The Royal Bank of Scotland was founded in Edinburgh in 1727.
Since the acquisition of NatWest, RBS has continued to grow the business through the combination of strong organic growth and acquisitions. In the US, Citizens’ footprint has been expanded from New England into the Mid-Atlantic states through the acquisition of the Mellon Bank regional franchise, and into the Midwest through the acquisition of Charter One, completed in 2004. Citizens is now one of the top ten US commercial banking organisations by deposits. In insurance, the acquisition of Churchill broadened the product and distribution channel capabilities of Direct Line and created the second largest general insurer in the UK. In corporate banking, RBS has entered the US, Continental European and Asia Pacific markets.
Divisional review 14 Corporate Markets 22 Retail Markets 30 Ulster Bank Group 32 Citizens 38 RBS Insurance 42 Manufacturing
� Total dividend for the year of 72.5p per share, up 25%
Group profit before tax rose by 21% to £7,936 million in 2005.
Group operating profit – profit before tax, purchased intangibles amortisation, integration costs and net gain on sale of strategic investments and subsidiaries (£m)
Earnings per share increased by 8% to 175.9p for 2005, adjusted for purchased intangibles amortisation, integration costs and net gain on sale of strategic investments and subsidiaries, and in 2001 – 2003 for the AVS dividend.
� Group operating profit up 16% � Profit before tax up 21% � Adjusted earnings per ordinary share up 8% to 175.9p � Total dividend for the year up 25% to 72.5p per share
The annual accounts have, for the first time, been prepared in accordance with International Financial Reporting Standards. Certain standards relating to financial instruments were not adopted until 1 January 2005. As explained on page 58, the Group has provided comparative information on a pro forma basis that includes the estimated effect of these standards for the year ended 31 December 2004.
C ha ir m an ’s s ta te m en t 2005 was another year of excellent performance by the Group. Increased earnings and strong capital generation have enabled us to continue investing for organic growth, as well as raise our dividend significantly and embark on a programme of repurchasing our shares.
We have maintained a high level of efficiency across the Group, reaping the benefits of scale from our Manufacturing operations while continuing to invest in our businesses.
All acquisition integration benefits are being achieved at or ahead of expectations. The integration of Churchill, acquired in September 2003, was completed in September 2005 with benefits in excess of those forecast at acquisition.
We bade farewell to Sir Angus Grossart, Lord Vallance, Eileen Mackay and Iain Robertson as non-executive directors, and Fred Watt as Group Finance Director. Their contribution during a period of dramatic growth and change for RBS has been highly appreciated, as has their experience of the economic cycle and its impact on business. On behalf of the Board I would like to pay tribute to their loyal service and express our thanks for the valued contribution they have made.
On 1 February 2006 Guy Whittaker joined the Board as Group Finance Director. He is an experienced senior executive of the highest calibre, with great breadth of international experience in financial services. On 14 February 2006 the Group was also very pleased to announce the appointments of Johnny Cameron, Chief Executive of Corporate Markets, and Mark Fisher, Chief Executive of Manufacturing, as executive directors, with effect from 1 March 2006.
Bank of China In August 2005 we signed strategic investment and cooperation agreements with Bank of China, the second largest bank in China. Following regulatory approvals, the transaction was completed in December. RBS led a consortium that invested $3.1 billion, taking a 10% stake in Bank of China.
We have ourselves invested $1.6 billion, financed by the sale of our shares in Banco Santander Central Hispano S.A. We are working closely with Bank of China to develop business co-operation initiatives in areas such as credit cards, wealth management and corporate banking. We are also supporting Bank of China in key infrastructure areas, including risk and financial management, human resources and information technology.
Our shareholders Strong earnings and capital generation strengthened our Tier 1 capital ratio to 7.6% at the end of 2005 and our total capital ratio to 11.7%. We are committed to capital strength and efficiency, returning capital to our shareholders both through increasing dividends and when appropriate via share buybacks. This year the Board proposed a 25% increase in our dividend to 72.5p per share, representing an increased payout ratio of 41%. In addition, we intend to repurchase up to £1 billion of our shares over the next 12 months.
Outlook Whilst displaying both opportunities and threats, the economic outlook for 2006 in all of the major economies in which we operate would appear to be supportive of the continued momentum of the Group. We believe that we have built a strong platform for future growth with a diverse range of opportunities in a number of geographies, and taken together with our strong capital base, continuing good credit metrics, and firm cost control, we remain optimistic about the future prospects of the Group.
Global Banking & Markets Geographical spread UK, Europe, US and Asia
�Banking relationships with over 90% of the Dow Jones Eurostoxx 50
Corporate Markets (formerly Corporate Banking & Financial Markets) is a leading provider of banking services and integrated financial solutions to corporate customers in the UK and major corporates and financial institutions globally.
Since the start of 2006 we have organised Corporate Markets into two distinct businesses: UK Corporate Banking, which focuses on the needs of UK domestic and international corporate and commercial customers, and Global Banking & Markets, which supports the requirements of large international corporates and financial institutions around the world.
Retail Markets has the largest network of bank branches and ATMs in the UK; it has leading positions in the UK in credit card issuing, merchant acquiring, consumer finance and supermarket banking; and it provides services to clients through premier brands in UK private banking and UK offshore banking. It offers a wide range of banking, financial, insurance, life assurance, pension, credit card and charge card products and client services for private, corporate, expatriate and offshore customers.
Retail Markets brands include The Royal Bank of Scotland and NatWest in retail banking and credit cards. MINT and Tesco Personal Finance also offer cards, and a range of products and services are available through The One account, First Active UK, Direct Line Financial Services, Lombard Direct and other brands. Through Streamline and International Merchant Services, which includes WorldPay and Bibit, we are the leading merchant acquirer in Europe. Wealth Management brands include Coutts Group, Adam & Company, Royal Bank of Scotland International and NatWest Offshore.
�Over 11 million credit card and storecard accounts in the UK
Citizens is the eighth largest commercial banking organisation in the US, based on deposits. The Charter One acquisition in August 2004 enabled it to expand into six adjacent states in the northeastern and midwestern US. Citizens offers personal banking, residential mortgages, home equity loans, credit cards and merchant card services, and a wide variety of commercial banking services through its extensive, convenient network of city centre, local and supermarket branches.
�Retail branch footprint extends to 13 states and 30% of the US consumer population
Geographical spread New England, Mid-Atlantic and Midwest regions of the US
Manufacturing’s diverse range of services supports the customer-facing operations of the Group’s multiple brands. It provides customer support via telephony, account management, lending, mortgage processing and money transmission.
Group Technology develops and maintains the infrastructure and technology that supports the branches, ATMs and internet banking for customers of Corporate Markets, Retail Markets and RBS Insurance.
� Profit contribution £5,224 million (2004 – £4,196 million) � Total income up 17% � Profit up 24%
Kew Gardens has an international reputation. In 2005 they selected RBS for the quality of online banking data we offered alongside a very competitive and flexible interest bearing account. RBS is UK market leader in the provision of banking services to the charitable sector.
��� Corporate Markets’ extensive product range includes cash and liquidity management and comprehensive debt, risk management and treasury services. Debt services include overdraft, bilateral and syndicated lending; primary bond issuance; trade finance; asset finance; and structured finance solutions for property, acquisition finance, project finance and infrastructure finance (including PPP/PFI). Risk management and treasury services include trading of corporate, institutional and public sector debt; futures brokerage; foreign exchange; and money markets, currency derivative and interest rate risk management services.
��� We differentiate ourselves through the strength of our long-term relationships with our customers. Service is delivered by a network of experienced and highly trained relationship managers operating in their local communities. Acting as a single point of contact, they work proactively with our product teams to deliver the right solutions for their customers’ needs. Quality operational service is provided by specialist customer service teams who are also closely aligned with our relationship managers.
Global Banking & Markets is a leading banking partner to major corporates and financial institutions around the world, specialising in providing these customers with a full range of debt financing, risk management and investment services.
��� We serve our Global Banking & Markets customers from offices in 20 countries, with a leading position in the UK, established and strongly-growing positions in the US and continental Europe and an increasing capability in Asia-Pacific. These sophisticated customers benefit from our sectoral expertise, product excellence and access to markets.
��� The integration of our banking operations in the US with RBS Greenwich Capital, our industryleading US government bonds and asset-backed securities business, has delivered excellent results during 2005, with strong growth in new corporate relationships, corporate loan syndications and interest rate derivative volumes.
RBS, through UK Corporate Banking, is the UK’s No.1 relationship bank.
Open University. RBS has a long standing relationship with The Open University, Britain’s first university dedicated to distance learning. In 2005 the Open University consolidated its loan facilities with RBS as sole lender.
��� A controlled expansion of our franchise over the last five years across France, Germany, Spain, Italy and the Nordic region has enabled us to capture and develop major client relationships in continental Europe. We now provide a full range of products to customers in these countries.
��� Our financial markets activities benefit from our established platform and the real scale that we have developed. We are able to provide a full range of solutions that deliver against different customer requirements, from rapid access to electronic platforms, to high quality advice and excellent execution by highly skilled sales people.
��� RBS jointly led the £18 billion acquisition of UK mobile operator 02 by Telefónica, underwriting £6.1 billion. This was one of the largest acquisitions in the telecom sector and the largest ever single acquisition made by a Spanish company (awarded Most Impressive Loan and Best Western European Loan by Euroweek).
��� Through long-standing relationships with both of the UK’s leading cable companies, deep sector knowledge and tactical use of our balance sheet we helped to pave the way for the merger between NTL and Telewest, thereby consolidating our position as a top-tier partner bank to this customer.
��� RBS was the only bank to be awarded both Bookrunner and Mandated Lead Arranger roles in funding each of the three deals to acquire stakes in France's leading motorway companies from the French government. This was achieved through the combined strength of our multi-product platform, infrastructure sector expertise and local corporate relationships. Our teams led the underwriting of innovative and competitive financing packages totalling some €17.5 billion in support of the €21.3 billion-worth of acquisitions.
��� RBS acted as Joint Arranger of a crossborder securitisation for SC First Bank (previously Korea First Bank) raising €500 million in triple-A rated notes. The issue was more than 2.5 times over-subscribed with more than 30 institutional investors and was structurally innovative, marking the first instance an amortising junior note was introduced for a Korean cross-border mortgagebacked securitisation.
��� RBS Aviation Capital, working closely with our Shanghai Branch, completed a major Japanese Operating Lease financing with China Southern Airlines. The deal comprised an initial US$93 million bridge loan financing of three Boeing 737-700 aircraft from RBS Shanghai which was subsequently restructured into a Japanese Operating Lease financed through RBS Tokyo.
Adidas. We acted as agent on a US$1 billion private placement for Adidas, a global leader in the sporting goods industry. It was the largest such placement in the US out of Germany. The funding will largely be used to finance their acquisition of Reebok in the US.
��� The number of personal Retail Banking customers increased by 274,000 (2%), with personal current accounts up 275,000 (2%); Retail Direct increased its total customer accounts by 734,000 (4%); and Wealth Management increased its client base with Coutts UK personal customers up 7% and Adam & Company up 11%.
��� We added nearly 800 people to our Royal Bank of Scotland and NatWest branch networks and telephony service, improved personal access for customers by opening new branches and continuing our refurbishment programme, increased the number of branches open on Saturdays and extended our mobile banking service.
��� The Royal Bank of Scotland and NatWest attracted more than 135,000 new Stakeholder Child Trust Funds during 2005, making us one of the key providers of this product.
��� Retail Direct’s Credit Cards business is one of Europe’s leading issuers of personal and commercial credit cards, as well as one of the major global merchant acquirers.
��� The commercial cards business has maintained its leading position in the UK. It offers a range of corporate cards, purchasing cards and travel solutions to a broad range of businesses. It enhanced its services by including ‘Smart data online’ as part of the onecard package. This allows business customers to receive and analyse all transaction data centrally.
NatWest Business Managers. In 2005 NatWest re-introduced local business managers covering 180 key branches. In Fareham Chris Jack meets Nick Bowes of Airport Bodyshop on his premises.
NatWest Mobile Bank. Last year NatWest launched a new mobile bank in Cornwall bringing banking services to 13 local communities weekly, travelling around 20,000 miles per year. Here it is seen on the Cornish coast.
��� Retail Direct has worked closely with the Group’s Irish mortgage business, First Active, to launch the brand in the UK. First Active has established itself as one of the fastest-growing UK mortgage lenders with total gross lending of £3.9 billion in 2005, and has expanded its product range with the launch of a buy-to-let mortgage product.
��� RBS’s mortgage intermediary business was brought under the stewardship of Retail Direct during 2005, in order to co-ordinate the Group’s mortgage brand offer in the growing intermediary marketplace.
��� Adam & Company continued its eleven year record of double-digit profit growth, and opened a new office in Aberdeen.
Wealth Management provides private banking and investment services to its global clients through a number of leading UK and overseas private banking subsidiaries and offshore banking businesses.
��� NatWest Kirkham Branch – Customer Service Team of the Year Financial Services Award
��� The Royal Bank of Scotland – Best Direct Banking for the fifth year in a row
��� The Royal Bank of Scotland – Best Online Business Banking Provider for the second year in a row
��� First Active – Best Mortgage Lender of the Year and Innovator of the Year
��� Coutts – Best Private Bank for super-affluent individuals (US$500k to US$1m)
��� Coutts – Best provider of services to artists and entertainers
The One account. “One Day” as the advertisements say… I’ll have my own music studio. Mark Young transferred his mortgage to The One account three years ago and saved enough to convert one of the bedrooms in the family home.
� Profit contribution £530 million (2004 – £460 million) � Total income increased 15% � Profit up 15%
University of Limerick. Ulster Bank and University of Limerick share a passion for innovation and high standards. A 10-year agreement has underlined Ulster Bank’s commitment to the education sector nationally and to the Munster region where the university is located – covering the University’s own banking and on-campus banking for students, staff and local businesses.
��� First Active introduced the Republic of Ireland’s first 100% First Time Buyers’ Mortgage confirming First Active’s reputation for innovative products. These include the Current Account Mortgage and Elevator savings account.
��� 89 branches were overhauled as part of our improvement to the Ulster Bank branch network, with work planned on a further 57 during 2006. The Ulster Bank and First Active branches together create a network of 272 branches.
��� 2005 was also significant for the visibility of our brands. The Ulster Bank brand adopted the RBS logo in November, enhancing its identity as a member of the RBS Group, while First Active continued its targeted focus on the mortgage sector.
��� Best practice in recruitment and employment of people with disabilities 02 Ability Award
K-Sea Transportation has been a business customer with Citizens for over 3 years. It builds ferries, tugs and barges, one of which is seen here on the famous Staten Island crossing. To help fund further investment in its business K-Sea looked to Citizens Bank for a US$37 million Senior Credit Facility, US$34 million in equipment leases, and foreign exchange services.
��� Through Citizens Bank and Charter One Bank, Citizens’ network of retail and corporate banking covers Connecticut, Delaware, Illinois, Indiana, Massachusetts, Michigan, New Hampshire, New Jersey, New York state, Ohio, Pennsylvania, Rhode Island and Vermont. Citizens has a retail and corporate presence in about 40 states.
��� Citizens made more than 900,000 new consumer loans totalling US$22 billion during 2005 and processed more than 1.5 million credit applications. Its Consumer Finance division is the No.2 bank auto lender in the US and a top home equity lender. The Consumer Finance division introduced two new business lines: Indirect Recreational Vehicle and National Home Equity. Both new initiatives contributed operating profit in their first year of operation.
��� Citizens’ “Switch Support” programme with automated concierge service has smoothed the transition of customers switching to Citizens and Charter One from other banks.
��� RBS National Bank, now part of Citizens’ US credit cards division, launched the Circle Rewards MasterCard that can be issued automatically when a qualifying customer opens an account at a Citizens Bank or Charter One branch.
��� Also in Ohio, Charter One is sponsoring the new Charter One Global Enterprise Center in Cleveland to fuel economic growth by maximising northeast Ohio’s international business development potential.
��� In addition to lending at the community banking, middle market and large corporate levels, Citizens Corporate Banking services has worked effectively in partnership with RBS Corporate Markets. This provides additional expertise and flexibility to meet the needs of larger customers and craft complex financings. Services include interest rate protection, foreign exchange, cash management, asset finance and administration, asset-based lending and private equity capital.
��� The management and business of RBS Asset Finance, Inc. has been transferred from RBS Corporate Markets to Citizens. This integration combined the existing Citizens asset finance company, Citizens Leasing, with Charter One’s ICX Corporation and the group formerly known as RBS Lombard to form RBS Asset Finance. The combined company is the eighth largest bankaffiliated leasing company in the US.
��� In late 2004, Citizens established new International Cash Management services with Corporate Markets for companies doing business in the US and the EU, resulting in nearly 300 new customer accounts at Citizens during 2005 for existing RBS customers. These customers use an extensive array of cash management services, and have brought in more than US$80 million of new core deposits.
Citizens is among the top 10 rankings in deposits among US commercial banking organisations. It ranks seventh in branches and ninth in ATMs.
Citizens was one of just two companies in 2005 to receive the US Chamber of Commerce Corporate Stewardship Award.
��� Citizens’ support for its own people includes the Home Buyer Assistance Programme, which since 2002 has helped more than 2,000 colleagues purchase primary residences – often their first homes – with forgivable loans totalling more than US$10 million. The military leave policy, which bridges pay and benefits to cover the duration of military leave, has benefited more than 190 colleagues, and over 70 employees with serving family members have been given time off with pay, air fares and help with travel expenses to visit their loved ones.
��� Since June 2005 Citizens has promoted local volunteering through the “Join Us” campaign and its associated website, which also provides information on the Champions in Action programme and enables visitors to let Citizens know about local non-profit organisations that they feel deserve the bank’s attention. Citizens created a special Tsunami Sabbatical to send a colleague to Indonesia for three months to help with relief and rebuilding efforts through Plan International. Citizens also matched colleague donations for Hurricane Katrina relief efforts, added its own corporate contribution, and collected customer donations to The Red Cross and The Salvation Army through its network of more than 1,600 branches.
��� Charter One secured the naming rights to the previously designated Lakefront Pavilion, a summer concert performance centre on Northerly Island, between Lake Michigan and the Chicago skyline.
Awards ��� Citizens was one of just two companies in the United States to be awarded the US Chamber of Commerce Corporate Stewardship Award. This recognition was for the company’s total performance and contribution to economic, community and social progress. It noted Citizens’ Champions in Action, the Citizens Job Bank, and the company’s Home Buyer Assistance Programme.
��� Citizens Bank of Pennsylvania received the 2005 Good Government Award from the League of Women Voters for its Citizens Job Bank initiative to grow new jobs during 2004 and 2005.
��� Citizens received the Alfred P. Sloan Award for Business Excellence in Workplace Flexibility from the Families and Work Institute, U.S. Chamber of Commerce’s Center for Workforce Preparation and the Center for Emerging Futures in recognition of its many programmes to support employees.
Circle Rewards. RBS National Bank, which sells credit cards in the US, is now offering these to Citizens’ customers. In 2005 we launched Circle Rewards, a loyalty programme with discounts for air travel, hotels and branded merchandise.
� � Fence America. RBS Lynk, based in Atlanta, offers a range of payment systems for retail and business customers. Fence America is one of the first to use the innovative new product Treo, which allows credit card payments to be made via mobile phones.
RBS Insurance is the second largest general insurer in the UK. It sells and underwrites insurance via the telephone, the internet, partnerships and a network of brokers. Its brands, including Direct Line, Churchill, Privilege, Green Flag and NIG, are some of the best known in the UK. In 2005 RBS Insurance increased its total income by 8% to £5,489 million.
��� The integration of the Direct Line and Churchill businesses was completed at the start of September 2005, within two years, ahead of time and within budget. The combined businesses now have close to 20,000 employees.
��� We celebrated the 20th anniversary of the Direct Line red telephone in 2005. When it first opened for business in April 1985, Direct Line employed just 63 people. Today it employs around 6,500 people and handles an average of 12,000 car quotes every day.
��� Across its range of brands and products, RBS Insurance increased its total policies in-force by 1.6 million to 25.9 million. Within this, total car policies increased by 5.7% to 10.6 million across the UK and continental Europe.
��� In the United Kingdom, RBS Insurance is the No.1 car insurer, with 8.7 million policies, and the No.2 home insurer, with 4.6 million policies.
��� In continental Europe, RBS Insurance increased its car insurance policies by 14% to 1.9 million.
��� Direct Line launched several major enhancements to its car product, including a No Claims Discount (NCD) for named drivers on a Direct Line policy, multi-car discounts, matched NCD and an NCD earned on company cars and motorbikes.
��� Since the re-launch of Privilege in August 2004, the ‘you don’t have to be posh to be privileged’ campaign has delivered excellent brand recognition and sales, with in-force car policies increasing by 50% and breakdown policies by 43% respectively.
��� Churchill launched its new travel product in June, with customers now able to tailor cover to their individual travel needs.
��� Direct Line – Best Motor Insurance Provider Your Money Magazine
��� Churchill – Best Home and Contents Insurance Provider Your Money Direct Awards
��� Churchill – Travel Insurer of the Year International Travel Insurance Journal Awards
��� Churchill – Customer Service Complaints Team of the Year The National Customer Service Awards
Direct Line. Over 1,000 uninsured cars have been taken off the roads as part of a joint initiative between Durham Police and Direct Line. Drivers who can't provide evidence of insurance within 14 days have their cars crushed.
��� In 2005 we reduced the time it takes for a customer to receive a fully operational debit card after loss or theft from 12 days to within three days.
��� During 2005 we introduced a programme called ‘Lean’ across our operations. Developed in the Japanese car industry and used worldwide, ‘Lean’ is a customer-focused approach that uses targeted tools and techniques to remove waste, improve the flow of work and improve customer service.
��� In November 2005 a new Tesco Personal Finance Centre was created in Glasgow bringing together telephony, loans and savings functions under one management team. Combining these areas has created efficiencies and improved service to customers by giving people in the Centre a greater understanding of the full range of products and services offered to customers.
��� The Group remains focused on reducing the threats associated with electronic attacks like phishing – used by fraudsters to try to obtain customers’ security details over the Internet. During 2005 we experienced one of the lowest number of successful phishing attacks in the UK banking industry.
��� In 2005 Group Workplace Operations, part of our Group Property function, was judged “World Class” by University College London, who made the independent assessment using the globally recognised ‘Attributes of a world class real estate organisation’ benchmark developed by the Real Estate Executive Board (REEB). REEB base this benchmark model on the top 10% practices drawn from their membership of over 150 global blue chip companies.
��� One customer service centre reduced its use of paper by 36% over 2005. Building on this experience, other centres are significantly reducing their use of paper.
��� RBS Group Purchasing achieved the highest scores within the 2005 Excellence in Procurement study, run by supply chain experts A.T. Kearney. The study, a multi-industry benchmark, involved more than 300 global blue chip companies and reinforced further our position as World Class global sourcing leaders.
��� Feedback from the employee opinion survey showed a significant improvement in engagement and motivation across Manufacturing, after more than 1,500 people attended workshops on coaching, developing and motivating their teams.
Awards ��� World Class Accreditation – Strategic Sourcing team, Group Purchasing
��� Top prize for Business Infrastructure and Facilities Management Strategy and Delivery
��� The Group’s internal mail handling service won a World Mail Award in the Quality category in May 2005.
Document Solutions processed 345 million customer communications in 2005, making it one of the largest mailing facilities in Europe. This enlarged facility in Scotland increased capacity and resilience for the Group.
Financial inclusion ��� We have 800,000 basic bank account holders, an increase of 20% over 2004.
��� Our 15 mobile banks bring banking services to 300 rural communities each week in the UK.
��� 86% of employees across the Group participated in our 2005 Employee Opinion Survey. The Group scored above the Global Financial Services Norm in every category. 84% of respondents believe that the Group is socially responsible in the community.
��� The Group’s new Edinburgh headquarters at Gogarburn has received a number of awards for environmental best practice, including BREEAM “Excellent” and ISO 14001.
The Group ranked 4th in the Dow Jones Sustainability World Index for the banking sector, bringing our overall score to 76%, an increase of 12%. Our score was 28% above the global average for the sector.
Our 2004 Corporate Responsibility Report ranked 14th amongst the 100 largest global companies in the 2005 Fortune 100 CR performance assessment. This placed the Group second amongst the 25 Financial Service sector companies.
Community investment In the UK, we focus on three programmes that we believe have a strong and positive impact: Supporting Staff Giving, Money Matters and Moving On.
Supporting Staff Giving ��� In 2005, over 14,500 of our staff took part in our unique double matched payroll giving scheme which generated £8.5 million for 3,200 charities across the UK and Ireland. In addition RBS supported a TV advertising campaign by 3 charities – Cancer Research UK, NSPCC and Oxfam – which encouraged more employers and employees to take part in payroll giving.
��� Together with a £1 million Christmas donation shared between the Top 10 Give As You Earn charities nominated by our staff, the three schemes generated a record £12 million in charitable donations.
��� The Lone Parent Helpline responded to 25,465 calls (up from 21,000 in 2004) and distributed 4,689 information packs.
��� In 2005 the Group continued to support the Aimhigher Roadshows in England, Wales, Scotland and Northern Ireland.
In the US, Citizens has a long history of working in partnership with its local community. Activities focus on five key areas: affordable housing, economic development and job creation, financial literacy, volunteering and the Champions in Action programme. Further details are on page 36.
First Tee. Using golf to teach life skills – RBS in the US has helped Sonya Mendez through The First Tee programme. As Achiever of the Year, she won US$10,000 towards college education and is now mentored by an RBS employee.
� � School Banks. New to the Face2Face programme – the school banks train pupils to manage a branch helping them to understand money and the banking system. In the first year, 20 school banks have been established across the UK.
O pe ra tin g an d fin an ci al r ev ie w Presentation of information
In the Report and Accounts, and unless specified otherwise, the term ‘company’ means The Royal Bank of Scotland Group plc, ‘RBS’ or the ‘Group’ means the company and its subsidiary undertakings, ‘the Royal Bank’ means The Royal Bank of Scotland plc and ‘NatWest’ means National Westminster Bank Plc.
The company publishes its financial statements in pounds sterling (“£” or “sterling”). The abbreviations ‘£m’ and ‘£bn’ represent millions and thousands of millions of pounds sterling, respectively, and references to ‘pence’ represent pence in the United Kingdom (“UK”). Reference to ‘dollars’ or ‘$’ are to United States of America (“US”) dollars. The abbreviations ‘$m’ and ‘$bn’ represent millions and thousands of millions of dollars, respectively, and references to ‘cents’ represent cents in the US. The abbreviation ‘€’ represents the ‘euro’, the European single currency and the abbreviations ‘€m’ and ‘€bn’ represent millions and thousands of millions of euros, respectively.
Certain information in this report is presented separately for domestic and foreign activities. Domestic activities primarily consist of the UK domestic transactions of the Group. Foreign activities comprise the Group’s transactions conducted through those offices in the UK specifically organised to service international banking transactions and transactions conducted through offices outside the UK.
The geographic analysis in the average balance sheet and interest rates, changes in net interest income and average interest rates, yields, spreads and margins in this report have been compiled on the basis of location of office – UK and Overseas. Management believes that this presentation provides more useful information on the Group’s yields, spreads and margins of the Group’s activities than would be provided by presentation on the basis of the domestic and foreign activities analysis used elsewhere in this report as it more closely reflects the basis on which the Group is managed. ‘UK’ in this context includes domestic transactions and transactions conducted through the offices in the UK which service international banking transactions.
The Group distinguishes its trading from non-trading activities by determining whether a business unit’s principal activity is trading or non-trading and then attributing all of that unit’s activities to one portfolio or the other. Although this method may result in some non-trading activity being classified as trading, and vice versa, the Group believes that any resulting misclassification is not material.
For a further discussion of certain risks faced by the Group, see Risk factors on page 56.
Organisational structure and business overview The Group’s activities are organised in the following business divisions: Corporate Markets (formerly Corporate Banking & Financial Markets), Retail Markets (comprising Retail Banking, Retail Direct and Wealth Management), Ulster Bank, Citizens, RBS Insurance and Manufacturing. A description of each of the divisions is given below.
Corporate Markets is focused on the provision of debt and risk management services to medium and large businesses and financial institutions in the UK and around the world. Corporate Banking & Financial Markets was renamed Corporate Markets on 1 January 2006 when its activities were reorganised into two businesses, UK Corporate Banking and Global Banking & Markets, in order to enhance our focus on the distinct needs of these two customer segments. These two divisions broadly correspond to the analysis of Corporate Markets by customer grouping presented in this review.
Retail Banking is one of the leading retail banks in the UK. The division comprises both the Royal Bank and NatWest retail brands. It offers a full range of banking products and related financial services to the personal, premium and small business markets.
In the personal banking market, Retail Banking offers a comprehensive product range: money transmission, savings, loans, mortgages and insurance. In the small business market, Retail Banking provides a full range of services which include money transmission and cash management, short, medium and long-term financing, deposit products and insurance.
Retail Direct consists of the Group’s non-branch based retail businesses. Retail Direct issues a comprehensive range of credit and charge cards to personal and corporate customers and provides card processing services for retail businesses. It also includes Tesco Personal Finance, The One account, First Active UK, Direct Line Financial Services and Lombard Direct, all of which offer products to customers through direct channels principally in the UK. In continental Europe, Retail Direct offers a similar range of products through the RBS and Comfort Card brands.
Ulster Bank Corporate Banking & Financial Markets caters for the banking needs of business and corporate customers, including treasury and money market activities, asset finance, ebanking and international services.
Citizens is the second largest commercial banking organisation in New England and the eighth largest commercial banking organisation in the US measured by deposits. Citizens provides retail and corporate banking services under the Citizens brand in Connecticut, Delaware, Massachusetts, New Hampshire, New Jersey, New York state, Pennsylvania, Rhode Island and Vermont and the Charter One brand in Illinois, Indiana, Michigan and Ohio. Through its branch network Citizens provides a full range of retail and corporate banking services, including personal banking, residential mortgages and cash management. In addition, Citizens engages in a wide variety of commercial lending, consumer lending, commercial and consumer deposit products, merchant credit card services, insurance products, trust services and retail investment services.
Competition for corporate and institutional customers in the UK is from UK banks and from large foreign financial institutions who are also active and offer combined investment and commercial banking capabilities. In asset finance, the Group competes with banks and specialised asset finance providers, both captive and non-captive.
In the small business banking market, the Group competes with other UK clearing banks, specialist finance providers and, for smaller businesses, building societies.
In the personal banking segment the Group competes with UK banks and building societies, major retailers, life assurance companies and internet-only players. In the mortgage market the Group competes with UK banks and building societies. NatWest Life and Royal Scottish Assurance compete with Independent Financial Advisors and life assurance companies. The competitive situation in the long-term savings market is dynamic due to the uncertainties created by regulatory change and the continued evolution of institutions, particularly in the mutual sector.
In Wealth Management, The Royal Bank of Scotland International competes with other UK and international banks to offer offshore banking services. Coutts and Adam & Company compete as private banks with UK clearing and private banks, and with international private banks.
RBS Insurance competes in personal lines insurance and to a limited extent in commercial insurance. There is strong competition from a range of insurance companies which now operate telephone and internet direct sales businesses. RBS Insurance also competes with local insurance companies in the direct motor insurance markets in Spain, Italy and Germany.
The financial performance of the Group is affected by borrower credit quality and general economic conditions, in particular in the UK, US and Europe Risks arising from changes in credit quality and the recoverability of loans and amounts due from counterparties are inherent in a wide range of the Group’s businesses. Adverse changes in the credit quality of the Group’s borrowers and counterparties or a general deterioration in UK, US, European or global economic conditions, or arising from systemic risks in the financial systems, could affect the recoverability and value of the Group’s assets and require an increase in the provision for impairment losses and other provisions.
Each of the Group’s businesses is subject to substantial regulation and regulatory oversight. Any significant regulatory developments could have an effect on how the Group conducts its business and on the results of operations The Group is subject to financial services laws, regulations, administrative actions and policies in each location in which the Group operates. This supervision and regulation, in particular in the UK and US, if changed could materially affect the Group’s business, the products and services offered or the value of assets.
The risk of litigation is inherent in the Group’s operations In the ordinary course of the Group’s business, legal actions, claims against and by the Group and arbitrations arise; the outcome of such legal proceedings could affect the financial performance of the Group.
The Group is exposed to the risk of changes in tax legislation and its interpretation and to increases in the rate of corporate and other taxes in the jurisdictions in which in operates The Group’s activities are subject to tax at various rates around the world computed in accordance with local legislation and practice. Action by governments to increase tax rates or to impose additional taxes would reduce the profitability of the Group. Revisions to tax legislation or to its interpretation might also affect the Group's results in the future.
Notes: (1) Total income for the year ended 31 December 2005 excludes gains on sale of strategic investments and subsidiaries. In the statutory consolidated income statement on page 145, these items are included in total income.
(3) Adjusted earnings per share is based on earnings adjusted for purchased intangibles amortisation, integration costs and net gain on sale of strategic investments and subsidiaries.
(4) Adjusted after-tax return on equity is based on profit attributable to ordinary shareholders adjusted for purchased intangibles amortisation, integration costs and net gain on sale of strategic investments and subsidiaries, and average equity shareholders’ funds.
(ii) Impairment provisions reflect the information and estimates on which previous GAAP provisions were established.
Summary consolidated income statement for the year ended 31 December 2005 The income statement set out below shows purchased intangibles amortisation, integration costs and net gain on sale of strategic investments and subsidiaries separately. In the statutory consolidated income statement on page 145, these items are included in non-interest income and operating expenses as appropriate.
Net interest income 9,918 9,071 9,003 Fees and commissions receivable 6,750 6,473 6,071 Fees and commissions payable (1,841) (1,926) (1,920) Other non-interest income 4,963 4,126 3,838 Insurance premium income 6,076 6,146 6,032
Profit before tax, purchased intangibles amortisation, integration costs and net gain on sale of strategic investments and subsidiaries 8,251 7,849 7,108 Amortisation of purchased intangible assets 97 45 45
Net gain on sale of strategic investments and subsidiaries 240 — — Profit before tax 7,936 7,284 6,543 Tax on profit 2,378 1,995 1,856 Profit for the year 5,558 5,289 4,687
Annual Report and Accounts 2005 2005 compared with 2004 Profit The implementation of IAS 32, IAS 39 and IFRS 4 affected the timing of recognition of income and costs, classification of debt and equity, impairment provisions and accounting for insurance contracts in 2005. The effect of implementing the requirements of these standards in 2004 would have been to reduce profit before tax by £741 million for the year ended 31 December 2004.
Profit before tax, purchased intangibles amortisation, integration costs and net gain on sale of strategic investments and subsidiaries increased by 5% or £402 million, from £7,849 million to £8,251 million. Profit before tax was up 9%, from £7,284 million to £7,936 million.
Non-interest income increased by 9% to £15,651 million with good growth in banking fee income, financial markets income and insurance premium income. Non-interest income represents 61% of total income. The effect of implementing the requirements of IAS 39 and IFRS 4 in 2004 would have been to reduce non-interest income by £808 million for the year ended
Integration Integration costs were £458 million compared with £520 million in 2004. Included in both periods are software amortisation under IFRS relating to the acquisition of NatWest. The balance principally relates to the integration of Churchill, First Active and Citizens’ acquisitions, including Charter One which was acquired in August 2004.
Cost:income ratio The Group’s cost:income ratio in 2005 excluding acquisitions was 41.8%, reflecting the impact on income in 2005 of IAS 32, IAS 39 and IFRS 4.
Impairment losses Impairment losses were £1,707 million compared with £1,485 million in 2004. Overall credit quality remained strong in 2005, with improvements in Corporate Markets partly offsetting higher impairment losses in Retail Markets. The effect of implementing the requirements of IAS 39 in 2004 would have been to increase loan impairment losses by £105 million for the year ended 31 December 2004.
Earnings Basic earnings per ordinary share increased by 8% from 157.4p to 169.4p. Earnings per ordinary share, adjusted for purchased intangibles amortisation, integration costs and net gain on sale of strategic investments and subsidiaries, increased by 3%, from 170.2p to 175.9p. The effect of implementing the requirements of IAS 32, IAS 39 and IFRS 4 in 2004 reduced both basic and adjusted earnings per share by 7.6p, 5%.
Balance sheet Total assets of £776.8 billion at 31 December 2005 were up £188.7 billion, 32%, compared with 31 December 2004, with £108.4 billion of this increase arising from the implementation of IAS 32, IAS 39 and IFRS 4 on 1 January 2005, and the balance reflecting business growth.
Loans and advances to customers were up £70.0 billion, 20%, at £417.2 billion of which £33.9 billion resulted from the implementation of IAS 32 and IAS 39, mainly as a result of the grossing up of previously netted customer balances. Excluding this and a decrease in reverse repos, down 24%, £15.7 billion to £48.9 billion, customer lending was up £51.8 billion, 16%, reflecting organic growth across all divisions.
Profit before tax was up 21%, from £6,543 million to £7,936 million, reflecting strong organic income growth in all divisions and a full year’s contribution from acquisitions made during 2004.
Total income The Group achieved strong growth in income during 2005. Total income was up 14% or £3,054 million to £25,569 million. Excluding acquisitions and at constant exchange rates, total income was up by 10%, £2,219 million.
Net interest income increased by 10% to £9,918 million and represents 39% of total income (2004 – 40%). Average loans and advances to customers and average customer deposits grew by 23% and 17% respectively, or 17% and 12% respectively excluding acquisitions.
Non-interest income increased by 16% to £15,651 million and represents 61% of total income (2004 – 60%).
Cost:income ratio The Group’s cost:income ratio was 42.4% compared with 42.0% in 2004. Excluding acquisitions and at constant exchange rates, the cost:income ratio was unchanged at 41.8%.
Net insurance claims Bancassurance and general insurance claims, after reinsurance, which under IFRS include maturities and surrenders, increased by 9% to £4,313 million reflecting volume growth and maturities of our guaranteed capital bonds.
Impairment losses Impairment losses were £1,707 million compared with £1,590 million in 2004, an increase of 7%, or 5% excluding acquisitions.
Provision coverage of risk elements in lending and potential problem loans was 65% compared with 70% at 1 January 2005. This reflects amounts written-off and the changing mix from unsecured to secured exposures.
Earnings and dividends Basic earnings per ordinary share increased by 13%, from 149.8p to 169.4p. Earnings per ordinary share adjusted for intangibles amortisation, integration costs and net gain on sale of strategic investments and subsidiaries increased by 8%, from 162.6p to 175.9p.
Gross yield on interest-earning assets of the banking business 5.60 5.26 5.34 Cost of interest-bearing liabilities of the banking business (3.35) (2.70) (2.80) Interest spread of the banking business 2.25 2.56 2.54 Benefit from interest-free funds 0.30 0.32 0.27 Net interest margin of the banking business 2.55 2.88 2.81
UK – The UK net interest margin declined 20 basis points to 2.66%. This arose primarily from organic growth in lower margin mortgage lending and large corporate loans, price repositioning, changes in deposit mix and higher levels of rental assets.
Overseas – The Overseas net interest margin declined 36 basis points from 2.71% to 2.35% mainly reflecting flattening of the US dollar yield curve and growth in lower margin mortgage lending.
Loans and advances to banks – UK 15,338 649 4.23 13,556 529 3.90
Total interest-earning assets – banking business (2, 3) 383,690 21,505 5.60 316,743 16,666 5.26
Customer accounts: other time deposits – UK 60,454 2,328 3.85 51,440 1,699 3.30
Debt securities in issue – UK 52,672 2,071 3.93 41,058 1,351 3.29
Internal funding of trading business – UK (37,628) (1,125) 2.99 (35,317) (920) 2.60
Assets Treasury bills and other eligible bills – UK 832 34 4.09
Total interest-earning assets – banking business (2, 3) 319,731 17,082 5.34
(4) Interest receivable and interest payable on trading assets and liabilities are included in income from trading activites.
Annual Report and Accounts 2005 2005 compared with 2004 Non-interest income increased by £1,331 million, 9% to £15,651 million reflecting strong performances in Corporate Markets and Citizens, and good growth in banking fee income, financial markets income and insurance premium income. The effect of implementing the requirements of IAS 39 and IFRS 4 in 2004 would have been to reduce non-interest income by £808 million for the year ended 31 December 2004.
General insurance premium income, after reinsurance, rose by 5%, or £256 million to £5,779 million reflecting volume growth in motor and home insurance products.
2005 compared with pro forma 2004 Operating expenses, excluding purchased intangibles amortisation and integration costs, rose by 14% to £11,298 million to support the strong growth in business volumes. Excluding acquisitions and at constant exchange rates, operating expenses were up by 10%, £962 million.
NatWest integration was fully amortised by the end of 2005. The balance of integration costs principally relates to the integration of Churchill, First Active and Citizens’ acquisitions, including Charter One which was acquired in August 2004.
Expected tax charge 2,381 2,185 1,963 Interest on subordinated debt not allowable for tax 79 — 83 Non-deductible items 230 110 110 Non-taxable items (166) (128) (128) Taxable foreign exchange movements (10) (10) (10) Foreign profits taxed at other rates 77 49 49 Unutilised losses – brought forward and carried forward (5) 6 6 Adjustments in respect of prior periods (208) (217) (217) Actual tax charge 2,378 1,995 1,856 2005 compared with 2004 Impairment losses were £1,707 million compared with £1,485 million in 2004 with higher provisions in Retail Markets partly offset by improvements in Corporate Markets. The effect of implementing the requirements of IAS 39 in 2004 would have been to increase loan impairment losses by £105 million for the year ended 31 December 2004.
2005 compared with pro forma 2004 New impairment losses were up 8%, £145 million to £1,879 million. Recoveries of amounts previously written off were up £28 million, 19% to £172 million. Consequently the net charge to the income statement was up £117 million, 7% to £1,707 million. Improvements in Corporate Markets partly offset higher impairment losses in Retail Markets.
Loan impairment losses were up from £1,507 million in 2004 to £1,703 million. Other impairment losses were £4 million compared with £83 million in 2004.
Total balance sheet provisions for impairment amounted to £3,887 million compared with £4,145 million at 1 January 2005. Total provision coverage (the ratio of total balance sheet provisions for impairment to total risk elements in lending) decreased from 70% to 65%.
Retail Banking 3,009 2,992 Retail Direct 790 748 Wealth Management 408 324
Net interest income 2,960 2,764 Non-interest income 5,855 4,758 Total income 8,815 7,522 Direct expenses
Total assets* 409.2 359.4 Loans and advances to customers – gross*
RBS remains the number 1 corporate bank in the UK and we have significantly expanded our franchise in Europe and North America, where we are also focussing on the opportunities for increased co-operation between Corporate Markets and Citizens. In Asia, our profile has benefited from the announcement of the Group’s strategic partnership with Bank of China.
The ratio of income, after deducting operating lease depreciation, to average weighted risk assets for 2005 was broadly stable at 4.1%, while the ratio of contribution to average weighted risk assets improved slightly.
Net interest income 1,760 1,607 Non-interest income 1,257 1,171 Total income 3,017 2,778 Direct expenses
Contribution before impairment losses 2,021 1,844 Impairment losses 218 277 31 December 1 January £bn £bn
Corporate Markets generated good results in the Mid-Corporate & Commercial customer segment in 2005, building on the strength of its UK franchise. We maintained our market-leading positions in corporate and commercial banking, asset finance and invoice finance. Total income rose by 9% to £3,017 million, whilst contribution rose by 15% to £1,803 million.
Non-interest income rose by 7% to £1,257 million, reflecting our success in cross-selling our full range of products and services to customers. Our business has benefited from the co-location of our Lombard and Invoice Finance managers with our corporate and commercial banking operations.
Impairment losses were 21% lower than in 2004 at £218 million, reflecting a further improvement in our strong credit metrics.
Net interest income excluding funding cost of rental assets 1,652 1,527 Funding cost of rental assets (452) (370) Net interest income 1,200 1,157 Fees and commissions receivable 1,060 871 Fees and commissions payable (252) (219) Income from trading activities 1,964 1,681 Income on rental assets 1,074 924 Other operating income 752 330 Non-interest income 4,598 3,587 Total income 5,798 4,744 Direct expenses
Rental assets 11.9 10.3 Customer deposits* 51.1 49.0 Weighted risk assets 128.4 112.8 * excluding repos and reverse repos
Total income, after deducting operating lease depreciation, rose by 23% to £5,400 million, with contribution up 30% to £3,421 million, benefiting from cost discipline and continuing benign credit conditions. Underlying income per full time equivalent employee has grown from £646,000 in 2004 to
Debt underwriting volumes remained strong throughout the course of the year, reflecting our involvement in many of the largest financings in the UK and Europe for both large corporates and private equity sponsors. We were the fourth most active bank worldwide in arranging and underwriting bank lending in 2005. A strong distribution performance brought weighted risk assets to £128.4 billion at year-end, up 14% over the year and back to a more consistent trend level than the amount at mid-year.
Our continuing success in aircraft, train, ship and hotel leasing delivered good growth in net income from rental assets. Other operating income grew strongly, with our structured finance investment portfolio producing good realised gains, notably in the second half of the year.
Customer deposits 105.9 97.0 Investment management assets – excluding deposits 31.4 26.6 Weighted risk assets 80.6 76.5
Total income increased by 7% to £8,213 million and contribution by 4% to £4,207 million, with good discipline on costs helping to offset increased impairment losses on unsecured lending.
Net interest income 3,175 3,173 Non-interest income 2,258 1,999 Total income 5,433 5,172 Direct expenses
Retail Banking produced a stronger performance in the second half, when it achieved year-on-year income growth of 7%, compared with 3% in the first half. Total income for 2005 rose by 5% to £5,433 million and contribution by 1% to £3,009 million. Contribution before impairment losses increased by 4% to £3,610 million.
Against the backdrop of a slower rate of growth in consumer borrowing, we have delivered robust growth in average loans and advances, which increased by 11%. Average mortgage lending grew by 12% to £46.1 billion, with particularly good growth in higher margin products such as the offset mortgage. Average unsecured personal lending, where we took further steps to enhance our focus on high quality new business, was up 10% to £13.3 billion. Average customer deposits grew by 6% to £70.9 billion, with particularly good inflows into savings products.
Contribution before impairment losses 1,361 1,158 Impairment losses 571 410 31 December 1 January £bn £bn
Total assets 27.2 23.0 Loans and advances to customers – gross
Total income rose by 11% to £1,966 million and contribution by 6% to £790 million, a strong performance in the context of slower growth in demand for unsecured credit and higher levels of consumer arrears. This performance reflected disciplined pricing, tight cost control and stringent credit assessment. Contribution before impairment losses increased by 18% to £1,361 million.
Net interest income increased by 13% to £882 million, reflecting the success of the First Active brand in the UK mortgage market and the maturing of the MINT portfolio. MINT, launched in December 2003, made a contribution of £37 million in 2005.
Average loans and advances rose by 15% to £24.9 billion with the fastest growth coming in mortgages, up 34% at £11.9 billion. Personal loan growth slowed, reflecting strategic decisions taken over the last 18 months to reposition pricing and tighten lending criteria for personal loans sold directly.
Net interest margin was only slightly lower than in 2004, as wider margins on our cards portfolio balanced the effects of the increasing weight of mortgage assets in our loan book.
Non-interest income was up 9% to £1,084 million, benefiting from higher volumes in both domestic and international card acquiring, strong sales through Tesco Personal Finance, the introduction of balance transfer fees and good growth in Europe.
Expenses decreased by 2% to £605 million, with stringent cost control across all activities, including reduced marketing costs on personal loans. This was consistent with our more cautious approach to direct lending and with our successful focus on branch recruitment.
Net interest income 442 410 Non-interest income 372 328 Total income 814 738 Expenses
Contribution before impairment losses 421 340 Impairment losses 13 16 31 December 1 January £bn £bn
Non-interest income increased by 13% to £372 million, driven by investment fees, with average assets under management up 9% to £23.1 billion as a result of good new business volumes in Coutts UK and the rise in equity markets. Assets under management at the year end were £25.4 billion, an increase of 18%.
Expenses decreased by 1% to £393 million, reflecting a continued focus on efficiency. Despite continued investment in growth markets in both the UK and overseas, staff costs were 2% lower than in 2004 which was affected by a number of one-off costs. Other costs also decreased slightly.
O p er at in g a nd f in an ci al r ev ie w
Net interest income 655 559 Non-interest income 203 190 Total income 858 749 Expenses
Contribution before impairment losses 588 505 Impairment losses 58 45 31 December 1 January £bn £bn
Total assets 35.9 28.7 Loans and advances to customers – gross
Total income increased by 15% to £858 million, with contribution also up 15% to £530 million, as Ulster Bank achieved another year of strong growth, with excellent customer recruitment, robust lending volumes and very good growth in deposits. First Active continues to perform well and in line with our integration plan. It led the Republic of Ireland market with the introduction of new mortgage products, as well as launching new credit card and direct loan products.
Non-interest income increased by £13 million or 7% to £203 million. This reflected increased volumes of customer transactions and good growth in income from financial markets services.
Expenses increased by 11% to £270 million, as a result of investment to support the growth of the business. This investment will continue into 2006. We have continued with our branch improvement programme, upgrading 50 branches in the Republic of Ireland and 39 in Northern Ireland.
Net interest income 2,122 1,619 Non-interest income 1,142 659 Total income 3,264 2,278 Expenses
Citizens performed well in 2005, delivering a strong underlying performance in challenging market conditions both from the old Citizens franchise and from Charter One. Total income, in US dollars, rose by 42% to $5,940 million and contribution by 46% to $2,867 million, including a full year’s contribution from Charter One. Excluding Charter One and other acquisitions, income rose by 6% and contribution by 10%, despite the impact of the flattening of the yield curve, which reduced net interest margin and the rate of growth in net interest income.
Our cards businesses, which are only active in the prime and superprime segments, have made good progress. Credit card balances increased by 19% to $2.5 billion, as RBS National launched into a number of new channels such as Charter One branches. RBS Lynk, our merchant acquiring business, increased its customer base by 24%.
The integration of Charter One progressed well and all phases of the IT conversion were completed in July 2005, five months ahead of schedule. This involved the conversion to Citizens’
Net interest income increased by 30% to $3,861 million. This reflected strong growth in both lending and deposits. Excluding acquisitions, average lending increased by 13% or $6.7 billion, with robust growth in secured consumer lending, and average customer deposits by 9% or $5.7 billion. However, as a consequence of the flattening yield curve, net interest income excluding acquisitions was only 3% higher at $2,534 million.
– Motor: UK 8,687 8,338 – Motor: Continental Europe 1,862 1,639 – Non-motor (including home, rescue, pet, HR24): UK 10,898 10,464
Total home insurance policies declined by 1%. Within this total, we continued to expand through our direct brands but there was attrition of some partner-branded books.
Expenses rose by 13%. Excluding the impact of a change in reinsurance arrangements, total income rose by 5% and expenses by 4%. Net insurance claims on the same basis were up by 5%, reflecting increased volumes, claims inflation in motor and an increase in home claims following severe storms in the UK in January 2005.
The UK combined operating ratio for 2005 was 93.6% (2004 – 93.3%).
Staff costs 740 753 Other costs 2,003 1,799 Total manufacturing costs 2,743 2,552
Manufacturing’s costs increased by 7% to £2,743 million. Excluding software amortisation, costs rose by 4%. Costs relating to internal software development, which under UK GAAP were written off as incurred, are now under IFRS capitalised and amortised.
Group Technology costs increased by 11% to £945 million. Excluding software amortisation, costs were up 2%, with support for increased business volumes offset by efficiency improvements. The Group Efficiency Programme was substantially completed during the year, with major implementations such as a new system for handling customer queries and a new customer account-opening platform. The Churchill systems integration was completed in September 2005.
Customer Support and other operations costs rose by just 2%, despite a much greater increase in the business volumes supported. Cash withdrawals from ATMs, for example, rose by 13%, while we handled 10% more mortgage applications and 7% more personal loan volumes. These increases were absorbed by improved efficiency through the delivery of new systems and ways of working.
Group total 137,000 136,600 2005 compared with 2004 The number of employees increased by 400 to 137,000, with increases in Retail Banking, Citizens and Ulster Bank partly offset by a reduction in Corporate Markets.
Funding costs 810 615 Departmental and corporate costs 658 395 Total Central items 1,468 1,010
Derivatives at fair value 95,663 89,905 17,800 Prepayments, accrued income and other assets 8,798 8,855 11,612
Reverse repurchase agreements and stock borrowing Loans and advances to banks 41,804 34,475 29,975 Loans and advances to customers 48,887 64,599 52,184
Overview of consolidated balance sheet To provide a more meaningful comparison, the commentary below compares the balance sheet at 31 December 2005 with the opening balance sheet at 1 January 2005, which includes the effect of applying IAS 32, IAS 39 and IFRS 4 from that date.
Treasury bills and other eligible bills decreased by £0.6 billion, 9%, to £5.5 billion, reflecting trading activity.
Loans and advances to banks increased £4.9 billion, 7%, to £70.6 billion. Growth in reverse repurchase agreements and stock borrowing (“reverse repos”) up £7.3 billion, 21%, to £41.8 billion, were partially offset by a reduction in bank placings, down £2.4 billion, 8% to £28.8 billion.
Intangible assets increased by £0.7 billion, 4% to £19.9 billion largely due to exchange rate movements.
Property, plant and equipment were up £1.6 billion, 10% to £18.1 billion, primarily reflecting growth in operating lease assets.
Derivatives at fair value, assets and liabilities, have increased reflecting growth in trading volumes and the effects of interest and exchange rates.
Deposits by banks rose by £4.4 billion, 4% to £110.4 billion to fund business growth mainly through increased inter-bank deposits, up £4.3 billion, 7% to £62.5 billion. Repurchase agreements and stock lending (“repos”) were broadly flat at £47.9 billion.
Debt securities in issue increased by £24.2 billion, 36%, to £90.4 billion primarily to meet the Group’s funding requirements.
The increase in settlement balances and short positions, up £10.6 billion, 32%, to £44.0 billion, reflected growth in customer activity.
Equity minority interests increased by £1.2 billion to £2.1 billion reflecting the co-investors interest in the Group’s subsidiary that invested in Bank of China and the issuance of preferred securities.
Net cash flows from operating activities 8,950 2,493 Net cash flows from investing activities (2,612) (9,398) Net cash flows from financing activities (703) 7,119 Effects of exchange rate changes on cash and cash equivalents (3,107) 1,686 Net increase in cash and cash equivalents 2,528 1,900
The major factors contributing to the net cash inflow of £8,950 million from operating activities in 2005 were the profit before tax of £7,936 million, increases in deposits and debt securities in issue of £56,571 million, and increases in short positions and settlement balances of £10,326 million, partially offset by increases in securities of £28,842 million and increases in loans and advances of £36,778 million.
Net purchases of fixed assets of £2,592 million, including operating lease assets and computer and other equipment, were the main contributors to the net cash outflow from investing activities of £2,612 million.
The major factors contributing to the net cash inflow of £2,493 million from operating activities in 2004 were the profit before tax of £7,284 million, increases in deposits and debt securities in issue of £72,146 million, and increases in short positions and settlement balances of £8,796, partially offset by increases in securities of £11,883 million and increase in loans and advances of £72,955 million.
The issue of £1,358 million preference shares and £2,845 million ordinary shares, and £4,624 million subordinated liabilities, partly offset by the payment of £1,635 million of dividends, were the main contributors to the net cash inflow from financing activities of £7,119 million.
The net income available for ordinary shareholders under US GAAP was £4,475 million; £917 million lower than profit attributable to ordinary shareholders under IFRS of £5,392 million. The principal reasons for the decrease are: • a reduction of £556 million relating to financial instruments principally foreign exchange gains on available-for-sale securities recognised in net income under IFRS but included directly in equity under US GAAP together with the adjustment for financial assets and liabilities designated as at fair value through profit or loss; US GAAP does not permit such designation.
US GAAP shareholders’ equity at £40,229 million is £4,794 million higher than IFRS equity of £35,435 million principally due to the inclusion of certain preference shares, classified as debt under IFRS, in US GAAP equity; the reinstatement of goodwill deducted from equity under previous GAAP; and the effect of deferring and amortising loan origination costs.
• Group Asset and Liability Management Committee (“GALCO”), is an executive committee which is responsible for reviewing the balance sheet, funding, liquidity, structural foreign exchange, intra-group limits, capital adequacy and capital raising across the Group as well as interest rate risk in the banking book. In addition, GALCO monitors and reviews external, economic and environmental changes affecting such risks.
Risk appetite Risk management across the Group is based on the risk appetite and philosophy set by the Board and the associated risk committees. The Board establishes the parameters for risk appetite for the Group through: • Setting strategic direction.
• Contributing to, and ultimately approving annual plans for each division.
O pe ra tin g an d fin an ci al r ev ie w
Credit risk Key principles of credit risk management The objective of credit risk management is to enable the Group to achieve sustainable and superior risk versus reward performance whilst maintaining credit risk exposure in line with approved risk appetite.
• Credit risk authority must be specifically granted in writing to all individuals involved in the granting of credit approval, whether this is exercised personally or collectively as part of a credit committee. In exercising credit authority, the individuals must act independently and with balanced commercial judgement.
• Where credit authority is exercised personally, the individual must not have any responsibility or accountability for business revenue generation.
• Customers with emerging credit problems must be identified early and classified accordingly. Remedial actions must be implemented promptly to minimise the potential loss to the Group.
• Obtaining approval from GRM for any new methodology or parameter estimates used in existing credit risk models prior to implementation.
Credit risk models used by the Group can be broadly grouped into four categories.
• Exposure at default (“EAD”) – these models estimate the expected level of utilisation of a credit facility at the time of a borrower’s default. The EAD will typically be higher than the current utilisation (e.g. in the case where further drawings are made on a revolving credit facility prior to default) but will not typically exceed the total facility limit. The methodologies used in EAD modelling recognise that customers may make more use of their existing credit facilities in the run up to a default.
• Loss given default (“LGD”) – these models estimate the economic loss that may be suffered by the Group on a credit facility in the event of default. The LGD of a facility represents the amount of debt which cannot be recovered and is typically expressed as a percentage of the EAD. The Group’s LGD models take into account the type of borrower, facility and any risk mitigation such as the presence of any security or collateral held. The LGD may also be affected by the industry sector of the borrower, the legal jurisdiction in which the borrower operates as well as general economic conditions which may impact the value of any assets held as security.
Credit risk assets are typically analysed excluding reverse repurchase agreements due to the short-term nature and low credit risk associated with this product. A breakdown of credit risk assets by division is shown below.
Credit risk asset quality Internal reporting and oversight of risk assets is principally differentiated by credit ratings. Internal ratings are used to assess the credit quality of borrowers. Customers are assigned credit ratings, based on various credit grading models that reflect the probability of default. All credit ratings across the Group map to a Group level asset quality scale.
Corporate Markets 273.0 235.2 Retail Banking 78.0 72.2 Retail Direct 26.6 21.7 Wealth Management 8.9 10.7
Note: Graph data are shown net of provisions and reverse repurchase agreements.
Distribution of credit risk assets by geography The Group is currently active in 27 countries, with its principal focus on the UK, North America and Europe.
REIL and PPL as % of lending to customers loans and advances – gross(5) 1.60% 1.84% 1.92%
* following the implementation of IAS 39, the sub-categories of REIL and PPL are calculated as per notes 1 to 4 below.
REIL as at 31 December 2005 was £5,937 million (1 January 2005 – £5,888 million), an increase of £49 million (1%) during the year. As a % of customer lending, REIL and PPL in aggregate show an improving trend, amounting to 1.60% of customer loans and
During 2005 REIL in Corporate Markets reduced by £633 million reflecting continued favourable conditions in the corporate environment in UK, Europe and the US. This was offset by a combined increase in REIL in Retail Banking and Retail Direct of £680 million (21%) due to the weakening of the consumer environment in the UK.
The adoption of IAS 39 under IFRS at the start of 2005 resulted in changes to the methodology used to identify impaired assets and therefore the way that REIL is calculated. Comparative financial information is given in the following tables for both 1 January 2005 and 31 December 2004. Commentary is based on comparison with information at 1 January 2005, which reflects the impact of IAS 32, IAS 39 and IFRS 4.
Latent loss provisions are provisions held against the estimated impairment in the performing portfolio which have yet to be identified as at the balance sheet date. To assess the latent loss within the 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.
Corporate portfolios consist of higher value, lower volume credits, which tend to be structured to meet individual customer requirements. Provisions are assessed on a case by case basis by experienced specialists, as well as professional valuations of collateral and the expert judgement of accountants. The Group operates a clear provisions governance framework which sets thresholds whereby suitable oversight and challenge is undertaken. These opinions and levels of provision are overseen by the division’s Provision Committee chaired by its Chief Executive, with representation from Group Risk Management. In addition, significant cases are presented to, and challenged by, the Group Problem Exposure Review Forum chaired by the Group Chief Executive or the Group Finance Director.
Charge as a % of customer loans and advances – gross(1) 0.46% 0.47% 0.47%
Balance as at 1 January 2005 4,145 Currency and other adjustments 51 Amounts written-off (2,040) Recoveries of amounts previously written-off 172 Charge to income statement 1,703 Discount unwind(1) (144) Balance as at 31 December 2005(2) 3,887
(2) Includes provisions against loans and advances to banks of £3 million (1 January 2005 – £5 million).
As at 31 December 2005 total customer provisions were £3,884 million, down £256 million (6%) from 1 January 2005. The movement in provisions balance is shown at the bottom of the page.
The coverage ratio of closing provisions to REIL and PPL decreased from 70% to 65% during 2005. The lower coverage ratio reflects a change of mix in the portfolios to more secured assets (e.g. residential mortgages) which, due to the level of collateral held, require a much lower level of provision.
Latent loss provisions 543 570 Collectively assessed provisions 2,587 2,484 Individually assessed provisions 754 1,086 Specific provisions 3,607 General provision 561
Total provision as a % of customer loans and advances – gross(2) 1.0% 1.3% 1.4%
Liquidity risk Liquidity risk management within the Group focuses on both overall balance sheet structure and the day-to-day control, within prudent limits, of risk arising from the mismatch of maturities across the balance sheet and from undrawn commitments and other contingent obligations.
Diversification of funding sources The structure of the Group’s balance sheet is managed to maintain substantial diversification, to minimise concentration across its various deposit sources, and to contain the level of reliance on total and net short-term wholesale sources of funds within prudent levels. As part of the Group’s planning process, the forecast structure of the balance sheet is regularly reviewed over the plan horizon and funding strategies and options are developed by Group Treasury and implemented after review and approval by GALCO.
Customer accounts (excluding repos), term debt securities of over 1 year remaining maturity, subordinated liabilities and capital continue to represent the core of the Group’s funding. These core funds in total increased by £74,732 million (24%) over the course of 2005 to represent 59% of total funding excluding other liabilities at 31 December 2005.
Customer accounts continue to provide a substantial proportion of the Group’s funding and comprise a well diversified and stable source of funds from a wide range of retail, corporate and non-bank institutional customers. Excluding repo agreements, customer accounts grew by £52,932 million (22%), to maintain 46% of total funding excluding other liabilities at 31 December 2005.
Term debt securities with an outstanding term of over 1 year increased £12,362 million (124%) to represent 3% of the Group’s funding at 31 December 2005, reflecting the activity of the Group in raising term funds through its Euro and US Medium Term Note and securitisation programmes.
Short term wholesale deposits are taken from a wide range of counterparties, with the largest single depositor continuing to represent less than 1% of the Group’s total funding. The level of funding from short term unsecured debt issuance and bank deposits, excluding repos and short positions, has increased by £20,020 million (18%) to represent 20% of total funding excluding other liabilities at 31 December 2005, reflecting the higher rate of growth in customer loans and advances (see ‘net customer activity’ below).
Short positions and repos with corporate, institutional customers and banks are undertaken primarily by RBS
Loans and advances to customers (gross, excluding reverse repos) 372,223 299,235 Customer accounts (excluding repos) 294,113 241,181 Customer lending less customer accounts 78,110 58,054
Management of term structure The degree of maturity mismatch within the overall long-term structure of the Group’s assets and liabilities is also managed within internal policy limits, to ensure that term asset commitments may be funded on an economic basis over their life. In managing its overall term structure, the Group analyses and takes into account the effect of retail and corporate customer behaviour on actual asset and liability maturities where they differ materially from the underlying contractual maturities.
As part of its stress testing of its access to sufficient liquidity, the Group regularly evaluates the potential impact of a range of levels of downgrade in its credit ratings and carries out stress tests of other relevant scenarios and sensitivity analyses.
Daily risk management The primary focus of the Group’s day to day risk management activity is to ensure access to sufficient liquidity to meet its cashflow obligations within key time horizons out to one month ahead. The short-term maturity structure of the Group’s liabilities and assets is managed on a daily basis to ensure that all material cashflow obligations, and potential cashflows arising from undrawn commitments and other contingent obligations, can be met as they arise from day to day, either from cash inflows, from maturing assets, new borrowing or the sale or repurchase of various debt securities held (after allowing for appropriate haircuts).
By remaining maturity up to 1 month: Deposits by banks (excluding repos) 35,153 34,041 Less: loans and advances to banks (gross, excluding reverse repos) (16,381) (17,067) Debt securities in issue 20,577 15,505 Net wholesale liabilities due within 1 month 39,349 32,479
Net surplus of marketable assets over wholesale liabilities due within 1 month 28,457 25,418
In measuring its non-sterling liquidity risk, due account is taken of the marketability within a short period of the wide range of debt securities held. Appropriate adjustments are applied in each case, dependent on various parameters, to determine the Group’s ability to realise cash at short notice via the sale or repo of such marketable assets if required to meet unexpected outflows.
The Group also provides liquidity back-up facilities to both its own conduits and certain other conduits which take funding from the US$ commercial paper market. Limits sanctioned for such facilities totalled less than £11 billion at 31 December 2005. The short-term contingent liquidity risk in providing such back-up facilities is also mitigated by the spread of maturity dates of the commercial paper taken by the conduits.
Following earlier consultation, the FSA also introduced in January 2005, new requirements for liquidity management systems and controls, particularly in respect of stress testing, contingency funding plans and related documentation. The Group has complied with these requirements and will continue to do so going forward.
Value-at-risk VaR is a technique that produces estimates of the potential negative change in the market value of a portfolio over a specified time horizon at given confidence levels. For internal risk management purposes, the Group’s VaR assumes a time horizon of one day and a confidence level of 95%. The Group uses historical simulation models in computing VaR. This approach, in common with many other VaR models, assumes that risk factor changes observed in the past are a good estimate of those likely to occur in the future and is, therefore, limited by the relevance of the historical data used. The Group’s method, however, does not make any assumption about the nature or type of underlying loss distribution. The Group typically uses the previous two years of market data. The Group’s VaR should be interpreted in light of the limitations of the methodology used. These limitations include: • Historical data may not provide the best estimate of the joint distribution of risk factor changes in the future and may fail to capture the risk of possible extreme adverse market movements which have not occurred in the historical window used in the calculations.
Treasury The Group’s treasury activities include its money market business and the management of internal funds flow within the Group’s businesses. Money market portfolios include cash instruments (principally debt securities, loans and deposits) and related hedging derivatives. VaR for the Group’s treasury portfolios, which relates mainly to interest rate risk including credit spreads, was £3.5 million at 31 December 2005 (2004 – £5.7 million). During the year the maximum VaR was £5.8 million (2004 – £9.3 million), the minimum £2.8 million (2004 – £5.7 million) and the average £4.0 million (2004 – £7.3 million).
Non-trading interest rate VaR Non-trading interest rate VaR for the Group’s treasury and retail and corporate banking activities was £81.5 million at 31 December 2005 (2004 – £72.4 million) with the major exposure being to changes in longer term US dollar interest rates. During the year, the maximum VaR was £104.2 million (2004 – £89.7 million), the minimum £10.8 million (2004 – £51.5 million) and the average £65.5 million (2004 – £71.2 million).
• economic value of equity (“EVE”) sensitivity to a series of parallel movements in interest rates.
Note 34 on the accounts includes, on pages 195 and 196, tables that summarise the Group’s interest rate sensitivity gap for its non-trading book at 31 December 2005 and 31 December 2004. The tables show the contractual re-pricing for each category of asset, liability and for off-balance sheet items and do not reflect the behaviouralised repricing used in the Group’s asset and liability management methodology and the nontrading interest rate VaR presented above.
The tables below set out the Group’s structural foreign currency exposures. Foreign currency Structural Net investments borrowings foreign in foreign hedging net currency operations investments exposures
An insurance contract transfers risk from the policyholder to the insurer, whereby, in return for a premium paid, the insurer indemnifies the policyholder on the occurrence of specified events.
• Other forms of reinsurance may be utilised according to need, subject to approval by senior management or the board as appropriate.
Reinsurance is only effective when the counterparty is financially secure. Before entering a contract with a new reinsurer, it must satisfy the Credit Risk Approval process that uses information derived internally and from security ratings agencies. Acceptable reinsurers are rated at A- or better unless specifically authorised by the RBS Insurance Group Board.
Reserving risk Reserving risk relates to both premiums and claims. It is the risk that reserves are assessed incorrectly such that insufficient funds have been retained to pay or handle claims as the amounts fall due, both in relation to those claims which have already occurred (in relation to the claims reserves, including claims handling expense reserves) or will occur in future periods of insurance (in relation to the premium reserves).
a) Premium reserves In respect of premium reserves, it is the Group’s policy to ensure that the net unearned premium reserves and deferred acquisition costs are adequate to meet the expected cost of claims and associated expenses in relation to the exposure after the balance sheet date. To the extent that the unearned premium reserves and deferred acquisition costs are inadequate, a liability adequacy provision will be held which will initially write down any deferred acquisition asset held. Once any deferred acquisition asset has been exhausted, an additional liability adequacy provision will be established.
b) Claims reserves It is the Group’s policy to hold undiscounted claims reserves (including reserves to cover claims which have occurred but not been reported (IBNR reserves)) for all classes at a sufficient level to meet all liabilities as they fall due, having regard to actuarial estimates and the volatility observed and expected in the claims in each class.
The Group’s policy is to hold provisions for the major classes of business in excess of the actuarial best estimate. The percentage margin in excess of this estimate is assessed by senior management, with particular reference to the volatility observed and expected in the claims in each class.
Frequency and severity of specific risks and sources of uncertainty Most general insurance contracts written by the Group are issued on an annual basis, which means that the Group’s liability extends for a 12 month period, after which the Group is entitled to decline or renew or can impose renewal terms by amending the premium or excess or both.
The major source of uncertainty in the Group’s property accounts is the volatility of weather. Weather in the UK can affect most of the above perils. Over a longer period, the strength of the economy is also a factor. There are many other sources of uncertainty which include operational, reserving and reinsurance issues.
d) Creditor insurance Creditor insurance contracts are designed to cover payments on secured or unsecured lending. These contracts are for a maximum term of 5 years. The causes of creditor insurance claims are loss of income through accident, sickness or unemployment or, in some circumstances, loss of life.
• Environment – risks arising due to demographic, macroeconomic, technical, cultural or environmental change.
Enterprise risk also includes the potential or actual impact on corporate reputation arising from any of the Group’s activities.
Enterprise risk management is achieved through monitoring the Group’s exposure to direct or indirect loss using a range of policies, procedures, data, analytical tools and reporting techniques. In particular, Group-wide risk management processes ensure that enterprise risk issues are quickly escalated and resolved, that the risks inherent in new products are fully evaluated, and that emerging external risks are actively monitored.
Contents 108 Board of directors and secretary 110 Report of the directors 115 Corporate governance 121 Directors’ remuneration report 130 Directors’ interests in shares 131 Statement of directors’ responsibilities
Deputy Chairman and Chairman-designate Sir Tom McKillop* (age 62) C, N Appointed to the Board as Deputy Chairman in September 2005, Sir Tom is a non-executive director of BP p.l.c., and was formerly chief executive of AstraZeneca plc. He was formely president of the European Federation of Pharmaceutical Industries and Associations and chairman of the British Pharma Group. He is Pro-Chancellor of the University of Leicester and a trustee of the Council for Industry and Higher Education.
Lawrence Fish (age 61) Chairman and Chief Executive Officer of Citizens Financial Group, Inc.
Appointed to the Board in January 1993, Lawrence Fish is an American national. He is a career banker and was a director of the Federal Reserve Bank of Boston. He is a trustee of The Brookings Institution and a director of the Financial Services Roundtable, Textron Inc., and numerous community organisations in the USA.
Jim Currie* (age 64) D.Litt R Appointed to the Board in November 2001, Jim Currie is a highly experienced senior international civil servant who spent many years working in Brussels and Washington. He was formerly director general at the European Commission with responsibility for the EU’s environmental policy and director general for Customs and Excise and Indirect Taxation. He is also a director of Total Holdings UK Limited, an international advisor to Eversheds and a consultant to Butera & Andrews UK Limited.
Bob Scott* (age 64) CBE, FCIBS C, N, R (Chairman) Appointed to the Board in January 2001, Bob Scott is an Australian national. He is the senior independent director. He has many years experience in the international insurance business and played a leading role in the consolidation of the UK insurance industry. He is a former group chief executive of CGNU plc and chairman of the board of the Association of British Insurers. He is chairman of Yell Group plc and a nonexecutive director of Swiss Reinsurance Company (Zurich), Jardine Lloyd Thompson Group plc and Focus DIY Group Limited. He is also a trustee of the Crimestoppers Trust and an adviser to Duke Street Capital.
Peter Sutherland* (age 59) KCMG C, N Appointed to the Board in January 2001, Peter Sutherland is an Irish national. He is a former attorney general of Ireland and from 1985 to 1989 was the European Commissioner responsible for competition policy. He is chairman of BP p.l.c. and Goldman Sachs International and honorary president and member of the Advisory Council for the European Movement – Ireland. He was formerly chairman of Allied Irish Bank and a director general of GATT and the World Trade Organisation.
Group Secretary and General Counsel Miller McLean (age 56) FCIBS C Miller McLean was appointed Group Secretary in August 1994. He is a trustee of the Industry and Parliament Trust, a non-executive chairman of The Whitehall and Industry Group and a director of The Scottish Parliament and Business Exchange.
Profit and dividends The profit attributable to the ordinary shareholders of the company for the year ended 31 December 2005 amounted to £5,392 million compared with £4,856 million for the year ended 31 December 2004, as set out in the consolidated income statement on page 145.
An interim dividend of 19.4p per ordinary share was paid on 7 October 2005 totalling £619 million (2004 – £529 million). The directors now recommend that a final dividend of 53.1p per ordinary share totalling £1,700 million (2004 – £1,308 million) be paid on 9 June 2006 to members on the register at the close of business on 10 March 2006. Subject to approval of the dividend at the Annual General Meeting, shareholders will be offered the opportunity to participate in a dividend reinvestment plan, which will replace the current scrip dividend scheme.
Directors The names and brief biographical details of the directors are shown on page 109. All directors, except: • Sir Angus Grossart, Lord Vallance and Iain Robertson, who retired from the Board on 20 April 2005, and Eileen Mackay, who retired from the Board on 31 December 2005,
• Fred Watt, who resigned from the Board on 31 January 2006, served throughout the year and to the date of signing of the financial statements.
Sir Tom McKillop, Colin Buchan, Janis Kong, Bob Scott, Peter Sutherland and Guy Whittaker will retire and offer themselves for election or re-election at the company’s Annual General Meeting. Bill Friedrich, Johnny Cameron and Mark Fisher have been appointed as directors with effect from 1 March 2006 and will also offer themselves for election at the company’s Annual General Meeting.
Sir George Mathewson will retire as Chairman of the Board with effect from the conclusion of the Annual General Meeting on 28 April 2006. The Group has secured his continued employment to serve in an advisory role to the Group. Sir Tom McKillop will succeed Sir George as Chairman.
Employee proposition The Group recognises that staff performance is central to the successful delivery of its overall business strategy. Accordingly, the Group focuses on maintaining an employee proposition that attracts, engages and retains the best available talent.
Shareholdings As at 27 February 2006, the company had been notified of the following interests in its shares, in accordance with section 198 of the Companies Act 1985: Number of shares % held Number of shares % held
Group-wide co-ordination and access to recruitment and interview skills training ensures recruitment complies with internal and regulatory requirements. In addition, the Group continues to ensure all appointees are appropriately referenced and screened prior to joining the organisation.
Employee reward The Group acknowledges that its continuing success is closely linked to the performance, skills and individual commitment of its employees. Significant focus is therefore given to offering an exceptional reward proposition to all RBS Group employees in order to attract, motivate and retain the best available talent at every level.
In 2005, employee costs of £5,992 million, including National Insurance and pension costs of £864 million, made up over a third of total expenditure.
RBSelect, the Group’s benefits choice programme, forms part of the Total Reward package. It provides for UK staff in the Group a flexible way of tailoring their reward to reflect their own individual lifestyle needs. Options range from subsidised childcare vouchers and discounted personal insurance products to environmentally friendly bicycle purchases.
To enable employees to get the most from Total Reward, a wide range of information about reward and benefits has been introduced through RBSpeople.com, an internet site offering 24 hour access from home or work.
The Group continues to offer membership of its final pension scheme, with the entire cost being met by the Group. The largest scheme is the Royal Bank of Scotland Group Pension Fund, with 80,000 employee members in the UK.
Employee communication Employee engagement is encouraged through a variety of means including a corporate intranet, Group and divisional magazines, team meetings led by line managers, briefings held by senior managers and regular dialogue with employees and employee representatives.
During 2005, the high quality of the Group’s internal communications was reflected by success in a number of prestigious external awards schemes. Awards were attained at both Group and divisional level and included a Gold Award for hub magazine, the Manufacturing division’s internal publication, at the UK Communicators in Business Awards, and a Gold Award for the Group Communications team in the Regular Communications category at the International Visual Communication Association Awards
The survey results are presented at Board, divisional and team levels. Action plans are developed to address any issues identified. With continuing year-on-year improvement, strong divisional results and improvements in all leading indicators, it is believed that results are sustainable, particularly given the Group’s focus on continuous improvement.
The success of this approach culminated in the Group receiving a Gold Standard Award in the Race for Opportunity Benchmarking Survey, having previously attained a Bronze in 2004. The Group maintains its involvement in and support of the UK Employers’ Forum on Age, Employers’ Forum on Disability, Employers’ Forum on Belief, Stonewall and of the Government’s Age Positive campaign.
Health, safety, wellbeing and security The health, safety, wellbeing and security of RBS staff and customers continue to be a priority for the Group. Regular reviews are undertaken of both policies and processes to ensure compliance with current legislation and best practice. The Group focus is on ensuring that these policies are closely linked to the operational needs of the business.
Charitable contributions In 2005 the contribution to the Group’s Community Investment programmes increased to £56.2 million (2004 – £45.8 million). The total amount given for charitable purposes by the company and its subsidiary undertakings during the year ended 31 December 2005 was £24.3 million (2004 – £20.1 million).
At the Annual General Meeting in 2002, shareholders gave authority for the company and certain of its subsidiaries to make political donations and incur political expenditure up to a maximum aggregate sum of £675,000 as a precautionary measure in light of the wide definitions in The Political Parties, Elections and Referendums Act 2000, for a period of four years. These authorities have not been used and it is not proposed that the Group’s longstanding policy of not making contributions to any political party be changed. A resolution to renew a general Group authority will be proposed at the Annual General Meeting on 28 April 2006.
Directors' indemnities In terms of section 309C of The Companies Act 1985 (as amended), the directors of the company, members of the Group Executive Management Committee and Approved Persons of the Group (under the Financial Services and Markets Act 2000) have been granted Qualifying Third Party Indemnity Provisions by the company.
Throughout the year ended 31 December 2005, the company has complied with all of the provisions set out in the revised Combined Code issued by the Financial Reporting Council in July 2003 (the “Code”) except in relation to the authority reserved to the Board to make the final determination of the remuneration of the executive directors, which is explained below in the paragraph headed ‘Remuneration Committee’.
Under the US Sarbanes-Oxley Act of 2002, enhanced standards of corporate governance and business and financial disclosure apply to companies, including the company, with securities registered in the US. The Group complies with all currently applicable sections of the Act.
The Board considers that all non-executive directors are independent for the purposes of the Code, with the exception of Bud Koch who was formerly Chairman, President and Chief Executive Officer of Charter One Financial, Inc. which was acquired by Citizens Financial Group, Inc. in 2004.
Re-election of directors At each Annual General Meeting, one third of the directors retire and offer themselves for re-election and each director must stand for re-election at least once every three years. Any non-executive directors who have served for more than nine years will also stand for annual re-election and the Board may consider their independence at that time. The proposed reelection of directors is subject to prior review by the Board.
The names of directors standing for re-election at the 2006 Annual General Meeting are contained on page 111 and further information will be given in the Chairman’s letter to shareholders in relation to the company’s Annual General Meeting.
Each new director receives a formal induction, including visits to all the Group’s major businesses and meetings with senior management. The induction is tailored to the director’s specific requirements. Existing directors undertake such professional development as they consider necessary in assisting them to carry out their duties as directors.
In addition, each director discussed his or her own performance with the Chairman and the senior independent director met individually with the executive directors and with the non-executive directors as a group without the Chairman present, to consider the Chairman’s performance. The report on the Board evaluation, which was designed to assist the Board in further improving its performance, was considered and discussed by the Board as a whole and specific actions are currently being implemented.
The terms of reference of the Audit, Remuneration and Nominations committees and the standard terms and conditions of the appointment of non-executive directors are available on the Group's website (www.rbs.com) and copies are available on request.
Audit Committee All members of the Audit Committee are independent nonexecutive directors. The Audit Committee holds at least five meetings each year. The Audit Committee’s report is contained on pages 119 and 120.
Remuneration Committee All members of the Remuneration Committee are independent non-executive directors. The Remuneration Committee holds at least three meetings each year.
* Sir Tom McKillop was appointed to the Board on 1 September 2005.
** Lord Vallance, Sir Angus Grossart and Iain Robertson retired from the Board on 20 April 2005.
Communication with the company’s largest institutional shareholders is undertaken as part of the company’s investor relations programme. During the year, the directors received copies of analysts’ reports and a monthly report from the Group’s investor relations department which includes an analysis of share price movements, the Group’s performance against the sector, and key broker comments. In addition, information on major investor relations activities and changes to external ratings are provided. In 2005, the senior independent director attended results presentations to enhance his understanding of the views of major shareholders and would be available to shareholders if concerns could not be addressed through the normal channels. The arrangements used to ensure that directors develop an understanding of the views of major shareholders are considered as part of the annual Board performance evaluation.
The Board 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 2005 and to 27 February 2006, 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: Guidance for Directors on the Combined Code’ issued by the Institute of Chartered Accountants in England and Wales in 1999.
Audit Committee Report The members of the Audit Committee are Archie Hunter (Chairman), Colin Buchan, Joe MacHale, Eileen Mackay, until her retirement on 31 December 2005, and Sir Steve Robson.
All members of the Audit Committee are independent nonexecutive directors. The Audit Committee holds at least five meetings each year, two of which are held immediately prior to submission of the interim and annual financial statements to the Group Board. This core agenda is supplemented by additional meetings as required, four being added in 2005.
Audit Committee meetings are attended by relevant executive directors, the internal and external auditors and risk management executives. At least twice per annum the Committee meets privately with the external auditors. The Audit Committee also visits business divisions and certain Group functions under a programme set at the beginning of each year.
The Board is satisfied that all the Audit Committee members have recent and relevant financial experience. Although the Board has determined that each Member of the Audit Committee is an ‘Audit Committee Financial Expert’ and is independent, each as defined in the SEC rules under the US Securities Exchange Act of 1934 and related guidance, the members of the Audit Committee are selected with a view to the expertise and experience of the Audit Committee as a whole, and the Audit Committee reports to the Board as a single entity. The designation of a director or directors as an ‘Audit Committee Financial Expert’ does not impose on any such director any duties, obligations or liability that are greater than the duties, obligations and liability imposed on such director as a member of the Audit Committee and Board in the absence of such a designation. Nor does the designation of a director as an ‘Audit Committee Financial Expert’ affect the duties, obligations or liability of any other member of the Board.
Full details of the responsibilities of the Audit Committee are available at www.rbs.com/content/corporate_responsibility /corporate_governance/downloads/group_audit.pdf.
The Audit Committee has adopted a policy on the engagement of the external auditors to supply audit and non-audit services, which takes into account relevant legislation regarding the provision of such services by an external audit firm. The Audit Committee reviews the policy annually and prospectively approves the provision of audit services and certain non-audit services by the external auditors.
The Audit Committee approves all other permitted non-audit services on a case by case basis. The relevant submissions by management outline the service required and confirm that the external auditor’s independence will not be compromised. In addition, the Audit Committee reviews and monitors the independence and objectivity of the external auditors when it approves non-audit work to be carried out by them, taking into consideration relevant legislation and ethical guidance. Information on the audit and non-audit services carried out by the external auditors is detailed in Note 4 to the Group’s accounts.
The Audit Committee makes recommendations to the Board in relation to the remuneration and terms of engagement of the external auditors and the re-appointment by the shareholders at the Annual General Meeting in April 2006 of Deloitte & Touche LLP as the external auditors.
During 2005 PricewaterhouseCoopers conducted an external review of the effectiveness of the Audit Committee. It is intended that there will be an external review of the effectiveness of the Audit Committee every three years, with internal reviews by the Board continuing in the intervening years.
During the accounting period, the Remuneration Committee received advice from Watson Wyatt, Mercer Human Resource Consulting and Ernst & Young LLP on matters relating to directors’ remuneration in the UK (Watson Wyatt and Ernst & Young) and US (Mercer). In addition, the Remuneration Committee has taken account of the views of the Chairman of the Board and the Group Chief Executive on performance assessment of the executive directors.
Remuneration policy The executive remuneration policy was approved by shareholders at the company’s Annual General Meeting in 2005. At the beginning of 2005, the Remuneration Committee decided to conduct a comprehensive review of all aspects of the executive remuneration package. A review of this depth had not been undertaken since 2000/2001. Its terms of reference were to examine all aspects of the executive remuneration strategy, policy and practice in light of the changing business make up and strategy of the Group and the evolution of best practice on executive remuneration. Following this review, the Remuneration Committee made no change to the overall executive remuneration policy, which is set out below. However, as a result of this review, the Group is making a number of changes to executive director remuneration practice which are described below.
The objective of the executive remuneration policy is to provide, in the context of the company’s business strategy, remuneration in form and amount which will attract, motivate and retain high calibre executives. In order to achieve this objective, the policy is framed around the following core principles: • Total rewards will be set at levels that are competitive within the relevant market, taking each executive director’s remuneration package as a whole.
• Total potential rewards will be earned through achievement of demanding performance targets based on measures consistent with shareholder interests over the short, medium and longer-term.
The RBS Fund is a non-contributory defined benefit fund which provides pensions and other benefits within Inland Revenue limits. Certain directors receive additional pension and life assurance benefits in excess of Inland Revenue limits. Details of pension arrangements of directors are shown on page 129.
From April 2006, new tax legislation will apply to UK pensions; in particular any pension in excess of the Lifetime Allowance will be subject to additional taxation. The Group will allow directors and employees whose benefits do, or are likely to exceed the Lifetime Allowance to opt-out of future taxapproved pension provision. In such cases the Group will pay the individual a salary supplement in lieu of pension provision. The Group will not meet the cost of any additional tax that individuals may incur as a result of their benefits exceeding the new Lifetime or Annual Allowances.
Short-term annual incentives As part of the overall review of the executive remuneration package referred to above, short term incentive levels were considered and the Remuneration Committee agreed to increase annual incentive potentials to reflect market practice and the setting of stretching new targets. As a result, from 2006 individual UK-based executive directors will normally have a maximum annual incentive potential of between 160% and 200% of salary. These will typically focus from year to year on the delivery of a combination of appropriate Group and individual financial and operational targets approved by the Remuneration Committee.
For the other executive directors a proportion of the annual incentive is based on Group financial performance and a proportion on division financial performance. The remainder of each individual’s annual incentive opportunity is dependent on achievement of a range of non-financial measures, specific objectives and key result areas. Divisional performance includes measures such as operating income, costs, bad debts or operating profit. Non-financial measures include customer measures (e.g. customer numbers, customer satisfaction), staff measures (e.g. employee engagement) and efficiency and change objectives.
For exceptional performance, as measured by the achievement of significant objectives, executive directors may be awarded incentive payments of up to 200% of salary, or 250% of salary, in the case of the Group Chief Executive. This discretion to pay additional bonuses for exceptional performance was last used in 2002 to recognise the successful integration of Natwest.
Long-term incentives The company provides long-term incentives in the form of share options and share or share equivalent awards. Their objective is to encourage the creation of value over the long-term and to align the rewards of the executive directors with the returns to shareholders.
The Group’s policy is to encourage executives to hold shares and retain vested long-term incentives. This policy has successfully built high levels of shareholdings and equity participation amongst executives. A table showing directors’ interests in shares and the estimated value of the shares and vested long term incentives held by executives is shown on page 130. In light of the already high levels of share price exposure, the Remuneration Committee is not proposing to introduce mandatory or guideline shareholding requirements for executives at this time.
Medium-term performance plan The medium-term performance plan (“MPP”) was approved by shareholders in April 2001. Each executive director is eligible for an annual award under the plan in the form of share or share equivalent awards. Whilst the rules of the plan allow awards over shares worth up to one and a half times earnings, the Remuneration Committee has adopted a policy of granting awards based on a multiple of salary. Normally awards are made at one times salary to executive directors, with one and a half times salary being granted in the case of the Group Chief Executive. No changes will be made to this policy without prior consultation with shareholders. All awards under the plan are subject to three-year performance targets.
D ire ct or s’ re m un er a tio n re po rt
For the TSR element, vesting will be based on the level of outperformance by the Group of the median of the comparator group TSR over the performance period. The Remuneration Committee believes this method of measuring relative TSR performance provides a more approriate measure of management performance. This change is permitted under the rules of the plan. Awards made under the plan will not vest if the company’s TSR is below the median of the comparator group. Achievement of median TSR performance against comparator companies will result in vesting of 25% of the award. Outperformance of median TSR performance by up to 9% will result in vesting on a straight-line basis from 25% to 125%, outperformance by 9% to 18% will result in vesting on a straight-line basis from 125% to 200%. Vesting at 200% will occur if the company outperforms the median TSR performance of the comparator group by at least 18%.
Options The executive share option scheme was approved by shareholders in January 1999. The operation of the scheme was reviewed as part of the overall executive remuneration review and the Remuneration Committee is satisfied that no changes are required. Each executive director is eligible for an annual grant of an option, exercisable at the market price at the time of grant. Options granted to executive directors are typically over shares worth one and a quarter times salary with an upper maximum in appropriate circumstances of two and a half times salary, over shares at the market value at date of grant. No payment is made by the executive director on the grant of an option award.
All executive share option grants are subject to a performance condition which is reviewed by the Remuneration Committee annually. The performance target is currently that the options are exercisable only if, over a three year period from the date of grant, the growth in the company’s EPS has exceeded the growth in the RPI plus nine per cent. This EPS performance target, which is consistent with market practice, measures underlying financial performance and represents a long-term test of performance. For awards made from 2004, there is no re-testing of the performance condition.
US based director – Lawrence Fish Lawrence Fish's total remuneration package was reviewed in 2004 by the Remuneration Committee as a result of the acquisition of Charter One and his changing RBS responsibilities in North America. A new cash long-term incentive plan was approved by shareholders at the 2005 Annual General Meeting. The remuneration policy for Mr Fish is as follows: Base salary is set having regard to the levels of base salary in other US banks and the appropriate balance of fixed and variable remuneration for US based executives of UK listed companies operating within the corporate governance frameworks of the UK.
Benefits Mr Fish accrues pension benefits under a number of arrangements in the US. Details are provided on page 129. In addition he is entitled to receive other benefits on a similar basis to other Citizens employees.
• A grant under the new Citizens Long Term Incentive Plan. Performance is measured on a combination of Growth in Profit before Tax and Relative Return on Equity based on a comparison of Citizens with comparator US banks. The targets for this plan are set on an annual basis over the three year term of the grant.
* Mr Watt resigned as a director on 31 January 2006.
All new service contracts for executive directors will be subject to approval by the Remuneration Committee. Those contracts will 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.
The non-executive directors do not have service contracts or notice periods although they have letters of engagement reflecting their responsibilities and commitments. Under the company’s articles of association, all directors must retire by rotation and seek re-election by shareholders at least every three years. The dates in the table above reflect the latest date for re-election. However, in 2007, at least one-third of the Board will retire by rotation as required by the company’s articles of association. No compensation would be paid to the Chairman or to any non-executive director in the event of early termination.
The tables and explanatory notes on pages 126 to 129 report the remuneration of each director for the year ended 31 December 2005 and have been audited by the company’s auditors, Deloitte & Touche LLP.
Except as noted below, in the event of severance of contract where any contractual notice period is not worked, the employing company may pay a sum to the executive in lieu of this period of notice. Any such payment would, at maximum, comprise base salary and a cash value in respect of fixed benefits (including pension plan contributions). In the event of situations involving breach of the employing company’s policies resulting in dismissal, reduced or no payments may be made to the executive. Depending on the circumstances of the termination of employment, the executive may be entitled, or the Remuneration Committee may exercise its discretion to allow, the executive to exercise outstanding awards under longterm incentive arrangements subject to the rules of relevant plan. The exception to these severance arrangements relates only to Mr Fish.
Deputy Chairman Sir Tom McKillop (appointed 1 September 2005) 67 — 67 — Vice-chairmen Lord Vallance of Tummel (retired 20 April 2005) 33 — 33 100 Sir Angus Grossart (retired 20 April 2005) 33 — 33 100
† In addition to his role as a non-executive director, Mr Koch has an agreement with Citizens Financial Group, Inc. to provide consulting services for a period of three years following the acquisition by Citizens of Charter One Financial, Inc. For these services Mr Koch receives $402,500 per annum.
* Mr Scott’s senior independent director fee covers all Board and Board Committee work including Chairmanship of the Remuneration Committee.
Share options Options to subscribe for ordinary shares of 25p each in the company granted to, and exercised by, directors during the year to 31 December 2005 are included in the table below: Options exercised in 2005
** Mr Robertson retired from the Board on 20 April 2005.
The performance conditions for options granted in 2005 are detailed on page 123.
D ire ct or s’ re m un er a tio n re po rt Directors’ remuneration report continued
The executive share options which are exercisable from March 2002 onwards are subject to the satisfaction of an EPS growth target which provides that options are exercisable only if, over a three year period, the growth in the company’s EPS has exceeded the growth in the RPI plus 9%. In respect of executive share options exercisable before March 2002 the performance condition is that the growth in the company’s EPS over three years has exceeded the growth in the RPI plus 6%.
Sir Fred Goodwin 93,040 16.35 93,040 vested 31.12.03 * Awards were granted on 12 June 2003. The vesting level was nil and these awards have now lapsed.
Note: 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. The performance measures are detailed on page 123.
Interests at 1 January 2005 Awards granted during year during year Interests at 31 December 2005
Lawrence Fish accrues pension benefits under a number of arrangements in the US. Defined benefits are built up under the Citizens’ Qualified Plan, Excess Plan and Supplemental Executive Retirement Arrangement. In addition, he is a member of two defined contribution arrangements – a Qualified 401(k) Plan and an Excess 401(k) Plan.
As in the 2004 Report and Accounts, disclosure of these benefits has been made in accordance with the United Kingdom Listing Authority Listing Rules and the Combined Code and with the Directors’ Remuneration Report Regulations 2002.
Age at 31 December 31 December 31 December 31 December 31 December 31 December 31 December 31 December 2005 2005 2005* 2005 2004 2005 2005*
(2) Mr Robertson continued to accrue pension during his service with the Group in 2005 after resignation as a director. The figures above include the pension accrued during this subsequent service.
(3) The transfer values disclosed above do not represent a sum paid or payable to the individual director. Instead they represent a potential liability of the company /pension scheme.
(4) No allowance is made in these transfer values for any enhanced benefits that may become payable on early retirement.
D ire ct or s’ in te re st s in s ha re s Directors’ interests in shares
Preference shares Mr Fish held 20,000 non-cumulative preference shares of US$0.01 each at 31 December 2005 (2004 – 20,000) and Mr Koch held 20,000 non-cumulative preference shares of US$0.01 each at 31 December 2005 (2004 – nil). No other director had an interest in the preference shares during the year.
No director held a non-beneficial interest in the shares of the company at 31 December 2005, at 1 January 2005 or date of appointment if later.
Shares beneficially owned at 31 December 2005 1 January 2005 Vested Value as at or date of Shares MPP shares Vested 31 December appointment owned or share share 2005 if later beneficially equivalents options Total (2,3)
On both 9 January 2006 and 7 February 2006, 7 ordinary shares of 25p each were acquired by Sir Fred Goodwin under the Group’s Buy As You Earn share scheme.
(3) The notional value of the vested share options has been calculated on the ‘in the money’ value.
S ta te m en t of d ire ct or s’
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 1985 have elected to prepare Company accounts, for each financial year in accordance with International Financial Reporting Standards. 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
Contents 134 Independent auditors’ report 136 Accounting policies 145 Consolidated income statement 146 Balance sheets 147 Statements of recognised income and expense 148 Cash flow statements 149 Notes on the accounts
We have audited the financial statements of The Royal Bank of Scotland Group plc (“the company”) and its subsidiaries (together “the Group”) for the year ended 31 December 2005 which comprise the accounting policies, the balance sheets as at 31 December 2005 and 2004, the consolidated income statement, the cash flow statements, the statements of recognised income and expense for each of the two years in the period ended 31 December 2005 and the related Notes 1 to 47. These financial statements have been prepared under the accounting policies set out therein. We have also audited the information in the part of the directors’ remuneration report that is described as having been audited.
Basis of audit opinion We conducted our audit in accordance with International Standards on Auditing (UK and Ireland) issued by the Auditing Practices Board and with the standards of the United States Public Company Accounting Oversight Board. An audit includes examination, on a test basis, of evidence relevant to the amounts and disclosures in the financial statements and the part of the directors’ remuneration report described as having been audited. The Group is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purposes of expressing an opinion on the effectiveness of the Group’s internal controls over financial reporting. Accordingly, we express no such opinion. It also includes an assessment of the significant estimates and judgements made by the directors in the preparation of the financial statements and of whether the accounting policies are appropriate to the circumstances of the company and the Group, consistently applied and adequately disclosed.
Independent auditors’ report to the members of The Royal Bank of Scotland Group plc
UK opinion In our opinion: • the Group financial statements give a true and fair view, in accordance with IFRS as adopted for use in the European Union, of the state of the Group’s affairs as at 31 December 2005 and of its profit and cash flows for the year then ended; • the company financial statements give a true and fair view, in accordance with IFRS as adopted for use in the European Union as applied in accordance with the requirements of the Companies Act 1985, of the state of affairs of the company as at 31 December 2005; • the financial statements and the part of the directors’ remuneration report described as having been audited have been properly prepared in accordance with the Companies Act 1985 and Article 4 of the IAS Regulation.
Separate opinion in relation to IFRS As explained in the Accounting policies, the Group in addition to complying with its legal obligation to comply with IFRS as adopted for use in the European Union, has also complied with the IFRS as issued by the International Accounting Standards Board. In our opinion the financial statements give a true and fair view, in accordance with IFRS, of the state of the Group’s affairs as at 31 December 2005 and of its profit for the year then ended.
A cc ou nt in g po lic ie s 1. Adoption of International Financial Reporting Standards The annual accounts have, for the first time, been prepared in accordance with International Financial Reporting Standards adopted by the International Accounting Standards Board (“IASB”), and interpretations issued by the International Financial Reporting Interpretations Committee of the IASB (together “IFRS”) as endorsed by the European Union (“EU”). The EU has not endorsed the complete text of IAS 39 ‘Financial Instruments: Recognition and Measurement’; it has relaxed some of the standard’s hedging requirements. The Group has not taken advantage of this relaxation and has adopted IAS 39 as issued by the IASB. The date of transition to IFRS for the Group and the company (The Royal Bank of Scotland Group plc) and the date of their opening IFRS balance sheets was 1 January 2004. The company accounts have been presented in accordance with the Companies Act 1985.
The main differences between IFRS and previously applied generally accepted accounting principles (“UK GAAP”) and the effect of implementing IFRS on the Group and company balance sheets and shareholders’ funds as at 1 January and 31 December 2004 and on the Group’s 2004 consolidated income statement are set out on pages 210 to 218.
Fair value or revaluation as deemed cost – under UK GAAP, the Group’s freehold and long leasehold property occupied for its own use was recorded at valuation on the basis of existing use value. The Group has elected to use this valuation as at 31 December 2003 as deemed cost for its opening IFRS balance sheet. At this date, the carrying value under UK GAAP of freehold and long leasehold property occupied for own use was £2,391 million.
Compound financial instruments – the Group has not separated compound instruments between liability and equity components, as required by IAS 32 ‘Financial Instruments: Disclosure and Presentation’, where the liability component was not outstanding at 1 January 2004. UK GAAP did not permit compound instruments to be separated between liability and equity components on issue.
Share based payments – IFRS 2 ‘Share-based Payment’ has been applied to equity instruments granted after 7 November 2002.
IFRS 1 prohibits retrospective application of some aspects of IFRS: Derecognition of financial assets and liabilities – nonderivative financial assets and liabilities derecognised before 1 January 1992 (the date from which the derecognition requirements of IAS 39 have been implemented) under the Group’s previous GAAP have not been recognised in its opening IFRS balance sheet.
Hedge accounting – hedging relationships of a type that does not qualify for hedge accounting under IAS 39 are not reflected in the Group’s opening IFRS balance sheet.
The Group has adopted the Amendment ‘Actuarial Gains and Losses, Group Plans and Disclosures’ to IAS 19 ‘Employee Benefits’ from 1 January 2004. Actuarial gains and losses are recognised in full as they occur outside profit or loss.
2. Accounting convention The company is incorporated in the UK and registered in Scotland. The financial statements have been prepared on the historical cost basis except that the following assets and liabilities are stated at their fair value: derivative financial instruments, held-for-trading financial assets and financial liabilities, financial assets and financial liabilities that are designated as at fair value through profit or loss, available-for-sale financial assets and investment property. Recognised financial assets and financial liabilities in fair value hedges are adjusted for changes in fair value in respect of the risk that is hedged.
3. Basis of consolidation The consolidated financial statements incorporate the financial statements of the company and entities (including certain special purpose entities) controlled by the Group (its subsidiaries). Control exists where the Group has the power to govern the financial and operating policies of the entity; generally conferred by holding a majority of voting rights. On acquisition of a subsidiary, its identifiable assets, liabilities and
Annual Report and Accounts 2005 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. Payment services income is usually charged to the customer’s account, monthly or quarterly in arrears. Accruals are raised for services provided but not charged at period end.
A cc ou nt in g po lic ie s economic lives and is included in Depreciation and amortisation. The estimated useful economic lives are as follows: Core deposit intangibles 7 years Other acquired intangibles 5-10 years Computer software 3-5 years
7. Property, plant and equipment Items of property, plant and equipment are stated at cost less accumulated depreciation (see below) and impairment losses. Where an item of property, plant and equipment comprises major components having different useful lives, they are accounted for separately. Property that is being constructed or developed for future use as investment property is classified as property, plant and equipment and stated at cost until construction or development is complete, at which time it is reclassified as investment property.
9. Foreign currencies The Group’s consolidated financial statements are presented in sterling which is the functional currency of the company.
Transactions in foreign currencies are translated into sterling at the foreign exchange rate ruling at the date of the transaction. Monetary assets and liabilities denominated in foreign currencies are translated into sterling at the rates of exchange ruling at the balance sheet date. Foreign exchange differences arising on translation are recognised in profit or loss except for differences arising on cash flow hedges and hedges of net investments in foreign operations. Non-monetary items denominated in foreign currencies that are stated at fair value are translated into sterling at foreign exchange rates ruling at the dates the values were determined. Translation differences arising on non-monetary items measured at fair value are recognised in profit or loss except for differences arising on available-for-sale non-monetary financial assets, for example equity shares, which are included in the available-for-sale reserve in equity unless the asset is the hedged item in a fair value hedge.
10. Leases Contracts to lease assets are classified as finance leases if they transfer substantially all the risks and rewards of ownership of the asset to the customer. Other contracts to lease assets are classified as operating leases.
11. Insurance General insurance General insurance comprises short-duration contracts principally property and liability insurance contracts. Due to the nature of the products sold – retail-based property and casualty, motor, home and personal health insurance contracts – the insurance protection is provided on an even basis throughout the term of the policy.
Life assurance The Group’s long-term assurance contracts include whole-life term assurance, endowment assurance, flexible whole-life, pension and annuity contracts that are expected to remain in force for an extended period of time. Long-term assurance contracts under which the Group does not accept significant insurance risk are classified as financial instruments. The Group recognises the value of in-force long-term assurance contracts as an asset. Cash flows associated with in-force contracts and related assets, including reinsurance cash flows, are projected, using appropriate assumptions as to future mortality, persistency and levels of expenses and excluding the value of future investment margins, to estimate future surpluses attributable to the Group. These surpluses, discounted at a risk-adjusted rate, are recognised as a separate asset. Changes in the value of this asset, which is determined on a post-tax basis, are included in operating profit.
The Group has reinsurance treaties that transfer significant insurance risk. Liabilities for reinsured contracts are calculated gross of reinsurance and a separate reinsurance asset recorded.
Premiums on long-term insurance contracts are recognised as income when receivable. Claims on long term insurance contracts reflect the cost of all claims arising during the year, including claims handling costs. Claims are recognised when the Group becomes aware of the claim.
12. Taxation Provision is made for taxation at current enacted rates on taxable profits, arising in income or in equity, taking into account relief for overseas taxation where appropriate. Deferred taxation is accounted for in full for all temporary differences between the carrying amount of an asset or liability for accounting purposes and its carrying amount for tax purposes, except in relation to overseas earnings where remittance is controlled by the Group, and goodwill.
Held-to-maturity investments – a financial asset is classified as a held-to-maturity investment only if it has fixed or determinable payments, a fixed maturity and the Group has the positive intention and ability to hold to maturity. Held-to-maturity investments are initially recognised at fair value plus directly related transaction costs. They are subsequently measured at amortised cost using the effective interest method (see note 4 above) less any impairment losses.
Designated as at fair value through profit or loss – financial assets that the Group designates on initial recognition as being at fair value through profit or loss are recognised at fair value, with transaction costs being recognised in profit or loss and are subsequently measured at fair value. Gains and losses on financial assets that are designated as at fair value through profit or loss are recognised in profit or loss as they arise.
The principal category of financial assets designated as at fair value through profit or loss is policyholders’ assets underpinning insurance and investment contracts issued by the Group's life assurance businesses. Fair value designation significantly reduces the measurement inconsistency that would arise if these assets were classified as available-for-sale.
Available-for-sale – financial assets that are not classified as held-to-maturity; held-for-trading; designated at fair value through profit or loss; or loans and receivables are classified as available-for-sale. Financial assets can be designated as available-for-sale on initial recognition. Available-for-sale financial assets are initially recognised at fair value plus directly related transaction costs. They are subsequently measured at fair value. Impairment losses and exchange differences resulting from retranslating the amortised cost of currency monetary available-for-sale financial assets are recognised in profit or loss together with interest calculated using the effective interest rate (see note 4 above). Other changes in the fair value of available-for-sale financial assets are reported in a separate component of shareholders’ equity until disposal, when the cumulative gain or loss is recognised in profit or loss.
14. 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.
Impairment losses are recognised in profit or loss and the carrying amount of the financial asset or group of financial assets reduced by establishing an allowance for impairment losses. If in a subsequent period the amount of the impairment loss reduces and the reduction can be ascribed to an event after the impairment was recognised, the previously recognised loss is reversed by adjusting the allowance. Once an impairment loss has been recognised on a financial asset or group of financial assets, interest income is recognised on the carrying amount using the rate of interest at which estimated future cash flows were discounted in measuring impairment.
The principal categories of financial liabilities designated as at fair value through profit or loss are (a) structured liabilities issued by the Group: designation significantly reduces the measurement inconsistency between these liabilities and the related derivatives carried at fair value, and (b) investment contracts issued by the Group's life assurance businesses: fair value designation significantly reduces the measurement inconsistency that would arise if these liabilities were measured at amortised cost.
All other financial liabilities are measured at amortised cost using the effective interest method (see note 4 above).
Cash flow hedge – where a derivative financial instrument is designated as a hedge of the variability in cash flows of a recognised asset or liability or a highly probable forecast transaction, the effective portion of the gain or loss on the hedging instrument is recognised directly in equity. The ineffective portion is recognised in profit or loss. When the forecast transaction results in the recognition of a financial asset or financial liability, the cumulative gain or loss is reclassified from equity in the same periods in which the asset or liability affects profit or loss. Otherwise the cumulative gain or loss is removed from equity and recognised in profit or loss at the same
Accounting policies continued time as the hedged transaction. Hedge accounting is discontinued if the hedge no longer meets the criteria for hedge accounting; if the hedging instrument expires or is sold, terminated or exercised; if the forecast transaction is no longer expected to occur; or if hedge designation is revoked. On the discontinuance of hedge accounting (except where a forecast transaction is no longer expected to occur), the cumulative unrealised gain or loss recognised in equity is recognised in profit or loss when the hedged cash flow occurs or, if the forecast transaction results in the recognition of a financial asset or financial liability, in the same periods during which the asset or liability affects profit or loss. Where a forecast transaction is no longer expected to occur, the cumulative unrealised gain or loss is recognised in profit or loss immediately.
19. Share-based payments The Group grants options over shares in The Royal Bank of Scotland Group plc to its employees under various share option schemes. The Group has applied IFRS 2 ‘Share-based Payment’ to grants under these schemes after 7 November 2002 that had not vested on 1 January 2005. The expense for these transactions is measured based on the fair value on the date the options are granted. The fair value is estimated using valuation techniques which take into account the option’s exercise price, its term, the risk free interest rate and the expected volatility of the market price of The Royal Bank of Scotland Group plc’s shares. Vesting conditions are not taken into account when measuring fair value, but are reflected by adjusting the number of options included in the measurement of the transaction such that the amount recognised reflects the number that actually vest. The fair value is expensed on a straight-line basis over the vesting period.
21. Cash and cash equivalents Cash and cash equivalents comprises cash and demand deposits with banks together with short-term highly liquid investments that are readily convertible to known amounts of cash and subject to insignificant risk of change in value.
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.
Collective component – this is made up of two elements: loan impairment provisions for impaired loans that are below individual assessment thresholds (collective impaired loan provisions) and for loan losses that have been incurred but have not been separately identified at the balance sheet date (latent loss provisions). These are established on a portfolio basis 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.
Details of financial instruments carried at fair value are given in Note 34 on the financial statements.
General insurance claims The Group makes provision for the full cost of settling outstanding claims arising from its general insurance business at the balance sheet date, including claims estimated to have been incurred but not yet reported at that date and claims handling expenses. General insurance claims provisions amounted to
Goodwill The Group capitalises goodwill arising on the acquisition of businesses, as disclosed in the Accounting policies. The carrying value of goodwill as at 31 December 2005 was
Goodwill is the excess of the cost of an acquisition over the fair value of its net assets. The determination of the fair value of assets and liabilities of businesses acquired requires the exercise of management judgement; for example those financial assets and liabilities for which there are no quoted prices, and those non-financial assets where valuations reflect estimates of market conditions such as property. Different fair values would result in changes to the goodwill arising and to the post-acquisition performance of the acquisition. Goodwill is not amortised but is tested for impairment annually or more frequently if events or changes in circumstances indicate that it might be impaired.
For the purposes of impairment testing goodwill acquired in a business combination is allocated to each of the Group’s cashgenerating units or groups of cash-generating units expected to benefit from the combination. Goodwill impairment testing involves the comparison of the carrying value of a cashgenerating unit or group of cash generating units with its recoverable amount. The recoverable amount is the higher of the unit's fair value and its value in use. Value in use is the present value of expected future cash flows from the cash-generating unit or group of cash-generating units. Fair value is the amount obtainable for the sale of the cash-generating unit in an arm’s length transaction between knowledgeable, willing parties.
The IASB has also issued three amendments to IAS 39 ‘Financial Instruments: Recognition and Measurement’. The first, ‘Cash Flow Hedge Accounting of Forecast Intragroup Transactions’, published in April 2005, amends IAS 39 to permit the foreign currency risk of a highly probable forecast intragroup transaction to qualify as a hedged item in consolidated financial statements. The amendment is effective for annual periods beginning on or after 1 January 2006.
In December 2005, the IASB issued amendments to IAS 21 ‘The Effects of Changes in Foreign Exchange Rates’ to clarify that a monetary item can form part of the net investment in overseas operations regardless of the currency in which it is denominated and that the net investment in a foreign operation can include a loan from a fellow subsidiary. The amendments are effective immediately but have not been endorsed by the EU.
The Group is reviewing IFRS 7 and the amendments to IAS 1 and IAS 21 and those to IAS 39 that it has not implemented, to determine their effect on its financial reporting.
US GAAP For a discussion of recent developments in US GAAP relevant to the Group, see Note 46 on the accounts.
Assets Cash and balances at central banks 4,759 4,293 — — Treasury bills and other eligible bills 10 5,538 6,110 — — Loans and advances to banks 11 70,587 61,073 9,122 4,106 Loans and advances to customers 12 417,226 347,251 567 305
Settlement balances and short positions 24 43,988 32,990 — — Derivatives at fair value 19 96,438 18,876 — — Accruals, deferred income and other liabilities 25 14,247 17,648 14 301 Retirement benefit liabilities 3 3,735 2,940 — — Deferred taxation liabilities 26 1,695 2,061 — —
Total liabilities and equity 776,827 588,122 30,742 26,629 * includes non-equity minority interests and preference shares in 2004.
The accounts were approved by the Board of directors on 27 February 2006 and signed on its behalf by: Sir George Mathewson Sir Fred Goodwin Guy Whittaker Chairman Group Chief Executive Group Finance Director
Statements of recognised income and expense for the year ended 31 December 2005
Available-for-sale investments Net valuation gains taken direct to equity 35 — Net profit taken to income on sales (582) —
Exchange differences on translation of foreign operations 842 (606) — — Actuarial losses on defined benefit plans (799) (1,601) — — Other movements — — — (1) (Expense)/income before tax on items recognised direct in equity (571) (2,207) 6 (1) Tax on items recognised direct in equity 478 465 (2) — Net (expense)/income recognised direct in equity (93) (1,742) 4 (1) Profit for the year 5,558 5,289 2,074 2,874 Total recognised income and expense for the year 5,465 3,547 2,078 2,873
Attributable to: Equity holders of the parent 5,355 3,558 2,078 2,873 Minority interests 110 (11) — —
Interest on subordinated liabilities (1,332) (613) (577) (318) Net cash flows from financing activities (703) 7,119 (1,523) 3,781 Effects of exchange rate changes on cash and cash equivalents (3,107) 1,686 (76) —
Administrative expenses Staff costs Wages, salaries and other staff costs 5,084 4,421 Social security costs 354 295 Share-based compensation 44 36 Pension costs (see note 3) – defined benefit schemes 462 397 – defined contribution schemes 48 39
The average number of persons employed by the Group during the year, excluding temporary staff, was 144,900 (2004 – 133,300).
Interim valuations of the Group’s schemes were prepared to 31 December by independent actuaries, using the following assumptions: Main Scheme All Schemes
Principal actuarial assumptions at 31 December (weighted average) 2005 2004 2005 2004
Government fixed interest bonds 4.1% 4.5% 4.1% 4.5% Corporate and other bonds 4.8% 5.4% 4.8% 5.4%
Statement of recognised income and expense: Acquisitions of subsidiaries — — — 45 88 43
Sales of investment securities – Gross gains 197 – Gross losses (30) – Net profit 167
Dividend income 108 79 Share of associated undertakings’ net profit 41 24 Rental income from investment properties 250 241 Net gains on financial assets and liabilities designated as at fair value through profit or loss 364
Expenses Interest on subordinated liabilities 1,271 681 Direct operating expenses of investment properties 61 72 Integration expenditure* relating to: – acquisition of NatWest 129 280 – other acquisitions 329 240 * Integration expenditure comprises: Staff costs 148 83 Premises and equipment 39 35 Other administrative expenses 131 149 Depreciation and amortisation 140 253 3 Pension costs (continued)
The pension plan assets include a holding of the company’s ordinary shares with a fair value of £78 million (2004 – £73 million), of which £76 million (2004 – £71 million) are held in the Main Scheme which also holds financial instruments issued by the Group with a value of £299 million (2004 – £726 million).
Cumulative net actuarial losses of £2,400 million (2004 – £1,601 million) have been recognised in the statement of recognised income and expense, of which £2,150 million (2004 – £1,433 million) relate to the Main Scheme.
History of defined benefit schemes £m £m £m £m £m £m
Present value of defined benefit obligations 19,118 16,051 13,594 21,123 17,738 14,898 Fair value of plan assets 15,914 13,569 11,797 17,388 14,798 12,862
Auditors’ remuneration Amounts paid to the auditors for statutory audit and other services were as follows: Group £m £m
Other services 0.4 3.0 * Includes fees relating to the transition to IFRS and work in respect of US Sarbanes-Oxley Act Section 404 reporting requirements.
Current taxation: UK corporation tax charge for the year at 30% 2,280 2,091 Over provision in respect of prior periods (101) (168) Relief for overseas taxation (171) (212)
The actual tax charge differs from the expected tax charge computed by applying the standard rate of UK corporation tax of 30% as follows: 2005 2004 £m £m
Expected tax charge 2,381 2,185 Interest on subordinated debt not allowable for tax 79 — Non-deductible items 230 110 Non-taxable items (166) (128) Taxable foreign exchange movements (10) (10) Foreign profits taxed at other rates 77 49 Unutilised losses brought forward and carried forward (5) 6 Adjustments relating to prior periods (208) (217) Actual tax charge for the year 2,378 1,995
7 Ordinary dividends Group p per share p per share £m £m
Final dividends are not accounted for until they have been ratified at the Annual General Meeting. At the meeting on 28 April 2006, a dividend in respect of 2005 of 53.1 pence per share (2004 – 41.2 pence per share) amounting to a total of £1.7 billion (2004 – £1.3 billion) is to be proposed. The financial statements for the year ended 31 December 2005 do not reflect this dividend which, if approved, will be accounted for in shareholders’ equity as an appropriation of retained profits in the year ending 31 December 2006.
8 Profit dealt with in the accounts of the company As permitted by section 230(3) of the Companies Act 1985, the primary financial statements of the company do not include an income statement. Condensed information is set out below: Company £m £m
Dividends received from banking subsidiary 2,082 3,000 Dividends received from other subsidiaries 100 — Total income 2,182 3,000 Interest receivable from subsidiaries 577 313 Interest payable to subsidiaries (189) (150) Other net interest payable and operating expenses (638) (273) Operating profit before tax 1,932 2,890
Profit attributable to: Ordinary shareholders 1,965 2,618 Other shareholders 109 256
Annual Report and Accounts 2005 9 Earnings per ordinary share The earnings per share are based on the following: Group £m £m
Earnings: Profit attributable to ordinary shareholders 5,392 4,856 Add back dividends on dilutive convertible non-equity shares 65 66 Diluted earnings attributable to ordinary shareholders 5,457 4,922
Held-for-trading 3,004 Available-for-sale 2,534 11 Loans and advances to banks Group Company £m £m £m £m
Held-for-trading 53,963 — Designated as at fair value through profit or loss 616 — Loans and receivables 350,960 567 Finance leases 11,687 —
Amounts above include: Due from subsidiaries 567 305 Subordinated advances 220 —
Securitisations may, depending on the individual arrangement, result in continued recognition of the securitised assets; continued recognition of the assets to the extent of the Group’s continuing involvement in those assets; or derecognition of the assets and the separate recognition, as assets or liabilities, of any rights and obligations created or retained in the transfer (see Accounting policy on page 141). The Group has securitisations in each of these categories.
(2) Mortgages have been transferred to special purpose vehicles, held ultimately by charitable trusts, funded principally through the issue of floating rate notes. The Group has entered into arm’s length fixed/floating interest rate swaps with the securitisation vehicles and provides mortgage management and agency services to the vehicles. On repayment of the financing, any further amounts generated by the mortgages will be paid to the Group. In 2004, the Group recognised net income of £26 million.
(4) Other loans originated by the Group have been transferred to special purpose vehicles funded through the issue of notes. Any proceeds from the loans in excess of the amounts required to service and repay the notes are payable to the Group after deduction of expenses. In 2004, the Group recognised net income of £37 million.
Continuing involvement In certain US securitisations of residential mortgages substantially all the risks and rewards have been neither transferred nor retained, but the Group has retained control, of the assets and continues to recognise the assets to the extent of its continuing involvement. Securitised assets were £39.8 billion; retained interests £863 million; subordination assets £609 million and related liabilities £609 million.
Derecognition Other securitisations of the Group’s financial assets in the US qualify for derecognition as substantially all the risks and rewards of the assets have been transferred. The Group continues to recognise any retained interests in the securitisation vehicles.
Prepayment speed 139 – 690 PSA 16 – 44% CPR (1) 0 – 100 CPY (1)
Key economic assumptions and the sensitivity of the current fair value of retained interests at 31 December 2005 to immediate adverse changes, as indicated below, in those assumptions are as follows: U.S. Agency Consumer Commercial retained retained retained
Fair value of retained interests at 31 December 2004 £1,179 million £764 million £128 million Prepayment speed(6) 9 – 25% CPR (1) 16 – 80% CPR (1) 0 – 75 CPY (2)
Impact on fair value of 10% adverse change £0.5 million £26.1 million — Impact on fair value of 20% adverse change £0.6 million £47.1 million — Weighted average life 0 – 19 years 1 – 10 years 1 – 20 years
Impact on fair value of 10% adverse change N/A £10.9 million N/A Impact on fair value of 20% adverse change N/A £19.8 million N/A
Notes: (1) Constant prepayment rate – the CPR range represents the low and high points of a dynamic CPR curve.
Mortgage-backed securities The Group sells originated mortgage loans to US Agencies in return for securities backed by these loans and guaranteed by the Agency whilst retaining the rights to service the mortgages. These securities may be subsequently sold. The purchaser has recourse to the Group for losses up to pre-determined levels on certain designated mortgages. The Group is not obliged, and does not intend, to support losses that may be suffered by the Agencies. Under the terms of the sale agreements, the
Bank and UK Other Other public building Other government government sector body society issuers Total 2005 £m £m £m £m £m £m
Designated as at fair value through profit or loss 451 7 — 864 2,669 3,991
Held-for-trading 41,544 39,109 80,653 Designated as at fair value through profit or loss 3,043 948 3,991 Available-for-sale 34,074 1,459 35,533 Loans and receivables — 788 788
N ot es o n th e ac co un ts Notes on the accounts continued 13 Debt securities (continued)
The Group considers that unrealised losses on available-for-sale debt securities are temporary principally because they reflect changes in benchmark interest rates.
Gross unrecognised gains 356 169 525 Gross unrecognised losses (78) (5) (83)
Unquoted equity investments at cost include £1.8 billion attributable to the Group’s investment in Bank of China which was completed on 31 December 2005. Also included are equity investments in the Federal Home Loans Bank and Federal Reserve Bank that are redeemable at cost (£0.8 billion). The remaining investments at cost cannot be measured reliably and comprised numerous small shareholdings including those received on trouble debt restructuring. Disposals in the year generated gains of £85 million.
Annual Report and Accounts 2005 15 Investments in Group undertakings Investments in Group undertakings are carried at cost less impairment. Movements during the year were as follows: Company £m £m
Implementation of IAS 32 and IAS 39 on 1 January 2005 (4,004) — Currency translation and other adjustments (6) (399)
The principal subsidiary undertakings of the company are shown below. Their capital consists of ordinary and preference shares which are unlisted with the exception of certain preference shares issued by NatWest. The Royal Bank and RBS Insurance Group Limited are directly owned by the company, and all of the other subsidiary undertakings are wholly owned directly, or indirectly through intermediate holding companies, by these companies. All of these subsidiaries are included in the Group’s consolidated financial statements and have an accounting reference date of 31 December.
(2) Coutts & Co is incorporated with unlimited liability. Its registered office is 440 Strand, London WC2R 0Q5.
Impairment losses charged to the income statement Loans and receivables and finance leases (see table below) 1,703 Available-for-sale 4 Loans and advances (see table below) 1,402 Amounts written-off fixed asset investments 83
(2) Balance at 31 December 2005 includes £3 million relating to banks (2004 – £6 million).
Loan impairment At 31 December 2005, the Group’s non-accrual loans, loans past due 90 days and troubled debt restructurings amounted to £5,937 million (2004 – £5,470 million). Loan impairment provisions of £3,344 million (2004 – £3,561 million) were held against these loans. Average non-accrual loans, loans past due 90 days and troubled debt restructurings for the year to 31 December 2005 were £5,923 million (2004 – £5,264 million).
Cost: Currency translation and other adjustments (518) (18) (2) — (538)
Disposals and write-off of fully amortised assets (16) — — (41) (57)
Accumulated amortisation and impairment: Currency translation and other adjustments — (1) — — (1) Disposals and write-off of fully amortised assets — — — (41) (41) Charge for the year — 23 22 474 519
The amortisation expense for each of the next five years is currently estimated to be: £m
Division Acquisition Cash generating unit £m £m Basis of valuation Key assumptions
** The key valuation parameters are the same as those used to support the Group’s decision to purchase the businesses.
Subsequent expenditure on investment properties 53 — — — — — 53 Change in fair value of investment properties 26 — — — — — 26 Disposals and write-off of fully depreciated assets (176) (560) (71) (127) (466) (1,372) (2,772)
Long Short Computers Operating Investment Freehold leasehold leasehold and other lease properties premises premises premises equipment assets Total 2004 £m £m £m £m £m £m £m
Contracts for future capital expenditure not provided for in the accounts at the year end (excluding investment properties) 38 447
Investment properties are valued to reflect fair market value. Valuations are carried out by qualified surveyors who are members of the Royal Institution of Chartered Surveyors, or an equivalent overseas body. The 31 December 2005 valuation for a significant majority of the Group’s investment properties was undertaken by external valuers.
Included in the above are cash flow hedging derivatives as follows: Spot, forwards and futures 5 25 Interest rate swaps 431 373
Included in the above are fair value hedging derivatives as follows: Interest rate swaps 1,096 676
Companies in the Group enter into various off-balance sheet financial instruments (derivatives) as principal either as a trading activity or to manage balance sheet foreign exchange and interest rate risk. Derivatives include swaps, forwards, futures and options. They may be traded on an organised exchange (exchange-traded) or over-the-counter (OTC). Holders of exchange traded derivatives are generally required to provide margin daily in the form of cash or other collateral.
The Group enters into fair value and cash flow hedges and hedges of net investments in foreign operations. Fair value hedges principally involve interest rate swaps hedging the interest rate risk in recognised financial assets and financial liabilities. Similarly the majority of the Group’s cash flow hedges relate to exposure to variability in future interest payments and receipts on forecast transactions and on recognised financial assets and financial liabilities and hedged by interest rate swaps for periods of up to 28 years. The Group hedges its net investments in foreign operations with currency borrowings.
Notional amounts Positive Negative Assets Liabilities 2004 £bn £m £m £m £m
Maturity of replacement cost of over-the-counter contracts (trading and non-trading) Replacement cost indicates the Group’s derivatives credit exposure. The following table sets forth the gross positive fair values by maturity. The replacement cost of internal trades is not included as there is no credit risk associated with them.
Within One to Over one year five years five years Total 2004 £m £m £m £m
Financial institutions 70,417 Others 19,481 20 Prepayments, accrued income and other assets Group Company £m £m £m £m
Amounts above include: Due from subsidiaries — 313 19 Derivatives at fair value (continued)
23 Debt securities in issue Group Company £m £m £m £m
Held-for-trading 1,469 — Designated as at fair value through profit or loss (1) 11,068 — Amortised cost 77,883 2,942
Settlement balances – amortised cost 6,561 4,067 Short positions – held-for-trading: Debt securities – Government 30,749 24,619 Debt securities – Other issuers 5,355 4,002 Treasury bills and other eligible bills 1,178 302 Equity shares 145 —
Property (1) Other (2) Total Provisions for liabilities and charges £m £m £m
Notes: (1) The Group has a number of leasehold properties where rents payable and other unavoidable costs exceed the value to the Group. Such costs arise over the period of the lease or to the expected termination date, and the provision has been discounted due to the long-term nature of certain of these obligations. (2) Other provisions arise in the normal course of business.
At 1 January 2004 under UK GAAP 75 2,440 (686) 38 — — — — 121 1,988 Implementation of IFRS (excluding IAS 32 and IAS 39) (582) (75) — 109 7 — 243 — (2) (300)
Implementation of IAS 32 and IAS 39 — — (24) — (288) 65 — 12 — (235)
Life assurance business: Unit linked insurance contracts 325 306 Other insurance contracts 1,974 1,735 Investment contracts — 2,102
Cash paid for claims settled in the year (3,198) 462 (2,736) Increase in liabilities
Cash paid for claims settled in the year (3,474) 147 (3,327) Increase in liabilities
(ii) Provisions for unearned premiums and unexpired short term insurance risks
Implementation of IAS 32, IAS 39 and IFRS 4 on 1 January 2005 47 Premiums received 429 86 Fees and expenses (11) (21) Investment return 252 333 Actuarial adjustments (91) — Account balances paid on surrender and other terminations in the year (368) (204)
Following implementation of IFRS 4 ‘Insurance Contracts’ on 1 January 2005, investment contracts have been reclassified as customer accounts.
N ot es o n th e ac co un ts 28 Subordinated liabilities Group Company £m £m £m £m
Currently 2005 2006 2007-2009 2010– 2014 thereafter perpetual Total 2004 – call date £m £m £m £m £m £m £m £m
Notes: (1) In the event of certain changes in tax laws, dated and undated loan capital issues may be redeemed in whole, but not in part, at the option of the Group, at the principal amount thereof plus accrued interest, subject to prior regulatory approval.
Non-equity shares Additional Value Shares of £0.01 — — 2,700,000 2,700,000 Non-cumulative preference shares of US$0.01 206,000 153,000 419,500 348,500 Non-cumulative convertible preference shares of US$0.01 1,000 1,900 3,900 3,900 Non-cumulative preference shares of €0.01 2,500 1,250 66,000 66,000 Non-cumulative convertible preference shares of €0.01 — 750 3,000 3,000 Non-cumulative convertible preference shares of £0.25 — — 900,000 900,000 Non-cumulative convertible preference shares of £0.01 200 200 1,000 1,000
(c) 2.3 million ordinary shares under the company’s employee share ownership plan.
In addition, options granted under the NatWest schemes were outstanding in respect of 0.8 million ordinary shares exercisable up to 2009 at prices ranging from 403p to 924p per share.
In May 2005, the company issued 40 million Series N noncumulative preference shares of US$0.01 each at US$25 per share, the net proceeds being US$969 million.
In December 2005, the company redeemed 400,000 Series 3 non-cumulative convertible preference shares of US$0.01 each at US$1,000 per share.
The costs of issue and discounts allowed on preference shares issued during the year were £42 million.
Non-cumulative preference shares of US$0.01 Series D 7 million 14 September 2005 US$25.00 Series E 8 million 17 October 2006 US$25.00 Series F 8 million 31 March 2007 US$25.00 Series G 10 million 31 March 2003 US$25.00 Series H 12 million 31 March 2004 US$25.00 Series I 12 million 30 September 2004 US$25.00
Series K 16 million 30 June 2006 US$25.00 Series L 34 million 30 September 2009 US$25.00 Series M 37 million 30 September 2009 US$25.00 Series N 40 million 30 June 2010 US$25 Series P 22 million 31 December 2010 US$25
Non-cumulative convertible preference shares of US$0.01 Series 1 1 million 31 March 2010 US$1,000 Non-cumulative preference shares of €0.01 Series 1 1.25 million 31 December 2009 €1,000
Non-cumulative convertible preference shares of £0.01 Series 1 0.2 million 31 December 2010 £1,000
Holders of the non-cumulative preference shares are not entitled to receive notice of or attend general meetings of the company except if any resolution is proposed for adoption by the shareholders of the company to vary or abrogate any of the rights attaching to the non-cumulative preference shares or proposing the winding-up or liquidation of the company. In any such case, they are entitled to receive notice of and to attend the general meeting of shareholders at which such resolution is to be proposed and will be entitled to speak and vote on such resolution (but not on any other resolution). In addition, in the event that, prior to any general meeting of shareholders, the company has failed to pay in full the three most recent quarterly dividend payments due on the non-cumulative dollar preference shares, the two most recent semi-annual dividend payments due on the non-cumulative convertible dollar preference shares and the most recent annual dividend payments due on the non-cumulative convertible euro preference shares and on the non-cumulative convertible sterling preference shares, the holders shall be entitled to receive notice of, attend, speak and vote at such meeting on all matters together with the holders of the ordinary shares, and in these circumstances only, the rights of the holders of the noncumulative preference shares so to vote shall continue until the company shall have resumed the payment in full of the dividends in arrears.
Available-for-sale reserve Implementation of IAS 32 and IAS 39 on 1 January 2005 289 — Currency translation adjustments 4 — Unrealised gains in the year 35 — Realised gains in the year (582) — Taxation 181 — At 31 December (73) —
Cash flow hedging reserve Implementation of IAS 32 and IAS 39 on 1 January 2005 67 (13) Unrealised (losses)/gains in the year (67) 6
Own shares held in relation to employee share schemes — (7) — (7)
Operating lease assets: Operating lease obligations: Amounts payable: Finance lease assets: Present value amounts receivable 817 1,813 6,093 8,723
N ot es o n th e ac co un ts Notes on the accounts continued 32 Leases (continued)
Loans and advances to customers 27,092 16,071 Debt securities 9,578 4,852 Property, plant and equipment 1,274 1,268 Loans to banks 60 —
Deposits by banks 11,407 5,628 Customer accounts 6,761 2,001 Debt securities in issue 11,347 6,561 Other liabilities 20 —
N ot es o n th e ac co un ts 34 Financial instruments
The key principles for credit risk management are set out in the Group’s Credit Risk Management Framework and include: • Approval of all credit exposure must be granted prior to any advance or extension of credit.
• Loss given default (“LGD”) – these models estimate the economic loss that may be suffered by the Group on a credit facility in the event of default. The LGD of a facility represents the amount of debt which cannot be recovered and is typically expressed as a percentage of the EAD. The Group's LGD models take into account the type of borrower, facility and any risk mitigation such as the presence of any security or collateral held. The LGD may also be affected by the industry sector of the borrower, the legal jurisdiction in which the borrower operates as well as general economic conditions which may impact the value of any assets held as security.
Risk asset quality Internal reporting and oversight of risk assets is principally differentiated by credit ratings. Internal ratings are used to assess the credit quality of borrowers. Customers are assigned credit ratings, based on various credit grading models that reflect the probability of default. All credit ratings across the Group map to a Group level asset quality scale.
Provisions methodology Under IAS 39 provisions are assessed under three categories as described below: Individually assessed provisions are the provisions required for individually significant impaired assets which are assessed on a case by case basis, taking into account the financial condition of the counterparty and any guarantor. This incorporates an estimate of the discounted value of any recoveries and realisation of security or collateral. The asset continues to be assessed on an individual basis until it is repaid in full, transferred to the performing portfolio or written off.
Collectively assessed provisions are the provisions on impaired credits below an agreed value threshold which are assessed on a portfolio basis, to reflect the homogenous nature of the assets, such as credit cards or personal loans. The provision is determined from a quantitative review of the relevant portfolio, taking account of the level of arrears, security and average loss experience over the recovery period.
Latent loss provisions are the provisions held against the estimated impairment in the performing portfolio which has yet to be identified and reported as at the balance sheet date. To assess the latent loss within the portfolio, the Group has developed methodologies to estimate the time that an asset can remain impaired within a performing portfolio before it is identified and reported as such.
Short-term liquidity risk is managed on a consolidated basis for the whole Group excluding the activities of Citizens and insurance businesses, which are subject to regulatory regimes that necessitate local management of liquidity.
Market risk The Group is exposed to market risk because of positions held in its trading portfolios and its non-trading business including the Group’s treasury operations. The Group manages the market risk in its trading and treasury portfolios through its market risk management framework, which is based on valueat -risk (“VaR”) limits, together with, but not limited to, stress testing, scenario analysis, and position and sensitivity limits. Stress testing measures the impact of abnormal changes in market rates and prices on the fair value of the Group’s trading portfolios. GEMC approves the high-level VaR and stress limits for the Group. The Group Market Risk function, independent from the Group’s trading businesses, is responsible for setting and monitoring the adequacy and effectiveness of the Group’s market risk management processes.
Any residual non-trading interest rate exposures are controlled by limiting repricing mismatches in the individual balance sheets. Potential exposures to interest rate movements in the medium to long term are measured and controlled using a version of the same VaR methodology that is used for the Group’s trading portfolios but without discount factors. Net accrual income exposures are measured and controlled in terms of sensitivity over time to movements in interest rates.
� Currency risk The Group does not maintain material non-trading open currency positions other than the structural foreign currency translation exposures arising from its investments in foreign subsidiaries and associated undertakings and their related currency funding. The Group’s policy in relation to structural positions is to match fund the structural foreign currency exposure arising from net asset value, including goodwill, in foreign subsidiaries, equity accounted investments and branches, except where doing so would materially increase the sensitivity of either the Group’s or the subsidiary’s regulatory capital ratios to currency movements. The policy requires structural foreign exchange positions to be reviewed regularly by GALCO. Gains or losses on foreign currency investments net of any gains or losses on related foreign currency funding or hedges are recognised in the statement of recognised income and expense.
Insurance risk is the risk of fluctuations in the timing, frequency and severity of insured events, relative to the expectations of the Group at the time of underwriting.
Underwriting and pricing risk The Group manages underwriting and pricing risk through underwriting guidelines for all business transacted restricting the types and classes of business that may be accepted; pricing policies by product line and by brand; and centralised control of policy wordings and any subsequent changes.
Reinsurance risk Reinsurance protects against the effect of major catastrophic events or unforeseen volumes of, or adverse trends in, large individual claims and to transfer risk that is outside the Group’s current risk appetite.
Reinsurance is only effective when the counterparty is financially secure. The rating profile of the top ten reinsurers of the Group which accounts for 67% of the total reinsurance debtors is as follows: Standard & Poor’s Rating Number of Reinsurers
Current estimate of cumulative claims 1,944 2,628 3,006 3,340 4,150 15,068
Liability recognised on the balance sheet 165 374 664 973 2,142 4,318
Liability in respect of prior years 138 Claims handling costs 109
The Group’s focus is on high volume and relatively straightforward products, for example home and motor. This facilitates the generation of comprehensive underwriting and claims data, which is used to monitor and accurately price the risks accepted. This attention to data analysis is reinforced by tight controls on costs and claims handling procedures.
The following table indicates the diversity of risks underwritten, the frequency and severity of claims and the corresponding loss ratios for each major class of business, gross and net of reinsurance.
c) Commercial other insurance contracts Other commercial claims come mainly from business interruption and loss arising from the negligence of the insured (liability insurance). Business interruption losses come from the loss of income, revenue and/or profit as a result of property damage claims. Liability insurance comprises employers liability and public/products liability. Liability insurance is written on an occurrence basis, and is subject to claims over a substantial period of time, but where loss was in existence during the life of the policy.
The Group has no interest rate exposure from general insurance liabilities because provisions for claims under short term insurance contracts are not discounted.
Life business The three regulated life companies of RBSG, NatWest Life Assurance Limited, Royal Scottish Assurance plc (“RSA”) and Direct Line Life Limited, are required to meet minimum capital requirements at all times under the Financial Service Authority’s Prudential Sourcebook. The capital resources covering the regulatory requirement are not transferable to other areas of the Group. To ensure that the capital requirement is satisfied at all times, each company holds an additional voluntary buffer above the absolute minimum. Sufficient capital resources are held to ensure that the capital requirements are covered over a two year projection period. Life insurance results are inherently uncertain, due to actual experience being different to modelled assumptions. Such differences affect regulatory capital resources, as do varying levels of new business. Therefore, projections are formally reviewed twice a year. Where there is a shortfall of capital, various options are available to provide new capital.
Sterling interest 2.85% net 3.0% net Unit growth 2.85% net 3.0% net
Mortality assumptions are set with regard to recent experience and general industry trends.
Mortality tables used: Pre-2001 products – RSA Term assurances 72% AM80 ult -2 + 33% AIDS R6A Unit-linked life assurances 76.5% / 72% AM80 ult.-2+ 33% AIDS R6A Unit-linked pensions 90% AM80 ult.-2
For contracts with fixed and guaranteed benefits and fixed future premiums, there are no mitigating terms and conditions that reduce the insurance risk accepted. Participating contracts can result in a significant portion of the insurance risk being shared with the insured party.
Purchased insurance The Insurance Sourcing Department is responsible to GEMC for the Group-wide purchase of insurance as a means of reducing other risk exposures.
Settlement balances and short positions 16,533 569 1,696 15,950 9,240 — 43,988
After 3 After 6 After 1 months months year Non but less but less but less interest Banking Trading 3 months than than than Over 5 earning/ book book or less 6 months 1 year 5 years years bearing total total Total 2004 £m £m £m £m £m £m £m £m £m
Shareholders’ equity — — — — — — — 17,538 17,538
Cumulative interest rate sensitivity gap (3,157) (3,170) (3,167) (2,923) (3,501) (3,501)
Financial assets Cash and balances at central banks 4,759 4,759 4,293 4,293 — — — —
Banking business 3,189 3,189 — — Trading business 2,921 2,921 — —
Loans and advance to customers Held-for-trading 53,963 53,963 — — Designated as at fair value through profit or loss 616 616 — —
Banking business 39,182 38,998 — — Trading business 54,726 54,726 — —
Customer accounts Held-for-trading 34,645 34,645 — — Designated as at fair value through profit or loss 3,683 3,683 — —
Banking business 242,182 241,971 — — Trading business 41,133 41,133 — —
Settlement balances and short positions 43,988 43,988 32,990 32,990 — — — —
Derivatives at fair value 96,438 96,438 18,876 18,876 — — — —
Liabilities: denominated in sterling 282,660 denominated in currencies other than sterling 305,462
Finance leases and instalment credit 13,909 4 — — 13,913 —
US Central and local government 472 27,420 — 112 28,004 —
Europe Central and local government 297 301 — — 598 121
Service industries and business activities 9,908 10 11 — 9,929 3,735 Agriculture, forestry and fishing 514 — — — 514 577
Finance leases and instalment credit 1,311 — — — 1,311 —
Rest of the World Central and local government 243 1,709 1,379 — 3,331 —
Service industries and business activities 1,610 24 17 — 1,651 — Agriculture, forestry and fishing 3 — — — 3 —
Finance lease and instalment credit — — — — — — Interest accruals 43 — — — 43 — Total Rest of the World 6,866 3,966 3,131 3 13,966 898
Service industries and business activities 75,462 4,099 2,289 162 82,012 10,036
Finance lease and instalment credit 18,193 4 — — 18,197 —
Contingent liabilities: Guarantees and assets pledged as collateral security 12,253 10,438 448 448 Other contingent liabilities 6,394 5,655 — —
Other commitments – these include forward asset purchases, forward deposits placed and undrawn note issuance and revolving underwriting facilities, documentary credits and other short-term trade related transactions.
Regulatory enquiries and investigations – in the normal course of business the Group and its subsidiaries co-operate with regulatory authorities in various jurisdictions in their enquiries or investigations into alleged or possible breaches of regulations.
Trustee and other fiduciary activities In its capacity as trustee or other fiduciary role, the Group may hold or place assets on behalf of individuals, trusts, companies, pension schemes and others. The assets and their income are not included in the Group’s financial statements.
Issue of ordinary shares 163 2,845 163 2,845 Issue of equity preference shares 1,649 1,358 1,649 1,358 Net proceeds from issue of
Other non-cash movements — 460 — (460) — 460 — (460)
40 Analysis of cash and cash equivalents Group Company £m £m £m £m
Comprising: Cash and balances at central banks 4,456 4,035 — — Treasury bills and debt securities 998 3,016 — — Loans and advances to banks repayable on demand 47,095 42,970 1,126 309 Cash and cash equivalents 52,549 50,021 1,126 309
Assets Liabilities assets Assets Liabilities assets Group £m £m £m £m £m £m
Corporate Retail Retail Wealth RBS Ulster Markets Banking Direct Management Citizens Insurance Bank Centre Total £m £m £m £m £m £m £m £m £m
Net assets attributable to equity shareholders and minority interests 19,381 14,325 3,676 162 37,544
The executive directors may also participate in the company’s executive share option, sharesave and option 2000 schemes and details of their interests in the company’s shares arising from their participation are contained on page 127. Details of the remuneration received by each director during the year and each director’s pension arrangements are given on pages 126 to 129.
Short-term benefits 26,180 23,652 Post-employment benefits 9,383 5,298 Other long-term 4,215 — Share-based payments 1,568 5,200
Loans and advances to customers 3,090 2,497 Customer accounts 12,604 8,021
Key management had no reportable transactions or balances with the company except for dividends.
(b) Intangibles other than goodwill Computer software development costs Most computer software development costs are written off as incurred.
Other intangibles An intangible asset acquired in a business combination is capitalised separately from goodwill only if it can be disposed of separately from the revenue-earning activity to which it contributes and its value can be measured reliably.
(e) Consolidation UK GAAP requires consolidation of entities controlled by the reporting entity. Control is the ability to direct the financial and operating policies of an entity.
45 Transition to IFRS (1) Significant differences between the Group’s UK GAAP accounting policies applied in its 2004 financial statements and its IFRS accounting policies
An intangible asset is recognised as an asset separately from goodwill if it is separable or if it arises from contractual or other legal rights regardless of whether these rights are transferable or separable.
Core deposit intangibles of £268 million, mortgage servicing rights of £81 million, customer relationships of £162 million and other intangibles of £18 million were recognised in business combinations that took place in 2004.
Dividends are recorded in the period in which they are declared.
All entities controlled by the Group are consolidated together with special purpose entities (SPEs) where the substance of the relationship between the reporting entity and the SPE indicates that it is controlled by the reporting entity.
Assets, liabilities, income and expense of life assurance business are consolidated on a line-by-line basis.
Movements in embedded value are not grossed up, instead they are included net of tax in profit before tax.
(g) Associates and joint ventures An associate is an entity in which the reporting entity holds a participating interest and over whose operating and financial policies it exercises a significant influence in practice. A joint venture is an entity in which the reporting entity in practice shares control with other investors. Associates are accounted for using the equity method and joint ventures using the gross equity method.
(i) Investment property Investment property is revalued annually to open market value and changes in market value reflected in the Statement of total recognised gains and losses.
(k) Pensions Pension scheme assets are measured at fair value using mid-market prices.
(m) Cash flow statements Cash comprises cash and balances with central banks and loans and advances to banks repayable on demand.
The Group’s freehold and long leasehold property occupied for its own use is recorded at cost less depreciation.
The Group has elected to use the UK GAAP valuation as at 31 December 2003 as deemed cost for freehold and long leasehold property occupied for its own use in its opening IFRS balance sheet (1 January 2004).
The Group has applied IFRS 2 ‘Share-based Payment’ to grants of options over shares after 7 November 2002 that had not vested on 1 January 2005. The expense for these transactions is measured based on the fair value on the date the options are granted. The fair value is expensed on a straight-line basis over the vesting period.
Pension scheme assets are measured at fair value using bid prices.
Deferred tax is provided on fixed asset revaluations and on taxable gains and losses on fixed asset sales rolled over into the tax cost of replacement assets.
Cash and cash equivalents comprise cash on hand and demand deposits with banks together with short-term highly liquid investments that are readily convertible to known amounts of cash and subject to insignificant risk of changes in value.
Impementation of IAS 32, IAS 39 and IFRS 4 45 Transition to IFRS (continued)
(q) Effective interest rate and lending fees Under UK GAAP, loan origination fees are recognised when received unless they are charged in lieu of interest.
(s) Loan impairment Under UK GAAP provisions for bad and doubtful debts are made so as to record impaired loans at their ultimate net realisable value. Specific provisions are established against individual advances or portfolios of smaller balance homogeneous advances and the general provision covers advances impaired at the balance sheet date but which have not been identified as such. Interest receivable from loans and advances is credited to the income statement as it accrues unless there is significant doubt that it can be collected.
On implementation of IAS 39, the carrying value of financial assets was reduced by £708 million and financial liabilities increased by £224 million, deferred tax was reduced by £283 million and shareholders’ equity reduced by £649 million.
Under IAS 39, all derivatives are measured at fair value. Hedge accounting is permitted for three types of hedge relationship: fair value hedge – the hedge of changes in the fair value of a recognised asset or liability or firm commitment; cash flow hedge – the hedge of variability in cash flows from a recognised asset or liability or a forecasted transaction; and the hedge of a net investment in a foreign entity. In a fair value hedge the gain or loss on the derivative is recognised in profit or loss as it arises offset by the corresponding gain or loss on the hedged item attributable to the risk hedged. In a cash flow hedge and in the hedge of a net investment in a foreign entity, the element of the derivative’s gain or loss that is an effective hedge is recognised directly in equity. The ineffective element is taken to the income statement. Certain conditions must be met for a relationship to qualify for hedge accounting. These include designation, documentation and prospective and actual hedge effectiveness. On implementation of IAS 39, nontrading derivatives were remeasured at fair value.
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 carried at fair value through profit or loss.
(u) Insurance contracts All contracts within the life assurance business are accounted for as insurance contracts and the obligations to policyholders presented as Long-term assurance liabilities attributable to policyholders.
(w) Extinguishment of liabilities Under UK GAAP, recognition of a financial liability ceases once any transfer of economic benefits to the creditor is no longer likely.
IFRS 4 requires life assurance products to be classified between insurance contracts and investment contracts. The latter are accounted for in accordance with IAS 39. Insurance contracts continue to be accounted for using the embedded value methodology.
There is no linked presentation under IFRS. If substantially all the risks and rewards have been retained, the gross assets and related funding are presented separately.
Opening balance sheet at 1 January 2004 – Group Software Share development Investment based Employee Total
Assets Cash and balances at central banks 3,822 — — — — — — — — — — 3,822 Treasury bills and other eligible bills 4,846 — — — — — — — — — — 4,846 Loans and advances to banks 54,392 — — — (2) — — — — 1,013 1,011 55,403 Loans and advances to customers 252,531 — — (147) 1,798 — (448) — — (541) 662 253,193
Debt securities in issue 41,016 — — — 3,129 — — — — — 3,129 44,145 Settlement balances and short positions 21,369 — — — — — — — — — — 21,369 Derivatives at fair value 15,173 — — — — — — — — (105) (105) 15,068 Accruals, deferred income
Long-term assurance liabilities 3,557 — — — — — — — — (3,557) (3,557) —
Reconciliation of shareholders’ funds as at 1 January 2004 Group Company £m £m
UK GAAP shareholders’ funds 26,098 28,545 Standards applicable to all periods: Valuation of subsidiaries — (16,857) Proposed dividend 1,059 1,059 Software development costs 814 –– Leasing (276) –– Share-based payments (6) –– Other (72) –– Tax effect on adjustments (167) –– Deferred tax (109) –– Shareholders' funds under IFRS 27,341 12,747
Balance sheet at 31 December 2004 – Group Property Software Share plant and development Investment based Employee Total UK GAAP Dividends Income tax equipment Leases Consolidation costs property payment benefits Insurance Goodwill adjustments IFRS
Assets Cash and balances at central banks 4,293 — — — — — — — — — — — — 4,293 Treasury bills and other eligible bills 6,110 — — — — — — — — — — — — 6,110 Loans and advances
Settlement balances 5,682 — — — — — — — — — — — — 5,682
Liabilities Deposits by banks 99,883 — — — — — — — — — — — — 99,883
Settlement balances and short positions 32,990 — — — — — — — — — — — — 32,990 Derivatives at fair value 19,034 — — — — — — — — — (158) — (158) 18,876 Accruals, deferred income and other
Balance sheet at 31 December 2004 – Company Valuation of Total UK GAAP Dividends subsidiaries adjustments IFRS
Assets Loans and advances to banks 4,106 — — — 4,106 Loans and advances to customers 305 — — — 305 Investments in Group undertakings 36,870 — (14,970) (14,970) 21,900 Prepayments, accrued income and other assets 322 (4) — (4) 318
Liabilities Deposits by banks 174 — — — 174 Debt securities in issue 1,608 — — — 1,608 Accruals, deferred income and other liabilities 1,609 (1,308) — (1,308) 301 Subordinated liabilities 5,935 — — — 5,935
(3) Analysis of IAS 32, IAS 39 and IFRS 4 adjustments
Cash and balances at central banks 4,293 — — — — — — — — — — — — — 4,293
Loans and advances to customers 347,251 28,566 1,533 — (31) — (82) 518 4,022 (615) — — — 33,911 381,162
Property, plant and equipment 16,428 — — — — — — — — (3) — — — (3) 16,425
Balance sheet at 1 January 2005 – Company IFRS prospective adjustments
IFRS Fair IFRS 31 December Debt/ Other Hedging & value Total 1 January 2004 equity IAS 32/39 measurement option adjustments 2005 £m £m £m £m £m £m £m
Financial assets – designated as at fair value through profit or loss 2,579 2,728 — — – Available-for-sale 40,161 39,718 — —
Section (3) summarises those areas where, though the recognition and measurement principles in US GAAP and IFRS are the same, adjustments to IFRS amounts are required due to differing implementation dates for the Group.
(a) Acquisition accounting All integration costs relating to acquisitions are expensed as post-acquisition expenses.
(b) Property revaluation and depreciation Freehold and long leasehold property occupied for the Group's use is carried at cost less accumulated depreciation. Depreciation is charged based on an estimated useful life of 50 years. As permitted by IFRS 1, valuation as at 31 December 2003 is its deemed cost.
Certain restructuring and exit costs incurred in the acquired business are treated as liabilities assumed on acquisition and taken into account in the calculation of goodwill.
Under US GAAP, revaluations of property are not permitted. Depreciation is charged, and gains or losses on disposal are based on the historical cost for both own-use and investment properties.
US GAAP requires a similar method but allows a certain portion of actuarial gains and losses to be deferred and allocated in equal amounts over the average remaining service lives of current employees. An additional minimum liability must be recognised if the accumulated benefit obligation (the current value of accrued benefits without allowance for future salary increases) exceeds the fair value of plan assets and the Group has recorded a prepaid pension cost or has an accrued liability that is less than the unfunded accumulated benefit obligation. Movements in the additional minimum liability, together with the related deferred tax, are recognised in a separate component of equity.
(g) Financial instruments Financial assets designated as at fair value through profit or loss Under IFRS, a financial asset may be designated as at fair value through profit or loss on initial recognition.