Divisional review 12 Corporate Markets 18 Retail Markets 24 Ulster Bank 26 Citizens 30 RBS Insurance 34 Manufacturing
Over the last year I have travelled widely across the Group, meeting many employees, customers and shareholders in Europe, the US and across the Asia Pacific region. I have been deeply impressed with the RBS people I have met and have found our businesses to be in good health, continuing to grow strongly and making significant impact in their respective markets.
Staff profit sharing This is the ninth successive year we have announced a profit share of 10% of salary for all eligible employees, in addition to performance bonuses. On behalf of the Board, I would like to express my warm thanks to our people for all they have done to deliver our success.
Sound control of risk is fundamental to the Group’s business. While we grew average customer lending by 14%, impairment losses have increased by just 10%. Central to this is our longstanding aversion to sub-prime lending, wherever we do business. We have also maintained the customer-driven nature of our trading activities, as reflected in trading income growth of 14%, compared with an increase of only 9% in our average daily value at risk.
Corporate Markets is aligned around two groups of customers: Global Banking & Markets is a leading banking partner to major corporations and financial and governmental institutions around the world, providing an extensive range of debt, risk and investment services; and UK Corporate Banking is the largest provider of banking, finance and risk management services to UK corporate and commercial customers.
Germany. It sells and underwrites motor, home and commercial insurance in the UK by telephone, the internet, partnerships and a network of brokers. Its brands include Direct Line,
Shanghai Time Shipping RBS’s strategic partnership with the Bank of China has opened up further opportunities for our Global Banking teams to work together. For Shanghai Time Shipping, one of the largest shippers in China, we successfully completed a $60 million financing facility for the purchase of three vessels.
Corporate Markets, formerly Corporate Banking & Financial Markets, was reorganised into two businesses, Global Banking & Markets and UK Corporate Banking, on 1 January 2006. This allowed us to focus on the distinct needs of these two customer groups and to enhance our services to them.
Business Banking � The Royal Bank of Scotland and NatWest are the market leaders in small business banking in the UK.
Cards & Direct Finance � Chip & PIN capability was successfully completed in February 2006. Implementation of this, together with other fraud prevention initiatives, contributed to a reduction in fraud losses in 2006 for our core Retail credit card portfolios.
Philadelphia Inquirer When the Philadelphia Inquirer was put up for sale last year, a consortium, led by local entrepreneurs Brian Tierney and Bruce Toll, looked to Citizens Financial Group and RBS for a funding package to give them the edge in their bid to keep the paper in local hands, despite stiff competition.
� In 2006 Citizens agreed more than 714,000 new consumer loans totalling US$20 billion, and processed more than 1.4 million credit applications.
RBS Insurance underwrites and sells motor, home, commercial and other insurance direct to customers over the telephone and internet as well as through partnerships and a network of 2,500 brokers. Its brands, which include Direct Line, Churchill, Privilege, Green Flag and NIG, are among the best known in the UK. Through its international operations, RBS sells general insurance, mainly motor, in Spain, Germany and Italy.
RBS has one of the best track records for reducing fraud and introducing robust measures which better protect our customers. One of the biggest successes of last year was the introduction of real-time monitoring of spending by our customers on their debit cards. Any uncharacteristic spending behaviour is immediately checked with customers and 3,000 frauds have already been stopped.
� In 2006, staff processed over 13% more new mortgage applications per person, compared with 2005.
World-class global sourcing leaders – Group Purchasing A. T. Kearney Assessment of Excellence in Procurement study
� Citizens Financial Group gained ‘outstanding’ Community Re-investment Act (CRA) rating in six states and contributed $27 million to non-profit organisations.
In addition, Citizens engages in a wide variety of commercial lending, consumer lending, commercial and consumer deposit products, merchant credit card services, trust services and retail investment services. Citizens includes RBS National Bank, our US credit card business, RBS Lynk, our merchant acquiring business, and Kroger Personal Finance, our credit card joint venture with the second largest US supermarket group.
Provision coverage of risk elements in lending and potential problem loans was 62% compared with 65% at 31 December 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 15%, from 169.4p to 194.7p. Earnings per ordinary share adjusted for purchased intangibles amortisation, integration costs and net gain on sale of strategic investments and subsidiaries increased by 14%, from 175.9p to 200.0p.
Growth in banking volumes contributed to a 13% rise in net interest income to £500 million. Average loans and advances to customers rose by 14% and average deposits by 10%, with net interest margin maintained at close to 2005 levels.
Allocation of Manufacturing costs 214 207 Operating profit 388 323 £bn £bn
Staff costs 763 725 Other costs 2,089 2,033 Total Manufacturing costs 2,852 2,758 Allocated to divisions (2,852) (2,758)
Global Banking & Markets 8,700 7,400 UK Corporate Banking 8,800 8,400
The increase in settlement balances and short positions, up £5.5 billion, 12%, to £49.5 billion, reflected growth in customer activity.
Net purchases of property, plant and equipment 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 net income available for ordinary shareholders under US GAAP was £5,440 million; £762 million lower than profit attributable to ordinary shareholders under IFRS of £6,202 million. The principal reasons for the decrease are: • reversal of net revaluation gains of £470 million on investment properties.
Credit approval process Different credit approval processes exist for each customer type in order to ensure appropriate skills and resources are employed in credit assessment and approval whilst following the key principles relating to credit approval.
Detailed liquidity position reports are compiled each day by Group Treasury and reviewed daily and weekly with Global Banking & Markets, who manage day-to-day and intra-day market execution within the policy parameters set.
Loans and advances to customers as a % of customer accounts (excluding repos) 127.4% 126.6% 124.1%
By remaining maturity up to one month: Deposits by banks (excluding repos) 36,089 35,153 34,041 Less: loans and advances to banks (gross, excluding reverse repos) (21,136) (16,381) (17,067) Debt securities in issue 19,924 20,577 15,505 Net wholesale liabilities due within one month 34,877 39,349 32,479
The Group also provides liquidity back-up facilities to both its own conduits and certain other conduits which take funding from the commercial paper market. Limits sanctioned for such facilities totalled less than £12 billion at 31 December 2006. The short-term contingent liquidity risk in providing such backup facilities is also mitigated by the spread of maturity dates of the commercial paper taken by the conduits.
N um b er o f tr ad in g d ay s
Reinsurance of risks above the Group’s risk appetite is only effective if the reinsurance premium payable makes economic sense and 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.
The following paragraphs explain the frequency and severity of claims and the sources of uncertainty for the key classes that the Group is exposed to: a) Motor insurance contracts (private and commercial) Claims experience is variable, due to a wide range of factors, but the principal ones are age, sex and driving experience of the driver, type and nature of vehicle and use of vehicle and area.
Chief Executive, Retail Markets 7. Gordon Pell (age 57) FCIBS, FCIB Appointed to the Board in March 2000, Gordon Pell was formerly group director of Lloyds TSB UK Retail Banking before joining National Westminster Bank Plc as a director in February 2000 and then becoming chief executive, Retail Banking. He is also a director of Race for Opportunity and a member of the National Employment Panel and the FSA Practitioner Panel. He was appointed chairman of the Business Commission on Racial Equality in the Workplace in July 2006.
A member of the Audit Committee C member of the Chairman’s Advisory Group N member of the Nominations Committee R member of the Remuneration Committee * independent non-executive director
Employee learning and development The Group maintains a strong commitment to creating and providing learning opportunities for all its employees through a variety of personal development and training programmes and learning networks. The Group’s employees are encouraged to volunteer to work with its community partners. The Group continues to invest in leadership and management development which is consistent with its objective of being the employer of choice: attracting, rewarding and retaining the very best talent.
In the first quarter of 2006 the Group launched a Wellbeing website which includes a health and wellbeing calendar. The site is designed to raise awareness of international health issues and events, and to provide lifestyle education, information and support to employees.
For the financial services sector, consumer banking issues are the primary focus, followed by financial inclusion and capability, financial crime and corruption, employee practices, the challenge of climate change, support for small businesses and community giving. The Group takes all these responsibilities seriously, continually monitoring and managing them through policies and practices across the Group. The Board regularly considers corporate responsibility issues and receives a formal report on these twice each year.
Lawrence Fish, Sir Fred Goodwin, Archie Hunter, Bud Koch, Joe MacHale and Gordon Pell will retire and offer themselves for re-election at the company’s Annual General Meeting.
The Group assessed the effectiveness of its internal control over financial reporting as of 31 December 2006 based on the framework set forth by the Committee of Sponsoring Organizations of the Treadway Commission in ‘Internal Control – Integrated Framework’. Based on this assessment, management has concluded that, as of 31 December 2006, the Group’s internal control over financial reporting is effective.
Audit Committee Report The members of the Audit Committee are Archie Hunter (Chairman), Colin Buchan, Bill Friedrich (since July 2006), Joe MacHale and Sir Steve Robson. All members of the Audit Committee are independent non-executive 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, three being added in 2006. Audit Committee meetings are attended by relevant executive directors, the internal and external auditors and finance and risk management executives. At least twice per annum the Audit Committee meets privately with the external auditors. The Audit Committee also visits business divisions and selected Group functions under a programme set at the beginning of each year.
In 2005 the Audit Committee reviewed the audit committee structure throughout the Group and, as a result, proposed to the Board a reorganisation and strengthening of the structure to ensure that audit committees would cover each separate Group business appropriately. That recommendation was accepted by the Board, and, whilst still in its initial year, the revised structure has bedded down well. The Audit Committee has an appropriately close relationship with each of the business audit committees.
The Remuneration Committee makes recommendations to the Board on the remuneration arrangements for the executive directors and the Chairman. The Remuneration Committee also approves the remuneration arrangements of senior executives below Board level who are members of the Group Executive Management Committee, on the recommendation of the Group Chief Executive, and reviews all long-term incentive arrangements which are operated by the Group.
In respect of 2006, the Remuneration Committee reviewed the annual incentive payments for all executive directors taking into account performance against the various targets set at the beginning of the year and covering overall Group financial metrics, divisional performance and each director’s other operational targets.
Mr Cameron 29 March 1998 12 months 6 months The Royal Bank of Scotland plc
Mr Fish 18 February 2004 12 months 12 months Citizens Financial Group, Inc.
Sir George Mathewson received life assurance cover under an individual arrangement until his retirement from the Board. Details of his current benefits are set out on page 119. The non-executive directors do not accrue pension benefits or receive life assurance cover.
(2) 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 Group pension scheme.
The directors are responsible for keeping proper accounting records which disclose with reasonable accuracy at any time the financial position of the Group and to enable them to ensure that the Annual Report and Accounts complies with the Companies Act 1985. They are also responsible for safeguarding the assets of the company and the Group and hence for taking reasonable steps for the prevention and detection of fraud and other irregularities.
US opinion In our opinion, the financial statements present fairly, in all material respects, the financial position of the Group as at 31 December 2006 and 2005 and the results of its operations and its cash flows for each of the three years in the period ended 31 December 2006, in accordance with IFRS.
Payment services: this comprises income received for payment services including cheques cashed, direct debits, Clearing House Automated Payments (the UK electronic settlement system) and BACS payments (the automated clearing house that processes direct debits and direct credits). These are generally charged on a per transaction basis. The income is earned when the payment or transaction occurs. Charges for payment services are usually debited to the customer’s account, monthly or quarterly in arrears. Accruals are raised for services provided but not charged at period end.
Interchange received: as issuer, the Group receives a fee (interchange) each time a cardholder purchases goods and services. The Group also receives interchange fees from other card issuers for providing cash advances through its branch and Automated Teller Machine networks. These fees are accrued once the transaction has taken place.
Acquired goodwill being the excess of the cost of an acquisition over the Group’s interest in the net fair value of the identifiable assets, liabilities and contingent liabilities of the subsidiary, associate or joint venture acquired is initially recognised at cost and subsequently at cost less any accumulated impairment losses. Goodwill arising on the acquisition of subsidiaries and joint ventures is included in the balance sheet caption ‘Intangible fixed assets’ and that on associates within their carrying amounts. The gain or loss on the disposal of a subsidiary, associate or joint venture includes the carrying value of any related goodwill.
Depreciation is charged to profit or loss on a straight-line basis so as to write-off the depreciable amount of property, plant and equipment (including assets owned and let on operating leases (except investment property – see accounting policy 19 below)) over their estimated useful lives. The depreciable amount is the cost of an asset less its residual value. Land is not depreciated. Estimated useful lives are as follows: Freehold and long leasehold buildings 50 years Short leaseholds unexpired period of the lease Property adaptation costs 10 to 15 years Computer equipment up to 5 years Other equipment 4 to 15 years
A derivative embedded in a contract is accounted for as a standalone derivative if its economic characteristics are not closely related to the economic characteristics of the host contract; unless the entire contract is carried at fair value through profit or loss.
21. Shares in Group entities The company’s investments in its subsidiaries are stated at cost less any impairment.
F in an ci al s ta te m en ts which is based on historical trends and, therefore, allows for some increase due to changes in common law and statute. Costs for both direct and indirect claims handling expenses are also included. Outward reinsurance recoveries are accounted for in the same accounting period as the direct claims to which they relate. The outstanding claims provision is based on information available to management and the eventual outcome may vary from the original assessment. Actual claims experience may differ from the historical pattern on which the estimate is based and the cost of settling individual claims may exceed that assumed.
In August 2005, the IASB issued an amendment, ‘Capital Disclosures’, to IAS 1 ‘Presentation of Financial Statements’. It requires disclosures about an entity’s capital and the way it is managed. This amendment is also effective for annual periods beginning on or after 1 January 2007.
Profit before other operating charges and impairment losses 15,522 13,956 13,029
Wages, salaries and other staff costs 5,652 5,084 4,421 Social security costs 389 354 295 Share-based compensation 65 44 36 Pension costs (see Note 3) – defined benefit schemes 580 462 397 – defined contribution schemes 37 48 39
Interest receivable from subsidiaries 516 577 313 Interest payable to subsidiaries (246) (189) (150) Other net interest payable and operating expenses (515) (638) (273) Operating profit before tax 3,486 1,932 2,890
Amounts above include: Reverse repurchase agreements 54,152 41,804 — — Items in the course of collection from other banks 3,471 2,901 Due from subsidiaries 7,252 9,122 12 Loans and advances to customers Group Company £m £m £m £m
Deferred tax liability 3,264 1,695 — — Deferred tax asset (included in Prepayments, accrued income and other assets, Note 20) (156) (156) (3) (3)
– arising from current year claims 4,267 (53) 4,214 – arising from prior year claims (242) 4 (238)
Group 2005 – call date £m £m £m £m £m £m £m £m
National Westminster Bank Plc US$500 million primary capital floating rate notes, Series A (callable on any interest payment date) 256 291 US$500 million primary capital floating rate notes, Series B (callable on any interest payment date) 267 295 US$500 million primary capital floating rate notes, Series C (callable on any interest payment date) 254 294 US$500 million 7.875% exchangeable capital securities (redeemed January 2006) — 295 US$500 million 7.75% reset subordinated notes (callable October 2007) 262 305 €400 million 6.625% fixed/floating rate undated subordinated notes (callable October 2009) 280 299 €100 million floating rate undated step-up notes (callable October 2009) 68 70 £325 million 7.625% undated subordinated step-up notes (callable January 2010) 359 372 £200 million 7.125% undated subordinated step-up notes (callable October 2022) 205 205 £200 million 11.5% undated subordinated notes (callable December 2022) (4) 272 277
Cumulative preference shares of £1 £0.4 million 5.5% (non-redeemable) — —
US$950 million 5.512% (redeemable September 2014) 529 529 US$1,000 million 3 month US$ LIBOR plus 0.80% (redeemable September 2014) 555 555 £400 million 5.6457% (issued December 2006; redeemable June 2017) 400 —
Preference shares In March 2006, the company redeemed the 7 million Series D and the 12 million Series I, non-cumulative preference shares of US$0.01 each at US$25 per share.
In January 2007, the company redeemed the 8 million Series E, the 10 million series G and the 16 million series K, non-cumulative preference shares of US$0.01 each at US$25 per share.
Currency translation adjustments — — (231) — — (231) Shares issued during the year 815 1,972 4,550 815 1,972 4,550 Shares repurchased during the year (381) — — (381) — — Redemption of preference shares classified as debt 271 — — 271 — — Conversion of exchangeable undated loan capital — — 460 — — 460 Other movements — — 10 — — 10
After 1 year Within 1 but within After 5 year 5 years years Total 2006 £m £m £m £m
Risk is managed within limits approved by GALCO through the execution of cash and derivative instruments. Execution of the hedging is carried out by the relevant division through the Group’s treasury function. The residual risk position is reported to divisional asset and liability committees, GALCO and Board.
Service industries and business activities 10,678 1,267 168 — 12,113 22 Agriculture, forestry and fishing 64 — — — 64 —
Europe Central and local government 488 423 — 3 914 —
Finance lease and instalment credit — — — — — — Interest accruals 43 — — — 43 — Total Rest of the World 6,866 3,966 3,131 3 13,966 898 35 Financial instruments (continued)
Total income £m £m £m £m £m £m £m £m £m
IAS 39 requires the amortised cost of a financial instrument to be calculated using the effective interest method. The effective interest rate is the rate that discounts estimated future cash flows over an instrument’s expected life to its net carrying value. It takes into account all fees and points paid that are an integral part of the yield, transaction costs and all other premiums and discounts.
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
Certain direct (but not necessarily incremental) costs are deferred and recognised over the period of the related loan or facility.
Under US GAAP, debt and equity securities having a readily determinable fair value are classified as available-for-sale. Such securities are measured at fair value with unrealised gains and losses reported in a separate component of equity.
Investment securities held by the Group’s private equity business are considered to be held by investment companies and carried at fair value, with changes in fair value being reflected in net income. The Group’s other investment debt securities and marketable investment equity shares are classified as available-for-sale securities and measured at fair value with unrealised gains and losses reported in a separate component of equity, except when the unrealised loss is considered other-than-temporary in which case the loss is included in net income.
Outstanding options to purchase shares are excluded from the computation of diluted EPS where the exercise prices of the options are greater than the average market price of the ordinary shares during the relevant period. At 31 December 2006, there were 5.1 million such options outstanding (2005 –
The following table shows additional information in respect of the loan impairment provisions.
Domestic Central and local government — 1.4 — 0.8 — 0.6
Return on average total assets (3) 0.73% 0.64% 0.70% 0.55% 0.75% Return on average ordinary shareholders’ equity (4) 16.0% 13.4% 13.2% 9.5% 12.1% Average shareholders’ equity as a percentage
Summary consolidated profit and loss account – UK GAAP £m £m £m
Net interest income 9,208 8,301 7,849 Non-interest income 13,546 10,980 9,167
Service industries and business activities 516 8.8 599 11.4 699 11.5
Service industries and business activities 163 393 180 Agriculture, forestry and fishing 9 4 10
Finance 2 — — Service industries and business activities 1 3 1 Property — — 1 Individuals – home mortgages 1 — —
Closing provisions for bad and doubtful debts as a % of total risk elements in lending 76% 76% 80% Closing provisions for bad and doubtful debts as a % of total risk elements in lending and potential problem loans 73% 68% 65% Risk elements in lending as a % of gross loans and advances to customers excluding reverse repos 1.86% 2.22% 2.37%
Off-balance sheet arrangements The Group is involved with several types of off-balance sheet arrangements, including special purpose vehicles, lending commitments and financial guarantees.
As regards the insurance industry, the FSA’s primary objective is to regulate and supervise the industry so that policyholders have confidence that they have bought appropriate products, and so that UK insurers are able to meet their liabilities and treat customers fairly. The FSA sets requirements relating to ‘margins of solvency’ (i.e. the excess of the value of assets over the amount of liabilities). Companies carrying out insurance business are required to submit regular returns covering reserves and solvency to the FSA.
Conduct of business standards essentially govern key aspects of firms’ relationships with customers, and require the provision of clear and adequate information, the managing of conflicts of interest and the recommending of products suitable to the needs of customers. The marketing of financial products (particularly investment products) is subject to detailed requirements. The FSA is scheduled to issue new conduct of business rules during 2007 to comply with the implementation of the Markets in Financial Instruments Directive in November 2007.
Major shareholders Details of major shareholders of the company’s ordinary and preference shares are given on page 107.