 2,714 (456) 455 — (1,015) 1,470 (155) — Corporate and other loans 5,205 6.03% 7,752 6,053 5,143 (74) 267 — (639) 906 (46) 3
Reclassified from AFS to LAR: Notes: (1) The amount taken to AFS reserves was £(2,193) million.
RBS Group Annual Report and Accounts 2009278 11 Financial instruments continued
A key element of the control environment is the independent price verification (‘IPV’) process. Valuations are first performed by the business which entered into the transaction. Such valuations may be directly from available prices, or may be derived using a model and variable model inputs. These valuations are reviewed, and if necessary amended, by a team, independent of those trading the financial instruments, in the light of available pricing evidence. IPV is performed at a frequency to match the availability of independent data. For liquid instruments IPV is performed daily. The minimum frequency of review in the Group is monthly for exposures in the regulatory trading book, and six monthly for exposures in the regulatory banking book. The IPV control includes formalised reporting and escalation of any valuation differences in breach of established thresholds. The Global Pricing Unit determines IPV policy, monitors adherence to that policy, and performs additional independent reviews on highly subjective valuation issues for GBM and Non-Core.
GBM’s senior management valuations control committee meets formally monthly to discuss independent pricing, reserving and valuation issues relating to both GBM and Non-Core exposures. All material methodology changes require review and ratification by this committee. The committee includes valuation specialists representing several independent review functions including Market Risk, the quantitative research centre and finance.
The Group Executive Valuation Committee discusses the issues escalated by the modelled product review committee, GBM senior management valuations control committee and other relevant issues. The committee covers key material and subjective valuation issues within the trading business. The committee will provide ratification to the appropriateness of areas with very high residual valuation uncertainty. Committee membership includes the Group Finance Director, the Group Chief Accountant, Head of Group Market Risk, GBM CFO and NonCore CFO, and representation from front office trading and Finance.
Notes on the accounts 279RBS Group Annual Report and Accounts 2009
• Credit spreads – where available, these are derived from prices of CDS or other credit based instruments, such as debt securities. For others, credit spreads are obtained from pricing services.
• Commodity prices – many commodities are actively traded in spot and forward contracts and futures on exchanges in London, New York and other commercial centres.
• Counterparty credit spreads – adjustments are made to market prices (or parameters) when the creditworthiness of the counterparty differs from that of the assumed counterparty in the market price (or parameters).
Credit valuation adjustments (CVA) represent an estimate of the adjustment to fair value that a market participant would make to incorporate the credit risk inherent in counterparty derivative exposures. The Group makes such credit adjustments to derivative exposures it has to counterparties, as well as debit valuation adjustments to liabilities issued by the Group. CVA is discussed in Risk, capital and liquidity management – Market turmoil exposures – Credit valuation adjustments (pages 193 to 199). Bid-offer and liquidity reserves and own credit are discussed below.
Bid-offer and liquidity reserves Trading positions are adjusted to bid (for assets) or offer (for liabilities) levels, by marking individual cash based positions directly to bid or offer or by taking bid-offer reserves calculated on a portfolio basis for derivatives.
Valuation reserves When valuing financial instruments in the trading book, adjustments are made to mid-market valuations to cover bid-offer spread, liquidity and credit risk.
The fair value of the Group’s derivative financial liabilities has also been adjusted to reflect the Group’s own credit risk. The adjustment takes into account collateral posted by the Group and the effects of master netting agreements.
(2) The effect of foreign exchange rates, new issues and redemptions are not captured separately.
2009 £bn £bn £bn £bn £m £m Level 3 valuation technique and related assumptions
Assets Loans and advances: – customers 44.3 — 43.2 1.1 80 (40) Proprietary model: credit spreads, indices Debt securities
RMBS 57.7 — 57.2 0.5 30 (10) Industry standard model: prepayment rates, probability of default, loss severity and yield
Equity shares 19.5 15.4 2.6 1.5 280 (220) Valuation statements: fund valuation Derivatives Foreign exchange 69.4 — 69.2 0.2 10 — Proprietary model: volatility, correlation Interest rate 323.6 0.3 321.8 1.5 80 (100) Proprietary model: volatility, correlation Equities 6.5 0.4 5.8 0.3 20 (20) Proprietary model; volatility, correlation, dividends
Credit – APS 1.4 — — 1.4 1,370 (1,540) Proprietary model: correlation, expected losses, recovery rates, credit spreads Credit – other 40.3 0.1 37.2 3.0 420 (360) Proprietary, industry option and correlation models: counterparty credit risk, correlation, volatility
Notes on the accounts 283RBS Group Annual Report and Accounts 2009
Total Level 1 Level 2 Level 3 Level 3 sensitivity (2)
– customers 53.6 — 50.5 3.1 70 (50) Proprietary model: credit spreads, indices Debt securities
Commodities – other 1.3 — 1.3 — — — Proprietary model: credit spreads, correlation, expected losses and recoveries Credit 142.4 0.8 133.6 8.0 1,030 (1,200) Proprietary, industry option and correlation models: counterparty credit risk, correlation, volatility
Liabilities Deposits: – customers 64.0 — 63.7 0.3 — — Proprietary model: credit spreads correlation Debt securities in issue 51.4 — 47.0 4.4 190 (170) Proprietary model: volatility, correlation Short positions 42.5 36.0 6.5 — — — Proprietary model: credit spreads, correlation Derivatives
Commodities – other 1.2 — 1.2 — — — Proprietary model: credit spreads, correlation, expected losses and recoveries Credit 132.7 0.1 130.0 2.6 180 (160) Proprietary, industry option and correlation models: counterparty credit risk, correlation, volatility
Liabilities Deposits by banks and customers 133.4 — 132.0 1.4 10 (10)
Level 3: includes cash instruments which trade infrequently, certain syndicated and commercial mortgage loans, unlisted equity shares, certain residual interests in securitisations, super senior tranches of high grade and mezzanine CDOs, other mortgage-based products and less liquid debt securities, certain structured debt securities in issue, and OTC derivatives where valuation depends upon unobservable inputs such as certain credit and exotic derivatives. No gain or loss is recognised on the initial recognition of a financial instrument valued using a technique incorporating significant unobservable data.
(3) Primarily includes debt securities issued by banks and building societies.
(4) Comprise subordinated liabilities and write downs relating to undrawn syndicated loan facilities.
Loans and advances to customers Loans in level 3 primarily comprise commercial mortgages.
The Group primarily uses an industry standard model to project the expected future cash flows to be received from the underlying mortgages and to forecast how these cash flows will be distributed to the various holders of the RMBS. This model utilises data provided by the servicer of the underlying mortgage portfolio, layering on assumptions for mortgage prepayments, probability of default, expected losses, and yield. The Group uses data from third-party sources to calibrate its assumptions, including pricing information from third party pricing services, independent research, broker quotes, and other independent sources. An assessment is made of third-party data source to determine its applicability and reliability. The Group adjusts the model price with a liquidity premium to reflect the price that the instrument could be traded in the market and may also make adjustments for model deficiencies.
Collateralised debt obligations CDOs purchased from third parties are valued using independent, thirdparty quotes or independent lead manager indicative prices. For super senior CDOs which have been originated by the Group no specific thirdparty information is available. The valuation of these super senior CDOs therefore takes into consideration outputs from a proprietary model, market data and appropriate valuation adjustments.
RBS Group Annual Report and Accounts 2009286 11 Financial instruments continued
The Group considers that valuations may rely significantly on the judgements and estimates made by the fund managers, particularly in assessing private equity components. Given the decline in liquidity in world markets, and the level of subjectivity, these are included in level 3.
The APS is a single contract providing credit protection in respect of the covered assets. Under IFRS, credit protection is treated either as a financial guarantee contract or as a derivative financial instrument depending on the terms of the agreement and the nature of the protected assets and exposures. The Group has concluded, principally because the covered portfolio includes significant exposure in the form of derivatives, that the APS does not meet the criteria to be treated as a financial guarantee contract. The contract has therefore been accounted for as a derivative financial instrument. It was recognised initially and measured subsequently at fair value with changes in fair value recognised in profit or loss. There is no change in the recognition and measurement of the covered assets as a result of the APS.
The model primarily uses the following information, obtained in relation to each individual asset: notional, maturity, probability of default and expected recovery rate given default. Other required information is the correlation between the underlying assets; and the size of the first loss.
The APS protects a wide range of asset types, and hence, the correlation between the underlying assets cannot be observed from market data. In the absence of this, the Group determines a reasonable level for this input. The expected recovery rate given default is based on internally assessed levels. The probability of default is calculated with reference to data observable in the market. Where possible, data is obtained for each asset within the APS, but for most of the assets, such observable data does not exist. Therefore, this important input is determined from information available for portfolios of similarly rated entities. As the inputs into the valuation model are not all observable the APS derivative is a level 3 asset. The value of the credit protection at 31 December 2009 was £1.4 billion, representing the initial premium paid at 31 December 2009.
Notes on the accounts 287RBS Group Annual Report and Accounts 2009
The Group has used the following reasonably possible alternative assumptions in relation to those inputs that could have significant effect on the valuation of the APS CDS: • correlation: +/- 10%
• range of possible recovery rates on non-triggered assets: +/- 10%
Credit derivatives – other The Group’s other credit derivatives include vanilla and bespoke portfolio tranches, gap risk products and certain other unique trades. The bespoke portfolio tranches are synthetic tranches referenced to a bespoke portfolio of corporate names on which the Group purchases credit protection. Bespoke portfolio tranches are valued using Gaussian Copula, a standard method which uses observable market inputs (credit spreads, index tranche prices and recovery rates) to generate an output price for the tranche via a mapping methodology. In essence this method takes the expected loss of the tranche expressed as a fraction of the expected loss of the whole underlying portfolio and calculates which detachment point on the liquid index, and hence which correlation level, coincides with this expected loss fraction. Where the inputs into this valuation technique are observable in the market, bespoke tranches are considered to be level 2 assets. Where inputs are not observable, bespoke tranches are considered to be level 3 assets. However, all transactions executed with a CDPC counterparty are considered level 3 as the counterparty credit risk assessment is a significant component of these valuations.
Other unique trades are valued using a specialised model for each instrument and the same market data inputs as all other trades where applicable. By their nature, the valuation is also driven by a variety of other model inputs, many of which are unobservable in the market. Where these instruments have embedded optionality it is valued using a variation of the Black-Scholes option pricing formula, and where they have correlation exposure it is valued using a variant of the Gaussian Copula model. The volatility or unique correlation inputs required to value these products are generally unobservable and the instruments are therefore deemed to be level 3 instruments.
Other financial instruments Other than the portfolios discussed above, there are other financial instruments which are held at fair value determined from data which are not market observable, or incorporating material adjustments to market observed data. These include subordinated liabilities and write downs relating to undrawn syndicated loan facilities.
RBS Group Annual Report and Accounts 2009288 11 Financial instruments continued
Level 3 portfolio movement table Gains or Gains or losses losses recognised relating to
The decrease in debt securities in issue is due to a transfer to level 2 of £1,600 million of constant proportion portfolio insurance notes reflecting the minimal residual equity component within these notes at 31 December 2009.
Carrying Fair Carrying Fair Carrying Fair value value value value value value £bn £bn £bn £bn £bn £bn
Financial assets Cash and balances at central banks 52.3 52.3 12.4 12.4 17.9 17.9
Loans and advances to banks 46.3 46.0 82.0 81.9 147.8 147.8
Loans and advances to customers 684.1 650.9 821.1 776.1 721.7 723.7
The fair value of subordinated liabilities of the company as at 31 December 2009 is £4.9 billion compared to a carrying value of £8.8 billion (2008 – £8.8 billion fair value on a carrying value of £10.3 billion; 2007 – £7.0 billion fair value on a carrying value £7.7 billion). The fair value of other financial assets and liabilities of the company are not materially different from their carrying values.
The fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. Quoted market values are used where available; otherwise, fair values have been estimated based on discounted expected future cash flows and other valuation techniques. These techniques involve uncertainties and require assumptions and judgments covering prepayments, credit risk and discount rates. Changes in these assumptions would significantly affect estimated fair values. The fair values reported would not necessarily be realised in an immediate sale or settlement. As a wide range of valuation techniques is available, it may be inappropriate to compare the Group’s fair value information to independent markets or other financial institutions’ fair values.
Debt securities in issue and subordinated liabilities Fair values are determined using quoted prices where available or by reference to valuation techniques and adjusting for own credit spreads where appropriate.
Assets Loans and advances to banks 16,447 14,791 31,238 16,096 10,935 27,031 1,655 6,031 7,686 Loans and advances to customers — 2,777 2,777 — — — 307 — 307
The following tables show, by contractual maturity, the undiscounted cash flows payable up to a period of 20 years from the balance sheet date, including future payments of interest.
Settlement balances and other liabilities 12,048 100 139 104 239 83
Guarantees and commitments – notional amount 331,586 — — — — —
Notes: (1) The Group is only called upon to satisfy a guarantee when the guaranteed party fails to meet its obligations. The Group expects most guarantees it provides to expire unused.
Company 0-3 months 3-12 months 1-3 years 3-5 years 5-10 years 10-20 years 2009 £m £m £m £m £m £m
Deposits by banks 93 — — — — — Customer accounts 964 12,337 — — — —
Deposits by banks 116 1,707 — — — — Debt securities in issue 4,448 3,105 1,334 6,105 — — Derivatives held for hedging 186 16 30 1 — —
Held-for-trading assets and liabilities – held-for-trading assets and liabilities amounting to £650.5 billion (assets) and £568.5 billion (liabilities) (2008 – £1,226.8 billion assets and £1,146.7 billion liabilities) have been excluded from the table in view of their short term nature.
Recoveries of amounts previously written-off 94 305 — 399 319 342 Charged to the income statement 8,625 4,197 1,312 14,134 7,091 1,946
Carrying Carrying Carrying Cost Provision value Cost Provision value Cost Provision value £m £m £m £m £m £m £m £m £m
Loans that have been renegotiated in the past 12 months that would otherwise have been past due or impaired amounted to £2,698 million as at 31 December 2009 (2008 – £2,637 million; 2007 – £930 million).
RBS Group Annual Report and Accounts 2009294 13 Derivatives Companies in the Group transact derivatives as principal either as a trading activity or to manage balance sheet foreign exchange, interest rate and credit risk.
For cash flow hedge relationships of interest rate risk, the hedged items are actual and forecast variable interest rate cash flows arising from financial assets and financial liabilities with interest rates linked to LIBOR, EURIBOR or the Bank of England Official Bank Rate. The financial assets are customer loans and the financial liabilities are customer deposits and LIBOR linked medium-term notes and other issued securities. As at 31 December 2009, variable rate financial assets of £47.9 billion and variable rate financial liabilities of £49.9 billion were hedged in such cash flow hedge relationships.
The following table shows the notional amounts and fair values of the Group’s derivatives.
Included above are derivatives held for hedging purposes as follows: Assets Liabilities Assets Liabilities Assets Liabilities £m £m £m £m £m £m
The following tables show, for the Group, when the hedged cash flows are expected to occur and when they will affect income for designated cash flow hedges.
0-1 1-2 2-3 3-4 4-5 5-10 10-20 Over 20 Hedged forecast cash flows years years years years years years years years Total expected to occur £m £m £m £m £m £m £m £m £m
Hedged forecast cash flows affect profit or loss 0-1 1-2 2-3 3-4 4-5 5-10 10-20 Over 20 Hedged forecast cash flows years years years years years years years years Total expected to occur £m £m £m £m £m £m £m £m £m
The following table shows the notional amounts and fair values of the company’s derivatives.
Notional Notional Notional amounts Assets Liabilities amounts Assets Liabilities amounts Assets Liabilities £bn £m £m £bn £m £m £bn £m £m
Notes on the accounts 297RBS Group Annual Report and Accounts 2009 14 Debt securities Group
UK central and local government 11,815 — 2,618 4.0 2,439 4.8 2,199 4.3 19,071 1.7 US central and local government 294 2.4 5,620 1.4 6,957 3.7 101 7.0 12,972 2.6 Other central and local government 11,446 2.6 17,736 3.3 10,496 4.0 5,834 5.0 45,512 3.5
(2) Includes securities, other than asset-backed securities, issued by US federal agencies and government sponsored entities.