As filed with the Securities and Exchange Commission on April 29, 2009


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 


FORM 20-F
 
(Mark One)
   
o
 
REGISTRATION STATEMENT PURSUANT TO SECTION 12(b) OR (g) OF THE SECURITIES EXCHANGE ACT OF 1934
  OR
x
 
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   
For the fiscal year ended December 31, 2008
  OR
o
 
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
  OR
o
 
SHELL COMPANY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Date of event requiring this shell company report ___________
For the transition period from ___________ to ___________

Commission file number 001-10306

THE ROYAL BANK OF SCOTLAND GROUP plc
(Exact name of Registrant as specified in its charter)

United Kingdom
(Jurisdiction of incorporation or organization)

RBS Gogarburn, PO Box 1000, Edinburgh EH12 1HQ
(Address of principal executive offices)
 
 
Miller McLean, Group General Counsel and Group Secretary, Tel: +44 (0) 131 523 2333, Fax: +44 (0) 131 626 3081,
PO Box 1000, Gogarburn, Edinburgh EH12 1HQ
(Name, Telephone, E-mail and/or Facsimile number and Address of Company Contact Person)
 
Securities registered or to be registered pursuant to Section 12(b) of the Act:

Title of each class
 
Name of each exchange on which registered
American Depositary Shares, each representing 20 ordinary shares, nominal value £0.25 per share
 
New York Stock Exchange
Ordinary shares, nominal value £0.25 per share
 
New York Stock Exchange*
American Depositary Shares Series F, H, L, M, N, P, Q, R, S, T and U each representing one Non-Cumulative Dollar Preference Share, Series F, H, L, M, N, P, Q, R, S, T and U respectively
 
New York Stock Exchange
Dollar Perpetual Regulatory tier one securities, Series 1
 
New York Stock Exchange

* Not for trading, but only in connection with the registration of American Depositary Shares representing such ordinary shares pursuant to the requirements of the Securities and Exchange Commission.
 
Securities registered or to be registered pursuant to Section 12(g) of the Act:
None


Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act:
None

 
Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock as of December 31, 2008, the close of the period covered by the annual report:

Ordinary shares of 25 pence each
39,456,004,899
 
Non-cumulative dollar preference shares, Series F, H and L to U
 
308,015,000
Non-voting Deferred Shares
2,660,556,304
 
Non-cumulative convertible dollar preference shares, Series 1
 
1,000,000
11% cumulative preference shares
500,000
 
Non-cumulative euro preference shares, Series 1 to 3
 
2,526,000
5½% cumulative preference shares
400,000
 
Non-cumulative convertible sterling preference shares, Series 1
 
200,000
      Non-cumulative sterling preference shares, Series 1 and 2   5,750,000

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act
Yes x   No o

If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.
Yes o  No x

Note — checking the box above will not relieve any registrant required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 from their obligations under those Sections.

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes x No o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes o No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer x
Accelerated filer o
Non-accelerated filer o
 
Indicate by check mark which basis of accounting the registrant has used to prepare the financial statements included in this filing:

U.S. GAAP o  International Financial Reporting Standards as issued by the International Accounting Standards Board x   Other o

If “Other” has been checked in response to the previous question, indicate by check mark which financial statement item the registrant has elected to follow.
Item 17 o   Item 18 o

If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o   No x

(APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PAST FIVE YEARS)
Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court.
Yes o   No o
 



 
SEC Form 20-F cross reference guide
 
Item
Item Caption
Pages
       
PART I
     
1
Identity of Directors, Senior Management and Advisers
Not applicable
2
Offer Statistics and Expected Timetable
Not applicable
3
Key Information
 
   
   
Capitalisation and indebtedness
Not applicable
   
Reasons for the offer and use of proceeds
Not applicable
   
4
   
   
   
   
4A
Unresolved Staff Comments
Not applicable
5
Operating and Financial Review and Prospects
 
   
   
   
Research and development, patents, licences etc
Not applicable
   
   
   
6
Directors, Senior Management and Employees
 
   
   
   
   
   
7
Major Shareholders and Related Party Transactions
 
   
   
   
Interests of experts and counsel
Not applicable
8
Financial Information
 
   
   
 
i

 
 
Item
Item Caption
Pages
       
9
The Offer and Listing
 
   
   
Plan of distribution
Not applicable
   
   
Selling shareholders
Not applicable
   
Dilution
Not applicable
   
Expenses of the issue
Not applicable
10
Additional Information
 
   
Share capital
Not applicable
   
   
   
   
   
Dividends and paying agents
Not applicable
   
Statement of experts
Not applicable
   
   
Subsidiary information
Not applicable
11
12
Description of Securities other than Equity Securities
Not applicable
 
PART II
   
13
Defaults, Dividend Arrearages and Delinquencies
Not applicable
14
Material Modifications to the Rights of Security Holders and Use of Proceeds
Not applicable
15
16
[Reserved]
 
16
A
 
B
 
C
 
D
Exemptions from the Listing Standards for Audit Committees
Not applicable
 
E
Purchases of Equity Securities by the Issuer and Affiliated Purchasers
Not applicable
  F Change in Registrants Certifying Accountant
Not applicable
  G Corporate Governance
PART III
   
17     
Financial Statements
Not applicable
18   
19   
    

ii

 
Business Review

 
2
3
4
6    
Recent developments
13
21
21
24
34
53
55
56
57

 
Presentation of information 

 
In this document, and unless specified otherwise, the term ‘company’ means The Royal Bank of Scotland Group plc, ‘RBS’, 'RBS Group', or the ‘Group’ means the company and its subsidiaries, ‘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 results, assets and liabilities of individual business units are classified as trading or non-trading based on their predominant activity. 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.
 
International Financial Reporting Standards
As required by the Companies Act 1985 and Article 4 of the European Union IAS Regulation, the consolidated financial statements of the Group are prepared in accordance with International Financial Reporting Standards issued by the International Accounting Standards Board (IASB) and interpretations issued by the International Financial Reporting Interpretations Committee of the IASB (together ‘IFRS’) as adopted by the European Union. It also complies with IFRS as issued by the IASB. On implementation of IFRS on 1 January 2005, the Group took advantage of the option in IFRS 1 ‘First-time Adoption of International Financial Reporting Standards’ to implement IAS 39 ‘Financial Instruments: Recognition and Measurement’, IAS 32 ‘Financial Instruments: Disclosure and Presentation’ and IFRS 4 ‘Insurance Contracts’ from 1 January 2005 without restating its 2004 income statement and balance sheet. The date of transition to IFRS for the Group and the company and the date of their opening IFRS balance sheets was 1 January 2004.
 
Acquisition of ABN AMRO
On 17 October 2007, RFS Holdings B.V. (‘RFS Holdings’), a company jointly owned by RBS, Fortis Bank Nederland (Holding) N.V. (‘Fortis’) and Banco Santander S.A. (‘Santander’) (together the ‘consortium members’) and controlled by RBS, completed the acquisition of ABN AMRO Holding N.V. (‘ABN AMRO’).
 
On 3 October 2008, the State of the Netherlands acquired Fortis Bank Nederland (Holding) N.V. including the Fortis participation in RFS Holdings that represents the acquired activities of ABN AMRO and their participation in Dutch insurance activities.
 
RFS Holdings is implementing an orderly separation of the business units of ABN AMRO with RBS retaining the following ABN AMRO business units:
 
·  
Continuing businesses of Business Unit North America;
 
·  
Business Unit Global Clients and wholesale clients in the Netherlands (including former Dutch wholesale clients) and Latin America (excluding Brazil);
 
·  
Business Unit Asia (excluding Saudi Hollandi); and
 
·  
Business Unit Europe (excluding Antonveneta).
 
Certain other assets will continue to be shared by the consortium members.
 
Statutory results
RFS Holdings is jointly owned by the consortium members. It is controlled by the company and is therefore fully consolidated in its financial statements. Consequently, the statutory results of the Group for the year ended 31 December 2007 and 2008 include the results of ABN AMRO for 76 days and the full year respectively. The interests of Fortis, and its successor the State of the Netherlands, and Santander, in RFS Holdings are included in minority interests.
 
 
 
2

 
Business review continued

 
Forward-looking statements

 
 
Certain sections in this document contain ‘forward-looking statements’ as that term is defined in the United States Private Securities Litigation Reform Act of 1995, such as statements that include the words ‘expect’, ‘estimate’, ‘project’, ‘anticipate’, ‘believes’, ‘should’, ‘intend’, ‘plan’, ‘probability’, ‘risk’, ‘Value-at-Risk (VaR)’, ‘target’, ‘goal’, ‘objective’, ‘will’, ‘endeavour’, ‘outlook’, ‘optimistic’, ‘prospects’ and similar expressions or variations on such expressions.
 
In particular, this document includes forward-looking statements relating, but not limited, to the Group’s potential exposures to various types of market risks, such as interest rate risk, foreign exchange rate risk and commodity and equity price risk. Such statements are subject to risks and uncertainties. For example, certain of the market risk disclosures are dependent on choices about key model characteristics and assumptions and are subject to various limitations. By their nature, certain of the market risk disclosures are only estimates and, as a result, actual future gains and losses could differ materially from those that have been estimated.
 
Other factors that could cause actual results to differ materially from those estimated by the forward-looking statements contained in this document include, but are not limited to: general economic conditions in the UK and in other countries in which the Group has significant business activities or investments, including the United States; the monetary and interest rate policies of the Bank of England, the Board of Governors of the Federal Reserve System and other G7 central banks; inflation; deflation; unanticipated turbulence in interest rates, foreign currency exchange rates, commodity prices and equity prices; changes in UK and foreign laws, regulations and taxes; changes in competition and pricing environments; natural and other disasters; the inability to hedge certain risks economically; the adequacy of loss reserves; acquisitions or restructurings; technological changes; changes in consumer spending and saving habits; and the success of the Group in managing the risks involved in the foregoing.
 
The forward-looking statements contained in this document speak only as of the date of this report, and the Group does not undertake to update any forward-looking statement to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.
 
For a further discussion of certain risks faced by the Group, see Risk factors on pages 13 to 20.
 
 
 
Business review continued

 
Business review


 
Description of business
Introduction
The Royal Bank of Scotland Group plc is the holding company of a large global banking and financial services group. Headquartered in Edinburgh, the Group operates in the United Kingdom, the United States and internationally through its two principal subsidiaries, the Royal Bank and NatWest. Both the Royal Bank and NatWest are major UK clearing banks whose origins go back over 275 years. In the United States, the Group’s subsidiary Citizens is a large commercial banking organisation. The Group has a large and diversified customer base and provides a wide range of products and services to personal, commercial and large corporate and institutional customers.
 
Following a placing and open offer in December 2008, referred to herein as the First Placing and Open Offer, Her Majesty's Treasury in the United Kingdom (HM Treasury) owned approximately 58% of the enlarged ordinary share capital of the company and £5 billion of non-cumulative sterling preference shares. In April 2009, the company issued new ordinary shares by way of a second placing and open offer, referred to herein as the Second Placing and Open Offer, the proceeds from which were used in full to fund the redemption of the preference shares held by HM Treasury at 101% of their issue price together with the accrued dividend and the commissions payable to HM Treasury under the Second Placing and Open Offer Agreement. The Second Placing and Open Offer was underwritten by HM Treasury and as a result, HM Treasury currently owns approximately 70% of the enlarged ordinary share capital of the company.
 
The Group had total assets of £2,401.7 billion and owners’ equity of £58.9 billion at 31 December 2008. The Group’s capital ratios, which include the equity minority interest of The State of the Netherlands and Santander in ABN AMRO, were a total capital ratio of 14.1 per cent., a core Tier 1 capital ratio of 6.8 per cent. and a Tier 1 capital ratio of 10.0 per cent., as at 31 December 2008.
 
Organisational structure and business overview
The Group’s activities are organised in the following business divisions: Global Markets (comprising Global Banking & Markets and Global Transaction Services), Regional Markets (comprising UK Retail & Commercial Banking, US Retail & Commercial Banking, Europe & Middle East Retail & Commercial Banking and Asia Retail & Commercial Banking), RBS Insurance and Group Manufacturing. A description of each of the divisions is given below.
 
Global Banking & Markets (GBM) is a leading banking partner to major corporations and financial institutions around the world, providing an extensive range of debt and equity financing, risk management and investment services to its customers. In 2008 the division was organised along four principal business lines: rates, currencies, and commodities, including RBS Sempra Commodities LLP (the commodities-marketing joint venture between RBS and Sempra Energy which was formed on 1 April 2008); equities; credit markets; and asset and portfolio management.
 
Following RBS’s strategic review, GBM is planning to re-focus its business around its core corporate and institutional clients, concentrating its activities in major financial centres and scaling back its presence elsewhere. It will exit illiquid proprietary trading and balance sheet-heavy niche products segments.
 
Globally, the intention is for GBM to move increasingly towards a “hub-and- spoke” model. Risk will be managed from regional hubs. It is intended that distribution and coverage will be delivered from a mix of hub countries and a scaled-back presence in some local offices. The aim, over time, will be to reduce much of the on-shore trading activity outside the key financial centres.
 
Assets, products and geographies that fit GBMs new client-focused proposition will be defined as “core” and will remain within the division.  Assets, business lines and some geographies that are non-core will be transferred to the new Non-Core Bank. These non-core activities accounted for approximately £205 billion of third party assets at end 2008.
 
Global Transaction Services ranks among the top five global transaction services providers, offering global payments, cash and liquidity management, as well as trade finance, United Kingdom and international merchant acquiring and commercial card products and services. It includes the Group’s corporate money transmission activities in the United Kingdom and the United States.
 
Following RBS’s strategic review, Global Transaction Services intends to reduce its international network while retaining the capability to serve multinational clients globally.
 
The business also plans to increase efficiency through development of a lower cost front and back-office operating model and explore joint ventures for growth and selective disposals.
 
UK Retail & Commercial Banking (RBS UK) comprises retail, corporate and commercial banking and wealth management services. It supplies financial services through both the RBS and NatWest brands.
 
UK Retail Banking offers a full range of banking products and related financial services to the personal market. It serves customers through two of the largest networks of branches and ATMs in the United Kingdom, and also through telephone and internet channels and, according to Gfk NOP, is the second largest provider of personal current accounts. The division also issues credit and charge cards, including through other brands such as MINT.
 
UK Business & Commercial Banking is the largest provider of banking, finance, and risk management services to the SME sector in the United Kingdom. It offers a full range of banking products and related financial services through a nationwide network of relationship managers, and also through telephone and internet channels. The product range includes asset finance, in which, according to the Finance Lease Association, it has a strong market presence through the Lombard brand.

According to Ph. Group, UK Corporate Banking holds the largest market share in the United Kingdom of relationships with larger companies, offering a full range of banking, finance, and risk management services.
 
UK Wealth Management provides private banking and investment services through Coutts, Adam & Co., RBS International and NatWest Offshore.
 
US Retail & Commercial Banking provides financial services primarily through the Citizens and Charter One brands.
 
Citizens is engaged in retail and corporate banking activities through its branch network in 12 states in the United States and through non-branch offices in other states. Citizens is a large commercial banking organization.
 
Following RBS’s strategic review, Citizens intends to invest in its core business through increased marketing activity and targeted technology investments while reducing activity in its out-of-footprint national businesses in consumer and commercial finance.
 
This strategy will allow Citizens to become fully funded from its own customer deposits over time, and will support a low risk profile.
 
Europe & Middle East Retail & Commercial Banking comprises Ulster Bank and the Group’s combined retail and commercial businesses in Europe and the Middle East.
 
Ulster Bank provides a comprehensive range of financial services across the island of Ireland. Its retail banking arm has a network of branches and operates in the personal, commercial and wealth management sectors, while its corporate markets operations provides services in the corporate and institutional markets.
 
The retail and commercial businesses in Europe and the Middle East have smaller activities in Romania, Kazakhstan and the United Arab Emirates. Following RBS’s strategic review, RBS has decided to exit sub-scale retail and commercial activities outside its core markets in the United Kingdom, Europe and the United States.
 
 
4

 
Business review continued

 
 
Asia Retail & Commercial Banking is present in markets including India, Pakistan, China, Taiwan, Hong Kong, Indonesia, Malaysia and Singapore. It provides financial services across four segments: affluent banking, cards and consumer finance, business banking and international wealth management, which offers private banking and investment services to clients in selected markets through the RBS Coutts brand.
 
Following RBS’s strategic review, RBS has decided to exit sub-scale retail and commercial activities outside its core markets in the United Kingdom, Europe and the United States.
 
RBS Insurance sells and underwrites retail and SME insurance over the telephone and internet, as well as through brokers and partnerships. Its brands include Direct Line, Churchill and Privilege, which sell general insurance products direct to the customer, as well as Green Flag and NIG. Through its international division, RBS Insurance sells general insurance, mainly motor, in Spain, Germany and Italy. The Intermediary and Broker division sells general insurance products through independent brokers.
 
Following RBS’s strategic review, RBS has decided to retain RBS Insurance.
 
Group Manufacturing comprises the Group’s worldwide manufacturing operations. It supports the customer-facing businesses and provides operational technology, customer support in telephony, account management, lending and money transmission, global purchasing, property and other services. Group Manufacturing drives efficiencies and supports income growth across multiple brands and channels by using a single, scalable platform and common processes wherever possible. It also leverages the Group’s purchasing power and has become the centre of excellence for managing large-scale and complex change.
 
The Centre comprises group and corporate functions, such as capital raising, finance, risk management, legal, communications and human resources. The Centre manages the Group’s capital resources and Group-wide regulatory projects and provides services to the operating divisions.
 
RFS Holdings minority interest comprises those activities of ABN AMRO that are attributable to the other consortium members.
 
Share of shared assets comprises the Group's share of the unallocated assets of ABN AMRO. 
 
Non-core division
RBS intends to create during the second quarter of 2009 a non-core division to manage separately approximately £240 billion of third party assets, £145 billion of derivative balances and £155 billion of risk weighted assets that it intends to run off or dispose of over the next three to five years. The division will contain primarily assets from the GBM division linked to proprietary trading portfolios, excess risk concentrations and other illiquid portfolios. It will also include excess risk concentrations from other divisions as well as a number of small Regional Markets businesses that RBS has concluded are no longer strategic.
 
Recent developments
 
HM Treasury Asset Protection Scheme and additional capital raising
 
On 26 February 2009, RBS confirmed its intended participation in the Asset Protection Scheme (“APS”). The arrangements between RBS and HM Treasury will, if completed, allow RBS to secure asset protection in respect of some of its riskiest assets that enhances its financial strength and provides improved stability for customers and depositors, and also enhances RBS’s ability to lend into the UK market.
 
Issuance of capital
 
On or after the proposed implementation of the APS, HM Treasury will subscribe for £13 billion of B Shares. The arrangements for the subscription of these B Shares are to be determined and the proceeds of such issue will, if such B Shares are issued, be used to increase further the Group’s Core Tier 1 capital. A summary of the expected terms of the B Shares is set out below. HM Treasury will also commit to subscribe for an additional £6 billion of B Shares at RBS’s option. The detailed terms of such option remain to be agreed between RBS and HM Treasury.
 
Scheme amount
 
RBS intends to participate in the APS in respect of assets with a par value of approximately £325 billion and a carrying value net of impairments and write downs of approximately £302 billion as at 1 January 2009.
 
First loss
 
The agreement would see RBS bear the first loss amount relating to the assets in the APS up to £19.5 billion (after taking into account historic impairments and write downs). Losses arising in respect of the assets after the first loss amount would be borne 90 per cent. by HM Treasury and 10 per cent. by RBS. The APS will, if entered into, apply to losses incurred on the protected assets on or after 1 January 2009.
 
Fee and issuance of capital
 
If it enters into the APS, RBS will pay a participation fee of £6.5 billion to HM Treasury. On 26 February 2009, RBS announced that it would issue £6.5 billion of B Shares, and the participation fee may be funded through the proceeds of such issuance. The £6.5 billion of B Shares, which will be issued if RBS enters into the APS, will be in addition to, and on the same terms as, the B Shares referred to above and will constitute Core Tier 1 capital. In addition, RBS has agreed in principle that, if it enters into the APS, it would not claim certain UK tax losses and allowances.
 
Assets
 
Specific assets to be included in the APS will be subject to the approval of HM Treasury. The assets would be drawn from RBS’s and certain of its affiliates’ portfolios of corporate and leveraged loans, commercial and residential property loans, structured credit assets and such other assets as HM Treasury and RBS agree are to be included in the APS. It is also envisaged that the APS may include structured synthetic assets and counterparty risk exposures associated with certain derivatives transactions with monoline insurers and credit derivative product companies. RBS expects that the APS will protect: £225 billion of third party assets, £44 billion of undrawn commitments, and £33 billion in other counterparty risk exposures.
 
Capital ratios
 
The APS and proceeds of the issue of B Shares are expected to improve the consolidated capital ratios of RBS by (i) substituting risk weight applicable to the UK Government for that of the protected assets; and (ii) the subscription for the B Shares by HM Treasury (being both the £6.5 billion of B Shares, the proceeds of which may be used to fund the fee for the APS and the additional £13 billion of B Shares to be issued on or after the implementation of the APS). Based on total covered assets of approximately £325 billion, risk weighted assets would reduce by approximately £144 billion. As an illustration, if the Company had issued £19.5 billion of B Shares on 31 December 2008 offset by the expected £6 billion reduction of first loss exposure under the APS from Core Tier 1 capital in accordance with the FSA Handbook, and with the redemption of the preference shares issued to HM Treasury (“Preference Share Redemption”), RBS expects there would have been a significant increase to the Core Tier 1 ratio.
 
In addition, RBS will continue to look at various market based and/or internal capital management opportunities to generate and further strengthen Core Tier 1 capital.
 
 
 
 
6

 
Business review continued

 
Term
 
While it is intended that the APS would apply to the protected assets until their maturity, RBS’s participation in the APS would be capable of termination in whole or in part by mutual agreement of RBS and HM Treasury.
 
Management of the assets
 
RBS would be required under the APS to manage the assets in accordance with certain asset management requirements as referred to in the APS. These would include, amongst others, (i) reporting requirements to provide financial, risk and performance data in respect of the protected assets and to monitor compliance with the APS, (ii) the adoption of oversight and control procedures with respect to the management of the protected assets, (iii) requirements in relation to organisational structure, staffing, resourcing, systems and controls required for implementation, administration and monitoring compliance with the APS and (iv) the monitoring and management of conflicts of interest and potential conflicts of interest. As the APS is intended to apply to losses on protected assets arising from 1 January 2009, RBS has agreed with HM Treasury certain interim arrangements (in force with immediate effect) relating to the management of those assets likely to be part of the APS.
 
Impact on the capital structure of the Company
 
If the additional £6 billion of B Shares are subscribed for by HM Treasury and £25.5 billion of B Shares convert mandatorily, or are converted by HM Treasury, into ordinary shares in the hands of HM Treasury, the percentage of HM Treasury’s ownership of RBS’s ordinary shares will be 84.4 per cent., with shareholders experiencing a corresponding dilution to their interests in the company. However, without prejudice to rights arising on the mandatory conversion into ordinary shares, HM Treasury shall not be entitled to exercise its option to convert B Shares into ordinary shares for as long as it holds 75 per cent. or more of the ordinary shares or if the exercise of such option would result in it holding 75 per cent. or more of the ordinary shares. Further details regarding the effect of the B Shares on the dividends payable are set out below.
 
Conditions to accession to the Scheme
 
Implementation of the APS for RBS will be subject to further due diligence by HM Treasury and its advisers, documentation and satisfaction of applicable conditions (including the application criteria and asset eligibility criteria of the APS), adoption of a prescribed remuneration policy in respect of assets managed under the APS and conditions precedent to accession in the APS, including state aid, regulatory and shareholder approvals. RBS has agreed to provide certain information to HM Treasury in the period prior to RBS’s proposed accession, including
 
 (i)           an indicative list of the Proposed Assets, with a view to agreeing such list by 30 April 2009;
 
(ii)           information and data relating to the Proposed Assets for the purposes of HM Treasury’s due diligence; and
 
(iii)           access to RBS’s premises, books, records, senior executives, relevant personnel and professional advisers.
 
As at the date of this document, the timing for the implementation of the APS is still to be determined. The proposed entry by the Company into the APS and any associated capitalisation would constitute a related party transaction for the purposes of the Listing Rules requiring the approval of Independent Shareholders. Therefore if the Company is to participate in the APS, it will convene a further general meeting to seek Independent shareholder approval and a circular explaining the proposals and containing the relevant general meeting notice will be sent to Shareholders in due course, although no prospectus will be required.
 
 
Terms and conditions of the B Shares
 
At the same time as it announced RBS plc’s intended participation in the APS, RBS announced that it expected to issue to HM Treasury (i) £6.5 billion of B Shares at the time of entering into the APS and (ii) a further £13 billion of B Shares on or after implementation of the APS. RBS also announced that it had been agreed with HM Treasury that, at RBS’s option, a further £6 billion of B Shares could be issued to HM Treasury. The detailed terms of this option remain to be agreed between RBS and HM Treasury. All of these B Shares are expected to constitute Core Tier 1 capital and will be issued on the same terms. Key terms of the B Shares are expected to include the following:
 
•           Nominal value and issue price: £0.50 per B Share.
 
•           Ranking: on a winding-up, holders of the B Shares will rank pari passu with the holders of any other classes of Ordinary Shares and junior to preference shareholders. For these purposes, on a winding-up each holder of a B Share will be deemed to hold one Ordinary Share of RBS for every B Share held at the date of the commencement of such winding-up (the “Winding Up Ratio”).
 
•           Dividend entitlement: non-cumulative dividends will be declared at the discretion of RBS, which dividends shall be paid in priority to any dividend on any other class of ordinary share capital. If declared, dividends on the B Shares will be paid semi-annually in arrear. The first such semi-annual dividend in respect of any financial year shall be payable on the date that is three business days after the record date in respect of the interim dividend payable on the Ordinary Shares in respect of such financial year, if such interim dividend on the Ordinary Shares is to be paid. The second such semi-annual dividend in respect of any financial year shall be payable on the date that is three business days after the record date in respect of the final dividend payable on the Ordinary Shares in respect of such financial year, if such final dividend on the Ordinary Shares is to be paid. If no interim dividend on the Ordinary Shares is to be paid in respect of any financial year, the first semi-annual dividend on the B Shares in respect of such financial year, if to be paid, shall be payable on 31 October in such financial year, and if no final dividend on the Ordinary Shares is to be paid in respect of any financial year the second semi-annual dividend on the B Shares in respect of such financial year, if to be paid, shall be payable on 31 May in the immediately following financial year.
 
•           If to be paid, the dividend per B Share will be equivalent to (i) 7 per cent. of the issue price of each B Share multiplied by the number of days in the period from (and including) the immediately preceding Relevant Date (as defined below) or, in the case of the first semi annual dividend in 2009, the date of issue to (but excluding) the current Relevant Date divided by 365 (or 366 in a leap year) or (ii) in the case of any second semi-annual dividend in respect of any financial year, if greater and if a dividend or dividends or other distribution(s) is/are paid or made (whether interim or final) on the Ordinary Shares in respect of the period from (but excluding) the Relevant Date falling on (or nearest to) one year prior to the current Relevant
 
 
 
7

 
Business review continued

 
Date to (and including) the current Relevant Date, 250 per cent. (the “Participation Rate”) of the aggregate amount of such dividend(s) or distribution(s) per Ordinary Share less the amount of the first semi-annual dividend (if any) paid in respect of such financial year. “Relevant Date” means each date on which RBS pays a semi-annual dividend or, if no such payment has been made, 31 October in respect of the first semi-annual dividend in respect of any financial year and 31 May in the immediately following financial year in respect of the second semi-annual dividend in respect of any financial year.
 
•           Scrip dividends: if RBS decides to pay a dividend on the B Shares in respect of a semi-annual period and either (i) no dividend has been paid on the Ordinary Shares and/or distribution made thereon in respect of the same period or (ii) a dividend has been paid and/or a distribution has been made thereon otherwise than in cash in respect of the same period, RBS may in its discretion determine that the dividend on the B Shares in respect of the corresponding period shall be paid in whole or in part by RBS issuing further B Shares to the holders of B Shares. The number of further B Shares to be issued to each holder shall be such number of B Shares as shall be certified by an independent investment bank (acting as expert) to equal the value in cash of the dividend otherwise payable on the B Shares in respect of the relevant period.
 
•           Restrictions following non-payment of dividend: if RBS decides not to pay any semi-annual dividend on the B Shares in cash or otherwise, then until such time as semi-annual dividends on the B Shares have been resumed in full RBS will be prohibited from paying dividends or other distributions (whether in cash or otherwise) on, or redeeming, purchasing or otherwise acquiring, (i) its Ordinary Shares or (ii) any other securities of RBS or any other member of the Group ranking or expressed to rank pari passu with the Ordinary Shares and the B Shares on a winding-up, either issued by RBS or, where issued by another member of the Group, where the terms of the securities benefit from a guarantee or support agreement entered into by RBS which ranks or is expressed to rank pari passu with the Ordinary Shares and the B Shares on a winding-up.
 
•           Redemption rights: none, but RBS may purchase the B Shares subject to applicable laws and FSA consent.
 
•           Conversion rights: at any time a holder of a B Share may deliver a notice to RBS requesting conversion of B Shares into Ordinary Shares of RBS. All B Shares shall automatically and mandatorily convert into Ordinary Shares if the volume weighted average trading price of the Ordinary Shares for 20 complete trading days in any 30 trading day period equals or exceeds £0.65 per Ordinary Share. The number of Ordinary Shares to be issued upon conversion will be determined by dividing the aggregate issue price (£0.50 per B Share) of the B Shares being converted by the Conversion Price. The conversion price of the B Shares will be £0.50 (the “Conversion Price”).
 
•           Limitations on optional conversion: without prejudice to the provisions above concerning the mandatory conversion of the B Shares, HM Treasury shall not be entitled to exercise its option to convert B Shares into Ordinary Shares to the extent that it holds 75 per cent. or more of the Ordinary Shares or to the extent that the exercise of such option would result in it holding 75 per cent. or more of the Ordinary Shares.
 
•           Voting rights before conversion: holders of the B Shares will only have voting rights in limited circumstances (resolutions varying/abrogating class rights and resolutions to wind up, or in relation to the winding-up of, RBS). If entitled to vote, on a poll holders of B Shares will have two votes for each B Share held. HM Treasury shall not be so entitled to vote the B Shares to the extent the votes cast on such B Shares, together with any other votes which HM Treasury is entitled to cast in respect of any Ordinary Shares held by or on behalf of HM Treasury, would exceed 75 per cent. of the total votes eligible to be cast on a resolution proposed at a general meeting of RBS.
 
•           Voting rights after conversion: HM Treasury shall not be entitled to vote in respect of Ordinary Shares acquired by it as a result of the conversion of B Shares into Ordinary Shares to the extent that votes cast on such Ordinary Shares, together with any other votes which HM Treasury is entitled to cast in respect of any other Ordinary Shares held by or on behalf of HM Treasury, would exceed 75 per cent. of the total votes eligible to be cast on a resolution proposed at a general meeting of RBS.
 
•           Pre-emption rights: HM Treasury shall agree that it shall not exercise any pre-emption rights it may be entitled to as a holder of B Shares in respect of future issues of Ordinary Shares.
 
•           Ordinary Share buy-back: for as long as any B Shares remain outstanding, RBS may not purchase any of its Ordinary Shares.
 
•           Listing: the B Shares will not initially be listed. HM Treasury is entitled to require RBS to seek a listing of the B Shares.
 
•           Adjustment events: the Winding Up Ratio and Participation Rate shall be subject to anti-dilution adjustments. The Conversion Price shall be adjusted in accordance with standard Euro-market anti-dilution adjustments other than customary change of control adjustments or extraordinary dividend adjustments (to the extent compensated by dividends paid at the Participation Rate).
 
 
 
Second Placing and Open Offer
 
Background to the Second Placing and Open Offer
 
In 2008 the Board concluded that the Group needed to strengthen its capital base and to accomplish this two capital raisings were carried out. A £12 billion rights issue was completed in June 2008. Then, due to a severe deterioration in financial markets and economic conditions, a further capital raising totalling £20 billion was completed in December 2008. Of the £20 billion raised in December, £15 billion was in the form of Ordinary Shares, and £5 billion was in the form of Preference Shares purchased entirely by HM Treasury. As a result of this capital raising, HM Treasury acquired approximately 57.9 per cent. of the issued ordinary share capital of the Company. The intention of the Board was that HM Treasury’s holding of Preference Shares would be redeemed as soon as practicable.
 
In the last few weeks of 2008 the continuing dislocation in financial markets and significant uncertainties in credit conditions, together with the sharp deterioration in economic conditions, negatively impacted the trading performance of many financial institutions globally, including RBS. As a result, RBS incurred significant credit impairment losses and credit market write downs.
 
In view of the above, the Board, in conjunction with HM Treasury, decided to take steps to improve the quality of the Group’s capital base by carrying out the Second Placing and Open Offer, and using the proceeds to redeem the Preference Shares held by HM Treasury. Shareholders were able to apply to subscribe for £5.37 billion of new ordinary shares pro rata to their existing shareholdings at a fixed price of 31.75 pence per share by way of the open offer.
 
The capital restructuring resulting from the Second Placing and Open Offer removed the £0.6 billion annual cost of the preference share dividend and created £5 billion of additional Core Tier 1 capital, which provides a higher quality level of capital support against the impact on the Group’s business of any further deterioration in economic and financial market conditions. Following the Second Placing and Open Offer, HM Treasury currently own approximately 70.3 per cent. of the issued ordinary share capital of the company.
 
Various initiatives, such as the Asset Protection Scheme (“APS”) and the Credit Guarantee Scheme, are being progressed by the UK Government to stabilise the UK banking system further and enhance support for the economy. The stated aims of the APS and the Credit Guarantee Scheme are to reinforce the stability of the financial system, to increase confidence and capacity to lend, and in turn to support the recovery of the UK economy. The other initiatives are expected to focus on asset and funding risks which are central to freeing up additional lending capacity whilst augmenting the impact of the capital measures described above.
 
By participating in the APS, the Group will be able to free up its lending capacity. Consequently, the Group announced on 26 February 2009 that it would increase its lending to UK homeowners and businesses subject to the Group’s ordinary course credit and pricing criteria on the Group’s normal contractual terms by £25 billion over the next 12 months. The increased lending will be split £9 billion to mortgage lending and the remaining £16 billion to business lending. Similar levels of lending have been committed to in 2010. This latest commitment supersedes the lending commitments the Group announced in October 2008 and in January 2009 and builds on NatWest’s and RBS plc’s recently announced pledge to continue to provide committed overdrafts and no increased pricing for small business customers until at least the end of 2009. These lending commitments will cease if RBS does not participate in the APS and Credit Guarantee Scheme by 1 June 2009 or will reduce if it participates in only one of the APS or Credit Guarantee Scheme prior to 1 June 2009.
 
While redemption of the Preference Shares allows the resumption of a sustainable and progressive dividend policy for the Ordinary Shares (it was a term of the Preference Shares that no such dividends may be paid while the Preference Shares were in issue), it is not the Board’s intention to pay a dividend on the Ordinary Shares in 2009. If the B Shares are issued as announced on 26 February 2009, no cash dividend may be paid on the Ordinary Shares unless the cash dividend payable in respect of the same period on the B Shares is paid in full, and no scrip dividend may be paid on the Ordinary Shares unless the cash or scrip dividend payable in respect of the same period on the B Shares is paid in full.
 
Impact of the Second Placing and Open Offer and the Preference Share Redemption on RBS
 
The effect of the Second Placing and Open Offer and the Preference Share Redemption was to improve the quality of RBS’s regulatory capital by increasing RBS’s Core Tier 1 ratio; the Tier 1 ratio was not affected. The Second Placing and Open Offer and the Preference Share Redemption had no other impact on RBS’s balance sheet. The Preference Shares carried a coupon of 12 per cent. at the discretion of the Board while the new shares issued in connection with the Second Placing and Open Offer rank pari passu with the existing shares of the company for any dividend payments. Accordingly, other than the elimination of the annual distribution at the discretion of the Board in respect of the preference share coupon, and the inclusion of the new shares in the payment of any future dividends on RBS’s ordinary shares, the Placing and Open Offer and Preference Share Redemption had no impact on the Group’s income statement.
 
Sale of Bank of China Investment
 
On 14 January 2009, the Group (through RBS China Investment Sarl.) sold its entire 4.26 per cent stake in Bank of China for HKD18.4 billion.
 
Debt Tender and Exchange Offer
 
On 26 March 2009, RBS Financing Limited ("RBSF"), a subsidiary of the Group, launched a cash tender offer in the United States (the “RBSF US Tender Offer”) for any and all of the outstanding securities of ten different series previously issued by the Group and certain of its affiliates.  Concurrently therewith, RBSF also launched a cash tender offer outside of the United States (the “RBSF Non-US Tender Offer”) for five different series of securities previously issued by The Royal Bank and certain of its affiliates and an offer outside of the United States to exchange (the “RBSF Exchange Offer”) any or all of the outstanding securities of fourteen different series previously issued by The Royal Bank and certain of its affiliates for new senior unsecured notes of The Royal Bank.
 
The RBSF Tender Offers and the RBSF Exchange Offer expired on 22 April 2009. In the RBSF US Tender Offer, an aggregate of approximately US $4.1 billion principal amount of securities were validly tendered, resulting in an aggregate purchase consideration paid for the tendered securities of approximately US $1.7 billion.
 
In the RBSF Non-US Tender Offer, an aggregate of approximately €2.3 billion principal amount of Euro-denominated securities and approximately US $264 million principal amount of Dollar-denominated securities were validly tendered, resulting in aggregate purchase consideration paid for the tendered securities of approximately €1.1 billion and US $100 million, respectively.
 
In the RBSF Exchange Offer, an aggregate of approximately £3.5 billion principal amount of securities were validly offered for exchange and exchanged for new senior unsecured notes of The Royal Bank in an aggregate principal amount of approximately £1.8 billion.
 
Litigation Update
 
Note 32 of the Notes on the Accounts provides disclosure regarding, among other things, litigation claims in the United Kingdom.  With respect to the claims regarding unarranged overdraft charges, the Group and other banks appealed against the orders of the High Court.  On 26 February 2009, the Court of Appeal delivered its judgment and rejected the appeals.  The House of Lords has granted the Group and other banks leave to appeal the Court of Appeals decision. That further appeal is scheduled to take place on 23 June 2009. With respect to class action complaints filed in the United States District Court for the Southern District of New York, complaints relating to public filings in connection with the broad class of RBS publicly traded securities between 26 June 2007 and 19 January 2009 are included in the description of class action complaints in Note 32.
 
Strategic review
 
RBS has embarked on a sweeping restructuring of the Group that will fit its activities to the goals outlined above. While the details of the strategic plan will be refined over the coming weeks to take account of the final agreements reached with HM Treasury in respect of RBS’s participation in the APS, the plan is expected to include the following:
 
•           RBS will create a “Non-Core” division of RBS during the second quarter of 2009, separately managed, but within the existing legal structures of the Group and matrix managed to donating divisions where necessary. RBS currently intends that this division will have approximately £240 billion of third party assets, £145 billion of derivative balances and £155 billion of risk-weighted assets, comprising individual assets, portfolios and businesses of the Group that RBS intends to run off or dispose of during the next three to five years. The specific timetable will vary in each case but will be as fast as RBS judges consistent with optimising shareholder value and risk. Approximately 90 per cent. of the Non-Core division will consist of GBM assets, primarily linked to proprietary portfolios, excess risk concentrations and illiquid ‘originate and hold’ asset portfolios. The rest of the Non-Core division will be risk concentrations, ‘out of footprint’ assets and smaller, less advantaged businesses within our Regional Markets activities across the world. As part of this effort it is intended that RBSs representation in approximately 36 of the 54 countries it operates in around the world will be significantly
 
 
9

 
Business review continued

 
 
reduced or sold. RBS will remain strong in all its major existing global hubs, however. Given the commercial and human sensitivity of these issues, detail on this will not be given until the interim results. The income, expenses, impairments and credit market and other trading asset write downs associated with the Non-Core Division in 2008 were approximately £3.9 billion, £1.1 billion, £3.2 billion and £9.2 billion respectively.
 
•           In addition to eliminating expenses associated with the Non-Core division, RBS has launched a restructuring plan to make efficiency savings across the Group, aimed at achieving run-rate reductions by 2011 of greater than £2.5 billion (16 per cent. of 2008 cost base) at constant exchange rates. This will involve a wide range of re-engineering and other measures and, regrettably, reductions in employment. This target excludes any impact of inflation, incentive pay movements or cost reductions arising from business exits or the impact of new projects (if any). It includes the £0.5 billion of ABN AMRO integration benefits previously announced but not reflected in 2008 expenses. We will book one-off charges against these actions over the next three years, with run-rate cost savings expected to provide ‘payback’ in 1.5 to 1.75 years.
 
•           RBS plans to retain each of its major business divisions since it believes, with intensive restructuring, they can meet the attractive business characteristics outlined as targets above. In many cases the restructuring of these businesses to achieve RBSs goals will be far-reaching, nevertheless. The greatest element of restructuring will be in GBM as signalled above. A substantial shrinkage of size, product and geographic scope will take place. This should leave GBM positioned profitably around those of its existing core strengths that rest on profitable customer franchise business with significantly less illiquid risk overall.
 
•           At all times RBS will responsibly compare the value to RBS of each of its businesses with realistic alternatives and take different action if they prove compelling. However, the distressed and pessimistic state of markets for financial assets and businesses offers little immediate encouragement in that regard.
 
•           Alongside our business restructuring activities will be substantive changes to management and internal processes. There will continue to be changes of personnel as RBS promotes and reassigns internal talent and add to its ranks externally. The Manufacturing division will re-align with the customer facing businesses. Businesses will have clear bottom-line returns, allocated equity and balance sheet and funding goals. While RBS drives for profit, there will be a concentration on earnings quality and sustainability, driven by strategic plans, to ensure alignment of our businesses to their markets and their risk targets. People evaluation and incentivisation will meet best practice levels to support the revised mission of the Company. This will be underpinned by a full suite of risk and funding constraints, including concentration limits.
 
RBS has already begun this major change programme. To carry it through in parallel with running its continuing business in difficult markets will test management capacity. RBS expects to be successful overall, though it will inevitably have setbacks and make mistakes along the way. But there is no alternative. RBS must change in a far-reaching way. If it does that, the strength, quality and power that are already present in RBS business across the world will have the chance to shine through once again.
 
 
 
 
Relationship with major shareholder
The UK Government currently owns 70.3 per cent. of the issued ordinary share capital of RBS. The UK Government’s shareholding in RBS is currently held by the Solicitor for the Affairs of HM Treasury as nominee for HM Treasury and managed by UK Financial Investments Limited (“UKFI”), a company wholly owned by HM Treasury. No formal relationship agreement has been concluded between RBS and the UK Government, although the relationship falls within the scope of the framework document between HM Treasury and UKFI published on 2 March 2009. This document states that UKFI will manage the UK financial institutions in which HM Treasury holds an interest “on a commercial basis and will not intervene in day-to-day management decisions of the Investee Companies (including with respect to individual lending or remuneration decisions)”, which is designed to ensure that control of the relationship is not abused. This document also makes it clear that such UK financial institutions will continue to be separate economic units with independent powers of decision and “will continue to have their own independent boards and management teams, determining their own strategies and commercial policies (including business plans and budgets).”
 
These goals are consistent with the stated public policy aims of the UK Government, as articulated in a variety of public announcements.
 
In the framework document between UKFI and HM Treasury, UKFI stated that its goal was to “develop and execute an investment strategy for disposing of the investments [in the banks] in an orderly and active way through sale, redemption, buy-back or other means within the context of an overarching objective of protecting and creating value for the taxpayer as shareholder, paying due regard to the maintenance of financial stability and to acting in a way that promotes competition.”
 
It was also stated that UKFI intended to “engage robustly with banks’ boards and management, holding both strategy and financial performance to account, and taking a strong interest in getting the incentives structures right on the board and beyond—accounting properly for risk and avoiding inefficient rewards for failure.”
 
In this connection, RBS announced on 17 February 2009 that it had reached an agreement with UKFI in respect of certain changes to its remuneration policy. RBS has also undertaken to conduct a review of its strategy and UKFI has been actively engaged in reviewing the output of this review.
 
In connection with its proposed access to the APS (further details of which are set out above), RBS has undertaken to provide lending to creditworthy UK homeowners and businesses in a commercial manner. RBS’s compliance with this commitment will be subject to a monthly reporting process to the UK Government. The lending commitment does not require RBS to lend in excess of its single name or sectoral risk concentration limits or otherwise to engage in uncommercial practices.
 
RBS, in common with other financial institutions, also works closely with a number of UK Government departments and agencies on various industry-wide initiatives that are intended to support the UK Government’s objective of supporting stability in the wider financial system.
 
Other than in relation to these areas, however, the UK Government has confirmed publicly that its intention is to allow the financial institutions in which it holds an interest to operate their business independently.

Following consultation with UKFI and other major institutional shareholders the Nominations Committee recommended the appointment of Philip Hampton to the Board of Directors, which approved the appointment.
 
As a result of the UK Government’s holding, the UK Government and UK Government controlled bodies became related parties of the Group.  The Group enters into transactions with many of these bodies on an arms' length basis. 

The Group is not a party to any transaction with the UK Government or any UK Government controlled body involving goods or services which is material to the Group, or any such transaction that is unusual in its nature or conditions. To the Group's knowledge, the Group does not believe it is a party to any transaction with the UK Government or any UK Government controlled body involving goods or services which is material to the UK Government or any UK Government controlled body, however, given the nature and extent of the UK Government controlled bodies, the Group may not know whether a transaction is material for such a party.

Any outstanding loans made by the Group to or for the benefit of the UK Government or any UK Government controlled body, were made on an arm's length basis and (A) such loans were made in the ordinary course of business, (B) were made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons, and (C) did not involve more than the normal risk of collectibility or present other unfavorable features.  The Group notes, however, that with respect to outstanding loans made by the Group to or for the benefit of the UK Government or any UK Government controlled body, there may not exist any comparable transactions with other persons. 
 
Trading and outlook
On 26 February 2009, RBS announced its results for the year ended 31 December 2008. In that announcement, RBS made the following statement about current trading and outlook for 2009.

‘‘To make any forecast is hazardous beyond the expectation that 2009 will be a very tough year for the world economy. RBS, in common with all banks, will see some erosion of underlying income levels as a result of weaker business activity and low interest rates squeezing savings margins whilst credit costs rise, probably sharply. We hope that markets will be less disrupted than in 2008, with lower associated write-downs, but time will tell. 2009 has, in fact, started positively for our businesses. At the time of writing, RBS is in discussions with the UK Government concerning participation in the proposed Asset Protection Scheme (‘‘APS’’). This would be subject to shareholder vote in due course. The result of the APS discussions will have a material impact on RBS’s outlook, positive or negative depending on outcome. More information will be made available as soon as practicable.

Notwithstanding the challenging outlook, our businesses all around the world are inherently good and fully engaged in sustaining as robust a performance as the environment permits. And the strategic restructuring we have embarked on will see high levels of activity designed to reposition RBS successfully.’’

Annual General Meeting held on 3 April 2009
On 3 April 2009, the Group held its Annual General Meeting. At the meeting, shareholders voted to (i) elect Philip Hampton, Stephen Hester, John McFarlane and Arthur 'Art' Ryan as directors of the Group, (ii) re-appoint Deloitte LLP as the company’s auditor and (iii) authorise the Audit Committee to fix the remuneration of the auditors. All other resolutions presented to shareholders at the Annual General Meeting were also approved by shareholders.

General Meeting held on 3 April 2009
On 3 April 2009, the Group held a General Meeting in connection with the Second Placing and Open Offer. At the meeting, all resolutions presented to shareholders were approved by shareholders.
 
 
Competition
The Group faces strong competition in all the markets it serves. However, the global banking crisis has reduced the capacity of many institutions to lend and has resulted in the withdrawal or disappearance of a number of market participants and significant consolidation of competitors, particularly in the US and UK. Competition for retail deposits has intensified significantly reflecting the difficulties in the wholesale money markets.
 
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 European and Asian corporate and institutional banking markets the Group competes with the large domestic banks active in these markets and with the major international banks.
 
In the small business banking market, the Group competes with other UK clearing banks, specialist finance providers and building societies.
 
In the personal banking segment the Group competes with UK banks and building societies, major retailers and life assurance companies. In the mortgage market the Group competes with UK banks and building societies. A number of competitors have either left or scaled back their lending in the mortgage and unsecured markets. The Group’s life assurance businesses compete with Independent Financial Advisers and life assurance companies.
 
In the UK credit card market large retailers and specialist card issuers, including major US operators, are active in addition to the UK banks. In addition to physical distribution channels, providers compete through direct marketing activity and the internet.
 
In Europe, Asia and the Middle East, the enlarged Group now competes in retail banking with local and international banks. In a number of these markets there are regulatory barriers to entry or expansion, and the state ownership of banks. Competition is generally intensifying as more players enter markets that are perceived to be de-regulating and offer significant growth potential.
 
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. Competition in wealth management remains strong as banks maintain their focus on competing for affluent and high net worth customers.
 
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. Competition in the UK motor market remains particularly intense, and price comparison internet sites now play a major role in the marketplace. RBS Insurance also competes with local insurance companies in the direct motor insurance markets in Spain, Italy and Germany.
 
In Ireland, Ulster Bank and First Active compete in retail and commercial banking with the major Irish banks and building societies, and with other UK and international banks and building societies active in the market.
 
In the United States, Citizens competes in the New England, Mid-Atlantic and Mid West retail and mid-corporate banking markets with local and regional banks and other financial institutions. The Group also competes in the US in large corporate lending and specialised finance markets, and in fixed-income trading and sales. Competition is principally with the large US commercial and investment banks and international banks active in the US.
 
 
Business review continued

 
Set out below are certain risk factors which could affect the Group’s future results and cause them to be materially different from expected results. The Group’s results are also affected by competition and other factors. The factors discussed in this report should not be regarded as a complete and comprehensive statement of all potential risks and uncertainties.
 
The company may face the risk of full nationalisation and under such circumstances shareholders may lose the full value of their shares.
Under the provisions of the Banking Act, substantial powers have been granted to HM Treasury, the Bank of England and the Financial Services Authority (FSA) as part of the Special Resolution Regime to stabilise banks that are in financial difficulties. The Special Resolution Regime gives the authorities three stabilisation options: private sector transfer, of all or part of the business of a UK-incorporated institution with permission to accept deposits (a “relevant entity”); transfer of all or part of the business of the relevant entity to a “bridge bank” established by the Bank of England; and temporary public ownership (nationalisation) of the relevant entity or its UK-incorporated holding company.
 
The purpose of the stabilising options is to address the situation where all or part of the business of the relevant entity has encountered, or is likely to encounter, financial difficulties. Accordingly, the stabilisation options may only be exercised if the FSA is satisfied that a relevant entity such as the Group’s banking subsidiaries, including the Royal Bank and NatWest, (i) is failing, or is likely to fail, to satisfy the threshold conditions set out in Schedule 6 to the Financial Services and Markets Act 2000 (the FSMA) and (ii) having regard to timing and other relevant circumstances it is not reasonably likely that action will be taken that will enable the relevant entity to satisfy those threshold conditions. The threshold conditions are conditions which an FSA-authorised institution must satisfy in order to retain its FSA authorisation. They are relatively wide-ranging and deal with most aspects of a relevant entity’s business, including, but not limited to, minimum capital resource requirements. It is therefore possible that the FSA may exercise one of the stabilisation options before a relevant entity is in severe difficulties and before an application for insolvency or an administration order could be made.
 
The stabilisation options may be exercised by means of powers to transfer property, rights or liabilities of a relevant entity and shares and other securities issued by a relevant entity. HM Treasury may also take the parent company of a relevant entity (such as the Company) into temporary public ownership provided that certain conditions set out in Section 82 of the Banking Act are met. Temporary public ownership is effected by way of a share transfer order.
 
If HM Treasury makes the decision to take the holding company of a relevant entity into temporary public ownership, it may take various actions in relation to securities issued by the holding company, including:
 
·  
to transfer securities free from any contractual or legislative restrictions on transfer;
 
·  
to transfer securities free from any trust, liability, or encumbrance;
 
·  
to extinguish rights to acquire securities;
 
·  
to delist securities; or
 
·  
to convert securities into another form or class.
 
Where HM Treasury has made a share transfer order in respect of securities issued by the holding company of a relevant entity, HM Treasury may make an order providing for the property, rights or liabilities of the holding company or of any relevant entity in the holding company group to be transferred.
 
Shareholders may have a claim for compensation under one of the compensation schemes provided for in the Banking Act. For the purposes of determining an amount of compensation, an independent valuer must disregard actual or potential financial assistance provided by the Bank of England or HM Treasury.
 
There can be no assurance that Shareholders would thereby recover compensation promptly and/or equal to any loss actually incurred.
 
If the Group were made subject to the Special Resolution Regime and a partial transfer of the Group’s business was effected, the nature and mix of the assets and liabilities not transferred may adversely affect its financial condition and increase the risk that the Group may eventually become subject to administration or insolvency proceedings.
 
Over the last six months, the UK Government has taken action under the Banking (Special Provisions) Act 2008 in respect of a number of UK financial institutions, including in extreme circumstances, full and part nationalisation. There have been concerns in the market in recent months regarding the risks of such nationalisation in relation to RBS and other UK banks. If economic conditions in the UK or globally continue to deteriorate, or the events described in the following risk factors occur to such an extent that they have a materially adverse impact on the financial condition, perceived or actual credit quality, results of operations or business of any of the relevant entities in the Group, the UK Government may decide to take similar action in relation to RBS. Given the extent of HM Treasury’s and the Bank of England’s powers under the Banking Act, it is difficult to predict what effect such actions might have on RBS and any securities issued by it. However, potential impacts may include full nationalisation of RBS and the total loss of value in RBS shares.
 
If RBS is unable to participate in the APS, or the operation of the APS fails to have the desired effect on RBS’s financial and capital position, the Company may face the increased risk of full nationalisation. If the costs of participation outweigh the benefits, this could have a negative impact on RBS’s business, earnings and financial prospects and its Share price may suffer.
On 26 February 2009, RBS announced its intention to participate in the APS. However, its ability to participate in the APS is subject to the satisfaction of a number of conditions which may not be satisfied, including, among others, the completion of due diligence by (and to the satisfaction of) HM Treasury, the receipt of certain regulatory approvals (including European Commission State Aid clearance), the approval of a majority of RBS’s Independent Shareholders, finalisation of the terms of the APS and RBS’s participation therein and the satisfaction by RBS of certain specified application criteria. The failure to satisfy these conditions could result in RBS being unable to participate in the APS and therefore failing to obtain protection against stressed losses through the economic cycle as well as failing to improve its capital ratios at the RBS consolidated Group level. The result of this may mean intervention by the UK Government, which could include full nationalisation, under which circumstances any compensation payable to Shareholders would be subject to the provisions of the Banking Act, and Shareholders may lose the full value of their Shares.
 
Furthermore, even if RBS is able to participate in the APS, there can be no assurance that such participation will enable RBS to achieve all of the stated goals of the APS. While the APS is expected to limit losses associated with assets to be covered by the APS, RBS would remain fully exposed in respect of a specified “first loss” amount and exposed to 10 per cent. of losses exceeding that “first loss” amount. In addition, RBS would continue to be exposed to the risk of losses, impairments and write-downs with respect to assets not covered by the APS. Although RBS would have the option to obtain an additional £6 billion in capital from HM Treasury (in the form of a subscription for further B Shares) there can be no assurance that such additional capital, together with RBS’s strengthened capital position as a result of the Placing and Open Offer, and the capital resulting from the proposed issue of the £6.5 billion and £13 billion of B Shares, will be sufficient to maintain the Group’s capital ratios in the event of further losses, which could cause RBS’s business, results of operation and financial condition to suffer, its credit rating to drop, its ability to lend and access funding to be further limited, its cost of funding to increase and its Share price to decline, any of which would increase the risk of the full nationalisation of RBS.
 
In addition, there can be no assurance that the costs to RBS of its participation in the APS will not outweigh any benefits received. For example, RBS has agreed in principle that if it accedes to the APS, it will give up the right to certain tax losses and allowances which may affect the after-tax returns of the Group in future years. As a result of RBS’s agreement to give up such UK tax losses and allowances it is likely that RBS will pay UK corporation tax in earlier accounting periods than it would otherwise have done.
 
The Group’s businesses, earnings and financial condition have been and will continue to be affected by the continued deterioration in the global economy, as well as ongoing instability in the global financial markets.
The performance of the Group has been and will continue to be influenced by the economic conditions of the countries in which it operates, particularly the United Kingdom, the United States and other countries throughout Europe and Asia. Recessionary conditions are present in many of these countries, including the United Kingdom and the United States, and such conditions are expected to continue or worsen over the near to medium term. In addition, the global financial system is continuing to experience the difficulties which first manifested themselves in August 2007, and the financial markets have deteriorated significantly since the bankruptcy filing by Lehman Brothers in September 2008. These conditions have led to severe and continuing dislocation of financial markets around the world and unprecedented levels of illiquidity, resulting in the development of significant problems at a number of the world’s largest corporate institutions operating across a wide range of industry sectors, many of whom are the Group’s customers and counterparties in the ordinary course of its business. In response to this economic instability and illiquidity in the market, a number of governments, including the UK Government, the governments of the other EU member states and the US Government, have intervened in order to inject liquidity and capital into the financial system, and, in some cases, to prevent the failure of these institutions.
 
 
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Despite such measures, the volatility and disruption of the capital and credit markets have continued at unprecedented levels, and global recessionary conditions are expected to continue. These conditions have produced and will continue to produce downward pressure on stock prices and on availability and cost of credit for financial institutions, including the Group, and will continue to impact on the credit quality of the Group’s customers and counterparties. Such conditions, alone or in combination with regulatory changes or actions of other market participants, may cause the Group to experience further reductions in business activity, increased funding costs and funding pressures, lower share prices, decreased asset values, additional write downs and impairment charges and lower profitability or to incur losses.
 
In addition, the Group will continue to be exposed to the risk of loss if major corporate borrowers or counterparty financial institutions fail or are otherwise unable to meet their obligations. The Group’s performance may also be affected by future recovery rates on assets and the historical assumptions underlying asset recovery rates, which may no longer be accurate given the unprecedented market disruption and general economic instability. The precise nature of all the risks and uncertainties the Group faces as a result of current economic conditions cannot be predicted and many of these risks are outside the Group’s control.
 
Any conversion of the B Shares would significantly increase HM Treasury’s ownership interest in RBS, have a corresponding dilutive effect on other RBS Shareholders and could result in the delisting of RBS’s securities.
At the same time as RBS announced its proposed participation in the APS, RBS announced that, if it participated in the APS, it would issue £6.5 billion of B Shares to HM Treasury. RBS also announced that it would issue a further £13 billion of B Shares to HM Treasury on or after implementation of the APS, and HM Treasury would grant RBS the option to require HM Treasury to purchase a further £6 billion of B Shares from it. The B Shares, if issued, will rank pari passu with the Ordinary Shares on a winding-up. The B Shares would be convertible, at the option of the holder at any time, into Ordinary Shares at an initial conversion price of £0.50 per Ordinary Share. HM Treasury would agree not to convert any B Shares it holds if, as a result of such conversion, it would hold 75 per cent. or more of the Ordinary Shares, unless the price of the Ordinary Shares is equal to or exceeds £0.65 for a specified period in which case conversion is mandatory in any event. If all £25.5 billion of B Shares are issued, such conversion of the B Shares would significantly increase HM Treasury’s ownership interest in RBS up to approximately 84.4 per cent. of the Company’s issued share capital, and have a corresponding dilutive effect on other RBS Shareholders (as would the issue of the B Shares themselves in the event of a winding-up) although any such conversion would have no impact on the Group’s Tier 1 capital position. Furthermore, a mandatory conversion of the B Shares by HM Treasury would put RBS in breach of the Listing Rules requirement that 25 per cent. of its issued share capital must be in public hands. Although RBS may apply to the UKLA for a waiver in such circumstances, there is no guarantee that such a waiver would be granted, the result of which could be the delisting of RBS from the Official List and potentially other exchanges where its securities are currently listed and traded. In addition, HM Treasury will not be entitled to vote in respect of Ordinary Shares acquired by it as a result of the conversion of B Shares into Ordinary Shares to the extent, but only to the extent, that votes cast on such Ordinary Shares, together with any other votes which HM Treasury is entitled to cast in respect of any other Ordinary Shares held by or on behalf of HM Treasury would exceed 75 per cent. of the total votes eligible to be cast on a resolution presented at a general meeting of the Company.
 
Lack of liquidity is a risk to the Group’s business and its ability to access sources of liquidity has been, and will continue to be, constrained.
Liquidity risk is the risk that a bank will be unable to meet its obligations, including funding commitments, as they fall due. This risk is inherent in banking operations and can be heightened by a number of enterprise specific factors, including an over-reliance on a particular source of funding (including, for example, short term and overnight funding), changes in credit ratings or market-wide phenomena such as market dislocation and major disasters. Credit markets worldwide have experienced and continue to experience a severe reduction in liquidity and term-funding in the aftermath of events in the US sub-prime residential mortgage market and the current severe market dislocation. Perception of counterparty risk between banks has also increased significantly following the bankruptcy filing by Lehman Brothers. This increase in perceived counterparty risk has led to further reductions in inter-bank lending, and hence, in common with many other banks, the Group’s access to traditional sources of liquidity has been, and may continue to be, restricted.
 
The Group’s liquidity management focuses on maintaining a diverse and appropriate funding strategy for its operations, controlling the mismatch of maturities and carefully monitoring its undrawn commitments and contingent liabilities. However, the Group’s ability to access sources of liquidity (for example, through the issue or sale of financial and other instruments or through the use of term loans) during the recent period of liquidity stress has been constrained to the point where it, like other banks, has had to rely on shorter term and overnight funding with a consequent reduction in overall liquidity, and to increase its recourse to liquidity schemes provided by central banks.
 
In addition, there is also a risk that corporate and institutional counterparties with credit exposures may look to reduce all credit exposures to banks, given current risk aversion trends. It is possible that credit market dislocation becomes so severe that overnight funding from non-government sources ceases to be available.
 
Furthermore, like many banks, the Group relies on customer deposits to meet a considerable portion of its funding requirements and such deposits are subject to fluctuation due to certain factors outside the Group’s control, such as a loss of confidence, competitive pressures or the encouraged or mandated repatriation of deposits by foreign wholesale or central bank depositors which could result in a significant outflow of deposits within a short period of time. Any material decrease in the Group’s deposits could, particularly if accompanied by one of the other factors described above, have a negative impact on the Group’s liquidity unless corresponding actions were taken to improve the liquidity profile of other deposits or to reduce assets.
 
The governments of some of the countries in which the Group operates have taken steps to guarantee the liabilities of the banks and branches operating in their respective jurisdiction. Whilst in some instances the operations of the Group are covered by government guarantees alongside other local banks, in other countries this may not necessarily always be the case. This may place subsidiaries operating in those countries, such as Ulster Bank Ireland Ltd, which did not participate in such government guarantee schemes, at a competitive disadvantage to the other local banks and therefore may require the Group to provide additional funding and liquidity support to these operations.
 
There can be no assurance that these measures, alongside other available measures, will succeed in improving the funding and liquidity in the markets in which the Group operates, or that these measures, combined with any increased cost of any funding currently available in the market, will not lead to a further increase in the Group’s overall cost of funding, which could have an adverse impact on the Group’s financial condition and results of operations or result in a loss of value in RBS shares.
 
 
 
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Governmental support schemes are subject to cancellation, change or withdrawal (on a general or individual basis), which may have a negative impact on the availability of funding in the markets in which the Group operates.
Governmental support schemes are subject to cancellation, change or withdrawal (on a general or individual basis), based on changing economic and political conditions in the jurisdiction of the relevant scheme. Furthermore, certain schemes which have been recently announced have in fact not been fully implemented, or their terms have not yet been finalised. To the extent government support schemes are cancelled, changed or withdrawn in a manner which diminishes their effectiveness, or to the extent such schemes fail to generate additional liquidity or other support in the relevant markets in which such schemes operate, the Group, in common with other banks, may continue to face limited access to, have insufficient access to, or incur higher costs associated with, funding alternatives, which could have a material adverse impact on the Group’s business, financial condition, results of operations and prospects and result in a loss of value in RBS shares.
 
The financial performance of the Group has been and will be affected by borrower credit quality.
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. The outlook for the global economy over the near to medium term has continued to deteriorate, particularly in the UK, the United States and other European economies. For example, there is an expectation of further reductions in residential and commercial property prices, higher unemployment rates and reduced profitability of corporate borrowers. As a result, the Group has seen and expects to continue to see adverse changes in the credit quality of its
 
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borrowers and counterparties, with increasing delinquencies, defaults and insolvencies across a range of sectors. This trend has led and may lead to further impairment charges, higher costs, additional write downs and losses for the Group or result in a loss of value in RBS shares.
 
The actual or perceived failure or worsening credit of the Group’s counterparties has adversely affected and could continue to adversely affect the Group.
The Group’s ability to engage in routine funding transactions has been and will continue to be adversely affected by the actual or perceived failure or worsening credit of its counterparties, including other financial institutions and corporate borrowers. The Group has exposure to many different industries and counterparties and routinely executes transactions with counterparties in the financial industry, including brokers and dealers, commercial banks, investment banks, mutual and hedge funds and other institutional clients. As a result, defaults by, or even the perceived creditworthiness of or concerns about, one or more corporate borrowers, financial services institutions, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by the Group or by other institutions. Many of these transactions expose the Group to credit risk in the event of default of the Group’s counterparty or client. In addition, the Group’s credit risk is exacerbated when the collateral it holds cannot be realised or is liquidated at prices not sufficient to recover the full amount of the loan or derivative exposure that is due to the Group, which is most likely to occur during periods of illiquidity and depressed asset valuations, such as those currently experienced. Any such losses could have a material adverse effect on the Group’s results of operations and financial condition or result in a loss of value in RBS shares.
 
The Group’s earnings and financial condition have been, and its future earnings and financial condition are likely to continue to be, affected by depressed asset valuations resulting from poor market conditions.
Financial markets are currently subject to significant stress conditions, where steep falls in perceived or actual asset values have been accompanied by a severe reduction in market liquidity, as exemplified by recent events affecting asset backed collateralised debt obligations (CDOs), the US sub-prime residential mortgage market and the leveraged loan market. In dislocated markets, hedging and other risk management strategies have proven not to be as effective as they are in normal market conditions due in part to the decreasing credit quality of hedge counterparties, including monoline and other insurance companies and credit derivative product companies. Severe market events have resulted in the Group recording large write-downs on its credit market exposures in 2007 and 2008. The Group expects that the deterioration in economic and financial market conditions will lead to further impairment charges and write-downs during the current financial year. Moreover, recent market volatility and illiquidity has made it difficult to value certain of the Group’s exposures. Valuations in future periods, reflecting, among other things, then-prevailing market conditions and changes in the credit ratings of certain of the Group’s assets, may result in significant changes in the fair values of the Group’s exposures, even in respect of exposures, such as credit market exposures, for which the Group has previously recorded write-downs. In addition, the value ultimately realised by the Group may be materially different from the current or estimated fair value. Any of these factors could require the Group to recognise further significant write-downs or realise increased impairment charges, any of which may adversely affect its capital position, its financial condition and its results of operations or result in a loss of value in RBS shares.
 
The value or effectiveness of any credit protection that the Group has purchased from monoline and other insurers and other market counterparties (including credit derivative product companies) depends on the value of the underlying assets and the financial condition of the insurers and such counterparties.
The Group has credit exposure arising from over-the-counter derivative contracts, mainly credit default swaps (CDSs), which are carried at fair value. The fair value of these CDSs, as well as the Group’s exposure to the risk of default by the underlying counterparties, depends on the valuation and the perceived credit risk of the instrument against which protection has been bought. Since 2007, monoline and other insurers and other market counterparties (including credit derivative product companies) have been adversely affected by their exposure to residential mortgage linked and corporate credit products. As a result, their actual and perceived credit worthiness deteriorated significantly in 2008 and may continue to be so impacted in 2009. If the financial condition of these counterparties or their actual and perceived credit worthiness deteriorates further, the Group may record further credit valuation adjustments on the CDSs bought from these counterparties in addition to those already recorded.
 
Changes in interest rates, foreign exchange rates, bond, equity and commodity prices, and other market factors have significantly affected and will continue to affect the Group’s business.
Some of the most significant market risks the Group faces are interest rate, foreign exchange, bond, equity and commodity price risks. Changes in interest rate levels, yield curves and spreads may affect the interest rate margin realised between lending and borrowing costs, the effect of which may be heightened during periods of liquidity stress, such as those experienced in recent months. Changes in currency rates, particularly in the sterling-US dollar and sterling-euro exchange rates, affect the value of assets, liabilities, income and expenses denominated in foreign currencies and the reported earnings of the Group’s non-UK subsidiaries (principally ABN AMRO, Citizens and RBS Greenwich Capital) and may affect income from foreign exchange dealing. The performance of financial markets may affect bond, equity and commodity prices and, therefore, cause changes in the value of the Group’s investment and trading portfolios. This has been the case during the period since August 2007, with market disruptions and volatility resulting in significant reductions in the value of such portfolios. While the Group has implemented risk management methods to mitigate and control these and other market risks to which it is exposed, it is difficult, particularly in the current environment, to predict with accuracy changes in economic or market conditions and to anticipate the effects that such changes could have on the Group’s financial performance and business operations or result in a loss of value in RBS shares.
 
The Group’s borrowing costs and its access to the debt capital markets depend significantly on its credit ratings.
On 19 January 2009, S&P affirmed the long-term and short-term counterparty credit ratings for the Royal Bank at A+ and A-1 respectively. The outlook for all entities of the Group was confirmed as stable, reflecting S&P’s view that the Group is of systemic importance to the UK banking system and that S&P now explicitly factor four notches of uplift into their long-term counterparty credit rating on the Group. At the same time S&P lowered its ratings on the Group’s hybrid capital issues to BB from BBB, additionally the BB rating was placed under CreditWatch with negative implications. On the same date, Fitch affirmed the Group and the Royal Bank’s Long-term and Short-term Issuer Default Ratings at AA- and F1+ respectively and downgraded the Group and the Royal Bank’s individual ratings to E from B/C. The outlook for the Issuer Default Ratings remains stable reflecting Fitch’s expectation of continued strong government support for the Group. The Group’s support rating was upgraded from 1 to 5 and its support floor revised to AA- from No Floor. Fitch also downgraded the Group and the Royal Bank’s Tier 1 preference shares to BB- from A+, and upper tier 2 hybrid capital instruments issued by Group companies to BB from A+ and placed all of these securities on Rating Watch Negative.  Moody’s on 20 January 2009 downgraded the senior unsecured rating of the Royal Bank to Aa3 from Aa1 with a negative outlook. The Group’s senior debt rating was downgraded to A1 from Aa2 again with a negative outlook. The Bank Financial Strength Rating was lowered to C- from B and remains under review for further possible downgrade. The short term P-1 ratings of both the Group and the Royal Bank were affirmed. The outlook for all Group entities incorporates Moody’s view on the long-term credit profile of the Group beyond the current government support-phase as well as their view of the very high probability of on-going support from the Aaa-rated UK Government. Any future reductions in the long-term credit ratings of the Group or one of its principal subsidiaries (particularly the Royal Bank) could further increase its borrowing costs. Any further reductions may also limit the Group’s access to the capital markets and trigger additional collateral requirements in derivative contracts and other secured funding arrangements. Credit ratings of the Group and the Royal Bank are also important to the Group when competing in certain markets, such as over-the-counter derivatives. As a result, any further reductions in the Group’s or the Royal Bank’s credit ratings could adversely affect its access to liquidity and competitive position, increase its funding costs and have a negative impact on the Group’s earnings and financial condition or result in a loss of value in RBS shares.
 
The Group’s business performance could be adversely affected if its capital is not managed effectively.
Effective management of the Group’s capital is critical to its ability to operate its businesses, to grow organically and to pursue its strategy. The Group is required by regulators in the United Kingdom, the United States, the Netherlands and in other jurisdictions in which it undertakes regulated activities, to maintain adequate capital. The maintenance of adequate capital is also necessary to enhance the Group’s financial flexibility in the face of continuing turbulence and uncertainty in the global economy. Accordingly, the purpose of the First Placing and Open Offer and the issue of the Preference Shares was to allow the company to strengthen its capital position. As at 31 December 2008 the Group’s Tier 1 and Core Tier 1 capital ratios were 10.0 per cent. and 6.8 per cent. respectively, using the Basel II methodology. Although the net proceeds of the First Placing and Open Offer and the Preference Share Issue strengthened the Group’s capital base significantly, and the net proceeds of the Second Placing and Open Offer were used to redeem the existing £5 billion of Preference Shares and which thereby improved the quality of the Group’s capital by increasing the Group’s Core Tier 1 capital ratio, any change that limits the Group’s ability effectively to manage its balance sheet and capital resources going forward (including, for example, reductions in profits and retained earnings as a result of write-downs or otherwise,
 
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increases in risk-weighted assets, delays in the disposal of certain assets or the inability to syndicate loans as a result of market conditions or otherwise) or to access funding sources, could have a material adverse impact on its financial condition and regulatory capital position or result in a loss of value in RBS shares.
 
The value of certain financial instruments recorded at fair value is determined using financial models incorporating assumptions, judgements and estimates that may change over time or may ultimately not turn out to be accurate.
Under IFRS, the Group recognises at fair value: (i) financial instruments classified as ‘held-for-trading’ or ‘designated as at fair value through profit or loss’; (ii) financial assets classified as ‘available-for-sale’; and (iii) derivatives, each as further described in ‘Accounting Policies’ on page 166 of the financial statements. Generally, to establish the fair value of these instruments, the Group relies on quoted market prices or, where the market for a financial instrument is not sufficiently active, internal valuation models that utilise observable market data. In certain circumstances, the data for individual financial instruments or classes of financial instruments utilised by such valuation models may not be available or may become unavailable due to changes in market conditions, as has been the case during the current financial crisis. In such circumstances, the Group’s internal valuation models require the Group to make assumptions, judgements and estimates to establish fair value. In common with other financial institutions, these internal valuation models are complex, and the assumptions, judgements and estimates the Group is required to make often relate to matters that are inherently uncertain, such as expected cash flows, the ability of borrowers to service debt, residential and commercial property price appreciation and depreciation, and relative levels of defaults and deficiencies. Such assumptions, judgements and estimates may need to be updated to reflect changing facts, trends and market conditions. The resulting change in the fair values of the financial instruments has had and could continue to have a material adverse effect on the Group’s earnings and financial condition. Also, recent market volatility and illiquidity has challenged the factual bases of certain underlying assumptions and has made it difficult to value certain of the Group’s financial instruments. Valuations in future periods, reflecting prevailing market conditions, may result in further significant changes in the fair values of these instruments, which could have a negative effect on the Group’s results of operations and financial condition or result in a loss of value in RBS shares.
 
The Group’s future earnings and financial condition in part depend on the success of the Group’s strategic refocus on core strengths and its disposal programme.
In light of the recently changed global economic outlook, the Group has embarked on a restructuring which focused on achieving appropriate risk-adjusted returns under these changed circumstances, reducing reliance on wholesale funding and lowering exposure to capital intensive businesses. The Group will also continue with its disposal programme and continue to review its portfolio to identify further disposals of certain non-core assets. For further details of these re-structuring plans, please read “Business Review – Strategic Review” on page 9 of this document.
Although the proceeds of the Second Placing and Open Offer improved the quality of the Group's capital by replacing the existing £5 billion of Preference Shares with £5 billion of Core Tier 1 capital, the global credit markets remain challenging and the Group’s execution of its current and future strategic plans may not be successful. In connection with the implementation of these plans, the Group may incur restructuring charges, which may be material. Furthermore, if the Group’s plans, including any planned disposals, are not successful or fail to achieve the results expected, the Group’s business, capital position financial condition, results of operations and future prospects may be negatively impacted or this could result in a loss of value in RBS shares.
 
The Group operates in markets that are highly competitive and consolidating. If the Group is unable to perform effectively, its business and results of operations will be adversely affected.
Recent consolidation among banking institutions in the United Kingdom, the United States and throughout Europe is changing the competitive landscape for banks and other financial institutions. This consolidation, in combination with the introduction of new entrants into the US and UK markets from other European and Asian countries, could increase competitive pressures on the Group. Moreover, if financial markets continue to be volatile, more banks may be forced to consolidate.
 
In addition to the effects of consolidation, increased government ownership of, and involvement in, banks generally may have an impact on the competitive landscape in the major markets in which the Group operates. Although, at present, it is difficult to predict what the effects of this increased government ownership and involvement will be or how it will differ from jurisdiction to jurisdiction, such involvement may cause the Group to experience stronger competition for corporate, institutional and retail clients and greater pressure on profit margins. Since the markets in which the Group operates are expected to remain highly competitive in all areas, these and other changes to the competitive landscape could adversely affect the Group’s business, margins, profitability and financial condition or result in a loss of value in RBS shares.
 
The Group has agreed to certain undertakings in relation to the operation of its business in the First Placing and Open Offer Agreement, the Second Placing and Open Offer Agreement and in connection with the proposed APS, which may serve to limit the Group’s operations.
Under the terms of the First Placing and Open Offer Agreement, the Group provided certain undertakings aimed at ensuring that the subscription by HM Treasury for the relevant Ordinary Shares and the Preference Shares and the Group’s potential participation in the guarantee scheme promoted by HM Treasury as part of its support for the UK banking industry are compatible with the common market under EU law. These undertakings include (i) supporting certain initiatives in relation to mortgage lending and lending to SMEs until 2011, (ii) regulating management remuneration and (iii) regulating the rate of growth of the Group’s balance sheet. Under the terms of the Second Placing and Open Offer Agreement, the Group’s undertakings in relation to mortgage lending and lending to SMEs were extended to larger commercial and industrial companies in the United Kingdom. These undertakings may serve to limit the Group’s operations. In addition, pursuant to the Lending Commitments Letter, the Group is subject to further undertakings, which supersede the lending commitments made to HM Treasury in October 2008 and January 2009 by agreeing to lend £16 billion above the amount the Group had budgeted to lend to UK businesses and £9 billion above the amount the Group had budgeted to lend to UK homeowners in the year commencing 1 March 2009, with a commitment to lend at similar levels in the year commencing 1 March 2010. For a description of these undertakings, please read “Material Contracts” on page 267 of this document.
 
The Group could fail to attract or retain senior management or other key employees.
The Group’s ability to implement its strategy depends on the ability and experience of its senior management and other key employees. The loss of the services of certain key employees, particularly to competitors, could have a negative impact on the Group’s business. The Group’s future success will also depend on its ability to attract, retain and remunerate highly skilled and qualified personnel competitively with its peers. This cannot be guaranteed, particularly in light of heightened regulatory oversight of banks and heightened scrutiny of, and (in some cases) restrictions placed upon, management compensation arrangements, in particular those in receipt of Government funding (such as the Group). The Group recently announced changes to its compensation structure which included significant reductions in bonuses to be paid in respect of 2008, and limitations on pay rises in 2009. Details of these changes are outlined in the letter from the Chairman of the Remuneration Committee on page 140. In addition to the effects of such measures on the Group’s ability to retain senior management and other key employees, the marketplace for skilled personnel is becoming more competitive, which means the cost of hiring, training and retaining skilled personnel may continue to increase. The failure to attract or retain a sufficient number of appropriately skilled personnel could prevent the Group from successfully implementing its strategy, which could have a material adverse effect on the Group’s financial condition and results of, operations or result in a loss of value in RBS shares.
 
Each of the Group’s businesses is subject to substantial regulation and oversight. Any significant regulatory developments could have an effect on how the Group conducts its business and on its results of operations and financial condition.
The Group is subject to financial services laws, regulations, administrative actions and policies in each location in which it operates. All of these are subject to change, particularly in the current market environment, where there have been unprecedented levels of government intervention and changes to the regulations governing financial institutions, including recent nationalisations in the United Kingdom, the United States and other European countries. As a result of these and other ongoing and possible future changes in the financial services regulatory landscape (including requirements imposed by virtue of the Group’s participation in any government or regulator-led initiatives), the Group expects to face greater regulation in the United Kingdom, the United States, the Netherlands and other countries in which it operates, including throughout the rest of Europe.
 
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Compliance with such regulations may increase the Group’s capital requirements and costs and have an adverse impact on its business, the products and services it offers and the value of its assets or result in a loss of value in RBS shares.
 
Other areas where governmental policies and regulatory changes could have an adverse impact include, but are not limited to:
 
·  
the monetary, interest rate, capital adequacy and other policies of central banks and regulatory authorities;
 
·  
general changes in government or regulatory policy or changes in regulatory regimes that may significantly influence investor decisions in particular markets in which the Group operates or may increase the costs of doing business in those markets;
 
·  
changes to financial reporting standards;
 
·  
other general changes in the regulatory requirements, such as prudential rules relating to the capital adequacy framework and the imposition of onerous compliance obligations, restrictions on business growth or pricing and requirements to operate in a way that prioritises objectives other than shareholder value creation;
 
·  
changes in competition and pricing environments;
 
·  
further developments in the financial reporting environment;
 
·  
differentiation amongst financial institutions by governments with respect to the extension of guarantees to bank customer deposits and the terms attaching to such guarantees, including requirements for the entire Group to accept exposure to the risk of any individual member of the Group, or even third party participants in guarantee schemes, failing;
 
·  
implementation of, or costs related to, local customer or depositor compensation or reimbursement schemes;
 
·  
transferability and convertibility of currency risk;
 
·  
expropriation, nationalisation and confiscation of assets;
 
·  
changes in legislation relating to foreign ownership; and
 
 
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·  
other unfavourable political, military or diplomatic developments producing social instability or legal uncertainty which, in turn, may affect demand for the Group’s products and services.
 
The Group’s results have been and could be further adversely affected in the event of goodwill impairment.
The Group capitalises goodwill, which is calculated as the excess of the cost of an acquisition over the net fair value of the identifiable assets, liabilities and contingent liabilities acquired. Acquired goodwill is recognised initially at cost and subsequently at cost less any accumulated impairment losses. As required by IFRS, the Group tests goodwill for impairment annually or more frequently, at external reporting dates, when events or circumstances indicate that it might be impaired. An impairment test involves comparing the recoverable amount (the higher of value in use and fair value less cost to sell) of an individual cash generating unit with its carrying value. The value in use and fair value of the Group’s cash generating units are affected by market conditions and the performance of the economies in which the Group operates. Where the Group is required to recognise a goodwill impairment, it is recorded in the Group’s income statement, although it has no effect on the Group’s regulatory capital position. For the year ended 31 December 2008, the Group recorded a £32.6 billion accounting write-down of goodwill and other intangibles relating to prior year acquisitions.
 
The Group may be required to make further contributions to its pension schemes if the value of pension fund assets is not sufficient to cover potential obligations.
The Group maintains a number of defined benefit pension schemes for past and current employees. Pensions risk is the risk that the liabilities of the Group’s various defined benefit pension schemes which are long term in nature will exceed the schemes’ assets, as a result of which the Group is required or chooses to make additional contributions to the schemes. The schemes’ assets comprise investment portfolios that are held to meet projected liabilities to the scheme members. Risk arises from the schemes because the value of these asset portfolios and returns from them may be less than expected and because there may be greater than expected increases in the estimated value of the schemes’ liabilities. In these circumstances, the Group could be obliged, or may choose, to make additional contributions to the schemes, and during recent periods, the Group has voluntarily made such contributions. Given the current economic and financial market difficulties and the prospects for them to continue over the near and medium term, the Group may be required or elect to make further contributions to the pension schemes and such contributions could be significant and have a negative impact on the Group’s capital position results of operations or financial condition or result in a loss of value in RBS shares.
 
The Group is and may be subject to litigation and regulatory investigations that may impact its business.
The Group’s operations are diverse and complex and it operates in legal and regulatory environments that expose it to potentially significant litigation, regulatory investigation and other regulatory risk. As a result, the Group is, and may in the future be, involved in various disputes, legal proceedings and regulatory investigations in the United Kingdom, the United States and other jurisdictions, including class-action litigation. Furthermore, the Group, like many other financial institutions, has come under greater regulatory scrutiny over the last year and expects that environment to continue for the foreseeable future, particularly as it relates to compliance with new and existing corporate governance, employee compensation, conduct of business, anti-money laundering and anti-terrorism laws and regulations, as well as the provisions of applicable sanctions programmes. Disputes, legal proceedings and regulatory investigations are subject to many uncertainties, and their outcomes are often difficult to predict, particularly in the earlier stages of a case or investigation. Adverse regulatory action or adverse judgements in litigation could result in restrictions or limitations on the Group’s operations or result in a material adverse effect on the Group’s reputation or results of operations or result in a loss of value in RBS shares. For details about certain litigation and regulatory investigations in which the Group is involved, see Note 32 on the financial statements.
 
Operational risks are inherent in the Group’s operations.
The Group’s operations are dependent on the ability to process a very large number of transactions efficiently and accurately while complying with applicable laws and regulations where it does business. The Group has complex and geographically diverse operations and operational risk and losses can result from internal or external fraud, errors by employees or third-parties, failure to document transactions properly or to obtain proper authorisation, failure to comply with applicable regulatory requirements and conduct of business rules (including those arising out of anti-money laundering and anti-terrorism legislation, as well as the provisions of applicable sanctions programmes), equipment failures, natural disasters or the inadequacy or failure of systems and controls, including those of the Group’s suppliers or counterparties. Although the Group has implemented risk controls and loss mitigation actions, and substantial resources are devoted to developing efficient procedures, to identifying and rectifying weaknesses in existing procedures and to training staff, it is not possible to be certain that such actions have been or will be effective in controlling each of the operational risks faced by the Group. Any weakness in these systems or controls, or any breaches or alleged breaches of applicable laws or regulations could have a materially negative impact on the Group’s business, reputation, results of operations and share price. Notwithstanding anything contained in this risk factor, it should not be taken as implying that either the company or the Group will be unable to comply with its obligations as a company with securities admitted to the Official List or as a supervised firm regulated by the FSA.
 
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 it 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 Group’s profitability. Revisions to tax legislation or to its interpretation might also affect the Group’s results in the future.
 
The acquisition of a majority shareholding in the Group by HM Treasury in December 2008 could lead to certain adverse tax consequences for the Group.
The acquisition by HM Treasury of a majority shareholding in the Group in consequence of the First Placing and Open Offer could, in certain circumstances, have adverse tax consequences which could affect the post-tax profitability of the Group. However, if the Group enters into the APS it has agreed, in principle, to give up the right to certain UK tax losses and allowances and this may limit the adverse tax consequences of the acquisition by HM Treasury of a majority shareholding in the Group.
 
 
19

 
Business review continued

 
 
The Group’s insurance businesses are subject to inherent risks involving claims.
Future claims in the Group’s general and life assurance business may be higher than expected as a result of changing trends in claims experience resulting from catastrophic weather conditions, demographic developments, changes in mortality and other causes outside the Group’s control. These trends could affect the profitability of current and future insurance products and services. The Group reinsures some of the risks it has assumed and is accordingly exposed to the risk of loss should its reinsurers become unable or unwilling to pay claims made by the Group against them.
 
The Group’s operations have inherent reputational risk.
Reputational risk, meaning the risk to earnings and capital from negative public opinion, is inherent in the Group’s business. Negative public opinion can result from the actual or perceived manner in which the Group conducts its business activities or from actual or perceived practices in the banking and financial industry. Negative public opinion may adversely affect the Group’s ability to keep and attract customers and, in particular, corporate and retail depositors. The Group cannot ensure that it will be successful in avoiding damage to its business from reputational risk.
 
In the United Kingdom and in other jurisdictions, the Group is responsible for contributing to compensation schemes in respect of banks and other authorised financial services firms that are unable to meet their obligations to customers.
In the United Kingdom, the Financial Services Compensation Scheme (the “Scheme”) was established under the FSMA and is the UK’s statutory fund of last resort for customers of authorised financial services firms. The Scheme can pay compensation to customers if a firm is unable, or likely to be unable, to pay claims against it and, if the Banking Bill is enacted in its current form, may be required to make payments either in connection with the exercise of a stabilisation power or in exercise of the bank insolvency procedures under that Bill. The Scheme is funded by levies on firms authorised by the FSA, including the Group. In the event that the Scheme raises funds from the authorised firms, raises those funds more frequently or significantly increases the levies to be paid by such firms, the associated costs to the Group may have a material impact on its results of operations and financial condition. During the financial year ended 31 December 2008, the Group made a provision of £150 million related to a levy by the Scheme.
 
In addition, to the extent that other jurisdictions where the Group operates have introduced or plan to introduce similar compensation, contributory or reimbursement schemes (such as in the United States with the Federal Deposit Insurance Corporation), the Group may make further provisions and may incur additional costs and liabilities, which may negatively impact its financial condition and results of operations or result in a loss of value in RBS shares.
 
The Group’s business and earnings may be affected by geopolitical conditions.
The performance of the Group is significantly influenced by the geopolitical and economic conditions prevailing at any given time in the countries in which it operates, particularly the United Kingdom, the United States and other countries in Europe and Asia. For example, the Group has a presence in countries where businesses could be exposed to the risk of business interruption and economic slowdown following the outbreak of a pandemic, or the risk of sovereign default following the assumption by governments of the obligations of private sector institutions. Similarly the Group faces the heightened risk of trade barriers, exchange controls and other measures taken by sovereign governments which may impact a borrower’s ability to repay. Terrorist acts and threats and the response to them of governments in any of these countries could also adversely affect levels of economic activity and have an adverse effect upon the Group's business.
 
The restructuring proposals for ABN AMRO are complex and may not realise the anticipated benefits for the Group.
The restructuring plan in place for the integration and separation of ABN AMRO into and among the businesses and operations of the consortium members is complex, involving substantial reorganisation of ABN AMRO’s operations and legal structure. In addition, the plan contemplates activities taking place simultaneously in a number of businesses and jurisdictions. Although integration efforts are well underway and are being advanced on a number of fronts, the implementation of the reorganisation and the realisation of the forecast benefits within the planned timescales, particularly given current market and economic conditions, remains challenging, although the Group remains confident that such goals will be achieved. Execution of the restructuring requires management resources previously devoted to the Group businesses and the retention of appropriately skilled ABN AMRO staff. The Group may not realise the benefits of the acquisition or the restructuring when expected or to the extent projected. The occurrence of any of these events, including as a result of staff losses or performance issues, may have a negative impact on the Group’s financial condition and results of operations. It is not expected that the Dutch State’s acquisition of Fortis Bank Nederland’s shares in RFS Holdings, which was effected in December 2008, will materially affect the integration benefits envisaged by the Group.
 
The recoverability of certain deferred tax assets recognised by the Group depend on the Group's ability to generate sufficient future taxable profits and there being no adverse changes to tax legislation.
In accordance with IFRS, the Group has recognised deferred tax assets on losses available to relieve future profits from tax only to the extent that it is probable that they will be recovered. The losses are quantified on the basis of current tax legislation and are subject to change in respect of the rate of tax or the rules for computing taxable profits and allowable losses. Failure to generate sufficient future taxable profits or changes in tax legislation may reduce the recoverable amount of the recognised deferred tax assets.
 
RBS’s ability to pay dividends on or make other distributions in respect of the Ordinary Shares will depend on the availability of distributable reserves and may be limited by the terms of the B Shares.
RBS’s ability to pay dividends is limited under UK company law, which limits a company to only paying cash dividends to the extent that it has distributable reserves and cash available for this purpose. As a holding company, RBS’s ability to pay dividends in the future is affected by a number of factors, principally its ability to receive sufficient dividends from subsidiaries. The payment of dividends to RBS by its subsidiaries is, in turn, subject to restrictions, including certain regulatory requirements and the existence of sufficient distributable reserves and cash in RBS’s subsidiaries. The ability of these subsidiaries to pay dividends and RBS’s ability to receive distributions from its investments in other entities are subject to applicable local laws and regulatory requirements and other restrictions, including, but not limited to, applicable tax laws and covenants in some of RBS’s debt facilities. These laws and restrictions could limit the payment of future dividends and distributions to RBS by its subsidiaries, which could restrict RBS’s ability to fund other operations or to pay, in due course, a dividend to holders of the Existing Shares or the New Shares.
 
In addition, if the B Shares are issued, no cash dividend may be paid on the Ordinary Shares unless the cash dividend payable in respect of the same period on the B Shares is paid in full, and no scrip dividend may be paid on the Ordinary Shares unless the cash or scrip dividend payable in respect of the same period on the B Shares is paid in full.
 
 

 
 
Key financials
 
   
2008
   
2007
   
2006
 
for the year ended 31 December
    £m       £m       £m  
Total income
    25,868       30,366       28,002  
Operating (loss)/profit before tax
    (40,667 )     9,832       9,186  
(Loss)/profit attributable to ordinary shareholders
    (24,137 )     7,303       6,202  
Cost:  income ratio
    208.9%       45.9%       44.6%  
Basic (loss)/earnings per share (pence) (1)
    (145.7p )     64.0p       54.4p  

   
2008
   
2007
   
2006
 
at 31 December
    £m       £m       £m  
Total assets
    2,401,652       1,840,829       856,832  
Loans and advances to customers
    874,722       828,538       466,893  
Deposits
    897,556       994,657       516,365  
Owners’ equity
    58,879       53,038       40,227  
Risk asset ratio – Tier 1 (2)
    10.0%       7.3%       7.5%  
                        – total
    14.1%       11.2%       11.7%  
 
Notes:
 
(1)
Prior year per share data have been restated to reflect the rights issue in June 2008 and the capitalisation issue in September 2008.
 
(2)
2008 data are on a Basel II basis; data for 2007 and 2006 are on a Basel I basis.
 
Overview of results
As discussed on page 2, the results of ABN AMRO are fully consolidated in the Group’s financial statements. Consequently, the statutory results of RBS for the year ended 31 December 2007 and 2008 include the results of ABN AMRO for 76 days and the full year respectively. The interests of the State of the Netherlands and Santander in RFS Holdings are included in minority interests.
 
Summary consolidated income statement for the year ended 31 December 2008
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Net interest income
    18,675       12,069       10,596  
Fees and commissions receivable
    9,831       8,278       7,116  
Fees and commissions payable
    (2,386 )     (2,193 )     (1,922 )
Other non-interest income
    (6,578 )     6,125       6,239  
Insurance net premium income
    6,326       6,087       5,973  
Non-interest income
    7,193       18,297       17,406  
Total income
    25,868       30,366       28,002  
Operating expenses
    54,033       13,942       12,480  
(Loss)/profit before other operating charges and impairment
    (28,165 )     16,424       15,522  
Insurance net claims
    4,430       4,624       4,458  
Impairment losses
    8,072       1,968       1,878  
Operating (loss)/profit before tax
    (40,667 )     9,832       9,186  
Tax
    (2,323     2,044       2,689  
(Loss)/profit after tax from continuing operations
    (38,344 )     7,788       6,497  
Profit/(loss) from discontinued operations, net of tax
    3,971       (76 )     -  
(Loss)/profit for the year
    (34,373 )     7,712       6,497  
Minority interests
    (10,832 )     163       104  
Other owners
    596       246       191  
(Loss)/profit attributable to ordinary shareholders
    (24,137 )     7,303       6,202  
                         
Basic earnings per ordinary share (1)
    (145.7p )     64.0 p     54.4 p
                         
Diluted earnings per ordinary share     (145.7p     63.4     53.9
 
Note:
 
(1)
Prior year data have been restated to reflect the rights issue in June 2008 and the capitalisation issue in September 2008.
 
 
 
Business review continued

 
 
2008 compared with 2007
Operating loss
Operating loss before tax was £40,667 million compared with an operating profit of £9,832 million in 2007. The results have been adversely affected by the write-down of goodwill and other assets, a substantial decline in non-interest income, a number of specific losses such as counterparty failures, and a marked increase in the credit impairment charge, reflecting weakness in financial markets and a deteriorating global economy.

Losses from credit market exposures increased to £7,781 million, compared with £1,410 million in 2007, with the great majority incurred in the first half of the year. Write-down of goodwill and other assets was £32,581 million. Other one-off items amounted to a credit  of £1,674 million, 25% higher than in 2007, principally as a result of a  £1,232 million increase in the carrying value of own debt carried at fair value.

Loss attributable to ordinary shareholders was £24,137 million, compared with an attributable profit of £7,303  million in 2007.

Total income
Total income declined by 15% to £25,868 million, with a significant deterioration experienced during the second half of the year principally as a result of £5.8 billion of trading asset write-downs, counterparty failure and incremental reserving within GBM. While income increased in 2008 in Global Transaction Services and Regional Markets, and held steady in Insurance, a significant reduction occurred in Global Banking & Markets, where a strong performance in rates, currencies and commodities was offset by marked deterioration in credit markets and equities.

Net interest income
Net interest income increased by 55% to £18,675 million, with average loans and advances to customers up 61% and average customer deposits up 53%. Group net interest margin fell from 2.32% to 2.12% largely reflecting tightened margins within Regional Markets as market interest rates fell, with deposit markets remaining competitive and price adjustments on lending taking some time to feed through to the back book.

Non-interest income
Non-interest income was severely affected by the weakness in financial markets experienced over the course of the year, particularly in the fourth quarter.  Non-interest income decreased to £7,193 million principally due to the credit market write-downs of £7,781 million offset by a movement in the fair value of own debt of £1,232 million. While the decline was particularly marked in GBM’s credit markets and equities businesses, with reduced business volumes and mounting mark-to-market trading losses, Regional Markets also saw non-interest income fall in the latter part of the year as declining consumer confidence led to lower demand for credit and other financial products.

Operating expenses
Total operating expenses rose to £54,033 million, with cost growth in the Group’s core retail and commercial banking franchises offset by efficiency programmes and a significant reduction in Global Banking & Markets staff costs. Integration and restructuring costs were £1,357 million compared with £108 million in 2007. Write-down of goodwill and other assets was £32,581 million.

Net insurance claims
Bancassurance and general insurance claims, after reinsurance, decreased by 4% to £4,430 million, reflecting improved risk selection, better claims management and the non-recurrence of the severe floods experienced in 2007 and as a result of movements in financial market values.

Impairment losses
Impairment losses increased to £8,072 million in 2008, compared with £1,968 million in 2007. The Group experienced a pronounced deterioration in impairments in the second half of the year, as financial stress spread to a broad range of customers. The greatest increase in impairments occurred in GBM, where fourth quarter impairments totalled £2,938 million, including a loss of approximately £900 million on the Group’s exposure to LyondellBasell.  However, the Regional Markets businesses in all geographies also experienced  a noticeable increase in impairments in the second half, particularly in the UK and Irish corporate and US personal segments.

Impairments represented 0.44% of gross loans and advances, excluding reverse repos, in the first half but reached 1.27% in the second half. For 2008 as a whole, impairments amounted to 0.82% of loans and advances, excluding reverse repos, compared with 0.28% in 2007. Risk elements in lending and potential problem loans at 31 December 2008 represented 2.52% of gross loans and advances to customers, excluding reverse repos, compared with 1.64% a year earlier. Provision coverage was 51%, compared with 57% at 31 December 2007 reflecting the higher proportion of secured loans included in risk elements in lending and potential problem loans.

Credit market losses
Losses for 2008 relating to the Group’s previously identified credit market exposures totalled £7,781 million, net of hedging gains of £1,642 million. This includes impairment losses of £466 million incurred on credit market assets reclassified out of the ‘held-for-trading’ category in line with the amendments to IAS 39 ‘Financial Instruments: Recognition and Measurement’ issued in October. While the majority of these write-downs were incurred in the first half of 2008, the severity of the financial market dislocation intensified in the fourth quarter, resulting
in further losses in particular on the Group’s structured credit portfolios.

Write-down of goodwill and other intangible assets
After reviewing the carrying value of goodwill and other purchased intangible assets, the Group has recorded an impairment charge of £32,581 million. Of this charge, £23,348 million relates to part of the goodwill in respect of the acquisition of ABN AMRO, while other significant impairments have been recorded on part of the Citizens/Charter One goodwill of £4,382 million, part of the NatWest goodwill (principally allocated to Global Banking & Markets) of £2,742 million and other goodwill of £720 million. Other intangible asset impairments of £1,389 million principally relate to the write-down in the value of customer relationships recognised on the acquisition of ABN AMRO.

These impairments have no cash impact, and minimal impact on the Group’s capital ratios.

Other non-operating items
Integration and restructuring costs totalled £1,357 million, primarily reflecting the integration of ABN AMRO into the Group, while the amortisation of purchased intangibles increased to £582 million from £124 million.

Taxation
The Group recorded a tax credit of £2,323 million in 2008, compared with a tax charge of £2,044 million in 2007. The effective tax rate for 2008 was 5.7% compared with 20.8% in 2007.

Earnings
Basic earnings per ordinary share decreased from 64.0p to (145.7p).

The number of shares in issue increased to 39,456 million at 31 December 2008, compared with 10,006 million in issue at 31 December 2007, reflecting the Group’s capital raisings in June and December and the capitalisation issue in lieu of the interim dividend for 2008.
 
 
Business review continued

 
 
2007 compared with 2006
Profit
Profit before tax was up 7%, from £9,186 million to £9,832 million. The results of ABN AMRO are included from the date of acquisition, 17 October 2007.

Total income
The Group achieved strong growth in income during 2007. Total income was up 8% or £2,364 million to £30,366 million, notwithstanding the significant impact of the developments in global credit markets in the second half of 2007.

Net interest income increased by 14% to £12,069 million and represents 40% of total income (2006 – 38%). Average loans and advances to customers grew by 23% and average customer deposits grew by 25%.

Non-interest income increased by £891 million to £18,297 million and represents 60% of total income (2006 – 62%).

Net interest margin
The Group’s net interest margin at 2.32% was down from 2.53% in 2006.

Operating expenses
Operating expenses increased by 12% to £13,942 million. Integration costs were £108 million compared with £134 million in 2006.

Cost:income ratio
The Group’s cost:income ratio was 45.9% compared with 44.6% in 2006.

Net insurance claims
Bancassurance and general insurance claims, after reinsurance, increased by 4% to £4,624 million reflecting adverse weather conditions in the summer of 2007.

Impairment losses
Impairment losses rose 5% to £1,968 million, compared with £1,878 million in 2006.

Risk elements in lending and potential problem loans represented 1.64% of gross loans and advances to customers excluding reverse repos at 31 December 2007 (2006 – 1.57%).

Provision coverage of risk elements in lending and potential problem loans was 57% (2006 – 62%).

Taxation
The effective tax rate for 2007 was 20.8% (2006 – 29.3%). The headline rate is lower than the standard rate of UK corporation tax of 30% principally due to certain non-taxable capital gains and changes to deferred tax balances following the change in rate of corporation tax.

Earnings and dividends
Basic earnings per ordinary share increased by 18%, from 54.4p to 64.0p.

A final dividend of 19.3p per ordinary share was recommended and paid, giving a total dividend for the year of 27.8p, an increase of 10%.

Balance sheet
Total assets were £1,840.8 billion at 31 December 2007. The acquisition of ABN AMRO in October 2007 increased assets by £774.5 billion, with the balance accounted for largely by growth in our lending to customers and in trading assets.

Lending to customers, excluding repurchase agreements and stock borrowing (“reverse repos”), increased in 2007 by 70% or £282.2 billion to £686.2 billion. Customer deposits, excluding repurchase agreements and stock lending (“repos”), grew by 71% or £227.2 billion to £547.5 billion.

Capital ratios at 31 December 2007 were 7.3% (Tier 1) and 11.2% (Total).

Bonus issue
In May 2007, the Group capitalised £1,576 million of its share premium account by way of a bonus issue of two new ordinary shares of 25p each for every one held.

Profitability
The after-tax return on ordinary shareholders’ equity, which is based on profit attributable to ordinary shareholders and average ordinary shareholders’ equity, was 18.8% compared with 18.5% in 2006.

 
Business review continued


Analysis of results
Net interest income
 
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Interest receivable
    49,522       32,252       24,688  
Interest payable
    (30,847 )     (20,183 )     (14,092 )
Net interest income
    18,675       12,069       10,596  
   
%
   
%
   
%
 
Gross yield on interest-earning assets of the banking business
    5.61       6.19       5.90  
Cost of interest-bearing liabilities of the banking business
    (3.79     (4.36     (3.85 )
Interest spread of the banking business
    1.82       1.83       2.05  
Benefit from interest-free funds
    0.30       0.49       0.48  
Net interest margin of the banking business
    2.12       2.32       2.53  

 
Yields, spreads and margins of the banking business
 
%
   
%
   
%
 
Gross yield (1)
                 
Group
    5.61       6.19       5.90  
UK
    5.72       6.69       6.13  
Overseas
    5.54       5.52       5.50  
Interest spread (2)
                       
Group
    1.82       1.83       2.05  
UK
    1.92       2.30       2.37  
Overseas
    1.76       1.20       1.47  
Net interest margin (3)
                       
Group
    2.12       2.32       2.53  
UK
    2.39       2.55       2.68  
Overseas
    1.91       1.99       2.26  
The Royal Bank of Scotland plc base rate (average)
    4.67       5.51       4.64  
London inter-bank three month offered rates (average):
                       
Sterling
    5.51       6.00       4.85  
Eurodollar
    2.92       5.29       5.20  
Euro
    4.63       4.28       3.08  
 
Notes:
 
(1)
Gross yield is the interest rate earned on average interest-earning assets of the banking business.
 
(2)
Interest spread is the difference between the gross yield and the interest rate paid on average interest-bearing liabilities of the banking business.
 
(3)
Net interest margin is net interest income of the banking business as a percentage of average interest-earning assets of the banking business.
 
24

 
Business review continued


Average balance sheet and related interest
 
   
2008
   
2007 - Restated
 
   
Average
balance
   
Interest
   
Rate
   
Average
balance
   
Interest
   
Rate
 
      £m       £m    
%
      £m       £m    
%
 
Assets
                                           
Loans and advances to banks
                                           
– UK
    19,039       939       4.93       21,133       1,024       4.85  
– Overseas
    31,388       1,417       4.51       12,654       546       4.31  
Loans and advances to customers
                                               
– UK
    319,696       19,046       5.96       268,911       18,506       6.88  
– Overseas
    393,405       22,766       5.79       175,301       10,062       5.74  
Debt securities
                                               
– UK
    33,206       1,276       3.84       10,883       600       5.51  
– Overseas
    85,625       4,078       4.76       31,792       1,514       4.76  
Total interest-earning assets
                                               
– banking business (2, 3)
    882,359       49,522       5.61       520,674       32,252       6.19  
– trading business (4)
    425,454                       313,110                  
Total interest-earning assets
    1,307,813                       833,784                  
Non-interest-earning assets (2, 3)
    732,872                       289,188                  
Total assets
    2,040,685                       1,122,972                  
Percentage of assets applicable to overseas operations
    48.6%                       38.0%                  
Liabilities and owners’ equity
                                               
Deposits by banks
                                               
– UK
    46,217       1,804       3.90       52,951       2,234       4.22  
– Overseas
    113,592       4,772       4.20       31,073       1,172       3.77  
Customer accounts: demand deposits
                                               
– UK
    99,852       2,829       2.83       93,764       3,296       3.52  
– Overseas
    70,399       1,512       2.15       30,739       1,031       3.35  
Customer accounts: savings deposits
                                               
– UK
    42,870       1,708       3.98       36,334       1,658       4.56  
– Overseas
    72,473       2,203       3.04       27,645       902       3.26  
Customer accounts: other time deposits
                                               
– UK
    94,365       4,011       4.25       88,089       4,201       4.77  
– Overseas
    105,660       4,097       3.88       43,141       2,100       4.87  
Debt securities in issue
                                               
– UK
    101,520       4,095       4.03       57,140       3,060       5.36  
– Overseas
    132,699       5,846       4.41       49,848       2,627       5.27  
Subordinated liabilities
                                               
– UK
    26,300       1,356       5.16       23,502       1,300       5.53  
– Overseas
    12,385       788       6.36       4,509       230       5.10  
Internal funding of trading business
                                               
– UK
    (85,664 )     (3,445 )     4.02       (68,395 )     (3,307 )     4.84  
– Overseas
    (18,090 )     (729 )     4.03       (7,454 )     (321 )     4.31  
Total interest-bearing liabilities
                                               
– banking business (2, 3)
    814,578       30,847       3.79       462,886       20,183       4.36  
– trading business (4)
    466,610                       316,453                  
Total interest-bearing liabilities
    1,281,188                       779,339                  
Non-interest-bearing liabilities:
                                               
Demand deposits
                                               
– UK
    45,472                       18,416                  
– Overseas
    9,721                       14,455                  
Other liabilities (3, 4)
    645,760                       267,403                  
Owners’ equity
    58,544                       43,359                  
Total liabilities and owners’ equity
    2,040,685                       1,122,972                  
Percentage of liabilities applicable to overseas operations
    46.8%                       35.9%                  
 
Notes:
 
(1)
The analysis into UK and Overseas has been compiled on the basis of location of office.
 
(2)
Interest-earning assets and interest-bearing liabilities include the Retail bancassurance assets and liabilities attributable to policyholders.
 
(3)
Interest income and interest expense do not include interest on financial assets and liabilities designated as at fair value through profit or loss.
 
(4)
Interest receivable and interest payable on trading assets and liabilities are included in income from trading activities.
 
The 2007 comparative amounts have been restated for the netting of certain derivative asset and derivative liability balances with the London Clearing House, the finalisation of the ABN AMRO acquisition accounting and for the classification of Banco Real as a discontinued operation.
 
 
25

 
Business review continued


Average balance sheet and related interest
   
2006 - Restated
 
   
Average balance
   
Interest
   
Rate
 
      £m       £m    
%
 
Assets
                     
Loans and advances to banks
                     
– UK
    15,934       681       4.27  
– Overseas
    7,237       237       3.27  
Loans and advances to customers
                       
– UK
    239,086       15,141       6.33  
– Overseas
    121,092       6,977       5.76  
Debt securities
                       
– UK
    12,816       598       4.67  
– Overseas
    22,032       1,054       4.78  
Total interest-earning assets
                       
– banking business (2, 3)
    418,197       24,688       5.90  
– trading business (4)
    202,408                  
Total interest-earning assets
    620,605                  
Non-interest-earning assets (2, 3)
    199,898                  
Total assets
    820,503                  
Percentage of assets applicable to overseas operations
    35.2%                  
Liabilities and owners’ equity
                       
Deposits by banks
                       
– UK
    35,985       1,393       3.87  
– Overseas
    28,772       1,228       4.27  
Customer accounts: demand deposits
                       
– UK
    86,207       2,428       2.82  
– Overseas
    13,113       441       3.36  
Customer accounts: savings deposits
                       
– UK
    30,933       1,058       3.42  
– Overseas
    19,766       529       2.68  
Customer accounts: other time deposits
                       
– UK
    67,126       2,807       4.18  
– Overseas
    36,177       1,636       4.52  
Debt securities in issue
                       
– UK
    45,829       2,210       4.82  
– Overseas
    25,249       1,076       4.26  
Subordinated liabilities
                       
– UK
    23,873       1,226       5.14  
– Overseas
    2,639       160       6.06  
Internal funding of trading business
                       
– UK
    (44,475 )     (1,893 )     4.26  
– Overseas
    (4,930 )     (207 )     4.20  
Total interest-bearing liabilities
                       
– banking business (2, 3)
    366,264       14,092       3.85  
– trading business (4)
    204,810                  
Total interest-bearing liabilities
    571,074                  
Non-interest-bearing liabilities:
                       
Demand deposits
                       
– UK
    17,909                  
– Overseas
    11,668                  
Other liabilities (3, 4)
    182,976                  
Owners’ equity
    36,876                  
Total liabilities and owners’ equity
    820,503                  
Percentage of liabilities applicable to overseas operations
    32.3%                  
 
Notes:
 
(1)
The analysis into UK and Overseas has been compiled on the basis of location of office.
 
(2)
Interest-earning assets and interest-bearing liabilities include the Retail bancassurance assets and liabilities attributable to policyholders.
 
(3)
Interest income and interest expense do not include interest on financial assets and liabilities designated as at fair value through profit or loss.
 
(4)
Interest receivable and interest payable on trading assets and liabilities are included in income from trading activities.
 
The 2006 comparative amounts have been restated for the netting of certain derivative asset and derivative liability balances with the London Clearing House.
 
 
Business review continued


Analysis of change in net interest income – volume and rate analysis
Volume and rate variances have been calculated based on movements in average balances over the period and changes in interest rates on average interest-earning assets and average interest-bearing liabilities. Changes due to a combination of volume and rate are allocated pro rata to volume and rate movements.
 
   
2008 over 2007 (restated)
   
2007 (restated) over 2006 (restated)
 
   
Increase/(decrease) due to changes in:
   
Increase/(decrease) due to changes in:
 
   
Average
volume
   
Average
rate
   
Net change
   
Average
volume
   
Average
rate
   
Net change
 
      £m       £m       £m       £m       £m       £m  
Interest-earning assets
                                               
Loans and advances to banks
                                               
UK
    (103 )     18       (85 )     243       100       343  
Overseas
    845       26       871       217       92       309  
Loans and advances to customers
                                               
UK
    3,221       (2,681 )     540       1,985       1,380       3,365  
Overseas
    12,621       83       12,704       3,112       (27 )     3,085  
Debt securities
                                               
UK
    906       (230 )     676       (98 )     100       2  
Overseas
    2,564       -       2,564       465       (5 )     460  
Total interest receivable of the banking business
                                               
UK
    4,024       (2,893 )     1,131       2,130       1,580       3,710  
Overseas
    16,030       109       16,139       3,794       60       3,854  
      20,054       (2,784 )     17,270       5,924       1,640       7,564  
Interest-bearing liabilities
                                               
Deposits by banks
                                               
UK
    271       159       430       (706 )     (135 )     (841 )
Overseas
    (3,452 )     (148 )     (3,600 )     (94 )     150       56  
Customer accounts: demand deposits
                                               
UK
    (204 )     671       467       (227 )     (641 )     (868 )
Overseas
    (956 )     475       (481 )     (591 )     1       (590 )
Customer accounts: savings deposits
                                               
UK
    (276 )     226       (50 )     (206 )     (394 )     (600 )
Overseas
    (1,367 )     66       (1,301 )     (241 )     (132 )     (373 )
Customer accounts: other time deposits
                                               
UK
    (286 )     476       190       (962 )     (432 )     (1,394 )
Overseas
    (2,500 )     503       (1,997 )     (332 )     (132 )     (464 )
Debt securities in issue
                                               
UK
    (1,932 )     897       (1,035 )     (587 )     (263 )     (850 )
Overseas
    (3,714 )     495       (3,219 )     (1,248 )     (303 )     (1,551 )
Subordinated liabilities
                                               
UK
    (148 )     92       (56 )     19       (93 )     (74 )
Overseas
    (489 )     (69 )     (558 )     (99 )     29       (70 )
Internal funding of trading business
                                               
UK
    751       (613 )     138       1,129       285       1,414  
Overseas
    430       (22 )     408       109       5       114  
Total interest payable of the banking business
                                               
UK
    (1,824 )     1,908       84       (1,540 )     (1,673 )     (3,213 )
Overseas
    (12,048 )     1,300       (10,748 )     (2,496 )     (382 )     (2,878 )
      (13,872 )     3,208       (10,664 )     (4,036 )     (2,055 )     (6,091 )
Movement in net interest income
                                               
UK
    2,200       (985 )     1,215       590       (93 )     497  
Overseas
    3,982       1,409       5,391       1,298       (322 )     976  
      6,182       424       6,606       1,888       (415 )     1,473  
 
27

 
Business review continued


Non-interest income
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Fees and commissions receivable
    9,831       8,278       7,116  
Fees and commissions payable
    (2,386 )     (2,193 )     (1,922 )
(Loss)/income from trading activities
    (8,477 )     1,292       2,675  
Other operating income (excluding insurance net premium income)
    1,899       4,833       3,564  
      867       12,210       11,433  
Insurance premium income
    6,626       6,376       6,243  
Reinsurers’ share
    (300 )     (289 )     (270 )
      6,326       6,087       5,973  
      7,193       18,297       17,406  

2008 compared with 2007
Non-interest income, decreased by 61%, £11,104 million to £7,193 million. Non-interest income was severely affected by the weakness in financial markets experienced over the course of the year. While the decline was particularly marked in Global Banking & Market's credit markets and equities businesses, with reduced business volumes and mounting mark-to-market trading losses, Regional Markets also saw non-interest income fall in the latter part of the year as declining consumer confidence led to lower demand for credit and other financial products.
 
Excluding general insurance premium income, non-interest income fell by £11,343 million to £867 million.
 
Within non-interest income, fees and commissions receivable increased by 19% or £1,553 million, to £9,831 million, while fees and commissions payable increased by 9%, £193 million to £2,386 million.
 
Income from trading activities was down from £1,292 million to a loss of £8,477 million. Currency trading activities benefited from increased volatility in the markets. However, this improvement was more than offset by substantial credit market write downs during the year.
 
Other operating income also decreased, falling by 61%, £2,934 million to £1,899 million. This was principally due to a fall in the fair value of securities and other financial assets and liabilities partially offset by profits from the sale of subsidiaries and associates.
 
Insurance premium income, after reinsurance, increased by 4% to £6,326 million primarily reflecting a full year of ABN AMRO businesses in comparison with 76 days in 2007. This was partly offset by the discontinuation of less profitable partnership contracts.
 
2007 compared with 2006
Non-interest income increased by 5%, £891 million to £18,297 million, including £810 million from the acquisition of ABN AMRO. Good organic growth was offset by write-downs in Global Banking & Markets in respect of US mortgage-related and leveraged finance exposures. Non-interest income represents 60% of total income (2006 – 62%). Excluding general insurance premium income, non-interest income rose by 7%, £777 million to £12,210 million.

Within non-interest income, fees and commissions receivable increased by 16% or £1,162 million, to £8,278 million, while fees and commissions payable increased by 14%, £271 million to £2,193 million.

Income from trading activities was down from £2,675 million to £1,292 million. Interest rate and currency trading activities benefited from increased volatility and there was good growth from a broadening product range. These improvements were, however, more than offset by credit markets write downs.

Other operating income increased by 36%, £1,269 million to £4,833 million. This was principally due to growth in income from rental and asset-backed activities and principal investments in Global Markets.

General insurance premium income, after reinsurance, increased by 2% to £6,087 million with good growth in policies in the core businesses, particularly in Continental Europe.
 
 
Business review continued


 
Credit market exposures
   
2008
   
2007
 
   
Net exposure (1)
   
Write-downs before tax
   
Average price
   
Net exposure(1)
   
Average price
 
      £m       £m    
%
      £m    
%
 
Asset-backed CDOs
                                   
High grade
    1,231       1,836       29       2,581       84  
Mezzanine
    144       1,140       6       1,253       70  
      1,375       2,976               3,834       79  
Monolines
    4,804       3,557       n/a       2,547       n/a  
                                         
US residential mortgages (2)
                                       
Sub-prime
          353       n/a       1,292       72  
Alt-A
          1,071       n/a       2,233       83  
Other non-agency
          43       n/a       794       94  
            1,467               4,319       81  
US commercial mortgages (2)
    437       95       87       1,809       97  
Leveraged finance (2)
                                     
Held-for-trading
    103       1,088       64       11,992       96  
Loans and receivables
    5,920             n/a       2,514       n/a  
      6,023       1,088               14,506          
CLOs
    520       240       81       1,386       93  
              9,423                          
CDS hedging
            (1,642 )                        
Total net of CDS hedging
            7,781                          
 
Note:
 
(1)
Net of hedges and write-downs.
 
(2)
Figures represent the Group’s remaining net exposure to its previously reported credit market exposures.
 
(3)
Includes commitments to lend.
 
Additional disclosures on these and other related exposures can be found in the rest of this document as follows:
 
 
Disclosure
 
 
Section
 
 
Sub-section
 
 
Page
Further analysis (1)
 
Risk management
 
Credit market and related disclosures
  101 – 123
Valuation aspects (1)
 
Financial statements
 
Note 11 Financial instruments
  186 – 191
Valuation of financial instruments (1)
 
Financial statements
 
Critical accounting policies
  170 – 171
(general and level 3)
     
Note 11 Financial instruments
  184 – 191
Reclassification of financial instruments
 
Financial statements
 
Note 11 Financial instruments
  193
Asset-backed CDOs
 
Risk management
 
Market risk
  88
 
Note:
 
(1)
In preparing these disclosures, the Group took into consideration the leading practice recommendations of the Financial Stability Forum issued in April 2008 and the report of the IASB Advisory Panel ‘measuring and disclosing fair value of financial instruments in markets that are no longer active’ issued in October 2008.
 
 
 
Business review continued


Operating expenses
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Administrative expenses:
                       
Staff costs
    10,241       7,338       6,723  
Premises and equipment
    2,593       1,703       1,421  
Other administrative expenses
    5,464       2,969       2,658  
Total administrative expenses
    18,298       12,010       10,802  
Depreciation and amortisation
    3,154       1,932       1,678  
Write-down of goodwill and other assets
    32,581              
      54,033       13,942       12,480  

2008 compared with 2007
Operating expenses increased by £40,091 million to £54,033 million, primarily reflecting the write-down of goodwill and other assets of £32,581 million following a review of the carrying value of goodwill and other assets. Cost growth in the Group’s core retail and commercial banking franchises was offset by efficiency programmes and a significant reduction in Global Banking & Markets staff costs. The 2008 costs reflect a full year of the retained ABN AMRO businesses in comparison with 76 days in 2007.
 
The Group’s ratio of operating expenses to total income was 208.9% compared with 45.9% in 2007, largely reflecting the impact on income of the year’s difficult market conditions and the write-down of goodwill and other assets.
 
2007 compared with 2006
Operating expenses increased by 12%, £1,462 million to £13,942 million including £1,387 million relating to ABN AMRO. Adjusting for this, operating expenses increased by just £75 million, 1%, reflecting tight cost management and the benefits of the Group’s manufacturing platform. Further improvements in productivity have supported growth in business volumes, and allowed the Group to maintain high levels of customer satisfaction.

The Group’s ratio of operating expenses to total income was 45.9% compared with 44.6% in 2006.
 
 
Business review continued


Integration costs
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Staff costs
    503       18       76  
Premises and equipment
    25       4       10  
Other administrative expenses
    486       26       32  
Depreciation and amortisation
    36       60       16  
      1,050       108       134  

2008 compared with 2007
Integration costs in 2008 were £1,050 million compared with £108 million in 2007. The significant increase reflects a full year of integration costs being incurred in respect of the ABN AMRO acquisition, compared to 76 days in 2007.
 
Accruals in relation to integration costs are set out below.
 
   
At 31 December 2007
   
Currency translation adjustments
   
Charge to income statement
   
Utilised during the year
   
At 31 December 2008
 
      £m       £m       £m       £m       £m  
Staff costs
    4             503       (502 )     5  
Premises and equipment
    2             25       (26 )     1  
Other
    1       1       522       (521 )     3  
      7       1       1,050       (1,049 )     9  
 
2007 compared with 2006
Integration costs in 2007 were £108 million compared with £134 million in 2006 comprising amortisation of internally developed software and other expenditure. Software costs were previously written-off as incurred under UK GAAP but under IFRS are now amortised over the expected useful lives of up to five years. Software amortisation included in integration costs principally relates to the integration of Churchill, First Active and Citizens’ acquisitions, including Charter One which was acquired in August 2004.
 
Restructuring costs
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Staff costs
    251              
Premises and equipment
    15              
Other administrative expenses
    41              
      307              
 
Accruals in relation to restructuring costs are set out below.
 
   
At 31 December 2007
   
Currency translation adjustments
   
Charge to income statement
   
Utilised during the year
   
At 31 December 2008
 
      £m       £m       £m       £m       £m  
Staff costs
          33       251             284  
Premises and equipment
                15             15  
Other
          10       41             51  
            43       307             350  
 
 
Business review continued


Impairment
   
2008
   
2007
   
2006
 
      £m       £m       £m  
New impairment
    8,391       2,310       2,093  
less: recoveries of amounts previously written-off
    (319 )     (342 )     (215 )
Charge to income statement
    8,072       1,968       1,878  
Comprising:
                       
Loan impairment
    7,091       1,946       1,877  
Impairment of available-for-sale securities
    981       22       1  
Charge to income statement
    8,072       1,968       1,878  

2008 compared with 2007
Credit impairment losses increased to £8,072 million in 2008, compared with £1,968 million in 2007. The Group experienced a pronounced deterioration in impairments during the year, as financial stress spread to a broad range of customers. The greatest increase in impairments occurred in Global Banking & Markets. However, the Regional Markets businesses in all geographies also experienced a noticeable increase in impairments during the year, particularly in the UK SME and US personal segments.
 
Total balance sheet provisions for impairment amounted to £11,016 million compared with £6,452 million in 2007.
 
Total provision coverage (the ratio of total balance sheet provisions for impairment to total risk elements in lending) decreased from 60% to 52%. The ratio of total balance sheet provisions for impairment to total risk elements in lending and potential problem loans also decreased to 51% compared with 57% in 2007.
 
2007 compared with 2006
Impairment losses were £1,968 million compared with £1,878 million. Impairment losses in ABN AMRO in the period since acquisition were £103 million. Adjusting for this, impairment losses fell by £13 million, 1%. This reflected improvement in Global Markets and UK Retail & Commercial Banking partially offset by higher impairment in US Retail & Commercial Banking. New impairment losses were up 10%, £217 million to £2,310 million. Recoveries of amounts previously written-off were up £127 million, 59% to £342 million. Consequently the net charge to the income statement was up £90 million, 5% to £1,968 million.
 
Total balance sheet provisions for impairment, including ABN AMRO, amounted to £6,452 million compared with £3,935 million in 2006.
 
Total provision coverage (the ratio of total balance sheet provisions for impairment to total risk elements in lending) decreased from 62% to 60%. The ratio of total balance sheet provisions for impairment to total risk elements in lending and potential problem loans decreased to 57% compared with 62% in 2006. This reflects amounts written-off and the slightly lower risk profile of the portfolio.
 
 
Business review continued



Taxation
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Tax
    (2,323 )     2,044       2,689  
                   
   
%
   
%
   
%
 
UK corporation tax rate
    28.5       30.0       30.0  
Effective tax rate
    5.7       20.8       29.3  

 
The actual tax charge differs from the expected tax charge computed by applying the standard rate of UK corporation tax as follows:
 
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Expected tax (credit)/charge
    (11,590 )     2,950       2,756  
Non-deductible goodwill impairment
    8,292       12        
Unrecognised timing differences
    274       29        
Other non-deductible items
    330       222       288  
Non-taxable items
    (491 )     (595 )     (251 )
Taxable foreign exchange movements
    80       16       5  
Reduction in deferred tax liability following change in the rate of UK corporation tax
          (189 )      
Foreign profits taxed at other rates
    203       (25 )     63  
Losses in year not recognised
    942       2        
Losses brought forward and utilised
    (11 )     (11 )     14  
Adjustments in respect of prior periods
    (352 )     (367 )     (186 )
Actual tax (credit)/charge
    (2,323 )     2,044       2,689  
 
The effective tax rate for the year was 5.7% (2007 – 20.8%; 2006 – 29.3%). The tax credit is lower than that arising from applying the standard rate of UK corporation tax of 28.5% to the loss for the period, principally due to non-deductible goodwill impairment and certain carried forward losses on which no tax relief has been recognised.
 
 
Business review continued


Divisional performance
The divisional results are stated before amortisation of purchased intangible assets, write-down of goodwill and other intangible assets and integration and restructuring costs (‘Contribution’). The Group manages costs where they arise. Customer-facing divisions control their direct expenses whilst Manufacturing is responsible for shared costs. In 2008, the Group did not allocate these shared costs between divisions in the day-to-day management of its businesses, and the way in which divisional results are presented reflects this.
 
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Global Markets
                       
Global Banking & Markets
    (10,515 )     3,653       3,811  
Global Transaction Services
    1,818       1,315       1,186  
Total Global Markets
    (8,697 )     4,968       4,997  
Regional Markets
                       
UK Retail & Commercial Banking
    5,679       6,225       5,718  
US Retail & Commercial Banking
    883       1,479       1,744  
Europe & Middle East Retail & Commercial Banking
    429       769       675  
Asia Retail & Commercial Banking
    127       91       67  
Total Regional Markets
    7,118       8,564       8,204  
RBS Insurance
    1,020       905       967  
Group Manufacturing
    (4,793 )     (3,773 )     (3,523 )
Central items
    (675 )     (552 )     (1,231 )
Share of shared assets
    (300 )     (73 )      
RFS Holdings minority interest
    41       163        
Contribution     (6,286 )     10,202       9,414  
Amortisation of purchased intangibles
    (443 )     (262 )     (94 )
Integration and restructuring costs
    (1,357 )     (108 )     (134 )
Write-down of goodwill and other intangible assets
    (32,581 )            
Operating (loss)/profit before tax
    (40,667 )     9,832       9,186  
 
The performance of each of the divisions is reviewed on pages 35 to 52.
 
Risk-weighted assets of each division were as follows:
 
   
Basel II
   
Basel II
   
Basel I
 
   
31 December 2008
   
1 January 2008
   
31 December 2007
 
   
£bn
   
£bn
   
£bn
 
Global Markets
                 
Global Banking & Markets
    278.5       211.9       188.7  
Global Transaction Services
    19.6       16.8       15.4  
Total Global Markets
    298.1       228.7       204.1  
Regional Markets
                       
UK Retail & Commercial Banking
    152.5       153.1       179.0  
US Retail & Commercial Banking
    78.0       53.8       57.1  
Europe & Middle East Retail & Commercial Banking
    30.9       30.3       36.7  
Asia Retail & Commercial Banking
    6.4       4.9       3.3  
Total Regional Markets
    267.8       242.1       276.1  
RFS Holdings minority interest     118.0       147.4       119.0  
Other
    11.9       15.3       9.8  
      695.8       633.5       609.0  
 
 
Business review continued


 
Global Markets – Global Banking & Markets
 
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Net interest income from banking activities
    3,894       1,303       1,547  
Funding costs of rental assets
    (404 )     (495 )     (519 )
Net interest income
    3,490       808       1,028  
Net fees and commissions receivable
    1,288       1,198       859  
Income from trading activities
    (8,098 )     1,789       2,341  
Other operating income
    800       3,024       2,476  
Non-interest income
    (6,010 )     6,011       5,676  
Total income
    (2,520 )     6,819       6,704  
Direct expenses
                       
– staff costs
    2,687       2,134       2,000  
– other
    1,441       561       402  
– operating lease depreciation
    224       404       406  
      4,352       3,099       2,808  
Impairment
    3,643       67       85  
Contribution
    (10,515 )     3,653       3,811  
 
 
   
£bn
   
£bn
   
£bn
 
Loans and advances
    354.3       254.1       125.7  
Reverse repos
    96.1       308.9       114.5  
Securities
    163.2       239.5       109.1  
Cash and eligible bills
    26.1       26.9       7.5  
Other assets
    52.2       44.5       24.8  
Total third party assets (excluding derivatives mark to market)
    691.9       873.9       381.6  
Net derivative assets (after netting)
    146.0       64.1       17.9  
Customer deposits (excluding repos)
    105.0       106.7       44.6  
Non-performing loans
    6.2       1.0       0.5  

 
2008 compared with 2007
Global Banking & Markets (GBM) contribution fell from £3,653 million in 2007 to a loss of £10,515 million. This sharp decline reflected the effect of the market turmoil on the enlarged business which severely affected the division’s results in 2008, with a particularly adverse impact in the fourth quarter. GBM incurred £5,776 million of losses, write-downs or reserves largely on credit trading, counterparty risk (including CDPCs), counterparty failure (notably Lehman and Madoff) and sovereign events as the effects of the down-turn widened. In addition, losses on previously identified credit market exposures totalled £7,781 million, including impairments of £466 million on reclassified assets. These were only partly offset by gains on the fair value of own debt.

After credit market write-downs and one-off items and trading asset write-down, GBM recorded negative income of £2,520 million. Total income before credit market write-downs and one-off items (£6,958 million) and trading asset write-downs (£5,776 millions) was £10,214 million, up 19% from 2007. The increase reflects good performances in a number of businesses, most notably in rates and currencies and the inclusion of the ABN AMRO businesses for a full twelve months. Direct costs were up by 40%, with the inclusion of the acquired businesses of ABN AMRO for a full year outweighing reduced bonus payments. Credit impairments rose sharply from a very low level, £67 million, to £3,643 million, resulting in a 2008 operating loss of £10,515 million.

Net interest income grew by £2,682 million to £3,490 million, with the rates business benefiting from the declining interest rate environment. Non-interest income reduced by £12,021 million to negative income of £6,010 million. Fees and commissions increased mainly as a result of the inclusion of the ABN AMRO businesses for a full twelve months partially offset by a decline in origination volumes. Income from trading activities fell from £1,789 million to negative income of £8,098 million primarily as a result of trading asset write-downs and credit market exposures. Other operating income fell sharply from £3,024 million to £800 million, reflecting losses incurred on European loan sales and much reduced gains on other portfolio assets, partially offset by the gain on sale of Angel Trains of £570 million.

By business line, the rates and currencies business achieved a particularly strong performance in 2008, with high volumes of customer activity and flow trading resulting in an increase in income from rates trading to £3,543 million and growth in currencies income to £1,697 million. The Sempra Commodities joint venture performed ahead of expectations in the nine months since its formation, with GBM’s commodities income reaching £778 million for the year.

Equities improved slightly primarily as a result of the inclusion of a full year of ABN AMRO related businesses. However, reduced customer flow and also experienced losses on illiquid trading positions as markets deteriorated rapidly partially offset this increase.

In a reduced market for debt origination, credit markets improved its market positions in a number of key areas such as international bond issuance. Results, however, were severely affected by the continuing market weakness, particularly in the second half of the year.

Asset and portfolio management income remained resilient, but some losses were incurred, including on capital and credit exposure management.

Credit impairments increased sharply to £3,643 million, including £466 million on assets reclassified out of the held for trading category following the amendments to IAS 39 issued in October. Of the total impairment charge, £2,938 million was incurred in the fourth quarter of 2008, including £918 million relating to the Group’s exposure to Lyondell Basell.

GBM’s total third party assets were reduced by £182 billion to £692 billion at 31 December 2008, a reduction of 21% from a year earlier, or 31% at constant exchange rates. Within this total, loans and advances to customers were £354 billion, an increase of 14% at constant exchange rates. This increase was more than offset by significant reductions in reverse repos and securities holdings, both of which have been managed down over the course of the year. Net derivative assets totalled £146 billion, compared with £64 billion at the end of 2007.


 
Business review continued


Although GBM took steps to reduce underlying risk-weighted assets, these measures were masked by the impact of foreign exchange movements and of Basel II pro-cyclicality, with the result that RWAs at 31 December 2008 totalled £279 billion, up 31% from a year earlier, or 14% at constant exchange rates.
 
2007 compared with 2006
GBM achieved strong performances in many of its businesses in 2007, with particularly strong growth in interest rate and currency trading activities, but financial results were held back by challenging credit market conditions in the second half of the year. Contribution was £3,653 million, 4% lower than 2006’s record result.

Total income of £6,819 million was 2% higher than in 2006, with £394 million as a result of the inclusion of 76 days of GBM related ABN AMRO businesses. Whilst many parts of GBM grew strongly, there were write-downs of our subprime related and leveraged finance positions and additional provisions in response to the weakening credit profile of certain financial guarantors. These losses were partially offset by a reduction in the carrying value of our own debt and by a gain of £712 million realised on the sale of Southern Water.

The strength of GBM and the successful diversification of its product capabilities resulted in a continuation of the strong growth we have achieved in Asia and continental Europe in recent years. In Asia we have now established a solid platform, with good product capabilities and client relationships. In 2007 this resulted in strong Asian income growth, with outstanding growth in our activities in China and Japan. In Europe, income grew considerably, with particularly good results in the Nordic region and in the Iberian Peninsula, where GBM further expanded its strong position in the provision of financing and risk management services to corporates and financial institutions. Income in the UK grew strongly, while results in North America declined as a result of credit market conditions affecting GBM’s asset-backed and structured credit businesses.

Net interest income fell by 21% to £808 million. Loans and advances to customers, excluding reverse repos, increased by £128.4 billion as a result of the continued expansion of our customer base outside the UK and the inclusion of GBM related ABN AMRO businesses (£102.7 billion). Customer deposits increased by £62.1 billion, with £48.3 billion from GBM related ABN AMRO businesses.

Net fee income rose by 39% to £1,198 million, reflecting our top tier position in arranging, structuring and distributing large scale financings and the inclusion of GBM related ABN AMRO businesses (£151 million). We achieved particularly strong growth in non-US loan markets.

Income from trading activities declined by £552 million, 24% to £1,789 million, with GBM related ABN AMRO businesses contributing income of £285 million. Strong performances in interest rate and currency trading activities were supplemented by good growth in our broadening product range, including equity derivatives and retail investor products. However, in credit markets, write-downs reflecting the weakening of the US housing market led to a sharp fall in income.

Other operating income increased by £548 million, 22% to £3,024 million, including the successful sale of Southern Water which concluded during the second half. The majority of our remaining private equity portfolio has been sold into a fund, managed by RBS, thereby improving capital efficiency while offering more predictable and stable returns.

Direct expenses increased by 10% to £3,099 million. We continued to invest in expanding our geographical footprint, our infrastructure and our product range.

Portfolio credit risk remained stable and impairment losses declined to £67 million in 2007, with no deterioration in overall corporate credit quality. The liquidity and profitability of our corporate customers remains generally strong.

Total assets increased to £873.9 billion, reflecting the inclusion of GBM related ABN AMRO businesses (£400.9 billion) and growth in derivative assets (mostly rates and currencies) accompanied by a corresponding increase in derivative liabilities. The derivatives increase was a result of the strong growth in client-driven interest rate and currency trading activities in a more volatile market environment. Risk-weighted assets increased by 39%, driven by the inclusion of £39.0 billion of risk-weighted assets from GBM related ABN AMRO businesses and careful risk and capital management.
 
36

 
Business review continued


 
Global Markets – Global Transaction Services
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Net interest income
    909       595       449  
Non-interest income
    1,563       1,183       1,081  
Total income
    2,472       1,778       1,530  
Direct expenses
                       
– staff costs
    392       271       231  
– other
    202       178       109  
      594       449       340  
Impairment
    60       14       4  
Contribution
    1,818       1,315       1,186  

 
   
£bn
   
£bn
   
£bn
 
Total third party assets
    24.0       22.5       7.4  
Loans and advances
    18.6       18.7       6.6  
Customer deposits
    60.9       56.8       34.2  

2008 compared with 2007
Global Transaction Services (GTS) grew income by 39% to £2,472 million and contribution by 38% to £1,818 million for the full year 2008, reflecting the strength and enhanced international capability of its cash management, trade finance and merchant acquiring platforms. The income growth rate was maintained in the second half of the year, despite difficult market conditions. The key driver of this growth has been the acquisition of the ABN AMRO business with the historic RBS business contributing year on year income growth of 5%.

Growth was driven by a strong performance in cash management, in particular international cash management in ABN AMRO. Steady growth was achieved in the RBS UK and US domestic markets. Average customer deposits were higher mitigating the impact of lower interest rates. International overdrafts have been re-priced, reflecting the increased cost of funds and higher risk premia during the second half of the year. Fee income from payment transactions increased strongly, particularly in the US and internationally. The division was successful throughout the year in winning new international cash management mandates from existing RBS Group clients due to the strength of the international payments platform and network.
 
Trade finance made good progress, with income continuing to grow strongly as the ABN AMRO platform enabled GTS to substantially improve its penetration into the Asia-Pacific market, and has expanded its supply chain finance activities with an enhanced product suite. Margins improved throughout the year reflecting the additional risk premium in the market conditions.
 
Merchant services and commercial cards delivered growth despite the worsening economic climate. Acquiring transaction volumes were up in the year driven by good growth in online volumes, but weaker consumer confidence in the latter part of the year meant that average transaction values decreased, slowing income growth. Commercial cards income saw strong growth for the full year, driven by higher interchange income particularly in the small and middle markets.
 
Direct expenses rose by 32% to £594 million, reflecting the full year costs of the ABN AMRO business, historic RBS business costs increased by 10%. The full year cost growth reflected investment in staffing and infrastructure to support GTS’s development.

Impairment losses were £60 million, up from £14 million in 2007, reflecting in particular the downturn in the global economy and some growth in defaults amongst mid-corporates and SMEs.
 
2007 compared with 2006
Global Transaction Services grew income by 16% to £1,778 million and contribution by 11% to £1,315 million, driven by growth in the Merchant Services business, combined with the enhanced international cash management and trade platforms introduced through the ABN AMRO acquisition.

Revenue growth was evident across all product lines. Cash management growth was the result of increased deposit balances combined with payment fee growth initiatives. Merchant services and commercial cards delivered a 6% increase in income with particularly good growth in the international businesses. This growth has been driven by increased volumes across both debit and credit card transactions.

The Trade finance business benefits materially from the product suite introduced through the ABN AMRO acquisition through improved international capabilities and a global reach. Margins in this business have also begun to see the benefit of improved pricing reflecting country risk premiums.

Direct expenses rose by 32% to £449 million in comparison with 2006, primarily reflecting investment to expand the business. This includes the acquisition of ABN AMRO which incorporates costs directly related to the GTS business.

Impairment losses were £14 million compared with £4 million in 2006.
 
37

 
Business review continued


 
Regional Markets – UK Retail & Commercial Banking
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Net interest income
    6,999       6,602       6,350  
Net fees and commissions – banking
    2,919       3,054       2,896  
Other non-interest income
    1,080       1,450       1,327  
Non-interest income
    3,999       4,504       4,223  
Total income
    10,998       11,106       10,573  
Direct expenses
                       
– staff costs
    1,978       1,919       1,788  
– other
    1,193       1,076       1,082  
      3,171       2,995       2,870  
Insurance net claims
    184       518       488  
Impairment
    1,964       1,368       1,497  
Contribution
    5,679       6,225       5,718  
 
 
   
£bn
   
£bn
   
£bn
 
Total banking assets
    249.4       232.8       202.4  
Loans and advances to customers – gross
                       
– UK Retail Banking
    117.5       111.0       107.4  
– UK Corporate & Commercial Banking
    110.4       99.3       86.1  
– UK Wealth
    10.1       8.4       7.2  
Customer deposits*
    186.1       189.4       179.7  
Investment management assets – excluding deposits
    22.5       25.8       34.5  
Non-performing loans
    7.9       5.5       5.1  
 
*
excluding bancassurance
 

UK Retail and Commercial Banking retains an extremely strong franchise and represents the core of the RBS Group. However, the external environment over the next few years will present significant challenges with pressure on income as a result of very low interest rates, lower fee income, and impairment costs likely to increase further.
 
The business plans to respond to this environment through reducing costs and increasing productivity by investing in online service channels, automation of activities and re-design of end-to-end processes. The business will tailor the cost of service for different client segments more closely to their value generation.
 
Wealth management remains a strong growth opportunity and the business plans to pursue a more consolidated approach to the market through more co-ordination across the multiple brands with which it currently faces the market, whilst investing in additional Relationship Managers and platform functionality.
 
The division will pursue above market growth in customer deposits to improve its funding contribution to the Group, and will diversify its customer lending, reducing its exposure to commercial property.
 
 
Business review continued



Regional Markets – UK Retail & Commercial Banking
UK Retail Banking
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Net interest income
    4,390       4,172       4,099  
Net fees and commissions – banking
    2,219       2,375       2,297  
Other non-interest income
    369       765       731  
Non-interest income
    2,588       3,140       3,028  
Total income
    6,978       7,312       7,127  
Direct expenses
                       
– staff costs
    1,258       1,266       1,203  
– other
    574       545       552  
      1,832       1,811       1,755  
Insurance net claims
    184       518       488  
Impairment
    1,281       1,184       1,307  
Contribution
    3,681       3,799       3,577  
 

 
   
£bn
   
£bn
   
£bn
 
Loans and advances to customers – gross
                 
– mortgages
    74.9       67.4       65.3  
– personal
    16.2       17.1       17.1  
– cards
    6.4       7.8       8.1  
– business
    20.0       18.7       16.9  
Customer deposits*
    95.9       96.1       86.8  
Investment management assets – excluding deposits
    5.7       7.0       6.7  
Non-performing loans
    4.8       4.3       4.4  
 
*
customer deposits exclude bancassurance
 
2008 compared with 2007
Despite an economic environment which became markedly weaker in the second half of the year, UK Retail Banking, which includes both personal and small business banking, held direct costs in line with 2007 while total income decreased 5% to £6,978 million. However the deterioration in the macroeconomic environment resulted in an 8% increase in impairment losses. Consequently, contribution decreased 3%, £118 million, to £3,681 million. In the personal segment, RBS retained top position and NatWest was again joint second for customer satisfaction amongst main high street banks. The business segment has continued to grow, maintaining market leadership with a share of 26%, alongside 23% of the start-up market. UK Retail continues to maintain availability of lending while managing risk exposure and focusing on supporting customers through a difficult economic environment.

Net interest income increased 5% to £4,390 million as a result of strong balance sheet growth. Net interest income performance in the personal segment was strong, up 7%, as a result of good volume growth coupled with improving new lending margins. The small business sector has seen more pressure on asset margins, from increased funding costs, which has restricted net interest income growth to 4%. Average loans and advances to customers increased 7% and average deposits were up 6% with personal savings growing 9% and small business deposits growing 3%. At year end deposit balances were in line with 2007 levels, reflecting increasing competitive pressure in a slowing market. Net interest margin reduced from 3.92% to 3.85%, reflecting increased funding and liquidity costs.

UK Retail mortgage balances grew 11% despite more muted demand in the second half, and net mortgage lending market share increased to 19% (2007 – 2%). Small business lending grew 7% despite a significant contraction in demand. Personal unsecured lending slowed, however, particularly in the second half of the year. Further, the sale of Tesco Personal Finance (TPF) reduced personal unsecured balances at 31 December 2008 by £1.9 billion, though income of £285 million from TPF was included up to the date of the sale completion on 19 December.

Non-interest income declined 18% to £2,588 million. Bancassurance sales grew 3% to £353 million annual premium equivalent in the year, however the negative performance of debt and equity markets reduced investment income by £48 million. Excluding this, underlying non-interest income declined 6% reflecting reduced demand for unsecured lending and lower sales of payment protection insurance.

Direct expenses increased 1% to £1,832 million. Direct staff costs reduced 1% reflecting increased efficiency. Other direct costs rose by 5% as a result of increased investment in selected business lines.
 
During 2008 the division almost doubled the number of branches open on a Saturday and introduced 1,000 MoneySense advisers into branches to provide impartial advice to customers on managing their money.

Impairment losses increased 8% to £1,281 million, with an increase in small business delinquencies and personal impairments reflecting the changed economic environment, particularly in the second half. In the small business segment impairments increased to £158 million (2007 – £80 million). In the personal segment the increase in impairments has been more modest, with mortgage impairment charges at £33 million (2007 – £21 million) on a total book of £74.9 billion, while unsecured personal lending impairments remained level with 2007 at £1,091 million (2007 – £1,084 million). Higher Loan-to-Value ratio mortgages have been restricted and affordability criteria tightened. The average LTV for new business was 67% (2007 – 62%). Repossessions represented 0.06% of outstanding mortgage balances at 31 December 2008, compared with a Council of Mortgage Lenders’ average at December 2008 of 0.21%.

Risk weighted assets totalled £63.8 billion at year end, a fall of 3% from 1 January 2008. The upward pressure from procyclicality, especially on the mortgage book, and book growth was offset by the disposal of TPF and improvements in Basel II methodologies.
 
2007 compared with 2006
UK Retail achieved strong results in 2007, increasing contribution by 6% to £3,799 million as a result of good income growth in both consumer and business banking combined with tight cost control and a reduction in impairment losses. Total income grew by 3% to £7,312 million, while income net of insurance claims grew by 2% to £6,794 million.

We have accelerated the expansion of our consumer banking franchise, opening more than 975,000 new personal current accounts in 2007 and maintaining the Group’s joint number one position in the current account market. RBS and NatWest continue to lead the other major high street banks
 
 
Business review continued


in Great Britain for customer satisfaction. We continue to focus on sales through the branch channel, and by adding more customer advisers in our branches have achieved a significant uplift in volumes.

Bancassurance continued its excellent progress with sales growth of 28% to £342 million annual premium equivalent, representing a doubling of 2005 sales. We invested further in our sales force, ending the year with more than 1,000 financial planning managers.

In business banking we strengthened our management team and improved operational processes, producing good results. During 2007 we placed an additional 500 business managers back in branches, launched additional products to support the start-up market, and added new roles supporting ethnic minorities, women in business and community banking.

In our cards and direct finance business, we have maintained our focus on credit card sales through the branch channel, where new business sales were up 47% on 2006, while continuing to take a cautious view on direct sales.

Savings balance growth was helped by good sales of new accounts to branch customers, with NatWest opening more than 1 million new savings accounts.

Mortgage activity focused on branch channels, where net lending was 14% higher than in the previous year. We also took advantage of improved margins in the intermediary segment in the latter part of the year to improve volumes. Direct loan balances declined over the year as we maintained our strategy of focussing unsecured personal lending on profitability rather than volume, although we continued to grow lending through the branch channel. After a decline in credit card balances in the first half of the year we improved recruitment and retention in the second half.

Net interest income increased by 2% to £4,172 million, with strong growth in deposits helping to mitigate the impact of lower unsecured lending volumes and lower average card balances. Net interest margin declined modestly, in line with previous guidance, with savings margins consistent with 2006, despite increased competition for deposits.

Non-interest income was £3,140 million, 4% ahead of 2006, with strong growth in investment income offset by lower levels of direct lending and reduced instances of current account fees.

Direct expenses rose by 3% to £1,811 million, driven by increased investment in customer-facing staff in branches and in our bancassurance and investment businesses. Other costs reduced by 1% to £545 million.

Impairment losses decreased by 9% to £1,184 million, reflecting the improvement in arrears trends on both credit cards and unsecured personal loans. Mortgage arrears remained very low, and we have maintained conservative lending criteria – the average loan-to-value ratio of UK Retail’s mortgages was 46% overall and 63% on new mortgages written in 2007, and this improved as the year progressed. Small business credit quality remained good.

40

 
Business review continued

 
 
Regional Markets – UK Retail & Commercial Banking
UK Corporate & Commercial Banking
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Net interest income
    2,039       1,924       1,807  
Net fees and commissions
    450       425       385  
Other non-interest income
    672       658       569  
Non-interest income
    1,122       1,083       954  
Total income
    3,161       3,007       2,761  
Direct expenses
                       
– staff costs
    486       431       381  
– other
    529       467       457  
      1,015       898       838  
Impairment
    671       180       188  
Contribution
    1,475       1,929       1,735  
 
 
   
£bn
   
£bn
   
£bn
 
Loans and advances to customers – gross
    110.4       99.3       86.1  
Customer deposits
    64.3       66.2       71.0  
Non-performing loans
    3.0       1.2       0.7  
 
2008 compared with 2007
UK Corporate & Commercial Banking experienced a solid performance in the first half of 2008, with the second half of 2008 being impacted by the marked deterioration in economic conditions. Total income increased 5% to £3,161 million. However, growth in impairments, especially in the second half of the year, resulted in a 24% fall in contribution to £1,475 million.

Net interest income increased 6% to £2,039 million. Average loans and advances were 18% higher than 2007, reflecting the Group’s continuing support for the UK economy. New business margins widened in the second half to reflect increasing risk premia, however, higher funding costs on the back book suppressed growth in net interest income.

Non interest income increased 4% to £1,122 million. 2007 benefited from the profit on disposal of the Securities Services Group business. This strong performance reflects increased sales of interest rate and currency risk management products.

Direct expenses increased 13% to £1,015 million, reflecting a 26% rise in operating lease depreciation to £401 million, due to higher volumes as well as additional provisions of £54 million for lower residual values in the Lombard vehicle leasing business. Direct expenses, excluding operating lease depreciation, increased by 6% to £614 million with cost growth reflecting the recruitment of additional relationship managers in 2007.

Impairment losses totalled £671 million, a sharp increase from the historically low levels seen in 2007. 48% of the charge related to house builder and property development companies. Losses were concentrated in the smaller end of the corporate sector, although a number of specific exposures in the larger corporate sector have also impacted the charge. The commercial businesses charge was £368 million (2007 – £100 million) and the corporate business charge was £303 million (2007 – £80 million).

The performance of our commercial property book remains under close watch. Average LTVs in the UK portfolio is 68% and less than 5% of the portfolio has LTVs greater than 85%.

RWA growth has been constrained by improvements in Basel II methodologies and active risk management, which have offset growth in the underlying balance sheet and the impacts of procyclicality.
 
2007 compared with 2006
UK Corporate & Commercial Banking had another successful year of profitable growth, building further on our market-leading position and achieving significant improvements in customer satisfaction. Total income rose by 9% to £3,007 million and contribution by 11% to £1,929 million.

There has been good growth in customer volumes, with average loans and advances up 15% and average deposits up 12%. Net interest income increased by 6% to £1,924 million as net interest margin narrowed slightly from the prior year. In recent months we have seen firmer margins in some areas.

Non-interest income rose by 14% to £1,083 million, as a result of growth in fees and continued progress in the distribution of trade and invoice finance products as well as of interest rate and foreign exchange products.

Direct expenses increased by 7% at £898 million due to investment targeted towards improving customer service. Around 600 new front line roles were created and major new functionality was added to the Bankline electronic banking platform. These initiatives have contributed to strongly favourable customer satisfaction scores in 2007.

Impairment losses totalled £180 million, 4% lower than in 2006, reflecting the strong quality of the portfolio. Corporate credit metrics remained stable.

41

 
Business review continued

 
 
Regional Markets – UK Retail & Commercial Banking
UK Wealth
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Net interest income
    570       506       444  
Net fees and commissions
    250       254       214  
Other non-interest income
    39       27       27  
Non-interest income
    289       281       241  
Total income
    859       787       685  
Direct expenses
                       
– staff costs
    234       222       204  
– other
    90       64       73  
      324       286       277  
Impairment
    12       4       2  
Contribution
    523       497       406  
 
 
   
£bn
   
£bn
   
£bn
 
Loans and advances to customers – gross
                 
– mortgages
    5.2       4.2       3.8  
– personal
    3.7       3.0       2.5  
– other
    1.2       1.2       0.9  
Customer deposits
    25.9       27.1       21.9  
Investment management assets – excluding deposits
    16.8       18.8       15.3  
Non-performing loans
    0.1              
 
2008 compared with 2007
UK Wealth delivered robust growth, with total income increasing by 9% to £859 million and contribution increasing by 5% to £523 million.

UK Wealth generates earnings from both private banking and investment services, and this has enabled the division to maintain strong organic growth, despite the deterioration in global market conditions. Coutts & Co. performed particularly well, with contribution up by 15%.

Average loans and advances to customers rose by 17% and average customer deposits by 11%, underpinning a 13% rise in net interest income to £570 million.

Non interest income grew by 3% to £289 million as higher fee income was offset by lower investment income. Although average assets under management were 4% higher than in 2007, lower stock market levels in the latter part of the year reduced assets under management by 11% to £16.8 billion.

Direct expenses rose by 13% to £324 million partly due to increased headcount and higher deposit protection scheme contributions.

Impairments rose from £4 million in 2007 to £12 million and represented approximately 0.1% of the total UK lending book.

2007 compared with 2006
Wealth Management’s offering of private banking and investment services continued to deliver very strong growth in income, up 15% in 2007 to £787 million. Contribution grew by 22% to £497 million.

We have continued Coutts & Co’s UK regional expansion programme, and this has helped us to grow customer numbers by 7% and income by 22%.

Growth in banking volumes contributed to a 14% rise in net interest income to £506 million. Average loans and advances to customers rose by 16% and average deposits by 22%.

Non-interest income grew by 17% to £281 million, reflecting higher investment management fees and new product sales, including new investment vehicles specialising in private equity and natural resources, as well as continued growth in underlying new business volumes. Assets under management rose to £18.8 billion at 31 December 2007, up 23% from a year earlier.

Direct expenses increased by 3% to £286 million, reflecting continued investment in the UK.
 
 
42

 
Business review continued

 
 
Regional Markets – US Retail & Commercial Banking
   
2008
   
2007
   
2006
   
2008
   
2007
   
2006
 
      £m       £m       £m       $m       $m       $m  
Net interest income
    2,106       1,935       2,041       3,902       3,872       3,764  
Non-interest income
    904       846       949       1,676       1,692       1,747  
Total income
    3,010       2,781       2,990       5,578       5,564       5,511  
Direct expenses
                                               
– staff costs
    675       598       664       1,250       1,197       1,225  
– other
    411       364       402       762       728       743  
      1,086       962       1,066       2,012       1,925       1,968  
Impairment – core
    722       177       180       1,337       351       332  
Impairment – SBO
    319       163       -       592       329       -  
Contribution
    883       1,479       1,744       1,637       2,959       3,211  
 
 
   
£bn
   
£bn
   
£bn
   
US$bn
   
US$bn
   
US$bn
 
Total assets
    103.9       79.6       82.1       151.8       159.2       161.3  
Loans and advances to customers – gross
                                               
– mortgages
    10.7       9.5       9.5       15.7       19.1       18.6  
– home equity
    23.8       17.9       17.6       34.8       35.9       34.5  
– other consumer
    14.6       10.8       11.7       21.3       21.6       23.1  
– corporate and commercial
    28.2       18.8       16.7       41.2       37.6       32.7  
Customer deposits
    64.6       52.8       51.5       94.3       105.8       101.1  
Non-performing loans
    0.8       0.3       0.2       1.1       0.6       0.3  
Average exchange rate – US$/£
                            1.853       2.001       1.844  
Spot exchange rate – US$/£
                            1.460       2.004       1.965  
 
2008 compared with 2007
US Retail & Commercial Banking increased income by 8% to £3,010 million, primarily as a result of movements in exchange rates, but experienced a sharp increase in impairment losses as economic conditions progressively worsened over the course of the year. As a result, contribution declined to £883 million, down 40%. In dollar terms, total income was held steady at $5,578 million while contribution declined by 45% to $1,637 million.
 
Total income of £3,010 million increased by 8%, with 20% growth in commercial banking to £664 million and a 5% growth in retail banking income to £2,346 million. In dollar terms, total income of $5,578 million was essentially unchanged, with 11% growth in commercial banking to $1,231 million offsetting a 2% decline in retail banking income to $4,347 million. Both segments were affected by the deterioration in credit conditions, with retail contribution down 54% to £499 million and commercial contribution flat at £384 million. In dollar terms, retail contribution was was down 58% to $926 million and commercial contribution was down 7% to $711 million.
 
Overall, net interest income grew modestly, offset by a small decline in non-interest income. Average loans and advances to retail customers decreased as a result of the slowing economy and tighter underwriting standards, but this decline was offset by continued strong growth in corporate and commercial lending. Core customer deposits declined by 5% and the division further reduced its reliance on brokered deposits by 80%, leading to an overall decline of 11% in total customer deposits. Net interest margin was held steady at 2.73%, reflecting widening asset margins and management of savings rates in a competitive deposit market.
 
Direct expenses increased by 13% to £1,086 million, reflecting increased costs from the expansion of the commercial banking relationship management teams, write-downs on mortgage servicing rights, and higher costs related to loan work-out and collection activity together with movements in exchange rates. In dollar terms, direct expenses increased by 5% to $2,012 million.
 
Credit conditions worsened significantly over the course of the year as the housing market continued to deteriorate and unemployment rose, exacerbating already challenging conditions. Impairment losses totalled £1,041 million, up from £340 million in 2007 reflecting the deterioration in economic conditions. In dollar terms, impairment losses totalled $1,929 million, up 184% from 2007.
 
In the core US Retail & Commercial portfolio, 2008 impairment losses totalled £722 million ($1,337 million), with a marked increase in the second half. Consumer non-performing loans represented 0.37% of core home equity balances and 1.20% of residential mortgage balances. While there has been a decline in some customers’ credit scores in line with weakening economic conditions, refreshed weighted average FICO scores for consumer real estate-secured lending at 31 December 2008 was approximately 740 with a weighted average LTV of 63%. Stress has emerged in all consumer segments during the second half of the year, with increased delinquency in core home equity (up 10bps to 0.86%), and auto (up 94bps to 2.78%). US Retail & Commercial does not originate negative amortization mortgages or option adjustable rate mortgages. Closing provision balances for the core portfolio were £892 million ($1,303 million) compared with £388 million ($777 million) at the end of 2007.
 
43

 
Business review continued

 
 
Credit quality has continued to deteriorate sharply in the externally sourced home equity portfolio (the Serviced By Others (SBO) portfolio). On a constant currency basis this portfolio, now managed by a separate work-out group and in run-off, has been reduced by £1.0 billion over the last year to £4.9 billion and $1.5 billion in dollar terms to $7.1 billion at 31 December 2008. Non-performing SBO loans represent 2.66% of SBO balances. Impairment losses in relation to the SBO portfolio totalled £319 million ($592 million) for 2008, with £155 million ($268 million) incurred in the second half of 2008 compared with £164 million ($324 million) in the first half. Closing SBO provision balances amounted to £325 million ($474 million) at 31 December 2008, up from £208 million ($413 million) at 30 June 2008, providing a coverage ratio of 2.5 times non-performing loans.
 
The overall commercial loan portfolio has begun to show signs of stress, with a marked deterioration in the commercial real estate book. Impairments in the commercial and industrial portfolio, including lease financing, totalled $212 million, or 0.74% of balances. Total impairments within the commercial real estate portfolio were $177 million, or 1.63% of balances.
 
The US business has continued to evaluate opportunities to optimise capital allocation by exiting or reducing exposure to lower growth or sub-scale segments. In the fourth quarter, 18 rural branches in the Adirondacks region were sold to Community Bank System. An agreement has also been announced to sell the Indiana retail branch banking network, consisting of 65 branches, and the business banking and regional banking activities, to Old National Bank.
 
2007 compared with 2006
Against the background of weaker housing and credit market conditions, the US Retail & Commercial Banking division demonstrated resilience in 2007, with a particularly good performance in corporate and commercial banking. Despite modest growth in net interest margins and strong fee growth in several products, total income fell by 7% to £2,781 million due mainly to the weak dollar exchange rate but, in dollar terms, total income was flat at $5,564 million. Tight cost control helped limit the fall in contribution. However, impairment losses increased from 0.31% of loans and advances to 0.60%, resulting in a decrease in contribution of 15% to £1,479 million, or 8% to $2,959 million in dollar terms.

Net interest income fell by 5% to £1,935 million due mainly to the unfavourable dollar exchange rate. In dollar terms, net interest income rose by 3% to $3,872 million. Average loans and advances to customers increased by 4%, with strong growth in corporate and commercial lending, up 13%, with close attention being paid to our risk appetite in light of prevailing market conditions. Average customer deposits were flat and deposit margins narrowed as a result of deposit pricing competition and continued migration from low-cost checking accounts and liquid savings to higher-cost products. Notwithstanding this migration, US Retail & Commercial Banking net interest margin increased slightly to 2.74% in 2007, compared with 2.66% in 2006, thanks in part to improved lending spreads in the latter part of the year.

Non-interest income fell by 11% to £846 million. In dollar terms, non-interest income fell by 3% to $1,692 million. Business and corporate fees rose strongly, with good results especially in foreign exchange and interest rate derivatives, driven by increasing cooperation with RBS Global Markets. Good progress was also made in credit card issuing, where we increased our customer base by 20%.

In response to more difficult market conditions the division intensified cost discipline, with a reduction in headcount helping to reduce direct expenses by 10%. In dollar terms, the fall in direct expenses was just 2%, despite enhancements to infrastructure and processes as well as continued investment in growth opportunities including mid-corporate banking, and contactless debit cards.

Rising losses and increased provisions lifted impairment costs from £180 million in 2006 to £340 million in 2007. In dollar terms, impairment losses rose from $332 million in 2006 to $680 million in 2007. Against a background of weaker economic activity the US Retail & Commercial Banking division portfolio is performing well, although we have experienced a reversion from the very low levels of impairment seen in recent years, reflecting both the planned expansion of our commercial loan book and the impact of a softer housing market. There has also been an increase in reserving. The average FICO scores on our consumer portfolios, including home equity lines of credit, remain in excess of 700, with 97% of lending secured. Average loan-to-value ratios at the end of 2007 were 58% on our residential mortgage book and 74% on our home equity book.
 
 
Business review continued

 

Regional Markets – Europe & Middle East Retail & Commercial Banking
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Net interest income
    1,087       958       824  
Net fees and commissions
    320       219       201  
Other non-interest income
    111       169       119  
Non-interest income
    431       388       320  
Total income
    1,518       1,346       1,144  
Direct expenses
                       
– staff costs
    404       307       251  
– other
    159       152       114  
      563       459       365  
Impairment
    526       118       104  
Contribution
    429       769       675  
 
 
   
£bn
   
£bn
   
£bn
 
Total assets
    66.4       56.1       44.5  
Loans and advances to customers – gross
                       
– mortgages
    24.6       18.3       14.9  
– corporate
    33.4       25.3       19.6  
– other
    3.7       4.2       3.6  
Customer deposits
    25.0       22.3       18.1  
Non-performing loans
    3.3       0.7       0.5  
 

2008 compared with 2007
The significant deterioration in global and local market conditions has impacted the main Europe & Middle East markets, with contribution falling to £429 million, 44% lower than in 2007. The main driver of this reduction has been an increase of £408 million in impairments, albeit from a low base, reflecting deterioration in credit quality particularly in the property and construction sectors, as economic conditions have slowed.

Total income was up £172 million, 13% at £1,518 million benefitting from the full year of the ABN AMRO businesses and movements in exchange rates. Direct expenses were up 23% to £563 million. Impairment losses rose sharply to £526 million from £118 million reflecting the economic environment.

In sterling terms the results have been materially affected by the movement in the euro exchange rate and references to percentage movement in the following analysis are in constant currency terms.

Within the core business of the region, Ulster Bank, contribution fell to £117 million. Total income decreased by 2% to £1,269 million; net interest income increased by 1%, with average loans and advances to customers up 12% in the year.  The benefit from growth in lending, particularly in the first half of the year has been offset by increased funding costs associated with the wholesale funding market dislocation. Other income was 12% lower than in 2007, reflecting a slowdown in particular in the bancassurance and wealth businesses.

Average mortgage balances in Ulster Bank were 11% higher than 2007.  New mortgage volumes in the second half of the year were significantly lower than in the first six months, although levels of redemptions have also fallen.

Average deposit balances in Ulster Bank were largely flat year-on-year reflecting the highly competitive market for resources in Ireland in 2008.  Deposit flows were strong in the latter part of the year and into the early months of 2009.  During 2008, we opened 119,000 new current accounts driven by particularly successful current account switcher and student campaigns.

Direct expenses rose by 8% to £432 million, reflecting the full year impact of the now completed investment programme in Ulster Bank’s footprint and operations. Cost growth in the second half of 2008 was significantly lower, reflecting disciplined management of the cost base.

Impairment losses in Ulster Bank rose to £394 million, reflecting the impact on credit quality of the slowdown in the Irish economy, with the final quarter showing the most notable decline in both activity and sentiment.  This was reflected in a significantly increased flow of cases into the problem debt management process.

In January 2009, Ulster Bank announced its intention to adopt a single brand strategy under the Ulster Bank brand.  This will see the merger of the operations of Ulster Bank and First Active in the Republic of Ireland (“RI”) by the end of 2009.  This action is being taken to strengthen the Ulster Bank Group franchise by positioning it to deal with the prevailing local and global market conditions. A number of cost management initiatives have also commenced across the business.

Ulster Bank has launched a series of initiatives to support its customers in this difficult economic period.  We announced in February 2009 that we will be making significant funds available to the Northern Ireland (“NI”) SME market.  A similar announcement will be made in the coming weeks regarding the RI SME market.  Ulster Bank has also indicated that it is adopting the RBS Group pledge regarding certainty of overdraft limits for this sector.

The Momentum and Secure Step mortgages have been launched in NI and RI respectively to support First Time Buyers and the Bank has confirmed its pledge of a six-month moratorium to mortgage customers facing potential repossession.  In support of our retail customers across the island of Ireland the Group’s MoneySense programme is being rolled out, with trained advisers being introduced to all Ulster Bank branches.

Outside Ireland, Europe & Middle East Retail & Commercial Banking continued to trade satisfactorily, although our markets in the United Arab Emirates, Romania and Kazakhstan have also experienced a marked slowdown in the past year. In UAE, we are a market leader in credit cards with over 430,000 cards in issue.

 
 
Business review continued


The sale of the European Consumer Finance business to Santander was completed on 1 July 2008, while the Imagine business in Spain was sold to Bank of America in the second half of 2008. The former ABN AMRO retail business in Russia was also closed during the year.
 
2007 compared with 2006
Europe and Middle East Retail & Commercial Banking maintained its success in building its personal and corporate banking business, particularly in the island of Ireland, with total income rising by 18% to £1,346 million and contribution by 14% to £769 million. These results reflect solid sales growth across all activities, driven by an enhanced range of innovative products and an expanded distribution network.

Net interest income increased by 16% to £958 million, reflecting good growth in both loans and deposits. Average loans and advances to customers increased by 24%, with particular strength in business lending, with a 29% increase spread across a variety of industrial sectors. Our mortgage book also saw very good growth in 2007, in spite of the slowdown in the housing market, with average balances up 17%. We achieved particular success in attracting remortgagers with our Switcher package. We were also successful in the current account switching market, winning 100,000 new current account customers during the year. This, together with new product launches such as the eSavings Account and Reward Reserve savings accounts, contributed to a 18% increase in average customer deposits. Net interest margin tightened, reflecting more competitive market conditions and increased funding costs.

Non-interest income rose by 21% to £388 million, driven by strong performances in Global Markets and credit cards. We successfully launched our new wealth business in the course of the year.

Direct expenses increased by 26% to £459 million, as we continued our investment programme to support the future growth of the business. We continued to expand our branch and business centre footprint and recruited additional customer-facing staff, particularly in our Global Markets business.

Impairment losses have risen to £118 million, reflecting growth in lending as well as a slowdown in economic conditions which has affected commercial credit metrics.
 
46

 
 
Business review continued  

 
Regional Markets – Asia Retail & Commercial Banking
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Net interest income
    379       123       52  
Net fees and commissions
    309       161       136  
Other non-interest income
    93       71       23  
Non-interest income
    402       232       159  
Total income
    781       355       211  
Direct expenses
                       
– staff costs
    284       150       95  
– other
    199       90       50  
      483       240       145  
Impairment
    171       24       (1
Contribution
    127       91       67  

 
   
£bn
   
£bn
   
£bn
 
Total assets
    8.3       7.6       3.1  
Loans and advances to customers – gross
    5.8       4.5       1.6  
Investment management assets – excluding deposits
    21.2       19.9       0.3  
Customer deposits
    15.1       10.8       6.5  
Non-performing loans
    0.3       0.5        
 
2008 compared with 2007
Total income rose by £426 million to £781 million largely reflecting the full year contribution from the acquired ABN AMRO businesses. Retail & Commercial Banking income was up £380 million reflecting the full year contribution of the ABN AMRO business with the Affluent banking income slowing markedly in the second half due to reduced structured product and equity fund sales, as investors stayed out of volatile markets. Income was particularly strong from RBS Coutts, increasing £46 million or 19%. Comparisons with the previous year are affected by the marked weakening of sterling over the course of the year.

Credit cards and consumer finance credit metrics have continually been reviewed over the period resulting in further tightening of consumer lending policies. This has led to lower levels of card and loan acquisition. There has also been a slowdown in the number of card transactions. Despite this, the cards and consumer finance business reported income growth together with an increase in consumer net receivables.

Business banking has seen strong growth across most regions, having performed particularly well in the Indian, Pakistani and Chinese markets.

RBS Coutts’ offering of private banking and investment services continued to deliver good income growth of 19% and strong levels of client acquisition, up 5% in the year. Net interest income grew 56% on the back of strong banking volumes, though this was offset in part by weaker sales of equity-related investment products and lower assets under management. Despite adverse financial markets and significant levels of client deleveraging, assets under management in the international wealth business grew by 8%.

Direct expenses rose by £243 million to £483 million, reflecting the full year impact of the acquired ABN AMRO businesses, legal costs and continued investment in the Group’s infrastructure in the region, including the recruitment of additional experienced private bankers in RBS Coutts Asia.

Impairments increased from £24 million to £171 million, relecting the full year impact of the acquired ABN AMRO businesses which are predominately consumer focused, and an increase in provisioning levels across a number of consumer finance markets in the region.

Total assets under management for the division at 31 December 2008 were 7% higher than a year earlier at £21.2 billion, while customer deposits were 40% higher at £15.1 billion, partly reflecting exchange rate movements.

2007 compared with 2006
2007 results reflect the introduction of ABN AMRO businesses in the Asia region. Asia Retail & Commercial’s 2007 results include the accounting for 76 days of the Asia Retail arm of ABN AMRO (total income £101 million, total direct expenses £57 million, total contribution £21 million including £23 million of impairment losses). Asia Retail & Commercial Banking reported strong growth, with total income rising 68% to £355 million. Contribution grew by 36% to £91 million.

The division operates in 8 countries in Asia: China, Hong Kong, India, Indonesia, Malaysia, Pakistan, Singapore and Taiwan, across 4 core business segments: affluent banking, cards & consumer finance, business banking and private banking.

RBS Coutts, which excludes the ABN AMRO businesses, offering of private banking and investment services delivered good organic income growth in 2007. The division has seen healthy levels of client acquisition with growth in banking volumes leading to a rise of 21% in net interest income. Non-interest income grew by 18%, largely driven by a rise in transactional, market-driven income and volumes as a result of consistent global equity market growth and positive client sentiment.

Direct expenses rose by 66% to £240 million, reflecting the part-year inclusion of ABN AMRO’s Asia Retail division and underlying investment in the existing wealth management businesses in the region. Despite the highly competitive market, RBS Coutts successfully recruited additional, experienced private bankers.

Impairment losses, at £24 million, have increased from negligible levels in 2006 reflecting the introduction of the ABN AMRO businesses in the Asia region.
 
 
47

 
Business review continued

 
RBS Insurance
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Earned premiums
    5,520       5,607       5,713  
Reinsurers’ share
    (227 )     (220 )     (212 )
Insurance premium income
    5,293       5,387       5,501  
Net fees and commissions
    (401 )     (465 )     (486 )
Other income
    674       734       664  
Total income
    5,566       5,656       5,679  
Direct expenses
                       
– staff costs
    309       297       319  
– other
    462       444       423  
      771       741       742  
Gross claims
    3,857       4,091       4,030  
Reinsurers’ share
    (124 )     (81 )     (60 )
Net claims
    3,733       4,010       3,970  
Impairment
    42              
Contribution
    1,020       905       967  
 
 
In-force policies (000’s)
                 
– Own-brand motor
    6,964       6,713       6,790  
– Own-brand non-motor (home, rescue, pet, HR24)
    5,642       3,752       3,759  
– Partnerships and broker (motor, home, rescue, SMEs, pet, HR24)
    8,450       9,302       11,242  
General insurance reserves – total (£m)
    8,159       8,192       8,068  
 
2008 compared with 2007
RBS Insurance made good progress in 2008, with contribution rising by £115 million to a record £1,020 million, an increase of 13%. Total income was £90 million lower at £5,566 million, reflecting a fall in insurance premium income following the continuation of the strategic decision to exit less profitable partnership contracts and the effect of financial market conditions on investment income.
 
Own-brand businesses increased income by 4% and contribution before impairments by 13%. In the UK motor market the Group increased premium rates to offset claims inflation and continued to target lower risk drivers, with price increases concentrated in higher risk categories in order to improve profitability. During 2008 selected brands were successfully deployed on a limited number of aggregator web sites. Our international businesses in Spain, Italy and Germany performed well, with income up 24% and contribution up 37%. Over the last year own-brand motor policy numbers have again begun to increase, and rose by 4% to 7.0 million.
 
In own-brand non-motor insurance we have continued to achieve good sales through the RBS Group, where home insurance policies in force have increased by 33%. In addition, Privilege and Churchill have grown home policies by 90% and 13% respectively compared with 2007, mainly due to an increase in online sales as a result of successful marketing campaigns. A new commercial insurance offering, Direct Line for Business, was launched, and has grown rapidly over the year with particularly strong performances in Residential Property and Tradesman policies. Overall own-brand non-motor policies in force have grown by 50% to 5.6 million, benefiting from the addition of rescue cover to RBS and NatWest current account package customers.
 
Results from partnerships and broker business confirmed the Group’s strategy of refocusing on the more profitable opportunities in this segment, where we provide underwriting and processing services to third parties. The Group did not renew a number of rescue contracts and pulled back from some less profitable segments of the broker market. As a result partnership and broker in-force policies have fallen by 9% over the last year with a corresponding 9% reduction in income, yet contribution grew by 27%.
 
For RBS Insurance as a whole, insurance premium income, net of fees and commissions, was broadly maintained at £4,892 million, reflecting 7% growth in the Group’s own brands offset by a 10% decline in the partnerships and broker segment. Other income declined by 8% to £674 million, reflecting the effect of depressed financial markets on investment income.
 
Direct expenses grew by 4% to £771 million, in part as a result of accelerated marketing development in own brands, including the launch of Direct Line for Business.
 
Net claims fell by 7% to £3,733 million, benefiting from ongoing claims containment and more benign weather conditions. Impairments of £42 million reflect impairments recognised in corporate bond and equities investment portfolios.
 
2007 compared with 2006
RBS Insurance has made good progress in 2007 in competitive markets. Total income was maintained at £5,656 million, in line with 2006 levels, with growth in our own-brand businesses offset by a decline in partnerships.
 
 
 
Business review continued

 
Contribution fell by 6% to £905 million, reflecting the impact of the severe flooding experienced in June and July. Excluding the £274 million impact of the floods, contribution grew by 22%, supported by strong claims management and the benefits of improved risk selection in this and prior years. We have continued to focus on selective underwriting of more profitable business.
 
Our own-brand businesses have performed well, with income rising by 1% and contribution growing by 4%. Excluding the impact of the floods, own-brand contribution grew by 24%. In the UK motor market we have pursued a strategy of targeting lower risk drivers and have increased premium rates to offset claims inflation, improving profitability by implementing heavier price increases in higher risk categories. Our international businesses performed well, with Spain delivering strong profit growth while, in line with plan, our German and Italian businesses also achieved profitability in 2007. Home insurance grew across all of our own brands in the second half, and we achieved particular success in the distribution of home policies through our bank branches, with sales up 40%.
 
In our partnerships and broker business, providing underwriting and processing services to third parties, we have concentrated on more profitable opportunities and have consequently not renewed a number of large rescue contracts. We also pulled back from some less profitable segments of the broker market. This resulted in a 17% reduction in in-force policies, but income fell by only 2%. Contribution from partnerships and brokers fell by 22% as a result of flood-related claims. Excluding the impact of the floods, contribution from partnerships and brokers increased by 18%.

For RBS Insurance as a whole, insurance premium income, net of fees and commissions, was 2% lower at £4,922 million, reflecting modest growth in our own brands offset by a 5% decline in the partnerships and broker segment. Other income rose by 11% to £734 million, reflecting increased investment income.

Direct expenses were flat at £741 million. Within this, staff costs reduced by 7%, reflecting our continued focus on improving efficiency whilst maintaining service standards. A 5% rise in non-staff costs reflects increased marketing investment in our own brands.

Net claims rose by 1% to £4,010 million. Gross claims relating to the floods in June and July cost more than £330 million, with a net impact, after allowing for profit sharing and reinsurance, of £274 million. Excluding the impact of the floods, net claims costs were reduced by 6%. In the motor book, while average claims costs have continued to rise, this has been mitigated by improvements in risk selection and management and by continuing efficiencies in claims handling.

49

 
Business review continued

 
Group Manufacturing
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Staff costs
    1,197       998       934  
Other costs
    3,596       2,775       2,589  
Total manufacturing costs
    4,793       3,773       3,523  
                         
Analysis of manufacturing costs:
                       
Technology Services and support functions
    1,757       1,336       1,222  
Group Property
    1,690       1,262       1,167  
Global Operations
    1,346       1,175       1,134  
Total manufacturing costs
    4,793       3,773       3,523  
 
2008 compared with 2007
Group Manufacturing costs increased by 27% to £4,793 million in 2008. This growth reflects movements in exchange rates and the inclusion of a full year of ABN AMRO related costs (£937 million) in 2008 whereas 2007 reflects the costs incurred from the date of acquisition (£193 million).

Increasing business volumes have been absorbed through improvements in productivity. Group Manufacturing has maintained high levels of customer satisfaction while continuing to invest in the further development of the business.

Technology Services and support functions costs increased by 32% to £1,757 million. This growth reflects the inclusion of a full year of ABN AMRO related costs (£453 million) in 2008 whereas 2007 includes only the post acquisition element of costs (£104 million).  In addition, increases in business demand have been balanced by savings delivered across the business.

Group Property costs increased by 34% to £1,690 million. This growth reflects the inclusion of a full year of ABN AMRO related costs (£309 million) in 2008 whereas 2007 includes only the post acquisition element of costs (£61 million) together with further development of the Group’s Corporate Banking branch network and investment in Manufacturing infrastructure.
 
Global Operations cost increased by 15% to £1,346 million. This growth reflects the inclusion of a full year of ABN AMRO costs (£174 million) in 2008 whereas 2007 includes only the post acquisition element of 2007 costs (£28 million).  Further improvements in productivity enabled us to continue to absorb increases in volumes and global inflationary pressure. Ongoing investment in process re-engineering across our operational centres under the 'Work-Out' banner continues to deliver efficiency gains.
 
2007 compared with 2006
Manufacturing costs increased by 7% to £3,773 million reflecting the inclusion of £193 million related to the ABN AMRO business which was acquired in October 2007. Excluding ABN AMRO, costs have increased by 2%. Further improvements in productivity have enabled us to support growth in business volumes and to maintain high levels of customer satisfaction while continuing to invest in the further development of our business.

Technology Services and Support Functions costs increased by 9% to £1,336 million. Excluding ABN AMRO (£104 million) costs from 2007, costs grew by only 1% as a result of continued tight cost control and investment in software development being balanced by significant improvements in productivity.

Group Property costs rose by 8% to £1,262 million. Excluding ABN AMRO costs (£61 million) from 2007, costs rose by 3% reflecting refurbishment and expansion of the Ulster Bank network and continuing investment to support the strong growth of our business in Europe and Asia, including the opening of a new Global Markets office in Paris and further development of our office portfolio in India and Singapore.

Global Operations costs rose by 4% to £1,175 million. Excluding ABN AMRO costs (£28 million) from 2007, costs rose by 1% with further significant improvements in productivity enabling us to continue to absorb significant increases in service volumes. At the same time we maintained our focus on service quality, and our UK-based telephony centres continued to record market-leading customer satisfaction scores. Our investment in process re-engineering across our operational centres under the ‘Work-Out’ banner is expected to deliver further improvements in efficiency.
 

50

 
Business review continued

 
Central items
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Funding costs
    1,330       623       566  
Departmental costs
    665       438       425  
Other corporate costs
    (1,320 )     (509 )      240  
Total central Items
    675       552       1,231  

 
2008 compared with 2007
Central costs increased by £123 million to £675 million.
 
Funding costs rose by £707 million to £1,330 million, reflecting higher funding costs for the full year related to the acquisition of ABN AMRO in October 2007. Funding costs also rose due to higher cost of funds including those relating to the Bank of England Special Liquidity Scheme. The Group seeks to hedge its interest rate risk economically, and it is not always possible to achieve hedge accounting in accordance with IFRS. The movements in interest rates, currencies and inflation indices, particularly in the latter part of 2008, resulted in volatility for accounting purposes, leading to a charge of £204 million in 2008. These costs were largely offset by increased dividends from Bank of China and benefits from the additional capital raised during the year.
 
Departmental costs rose by £227 million to £665 million, including the full year impact of the acquisition of ABN AMRO. This also reflects an increase in central function headcount as well as higher Basel II costs.
 
Other corporate costs amounted to a net credit of £1,320 million, compared with a net credit of £509 million in 2007. The increase reflects higher gains in the fair value of own debt and the profit on sale of Tesco Personal Finance in 2008.
 
2007 compared with 2006
 
Central Costs reduced by £679 million to £552 million.
 
Funding costs rose by £57 million reflecting an increase in funding costs of £144 million relating to ABN AMRO partially offset by a reduction in the carrying value of our own debt accounted for at fair value and the receipt of a dividend on our investment in Bank of China.
 
Departmental and other costs increased by 3% to £438 million. This largely reflects the centralisation of certain functions and increased regulatory requirements.

Other Corporate costs were substantially lower amounting to a net credit of £509 million, reflecting the gains realised on a number of planned disposals that formed part of the Group’s funding arrangements for the acquisition of ABN AMRO.
 
 
51

 

 
Share of Shared Assets
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Net interest income
    (175     15        -  
Non-interest income
    (18     (54      -  
Total income      (193      (39      -  
Operating expenses      62        37        -  
Depreciation and amortisation      41        -        -  
       103        37        -  
Impairment      4        (3      -  
Contribution
    (300     (73     -  
                         
                         
       £bn       £bn       £bn  
Total assets     2.0       27.2       -  
 
Share of shared assets recorded a loss of £300 million in 2008 compared with a loss of £73 million in 2007.  This reflected the inclusion of a full year compared with 76 days in 2007.
 
RFS Holdings minority interest
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Net interest income
    2,911       545        -  
Non-interest income
    1,916       287        -  
Total income      4,827        832        -  
Operating expenses     3,303        573        -  
Depreciation and amortisation      843        58        -  
       4,146        631        -  
Impairment      640        38        -  
Contribution
    41       163       -  
                         
                         
       £bn       £bn       £bn  
Total assets     183.0       245.8       -  
 
RFS Holdings minority interest recorded a contribution of  £41 million (2007 - £163 million).  This reflected the full year contribution in 2008 compared with 76 days in 2007, offset by increased impairment.
 
Employee numbers at 31 December (full time equivalents rounded to the nearest hundred)
   
2008
   
2007
   
2006
 
Global Banking & Markets
    20,200       24,100       8,500  
Global Transaction Services
    4,500       3,700       2,600  
UK Retail & Commercial Banking
    46,500       46,200       42,900  
US Retail & Commercial Banking
    17,600       17,800       18,300  
Europe & Middle East Retail & Commercial Banking
    7,900       7,900       5,600  
Asia Retail & Commercial Banking
    11,500       8,900       4,500  
RBS Insurance
    16,600       17,300       17,600  
Group Manufacturing
    44,900       42,500       32,200  
Centre
    4,300       4,200       2,800  
      174,000       172,600       135,000  
Integration
    900              
Share of shared assets
    400       1,200        
RFS minority interest
    24,500       21,600        
Group total
    199,800       195,400       135,000  
 
 
 
 
 
 
 
 
52

 
Business review continued

 
Consolidated balance sheet at 31 December 2008
   
2008
   
2007
 
      £m       £m  
Assets
               
Cash and balances at central banks
    12,400       17,866  
Loans and advances to banks
    138,197       219,460  
Loans and advances to customers
    874,722       828,538  
Debt securities
    267,549       294,656  
Equity shares
    26,330       53,026  
Settlement balances
    17,832       16,589  
Derivatives
    992,559       277,402  
Intangible assets
    20,049       49,916  
Property, plant and equipment
    18,949       18,745  
Deferred tax
    7,082       3,119  
Prepayments, accrued income and other assets
    24,402       15,662  
Assets of disposal groups
    1,581       45,850  
Total assets
    2,401,652       1,840,829  
Liabilities
               
Deposits by banks
    258,044       312,294  
Customer accounts
    639,512       682,363  
Debt securities in issue
    300,289       274,172  
Settlement balances and short positions
    54,277       91,021  
Derivatives
    971,364       272,052  
Accruals, deferred income and other liabilities
    31,482       34,208  
Retirement benefit liabilities
    2,032       460  
Deferred tax
    4,165       5,400  
Insurance liabilities
    9,976       10,162  
Subordinated liabilities
    49,154       38,043  
Liabilities of disposal groups
    859       29,228  
Total liabilities
    2,321,154       1,749,403  
                 
Minority interests
    21,619       38,388  
Equity owners
    58,879       53,038  
Total equity
    80,498       91,426  
                 
Total liabilities and equity
    2,401,652       1,840,829  
                 
Analysis of repurchase agreements included above
               
Reverse repurchase agreements and stock borrowing
               
Loans and advances to banks
    58,771       175,941  
Loans and advances to customers
    39,313       142,357  
      98,084       318,298  
Repurchase agreements and stock lending
               
Deposits by banks
    83,666       163,038  
Customer accounts
    58,143       134,916  
      141,809       297,954  

Overview of consolidated balance sheet
Total assets of £2,401.7 billion at 31 December 2008 were up £560.8 billion, 30%, compared with 31 December 2007.
 
Loans and advances to banks decreased by £81.3 billion, 37%, to £138.2 billion. Reverse repurchase agreements and stock borrowing (‘reverse repos’) were down by £117.2 billion, 67% to £58.8 billion. Excluding reverse repos, bank placings increased by £35.9 billion, 83%, to £79.4 billion.
 
Loans and advances to customers were up £46.2 billion, 6%, at £874.7 billion or £68.0 billion, 8% following the disposal of the Banco Real and other businesses to Santander and Tesco Personal Finance. Within this, reverse repos decreased by 72%, £103.0 billion to £39.3 billion. Excluding reverse repos, lending rose by £149.2 billion, 22% to £835.4 billion reflecting both organic growth and the effect of exchange rate movements following the weakening of sterling during the second half of 2008.
 
Debt securities decreased by £27.1 billion, 9%, to £267.5 billion and equity shares decreased by £26.7 billion, 50%, to £26.3 billion principally due to lower holdings in Global Banking & Markets.
 
53

 
Business review continued

 
Movements in the value of derivatives, assets and liabilities, primarily reflect changes in interest and exchange rates, together with growth in trading volumes.
 
Intangible assets declined by £29.9 billion, 60% to £20.0 billion, reflecting impairment of £32.6 billion and the disposals of the Asset Management business of ABN AMRO, Banca Antonveneta and the Banco Real and other businesses of ABN AMRO acquired by Santander, £7.2 billion. This was offset by exchange rate movements of £11.8 billion, goodwill of £0.2 billion arising on the Sempra joint venture and £0.3 billion on the buyout of the outstanding ABN AMRO shareholdings not previously owned by the Group.
 
Deferred tax assets increased £4.0 billion to £7.1 billion principally due to carried forward trading losses.
 
Prepayments, accrued income and other assets were up £8.7 billion, 56% to £24.4 billion.
 
Assets and liabilities of disposal groups decreased following completion of the sales of the Asset Management business of ABN AMRO to Fortis, Banca Antonveneta to Monte dei Paschi di Sienna and the majority of ABN AMRO’s Private Equity business to third parties.
 
Deposits by banks declined by £54.3 billion, 17% to £258.0 billion. This reflected decreased repurchase agreements and stock lending (‘repos’), down £79.4 billion, 49% to £83.7 billion partly offset by increased inter-bank deposits, up £25.1 billion, 17% to £174.4 billion.
 
Customer accounts were down £42.9 billion, 6% to £639.5 billion or £21.6 billion, 3% excluding disposals of subsidiaries. Within this, repos decreased £76.8 billion, 57% to £58.1 billion. Excluding repos, deposits rose by £33.9 billion, 6%, to £581.4 billion.
 
Debt securities in issue were up £26.1 billion, 10% to £300.3 billion mainly resulting from the effect of exchange rate movements.
 
Settlement balances and short positions were down £36.7 billion, 40%, to £54.3 billion reflecting reduced customer activity.
 
Accruals, deferred income and other liabilities decreased £2.7 billion, 8%, to £31.5 billion primarily as a result of disposals.
 
Retirement benefit liabilities increased by £1.6 billion to £2.0 billion due to reduced asset values only partly offset by the effect of increased discount rates.
 
Deferred taxation liabilities decreased by £1.2 billion, 23% to £4.2 billion due in part to the sale of Angel Trains.
 
Subordinated liabilities were up £11.1 billion, 29% to £49.2 billion. The issue of £2.4 billion dated loan capital and the effect of exchange rate and other adjustments, £11.3 billion, were partially offset by the redemption of £1.6 billion of dated loan capital, £0.1 billion undated loan capital and £0.9 billion in respect of the disposal of the Banco Real and other businesses of ABN AMRO to Santander.
 
Equity minority interests decreased by £16.8 billion, 44% to £21.6 billion. Attributable losses of £ 10.8 billion, including £15.7 billion of write downs of goodwill and other intangible assets in respect of the State of the Netherlands investment in RFS Holdings, equity withdrawals of £13.6 billion, including £12.3 billion by Santander following the disposals of Banca Antonveneta and Banco Real, reductions in the market value of available-for-sale securities of £1.4 billion, mainly the investment in Bank of China attributable to minority shareholders, movements in cash flow hedging reserves, £0.8 billion, actuarial losses on defined benefit pension schemes net of tax of £0.5 billion and dividends paid of £0.3 billion, were partially offset by effect of exchange rate movements of £9.1 billion of which £8.0 billion related to the State of the Netherlands and Santander investments in RFS Holdings, the £0.8 billion equity raised as part of the Sempra joint venture and £0.4 billion additional equity in respect of the buy-out of the ABN AMRO minority shareholders.
 
Owners’ equity increased by £5.8 billion, 11% to £58.9 billion. Proceeds of £12.0 billion from the rights issue, net of £246 million expenses, and £19.7 billion from the placing and open offer, net of expenses of £265 million, together with exchange rate movements of £6.8 billion were partially offset by the attributable loss for the period of £23.5 billion, a £4.6 billion decrease in available-for-sale reserves, net of tax, reflecting £1.0 billion in the Group’s share in the investment in Bank of China and £3.6 billion in other securities, the majority of which related to Global Banking & Markets, actuarial losses net of tax of £1.3 billion, the payment of the 2007 final ordinary dividend of £2.3 billion and other dividends of £0.6 billion, and a reduction in the cash flow hedging reserve of £0.3 billion.
 
 
Cash flow
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Net cash flows from operating activities
    (75,338 )     25,604       17,441  
Net cash flows from investing activities
    16,997       15,999       6,645  
Net cash flows from financing activities
    15,102       29,691       (1,516 )
Effects of exchange rate changes on cash and cash equivalents
    29,209       6,010       (3,468 )
Net (decrease)/increase in cash and cash equivalents
    (14,030 )     77,304       19,102  
 
2008
The major factors contributing to the net cash outflow from operating activities of £75,338 million were the net operating loss before tax of £36,459 million from continuing and discontinued operations, the decrease of £42,219 million in operating liabilities less operating assets, and the elimination of foreign exchange differences of £41,874 million, partly offset by the write down of goodwill and other intangible assets, £32,581 million and other non-cash items, £8,603 million.
 
Proceeds on disposal of discontinued activities of £20,113 million was the largest element giving rise to net cash flows of investing activities of £16,997 million. Outflow from net purchases of securities of £1,839 million and net disposals of property, plant and equipment, £3,529 million less the net cash inflow of £2,252 million in respect of other acquisitions and disposals represented the other principle factors.
 
Net cash flows from financing activities of £15,102 million primarily arose from the capital raised from the placing and open offer of £19,741 million and the rights issue of £12,000 million, the issue of subordinated liabilities of £2,413 million and proceeds of minority interests, £1,427 million. This was offset in part by the cash outflow on redemption of minority interests of £13,579 million, repayment of subordinated liabilities of £1,727 million, dividends paid of £3,193 million and interest paid on subordinated liabilities of £1,967 million.
 
2007
The major factors contributing to the net cash inflow from operating activities of £25,604 million were the increase of £28,261 million in operating liabilities less operating assets and the profit before tax of £9,900 million, partly offset by the elimination of foreign exchange differences of £10,282 million and income taxes paid of £2,442 million.
 
The acquisition of ABN AMRO, included within net investment in business interests and intangible assets of £13,640 million, was the largest element giving rise to net cash flows from investing activities of £15,999 million, with cash and cash equivalents acquired of £60,093 million more than offsetting the cash consideration paid of £45,856 million. Net sales and maturities of securities of £1,987 million and net disposals of property, plant and equipment, £706 million less the net cash outflow of £597 million in respect of other acquisitions and disposals represented the other principle factors.
 
Net cash flows from financing activities of £29,691 million primarily relate to the cash injection of £31,019 million from the consortium partners in relation to the acquisition of ABN AMRO, together with the issue of £4,829 million of equity securities and £1,018 million of subordinated liabilities, offset in part by dividend payments of £3,411 million, the repayment of £1,708 million subordinated liabilities, interest on subordinated liabilities of £1,522 million and the redemption of £545 million of minority interests.
 
2006
The major factors contributing to the net cash inflow from operating activities of £17,441 million were the profit before tax of £9,186 million adjusted for the elimination of foreign exchange differences of £4,516 million and depreciation and amortisation of £1,678 million, together with an increase of  £3,980 million in operating liabilities less operating assets.

Net sales and maturities of securities of £8,000 million was partially offset by net purchases of property, plant and equipment of £1,292 million, resulting in the net cash inflow from investing activities of £6,645 million.

The issue of £671 million of equity preference shares, £3,027 million of subordinated liabilities and proceeds of £1,354 million from minority interests issued were more than offset by dividend payments of £2,727 million, purchase of ordinary shares amounting to £991 million, repayment of £1,318 million of subordinated liabilities and interest on subordinated liabilities of £1,409 million, resulting in a net cash outflow from financing activities of £1,516 million.
 

Capital resources
The following table analyses the Group’s regulatory capital resources on a fully consolidated basis at 31 December:
 
   
2008
   
2007
   
2006
   
2005
   
2004
 
      £m       £m       £m       £m       £m  
Capital base
                                       
Tier 1 capital
    69,847       44,364       30,041       28,218       22,694  
Tier 2 capital
    32,223       33,693       27,491       22,437       20,229  
Tier 3 capital
    260       200                    
      102,330       78,257       57,532       50,655       42,923  
Less: investments in insurance subsidiaries, associated undertakings and other supervisory deductions
    (4,155 )     (10,283 )     (10,583 )     (7,282 )     (5,165 )
Total capital
    98,175       67,974       46,949       43,373       37,758  
                                         
Risk-weighted assets
                                       
Credit risk
    551,400                                  
Counterparty risk
    61,100                                  
Market risk
    46,500                                  
Operational risk
    36,800                                  
      695,800                                  
Banking book:
                                       
On-balance sheet
            480,200       318,600       303,300       261,800  
Off-balance sheet
            84,600       59,400       51,500       44,900  
Trading book
            44,200       22,300       16,200       17,100  
              609,000       400,300       371,000       323,800  
                               
Risk asset ratios
 
%
   
%
   
%
   
%
 
 
%
 
Tier 1
    10.0       7.3       7.5       7.6       7.0  
Total
    14.1       11.2       11.7       11.7       11.7  
 
Notes:
 
(1)
The data for 2008 are on a Basel II basis; prior periods are on a Basel I basis.
 
(2)
The data for 2004 are based on UK GAAP as previously published and regulated. As from 1 January 2005, the Group is regulated on an IFRS basis.
 
It is the Group’s policy to maintain a strong capital base, to expand it as appropriate and to utilise it efficiently throughout its activities to optimise the return to shareholders while maintaining a prudent relationship between the capital base and the underlying risks of the business. In carrying out this policy, the Group has regard to the supervisory requirements of the Financial Services Authority (FSA). The FSA uses Risk Asset Ratio (RAR) as a measure of capital adequacy in the UK banking sector, comparing a bank’s capital resources with its risk-weighted assets (the assets and off-balance sheet exposures are ‘weighted’ to reflect the inherent credit and other risks); by international agreement, the RAR should be not less than 8% with a Tier 1 component of not less than 4%. At 31 December 2008, the Group’s total RAR was 14.1% (2007 – 11.2%) and the Tier 1 RAR was 10.0% (2007 – 7.3%).
 
 
On pages 57 to 123 of the Business review certain information has been audited and is labelled as such.
 
Risk, capital and liquidity management (unaudited)
2008 has been one of the most challenging years for banks. The financial markets turmoil, which started in the second half of 2007 following concerns over the US sub-prime mortgage market, resulted in a global reduction in liquidity and the availability of term-funding. Confidence in financial institutions was eroded through 2008 as a result of an increased perception of counterparty risk following notable banking and insurance failures.
 
During the recent market turbulence, in common with other banks, the Group saw the availability of long term funding from both the capital markets and money markets decline significantly during the second half of 2008. As a result, reliance on shorter term funding increased with a consequent deterioration in the Group’s liquidity profile. In response to the market stress, central banks increased liquidity through a number of facilities and schemes available to support their respective banking systems. In addition, governments around the world have provided capital to financial institutions and moved to offer guarantees and increase deposit insurance to reassure investors and depositors. As a global bank, the Group has access to a number of those facilities and schemes which, in common with many other banks, it has used to support funding.
 
Whilst the international stabilisation efforts led by various governments since September 2008 have helped, the knock-on economic impacts are now evident in markets globally. 2009 will see further strains for financial institutions. Whilst the liquidity crisis is likely to stabilise, the level of impairments will increase as recession spreads worldwide.
 
The Board, in the light of the severe and increasing deterioration in market conditions, the worsening economic outlook and difficulties in the credit markets, concluded that it was appropriate for the Group to strengthen its capital position.
 
The Group has responded to the changing business and economic conditions by reducing leverage, building and improving liquidity, raising additional capital and through augmenting its risk management resources to drive forward a number of strategic initiatives. The overall risk operating model has been strengthened to ensure its adequacy for changing market conditions and additional capital management disciplines are being embedded across the Group. There is an increased emphasis on the independence of the control functions, capital allocation, stress testing and risk return throughout the Group.
 
Risk governance (unaudited)
Risk and capital management strategy is owned and set by the Group’s Board of Directors, and implemented by executive management led by the Group Chief Executive. There are a number of committees and executives that support the execution of the business plan and strategy.
 
 
 
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The role and remit of these committees is as follows:
 
Committee
 
Focus
 
Membership
Group Audit Committee (GAC)
 
Financial reporting and the application of accounting policies as part of the internal control and risk assessment process. GAC monitors the identification, evaluation and management of all significant risks throughout the Group.
 
Independent non-executive directors
Advances Committee (AC)
 
Deals with transactions that exceed the Group Credit Committee’s delegated authority and large exposures.
 
Members of GEMC
Group Chief Credit Officer
Group Executive Management Committee (GEMC)  
Ensures implementation of strategy consistent with risk appetite.
 
Business and function heads, as determined by the Group Chief Executive/Board
Executive Risk Forum (ERF)
 
Acts on all strategic risk and control matters across the Group including, but not limited to, credit risk, market risk, operational risk, compliance and regulatory risk, enterprise risk, treasury and liquidity risk, reputational risk, insurance risk and country risk.
 
Group Chief Executive
Group Finance Director
Group Chief Risk Officer
Chairman, Regional Markets
Chief Executive, RBS UK
Chief Executive, Global Banking & Markets
Group Risk Committee (GRC)
 
Recommends limits and approves processes and policies to ensure the effective management of all material risks across the Group.
 
Group Chief Risk Officer
Group head of each risk type
Group Treasurer
Chief Executive and Chief Risk Officer from each division
Group General Counsel and Group Secretary
Group Chief Economist
Group Credit Committee (GCC)
 
Approves credit proposals under the authority delegated to the committee by the Board and/or the Advances Committee.
 
Members as determined by GEMC
Group Asset and Liability Management Committee (GALCO)
 
Identifies, manages and controls the Group balance sheet risks.
 
Group Finance Director
Chairman/Chief Executive from each division
Group Treasurer
Group Chief Risk Officer
Heads of Group functions
Group Chief Executive’s Advisory Group (GCEAG)
 
Acts as a forum for the provision of information and advice to the Group Chief Executive. Forms part of the control process of the Group.
 
Group Chief Executive
Group Finance Director
Chairman and Chief Executives from each division
Group Chief Risk Officer
Group General Counsel and Group Secretary
Group Directors, Strategy, Communications and Human Resources
 
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Management responsibilities (unaudited)
All staff have a role to play in the day to day management of risk, in line with Group policy, which is set and managed by specialist staff in:
 
Risk Management: credit, market, operational, regulatory, enterprise and insurance risk, together with risk analytics.
 
Group Treasury: balance sheet, capital management, intra-group exposure, funding, liquidity and hedging policies.
 
Independence underpins the approach to risk management, which is reinforced throughout the Group by appropriate reporting lines. Risk Management and Group Treasury functions are independent of the revenue generating business. As part of the move toward greater functional independence, the divisional Chief Risk Officers now have a direct reporting line to the Group Chief Risk Officer.
 
Group Internal Audit (GIA) supports the GAC in providing an independent assessment of the design, adequacy and effectiveness of internal controls.
 
Risk appetite (unaudited)
Risk and capital management across the Group is based on the risk appetite set by the Board, which is established through setting strategic direction, contributing to, and ultimately approving annual plans for each division and regularly reviewing and monitoring the Group’s performance in relation to risk through monthly Board reports.
 
Risk appetite is defined in both quantitative and qualitative terms as follows:
 
Quantitative: encompassing stress testing, risk concentration, value- at-risk, liquidity and credit related metrics.
 
Qualitative: focusing on ensuring that the Group applies the correct principles, policies and procedures.
 
Different techniques are used to ensure that the Group’s risk appetite is achieved.
 
The GEMC is responsible for ensuring that the implementation of strategy and operations are in line with the risk appetite determined by the Board. This is reinforced through a policy framework ensuring that all staff within the Group make appropriate risk and reward trade-offs within pre-agreed boundaries.
 
How we do business
Policy
Customers
Identifying our customers.
Treating our customers fairly.
Delivering customer value.
Respecting customer confidentiality.
Risks
Identifying and managing our risks.
Understanding our markets.
Security
Protecting our assets, premises, systems and data.
Operating our processes, systems and controls.
Dealing with external suppliers.
People
Working in the Group.
Promoting diversity and inclusion.
Reputation
Working within laws and regulation.
Investing in the community.
Conducting sustainable business.
Maintaining key services and processes.
Finances
Managing our capital and resources.
Accounting and financial reporting.
 
The annual business planning and performance management process and associated activities ensure the expression of risk appetite remains appropriate. GRC and GALCO support this work.
 
 
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Capital (unaudited)
The Group aims to maintain appropriate levels of capital, in excess of regulatory requirements, to ensure its capital position remains appropriate given the economic and competitive environment. Capital adequacy and risk management are closely aligned. The Group undertakes a regular assessment of its internal capital requirement based on a quantification of the material risks to which it is exposed.
 
Composition of capital
The Group’s regulatory capital resources at 31 December 2008 on a fully consolidated basis, and in accordance with Financial Services Authority (FSA) definitions were as follows:
 
   
Basel II
31 December
2008
£m
   
Basel II
1 January
2008
£m
   
Basel I
31 December
2007
£m
 
Capital base:
                 
Core Tier 1 capital: ordinary shareholders’ funds and minority interests less intangibles
    47,623       27,324       27,324  
Preference shares and tax deductible securities
    24,038       17,040       17,040  
Less deductions from Tier 1 capital
    (1,814 )     (1,457 )     n/a  
Tier 1 capital
    69,847       42,907       44,364  
Tier 2 capital
    32,223       28,767       33,693  
Tier 3 capital
    260       200       200  
      102,330       71,874       78,257  
Less: supervisory deductions
    (4,155 )     (5,078 )     (10,283 )
Total regulatory capital
    98,175       66,796       67,974  
Risk-weighted assets:
                       
Credit risk
    551,400       542,100          
Counterparty risk
    61,100       37,500          
Market risk
    46,500       17,900          
Operational risk
    36,800       36,000          
      695,800       633,500          
Banking book
                    564,800  
Trading book
                    44,200  
                      609,000  
Risk asset ratio:
                       
Core Tier 1
    6.8%       4.3%       4.5%  
Tier 1
    10.0%       6.8%       7.3%  
Total
    14.1%       10.5%       11.2%  

The FSA uses Risk Asset Ratio (RAR) as a measure of capital adequacy in the UK banking sector, comparing a bank’s capital resources with its risk-weighted assets (the assets and off-balance sheet exposures are ‘weighted’ to reflect the inherent credit and other risks); by international agreement, the RAR should be not less than 8% with a Tier 1 component of not less than 4%. The Group has complied with the FSA’s capital requirements throughout the year. A number of subsidiaries and sub-groups within the Group, principally banking and insurance entities are subject to additional individual regulatory capital requirements in the UK and overseas.
 
Capital allocation
As part of the annual planning and budgeting cycle, each division is allocated capital based upon risk-weighted assets (RWAs) and their associated regulatory deductions. The budgeting process considers risk appetite, available capital resources, stress testing results and business strategy. The budget is agreed by the Board and allocated to the divisions to manage their allocated RWAs.
 
Group Treasury and GALCO monitor actual utilisation by tracking capital available and the utilisation of capital by divisions. GALCO makes the necessary decisions around re-allocation of budget and changes in RWA allocations.
 
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Basel II
The Group adopted Basel II on 1 January 2008. Pillar 1 focuses on the calculation of minimum capital required to support the credit, market and operational risks in the business. For credit risk, the majority of the Group uses the Advanced Internal Ratings Based Approach (AIRB) for calculating RWAs, making the Group one of a small number of banks whose risk systems and approaches have reached the regulatory standards.
 
For operational risk, the Group uses The Standardised Approach (TSA), which calculates operational risk-weighted assets based on gross income. In line with other banks, the Group is considering adopting the Advanced Measurement Approach (AMA) for all or part of the business.
 
Using these approaches, the RWA requirements, by division, are as follows:
 
   
Basel II
31 December
2008
£bn
   
Basel II
1 January
2008
£bn
   
Basel I
31 December
2007
£bn
 
Global Markets
                 
– Global Banking & Markets
    278.5       211.9       188.7  
– Global Transaction Services
    19.6       16.8       15.4  
Regional Markets
                       
– UK Retail & Commercial Banking
    152.5       153.1       179.0  
– US Retail & Commercial Banking
    78.0       53.8       57.1  
– Europe & Middle East Retail & Commercial Banking
    30.9       30.3       36.7  
– Asia Retail & Commercial Banking
    6.4       4.9       3.3  
Other
    11.9       15.3       9.8  
RFS Holdings minority interest
    118.0       147.4       119.0  
Group
    695.8       633.5       609.0  

Basel II is cyclical, unlike Basel I where RWAs are stable through the cycle. Changes in RWA totals are driven by external economic factors and their impact on the risk profile of the underlying portfolio of assets, rather than changes in the asset mix. Whilst Basel II tries to reduce this variation by incorporating measures correlated to downturn conditions, it remains sensitive to cyclical variations.
 
The AIRB approach to Basel II is based on the following metrics.
 
Probability of default (PD) models estimate the likelihood that a customer will fail to make full and timely repayment of credit obligations over a one year time horizon. Customers are assigned an internal credit grade which corresponds to PD. Every customer credit grade across all grading scales in the Group can be mapped to a Group level credit grade.
 
Exposure at default (EAD) models estimate the expected level of utilisation of a credit facility at the time of a borrower’s default. The EAD may be assumed to be higher than the current utilisation (e.g. in the case where further drawings may be made on a revolving credit facility prior to default) but will not typically exceed the total facility limit.
 
Loss given default (LGD) models estimate the economic loss that may occur in the event of default and represent the debt that cannot be recovered. The Group’s LGD models take into account the type of borrower, facility and any risk mitigation such as security or collateral held.
 
In addition to minimum capital calculated, for credit, market and operational risk, banks are required to undertake an Individual Capital Adequacy Assessment Process (ICAAP) for other risks. The Group’s ICAAP, in particular, focuses on pension fund, interest rate risk in the banking book together with stress tests to assess the adequacy of capital over one year and the economic cycle.
 
The Group will publish its Pillar 3 (Market disclosures) on the external website, providing a range of additional information relating to Basel II and risk and capital management across the Group. The disclosures focus on Group level capital resources and adequacy, discuss a range of credit risk approaches and their associated risk weighted assets (under various Basel II approaches) such as credit risk mitigation, counterparty credit risk and provisions. Detailed disclosures are also made on equity, securitisation, operational and market risk, as well as providing Interest Rate Risk in the Banking Book disclosures.
 
Stress and scenario testing
Stress testing is central to the Group’s risk and capital framework and integral to Basel II. Stress testing is used at divisional and Group level to assess risk concentrations, estimate the impact of earnings on capital, determine the overall capital adequacy under stress conditions and identify mitigating actions. The principal business benefits of the stress testing framework are: understanding the impact of recessionary scenarios; assessing material risk concentrations; and forecasting the impact of market stress scenarios on the Group’s balance sheet liquidity.
 
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At Group level, a series of stress events are monitored on a regular basis to assess the potential impact of an extreme yet plausible event on the Group. There are two core elements of scenario stress testing:
 
Recessionary stress testing considers the impact on both earnings and capital of a range of recessionary scenarios. These are multi-year systemic shocks to assess the Group’s ability to meet its capital requirements and liabilities as they fall due under a significant but plausible downturn in the business cycle and/or macroeconomic environment. The summary results are included within the monthly risk report to the Board and discussed in separate papers on a half-yearly basis.
 
Integrated stress testing considers firm wide stress tests to measure the Group’s exposure to exceptional but plausible economic and geopolitical events. Stress testing supports the identification and quantification of material risks that may arise under stress scenarios, and provides information to support management decision-making around risk appetite and control.
 
Cross divisional stress testing, undertaken to support the Group’s framework for managing industry and geographical sector concentrations, is performed through the identification of scenarios which are likely to affect groups of inter-related (correlated) sectors. These stress tests are discussed with senior divisional management and are reported to GRC, GEMC, GALCO and GAC. The Group manages to a trigger limit on the stressed impairment charge for an individual scenario.
 
Portfolio analysis, using historic performance and forward looking indicators of change, uses stress testing to facilitate the measurement of potential exposure to events and seeks to quantify the impact of an adverse change in factors which drive the performance and profitability of a portfolio.
 
Risk coverage
The main risks facing the Group are shown below.
 
Risk type
Definition
Features
Credit risk (including country and political risks)
The risk arising from the possibility that the Group will incur losses from the failure of customers to meet their financial obligations to the Group.
Loss characteristics vary materially across portfolios.
Significant correlation between losses and the macroeconomic environment.
Concentration risk.
Funding and liquidity risk
The risk of losses through being unable to meet obligations as they fall due.
Potential to disrupt the business model and stop normal functions of the Group.
Significantly correlated with credit risk losses.
Market risk
The risk that the value of an asset or liability may change as a result of a change in market rates.
Potential for large material losses.
Significantly correlated with equity risk and the macroeconomic environment.
Insurance risk
The risk of financial loss through fluctuations in the timing, frequency and/or severity of insured events, relative to the expectations at the time of underwriting.
Frequent small losses.
Infrequent material losses.
Operational risk
The risk of financial loss or reputational impact resulting from fraud; human error; ineffective or inadequately designed processes or systems; improper behaviour; legal events; or from external events.
Generally immaterial losses.
Regulatory risk
The risks arising from regulatory changes/enforcement.
Risk of regulatory changes.
Compliance with regulations.
Potential for fines and/or restrictions in business activities.
Other risk
The risks arising from reputation and pension fund risk.
Additional regulation can be introduced as a result of other risk losses.
 
Credit risk
Principles for credit risk management (audited)
The key principles for credit risk management in the Group are as follows:
 
A credit risk assessment of the customer and credit facilities is undertaken prior to approval of credit exposure. Typically, this includes both quantitative and qualitative elements including, the purpose of the credit and sources of repayment; compliance with affordability tests; repayment history; ability to repay; sensitivity to economic and market developments; and risk-adjusted return based on credit risk measures appropriate to the customer and facility type.
 
Credit risk authority is specifically granted in writing to individuals involved in the granting of credit approval, whether this is individually or collectively as part of a credit committee. In exercising credit authority, individuals are required to act independently of business considerations and must declare any conflicts of interest.
 
Credit exposures, once approved, are monitored, managed and reviewed periodically against approved limits. Lower quality exposures are subject to more frequent analysis and assessment.
 
Credit risk management works with business functions on the ongoing management of the credit portfolio, including decisions on mitigating actions taken against individual exposures or broader portfolios.
 
Customers with emerging credit problems are identified early and classified accordingly. Remedial actions are implemented promptly and are intended to restore the customer to a satisfactory status and minimise any potential loss to the Group.
 
Stress testing of portfolios is undertaken to assess the potential credit impact of non-systemic scenarios and wider macroeconomic events on the Group’s income and capital.
 
Specialist credit risk teams oversee the credit process independently, making credit decisions within their discretion, or recommending decisions to the appropriate credit committee.
 
Assessments of corporate borrower and transaction risk are undertaken using fundamental credit analysis and the application of general corporate and certain specialist counterparty credit risk models. Financial markets counterparties are approved by a dedicated credit function which specialises in traded market product risk. Specialist credit grading models exist for certain bank and non-bank financial institutions.
 
Different approaches are used for the management of wholesale and retail businesses:
 
Wholesale businesses: exposures are aggregated to determine the appropriate level of credit approval required and to facilitate consolidated credit risk management. Credit applications for corporate customers are prepared by relationship managers (RMs) in the units originating the credit exposures, or by the RM team with lead responsibility for a counterparty where a customer has relationships with different divisions and business units across the Group. This includes the assignment of counterparty credit grades and LGD estimates using approved models, which are also independently checked by the credit team.
 
Retail businesses: the retail business makes a large volume of small value credit decisions. Credit decisions will typically involve an application for a new or additional product or a change in facilities on an existing product. The majority of these decisions are based upon automated strategies utilising industry standard credit and behaviour scoring techniques.
 
Model validation (audited)
The performance and accuracy of credit models is critical, both in terms of effective risk management and also the calculation of risk parameters (PD, LGD and EAD) used by the Group to calculate RWAs. The models are subject to frequent validation internally and, if used as part of the AIRB Basel II framework (see page 61), have been reviewed and approved for use by the FSA.
 
Independent model validation is performed by the Group. This includes an evaluation of the model development and validation for the data set used, logic and assumptions, and performance of the model analysis. Where required, the Group has engaged external risk management consultants to undertake independent reviews and report their findings to the Wholesale or Retail Credit Model Committee. This provides a benchmark against industry practices.
 
The validation results are a key factor in deciding whether a model is recommended for ongoing use. The frequency, depth and extent of the validation are consistent with the materiality and complexity of the risk being managed. The Group’s validation processes include:
 
Developmental evidence: to ensure that the credit risk model adequately discriminates between different levels of risk and delivers accurate risk estimates.
 
Process verification: whether the methods used in the credit risk models are being used, monitored and updated in the way intended in the design of the model. Initial testing and validation is performed when the model is developed with the performance of models being assessed on an ongoing basis.
 
 
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Credit risk mitigation (audited)
The Group takes a number of steps to mitigate credit risk. The key risk mitigants are as follows:
 
Real estate: the most common form of security held is real estate within the consumer and wholesale businesses.
 
Financial collateral: is taken to support credit exposures in the non-trading book. Financial collateral is also taken in Global Markets and Regional Markets to support trading book exposures and is incorporated in E* (adjustment to the exposure value) calculations.
 
Other physical collateral: the Group takes a wide range of other physical collateral including business assets (stock and inventory, plant and machinery, equipment), project assets, intangible assets which provide a future cashflow and real value, commodities, vehicles, rail stock, aircraft, ships and receivables (not purchased).
 
Guarantees: third party guarantees are taken from banks, government entities, export credit agencies, and corporate entities. The Group’s recovery value estimation methodology is sensitive to the variations in the credit quality of guarantors. Standby letters of credit are also given value in LGD models. Conditional guarantees are accepted, in accordance with internal requirements, and are included as appropriate in PD and LGD estimates (e.g. small firms loan guarantee schemes, completion guarantees). Personal guarantees are considered in the normal credit process where there is a charge over specific assets. While personal guarantees may be called for and are always accepted, no value is given to unsupported personal guarantees in any credit models.
 
Credit derivatives: credit derivative activity is conducted through designated units within GBM to ensure consistency and appropriate control. Group policies are designed to ensure that the credit protection is appropriate to support offset for an underlying trading book asset or improvement to the LGD of a banking book asset. Within the banking book, credit derivatives are used as risk and capital management tools. The principal counterparties are banks, investment firms and other market participants, with the majority subject to collateralisation under a credit support annex. In accordance with internal policy, stress testing is conducted on the counterparty credit risk created by the purchase of credit protection.
 
Minimum standards (for example loan to value, legal certainty) are ensured through the policy framework.
 
Credit risk assets (audited)
Credit risk assets consist of loans and advances (including overdraft facilities), instalment credit, finance lease receivables and other traded instruments across all customer types. The Group uses a series of models to measure the size of its exposure to credit risk and to calculate expected EAD in both its trading and banking books. In so doing, the Group recognises the effects of credit risk mitigation that reduces potential loss.
 
Credit risk assets (unaudited)
 
2008
£bn
   
2007
£bn
 
Global Markets
    469.8       307.4  
Regional Markets
               
– UK Retail & Commercial Banking
    223.5       202.1  
– US Retail & Commercial Banking
    82.9       58.1  
– Europe & Middle East Retail & Commercial Banking
    64.7       47.1  
– Asia Retail & Commercial Banking
    7.5       6.8  
RBS Insurance
    4.6       5.1  
Other
    2.0        
RFS Holdings minority interest
    176.8       206.0  
Group
    1,031.8       832.6  

Note:
 
(1)
Excluding reverse repurchase agreements and issuer risk.
 
Credit risk assets as at 31 December 2008 were £1,031.8 billion (2007 – £832.6 billion), an increase of £199.2 billion during the year.
 
The discussion and disclosures on pages 65 to 72 relate only to the Group before RFS Holdings minority interest.
 
Facilities included within RFS Holdings minority interests have not been migrated to RBS risk systems, as they will not be part of the Group following separation of the ABN AMRO business.
 
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Credit concentration risk (including country risk) (audited)
The Group defines three key areas of concentration in credit risk that are monitored, reported and managed at Group and divisional levels. These are single name concentration, industry/sector and country risk. The Group has a series of quantitative and qualitative controls in place to limit the amount of concentration risk in credit portfolios.
 
A threshold is set on the aggregate LGD to a single customer group above which approval is required from the Group’s most senior credit committee, the Advances Committee.
 
During the year work progressed on an enhancement of the frameworks for managing single name and sector concentrations. These enhancements are planned to be fully implemented in 2009 to improve the identification and management of concentrations in the portfolio through the introduction of additional parameters and increased scrutiny of concentration limit excesses.
 
A stress testing framework, Correlated Exposure Loss Testing, assesses the impact on the Group’s impairment charge of non-systemic events that affect groups of inter-related sectors in order to limit the impact of these scenarios to within defined tolerances.
 
Country risk arises from sovereign events (e.g. default or restructuring); economic events (e.g. contagion of sovereign default to other parts of the economy, cyclical economic shock); political events (e.g. convertibility restrictions and expropriation or nationalisation) and natural disaster or conflict. Losses are broadly defined and include credit, market, liquidity, operational and franchise risk related losses. The acquisition of ABN AMRO materially increased the Group's country risk profile, therefore significant enhancements to the Group’s country risk framework have been implemented and continue to be developed.
 
It is the Group’s policy to monitor and control country risk exposures and to avoid excessive concentrations. The Group’s appetite is expressed by a matrix of limits by country risk grade and is approved by GEMC. The Group’s exposure is managed and measured within this appetite by the Group Country Risk Management Committee (GCRMC), that has delegated authority from the GRC to manage country risk and agree related policy. Membership of GCRMC comprises the Group Chief Credit Officer, Heads of Credit and business representatives from those divisions with material country risk exposures. GCRMC sets limits for each country based on a risk assessment taking into account the Group’s franchise and business mix in that country. Additional limitations – on product types with higher loss potential and longer tenor transactions, for example – may be established depending on the country outlook and business strategy. A country watch list framework is in place to proactively monitor emerging issues and facilitates the development of mitigation strategies.
 
The country risk table below shows credit risk assets exceeding £1 billion by borrower domicile and is stated gross of mitigating action which may have been taken to reduce or eliminate exposure to country risk events.
 
Risk countries (unaudited)
 
Consumer
£m
   
Sovereign
£m
   
Banks and
financial
institutions
£m
   
Corporate
£m
   
Total
£m
 
Russia
    51.0             362.0       5,361.0       5,774.0  
United Arab Emirates
    756.8       91.5       1,721.9       2,988.6       5,558.8  
India
    1,020.0       5.7       737.9       3,800.6       5,564.2  
Turkey
    24.8       363.6       603.2       3,035.5       4,027.1  
China
    24.6       61.1       1,146.3       2,027.2       3,259.2  
South Korea
    1.5             1,743.0       1,104.1       2,848.6  
Taiwan
    1,019.3             1,393.2       825.0       3,237.5  
Mexico
    4.2       57.1       210.9       1,999.9       2,272.1  
Czech Republic
    2.1       593.5       175.5       1,057.9       1,829.0  
Kazakhstan
    69.5       17.0       900.8       858.9       1,846.2  
Poland
    6.8       38.5       309.1       1,308.6       1,663.0  
Chile
    0.3       26.1       383.7       1,250.5       1,660.6  
Brazil
    3.6             1,012.3       641.7       1,657.6  
Saudi Arabia
    23.2             534.9       679.4       1,237.5  
Romania
    583.6       145.3       160.4       916.8       1,806.1  
Greece
    15.1       135.3       210.3       702.7       1,063.4  
Hungary
    5.1       73.9       101.3       831.4       1,011.7  

Note:
 
(1)
Risk countries are defined as those with an internal rating of A+ and below. In addition, United Arab Emirates is included which has a rating of AA.
 
(unaudited)
The outlook for developing markets in 2009 is very challenging, as developed economy demand is weak, liquidity conditions are tight and risk appetite is yet to return. Asian growth is slowing sharply as trade contracts, but generally, both sovereign and private sector leverage is lower than during the 1998 crisis, providing scope for recovery. The Middle East is more insulated from the effects of economic disruption but certain high growth countries, such as UAE, will face challenges. Eastern Europe faces a deep correction as large economic imbalances unwind. Falling commodity prices and US weakness will also affect Latin America, but the region is more resilient than during previous downturns due to reform progress and policy orthodoxy in its largest economies.
 
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Asset quality by industry and geography (unaudited)
Industry analysis plays an important part in assessing potential concentration risk in the loan portfolio. Particular attention is given to industry sectors where the Group believes there is a high degree of risk or potential for volatility in the future.
 
Credit risk assets by industry sector (Group before RFS Holdings minority interest)


 
Note:
(1) Graph data are shown net of provisions, reverse repurchase agreements and issuer risk for 2008 and 2007.

As at 31 December 2008, 26% of credit risk assets (2007 – 27%) related to personal and includes mortgage lending and other smaller loans that are intrinsically well-diversified. Corporate industry exposure comprised 48% of credit risk assets (2007 – 50%), which are well diversified across a range of sectors. Banks and financial services account for 21% of credit risk assets (2007 – 19%) and public sector and quasi government credit risk assets make up the remaining 5% (2007 – 4%).
 
Credit risk assets by geography (Group before RFS Holdings minority interest)
Note:
(1) Graph data are shown net of provisions, reverse repurchase agreements and issuer risk for 2008 and 2007.

As at 31 December 2008, 38% of credit risk assets (2007 – 46%) related to the United Kingdom. Western Europe comprised 27% of credit risk assets (2007 – 23%). North America comprised 21% of credit risk assets (2007 – 19%).
 
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Credit risk asset quality (audited)
Internal reporting and oversight of risk assets is principally differentiated by credit grades. Customers are assigned credit grades, based on various credit grading models that reflect the key drivers of default for the customer type. All credit grades across the Group map to both a Group level asset quality scale, used for external financial reporting, and a master grading scale for wholesale exposures used for internal management reporting across disparate portfolios. Accordingly, measurement of risk is easily aggregated and can be reported at increasing levels of granularity depending on audience and business need.
 
The Group has adopted, as part of the move to Basel II, a new master grading scale for wholesale exposures which comprises 27 grades. These in turn map to ten asset quality (AQ) bands used for both wholesale and retail exposures. This replaced the less granular AQ1-5 bands used prior to 2008.
 
The relationship between these measures is shown below. (unaudited)
 
   
  PD Range
       
 
Master grading scale
 
Lower
 
Upper 
 
New AQ1-
10 bands
 
Old AQ1-5
bands
1
 
0%
 
0.006%
       
2
 
0.006%
 
0.012%
       
3
 
0.012%
 
0.017%
 
AQ1
   
4
 
0.017%
 
0.024%
       
5
 
0.024%
 
0.034%
     
AQ1
6
 
0.034%
 
0.048%
 
AQ2
   
7
 
0.048%
 
0.067%
 
AQ3
   
8
 
0.067%
 
0.095%
       
9
 
0.095%
 
0.135%
       
10
 
0.135%
 
0.190%
       
11
 
0.190%
 
0.269%
 
AQ4
   
12
 
0.269%
 
0.381%
     
AQ2
13
 
0.381%
 
0.538%
       
14
 
0.538%
 
0.761%
 
AQ5
   
15
 
0.761%
 
1.076%
     
AQ3
16
 
1.076%
 
1.522%
 
AQ6
   
17
 
1.522%
 
2.153%
     
AQ4
18
 
2.153%
 
3.044%
       
19
 
3.044%
 
4.305%
 
AQ7
   
20
 
4.305%
 
6.089%
       
21
 
6.089%
 
8.611%
       
22
 
8.611%
 
12.177%
 
AQ8
   
23
 
12.177%
 
17.222%
     
AQ5
24
 
17.222%
 
24.355%
       
25
 
24.355%
 
34.443%
 
AQ9
   
26
 
34.443%
 
100%
       
27
 
100%
 
100%
 
AQ10
   

Credit risk assets by new AQ1-10 bands (Group before RFS Holdings minority interest) (unaudited)
 
TCRE (%)
 
 
Note:
(1)
Graph data are shown net of provisions, reverse repurchase agreements and issuer risk for 2008.
 
The following table shows the movement between 2007 and 2008 based on the old AQ1-5 bands for the Group before RFS minority interest. (unaudited)


Note:
(1) Graph data are shown net of provisions, reverse repurchase agreements and issuer risk for 2008 and 2007.
(unaudited)
As at 31 December 2008, including ABN AMRO net of minority interest, exposure to investment grade counterparties (AQ1) accounted for 47% (2007 – 37%) of credit risk assets and 46% (2007 – 59%) of exposures were to counterparties between AQ2 and AQ4. The exposure to the lowest asset quality (AQ5) is 7% (2007 – 4%).
 
 
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Expressed as an annual PD, the upper and lower boundaries and the midpoint for each of these Group level asset quality grades are as follows:
 
   
Annual probability of default
     
Asset quality grade
 
Minimum
%
   
Midpoint
%
   
Maximum
%
   
S&P
equivalent
AQ1
   
0.00
     
0.10
     
 0.20
   
AAA to BBB-
AQ2
   
0.21
     
0.40
     
 0.60
   
BB+ to BB
AQ3
   
0.61
     
1.05
     
 1.50
   
BB- to B+
AQ4
   
1.51
     
3.25
     
 5.00
   
B+ to B
AQ5
   
5.01
     
 52.50
     
   100.00
   
B and below

Key credit portfolios (unaudited)
The following discussion relates only to the Group before RFS Holdings minority interest. All exposures are monitored closely, but in the current environment the following are under specific scrutiny:
 
Property lending (unaudited)
Commercial property
The commercial property portfolio totals £97 billion. The bulk of this is concentrated in GBM (£31 billion) and RBS UK (£42 billion) with the remainder in Ulster Bank (£17 billion) and CFG (£6 billion).
 
Lending falls into different categories and is spread across Investment (72.6%), Development (24.1%) and Other (3.3%). Speculative lending represents 1.6% of this portfolio. 58% of the lending is in the UK, 30% Western Europe, 8% North America and 4% RoW but with the extent of the current global downturn all markets are coming under considerable pressure.
 
Whilst the Group expects to see an overall deterioration in LTV ratios, 72% of the portfolio within GBM and UKCB continue to have an LTV less than 75% and an average interest coverage ratio (ICR) for GBM of 164% and 151 % for RBS UK. The Group’s lending approach has always been predominantly cash flow driven and areas of stress in the portfolio will primarily be impacted by the wider corporate and economic environment affecting tenant quality with the retail sector being an area of focus at the present time.
 
The Group has experienced a number of defaults in its Spanish portfolio with current limits of £2 billion managed via the Global Restructuring Group. Total impaired limits across the portfolio are £3.9 billion. Limits currently subject to a higher level of monitoring (watch) total £18.9 billion and are actively risk managed.
 
The outlook for commercial property will remain challenging during 2009 with further falls in capital values expected due to a lack of liquidity and weak demand for assets. There is emerging evidence of falling rents and increasing vacancy rates although downward pressure on rents and longer void periods can be expected due to the weakening economic climate. The Group’s strategy throughout 2008 has been to reduce its exposures wherever prudent, continuing the process of tightening lending parameters begun in the second half of 2007.
 
Residential mortgages
The Group originates residential mortgages through retail channels in all four divisions within Regional Markets however activity is primarily in the UK, the US and Ireland.
 
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UK residential mortgages
The UK mortgage portfolio totalled £74.4 billion (as at 31 December 2008) an increase of 11% during the year due to strong sales growth and lower redemption rates. The main brands are the Royal Bank, NatWest, the One Account, First Active and Direct Line. The assets comprise prime mortgage lending and include 7.0% (£5.2 billion) of exposure to residential buy-to-let. There is a very small legacy self-certification book (0.5% of total assets) which was withdrawn from sale in 2004.
 
The Group exited the 100% LTV market in the first quarter of 2008, further restricted the proportion of highest LTV loans and reviewed affordability criteria during the year. The average LTV for new business increased from 62% to 67% in 2008 mainly due to a reduction in the proportion of business within the lowest LTV bands.
 
The arrears rate (three or more payments missed) on the combined Royal Bank and NatWest brands was 1.5% (31 December 2008) up from 1.0% (31 December 2007). The mortgage impairment charge was £33 million for 2008 (2007 – £19 million) and in current economic conditions is expected to increase further. Anticipated losses from impaired mortgages are covered by a combination of impairment provisions and post default suspended interest. The combined provision cover is currently 0.18% of balances.
 
Repossessions totalled 1,141 in 2008 (compared with 758 in 2007) with similar volumes in each half of the year.
 
US real estate
Citizens Financial Group’s (CFG) residential real estate portfolio totalled $50.1 billion at 31 December 2008 (2007 – $53.1 billion) comprising $13.8 billion of first mortgages and $36.3 billion of Home Equity loans and lines. This reduction includes the sale of $1.4 billion of real estate assets to the Federal National Mortgage Association in December 2008.
 
CFG has historically adopted conservative risk policies in comparison to the general market. Small exposures to sub-prime (FICO <=620, approximately 0.6%) and Alt-A / other non-conforming (4.5%) from past bank acquisitions are in run-off. The average indexed LTV was 69% as at 31 December 2008 (2007 – 62%). Loan acceptance criteria were further tightened during 2008 to address deteriorating economic conditions.
 
The Serviced By Others (SBO) portfolio consists of purchased pools of home equity loans and lines whose LTV and geographic profiles have in the current economic conditions resulted in a higher write-off rate of 4.8% in 2008 than core portfolios. SBO was closed to new purchases in the third quarter of 2007 and is in run-off with exposure down from $8.3 billion (31 December 2007) to $7.0 billion (31 December 2008).
 
Ireland residential mortgages
The residential mortgage portfolio in Ireland across the Ulster Bank and First Active brands totalled £24.6 billion (as at 31 December 2008) with 92.8% in the Republic of Ireland and 7.2% in Northern Ireland. This represents growth of 6% in the Republic of Ireland (ignoring exchange rate movements) and 6% in Northern Ireland. During the course of 2008, Ulster Bank exited the 100% LTV market and tightened LTV and affordability criteria in other segments. The arrears rate (three or more payments missed) increased to 1.6% at 31 December 2008 from 0.8% at end 2007 driven by deteriorating economic conditions. Repossession remained low and totalled 37 for 2008.
 
Financial institutions
The confidence and liquidity crisis affecting the banking sector saw the near collapse of some major banks in Western countries along with the fall of Lehman Brothers and the Icelandic banking system, which in turn threatened the stability of national and global banking systems. Government actions to restore stability by providing guarantees, liquidity facilities, capital injections and facilitating the consolidation of weaker banks with stronger ones met with some success. There remains a high level of risk in the banking sector in 2009, particularly due to the deepening recession that many countries face and increasing corporate defaults.
 
Financial Institutions constitute the largest segment of the Group’s wholesale credit portfolio with exposure of £181 billion. Due to difficulties faced by the sector, the portfolio quality has weakened during 2008. 92% of exposure is to counterparties in developed OECD countries while 90% of exposure is to investment grade counterparties.
 
The Banks portfolio is the biggest sub-sector with exposure of £86 billion. At the time of default, the Group’s exposures to Lehman Brothers and the Icelandic banks totalled £802 million and £494 million respectively and represented less than 1% of the total Banks portfolio.
 
2008 was a difficult year for the hedge funds sector. More hedge funds collapsed during 2008 than in the previous ten years and the values of many declined significantly. The spate of redemptions from investors forced major hedge fund groups to halt withdrawals. The trends are set to continue in 2009 and the contraction of this sector is expected.
 
The Group’s exposure to leveraged funds (including hedge funds) totalled £10.3 billion. The majority of hedge funds are domiciled in the UK and US but the portfolio is diversified by fund strategy. The Group’s activities with hedge funds are primarily collateralised derivatives trading. Exposures to funds encountering problems were reduced, collateral margining was reviewed upwards to further mitigate risk and the appropriateness of limits is regularly reviewed.
 
During 2009, the Group will continue to place emphasis on the pro-active management of financial institutions at counterparty and portfolio levels, recognising that liquidity is likely to remain tight and credit quality is likely to deteriorate further across a range of portfolios.
 
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Corporate sectors (unaudited)
This section discusses the automotive, shipping, oil and gas sectors, given their significance in the current market environment.
 
Automotive
The automotive sector exposure totals £14.5 billion, the majority falling within GBM (£9.1 billion), RBS UK (£3.3 billion) and CFG (£1.3 billion). The exposure is spread across the following segments and geographies:
 
   
Credit book
       
Segment
 
£bn
   
%
 
Original equipment manufacturer/commercial vehicles
   
3.3
     
23
 
Captive finance companies
   
1.1
 
   
  8
 
Component suppliers
   
2.4
     
16
 
Retailers/services
   
5.1
     
35
 
Rental
   
2.6
     
18
 
Total
   
14.5
     
100
 

   
Credit book
 
     
Domicile
 
£bn
   
%
 
Americas
   
4.0
     
28
 
Central Eastern Europe Middle East and Africa
   
1.1
     
 7
 
UK
   
4.2
     
29
 
Western Europe
   
4.3
     
30
 
Asia
   
0.9
     
  6
 
Total
   
14.5
     
100
 

The automotive sector faces numerous challenges with a heavy reliance on discretionary consumer spending, high leverage, volatile input prices and an ongoing pressure to reduce fuel emissions resulting in a shift to smaller cars and overseas production. The Group has maintained a cautious approach to this sector and focus on the largest, most diversified and financially strong counterparties with a wide product offering. Notwithstanding this approach, due to the scale of the downturn in this sector the Group can expect further pressure to be seen across the portfolio. Of particular concern are exposures to the captive finance companies where credit impaired limits total £1.4 billion. The Group continues to seek ongoing limit reductions and improved security.
 
Shipping
The shipping exposure is £16.6 billion and is almost entirely within GBM. The portfolio is divided across the following sectors:
 
   
Credit book
       
Sector
 
£bn
   
%
 
Dry bulk
   
4.8
     
29
 
Tankers
   
6.3
     
38
 
Container
   
1.6
     
10
 
Gas/offshore
   
2.3
     
14
 
Other
   
1.6
     
  9
 
Total
   
16.6 
     
100 
 

The majority of the exposures are strong relationships with loans structured to capture direct vessel cash flows, secured on the vessels themselves with the benefit of full security over the asset and all related cash flows. The Group’s approach to the sector recognises the cyclical nature of shipping with a focus on experienced independent owners with strong liquidity; customer deposits across the portfolio total £5 billion. Assets financed are non-specialist dry bulk, double hulled tankers and containers.
 
Following an unprecedented rise in ship values over recent years there has been a material correction since mid 2008 with the dry bulk index falling by c.90% which may affect owners’ ability to meet collateral calls. Combined with record ship deliveries for 2009-10 the Group has seen a significant decline in asset values. The Group’s exposure to new build assets is significant with commitments relating to 236 vessels in the dry bulk and tanker segment.
 
The Group currently has £0.5 billion of limits to clients on watch list, but the portfolio comprises modern assets (86% of exposures are secured on vessels built since 2000), which exhibit, for the most part, good cash flow and liquidity.
 
Oil and gas
The Group’s exposure to this sector totals £24.0 billion across the following sectors and geographies:
 
   
Credit book
       
Sector
 
£bn
   
%
 
Vertically integrate/exploration and production
   
9.5
     
40
 
Midstream
   
5.0
 
   
21
 
Refining and marketing
   
4.6
     
19
 
Oilfield services
   
4.9
     
20
 
Total
   
24.0
     
100
 

   
Credit book
       
Domicile
 
£bn
   
%
 
Americas
   
10.6
     
44
 
Western Europe
   
  7.6
     
32
 
CEEMEA
   
  4.6
     
19
 
Asia Pacific
   
  1.2
     
  5
 
Total
   
24.0
     
100
 
 
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ABN AMRO and RBS have a number of common clients in this sector, and the Group is working to reduce exposures back within Group concentration limits, primarily in relation to investment grade, vertically integrated counterparties and several of the larger, global exploration and production companies. The Group’s exposures to exploration and production companies are principally secured borrowing base facilities referenced to conservative forward looking oil price assumptions that are adjusted on a regular basis. Unsecured exposures are primarily to oil majors and state owned entities.
 
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Global Restructuring Group (GRG) (audited)
GRG was formed in 2008, tasked with managing the Group’s problem and potential problem exposures to help rejuvenate and restore customers to profitable business. This may include assisting with the restructuring of their businesses and/or renegotiation.
 
GRG brings together previously disparate functions across the Group. Its primary function is to work closely with the Group’s customer facing businesses to support the proactive management of any problem lending. This is based on a clear process (watch listing) which requires the transfer of problem credits to GRG. GRG reports to the Group Chief Risk Officer.
 
Given the current economic outlook, it is particularly important that potential problems are identified early and referred to GRG as the Group’s past experience has shown that the sooner specialists in restructuring are engaged, the greater the likelihood of a successful outcome. Early identification of potential problems therefore has a benefit to the borrower as well as to the Group.
 
GRG is structured with specialist teams focused on: large corporate cases (higher value, multiple lenders); small/mid size business cases (lower value, bilateral relationships); and recovery/litigations. Given the negative trends in the portfolio in 2008, the size of GRG has grown substantially and further investment in staffing is expected in 2009.
 
Originating business units liaise with GRG upon the emergence of a potentially negative event or trend that may impact a borrowers’ ability to service its debt. This may be a significant deterioration in some aspect of the borrowers’ activity, such as trading, where a breach of covenant is likely or where a borrower has missed or is expected to miss a material contractual payment to the Group or another creditor.
 
On transfer of a relationship to GRG a strategy is devised to:
 
Work with the borrower to facilitate changes that will maximise the potential for turnaround of their situation and return them to profitability.
 
Define the Group’s role in the turnaround situation and assess the risk/return dimension of the Group’s participation.
 
Return customers to the originating business unit in a sound and stable condition or, if such recovery cannot be achieved, avoid additional losses and maximise recoveries.
 
Ensure key lessons learned are fed back into origination policies and procedures.
 
At the start of 2008, the volume and value of cases managed by GRG was low relative to historic levels. During the year, the rate of transfer of cases to GRG accelerated sharply. Cases originated from all divisions and across most sectors although the rate of value growth was sharply higher due to the transfer of a number of high value cases from GBM. Commercial property cases made up a significant proportion of transfers from all divisions.
 
Retail collections and recoveries (audited)
There are collections and recoveries functions in each of the four regional markets. Their role is to provide support and assistance to customers who are currently experiencing difficulties meeting their financial obligations.
 
Where possible, the aim of collections and recoveries teams is to return the customer to a satisfactory position, by working with them to restructure their finances and/or business. If this is not possible, the team has the objective of reducing the loss to the Group.
 
There have been material increases in staffing levels in all collections functions to manage the increase in the number of customers in financial difficulty. In the UK and Ireland, there is a common collection and recovery operational model managed by Group Manufacturing. During 2008, there was significant investment in systems development and staff training to make collections activity more efficient and effective.
 
In the UK there have been several initiatives to ensure fair and appropriate treatment of customers experiencing difficulties. For mortgage customers the Group will not initiate repossession proceedings for at least six months after arrears are evident.
 
Preventative measures have also been a key focus throughout 2008, and as a result, the Group has announced the introduction of over 1,000 dedicated Money Sense advisers in its branch network who will provide free financial counselling to both customers and non-customers. The Group has also implemented a programme to proactively contact customers who exhibit early signs of financial stress but are not yet in Collections to offer them assistance in managing their finances more effectively.
 
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Balance sheet analysis (audited)
The following table provides an analysis of the credit quality of financial assets by the Group’s internal credit quality steps.
 
2008
 
AQ1
£m
   
AQ2
£m
   
AQ3
£m
   
AQ4
£m
   
AQ5
£m
   
Accruing
past due
£m
   
Non-
accrual
£m
   
Impairment
provision
£m
   
Total
£m
 
Cash and balance at central banks
    12,400                                                 12,400  
Loans and advances to banks (2)
    131,963       872       1,247       282       943             129       (127 )     135,309  
Loans and advances to customers
    310,950       141,849       187,899       150,705       59,191       15,667       19,350       (10,889 )     874,722  
Debt securities
    259,207       1,461       1,485       3,755       1,626             52       (37 )     267,549  
Settlement balances
    12,612       516       290       129       256       4,029                   17,832  
Derivatives
    912,728       36,528       30,079       5,181       8,032       11                   992,559  
Other financial instruments
    691             161                                     852  
      1,640,551       181,226       221,161       160,052       70,048       19,707       19,531       (11,053 )     2,301,223  
                                                                         
Commitments
    209,359       55,109       48,554       23,458       25,244                         361,724  
Contingent liabilities
    19,693       18,461       19,502       10,977       2,904                         71,537  
Total off-balance sheet
    229,052       73,570       68,056       34,435       28,148                         433,261  
                                                                         
2007
                                                                       
Cash and balance at central banks
    17,866                                                 17,866  
Loans and advances to banks (2)
    204,083       5,797       4,937       407       1,119             25       (3 )     216,365  
Loans and advances to customers
    275,715       174,074       221,561       84,791       55,273       13,236       10,337       (6,449 )     828,538  
Debt securities
    258,895       15,688       2,339       1,372       16,361             5       (4 )     294,656  
Settlement balances
    14,491       98       344       21       68       1,567                   16,589  
Derivatives
    240,114       23,333       11,299       2,352       304                         277,402  
Other financial instruments
    669                         143       65                   877  
      1,011,833       218,990       240,480       88,943       73,268       14,868       10,367       (6,456 )     1,652,293  
                                                                         
Commitments
    131,750       89,682       74,126       25,320       17,301                         338,179  
Contingent liabilities
    26,120       16,314       11,740       4,032       3,714                         61,920  
Total off-balance sheet
    157,870       105,996       85,866       29,352       21,015                         400,099  

Notes:
 
(1)
Credit risk assets as reported internally to senior management exclude certain exposures and take account of netting agreements including master netting arrangements that provide a right of legal set off but do not meet the criteria for offset in IFRS. The analysis of credit risk assets on page 68 uses the same risk bands as above and is a sub-set of the full analysis given above.
 
(2)
Excluding items in the course of collection of £2,888 million (2007 – £3,095 million).
 
The following loans and advances to customers were past due at the balance sheet date but not considered impaired:
 
   
Past due
1-29 days
£m
   
Past due
30-59 days
£m
   
Past due
60-89 days
£m
   
Past due
90 days
or more
£m
   
Total
£m
 
2008
    9,517       2,941       1,427       1,782       15,667  
2007
    8,768       2,745       1,354       369       13,236  

These balances include loans and advances to customers that are past due through administrative and other delays in recording payments or in finalising documentation and other events unrelated to credit quality.
 
74

 
Business review continued

 
Industry risk – geographical analysis (audited)
The following table analyses financial assets by location of office and by industry type.
 
   
Group
 
2008
 
Loans and
advances to
banks and
customers
£m
   
Debt
securities and
equity shares
£m
   
Derivatives
£m
   
Other (1)
£m
   
Total
£m
   
Netting and
offset (2)
£m
 
UK
                                   
Central and local government
    6,106       36,466       5,798       14       48,384       1,987  
Manufacturing
    26,006       1,080       11,208       180       38,474       6,279  
Construction
    13,426       144       754       26       14,350       1,485  
Finance
    197,659       84,696       532,857       6,257       821,469       480,762  
Service industries and business activities
    88,420       10,154       13,278       1,471       113,323       7,624  
Agriculture, forestry and fishing
    3,118       93       34       15       3,260       87  
Property
    74,050       2,008       5,094       71       81,223       1,026  
Individuals:
                                               
Home mortgages
    80,967             14             80,981       52  
Other
    27,479       250       36       25       27,790       5  
Finance leases and instalment credit
    17,363       3       25             17,391       119  
Interest accruals
    4,323       774                   5,097        
Total UK
    538,917       135,668       569,098       8,059       1,251,742       499,426  
US
                                               
Central and local government
    482       24,996       45       33       25,556        
Manufacturing
    13,298       102       1,809       128       15,337       217  
Construction
    885       63       122       6       1,076        
Finance
    30,433       37,346       355,502       5,754       429,035       323,910  
Service industries and business activities
    28,232       1,498       8,535       907       39,172       2,346  
Agriculture, forestry and fishing
    30             3       1       34        
Property
    6,579       5       97             6,681        
Individuals:
                                               
Home mortgages
    34,235                         34,235        
Other
    14,368                         14,368        
Finance leases and instalment credit
    3,066                         3,066        
Interest accruals
    499       466                   965        
Total US
    132,107       64,476       366,113       6,829       569,525       326,473  
Europe
                                               
Central and local government
    2,045       24,065       228       5       26,343        
Manufacturing
    29,348       776       371             30,495       2  
Construction
    5,838       1       91             5,930        
Finance
    35,989       34,533       8,174       3,621       82,317       61  
Service industries and business activities
    60,179       11,754       2,823       92       74,848       780  
Agriculture, forestry and fishing
    5,750       50       1             5,801        
Property
    23,072       19       299             23,390        
Individuals:
                                               
Home mortgages
    118,549       50       4             118,603        
Other
    9,024       29       218               9,271        
Finance leases and instalment credit
    1,815       15                   1,830        
Interest accruals
    1,889       1                   1,890        
Total Europe
    293,498       71,293       12,209       3,718       380,718       843  
Rest of the World
                                               
Central and local government
    7,079       16,766       311       145       24,301        
Manufacturing
    6,837       178       772             7,787        
Construction
    758       6       17             781       3  
Finance
    21,469       4,267       42,621       407       68,764       31,695  
Service industries and business activities
    13,706       949       1,297             15,952       108  
Agriculture, forestry and fishing
    157       1       7             165        
Property
    2,932       480       96             3,508       41  
Individuals:
                                               
Home mortgages
    847                         847        
Other
    5,089             18             5,107       79  
Finance leases and instalment credit
    111       5                   116        
Interest accruals
    428                         428        
Total Rest of the World
    59,413       22,652       45,139       552       127,756       31,926  
 
75

 
Business review continued

 
   
Group
 
2008
 
Loans and
advances to
banks and
customers
£m
   
Debt
securities and
equity shares
£m
   
Derivatives
£m
   
Other (1)
£m
   
Total
£m
   
Netting and
offset (2)
£m
 
Total
                                   
Central and local government
    15,712       102,293       6,382       197       124,584       1,987  
Manufacturing
    75,489       2,136       14,160       308       92,093       6,498  
Construction
    20,907       214       984       32       22,137       1,488  
Finance
    285,550       160,842       939,154       16,039       1,401,585       836,428  
Service industries and business activities
    190,537       24,355       25,933       2,470       243,295       10,858  
Agriculture, forestry and fishing
    9,055       144       45       16       9,260       87  
Property
    106,633       2,512       5,586       71       114,802       1,067  
Individuals:
                                               
Home mortgages
    234,598       50       18             234,666       52  
Other
    55,960       279       272       25       56,536       84  
Finance leases and instalment credit
    22,355       23       25             22,403       119  
Interest accruals
    7,139       1,241                   8,380        
      1,023,935       294,089       992,559       19,158       2,329,741       858,668  

Notes:

(1)
Includes settlement balances of £17,832 million.
 
(2)
This column shows the amount by which the Group’s credit risk exposure is reduced through arrangements, such as master netting agreements, which give the Group a legal right to set-off the financial asset against a financial liability due to the same counterparty. In addition, the Group holds collateral in respect of individual loans and advances to banks and to customers. This collateral includes mortgages over property (both personal and commercial); charges over business assets such as plant, inventories and trade debtors; and guarantees of lending from parties other than the borrower. The Group obtains collateral in the form of securities in reverse repurchase agreements. Cash and securities are received as collateral in respect of derivative transactions.
 
   
Group
 
2007
 
Loans and
advances to
banks and
customers
£m
   
Debt
securities and
equity shares
£m
   
Derivatives
£m
   
Other (1)
£m
   
Total
£m
   
Netting and
offset (2)
£m
 
UK
                                   
Central and local government
    4,728       30,285       3,912             38,925       1,531  
Manufacturing
    21,083       2,751       4,800             28,634       4,032  
Construction
    12,363       456       741             13,560       1,684  
Finance
    294,682       106,201       239,858       12,716       653,457       186,420  
Service industries and business activities
    74,399       16,801       4,412             95,612       6,687  
Agriculture, forestry and fishing
    2,570       66       58             2,694       104  
Property
    63,715       640       969       7       65,331       2,033  
Individuals:
                                               
Home mortgages
    73,916       1,795       5             75,716        
Other
    28,747       1,140       15       23       29,925       7  
Finance leases and instalment credit
    15,632       131       27             15,790       5  
Interest accruals
    3,512       1,607                   5,119        
Total UK
    595,347       161,873       254,797       12,746       1,024,763       202,503  
US
                                               
Central and local government
    386       23,506       10       212       24,114        
Manufacturing
    7,399       608       111             8,118       13  
Construction
    793       96                   889        
Finance
    69,867       39,049       9,354       3,095       121,365       23,026  
Service industries and business activities
    16,474       2,190       233       1       18,898       18  
Agriculture, forestry and fishing
    20       4                   24        
Property
    6,456       4,089                   10,545        
Individuals:
                                               
Home mortgages
    27,882                         27,882        
Other
    10,879                         10,879        
Finance leases and instalment credit
    2,228                         2,228        
Interest accruals
    1,421       379                   1,800       2  
Total US
    143,805       69,921       9,708       3,308       226,742       23,059  
 
76

 
Business review continued

 
Industry risk – geographical analysis (continued)
 
   
Group
 
2007
 
Loans and
advances to
banks and
customers
£m
   
Debt
securities and
equity shares
£m
   
Derivatives
£m
   
Other( 1)
£m
   
Total
£m
   
Netting and
offset (2)
£m
 
Europe
                                   
Central and local government
    2,371       30,593       132             33,096       9  
Manufacturing
    15,159       13       361             15,533       214  
Construction
    4,779             13             4,792        
Finance
    40,481       42,418       6,285       157       89,341       84,200  
Service industries and business activities
    46,500       540       481             47,521       24,648  
Agriculture, forestry and fishing
    4,650       2       42             4,694        
Property
    15,768       67       8             15,843        
Individuals:
                                               
Home mortgages
    81,557       18                   81,575        
Other
    16,292       3,292                   19,584        
Finance leases and instalment credit
    1,620                         1,620        
Interest accruals
    2,872       1,101                   3,973        
Total Europe
    232,049       78,044       7,322       157       317,572       109,071  
Rest of the World
                                               
Central and local government
    2,592       18,821       94             21,507        
Manufacturing
    8,078       46       738             8,862        
Construction
    825       79       3             907       1  
Finance
    37,502       16,919       3,797       1,210       59,428       6,059  
Service industries and business activities
    14,449       1,825       661             16,935       103  
Agriculture, forestry and fishing
    1,941                         1,941        
Property
    2,898       217       28             3,143        
Individuals:
                                               
Home mortgages
    1,740                         1,740        
Other
    12,261                         12,261       3  
Finance leases and instalment credit
    18             254       45       317        
Interest accruals
    945       11                   956        
Total Rest of the World
    83,249       37,918       5,575       1,255       127,997       6,166  
Total
                                               
Central and local government
    10,077       103,205       4,148       212       117,642       1,540  
Manufacturing
    51,719       3,418       6,010             61,147       4,259  
Construction
    18,760       631       757             20,148       1,685  
Finance
    442,532       204,587       259,294       17,178       923,591       299,705  
Service industries and business activities
    151,822       21,356       5,787       1       178,966       31,456  
Agriculture, forestry and fishing
    9,181       72       100             9,353       104  
Property
    88,837       5,013       1,005       7       94,862       2,033  
Individuals:
                                               
Home mortgages
    185,095       1,813       5             186,913    
 
Other
    68,179       4,432       15       23       72,649       10  
Finance leases and instalment credit
    19,498       131       281       45       19,955       5  
Interest accruals
    8,750       3,098                   11,848       2  
      1,054,450       347,756       277,402       17,466       1,697,074       340,799  

Notes:   
 
(1)   Incudes settlement balances of £16,589 million.
   
(2)
This column shows the amount by which the Group’s credit risk exposure is reduced through arrangements, such as master netting agreements, which give the Group a legal right to set-off the financial asset against a financial liability due to the same counterparty. In addition, the Group holds collateral in respect of individual loans and advances to banks and to customers. This collateral includes mortgages over property (both personal and commercial); charges over business assets such as plant, inventories and trade debtors; and guarantees of lending from parties other than the borrower. The Group obtains collateral in the form of securities in reverse repurchase agreements. Cash and securities are received as collateral in respect of derivative transactions.
 
77

 
Business review continued

 
Impairment (audited)
The Group classifies impaired assets as either Risk Elements in Lending (REIL) or Potential Problem Loans (PPL). REIL represents non-accrual loans, loans that are accruing but are past due 90 days and restructured loans. PPL represents impaired assets which are not included in REIL but where information about possible credit problems cause management to have serious doubts about the future ability of the borrower to comply with loan repayment terms.
 
Both REIL and PPL are reported gross of the value of any security held, which could reduce the eventual loss should it occur, and gross of any provision marked. Therefore impaired assets which are highly collateralised, such as mortgages, will have a low coverage ratio of provisions held against reported impaired balance.
 
The analyses of risk elements and impairment charges as discussed below form a key part of the data provided to senior management on the credit performance of the Group’s portfolios.
 
Risk elements in lending and potential problem loans (audited)
 
               
2008
                            2007              
Division
 
REIL
£m
   
PPL
£m
   
REIL and
PPL
£m
   
Total
provision
£m
   
Total
provision
as % of REIL
%
   
Total
provision
as % of REIL &
PPL
%
   
REIL
£m
   
PPL
£m
   
REIL and
PPL
£m
   
Total
provision
£m
   
Total
provision
as % of REIL
%
   
Total
provision
as % of
REIL &
PPL
%
 
Global Markets
                         
 
                                           
– Global Banking & Markets
    6,192       18       6,210       3,491       56 %     56 %     952       67       1,019       586       62 %     58 %
– Global Transaction Services
    284             284       245       86 %     86 %     336             336       170       51 %     51 %
Total Global Markets
    6,476       18       6,494       3,736       58 %     58 %     1,288       67       1,355       756       59 %     56 %
Regional Markets
                                                                                               
– UK Retail & Commercial Banking
    7,900       200       8,100       3,709       47 %     46 %     5,535       63       5,598       3,281       59 %     59 %
– US Retail & Commercial Banking
    770             770       932       121 %     121 %     317             317       304       96 %     96 %
– Europe & Middle East Retail & Commercial Banking
    3,341       8       3,349       822       25 %     25 %     725       1       726       418       58 %     58 %
– Asia Retail & Commercial Banking
    304             304       252       83 %     83 %     386             386       183       47 %     47 %
Total Regional Markets
    12,315       208       12,523       5,715       46 %     46 %     6,963       64       7,027       4,186       60 %     60 %
Other
                                                          14              
RBS share of shared assets
                                                          16              
RFS Holdings minority interest
    2,470             2,470       1,565       63 %     63 %     2,480       540       3,020       1,480       60 %     49 %
Group
    21,261       226       21,487       11,016       52 %     51 %     10,731       671       11,402       6,452       60 %     57 %
 
78

 
Business review continued

 
The table below sets out the Group’s loans that are classified as REIL and PPL.

   
2008
   
2007
 
   
Group
£m
   
Group
£m
 
Non-accrual loans (1)
    19,479       10,362  
Accrual loans past due 90 days (2)
    1,782       369  
Total REIL
    21,261       10,731  
PPL (3)
    226       671  
Total REIL and PPL
    21,487       11,402  
REIL and PPL as % of customer loans and advances – gross (4)
    2.52 %     1.64 %

The sub-categories of REIL and PPL are calculated as described in notes 1 to 4 below.
 
Notes:
 
(1)
All loans against which an impairment provision is held are reported in the non-accrual category.
 
(2)
Loans where an impairment event has taken place but no impairment recognised. This category is used for fully collateralised non-revolving credit facilities.
 
(3)
Loans for which an impairment event has occurred but no impairment provision is necessary. This category is used for fully collateralised advances and revolving credit facilities where identification as 90 days overdue is not feasible.
 
(4)
Gross of provisions and excluding reverse repurchase agreements.
 
REIL as at 31 December 2008 was £21,261 million (2007 – £10,731 million). As a percentage of customer lending, REIL and PPL in aggregate was 2.52% of customer loans and advances at 31 December 2008 (2007 – 1.64%).
 
Impairment loss provision methodology (audited)
Provisions for impairment losses are assessed under three categories:
 
Individually assessed provisions: provisions required for individually significant impaired assets which are assessed on a case by case basis, taking into account the financial condition of the counterparty and any guarantor and collateral held after being stressed for downside risk. This incorporates an estimate of the discounted value of any recoveries and realisation of security or collateral. The asset continues to be assessed on an individual basis until it is repaid in full, transferred to the performing portfolio or written-off.
 
Collectively assessed provisions: provisions on impaired credits below an agreed threshold which are assessed on a portfolio basis, to reflect the homogeneous nature of the assets, such as credit cards or personal loans. The provision is determined from a quantitative review of the relevant portfolio, taking account of the level of arrears, security and average loss experience over the recovery period.
 
Latent loss provisions: 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.
 
Provision analysis (audited)
The Group’s consumer portfolios, which consist of high volume, small value credits, have highly efficient largely automated processes for identifying problem credits and very short timescales, typically three months, before resolution or adoption of various recovery methods. Corporate portfolios consist of higher value, lower volume credits, which tend to be structured to meet individual customer requirements. Provisions are assessed on a case by case basis by experienced specialists with input from professional valuers and accountants. The Group operates a clear provisions governance framework which sets thresholds whereby suitable oversight and challenge is undertaken and significant cases will be presented to a committee chaired by the Group Chief Executive or the Group Finance Director.
 
79

 
Business review continued

 
Impairment charge (audited)
The following table shows total impairment losses charged to the income statement.
 
     
2008
£m
     
 
2007
£m
 
New impairment losses
    8,391       2,310  
less: recoveries of amounts previously written-off
    (319 )     (342 )
Charge to income statement
    8,072       1,968  
Comprising:
               
Loan impairment losses
    7,091       1,946  
Impairment losses on available-for-sale securities
    981       22  
Charge to income statement
    8,072       1,968  
Impairment losses by division:
               
Global Markets
               
– Global Banking & Markets
    3,643       67  
– Global Transaction Services
    60       14  
Regional Markets
               
– UK Retail & Commercial Banking
    1,964       1,368  
– US Retail & Commercial Banking
    1,041       340  
– Europe & Middle East Retail & Commercial Banking
    526       118  
– Asia Retail & Commercial Banking
    171       24  
RBS Insurance
    42        
Other
    (15 )     (1 )
RFS Holdings minority interest
    640       38  
Group
    8,072       1,968  

Analysis of loan impairment charge (audited)

   
2008
£m
 
 
2007
£m
 
Latent loss impairment charge
    822       88  
Collectively assessed impairment charge
    2,606       1,584  
Individually assessed impairment charge (1)
    3,545       274  
Charge to income statement
    6,973       1,946  
Charge as a % of customer loans and advances – gross (2)
    0.82 %     0.28 %

Notes:
 
(1)   Excludes loan impairment charge against loans and advances to banks of £118 million (2007 – nil).
 
(2)   Gross of provisions and excluding reverse repurchase agreements.
 
Analysis of loan impairment provisions (audited)
 
   
2008
£m
 
 
2007
£m
 
Latent loss provisions
    1,944       1,050  
Collectively assessed provisions
    4,102       3,845  
Individually assessed provisions
    4,843       1,554  
Total provisions (1)
    10,889       6,449  
Total provision as a % of customer loans and advances – gross (2)
    1.3 %     0.9 %

Notes:
 
(1)   Excludes provisions against loans and advances to banks of £127 million (2007 – £3 million).
 
(2)   Gross of provisions and excluding reverse repurchase agreements.
 
80

 
Business review continued

 
Provisions coverage (audited)
The Group’s provision coverage ratios are shown in the table below.
 
   
2008
   
2007
 
   
£m
   
£m
 
Total provision expressed as a:
           
% of REIL
    52%       60%  
% of REIL and PPL
    51%       57%  
 
The coverage ratio of closing provisions to REIL and PPL decreased from 57% to 51% during 2008. The lower coverage ratio reflects amounts written-off and the changing mix from unsecured to secured exposures.
 
Movement in loan impairment provisions (audited)
The following table shows the movement in the provision for impairment losses for loans and advances.
 
   
Individually
assessed
£m
   
Collectively
assessed
£m
   
Latent
£m
   
Total
2008
£m
     
 
2007
£m
 
At 1 January
    1,568       3,834      
1,050
      6,452       3,935  
Transfer to disposal groups
    (222 )     (351 )     (194 )     (767 )      
Currency translation and other adjustments
    1,065       81       295       1,441       137  
Acquisition of subsidiaries
                            2,221  
Disposal of subsidiaries
          (149 )     (29 )     (178 )      
Net increase in provisions of discontinued operations
                            46  
Amounts written-off
    (1,165 )     (1,983 )           (3,148 )     (2,011 )
Recoveries of amounts previously written-off
    113       206             319       342  
Charged to the income statement
    3,663       2,606       822       7,091       1,946  
Unwind of discount
    (52 )     (142 )           (194 )     (164 )
At 31 December (1)
    4,970       4,102       1,944       11,016       6,452  

Note:
 
(1)
The provison for impairment losses at 31 December 2008 include £127 million relating to loans and advances to banks (2007 – £3 million).
 
Movement in loan impairment provisions (audited)
The movement in provisions balance by division is shown in the table below.
 
   
Global
Banking &
Markets
£m
   
Global
Transaction
Services
£m
   
UK Retail &
Commercial
Banking
£m
   
US Retail &
Commercial
Banking
£m
   
Europe &
Middle East
Retail &
Commercial
Banking
£m
   
Asia
Retail &
Commercial
Banking
£m
   
Central
Items
£m
   
RBS
Share of
Shared
Assets
£m
   
RFS
Holdings
minority
interest
£m
   
Total
2008
£m
   
2007
£m
 
At 1 January
    586       170       3,281       304       418       183       14       16       1,480       6,452       3,935  
Transfers to disposal groups
                                                    (767 )     (767 )      
Currency translation and other adjustments
    496       52       12       219       147       57                   458       1,441       137  
Acquisition of subsidiaries
                                                                2,221  
Disposal of subsidiaries
                (108 )           (70 )                             (178 )      
Net increase in provisions of discontinued operations
                                                                46  
Amounts written-off
    (307 )     (34 )     (1,414 )     (710 )     (174 )     (153 )     (64 )     (16 )     (276 )     (3,148 )     (2,011 )
Recoveries of amounts previously written-off
    10       1       113       80       7             50             58       319       342  
Charge to income statement
    2,718       59       1,965       1,039       526       171                   613       7,091       1,946  
Discount unwind
    (12 )     (3 )     (140 )           (32 )     (6 )                 (1 )     (194 )     (164 )
At 31 December
    3,491       245       3,709       932       822       252                   1,565       11,016       6,452  
 
Liquidity risk (audited)
The Group’s liquidity policy is designed to ensure that the Group can at all times meet its obligations as they fall due.
 
Liquidity management within the Group addresses the overall balance sheet structure and the control, within prudent limits, of risk arising from the mismatch of maturities across the balance sheet and from exposure to undrawn commitments and other contingent obligations.
 
The management of liquidity risk within the Group is undertaken within a formal governance structure. The Group Board of Directors oversees the liquidity risk appetite and strategy of the Group; the Group Executive Management Committee reviews the key liquidity metrics and trends in the context of the Group’s overall risk profile; the Group Asset and Liability Management Committee (GALCO), chaired by the Group Finance Director and including the chief executives of the business divisions as well as the Group Treasurer, Group Chief Risk Officer and heads of other relevant Group functions, sets explicit metrics across a number of asset and liability targets and these are cascaded to the business and monitored by the Group Treasury and risk functions.
 
Group Treasury has overall responsibility for the daily monitoring and control of the Group’s liquidity and funding positions. The Liquidity Managers’ Forum is chaired and directed by the Group Treasurer with membership including the Head of Short Term Markets and Financing, GBM. The forum typically meets weekly with more frequent, ad hoc, meetings as necessary. There are Regional and Country ALCOs that oversee Group policy in businesses in Europe, Asia and the Americas. The Group is divided into Liquidity Reporting Units each of which is required to have its own liquidity limits and contingency funding plan. In addition, all subsidiaries and branches outside the UK are required to comply with local regulatory liquidity requirements and are subject to Group Treasury oversight.
 
Management of term structure
The Group evaluates on a regular basis its structural liquidity risk and applies a variety of balance sheet management and term funding strategies to maintain this risk within its normal policy parameters. The degree of maturity mismatch within the overall long-term structure of the Group’s assets and liabilities is managed within internal policy guidelines, aimed at ensuring 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.
 
Daily management
The primary focus of the daily management activity is to ensure access to sufficient liquidity to meet cash flow obligations within key time horizons, in particular out to one month ahead. The short-term maturity structure of the Group’s liabilities and assets is managed daily to ensure that all material or potential cash flow obligations, arising from undrawn commitments and other contingent obligations can be met.
 
Potential sources include cash inflows from maturing assets, new borrowings or the sale of various debt securities held (after allowing for appropriate haircuts). Short-term liquidity risk is generally managed on a consolidated basis with liquidity mismatch limits in place for subsidiaries and non-UK branches which have material local treasury activities, thereby assuring that the daily maintenance of the Group’s overall liquidity risk position is not compromised. ABN AMRO, Citizens Financial Group and RBS Insurance manage liquidity locally, given different regulatory regimes, subject to review by Group Treasury. As integration of ABN AMRO’s businesses within the Group proceeds, the liquidity risk policies, parameters and metrics used will be progressively aligned within a single framework.
 
Stress testing
The Group performs stress tests to simulate how events may impact its funding and liquidity capabilities. Such tests inform the overall balance sheet structure and help define suitable limits for control of the risk arising from the mismatch of maturities across the balance sheet and from undrawn commitments and other contingent obligations. The form and content of stress tests are updated where required as market conditions evolve.
 
Contingency planning
Contingency funding plans have been developed to anticipate and respond to approaching or actual material deterioration in market conditions. The Group reviews its contingency plans in the light of evolving market conditions. The contingency funding plan covers: the available sources of contingent funding to supplement cash flow shortages; the lead times to obtain such funding; the roles and responsibilities of those involved in the contingency plans, including the communication lines for escalation of events which give rise to liquidity stress; assumptions, including the expected change impact of market conditions; and the ability and circumstances within which the Group accesses central bank liquidity.
 
Global developments (unaudited)
The global financial system has experienced its greatest crisis in the post war period and the dislocation became most acute in the second half of 2008. This loss of confidence in the world’s banking system led to massive dislocation in the capital markets and resulted in the effective closure of the term debt and securitisation markets and money markets. Government intervention in, and support for, the international financial system has increased to unprecedented levels taking the form of capital injections, guaranteed funding, asset insurance schemes and expanded facilities from a number of central banks:
 
In September 2007, the Bank of England announced that to alleviate strains in longer-maturity money markets, it would conduct auctions to provide funds at three month maturity against a wider range of collateral, including mortgage collateral, than in its weekly open market operations.
 
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Business review continued

 
In April 2008, the Bank of England launched a special liquidity scheme allowing banks to swap temporarily illiquid mortgage and other assets for Treasury Bills. The scheme closed to new issuances on 30 January 2009. However, it will provide liquidity support for a further three years.
 
In September 2008, the major central banks announced coordinated action to improve US$ liquidity. As part of this action, the Bank of England and ECB commenced US dollar repo operations. Eligible collateral consists of securities routinely eligible in the Bank of England’s and ECB’s short-term repo open market operations together with conventional US Treasuries. The Bank of England concluded a reciprocal swap agreement (swap line) with the US Federal Reserve. On 3 February 2009, the Bank of England announced the extension of this facility until 30 October 2009.
 
In October 2008, the pool of eligible collateral securities for its open market operations was extended to include bank debt guaranteed under the Government’s bank debt guarantee scheme.
 
In October 2008, the Government announced a credit guarantee scheme. It will guarantee new unsecured borrowing in return for a fee. Initially the guarantee period ended on 9 April 2009 but on 19 January 2009 the Government announced an extension to 31 December 2009. It also announced new arrangements, expected to start in April 2009, to guarantee asset-backed securities issued by banks.
 
In October 2008 the European Central Bank expanded its list of eligible collateral to include marketable debt instruments denominated in non-euro currencies (and issued in the euro area) among others. This is to remain in force until the end of 2009. Enhancements were also made to the provision of longer-term refinancing operations including conducting them through a fixed rate tender procedure with full allotment. This is to stay in place for as long as needed and at least until 31 March 2009.
 
On 27 October 2008 the Federal Reserve Bank commenced the Commercial Paper Funding Facility to provide a liquidity backstop to issuers of commercial paper. A special purpose vehicle (SPV) funded by the Federal Reserve Bank of New York will purchase eligible three- month unsecured and asset-backed commercial paper from eligible issuers. In February 2009 the FED announced an extension to this facility until 30 October 2009.
 
In October 2008 the UK Government announced recapitalisation plans for a number of UK banks including RBS.
 
In January 2009, it was announced that the Bank of England will permit drawings from the discount window facility with a term of 364 days, in addition to the standard option to draw for 30 days.
 
In January 2009, the Government announced that the Bank of England had been authorised to purchase up to £50 billion of high-quality private sector assets under an asset purchase facility. The following sterling assets are initially eligible for purchase: commercial paper, corporate bonds, paper issued under the Credit Guarantee Scheme (CGS), syndicated loans and asset-backed securities created in viable securitisation structures.
 
In January 2009, the Government announced an asset protection scheme. The Government will insure, for a commercial fee, certain bank assets against losses. It is anticipated that the scheme will commence in April 2009. The UK banks, including the Group, have been in discussions with the Tripartite Authorities about the scheme’s terms.
 
In January 2009, the FSA has announced that it will ensure that the application of the current International Basel Accord does not create any unnecessary or unintended pro-cyclical effects.
 
On 3 February 2009 the Federal Reserve Bank announced an extension to a number of its liquidity facilities until 30 October 2009. These included the Term Securities Lending Facility (TSLF), originally announced in March 2008. Under the TSLF, the Federal Reserve Bank of New York auctions 28-day term loans of Treasury securities to primary dealers in exchange for other program eligible collateral.
 
Liquidity management in 2008 (audited)
The exposure of the Group to wholesale market funding increased markedly in 2008 following the acquisition of the wholesale banking business of ABN AMRO in the latter half of 2007. The amount of unsecured wholesale funding represented by bank funding and debt securities increased from £154 billion in June 2007 to £362 billion in December 2007. The gap between customer loans and customer deposits increased over this period from £86 billion to £121 billion.
 
The market disruption during 2008 had a marked effect on the Group’s liquidity and funding which was at its most acute in the autumn of 2008 following the collapse of Lehman Brothers. During that period, the Group’s credit ratings were downgraded constraining both access to and tenor of wholesale funding and there was an outflow of customer deposits. The effective closure of the term funding markets and sharp reduction in the quantity and maturity of short term bank funding had profound consequences for the Group.
 
Whilst the Group’s customer funding sources remain well diversified and its retail franchise proved resilient, the availability of longer term funding diminished. The Group therefore increased its shorter term wholesale funding exposure, increased its access to central bank funding and issued government guaranteed debt to fund the balance sheet. The government schemes have enabled the mitigation of the financial crisis as the Group rebalances its asset and liability structure.
 
 
 
An analysis of the Group’s funding is set out below.
 
   
2008
   
2007
 
Sources of funding
 
£m
   
%
   
£m
   
%
 
Customer accounts (excluding repos)                                
Repayable on demand
    327,547       24       346,074       24  
Time deposits
    253,822        19       201,373        14  
Total customer accounts (excluding repos)
    581,369       43       547,447       38  
Debt securities in issue over one year remaining maturity
    125,782       9       118,152       8  
Subordinated liabilities
    49,154       4       38,043       3  
Owners’ equity
    58,879       4       53,038       4  
Total customer accounts and long term funds
    815,184       60       756,680       53  
Repo agreements with customers
    58,143       5       134,916       10  
Repo agreements with banks
    83,666       6       163,038       11  
Total customer accounts, long term funds and collateralised borrowing
    956,993       71       1,054,634       74  
Debt securities in issue up to one year remaining maturity
    174,507       13       156,020       11  
Deposits by banks (excluding repos)
    174,378       13       149,256       10  
Short positions
    42,536       3       73,501       5  
Total
    1,348,414       100       1,433,411       100  

Customer accounts – the principal source of funds for the Group is its core customer deposits gathered by its retail banking, private client, corporate and SME franchises. The underlying strength of the franchise is demonstrated by the performance of the Group in these markets as customer deposits increased from £547 billion in December 2007 to £581 billion at the end of December 2008. There was a fluctuation in balances at the height of the market disruption in October 2008 but this was recovered by the year end. The Group’s multi-brand offering and strong client focus is a key part of the funding strategy and continues to benefit the Group’s funding position.
 
Repo agreements are borrowings collateralised by a range of debt securities and other assets undertaken with a range of corporate and institutional customers and banks. These reduced significantly in the course of 2008 as the Group took strategic actions and wholesale markets retrenched.
 
Short positions in various securities are held primarily by GBM including RBS Greenwich Capital in the US.
 
Debt securities in issue over one year, subordinated liabilities and equity – during 2008, the debt markets saw reduced activity, in both the term and the securitisation markets; as a result the maturity profile of the Group’s wholesale funding has become shorter in duration over the course of the year. This was partly offset by issues of government guaranteed debt in the latter part of 2008. The maturity profile of debt securities is predominantly concentrated under one year and this is a source of refinancing risk in the coming twelve months.
 
The Group raised £27 billion of equity capital during the course of 2008 from a rights issue of £12 billion in June 2008 and a placing and open offer in December 2008 which provided a further £15 billion of equity capital. In December 2008 a further £5 billion was raised from a preference share issue which was repaid from the proceeds of the Second Placing and Open Offer in April 2009.
 
Short term debt and bank deposits – the Group saw considerable pressure and risk aversion in the short term debt and bank deposit markets. In order to relieve funding shortages in the market, central banks across the world allowed banks to pledge assets to access funding. The Group has used central bank schemes to support its funding and pledged assets into several of these schemes in a number of countries in which it operates. The Group has set up a series of initiatives to improve the liquidity value of its assets to assist in relieving funding pressures.
 
Undrawn commitments – the Group provides undrawn commitments to both its corporate and personal customers in the form of products such as overdrafts and credit card facilities. The commitments portfolio is well diversified in terms of customers, geography and business type. The total amount of the Group’s undrawn commitments at the end of 2008 was £352 billion.
 
84

 
Business review continued

 
Conduits – the Group’s most significant multi-seller conduits have thus far continued to fund the vast majority of their assets solely through ABCP issuance. There were significant disruptions to the liquidity of the financial markets during the year following the bankruptcy filing of Lehman Brothers in September 2008 and this required a small amount of the assets held in certain conduits to be funded by the Group rather than through ABCP issuance. By the end of 2008 there had been an improvement in market conditions, supported by central bank initiatives, which enabled normal ABCP funding to replace this Group funding of the conduits.
 
The average maturity of ABCP issued by the Group’s conduits as at 31 December 2008 was 72.1 days (2007– 60.9 days).
 
The total assets held by the Group’s sponsored conduits are £49.9 billion (2007– £48.1 billion). Since these liquidity facilities are sanctioned on the basis of total conduit purchase commitments, the liquidity facility commitments will exceed the level of assets held, with the difference representing undrawn commitments.
 
The Group values the funding flexibility and liquidity provided by the ABCP market to fund client and Group-originated assets. Whilst there are plans to decrease the multi-seller conduit business in line with the Group’s balance sheet, the Group is reviewing the potential for new own-asset conduit structures to add funding diversity.
 
Outlook for 2009 (unaudited)
The market outlook for 2009 remains uncertain with the prospect of recession on a global scale. The wholesale funding markets remain difficult with a high degree of risk aversion towards the banking market and no restoration of the unguaranteed debt capital markets for bank issuance yet visible. The continuation of these conditions means that the use of central bank and other government facilities are likely to be required for some time. Other deposit initiatives have commenced to widen wholesale and other retail deposit gathering actions.
 
Group balance sheet (audited)
The following tables show the contractual undiscounted cash flows receivable and payable up to a period of twenty years including future receipts and payments of interest.
 
On balance sheet assets by contractual maturity
 
   
Group
 
2008
 
0-3 months
£m
   
3-12 months
£m
   
1-3 years
£m
   
3-5 years
£m
   
5-10 years
£m
   
10-20 years
£m
 
Cash and balances at central banks
    12,333       25                   2       29  
Loans and advances to banks
    61,630       19,369       2,673       921       111       70  
Loans and advances to customers
    195,553       81,054       138,378       125,621       160,271       152,084  
Debt securities
    26,006       12,895       24,629       23,927       57,846       24,535  
Derivatives held for hedging
    266       1,796       2,281       1,359       1,517       649  
Settlement balances
    17,830                         2        
Other financial assets
    621       193       58       111       343        
      314,239       115,332       168,019       151,939       220,092       177,367  

 
On balance sheet liabilities by contractual maturity
 
   
Group
 
2008
 
0-3 months
£m
   
3-12 months
£m
   
1-3 years
£m
   
3-5 years
£m
   
5-10 years
£m
   
10-20 years
£m
 
Deposits by banks
    154,614       14,347       3,345       2,754       2,048       34  
Customer accounts
    523,268       33,450       6,577       6,337       7,298       5,319  
Debt securities in issue
    131,714       48,652       40,067       38,223       38,667       5,626  
Derivatives held for hedging
    394       2,216       2,543       1,334       2,682       1,373  
Subordinated liabilities
    1,753       4,271       6,824       5,793       24,503       13,030  
Settlement balances and other liabilities
    13,351       5       12       6       10       6  
      825,094       102,941       59,368       54,447       75,208       25,388  
 
85

 
Business review continued

 
Other contractual cash obligations
The table below summarises the Group’s other contractual cash obligations by payment date.
 
   
Group
 
2008
 
0-3 months
£m
   
3-12 months
£m
   
1-3 years
£m
   
3-5 years
£m
   
5-10 years
£m
   
10-20 years
£m
 
Operating leases
    146       433       976       751       1,448       1,851  
Contractual obligations to purchase goods or services
    237       892       486       208       303       1  
      383       1,325       1,462       959       1,751       1,852  

 
2007
                                   
Operating leases
    90       268       655       569       1,060       1,958  
Contractual obligations to purchase goods or services
    441       1,007       748       199       5       2  
      531       1,275       1,403       768       1,065       1,960  
 
The Group’s undrawn formal facilities, credit lines and other commitments to lend were £352,398 million (2007 – £332,811 million). While the Group has given commitments to provide these funds, some facilities may be subject to certain conditions being met by the counterparty. The Group does not expect all facilities to be drawn, and some may lapse before drawdown.
 
The tables above show the timing of cash inflows and outflows to settle financial assets and liabilities. They have been prepared on the following basis:
 
Financial assets have been reflected in the time band of the latest date on which they could be repaid unless earlier repayment can be demanded by the reporting entity; financial liabilities are included at the earliest date on which the counterparty can require repayment regardless of whether or not such early repayment results in a penalty. If the repayment of a financial asset or liability is triggered by, or is subject to, specific criteria such as market price hurdles being reached, the asset is included in the latest date on which it can repay regardless of early repayment whereas the liability is included at the earliest possible date that the conditions could be fulfilled without considering the probability of the conditions being met. For example, if a structured note is automatically prepaid when an equity index exceeds a certain level, the cash outflow will be included in the less than three months period whatever the level of the index at the year end. The settlement date of debt securities in issue issued by certain securitisation vehicles consolidated by the Group depends on when cash flows are received from the securitised assets. Where these assets are prepayable, the timing of the cash outflow relating to securities assumes that each asset will be prepaid at the earliest possible date. As the repayment of assets and liabilities are linked, the repayment of assets in securitisations are shown on the earliest date that the asset can be prepaid as this is the basis used for liabilities.
 
Assets and liabilities with a contractual maturity of greater than 20 years – the principal amounts of financial assets and liabilities that are repayable after 20 years or where the counterparty has no right to repayment of the principal are excluded from the table as are interest payments after 20 years.
 
Held-for-trading assets and liabilities – held-for-trading assets and liabilities amounting to £1,226.8 billion (assets) and £1,146.7 billion (liabilities) (2007 – £678.6 billion assets, £478.6 billion liabilities) have been excluded from the table in view of their short term nature.
 
This contractual analysis highlights the maturity transformation of the balance sheet that is fundamental to the structure of banking. In practice, this is not a reflection of the actual behaviour of assets or liabilities. In particular the customer funding of the balance sheet exhibits much greater stability and maturity than the tables indicate. This is because the funding franchise of the Group is diversified across an extensive retail network.
 
Regulatory environment (audited)
The Group is subject to the FSA’s liquidity regime, whilst overseas subsidiaries and branches are subject to local regimes.
 
Sterling liquidity
The FSA requires the Group, on a consolidated basis, to maintain daily a minimum ratio of 100% between:
 
a stock of qualifying high quality liquid assets (primarily UK and EU government securities, treasury bills and cash held in branches); and
 
the sum of: sterling wholesale net outflows contractually due within five working days (offset up to a limit of 50%, by 85% of sterling certificates of deposit held which mature beyond five working days); and 5% of retail deposits with a residual contractual maturity of five working days or less. The FSA also sets an absolute minimum level for the stock of qualifying liquid assets that the Group is required to maintain each day.
 
Given the developments in 2008 the FSA has published new proposals for liquidity management (CP08/22) to replace the current regulatory framework. The FSA is proposing a major overhaul of liquidity risk regulation that will include:
 
Improved systems and controls including governance standards, pricing, intra day systems and collateral management.
 
Individual liquid assessments that will include mandatory scenarios and an analysis of principal liquidity exposure factors.
 
Reporting standards improved both in scope and frequency by enhanced mismatch reporting.
 
Market risk (audited)
Market risk arises from changes in interest rates, foreign currency, credit spread, equity prices and risk related factors such as market volatilities. Market risk is actively managed and aligned with the Group’s risk appetite. Market conditions were difficult throughout 2008 with significant volatility and write-downs across markets and portfolios.
 
The Group manages market risk in the trading and non-trading (treasury) portfolios using the market risk management framework. The framework includes value-at-risk (VaR) limits, backtesting, stress testing, scenario analysis, position/sensitivity analysis and model validation.
 
The focus through 2008 has been on overhauling and reviewing the market risk limits for trading book activities, reflecting market performance and events.
 
Measurement (audited)
A number of techniques are used to calculate the Group’s exposure to market risk, including VaR, sensitivity analysis and stress testing.
 
VaR is a technique that produces estimates of the potential change in the market value of a portfolio over a specified time horizon at given confidence levels. For internal risk management purposes, the Group’s VaR assumes a time horizon of one trading day and a confidence level of 95%. The trading book market risk is calculated using VaR at a confidence level of 99% and a time horizon of ten trading days. From 2009, the Group is adopting 99% confidence limits, in line with industry practice.
 
The Group calculates VaR using historical simulation models but does not make any assumption about the nature or type of underlying loss distribution. The methodology uses the previous 500 trading days of market data and calculates both general market risk (i.e. the risk due to movement in general market benchmarks) and idiosyncratic market risk (i.e. the risk due to movements in the value of securities by reference to specific issuers). All VaR models have limitations, which 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.
 
VaR using a one-day time horizon does not fully capture the market risk of positions that cannot be liquidated or hedged within one day.
 
VaR using a 95% confidence level does not reflect the extent of potential losses beyond that percentile.
 
Traded portfolios (audited)
The primary focus of the Group’s trading activities is client facilitation. The Group also undertakes:
 
Market making – quoting firm bid (buy) and offer (sell) prices with the intention of profiting from the spread between the quotes.
 
Arbitrage – entering into offsetting positions in different but closely related markets in order to profit from market imperfections.
 
Proprietary activity – taking positions in financial instruments as principal in order to take advantage of anticipated market conditions.
 
Financial instruments held in the Group’s trading portfolios include, but are not limited to: debt securities, loans, deposits, equities, securities sale and repurchase agreements and derivative financial instruments (futures, forwards, swaps and options).
 
The Group participates in exchange traded and over the counter (OTC) derivatives markets. The Group buys and sells financial instruments that are traded or cleared on an exchange, including interest rate swaps, futures and options. Holders of exchange traded instruments provide margin daily with cash or other security at the exchange, to which the holders look for ultimate settlement. The Group also buys and sells financial instruments that are traded OTC, rather than on a recognised exchange. These instruments range from commoditised transactions in derivative markets, to trades where the specific terms are tailored to the requirements of the Group’s customers. In many cases, industry standard documentation is used, most commonly in the form of a master agreement, with individual transaction confirmations.
 
The Group calculates the VaR of trading portfolios at the close of business and positions may change substantially during the course of a trading day. Further controls are in place to limit the Group’s intra-day exposure, such as the calculation of the VaR for selected portfolios. The Group cannot guarantee that losses will not exceed the VaR amounts indicated due to the limitations and nature of VaR measurements.
 
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Assets and liabilities in the trading book are measured at their fair value. Fair value is the amount at which the instrument could be exchanged in a current transaction between willing parties. The fair values are determined following IAS 39 guidance which requires banks to use quoted market prices or valuation techniques (models) that make the maximum use of observable inputs. When marking to market using a model, the valuation methodologies are reviewed and approved either by the market risk function in the business or at Group level. Group Risk provides an independent evaluation of the model for transactions deemed by the Model Product Review Committee (MPRC) to be large, complex and/or innovative. Any profits or losses on the revaluation of positions are recognised in the daily profit and loss.
 
The VaR for the Group’s 2008 trading portfolios segregated by type of market risk exposure is shown below.
 
£ million (unaudited)
 
 
Note:
 
(1) The traded market risk VaR excludes super senior tranches of asset backed CDOs.
 
The average total VaR utilisation increased in 2008 compared with 2007 as a result of increased market volatility. This increase was offset by a reduction in trading book exposure throughout the period, due to a reduction in the size of the inventory held on the balance sheet as a result of sales, reclassification of assets to the non-trading book and write-downs. The average equity VaR increased in 2008 compared with 2007, due to the integration of ABN AMRO from 17 October 2007.
 
   
2008
   
2007
 
   
Average
£m
   
Period end
£m
   
Maximum
£m
   
Minimum
£m
   
Average
£m
   
Period end
£m
   
Maximum
£m
   
Minimum
£m
 
Interest rate
    20.7       26.3       36.5       12.1       12.5       15.0       21.8       7.6  
Credit spread
    37.2       40.4       51.2       26.0       18.8       41.9       45.2       12.6  
Currency
    4.5       8.7       10.5       1.2       2.6       3.0       6.9       1.1  
Equity
    12.3       9.4       19.9       6.0       5.4       14.0       22.0       1.4  
Commodity
    6.7       6.3       18.2             0.2       0.5       1.6        
Diversification
          (43.3 )                       (28.7 )            
Total
    44.6       47.8       60.9       29.9       21.6       45.7       50.1       13.2  

The 2008 data in the table above excludes exposures to super-senior tranches of asset backed CDOs, as VaR no longer produces an appropriate measure of risk for these exposures due to the illiquidity and opaqueness of the pricing of these instruments over an extended period. For these exposures, the maximum potential loss is equal to the aggregate net exposure, which was £1,398 million as at 31 December 2008. For more information, please refer to the discussion of Credit market and related exposures – Super senior CDOs on page 111 and Financial statements: Note 11, Financial instruments – Valuation – level 3 portfolios – collateralised debt obligations on pages 189 and 190.
 
RBS Sempra Commodities LLP, the commodities-marketing joint venture between RBS and Sempra Energy, was formed on 1 April 2008, and its trading risks were included in the disclosed VaR from that date.
 
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Backtesting, stress testing and sensitivity analysis (audited)
The Group undertakes a programme of daily backtesting, which compares the actual profit or loss realised in trading activity to the VaR estimation. The results of the backtesting process are one of the methods by which the Group monitors the ongoing suitability of its VaR model.
 
A ‘Risks not in VaR’ framework has been developed to address those market risks not adequately captured by the market standard VaR methodology. Where risks are not included in the model various non-VaR controls (e.g. position monitoring, sensitivity limits, triggers or stress limits) are in place.
 
The Group undertakes daily stress testing to identify the potential losses in excess of VaR. Stress testing is used to calculate a range of trading book exposures which result from exceptional but plausible market events. 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 market stress test limit for the Group. The Group calculates historical stress tests and hypothetical stress tests.
 
Historical stress tests calculate the loss that would be generated if the market movements that occurred during historical market events were repeated. Hypothetical stress tests calculate the loss that would be generated if a specific set of adverse market movements were to occur.
 
Stress testing is also undertaken at key trading strategy level, for those strategies where the associated market risks are not adequately captured by VaR. Stress test exposures are discussed with senior management and are reported to GRC, GEMC and the Board. Breaches in the Group’s market risk stress testing limits are monitored and reported.
 
In addition to VaR and stress testing, the Group calculates a wide range of sensitivity and position risk measures, for example interest rate ladders or option revaluation matrices. These measures provide valuable additional controls, often at individual desk or strategy level.
 
Model validation governance (audited)
Pricing models are developed and owned by the front office. Where pricing models are used as the basis of books and records valuations, they are all subject to independent review and sign-off. Models are assessed by MPRC as having either immaterial or material model risk (valuation uncertainty arising from choice of modelling assumptions), the assessment being made on the basis of expert judgement. Those models assessed as having material model risk are prioritised for independent quantitative review. Independent quantitative review aims to quantify model risk by comparing model outputs against alternative independently developed models. The results of independent quantitative review are used by Market Risk to inform risk limits and by Finance to inform reserves. Governance over this process is provided by MPRC, a forum which brings together front office quants, market risk, finance and QuaRC (Quantitative Research Centre, Group Risk’s independent quantitative model review function). Risk (market risk, incremental default risk, counterparty credit risk) models are developed both within business units and by Group functions. Risk models are also subject to independent review and sign-off. Meetings are held with the FSA every quarter to discuss the traded market risk, including changes in models, management, back testing results, other risks not included in the VaR framework and other model performance statistics.
 
Risk control (audited)
All divisions that are exposed to market risk in the course of their business are required to comply with the requirements of the Group’s Market Risk Policy Standards (MRPS). The main risk management tools are delegated authorities, specifically hard limits and discussion triggers, independent model valuation, a robust and efficient risk system and timely and accurate management information.
 
Limits form part of the dealing authorities and constitute one of the cornerstones of the market risk management framework. Upon notification of a limit breach, the appropriate body must take one of the following actions:
 
Instructions can be given to reduce positions so as to bring the Group within the agreed limits.
 
A temporary increase in the limit (for instance, in order to allow orderly unwinding of positions) can be granted.
 
A permanent increase in the limit can be granted.
 
Non-traded portfolios (audited)
Risks in non-traded portfolios mainly arise in retail and commercial banking assets and liabilities and financial investments designated as available-for-sale and held-to-maturity.
 
Group Treasury is responsible for setting and monitoring the adequacy and effectiveness of management, using a framework that identifies, measures, monitors and controls the underlying risk. GALCO approves the Group’s non-traded market risk appetite, expressed as statistical and non-statistical risk limits, which are delegated to the businesses responsible.
 
Various banking regulators review non-trading market risk as part of their regulatory oversight. As home regulator, the FSA has responsibility for reviewing non-trading market risk at a Group consolidated level.
 
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The Group is exposed to the following non-traded risks:
 
Interest Rate Risk in the Banking Book (IRRBB) represents exposures to instruments whose values vary with the level or volatility of interest rates. These instruments include, but are not limited to, loans, debt securities, equity shares, deposits, certificates of deposits, and other debt securities issued, loan capital and derivatives. Hedging instruments used to mitigate these risks include related derivatives such as options, futures, forwards and swaps. Interest rate risk arises from the Group’s non-trading activities in four principal forms:
 
Repricing risk – arises from differences in the repricing terms of the Group’s assets and liabilities.
 
Optionality – arises where a customer has an option to exit a deal early.
 
Basis risk – arises, for example, where one month LIBOR is used to fund base rate assets.
 
Yield curve risk – arises as a result of non-parallel changes in the yield curve.
 
From an economic perspective, it is the Group’s policy to minimise the sensitivity to changes in interest rates in its retail and commercial businesses and, where interest rate risk is retained, to ensure that appropriate resources, measures and limits are applied.
 
Non-trading interest rate risk is calculated in each business on the basis of establishing the repricing behaviour of each asset, liability and off-balance sheet product. For many retail and commercial products, the actual interest rate repricing characteristics differ from the contractual repricing. In most cases, the repricing maturity is determined by the market interest rate that most closely fits the historical behaviour of the product interest rate. For non-interest bearing current accounts, the repricing maturity is determined by the stability of the portfolio. The repricing maturities used are approved by Group Treasury and divisional asset and liability committees at least annually. Key conventions are reviewed annually by GALCO.
 
A static maturity gap report is produced as at the month-end for each business, in each functional currency based on the behavioural repricing for each product. It is Group policy to include in the gap report, non-financial assets and liabilities, mainly property, plant and equipment and the Group’s capital and reserves, spread over medium and longer term maturities. The report includes hedge transactions, principally derivatives.
 
Any residual non-trading interest rate exposures are controlled by limiting repricing mismatches in the individual business balance sheets. Potential exposures to interest rate movements in the medium to long-term are measured and controlled using a version of the same VaR methodology that is used for the Group’s trading portfolios. Net accrual income exposures are measured and controlled in terms of sensitivity over time to movements in interest rates.
 
Risk is managed within VaR limits approved by GALCO, through the execution of cash and derivative instruments (see Note 13 on the accounts, on page 199). Execution of the hedging is carried out by the relevant division through the Group’s treasury functions. The residual risk position is reported to divisional asset and liability committees, GALCO and the Board.
 
Foreign Exchange Risk in the Banking Book (FXRBB) represents exposures to changes in the values of current holdings and future cashflows denominated in other currencies. Hedging instruments used to mitigate these risks include foreign currency options, currency swaps, futures, forwards and deposits. Foreign exchange risk results from the Group’s investments in overseas subsidiaries, associates and branches in three principal forms:
 
(i)
Structural foreign currency exposures that arise from net investment in overseas subsidiaries, associates and branches;
 
(ii)
Transactional/commercial foreign currency exposures that arise from mismatches in the currency balance sheet; and
 
(iii)
Foreign currency profit streams.
 
Equity Risk in the Banking Book (ERBB) is defined as the potential variation in the Group’s non-trading income and reserves arising from changes in equity prices/income. This risk may crystallise during the course of normal business activities or in stressed market conditions. Equity positions in the Group’s banking book are retained to achieve strategic objectives, support venture capital transactions or in respect of restructuring arrangements. From an economic perspective, it is the Group’s policy to ensure that equity exposures in the banking book are identified, monitored and controlled, with the aim of maximising their potential strategic or business value.
 
The commercial decision to invest in equity holdings is taken by GEMC, GCC or an appropriate sub-committee within delegated authority. Investments of a strategic nature are referred to GEMC for approval; those involving the purchase or sale by the Group or subsidiary companies also require Board approval, after consideration by GEMC.
 
Treasury (audited)
The Group’s treasury activities include its money market business and the management of internal funds flow within the Group’s businesses. In addition, this includes GBM trading portfolio assets that have been reclassified to available-for-sale. 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 £52.0 million at 31 December 2008 (2007 – £5.5 million). During the year the maximum VaR was £52.0 million (2007 – £6.4 million), the minimum £4.8 million (2007 – £1.3 million) and the average £8.3 million (2007 – £3.7 million).
 
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Non-trading interest rate VaR (audited)
Non-trading interest rate VaR for the Group’s treasury and retail and commercial banking activities was £70.6 million at 31 December 2008 (2007 – £42.9 million) with the major exposure being to changes in longer term US dollar interest rates. During 2008, the maximum VaR was £117.6 million (2007 – £53.6 million), the minimum was £53.9 million (2007 – £32.9 million) and the average was £75.1 million (2007 – £43.2 million).
 
A breakdown of the Group’s non-trading VaR on a statutory basis by currency is shown below.
 
     
2008
 £m
     
 
2007
£m
 
EUR
    19.0       4.5  
GBP
    18.3       7.3  
USD
    64.8       52.8  
Other
    4.5       2.6  

 
Citizens Financial Group (CFG) was the main contributor to overall non- trading interest rate VaR. CFG manages non-trading interest rate risk with the objective of minimising accrual accounted earnings volatility. To do so it uses a variety of income simulation and valuation risk measures that more effectively capture the risk to earnings due to mortgage prepayment and competitive deposit pricing behaviour than a VaR-based methodology would. This balance sheet management approach is common for US retail banks. Interest rate risk in the banking book is managed by a professional treasury function which optimises the yield, whilst staying within approved limits on interest rate risk, liquidity and capitalisation.
 
Mortgages, home equity loans and mortgage-backed securities (MBS) comprise a large portion of CFG’s assets. In the US, mortgage and home equity customers may prepay loans without penalty. However, under the requirements of FAS 133, the risk that they may do so cannot be hedged in a cost effective manner and must be born by the lender. Prepayment risk is a primary component of interest rate risk in the banking book at CFG.
 
   
2008
   
2007
 
   
Principal(1)
US$m
   
Carrying amount
US$m
   
Principal(1)
US$m
   
Carrying amount
US$m
 
Total MBS and mortgages
    63,542       63,165       69,948       69,672  
MBS – total
                               
– high grade (AA or AAA rated)
    26,268       25,893       26,848       26,572  
– rated C to A
    602       600              
MBS – commercial
                               
– high grade (AA or AAA rated)
    2,253       2,089       2,205       2,211  
MBS – retail
                               
– high grade (AA or AAA rated)
    24,015       23,804       24,643       24,631  
– rated C to A
    602       600              
Residential Mortgage and Home Equity Loans (non-securitised, fixed rate and ARM, prepayable)
    36,672       36,672       43,100       43,100  
 
Note:
 
(1)   The principal on MBS is the redemption amount on maturity or, in the case of an amortising instrument, the sum of future redemption amounts through the residual life of the security.
 
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In addition to VaR, the following measures are reported to CFG ALCO, Group Treasury, GALCO and the Board:
 
The sensitivity of net accrual earnings to a variety of parallel and non-parallel movements in interest rates.
 
Economic value of equity (EVE) sensitivity to a series of parallel movements in interest rates. EVE is only used within CFG and to meet the FSA prescribed standard shock test of +/- 200bp parallel shock.
 
   
Percent increase/
decrease in CFG EVE(1)
 
(unaudited)
 
2% parallel upward movement in US interest rates
   
2% parallel downward movement in US interest rates (No negative rates allowed)
 
Period end
    (0.7 )     (19.0 )
Maximum
    (18.2 )     (20.8 )
Minimum
    (0.7 )     (4.4 )
Average
    (12.2 )     (12.6 )
 
Note:
 
(1) Economic value of equity is the net present value of assets and liabilities calculated by discounting expected cash flows of each instrument over its expected life. Risk to EVE is quantified by calculating the impact of interest rate changes on the net present value of equity and is expressed as a percentage of CFG regulatory capital.
 
Sensitivity of net interest income (unaudited)
There have been no material changes to the Group’s measurement and management of the sensitivity of net interest income to movement in interest rates.
 
The Group aims, through its management of market risk in non-trading portfolios, to mitigate the effect of prospective interest movements which could reduce future net interest income, whilst balancing the cost of such hedging activities on the current net revenue stream.
 
The table below sets out the effect on future net interest income of a sustained +/-100bp parallel rise/fall in all yield curves.
 
   
Year 1
£m
 
+ 100bp shift in yield curves
    138.9  
– 100bp shift in yield curves
    (234.1 )

 
The interest rate sensitivities in the table above are illustrative only and are based on simplified scenarios.
 
The figures represent the effect on pro forma net interest income of movements of the yield curve based on the Group’s current non-trading interest rate risk profile. This effect however does not incorporate actions that would be taken by the business units to mitigate the effect of this interest rate risk. In reality the business units proactively seek to change the interest rate risk profile to minimise losses and optimise net revenues.
 
The projections also assume that interest rates of all maturities move by the same amount and therefore do not reflect the potential effect on net interest income of some rates changing whilst others remain the same.
 
The projections do not take into account the effect on net interest income of anticipated differences in changes between interest rates and interest rates linked to other bases (such as central bank rates or product rates for which the entity has discretion over the timing and extent of rate changes). The projections make other simplifying assumptions, including that all positions run to maturity and that there are no negative interest rates.
 
Currency risk (audited)
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. Foreign exchange differences arising on the translation of foreign operations are recognised directly in equity together with the effective portion of foreign exchange differences arising on hedging instruments.
 
Equity classification of foreign currency denominated preference share issuances requires that these shares be held on the balance sheet at historic cost. Consequently, these share issuances have the effect of increasing the Group’s structural foreign currency position.
 
The tables below set out the Group’s structural foreign currency exposures:
 
2008
 
Net assets of overseas operations
£m
   
Minority interests
£m
   
Net investments in foreign operations
£m
   
Net investment hedges
£m
   
Structural foreign currency exposures
£m
 
US dollar
    17,480       (19 )     17,499       (3,659 )     13,840  
Euro
    26,943       15,431       11,512       (7,461 )     4,051  
Chinese RMB
    3,928       1,898       2,030       (1,082 )     948  
Other non-sterling
    5,088       621       4,467       (3,096 )     1,371  
      53,439       17,931       35,508       (15,298 )     20,210  

 
2007
                             
US dollar
    14,819       303       14,516       (2,541 )     11,975  
Euro
    46,629       28,647       17,982       (8,818 )     9,164  
Chinese RMB
    2,600             2,600       (1,939 )     661  
Brazilian real
    3,755       3,755                    
Other non-sterling
    3,905       519       3,386       (1,219 )     2,167  
      71,708       33,224       38,484       (14,517 )     23,967  

Retranslation gains and losses on the Group’s net investments in operations together with those on instruments hedging these investments are recognised directly in equity. Changes in foreign currency exchange rates will affect equity in proportion to the structural foreign currency exposure. A five percent strengthening in foreign currencies would result in a gain of £1,010 million (2007 – £1,200 million) recognised in equity, while a five per cent weakening in foreign currencies would result in a loss of £960 million (2007 - £1,140 million) recognised in equity. These movements in equity would offset retranslation effects on the Group's foreign currency denominated risk weighted assets, reducing the sensitivity of the Group's Tier 1 capital ratio to movements in foreign currency exchange rates.
 
Equity risk (audited)
Equity positions are measured at fair value. Fair value calculations are based on available market prices wherever possible. In the event that market prices are not available, fair value is based on appropriate valuation techniques or management estimates.
 
The types, nature and amounts of exchange-traded exposures, private equity exposures, and other exposures vary significantly. Such exposures may take the form of listed and unlisted equity shares, linked equity fund investments, private equity and venture capital investments, preference shares classified as equity and Federal Home Loan Stock.
 
The table below sets out the balance sheet value of equity exposures at December 2008.
 
 
Listed
£m
   
Unlisted
£m
   
Total
£m
 
Equity exposures*
    4,267       3,018       7,285  
 
 
* excludes equity exposures held-for-trading purposes and by insurance/assurance entities
 
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Risk control (unaudited)
The prime risk control mechanism for non-traded market risk exposures is the completion of monthly IRRBB and quarterly FXRBB returns by the Group’s business units, collated as part of month-end reporting by Group Treasury to GALCO. In relation to equity risk, risk is mitigated by proper controls in relation to identification of risk prior to investing.
 
Financial control functions are required to confirm to Group Treasury that returns materially capture all balance sheet items and thus reconcile to core source systems.
 
Monthly returns by the Group’s business units, collated as part of month-end reporting by Group Treasury to GALCO, are used to build a Group IRRBB VaR position and to ensure businesses comply with materiality limits on a pre and post hedge basis for interest rates, as stipulated by Group Treasury.
 
For FXRBB, the Group policy states that any foreign currency exposure is managed to de minimis limits. Group Treasury monitors adherence to this policy via a quarterly return.
 
For both IRRBB and FXRBB information is included in regulatory and statutory returns.
 
Group Market Risk exercise independent oversight and governance of the interest rate and foreign exchange exposures managed in Group Treasury by granting market risk limits in addition to authorising Group Treasury to deal in specific instruments for the purpose of managing the Group's non-trading interest rate and foreign exchange exposures. All market risk methodologies that relate to limits specified under this delegated authority are applied under the direction of Group Market Risk.
 
Insurance risk (unaudited)
The Group is exposed to insurance risk directly through its general and life insurance businesses.
 
Insurance risk arises through fluctuations in the timing, frequency and/or severity of insured events, relative to the expectations at the time of underwriting. Insurance risk is managed in four distinct ways:
 
Underwriting and pricing risk management: is managed through the use of underwriting guidelines which detail the class, nature and type of business that may be accepted, pricing policies by product line and brand and centralised control of wordings and any subsequent changes.
 
Claims risk management: is handled using a range of automated controls and manual processes.
 
Reserving risk management: is the risk that the technical reserves are assessed incorrectly such that insufficient funds have been retained to handle and pay claims as the amounts fall due, both in relation to those claims which have already occurred or will occur in future periods of insurance. Claims development data provides information on the historical pattern of reserving risk.
 
Reinsurance risk management: is used to protect against adverse claims experience on business within normal risk appetite (e.g. catastrophic events, adverse frequency of large claims) and to provide protection on business not within its risk appetite (e.g. quota share reinsurance on certain classes of business).
 
The aggregate amount of business by product and entity is determined through the business plans.
 
Overall, insurance risk is predictable over time, given the large volumes of data. Uncertainty does exist, especially around predictions such as the variations in weather. Risk is minimised through the application of documented risk policies, coupled with governance frameworks.
 
General insurance business
The Group’s focus in its general insurance operation is on high volume, relatively straightforward products. The key insurance risks are as follows:
 
Motor insurance contracts (private and commercial): claims experience varies due to a range of factors, including age, gender and driving experience together with the type of vehicle and location.
 
Property insurance contracts (residential and commercial): the major causes of claims for property insurance are weather (flood, storm), theft, fire, subsidence and various types of accidental damage.
 
Other commercial insurance contracts: risk arises from business interruption and loss arising from the negligence of the insured (liability insurance). Business interruption claims arise from the losses of income, revenue and/or profit as a result of property damage claims. Liability insurance includes employer’s liability and public/products liability.
 
Most general insurance contracts are written 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 to renew or can impose renewal terms by amending the premium, terms and conditions.
 
An analysis of gross and net insurance claims can be found in Note 24 on the report and accounts (see page 216).
 
94

 
Business review continued

 
Life insurance business
The Group’s three regulated life companies, National Westminster Life Assurance Limited, Royal Scottish Assurance plc (RSA) and Direct Line Life Insurance Company Limited, are required to meet minimum capital requirements at all times under the FSA 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 a voluntary buffer above the regulatory minimum. Reserving risk is managed for life businesses through detailed analysis of historical and industry claims data and robust control procedures around reserving models. The Group uses exclusively proportional reinsurance, quota share and surplus, for its life insurance entities.
 
The Group is not exposed to price, currency, credit, or interest risk on unit linked life contracts but it is exposed to variation in management fees. In the UK, the Group also writes insurance contracts with minimum guaranteed death benefits that expose it to the risk that declines in the value of underlying investments may increase the Group’s net exposure to mortality risk.
 
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. Contracts under which the Group does not accept significant insurance risk are classified as investment contracts. Long term business provisions are calculated in accordance with the UK accounting standard FRS 27 ‘Life Assurance’.
 
Estimations (assumptions) including future mortality, morbidity, persistency and levels of expenses are made in calculating actuarial reserves. Key metrics include:
 
Assumptions
 
2008
   
2007
   
2006
 
Valuation interest rate
                 
Term assurance
    2.50%       3.00%       3.00%  
Interest
    2.50%       3.00%       3.00%  
Unit growth
    3.70%       3.50%       3.50%  
Expense inflation
    3.00%       4.00%       4.00%  
 
Sample mortality rates, expressed as deaths per million per annum, for term assurance products (age 40).
 
Mortality
 
2008
per annum
   
2007
per annum
   
2006
per annum
 
Male non-smoker
    723       810       517  
Male smoker
    1,590       1,830       983  
Female non-smoker
    568       460       278  
Female smoker
    1,277       1,310       618  

Expenses:
 
Pre-2000 products – RSA
 
2008
per annum
   
2007
per annum
   
2006
per annum
 
Lifestyle protection plan
    £29.30       £25.18       £28.96  
Mortgage savings plan
    £65.92       £56.67       £65.15  
 
 
Pre-2000 products – NatWest Life
                 
Term assurances
    £26.01       £26.01       £26.01  
Linked life bonds
    £26.01       £26.01       £26.01  
 
 
Post-2000 products
                 
Term assurances
    £23.17       £23.16       £23.16  
Guaranteed bonds
    £25.71       £25.71       £25.71  
 
95

 
Business review continued

 
The key factors that increase the frequency of claims include epidemics or widespread changes in lifestyle.
 
The Group uses base tables of standard mortality appropriate to the type of contract being written and the territory in which the insured person resides. These are adjusted to reflect the Group’s experience and expectations for future mortality improvements as appropriate.
 
Sensitivity factor
Description of sensitivity factor applied
Interest rate and investment return
Change in market interest rates of ±1%
The test allows consistently for similar changes to investment returns and movements in the market value of backing fixed interest securities
Expenses
Increase in maintenance expenses of 10%
Assurance mortality/morbidity
Increase in mortality/morbidity rates for assurance contracts of 5%
Annuitant mortality
Reduction in mortality rates for annuity contracts of 5%

The above UK sensitivity factors are applied through actuarial and statistical models, with the following impact on the financial statements.
 
   
Impact on profit and equity
 
Risk factor
 
Variability
     
2008
 £m
     
2007
£m
 
Interest rates
    +1%       (11 )     (18 )
Interest rates
    –1%       11       15  
Expenses
    +10%       (7 )     (5 )
Assurance mortality/morbidity
    +5%       (9 )     (8 )
Annuitant mortality
    –5%              
 
Reinsurance
The Group uses various types of reinsurance to transfer risk that is outside the Group’s risk appetite, including:
 
Per individual risk excess of loss reinsurance.
 
Catastrophe excess of loss reinsurance.
 
Quota share and surplus reinsurance.
 
Business review continued

 
Operational risk (unaudited)
Operational risk is the risk of financial loss or reputational impact resulting from fraud; human error; ineffective or inadequately designed processes or systems; improper behaviour; legal events; or from external events. Operational risk is an integral and unavoidable part of the Group’s business as it is inherent in the processes it operates to provide services to customers and generate profit for shareholders.
 
An objective of operational risk management is not to remove operational risk altogether, but to manage the risk to an acceptable level, taking into account the cost of minimising the risk with the resultant reduction in exposure. Strategies to manage operational risk include avoidance, transfer, and mitigation by controls or risk acceptance.
 
To ensure appropriate responsibility is allocated for the management, reporting and escalation of operational risk, the Group operates a three lines of defence model which outlines principles for the roles, responsibilities and accountabilities for operational risk management.
 
Operational Risk – three lines of defence model
1st Line of defence
   
2nd Line of defence
   
3rd Line of defence
             
The Business
Accountable for the ownership and day-to-day management and control of operational risk.
   
Operational Risk
Responsible for the implementation and maintenance of the operational risk framework, tools and methodologies.
   
Group Internal Audit
Responsible for providing independent assurance on the design, adequacy and effectiveness of the Group’s system of internal controls.
Responsible for implementing processes in compliance with Group policies.
   
Responsible for oversight and challenge on the adequacy of the risk and control processes operating in the business.
     
Responsible for testing key controls and monitoring compliance with Group policies.
   
 
        
 
The three lines of defence model and the Operational Risk Policy and Principles (ORPP) apply throughout the Group and are implemented taking into account the nature and scale of the underlying business. The ORPP provides the direction for delivering effective operational risk management. It comprises principles, minimum standards and processes that enable the consistent identification, assessment, management, monitoring and reporting of operational risk across the Group. The objectives of the ORPP are to protect the Group from financial loss or damage to its reputation, its customers or staff and to ensure that it meets all necessary regulatory and legal requirements.
 
The Group-wide processes defined in the ORPP are supported by the following key operational risk management techniques:
 
Risk and control assessments: business units identify and assess operational risks to ensure that they are effectively managed, prioritised, documented and aligned to risk appetite.
 
Scenario analysis: scenarios for operational risk are used to assess the possible impact of extreme but plausible operational risk loss events. Scenario assessments provide a forward-looking basis for managing exposures that are beyond the Group’s risk appetite.
 
Loss data management: each business unit’s internal loss data management process captures all operational risk loss events above £10,000. This is used to enhance the adequacy and effectiveness of controls, identify opportunities to prevent or reduce the impact of re-occurrence, identify emerging themes, enable formal loss event reporting and inform risk and control assessments and scenario analysis. Escalation of individual events to senior management is determined by the seriousness of the event. Operational loss events are categorised under the following headings:
 
 
Clients, products and business practices;
 
 
Technology and infrastructure failures;
 
 
Employment practices and workplace safety;
 
 
Internal fraud;
 
 
External fraud;
 
 
Execution, delivery and process management;
 
 
Malicious damage; and
 
 
Disaster and public safety.
 
Key risk indicators: business units monitor key risk indicators against their material risks. These indicators are used to monitor the operational risk profile and exposure to losses against thresholds which trigger risk management actions.
 
New product approval process: ensures that all new products or significant variations to existing products are subject to a comprehensive risk assessment. Products are evaluated and approved by specialist areas and are subject to executive approval prior to launch.
 
 
Business review continued

 
In 2008, the Group introduced a new self-certification process, which requires management to regularly monitor and report on the internal control framework for which they are responsible and regularly review and confirm its adequacy and effectiveness. This includes certifying compliance with the requirements of Group policies.
 
The ORPP requires each business unit to determine appropriate mitigation techniques to reduce its risk exposure to an acceptable level, and that the adequacy and effectiveness of controls and other risk mitigants (e.g. insurance) are tested regularly and the results documented. Where unacceptable control weaknesses are identified, action plans must be produced and tracked to completion.
 
The Group purchases insurance to provide the business with financial protection against specific losses and to comply with statutory or contractual requirements. Insurance is primarily used as an additional risk mitigation tool in controlling the Group’s exposures. However, as insurance only provides protection against financial loss once a risk has crystallised, it is used as a complement to other controls.
 
Operational risk metrics
Reporting forms an integral part of operational risk management. The Group’s risk management processes are designed to ensure that operational risk issues are identified, escalated and managed on a timely basis. Operational risk exposures for each division are reported through monthly risk and control reports, which provide detail on the risk exposures and action plans for each significant business process.
 
Operational risk events that have an actual or potential financial impact in excess of £1 million, or which have a material impact on the Group’s reputation or customers, are escalated and reported to divisional and Group executive.
 
The graph below shows the operational risk events by category and value for 2007 and 2008.
 
Operational risk events by risk category – % of total risk events by count
The chart below shows a similar distribution of loss event numbers across the risk categories in 2008 as those in 2007.
 
 
 
 
Business review continued

 
Operational risk events by category – % of total by value
The charts below show that execution, delivery, and process management accounted for over 60% of losses by value during 2008. This differs from 2007 where a single large value event meant that clients, products and business practices was the largest category.
 
 
Financial crime
Financial crime remains a big challenge for the Group, especially given the sophistication of the criminal fraternity. However, the Group continues to respond to such threats, by continuing to invest in people and processes for both detective and preventative measures especially relating to card fraud and cyber crime. Key initiatives include changes to authentication of payments, ATM security, software enhancements and improvement in counterfeit detection.
 
Physical security environment
The number of physical attacks on our retail business was broadly static in 2008 compared with 2007. Business plans and controls have been enhanced to reflect the increase in size of the global business during the year, for example changes to retail and ATM security and sharing best practice with competitors and law enforcement agencies.
 
Information security
The Group is committed to protecting customer and Group information. Under a Group-wide policy framework, Group Information Security is developing, maintaining and implementing policies and systems to secure such information. All employees and agents of the Group are responsible for the protection of Group assets, systems and information. All customer information is treated as confidential and appropriate security is applied to protect the information. The Group Information Security Policies are aligned to international standards and regulatory requirements.
 
The Group recognises information security, relating to the loss of confidentiality, integrity or availability of our information and systems, as a specific risk, which is managed through a Group Information Security Policy. This is reviewed annually and includes processes for managing and ensuring compliance with the policy. The same standards apply to information controlled by the Group or managed by authorised third parties. The Group continues to invest in programmes to enhance and maintain information security controls and systems. For example, during 2008, security reviews on third party suppliers and vendors were significantly increased.
 
Business continuity
The management of crisis situations and the need to ensure the continuity of business across the Group is a key activity within the risk function. A consistent crisis and incident management framework has been rolled out across the Group, to ensure that any incident is identified, managed and resolved through skilled divisional, country, regional and global teams. A six step methodology is in place within the Group for managing incidents.
 
Key risks and threats that the Group is consistently monitoring from the crisis and incident management perspective include pandemics, terrorism, environmental impacts and technology disruptions.
 
Business continuity plans have been implemented to ensure that the Group can continue key services, products and operations.
 
 
 
Business review continued

 
Other risks (unaudited)
Regulatory risk
Regulatory risk is managed by designing, maintaining and implementing policies and systems in order to ensure effective compliance with all regulatory and legal requirements in the jurisdictions in which the Group operates. The Group’s approach to regulatory risk has three distinct elements:
 
·
The review of potential changes in regulation to ensure that the Group addresses the risks arising from such changes and responds appropriately;
 
·
The monitoring of compliance with existing rules and regulations and the mitigation of the consequences of any inadvertent non compliance; and
 
·
The management of effective relationships with regulators to ensure constructive engagement.
 
Under a Group-wide framework of high-level policies, the Group and its subsidiaries engage co-operatively with all regulatory authorities in all the relevant jurisdictions, whether in response to regulatory change, on-going supervisory requirements or regulatory investigations.
 
During the course of 2008, responsibility for policy and oversight of anti-money laundering, sanctions and counter-terrorist financing moved to the Group Head of Regulatory Risk & Compliance.
 
Reputation risk
Reputation is the body of perceptions and opinions held by the stakeholders of an organisation; customers, suppliers, employees, investors, interest groups, regulators and government. Reputation determines how stakeholders are likely to behave towards an organisation. Reputation risk arises from any activity that could have an adverse impact on the reputation of the Group. There are several important drivers of the reputation of a company (and reputation risk) including: financial performance; corporate governance and quality of management; ethical, social and environmental performance; marketing, innovation and customer relationships; and regulatory compliance and litigation.
 
The Group protects its reputation by understanding and managing reputation risks, including failure to meet the expectations of stakeholders.
 
The Group will only enter into a commercial transaction or customer relationship which is legal and complies with regulatory requirements, has economic substance or business purpose and is not designed or used for inappropriate accounting or tax purposes. The Group takes care to understand the issues that matter most to stakeholders, balance the views of all stakeholders and address them coherently. Risks to the reputation of the Group are identified, assessed, managed, monitored and reported. The Group pays particular attention to the reputation risks associated with the introduction of new products or customer relationships.
 
It is the responsibility of the management of all Group companies, acting through individual business units, to ensure that appropriate controls and procedures are in place to identify and manage the risks to the reputation of the Group arising from their activity.
 
The Board has ultimate responsibility for managing any impact on the reputation of the Group arising from its operations. However all parts of the Group take responsibility for reputation management.
 
Pension risk
The Group is exposed to risk to its defined benefit pension schemes as assets comprise investment portfolios which are held to meet projected liabilities to scheme members. Risk arises because returns from these investments may be less than expected or there may be greater than expected increases in the estimated value of the schemes’ liabilities. In such circumstances, the Group could be obliged, or may choose, to make additional contributions to the schemes.
 
The largest of the schemes, and the main source of pension obligation risk, is the RBS Group Pension Fund. In October 2006, this scheme was closed to new employees.
 
Risk appetite and investment policy are agreed by the Board of Trustees with quantitative and qualitative input from the scheme actuaries and investment advisers. The Board of Trustees also consults with the Group to obtain its view on the appropriate level of risk within the pension fund.
 
The Group maintains an independent review of risk within the Pension Funds.
 
GALCO monitors pension obligation risk which is assessed by estimating the potential funding deficit of the scheme with a twelve month risk horizon, and with a number of different confidence levels. Monte Carlo simulations are used, based on assumptions of statistical distribution of future equity returns, future real and nominal interest rates, sensitivity of asset and liability values to changes in equity returns and real and nominal interest rates, the impact of an adverse change in longevity assumptions and mitigation available to the Group.
 
The most recent funding valuation was carried out as at 31 March 2007. This showed the fund to be in surplus, and therefore there was no need in 2008 for additional payments over and above the regular contributions. The next funding valuation is scheduled to be carried out as at 31 March 2010.
 
 
Business review continued

 
Credit market and related exposures
Explanatory note (unaudited)
These disclosures provide information for certain of the Group’s business activities affected by the unprecedented market events of 2008, the majority of which arose within Global Banking and Markets (GBM). The disclosures are focused around GBM’s credit markets activities, including the conduit business, which have been particularly affected by the widespread market disruptions, as well as similar exposures in US Retail & Commercial (‘Citizens’) and Group Treasury.
 
In preparing these disclosures, the Group took into consideration the leading practice disclosure recommendations of the Financial Stability Forum issued in April 2008.
 
Market background (unaudited)
Overall, 2008 has been characterised by rapid dislocation in financial markets. In many cases, the dramatic liquidity squeeze and rise in funding costs for financial institutions has resulted in reluctance or inability of market participants to transact, and has adversely affected the performance of most financial institutions globally, including the Group. Stock markets have experienced extraordinary falls, and levels of volatility have been at record highs. Commodity prices have reduced sharply in the second half of the year, and credit spreads continued to widen. Market perception of counterparty risk increased and the failure of major credit protection providers caused fair value losses for the Group and other market participants and further increased the costs of mitigating credit exposure. Sustained falls globally in both residential and commercial real estate prices, fund valuations and worsening loan performance combined with a sustained lack of liquidity in the market, resulted in a greater amount of assets being valued at significantly lower prices.
 
An indication of the continued decline in the price of asset backed securities (ABS), in particular those collateralised with sub-prime assets, is shown in the following graph. While not fully representative of the Group’s ABS exposures or pricing basis, the ABX series of indices charted in the graph show, in bond price terms, how differently rated ABS referencing US sub-prime mortgages securitised in 2007 have performed during the year.
 
 
The graph below provides an indication of the change in credit worthiness of corporate entities to which the Group has significant exposure through its credit products in the form of credit derivatives and bonds. The MarkiT iTraxx Europe graph demonstrates the impact of the movement of credit spreads in price terms for a basket of European corporate entities (prices rebased to 100 at the beginning of the year).
 
 
 
Business review continued


The first quarter of 2008 saw a further credit and liquidity shortages experienced during 2007, culminating in the collapse of Bear Stearns in March. The centre of the credit issues remained the ABS market with worsening US economic data supporting higher levels of default expectation in the property market. However, these default expectations started to go beyond the sub-prime market with Alt A and other non-conforming classes of loans particularly seeing significant price deterioration. In addition, wider economic concerns led to heavy fair value losses in the commercial mortgage backed securities (CMBS) market, in corporate debt and in leveraged loan exposures. Following this tightening of conditions, the Group incurred significant losses in March and took steps in April to materially strengthen its capital base through a £12 billion rights issue which was completed in June.
 
During the second quarter ABS prices initially rallied and steadied, however towards the end of the quarter a negative house price trend in the UK became clear, and in the US, market reaction to sub-prime mortgages extended to prime and near prime lending. Corporate credit spreads followed a similar pattern reacting to rising oil prices, inflationary pressures and continuing high LIBOR despite base rate cuts to 5% in April.
 
Credit spreads continued to widen across the market through the third quarter and liquidity levels reduced further, resulting in pressure on banks and economies worldwide. This culminated in the demise of Lehman Brothers in September and further market consolidation and global state intervention to provide support to the banking sector.
 
During the fourth quarter there was a continued lack of confidence in the inter-bank market, with demand for stable investments resulting in US treasuries reaching negative spreads. Corporate and ABS prices fell further particularly in the last two months of the year increasing pressure on banks’ capital positions. The Group moved to strengthen its capital position through an open offer to raise £15 billion, underwritten by the UK government. The year concluded with S&P downgrading the credit ratings of eleven global banks, including the Group.
 
Asset-backed exposures
Significant risk concentrations (audited)
The Group’s credit markets activities gives rise to risk concentrations that have been particularly affected by the market turmoil experienced since the second half of 2007. The Group structures, originates, distributes and trades debt in the form of loan, bond and derivative instruments in all major currencies and debt capital markets in North America, Western Europe, Asia and major emerging markets.
 
During 2008, certain assets identified as being high risk were also transferred to a centrally managed asset unit, set up to provide specific management of this portfolio of higher risk assets. Transferred assets are predominantly ABS and associated protection purchased from monoline insurers and other counterparties.
 
The tables below summarise the net exposures and balance sheet carrying values of these securities by measurement classification and references to sections with further information on specific products.
 
   
Held-for-trading
   
Available-for-sale
   
Loans and receivables
   
Designated at fair value
   
All ABS
 
Net exposure (1)
   
2008
£m
      2007
£m
      2008
£m
      2007
£m
      2008
£m
      2007
£m
      2008
£m
      2007
£m
      2008
£m
      2007
£m
 
RMBS
    24,462       35,105       44,450       27,875       2,578       5       182       90       71,672       63,075  
CMBS
    1,178       2,749       918       977       1,437       626       13       47       3,546       4,399  
CDOs/CLOs
    2,463       7,288       2,538       2,174       1,282                   23       6,283       9,485  
Other ABS
    195       3,479       6,572       5,579       3,621       72       40       186       10,428       9,316  
Total
    28,298       48,621       54,478       36,605       8,918       703       235       346       91,929       86,275  

 
Carrying value (2)
                                                       
RMBS
    27,849       37,280       44,791       27,880       2,618       5       182       90       75,440       65,255  
CMBS
    2,751       3,916       1,126       976       1,437       626       13       37       5,327       5,555  
CDOs/CLOs
    7,774       15,477       9,579       2,173       1,284                   26       18,637       17,676  
Other ABS
    1,505       5,758       6,572       5,579       3,621       72       41       186       11,739       11,595  
Total
    39,879       62,431       62,068       36,608       8,960       703       236       339       111,143       100,081  
 
Notes:
 
(1)
Net exposure is carrying value after taking account of hedge protection purchased from monolines and other counterparties but excludes the effect of counterparty credit valuation adjustment. The protection provides credit protection against the notional and interest cash flows due to the holders of debt instruments in the event of default by the debt security counterparty. The value of the protection is based on the underlying instrument being protected.
 
(2)
Carrying value is the amount recorded on the balance sheet.
 
(3)
Certain instruments have been reclassified from the held-for-trading category to loans and receivables or available-for-sale categories, as permitted by the amendment to IAS 39 issued in October 2008, therefore affecting comparability by measurement classification.
 
 
 
Business review continued

 
Asset backed securities (ABS) are securities that represent an interest in an underlying pool of referenced assets. The referenced pool can comprise any assets which attract a set of associated cash flows but are commonly pools of residential or commercial mortgages and, in the case of Collateralised Debt Obligations (CDOs), the referenced pool may be ABS or other classes of assets. The process by which the risks and rewards of the pool are passed on to investors via the issuance of securities with varying seniority is commonly referred to as securitisation.
 
During 2008, as the problems in the sub-prime sector spread to other asset classes on a global basis and credit spreads widened due to concerns over creditworthiness of underlying assets, securitisation volumes continued to be thin. Over the preceding years GBM had established itself as an active arranger of third-party securitisations and a secondary dealer in these securities, and GBM had therefore accumulated assets that became difficult to sell given market conditions.
 
The Group has exposures to ABS which are predominantly debt securities but can be held in derivative form. These positions had been acquired primarily through the Group’s activities in the US leveraged finance market which were expanded during 2007. These include residential mortgage backed securities (‘RMBS’), commercial mortgage backed securities (‘CMBS’), ABS CDOs and other ABS. In many cases the risk on these assets is hedged via credit derivative protection purchased over the specific asset or relevant ABS indices. The counterparty to some of these hedge transactions are monoline insurers (see Monoline insurers on page 114).
 
The net exposure of the Group’s holdings of ABS increased from £86.3 billion at 31 December 2007 to £91.9 billion by 31 December 2008, where underlying reductions have been more than offset by the effect of exchange rates. The net exposure incorporates hedge protection but excludes counterparty credit valuation adjustments. All hedge protection referred to in the credit market and related exposures section relates to economic hedges that do not qualify for hedge accounting.
 
Through a sustained de-risking exercise the Group made reductions to the overall risk through a combination of direct asset sales and switching to lower risk assets through trading activities. As a large proportion of the ABS are denominated in US dollars, these reductions in exposure were partially offset due to the movement in the exchange rate against sterling.
 
The majority of the Group’s RMBS portfolio at 31 December 2008, in terms of net exposure, was AAA rated guaranteed or effectively guaranteed securities of £51.1 billion, comprising:
 
·
£33.5 billion of US agency securities
 
·
£7.6 billion of Dutch government guaranteed RMBS
 
·
£10.0 billion of European mortgage covered bonds issued by financial institutions
 
 
Business review continued

 
The tables below analyse carrying values of these debt securities by measurement classification and rating and fair value hierarchy level.
 
   
 RMBS
                       
         
Non
   
Prime
                         
   
Sub-prime
   
conforming
   
Guaranteed
   
Other
   
CMBS
   
CDOs/CLOs
   
Other ABS
   
Total
 
2008
    £m       £m       £m       £m       £m       £m       £m       £m  
AAA rated (1)
                                                               
Held-for-trading
    393       203       18,622       6,226       2,306       4,698       380       32,828  
Available-for-sale
    522       1,914       22,546       18,764       982       6,459       4,826       56,013  
Loans and receivables
    431       1,415             476       405       652       1,443       4,822  
Designated at fair value
    16                   166       9                   191  
      1,362       3,532       41,168       25,632       3,702       11,809       6,649       93,854  

BBB- and above rated (1)
                                               
Held-for-trading
    564       79             985       407       1,439       890       4,364  
Available-for-sale
    267       194             338       144       1,642       1,292       3,877  
Loans and receivables
    105       64             94       1,031       561       1,296       3,151  
Designated at fair value
                            4             41       45  
      936       337             1,417       1,586       3,642       3,519       11,437  

Non-investment grade (1)
                                               
Held-for-trading
    636       69             59       38       1,299       120       2,221  
Available-for-sale
    124       74             47             1,057       50       1,352  
Loans and receivables
    30       3                               72       105  
      790       146             106       38       2,356       242       3,678  

Not publicly rated (1)
                                               
Held-for-trading
    1       1       9       2             338       115       466  
Available-for-sale
          1                         421       404       826  
Loans and receivables
                            1       71       810       882  
      1       2       9       2       1       830       1,329       2,174  

Total
                                               
Held-for-trading
    1,594       352       18,631       7,272       2,751       7,774       1,505       39,879  
Available-for-sale
    913       2,183       22,546       19,149       1,126       9,579       6,572       62,068  
Loans and receivables
    566       1,482             570       1,437       1,284       3,621       8,960  
Designated at fair value
    16                   166       13             41       236  
Total
    3,089       4,017       41,177       27,157       5,327       18,637       11,739       111,143  

Of which carried at fair value:
                                               
Level 2 (2)
    2,459       2,485       40,942       26,442       3,316       14,643       6,677       96,964  
Level 3 (3)
    64       50       235       145       574       2,710       1,441       5,219  
      2,523       2,535       41,177       26,587       3,890       17,353       8,118       102,183  
 
Notes:
 
(1)
Credit ratings are based on those from S&P, Fitch or Moody’s and have been mapped on to S&P scale.
 
(2)
Valued using techniques based significantly on observable market data. Instruments in this level are valued using:
 
 
(a)
quoted prices for similar instruments in markets which are not considered to be active; or
 
 
(b)
valuation techniques where all the inputs that have a significant effect on the valuation are directly or indirectly based on observable market data.
 
(3)
Instruments in this category have been valued using a valuation technique where at least one input which could have a significant effect on the instrument’s valuation is not based on observable market data.
 
 
 
Business review continued

 
   
RMBS
                         
               
Prime
                         
2007(1)
 
Sub-prime
£m
   
Non conforming
£m
   
Guaranteed £m
   
Other
£m
   
CMBS
£m
   
CDOs/CLOs
 £m
   
Other ABS
 £m
   
Total
£m
 
Carrying value: credit rating and classification
AAA rated (2)
                                               
Held-for-trading
    1,790       2,093       15,502       12,952       3,285       12,067       3,495       51,184  
Available-for-sale
    139       865       16,545       10,313       964       2,152       5,073       36,051  
Designated at fair value
                      72       37       7             116  
      1,929       2,958       32,047       23,337       4,286       14,226       8,568       87,351  

BBB- and above rated (2)
                                               
Held-for-trading
    2,476       530             557       574       1,509       1,077       6,723  
Available-for-sale
                      18       12       1       208       239  
Loans and receivables
                            626                   626  
Designated at fair value
    2                               17             19  
      2,478       530             575       1,212       1,527       1,285       7,607  

Non-investment grade (2)
                                               
Held-for-trading
    616       146             27       35       1,082       91       1,997  
Available-for-sale
                                        14       14  
Loans and receivables
    5                                     72       77  
Designated at fair value
    16                                           16  
      637       146             27       35       1,082       177       2,104  

Not publicly rated
                                               
Held-for-trading
    191       144       125       131       22       819       1,095       2,527  
Available-for-sale
                                  20       284       304  
Designated at fair value
                                  2       186       188  
      191       144       125       131       22       841       1,565       3,019  

Total
                                               
Held-for-trading
    5,073       2,913       15,627       13,667       3,916       15,477       5,758       62,431  
Available-for-sale
    139       865       16,545       10,331       976       2,173       5,579       36,608  
Loans and receivables
    5                         626             72       703  
Designated at fair value
    18                   72       37       26       186       339  
Total
    5,235       3,778       32,172       24,070       5,555       17,676       11,595       100,081  

Of which:
                                               
                                                 
Level 2 (3)
    5,171       3,598       32,172       24,070       4,929       15,926       11,393       97,259  
Level 3 (4)
    59       180                         1,750       130       2,119  
      5,230       3,778       32,172       24,070       4,929       17,676       11,523       99,378  
 
Notes:
 
(1)
Carrying values at 31 December 2007 above include ABN AMRO’s liquidity portfolio of £18.6 billion of ABS which were part of shared assets then; this portfolio was transferred to RBS Group Treasury in the first half of 2008.
 
(2)
Credit ratings are based on those from rating agencies Standard & Poor’s (S&P), Moody’s and Fitch and have been mapped onto S&P scale.
 
(3)
Valuation is based significantly on observable market data. Instruments in this category are valued using:
 
 
quoted prices for similar instruments or identical instruments in markets which are not considered to be active; or
 
 
valuation techniques where all the inputs that have a significant effect on the valuation are directly or indirectly based on observable market data.
 
(4)
Instruments in this category have been valued using a valuation technique where at least one input which could have a significant effect on the instrument’s valuation is not based on observable market data.
 
 
Business review continued


Residential mortgage-backed securities (audited)
Residential mortgage backed securities (RMBS) are securities that represent an interest in a portfolio of residential mortgages. Repayments made on the underlying mortgages are used to make payments to holders of the RMBS. The risk of the RMBS will vary primarily depending on the quality and geographic region of the underlying mortgage assets and the credit enhancement of the securitisation structure.
 
Several tranches of notes are issued, each secured against the same portfolio of mortgages, but providing differing levels of seniority to match the risk appetite of investors. The most junior (or equity) notes will suffer early capital and interest losses experienced by the referenced mortgage collateral, with each more senior note benefiting from the protection provided by the subordinated notes below. Additional credit enhancements may be provided to the holder of senior RMBS notes, including guarantees over the value of the exposures, often provided by monoline insurers.
 
The main categories of mortgages that serve as collateral to RMBS held by the Group are described below. As can be seen from the table below, the Group’s RMBS portfolio covers a range of geographic locations and different categories are used to classify the exposures depending on the geographical region of the underlying mortgage. These categories are described below. The US market has more established definitions of differing underlying mortgage quality and these are used as the basis for the Group’s RMBS categorisation.
 
Sub-prime mortgages: are loans to sub-prime borrowers typically having weakened credit histories that include payment delinquencies, and potentially more severe problems such as court judgements and bankruptcies. They may also display reduced repayment capacity as measured by credit scores, high debt-to-income ratios, or other criteria indicating heightened risk of default.
 
Non-conforming mortgages (or ‘Alt-A’ used for US exposure) have a higher credit quality than sub-prime mortgages, but lower than those prime borrowers. Within the US mortgage industry, non-conforming mortgages are those that do not meet the lending criteria for US agency mortgages (described below). For non-US mortgages, judgement is applied in identifying loans with similar characteristics to US non-conforming loans and also include self-certified loans. Alt-A describes a category of mortgages in which lenders consider the risk to be greater than prime mortgages though less than sub-prime. The offered interest rate is usually representative of the associated risk level.
 
Guaranteed mortgages are mortgages that form part of a mortgage backed security issuance by a government agency, or in the US an entity that benefits from a guarantee (direct or indirect) provided by the US government. For US RMBS, this category includes, amongst others, RMBS issued by Ginnie Mae, Freddie Mac and Fannie Mae. For European RMBS, this includes mortgages guaranteed by the Dutch Government.
 
Other prime mortgages are those of a higher credit quality than non-conforming and sub-prime mortgages, and exclude guaranteed mortgages.
 
Covered mortgage bonds are debt instruments that have recourse to a pool of mortgage assets, where investors have a preferred claim if a default occurs. These underlying assets are segregated from the other assets held by the issuing entity. These underlying assets are segregated from other assets held by the issuing entity.
 
The tables below show the Group’s RMBS net exposures and carrying values by measurement classification, underlying asset type, the main geographical locations of the property that the mortgage is secured against, and the year in which the underlying mortgage was originated.
 
   
2008
   
2007
 
               
Prime
                     
Prime
       
   
Sub-prime
   
Non conforming
   
Guaranteed
(2)
   
Other(3)
   
Total
   
Sub-prime
   
Non conforming
   
Guaranteed
(2)
   
Other(3)
   
Total
 
      £m       £m       £m       £m       £m       £m       £m       £m       £m       £m  
Net exposure: (1)
                                                                               
Held-for-trading
    345       346       18,631       5,140       24,462       3,497       2,913       15,627       13,068       35,105  
Available-for-sale
    572       2,184       22,546       19,148       44,450       139       865       16,539       10,332       27,875  
Loans and receivables
    527       1,482             569       2,578       5                         5  
Designated at fair value
    16                   166       182       18                   72       90  
      1,460       4,012       41,177       25,023       71,672       3,659       3,778       32,166       23,472       63,075  

Carrying values: (2)
                                                           
Held-for-trading
    1,594       352       18,631       7,272       27,849       5,073       2,913       15,627       13,667       37,280  
Available-for-sale
    913       2,183       22,546       19,149       44,791       139       865       16,545       10,331       27,880  
Loans and receivables
    566       1,482             570       2,618       5                         5  
Designated at fair value
    16                   166       182       18                   72       90  
      3,089       4,017       41,177       27,157       75,440       5,235       3,778       32,172       24,070       65,255  
 
Notes:
 
(1)
Net exposures reflect the effect of hedge protection purchased from monolines and other counterparties but excludes the effect of counterparty credit valuation adjustment. Carrying value is the amount recorded on the balance sheet.
 
(2)
Prime guaranteed exposures and carrying values include:
 
 
·
£7.6 billion (2007 – £6.0 billion) available-for-sale exposures guaranteed by the Dutch government
 
 
·
£5.7 billion (2007 – £5.0 billion) guaranteed by US government via Ginnie Mae of which £0.5 billion (2007 – £0.3 billion) are held-for-trading
 
 
·
£27.8 billion (2007 – £21.0 million) effectively guaranteed by the US government via its support for Freddie Mac and Fannie Mae of which £18.1 billon (2007 – £15.2 billion) are held-for-trading
 
(3)
Other prime mortgage exposures include £10.0 billion (2007 – £7.8 billion) covered European mortgage bonds.
 
 
Business review continued

 
   
2008
   
2007
 
               
Prime
                     
Prime
       
United States
 
Sub-prime
£m
   
Alt-A
£m
   
Guaranteed
£m
   
Other
£m
   
Total
£m
   
Sub-prime
£m
   
Alt-A
£m
   
Guaranteed
£m
   
Other
£m
   
Total
£m
 
Net exposure
                                                           
Held-for-trading
    302       346       18,577       968       20,193       2,953       2,189       15,502       1,419       22,063  
Available-for-sale
    53       760       14,887       4,409       20,109             640       10,504       1,359       12,503  
Loans and receivables
    3                   215       218                                
      358       1,106       33,464       5,592       40,520       2,953       2,829       26,006       2,778       34,566  

Carrying values
                                                           
Held-for-trading
    1,427       352       18,577       1,043       21,399       4,277       2,189       15,502       1,419       23,387  
Available-for-sale
    394       760       14,887       4,409       20,450             640       10,504       1,359       12,503  
Loans and receivables
    3                   215       218                                
      1,824       1,112       33,464       5,667       42,067       4,277       2,829       26,006       2,778       35,890  

Of which originated in:
                                                           
– 2004 and earlier
    474       122       5,534       709       6,839       746       165       2,532       406       3,849  
– 2005
    259       718       6,014       2,675       9,666       1,065       437       3,209       275       4,986  
– 2006
    718       115       1,689       614       3,136       1,734       1,188       5,557       1,017       9,496  
– 2007 and later
    373       157       20,227       1,669       22,426       732       1,039       14,708       1,080       17,559  
      1,824       1,112       33,464       5,667       42,067       4,277       2,829       26,006       2,778       35,890  

 
   
2008
   
2007
 
United Kingdom
 
 
Sub-prime
£m
   
Non
conforming
£m
   
Prime
£m
   
Total
£m
   
Sub-prime
£m
   
Non
conforming
£m
   
Prime
£m
   
Total
£m
 
Net exposure
                                               
Held-for-trading
    33             258       291       150       724       2,411       3,285  
Available-for-sale
    154       1,423       3,446       5,023       7       157       931       1,095  
Loans and receivables
    205       1,482       118       1,805       5                   5  
Designated at fair value
    16             166       182       18             72       90  
      408       2,905       3,988       7,301       180       881       3,414       4,475  

Carrying values:
                                               
Held-for-trading
    70             1,345       1,415       150       724       2,740       3,614  
Available-for-sale
    154       1,423       3,446       5,023       7       157       935       1,099  
Loans and receivables
    205       1,482       118       1,805       5                   5  
Designated at fair value
    16             166       182       18             72       90  
      445       2,905       5,075       8,425       180       881       3,747       4,808  

Of which originated in:
                                               
– 2004 and earlier
    72             815       887       13       22       911       946  
– 2005
    42       652       1,000       1,694       1       10       512       523  
– 2006
    209       756       2,308       3,273       49       110       1,256       1,415  
– 2007 and later
    122       1,497       952       2,571       117       739       1,068       1,924  
      445       2,905       5,075       8,425       180       881       3,747       4,808  
 
 
Business review continued


   
2008
   
2007
 
               
Prime
                     
Prime
       
Europe
 
Sub-prime
£m
   
Guaranteed
£m
   
Covered
£m
   
Other
£m
   
Total
£ml
   
Sub-prime
£m
   
Guaranteed
£m
   
Covered
£m
   
Other
£m
   
Total
£m
 
Net exposure
                                                           
Held-for-trading
    10                   3,898       3,908       321                   9,157       9,478  
Available-for-sale
    57       7,642       10,040       1,106       18,845             6,012       7,822       57       13,891  
Loans and securities
    313                   208       521                                
      380       7,642       10,040       5,212       23,274       321       6,012       7,822       9,214       23,369  

Carrying values
                                                           
Held-for-trading
    30                   4,839       4,869       324                   9,429       9,753  
Available-for-sale
    57       7,642       10,040       1,107       18,846             6,012       7,822       57       13,891  
Loans and securities
    352                   208       560                                
      439       7,642       10,040       6,154       24,275       324       6,012       7,822       9,486       23,644  

Of which originated in:
                                                           
– 2004 and earlier
    48       418       702       954       2,122       81       367       577       1,395       2,420  
– 2005
    17       1,165       2,993       1,090       5,265       33       1,117       2,160       1,946       5,256  
– 2006
    148       2,059       4,466       2,466       9,139       63       1,780       3,801       3,897       9,541  
– 2007 and later
    226       4,000       1,879       1,644       7,749       147       2,748       1,284       2,248       6,427  
      439       7,642       10,040       6,154       24,275       324       6,012       7,822       9,486       23,644  
 
In other geographical regions not covered above, RMBS portfolios included:
 
·
net RMBS exposures of £314 million (2007 – £205 million) comprising: held-for-trading nil (2007 – £73 million); available-for-sale £308 million (2007 – £132 million) and loans and receivables £6 million (2007 – nil).
 
·
RMBS carrying values of £381 million (2007 – £454 million) comprising: held-for-trading £67 million (2007 – £322 million); available-for-sale £308 million (2007 – £132) and loans and receivables £6 million (2007 – nil).
 
·
RMBS non-conforming available-for-sale net exposures and carry values of nil (2007 – £68 million).
 
 
Business review continued

 
The Group’s largest concentration of RMBS assets relate to a portfolio of US agency asset backed securities comprising mainly current year vintage positions of £33.5 billion at 31 December 2008 (2007: £26.0 billion). Due to the US government backing explicit or implicit in these securities, the counterparty credit risk exposure is low. The losses arising from the movements in fair value recorded for these assets were comparatively lower than other RMBS. Financial markets and economic conditions have been extremely difficult in the US throughout 2008, particularly in the last quarter. Credit conditions have deteriorated and financial markets have experienced widespread illiquidity and elevated levels of volatility due to forced de-leveraging. Transaction activity in the securities portfolio has been reduced due to general market illiquidity. Residential mortgages have been affected by the stress that consumers experienced from depreciating house prices, rising unemployment and tighter credit conditions, resulting in higher levels of delinquencies and foreclosures. In particular, the deteriorating economy and financial markets have negatively impacted the valuation, liquidity, and credit quality of private-label securities.
 
Citizens maintains an available-for-sale investment securities portfolio to provide high-quality collateral to provide a liquidity buffer and to enhance earnings. The size of the portfolio has been relatively stable through 2008, but both the absolute and relative size (% of earning assets) declined in 2006-2007. The portfolio comprises high credit quality mortgage-backed securities, to ensure both pledgeability and liquidity. The U.S. Government guarantees on MBS, whether explicit or implicit, put most of the portfolio in a secure credit position. The non-agency MBS holdings derive credit support in two ways. Firstly, there is senior and subordinated structuring, and Citizens hold only the most senior tranches. Secondly, there is high quality supporting loan collateral. The collateral quality is evidenced (a) by the vintages, with 82% issued in 2005 and earlier, (b) by the borrower’s weighted loan to value (LTV) ratio of 65%, and (c) by the borrower’s weighted-average FICO score of 734.
 
£7.6 billion (2007 – £6.0 billion) of the RMBS exposure consists of available-for-sale portfolio of European RMBS in Group Treasury, referencing primarily Dutch and Spanish government-backed loans, and accordingly the quality of these assets has held up relative to other RMBS types. A further £10.0 billion (2007 – £7.8 billion) European RMBS comprised covered mortgage bonds.
 
The Group has other portfolios of RMBS from secondary trading activities, warehoused positions previously acquired with the intention of further securitisation and a portfolio of assets from the unwinding of a securities arbitrage conduit. This conduit was established to benefit from the margin between the assets purchased and the notes issued. The majority of these held-for-trading RMBS have been grouped together for management purposes.
 
Some of these assets (£7.0 billion) were reclassified from held-for-trading category to the loans and receivables (£1.8 billion) and available-for-sale categories during the year (£5.2 billion).
 
Overall, the Group has recognised significant fair value losses on RMBS assets during the year due to reduced market liquidity and deteriorating credit ratings of these assets. The Group has reduced its exposure to RMBS predominantly through fair value hedges and asset sales during the year. These decreases were partially offset by the weakening of sterling relative to the US dollar and euro.
 
Commercial mortgage-backed securities (audited)
Commercial mortgages backed securities (CMBS) are securities that are secured by mortgage loans on commercial land and buildings. The securities are structured in the same way as an RMBS but typically the underlying assets referenced will be of greater individual value. The performance of the securities are highly dependent upon the sector of commercial property referenced and the geographical region.
 
The Group accumulated CMBS for the purpose of securitisation and secondary trading. The largest holding of CMBS arose as a result of the Group’s purchase of senior tranches in mezzanine and high grade CMBS structures from third parties. These securities are predominantly hedged with monoline insurers. As a result, the Group’s risk is limited to the counterparty credit risk exposure to the hedge. The Group also holds CMBS arising from securitisations of European commercial mortgages originated by the Group.
 
The following table shows the composition of the Group’s holdings of CMBS portfolios.
 
   
2008
   
2007
 
   
US
£m
   
UK
£m
   
Europe
£m
   
ROW(1)
£m
   
Total
£m
   
US
£m
   
UK
£m
   
Europe
£m
   
ROW
£m
   
Total
£m
 
Office
    435       938       402             1,775       599       534                   1,133  
Mixed use
    32       106       1,048       45       1,231             73       192             265  
Healthcare
    805       143                   948       1,210                         1,210  
Retail
    295       43       17       48       403       398       13                   411  
Industry
    24       13       81             118       61                   100       161  
Multi-family
    40             49             89       48                         48  
Leisure
          76                   76                                
Hotel
    40       35                   75       36                         36  
Other
    474       41       49       48       612       932       530       765       64       2,291  
      2,145       1,395       1,646       141       5,327       3,284       1,150       957       164       5,555  
 
Note:
 
(1)
Rest of the World.
 
 
Business review continued


Asset-backed collateralised debt and loan obligations (audited)
Collateralised debt obligations are securities whose performance is dependant on a portfolio of referenced underlying securitised assets. The referenced assets generally consist of ABS, but may also include other classes of assets. Collateralised loan obligations represent securities in special purpose entities, the assets of which are primarily cash flows from underlying leveraged loans.
 
The Group’s ABS CDO and CLO net exposures comprised:
 
      2008
£m
      2007
£m
 
Super senior CDOs
    1,375       3,834  
Other CDOs
    1,465       1,569  
CLOs
    3,443       4,082  
      6,283       9,485  

The Group’s CDO exposures comprise CDOs structured by the Group from 2003 to 2007 that were unable to be sold to third parties due to prevailing illiquid markets with net exposures of £1.4 billion (2007 – £3.8 billion), as well as other CDO net exposures of £1.5 billion (2007 – £1.6 billion) purchased from third parties some of which are fully hedged through CDSs with other banks or monoline insurers.
 
 
Business review continued

 
Super senior CDOs
Super senior CDOs represent the most senior positions in a CDO, having subordination instruments (usually represented by a combination of equity, mezzanine and senior notes) which absorb losses before the super senior note is affected. Losses will only be suffered by the super senior note holders after a certain threshold of defaults of the underlying reference assets has been reached. The threshold is usually referred to in percentage terms of defaults of the remaining pool, and known as the ‘attachment point’. These super senior instruments carry an AAA rating at point of origination, or are senior to other AAA rated notes in the same structure. The level of defaults occurring on recent vintage sub-prime mortgages and other asset classes has been higher than originally expected. This has meant that the subordinate positions have diminished significantly in value, credit quality and rating and, as a result, the super senior tranches of the CDOs have a higher probability of suffering losses than at origination. The ratings of the majority of the underlying collateral are now below investment grade.
 
Depending on the quality of the underlying reference assets at issuance, the super senior tranches will be either classified as high grade or mezzanine. The majority of the Group’s total exposure relates to high grade super senior tranches of ABS CDOs. This is based upon the original classification of the deals derived from the underlying reference asset rating quality. The table below summarises the carrying amounts and net exposures after hedge protection of the Group’s super senior CDOs as at 31 December 2008. The collateral rating is determined with reference to S&P ratings where available. Where S&P ratings are not available the lower of Moody’s and Fitch ratings have been used.
 
   
2008
   
2007
 
   
High grade
   
Mezzanine
   
Total
   
High grade
   
Mezzanine
   
Total
 
      £m       £m       £m       £m       £m       £m  
Gross exposure
    7,673       3,720       11,393       6,420       3,040       9,460  
Fair value adjustment
    (3,423 )     (691 )     (4,114 )     (3,347 )     (1,250 )     (4,597 )
      4,250       3,029       7,279       3,073       1,790       4,863  
Write-downs on net open position
    (3,019 )     (2,885 )     (5,904 )     (492 )     (537 )     (1,029 )
Net exposure after hedges
    1,231       144       1,375       2,581       1,253       3,834  

   
%
   
%
   
%
   
%
   
%
   
%
 
Average price
    29       6       21       84       70       79  
Underlying RMBS sub-prime assets (origination)
    69       91       79       69       91       79  

Of which originated in:
                                   
2005 and earlier
    24       23       24       24       23       24  
2006
    28       69       46       28       69       46  
2007
    48       8       30       48       8       30  

Collateral by rating at reporting date: (2)
                                   
AAA
    14             9       36             23  
BBB- and above
    35       5       24       62       31       51  
Non-investment grade
    51       95       67       2       69       26  
                                                 
Attachment point (3)
    29       46       36       29       46       35  
Attachment point post write down
    77       97       88       40       62       50  

Notes:
 
(1)
The above table includes data for two trades liquidated in the last quarter of 2008 to provide consistency with comparatives.
 
(2)
Credit ratings are based on those from rating agencies Standard & Poor’s (S&P), Moody’s and Fitch and have been mapped onto S&P scale.
 
(3)
Attachment point is the minimum level of losses in a portfolio which a tranche is exposed to, as a percentage of the total notional size of the portfolio. For example, a 5 – 10% tranche has an attachment point of 5% and a detachment point of 10%. When the accumulated loss of the reference pool is less than 5% of the total initial notional of the pool, the tranche will not be affected. However, when the loss has exceeded 5%, any further losses will be deducted from the tranche’s notional principal until detachment point, 10%, is reached.
 
The change in net exposure during the year is analysed below.
 
   
High grade
£m
   
Mezzanine
£m
   
Total
£m
 
Net exposure at 1 January 2008
    2,581       1,253       3,834  
Net income statement effect
    (1,836 )     (1,140 )     (2,976 )
Foreign exchange and other movements
    486       31       517  
Net exposure at 31 December 2008
    1,231       144       1,375  

 
Business review continued

 
High grade super senior exposures
As shown in the table below, the majority of the Group’s high grade super senior exposures, represent securities retained in CDO structures originated by the Group.
 
   
Gross exposure
£m
 
Group originated deals
    6,776  
Third party structures
    897  
      7,673  

At origination, the reference assets of the high grade structures predominantly comprised investment grade tranches of sub-prime residential mortgage securitisations along with other senior tranches of some combination of ABS assets, including prime and Alt-A RMBS, CMBS, trust preferred ABS, student loan backed ABS and CDO assets. The underlying assets referenced by these super senior securities are primarily more recent vintages (the year the underlying loan was originated), with 48% being 2007. Generally, loans with more recent vintages carry greater discounts, reflecting the market perception of greater default levels than on earlier loan vintages.
 
The fair value of these assets has fallen significantly during the period, representing the decline in performance in the underlying reference assets and the lack of an active market for the securities. Some of the Group’s holdings (£3.4 billion) have been hedged with monoline counterparties (see page 114).
 
Mezzanine super senior CDOs
The tranches of CDOs have suffered a greater level of price decline than high grade tranches due to the relative credit quality of the underlying assets. As shown in the table below, the majority of the Group’s mezzanine super senior net exposures represent securities retained in CDO structures originated by the Group.
 
   
Gross exposure
£m
 
Group originated deals
    3,565  
Third party structures
    155  
      3,720  
 
 
112

 
Business review continued

 
Other CDOs
The net exposure of the Group’s other senior CDOs was £1.5 billion after hedge protection with bank or monoline counterparties. The unhedged exposures comprise CDOs representing smaller positions with various types of underlying collateral, rating and vintage characteristics. The positions hedged with derivative protection from banks include a number of positions referencing early vintages of RMBS and other ABS assets. The Group therefore has no net exposure to certain CDOs before credit valuation adjustment. Due to the early vintage, the assets underlying these structures have not deteriorated to the same degree as the more recently issued securities. The protection purchased is from banks as opposed to monoline insurers and the credit valuation adjustment on banks is less than on monoline insurers.
 
Additionally, the Group has one exposure that, while not structured as a super senior security, incorporates similar risk characteristics. The exposure results from options sold to a third-party conduit structure on a portfolio of ABS. The Group assumed the risk of these securities only after the first loss protection of had been eroded. The Group also has protection purchased against the remainder of this exposure through a CDS purchased from a monoline insurer.
 
The Group holds other subordinated note positions in CDO vehicles which have experienced significant reductions in value since inception. The majority of these positions are junior notes that have been fully written down by the Group with no ongoing exposure remaining at the balance sheet date.
 
CLOs
Collateralised loan obligations represent securities in special purpose entities (SPEs), the assets of which are primarily cash flows from underlying leveraged loans.
 
The Group has CLO exposures resulting from a number of trading activities. They consist of exposures retained by the Group and from notes purchased from third-party structures. The Group holds super senior securities in two CLO structures which were originated by the Group in 2005 and 2007. The underlying collateral of these structures predominantly references leveraged loans.
 
£2.3 billion of these assets were reclassified from the held-for-trading category to the loans and receivables (£0.8 billion) and available-for-sale (£1.5 billion) categories during the year.
 
Other asset backed securities (audited)
Other assets backed securities are securities issued from securitisation vehicles, similar to those in RMBS and CMBS structures, which reference cashflow generating assets other than mortgages. The wide variety of referenced underlying assets result in diverse asset performance levels.
 
The Group has accumulated these assets from a range of trading and funding activities. The Group’s other asset-backed securities (carrying value) by underlying asset type and geographical region are shown below.
 
   
2008
   
2007
 
   
US
£m
   
UK
£m
   
Europe
£m
   
ROW
£m
   
Total
£m
   
US
£m
   
UK
£m
   
Europe
£m
   
ROW
£m
   
Total
£m
 
Covered bonds
                3,301             3,301                   2,895             2,895  
Auto
    97       29       466       13       605       156       36       108       13       313  
Equipment
    15                   16       31       60       20       20       7       107  
Other consumer
    956       428       118       729       2,231       384       17       56       6       463  
Utilities and energy
    47       19       48       143       257       99       35       34       13       181  
Aircraft leases
    459       24             273       756       287       36       36       141       500  
Other leases
    1       525       455             981       378       135       133       50       696  
Trade receivables
    15       8                   23       68       24       24       9       125  
Film / entertainment
    134                         134       84       30       29       11       154  
Student loans
    953                         953       629       32       32       12       705  
Other
    905       588       711       263       2,467       2,797       1,120       1,200       339       5,456  
      3,582       1,621       5,099       1,437       11,739       4,942       1,485       4,567       601       11,595  
 

 
Business review continued

 
The covered bonds comprise asset-backed securities issued by several Spanish financial institutions. These securities benefit from additional credit enhancement provided by the issuing institutions. The other major asset types that increased since 2007 include other consumer loans by £1.8 billion, leases by £0.5 billion and student loans by £0.2 billion. These and other increases were driven by the weakening of sterling against the US dollar and euro.
 
Other mortgage-related exposures (unaudited)
The Group’s whole loans and warehouse facilities collateralised by mortgages are analysed below. These facilities primarily relate to UK and European mortgages with US mortgages representing £260 million of whole loans, of which more than 75% comprised prime mortgages.
 
   
2008
   
2007
 
   
Whole
loans
£m
   
Warehouse
facilities
£m
   
Whole
loans
£m
   
Warehouse
facilities
£m
 
Prime
    1,905       1,731       453       575  
Commercial
    1,262       409       2,200       900  
Non-conforming
    1,396       1,019       57       1,445  
Sub-prime
    27             97        
      4,590       3,159       2,807       2,920  

Counterparty valuation adjustments (audited)
Credit valuation adjustments
Credit valuation adjustments (CVAs) represent an estimate of the adjustment to fair value that a market participant would make to incorporate the credit risk inherent in counterparty derivative exposures. During 2008, as credit spreads have widened, there has been a significant increase in the CVA as set out in the table below.
 
      2008
£m
      2007
£m
 
Monoline insurers
    5,988       862  
CDPCs
    1,311       44  
Other counterparties
    1,738       263  
Total CVA adjustments
    9,037       1,169  

The widening of credit spreads of corporate and financial institution counterparties during the year contributed to a significant increase in the level of CVA adjustments recorded across all counterparties particularly monoline insurers and credit derivative product companies.
 
The monoline insurer CVA is calculated on a trade-by-trade basis, and is derived using market observable monoline credit spreads. The majority of the monoline CVA is taken against credit derivatives hedging exposures to ABS. The CDPC CVA is calculated using a similar approach. However, in the absence of market observable credit spreads, the cost of hedging the counterparty risk is estimated by analysing the underlying trades and the cost of hedging expected default losses in excess of the capital available in each vehicle.
 
The CVA for all other counterparties, including those in respect of derivatives with banks, is calculated either on a trade-by-trade basis, reflecting the estimated cost of hedging the risk through credit derivatives, or on a portfolio basis reflecting an estimate of the amount a third party would charge to assume the risk.
 
Monoline insurers
The Group has purchased protection from monoline insurers, mainly against specific ABS, CDOs and CLOs. Monoline insurers are entities which specialise in providing credit protection against the notional and interest cash flows due to the holders of debt instruments in the event of default by the debt security counterparty. This protection is typically held in the form of derivatives such as credit default swaps (CDS) referencing the underlying exposures held by the Group.
 
During the year the market value of securities protected by monoline insurers continued to decline as markets deteriorated. As the fair value of the protected assets declined, the fair value of the CDS protection from monoline insurers increased. As the monoline insurers had concentrated their exposures to credit market risks, their perceived credit quality has deteriorated as concerns increased regarding the ability of these counterparties to meet their contractual obligations. This resulted in increased levels of CVA being recorded on the protection asset.
 
The change in exposure during the year has been driven by the increased value of purchased derivative protection and the strengthening of the US dollar against sterling as significantly all of the exposures are US dollar denominated. The combination of greater exposure and widening credit spreads has increased the level of CVA required. Towards the end of the year the Group reached settlement on a group of contracts with one monoline counterparty, thereby reducing the overall exposure.
 
The tables below analyse the Group’s holdings of CDS with monoline counterparties.
 
      2008
£m
      2007
£m
 
Gross exposure to monolines
    11,581       3,409  
Hedges with bank counterparties
    (789 )      
Credit valuation adjustment
    (5,988 )     (862 )
Net exposure to monolines
    4,804       2,547  

 
 
Business review continued

 
The change in CVA is analysed in the table below:
 
      £m  
At 1 January 2008
    862  
CVA realised in 2008
    (1,737 )
Net benefit on counterparty hedges
    304  
Foreign currency movements
    1,086  
Net benefit on reclassified debt securities
    1,916  
Net income statement effect
    3,557  
Balance at 31 December 2008
    5,988  

   
2008
   
2007
 
   
Notional
amount
protected
assets
£m
   
Fair value
protected
assets
£m
   
Gross
exposure
£m
   
Credit
valuation
adjustment
£m
   
Notional
amount
protected
assets
£m
   
Fair
value
protected
assets
£m
   
Gross
exposure
£m
   
Credit
valuation
adjustment
£m
 
AAA/AA rated
                                               
CDOs
                            4,976       3,006       1,970       150  
RMBS
    3       2       1             73       73              
CMBS
    613       496       117       51       3,731       3,421       310       34  
CLOs
    6,506       4,882       1,624       718       9,941       9,702       239       44  
Other ABS
    1,548       990       558       251       4,553       4,388       165       14  
Other
    267       167       100       47       622       516       106       1  
      8,937       6,537       2,400       1,067       23,896       21,106       2,790       243  

A/BBB rated
                                               
CDO of RMBS
    5,385       1,363       4,022       1,938                          
RMBS
    90       63       27       10                          
CMBS
    4,236       1,892       2,344       1,378                          
CLOs
    6,009       4,523       1,486       778                          
Other ABS
    910       433       477       243                          
Other
    265       122       143       79                          
      16,895       8,396       8,499       4,426                          

Sub-investment grade
                                               
CDO of RMBS
    394       32       362       263       918       453       465       465  
RMBS
                                               
CMBS
                                               
CLOs
    350       268       82       60                          
Other ABS
    1,208       1,037       171       123                          
Other
    237       169       68       49       154             154       154  
      2,189       1,506       683       495       1,072       453       619       619  

Total
                                               
CDO of RMBS
    5,779       1,395       4,384       2,201       5,894       3,459       2,435       615  
RMBS
    93       65       28       10       73       73              
CMBS
    4,849       2,388       2,461       1,429       3,731       3,421       310       34  
CLOs
    12,865       9,673       3,192       1,556       9,941       9,702       239       44  
Other ABS
    3,666       2,460       1,206       617       4,553       4,388       165       14  
Other
    769       458       311       175       776       516       260       155  
      28,021       16,439       11,582       5,988       24,968       21,559       3,409       862  

The Group also has indirect exposure through wrapped securities and assets which have an intrinsic credit enhancement from a monoline insurer. These securities are traded with the benefit of this credit enhancement and therefore any deterioration in the credit rating of the monoline is reflected in the market prices for these assets.
 
 
Business review continued

 
Credit derivative product companies
A credit derivative product company (CDPC) is a company that sells protection on credit derivatives. CDPCs are similar to monoline insurers. However, unlike monoline insurers, they are not regulated as insurers.
 
The Group has £4.8 billion of exposures with CDPCs which predominatly relates to tranched credit derivatives. Tranched credit derivatives have exposure to certain default losses that arise in reference portfolio of assets. The Group has bought protection on tranched credit derivatives from CDPCs. The reference portfolios of assets are predominantly investment grade loans and bonds and on average, the trades have exposure to total portfolio default losses that exceed 16% of the portfolio notional up to a level of 50%. CDS spreads have widened and credit protection has become more valuable and the gross exposure to CDPC counterparties has increased. At the same time, the credit quality of CDPC counterparties has declined, reflecting the negative impact of their concentrated credit risk in a declining market. As a result CVA adjustments taken against exposures to these counterparties have increased significantly as described above.
 
The tables below present a comparison of the protected assets and the fair value and CVA of the CDPC protection.
 
   
2008
   
2007
 
      £m       £m  
Gross exposure to CDPCs
    4,776       863  
Credit valuation adjustment
    (1,311 )     (44 )
Net exposure to CDPCs
    3,465       819  

   
2008
   
2007
 
   
Notional
amount
protected
assets
£m
   
Fair value
protected
assets
£m
   
Gross
exposure
£m
   
Credit
valuation
adjustment
£m
   
Notional
amount protected assets
£m
   
Fair value protected
assets
£m
   
Gross
exposure
£m
   
Credit valuation
adjustment
£m
 
AAA/AA rated
    19,092       15,466       3,626       908       20,605       19,742       863       44  
A/BBB rated
    6,147       4,997       1,150       403                          
      25,239       20,463       4,776       1,311       20,605       19,742       863       44  

The movement in the year in CDPC CVA is analysed below:
 
      £m  
At 1 January 2008
    44  
Net benefit on CVA hedges
    533  
Net benefit on FX hedges
    119  
Net income statement effect
    615  
Balance at 31 December 2008
    1,311  
 
 
Business review continued


Leverage finance (audited)
Leveraged finance is commonly employed to facilitate corporate finance transactions, such as acquisitions or buy-outs. A bank acting as a lead manager will typically underwrite the loan, alone or with others, and then syndicate the loan to other participants.
 
The Group’s syndicated loan book represent amounts retained from underwriting positions where the Group was lead manager or underwriter, in excess of the Group’s intended long term participation.
 
Since the beginning of the credit market dislocation in the second half of 2007, investor appetite for leveraged loans and similar risky assets has fallen dramatically, with secondary prices falling due to selling pressure and margins increasing, thus also affecting the primary market. There were a small number of deals executed in the first half of 2008 which were much less significant in overall quantum and leverage and which were priced at less than mid-2007 levels. Concerted efforts to sell positions during the first half of 2008 were only partially successful due to the rapid change in market conditions since origination of the loans. Most of the leveraged finance loans were reclassified from the held-for-trading category to loans and receivables category in the second half of 2008.
 
The table below shows the carrying value of leveraged finance exposures by industry and geography.
 
   
2008
    2007(1)  
   
Americas
£m
   
UK
£m
   
Europe
£m
   
ROW
£m
   
Total
£m
   
Americas
£m
   
UK
£m
   
Europe
£m
   
ROW
£m
   
Total
£m
 
TMT
    1,681       628       402       45       2,756       6,924       424       482       25       7,855  
Retail
    166       550       707       21       1,444       542       1,318       800       49       2,709  
Industrial
    280       391       413             1,084       249       2,003       1,074       44       3,370  
Other
    11       552       141       35       739       25       339       271       13       648  
      2,138       2,121       1,663       101       6,023       7,740       4,084       2,627       131       14,582  

Of which:
                                                           
Held-for-trading
    31       31       41             103       7,607       3,694       689       51       12,041  
Loan and receivables
    2,107       2,090       1,622       101       5,920       133       390       1,938       80       2,541  
      2,138       2,121       1,663       101       6,023       7,740       4,084       2,627       131       14,582  
 
Of which:
                                                           
Drawn
    2,081       2,090       1,453       94       5,718       2,249       4,025       2,478       122       8,874  
Undrawn
    57       31       210       7       305       5,491       59       149       9       5,708  
      2,138       2,121       1,663       101       6,023       7,740       4,084       2,627       131       14,582  

Note:
 
(1)
Leveraged finance as disclosed above for 31 December 2007 has been aligned with definitions used in 2008 and is consequently £76 million higher than previously published.
 
The table below analyses the movement in the amounts reported above.
 
   
Held-for-trading
   
Loans and receivables
 
   
Drawn
£m
   
Undrawn
£m
   
Total
£m
   
Drawn
£m
   
Undrawn
£m
   
Total
£m
 
At 1 January 2008
    6,516       5,525       12,041       2,358       183       2,541  
Reclassifications
    (3,602 )           (3,602 )     3,602             3,602  
Reclassifications – income effect
    216             216       19             19  
Additions
    1,171       682       1,853       235             235  
Sales
    (3,826 )     (1,882 )     (5,708 )     (473 )     (81 )     (554 )
Realised losses on sales
    (298 )           (298 )     (197 )           (197 )
Funded deals
    1,298       (1,298 )                        
Lapsed/collapsed deals
    (415 )     (3,738 )     (4,153 )     (173 )           (173 )
Change in fair value
    (462 )     (156 )     (618 )     n/a       n/a       n/a  
Impairment provisions
    n/a       n/a       n/a       (1,191 )           (1,191 )
Exchange and other movements
    211       161       372       1,603       35       1,638  
Presentation changes
    (778 )     778             (96 )     96        
At 31 December 2008
    31       72       103       5,687       233       5,920  

In addition to the leveraged finance syndicated portfolio discussed above, the Group has £7 billion of portfolio positions, mostly to European companies, that have been classified as loans and receivables since origination.
 
 
Business review continued

 
SPEs and conduits
SPEs (audited)
The Group arranges securitisations to facilitate client transactions and undertakes securitisations to sell financial assets or to fund specific portfolios of assets. The Group also acts as an underwriter and depositor in securitisation transactions involving both client and proprietary transactions. In a securitisation, assets, or interests in a pool of assets, are transferred generally to a special purpose entity (SPE) which then issues liabilities to third party investors. SPEs are vehicles established for a specific, limited purpose, usually do not carry out a business or trade and typically have no employees. They take a variety of legal forms – trusts, partnerships and companies – and fulfil many different functions. As well as being a key element of securitisations, SPEs are also used in fund management activities to segregate custodial duties from the fund management advice provided by the Group.
 
It is primarily the extent of risks and rewards assumed that determines whether these entities are consolidated in the Group’s financial statements. The following section aims to address the significant exposures which arise from the Group’s activities through specific types of SPEs.
 
The Group sponsors and arranges own-asset securitisations, whereby the sale of assets or interests in a pool of assets into an SPE is financed by the issuance of securities to investors. The pool of assets held by the SPE may be originated by the Group, or (in the case of whole loan programmes) purchased from third parties, and may be of varying credit quality. Investors in the debt securities issued by the SPE are rewarded through credit-linked returns, according to the credit rating of their securities. The majority of securitisations are supported through liquidity facilities, other credit enhancements and derivative hedges extended by financial institutions, some of which offer protection against initial defaults in the pool of assets. Thereafter, losses are absorbed by investors in the lowest ranking notes in the priority of payments. Investors in the most senior ranking debt securities are typically shielded from loss, since any subsequent losses may trigger repayment of their initial principal.
 
The Group also employs synthetic structures, where assets are not sold to the SPE, but credit derivatives are used to transfer the credit risk of the assets to an SPE. Securities may then be issued by the SPE to investors, on the back of the credit protection sold to the Group by the SPE.
 
In general residential and commercial mortgages and credit card receivables form the types of assets generally included in cash securitisations, while corporate loans and commercial mortgages typically serve as reference obligations in synthetic securitisations.
 
The Group sponsors own-asset securitisations as a way of diversifying funding sources, managing specific risk concentrations, and achieving capital efficiency. The Group purchases the securities issued in own-asset securitisations set up for funding purposes. During 2008, the Group was able to pledge AAA-rated asset-backed securities as collateral for repurchase agreements with major central banks under schemes such as the Bank of England’s Special Liquidity Scheme, launched in April 2008, which allowed banks to temporarily swap high-quality mortgage-backed and other securities for liquid UK Treasury Bills. This practice has contributed to the Group’s sources of funding during 2008 in the face of the contraction in the UK market for inter-bank lending and the investor base for securitisations.
 
The Group typically does not retain the majority of risks and rewards of own-asset securitisations set up for the purposes of risk diversification and capital efficiency, where the majority of investors tend to be third parties. Therefore, the Group is typically not required to consolidate the related SPEs.
 
The Group has also established whole loan securitisation programmes in the US and UK where assets originated by third parties are warehoused by the Group for securitisation. The majority of these vehicles are not consolidated by the Group, as it is not exposed to the risks and rewards of ownership.
 
Conduits (audited)
The Group sponsors and administers a number of asset-backed commercial paper (ABCP) conduits. A conduit is an SPE that issues commercial paper and uses the proceeds to purchase or fund a pool of assets. The commercial paper is secured on the assets and is redeemed either by further commercial paper issuance, repayment of assets or liquidity drawings. Commercial paper is typically short-dated – the length of time from issuance to maturity of the paper is typically up to three months.
 
The Group’s conduits can be divided into multi-seller conduits and own- asset conduits. In line with market practice, the Group consolidates both types of conduit where it is exposed to the majority of risks and rewards of ownership of these entities. The Group also extends liquidity commitments to multi-seller conduits sponsored by other banks, but typically does not consolidate these entities as it is not exposed the majority of the risks and rewards.
 
Funding and liquidity
The Group’s most significant multi-seller conduits have thus far continued to fund the vast majority of their assets solely through ABCP issuance. There were significant disruptions to the liquidity of the financial markets during the year following the bankruptcy filing of Lehman Brothers in September 2008 and this required a small amount of the assets held in certain conduits to be funded by the Group rather than through ABCP issuance. By the end of 2008 there had been an improvement in market conditions, supported by central bank initiatives, which enabled normal ABCP funding to replace this Group funding of the conduits.
 
The average maturity of ABCP issued by the Group’s conduits as at 31 December 2008 was 72.1 days (2007 – 60.9 days).
 
The total assets held by the Group’s sponsored conduits are £49.9 billion (2007 – £48.1 billion). Since these liquidity facilities are sanctioned on the basis of total conduit purchase commitments, the liquidity facility commitments will exceed the level of assets held, with the difference representing undrawn commitments.
 
 
Business review continued

 
The Group values the funding flexibility and liquidity provided by the ABCP market to fund client- and Group-originated assets. Whereas there are plans to decrease the multi-seller conduit business in line with the Group’s balance sheet, the Group is reviewing the potential for new own-asset conduit structures to add funding diversity.
 
Multi-seller conduits
The multi-seller conduits were established by the Group for the purpose of providing its clients with access to diversified and flexible funding sources. A multi-seller conduit typically purchases or funds assets originated by the banks’ clients. The multi-seller conduits form the vast majority of the Group’s conduit business (69.4% of the total liquidity and credit enhancements committed by the Group). The Group sponsors six multi-seller conduits which finance assets from Europe, North America and Asia-Pacific.
 
Assets purchased or financed by the multi-seller conduits include auto loans, residential mortgages, credit card receivables, consumer loans and trade receivables. All assets held by the conduits are recorded on the Group’s balance sheet either as loans and receivables or debt securities.
 
The third-party assets financed by the conduits are structured with a significant degree of first-loss credit enhancement provided by the originators of the assets. This credit enhancement, which is specific to each transaction, can take the form of over-collateralisation, excess spread or subordinated loan, and typically ensures the conduit asset has a rating equivalent to at least a single-A credit. In addition, and in line with general market practice, the Group provides a small second-loss layer of programme-wide protection to the multi-seller conduits. Given the nature and investment grade equivalent quality of the first loss enhancement provided to the structures, the Group has only a minimal risk of loss on its program wide exposure. The issued ABCP is rated P-1/A1 by Moody’s and Standard & Poor’s.
 
The Group provides liquidity back-up facilities to the conduits it sponsors. These facilities can be drawn upon by the conduits in the event of a disruption in the ABCP market, or when certain trigger events occur such that ABCP cannot be issued. For a very small number of transactions within two of the multi-seller conduits sponsored by the Group these liquidity facilities have been provided by third-party banks. This typically occurs on transactions where the third-party bank does not use, or have, its own conduit vehicles. Conduit commercial paper issuance is managed such that the spread of maturity dates of the issued ABCP mitigates the short-term contingent liquidity risk of providing back-up facilities. Limits sanctioned for such facilities as at 31 December 2008 totalled approximately £42.9 billion (2007 – £49.2 billion).
 
The Group’s maximum exposure to loss on its multi-seller conduits is £43.2 billion (2007 – £49.4 billion), being the total amount of the Group’s liquidity commitments plus the extent of programme-wide credit enhancements which relate to conduit assets for whom liquidity facilities were provided by third parties.
 
Own-asset conduits
The Group also holds three own-asset conduits which fund assets which have been funded at one time by the Group. These vehicles represent 25% of the Group’s conduit business (as a percentage of the total liquidity and credit enhancements committed by the Group), with £14.8 billion of ABCP outstanding at 31 December 2008 (2007 – £10.4 billion). The Group’s maximum exposure to loss on its own-asset conduits is £15.9 billion (2007 – £13.5 billion), being the total drawn and undrawn amount of the Group’s liquidity commitments to these conduits.
 
Securitisation arbitrage conduits
The Group no longer sponsors any securitisation arbitrage conduits. As part of the integration of ABN AMRO and a strategic review of the conduit business, the sole securitisation arbitrage conduit was dissolved in 2008. All of its assets were transferred to a centrally managed asset unit for run-off or sale.
 
The Group’s exposure from both its consolidated conduits, including those to which the Group is economically exposed and those which are shared with the other consortium members, and its involvement with third-party conduits are set out in the following table.
 
 
Business review continued

 
   
2008
   
2007 (1)
 
   
Consolidated
conduits
£m
   
Third party
£m
   
Total
£m
   
Consolidated
conduits
£m
   
Third party
£m
   
Total
£m
 
Total assets held by the conduits
    49,857                   48,070              
                                         
Commercial paper issued
    48,684                   46,532              
                                         
Liquidity and credit enhancements:
                                       
deal specific drawn liquidity
                                               
– drawn
    1,172       3,078       4,250       1,537       2,280       3,817  
– undrawn
    57,929       198       58,127       61,347       490       61,837  
                                                 
programme-wide liquidity
                                               
– drawn
          102       102             250       250  
– undrawn
          504       504       75       899       974  
Programme-wide credit enhancements (2)
    2,391             2,391       3,096             3,096  
      61,492       3,882       65,374       66,055       3,919       69,974  
Maximum exposure to loss (3)
    59,101       3,882       62,983       62,959       3,919       68,878  
 
Notes:
 
(1)
Total assets held by the conduits and commercial paper issued at 31 December 2007 included:
 
 
·
£5.2 billion assets and commercial paper issued relating to and by the Group’s securitisation arbitrage conduit which was dissolved in 2008
 
 
·
£10.7 billion assets (corporate loans) and £10.5 billion commercial paper issued relating to a shared conduit – see below.
 
 
·
£1.3 billion assets relating to reactivated conduits which started to issue commercial paper in the second half of 2008.
 
(2)
Programme-wide credit enhancement.
 
(3)
Maximum exposure to loss is determined as the maximum loss being the maximum amount by borrowers may drawn on their conduits facility for which the Group has provided committed liquidity and credit backstop facilities.
 
 
 
Business review continued

 
The Group’s exposure from the conduit shared with the other consortium members is set out below:
 
     
2008
£m
     
2007
£m
 
Total assets held by the conduits
    13,286       10,650  
                 
Commercial paper issued
    13,028       10,452  
                 
Liquidity and credit enhancements: deal specific drawn liquidity
               
– drawn
    258       198  
– undrawn
    13,566       11,868  
      13,824       12,066  
Maximum exposure to loss
    13,824       12,066  

Collateral analysis, geographic, profile, credit ratings and weighted average lives of the assets in the assets relating to the Group’s consolidated conduits and related undrawn commitments are set out in the tables below.
 
   
2008
   
2007
 
   
Funded assets
         
Liquidity from third
   
Total
   
Funded assets
         
Liquidity from third
   
Total
 
   
Loans
£m
   
Securities
£m
   
Total
£m
   
Undrawn
£m
   
parties
£m
   
exposure
£m
   
Loans
£m
   
Securities
£m
   
Total
£m
   
Undrawn
£m
   
parties
£m
   
exposure
£m
 
Auto loans
    9,924       383       10,307       1,871             12,178       8,066       578       8,644       3,701       (102 )     12,243  
Corporate loans
    430       11,042       11,472       534             12,006       36       8,927       8,963       1,390             10,353  
Credit card receivables
    5,844             5,844       922             6,766       5,104       90       5,194       1,206             6,400  
Trade receivables
    2,745             2,745       1,432       (71 )     4,106       3,068       320       3,388       2,386             5,774  
Student loans
    2,555             2,555       478       (132 )     2,901       335       262       597       1,082       (132 )     1,547  
Consumer loans
    2,371             2,371       409             2,780       1,886             1,886       403             2,289  
Mortgages
                                                                                               
Prime
    4,416       2,250       6,666       1,188             7,854       4,424       2,263       6,687       664             7,351  
Non-conforming
    2,181             2,181       727             2,908       2,343       234       2,577       740             3,317  
Sub-prime
                                        9       117       126       363             489  
Commercial
    1,228       507       1,735       66       (23 )     1,778       799       1,094       1,893       168       (23 )     2,038  
Buy-to-let
                                              61       61       8             69  
CDOs
                                              2,129       2,129       268             2,397  
Other
    1,851       2,130       3,981       1,615             5,596       2,976       2,947       5,923       2,433             8,356  
      33,545       16,312       49,857       9,242       (226 )     58,873       29,046       19,022       48,068       14,812       (257 )     62,623  
 
   
CP funded assets
 
   
Geographic Distribution
   
Weighted
Average life
   
Credt ratings (S&P equivalent)
 
2008
 
UK
£m
   
Europe
£m
   
US
£m
   
ROW
£m
   
Total
£m
   
AAA
£m
   
AA
£m
     
A
£m
   
BBB
£m
   
Below
BBB
£m
 
Auto loans
    801       1,706       7,402       398       10,307       1.7       6,075       883       3,349              
Corporate loans
    1,714       4,347       3,289       2,122       11,472       4.9       10,767       132       573              
Credit card receivables
    633             4,999       212       5,844       0.7       3,465       62       2,171       146        
Trade receivables
    68       922       1,371       384       2,745       0.7       120       1,025       1,600              
Student loans
    144             2,411             2,555       0.3       2,296       144       115              
Consumer loans
    708       1,195       468             2,371       1.7       387       993       923       68        
Mortgages
                                                                                       
Prime
          2,244             4,422       6,666       2.8       2,675       3,876       115              
Non-conforming
    960       1,221                   2,181       4.6       351       368       475       987        
Sub-prime
                                                                 
Commercial
    713       453       74       495       1,735       11.0       274       518       474       469        
Buy-to-let
                                                                 
CDOs
                                                                 
Other
    166       1,198       684       1,933       3,981       3.5       3       958       2,786       234        
      5,907       13,286       20,698       9,966       49,857       2.8       26,413       8,959       12,581       1,904        
 
 
 
Business review continued


   
CP funded assets
 
   
Geographic Distribution
   
Weighted
average life
£m
   
Credt ratings (S&P equivalent)
 
   
UK
£m
   
Europe
£m
   
US
£m
   
ROW
£m
   
Total
£m
   
AAA
£m
   
AA
£m
     
A
£m
   
BBB
£m
   
Below
BBB
£m
 
2007
Auto loans
    2,250       1,259       4,793       341       8,643       1.9       1,457       3,184       3,940       62        
Corporate Loans
    1,127       1,551       4,658       1,627       8,963       6.5       8,838       15       110              
Credit card receivables
    654             4,402       138       5,194       1.0       1,286       913       2,848       147        
Trade receivables
    299       816       1,965       309       3,389       0.9       187       732       2,183       236       51  
Student loans
    140             457             597       1.6       270       311       16              
Consumer loans
    648       724       514             1,886       1.2       1,018       473       395              
Mortgages
                                                                                   
Prime
    276       565       983       4,863       6,687       3.3       1,896       2,181       2,610              
Non-conforming
    1,675       833             69       2,577       5.1       268       1,596       713              
Sub-prime
                9       117       126       0.2       117             9              
Commercial
    1,023       233       198       439       1,893       9.6       746       630       401       116        
Buy-to-let
    61                         61             37       24                      
CDOs
    137       520       1,473             2,130       2.7       2,115       15                    
Other
    579       1,071       1,950       2,323       5,923       2.8       2,362       784       2,652       125        
      8,869       7,572       21,402       10,226       48,069       3.3       20,597       10,858       15,877       686       51  
 
Structured investment vehicles (unaudited)
The Group does not sponsor any structured investment vehicles.
 
 
 
 
Business review continued

 
Investment funds set up and managed by the Group (unaudited)
The Group’s investment funds are managed by RBS Asset Management (RBSAM), which is an integrated asset management business, which manages investments on behalf of third-party institutional and high net worth investors, as well as for the Group. RBSAM is active in most traditional asset classes and employs both fund of funds structures and multi-manager strategies. Its offering includes money market funds, long only funds and alternative investment funds.
 
Money market funds
The Group has established and manages a number of money market funds for its customers. When a new fund is launched, RBSAM as fund manager typically provides a limited amount of seed capital to the funds. RBSAM does not have investments in these funds greater than £25 million. As RBSAM does not have holdings in these funds of significant size and as the risks and rewards of ownership are not with the Group, these funds are not consolidated by the Group.
 
The funds have been authorised by the Irish Financial Services Regulatory Authority as UCITS pursuant to the UCITS Regulations (UCITS Regulations refer to the European Communities’ Undertakings for Collective Investment in Transferable Securities Regulations) and are therefore restricted in the types of investments and borrowings they can make. The structure of the assets within the funds is designed to meet the liabilities of the funds to their investors who have no recourse other than to the assets of the funds. The risks to the Group as a result are restricted to reputational damage if the funds were unable to meet withdrawals when requested on a timely basis or in full.
 
Money market funds had total assets of £13.6 billion at 31 December 2008 (2007 – £11.2 billion). The sub categories of money market funds are:
 
·
£8.0 billion (2007 – £5.1 billion) in Money Funds denominated in sterling, US dollars and euro, which invest in short-dated, highly rated money market securities with the objective of providing security, performance and liquidity.
 
·
£4.9 billion (2007 – £5.5 billion) in multi-manager money market funds denominated in sterling, US dollars and euro, which invest in short dated, highly rated securities.
 
·
£0.7 billion (2007 – £0.6 billion) in Money Funds Plus denominated in sterling, US dollars and euro, which invest in longer-dated, highly rated securities with the objective of providing security, enhanced performance and liquidity.
 
Non-money market funds
RBSAM has also established a number of non-money market funds to enable investors to invest in a range of assets including bonds, equities, hedge funds, private equity and real estate. The Group does not have investments in these funds greater than £200 million. As RBSAM does not have holdings in these funds of significant size and as the risks and rewards of ownership are not with the Group, these funds are not consolidated by the Group.
 
The non-money market funds had total assets of £18.7 billion at 31 December 2008 (31 December 2007 – £19.4 billion). The sub categories of non-money market funds are:
 
·
£16.0 billion (2007 – £17.0 billion) in multi-manager funds, which offer fund of funds products across bond, equity, hedge fund, private equity and real estate asset classes.
 
·
£1.6 billion (2007 – £1.3 billion) in committed capital to private equity investments, which invests primarily in equity and debt securities of private companies.
 
·
£1.1 billion (2007 – £1.1 billion) in credit investments, which invests in various financial instruments.
 
The structure of the assets within the funds is designed to meet the liabilities of the funds to their investors who have no recourse other than to the assets of the funds. The risks to the Group as a result are restricted to reputational damage if the funds were unable to meet withdrawals when requested on a timely basis or in full, and the Group’s own investment in the funds.
 
The Group’s maximum exposure to non-money market funds is represented by the investment in the shares of each fund and was £200 million at 31 December 2008 (2007 – £171 million).
 
 
 
Governance

 
125
127
133
140
141
153
154
 
 
 
Board of directors and secretary

 
Chairman
 
 
 
Appointed to the Board on 19 January 2009, Philip Hampton is currently chairman of J Sainsbury plc. Previously, he was group finance director of Lloyds TSB Group plc, BT Group plc, BG Group plc, British Gas and British Steel plc, an executive director of Lazards and a non-executive director of RMC Group plc. He is also former chairman of UK Financial Investments Limited, the company established to manage the UK Government's shareholding in banks subscribing to its recapitalisation fund, and is a non-executive director of Belgacom SA.
 
 
Executive directors
 
 
 
Appointed to the Board on 1 October 2008 and as Group Chief Executive on 21 November 2008, Stephen Hester was chief executive of The British Land Company PLC. He was previously chief operating officer of Abbey National plc and prior to that he held positions with Credit Suisse First Boston including Chief Financial Officer, Head of Fixed Income and co-Head of European Investment Banking. In February 2008, he was appointed non-executive deputy chairman of Northern Rock plc, a position he relinquished on 1 October 2008. He is also a trustee of The Foundation and Friends of the Royal Botanical Gardens, Kew.
 
 
 
 
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 FSA Practitioner Panel. He was appointed chairman of the Business Commission on Racial Equality in the Workplace in July 2006 and deputy chairman of the Board of the British Bankers Association in September 2007.
 
 
 
 
Appointed to the Board in February 2006, Guy Whittaker joined RBS after spending 25 years with Citigroup where he was the group treasurer based in New York and prior to that had held a number of management positions within the financial markets business based in London.
 


Key to abbreviations
A  member of the Audit Committee
N  member of the Nominations Committee
R  member of the Remuneration Committee
*  independent non-executive director
 
 
 
 

 
Non-executive directors

 
Appointed to the Board in June 2002, Colin Buchan was educated in South Africa and spent the early part of his career in South Africa and the Far East. He has considerable international investment banking experience, as well as experience in very large risk management in the equities business. He was formerly a member of the group management board of UBS AG and head of equities of UBS Warburg, and was the former chairman of UBS Securities Canada Inc. He is chairman of Standard Life Investments Limited and a director of Standard Life plc and Black Rock World Mining Trust Plc.
 
 
 
 
Appointed to the Board in September 2004, Archie Hunter is a chartered accountant. He was Scottish senior partner of KPMG between 1992 and 1999 and president of The Institute of Chartered Accountants of Scotland in 1997/1998. He has extensive professional experience in the UK and North and South America. He is currently chairman of Macfarlane Group plc, a director of Edinburgh US Tracker Trust plc and a governor of the Beatson Institute for Cancer Research.
 
 
 
 
Appointed to the Board in September 2004, Joe MacHale is currently a non-executive director and chairman of the remuneration committee of Brit Insurance Holdings plc, and a trustee and treasurer of MacMillan Cancer Support. He held a number of senior executive positions with J P Morgan between 1979 and 2001 and was latterly chief executive of J P Morgan Europe, Middle East and Africa Region. He is a fellow of the Institute of Chartered Accountants.
 
 
 
 
Appointed to the Board on 1 October 2008, John McFarlane is former chief executive officer of Australia and New Zealand Banking Group Limited. Previously he was a group executive director of Standard Chartered and was head of Citicorp/Citibank in the UK and Ireland. He is currently a non-executive director of Westfield Holdings Limited and a director of Old Oak Holdings Limited. He is a former president of the International Monetary Conference and a former chairman of the Australian Bankers Association. He has previously served as a director of the London Stock Exchange and a member of the Auditing Practices Board.
 
 
 
 
Appointed to the Board on 1 October 2008, Arthur Ryan is the former chairman, chief executive officer and president of Prudential Financial Inc. Previously he held senior positions with Prudential Insurance and the former Chase Manhattan Bank NA. He is currently a non-executive director of Regeneron Pharmaceuticals Inc. and an active member of numerous community boards. He was a founding member of the Financial Services Forum.
 
 
Group General Counsel and Group Secretary

 
Miller McLean was appointed Group Secretary in August 1994. He is a trustee of the Industry and Parliament Trust, non-executive chairman of The Whitehall and Industry Group, and president of the Chartered Institute of Bankers in Scotland.
 
 
 
Report of the directors

 
 
For certain recent developments relating to matters discussed in this report, which is dated 25 February 2009, you should read the “Recent Developments” section of this document.
 
The directors present their report together with the audited accounts for the year ended 31 December 2008.
 
Capital restructuring
In November 2008, HM Treasury announced the establishment of UK Financial Investments Limited, a company wholly owned by the UK Government which will manage, on an arms-length basis, the UK Government’s shareholding in the company and other banks that subscribed to the government’s recapitalisation fund.
 
Following a placing and open offer in December 2008, HM Treasury now holds approximately 58% of the enlarged issued ordinary share capital of the company. In addition, HM Treasury holds £5 billion non- cumulative sterling preference shares in the company.
 
Subsequently, on 19 January 2009, the company announced in conjunction with HM Treasury and UK Financial Investments Limited, that the preference shares held by HM Treasury will be replaced with new ordinary shares. Eligible shareholders will be able to apply to subscribe for approximately £5 billion of new ordinary shares pro rata to their existing shareholdings at a fixed price of 31.75 pence per share by way of an open offer. Any shares not taken up by shareholders in the open offer (or otherwise placed on behalf of the company) will be subscribed for by HM Treasury at a fixed price of 31.75 pence per share and the aggregate proceeds of the open offer will be used to fund the redemption of the preference shares held by HM Treasury, together with the redemption premium on the preference shares, accrued dividend, and commissions payable to HM Treasury on the offer. The preference shares will be redeemed at 101 per cent of their issue price. Dividends will continue to accrue on the preference shares until redemption. This may result in HM Treasury’s shareholding increasing to approximately 70% of the enlarged ordinary share capital of the company.
 
Results and dividends
The loss attributable to the ordinary shareholders of the company for the year ended 31 December 2008 amounted to £24,137 million compared with a profit of £7,303 million for the year ended 31 December 2007, as set out in the consolidated income statement on page 158.
 
The company did not pay an interim dividend in 2008. On 15 September 2008, shareholders received one new ordinary share for every 40 shares held on the record date of 12 September 2008 by way of a capitalisation issue.
 
As part of an agreement with HM Treasury, the company undertook not to pay any dividends on the ordinary shares until such time as the £5 billion non-cumulative sterling preference shares issued to HM Treasury in December 2008 were repaid.
 
Upon redemption of the preference shares as noted above, the restriction on payment of ordinary dividends will be removed. However, it is not the Board’s intention to pay a dividend on ordinary shares in 2009.
 
Business review
Activities
The company is a holding company owning the entire issued ordinary share capital of The Royal Bank of Scotland plc, the principal direct operating subsidiary undertaking of the company. The “Group” comprises the company and all its subsidiary and associated undertakings, including the Royal Bank and NatWest. Details of the principal subsidiary undertakings of the company are shown in Note 16 on the accounts.
 
The Group is engaged principally in providing a wide range of banking, insurance and other financial services. Further details of the organisational structure and business overview of the Group, including the products and services provided by each of its divisions and the competitive markets in which they operate, is contained in the Business review on pages 4 to 5 and 12.
 
The Group is currently undertaking a strategic review that is expected to re-focus the Group on those businesses with clear competitive advantages and attractive marketing positions, primarily in stable, low-to-medium risk sectors.
 
Risk factors
The Group’s future performance and results could be materially different from expected results depending on the outcome of certain potential risks and uncertainties. Details of the principal risk factors the Group faces are given in the Business review on pages 13 to 20.
 
The reported results of the Group are also sensitive to the accounting policies, assumptions and estimates that underlie the preparation of its financial statements. Details of the Group’s critical accounting policies and key sources of accounting judgements are included in the Accounting policies on pages 162 to 172.
 
The Group’s approach to risk management, including its financial risk management objectives and policies and information on the Group’s exposure to price, credit, liquidity and cash flow risk, is discussed in the Risk, capital and liquidity management section of the Business review on pages 57 to 123.
 
Financial performance
A review of the Group’s performance during the year ended 31 December 2008, including details of each division, and the Group’s financial position as at that date is contained in the Business review on pages 34 to 52.
 
Business developments
In October 2007, RFS Holdings B.V. (RFS Holdings), a company jointly owned by the company, Fortis N.V., Fortis SA/NV and Banco Santander S.A. and controlled by the company, completed the acquisition of ABN AMRO Holding N.V. (ABN AMRO).
 
On 3 October 2008, the State of the Netherlands acquired Fortis Bank Nederland (Holding) N.V. (including the Fortis interest in RFS Holdings that represents the remaining Fortis-acquired businesses of ABN AMRO) as well as Fortis’ participation in certain Dutch insurance activities. On 24 December 2008, the Fortis interest in RFS Holdings was transferred from Fortis Bank Nederland (Holding) N.V. into the direct ownership of the State of the Netherlands, subject to completion of certain formalities. On the same date, the State of the Netherlands executed a Deed of Accession with the company, Banco Santander S.A., and RFS Holdings pursuant to which it acceded to the Consortium and Shareholders’ Agreement dated 28 May 2007 (as subsequently amended from time to time).
 
 
 
Report of the directors (continued)

 
RFS Holdings is implementing an orderly separation of the business units of ABN AMRO with the company retaining the following ABN AMRO business units:
 
·
Continuing businesses of Business Unit North America;
 
·
Business Unit Global Clients (excluding the Brazil Global Clients Business) and wholesale clients in the Netherlands (including former Dutch wholesale clients) and Latin America (excluding Brazil);
 
·
Business Unit Asia including Private Clients India and Indonesia; and Interest in Prime Bank, Pakistan (excluding the interest in Saudi Hollandi);
 
·
Business Unit Europe (excluding Antonveneta);
 
Employees
As at 31 December 2008, the Group employed over 199,000 employees (full-time equivalent basis) throughout the world. Details of employee related costs are included in Note 3 on the accounts on page 175.
 
The Group utilises a wide range of recruitment channels to ensure that the recruitment and development of its employees are fully aligned to its organisational requirements.
 
The Group offers a competitive remuneration and benefits package to all employees.
 
Employees are able to participate in incentive plans specific to their business, and the Buy As You Earn and Sharesave schemes align the interests of employees with those of shareholders.
 
Employee learning and development
The Group maintains a strong commitment to creating and providing learning opportunities for all its employees through a variety of personal development and training programmes and learning networks. Employees are encouraged to do voluntary work with community partners.
 
Employee communication
Employee engagement is encouraged through a range of communication channels, at both a divisional and Group level. These channels provide access to news and information in a number of ways, including the intranet, magazines, video, team meetings led by line managers, briefings held by senior managers and regular dialogue with employees and employee representatives.
 
The Group Chief Executive and other senior Group executives regularly communicate with employees across a range of channels.
 
Employee consultation
Each year, all employees are invited to complete the global employee opinion survey. The survey is confidential and independently managed by Towers Perrin-ISR. The survey provides a channel for employees to express their views and opinions about the Group on a range of key issues.
 
In 2008, the response rate was 88%, the second highest response rate since the survey began. This represents over 156,000 employees participating in the survey, from more than 50 countries and in 20 languages. For the first time, this survey was extended to former ABN AMRO employees.
 
The Group recognises employee representative organisations such as trade unions and work councils in a number of businesses and countries. The Group has a European Employee Communication Council that provides elected representatives with an opportunity to understand better the impact on its European operations.
 
Diversity
The Group's Diversity policy and associated policy standards set a framework for broadening the Group’s talent base, achieving the highest levels of performance and enabling all employees to reach their full potential irrespective of age, disability, gender, marital status, political opinion, race, religion or belief or sexual orientation.
 
The Group is also committed to ensuring that all prospective applicants for employment are treated fairly and equitably throughout the recruitment process and its comprehensive resourcing standards cover the attraction and retention of individuals with disabilities. Reasonable adjustments are provided to support applicants in the recruitment process where these are required. The Group provides reasonable workplace adjustments for new entrants into the Group and for existing employees who become disabled during their employment.
 
Safety, health and wellbeing
Protecting its employees and customers from harm is a fundamental principle of the way the Group operates and its goal is to minimise work related injuries and ill health. The Group also recognises that the general health and wellbeing of its employees impacts on their engagement and productivity. Promoting good health, and providing support to its employees when they need it, is therefore also core to its approach.
 
During 2008, the Group focused on the core themes of globalisation of safety, health and wellbeing, improving health and raising awareness, while continuing to manage safety and health risks.
 
Pre-employment screening
The Group has a comprehensive pre-employment screening policy to guard against possible infiltration and employee-related fraud. In addition to existing workplace security measures, all people engaged on Group business are now being screened prior to commencing employment.
 
Code of conduct
The Code of Conduct and related policies forms part of the terms and conditions of employment for all those employed by the Group and sets standards for those not directly employed such as contractors and agency workers.
 
The code supports the Group’s aim to operate in a similar way across the many countries in which it operates and is therefore applicable to employees in all locations. The code is a high level collection of key policies to inform employees of the Group’s expectations of their behaviour and practices.
 
 
 
Report of the directors (continued)

 
Corporate responsibility
The Group believes that meeting high standards of environmental, social and ethical responsibility is key to the way it does business.
 
The Group’s business is managed in a way that takes account of the social and environmental impact of its activities. In order to identify the issues that matter most to its stakeholders, an annual research project is conducted. This work provides the foundation of the corporate responsibility strategy. It enables all parts of the Group to focus their efforts and resources on the most important issues. Having the right management structures in place and clear leadership helps set the framework against which this happens. There are issue-specific steering groups that feed into the Corporate Responsibility Forum, which considers the Group’s current performance and proposes new initiatives. The Group’s governance structure for corporate responsibility extends throughout the organisation.
 
Further details of the Group’s corporate responsibility policies will be contained in the 2008 Corporate Responsibility Report.
 
Going concern
The Group’s business activities and financial position; the factors likely to affect its future development and performance; and its objectives and policies in managing the financial risks to which it is exposed and its capital are discussed in the Business review.
 
As set out in the Business review, recent economic conditions have seen severe dislocation in many financial markets and an unprecedented reduction in liquidity globally. ‘Liquidity risk’ describes the measures governments and central banks in the UK and around the world have taken to provide capital and liquidity to banks. The Group used a number of these funding facilities during 2008 and its funding and capital plans for the next twelve months from the date of approval of these accounts assume continuing reliance on and the continuation of these measures. These plans have been shared with the Tripartite Authorities in the UK.
 
Following the rights issue in June 2008 and the open offer in December 2008, the Group’s capital ratios are at historically high levels and will be further strengthened by the restructuring of the UK Government’s preference shares. The UK Government owns 57.9% of the ordinary share capital of the Group. This could increase to 70.4% following the fully underwritten open offer announced in January 2009 and provides tangible evidence of the UK Government’s support for the Group reflecting its importance to the UK economy and financial system.
 
The directors have reviewed the Group’s forecasts, projections and other relevant evidence including the ongoing measures from governments and central banks in the UK and around the world to sustain the banking sector. Whilst the Group has received no guarantees, the directors have a reasonable expectation, based on experience to date, of continued and sufficient access to the funding facilities referred to above and, accordingly, that the Group and the company will continue in operational existence for the foreseeable future. The financial statements of the Group and of the company have, therefore, been prepared on a going concern basis.
 
Corporate governance
The company is committed to high standards of corporate governance. Details are given on pages 133 to 137.
 
Ordinary share capital
In June 2008, the company issued 6,123 million ordinary shares of 25p each through a rights issue on the basis of 11 new ordinary shares for every 18 existing shares held, at an issue price of £2 per share, raising £12 billion.
 
In September 2008, the company issued 403 million ordinary shares of 25p to existing shareholders by way of a capitalisation issue on the basis of one new ordinary share for every 40 shares held.
 
In December 2008, the company issued 22,910 million ordinary shares of 25p each by way of a Placing and Open Offer on the basis of 18 new ordinary shares for every 13 existing shares held, at an issue price of 65.5 pence per share, raising £14.7 billion. HM Treasury acquired 22,854 million of these shares and now holds 57.9% of the enlarged ordinary share capital of the company.
 
During the year, the ordinary share capital was also increased by 13.5 million ordinary shares allotted as a result of awards and the exercise of options under the company’s share schemes.
 
Details of the authorised and issued ordinary share capital at 31 December 2008 are shown in Note 27 on the accounts.
 
Preference share capital
In December 2008, the company issued 5 million non-cumulative sterling preference shares to HM Treasury at £1,000 per preference share, raising £5 billion.
 
As discussed on page 127, the company, subject to shareholder approval, intends to issue new ordinary shares by way of an open offer, the proceeds from which will be used to redeem the preference shares issued to HM Treasury, together with the accrued dividend.
 
Details of the authorised and issued preference share capital at 31 December 2008 are shown in Note 27 on the accounts.
 
Authority to repurchase shares
At the Annual General Meeting in 2008, shareholders renewed the authority for the company to make market purchases of up to 1,000,710,085 ordinary shares. The directors have not used this authority to date and there is no current intention that the authority will be exercised. This authority will lapse at the conclusion of the AGM of the company in 2009 and no renewal will be sought.
 
Additional information
Where not provided previously in the Report of the directors, the following provides the additional information required to be disclosed by Part 7 of the Companies Act 1985 as amended.
 
The rights and obligations attaching to the company’s ordinary shares and preference shares are set out in the company’s Articles of Association, copies of which can be obtained from Companies House in the UK or at www.rbs.com.
 
On a show of hands at a general meeting of the company every holder of ordinary shares and cumulative preference shares present in person or by proxy and entitled to vote shall have one vote. On a poll, every holder of ordinary shares present in person or by proxy and entitled to vote shall have one vote for every share held. On a poll, holders of
 
 
 
Report of the directors (continued)

 
cumulative preference shares present in person or by proxy and entitled to vote shall have four votes for every share held. The Notice of the Annual General Meeting specifies the deadlines for exercising voting rights and appointing a proxy or proxies to vote in relation to resolutions to be passed at the meeting.
 
The cumulative preference shares represent less than 0.01 % of the total voting rights of the company, the remainder being represented by the ordinary shares.
 
There are no restrictions on the transfer of ordinary shares in the company other than certain restrictions which may from time to time be imposed by laws and regulations (for example, insider trading laws). Pursuant to the Listing Rules of the Financial Services Authority, certain employees of the company require the approval of the company to deal in the company’s shares.
 
A number of the company’s share plans include restrictions on transfers of shares while the shares are subject to the plans, in particular the Employee Share Ownership Plan.
 
The rights and obligations of holders of non-cumulative preference shares are set out in Note 27 on the accounts on pages 227 to 229.
 
The company is not aware of any agreements between shareholders that may result in restrictions on the transfer of securities and/or voting rights. There are no persons holding securities carrying special rights with regard to control of the company.
 
Under the rules of certain employee share plans, eligible employees are entitled to acquire shares in the company, and shares are held in trust for participants by The Royal Bank and Ulster Bank Dublin Trust Company as Trustees. Voting rights are exercised by the Trustees on receipt of participants’ instructions. If a participant does not submit an instruction to the Trustee no vote is registered.
 
The Royal Bank of Scotland Group plc 2001 Employee Share Trust, The Royal Bank of Scotland Group plc 2007 US Employee Share Trust and The Royal Bank of Scotland plc 1992 Employee Share Trust hold shares on behalf of the Group’s employee share plans. The voting rights are exercisable by the Trustees, however, in accordance with investor protection guidelines, the Trustees abstain from voting. The Trustees would take independent advice before accepting any offer in respect of their shareholdings for the company in a takeover bid situation.
 
The rules governing the appointment of directors are set out in Corporate governance on page 133. The company’s Articles of Association may only be amended by a special resolution at a general meeting of shareholders.
 
A change of control of the company following a takeover bid may cause a number of agreements to which the company is party to take effect, alter or terminate. In addition, a number of executive directors' service agreements may be affected on a change of control. All of the company’s employee share plans contain provisions relating to a change of control. Outstanding awards and options may vest and become exercisable on change of control, subject where appropriate to the satisfaction of any performance conditions at that time and pro- rating of awards. In the context of the company as a whole, these agreements are not considered to be significant.
 
Directors
The names and brief biographical details of the directors are shown on pages 125 and 126.
 
Gordon Pell, Guy Whittaker, Colin Buchan, Archie Hunter and Joe MacHale served throughout the year and to the date of signing of the financial statements.
 
Stephen Hester, John McFarlane and Arthur 'Art' Ryan were appointed as directors on 1 October 2008.
 
Johnny Cameron ceased to be a director on 13 October 2008.
 
Sir Fred Goodwin and Mark Fisher ceased to be directors on 21 November 2008.
 
Larry Fish ceased to be a director on 31 December 2008.
 
Sir Tom McKillop ceased to be Chairman on 3 February 2009.
 
Philip Hampton was appointed as a director and Chairman-designate on 19 January 2009 and as Chairman on 3 February 2009.
 
Jim Currie, Bill Friedrich, Bud Koch, Janis Kong, Sir Steve Robson, Bob Scott and Peter Sutherland ceased to be directors on 6 February 2009.
 
Philip Hampton, Stephen Hester, John McFarlane and Arthur ‘Art’ Ryan will retire and offer themselves for election at the forthcoming Annual General Meeting. Details of the service agreement for Stephen Hester are set out on page 143. No other director seeking election has a service agreement.
 
Directors’ interests
The interests of the directors in the shares of the company at 31 December 2008 are shown on page 153. None of the directors held an interest in the loan capital of the company or in the shares or loan capital of any of the subsidiary undertakings of the company, during the period from 1 January 2008 to 25 February 2009.
 
Directors' indemnities
In terms of section 236 of the Companies Act 2006, 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.
 
Directors' disclosure to auditors:
Each of the directors at the date of approval of this report confirms that:
 
(a) 
so far as the director is aware, there is no relevant audit information of which the company’s auditors are unaware; and
 
 
 
Report of the directors (continued)

 
(b)
 the director has taken all the steps that he ought to have taken as a director to make himself aware of any relevant audit information and to establish that the company’s auditors are aware of that information.
 
This confirmation is given and should be interpreted in accordance with the provisions of section 234ZA of the Companies Act 1985.
 
 
Report of the directors (continued)

 
Shareholdings
The table below shows the shareholders that have notified the Group that they hold more than 3% of the voting rights in the undernoted classes of shares as at 31 December 2008.
 
   
Number of shares
   
% held
 
Ordinary shares:
           
Solicitor For The Affairs of Her Majesty’s Treasury As Nominee for Her Majesty’s Treasury
    22,853,798,818       57.92  
11% cumulative preference shares:
               
Guardian Royal Exchange Assurance plc
    129,830       25.97  
Windsor Life Assurance Company Limited
    51,510       10.30  
Cleaning Tokens Limited
    25,500       5.10  
Mr S J and Mrs J A Cockburn
    15,520       3.10  
Mr Stephen J Cockburn
    15,290       3.06  
51/2% cumulative preference shares:
               
Mr P S and Mrs J M Allen; Miss C L Allen, and Miss J C Allen
    112,949       28.23  
Commercial Union Assurance plc
    91,429       22.86  
Bassett-Patrick Securities Limited (1)
    46,255       11.56  
E M Behrens Charitable Trust
    20,000       5.00  
Trustees of The Stephen Cockburn Limited Pension Scheme
    19,879       4.97  
Mrs Gina Wild
    19,800       4.95  
Miss Elizabeth Hill
    16,124       4.03  
Mr W T Hardison Jr.
    13,532       3.38  

Note:
 
(1)
Notification has been received on behalf of Mr A W R Medlock and Mrs H M Medlock that they each have an interest in the holding of 512% cumulative preference shares registered in the name of Bassett-Patrick Securities Limited noted above and that there are further holdings of 5,300 and 5,000 shares, respectively, of that class registered in each of their names.
 

Charitable contributions
In 2008 the contribution to the Group’s Community Investment programmes was £66.3 million (2007 – £57.7 million). The total amount given for charitable purposes by the company and its subsidiary undertakings during the year ended 31 December 2008 was £24.8 million (2007 – £32.1 million).
 
The company’s community investment is focused on the issues most relevant to it as a financial institution, including preventing exclusion from banking services, promoting financial understanding and supporting small businesses and entrepreneurs.
 
Political donations
At the Annual General Meeting in 2006, shareholders gave authority for the company to make political donations and incur political expenditure up to a maximum aggregate sum of £500,000 as a precautionary measure in light of the wide definitions in The Political Parties, Elections and Referendums Act 2000, for a period of four years. These authorities have not been used.
 
No political donations were made during the year and it is not proposed that the Group’s longstanding policy of not making contributions to any political party be changed.
 
Policy and practice on payment of creditors
The Group is committed to maintaining a sound commercial relationship with its suppliers. Consequently, it is the Group’s policy to negotiate and agree terms and conditions with its suppliers, which includes the giving of an undertaking to pay suppliers within 30 days of receipt of a correctly prepared invoice submitted in accordance with the terms of the contract or such other payment period as may be agreed.
 
At 31 December 2008, the Group’s trade creditors represented 30 days (2007 – 30 days) of amounts invoiced by suppliers.
 
Auditors
The auditors, Deloitte LLP, have indicated their willingness to continue in office. A resolution to re-appoint Deloitte LLP as the company’s auditor will be proposed at the forthcoming Annual General Meeting.
 
By order of the Board
 
Miller McLean
Secretary
25 February 2009
 
The Royal Bank of Scotland Group plc
is registered in Scotland No. 45551.
 
 
 
Corporate governance

 
The company is committed to high standards of corporate governance, business integrity and professionalism in all its activities.
 
Throughout the year ended 31 December 2008, the company has complied with all of the provisions of the Combined Code issued by the Financial Reporting Council in June 2006 (the “Code”) except in relation to the provision that the Remuneration Committee should have delegated responsibility for setting remuneration for the Chairman and executive directors. The company considers that this is a matter which should rightly be reserved for the Board. No director is involved in decisions regarding his or her own remuneration.
 
During the period following the changes to the Board on 6 February 2009 to the date of this Report and Accounts, the company has not had a senior independent director and the Remuneration Committee has comprised two independent non-executive directors and the Chairman of the Board, not the three independent non-executive directors required by the Code. The Board is in the process of recruiting three additional independent non-executive directors and plans to appoint a senior independent director and an additional member of the Remuneration Committee as part of the recruitment process.
 
The company has also complied with the Financial Reporting Council Guidance on Audit Committees issued in October 2008 in all material respects.
 
Under the US Sarbanes-Oxley Act of 2002 (the “Act”), specific standards of corporate governance and business and financial disclosures apply to companies with securities registered in the US. The company complies with all applicable sections of the Act.
 
The New York Stock Exchange
As a foreign issuer with American Depositary Shares (ADS) representing ordinary shares, preference shares and debt securities listed on the New York Stock Exchange (NYSE), the company must disclose any significant ways in which its corporate governance practices differ from those followed by US companies under the NYSE’s corporate governance listing standards. In addition, the company must comply fully with the provisions of the listing standards that relate to the composition, responsibilities and operation of audit committees. These provisions incorporate the relevant rules concerning audit committees of the US Securities Exchange Act of 1934.
 
The company has reviewed its corporate governance arrangements and is satisfied that these are consistent with the NYSE’s corporate governance listing practices, with the exception that the Chairman of the Board is Chairman of the Nominations Committee and is a member of the Remuneration Committee, both of which are permitted by the UK Combined Code (since the Chairman was considered independent on appointment). The company’s Audit, Nomination and Remuneration Committees are otherwise composed solely of non-executive directors deemed by the Board to be independent. The NYSE’s corporate governance listing standards also require that a compensation committee has direct responsibility to review and approve Group Chief Executive remuneration. The Board, rather than the Remuneration Committee, reserves the authority to make the final determination of the remuneration of the Group Chief Executive.
 
The Group Audit Committee complies with the provisions of the NYSE’s corporate governance listing standards that relate to the composition, responsibilities and operation of audit committees. In June 2008, the company submitted its required annual written affirmation to the NYSE confirming its full compliance with those and other applicable provisions. More detailed information about the Audit Committee and its work during 2008 is set out in the Audit Committee Report on pages 136 and 137.
 
Board of directors
The Board is the principal decision-making forum for the company. It has overall responsibility for leading and controlling the company and is accountable to shareholders for financial and operational performance. The Board approves Group strategy and monitors performance. The Board has adopted a formal schedule of matters detailing key aspects of the company’s affairs reserved to it for its decision. This schedule is reviewed annually.
 
The roles of the Chairman and Group Chief Executive are distinct and separate, with a clear division of responsibilities. The Chairman leads the Board and ensures the effective engagement and contribution of all executive and non-executive directors. The Group Chief Executive has responsibility for all Group businesses and acts in accordance with the authority delegated by the Board. Responsibility for the development of policy and strategy and operational management is delegated to the Group Chief Executive and other executive directors.
 
All directors participate in discussing strategy, performance and the financial and risk management of the company. Meetings of the Board are structured to allow open discussion.
 
There were nine scheduled Board meetings during 2008. The directors were supplied with comprehensive papers in advance of each Board meeting covering the Group’s principal business activities. Members of executive management attend and make regular presentations at meetings of the Board. In addition to scheduled meetings, a number of ad hoc Board meetings and Chairman’s Committee meetings were held during 2008. These meetings were attended by the majority of directors.
 
The Board is aware of the other commitments of its directors and has established procedures for ensuring that the Board’s powers for authorising directors’ conflicts of interest are being operated effectively. With effect from 1 October 2008, the Companies Act 2006 introduced a statutory duty on directors to avoid conflicts of interest. Since that date, the Board has considered, and where appropriate authorised, any actual or potential conflicts of interests that directors may have.
 
 
 

 
Board balance and independence
The Board currently comprises the Chairman, three executive directors and five non-executive directors. The Board functions effectively and efficiently and is considered to be of an appropriate size. The directors provide the Group with the knowledge, mix of skills, experience and networks of contacts required. The Board Committees comprise directors with a variety of relevant skills and experience so that no undue reliance is placed on any individual.
 
The non-executive directors combine broad business and commercial experience with independent and objective judgement. The balance between non-executive and executive directors enables the Board to provide clear and effective leadership and maintain the highest standards of integrity across the company’s business activities. The names and biographies of all Board members are set out on pages 125 and 126.
 
In addition to the Chairman, there are five independent and three non-independent directors (i.e. the executive directors) on the Board. Following Bob Scott ceasing to be a director on 6 February 2009, a replacement senior independent director will be appointed in due course. The Board plans to appoint, in consultation with HM Treasury, three new independent non-executive directors to the Board during 2009.
 
The Board considers that the Chairman was independent on appointment and all non-executive directors are independent for the purposes of the Code.
 
Re-election of directors
Directors must stand for re-election by shareholders 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 will consider their independence at that time. The proposed re-election of directors is subject to prior review by the Board.
 
The names of directors standing for election at the 2009 Annual General Meeting are included on page 130 and further information will be given in the Chairman’s letter to shareholders in relation to the company’s Annual General Meeting.
 
Information, induction and professional development
All directors receive accurate, timely and clear information on all relevant matters, and have access to the advice and services of the Group General Counsel and Group Secretary who is responsible to the Board for ensuring that Board procedures are followed and that applicable rules and regulations are complied with. In addition, all directors are able, if necessary, to obtain independent professional advice at the company’s expense.
 
Each new director receives a formal induction on joining the Board, including visits to the Group’s major businesses and meetings with directors and senior management. The induction is tailored to the director’s specific requirements. Directors are advised of appropriate training and professional development opportunities and undertake the training and professional development they consider necessary in assisting them to carry out their duties as a director.
 
Performance evaluation
The Board has undertaken a formal and rigorous evaluation of its own performance and that of its committees and individual directors.
 
In 2008, this was conducted internally using detailed questionnaires and individual meetings with each director. Amongst the areas reviewed were the role of the Board and Committees, composition, meetings and processes, performance and reporting, and external relationships. The Board has considered and discussed reports on the outcomes of the evaluations and is satisfied with the way in which the evaluations have been conducted.
 
A number of initiatives are already underway aimed at improving the overall performance and effectiveness of the Board, including further Board appointments, restructuring Board agendas and allowing more time at Board meetings to consider strategic issues. In addition, a number of actions have already been taken to enhance reporting to the Board and Audit Committee on risk matters, liquidity and funding.
 
In addition, the former Chairman evaluated the individual performance of each director. The former senior independent director canvassed the views of the executive directors and met with the non-executive directors as a group without the former Chairman present to consider his performance.
 
Board Committees
In order to provide effective oversight and leadership, the Board has established a number of Board Committees with particular responsibilities. The Committee chairmanship and membership are reviewed on a regular basis. The names and biographies of all Board Committee members are set out on pages 125 and 126.
 
The terms of reference of the Audit, Remuneration and Nominations Committees and the standard terms and conditions of 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 non-executive directors. The Audit Committee holds at least five meetings each year. The Audit Committee’s report is set out on pages 136 and 137.
 
Remuneration Committee
The Remuneration Committee is comprised of independent non-executive directors, together with the Chairman of the Board. The Remuneration Committee holds at least three meetings each year.
 
The Directors’ Remuneration Report is contained on pages 141 to 152.
 
 
 

 
Nominations Committee
The Nominations Committee comprises independent non-executive directors, under the chairmanship of the Chairman of the Board. The Nominations Committee meets as required.
 
The Nominations Committee is responsible for assisting the Board in the formal selection and appointment of directors. The committee engages with external consultants, it considers potential candidates and recommends appointments of new directors to the Board. The appointments are based on merit against objective criteria, including the time available of the potential director and the commitment which will be required.
 
In addition, the Nominations Committee considers succession planning for the Chairman, Group Chief Executive and non-executive directors. The Nominations Committee takes into account the knowledge, mix of skills, experience and networks of contacts which are anticipated to be needed on the Board in the future. The Chairman, Group Chief Executive and non-executive directors meet to consider executive succession planning. No director is involved in decisions regarding his or her own succession.
 
Meetings
The number of scheduled meetings of the Board and the Audit, Remuneration and Nominations Committees and individual attendance by members in 2008 is shown below.
 
 
Board
Audit
Remuneration
Nominations
Total number of
       
meetings in 2008
9
6
3
5
Number of meetings
       
attended in 2008:
       
Sir Tom McKillop (1)
9
3
5
Sir Fred Goodwin (2)
8
Mr Buchan
8
6
2
Mr Cameron (3)
7
Dr Currie (4)
9
3
Mr Fish
8
Mr Fisher (2)
6
Mr Friedrich (4)
9
6
Mr Hester (5)
3
Mr Hunter
9
6
5
Mr Koch (4)
9
Mrs Kong (4)
9
3
Mr MacHale
9
6
Mr McFarlane (5)
3
Mr Pell
9
Sir Steve Robson (4)
7
6
Mr Ryan (5)
3
Mr Scott (4)
9
3
3
Mr Sutherland (4)
7
3
4
Mr Whittaker
9

Notes:
 
(1)
Sir Tom McKillop ceased to be a director on 3 February 2009.
 
(2)
Sir Fred Goodwin and Mark Fisher ceased to be directors on 21 November 2008.
 
(3)
Johnny Cameron ceased to be a director on 13 October 2008.
 
(4)
Jim Currie, Bill Friedrich, Bud Koch, Janis Kong, Sir Steve Robson, Bob Scott and Peter Sutherland ceased to be directors on 6 February 2009.
 
(5)
Stephen Hester, John McFarlane and Arthur 'Art' Ryan were appointed as directors on 1 October 2008.
 
 
Relations with shareholders
The company communicates with shareholders through the Annual Report and Accounts and by providing information in advance of the Annual General Meeting. Individual shareholders can raise matters relating to their shareholdings and the business of the Group at any time throughout the year primarily by letter, telephone or email via the Group’s website (www.rbs.com/ir).
 
Shareholders are given the opportunity to ask questions at the Annual General Meeting or submit written questions in advance. The chairmen of the Audit, Remuneration and Nominations Committees are available to answer questions at the Annual General Meeting.
 
Communication with the company’s largest institutional shareholders is undertaken as part of the company’s investor relations programme. The Chairman meets with the Group’s top 20 investors at least once every 12 months to discuss issues such as strategy, business performance and corporate governance. During the year, the directors received 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 credit ratings is provided. Detailed market and shareholder feedback is provided to the Board after results and other market announcements. The senior independent director was available throughout 2008 to shareholders should they have considered their concerns were not being 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 Chairman, Group Chief Executive and Group Finance Director communicate shareholder views to the Board as a whole.
 
The Board commissions a survey of investor perceptions periodically. The survey is undertaken on behalf of the Board by independent consultants and the outcomes of the study are considered by the Board.
 
 
 

 
Audit Committee Report
The current members of the Audit Committee are Archie Hunter (Chairman), Colin Buchan and Joe MacHale. All served throughout 2008 as did former members of the committee, Bill Friedrich and Sir Steve Robson, until their retirement as directors on 6 February 2009. All members of the Audit Committee are independent non-executive directors. The Audit Committee holds at least five scheduled meetings each year, two of which are held immediately prior to submission of the interim and annual financial statements to the Board. This core programme is supplemented by additional meetings as required. A total of ten meetings were held in 2008. 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. Since 2000, the Audit Committee has undertaken an annual programme of visits to the Group's business divisions and control functions. The object of the programme is to allow the Audit Committee to gain a better understanding of the Group and an invitation to attend is extended to all non-executive directors. The programme of future visits is considered annually and the norm is for two to three visits to be undertaken each year. The Committee undertook three visits in 2008.
 
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.
 
The Audit Committee is responsible for:
 
 
 
 
 
The terms of reference of the Audit Committee are available at www.rbs.com and these are considered annually by the Audit Committee and approved by the Board.
 
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.
 
Annual audit services include all services detailed in the annual engagement letter including the annual audit and interim reviews (including US reporting requirements), periodic profit verifications and reports to regulators including skilled persons reports commissioned by the Financial Services Authority (e.g. Reporting Accountants Reports).
 
Annual audit services also include statutory or non-statutory audits required by any Group companies that are not incorporated in the UK. Terms of engagement for these audits are agreed separately with management, and are consistent with those set out in the audit engagement letter insofar as local regulations permit.
 
The prospectively approved non-audit services include the following classes of service:
 
 
 
 
 
 
 
For all other permitted non-audit services, Audit Committee approval must be sought, on a case by case basis, before the provision of the service commences. 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 5 to the Group’s accounts.
 
 
 

 
2008 saw considerable economic uncertainty and unprecedented upheaval in financial markets worldwide. These conditions severely affected the Group and it has recorded significant asset write-downs in its 2008 financial statements. In these circumstances, particular attention of the Audit Committee was focused on a number of salient judgments involved in the preparation of the accounts:
 
 
 
 
In its consideration of each of these issues, the aims of the Audit Committee have been to:
 
 
 
 
An issue of key interest to the Audit Committee, given the current economic environment, was management's going concern assessment. In particular, the Committee's attention was directed to understanding the way in which management had satisfied itself that the Group has access to sufficient funding and capital over the next 12 months. The Committee reviewed and challenged the assumptions underlying management's analysis and discussed with the external auditors its review of management's analysis and conclusions.
 
As far as it can determine, the Committee received all the information and material it required to allow it to meet its obligations in respect of the 2008 financial statements.
 
The Committee reviews the work of the Group’s risk management and internal audit functions regularly. Four additional sessions of the Committee were held in 2008 that focused solely on risk issues; these sessions included contributions from independent advisors.
 
The Audit Committee undertakes an annual evaluation to assess the independence and objectivity of the external auditors and the effectiveness of the audit process, taking into consideration relevant professional and regulatory requirements. The outcomes of this evaluation are considered by the Board together with the Audit Committee’s recommendation on the re-appointment of the external auditor. In 2009 and subsequently, the annual evaluation will be carried out immediately following completion of the annual accounts and audit.
 
The Audit Committee is responsible for making recommendations to the Board, for it to submit the Audit Committee’s recommendations to shareholders for their approval at the Annual General Meeting in relation to the appointment, reappointment and removal of the external auditors. The Board has endorsed the Audit Committee’s recommendation that shareholders be requested to approve the reappointment of Deloitte LLP as external auditors at the Annual General Meeting in April 2009.
 
The Audit Committee also fixes the remuneration of the external auditors as authorised by shareholders at the Annual General Meeting.
 
The Audit Committee approves the terms of engagement of the external auditors.
 
It is intended that there will be an external review of the effectiveness of Group Internal Audit every three to five years, in line with best practice, with internal reviews continuing in the intervening years. In 2007, KPMG conducted a review of the effectiveness of Group Internal Audit and concluded that the function operated effectively and the Board agreed with these findings. In 2008, the Audit Committee conducted an internal review of Group Internal Audit that involved participants throughout the Group as well as the external auditors. The Audit Committee concluded that the function operated effectively and the Board agreed with the Audit Committee’s findings.
 
It is also intended that there will be an external review of the effectiveness of the Audit Committee every three to five years, with internal reviews by the Board continuing in the intervening years. PricewaterhouseCoopers conducted an external review of the effectiveness of the Audit Committee in 2005. An internal review of the Audit Committee’s performance was undertaken in 2008 and a separate report on the outcome was considered and discussed by the Board.
 
Since 2005, divisional audit committees have been responsible for reviewing each division’s business. During 2008, the divisional audit committee structure was revised to take account of the acquisition of ABN AMRO, the significant international growth of the Group’s businesses and best practice requirements. The divisional audit committees report to the Audit Committee and the Audit Committee is satisfied that these committees continue to discharge their terms of reference.
 
Archie Hunter
Chairman of the Audit Committee
25 February 2009
 
 
 

 
Internal Control
Management of The Royal Bank of Scotland Group (“the Group”) is responsible for the Group’s system of internal control that is designed to facilitate effective and efficient operations and to ensure the quality of internal and external reporting and compliance with applicable laws and regulations. In devising internal controls, the Group has regard to the nature and extent of the risk, the likelihood of it crystallising and the cost of controls. A system of internal control is designed to manage, but not eliminate, the risk of failure to achieve business objectives and can only provide reasonable, and not absolute, assurance against the risk of material misstatement, fraud or losses.

Management’s report on internal control over financial reporting

Management of the Group is responsible for establishing and maintaining adequate internal control over financial reporting for the Group.

The Group’s internal control over financial reporting is a component of an overall system of internal control. The Group’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the preparation, reliability and fair presentation of financial statements for external purposes in accordance with International Financial Reporting Standards (“IFRS”) and it includes:




Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. In addition, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or because the degree of compliance with policies or procedures may deteriorate.

Management assessed the effectiveness of the Group’s internal control over financial reporting as of 31 December 2008 based on the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in “Internal Control – Integrated Framework”.

Based on its assessment, management believes that, as of 31 December 2008, the Group’s internal control over financial reporting is effective.

The effectiveness of the Group’s internal control over financial reporting as of 31 December 2008 has been audited by Deloitte LLP, the Group’s independent registered public accounting firm. The report of the independent registered public accounting firm to the directors of the Royal Bank of Scotland Group plc expresses an unqualified opinion on the effectiveness of the Group’s internal control over financial reporting as of 31 December 2008.

Disclosure controls and procedures
As required by US regulations, the effectiveness of the company’s disclosure controls and procedures (as defined in the rules under the US Securities Exchange Act of 1934) have been evaluated. This evaluation has been considered and approved by the Board which has instructed the Group Chief Executive and the Group Finance Director to certify that, as at 31 December 2008, the company’s disclosure controls and procedures were adequate and effective and designed to ensure that material information relating to the company and its consolidated subsidiaries would be made known to them by others within those entities.

Changes in internal controls
There was no change in the company’s internal control over financial reporting that occurred during the period covered by this report that has materially affected, or is reasonably likely to materially affect, the company’s internal control over financial reporting.

 

 
Report of Independent Registered Public Accounting Firm to the members of The Royal Bank of Scotland Group plc
 
We have audited the internal control over financial reporting of The Royal Bank of Scotland Group plc and subsidiaries (‘’the Group”) as of 31 December 2008, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

The Group's management is responsible for maintaining effective internal control over financial reporting and for assessing its effectiveness as described in Managements Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the effectiveness of the Group's internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk of whether a material weakness existed, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company's internal control over financial reporting is a process designed by, or under the supervision of, the company's principal executive and principal financial officers, or persons performing similar functions, and implemented by the company's board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorisations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorised acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the Group maintained, in all material respects, effective internal control over financial reporting as of 31 December 2008, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as at and for the year ended 31 December 2008 of the Group and our report dated 25 February 2009 expressed an unqualified opinion on those financial statements.


DELOITTE LLP
Chartered Accountants and Registered Auditors
Edinburgh, United Kingdom
25 February 2009
 
 
Letter from the Chairman of the Remuneration Committee

 
In recognition of the crisis in global financial services and the unprecedented losses incurred by the Group in 2008, the Remuneration Committee has been working with the executive to bring about fundamental change to the way remuneration works throughout the Group. There is an obvious need for very significant change to compensation policy and practice across the industry and we intend that the Group will lead that process in consultation with our major shareholders.
 
As we embark on a process of change, our approach has sought to balance the reality of our current situation with the need to offer a competitive remuneration package for teams and individuals that are performing well and in a manner that is sustainable in the long-term. Achieving this balance is essential to our task of rebuilding the Group's standalone strength as well as repaying the support of the UK taxpayers.
 
In previous years the Directors’ Remuneration Report has described how remuneration policies are being implemented for executive directors, but given the exceptional circumstances, I would like to take this opportunity to describe in greater detail how the Group is approaching remuneration for all employees.
 
Immediate key decisions taken by the Group were as follows:
 
·
There have been no discretionary cash bonuses for any employees for performance in 2008. No bonuses have been paid to anyone directly associated with the Group’s major losses. There are some limited contractual commitments to pay bonuses, typically as part of an agreement on recruitment, and these have been honoured.
 
·
Where there has been exceptional performance by key individuals and teams, employees have been given deferred bonus awards. These awards will be released in three instalments in 2010, 2011 and 2012, in the form of RBS Group subordinated debt, by which time we hope the Group will be well on its way to standalone financial strength.
 
If the performance on which these deferred bonus awards was based later turns out to have been materially different or if there is subsequent material loss or reputational damage as a result of activity in the deferral period, or otherwise at the discretion of the Remuneration Committee, then part of these awards may be reduced or cancelled without payment (‘clawback’).
 
·
No profit share payment has been made for financial year 2008 and the scheme has been withdrawn going forward. We have made changes to benefits for some employees below manager level as part of the transitional arrangements to end the annual entitlement to profit share bonuses.
 
·
Annual base salary increases in 2009 will be made to a limited number of employees and salary increases will be below inflation for all businesses across the Group.
 
No bonuses have been paid to executive directors in relation to 2008 performance, and no deferred awards have been made. Over the past four years, the long term incentive awards granted under the Medium Term Performance Plan have lapsed due to the performance criteria not being met.
 
In respect of 2009, the Remuneration Committee has made key decisions in relation to the remuneration of executive directors:
 
·
There will be no base salary increase in 2009.
 
·
Any bonus earned in 2009 will be deferred and subject to clawback provisions.
 
·
No further payments will be made under the company’s Profit Sharing Scheme for 2009 onwards.
 
·
Annual incentives for 2009 will be based on performance against a framework of measures, with all payments deferred for up to three years with potential clawback.
 
·
The exceptional maximum annual incentive opportunity will not be available.
 
·
The individual performance management processes will be strengthened at executive levels. This includes a revised performance scorecard. The five performance areas are strategic direction, finance and operations, stakeholder management (including employee and customer satisfaction), efficiency and control, and capability and development.
 
·
Long term incentive awards will continue to be made under the Medium-term Performance Plan and the Executive Share Option Plan but the level of awards will be lowered compared to 2008. All awards will only vest if stretching performance conditions are met in three years’ time.
 
·
The provision for an undiscounted pension on early retirement at employer request will not apply to any executive director appointed in the future.
 
The Remuneration Committee recognises that the Group’s performance has not only impacted its shareholders and customers, but also its employees who have worked so very hard over many years to build an organisation of which they were proud and which provided a secure livelihood for them and their families. The Board deeply regrets that our employees’ trust has been eroded and their welfare affected during the last year. While it is both necessary and appropriate that we adopt stringent measures for employee compensation, we are more mindful than ever of the need for the Group to continue to develop the best employment practices in our industry to enable us to retain and recruit outstanding talent. This is critical to the delivery of our strategic plan and to build a sustainable and successful Group for the future.
 
Colin Buchan
Chairman of the Remuneration Committee
25 February 2009
 
 
 
Directors remuneration report

 
 
For certain recent developments relating to matters discussed in this report, which is dated 25 February 2009, you should read the “Recent Developments” section of this document.
 
The Remuneration Committee
The current members of the Remuneration Committee are Colin Buchan (committee chairman), John McFarlane and Philip Hampton. The members of the Remuneration Committee comprise independent non- executive directors, together with the Chairman of the Board.
 
During 2008, Jim Currie, Janis Kong, Sir Tom McKillop, Bob Scott and Peter Sutherland were members of the Remuneration Committee.
 
The Remuneration Committee makes recommendations to the Board on the remuneration arrangements for the executive directors and the Chairman. The Board as a whole reserves the authority to make the final determination of the remuneration of directors as it considers that this two-stage process allows greater consideration and evaluation and is consistent with the unitary nature of the Board. No director is included in decisions regarding his or her own remuneration.
 
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 maintains high level oversight of the application of remuneration policy below this level. The Committee oversees annual incentive plans and reviews all long-term incentive arrangements operated by the Group.
 
The non-executive directors’ fees are reviewed annually by the Board, on the recommendation of the Chairman of the Board. The level of remuneration reflects the responsibility and time commitment of directors and the level of fees paid to non-executive directors of comparable major UK companies. Non-executive directors do not participate in any incentive or performance plan; with the exception of the Chairman, more details of which can be found on page 143. It has been agreed that no increase to non-executive directors’ fees will be made in 2009.
 
During the year, the Remuneration Committee received advice from Watson Wyatt and Mercer on matters relating to directors’ remuneration in the UK and US respectively, together with advice from the Group Director, Human Resources and the Group General Counsel and Group Secretary on general remuneration matters. In addition, the Remuneration Committee has taken account of the views of the Group Chief Executive on performance assessment of the executive directors and members of the Group Executive Management Committee.
 
Watson Wyatt also provided professional services in the ordinary course of business, including actuarial advice and benefits administration services to subsidiaries of the Group and investment consulting and actuarial advice to the trustees of some of the Group’s pension funds. Mercer provided advice and support in connection with a range of compensation benefits, pension actuarial and investment matters. The advisers to the Remuneration Committee are appointed independently by the Committee, which reviews its selection of advisers annually. The Committee is satisfied that the consultants from Watson Wyatt and Mercer who advise the Committee operate independently of the consulting teams undertaking other work with the Group.
 
Remuneration policy
It has been agreed with HM Treasury that, in addition to complying with the Association of British Insurer's best practice code on remuneration, the Remuneration Committee will continue to work to ensure that future remuneration arrangements are linked to long-term value creation in line with the Group’s business strategy, with appropriate account taken of risk and avoiding a bias towards short-term indicators such as profit or revenues. The company is also actively engaged in discussions with the Financial Services Authority (FSA) in relation to remuneration policies and practices across the banking sector and intends that any remuneration policies should take account of the FSA’s remuneration design criteria.
 
Accordingly, in conjunction with the Board and independent advisers and in consultation with shareholders, the Remuneration Committee is undertaking a comprehensive review of its remuneration policy which it will complete during 2009.
 
UK-based executive directors’ remuneration balance
 
 
The chart above shows the make up of remuneration opportunity for on- target annual performance, and with long term incentive awards shown at their fair value at the date of grant. Short term incentive payments earned in relation to 2009 performance will be deferred and will vest, subject to satisfactory performance, over the following three years. The actual value of the share option and MPP awards will depend on performance over the period 2009 – 2011 and the share price at the time awards vest.
 
Components of executive remuneration 2009
UK based directors
Salary
Base salaries of executive directors have been reviewed and it has been agreed that no increases in base salaries will be made as part of the annual 2009 review.
 
 
 

 
Benefits
Executive directors are eligible to receive various employee benefits or a cash equivalent from a flexible benefits account, on a similar basis to other employees.
 
 

 
Details of pension arrangements of directors are shown on page 152. Where cash allowances are paid in place of pension accrual (or of pension accrual on salary over the pension earnings cap), they are shown on page 147. Executive directors also receive cover for death-in-service benefits.
 
For all executive directors joining on or after 1 October 2006, pension provision is in the form of a pension allowance which may be used to participate in The Royal Bank of Scotland Group Defined Contribution Pension Fund which is open to all employees, or to invest in alternative pension arrangements, or to take all or some of the allowance in cash. In addition, as employees, executive directors are eligible to participate in Sharesave and Buy As You Earn schemes. These schemes are not subject to performance conditions since they are operated on an all- employee basis.
 
Annual incentives
No annual incentive has been awarded to any executive director in relation to 2008 performance.
 
UK-based executive directors have a normal maximum annual incentive opportunity of between 160% and 200% of salary (with an exceptional maximum opportunity of 200-250% of salary). The on-target opportunity is 107% to 133% of salary.
 
The Remuneration Committee has determined that, for the financial year ending 31 December 2009, the exceptional maximum incentive opportunity will not be available.
 
Any annual incentive payments earned in 2009 will be deferred and released in equal annual instalments over three years. The Remuneration Committee will reserve the right to review performance prior to each element of deferred incentive vesting and reduce the proportion that vests if there is evidence that the financial performance for 2009 was materially inaccurate or there is a material loss or reputational damage as a result of activity during the deferral period.
 
Any incentive payments to executive directors in 2009 will reflect performance across five performance categories: Strategic Direction, Finance and Operations, Stakeholders, Efficiency and Control and Capability and Development. Group business unit and functional performance will be considered as appropriate.
 
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 Remuneration Committee is formulating proposals under which awards may be made in the future under two plans; the Medium-term Performance Plan and the Executive Share Option Plan. Any awards will be subject to rigorous performance conditions on which shareholders will be consulted.
 
Medium-term Performance Plan
The Medium-term Performance Plan 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. No changes will be made to this policy without prior consultation with shareholders.
 
The award levels for 2009 will be reduced from the policy applied for awards in 2008.
 
Options
The Executive Share Option Plan was approved by shareholders at the company’s 2007 Annual General Meeting.
 
In 2008, options were granted to executive directors under the Executive Share Option Plan approved by shareholders in 2007, over shares worth between one and a half times salary and three times salary. For 2009, the award levels will be reduced from the policy applied in 2008.
 
Shareholding guidelines
The Group operates shareholding guidelines for executive directors. The target shareholding level is 200% of gross annual salary for the Group Chief Executive and 100% of gross annual salary for executive directors. Target shareholding levels are determined by reference to ordinary shares held, together with any vested awards under the Group’s Medium-term Performance Plan. Executive directors have a period of five years in which to build up their shareholdings to meet the guideline levels.
 
Group Chief Executive – Stephen Hester
Stephen Hester became Group Chief Executive on 21 November 2008. His annual basic salary is £1,200,000.
 
Mr Hester also received certain share awards on appointment as Group Chief Executive and share awards to replace bonus and share awards he forfeited on leaving The British Land Company PLC. Mr Hester was granted conditional share awards over a total of 10,407,081 shares. Subject to their terms, the majority of these awards will vest between February 2009 (immediately after the announcement of the 2008 annual results) and the third anniversary of his appointment as Group Chief Executive.
 
Chairman – Philip Hampton
Philip Hampton became Chairman-designate on 19 January 2009, and Chairman on 3 February 2009. His fee is £750,000 per annum. He will also receive a one-off restricted share award over shares in the company which will vest, subject to the satisfaction of appropriate performance conditions, on the third anniversary of the date of grant. The amount of this award will be two times his annual fee, based on the share price at the date of grant.
 
Former executive directors
Sir Fred Goodwin
Sir Fred Goodwin’s employment with the company ended on 31 January 2009. Under the terms of an agreement reached on 13 October 2008, he has waived any payment in lieu of notice and his rights in respect of unvested executive share options and unvested awards under the Medium-term Performance Plan have lapsed. He will not receive a short term incentive payment for the financial year ended 31 December 2008.
 
Johnny Cameron
Johnny Cameron’s employment with the company will end on 28 February 2009. Under the terms of an agreement reached with him on 19 December 2008, he will not receive pay in lieu of notice or short term incentive payments for 2008 or 2009.
 
 

 
 
Mark Fisher
Mark Fisher’s employment with the company will end on 6 March 2009. He will not receive any short term incentive payment in respect of either 2008 or 2009.
 
 

 
 
Total shareholder return performance
The performance graph illustrates the performance of the company over the past five years in terms of total shareholder return compared with that of the companies comprising the FTSE 100 Index. This Index has been selected because it represents a cross-section of leading UK companies. The total shareholder return for FTSE banks for the same period has been added for comparison. The total shareholder return for the company and the indices have been rebased to 100 for 2003.
 
Total shareholder return
 
Service contracts
The company’s policy in relation to the duration of contracts with directors is that executive directors’ contracts generally continue until termination by either party, subject to the required notice, or until retirement. The notice period under the service contracts of executive directors will not normally exceed 12 months. In relation to newly recruited executive directors, subject to the prior approval of the Remuneration Committee, the notice period may be extended beyond 12 months if there is a clear case for this. Where a longer period of notice is initially approved on appointment, it will normally be structured such that it will automatically reduce to 12 months in due course.
 
All new service contracts for executive directors are subject to approval by the Remuneration Committee. Those contracts normally include standard clauses covering the performance review process, the company’s normal disciplinary procedure, and terms for dismissal in the event of failure to perform or in situations involving actions in breach of the Group’s policies and standards.
 
Any compensation payment made in connection with the departure of an executive director will be subject to approval by the Remuneration Committee, having regard to the terms of the service contract and the reasons for termination. Any Board members who leave the company in the future will receive a severance package which is reasonable and perceived as fair.
 
No compensation payment was made to Sir Fred Goodwin, Johnny Cameron or Mark Fisher in respect of their ceasing to be directors.
 
Information regarding directors’ service contracts is shown below:
 
 
Date of
current contract
Notice period –
from company
Notice period –
from executive
Executive directors
     
Mr Hester
4 November 2008
see note (1)
12 months
Mr Pell
20 February 2006
12 months
6 months
Mr Whittaker
19 December 2005
12 months
12 months
       
Former executive directors
     
Sir Fred Goodwin
1 August 1998
see page 143
see page 143
Mr Cameron
29 March 1998
12 months
6 months
Mr Fisher
27 February 2007
12 months
12 months
 
Note:
 
(1)
On appointment, Mr Hester was entitled to 24 months notice from the company. This will be reduced on a daily basis, so that it will be 12 months by the first anniversary of the commencement of his employment. As at 25 February 2009, Mr Hester’s notice period was 20½ months.
 
 
 

 

 
 
Except as noted below, in the event of severance where any contractual notice period is not worked, the employing company may pay a sum to the executive in lieu of 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 long-term incentive arrangements subject to the rules of the relevant plan.
 
In the event that Stephen Hester’s employment is terminated by the company (other than by reason of his personal underperformance), the following will apply. First Mr Hester will be entitled to receive a payment in lieu of notice to the value of base salary, bonus and benefits (including pension contributions). Secondly, any share awards granted to him to replace bonus and share awards he forfeited on leaving The British Land Company PLC will vest immediately on such termination.
 
If Mr Hester’s employment is terminated by reason of his personal underperformance, the company is entitled to terminate by giving written notice with immediate effect and without making any payment in lieu thereof and Mr Hester will forfeit any unvested stock awards. If he resigns voluntarily and the company does not require him to work out his notice period, Mr Hester may receive a payment in lieu of notice based on salary only (i.e. no bonus or benefits) and he will also forfeit any unvested stock awards.
 
Gordon Pell is a member of The Royal Bank of Scotland Group Pension Fund (the RBS Fund) and is contractually entitled to receive all pension benefits in accordance with its terms. The RBS Fund rules allow all members, including executive directors, who retire early at the request of their employer to receive a pension based on accrued service with no discount applied for early retirement. The provision for an undiscounted pension on early retirement at employer request will not apply to any executive director appointed in the future. The RBS Fund is closed to employees, including any executive directors, joining the Group after 30 September 2006.
 
Chairman and non-executive directors
The original dates of appointment as directors of the company and the dates for the Chairman and non-executive directors next election or re-election are as follows:
 
 
Date first appointed
Date for election
or next re-election
Philip Hampton
19 January 2009
2009
Mr Buchan
1 June 2002
2011
Mr Hunter
1 September 2004
2010
Mr MacHale
1 September 2004
2010
Mr McFarlane
1 October 2008
2009
Mr Ryan
1 October 2008
2009

 
Under the company’s Articles of Association, all directors must resign and seek re-election by shareholders at least every three years. The dates in the table above reflect the latest date for election or re-election.
 
The non-executive directors do not have service contracts or notice periods although they have letters of engagement reflecting their responsibilities and commitments. No compensation would be paid to any non-executive director in the event of termination.
 
The Chairman, Philip Hampton, will be entitled to receive a payment in lieu of notice if his appointment is terminated by the Group other than by reason of his personal underperformance. This payment will be based on a notice period of 24 months initially, reducing on a daily basis so that from the first anniversary of his appointment his notice period is 12 months.
 

 
 
The tables and explanatory notes on pages 147 to 152 report the remuneration of each director for the year ended 31 December 2008 and have been audited by the company’s auditors, Deloitte LLP.
 
Directors’ remuneration
   
Salary/
fees
£000
   
Pension
allowance
£000
   
Benefits
£000
   
2008
Total
£000
   
2007
Total
£000
 
Executive directors
                             
Mr Hester (1)
    163       52       1       216        
Mr Pell
    908             1       909       2,204  
Mr Whittaker
    829       282       4       1,115       2,450  
                                         
Former Chairman
                                       
Sir Tom McKillop (2)
    787                   787       750  
                                         
Former executive directors
                                       
Sir Fred Goodwin (3)
    1,297             39       1,336       4,190  
Mr Cameron (4)
    902       312       25       1,239       3,256  
Mr Fish (5)
    324             40       364       1,253  
Mr Fisher (6)
    760       187       441       1,388       2,358  

Notes:
 
(1)
Mr Hester was appointed Group Chief Executive on 21 November 2008. He was previously a non-executive director from 1 October 2008.
 
(2)
Sir Tom McKillop ceased to be Chairman and a director on 3 February 2009.
 
(3)
Sir Fred Goodwin ceased to be Group Chief Executive and a director on 21 November 2008. His employment with the Group ceased on 31 January 2009.
 
(4)
Mr Cameron ceased to be a director on 13 October 2008 and will cease employment with the Group on 28 February 2009.
 
(5)
From 1 January 2008 until 30 April 2008, Mr Fish was an executive director of the company. He became a non-executive director on 1 May 2008 and ceased to be a director on 31 December 2008. Throughout this period, he was non-executive chairman of RBS America and Citizens. Mr Fish is a non-executive director of Textron Inc. and Tiffany & Co. and retained the fees paid to him in this respect. For 2008, he received remuneration from Textron Inc. of US$260,500, including deferred fees. He received an annual fee of US$48,500 from Tiffany & Co.
 
(6)
Mr Fisher ceased to be a director on 21 November 2008 and will cease employment with the Group on 6 March 2009. In line with the its international assignment policy, costs such as additional tax and accommodation incurred as a result of Mr Fisher’s assignment to the Netherlands are met by the Group. These additional costs are shown in ‘Benefits’ above.
 

   
Board
fees
£000
   
Board
committee
fees
£000
   
2008
Total
£000
   
2007
Total
£000
 
Non-executive directors
                       
Mr Buchan
    73       57       130       122  
Mr Hunter
    73       101       174       162  
Mr MacHale
    73       33       106       100  
Mr McFarlane (1)
    18             18        
Mr Ryan (1)
    18             18        
                                 
Former non-executive directors
                               
Dr Currie (2)
    73       16       89       85  
Mr Friedrich (2)
    73       33       106       100  
Mr Koch (2)
    73             73       70  
Mrs Kong (2)
    73       16       89       85  
Sir Steve Robson (2)
    73       33       106       100  
Mr Scott (2, 3)
                    174       160  
Mr Sutherland (2)
    73       29       102       97  

Notes:
 
(1)
Appointed as directors on 1 October 2008.
 
(2)
Retired as directors on 6 February 2009.
 
(3)
Mr Scott’s senior independent director fee covered all Board and Board Committee work including Chairmanship of the Remuneration Committee.
 
No director received any expense allowances chargeable to UK income tax or compensation for loss of office/termination payment. The non-executive directors did not receive any bonus payments or benefits.
 

 
Share options
Options to subscribe for ordinary shares of 25p each i n the company granted to, and exercised by, directors during the year ended 31 December 2008 are shown in the table below. Options held at 1 January 2008 and all subsequent figures have been restated to reflect the rights issue in June 2008 and the capitalisation issue in September 2008.
 
               
Options exercised in
2008
                 
   
Options held at 1 January
2008
   
Options
granted in
2008
   
Number
   
Market
price
at date of exercise
£
   
Options
lapsed in
2008
   
Option price £
     
Options held at 31 December 2008
 
Number
     
Exercise period
 
Mr Pell
    104,252                               4.80     104,252         14.08.04 – 13.08.11  
      98,879                               5.07     98,879         14.03.05 – 13.03.12  
      178,412                               3.45     178,412         13.03.06 – 12.03.13  
      169,158                               4.84     169,158         11.03.07 – 10.03.14  
      181,304                               4.83     181,304         10.03.08 – 09.03.15  
      223,428                               5.17     223,428         09.03.09 – 08.03.16  
      310,364                               4.70     310,364         16.08.10 – 15.08.17  
              640,871                         2.97     640,871         06.03.11 – 05.03.18  
      1,265,797                                       1,906,668            
Mr Whittaker
    203,113                                 5.17     203,113         09.03.09 – 08.03.16  
      335,269                                 4.70     335,269         16.08.10 – 15.08.17  
      4,423                           4,423       3.86                
              582,803                           2.97     582,803         06.03.11 – 05.03.18  
              9,218                           1.89     9,218         01.10.15 – 31.03.16 (1)
      542,805                                         1,130,403            
Sir Fred Goodwin (2)
    10,614                                   3.12     10,614         01.02.09 – 03.03.09  
      97,826                                   3.34     97,826         01.02.09 – 02.06.09  
      550,458                                   2.18     550,458         01.02.09 – 31.01.10  
      4,538                                   3.64     4,538         01.02.09 – 31.07.09 (1)
      156,559                                   4.80     156,559         01.02.09 – 31.01.10  
      147,960                                   5.07     147,960         01.02.09 – 31.01.10  
      260,812                                   3.45     260,812         01.02.09 – 31.01.10  
      516,521                                   4.84     516,521         01.02.09 – 31.01.10  
      569,814                                   4.83     569,814         01.02.09 – 31.01.10  
      580,333                                   5.17      
waived
    09.03.09 – 08.03.16  
      830,192                                   4.70      
waived
    16.08.10 – 15.08.17  
              1,508,727                           2.97      
waived
    06.03.11 – 05.03.18  
      3,725,627                                         2,315,102            
Mr Cameron (3)
    68,764                                   3.12      
lapsed
     
      137,610                                     2.18      
lapsed
     
      93,863                                     4.80      
lapsed
     
      113,925                                     5.07      
lapsed
     
      188,444                                     3.45      
lapsed
     
      180,781                                     4.84      
lapsed
     
      290,089                                     4.83      
lapsed
     
      304,674                                     5.17      
lapsed
     
      447,026                                     4.70      
lapsed
     
              847,713                             2.97      
lapsed
     
              4,966                             1.89      
lapsed
    (1)
      1,825,176                                                      
Mr Fish
    386,479               386,479       2.80               2.60                
      134,715                                       4.83     134,715         10.03.08 – 09.03.15  
      398,130                                       5.17     398,130         09.03.09 – 08.03.16  
      625,329                                       4.70     625,329         16.08.10 – 15.08.17  
      1,544,653                                             1,158,174            
Mr Fisher(4)
    51,162                                       2.58     51,162         01.04.02 – 31.03.09  
      518                                       3.64     518         01.10.08 – 31.03.09 (1)
      119,267                                       2.18     119,267         29.03.03 – 28.03.10  
      78,099                                       4.80     78,099         14.08.04 – 13.08.11  
      81,324                                       5.07     81,324         14.03.05 – 13.03.12  
      145,094                                       3.45     145,094         13.03.06 – 12.03.13  
      142,041                                       4.84     142,041         11.03.07 – 10.03.14  
      217,565                                       4.83     217,565         10.03.08 – 09.03.15  
      220,042                                       5.17     220,042         09.03.09 – 08.03.16  
      312,919                                       4.70     312,919         16.08.10 – 15.08.17  
      1,922                               1,922       3.93                
              593,399                               2.97     593,399         06.03.11 – 05.03.18  
              4,966                               1.89     4,966         01.10.11 – 31.03.12 (1)
      1,369,953                                             1,966,396            

Notes:
 
(1)
Options held under the sharesave schemes, which are not subject to performance conditions.
 
(2)
Options held at 21 November 2008 when he ceased to be a director. Unvested awards were waived on cessation and lapsed on 31 January 2009. In respect of his vested options under The Royal Bank of Scotland Group plc 1999 Executive Share Option Scheme, any options.
 
 
 

 
exercisable at 31 January 2009 remain exercisable subject to and in accordance with the rules of that plan for 12 months from that date, but not after the 10th anniversary of their grant.
 
(3)
Options held at 13 October 2008 when he ceased to be a director. All outstanding awards will lapse when his employment with the company ends on 28 February 2009, which is reflected in the table above.
 
(4)
Options held at 21 November 2008 when he ceased to be a director. All outstanding awards will lapse when his employment with the company ends on 6 March 2009.
 
 

 
No options had their terms and conditions varied during the accounting period to 31 December 2008. No payment is required on the award of an option.
 
For executive share options granted in 2007 and 2008, the performance condition is based on the average annual growth in the company’s adjusted EPS over the three-year performance period commencing with the year of grant. The calibration of the EPS growth measure is agreed by the Remuneration Committee at the time of each grant having regard to the business plan, prevailing economic conditions and analysts’ forecasts.
 
In respect of the grant of options in 2008, options will only be exercisable if, over the three-year period, the growth in the company’s adjusted EPS has been at least 5 per cent. per annum (the “threshold level”). The percentage of options that vest is then determined on a straight-line basis between 30 per cent. at the threshold level and 100 per cent. at the maximum level for growth in adjusted EPS of 9 per cent. per annum.
 
The market price of the company’s ordinary shares at 31 December 2008 was 49.4p and the range during the year ended 31 December 2008 was 41.4p to 370.5p.
 
In the ten year period to 31 December 2008, awards made that could require new issue shares under the company’s share plans represented 2.1 % of the company’s issued ordinary share capital, leaving an available dilution headroom of 7.9%. The company meets its employee share plan obligations through a combination of new issue shares and market purchase shares.
 
Medium Term Performance Plan
Scheme interests at 1 January 2008 and the related market price on award in the table below have been restated to reflect the rights issue in June 2008 and the capitalisation issue in September 2008.
 
   
Scheme interests
(share equivalents) at 1 January 2008
   
Awards
granted
in 2008
   
Market
price on
award
£
 
Awards
vested in
2008
Awards
exercised
in 2008
   
Share interest (share equivalents) at
31 December 2008
   
End of period
for qualifying
conditions to
be fulfilled
 
Mr Pell
    148,953             5.17  
Nil
         
lapsed
31.12.08  
      138,384             5.85             138,384       31.12.09  
              305,177       2.97             305,177       31.12.10  
      287,337                             443,561          
Mr Whittaker
    135,410               5.17  
Nil
         
lapsed
31.12.08  
      128,134               5.85             128,134       31.12.09  
              277,525       2.97             277,525       31.12.10  
      263,544                             405,659          
Sir Fred Goodwin (1)
    333,324               4.56             333,324  
vested
31.12.03  
      121,288               5.19             121,288  
vested
31.12.04  
      348,202               5.17  
Nil
         
lapsed
31.12.08  
      333,145               5.85              
waived
31.12.09  
              754,364       2.97              
waived
31.12.10  
      1,135,959                             454,612          
Mr Cameron (2)
    199,994               4.56              
vested
31.12.03  
      79,096               5.19              
vested
31.12.04  
      174,103               5.17  
Nil
         
lapsed
31.12.08  
      170,845               5.85              
lapsed
31.12.09  
              403,673       2.97              
lapsed
31.12.10  
      624,038                                      
Mr Fish
    111,479               5.17  
Nil
         
lapsed
31.12.08  
      102,587               5.85             102,587       31.12.09  
      214,066                             102,587          
Mr Fisher (3)
    71,651               4.56             71,651  
vested
31.12.03  
      28,660               5.19             28,660  
vested
31.12.04  
      125,741               5.17  
Nil
         
lapsed
31.12.08  
      119,593               5.85             119,593       31.12.09  
              282,570       2.97             282,570       31.12.10  
      345,645                             502,474          
 
Notes:
 
(1)
Awards held at 21 November 2008 when he ceased to be a director. Unvested awards were waived on cessation and lapsed on 31 January 2009.
 
(2)
Awards held at 13 October 2008 when he ceased to be a director. Subsequently Mr Cameron exercised his vested awards on 5 December 2008. All outstanding awards will lapse when his employment with the company ends on 28 February 2009.
 
(3)
Awards held at 21 November 2008 when he ceased to be a director. All unvested awards and any vested, but unexercised, awards will lapse when his employment with the company ends on 6 March 2009.
 
For any awards that have vested, participants holding option-based awards can exercise their right over the underlying share equivalents at any time up to ten years from the date of grant.
 
No variation was made to any of the terms of the plan during the year.


 
 
Awards made in 2007 and 2008 are subject to two performance measures; 50% of the award vests on a relative Total Shareholder Return (TSR) measure and 50% vests on growth in adjusted earnings per share (EPS) over the three year performance period.
 
For the TSR element, vesting is based on the level of outperformance by the Group of the median of the comparator group TSR over the performance period. 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%. For awards made in 2007, the companies in the comparator group were ABN AMRO Holdings N.V.; Banco Santander Central Hispano, S.A.; Barclays PLC; Citigroup Inc; HBOS plc; HSBC Holdings plc; Lloyds TSB Group plc and Standard Chartered PLC. Following the acquisition of ABN AMRO by the consortium members in October 2007, the Remuneration Committee agreed that Fortis N.V. would replace ABN AMRO in the comparator group. Subsequently, for awards made in 2008, Fortis N.V. was replaced by Deutsche Bank Group.
 
The level of EPS growth over the three year period is calculated by comparing the adjusted EPS in the year prior to the year of grant with that in the final year of the performance period. Each year the vesting schedule for the EPS growth measure is agreed by the Remuneration Committee at the time of grant, having regard to the business plan, performance relative to comparators and analysts’ forecasts.
 
For the awards made in 2007, the EPS element of the awards will not vest if EPS growth is below 5% per annum compound over the three year period. Where EPS growth is between 5% per annum and 10% per annum vesting will occur on a straight-line basis from 25% to 100%. Vesting at 100% will occur if EPS growth is at least 10% per annum compound. For the awards made in 2008, an EPS growth threshold level of 5% per annum to a maximum level of 9% per annum was agreed.
 
Restricted Share Award
Interests at 1 January 2008 and the related prices on award and vesting in the table below have been restated to reflect the rights issue in June 2008 and the capitalisation issue in September 2008.
 
   
Awards
held at
1 January
2008
   
Awards
granted in
2008
   
Market price on award
£
   
Awards
vested in
2008
   
Market
price on
vesting
£
   
Value of Awards
vested
£
   
Awards
held at
31 December 2008
   
End of the
period for
qualifying
conditions to
be fulfilled
 
Mr Hester
          8,575,019       0.48       577,964       0.48       277,423       7,997,055       21.11.08 – 29.05.11 (1)
            1,832,062       0.48                               1,832,062       21.11.09 – 21.11.11 (2)
            10,407,081                                       9,829,117          
                                                                 
Mr Whittaker (3)
    109,208               5.41       109,208       3.37       368,503                
      90,718               5.41                               90,718       01.02.09 (4,5)
      44,500               5.41                               44,500       01.02.10  
      244,426                                               135,218          

Notes:
 
(1)
Awards to replace bonus and share awards Mr Hester forfeited on leaving The British Land Company PLC, which reflect the vesting dates of the original awards.
 
(2)
These awards vest as to 1/3 on each of the first, second and third anniversary of award, subject to their terms.
 
(3)
Awards were granted to Mr Whittaker in lieu of unvested share awards from his previous employer.
 
(4)
The end period for qualifying conditions is subject to any restrictions on dealing in the Group’s shares which may be in place and to which Mr Whittaker may be subject. As a result of the close period prior to the announcement of the Group’s results, the end of the period for qualifying conditions to be fulfilled in 2009 is 26 February 2009.
 
(5)
Award has now vested and shares will be released to Mr Whittaker on 26 February 2009.
 
Citizens Long Term Incentive Plan (1)

 
Interests at 1 January 2008
Benefits received from awards
vesting during the year
Interests at 31 December 2008
Mr Fish
LTIP awards for the 3 year periods:
   
 
01.01.05 – 31.12.07
nil 
 
01.01.06 – 31.12.08
nil(2)
 
01.01.07 – 31.12.09
nil(2)

Notes:
 
(1)
This cash LTIP was approved by shareholders at the company’s Annual General Meeting in April 2005. 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.
 
(2)
When Mr Fish stepped down from the Board on 31 December 2008, under the terms of the Citizens LTIP, his outstanding awards vested, subject to pro-rating for the elapsed proportion of the performance period and for performance to date. As a result, there was nil vesting for all awards.
 
No variation was made to any of the terms of the plan during the year.
 


 
 
Directors’ pension arrangements
Stephen Hester and Guy Whittaker are provided with a cash allowance in place of pension benefits as detailed on page 147.
 
During 2008, Johnny Cameron, Sir Fred Goodwin and Gordon Pell accrued pensionable service in The Royal Bank of Scotland Group Pension Fund (the “RBS Fund”). The RBS Fund is a defined benefit fund registered with HM Revenue & Customs under the Finance Act 2004.
 
Sir Fred Goodwin was, and Gordon Pell is, provided with additional pension benefits on a defined benefit basis outwith the RBS Fund. The figures shown below include the accrual in respect of these arrangements. A funded, non-registered arrangement provides Sir Fred Goodwin’s benefits to the extent they are not provided by the RBS Fund.
 
Johnny Cameron’s benefits were based on salary limited to the pensions earning cap and he received a cash allowance in place of pension on salary above this cap.
 
Mark Fisher opted to cease future accrual of pension benefit within the RBS Fund with effect from 6 April 2006. The increase in pension shown in the table arises from his increase in pensionable salary over the year. He was provided with a cash allowance in place of further pension benefits as detailed on page 147.
 
The cash allowances for Johnny Cameron and Mark Fisher are shown on page 147.
 
Larry Fish accrued pension benefits under a number of arrangements in the US. Defined benefits were built up under the Citizens’ Qualified Plan, Excess Plan and Supplemental Executive Retirement Arrangement. In addition, he was a member of two defined contribution arrangements: a Qualified 401(k) Plan and an Excess 401(k) Plan until he became a non-executive director on 1 May 2008.
 
Of the total transfer value shown as at 31 December 2008, 54% relates to benefits in funded pension schemes.
 
Disclosure of these benefits has been made in accordance with the United Kingdom Listing Authority Listing Rules and with the Directors’ Remuneration Report Regulations 2002.
 
 
Age at
31 December 2008
   
Accrued entitlement at 31 December 2008
£000 p.a
   
Additional pension
earned
during the
year ended
31 December 2008
£000 p.a
   
Additional pension
earned
during the
year ended
31 December 2008*
£000 p.a
   
Transfer
value as at
31 December 2008
£000
   
Transfer
value as at
31 December 2007
£000
   
Increase
in transfer
value during year ended
31 December 2008
£000
   
Transfer value
for the additional pension
earned
during the
year ended
31 December
2008*
£000
 
Mr Pell
    58       517       94       77       9,831       8,403       1,428       1,473  
Sir Fred Goodwin
    50       693       114       92       16,630 (1)     8,370       8,260       2,060  
Mr Cameron
    54       62       6       4       1,363 (1)     931       432       78  
Mr Fish
    64       $2,237       $157       $157       $27,004       $24,101       $2,903       $1,893  
Mr Fisher
    48       398       61       48       4,810       4,562       248       581  

*Net of statutory revaluation applying to deferred pensions
 
Note:
 
(1)
Sir Fred Goodwin retired from employment with effect from 31 January 2009 and Johnny Cameron will retire from employment with effect from 28 February 2009. They were contractually entitled to an immediate pension based on their accrued service, including any service transferred in, with no discount for early payment. The valuation of their pensions as at 31 December 2008 in the table above takes account of the payment dates of these pensions. Employees in the RBS Fund, including directors, who retire early at the request of their employer, are entitled to an immediate pension with no discount for early payment. The provision for an early undiscounted pension on early retirement at employer request will not apply to any executive director appointed in the future. Except as noted above for Sir Fred Goodwin and Johnny Cameron, the valuations in the table above make no allowance for early retirement.
 
There is a significant difference in the form of disclosure required by the Combined Code and the Directors’ Remuneration Report Regulations 2002. The former requires disclosure of the additional pension earned during the year and the transfer value equivalent to this pension based on stock market conditions at the end of the year. The latter requires disclosure of the difference between the transfer value at the start and end of the year and is therefore dependent on the change in stock market conditions over the course of the year. The above disclosure has been made in accordance with both of these documents.
 
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’s pension schemes.
 
The proportion of benefits represented by funded pension schemes for Gordon Pell and Larry Fish is 46% and 2% respectively. All benefits for Johnny Cameron, Mark Fisher and Sir Fred Goodwin are in funded pension schemes.
 
In accordance with US market practice, Larry Fish’s pensionable remuneration was limited to US$4 million per annum.
 
Larry Fish retired from employment with effect from 30 April 2008 and his pension benefits started on 1 May 2008.
 
Contributions and allowances paid in the year ended 31 December 2008 under defined contribution arrangements were:
 
     
2008
$000
     
2007
$000
 
Mr Fish
    6       60  
 
Colin Buchan
Chairman of the Remuneration Committee
25 February 2009
 
 
Shares beneficially owned at 1 January 2008 in the tables below have been restated to reflect the capitalisation issue of ordinary shares in September 2008.
           
31 December 2008
 
Executive directors
 
Shares
beneficially
owned at
1 January 2008
or date of
appointment,
if later
   
Shares
beneficially
owned
   
Value (1)
£
 
Mr Hester (2)
 
     
340,524
     
168,219
 
Mr Pell
   
159,278
     
611,927
     
302,292
 
Mr Whittaker
   
285,145
     
1,313,173
     
648,707
 

 
Notes:
 
(1)
The value is based on the share price at 31 December 2008, which was 49.4p. During the year ended 31 December 2008 the share price ranged from 41.4p to 370.5p.
 
(2)
Appointed as a director on 1 October 2008.
 
As at 31 December 2008, the executive directors held a technical interest as potential beneficiaries in The Royal Bank of Scotland Group plc 2001 Employee Share Trust (51,680,795 shares), The Royal Bank of Scotland plc 1992 Employee Share Trust (1,028,914 shares) and The Royal Bank of Scotland Group plc 2007 US Employee Share Trust (8,455,545 shares), being trusts operated for the benefit of employees of the company and its subsidiaries.
 
Non-executive directors
 
Shares
beneficially
owned at
1 January
2008
or date of
appointment,
if later
   
Shares
beneficially
owned at
31 December
2008
   
Value(1)
£
 
Mr Buchan
   
41,000
     
157,515
     
77,812
 
Mr Hunter
   
10,762
     
41,344
     
20,424
 
Mr MacHale
   
74,005
     
284,317
     
140,453
 
Mr Ryan (4)
   
     
50,000
     
24,700
 
                         
Former Chairman
                       
Sir Tom McKillop (2)
   
213,200
     
819,086
     
404,628
 
                         
Former Non-executive directors
                       
Dr Currie (3)
   
1,709
     
10,504
     
5,189
 
Mr Friedrich (3)
   
113,236
     
435,039
     
214,909
 
Mr Koch (3)
   
92,250
     
354,413
     
175,080
 
Mrs Kong (3)
   
26,650
     
102,383
     
50,577
 
Mr Scott (3)
   
23,927
     
91,915
     
45,406
 
Mr Sutherland (3)
   
18,084
 
   
69,473
     
34,320
 

Notes:
 
(1)
The value is based on the share price at 31 December 2008, which was 49.4p. During the year ended 31 December 2008 the share price ranged from 41.4p to 370.5p.
 
(2)
Sir Tom McKillop ceased to be Chairman and a director on 3 February 2009.
 
(3)
Retired as directors on 6 February 2009.
 
(4)
Appointed as a director on 1 October 2008.
 
No other director had an interest in the company’s ordinary shares during the year.
 
No director held a non-beneficial interest in the shares of the company at 31 December 2008, at 1 January 2008 or date of appointment if later.
 
As at 25 February 2009 there were no changes to the directors’ interests in shares shown in the tables above.
 
Preference shares
Mr Koch held 20,000 non-cumulative preference shares of US$0.01 each at 31 December 2008 (2007 – 20,000). No other director shown above had an interest in the preference shares during the year.
 
Update to shareholdings of directors

Gordon Pell’s option over 223,428 shares at ₤5.17 lapsed on 9 March 2009. Guy Whittaker’s options over (i) 45,592 shares at £0.38 were granted on 16 January 2009; (ii) 9,218 shares at £1.89 lapsed on 6 January 2009 and (iii) 203,113 shares at £5.17 lapsed on 9 March 2009.

Guy Whittaker’s restricted stock award over 90,718 shares vested on 26 February 2009. Stephen Hester’s restricted stock award over 1,502,291 shares vested on 26 February 2009. Philip Hampton’s restricted stock award over 5,172,413 shares was granted on 27 February 2009.

As at 24 April, 2009, the most recent practicable date prior to the filing of this annual report on Form 20-F, the shareholdings of (i) Stephen Hester increased to 1,225,643 shares, (ii) Guy Whittaker increased to 1,366,622 shares and (iii) Philip Hampton increased to 26,312 shares.
 
 
 
Statement of directors’ responsibilities 

 
 
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 as adopted by the European Union. They are responsible for preparing accounts that present fairly the financial position, financial performance and cash flows of the Group and the company. In preparing those accounts, the directors are required to:
 
· 
select suitable accounting policies and then apply them consistently;
 
· 
make judgements and estimates that are reasonable and prudent; and
 
· 
state whether applicable accounting standards have been followed, subject to any material departures disclosed and explained in the accounts.
 
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 Group and hence for taking reasonable steps for the prevention and detection of fraud and other irregularities.
 
By order of the Board
 
Miller McLean
Secretary
25 February 2009
 


We, the directors listed below, confirm that to the best of our knowledge:
 
· 
the financial statements, prepared in accordance with International Financial Reporting Standards, give a true and fair view of the assets, liabilities, financial position and profit or loss of the company and the undertakings included in the consolidation taken as a whole; and
 
· 
the Business review, which is incorporated into the Directors’ report, includes a fair review of the development and performance of the business and the position of the company and the undertakings included in the consolidation taken as a whole, together with a description of the principal risks and uncertainties that they face.
 
By order of the Board
 
Philip Hampton
Chairman
Stephen Hester
Group Chief Executive
Guy Whittaker
Group Finance Director
     
25 February 2009
   
     
Board of directors
   
     
Chairman
Philip Hampton
Executive directors
Stephen Hester
Gordon Pell
Guy Whittaker
Non-executive directors
Colin Buchan
Archie Hunter
Joe MacHale
John McFarlane
Arthur ‘Art’ Ryan
 
 
Financial statements

 
 
   
156
158
159
160
161
162
173

 
1
Net interest income
173
 
2
Non-interest income
173
   
(excluding insurance premium income)
 
 
3
Operating expenses
174
 
4
Pension costs
176
 
5
Auditors’ remuneration
178
 
6
Tax
179
 
7
Profit attributable to other owners
180
 
8
Ordinary dividends
180
 
9
Profit dealt with in the accounts of the company
180
 
10
Earnings per ordinary share
181
 
11
Financial instruments
181
 
12
Past due and impaired financial assets
197
 
13
Derivatives
199
 
14
Debt securities
201
 
15
Equity shares
203
 
16
Investments in Group undertakings
204
 
17
Intangible assets
205
 
18
Property, plant and equipment
208
 
19
Prepayments, accrued income and other assets
209
 
20
Discontinued operations and assets and liabilities of disposal groups
210
 
21
Settlement balances and short positions
211
 
22
Accruals, deferred income and other liabilities
211
 
23
Deferred taxation
212
 
24
Insurance business
213
 
25
Subordinated liabilities
220
 
26
Minority interests
226
 
27
Share capital
227
 
28
Owners’ equity
230
 
29
Leases
232
 
30
Collateral and securitisations
233
 
31
Capital resources
235
 
32
Memorandum items
236
 
33
Net cash (outflow)/inflow from operating activities
240
 
34
Analysis of the net investment in business interests and intangible assets
241
 
35
Interest received and paid
243
 
36
Analysis of changes in financing during the year
244
 
37
Analysis of cash and cash equivalents
244
 
38
Segmental analysis
245
 
39
Directors’ and key management remuneration
250
 
40
Transactions with directors, officers and others
251
 
41
Related parties
251
 
42
Post balance sheet events
252
 
 
 
Independent auditors’ report to the members of The Royal Bank of Scotland Group plc

 
 
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 2008 which comprise the accounting policies, the balance sheets as at 31 December 2008 and 2007, the consolidated income statements, the cash flow statements, the statements of recognised income and expense for each of the three years in the period ended 31 December 2008, the related Notes 1 to 42 and the information identified as ‘audited’ in the Risk, capital and liquidity management section of the Business review. 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.
 
Respective responsibilities of directors and auditors
The directors’ responsibilities for preparing the annual report, the directors’ remuneration report and the financial statements in accordance with applicable law and International Financial Reporting Standards (IFRS), as adopted by the European Union, are set out in the statement of directors’ responsibilities.
 
Our responsibility is to audit the financial statements and the part of the directors’ remuneration report described as having been audited in accordance with relevant legal and regulatory requirements and International Standards on Auditing (UK and Ireland).
 
We report to you our opinion as to whether the financial statements give a true and fair view and whether the financial statements and the part of the directors’ remuneration report described as having been audited have been properly prepared in accordance with the Companies Act 1985, and as regards the Group’s consolidated financial statements, Article 4 of the IAS Regulation. We also report to you whether in our opinion, the information given in the directors’ report is consistent with the financial statements. The information given in the directors’ report includes that specific information presented in the Business review that is cross referred from the business review section of the directors’ report.
 
In addition we report to you if, in our opinion, the company has not kept proper accounting records, we have not received all the information and explanations we require for our audit, or if information specified by law regarding directors’ remuneration and other transactions is not disclosed.
 
We review whether the corporate governance statement reflects the company’s compliance with the nine provisions of the 2006 Combined Code specified for our review by the Listing Rules of the Financial Services Authority, and we report if it does not.
 
The Listing Rules do not require us to consider whether the Board or management’s statements on internal control cover all risks and controls, or form an opinion on the effectiveness of the Group’s corporate governance procedures or its risk and control procedures.
 
We read the other information contained in the Annual Report and Accounts 2008 as described in the contents section, including the unaudited part of the directors’ remuneration report, and consider whether it is consistent with the audited financial statements. We consider the implications for our report if we become aware of any apparent misstatements or material inconsistencies with the financial statements. Our responsibilities do not extend to any further information outside the Annual Report and Accounts 2008.
 
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 Public Company Accounting Oversight Board (United States). 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. 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.
 
We planned and performed our audit so as to obtain all the information and explanations which we considered necessary in order to provide us with sufficient evidence to give reasonable assurance that the financial statements and the part of the directors’ remuneration report described as having been audited are free from material misstatement, whether caused by fraud or other irregularity or error. In forming our opinion, we also evaluated the overall adequacy of the presentation of information in the financial statements and the part of the directors’ remuneration report described as having been audited.
 
 
 

 
 
UK opinion
In our opinion:
· 
the Group financial statements give a true and fair view, in accordance with IFRS as adopted by the European Union, of the state of the Group’s affairs as at 31 December 2008 and of its loss and cash flows for the year then ended;
 
· 
the company financial statements give a true and fair view, in accordance with IFRS as adopted by the European Union as applied in accordance with the provisions of the companies Act 1985, of the state of affairs of the company as at 31 December 2008;
 
· 
the financial statements and the part of the directors’ remuneration report described as having been audited have been properly prepared in accordance with the Companies Act 1985 and, as regards the Group financial statements, Article 4 of the IAS Regulation; and
 
· 
the information given in the directors’ report is consistent with the financial statements.
 
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 by the European Union, has also complied with IFRS as issued by the International Accounting Standards Board (IASB).
 
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 2008 and of its loss and cash flows for the year then ended.
 
US opinion
In our opinion, the financial statements present fairly, in all material respects, the financial position of the Group as at 31 December 2008 and 2007 and the results of its operations and its cash flows for each of the three years in the period ended 31 December 2008, in conformity with IFRS as adopted for use in the European Union and IFRS as issued by the IASB.
 
The financial statements for the year ended 31 December 2007 were restated for the matters disclosed in Note 1 of the Accounting Polices.
 
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Group’s internal control over financial reporting as at 31 December 2008, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organisations of the Treadway Commission.
 
Our report dated 25 February 2009 which is included in this Annual Report on Form 20-F for the year ended 31 December 2008 expresses an unqualified opinion on the effectiveness of the Group’s internal control over financial reporting of the Group.
 
Deloitte LLP
Chartered Accountants and Registered Auditors
Edinburgh, United Kingdom
25 February 2009
 
Consolidated income statement for the year ended 31 December 2008

 
         
2008
   
2007
   
2006
 
   
Note
      £m       £m       £m  
Interest receivable
          49,522       32,252       24,688  
Interest payable
          (30,847 )     (20,183 )     (14,092 )
Net interest income
    1       18,675       12,069       10,596  
Fees and commissions receivable
    2       9,831       8,278       7,116  
Fees and commissions payable
    2       (2,386 )     (2,193 )     (1,922 )
(Loss)/income from trading activities
    2       (8,477 )     1,292       2,675  
Other operating income (excluding insurance premium income)
    2       1,899       4,833       3,564  
Insurance net premium income
    24       6,326       6,087       5,973  
Non-interest income
            7,193       18,297       17,406  
Total income
            25,868       30,366       28,002  
Staff costs
            10,241       7,338       6,723  
Premises and equipment
            2,593       1,703       1,421  
Other administrative expenses
            5,464       2,969       2,658  
Depreciation and amortisation
            3,154       1,932       1,678  
Write-down of goodwill and other intangible assets
            32,581              
Operating expenses
    3       54,033       13,942       12,480  
(Loss)/profit before other operating charges and impairment
            (28,165 )     16,424       15,522  
Insurance net claims
    24       4,430       4,624       4,458  
Impairment
    12       8,072       1,968       1,878  
Operating (loss)/profit before tax
            (40,667 )     9,832       9,186  
Tax
    6       (2,323 )     2,044       2,689  
(Loss)/profit from continuing operations
            (38,344 )     7,788       6,497  
Profit/(loss) from discontinued operations, net of tax
    20       3,971       (76 )      
(Loss)/profit for the year
            (34,373 )     7,712       6,497  
                                 
(Loss)/profit attributable to:
                               
Minority interests
            (10,832 )     163       104  
Other owners
    7       596       246       191  
Ordinary shareholders
            (24,137 )     7,303       6,202  
              (34,373 )     7,712       6,497  
Per 25p ordinary share:
                               
Basic earnings
    10       (145.7p )     64.0 p     54.4 p
                                 
Diluted earnings
    10       (145.7p )     63.4 p     53.9 p
                                 
Dividends
    8       19.3 p     27.0 p     21.6 p

The accompanying notes on pages 173 to 252, the accounting policies on pages 162 to 172 and the audited sections of ‘The Business Review: Risk, Capital and Liquidity Management’ on pages 57 to 123 form an integral part of these financial statements.
 
158

 
Balance sheets at 31 December 2008

 
         
Group
   
Company
 
           
2008
£m
   
Restated
2007
£m
     
2008
£m
     
2007
£m
 
   
Note
 
Assets
                                   
Cash and balances at central banks
    11       12,400       17,866              
Loans and advances to banks
    11       138,197       219,460       27,031       7,686  
Loans and advances to customers
    11       874,722       828,538             307  
Debt securities subject to repurchase agreements
    30       80,576       107,651              
Other debt securities
            186,973       187,005              
Debt securities
    14       267,549       294,656              
Equity shares
    15       26,330       53,026              
Investments in Group undertakings
    16                   42,196       43,542  
Settlement balances
            17,832       16,589              
Derivatives
    13       992,559       277,402       1,168       173  
Intangible assets
    17       20,049       49,916              
Property, plant and equipment
    18       18,949       18,745              
Deferred taxation
    23       7,082       3,119       3        
Prepayments, accrued income and other assets
    19       24,402       15,662       489       127  
Assets of disposal groups
    20       1,581       45,850              
Total assets
            2,401,652       1,840,829       70,887       51,835  
                                         
Liabilities
                                       
Deposits by banks
    11       258,044       312,294       1,802       5,572  
Customer accounts
    11       639,512       682,363       26        
Debt securities in issue
    11       300,289       274,172       14,179       13,453  
Settlement balances and short positions
    21       54,277       91,021              
Derivatives
    13       971,364       272,052       361       179  
Accruals, deferred income and other liabilities
    22       31,482       34,208       47       8  
Retirement benefit liabilities
    4       2,032       460              
Deferred taxation
    23       4,165       5,400             3  
Insurance liabilities
    24       9,976       10,162              
Subordinated liabilities
    25       49,154       38,043       10,314       7,743  
Liabilities of disposal groups
    20       859       29,228              
Total liabilities
            2,321,154       1,749,403       26,729       26,958  
                                         
Minority interests
    26       21,619       38,388              
Equity owners
    27, 28       58,879       53,038       44,158       24,877  
Total equity
            80,498       91,426       44,158       24,877  
                                         
Total liabilities and equity
            2,401,652       1,840,829       70,887       51,835  

The accompanying notes on pages 173 to 252, the accounting policies on pages 162 to 172 and the audited sections of ‘The Business Review: Risk, Capital and Liquidity Management’ on pages 57 to 123 form an integral part of these financial statements.
 
The accounts were approved by the Board of directors on 25 February 2009 and signed on its behalf by:

 
Philip Hampton
Stephen Hester
Guy Whittaker
Chairman
Group Chief Executive
Group Finance Director
 
 
159


 

 
Statements of recognised income and expense for the year ended 31 December 2008

 
   
Group
   
Company
 
   
2008
   
2007
   
2006
   
2008
   
2007
   
2006
 
      £m       £m       £m       £m       £m       £m  
Available-for-sale investments
                                               
Net valuation (losses)/gains taken direct to equity
    (8,096 )     (776 )     4,792                    
Net loss/(profit) taken to income
    690       (513 )     (313 )                  
                                                 
Cash flow hedges
                                               
Net losses taken direct to equity
    (1,618 )     (426 )     (109 )                  
Net losses/(gains) taken to earnings
    162       (138 )     (140 )     2       3       3  
                                                 
Exchange differences on translation of foreign operations
    15,425       2,210       (1,681 )                  
Actuarial (losses)/gains on defined benefit plans
    (2,287 )     2,189       1,781                    
Income before tax on items recognised direct in equity
    4,276       2,546       4,330       2       3       3  
Tax on items recognised direct in equity
    2,786       (170 )     (1,173 )     (1 )     (1 )     (1 )
Net income recognised direct in equity
    7,062       2,376       3,157       1       2       2  
(Loss)/profit for the period
    (34,373 )     7,712       6,497       (9,602 )     2,499       3,499  
Total recognised income and expense for the year
    (27,311 )     10,088       9,654       (9,601 )     2,501       3,501  
                                                 
Attributable to:
                                               
Equity owners
    (22,979 )     8,610       7,707       (9,601 )     2,501       3,501  
Minority interests
    (4,332 )     1,478       1,947                    
      (27,311 )     10,088       9,654       (9,601 )     2,501       3,501  

 
The accompanying notes on pages 173 to 252, the accounting policies on pages 162 to 172 and the audited sections of ‘The Business Review: Risk, Capital and Liquidity Management’ on pages 57 to 123 form an integral part of these financial statements.
 
  
Cash flow statements for the year ended 31 December 2008

 

         
Group
   
Company
 
         
2008
   
2007
   
2006
   
2008
   
2007
   
2006
 
   
Note
      £m       £m       £m       £m       £m       £m  
Operating activities
                                                     
Operating (loss)/profit before tax
          (40,667 )     9,832       9,186       (10,017 )     2,372       3,486  
Operating profit before tax on discontinued activities
      4,208       68                          
                                                       
Adjustments for:
                                                     
Depreciation and amortisation
          3,154       1,932       1,678                    
Write-down of goodwill and other intangible assets
      32,581                                
Write-down of investment in subsidiaries
                                  14,321              
Interest on subordinated liabilities
          2,144       1,518       1,386       499       470       520  
Charge for defined benefit pension schemes
          490       489       580                    
Cash contribution to defined benefit pension schemes
      (810 )     (599 )     (536 )                  
Elimination of non-cash items on discontinued activities
      592       62                          
Elimination of foreign exchange differences
          (41,874 )     (10,282 )     4,516       1,778       (58 )     (22 )
Other non-cash items
          8,603       (3,235 )     (1,120 )     (478 )     1       18  
Net cash (outflow)/inflow from trading activities
      (31,579 )     (215 )     15,690       6,103       2,785       4,002  
Changes in operating assets and liabilities
          (42,219 )     28,261       3,980       (22,254 )     15,562       (508 )
Net cash flows from operating activities before tax
      (73,798 )     28,046       19,670       (16,151 )     18,347       3,494  
Income taxes (paid)/received
          (1,540 )     (2,442 )     (2,229 )     119       6       154  
Net cash flows from operating activities
    33       (75,338 )     25,604       17,441       (16,032 )     18,353       3,648  
                                                         
Investing activities
                                                       
Sale and maturity of securities
            53,390       63,007       27,126                    
Purchase of securities
            (55,229 )     (61,020 )     (19,126 )                  
Investment in subsidiaries
                              (10,349 )     (18,510 )     (1,097 )
Disposal of subsidiaries
                              700       6        
Sale of property, plant and equipment
            2,228       5,786       2,990                    
Purchase of property, plant and equipment
            (5,757 )     (5,080 )     (4,282 )                  
Proceeds on disposal of discontinued activities
        20,113       (334 )                        
Net investment in business interests and intangible assets
34       2,252       13,640       (63 )                  
Loans to subsidiaries
                                           
Repayments from subsidiaries
                                    469       547  
Net cash flows from investing activities
            16,997       15,999       6,645       (9,649 )     (18,035 )     (550 )
                                                         
Financing activities
                                                       
Issue of ordinary shares
            49       77       104       49       77       104  
Placing and open offer
            19,741                   19,741              
Rights issue
            12,000                   12,000              
Issue of other equity interests
                  3,600       671               3,600       671  
Issue of paid up equity
                  1,073                   1,073        
Issue of subordinated liabilities
            2,413       1,018       3,027                   399  
Proceeds of minority interests issued
            1,427       31,095       1,354                    
Redemption of minority interests
            (13,579 )     (545 )     (81 )                  
Repurchase of ordinary shares
                        (991 )                 (991 )
Shares purchased by employee trusts
            (64 )     (65 )     (254 )                  
Shares issued under employee share schemes
        2       79       108                   7  
Repayment of subordinated liabilities
            (1,727 )     (1,708 )     (1,318 )           (469 )     (547 )
Dividends paid
            (3,193 )     (3,411 )     (2,727 )     (2,908 )     (3,290 )     (2,661 )
Interest on subordinated liabilities
            (1,967 )     (1,522 )     (1,409 )     (466 )     (455 )     (497 )
Net cash flows from financing activities
            15,102       29,691       (1,516 )     28,416       536       (3,515 )
Effects of exchange rate changes on cash and cash equivalents
            29,209       6,010       (3,468 )     761       62       (52 )
                                                         
Net (decrease)/increase in cash and cash equivalents
        (14,030 )     77,304       19,102       3,496       916       (469 )
Cash and cash equivalents 1 January
            148,955       71,651       52,549       1,573       657       1,126  
Cash and cash equivalents 31 December
            134,925       148,955       71,651       5,069       1,573       657  
 
The accompanying notes on pages 173 to 252, the accounting policies on pages 162 to 172 and the audited sections of ‘The Business Review: Risk, Capital and Liquidity Management’ on pages 57 to 123 form an integral part of these financial statements.
 

 
Accounting policies 

 
 
1. Presentation of accounts
The accounts are prepared in accordance with International Financial Reporting Standards issued by the International Accounting Standards Board (IASB) and interpretations issued by the International Financial Reporting Interpretations Committee of the IASB (together IFRS) as adopted by the European Union (EU). The EU has not adopted the complete text of IAS 39 ‘Financial Instruments: Recognition and Measurement’; it has relaxed some of the standard’s hedging requirements. The Group has not taken advantage of this relaxation and has adopted IAS 39 as issued by the IASB: the Group’s financial statements are prepared in accordance with IFRS as issued by the IASB. The 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 Group adopted IFRS 8 ‘Operating Segments’ with effect from 1 January 2008. Early adoption of IFRS 8 has not materially affected segmental disclosures.
 
In October 2008, the IASB issued and, the European Union endorsed, amendments to IAS 39 ‘Financial Instruments: Recognition and Measurement’ to permit the reclassification of financial assets out of the held-for-trading (HFT) and available-for-sale (AFS) categories subject to certain restrictions. Transfers must be made at fair value and this fair value becomes the instruments’ new cost or amortised cost. The amendments are effective from 1 July 2008. Reclassifications made before 1 November 2008 were backdated to 1 July 2008; subsequent reclassifications were effective from the date the reclassification was made.
 
The Group has reclassified certain loans and debt securities out of the held-for-trading and available-for-sale categories into the loans and receivables category. It has also reclassified certain debt securities out of the held-for-trading category into the available-for-sale category. The balance sheet values of these assets, the effect of the reclassification on the income statement and the impairment losses relating to these assets are shown in Note 11 Financial instruments on page 193.
 
The 2007 comparative amounts have been restated for the netting of certain derivative asset and derivative liability balances with the London Clearing House as described in Note 13; the finalisation of the ABN AMRO acquisition accounting as set out in Note 34; and for the classification of Banco Real as a discontinued operation as described in Note 20.
 
The Group is not required to include reconciliations of shareholders’ equity and net income under IFRS and US GAAP in its filings with the Securities and Exchange Commission in the US.
 
The company is incorporated in the UK and registered in Scotland. The accounts are prepared on the historical cost basis except that the following assets and liabilities are stated at their fair value: derivative financial instruments, held-for-trading financial assets and financial liabilities, financial assets and financial liabilities that are designated as at fair value through profit or loss, available-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.
 
The company accounts are presented in accordance with the Companies Act 1985.
 
2. Basis of consolidation
The consolidated financial statements incorporate the financial statements of the company and entities (including certain special purpose entities) that continue to be 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 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.
 
The results of subsidiaries acquired are included in the consolidated income statement from the date control passes up until the Group ceases to control them through a sale or significant change in circumstances.
 
All intra-group balances, transactions, income and expenses are eliminated on consolidation. The consolidated accounts are prepared using uniform accounting policies.
 
3. Revenue recognition
Interest income on financial assets that are classified as loans and receivables, available-for-sale or held-to-maturity and interest expense on financial liabilities other than those at fair value through profit or loss are determined using the effective interest method. The effective interest method is a method of calculating the amortised cost of a financial asset or financial liability (or group of financial assets or liabilities) and of allocating the interest income or interest expense over the expected life of the asset or liability. The effective interest rate is the rate that exactly discounts estimated future cash flows to the instrument’s initial carrying amount. Calculation of the effective interest rate takes into account fees payable or receivable, that are an integral part of the instrument’s yield, premiums or discounts on acquisition or issue, early redemption fees and transaction costs. All contractual terms of a financial instrument are considered when estimating future cash flows.
 
Financial assets and financial liabilities held-for-trading or designated as at fair value through profit or loss are recorded at fair value. Changes in fair value are recognised in profit or loss together with dividends and interest receivable and payable.
 
Commitment and utilisation fees are determined as a percentage of the outstanding facility. If it is unlikely that a specific lending arrangement will be entered into, such fees are taken to profit or loss over the life of the facility otherwise they are deferred and included in the effective interest rate on the advance.
 

 
 
Fees in respect of services are recognised as the right to consideration accrues through the provision of the service to the customer. The arrangements are generally contractual and the cost of providing the service is incurred as the service is rendered. The price is usually fixed and always determinable. The application of this policy to significant fee types is outlined below.
 
Payment services: this comprises income received for payment services including cheques cashed, direct debits, Clearing House Automated Payments (the UK electronic settlement system) and CHAPs payments (the automated clearing house that processes direct debits and direct credits). These are generally charged on a per transaction basis. The income is earned when the payment or transaction occurs. Charges for payment services are usually debited to the customer’s account monthly or quarterly in arrears. Accruals are raised for services provided but not charged at period end.
 
Card related services: fees from credit card business include:
 
· 
Commission received from retailers for processing credit and debit card transactions: income is accrued to the income statement as the service is performed;
 
· 
Interchange received: as issuer, the Group receives a fee (interchange) each time a cardholder purchases goods and services. The Group also receives interchange fees from other card issuers for providing cash advances through its branch and Automated Teller Machine networks. These fees are accrued once the transaction has taken place; and
 
·
An annual fee payable by a credit card holder is deferred and taken to profit or loss over the period of the service i.e. 12 months.
 
Insurance brokerage: this is made up of fees and commissions received from the agency sale of insurance. Commission on the sale of an insurance contract is earned at the inception of the policy, as the insurance has been arranged and placed. However, provision is made where commission is refundable in the event of policy cancellation in line with estimated cancellations.
 
Investment management fees: fees charged for managing investments are recognised as revenue as the services are provided. Incremental costs that are directly attributable to securing an investment management contract are deferred and charged as expense as the related revenue is recognised.
 
Insurance premiums: see accounting policy 12.
 
4. Assets held for sale and discontinued operations
A non-current asset (or disposal group) is classified as held for sale if the Group will recover the carrying amount principally through a sale transaction rather than through continuing use. A non-current asset (or disposal group) classified as held for sale is measured at the lower of its carrying amount and fair value less costs to sell. If the asset (or disposal group) is acquired as part of a business combination it is initially measured at fair value less costs to sell. Assets and liabilities of disposal groups classified as held for sale and non-current assets classified as held for sale are shown separately on the face of the balance sheet.
 
The results of discontinued operations are shown as a single amount on the face of the income statement comprising the post-tax profit or loss of discontinued operations and the post-tax gain or loss recognised either on measurement to fair value less costs to sell or on the disposal of the discontinued operation. A discontinued operation is a cash-generating unit or a group of cash-generating units that either has been disposed of, or is classified as held for sale, and (a) represents a separate major line of business or geographical area of operations, (b) is part of a single co-ordinated plan to dispose of a separate major line of business or geographical area of operations or (c) is a subsidiary acquired exclusively with a view to resale.
 
5. Pensions and other post-retirement benefits
The Group provides post-retirement benefits in the form of pensions and healthcare plans to eligible employees.
 
For defined benefit schemes, scheme liabilities are measured on an actuarial basis using the projected unit credit method and discounted at a rate that reflects the current rate of return on a high quality corporate bond of equivalent term and currency to the scheme liabilities. Scheme assets are measured at their fair value. Any surplus or deficit of scheme assets over liabilities is recognised in the balance sheet as an asset (surplus) or liability (deficit). The current service cost and any past service costs together with the expected return on scheme assets less the unwinding of the discount on the scheme liabilities is charged to operating expenses. Actuarial gains and losses are recognised in full in the period in which they occur outside profit or loss and presented in the statement of recognised income and expense. Contributions to defined contribution pension schemes are recognised in the income statement when payable.
 
6. Intangible assets and goodwill
Intangible assets that are acquired by the Group are stated at cost less accumulated amortisation and impairment losses. Amortisation is charged to profit or loss over the assets’ estimated economic lives using methods that best reflect the pattern of economic benefits and is included in depreciation and amortisation. The estimated useful economic lives are as follows:
 
Core deposit intangibles
6 to 10 years
Other acquired intangibles
5 to 10 years
Computer software
3 to 5 years

Expenditure on internally generated goodwill and brands is written-off as incurred. Direct costs relating to the development of internal-use computer software are capitalised once technical feasibility and economic viability have been established. These costs include payroll, the costs of materials and services, and directly attributable overheads. Capitalisation of costs ceases when the software is capable of operating as intended. During and after development, accumulated costs are reviewed for impairment against the projected benefits that the software is expected to generate. Costs incurred prior to the establishment of technical feasibility and economic viability are expensed as incurred as are all training costs and general overheads. The costs of licences to use computer software that are expected to generate economic benefits beyond one year are also capitalised.
 
 

 
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 category ‘Intangible 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.
 
On implementation of IFRS, the Group did not restate business combinations that occurred before January 2004. Under previous GAAP, goodwill arising on acquisitions after 1 October 1998 was capitalised and amortised over its estimated useful economic life. Goodwill arising on acquisitions before 1 October 1998 was deducted from equity. The carrying amount of goodwill in the Group’s opening IFRS balance sheet (1 January 2004) was £ 13,131 million, its carrying value under previous GAAP.
 
7. Property, plant and equipment
Items of property, plant and equipment are stated at cost less accumulated depreciation 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.
 
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 9)) 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

Under previous GAAP, the Group’s freehold and long leasehold property occupied for its own use was recorded at valuation on the basis of existing use value. The Group elected to use this valuation as at 31 December 2003 (£ 2,391 million) as deemed cost for its opening IFRS balance sheet (1 January 2004).
 
8. Impairment of intangible assets and property, plant and equipment
At each reporting date, the Group assesses whether there is any indication that its intangible assets, or property, plant and equipment are impaired. If any such indication exists, the Group estimates the recoverable amount of the asset and the impairment loss if any. Goodwill is tested for impairment annually or more frequently if events or changes in circumstances indicate that it might be impaired. If an asset does not generate cash flows that are independent from those of other assets or groups of assets, recoverable amount is determined for the cash-generating unit to which the asset belongs. The recoverable amount of an asset is the higher of its fair value less cost to sell and its value in use. Value in use is the present value of future cash flows from the asset or cash-generating unit discounted at a rate that reflects market interest rates adjusted for risks specific to the asset or cash-generating unit that have not been reflected in the estimation of future cash flows. If the recoverable amount of an intangible or tangible asset is less than its carrying value, an impairment loss is recognised immediately in profit or loss and the carrying value of the asset reduced by the amount of the loss. A reversal of an impairment loss on intangible assets (excluding goodwill) or property, plant and equipment is recognised as it arises provided the increased carrying value does not exceed that which it would have been had no impairment loss been recognised. Impairment losses on goodwill are not reversed.
 
9. Investment property
Investment property comprises freehold and leasehold properties that are held to earn rentals or for capital appreciation or both. It is not depreciated but is stated at fair value based on valuations by independent registered valuers. Fair value is based on current prices for similar properties in the same location and condition. Any gain or loss arising from a change in fair value is recognised in profit or loss. Rental income from investment property is recognised on a straight-line basis over the term of the lease. Lease incentives granted are recognised as an integral part of the total rental income.
 
10. 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 reported in income from trading activities 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.
 
The assets and liabilities of foreign operations, including goodwill and fair value adjustments arising on acquisition, are translated into sterling at foreign exchange rates ruling at the balance sheet date. The revenues and expenses of foreign operations are translated into sterling at average exchange rates unless these do not approximate to the foreign exchange rates ruling at the dates of the transactions. Foreign exchange differences arising on the translation of a foreign operation are recognised directly in equity and included in profit or loss on its disposal.
 
 
 

 
11. 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.
 
Finance lease receivables are stated in the balance sheet at the amount of the net investment in the lease being the minimum lease payments and any unguaranteed residual value discounted at the interest rate implicit in the lease. Finance lease income is allocated to accounting periods so as to give a constant periodic rate of return before tax on the net investment. Unguaranteed residual values are subject to regular review to identify potential impairment. If there has been a reduction in the estimated unguaranteed residual value, the income allocation is revised and any reduction in respect of amounts accrued is recognised immediately.
 
Rental income from operating leases is credited to the income statement on a receivable basis over the term of the lease. Operating lease assets are included within Property, plant and equipment and depreciated over their useful lives (see accounting policy 7).
 
12. 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.
 
Premiums from general insurance contracts are recognised in the accounting period in which they begin. Unearned premiums represent the proportion of the net premiums that relate to periods of insurance after the balance sheet date and are calculated over the period of exposure under the policy, on a daily basis, 24th’s basis or allowing for the estimated incidence of exposure under policies which are longer than twelve months. Provision is made where necessary for the estimated amount of claims over and above unearned premiums including that in respect of future written business on discontinued lines under the run-off of delegated underwriting authority arrangements. The provision is designed to meet future claims and related expenses and is calculated across related classes of business on the basis of a separate carry forward of deferred acquisition expenses after making allowance for investment income.
 
Acquisition expenses relating to new and renewed business for all classes are expensed over the period during which the premiums are earned. The principal acquisition costs so deferred are commissions payable, costs associated with the telesales and underwriting staff and prepaid claims handling costs in respect of delegated claims handling arrangements for claims which are expected to occur after the balance sheet date. Claims and the related reinsurance are recognised in the accounting period in which the loss occurs. Provision is made for the full cost of settling outstanding claims at the balance sheet date, including claims estimated to have been incurred but not yet reported at that date, and claims handling expenses. The related reinsurance receivable is recognised at the same time.
 
Life assurance
The Group’s long-term assurance contracts include whole-life term assurance, endowment assurance, flexible whole-life, pension and annuity contracts that are expected to remain in force for an extended period of time. Long-term assurance contracts under which the Group does not accept significant insurance risk are classified as financial instruments.
 
The Group recognises the value of in-force long-term assurance contracts as an asset. Cash flows associated with in-force contracts and related assets, including reinsurance cash flows, are projected, using appropriate assumptions as to future mortality, persistency and levels of expenses and excluding the value of future investment margins, to estimate future surpluses attributable to the Group. These surpluses, discounted at a risk-adjusted rate, are recognised as a separate asset. Changes in the value of this asset are included in profit or loss.
 
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.
 
Reinsurance
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.
 
13. Provisions
The Group recognises a provision for a present obligation resulting from a past event when it is more likely than not that it will be required to transfer economic benefits to settle the obligation and the amount of the obligation can be estimated reliably.
 
Provision is made for restructuring costs, including the costs of redundancy, when the Group has a constructive obligation to restructure. An obligation exists when the Group has a detailed formal plan for the restructuring and has raised a valid expectation in those affected by starting to implement the plan or announcing its main features.
 
If the Group has a contract that is onerous, it recognises the present obligation under the contract as a provision. An onerous contract is one where the unavoidable costs of meeting the obligations under it exceed the expected economic benefits. When the Group vacates a leasehold property, a provision is recognised for the costs under the lease less any expected economic benefits (such as rental income).
 
Contingent liabilities are possible obligations arising from past events whose existence will be confirmed only by uncertain future events or present obligations arising from past events that are not recognised because either an outflow of economic benefits is not probable or the amount of the obligation cannot be reliably measured. Contingent liabilities are not recognised but information about them is disclosed unless the possibility of any outflow of economic benefits in settlement is remote.
 
 


14. 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.
 
Deferred tax assets are only recognised to the extent that it is probable that they will be recovered.
 
15. Financial assets
On initial recognition, financial assets are classified into held-to-maturity investments; available-for-sale financial assets; held-for-trading; designated as at fair value through profit or loss; or loans and receivables.
 
Held-to-maturity investments – a financial asset may be 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 accounting policy 3) less any impairment losses.
 
Held-for-trading – a financial asset is classified as held-for-trading if it is acquired principally for sale in the near term, or forms part of a portfolio of financial instruments that are managed together and for which there is evidence of short-term profit taking, or it is a derivative (not in a qualifying hedge relationship). Held-for-trading financial assets are recognised at fair value with transaction costs being recognised in profit or loss. Subsequently they are measured at fair value. Gains and losses on held-for-trading financial assets are recognised in profit or loss as they arise.
 
Designated as at fair value through profit or loss – financial assets may be designated as at fair value through profit or loss only if such designation (a) eliminates or significantly reduces a measurement or recognition inconsistency; or (b) applies to a group of financial assets, financial liabilities or both, that the Group manages and evaluates on a fair value basis; or (c) relates to an instrument that contains an embedded derivative which is not evidently closely related to the host contract.
 
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.
 
Loans and receivables – non-derivative financial assets with fixed or determinable repayments that are not quoted in an active market are classified as loans and receivables, except those that are classified as available-for-sale or as held-for-trading, or designated as at fair value through profit or loss. Loans and receivables are initially recognised at fair value plus directly related transaction costs. They are subsequently measured at amortised cost using the effective interest method (see accounting policy 3) less any impairment losses.
 
Available-for-sale –financial assets that are not classified as held-to-maturity; held-for-trading; designated as at fair value through profit or loss; or loans and receivables, are classified as available-for-sale. Financial assets can be designated as available-for-sale on initial recognition. Available-for-sale financial assets are initially recognised at fair value plus directly related transaction costs. They are subsequently measured at fair value. Unquoted equity investments whose fair value cannot be measured reliably are carried at cost and classified as available-for-sale financial assets. Impairment losses and exchange differences resulting from retranslating the amortised cost of foreign currency monetary available-for-sale financial assets are recognised in profit or loss together with interest calculated using the effective interest method (see accounting policy 3). 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.
 
Reclassifications – held-for-trading and available-for-sale financial assets that meet the definition of loans and receivables (non-derivative financial assets with fixed or determinable payments that are not quoted in an active market) may be reclassified to loans and receivables if the Group has the intention and ability to hold the financial asset for the foreseeable future or until maturity. The Group typically regards the foreseeable future as twelve months from the date of reclassification. Additionally, held-for-trading financial assets that do not meet the definition of loans and receivables may, in rare circumstances, be transferred to available-for-sale financial assets or to held-to-maturity investments.
 
Regular way purchases of financial assets classified as loans and receivables are recognised on settlement date; all other regular way purchases are recognised on trade date.
 
Fair value for a net open position in a financial asset that is quoted in an active market is the current bid price times the number of units of the instrument held. Fair values for financial assets not quoted in an active market are determined using appropriate valuation techniques including discounting future cash flows, option pricing models and other methods that are consistent with accepted economic methodologies for pricing financial assets.
 
 


16. Impairment of financial assets
The Group assesses at each balance sheet date whether there is any objective evidence that a financial asset or group of financial assets classified as held-to-maturity, available-for-sale or loans and receivables is impaired. A financial asset or portfolio of financial assets is impaired and an impairment loss incurred if there is objective evidence that an event or events since initial recognition of the asset have adversely affected the amount or timing of future cash flows from the asset.
 
Financial assets carried at amortised cost – if there is objective evidence that an impairment loss on a financial asset or group of financial assets classified as loans and receivables or as held-to- maturity investments has been incurred, the Group measures the amount of the loss as the difference between the carrying amount of the asset or group of assets and the present value of estimated future cash flows from the asset or group of assets discounted at the effective interest rate of the instrument at initial recognition.
 
Impairment losses are assessed individually for financial assets that are individually significant and individually or collectively for assets that are not individually significant. In making collective assessment of impairment, financial assets are grouped into portfolios on the basis of similar risk characteristics. Future cash flows from these portfolios are estimated on the basis of the contractual cash flows and historical loss experience for assets with similar credit risk characteristics. Historical loss experience is adjusted, on the basis of current observable data, to reflect the effects of current conditions not affecting the period of historical experience.
 
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.
 
Financial assets carried at fair value – when a decline in the fair value of a financial asset classified as available-for-sale has been recognised directly in equity and there is objective evidence that the asset is impaired, the cumulative loss is removed from equity and recognised in profit or loss. The loss is measured as the difference between the amortised cost of the financial asset and its current fair value. Impairment losses on available-for-sale equity instruments are not reversed through profit or loss, but those on available-for-sale debt instruments are reversed, if there is an increase in fair value that is objectively related to a subsequent event.
 
17. Financial liabilities
On initial recognition financial liabilities are classified into held-for-trading; designated as at fair value through profit or loss; or amortised cost.
 
A financial liability is classified as held-for-trading if it is incurred principally for repurchase in the near term, or forms part of a portfolio of financial instruments that are managed together and for which there is evidence of short-term profit taking, or it is a derivative (not in a qualifying hedge relationship). Held-for-trading financial liabilities are recognised at fair value with transaction costs being recognised in profit or loss. Subsequently they are measured at fair value. Gains and losses are recognised in profit or loss as they arise.
 
Financial liabilities 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 liabilities that are designated as at fair value through profit or loss are recognised in profit or loss as they arise.
 
Financial liabilities may be designated as at fair value through profit or loss only if such designation (a) eliminates or significantly reduces a measurement or recognition inconsistency; or (b) applies to a group of financial assets, financial liabilities or both that the Group manages and evaluates on a fair value basis; or (c) relates to an instrument that contains an embedded derivative which is not evidently closely related to the host contract.
 
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 accounting policy 3).
 
Fair value for a net open position in a financial liability that is quoted in an active market is the current offer price times the number of units of the instrument held or issued. Fair values for financial liabilities not quoted in an active market are determined using appropriate valuation techniques including discounting future cash flows, option pricing models and other methods that are consistent with accepted economic methodologies for pricing financial liabilities.
 
 


18. Loan commitments
Provision is made for loan commitments, other than those classified as held-for-trading, if it is probable that the facility will be drawn and the resulting loan will be recognised at a value less than the cash advanced. Syndicated loan commitments in excess of the level of lending under the commitment approved for retention by the Group are classified as held-for-trading and measured at fair value.
 
19. Derecognition
A financial asset is derecognised when it has been transferred and the transfer qualifies for derecognition. A transfer requires that the Group either: (a) transfers the contractual rights to receive the asset’s cash flows; or (b) retains the right to the asset’s cash flows but assumes a contractual obligation to pay those cash flows to a third party. After a transfer, the Group assesses the extent to which it has retained the risks and rewards of ownership of the transferred asset. If substantially all the risks and rewards have been retained, the asset remains on the balance sheet. If substantially all the risks and rewards have been transferred, the asset is derecognised. If substantially all the risks and rewards have been neither retained nor transferred, the Group assesses whether or not it has retained control of the asset. If it has not retained control, the asset is derecognised. Where the Group has retained control of the asset, it continues to recognise the asset to the extent of its continuing involvement.
 
A financial liability is removed from the balance sheet when the obligation is discharged, or cancelled, or expires.
 
20. Sale and repurchase transactions
Securities subject to a sale and repurchase agreement under which substantially all the risks and rewards of ownership are retained by the Group continue to be shown on the balance sheet and the sale proceeds recorded as a deposit. Securities acquired in a reverse sale and repurchase transaction under which the Group is not exposed to substantially all the risks and rewards of ownership are not recognised on the balance sheet and the consideration is recorded in Loans and advances to banks or Loans and advances to customers as appropriate.
 
Securities borrowing and lending transactions are usually secured by cash or securities advanced by the borrower. Borrowed securities are not recognised on the balance sheet or lent securities derecognised. Cash collateral received or given is treated as a loan or deposit; collateral in the form of securities is not recognised. However, where securities borrowed are transferred to third parties, a liability for the obligation to return the securities to the stock lending counterparty is recorded.
 
21. Netting
Financial assets and financial liabilities are offset and the net amount presented in the balance sheet when, and only when, the Group currently has a legally enforceable right to set off the recognised amounts; and it intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously. The Group is party to a number of arrangements, including master netting agreements, that give it the right to offset financial assets and financial liabilities but where it does not intend to settle the amounts net or simultaneously and therefore the assets and liabilities concerned are presented gross.
 
22. Capital instruments
The Group classifies a financial instrument that it issues as a financial asset, financial liability or an equity instrument in accordance with the substance of the contractual arrangement. An instrument is classified as a liability if it is a contractual obligation to deliver cash or another financial asset, or to exchange financial assets or financial liabilities on potentially unfavourable terms. An instrument is classified as equity if it evidences a residual interest in the assets of the Group after the deduction of liabilities. The components of a compound financial instrument issued by the Group are classified and accounted for separately as financial assets, financial liabilities or equity as appropriate.
 
23. Derivatives and hedging
Derivative financial instruments are initially recognised, and subsequently measured, at fair value. Derivative fair values are determined from quoted prices in active markets where available. Where there is no active market for an instrument, fair value is derived from prices for the derivative’s components using appropriate pricing or valuation models.
 
A derivative embedded in a contract is accounted for as 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.
 
Gains and losses arising from changes in the fair value of a derivative are recognised as they arise in profit or loss unless the derivative is the hedging instrument in a qualifying hedge. The Group enters into three types of hedge relationship: hedges of changes in the fair value of a recognised asset or liability or firm commitment (fair value hedges); hedges of the variability in cash flows from a recognised asset or liability or a forecast transaction (cash flow hedges); and hedges of the net investment in a foreign operation.
 
Hedge relationships are formally documented at inception. The documentation includes identification of the hedged item and the hedging instrument, details the risk that is being hedged and the way in which effectiveness will be assessed at inception and during the period of the hedge. If the hedge is not highly effective in offsetting changes in fair values or cash flows attributable to the hedged risk, consistent with the documented risk management strategy, hedge accounting is discontinued.
 
Fair value hedge – in a fair value hedge, the gain or loss on the hedging instrument is recognised in profit or loss. The gain or loss on the hedged item attributable to the hedged risk is recognised in profit or loss and adjusts the carrying amount of the hedged item. Hedge accounting is discontinued if the hedge no longer meets the criteria for hedge accounting or if the hedging instrument expires or is sold, terminated or exercised or if hedge designation is revoked. If the hedged item is one for which the effective interest rate method is used, any cumulative adjustment is amortised to profit or loss over the life of the hedged item using a recalculated effective interest rate.
 
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 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.
 
Hedge of net investment in a foreign operation – in the hedge of a net investment in a foreign operation, the portion of foreign exchange differences arising on the hedging instrument determined to be an effective hedge is recognised directly in equity. Any ineffective portion is recognised in profit or loss. Non-derivative financial liabilities as well as derivatives may be the hedging instrument in a net investment hedge.
 
24. 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.
 
25. 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.
 
26. Shares in Group entities
The company’s investments in its subsidiaries are stated at cost less any impairment.
 
Critical accounting policies and key sources of estimation uncertainty
The reported results of the Group are sensitive to the accounting policies, assumptions and estimates that underlie the preparation of its financial statements. UK company law and IFRS require the directors, in preparing the Group’s financial statements, to select suitable accounting policies, apply them consistently and make judgements and estimates that are reasonable and prudent. In the absence of an applicable standard or interpretation, IAS 8 ‘Accounting Policies, Changes in Accounting Estimates and Errors’, requires management to develop and apply an accounting policy that results in relevant and reliable information in the light of the requirements and guidance in IFRS dealing with similar and related issues and the IASB’s Framework for the Preparation and Presentation of Financial Statements. The judgements and assumptions involved in the Group’s accounting policies that are considered by the Board to be the most important to the portrayal of its financial condition are discussed below. The use of estimates, assumptions or models that differ from those adopted by the Group would affect its reported results.
 
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.
 
At 31 December 2008, gross loans and advances to customers totalled £ 885,611 million (2007 – £ 834,987 million) and customer loan impairment provisions amounted to £ 10,889 million (2007 – £ 6,449 million).
 
There are two components to the Group’s loan impairment provisions: individual and collective.
 
Individual component – all impaired loans that exceed specific thresholds are individually assessed for impairment. Individually assessed loans principally comprise the Group’s portfolio of commercial loans to medium and large businesses. Impairment losses are recognised as the difference between the carrying value of the loan and the discounted value of management’s best estimate of future cash repayments and proceeds from any security held. These estimates take into account the customer’s debt capacity and financial flexibility; the level and quality of its earnings; the amount and sources of cash flows; the industry in which the counterparty operates; and the realisable value of any security held. Estimating the quantum and timing of future recoveries involves significant judgement. The size of receipts will depend on the future performance of the borrower and the value of security, both of which will be affected by future economic conditions; additionally, collateral may not be readily marketable. The actual amount of future cash flows and the date they are received may differ from these estimates and consequently actual losses incurred may differ from those recognised in these financial statements.
 
 

 
Collective component –this is made up of two elements: loan impairment provisions for impaired loans that are below individual assessment thresholds (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 using a present value methodology taking into account the level of arrears, security, past loss experience, credit scores and defaults based on portfolio trends. The most significant factors in establishing these provisions are the expected loss rates and the related average life. These portfolios include credit card receivables and other personal advances including mortgages. The future credit quality of these portfolios is subject to uncertainties that could cause actual credit losses to differ materially from reported loan impairment provisions. These uncertainties include the economic environment, notably interest rates and their effect on customer spending, the unemployment level, payment behaviour and bankruptcy trends.
 
Pensions
The Group operates a number of defined benefit pension schemes as described in Note 4 on the accounts. The assets of the schemes are measured at their fair value at the balance sheet date. Scheme liabilities are measured using the projected unit method, which takes account of projected earnings increases, using actuarial assumptions that give the best estimate of the future cash flows that will arise under the scheme liabilities. These cash flows are discounted at the interest rate applicable to high-quality corporate bonds of the same currency and term as the liabilities. Any recognisable surplus or deficit of scheme assets over liabilities is recognised in the balance sheet as an asset (surplus) or liability (deficit). In determining the value of scheme liabilities, assumptions are made as to price inflation, dividend growth, pension increases, earnings growth and employees. There is a range of assumptions that could be adopted in valuing the schemes’ liabilities. Different assumptions could significantly alter the amount of the surplus or deficit recognised in the balance sheet and the pension cost charged to the income statement. The assumptions adopted for the Group’s pension schemes are set out in Note 4 on the accounts together with the sensitivity of reported amounts to changes in those assumptions. A pension asset of £36 million and a liability of £2,032 million were recognised in the balance sheet at 31 December 2008 (2007 asset – £575 million; liability – £460 million).
 
Fair value – financial instruments
Financial instruments classified as held-for-trading or designated as at fair value through profit or loss and financial assets classified as available-for-sale are recognised in the financial statements at fair value. All derivatives are measured at fair value. Gains or losses arising from changes in the fair value of financial instruments classified as held-for-trading or designated as at fair value through profit or loss are included in the income statement. Unrealised gains and losses on available-for-sale financial assets are recognised directly in equity unless an impairment loss is recognised.
 
Financial instruments measured at fair value include:
 
Loans and advances (held-for-trading and designated as at fair value though profit or loss) – principally comprise reverse repurchase agreements (reverse repos) and syndicated loans. In repurchase agreements one party agrees to sell securities to another and simultaneously agrees to repurchase the securities at a future date for a specified price. The repurchase price is fixed at the outset, usually being the original sale price plus an amount representing interest for the period from the sale to the repurchase. Syndicated loans measured at fair value are amounts retained, from syndications where the Group was lead manager or underwriter, in excess of the Group’s intended long term participation.
 
Debt securities (held-for-trading, designated as at fair value though profit or loss and available-for-sale) – debt securities include those issued by governments, municipal bodies, mortgage agencies and financial institutions as well as corporate bonds, debentures and residual interests in securitisations.
 
Equity securities (held-for-trading, designated as at fair value though profit or loss and available-for-sale) comprise equity shares of companies or corporations both listed and unlisted.
 
Deposits by banks and customer accounts (held-for-trading and designated as at fair value though profit or loss) – deposits measured at fair value principally include repurchase agreements (repos) discussed above and investment contracts issued by the Group’s life assurance businesses.
 
Debt securities in issue (held-for-trading and designated as at fair value though profit or loss) – measured at fair value and principally comprise medium term notes.
 
Short positions (held-for-trading) – arise in dealing and market making activities where debt securities and equity shares are sold which the Group does not currently possess.
 
Derivatives – these 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.
 
Swaps include currency swaps, interest rate swaps, credit default swaps, total return swaps and equity and equity index swaps. A swap is an agreement to exchange cash flows in the future in accordance with a pre-arranged formula. In currency swap transactions, interest payment obligations are exchanged on assets and liabilities denominated in different currencies; the exchange of principal may be notional or actual. Interest rate swap contracts generally involve exchange of fixed and floating interest payment obligations without the exchange of the underlying principal amounts.
 
Forwards include forward foreign exchange contracts and forward rate agreements. A forward contract is a contract to buy (or sell) a specified amount of a physical or financial commodity, at an agreed price, on an agreed future date. Forward foreign exchange contracts are contracts for the delayed delivery of currency on a specified future date. Forward
 
 


rate agreements are contracts under which two counterparties agree on the interest to be paid on a notional deposit of a specified term starting on a specific future date; there is no exchange of principal. Futures are exchange-traded forward contracts to buy (or sell) standardised amounts of underlying physical or financial commodities. The Group buys and sells currency, interest rate and equity futures.
 
Options include exchange-traded options on currencies, interest rates and equities and equity indices and OTC currency and equity options, interest rate caps and floors and swaptions. They are contracts that give the holder the right but not the obligation to buy (or sell) a specified amount of the underlying physical or financial commodity at an agreed price on an agreed date or over an agreed period.
 
Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. Fair values are determined from quoted prices in active markets for identical financial assets or financial liabilities where these are available. Fair value for a net open position in a financial asset or financial liability in an active market is the current bid or offer price times the number of units of the instrument held. Where a trading portfolio contains both financial assets and financial liabilities which are derivatives of the same underlying instrument, fair value is determined by valuing the gross long and short positions at current mid market prices, with an adjustment at portfolio level to the net open long or short position to amend the valuation to bid or offer as appropriate. Where the market for a financial instrument is not active, fair value is established using a valuation technique. These valuation techniques involve a degree of estimation, the extent of which depends on the instrument’s complexity and the availability of market-based data. The sensitivity to reasonably possible alternative assumptions of the fair value of financial instruments valued using techniques where at least one significant input is unobservable is given in Note 11 on pages 187 and 188.
 
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 £ 5,478 million at 31 December 2008 (2007 – £ 5,466 million).
 
Provisions are determined by management based on experience of claims settled and on statistical models which require certain assumptions to be made regarding the incidence, timing and amount of claims and any specific factors such as adverse weather conditions. In order to calculate the total provision required, the historical development of claims is analysed using statistical methodology to extrapolate, within acceptable probability parameters, the value of outstanding claims at the balance sheet date. Also included in the estimation of outstanding claims are other assumptions such as the inflationary factor used for bodily injury claims 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.
 
Goodwill
The Group capitalises goodwill arising on the acquisition of businesses, as discussed in accounting policy 6. The carrying value of goodwill as at 31 December 2008 was £ 15,562 million (2007 – £42,953 million).
 
Goodwill is the excess of the cost of an acquired business 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 cash-generating 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 cash-generating 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.
 
Impairment testing inherently involves a number of judgmental areas: the preparation of cash flow forecasts for periods that are beyond the normal requirements of management reporting; the assessment of the discount rate appropriate to the business; estimation of the fair value of cash-generating units; and the valuation of the separable assets of each business whose goodwill is being reviewed. Sensitivity to changes in assumptions is discussed in Note 17 on page 207.
 
Deferred tax
The Group makes provision for deferred tax on short-term and other temporary differences where tax recognition occurs at a different time from accounting recognition.
 
The Group has recognised deferred tax assets in respect of losses, principally in the UK, and short-term timing differences. Tax relief is given for operating losses by offset when future profits arise and therefore the recoverability of deferred tax assets is a matter of judgement.
 
 


Accounting developments
International Financial Reporting Standards
The International Accounting Standards Board issued a revised IAS 23 ‘Borrowing Costs’ in March 2007. Entities are required to capitalise borrowing costs attributable to the development or construction of intangible assets or property plant or equipment. The standard is effective for accounting periods beginning on or after 1 January 2009 and is not expected to have a material effect on the Group or company.
 
The IASB issued a revised IAS 1 ‘Presentation of Financial Statements’ in September 2007 effective for accounting periods beginning on or after 1 January 2009. The amendments to the presentation requirements for financial statements are not expected to have a material effect on the Group or company.
 
The IASB published a revised IFRS 3 ‘Business Combinations’ and related revisions to IAS 27 ‘Consolidated and Separate Financial Statements’ following the completion in January 2008 of its project on the acquisition and disposal of subsidiaries. The standards improve convergence with US GAAP and provide new guidance on accounting for changes in interests in subsidiaries. The cost of an acquisition will comprise only consideration paid to vendors for equity; other costs will be expensed immediately. Groups will only account for goodwill on acquisition of a subsidiary; subsequent changes in interest will be recognised in equity and only on a loss of control will there be a profit or loss on disposal to be recognised in income. The changes are effective for accounting periods beginning on or after 1 July 2009 but both standards may be adopted together for accounting periods beginning on or after 1 July 2007. These changes will affect the Group’s accounting for future acquisitions and disposals of subsidiaries.
 
The IASB published revisions to IAS 32 ‘Financial Instruments: Presentation’ and consequential revisions to other standards in February 2008 to improve the accounting for and disclosure of puttable financial instruments. The revisions are effective for accounting periods beginning on or after 1 January 2009 but together they may be adopted earlier. They are not expected to have a material affect on the Group or the company.
 
The IASB issued an amendment, 'Vesting Conditions and Cancellations', to IFRS 2 'Share-based Payment' in January 2008 that will change the accounting for share awards that have non-vesting conditions. The fair value of these awards does not currently take account of the effect of non-vesting conditions and where such conditions are not subsequently met, costs recognised up to the date of cancellation are reversed. The amendment requires costs not recognised up to the date of cancellation to be recognised immediately. The amendment is effective for accounting periods beginning on or after 1 January 2009. The Group estimates that adoption will cause a restatement of 2008 results, reducing profit by £ 110 million with no material affect on earlier periods. There is not expected to be a material effect on the company.
 
The IASB issued amendments to a number of standards in May 2008 as part of its annual improvements project. The amendments are effective for accounting periods beginning on or after 1 January 2009 and are not expected to have a material effect on the Group or company.
 
Also in May 2008, the IASB issued amendments to IFRS 1 ‘First-time Adoption of International Financial Reporting Standards’ and IAS 27 ‘Consolidated and Separate Financial Statements’ that change the investor's accounting for the cost of an investment in a subsidiary, jointly controlled entity or associate. It does not affect the consolidated accounts but may prospectively affect the company’s accounting and presentation of receipts of dividends from such entities.
 
The IASB issued an amendment to IAS 39 in July 2008 to clarify the IFRS stance on eligible hedged items. The amendment is effective for accounting periods beginning on or after 1 January 2009 and is not expected to have a material effect on the Group or the Bank.
 
The International Financial Reporting Interpretations Committee (IFRIC) issued interpretation IFRIC 15 ‘Agreements for the Construction of Real Estate’ in July 2008. This interpretation clarifies the accounting for construction profits. It is applicable for accounting periods beginning on or after 1 January 2009 and is not expected to have a material effect on the Group or company.
 
The IFRIC issued interpretation IFRIC 16 ‘Hedges of a Net Investment in a Foreign Operation’ in July 2008. The interpretation addresses the nature of the hedged risk and the amount of the hedged item; where in a group the hedging item could be held; and what amounts should be reclassified from equity on the disposal of a foreign operation that had been subject to hedging. The interpretation is effective for accounting periods beginning on or after 1 October 2008 and is not expected to have a material effect on the Group or company.
 
The IFRIC issued interpretation IFRIC 17 ‘Distributions of Non-Cash Assets to Owners’ and the IASB made consequential amendments to IFRS 5 'Non-Current Assets Held for Sale and Discontinued Operations' in December 2008. The interpretation requires distributions to be presented at fair value with any surplus or deficit to be recognised in income. The amendment to IFRS 5 extends the definition of disposal groups and discontinued operations to disposals by way of distribution. The interpretation is effective for accounting periods beginning on or after 1 July 2009, to be adopted at the same time as IFRS 3 (revised 2008), and is not expected to have a material effect on the Group or company.
 
The IFRIC issued interpretation IFRIC 18 ‘Transfers of Assets from Customers’ in January 2009. The interpretation addresses the accounting by suppliers that receive assets from customers, requiring measurement at fair value. The interpretation is effective for assets from customers received on or after 1 July 2009 and is not expected to have a material effect on the Group or company.
 

 
Notes on the accounts

 
1           Net interest income
 
   
Group
 
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Loans and advances to customers
    41,812       28,568       22,195  
Loans and advances to banks
    2,356       1,570       843  
Debt securities
    5,354       2,114       1,650  
Interest receivable
    49,522       32,252       24,688  
                         
Customer accounts: demand deposits
    4,341       4,327       3,083  
Customer accounts: savings deposits
    3,911       2,560       1,373  
Customer accounts: other time deposits
    8,108       6,301       4,444  
Deposits by banks
    6,576       3,406       2,621  
Debt securities in issue
    9,941       5,687       3,286  
Subordinated liabilities
    2,144       1,530       1,386  
Internal funding of trading business
    (4,174 )     (3,628 )     (2,101 )
Interest payable
    30,847       20,183       14,092  
                         
Net interest income
    18,675       12,069       10,596  
 
2           Non-interest income (excluding insurance premium income)
 
   
Group
 
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Fees and commissions receivable
    9,831       8,278       7,116  
Fees and commissions payable:
                       
– banking
    (1,985 )     (1,727 )     (1,432 )
– insurance related
    (401 )     (466 )     (490 )
      (2,386 )     (2,193 )     (1,922 )
                         
(Loss)/income from trading activities:
                       
Foreign exchange (1)
    1,994       1,085       738  
Interest rate (2)
    1,454       1,414       973  
Credit (3)
    (12,200 )     (1,446 )     841  
Equities and commodities (4)
    275       239       123  
      (8,477 )     1,292       2,675  
Other operating income:
                       
Operating lease and other rental income
    1,525       1,671       1,755  
Changes in the fair value of own debt
    977       152        
Changes in the fair value of securities and other financial assets and liabilities
    (1,730 )     970       430  
Changes in the fair value of investment properties
    (86 )     288       486  
Profit on sale of securities
    342       544       369  
Profit on sale of property, plant and equipment
    167       741       216  
Profit on sale of subsidiaries and associates
    943       67       44  
Life company (losses)/profits
    (52 )     187       219  
Dividend income
    281       137       92  
Share of profits less losses of associated entities
    69       25       36  
Other income
    (537 )     51       (83 )
      1,899       4,833       3,564  

The analysis of trading income is based on how the business is organised and the underlying risks managed.
 
Notes:
 
Trading income comprises gains and losses on financial instruments held for trading, both realised and unrealised, interest income and dividends and the related funding costs. The types of instruments include:
 
(1)
Foreign exchange: spot foreign exchange contracts, currency swaps and options, emerging markets and related hedges and funding.
 
(2)
Interest rate: interest rate swaps, forward foreign exchange contracts, forward rate agreements, interest rate options, interest rate futures and related hedges and funding.
 
(3)
Credit: asset-backed securities, corporate bonds, credit derivatives and related hedges and funding.
 
(4)
Equities and commodities: equities, commodities, equity derivatives, commodity contracts and related hedges and funding.
 
 

 
3           Operating expenses
 
   
Group
 
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Wages, salaries and other staff costs
    8,907       6,230       5,652  
Social security costs
    696       471       389  
Share-based compensation
          65       65  
Pension costs
                       
– defined benefit schemes (see Note 4)
    490       489       580  
– defined contribution schemes
      148       83       37  
Staff costs
     10,241        7,338        6,723  
                         
Premises and equipment
    2,593       1,703       1,421  
Other administrative expenses
    5,464       2,969       2,658  
                         
Property, plant and equipment (see Note 18)
    1,584       1,297       1,293  
Intangible assets (see Note 17)
    1,570       635       385  
Depreciation and amortisation
    3,154       1,932       1,678  
                         
Write-down of goodwill and other intangible assets
    32,581              
      54,033       13,942       12,480  

Integration costs included in operating expenses comprise expenditure incurred in respect of cost reduction and revenue enhancement programmes set in connection with the various acquisitions made by the Group.
 
   
Group
 
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Staff costs
    503       18       76  
Premises and equipment
    25       4       10  
Other administrative expenses
    486       26       32  
Depreciation and amortisation
    36       60       16  
      1,050       108       134  

 
Restructuring costs included in operating expenses comprise:
 
     
2008
£m
 
Staff costs
    251  
Premises and equipment
    15  
Other administrative expenses
    41  
      307  

 
No restructuring costs were incurred in 2007 and 2006.
 
 

 
The average number of persons employed in the continuing operations of the Group during the year, excluding temporary staff, was 197,100 (2007 – 157,200; 2006 – 142,600); on the same basis the discontinued operations employed 32,200 (2007 – 13,300; 2006 – nil). The average number of temporary employees during 2008 was 7,000 (2007 – 4,900). The number of persons employed in the continuing operations of the Group at 31 December, excluding temporary staff, was as follows:
 
   
Group
 
   
2008
   
2007
   
2006
 
Global Banking & Markets
    18,700       17,600       7,600  
Global Transaction Services
    4,200       3,900       2,500  
UK Retail & Commercial Banking
    46,100       45,700       46,300  
US Retail & Commercial Banking
    18,700       19,000       19,800  
Europe & Middle East Retail & Commercial Banking
    7,900       8,700       5,700  
Asia Retail & Commercial Banking
    11,600       12,500       4,600  
RBS Insurance
    17,400       18,000       18,500  
Group Manufacturing
    43,600       44,500       34,100  
Centre
    4,200       3,800       2,700  
RBS share of shared assets
    400       1,200        
RFS Holdings minority interest
    26,700       28,600        
Total
    199,500       203,500       141,800  
                         
UK
    105,800       108,000       105,700  
US
    27,100       26,500       26,200  
Europe
    40,200       40,500       8,100  
Rest of the World
    26,400       28,500       1,800  
Total
    199,500       203,500       141,800  

Discontinued operations, excluding temporary staff, employed 2,600 persons at 31 December 2008 (2007 – 53,200; 2006 – nil).
 
 


4           Pension costs
Members of the Group sponsor a number of pension schemes in the UK and overseas, predominantly defined benefit schemes, whose assets are independent of the Group’s finances. The Group’s defined benefit schemes generally provide a pension of one-sixtieth of final pensionable salary for each year of service prior to retirement up to a maximum of 40 years. Employees do not make contributions for basic pensions but may make voluntary contributions to secure additional benefits on a money-purchase basis. Since October 2006 The Royal Bank of Scotland Group Pension Fund (‘Main scheme’) has been closed to new entrants.
 
The Group also provides post-retirement benefits other than pensions, principally through subscriptions to private healthcare schemes in the UK and the US and unfunded post-retirement benefit plans. Provision for the costs of these benefits is charged to the income statement over the average remaining future service lives of eligible employees. The amounts are not material.
 
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
 
2008
   
2007
   
2006
   
2008
   
2007
   
2006
 
                     
Weighted average
 
Discount rate
    6.5 %     6.0 %     5.3 %     6.0 %     5.8 %     5.3 %
Expected return on plan assets (weighted average)
    7.1 %     6.9 %     6.9 %     6.3 %     6.8 %     6.9 %
Rate of increase in salaries*
    4.0 %     4.5 %     4.2 %     3.4 %     4.0 %     4.1 %
Rate of increase in pensions in payment
    2.7 %     3.2 %     2.9 %     2.4 %     2.8 %     2.8 %
Inflation assumption
    2.7 %     3.2 %     2.9 %     2.4 %     2.9 %     2.9 %
 
* Rate of increase in salaries in the Main Scheme assumed to be 2.0% over the next two years.
 
   
Main scheme
   
All schemes
 
Major classes of plan assets as a percentage of total plan assets
 
2008
   
2007
   
2006
   
2008
   
2007
   
2006
 
Equities
    59.4 %     61.0 %     60.5 %     42.2 %     57.8 %     60.7 %
Index-linked bonds
    18.0 %     18.2 %     17.3 %     11.4 %     13.1 %     16.1 %
Government fixed interest bonds
    1.2 %     1.2 %     2.5 %     26.8 %     12.9 %     3.3 %
Corporate and other bonds
    18.5 %     15.1 %     14.0 %     14.3 %     12.0 %     13.9 %
Property
    3.7 %     3.8 %     4.3 %     3.9 %     3.0 %     4.5 %
Cash and other assets
    (0.8 %)     0.7 %     1.4 %     1.4 %     1.2 %     1.5 %

Ordinary shares of the company with a fair value of £15 million (2007 – £69 million; 2006 – £89 million) are held by the Group’s pension schemes; £15 million (2007 – £65 million; 2006 – £87 million) in the Main scheme which also holds other financial instruments issued by the Group with a value of £ 421 million (2007 – £ 606 million; 2006 – £ 258 million).
 
The expected return on plan assets at 31 December is based upon the weighted average of the following assumed returns on the major classes of plan assets:
 
   
Main scheme
   
All schemes
 
   
2008
   
2007
   
2006
   
2008
   
2007
   
2006
 
Equities
    8.4 %     8.1 %     8.1 %     8.4 %     8.1 %     8.1 %
Index-linked bonds
    3.9 %     4.5 %     4.5 %     3.9 %     4.5 %     4.5 %
Government fixed interest bonds
    3.9 %     4.5 %     4.5 %     4.3 %     4.7 %     4.5 %
Corporate and other bonds
    6.1 %     5.5 %     5.3 %     5.7 %     5.5 %     5.3 %
Property
    6.1 %     6.3 %     6.3 %     6.1 %     6.3 %     6.3 %
Cash and other assets
    2.5 %     4.6 %     4.6 %     5.1 %     4.5 %     4.4 %
 
Post-retirement mortality assumptions (Main scheme)
 
2008
   
2007
   
2006
 
Longevity at age 60 for current pensioners (years):
                 
Males
    26.1       26.0       26.0  
Females
    26.9       26.8       28.9  
                         
Longevity at age 60 for future pensioners (years):
                       
Males
    28.1       28.1       26.8  
Females
    28.2       28.2       29.7  

 
 

 
   
Main scheme
   
All schemes
 
   
Fair value of plan assets
   
Present
value of defined benefit obligations
   
Net pension deficit/
(surplus)
   
Fair value of plan assets
   
Present
value of defined benefit obligations
   
Net pension deficit/
(surplus)
 
Changes in value of net pension deficit/(surplus)
    £m       £m       £m       £m       £m       £m  
At 1 January 2007
    17,374       19,004       1,630       18,959       20,951       1,992  
Currency translation and other adjustments
                      381       397       16  
Income statement:
                                               
Expected return
    1,182               (1,182 )     1,394               (1,394 )
Interest cost
            1,007       1,007               1,177       1,177  
Current service cost
            566       566               684       684  
Past service cost
            19       19               22       22  
      1,182       1,592       410       1,394       1,883       489  
Statement of recognised income and expense:
                                               
Actuarial gains and losses
    163       (1,937 )     (2,100 )     19       (2,170 )     (2,189 )
Acquisition of subsidiaries
                      6,997       7,173       176  
Intra-group transfers
    30       30                          
Contributions by employer
    416             (416 )     599             (599 )
Contributions by plan participants
                      5       5        
Benefits paid
    (551 )     (551 )           (652 )     (652 )      
Expenses included in service cost
    (39 )     (39 )           (40 )     (40 )      
At 1 January 2008
    18,575       18,099       (476 )     27,662       27,547       (115 )
Transfers to disposal groups
                      (1 )     (49 )     (48 )
Currency translation and other adjustments
                      2,497       2,692       195  
Income statement:
                                               
Expected return
    1,271               (1,271 )     1,865               (1,865 )
Interest cost
            1,080       1,080               1,622       1,622  
Current service cost
            437       437               705       705  
Past service cost
            21       21               28       28  
      1,271       1,538       267       1,865       2,355       490  
Statement of recognised income and expense:
                                               
Actuarial gains and losses
    (4,784 )     (3,389 )     1,395       (6,051 )     (3,764 )     2,287  
Disposal of subsidiaries
                      (31 )     (34 )     (3 )
Contributions by employer
    396             (396 )     810             (810 )
Contributions by plan participants
                      9       9        
Benefits paid
    (630 )     (630 )           (978 )     (978 )      
Expenses included in service cost
    (24 )     (24 )           (26 )     (26 )      
At 31 December 2008
    14,804       15,594       790       25,756       27,752       1,996  

 
Net pension deficit comprises:
    £m  
Net assets of schemes in surplus (included in Prepayments, accrued income and other assets, Note 19)
    (36 )
Net liabilities of schemes in deficit
    2,032  
      1,996  

At 31 December 2008, ABN AMRO’s principal pension scheme in the Netherlands had fair value of plan assets of £8,181 million (2007 – £6,417 million) and present value of defined benefit obligations £8,589 million (2007 – £6,189 million). The principal actuarial assumptions at 31 December 2008 were: discount rate 5.4% (2007 – 5.4%); expected return on plan assets (weighted average) 4.7% (2007 – 6.2%); rate of increase in salaries 2.5% (2007 – 2.5%); rate of increase in pensions in payment 2.0% (2007 – 2.0%); and inflation assumption 2.0% (2007 – 2.0%).
 
The Group expects to contribute £807 million to its defined benefit pension schemes in 2009 (Main scheme – £385 million). Of the net liabilities of schemes in deficit, £201 million (2007 – £212 million) relates to unfunded schemes.
 
Cumulative net actuarial losses of £717 million (2007 – £1,570 million gains; 2006 – £619 million losses) have been recognised in the statement of recognised income and expense, of which £184 million gains (2007 – £1,579 million gains; 2006 – £521 million losses) relate to the Main scheme.
 
 
 


4           Pension costs (continued)
 
   
Main scheme
   
All schemes
 
History of defined benefit schemes
   
2008
£m
     
2007
£m
     
2006
£m
     
2005
£m
     
2004
£m
     
2008
£m
     
2007
£m
     
2006
£m
     
2005
£m
     
2004
£m
 
Fair value of plan assets
    14,804       18,575       17,374       15,914       13,569       25,756       27,662       18,959       17,388       14,798  
Present value of defined benefit obligations
    15,594       18,099       19,004       19,118       16,051       27,752       27,547       20,951       21,123       17,738  
Net (deficit)/surplus
    (790 )     476       (1,630 )     (3,204 )     (2,482 )     (1,996 )     115       (1,992 )     (3,735 )     (2,940 )
Experience losses on plan liabilities
    (55 )     (256 )     (4 )     (41 )     (624 )     (65 )     (210 )     (19 )     (68 )     (631 )
Experience gains on plan assets
    (4,784 )     163       552       1,556       392       (6,051 )     19       587       1,661       408  
Actual return on pension schemes assets
    (3,513 )     1,345       1,574       2,486       1,230       (4,186 )     1,413       1,660       2,677       1,328  
 
The table below sets out the sensitivities of the pension cost for the year and the present value of detailed benefit obligations at the balance sheet dates to a change in the principal actuarial assumptions:
 
   
Main scheme
   
All schemes
 
   
Increase/(decrease)
   
Increase/(decrease)
 
   
in pension cost
for the year
   
in obligation
at 31 December
   
in pension cost
for the year
   
in obligation
at 31 December
 
   
2008
   
2007
   
2008
   
2007
   
2008
   
2007
   
2008
   
2007
 
      £m       £m       £m       £m       £m       £m       £m       £m  
25 bps increase in the discount rate
    (37 )     (41 )     (696 )     (874 )     (53 )     (49 )     (1,161 )     (1,318 )
25 bps increase in inflation
    77       83       624       800       114       98       1,089       1,245  
25 bps additional rate of increase in pensions in payment
    41       43       383       461       63       51       695       760  
25 bps additional rate of increase in deferred pensions
    8       5       94       113       15       7       227       239  
25 bps additional rate of increase in salaries
    28       35       168       216       35       40       219       265  
Longevity increase of 1 year
    31       31       302       390       50       37       700       761  
 
5           Auditors’ remuneration
Amounts paid to the company’s auditors for statutory audit and other services were as follows:
 
   
Group
 
   
2008
   
2007
 
      £m       £m  
Audit Services
               
     – Statutory audit (1)
    44.1       20.4  
– Audit related including regulatory reporting
    3.1       1.4  
      47.2       21.8  
Tax Services
               
– Compliance services
    0.3       0.2  
– Advisory services
    0.3       0.2  
      0.6       0.4  
All other services
    10.9       9.0  
Total
    58.7       31.2  
 
Note:
 
(1)
Includes fees of £23.1 million (2007 – nil) in respect of the audit of ABN AMRO Holding N.V. Deloitte were appointed as auditors of ABN AMRO in 2008. In 2007, fees paid to Ernst & Young for the audit of ABN AMRO Holding N.V. were £33.9 million. These fees are not included above.
 
 
 
178

 


6           Tax
 
   
Group
 
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Current taxation:
                       
Charge for the year
    1,230       2,514       2,626  
Over provision in respect of prior periods
    (254 )     (39 )     (253 )
Relief for overseas taxation
    (34 )     (198 )     (147 )
      942       2,277       2,226  
Deferred taxation:
                       
(Credit)/charge for the year
    (3,167 )     95       396  
(Under)/over provision in respect of prior periods
    (98 )     (328 )     67  
Tax (credit)/charge for the year
    (2,323 )     2,044       2,689  

 

 
The actual tax charge differs from the expected tax charge computed by applying the standard rate of UK corporation tax of 28.5% (2007 – 30%; 2006 – 30%) as follows:
 
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Expected tax (credit)/charge
    (11,590 )     2,950       2,756  
Non-deductible goodwill impairment
    8,292       12        
Unrecognised timing differences
    274       29        
Other non-deductible items
    330       222       288  
Non-taxable items
    (491 )     (595 )     (251 )
Taxable foreign exchange movements
    80       16       5  
Foreign profits taxed at other rates
    203       (25 )     63  
Reduction in deferred tax liability following change in the rate of UK corporation tax
          (189 )      
Losses in year not recognised
    942       2        
Losses brought forward and utilised
    (11 )     (11 )     14  
Adjustments in respect of prior periods (1)
    (352 )     (367 )     (186 )
Actual tax (credit)/charge
    (2,323 )     2,044       2,689  

Note:
 
(1) Prior period tax adjustments principally comprise releases of tax provisions in respect of structured transactions and investment disposals, and adjustments to reflect submitted tax computations in the UK and overseas.
 
The effective tax rate for the year was 5.7% (2007 – 20.8%; 2006 – 29.3%). The deferred tax credit is net of £210 million deferred tax expense arising from the write-down of the carrying value of previously recognised deferred tax assets.
 
7           Profit attributable to other owners
   
Group
 
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Dividends paid to other owners:
                       
Non-cumulative preference shares of US$0.01
    293       152       99  
Non-cumulative preference shares of €0.01
    183       94       92  
Non-cumulative preference shares of £1
    60              
Interest on securities classified as equity, net of tax
    60              
Total
    596       246       191  

Notes:
 
(1) In accordance with IAS 32, certain preference share issued by the company are included in subordinated liabilities and the related finance cost in interest payable.
 
(2) Between 1 January 2009 and the date of approval of these accounts, dividends amounting to US$163 million have been declared in respect of equity preference shares for payment on 31 March 2009.
 
8           Ordinary dividends
Prior year ordinary dividends per share in the table below have been restated for the effect of the rights issue in June 2008 and the capitalisation issue in September 2008.
 
   
Group
 
   
2008
   
2007
   
2006
   
2008
   
2007
   
2006
 
   
p per share
   
p per share
   
p per share
      £m       £m       £m  
Final dividend for previous year declared during the current year
    19.3       18.5       14.8       2,312       2,091       1,699  
Interim dividend
          8.5       6.8             953       771  
Total dividends paid on ordinary equity shares
    19.3       27.0       21.6       2,312       3,044       2,470  

9           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
 
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Dividends received from banking subsidiary
    4,639       2,330       3,502  
Dividends received from other subsidiaries
    163       415       229  
Total income
    4,802       2,745       3,731  
Interest receivable from subsidiaries
    793       460       516  
Interest payable to subsidiaries
    (495 )     (307 )     (246 )
Other net interest payable and operating expenses
    (796 )     (526 )     (515 )
Write-down of investments in subsidiaries
    (14,321 )            
Operating (loss)/profit before tax
    (10,017 )     2,372       3,486  
Tax
    415       127       13  
(Loss)/profit for the year
    (9,602 )     2,499       3,499  
                         
(Loss)/profit attributable to:
                       
Ordinary shareholders
    (10,198 )     2,253       3,308  
Other owners
    596       246       191  
      (9,602 )     2,499       3,499  

 
 


10           Earnings per ordinary share
The earnings per share are based on the following:
 
   
Company
 
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Earnings:
                       
(Loss)/profit attributable to ordinary shareholders
    (24,137 )     7,303       6,202  
Add back finance cost on dilutive convertible securities
          60       64  
Diluted earnings attributable to ordinary shareholders
    (24,137 )     7,363       6,266  
 
   
Number of shares - millions
 
Number of ordinary shares:
                 
Weighted average number of ordinary shares in issue during the year
    16,563       11,413       11,411  
Effect of dilutive share options and convertible securities
          198       208  
Diluted weighted average number of ordinary shares during the year
    16,563       11,611       11,619  

The numbers of ordinary shares in issue in prior years have been adjusted retrospectively for the bonus element of the rights issue completed in June 2008 and the capitalisation issue in September 2008. None of the convertible securities had a dilutive effect in 2008. All convertible securities had a dilutive effect in 2007 and 2006 and have been included in the computation of diluted earnings per share.
 
The effect of discontinued operations on earnings per share is not material.
 
11           Financial instruments
Classification
The following tables analyse the Group’s financial assets and financial liabilities in accordance with the categories of financial instruments in IAS 39. Assets and liabilities outside the scope of IAS 39 are shown separately.
 
   
Group
 
   
Held-for-trading
   
Designated as at fair value through profit or loss
   
Hedging derivatives
   
Available-for-sale
   
Loans and receivables
   
Other (amortised cost)
   
Finance leases
   
Non financial assets/
liabilities
   
Total
 
2008
    £m       £m       £m       £m       £m       £m       £m       £m       £m  
Assets
                                                                       
Cash and balances at central banks
                              12,400                             12,400  
Loans and advances to banks (1)
    56,234                           81,963                             138,197  
Loans and advances to customers (2, 3)
    51,501       2,141                     806,627               14,453               874,722  
Debt securities (4)
    116,280       5,428               132,856       12,985                             267,549  
Equity shares
    17,054       2,101               7,175                                   26,330  
Settlement balances
                              17,832                             17,832  
Derivatives
    985,700             6,859                                         992,559  
Intangible assets
                                                    20,049       20,049  
Property, plant and equipment
                                                      18,949       18,949  
Deferred taxation
                                                  7,082       7,082  
Prepayments, accrued income and other assets
                              1,326                       23,076       24,402  
Assets of disposal groups
                                                      1,581       1,581  
      1,226,769       9,670       6,859       140,031       933,133               14,453       70,737       2,401,652  
Liabilities
                                                                       
Deposits by banks (5)
    81,154                                     176,890                     258,044  
Customer accounts (6, 7)
    55,926       8,054                               575,532                     639,512  
Debt securities in issue (8, 9)
    3,992       47,451                               248,846                     300,289  
Settlement balances and short positions
    42,536                                     11,741                     54,277  
Derivatives
    963,088             8,276                                           971,364  
Accruals, deferred income and other liabilities
    260                                     1,619       22       29,581       31,482  
Retirement benefit liabilities
                                                            2,032       2,032  
Deferred taxation
                                                            4,165       4,165  
Insurance liabilities
                                                            9,976       9,976  
Subordinated liabilities
          1,509                               47,645                   49,154  
Liabilities of disposal groups
                                                      859       859  
      1,146,956       57,014       8,276                       1,062,273       22       46,613       2,321,154  
Equity
                                                                    80,498  
                                                                      2,401,652  
 

 
 

 
   
Group
 
   
Held-for-trading
   
Designated as at fair value through profit or loss
   
Hedging derivatives
   
Available-for-sale
   
Loans and receivables
   
Other (amortised cost)
   
Finance leases
   
Non financial assets/
liabilities
   
Total
 
2007
    £m       £m       £m       £m       £m       £m       £m       £m       £m  
Assets
                                                                       
Cash and balances at central banks
                              17,866                             17,866  
Loans and advances to banks (1)
    71,639                           147,821                             219,460  
Loans and advances to customers (2, 3)
    103,811       3,067                     709,090               12,570               828,538  
Debt securities (4)
    190,671       5,777               95,536       2,672                             294,656  
Equity shares
    37,546       7,866               7,614                                   53,026  
Settlement balances
                              16,589                             16,589  
Derivatives
    274,849             2,553                                         277,402  
Intangible assets
                                                            49,916       49,916  
Property, plant and equipment
                                                            18,745       18,745  
Deferred taxation
                                              3,119       3,119  
Prepayments, accrued income and other assets
                              877                     14,785       15,662  
Assets of disposal groups
                                                            45,850       45,850  
      678,516       16,710       2,553       103,150       894,915               12,570       132,415       1,840,829  
Liabilities
                                                                       
Deposits by banks (5)
    65,491                                     246,803                     312,294  
Customer accounts (6, 7)
    60,426       7,505                               614,432                     682,363  
Debt securities in issue (8, 9)
    9,455       41,834                               222,883                     274,172  
Settlement balances and short positions
    73,501                                     17,520                     91,021  
Derivatives
    269,343             2,709                                           272,052  
Accruals, deferred income and other liabilities
    209                                     1,545       19       32,435       34,208  
Retirement benefit liabilities
                                                            460       460  
Deferred taxation
                                                            5,400       5,400  
Insurance liabilities
                                                            10,162       10,162  
Subordinated liabilities
          897                               37,146                   38,043  
Liabilities of disposal groups
                                                            29,228       29,228  
      478,425       50,236       2,709                       1,140,329       19       77,685       1,749,403  
Equity
                                                                    91,426  
                                                                      1,840,829  

 
Notes:
 
(1)
Includes reverse repurchase agreements of £58,771 million (2007 – £175,941 million) and items in the course of collection from other banks of £2,888 million (2007 – £3,095 million).
 
(2)
Includes reverse repurchase agreements of £39,313 million (2007 – £142,357 million).
 
(3)
The change in fair value of loans and advances to customers designated as at fair value through profit and loss attributable to changes in credit risk was £328 million for the year and £440 million cumulatively. The amounts for 2007 were not material.
 
(4)
Includes treasury bills and similar securities of £31,509 million (2007 – £16,315 million) and other eligible bills of £25,028 million (2007 – £1,914 million).
 
(5)
Includes repurchase agreements of £83,666 million (2007 – £163,038 million) and items in the course of transmission to other banks of £542 million (2007 – £372 million).
 
(6)
Includes repurchase agreements of £58,143 million (2007 – £134,916 million).
 
(7)
The carryng amount of other customer accounts designated as at fair value through profit or loss is £47 million lower (2007 – £77 million greater) than the principal amount. No amounts have been recognised in profit or loss for changes in credit risk associated with these liabilities as the changes are immaterial measured as the change in fair value from movements in the period in the credit risk premium payable. The amounts include investment contracts with a carrying value of £5,364 million (2007 – £5,555 million).
 
(8)
Comprises bonds and medium term notes of £156,841 million (2007 – £119,578 million) and certificates of deposit and other commercial paper of £143,448 million (2007 – £154,594 million).
 
(9)
£1,054 million (2007 – £162 million) has been recognised in profit or loss for changes in credit risk associated with debt securities in issue designated as at fair value through profit or loss measured as the change in fair value from movements in the period in the credit risk premium payable by the Group. The carrying amount is £1,145 million (2007 – £317 million) lower than the principal amount.
 
(10)
During 2008 the Group reclassified financial assets from the held-for-trading and available-for-sale categories into the loans and receivables category and from the held-for-trading category into the available-for-sale category (see page 193).
 

 
 


11           Financial instruments (continued)
The following tables analyse the company’s financial assets and financial liabilities in accordance with the categories of financial instruments in IAS 39. Assets and liabilities outside the scope of IAS 39 are shown separately.
 
   
Company
 
   
Held-for-trading
   
Hedging derivatives
   
Loans and receivables
   
Other (amortised cost)
   
Non financial assets/
liabilities
   
Total
 
2008
    £m       £m       £m       £m       £m       £m  
Assets
                                               
Loans and advances to banks (1)
                  27,031                     27,031  
Investments in Group undertakings
                                42,196       42,196  
Derivatives (3)
    975       193                           1,168  
Deferred taxation
                            3       3  
Prepayments, accrued income and other assets
                                489       489  
      975       193       27,031               42,688       70,887  
Liabilities
                                               
Deposits by banks (2)
                        1,802             1,802  
Customer accounts (2)
                            26               26  
Debt securities in issue
                          14,179             14,179  
Derivatives (2)
    136       225                         361  
Accruals, deferred income and other liabilities
                              47       47  
Subordinated liabilities
                        10,314             10,314  
      136       225             26,321       47       26,729  
                                                 
Equity
                                            44,158  
                                              70,887  
 
2007
                                   
Assets
                                   
Loans and advances to banks (1)
                7,686                   7,686  
Loans and advances to customers (3)
                307                   307  
Investments in Group undertakings
                            43,542       43,542  
Derivatives (3)
    173                               173  
Prepayments, accrued income and other assets
                            127       127  
      173             7,993             43,669       51,835  
Liabilities
                                             
Deposits by banks (2)
                        5,572             5,572  
Debt securities in issue
                        13,453             13,453  
Derivatives (2)
    125       54                           179  
Accruals, deferred income and other liabilities
                              8       8  
Deferred taxation
                              3       3  
Subordinated liabilities
                        7,743             7,743  
      125       54               26,768       11       26,958  
                                                 
Equity
                                            24,877  
                                              51,835  

Notes:
 
(1) Incudes amounts due from subsidiaries of £27,031 million (2007 – £7,130 million).
 
(2) Due to subsidiaries.
 
(3) Due from subsidiaries.
 
 
 

 
Valuation of financial instruments
Control environment
The Group’s control environment for the determination of the fair value of financial instruments has been designed to ensure there are formalised review protocols for independent review and validation of fair values separate from those businesses entering into the transactions. This includes specific controls to ensure consistent pricing policies and procedures, incorporating disciplined price verification for both proprietary and counterparty risk trades. The Group ensures special attention is given to bespoke transactions, structured products, illiquid products, and other assets which are difficult to price.
 
The business entering into the transaction is responsible for the initial determination and recording of the fair value of the transaction. There are daily controls over the profit or loss recorded by trading and treasury front office traders.
 
A key element of the control environment, segregated from the recording of the transaction’s valuation, is the independent price verification (IPV) process. Valuations are first calculated by the business which entered into the transaction. Such valuations may be direct prices, or may be derived using a model and variable model inputs. These valuations are reviewed, and if necessary amended, by the IPV process. This process involves a team, independent of those trading the financial instruments, reviewing valuations in the light of available pricing evidence. IPV is performed at a frequency to match the availability of independent data, and the size of the Group’s exposure. For liquid instruments the process is performed daily. The minimum frequency of review in GBM is monthly for regulatory trading book positions, and six monthly for regulatory banking book positions. The IPV control includes formalised reporting and escalation of any valuation differences in breach of defined thresholds. In addition, within GBM, there is a dedicated team (the Global Pricing Unit) which determines IPV policy, monitors adherence to policy, and performs additional independent review on highly subjective valuation issues.
 
In GBM, when models are used to value products, those models are subject to a review process which requires different levels of model documentation, testing and review, depending on the complexity of the model and the size of the Group’s exposure. A key element of the control environment over model use in GBM is a review committee which comprises of valuations experts from several functions within GBM. The committee sets the policy for model documentation, testing and review, and prioritises models with significant exposure for review by the Group’s quantitative research centre. This centre, which is independent of the trading businesses, assesses the appropriateness of the application of the model to the product, the mathematical robustness of the model, and (where appropriate), considers alternative modelling approaches.
 
GBM also maintains a valuation control committee that meets formally on a monthly basis to discuss and review escalated items and to consider highly complex and subjective valuation matters. The committee includes valuation specialists representing several independent review functions (including market risk, quantitative research and finance) and senior members of the Group’s front office trading businesses.
 
Certain financial instruments have become more difficult and subjective to value and have therefore been transferred to a centrally managed asset unit, to separate them from business as usual activities and to allow dedicated focus on the management and valuation of the exposures. The unit has a valuation committee comprising senior representatives of the trading function, risk management and GBM Global Pricing Unit which meets regularly and is responsible for monitoring, assessing and enhancing the adequacy of the valuation techniques being adopted for these instruments.
 
Valuation techniques
The Group uses a number of methodologies to determine the fair values of financial instruments for which observable prices in active markets for identical instruments are not available. These techniques include: relative value methodologies based on observable prices for similar instruments; present value approaches where future cash flows from the asset or liability are estimated and then discounted using a risk-adjusted interest rate; option pricing models (such as Black-Scholes or binomial option pricing models) and simulation models such as Monte-Carlo.
 
The principal inputs to these valuation techniques are listed below. Values between and beyond available data points are obtained by interpolation and extrapolation. When utilising valuation techniques, the fair value can be significantly affected by the choice of valuation model and underlying assumptions made concerning factors such as the amounts and timing of cash flows, discount rates and credit risk.
 
·
Bond prices – quoted prices are generally available for government bonds, certain corporate securities and some mortgage-related products.
 
·
Credit spreads – where available, these are derived from prices of CDS or other credit based instruments, such as debt securities. For others, credit spreads are obtained from pricing services.
 
·
Interest rates – these are principally benchmark interest rates such as the London Inter-Bank Offered Rate (LIBOR) and quoted interest rates in the swap, bond and futures markets.
 
·
Foreign currency exchange rates – there are observable markets both for spot and forward contracts and futures in the world’s major currencies.
 
 
 

 
11           Financial instruments (continued)
·
Equity and equity index prices – quoted prices are generally readily available for equity shares listed on the world’s major stock exchanges and for major indices on such shares.
 
·
Commodity prices – many commodities are actively traded in spot and forward contracts and futures on exchanges in London, New York and other commercial centres.
 
·
Price volatilities and correlations – volatility is a measure of the tendency of a price to change with time. Correlation measures the degree to which two or more prices or other variables are observed to move together. If they move in the same direction there is positive correlation; if they move in opposite directions there is negative correlation. Volatility is a key input in valuing options and the valuation of certain products such as derivatives with more than one underlying variable that are correlation-dependent. Volatility and correlation values are obtained from broker quotations, pricing services or derived from option prices.
 
·
Prepayment rates – the fair value of a financial instrument that can be prepaid by the issuer or borrower differs from that of an instrument that cannot be prepaid. In valuing prepayable instruments that are not quoted in active markets, the Group considers the value of the prepayment option.
 
·
Counterparty credit spreads – adjustments are made to market prices (or parameters) when the creditworthiness of the counterparty differs from that of the assumed counterparty in the market price (or parameters).
 
·
Recovery rates / loss given default – these are used as an input to valuation models and reserves for ABS and other credit products as an indicator of severity of losses on default. Recovery rates are primarily sourced from market data providers or inferred from observable credit spreads.
 
In order to determine a reliable fair value, where appropriate, the Group applies valuation adjustments to the pricing information derived from the above sources. These adjustments reflect the Group’s assessment of factors that market participants would consider in setting a price, to the extent that these factors have not already been included in the information from the above sources. Furthermore, on an ongoing basis, the Group assesses the appropriateness of any model used. To the extent that the price provided by internal models does not represent the fair value of the instrument, for instance in highly stressed market conditions, the Group makes adjustments to the model valuation to calibrate to other available pricing sources. Where unobservable inputs are used, the Group may determine a range of possible valuations based upon differing and stress scenarios to determine the sensitivity associated with the valuation. When establishing the fair value of a financial instrument using a valuation technique, the Group considers certain adjustments to the modelled price which market participants would make when pricing that instrument. Such adjustments include the credit quality of the counterparty and adjustments to correct model valuations for any known limitations. In addition, the Group makes adjustments to defer income for financial instruments valued at inception where the valuation of that financial instrument materially depends on one or more unobservable model inputs.
 
The Group refines and modifies its valuation techniques as markets and products develop and as the pricing for individual products becomes more or less readily available. While the Group believes its valuation techniques are appropriate and consistent with other market participants, the use of different methodologies or assumptions could result in different estimates of fair value at the balance sheet date.
 
 
 


Valuation hierarchy
The table below shows the financial instruments carried at fair value by valuation method.
 
   
31 December 2008
   
31 December 2007
 
   
Level 1(1)
   
Level 2 (2)
   
Level 3 (3)
   
Total
   
Level 1 (1)
   
Level 2 (2)
   
Level 3 (3)
   
Total
 
   
£bn
   
£bn
   
£bn
   
£bn
   
£bn
   
£bn
   
£bn
   
£bn
 
Assets
                                               
Fair value through profit or loss:
                                               
Loans and advances to banks
          56.2             56.2             71.5       0.1       71.6  
Loans and advances to customers
          50.5       3.1       53.6             93.8       13.1       106.9  
Debt securities
    52.8       65.1       3.8       121.7       83.1       101.8       11.6       196.5  
Equity shares
    10.6       7.8       0.8       19.2       36.5       8.0       0.9       45.4  
Derivatives
    3.9       978.4       10.3       992.6       1.9       270.3       5.2       277.4  
      67.3       1,158.0       18.0       1,243.3       121.5       545.4       30.9       697.8  
Available-for-sale:
                                                               
Debt securities
    20.9       108.8       3.1       132.8       32.1       62.3       1.1       95.5  
Equity shares
    4.8       2.1       0.3       7.2       5.8       1.0       0.8       7.6  
      25.7       110.9       3.4       140.0       37.9       63.3       1.9       103.1  
                                                                 
      93.0       1,268.9       21.4       1,383.3       159.4       608.7       32.8       800.9  
Liabilities
                                                               
Deposits by banks and customers
          144.8       0.3       145.1             132.0       1.4       133.4  
Debt securities in issue
          47.0       4.4       51.4             42.1       9.2       51.3  
Short positions
    36.0       6.5          
42.5
      63.6       9.9             73.5  
Derivatives
    3.6       963.8       4.0       971.4       2.1       265.6       4.4       272.1  
Other financial liabilities (4)
          1.5       0.3       1.8             0.9       0.2       1.1  
      39.6       1,163.8       9.0       1,212.2       65.7       450.5       15.2       531.4  

Notes:
 
(1)
Valued using unadjusted quoted prices in active markets for identical financial instruments. This category includes listed equity shares, certain exchange-traded derivatives, G10 government securities and certain US agency securities.
 
(2)
Valued using techniques based significantly on observable market data. Instruments in this category are valued using:
 
(a)
quoted prices for similar instruments or identical instruments in markets which are not considered to be active; or
 
(b)
valuation techniques where all the inputs that have a significant effect on the valuation are directly or indirectly based on observable market data.
 
The type of instruments that trade in markets that are not considered to be active, but are based on quoted market prices, broker dealer quotations, or alternative pricing sources with reasonable levels of price transparency and those instruments valued using techniques include most government agency securities, investment-grade corporate bonds, certain mortgage products, certain bank and bridge loans, repos and reverse repos, less liquid listed equities, state and municipal obligations, most physical commodities, investment contracts issued by the Group’s life assurance businesses and certain money market securities and loan commitments and most OTC derivatives.
 
(3)
Instruments in this category have been valued using a valuation technique where at least one input (which could have a significant effect on the instrument’s valuation) is not based on observable market data. Where inputs can be observed from market data without undue cost and effort, the observed input is used. Otherwise, the Group determines a reasonable level for the input.
 
Financial instruments included within level 3 of the fair value hierarchy primarily consist of cash instruments which trade infrequently, certain syndicated and commercial mortgage loans, unlisted equity shares, certain residual interests in securitisations, super senior tranches of high grade and mezzanine collateralised debt obligations (CDOs), and other mortgage-based products and less liquid debt securities, certain structured debt securities in issue and OTC derivatives where valuation depends upon unobservable inputs such as certain credit and exotic derivatives. No gain or loss is recognised on the initial recognition of a financial instrument valued using a technique incorporating significant unobservable data.
 
(4)
Other financial liabilities comprise subordinated liabilities and write downs relating to undrawn syndicated loan facilities.
 
 
 

 
11           Financial instruments (continued)
Level 3 portfolios
Level 3 loans and advances decreased by £10 billion, primarily reflecting reclassification of certain loans (leveraged finance and other corporate loans) to loans and receivables (LAR) and fair value adjustments on the remaining portfolio at the end of the year.
 
Debt securities categorised as level 3 at the end of the year include £5.2 billion of asset-backed securities and £1.7 billion of corporate and other debt securities. The decrease during the year reflects termination of a deal in early 2008, reclassification of illiquid mortgage-backed securities (MBS) to loans and receivables, fair value changes, and the transfer of certain previous illiquid MBS, primarily sub-prime from level 3 to level 2.
 
Level 3 derivative assets at 31 December 2008 include credit derivative trades with credit derivative product companies (CDPCs) with a fair value of £3.5 billion after credit valuation adjustments of £1.3 billion. At 31 December 2007 these credit derivative trades with CDPCs had a fair value of £0.8 billion after a credit valuation of £44 million and were included within level 2 of the fair value hierarchy. Other level 3 derivative assets at 31 December 2008 include illiquid credit default swaps (CDSs), other credit derivatives, commodity derivatives and illiquid interest rate derivatives.
 
Debt securities in issue, categorised as level 3, were structured medium term notes and the decrease in the year primarily reflects the termination of a deal in the first half of 2008.
 
The tables below presents the Level 3 financial instruments carried at fair value as at the balance sheet date, valuation basis, main assumptions used in the valuation of these instruments and reasonably possible increases or decreases in fair value based on reasonably possible alternative assumptions:
 
               
Reasonably possible
alternative assumptions
 
Assets
Valuation basis/
technique
 
Main
assumptions
 
Carrying
value
£bn
   
Increase in
fair value
£m
   
Decrease in
fair value
£m
 
Loans and advances
Proprietary model
 
Credit spreads, indices
    3.1       70       50  
Debt securities:
                             
– RMBS (1)
Industry standard model
 
Prepayment rates, probability of
                       
     
default, loss severity and yield
    0.5       40       90  
– CMBS (2)
Industry standard model
 
Prepayment rates, probability of
                       
     
default, loss severity and yield
    0.6       30       30  
– CDOs
Proprietary model
 
Implied collateral
                       
     
valuation, defaults rates,
                       
     
housing prices, correlation
    1.7       410       440  
– CLOs (3)
Industry standard simulation model
 
Credit spreads
                       
     
recovery rates, correlation
    1.0       40       40  
– Other
Proprietary model
 
Credit spreads
    3.1       50       50  
Derivatives
                             
– credit
Proprietary CVA model, industry
 
Counterparty credit risk,
                       
 
option models, correlation model
 
correlation, volatility
    8.0       1,030       1,200  
– equity
Proprietary model
 
Volatility, correlation, dividends
    0.1             10  
– interest rate and commodity
Proprietary model
 
Volatility, correlation
    2.2       130       130  
Equity shares – private equity
Valuation statements
 
Fund valuations
    1.1       80       160  
31 December 2008
          21.4       1,880       2,200  
                               
31 December 2007
          32.7       610       700  
 
Notes:
 
(1) Residential mortgage-backed securities.
 
(2) Commercial mortgage-backed securities.
 
(3) Collateralised loan obligations.
 
 
 

 
               
Reasonably possible
alternative assumptions
 
Liabilities
Valuation basis/
technique
 
Main
assumptions
 
Carrying
amount
£bn
   
Increase
fair value
£m
   
Decrease
fair value
£m
 
Debt securities in issue
Proprietary model
 
Credit spreads
    4.4       170       190  
Derivatives
                             
Credit derivatives
Proprietary CVA model,
 
Counterparty credit risk
                       
 
industry option models, correlation model
 
correlation, volatility
    2.6       160       180  
Other derivatives
Proprietary model
 
Volatility, correlation
    1.4       120       120  
Other portfolios
Proprietary model
 
Credit spreads, correlation
    0.6       40       60  
31 December 2008
          9.0       490       550  
                               
31 December 2007
          15.3       120       120  

For each of the portfolio categories shown in the above table, set out below is a description of the types of products that comprise the portfolio and the valuation techniques that are applied in determining fair value, including a description of valuation techniques used, including for those in level 2, and inputs to those models and techniques. Where reasonably possible alternative assumptions of unobservable inputs used in models would change the fair value of the portfolio significantly, the alternative inputs are indicated along with the impact this would have on the fair value. Where there have been significant changes to valuation techniques during the year a discussion of the reasons for this are also included.
 
Loans and advances to customers
Loans in level 3 primarily comprise US commercial mortgages and syndicated loans.
 
Commercial mortgages
These senior and mezzanine commercial mortgages are loans secured on commercial land and buildings that were originated or acquired by GBM for securitisation. Senior commercial mortgages carry a variable interest rate and mezzanine or more junior commercial mortgages may carry a fixed or variable interest rate. Factors affecting the value of these loans may include, but are not limited to, loan type, underlying property type and geographic location, loan interest rate, loan to value ratios, debt service coverage ratios, prepayment rates, cumulative loan loss information, yields, investor demand, market volatility since the last securitisation, and credit enhancement. Where observable market prices for a particular loan are not available, the fair value will typically be determined with reference to observable market transactions in other loans or credit related products including debt securities and credit derivatives. Assumptions are made about the relationship between the loan and the available benchmark data. Using reasonably possible alternative assumptions for credit spreads (taking into account all other applicable factors) would reduce the fair value of these mortgages of £1.1 billion by up to £18 million or increase the fair value by up to £25 million.
 
Syndicated lending
The Group’s syndicated lending activities are conducted by the syndicate business in conjunction with the various product lines covering corporate, leveraged, real estate and project finance activities. When a commitment to lend is entered into, the Group estimates the proportion of the loan that is intended to be held for trading on draw down, and the proportion it anticipates to retain on its balance sheet as a loan and receivable. Where the commitment is intended to be syndicated, the commitment to lend is fair valued through profit or loss. On drawdown, the portion of the loan expected to be syndicated is recorded at fair value as a held-for-trading asset, and the expected hold portion is measured at amortised cost less, where appropriate, impairment.
 
The Group values the portion of the loan expected to be syndicated held at fair value by using market observable syndication prices in the same or similar assets. Where these prices are not available, a discounted cash flow model is used. The model incorporates observable assumptions such as current interest rates and yield curves, the notional and tender amount of the loan, and counterparty credit quality where it is derived from credit default swap spreads using market indices. The model also incorporates unobservable assumptions, including expected refinancing periods, and counterparty credit quality where it is derived from the Group’s internal risk assessments. Derivatives arising from commitments to lend are measured using the same model, based on proxy notional amounts.
 
Using reasonably possible alternative assumptions for expected cash flows to value these assets of £2.0 billion would reduce the fair value by up to £32 million or increase the fair value by up to £45 million. The assumptions to determine these amounts were based on restructuring scenarios and expected margins.
 
Debt securities
Residential mortgage backed securities (RMBS)
RMBS where the underlying assets are US agency-backed mortgages and there is regular trading are generally classified as level 2 in the fair value hierarchy. RMBS are also classified as level 2 when regular trading is not prevalent in the market, but similar executed trades or third-party data including indices, broker quotes and pricing services can be used to substantiate the fair value. RMBS are classified as level 3 when trading activity is not available and a model is utilised which uses significant unobservable data.
 
In determining whether an instrument is similar to that being valued, the Group considers a range of factors, principally: the lending standards of the brokers and underwriters that originated the mortgages, the lead manager of the security, the issue date of the respective securities, the underlying asset composition (including origination date, loan to value ratios, historic loss information and geographic location of the mortgages), the credit rating of the instrument, and any credit protection that the instrument may benefit from, such as insurance wraps or subordinated tranches. Where there are instances of market observable data for several similar RMBS tranches, the Group considers the extent of similar characteristics shared with the instrument being valued, together with the frequency,
 
 
 

 
11           Financial instruments (continued)
tenor and nature of the trades that have been observed. This method is most frequently used for US and UK RMBS. The RMBS of Dutch and Spanish originated mortgages guaranteed by those governments are valued using the credit spreads of the respective government debt and certain assumptions made by the Group, or based on observable prices from Bloomberg or consensus pricing services.
 
Where there is an absence of trading activity, models are used. The Group primarily uses an industry standard model to project the expected future cash flows to be received from the underlying mortgages and to forecast how these cash flows will be distributed to the various holders of the RMBS. This model utilises data provided by the servicer of the underlying mortgage portfolio, layering on assumptions for mortgage prepayments, probability of default, expected losses, and yield. The Group uses data from third-party sources to calibrate its assumptions, including pricing information from third party pricing services, independent research, broker quotes, and other independent sources. An assessment is made of third-party data source to determine its applicability and reliability. The Group adjusts the model price with a liquidity premium to reflect the price that the instrument could be traded at in the market and may also make adjustments for model deficiencies.
 
The weighted average of the key significant inputs utilised in valuing US level 3 RMBS positions are shown in the table below.
 
 
Weighted-average inputs
 
2008
Non-agency
prime RMBS
   
Alt-A RMBS
 
Yield
11.02%
   
20.69%
 
Probability of default
3.00 CDR
(2)  
40.00 CDR
(1) 
Loss severity
45.00%
(2)  
52.25%
(2) 
Prepayment
12.67 CPR
   
10.65 CPR
 
 
Notes:
 
(1) Constant default rate or probability of default.
 
(2) Constant prepayment rate.
 
The fair value of securities within each class of asset changes on a broadly consistent basis in response to changes in given market factors. However, the extent of the change, and therefore the range of reasonably possible alternative assumptions, may be either more or less pronounced, depending on the particular terms and circumstances of the individual security. Through most of 2008, while default rates on sub-prime mortgages were on the rise, there was less transparency and historical data to predict future defaults on both Alt-A and prime securities. As such, the Group felt that probability of default was the least transparent input into Alt-A and prime RMBS modelled valuations throughout 2008 (and most sensitive to variations). The Group believes that a range of 500 basis points greater than and 500 basis points less than the weighted average constant default rate, and a range of 200 basis points greater than and 200 basis points less than the weighted average constant default rate represents a reasonably possible set of acceptable pricing alternatives for Alt-A and prime RMBS, respectively. These assumptions consider the inherently risky nature of Alt-A over prime securities, as well as declining economic conditions leading to an increased likelihood of default at year-end. While other key inputs may possess characteristics of unobservability in both Alt-A and prime modelled valuations, the effect of utilising reasonably possible alternatives for these respective inputs would have an immaterial effect on the overall valuation. Using these reasonably possible alternative assumptions the fair value of RMBS of £0.5 billion would be £90 million lower or £40 million higher.
 
Commercial mortgage backed securities
CMBS is valued using an industry standard model and the inputs, where possible, are corroborated using observable market data.
 
For senior CMBS and subordinated tranches, the Group determined that the most sensitive input to reasonably possible alternatives valuation is probability of default and yield respectively. Using reasonably possible alternative assumptions for these inputs, the fair value of CMBS of £0.6 billion would be £30 million lower or £30 million higher.
 
Collateralised debt obligations
CDOs purchased from third parties are valued using independent, third- party quotes or independent lead manager indicative prices. For super senior CDOs which have been originated by the Group no specific third- party information is available. The valuation of these super senior CDOs therefore takes into consideration outputs from a proprietary model, market data and appropriate valuation adjustments.
 
The Group’s proprietary model calculates the expected cashflows from the underlying mortgages using assumptions, derived from publicly available data on future macroeconomic conditions (including house price appreciation and depreciation) and on defaults and delinquencies on these underlying mortgages. The model used by the Group comprises an econometric loan-level model which provides the input to an industry standard ABS model, the output of which feeds a proprietary model generating expected cashflows which are discounted using a risk adjusted rate.
 
 

 
Due to the subjectivity of the inputs to the pricing model, alternative valuation points are constructed to benchmark the output of the model. These valuation points include determining an ABS index implied collateral valuation, which provides a market calibrated valuation data point. A collateral net asset value methodology is also considered which uses dealer buy side marks to determine an upper bound for super senior CDO valuations. Both the ABS index implied valuation and the collateral net asset value methodology apply an assumed immediate liquidation approach.
 
The Group, using all pricing points available, may make necessary and appropriate valuation adjustments to the pricing information derived from the proprietary model. These adjustments reflect the Group’s assessment of factors that market participants would consider in setting a price, to the extent that these factors that have not already been included in the model and may include adjustments made for liquidity discounts.
 
In order to provide disclosures of the valuation of super senior CDOs using reasonably possible alternative assumptions, the Group has considered macroeconomic conditions, including house price appreciation and depreciation, and the effect of regional variations. The output from using these alternative assumptions has been compared with inferred pricing from other published data. The Group believes that reasonably possible alternative assumptions could reduce or increase valuations by up to 4%. Using these alternative assumptions would reduce the fair value of level 3 CDOs of £1.7 billion by up to £440 million (super senior CDOs: £292 million) and increase the fair value by up to £410 million (super senior CDOs: £ 292 million).
 
Collateralised loan obligations
To determine the fair value of CLOs purchased from third parties, the Group use third-party broker or lead manager quotes as the primary pricing source. These quotes are benchmarked to consensus pricing sources where they are available.
 
For CLOs originated and still held by the Group, the fair value is determined using a correlation model based on a Monte Carlo simulation framework. The main model inputs are credit spreads and recovery rates of the underlying assets and their correlation. A credit curve is assigned to each underlying asset based on prices, from third- party dealer quotes, and cash flow profiles, sourced from an industry standard model. Losses are calculated taking into account the attachment and detachment point of the exposure. As the correlation inputs to this model are not observable CLOs are deemed to be level 3. Using reasonably possible alternative assumptions the fair value of CLOs of £1.0 billion would be £40 million lower or £40 million higher.
 
Other debt securities
Other level 3 debt securities comprise £1.4 billion of other ABS and £1.7 billion of other debt securities. Where observable market prices for a particular debt security are not available, the fair value will typically be determined with reference to observable market transactions in other related products, such as similar debt securities or credit derivatives. Assumptions are made about the relationship between the individual debt security and the available benchmark data. Where significant management judgement has been applied in identifying the most relevant related product, or in determining the relationship between the related product and the instrument itself, the valuation is shown in level 3. Using differing assumptions about this relationship would result in different fair values for these assets. The main assumption made is that of relative creditworthiness. Using reasonably possible alternative assumption credit assumptions, taking into account the underlying currency, tenor, and rating of the debt securities within each portfolio, would reduce the fair value of other debt securities of £3.1 billion by up to £50 million or increase the fair value by up to £50 million.
 
Derivatives
Level 3 derivative assets comprised credit derivatives of £8.0 billion, equity derivatives of £0.1 billion and interest rate, foreign exchange rate and commodity derivative contracts of £2.2 billion. Derivative liabilities comprise credit derivatives of £2.6 billion interest rate, foreign exchange rate and commodity derivatives contracts of £1.4 billion.
 
Derivatives are priced using quoted prices for the same or similar instruments where these are available. However, the majority of derivatives are valued using pricing models. Inputs for these models are usually observed directly in the market, or derived from observed prices. However, it is not always possible to observe or corroborate all model inputs. Unobservable inputs used are based on estimates taking into account a range of available information including historic analysis, historic traded levels, market practice, comparison to other relevant benchmark observable data and consensus pricing data.
 
Credit derivatives
The Group’s credit derivatives include vanilla and bespoke portfolio tranches, gap risk products and certain other unique trades. The bespoke portfolio tranches are synthetic tranches referenced to a bespoke portfolio of corporate names on which the Group purchases credit protection. Bespoke portfolio tranches are valued using Gaussian Copula, a standard method which uses observable market inputs (credit spreads, index tranche prices and recovery rates) to generate an output price for the tranche via a mapping methodology. In essence this method takes the expected loss of the tranche expressed as a fraction of the expected loss of the whole underlying portfolio and calculates which detachment point on the liquid index, and hence which correlation level, coincides with this expected loss fraction. Where the inputs into this valuation technique are observable in the market, bespoke tranches are considered to be level 2 assets. Where inputs are not observable, bespoke tranches are considered to be level 3 assets. However, all transactions executed with a CDPC counterparty are considered level 3 as the counterparty credit risk assessment is a significant component of these valuations.
 
Gap risk products are leveraged trades, with the counterparty’s potential loss capped at the amount of the initial principal invested. Gap risk is the probability that the market will move discontinuously too quickly to exit a portfolio and return the principal to the counterparty without incurring losses, should an unwind event be triggered. This optionality is embedded within these portfolio structures and is very rarely traded outright in the market. Gap risk is not observable in the markets and, as such, these structures are deemed to be level 3 instruments.
 
Other unique trades are valued using a specialised model for each instrument and the same market data inputs as all other trades where applicable. By their nature, the valuation is also driven by a variety of other model inputs, many of which are unobservable in the market.
 
 
 

 
11           Financial instruments (continued)
Where these instruments have embedded optionality it is valued using a variation of the Black-Scholes option pricing formula, and where they have correlation exposure it is valued using a variant of the Gaussian Copula model. The volatility or unique correlation inputs required to value these products are generally unobservable and the instruments are therefore deemed to be level 3 instruments.
 
Other derivatives
Exotic equity, interest rate and commodity options provide a payout (or series of payouts) linked to the performance of one or more underlying, including equities, interest rates, foreign exchange rates and commodities. Included in commodities derivatives are energy contracts entered into by RBS Sempra Commodities. Most of these contracts are valued using models that incorporate observable data. A small number are more complex, structured derivatives which incorporate in their valuation assumptions regarding power price volatilities and correlation between inputs, which are not market observable. These include certain tolling agreements, where power is purchased in return for a given quantity of fuel, and load deals, where a seller agrees to deliver a fixed proportion of power used by a client’s utility customers.
 
Exotic options do not trade in active markets except in a small number of cases. Consequently, the Group uses models to determine fair value using valuation techniques typical for the industry. These techniques can be divided, firstly, into modelling approaches and, secondly, into methods of assessing appropriate levels for model inputs. The Group uses a variety of proprietary models for valuing exotic trades.  Exotic valuation inputs include correlation between equities, interest rates, foreign exchange rates and commodity prices. Correlations for more liquid equity and rate pairs are valued using independently sourced consensus pricing levels. Where a consensus pricing benchmark is unavailable, these instruments are categorised as level 3.
 
Reasonably possible alternative assumptions
In determining the effect of reasonably possible alternative assumptions for unobservable inputs, the Group has considered credit derivative trades with CDPCs separately from all other level 3 derivatives due to the significant element of subjectivity in determining the counterparty credit risk.
 
The fair value of credit derivative trades with CDPCs as at 31 December 2008 was £4.8 billion before applying a CVA of £1.3 billion. The Group’s credit derivative exposures to CDPCs are valued using pricing models with inputs observed directly in the market. An adjustment is made to the model valuation as the creditworthiness of CDPC counterparties differs from that of the credit risk assumptions used in the model. The adjustment reflects the estimated cost of hedging the counterparty risk arising from each trade. In the absence of market observable credit spreads of CDPCs, the cost of hedging the counterparty risk is estimated from an analysis of the underlying trades and the cost of hedging expected default losses in excess of the capital available in each vehicle. A reasonably possible alternative approach would be to estimate the cost of hedging the counterparty risk from market observable credit spreads of entities considered similar to CDPCs (for example monoline insurers with similar business or similarly rated entities). These reasonably possible alternative approaches would reduce the fair value credit derivatives with CDPCs by up to £740 million or increase the fair value by up to £600 million.
 
For all other level 3 derivatives, unobservable inputs are principally comprised of correlations and volatilities. Where a derivative valuation relies significantly on an unobservable input, the valuation is shown in level 3. It is usual for such derivative valuations to depend on several observable, and one or few unobservable model inputs. In determining reasonably possible alternative assumptions, the relative impact of unobservable inputs as compared to those which may be observed was considered. Using reasonably possible alternative assumptions the fair value of all other level 3 derivative assets (excluding CDPCs) would be reduced by up to £600 million or increased by up to £560 million and derivative liabilities of £4.0 billion, would be reduced by up to £300 million or increased by upto £280 million.
 
Equity shares – private equity
Private equity investments include unit holdings and limited partnership interests primarily in corporate private equity funds, debt funds and fund of hedges funds. Externally managed funds are valued using recent prices where available. Where not available, the fair value of investments in externally managed funds is generally determined using statements or other information provided by the fund managers.
 
Although such valuations are provided from third parties, the Group recognises that such valuations may rely significantly on the judgements and estimates made by those fund managers, particularly in assessing private equity components. Following the decline in liquidity in world markets, the Group believes that there is sufficient subjectivity in such valuations to report them in level 3.
 
Reasonably possible alternative valuations have been determined based on the historic trends in valuations received, and by considering the possible impact of market movements towards the end of the reporting period, which may not be fully reflected in valuations received. Using these reasonably possible alternate assumptions would reduce the fair value of externally managed funds of £1.1 billion by up to £160 million or increase the fair value by up to £80 million.
 
Other financial instruments
Other than the portfolios discussed above, there are other financial instruments which are held at fair value determined from data which are not market observable, or incorporating material adjustments to market observed data. Using reasonably possible alternate assumptions appropriate to the liability in question, such as credit spreads, derivative inputs and equity correlations, would reduce the fair value of other financial instruments held at fair value of £5.0 billion, primarily debt securities in issue of £4.4 billion, by up to £250 million or increase the fair value by up to £210 million.
 
 
 


Own credit
When valuing financial liabilities recorded at fair value, the Group takes into account the effect of its own credit standing. The categories of financial liabilities on which own credit spread adjustments are made are issued debt, including issued structured notes, and derivatives. An own credit adjustment is applied to positions where it is believed that counterparties would consider the Group’s creditworthiness when pricing trades.
 
For issued debt and structured notes, this adjustment is based on independent quotes from market participants for the debt issuance spreads above average inter-bank rates (at a range of tenors) which the market would demand when purchasing new senior or sub-debt issuances from the Group. Where necessary, these quotes are interpolated using a curve shape derived from CDS prices.
 
The fair value of the Group’s derivative financial liabilities reflects the Group’s own credit risk. The adjustment takes into account collateral posted by the Group and the effects of master netting agreements. No adjustments were made for own credit risk in relation to derivative liabilities in prior periods as it was not a significant factor in the pricing of derivative transactions by market participants. The change in methodology reflects market turbulence in 2008 which led to participants focussing increased attention on counterparty credit quality.
 
The table below shows the own credit spread adjustments on liabilities recorded in the income statement during the year.
 
   
Debt securities in issue
 
   
Held-for-trading
   
Designated at
fair value through profit and loss
   
Total
   
Derivatives
   
Total
 
      £m       £m       £m       £m       £m  
At 1 January 2008
    304       152       456             456  
Effect of changes to credit spreads
    376       583       959       450       1,409  
Benefit of foreign exchange hedges
    392       195       587             587  
New issues
    274       97       371             371  
At 31 December 2008
    1,346       1,027       2,373       450       2,823  

 
 


11           Financial instruments (continued)
Reclassification of financial instruments
As discussed in accounting policies on page 162, during 2008 the Group reclassified financial assets from the held-for-trading and available-for-sale categories into the loans and receivables category (as permitted by paragraph 50D of IAS 39 as amended) and from the held¬for-trading category into the available-for-sale category (as permitted by paragraph 50B of IAS 39 as amended).
 
The turbulence in the financial markets during the second half of 2008 was regarded by management as rare circumstances in the context of paragraph 50B of IAS 39 as amended.
 
The balance sheet values of these assets, the effect of the reclassification on the income statement for the period from the date of reclassification to 31 December 2008 and the gains and losses relating to these assets recorded in the income statement for the years ended 31 December 2008, 2007 and 2006 were as follows:
 
               
2008
   
2007
   
2006
 
   
2008 – on reclassification
   
31 December 2008
         
After reclassification
                   
   
Carrying
value
   
Effective
interest
rate
   
Expected
cash
flows
   
Carrying
value
   
Fair
value
   
Gains/(losses)
up to the
date of
reclassi-
fication
   
Income
   
Impairment
losses
   
Gains/
(losses)
in AFS
reserves
   
Amount
that would
have been
recognised
   
Gains/(losses)
recognised in
the income
statement
in prior
periods
 
      £m    
%
      £m       £m       £m       £m       £m       £m       £m       £m       £m       £m  
Reclassified from HFT to LAR:
                                                                                             
Loans:
                                                                                             
Leveraged finance
    3,602       10.15       6,083       4,304       2,523       (457 )     454                     (1,206 )     (155 )      
Corporate loans
    5,040       6.19       7,582       5,827       4,940       (76 )     198                     (681 )     (50 )     3  
      8,642               13,665       10,131       7,463       (533 )     652                     (1,887 )     (205 )     3  
Debt securities:
                                                                                               
CDO of RMBS
    215       4.92       259       236       221       4       5                     (11 )     5       6  
RMBS
    1,765       6.05       2,136       2,011       1,536       (115 )     157                     (302 )     (12 )      
CMBS
    1       11.11       4       1       1       1                                        
CLOs
    835       6.34       1,141       952       717       (22 )     104                     (130 )     (14 )     (2 )
Other ABS
    2,203       5.07       3,202       2,514       2,028       (67 )     129                     (338 )     3       (1
Other
    2,538       2.62       2,764       2,602       2,388       72       3                     (166 )     94       476  
      7,557               9,506       8,316       6,891       (127 )     398                     (947 )     76       479  
Total
    16,199               23,171       18,447       14,354       (660 )     1,050                     (2,834 )     (129 )     482  
                                                                                                 
Reclassified from HFT to AFS:
                                                                                               
Debt securities:
                                                                                               
CDO of RMBS
    6,228       8.14       8,822       5,695       5,695       (1,330 )     1,147       (464 )     (1,069 )     (280 )     (400 )      
RMBS
    5,205       8.03       8,890       5,171       5,171       (530 )     24             (162 )     (122 )     (4 )     73  
CMBS
    32       6.81       85       31       31       (5 )     5             (3 )     2       (4 )      
CLOs
    1,457       5.02       1,804       1,288       1,288       (168 )     421               (383 )     58       (36 )     1  
Other ABS
    2,199       6.02       3,183       1,847       1,847       (356 )     (10 )           (354 )     (311 )     (42 )     72  
Other
    614       12.55       1,311       698       698             130             (166 )     (5 )     (1 )      
      15,735               24,095       14,730       14,730       (2,389 )     1,717       (464 )     (2,137 )     (658 )     (487 )     146  
                                                                                                 
Reclassification from AFS to LAR:
                                                                                               
Debt securities
    704       1.38       772       1,028       968       (12 )(1)     6                   (37 )(1)            
Total
    32,638               48,038       34,205       30,052       (3,061 )     2,773       (464 )     (2,137 )     (3,529 )     (616 )     628  

Note:
 
(1) Gains/(losses) recognised in the available-for-sale reserve.
 
 


 
Amounts included in the consolidated income statement:
 
   
Group
 
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Gains on financial assets/liabilities designated as at fair value through profit or loss
    (901 )     1,074       573  
Gains on disposal or settlement of loans and receivables
    4       3       21  
 
On the initial recognition of financial assets and liabilities valued using valuation techniques incorporating information other than observable market data, any difference between the transaction price and that derived from the valuation technique is deferred. Such amounts are recognised in profit or loss over the life of the transaction; when market data become observable; or when the transaction matures or is closed out as appropriate. At 31 December 2008, net gains of £ 102 million (2007 – £ 72 million) were carried forward in the balance sheet. During the year net gains of £89 million (2007 – £67 million) were deferred and £65 million (2007 – £ 10 million) released to profit or loss.
 
Fair value of financial instruments not carried at fair value
The following table shows the carrying values and the fair values of financial instruments carried on the balance sheets at amortised cost.
 
   
Group
   
Company
 
   
2008
Carrying
Value
   
2008
Fair
value
   
2007
Carrying
value
   
2007
Fair
value
   
2008
Carrying
value
   
2008
Fair
value
   
2007
Carrying
value
   
2007
Fair
value
 
      £m       £m       £m       £m       £m       £m       £m       £m  
Financial assets
                                                               
Cash and balances at central banks
    12,400       12,400       17,866       17,866                          
                                                                 
Loans and advances to banks
                                                               
Loans and receivables
    81,963       81,929       147,821       147,818       27,031       27,031       7,686       7,686  
                                                                 
Loans and advances to customers
                                                               
Loans and receivables
    806,627       761,619       709,090       711,346                   307       307  
Finance leases
    14,453       14,527       12,570       12,376                          
                                                                 
Debt securities
                                                               
Loans and receivables
    12,985       11,500       2,672       2,644                          
                                                                 
Settlement balances
    17,832       17,832       16,589       16,589                          
                                                                 
Financial liabilities
                                                               
Deposits by banks
    176,890       176,266       246,803       246,627       1,802       1,802       5,572       5,572  
                                                                 
Customer accounts
    575,532       576,378       614,432       614,067       26       26              
                                                                 
Debt securities in issue
    248,846       241,295       222,883       222,763       14,179       14,010       13,453       13,453  
                                                                 
Settlement balances
    11,741       11,741       17,520       17,520                          
                                                                 
Subordinated liabilities
    47,645       36,446       37,146       35,793       10,314       8,752       7,743       6,983  

Notes:
 
(1) 
Financial assets and financial liabilities for which carrying amount approximates to fair value because they are of short maturity.
 
(2) 
Fair values are estimated by discounting expected future cash flows; using current interest rates and making adjustments for credit.
 
(3) 
The fair value of deposits repayable on demand is equal to their carrying value. The fair value of other deposits by banks and customer accounts is estimated by discounting expected future cash flows at current rates and adjusting, where appropriate, for the Group’s own credit spread. The fair value of many of these instruments approximates to their carrying value because they are of short maturity or reprice frequently.
 
(4) 
The fair value of short-term debt securities in issue is close to their carrying value. The fair value of other debt securities in issue is based on quoted prices; where these are unavailable fair value is estimated using other valuation techniques.
 
(5) 
The fair value of subordinated liabilities in issue is based on quoted prices; where these are unavailable fair value is estimated using other valuation techniques.
 
(6) 
The fair value of amounts due from and to subsidiaries is equal to their carrying value.
 

194

 

 
11
Financial instruments (continued)
 
Remaining maturity
The following table shows the residual maturity of financial instruments, based on contract date of maturity.
 
   
Group
 
   
2008
   
2007
 
   
Less than
12 months
   
More than
12 months
   
Total
   
Less than
12 months
   
More than
12 months
   
Total
 
      £m       £m       £m       £m       £m       £m  
Assets
                                               
Cash and balances at central banks
    12,364       36       12,400       17,866             17,866  
Loans and advances to banks
    133,565       4,632       138,197       187,969       31,491       219,460  
Loans and advances to customers
    338,751       535,971       874,722       395,753       432,785       828,538  
Debt securities
    69,912       197,637       267,549       70,088       224,568       294,656  
Equity shares
          26,330       26,330             53,026       53,026  
Settlement balances
    17,795       37       17,832       16,561       28       16,589  
Derivatives
    184,278       808,281       992,559       50,841       226,561       277,402  
                                                 
Liabilities
                                               
Deposits by banks
    248,896       9,148       258,044       302,934       9,360       312,294  
Customer accounts
    611,047       28,465       639,512       650,685       31,678       682,363  
Debt securities in issue
    174,507       125,782       300,289       156,020       118,152       274,172  
Settlement balances and short positions
    24,448       29,829       54,277       44,466       46,555       91,021  
Derivatives
    175,908       795,456       971,364       54,624       217,428       272,052  
Subordinated liabilities
    3,394       45,760       49,154       1,896       36,147       38,043  
 
   
Company
 
   
2008
   
2007
 
   
Less than
12 months
   
More than
12 months
   
Total
   
Less than
12 months
   
More than
12 months
   
Total
 
      £m       £m       £m       £m       £m       £m  
Assets
                                               
Loans and advances to banks
    16,096       10,935       27,031       1,655       6,031       7,686  
Loans and advances to customers
                      307             307  
Derivatives
    221       947       1,168       127       46       173  
                                                 
Liabilities
                                               
Deposits by banks
    1,802             1,802       5,572             5,572  
Customer accounts
    26             26                    
Debt securities in issue
    7,253       6,926       14,179       8,855       4,598       13,453  
Derivatives
    227       134       361       102       77       179  
Subordinated liabilities
    424       9,890       10,314       119       7,624       7,743  
 
 
195

 

 
The following tables show the contractual undiscounted cash flows payable up to a period of twenty years including future payments of interest.
 
On balance sheet liabilities

   
Group
 
   
2008
   
2007
 
   
0-3 months
   
3-12 months
   
1-3 years
   
3-5 years
   
5-10 years
   
10-20 years
 
2008
    £m       £m       £m       £m       £m       £m  
Deposits by banks
    154,614       14,347       3,345       2,754       2,048       34  
Customer accounts
    523,268       33,450       6,577       6,337       7,298       5,319  
Debt securities in issue
    131,714       48,652       40,067       38,223       38,667       5,626  
Derivatives held for hedging
    394       2,216       2,543       1,334       2,682       1,373  
Subordinated liabilities
    1,753       4,271       6,824       5,793       24,503       13,030  
Settlement balances and other liabilities
    13,351       5       12       6       10       6  
      825,094       102,941       59,368       54,447       75,208       25,388  
2007
                                               
Deposits by banks
    220,914       21,580       3,206       2,225       1,509       434  
Customer accounts
    561,003       30,539       9,430       4,509       11,615       9,052  
Debt securities in issue
    111,292       37,292       57,562       34,917       44,166       4,223  
Derivatives held for hedging
    252       667       822       449       605       118  
Subordinated liabilities
    641       3,720       5,603       3,466       22,735       6,354  
Settlement balances and other liabilities
    17,998       5       14       6       12       7  
      912,100       93,803       76,637       45,572       80,642       20,188  


   
Company
 
   
2008
   
2007
 
   
0-3 months
   
3-12 months
   
1-3 years
   
3-5 years
   
5-10 years
   
10-20 years
 
2008
    £m       £m       £m       £m       £m       £m  
Deposits by banks
    116       1,707                          
Debt securities in issue
    4,448       3,105       1,334       6,105              
Derivatives held for hedging
    186       16       30       1              
Subordinated liabilities
    158       458       1,464       1,376       4,241       5,149  
      4,908       5,286       2,828       7,482       4,241       5,149  
2007
                                               
Deposits by banks
    116       5,544                          
Debt securities in issue
    824       8,477       3,447       1,372              
Derivatives held for hedging
    52       1             2              
Subordinated liabilities
    116       347       1,119       1,045       3,282       3,909  
      1,108       14,369       4,566       2,419       3,282       3,909  

The tables above show the timing of cash outflows to settle financial liabilities. They have been prepared on the following basis:
 
Financial liabilities are included at the earliest date on which the counterparty can require repayment regardless of whether or not such early repayment results in a penalty. If repayment is triggered by, or is subject to, specific criteria such as market price hurdles being reached, the liability is included at the earliest possible date that the conditions could be fulfilled without considering the probability of the conditions being met. For example, if a structured note is automatically prepaid when an equity index exceeds a certain level, the cash outflow will be included in the less than three months period whatever the level of the index at the year end. The settlement date of debt securities in issue issued by certain securitisation vehicles consolidated by the Group depends on when cash flows are received from the securitised assets. Where these assets are prepayable, the timing of the cash outflow relating to securities assumes that each asset will be prepaid at the earliest possible date.
 
Liabilities with a contractual maturity of greater than 20 years – the principal amounts of financial liabilities that are repayable after 20 years or where the counterparty has no right to repayment of the principal are excluded from the table as are interest payments after 20 years.
 
Held-for-trading liabilities – held-for-trading liabilities amounting to £1,146.7 billion (liabilities) (2007 – £ 478.6 billion) have been excluded from the table in view of their short term nature.
 
 
196

 

 
 
The following table shows the movement in the provision for impairment losses for loans and advances.
 
   
Group
 
   
Individually
assessed
   
Collectively
assessed
   
Latent
   
Total
2008
   
2007
   
2006
 
      £m       £m       £m       £m       £m       £m  
At 1 January
    1,568       3,834       1,050       6,452       3,935       3,887  
Transfer to disposal groups
    (222 )     (351 )     (194 )     (767 )            
Currency translation and other adjustments
    1,065       81       295       1,441       137       (61 )
Acquisition of subsidiaries
                            2,221        
Disposal of subsidiaries
          (149 )     (29 )     (178 )            
Net increase in provisions of discontinued operations
                            46        
Amounts written-off
    (1,165 )     (1,983 )           (3,148 )     (2,011 )     (1,841 )
Recoveries of amounts previously written-off
    113       206             319       342       215  
Charged to the income statement
    3,663       2,606       822       7,091       1,946       1,877  
Unwind of discount
    (52 )     (142 )           (194 )     (164 )     (142 )
At 31 December (1)
    4,970       4,102       1,944       11,016       6,452       3,935  
 
Notes:
 
(1) 
The provision for impairment losses at 31 December 2008 includes £127 million relating to loans and advances to banks (2007 – £3 million; 2006 – £2 million).
 
(2)
There is no provision for impairment losses in the company.
 
   
Group
 
   
2008
   
2007
   
2006
 
Impairment losses charged to the income statement
    £m       £m       £m  
Loans and advances to customers
    6,973       1,946       1,877  
Loans and advances to banks
    118              
      7,091       1,946       1,877  
                         
Debt securities
    878       20        
Equity shares
    103       2       1  
      981       22       1  
      8,072       1,968       1,878  


   
Group
 
   
2008
   
2007
   
2006
 
      £m       £m       £m  
Gross income not recognised but which would have been recognised under the original terms of non-accrual and restructured loans
                       
Domestic
    393       390       370  
Foreign
    342       155       77  
      735       545       447  
                         
Interest on non-accrual and restructured loans included in net interest income
                       
Domestic
    150       165       142  
Foreign
    43       16       15  
      193       181       157  
 
 
197

 

 
The following table shows analysis of impaired financial assets.
 
   
Group
 
   
2008
   
2007
 
   
Cost
£m
   
Provision
£m
   
Net book
value
£m
   
Cost
£m
   
Provision
£m
   
Net book
value
£m
 
Impaired financial assets
                                   
Loans and advances to banks (1)
    129       127       2       25       3       22  
Loans and advances to customers (2)
    19,350       8,945       10,405       10,337       5,399       4,938  
Debt securities (1)
    52       37       15       5       4       1  
Equity shares (1)
    260       173       87       142       70       72  
      19,791       9,282       10,509       10,509       5,476       5,033  
 
Notes:
 
(1) 
Impairment provisions individually assessed.
 
(2)
Impairment provisions individually assessed on balances of £11,313 million (2007 – £3,178 million).
 
The Group holds collateral in respect of certain loans and advances to banks and to customers that are past due or impaired. Such collateral includes mortgages over property (both personal and commercial); charges over business assets such as plant, inventories and trade debtors; and guarantees of lending from parties other than the borrower.
 
The following table shows financial and non-financial assets, recognised on the Group's balance sheet, obtained during the year by taking possession of collateral or calling on other credit enhancements.
 
   
2008
   
2007
 
Group
    £m       £m  
Residential property
    41       32  
Other property
    6       8  
Cash
    59       18  
Other assets
    30       5  
      136       63  

In general, the Group seeks to dispose of property and other assets obtained by taking possession of collateral that are not readily convertible into cash as rapidly as the market for the individual asset permits.
 
Loans that have been renegotiated in the past 12 months that would otherwise have been past due or impaired amounted to £2,637 million as at 31 December 2008 (2007 – £ 930 million).
 
 
 

 
 
Companies in the Group transact derivatives as principal either as a trading activity or to manage balance sheet foreign exchange, interest rate and credit risk.
 
The Group enters into fair value hedges, cash flow hedges and hedges of net investments in foreign operations. The majority of the Group’s interest rate hedges relate to the management of the Group’s non-trading interest rate risk. The Group manages this risk to Value-at-Risk limits. The risk is assessed using gap reports that show maturity mismatches. To the extent that such mismatches exceed predetermined limits they are closed by executing derivatives principally interest rate swaps. Suitable larger ticket financial instruments are fair value hedged; the remaining exposure, where possible, is hedged by derivatives documented as cash flow hedges and qualifying for hedge accounting. The majority of the Group’s fair value hedges involve interest rate swaps hedging the interest rate risk in recognised financial assets and financial liabilities. 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. The Group hedges its net investments in foreign operations with currency borrowings and forward foreign exchange contracts.
 
For cash flow hedge relationships of interest rate risk, the hedged items are actual and forecast variable interest rate cash flows arising from financial assets and financial liabilities with interest rates linked to LIBOR, EURIBOR or the Bank of England Official Bank Rate. The financial assets are customer loans and the financial liabilities are customer deposits and LIBOR linked medium-term notes and other issued securities. As at 31 December 2008, variable rate financial assets of £34.6 billion and variable rate financial liabilities of £56.4 billion were hedged in such cash flow hedge relationships.
 
For cash flow hedging relationships, the initial and ongoing prospective effectiveness is assessed by comparing movements in the fair value of the expected highly probable forecast interest cash flows with movements in the fair value of the expected changes in cash flows from the hedging interest rate swap or by comparing the respective changes in the price value of a basis point. Prospective effectiveness is measured on a cumulative basis i.e. over the entire life of the hedge relationship. The method of calculating hedge ineffectiveness is the hypothetical derivative method. Retrospective effectiveness is assessed by comparing the actual movements in the fair value of the cash flows and actual movements in the fair value of the hedged cash flows from the interest rate swap over the life to date of the hedging relationship.
 
Exchange rate contracts in cash flow hedge relationships hedge future foreign currency cash inflow and outflows; mainly principal and interest on foreign currency loans.
 
For fair value hedge relationships of interest rate risk, the hedged items are typically large corporate fixed-rate loans, fixed-rate finance leases, fixed-rate medium-term notes or preference shares classified as debt. As at 31 December 2008 fixed rate financial assets of £42.5 billion and fixed rate financial liabilities of £46.4 billion were hedged by interest rate swaps in fair value hedge relationships.
 
The initial and ongoing prospective effectiveness of fair value hedge relationships is assessed on a cumulative basis by comparing movements in the fair value of the hedged item attributable to the hedged risk with changes in the fair value of the hedging interest rate swap or by comparing the respective changes in the price value of a basis point. Retrospective effectiveness is assessed by comparing the actual movements in the fair value of the hedged items attributable to the hedged risk with actual movements in the fair value of the hedging derivative over the life to date of the hedging relationship.
 
 
199

 

 
   
Group
 
   
2008
   
2007
 
   
Notional
amounts
£bn
   
Assets
£m
   
Liabilities
£m
   
Notional
amounts
£bn
   
Assets
£m
   
Liabilities
£m
 
Exchange rate contracts
                                   
Spot, forwards and futures
    2,316       83,065       83,568       2,134       29,829       29,629  
Currency swaps
    1,074       53,398       54,728       887       14,785       13,789  
Options purchased
    616       36,762             488       13,750        
Options written
    668             35,017       519             13,892  
                                                 
Interest rate contracts
                                               
Interest rate swaps
    37,901       548,040       532,180       24,798       142,470       141,479  
Options purchased
    5,673       99,192             4,084       30,681        
Options written
    3,775             102,216       3,640             31,199  
Futures and forwards
    8,555       7,600       6,620       3,164       807       987  
                                                 
Credit Derivatives
    2,208       142,366       132,734       2,402       34,123       29,855  
                                                 
Equity and commodity contracts
    622       22,136       24,301       281       10,957       11,222  
              992,559       971,364               277,402       272,052  

Certain derivative asset and liability balances with the London Clearing House, which meet the offset criteria in IAS 32 ‘Financial Instruments Presentation’, are now shown net. Comparative figures have been restated, reducing derivative assets and liabilities at 31 December 2007 by £60,008 million.
 
Included above are derivatives held for hedging purposes as follows:
 
   
2008
   
2007
 
   
Assets
£m
   
Liabilities
£m
   
Assets
£m
   
Liabilities
£m
 
Fair value hedging:
                       
Exchange rate contracts
    1,257       1,412       62       344  
Interest rate contracts
    2,944       3,330       1,598       1,062  
                                 
Cash flow hedging:
                               
Exchange rate contracts
    2       90       155       78  
Interest rate contracts
    2,503       2,834       738       1,014  
Commodity contracts
    39       14              
                                 
Net investment hedging:
                               
Exchange rate contracts
    114       596             211  

Hedge ineffectiveness recognised in other operating income comprised:
 
     
2008
£m
     
2007
£m
     
2006
£m
 
Fair value hedging:
                       
(Losses)/gains on the hedged items attributable to the hedged risk
    (965 )     81       219  
Gains/(losses) on the hedging instruments
    884       (87 )     (215 )
Fair value ineffectiveness
    (81 )     (6 )     4  
Cash flow hedging ineffectiveness
    (16 )     9       4  
      (97 )     3       8  
 
 
 

 
Derivatives (continued)
 
The following tables show for interest rate swaps in cash flow hedges, when the hedged cash flows are expected to occur and when they will affect profit or loss.
 
   
2008
 
Hedged forecast cash flows
expected to occur
 
0-1
years
£m
   
1-2
years
£m
   
2-3
years
£m
   
3-4
years
£m
   
4-5
years
£m
   
5-10
years
£m
   
10-20
years
£m
   
Over 20
years
£m
   
Total
£m
 
Forecast receivable cash flows
    985       779       667       554       423       1,323       407       45       5,183  
Forecast payable cash flows
    (1,732 )     (1,614 )     (1,390 )     (1,059 )     (890 )     (2,880 )     (1,397 )     (257 )     (11,219 )


   
2008
 
Hedged forecast cash flows
affect profit or loss
 
0-1
years
£m
   
1-2
years
£m
   
2-3
years
£m
   
3-4
years
£m
   
4-5
years
£m
   
5-10
years
£m
   
10-20
years
£m
   
Over 20
years
£m
   
Total
£m
 
Forecast receivable cash flows
    871       758       659       548       421       1,284       397       40       4,978  
Forecast payable cash flows
    (1,701 )     (1,576 )     (1,323 )     (1,023 )     (878 )     (2,771 )     (1,337 )     (128 )     (10,737 )


   
Company
 
   
2008
   
2007
 
   
Notional
amounts
£bn
   
Assets
£m
   
Liabilities
£m
   
Notional
amounts
£bn
   
Assets
£m
   
Liabilities
£m
 
Exchange rate contracts
    7       792       353       13       154       178  
Interest rate contracts
    5       376       8       1       19       1  
              1,168       361               173       179  

Included above are derivatives held for hedging purposes as follows;
 
   
2008
   
2007
 
Fair value hedging
 
Assets
£m
   
Liabilities
£m
   
Assets
£m
   
Liabilities
£m
 
Exchange rate contracts
          225             54  
Interest rate contracts
    193                    
 
 
   
Group
 
   
UK
central
and local
government
   
US
central
and local
government
   
Other
central
and local
government
   
Bank and
building
society
   
Mortgage and
other asset
backed
securities(1)
   
Corporate
   
Other(2)
   
Total
 
2008
    £m       £m       £m       £m       £m       £m       £m       £m  
Held-for-trading
    5,372       9,859       37,519       4,407       39,879       17,671       1,573       116,280  
Designated as at fair value
through profit or loss
    2,085       510       472       89       236       1,580       456       5,428  
Available-for-sale
    11,330       6,152       32,480       12,038       62,067       6,501       2,288       132,856  
Loans and receivables
                      114       8,961       3,749       161       12,985  
      18,787       16,521       70,471       16,648       111,143       29,501       4,478       267,549  
                                                                 
Available-for-sale
                                                               
Gross unrealised gains
    41       41       1,104       1,372       1,238       332       266       4,394  
Gross unrealised losses
          (166 )     (3,457 )     (146 )     (3,533 )     (448 )     (80 )     (7,830 )

 
201

 

 
   
Group
 
   
UK central and local government
   
US central and local government
   
Other central and local government
   
Bank and building society
   
Mortgage and other asset backed securities(1)
   
Corporate
   
Other(2)
   
Total
 
2007
    £m       £m       £m       £m       £m       £m       £m       £m  
Held-for-trading
    10,370       12,670       60,356       7,830       62,430       35,769       1,246       190,671  
Designated as at fair value
                                                               
through profit or loss
    2,235       397       101       154       340       2,125       425       5,777  
Available-for-sale
    1,030       2,169       31,597       11,835       36,607       6,551       5,747       95,536  
Loans and receivables
                1,896             704             72       2,672  
      13,635       15,236       93,950       19,819       100,081       44,445       7,490       294,656  
Available-for-sale
                                                               
Gross unrealised gains
    29       14       56       12       18       22       1       152  
Gross unrealised losses
          (62 )     (276 )     (42 )     (181 )     (22 )     (10 )     (593 )
 
Notes:
 
(1)
Includes securities issued by US federal agencies and government sponsored entities.
 
(2)
Includes non asset backed securities issued by US federal agencies and government sponsored entities.
 
(3)
During 2008 the Group reclassified financial assets from the held-for-trading and available-for-sale categories into the loans and receivables category and from the held-for-trading category into the available-for-sale category (see page 193).
 
The following table analyses by issuer the Group’s available-for-sale debt securities by remaining maturity and the related yield (based on weighted averages).
 
   
Within 1 year
   
After 1 but
within 5 years
   
After 5 but
within 10 years
   
After 10 years
   
Total
 
   
Amount
   
Yield
   
Amount
   
Yield
   
Amount
   
Yield
   
Amount
   
Yield
   
Amount
   
Yield
 
2008
    £m    
%
      £m    
%
      £m    
%
      £m    
%
      £m    
%
 
UK central and local government
    9,320       2.0 %     1,307       3.8 %     670       7.2 %     33       4.6 %     11,330       2.5 %
US central and local government
    37       3.6 %     232       3.9 %     4,980       3.8 %     903       5.6 %     6,152       4.0 %
Other central and local government
    4,770       3.5 %     9,046       4.3 %     18,655       3.2 %     9       3.2 %     32,480       3.5 %
Bank and building society
    5,753       2.2 %     3,919       3.7 %     2,046       4.8 %     320       3.3 %     12,038       3.0 %
Mortgage-backed securities(1)
    2,806       4.1 %     13,286       2.6 %     17,510       3.9 %     28,465       4.6 %     62,067       3.9 %
Corporate
    1,024       4.6 %     3,454       5.1 %     1,565       7.4 %     458       3.5 %     6,501       5.4 %
Other(2)
    202       3.4 %     298       3.9 %     1,134       4.5 %     654       4.4 %     2,288       4.2 %
Total fair value
    23,912       2.7 %     31,542       3.5 %     46,560       3.8 %     30,842       4.6 %     132,856       3.7 %
 
Notes:
 
(1)
Includes securities issued by US federal agencies and government sponsored entities.
 
(2)
Includes non-asset backed securities issued by US federal agencies and government sponsored entities.
 
The table below shows the fair value of available-for-sale debt securities that were in an unrealised loss position at 31 December.
 
   
Less than 12 months
   
More than 12 months
   
Total
 
   
Fair value
   
Gross unrealised losses
   
Fair value
   
Gross unrealised losses
   
Fair value
   
Gross unrealised losses
 
2008
    £m       £m       £m       £m       £m       £m  
US central and local government
    260       3       10,777       163       11,037       166  
Other central and local government
    17,939       3,450       39       7       17,978       3,457  
Bank and building society
    1,402       95       1,192       51       2,594       146  
Mortgage-backed securities(1)
    15,032       2,840       25,033       693       40,065       3,533  
Corporate
    618       267       2,326       181       2,944       448  
Other(2)
    9       1       235       79       244       80  
      35,260       6,656       39,602       1,174       74,862       7,830  
 
Notes:
 
(1) 
Includes securities issued by US federal agencies and government sponsored entities.
 
(2) 
Includes non asset-backed securities issued by US federal agencies and government sponsored entities.
 
Gross gains of £1,633 million (2007 – £60 million) and gross losses of £1,411 million (2007 – £12 million) were realised on the sale of available-for-sale securities.
 
 
 

 
14
Debt securities (continued)
 
Impairment losses on available-for-sale debt securities are recognised when there is objective evidence of impairment. The Group reviews its portfolios of available-for-sale financial assets for such evidence which includes: default or delinquency in interest or principal payments; significant financial difficulty of the issuer or obligor; and it becoming probable that the issuer will enter bankruptcy or other financial reorganisation. However, the disappearance of an active market because an entity’s financial instruments are no longer publicly traded is not evidence of impairment. Furthermore, a downgrade of an entity’s credit rating is not, of itself, evidence of impairment, although it may be evidence of impairment when considered with other available information. A decline in the fair value of a financial asset below its cost or amortised cost is not necessarily evidence of impairment. Determining whether objective evidence of impairment exists requires the exercise of management judgment. The unrecognised losses on the Group’s available-for-sale debt securities are concentrated in its portfolios of mortgage-backed securities and of securities issued by central and local governments other than the UK and the US. The losses reflect the widening of credit spreads as a result of the reduced market liquidity in these securities and the current uncertain macro-economic outlook in US and Europe. The underlying securities remain unimpaired.
 
 
   
Group
 
   
2008
   
2007
 
   
Listed
   
Unlisted
   
Total
   
Listed
   
Unlisted
   
Total
 
      £m       £m       £m       £m       £m       £m  
Held-for-trading
    15,894       1,160       17,054       33,696       3,850       37,546  
Designated as at fair value through profit or loss
    1,340       761       2,101       1,856       6,010       7,866  
Available-for-sale
    4,882       2,293       7,175       5,622       1,992       7,614  
      22,116       4,214       26,330       41,174       11,852       53,026  
Available-for-sale
                                               
Gross unrealised gains
    1,505       172       1,677       3,467       130       3,597  
Gross unrealised losses
    (225 )     (103 )     (328 )     (3 )     (7 )     (10 )
 
Gross gains of £190 million (2007 – £475 million) and gross losses of £70 million (2007 – £9 million) were realised on the sale of available-for- sale equity shares.
 
Dividend income from available-for-sale equity shares was £281 million (2007 – £ 137 million; 2006 – £92 million).
 
Unquoted equity investments whose fair value cannot be reliably measured are carried at cost and classified as available-for-sale financial assets. They include capital stock (redeemable at cost) in the Federal Home Loan Bank and the Federal Reserve Bank of £0.9 billion (2007 – £0.5 billion) that the Group’s banking subsidiaries in the US are required to hold; and a number of individually small shareholdings in unlisted companies. Disposals in the year generated no gains or losses (2007 – £0.5 million gain; 2006 – £ 56 million gain).
 
 
203

 

 
Investments in Group undertakings
 
Investments in Group undertakings are carried at cost less impairment. Movements during the year were as follows:
 
   
Company
 
   
2008
   
2007
 
      £m       £m  
At 1 January
    43,542       21,784  
Currency translation and other adjustments
    2,839       535  
Additional investments in Group undertakings
    10,323       3,663  
Impairment of investment in RFS Holdings B.V.
    (14,321 )      
Disposals
    (213 )     (6 )
Additions
    26       17,566  
At 31 December
    42,196       43,542  
 
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 and ABN AMRO. The Royal Bank of Scotland plc, RBS Insurance Group Limited and RFS Holdings B.V. are directly owned by the company, and all of the other subsidiary undertakings are 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.
 
  Nature of business Country of incorporation
and principal area of
operation
Group interest
The Royal Bank of Scotland plc Banking Great Britain 100%
National Westminster Bank Plc(1) Banking Great Britain 100%
Citizens Financial Group, Inc. Banking US 100%
Coutts & Co(2) Private banking Great Britain 100%
Greenwich Capital Markets, Inc. Broker dealer US 100%
RBS Insurance Group Limited Insurance Great Britain 100%
Ulster Bank Limited(3) Banking Northern Ireland 100%
ABN AMRO Bank N.V.(4) Banking The Netherlands 38%
 
Notes:
 
(1) The company does not hold any of the NatWest preference shares in issue.
   
(2) Coutts & Co is incorporated with unlimited liability. Its registered office is 440 Strand, London WC2R 0QS.
   
(3) Ulster Bank Limited and its subsidiaries also operate in the Republic of Ireland.
   
(4) RFS Holdings B.V. (RFS) owns 100% of the outstanding shares of ABN AMRO Holding N.V. (ABN AMRO). The company owns 38% of RFS; the balance of shares is held by the State of the Netherlands, successor to Fortis N.V., Fortis SA/NV, and Banco Santander S.A. (the consortium members). Although the company does not control a majority of the voting rights in RFS, through the terms fo the Consortium and Shareholders' Agreement and RFS's Articles of Association, it controls the board of RFS and RFS is a subsidiary of the company. The capital and income rights of shares issued by RFS are linked to the net assets and income of the ABN AMRO business units which the individual consortium members have agreed to acquire.
 
The above information is provided in relation to the principal related undertakings as permitted by Section 231(5) of the Companies Act 1985. Full information on all related undertakings will be included in the Annual Return delivered to the Registrant of Companies for Scotland.
 
 
204

 

 
 
   
Group
 
   
Goodwill
   
Core deposit intangibles
   
Other purchased intangibles
   
Internally generated software
   
Total
 
2008
    £m       £m       £m       £m       £m  
Cost:
                                       
At 1 January 2008
    42,953       2,344       3,489       3,882       52,668  
Transfers to disposal groups
    (3,692 )     (240 )     (105 )     (146 )     (4,183 )
Currency translation and other adjustments
    8,905       680       961       214       10,760  
Acquisition of subsidiaries
    524                         524  
Additions
                23       602       625  
Disposal of subsidiaries
    (3,066 )                 (7 )     (3,073 )
Disposals and write-off of fully amortised assets
          (4 )     (1 )     (21 )     (26 )
At 31 December 2008
    45,624       2,780       4,367       4,524       57,295  
Accumulated amortisation and impairment:
                                       
At 1 January 2008
          238       223       2,291       2,752  
Transfer to disposal groups
                      (37 )     (37 )
Currency translation and other adjustments
          150       210       69       429  
Disposals and write-off of fully amortised assets
          (3 )     (1 )     (19 )     (23 )
Charge for the year
          337       582       651       1,570  
Write down of goodwill and other intangible assets
    30,062       685       1,355       453       32,555  
At 31 December 2008
    30,062       1,407       2,369       3,408       37,246  
Net book value at 31 December 2008
    15,562       1,373       1,998       1,116       20,049  
2007
                                          
Cost:
                                       
At 1 January 2007
    17,889       265       275       2,642       21,071  
Currency translation and other adjustments
    1,187       105       177       52       1,521  
Acquisition of subsidiaries
    23,917       1,974       3,034       791       29,716  
Additions
                6       481       487  
Goodwill written off
    (40 )                       (40 )
Disposals and write-off of fully amortised assets
                (3 )     (84 )     (87 )
At 31 December 2007
    42,953       2,344       3,489       3,882       52,668  
Accumulated amortisation:
                                       
At 1 January 2007
          127       97       1,943       2,167  
Currency translation and other adjustments
          1       3       3       7  
Disposals and write-off of fully amortised assets
                (1 )     (80 )     (81 )
Charge for the year – continuing operations
          110       124       401       635  
Charge for the year – discontinued operations
                      24       24  
At 31 December 2007
          238       223       2,291       2,752  
Net book value at 31 December 2007
    42,953       2,106       3,266       1,591       49,916  
 
 
205

 


Impairment review
The Group’s goodwill acquired in business combinations is reviewed annually at 30 September for impairment by comparing the recoverable amount of each cash generating unit (CGU) to which goodwill has been allocated with its carrying value. In light of the unprecedented market conditions the review has been updated to reflect the latest position as at 31 December 2008.
 
The Group recognised goodwill of £23.3 billion (€33.5 billion) following the preliminary allocation of fair values since acquiring ABN AMRO on 17 October 2007. On final allocation of fair values, goodwill of £23.9 billion (€34.2 billion) was recognised (see Note 34), of which £17.6 billion (€25.3 billion) was attributable to minority interests. Of the minority interests goodwill, £5.4 billion (€5.7 billion) was in respect of Santander acquired businesses which were subsequently sold during 2008. The remaining goodwill in respect of the State of the Netherlands minority interest of £18.8 billion (€19.6 billion) was reduced in part by £2.7 billion (€2.9 billion) following the sale of the Asset Management business with £14.6 billion (€15.2 billion) of the remainder subsequently impaired following the acquisition by the State of the Netherlands for £6.2 billion (€6.5 billion). In addition, a further £1.1 billion (€1.2 billion) impairment was recognised on other intangible assets attributable to the State of the Netherlands acquired businesses.
 
On the finalisation of the allocation of fair values, goodwill arising on the acquisition of ABN AMRO attributable to the Group has been allocated to those CGUs which are expected to benefit from the synergies of the combination based on their relative values. In addition, following the reorganisation of the Group reporting structure, NatWest and Citizens goodwill was reallocated to the appropriate CGUs.
 
The CGUs where the goodwill arising is significant, principally on the acquisitions of NatWest, Charter One, ABN AMRO and Churchill, are as follows:
 
 
Recoverable
amount
based on:
 
Goodwill
prior to
write down
   
Write down
   
Goodwill at
31 December
 
2008
      £m       £m       £m  
Global Banking & Markets
Value in use
    8,946       (8,946 )      
Global Transaction Services
Value in use
    3,121             3,121  
UK Retail & Commercial Banking
Value in use
    6,009             6,009  
US Retail & Commercial Banking
Value in use
    7,405       (4,382 )     3,023  
Europe & Middle East Retail & Commercial Banking
Value in use
    1,201       (1,201 )      
Asia Retail & Commercial Banking
Value in use
    970       (863 )     107  
RBS Insurance
Value in use
    935             935  

 
 
Recoverable amount
 
Goodwill at
30 September
 
2007
based on:
    £m  
RBS Insurance
Fair value less costs to sell
    1,064  
Global Banking & Markets
Fair value less costs to sell
    2,346  
UK Corporate Banking
Fair value less costs to sell
    1,630  
Retail
Fair value less costs to sell
    4,278  
Wealth Management
Fair value less costs to sell
    1,100  
Citizens – Retail Banking
Value in use
    2,067  
Citizens – Commercial Banking
Value in use
    2,274  
Citizens – Consumer Financial Services
Value in use
    1,701  
 
The analysis of goodwill by operating segment is shown in Note 38.
 
 
206

 

 
17
Intangible assets (continued)
 
In 2007, the recoverable amounts for all CGUs, except Citizens, were based on fair value less costs to sell. Fair value was based upon a price-earnings methodology using current earnings for each unit. Approximate price earnings multiples, validated against independent analyst information, were applied to each CGU. The multiples used were in the range 9.5 – 13.0 times earnings after charging manufacturing costs. The goodwill allocated to Global Banking & Markets, UK Corporate Banking, Retail and Wealth Management principally arose from the acquisition of NatWest in 2000. The recoverable amount of these cash generating units exceeded their carrying value by over £15 billion. The recoverable amount for RBS Insurance exceeded its carrying value by over £1.5 billion. The multiples or earnings would have to be less than one third of those used to cause the value in use of the units to equal their carrying value.
 
In light of the unprecedented market turmoil, fair value was increasingly hard to appraise and consequently the Group has generally adopted value in use tests for CGUs in 2008, based upon management’s latest five year forecasts. The long-term growth rates have been based on respective country GDP rates adjusted for inflation. The risk discount rates are based on observable market long-term government bond yields and average industry betas adjusted for an appropriate risk premium based on independent analysis.
 
Goodwill in respect of Global Banking & Markets principally arose from the acquisition of ABN AMRO in October 2007. The failure of a number of banks and severe weakness in the global economy during the second half of 2008 resulted in a fundamental reappraisal of business forecasts, leading to the conclusion that the Global Banking & Markets business at 31 December 2008 could support no goodwill allocated from the ABN AMRO or NatWest acquisitions. In addition, impairments were recognised in respect of intangible assets and certain property, plant and equipment: the customer relationship intangible was impaired by £0.9 billion and capitalised software was impaired by £0.4 billion. The value in use was based on a 3% terminal growth rate and pre-tax discount rate of 19.5%. The result was insensitive to reasonably possible changes in key assumptions.
 
The recoverable amount of the Global Transaction Services business based on a 3% terminal growth rate and 15.7% pre tax risk discount rate exceeded its carrying value by more than 100% and was insensitive to a reasonably possible change in key assumptions. The goodwill arises principally from the global payments business acquired through the ABN AMRO acquisition along with cash management and corporate money transmission businesses previously in Citizens and Regional businesses.
 
UK Retail and Commercial Banking was formed at the beginning of 2008 when the Group brought together the businesses that use its UK branch network. It primarily comprised the UK Retail and Corporate banks but excluded their transaction services business. The recoverable amount was equal to the carrying amount including goodwill arising from the NatWest acquisition. This is based on a 4% terminal growth rate and 15.9% pre tax risk discount rate. A 1 % change in discount rate or the terminal growth rate would change the recoverable amount by over £2 billion and £1 billion respectively. In addition, a 5% change in forecast pre-tax earnings would change the recoverable amount by approximately £1 billion.
 
The goodwill in Europe & Middle East Retail and Commercial Banking arose from the Group’s interests in Ulster Bank Group principally arising out of the acquisitions of NatWest and First Active. The Irish economy stalled in 2008, with the Government providing rescue packages to local banks, and forecasts within the eurozone economies have reduced accordingly. The impairment review, based on a 3% terminal growth rate and 14.1 % pre-tax risk discount rate, showed all goodwill associated with the business was impaired. The result was insensitive to reasonably possible changes in key assumptions.
 
The Asia Retail and Commercial Banking business comprises much of the Group’s Wealth management business and retail operations in Asia. The outlook in the Asian economies has deteriorated and falling investment values have reduced the yield from managed portfolios. The allocated goodwill principally arising on the acquisition of ABN AMRO was impaired by £862 million based on a 5% terminal growth rate and 14% pre-tax risk discount rate. A 1% change in the discount rate or similar change in the terminal growth rate would change the recoverable amount by approximately £200 million and £100 million respectively. In addition, a 5% change in forecast pre-tax earnings would change the recoverable amount by approximately £50 million.
 
Further developments in the Group’s US businesses have led to the separation of the transaction services business, with the retail and commercial business being managed as a single unit. The 2007 impairment review indicated the recoverable amount of Citizens exceeded its carrying value by over £2.5 billion ($5 billion) using a terminal growth rate of 5% and a pre tax discount rate of 16.5%. In 2008, rates of 5% and 18% were used respectively and the recoverable amount indicated an impairment of £4.4 billion ($6.4 billion). A 1% change in discount rate or the terminal growth rate would change the recoverable amount and hence goodwill impairment by over £1 billion ($2 billion) and £0.7 billion ($1 billion) respectively. In addition, a 5% change in forecast pre-tax earnings would change the recoverable amount by approximately £0.5 billion ($0.8 billion).
 
The goodwill allocated to RBS Insurance principally arose from the acquisition of Churchill in 2003. The recoverable amount based on a 3% terminal growth rate and 14.6% pre tax risk discount rate exceeded the carrying amount by over £3 billion, and was insensitive to reasonably possible changes in key assumptions.
 
 
 

 
 
   
Group
 
   
Investment
properties
   
Freehold
premises
   
Long
leasehold
premises
   
Short
leasehold
premises
   
Computers
and other
equipment
   
Operating
lease
assets
   
Total
 
2008
    £m       £m       £m       £m       £m       £m       £m  
Cost or valuation:
                                                       
At 1 January 2008
    3,431       3,645       215       1,688       3,929       11,437       24,345  
Transfers to disposal groups
          (262 )           (188 )     (349 )           (799 )
Currency translation and other adjustments
    320       452       5       149       436       1,313       2,675  
Acquisition of subsidiaries
                      30       31             61  
Disposal of subsidiaries
                      (2 )     (57 )     (5,015 )     (5,074 )
Reclassifications
          (176 )           197       (14 )     (7 )      
Additions
    417       486       22       61       837       3,794       5,617  
Expenditure on investment properties
    8                                     8  
Change in fair value of investment properties
    (86 )                                   (86 )
Disposals and write-off of fully depreciated assets
    (222 )     (113 )     (18 )     (68 )     (645 )     (2,188 )     (3,254 )
At 31 December 2008
    3,868       4,032       224       1,867       4,168       9,334       23,493  
Accumulated impairment, depreciation and amortisation:
                                                       
At 1 January 2008
          391       74       436       1,952       2,747       5,600  
Transfers to disposal groups
          (60 )           (91 )     (243 )           (394 )
Currency translation and other adjustments
          (9 )     1       9       148       202       351  
Disposal of subsidiaries
                      (1 )     (39 )     (1,447 )     (1,487 )
Reclassifications
          17       (2 )     1       (9 )     (7 )      
Write-off of property, plant and equipment
          19                   7             26  
Disposals and write-off of fully depreciated assets
          (22 )           (31 )     (539 )     (544 )     (1,136 )
Charge for the year
          86       6       169       639       684       1,584  
At 31 December 2008
          422       79       492       1,916       1,635       4,544  
Net book value at 31 December 2008
    3,868       3,610       145       1,375       2,252       7,699       18,949  

 
2007
                                         
Cost or valuation:
                                         
At 1 January 2007
    4,885       2,579       310       1,254       3,069       11,589       23,686  
Currency translation and other adjustments
    96       65       1       11       12       (10 )     175  
Acquisition of subsidiaries
          950             157       191       202       1,500  
Reclassifications
    3       (4 )     3       1       (3 )            
Additions
    450       592       34       309       857       2,791       5,033  
Transfers to disposal groups
          (4 )     (13 )                 (422 )     (439 )
Expenditure on investment properties
    41                                     41  
Change in fair value of investment properties
    288                                     288  
Disposals and write-off of fully depreciated assets
    (2,332 )     (533 )     (120 )     (44 )     (197 )     (2,713 )     (5,939 )
At 31 December 2007
    3,431       3,645       215       1,688       3,929       11,437       24,345  
Accumulated depreciation and amortisation:
                                                       
At 1 January 2007
          446       96       374       1,670       2,680       5,266  
Currency translation and other adjustments
          (4 )           (1 )     (1 )     2       (4 )
Transfers to disposal groups
                                  (52 )     (52 )
Reclassifications
          (2 )     2                          
Disposals and write-off of fully depreciated assets
          (122 )     (32 )     (25 )     (132 )     (610 )     (921 )
Charge for the year – continuing operations
          66       8       87       409       727       1,297  
Charge for the year – discontinued operations
          7             1       6             14  
At 31 December 2007
          391       74       436       1,952       2,747       5,600  
Net book value at 31 December 2007
    3,431       3,254       141       1,252       1,977       8,690       18,745  
 
 
 

 
18
Property, plant and equipment (continued)
 
   
2008
   
2007
 
      £m       £m  
Contracts for future capital expenditure not provided for in the accounts at the year end (excluding investment properties and operating lease assets)
    128       201  
Contractual obligations to purchase, construct or develop investment properties or to repair, maintain or enhance investment properties
    7       9  
Property, plant and equipment pledged as security
          935  
 
Investment properties are valued to reflect fair value, that is, the market value of the Group’s interest at the reporting date excluding any special terms or circumstances relating to the use or financing of the property and transaction costs that would be incurred in making a sale. Observed market data such as rental yield, replacement cost and useful life, reflect relatively few transactions involving property that is not necessarily identical to property owned by the Group.
 
Valuations are carried out by management with the support of qualified surveyors who are members of the Royal Institution of Chartered Surveyors, or an equivalent overseas body. The valuation as at 31 December 2008 for a significant majority of the Group’s investment properties was undertaken by external valuers.
 
The fair value of investment properties includes £172 million (2007 – £234 million) of appreciation since purchase.
 
Rental income from investment properties was £257 million (2007 – £300 million; 2006 – £278 million). Direct operating expenses of investment properties were £22 million (2007 – £49 million; 2006 – £54 million).
 
Property, plant and equipment, excluding investment properties, include £1,132 million (2007 – £717 million) assets in the course of construction.
 
Freehold and long leasehold properties with a net book value of nil (2007 – £451 million; 2006 – £164 million) were sold subject to operating leases.
 
 
   
Group
   
Company
 
   
2008
   
2007
   
2008
   
2007
 
      £m       £m       £m       £m  
Prepayments
    1,949       1,988              
Accrued income
    1,206       1,214              
Deferred expenses
    709       385              
Pension schemes in net surplus
    36       575              
Other assets
    20,502       11,500       489       127  
      24,402       15,662       489       127  
 
 
209

 

 
Discontinued operations and assets and liabilities of disposal groups
 
(a) Profit/(loss) from discontinued operations, net of tax

   
2008
   
2007
 
      £m       £m  
Discontinued operations:
               
Total income
    2,571       749  
Operating expenses
    (1,407 )     (493 )
Insurance net claims
          (28 )
Impairment losses
    (564 )     (160 )
Profit before tax
    600       68  
Gain on disposal
    3,859        
Operating profit before tax
    4,459       68  
Tax on profit
    (204 )     (8 )
Tax on gain on disposal
    (33 )      
Profit after tax
    4,222       60  
Businesses acquired exclusively with a view to disposal
               
Loss after tax
    (251 )     (136 )
Profit/(loss) from discontinued operations, net of tax
    3,971       (76 )

Discontinued operations reflect the results of Banco Real sold to Santander on 24 July 2008. There were no discontinued operations during 2006.
 
Businesses acquired exclusively with a view to disposal comprise those ABN AMRO businesses, including Banca Antonveneta, Asset Management and Private Equity, classified as disposal groups on the acquisition of ABN AMRO on 17 October 2007. The Asset Management business was sold to Fortis on 3 April 2008. Banca Antonveneta, excluding its subsidiary Interbanca, was sold to Banca Monte dei Paschi di Siena S.p.A. on 30 May 2008.
 
(b) Cash flows attributable to discontinued operations
Included within the Group’s cash flows are the following amounts attributable to discounted operations:
 
   
2008
   
2007
 
      £m       £m  
Net cash flows from operating activities
    (124 )     (1,304 )
Net cash flows from investing activities
    (368 )     4,341  
Net cash flows from financing activities
    339       (25 )
Net increase in cash and cash equivalents
    287       3,172  
 
(c) Assets and liabilities of disposal groups
 
   
2008
   
2007
 
Assets of disposal groups
    £m       £m  
Disposal groups and other disposals
    66       395  
Assets acquired exclusively with a view to disposal
    1,515       45,455  
      1,581       45,850  
Liabilities of disposal groups
               
Liabilities acquired exclusively with a view to disposal
    859       29,228  
 
 
 

 
 
   
Group
 
     
2008
£m
     
2007
£m
 
Settlement balances (amortised cost)
    11,741       17,520  
Short positions (held-for-trading):
               
Debt securities – Government
    32,519       41,048  
– Other issuers
    6,374       25,310  
Equity shares
    3,643       7,143  
      54,277       91,021  
 
 
   
Group
   
Company
 
     
2008
£m
     
2007
£m
     
2008
£m
     
2007
£m
 
Notes in circulation
    1,619       1,545              
Current taxation
    585       1,630              
Accruals
    7,531       8,377       3        
Deferred income
    7,640       6,289       4        
Other liabilities (1)
    14,107       16,367       40       8  
      31,482       34,208       47       8  
 
Note:
 
(1) 
Other liabilities include £1 million (2007 – £9 million) in respect of share-based compensation.
 
Included in other liabilities are provisions for liabilities and charges as follows:
 
Group
    £m  
At 1 January 2008
    168  
Currency translation and other movements
    12  
Charge to income statement
    116  
Releases to income statement
    (42 )
Provisions utilised
    (32 )
At 31 December 2008
    222  

Note:
 
(1) 
 Comprises property provisions and other provisions arising in the normal course of business.
 
 
211

 

 
 
Provision for deferred taxation has been made as follows:
 
   
Group
   
Company
 
     
2008
£m
     
2007
£m
     
2008
£m
     
2007
£m
 
Deferred tax liability
    4,165       5,400             3  
Deferred tax asset
    (7,082 )     (3,119 )     (3 )      
Net deferred tax
    (2,917 )     2,281       (3 )     3  
 
         
Group
 
   
Pension
£m
   
Accelerated capital allowances
£m
   
Provisions
£m
   
Deferred gains
£m
   
IFRS transition
£m
   
Fair value of financial instruments
£m
   
Available for sale financial assets
£m
   
Intangibles
£m
   
Cash flow hedging
£m
   
Share schemes
£m
   
Tax losses carried forward
£m
   
Other
£m
   
Total
£m
 
At 1 January 2007
    (628 )     3,818       (284 )     922       (669 )     (132 )           255       (97 )     (75 )           (2 )     3,108  
Acquisition/(disposals) of subsidiaries
    (119 )     (284 )     (539 )     50             (184 )           1,037                   (867 )     (64 )     (970 )
Charge/(credit) to income statement
    43       (138 )     (44 )     (141 )     46       72             (65 )     (48 )     8       (57 )     91       (233 )
Charge/(credit) to equity directly
    660                   (187 )           17                   (107 )     57             (14 )     426  
Other
    (7 )     (12 )     (19 )     (38 )     4       (6 )             26             (1 )     20       (17 )     (50 )
At 1 January 2008
    (51 )     3,384       (886 )     606       (619 )     (233 )           1,253       (252 )     (11 )     (904 )     (6 )     2,281  
Transfers to disposal groups
    19       69       528       36                   80       (29 )                       238       941  
Acquisition/(disposals)of subsidiaries
          (509 )                 6       2       (2 )     3       1                   58       (441 )
Charge/(credit) to income statement
    157       (127 )     (106 )     21       195       (125 )     350       (898 )     286       (2 )     (3,079 )     63       (3,265 )
(Credit)/charge to equity directly
    (476 )                 (6 )     1       3       (547 )           (317 )     10       (709 )     (3 )     (2,044 )
Other
    (31 )     267       (350 )     (46 )     (3 )           84       445       (201 )           (38 )     (516 )     (389 )
At 31 December 2008
    (382 )     3,084       (814 )     611       (420 )     (353 )     (35 )     774       (483 )     (3 )     (4,730 )     (166 )     (2,917 )

Company
 
IFRS transition
£m
   
Cash flow hedging
£m
   
Other
£m
   
Total
£m
 
At 1 January 2007
          (3 )           (3 )
Charge to equity directly
          1       5       6  
At 1 January 2008
          (2 )     5       3  
(Credit)/charge to income statement
    (4 )     2       (5 )     (7 )
Other
    1                   1  
At 31 December 2008
    (3 )                 (3 )
 
Notes:
 
(1)
Deferred tax assets are recognised, as set out above, that depend on the availability of future taxable profits in excess of profits arising from the reversal of other temporary differences. Business projections prepared for impairment reviews (see Note 17) indicate it is probable that sufficient future taxable income will be available against which to offset these recognised deferred tax assets within 8 years. UK losses do not expire and Netherlands losses expire after nine years. In jurisdictions where doubt exists over the availability of future taxable profits, deferred tax assets of £1,748 million (2007 – £687 million) have not been recognised in respect of tax losses carried forward of £5,779 million (2007 – £2,043 million). Of these losses, £15 million will expire within one year, £137 million within five years and £5,214 million thereafter. The balance of tax losses carried forward has no time limit.
 
(2)
Deferred tax liabilities of £980 million (2007 – £977 million) have not been recognised in respect of retained earnings of overseas subsidiaries and held-over gains on the incorporation of overseas branches. Retained earnings of overseas subsidiaries are expected to be reinvested indefinitely or remitted to the UK free from further taxation. No taxation is expected to arise in the foreseeable future in respect of held-over gains.
 
 
 
 
   
Group
 
      2008
£m
      2007
£m
      2006
£m
 
Insurance premium income
    6,626       6,376       6,243  
Reinsurer’s share
    (300 )     (289 )     (270 )
Net premium income
    6,326       6,087       5,973  
                         
Insurance claims
    4,603       4,742       4,550  
Reinsurer’s share
    (173 )     (118 )     (92 )
Net claims
    4,430       4,624       4,458  
 
   
Group
 
Insurance liabilities
    2008
£m
      2007
£m
 
Life assurance business:
               
Unit linked insurance contracts
    260       364  
Other linked insurance contracts
    3,929       4,034  
Other insurance contracts
    309       298  
      4,498       4,696  
General insurance business
    5,478       5,466  
      9,976       10,162  

General insurance business
(i) Claims and loss adjustment expenses
 
   
Group
 
   
Gross
£m
   
Reinsurance
£m
   
Net
£m
 
Notified claims
    3,735       (205 )     3,530  
Incurred but not reported
    1,512       (86 )     1,426  
At 1 January 2007
    5,247       (291 )     4,956  
Cash paid for claims settled in the year
    (3,876 )     94       (3,782 )
Increase/(decrease) in liabilities
                       
– arising from current year claims
    4,643       (49 )     4,594  
– arising from prior year claims
    (573 )     (20 )     (593 )
Net exchange differences
    25       3       28  
At 31 December 2007
    5,466       (263 )     5,203  
                         
Notified claims
    3,894       (264 )     3,630  
Incurred but not reported
    1,572       1       1,573  
At 1 January 2008
    5,466       (263 )     5,203  
Cash paid for claims settled in the year
    (3,969 )     97       (3,872 )
Increase/(decrease) in liabilities
                       
– arising from current year claims
    4,079       (45 )     4,034  
– arising from prior year claims
    (241 )     (66 )     (307 )
Net exchange differences
    143       (10 )     133  
At 31 December 2008
    5,478       (287 )     5,191  
                         
Notified claims
    4,052       (260 )     3,792  
Incurred but not reported
    1,426       (27 )     1,399  
At 31 December 2008
    5,478       (287 )     5,191  
 
 
 
 
 
 
(ii) Provisions for unearned premiums and unexpired short-term insurance risks
 
   
Group
 
Unearned premium provision
 
Gross
£m
   
Reinsurance
£m
   
Net
£m
 
At 1 January 2007
    2,850       (43 )     2,807  
Release in the year
    (98 )     2       (96 )
At 1 January 2008
    2,752       (41 )     2,711  
Increase in the year
    175             175  
Release in the year
    (280 )     (38 )     (318 )
Net exchange differences
    64             64  
At 31 December 2008
    2,711       (79 )     2,632  

   
Group
 
Gross performance of life business (life contracts)
   
2008
£m
     
2007
£m
 
Opening net assets
    604       579  
Profit from existing business:
               
Expected return
    41       35  
Experience variances
    (15 )     (23 )
      26       12  
New business contribution (1)
    14       5  
Operating assumption changes
    2       6  
Investment return variances
    (46 )     (14 )
Economic assumption changes
    (2 )      
Other
    (10 )     16  
Closing net assets
    588       604  
 
Note:
 
(1)
New business contribution represents the present value of future profits on new insurance contract business written during the year.
 
214

 

 
24 Insurance business (continued)
   
Group
 
Movement in provision for liabilities under life contracts and under linked and other investment contracts
 
Life contracts
£m
   
Investment contracts
£m
 
At 1 January 2007
    2,209       2,246  
Acquisition of subsidiaries
    2,275       3,245  
Premiums received
    784       140  
Fees and expenses
    (30 )     (25 )
Investment return
    251       93  
Actuarial adjustments
    (493 )      
Account balances paid on surrender and other terminations in the year
    (468 )     (320 )
Exchange and other adjustments
    168       176  
At 1 January 2008
    4,696       5,555  
Premiums received
    868       330  
Fees and expenses
    (21 )     (38 )
Investment return
    17       (970 )
Actuarial adjustments
    (233 )      
Account balances paid on surrender and other terminations in the year
    (734 )     (455 )
Transfers to disposal groups
    (686 )      
Exchange and other adjustments
    591       904  
At 31 December 2008
    4,498       5,326  
 
Investment contracts are presented within customer deposits.
 
Changes in assumptions during the year were not material to the profit recognised.
 
   
Group
 
Assets backing linked liabilities
   
2008
£m
     
2007
£m
 
Debt securities
    4,500       2,899  
Equity securities
    4,816       6,863  
Cash and cash equivalents
    81       68  
                 
The associated liabilities are:
               
Linked contracts classified as insurance contracts
    4,189       4,398  
Linked contracts classified as investment contracts
    5,208       5,432  

There are no options and guarantees relating to life assurance contracts that could in aggregate have a material effect on the amount, timing and uncertainty of the Group’s future cash flows.
 
The Group is exposed to insurance risk, either directly through its businesses or through using insurance to reduce other risk exposures.
 
Insurance risk is the risk of fluctuations in the timing, frequency or 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 the use of underwriting guidelines which detail the class, nature and type of business that may be accepted; pricing policies by product line and by brand; and centralised control of policy wordings and any subsequent changes.
 
Claims management risk
The risk that claims are handled or paid inappropriately is managed using a range of IT system controls and manual processes conducted by experienced staff. These, together with a range of detailed policies and procedures ensure that all claims are handled in a timely, appropriate and accurate manner.
 
Reinsurance risk
Reinsurance is used to protect against the impact of major catastrophic events or unforeseen volumes of, or adverse trends in, large individual claims and to transfer risk that is outside the Group’s current risk appetite.
 
Reinsurance of risks above the Group’s risk appetite is only effective if the reinsurance premium makes economic sense and the counterparty is financially secure. Acceptable reinsurers are rated A- or better unless specifically authorised.
 
215

 

 
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. Claims development data provides information on the historical pattern of reserving risk.
 
   
Accident year
Insurance claims – gross
   
2001
£m
     
2002
£m
     
2003
£m
     
2004
£m
     
2005
£m
     
2006
£m
     
2007
£m
     
2008
£m
   
Total
£m
Estimate of ultimate claims costs:
                                                                   
At end of accident year
    2,395       3,013       3,658       3,710       4,265       4,269       4,621       4,080       30,011  
One year later
    (70 )     91       (140 )     (186 )     (92 )     (275 )     (71 )           (743 )
Two years later
    20       1       (106 )     (88 )     (147 )     (77 )                 (397 )
Three years later
    12       (12 )     (55 )     (85 )     (60 )                       (200 )
Four years later
    (40 )     (17 )     (47 )     (31 )                             (135 )
Five years later
    (1 )     (19 )     (21 )                                   (41 )
Six years later
    (9 )     (11 )                                         (20 )
Seven years later
    6                                                 6  
Current estimate of cumulative claims
    2,313       3,046       3,289       3,320       3,966       3,917       4,550       4,080       28,481  
Cumulative payments to date
    (2,235 )     (2,932 )     (3,060 )     (2,977 )     (3,442 )     (3,121 )     (3,393 )     (2,052 )     (23,212 )
      78       114       229       343       524       796       1,157       2,028       5,269  
             
Liability in respect of prior years
      91    
Claims handling costs
      118    
Gross general insurance claims liability
      5,478    

   
Accident year
 
Insurance claims – net of reinsurance
   
2001
£m
     
2002
£m
     
2003
£m
     
2004
£m
     
2005
£m
     
2006
£m
     
2007
£m
     
2008
£m
   
Total
£m
 
Estimate of ultimate claims costs:
                                                                     
At end of accident year
    2,011       2,584       3,215       3,514       4,168       4,215       4,572       4,034       28,313  
One year later
    (61 )     59       (106 )     (168 )     (67 )     (261 )     (90 )           (694 )
Two years later
    22       (12 )     (103 )     (90 )     (161 )     (87 )                 (431 )
Three years later
    13       (3 )     (53 )     (81 )     (64 )                       (188 )
Four years later
    (41 )     (21 )     (44 )     (46 )                             (152 )
Five years later
    1       (24 )     (23 )                                   (46 )
Six years later
    (19 )     (5 )                                         (24 )
Seven years later
                                                     
Current estimate of cumulative claims
    1,926       2,578       2,886       3,129       3,876       3,867       4,482       4,034       26,778  
Cumulative payments to date
    (1,873 )     (2,492 )     (2,714 )     (2,835 )     (3,364 )     (3,085 )     (3,347 )     (2,032 )     (21,742 )
      53       86       172       294       512       782       1,135       2,002       5,036  
                                                                         
Liability in respect of prior years
                                                                    42  
Claims handling costs
                                                                    113  
Net general insurance claims liability
                                                                    5,191  
 
Claims reserves
It is the Group’s policy to hold undiscounted claims reserves (including reserves to cover claims which have been incurred but not reported (IBNR reserves)) for all classes at a sufficient level to meet all liabilities as they fall due.
 
The Group’s focus is on high volume and relatively straightforward products, for example home and motor. This facilitates the generation of comprehensive underwriting and claims data, which are used to accurately price and monitor the risks accepted.
 
216

 

 
24           Insurance business (continued)
The following table shows loss ratios for each major class of business, gross and net of reinsurance.
 
     
2008
   
2007
   
2006
 
     
Earned premiums
£m
   
Claims incurred
£m
   
Loss
ratio
%
   
Earned premiums
£m
   
Loss
ratio
%
   
Earned premiums
£m
   
Loss
ratio
%
 
Residential property
Gross
    1,103       529       48       1,087       82       1,121       56  
 
Net
    1,034       529       51       1,020       86       1,061       59  
Personal motor
Gross
    3,173       2,679       84       3,254       80       3,384       84  
 
Net
    3,075       2,565       83       3,161       81       3,279       85  
Commercial property
Gross
    194       79       41       211       55       218       37  
 
Net
    174       80       46       191       60       198       38  
Commercial motor
Gross
    143       130       91       142       75       90       69  
 
Net
    141       128       91       133       80       88       68  
Other
Gross
    994       422       42       851       40       842       47  
 
Net
    828       426       51       839       41       833       49  
Total
Gross
    5,607       3,839       68       5,545       73       5,655       71  
 
Net
    5,252       3,728       71       5,344       75       5,459       73  

The Group has no interest rate exposure from general insurance liabilities because provisions for claims under short-term insurance contracts are not discounted.
 
Frequency and severity of specific risks and sources of uncertainty
Most general insurance contracts are written on an annual basis, which means that the Group’s liability extends for a 12 month period, after which the Group is entitled to decline or renew or can impose renewal terms by amending the premium, terms and conditions, or both.
 
The frequency and severity of claims and the sources of uncertainty for the key classes that the Group is exposed to are as follows:
 
Motor insurance contracts (private and commercial)
Claims experience is quite variable, due to a wide range of factors, but the principal ones are age, sex and driving experience of the driver, type and nature of vehicle, use of vehicle and area.
 
There are many sources of uncertainty that will affect the Group’s experience under motor insurance, including operational risk, reserving risk, premium rates not matching claims inflation rates, weather, the social, economic and legislative environment and reinsurance failure risk.
 
Property insurance contracts (residential and commercial)
The major causes of claims for property insurance are theft, flood, escape of water, fire, storm, subsidence and various types of accidental damage.
 
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.
 
Other commercial 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 includes employers liability and public/products liability. Liability insurance is written on an occurrence basis, and is subject to claims that are identified over a substantial period of time, but where the loss event occurred during the life of the policy.
 
Fluctuations in the social and economic climate are a source of uncertainty in the Group’s business interruption and general liability accounts. Other sources of uncertainty are changes in the law, or its interpretation, and reserving risk. Other uncertainties are significant events (for example terrorist attacks) and any emerging new heads of damage or types of claim that are not envisaged when the policy is written.
 
The following table shows the expected maturity of insurance liabilities up to twenty years excluding those linked directly to the financial assets backing these contracts (2008 – £4,189 million; 2007 – £4,398 million).
 
   
Group
 
   
0-3 months
£m
   
3-12 months
£m
   
1-3 years
£m
   
3-5 years
£m
   
5-10 years
£m
   
10-20 years
£m
 
2008
    623       1,645       1,899       903       487       53  
                                                 
2007
    710       1,796       1,961       882       395       33  
 
217

 

 
Life business
The Group’s three UK regulated life companies, National Westminster Life Assurance Limited (NatWest Life), Royal Scottish Assurance plc (RSA) and Direct Line Life Insurance Company Limited, are required to meet minimum capital requirements at all times under the UK 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 regulatory minimum.
 
The Group is not exposed to price, currency, credit, or interest risk on unit linked life contracts but it is exposed to variation in management fees. A decrease of 10% in the value of the assets would reduce the asset management fees by £5 million per annum (2007 – £2 million). The Group writes insurance contracts with minimum guaranteed death benefits that expose it to the risk that declines in the value of underlying investments may increase the Group’s net exposure to death risk.
 
The Group’s long-term assurance contracts include whole-life, term assurance, endowment assurances, flexible whole life, pension and annuity contracts that are expected to remain in force for an extended period of time.
 
Contracts under which the Group does not accept significant insurance risk are classified as investment contracts. As required by IFRS 4 ‘Insurance Contracts’ long term business provisions are calculated in accordance with existing local GAAP (UK accounting standard FRS 27 ‘Life Assurance’).
 
Estimations (assumptions) including future mortality, morbidity, persistency and levels of expenses are made in calculating actuarial reserves. Key metrics for the UK include:
 
Assumptions
 
2008
   
2007
   
2006
 
Valuation interest rate
                 
Term assurance
    2.50 %     3.00 %     3.00 %
Interest
    2.50 %     3.00 %     3.00 %
Unit growth
    3.70 %     3.50 %     3.50 %
Expense inflation
    3.00 %     4.00 %     4.00 %

Sample mortality rates, expressed as deaths per million per annum, for term assurance products (age 40).
 
Mortality
                 
Male non-smoker
    723       810       517  
Male smoker
    1,590       1,830       983  
Female non-smoker
    568       460       278  
Female smoker
    1,277       1,310       618  

In 2007 the Group moved from the UK 80 series to the 00 series for mortality.
 
Expenses:
Pre-2000 products – RSA
 
2008
per annum
   
2007
per annum
   
2006
per annum
 
Lifestyle protection plan
    £29.30       £25.18       £28.96  
Mortgage savings plan
    £65.92       £56.67       £65.15  
                         
Pre-2000 products – NatWest Life
                       
Term assurances
    £26.01       £26.01       £26.01  
Linked life bonds
    £26.01       £23.17       £23.17  
                         
Post-2000 products
                       
Term assurances
    £23.17       £23.16       £23.16  
Guaranteed bonds
    £25.71       £25.71       £25.71  
 
218

 

 
24           Insurance business (continued)
Frequency and severity of claims – for contracts where death is the insured risk, the most significant factors that could increase the overall frequency of claims are epidemics or widespread changes in lifestyle, resulting in earlier or more claims than expected.
 
For contracts where survival is the insured risk, the most significant factor is continued improvement in medical science and social conditions that would increase longevity.
 
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.
 
Sources of uncertainty in the estimation of future benefit payments and premium receipts – the Group uses base tables of standard mortality appropriate to the type of contract being written and the territory in which the insured person resides. These are adjusted to reflect the Group’s experience, mortality improvements and voluntary termination behaviour.
 
Sensitivity factor
Description of sensitivity factor applied
Interest rate and investment return
Change in market interest rates of ±1 %.
 
The test allows consistently for similar changes to investment returns and movements in the market value of backing fixed interest securities.
Expenses
Increase in maintenance expenses of 10%
Assurance mortality/morbidity
Increase in mortality/morbidity rates for assurance contracts of 5%
Annuitant mortality
Reduction in mortality rates for annuity contracts of 5%

The above sensitivity factors are applied via actuarial and statistical models, with the following effect on the financial statements.
 
   
Increase/(decrease)
in profit and equity
 
Risk factor
   
2008
£m
     
2007
£m
 
Interest rates
    (11 )     (18 )
Interest rates
    11       15  
Expenses
    (7 )     (5 )
Assurance mortality/morbidity
    (9 )     (8 )

Limitations of sensitivity analysis: the above tables demonstrate the effect of a change in a key UK assumption whilst other assumptions remain unaffected. In reality, such an occurrence is unlikely, due to correlation between the assumptions and other factors. It should also be noted that these sensitivities are non-linear, and larger or smaller impacts should not be interpolated or extrapolated from these results. The sensitivity analyses do not take into consideration that assets and liabilities are actively managed and may vary at the time that any actual market movement occurs.
 
219

 

 
25           Subordinated liabilities
   
Group
   
Company
 
     
2008
£m
     
2007
£m
     
2008
£m
     
2007
£m
 
Dated loan capital
    30,162       23,065       7,421       5,585  
Undated loan capital
    11,697       9,866       1,071       781  
Preference shares
    2,194       1,686       1,822       1,377  
Trust preferred securities
    5,101       3,426              
      49,154       38,043       10,314       7,743  

Certain preference shares issued by the company are classified as liabilities; these securities remain subject to the capital maintenance rules of the Companies Act 1985.
 
The following tables analyse the remaining maturity of subordinated liabilities by (1) the final redemption date; and (2) the next callable date.
 
   
Group
 
2008 – final redemption
   
2009
£m
     
2010
£m
     
2011-2013
£m
     
2014-2018
£m
   
Thereafter
£m
   
Perpetual
£m
   
Total
£m
 
Sterling
    192       15       176       1,458       370       6,287       8,498  
US dollars
    1,308       342       1,123       7,435       561       7,655       18,424  
Euro
    1,865       1,378       1,991       7,923       1,957       4,087       19,201  
Other
    29             7       2,284       34       677       3,031  
Total
    3,394       1,735       3,297       19,100       2,922       18,706       49,154  

   
Group
 
2008 – call date
 
Currently
£m
     
2009
£m
     
2010
£m
     
2011-2013
£m
     
2014-2018
£m
   
Thereafter
£m
   
Perpetual
£m
   
Total
£m
 
Sterling
          192       752       1,039       2,729       3,615       171       8,498  
US dollars
    1,833       3,247       2,601       4,814       1,951       2,053       1,925       18,424  
Euro
          2,351       3,137       5,699       7,021       942       51       19,201  
Other
          500       405       922       954       250             3,031  
Total
    1,833       6,290       6,895       12,474       12,655       6,860       2,147       49,154  

   
Group
 
2007 – final redemption
   
2008
£m
     
2009
£m
     
2010-2012
£m
     
2013-2017
£m
   
Thereafter
£m
   
Perpetual
£m
   
Total
 
Sterling
    194             34       1,405       389       5,818       7,840  
US dollars
    903       1,540       620       5,477       743       3,985       13,268  
Euro
    764       1,312       1,405       5,711       1,674       3,164       14,030  
Other
    35             6       2,076       325       463       2,905  
Total
    1,896       2,852       2,065       14,669       3,131       13,430       38,043  

   
Group
 
2007 – call date
 
Currently
£m
     
2008
£m
     
2009
£m
     
2010-2012
£m
     
2013-2017
£m
   
Thereafter
£m
   
Perpetual
£m
   
Total
£m
 
Sterling
          194             1,497       2,456       3,527       166       7,840  
US dollars
    1,347       1,492       2,585       4,485       1,678       1,681             13,268  
Euro
          1,612       1,685       4,992       5,091       611       39       14,030  
Other
          35       431       843       1,468       128             2,905  
Total
    1,347       3,333       4,701       11,817       10,693       5,947       205       38,043  
 
220

 

 
25 Subordinated liabilities (continued)
   
Company
 
2008 – final redemption
   
2009
£m
     
2010
£m
     
2011-2013
£m
     
2014-2018
£m
   
Thereafter
£m
   
Perpetual
£m
   
Total
£m
 
Sterling
    9                         400       200       609  
US dollars
    415             717       1,381       2,863       2,661       8,037  
Euro
                            1,668             1,668  
Total
    424             717       1,381       4,931       2,861       10,314  

   
Company
 
2008 – call date
 
Currently
£m
     
2009
£m
     
2010
£m
     
2011-2013
£m
     
2014-2018
£m
   
Thereafter
£m
   
Perpetual
£m
   
Total
£m
 
Sterling
          9       199             400             1       609  
US dollars
    582       1,511       682       1,296       2,710       1,256             8,037  
Euro
                      1,190       478                   1,668  
Total
    582       1,520       881       2,486       3,588       1,256       1       10,314  

   
Company
 
2007 – final redemption
   
2008
£m
     
2009
£m
     
2010-2012
£m
     
2013-2017
£m
   
Thereafter
£m
   
Perpetual
£m
   
Total
£m
 
Sterling
    13                         399       199       611  
US dollars
    61       199       148       1,204       2,259       1,935       5,806  
Euro
    45                         1,281             1,326  
Total
    119       199       148       1,204       3,939       2,134       7,743  

   
Company
 
2007 – call date
 
Currently
£m
     
2008
£m
     
2009
£m
     
2010-2012
£m
     
2013-2017
£m
   
Thereafter
£m
   
Perpetual
£m
   
Total
£m
 
Sterling
          13             198       399             1       611  
US dollars
    425       435       620       643       2,594       1,089             5,806  
Euro
          45             914       367                   1,326  
Total
    425       493       620       1,755       3,360       1,089       1       7,743  

221

 

 
Dated loan capital
     
2008
£m
     
2007
£m
 
The company
               
US$400 million 6.4% subordinated notes 2009 (1)
    278       202  
US$300 million 6.375% subordinated notes 2011 (1)
    231       163  
US$750 million 5% subordinated notes 2013 (1)
    579       382  
US$750 million 5% subordinated notes 2014 (1)
    616       386  
US$250 million 5% subordinated notes 2014 (1)
    169       123  
US$675 million 5.05% subordinated notes 2015 (1)
    550       357  
US$350 million 4.7% subordinated notes 2018 (1)
    286       173  
      2,709 *     1,786 *
The Royal Bank of Scotland plc
               
€255 million 5.25% subordinated notes 2008 (redeemed July 2008)
          192  
€300 million 4.875% subordinated notes 2009
    298       228  
€1,000 million 6% subordinated notes 2013
    1,083       790  
US$50 million floating rate subordinated notes 2013
    36       26  
€1,000 million floating rate subordinated notes 2013 (redeemed October 2008)
          744  
€500 million 6% subordinated notes 2013
    487       374  
£150 million 10.5% subordinated bonds 2013 (2)
    180       169  
US$1,250 million floating rate subordinated notes 2014 (callable July 2009)
    862       630  
AUD590 million 6% subordinated notes 2014 (callable October 2009)
    281       254  
AUD410 million floating rate subordinated notes 2014 (callable October 2009)
    195       182  
CAD700 million 4.25% subordinated notes 2015 (callable March 2010)
    409       358  
£250 million 9.625% subordinated bonds 2015
    311       286  
US$750 million floating rate subordinated notes 2015 (callable September 2010)
    513       374  
€750 million floating rate subordinated notes 2015
    783       564  
CHF400 million 2.375% subordinated notes 2015
    257       166  
CHF100 million 2.375% subordinated notes 2015
    72       41  
CHF200 million 2.375% subordinated notes 2015
    125       86  
US$500 million floating rate subordinated notes 2016 (callable October 2011)
    346       252  
US$1,500 million floating rate subordinated notes 2016 (callable April 2011)
    1,038       757  
€500 million 4.5% subordinated 2016 (callable January 2011)
    511       379  
CHF200 million 2.75% subordinated notes 2017 (callable December 2012)
    129       89  
€100 million floating rate subordinated notes 2017
    97       73  
€500 million floating rate subordinated notes 2017 (callable June 2012)
    482       371  
€750 million 4.35% subordinated notes 2017 (callable January 2017)
    770       548  
AUD450 million 6.5% subordinated notes 2017 (callable February 2012)
    217       202  
AUD450 million floating rate subordinated notes 2017 (callable February 2012)
    214       199  
US$1,500 million floating rate subordinated callable step up
               
notes 2017 (callable August 2012)
    1,029       752  
€2,000 million 6.93% subordinated notes 2018 (issued April 2008; callable April 2018)
    2,136        
US$125.6 million floating rate subordinated notes 2020
    87       64  
€1,000 million 4.625% subordinated notes 2021 (callable September 2016)
    1,019       724  
€300 million CMS linked floating rate subordinated notes 2022
    303       228  
€144.4 million floating rate subordinated notes 2022 (issued June 2008; callable June 2022)
    152        
                 
National Westminster Bank Plc
               
US$1,000 million 7.375% subordinated notes 2009
    697       507  
€600 million 6% subordinated notes 2010
    623       474  
€500 million 5.125% subordinated notes 2011
    488       376  
£300 million 7.875% subordinated notes 2015
    379       349  
£300 million 6.5% subordinated notes 2021
    376       330  
                 
Charter One Financial, Inc
               
US$400 million 6.375% subordinated notes 2012
    287       212  
                 
Greenwich Capital Holdings, Inc
               
US$170 million subordinated loan capital floating rate notes 2009
    116       85  
US$100 million 5.575% senior subordinated revolving credit 2009
    69       50  
US$500 million subordinated loan capital floating rate notes 2010 (callable on any interest payment date)
    342       249  
                 
First Active Plc
               
£60 million 6.375% subordinated bonds 2018 (callable April 2013)
    66       65  
 
222

 

 
25 Subordinated liabilities (continued)
Dated loan capital (continued)
 
     
2008
£m
     
2007
£m
 
Other minority interest subordinated issues
    16       16  
                 
ABN AMRO and subsidiaries
               
€113 million 7.50% subordinated notes 2008 (redeemed January 2008)
          83  
€182 million 6.00% subordinated notes 2009
    169       132  
€182 million 6.13% subordinated notes 2009
    165       127  
€1,150 million 4.63% subordinated notes 2009
    1,104       848  
€250 million 4.70% CMS linked subordinated notes 2019
    195       131  
€800 million 6.25% subordinated notes 2010
    795       598  
€100 million 5.13% flip flop Bermudan callable subordinated notes 2017 (callable December 2012)
    89       75  
€500 million floating rate Bermudan callable subordinated lower tier 2 notes 2018 (callable May 2013)
    455       350  
€1,000 million floating rate Bermudan callable subordinated lower tier 2 notes 2016 (callable September 2011)
    923       710  
€13 million zero coupon subordinated notes 2029 (callable June 2009)
    8       2  
€82 million floating rate subordinated notes 2017
    72       55  
€103 million floating rate subordinated lower tier 2 notes 2020
    89       68  
€170 million floating rate sinkable subordinated notes 2041
    205       184  
€15 million CMS linked floating rate subordinated lower tier 2 notes 2020
    10       11  
€1,500 million floating rate Bermudan callable subordinated lower tier 2 notes 2015 (callable June 2010)
    1,419       1,087  
€5 million floating rate Bermudan callable subordinated lower tier 2 notes 2015 (callable October 2010)
    5       4  
€65 million floating rate Bermudan callable subordinated lower tier 2 notes 2015 (callable October 2010)
    62       48  
US$12 million floating rate subordinated notes 2008 (redeemed June 2008)
          6  
US$12 million floating rate subordinated notes 2008 (redeemed June 2008)
          6  
US$165 million 6.14% subordinated notes 2019
    152       94  
US$72 million 5.98% subordinated notes 2019
    49       7  
US$500 million 4.65% subordinated notes 2018
    359       214  
US$500 million floating rate Bermudan callable subordinated notes 2013 (redeemed September 2008)
          232  
US$1,500 million floating rate Bermudan callable subordinated notes 2015 (callable March 2010)
    982       717  
US$100 million floating rate Bermudan callable subordinated lower tier 2 notes 2015 (callable October 2010)
    68       50  
US$36 million floating rate Bermudan callable subordinated lower tier 2 notes 2015 (callable October 2010)
    25       18  
US$1,000 million floating rate Bermudan callable subordinated lower tier 2 notes 2017 (callable January 2012)
    661       479  
AUD575 million 6.50% Bermudan callable subordinated lower tier 2 notes 2018 (callable May 2013)
    286       231  
AUD175 million 7.46% Bermudan callable subordinated lower tier 2 notes 2018 (callable May 2013)
    79       73  
€26 million 7.42% subordinated notes 2016
    28       20  
€7 million 7.38% subordinated notes 2016
    8       6  
€256 million 5.25% subordinated notes 2008 (redeemed July 2008)
          190  
€13 million floating rate subordinated notes 2008 (redeemed June 2008)
          9  
£42 million 8.18% subordinated notes 2010
    15       19  
£25 million 9.18% amortising MTN subordinated lower tier 2 notes 2011
    9       15  
£750 million 5% Bermudan callable subordinated upper tier 2 notes 2016
    728       642  
US$250 million 7.75% subordinated notes 2023
    173       127  
US$150 million 7.13% subordinated notes 2093
    104       76  
US$250 million 7.00% subordinated notes 2008 (redeemed April 2008)
          127  
US$68 million floating rate subordinated notes 2009 (6)
          34  
US$12 million floating rate subordinated notes 2009 (6)
          6  
BRL50 million floating rate subordinated notes 2013 (6)
          14  
BRL250 million floating rate subordinated notes 2013 (6)
          71  
BRL250 million floating rate subordinated notes 2014 (6)
          71  
BRL885 million floating rate subordinated notes 2014 (6)
          251  
BRL300 million floating rate subordinated notes 2014 (6)
          85  
PKR0.80 million floating rate subordinated notes 2012
    7       6  
MYR200 million subordinated notes 2017
    40       30  
TRY60 million subordinated notes
    34       25  
      30,162       23,065  
 
*
In addition the company has issued 0.5 million subordinated loan notes of €1,000 each, 1.95 million subordinated loan notes of US$1,000 each and 0.4 million subordinated loan notes of £1,000 each. These loan notes are included in the company balance sheet as loan capital but are reclassified as minority interest Trust Preferred Securities on consolidation (see Note 26).
 
Notes:
 
(1)
On-lent to The Royal Bank of Scotland plc on a subordinated basis.
 
(2)
Unconditionally guaranteed by the company.
 
(3)
In the event of certain changes in tax laws, dated loan capital issues may be redeemed in whole, but not in part, at the option of the issuer, at the principal amount thereof plus accrued interest, subject to prior regulatory approval.
 
(4)
Except as stated above, claims in respect of the Group’s dated loan capital are subordinated to the claims of other creditors. None of the Group’s dated loan capital is secured.
 
(5)
Interest on all floating rate subordinated notes is calculated by reference to market rates.
 
(6)
Transferred to Banco Santander S.A in July 2008.
 
223

 

 
Undated loan capital
     
2008
£m
     
2007
£m
 
The company
               
US$350 million undated floating rate primary capital notes (callable on any interest payment date) (1)
    240       175  
US$1,200 million 7.648% perpetual regulatory tier one securities (callable September 2031) (1, 2)
    831       606  
      1,071       781  
The Royal Bank of Scotland plc
               
£150 million 5.625% undated subordinated notes (callable June 2032)
    144       144  
£175 million 7.375% undated subordinated notes (callable August 2010)
    190       183  
€152 million 5.875% undated subordinated notes (redeemed October 2008)
          114  
£350 million 6.25% undated subordinated notes (callable December 2012)
    380       354  
£500 million 6% undated subordinated notes (callable September 2014)
    565       517  
€500 million 5.125% undated subordinated notes (callable July 2014)
    516       371  
€1,000 million floating rate undated subordinated notes (callable July 2014)
    966       742  
£500 million 5.125% undated subordinated notes (callable March 2016)
    556       499  
£200 million 5.625% subordinated upper tier 2 notes (callable September 2026)
    210       210  
£600 million 5.5% undated subordinated notes (callable December 2019)
    677       595  
£500 million 6.2% undated subordinated notes (callable March 2022)
    614       543  
£200 million 9.5% undated subordinated bonds (callable August 2018) (3)
    253       228  
£400 million 5.625% subordinated upper tier 2 notes (callable September 2026)
    397       397  
£300 million 5.625% undated subordinated notes (callable September 2026)
    431       318  
£350 million 5.625% undated subordinated notes (callable June 2032)
    364       363  
£400 million 5% undated subordinated notes (callable March 2011)
    424       402  
JPY25 billion 2.605% undated subordinates notes (callable November 2034)
    217       103  
CAD700 million 5.37% fixed rate undated subordinated notes (callable May 2016)
    464       363  
                 
National Westminster Bank Plc
               
US$500 million primary capital floating rate notes, Series A (callable on any interest payment date)
    343       251  
US$500 million primary capital floating rate notes, Series B (callable on any interest payment date)
    347       256  
US$500 million primary capital floating rate notes, Series C (callable on any interest payment date)
    346       255  
€400 million 6.625% fixed/floating rate undated subordinated notes (callable October 2009)
    388       303  
€100 million floating rate undated step-up notes (callable October 2009)
    97       74  
£325 million 7.625% undated subordinated step-up notes (callable January 2010)
    363       357  
£200 million 7.125% undated subordinated step-up notes (callable October 2022)
    201       205  
£200 million 11.5% undated subordinated notes (callable December 2022) (4)
    269       269  
                 
First Active plc
               
£20 million 11.75% perpetual tier two capital
    26       23  
€38 million 11.375% perpetual tier two capital
    52       39  
£1.3 million floating rate perpetual tier two capital
    2       2  
                 
ABN AMRO and subsidiaries
               
€9 million 4.650% perpetual convertible financing preference shares (redeemed October 2008)
          7  
€1,000 million 4.310% perpetual Bermudan callable subordinated tier 1 notes (callable March 2016)
    824       598  
      11,697       9,866  
 
Notes:
 
(1)
On-lent to The Royal Bank of Scotland plc on a subordinated basis.
 
(2)
The company can satisfy interest payment obligations by issuing sufficient ordinary shares to appointed Trustees to enable them, on selling these shares, to settle the interest payment.
 
(3)
Guaranteed by the company.
 
(4)
Exchangeable at the option of the issuer into 200 million 8.392% (gross) non-cumulative preference shares of £1 each of National Westminster Bank Plc at any time.
 
(5)
Except as stated above, claims in respect of the Group’s undated loan capital are subordinated to the claims of other creditors. None of the Group’s undated loan capital is secured.
 
(6)
In the event of certain changes in tax laws, undated loan capital issues may be redeemed in whole, but not in part, at the option of the Group, at the principal amount thereof plus accrued interest, subject to prior regulatory approval.
 
(7)
Interest on all floating rate subordinated notes is calculated by reference to market rates.
 
224

 

 
25      Subordinated liabilities (continued)
Preference shares
     
2008
£m
     
2007
£m
 
The company
               
Non-cumulative preference shares of US$0.01 (1)
               
Series F US$200 million 7.65% (redeemable at option of issuer)
    137       100  
Series H US$300 million 7.25% (redeemable at option of issuer)
    205       150  
Series L US$850 million 5.75% (redeemable September 2009)
    582       421  
Non-cumulative convertible preference shares of US$0.01 (1)
               
Series 1 US$1,000 million 9.118% (redeemable March 2010)
    698       510  
Non-cumulative convertible preference shares of £0.01 (1)
               
Series 1 £200 million 7.387% (redeemable December 2010)
    211       201  
Cumulative preference shares of £1
               
£0.5 million 11 % and £0.4 million 5.5% (non-redeemable)
    1       1  
      1,834       1,383  
National Westminster Bank Plc
               
Non-cumulative preference shares of £1
               
Series A £140 million 9% (non-redeemable)
    145       143  
Non-cumulative preference shares of US$25
               
Series C US$300 million 7.7628% (2)
    215       160  
      2,194       1,686  
 
Notes:
 
(1)
Further details of the contractual terms of the preference shares are given in Note 27 on page 229.
 
(2) 
Series C preference shares each carry a gross dividend of 8.625% inclusive of associated tax credit. Redeemable at the option of the issuer at par.
 
Trust preferred securities
     
2008
£m
     
2007
£m
 
€1,250 million 6.467% (redeemable June 2012) (1)
    1,325       979  
US$750 million 6.8% (redeemable March 2008) (1)
    514       374  
US$850 million 4.709% (redeemable July 2013) (1)
    640       421  
US$650 million 6.425% (redeemable January 2034) (1)
    677       344  
                 
ABN AMRO and subsidiaries
               
US$1,285 million 6.03% Trust Preferred V
    760       464  
US$200 million 6.25% Trust Preferred VI
    121       82  
US$1,800 million 6.08% Trust Preferred VI I
    1,064       762  
      5,101       3,426  
 
 
Note:
 
(1)
The trust preferred securities issued by subsidiaries have no maturity date and are not redeemable at the option of the holders at any time. These securities may, with the consent of the UK Financial Services Authority, be redeemed, by the issuer on the dates specified above or on any interest payment date thereafter. They may also be redeemed in whole, but not in part, upon the occurrence of certain tax and regulatory events. The company classifies its obligations to these subsidiaries as dated loan capital.
 
225

 

 
26      Minority interests
   
ABN AMRO
£m
   
Other interests
£m
   
Total
£m
 
At 1 January 2007
          5,263       5,263  
Currency translation and other adjustments
    1,694       140       1,834  
Acquisition of ABN AMRO
    31,317       928       32,245  
Profit attributable to minority interests
    10       153       163  
Dividends paid
          (121 )     (121 )
Losses on available-for-sale securities, net of tax
    (59 )     (505 )     (564 )
Movements in cash flow hedging reserves, net of tax
    26             26  
Actuarial gains recognised in retirement benefit schemes, net of tax
    19             19  
Equity raised
    10       66       76  
Equity withdrawn
    (20 )     (533 )     (553 )
At 31 December 2007
    32,997       5,391       38,388  
Currency translation and other adjustments
    8,098       1,158       9,256  
Acquisition of outstanding ABN AMRO ordinary shares
    356             356  
(Loss)/profit attributable to minority interests
    (11,244 )     412       (10,832 )
Dividends paid
          (285 )     (285 )
Losses on available-for-sale securities, net of tax
    (144 )     (1,303 )     (1,447 )
Movements in cash flow hedging reserves, net of tax
    (831 )           (831 )
Actuarial losses recognised in retirement benefit schemes, net of tax
    (478 )           (478 )
Equity raised
          1,071       1,071  
Equity withdrawn
    (12,571 )     (1,008 )     (13,579 )
At 31 December 2008
    16,183       5,436       21,619  
 
ABN AMRO represents the other consortium members’ interests in RFS Holdings B.V. The capital and income rights of shares issued by RFS Holdings B.V. are linked to the net assets and income of the ABN AMRO business units which the individual consortium members have agreed to acquire. Other minority interests include trust preferred securities of £1,821 million (2007 – £1,821 million) and RBS China Sarl of £1,898 million (2007 – £2,438 million). Equity withdrawn in respect of ABN AMRO relates to distributions to consortium members.
 
Included in minority interests are the following trust preferred securities (1):
 
     
2008
£m
     
2007
£m
 
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  
€500 million 4.243% (redeemable January 2016)
    337       337  
£400 million 5.6457% (redeemable June 2017)
    400       400  
      1,821       1,821  
 
Note:
 
(1)
The trust preferred securities issued by subsidiaries have no maturity date and are not redeemable at the option of the holders at any time. These securities may, with the consent of the UK Financial Services Authority, be redeemed, in whole or in part, by the issuer on the dates specified above or on any interest payment date thereafter. They may also be redeemed in whole, but not in part, upon the occurrence of certain tax and regulatory events. The company classifies its obligations to these subsidiaries as dated loan capital.
 
226

 

 
27      Share capital
   
Allotted, called up and fully paid
   
Authorised
 
   
1 January
2008
£m
   
Issued
during the year
£m
   
31 December
2008
£m
   
31 December
2008
£m
   
31 December
2007
£m
 
Ordinary shares of 25p
    2,501       7,363       9,864       11,151       3,018  
Non-voting deferred shares of £0.01
    27             27       323       323  
Additional Value Shares of £0.01
                      27       27  
Non-cumulative preference shares of US$0.01
    2             2       3       2  
Non-cumulative convertible preference shares of US$0.01
                             
Non-cumulative preference shares of €0.01
                             
Non-cumulative convertible preference shares of €0.01
                             
Non-cumulative convertible preference shares of £0.25
                      225       225  
Non-cumulative convertible preference shares of £0.01
                             
Cumulative preference shares of £1
    1             1       1       1  
Non-cumulative preference shares of £1
    1       5       6       300       300  


   
Allotted, called up and fully paid
   
Authorised
 
Number of shares – thousands
 
2008
   
2007
   
2006
   
2008
   
2007
   
2006
 
Ordinary shares of 25p
    39,456,005       10,006,215       3,152,844       44,603,278       12,070,492       5,079,375  
Non-voting deferred shares of £0.01
    2,660,556       2,660,556       2,660,556       32,300,000       32,300,000       32,300,000  
Additional Value Shares of £0.01
                      2,700,000       2,700,000       2,700,000  
Non-cumulative preference shares of US$0.01
    308,015       308,015       240,000       516,000       419,500       419,500  
Non-cumulative convertible preference shares of US$0.01
    1,000       1,000       1,000       3,900       3,900       3,900  
Non-cumulative preference shares of €0.01
    2,526       2,526       2,500       66,000       66,000       66,000  
Non-cumulative convertible preference shares of €0.01
                      3,000       3,000       3,000  
Non-cumulative convertible preference shares of £0.25
                      900,000       900,000       900,000  
Non-cumulative convertible preference shares of £0.01
    200       200       200       1,000       1,000       1,000  
Cumulative preference shares of £1
    900       900       900       900       900       900  
Non-cumulative preference shares of £1
    5,750       750             300,000       300,000       300,000  
 
Movement in ordinary shares in issue during the year:
 
   
Number of shares - thousands
 
At 1 January 2008
    10,006,215  
Shares issued in respect of the rights issue
    6,123,010  
Shares issued in respect of the capitalisation issue
    403,468  
Shares issued in respect of the placing and open offer
    22,909,776  
Other shares issued
    13,536  
At 31 December 2008
    39,456,005  
 
227

 

 
Ordinary shares
In June 2008, the company issued 6,123 million ordinary shares of 25p each at 200p per share by way of a rights issue. The rights issue was on the basis of 11 new shares for every 18 shares held on 9 May 2008. The net proceeds were £12 billion.
 
In September 2008, the company issued 403 million ordinary shares of 25p each by way of a capitalisation issue. The capitalisation was on the basis of one new share for every 40 shares held by shareholders on 12 September 2008.
 
In December 2008, the company issued 22,910 million ordinary shares of 25p each at 65.5p per share through a placing and open offer. This placing and open offer, which was fully underwritten by HM Treasury, was made available to shareholders on 31 October 2008. The net proceeds were £14.7 billion.
 
In addition, 13.5 million ordinary shares were issued during the year ended 31 December 2008 following the exercise of options under the company’s share schemes.
 
Total consideration, including the rights issue and placing and open offer identified above, of £27.3 billion was received on the issue of ordinary shares for cash.
 
During the year ended 31 December 2008, options were granted over 187.7 million ordinary shares under the company’s executive and sharesave schemes. At 31 December 2008, options granted under the company’s various schemes, exercisable up to 2018 at prices ranging from 189p to 586p per share, were outstanding in respect of 181.9 million ordinary shares.
 
On 16 January 2009, further options were granted over 1,176.1 million ordinary shares under the company’s sharesave scheme.
 
In addition, options granted under the NatWest executive scheme were outstanding in respect of 0.8 million ordinary shares exercisable up to 2009 at prices ranging from 248p to 258p per share.
 
Employee share trusts purchased 54.0 million ordinary shares at a cost of £63.7 million and awarded 3.3 million ordinary shares on receipt of £0.9 million on the exercise of awards under employee share schemes.
 
The employee share trusts incurred costs of £0.3 million in purchasing the company’s ordinary shares.
 
Preference shares
In December 2008, the company issued 5 million Series 2 non- cumulative preference shares of £1 at £1,000 each, the net proceeds being £5 billion.
 
On 19 January 2009, the Group announced that it had reached agreement with HM Treasury and UK Financial Investments to replace the £5 billion of preference shares it holds with new ordinary shares. The offer of the new ordinary shares and redemption of the preference shares are subject to shareholder approval at an Extraordinary General Meeting.
 
Under IFRS certain of the Group’s preference shares are classified as debt and are included in subordinated liabilities on the balance sheet.
 
Other securities
Certain of the Group’s subordinated securities in the legal form of debt are classified as equity under IFRS.
 
These securities entitle the holders to interest which may be deferred at the sole discretion of the company. Repayment of the securities is at the sole discretion of the company on giving between 30 and 60 days notice.
 
Non-cumulative preference shares
Non-cumulative preference shares entitle the holders thereof (subject to the terms of issue) to receive periodic non-cumulative cash dividends at specified fixed rates for each Series payable out of distributable profits of the company.
 
The non-cumulative preference shares are redeemable at the option of the company, in whole or in part from time to time at the rates detailed on the next page plus dividends otherwise payable for the then current dividend period accrued to the date of redemption.
 
 
228

 
 
 
 

 
27           Share capital (continued)
 
Class of preference share
Number of
shares in issue
Interest rate
Redemption date on or
after
Redemption
price per share
Debt or equity(1)
Non-cumulative preference shares of US$0.01
         
Series F
8 million
7.65%
31 March 2007
US$25
Debt
Series H
12 million
7.25%
31 March 2004
US$25
Debt
Series L
34 million
5.75%
30 September 2009
US$25
Debt
Series M
37 million
6.4%
30 September 2009
US$25
Equity
Series N
40 million
6.35%
30 June 2010
US$25
Equity
Series P
22 million
6.25%
31 December 2010
US$25
Equity
Series Q
27 million
6.75%
30 June 2011
US$25
Equity
Series R
26 million
6.125%
30 December 2011
US$25
Equity
Series S
38 million
6.6%
30 June 2012
US$25
Equity
Series T
64 million
7.25%
31 December 2012
US$25
Equity
Series U
15,000
7.64%
29 September 2017
US$100,000
Equity
Non-cumulative convertible preference shares of US$0.01
         
Series 1
1 million
9.118%
31 March 2010
US$1,000
Debt
Non-cumulative preference shares of €0.01
         
Series 1
1.25 million
5.5%
31 December 2009
€1,000
Equity
Series 2
1.25 million
5.25%
30 June 2010
€1,000
Equity
Series 3
26,000
7.0916%
29 September 2017
€50,000
Equity
Non-cumulative convertible preference shares of £0.01
         
Series 1
200,000
7.387%
31 December 2010
£1,000
Debt
Non-cumulative preference shares of £1
         
Series 1
750,000
8.162%
5 October 2012
£1,000
Equity
Series 2
5 million
12%
2 December 2013
£1,000
Equity
 
Notes:
 
(1)
Those preference shares where the Group has an obligation to pay dividends are classified as debt; those where distributions are discretionary are classified as equity. The conversion rights attaching to the convertible preference shares may result in the Group delivering a variable number of equity shares to preference shareholders; these convertible preference shares are treated as debt.
 
(2)
The whole of each series of preference share is issued or redeemed at the same time.
 
In the event that the non-cumulative convertible preference shares are not redeemed on or before the redemption date, the holder may convert them into ordinary shares in the company.
 
Under existing arrangements, no redemption or purchase of any non-cumulative preference shares may be made by the company without the prior consent of the UK Financial Services Authority.
 
On a winding-up or liquidation of the company, the holders of the non-cumulative preference shares will be entitled to receive, out of any surplus assets available for distribution to the company’s shareholders (after payment of arrears of dividends on the cumulative preference shares up to the date of repayment) pari passu with the cumulative preference shares and all other shares of the company ranking pari passu with the non-cumulative preference shares as regards participation in the surplus assets of the company, a liquidation distribution per share equal to the applicable redemption price detailed in the table above, together with an amount equal to dividends for the then current dividend period accrued to the date of payment, before any distribution or payment may be made to holders of the ordinary shares as regards participation in the surplus assets of the company.
 
Except as described above, the holders of the non-cumulative preference shares have no right to participate in the surplus assets of the company.
 
Holders of the non-cumulative preference shares are not entitled to receive notice of or attend general meetings of the company except if any resolution is proposed for adoption by the shareholders of the company to vary or abrogate any of the rights attaching to the non- cumulative preference shares or proposing the winding-up or liquidation of the company. In any such case, they are entitled to receive notice of and to attend the general meeting of shareholders at which such resolution is to be proposed and are entitled to speak and vote on such resolution (but not on any other resolution). In addition, in the event that, prior to any general meeting of shareholders, the company has failed to pay in full the three most recent quarterly dividend payments due on the non-cumulative dollar preference shares (other than Series U), the two most recent semi-annual dividend payments due on the non-cumulative convertible dollar preference shares and the most recent dividend payments due on the non-cumulative euro preference shares, the non- cumulative sterling preference shares, the Series U non-cumulative dollar preference shares and 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. In these circumstances only, the rights of the holders of the non-cumulative preference shares so to vote shall continue until the company shall have resumed the payment in full of the dividends in arrears.
 
The series 2 non-cumulative preference shares of £1 each were issued to HM Treasury. The company, subject to shareholder approval, intends to issue new ordinary shares by way of an open offer, the proceeds will be used to repay the preference shares, issued to HM Treasury, together with the accrued dividend.
 

 
28           Owners’ equity
 
   
Group
   
Company
 
     
2008
£m
     
2007
£m
     
2006
 £m
     
2008
£m
     
2007
£m
     
2006
£m
 
Called-up share capital
                                               
At 1 January
    2,530       815       826       2,530       815       826  
Ordinary shares issued in respect of rights issue
    1,531                   1,531              
Ordinary shares issued in respect of capitalisation issue
    101                   101              
Ordinary shares issued in respect of placing and open offer
    5,728                   5,728              
Preference shares issued in respect of placing and open offer
    5                   5              
Other shares issued
    3       139       2       3       139       2  
Bonus issue of ordinary shares
          1,576                   1,576        
Shares repurchased
                (13 )                 (13 )
At 31 December
    9,898       2,530       815       9,898       2,530       815  
Paid-in equity
                                               
At 1 January
    1,073                   1,073              
Securities issued during the year
          1,073                   1,073        
At 31 December
    1,073       1,073             1,073       1,073        
Share premium account
                                               
At 1 January
    17,322       12,482       11,777       17,322       12,482       11,777  
Ordinary shares issued in respect of rights issue,
                                               
net of £246 million expenses
    10,469                   10,469              
Ordinary shares issued in respect of capitalisation issue
    (101 )                 (101 )            
Expenses of placing and open offer
    (265 )                 (265 )            
Other shares issued
    46       6,257       815       46       6,257       815  
Bonus issue of ordinary shares
          (1,576 )                 (1,576 )      
Redemption of preference shares classified as debt
          159       271             159       271  
Shares repurchased
                (381 )                 (381 )
At 31 December
    27,471       17,322       12,482       27,471       17,322       12,482  
Merger reserve
                                               
At 1 January
    10,881       10,881       10,881                    
Placing and open offer
    14,273                   14,273              
Transfer to retained earnings
    (14,273 )                 (14,273 )            
At 31 December
    10,881       10,881       10,881                    
Available-for-sale reserve
                                               
At 1 January
    1,032       1,528       (73 )                  
Unrealised (losses)/gains in the year
    (6,808 )     (191 )     2,609                    
Realised losses/(gains) in the year
    842       (513 )     (313 )                  
Tax
    1,373       208       (695 )                  
At 31 December
    (3,561 )     1,032       1,528                    
Cash flow hedging reserve
                                               
At 1 January
    (555 )     (149 )     59       (5 )     (7 )     (9 )
Amount recognised in equity during the year
    (603 )     (460 )     (109 )                  
Amount transferred from equity to earnings in the year (1)
    198       (138 )     (140 )     2       3       3  
Tax
    84       192       41       (1 )     (1 )     (1 )
At 31 December
    (876 )     (555 )     (149 )     (4 )     (5 )     (7 )
Foreign exchange reserve
                                               
At 1 January
    (426 )     (872 )     469                    
Retranslation of net assets
    11,970       1,339       (2,159 )                  
Foreign currency (losses)/gains on hedges of net assets (2)
    (5,801 )     (963 )     818                    
Tax
    642       70                          
At 31 December
    6,385       (426 )     (872 )                  
Capital redemption reserve
                                               
At 1 January
    170       170       157       170       170       157  
Shares repurchased during the year
                13                   13  
At 31 December
    170       170       170       170       170       170  
 
Notes:
 
(1)
Of the amount transferred to earnings, £198 million (2007 – £138 million; 2006 – £140 million) was recorded in net interest income and nil (2007 and 2006 – nil) in other operating income.
 
(2)
The hedging instruments in the majority of the Group’s net investment hedges are foreign currency borrowings, the effectiveness of these hedges is assessed prospectively (and on an ongoing basis) by comparing expected (actual) changes in the fair value of the currency net investments in foreign operations and expected (actual) changes in the fair value of the external currency liabilities (excluding accrued interest) attributable to changes in the spot exchange rate between the currency of the investment and sterling.
 
 

 
 
28 Owners’ equity (continued)
 
   
Group
   
Company
 
     
2008
£m
     
2007
£m
     
2006
£m
     
2008
£m
     
2007
£m
     
2006
£m
 
Retained earnings
                                               
At 1 January
    21,072       15,487       11,346       3,787       4,737       4,794  
(Loss)/profit attributable to ordinary and equity preference shareholders
    (23,541 )     7,549       6,393       (9,602 )     2,499       3,499  
Ordinary dividends paid
    (2,312 )     (3,044 )     (2,470 )     (2,312 )     (3,044 )     (2,470 )
Equity preference dividends paid
    (536 )     (246 )     (191 )     (536 )     (246 )     (191 )
Paid-in equity dividends paid, net of tax
    (60 )                 (60 )            
Shares repurchased during the year
                (624 )                 (624 )
Redemption of preference shares classified as debt
          (159 )     (271 )           (159 )     (271 )
Transfer from merger reserve
    14,273                   14,273              
Actuarial (losses)/gains recognised in retirement benefit schemes, net of tax
    (1,335 )     1,517       1,262                    
Net cost of shares bought and used to satisfy share-based payments
    (19 )     (40 )     (38 )                    
Share-based payments, net of tax
          8       80                    
At 31 December
    7,542       21,072       15,487       5,550       3,787       4,737  
                                                 
Own shares held
                                               
At 1 January
    (61 )     (115 )     (7 )                 (7 )
Shares purchased during the year
    (64 )     (65 )     (254 )                  
Shares issued under employee share schemes
    21       119       146                   7  
At 31 December
    (104 )     (61 )     (115 )                  
                                                 
Owners’ equity at 31 December
    58,879       53,038       40,227       44,158       24,877       18,197  

The merger reserve comprises the premium on shares issued to acquire NatWest less goodwill amortisation charged under previous GAAP. No share premium was recorded in the company financial statements through the operation of the merger relief provisions of the Companies Act 1985.
 
UK law prescribes that only the reserves of the company are taken into account for the purpose of making distributions and in determining the permissible applications of the share premium account.
 
The Group optimises capital efficiency by maintaining reserves in subsidiaries, including regulated entities. Certain preference shares and subordinated debt are also included within regulatory capital. The remittance of reserves to the company or the redemption of shares or subordinated capital by regulated entities may be subject to maintaining the capital resources required by the relevant regulator.
 
At 31 December 2008, 61,165,254 (2007 – 10,474,782) ordinary shares of 25p each of the company were held by Employee Share Trusts in respect of share awards and options granted to employees.
 
Paid-in equity represents notes issued under the company’s euro medium term note programme with par value of US$1,600 million and CAD600 million that are classified as equity under IFRS. The notes attract coupons of 6.99% and 6.666% respectively until October 2017 when they change to 2.67% above the London interbank offered rate for 3-month US dollar deposits and 2.76% above the Canadian dollar offered rate respectively.
 
Under the arrangements for the placing and open offer in December 2008, the company issued shares in exchange for shares in Encuentro Limited. No share premium was recorded in the company financial statements through the operation of the merger relief provisions of the Companies Act 1985. The subsequent redemption of these shares gave rise to distributable profits of £14,273 million which have been transferred from merger reserve to retained earnings.
 

 
 
29           Leases
Minimum amounts receivable and payable under non-cancellable leases.
 
   
Group
 
   
Year in which receipt or payment will occur
 
2008
 
Within 1 year
£m
   
After 1 but within 5 years £m
   
After 5 year
£m
   
Total £m
 
Finance lease assets:
                       
Amounts receivable
    1,485       6,112       12,567       20,164  
Present value adjustment
    (613 )     (2,004 )     (3,094 )     (5,711 )
Other movements
    (24 )     (128 )     (341 )     (493 )
Present value amounts receivable
    848       3,980       9,132       13,960  
                                 
Operating lease assets:
                               
Future minimum lease receivables
    918       2,479       1,141       4,538  
                                 
Operating lease obligations:
                               
Future minimum lease payables:
                               
Premises
    567       1,715       3,299       5,581  
Equipment
    12       12             24  
      579       1,727       3,299       5,605  
                                 
2007
                               
Finance lease assets:
                               
Amounts receivable
    1,297       4,968       11,648       17,913  
Present value adjustment
    (390 )     (1,766 )     (3,187 )     (5,343 )
Other movements
    (23 )     (144 )     (288 )     (455 )
Present value amounts receivable
    884       3,058       8,173       12,115  
                                 
Operating lease assets:
                               
Future minimum lease receivables
    1,073       3,046       1,473       5,592  
                                 
Operating lease obligations:
                               
Future minimum lease payables:
                               
Premises
    350       1,210       3,017       4,577  
Equipment
    9       14             23  
      359       1,224       3,017       4,600  

   
Group
 
     
2008
£m
     
2007
£m
 
Nature of operating lease assets in balance sheet
               
Transportation
    5,883       6,859  
Cars and light commercial vehicles
    1,199       1,390  
Other
    617       441  
      7,699       8,690  
                 
Amounts recognised as income and expense
               
Finance lease receivables – contingent rental income
    (37 )     (23 )
Operating lease payables – minimum payments
    566       322  
                 
Contracts for future capital expenditure not provided for at the year end
               
Operating leases
    237       545  
                 
Finance lease receivables
               
Unearned finance income
    5,711       5,343  
Accumulated allowance for uncollectible minimum lease receivables
    96       63  
 

 
 
29 Leases (continued)
Residual value exposures
The tables below give details of the unguaranteed residual values included in the carrying value of finance lease receivables (see page 194) and operating lease assets (see page 208).
 
   
Year in which residual value will be recovered
 
2008
 
Within 1 year
£m
   
After 1 year but within 2 years
£m
   
After 2 years but within 5 years
£m
   
After 5 years
£m
   
Total
£m
 
Operating leases
                             
Transportation
    794       130       1,701       2,103       4,728  
Cars and light commercial vehicles
    577       195       182       8       962  
Other
    112       35       48       8       203  
Finance leases
    24       29       99       341       493  
      1,507       389       2,030       2,460       6,386  
                                         
2007
                                       
Operating leases
                                       
Transportation
    485       253       1,762       2,505       5,005  
Cars and light commercial vehicles
    331       467       118             916  
Other
    26       47       64       18       155  
Finance leases
    23       29       115       288       455  
      865       796       2,059       2,811       6,531  

The Group provides asset finance to its customers through acting as a lessor. It purchases plant, equipment and intellectual property, renting them to customers under lease arrangements that, depending on their terms, qualify as either operating or finance leases.
 
30           Collateral and securitisations
Securities repurchase agreements and lending transactions
The Group enters into securities repurchase agreements and securities lending transactions under which it receives or transfers collateral in accordance with normal market practice. Generally, the agreements require additional collateral to be provided if the value of the securities falls below a predetermined level.
 
Under standard terms for repurchase transactions in the UK and US markets, the recipient of collateral has an unrestricted right to sell or repledge it, subject to returning equivalent securities on settlement of the transaction.
 
The fair value (and carrying value) of securities transferred under repurchase transactions included within debt securities on the balance sheet were £80,576 million (2007 – £107,651 million). All of these securities could be sold or repledged by the holder. Securities received as collateral under reverse repurchase agreements amounted to £89.3 billion (2007 – £373.7 billion), of which £49.0 billion (2007 – £337.8 billion) had been resold or repledged as collateral for the Group’s own transactions.
 

 
233

 

 
Other collateral given
Group assets charged as security for liabilities
   
2008
£m
     
2007
£m
 
Loans and advances to banks
    13       753  
Loans and advances to customers
    118,933       80,719  
Debt securities
    15,490       29,709  
Property, plant and equipment
          935  
Other
    8       1,765  
      134,444       113,881  

Liabilities secured by charges on Group assets
   
2008
£m
     
2007
£m
 
Deposits by banks
    15,429       21,693  
Customer accounts
    11,050       6,670  
Debt securities in issue
    58,689       65,080  
      85,168       93,443  
 
Note:
 
(1)
The table above includes assets used as collateral for central bank liquidity schemes.
 
Of the assets above, £91.3 billion (2007 – £62.0 billion) relate to securitisations. In securitisations, debt securities are issued that are secured on assets of the Group: the rights to the cash flows from those assets are transferred to special purpose vehicles which issue debt securities. The holders of the notes are generally not able to sell or repledge the underlying assets. The remaining balances mainly relate to assets charged as security against deposits from central and federal banks and other public sector bodies.
 
Securitisations and other asset transfers
Continued recognition
The table below sets out the asset categories together with the carrying amounts of the assets and associated liabilities for those securitisations and other asset transfers where substantially all the risks and rewards of the asset have been retained by the Group.
 
   
2008
   
2007
 
Asset type
 
Assets
£m
   
Liabilities
£m
   
Assets
£m
   
Liabilities
£m
 
Residential mortgages
    49,184       20,075       23,652       23,436  
Credit card receivables
    3,004       3,197       2,948       2,664  
Other loans
    1,679       1,071       1,703       1,149  
Commercial paper conduits
    36,395       35,835       32,613       31,193  
Finance lease receivables
    1,077       857       1,038       823  
      91,339       61,035       61,954       59,265  

Continuing involvement
At 31 December 2008, securitised assets were £1.1 billion (2007 – £18.1 billion); retained interest £50 million (2007 – £1,037 million); subordinated assets £9 million (2007 – £314 million); and related liabilities £9 million (2007 – £314 million).
 
 

 
 
31           Capital resources
The Group’s regulatory capital resources at 31 December in accordance with Financial Services Authority (FSA) definitions were as follows:
 
Composition of regulatory capital
 
Basel II
2008
£m
   
Basel I
2007
£m
 
Tier 1:
           
Ordinary shareholders’ equity
    45,525       44,684  
Minority interests
    21,619       38,388  
Adjustment for:
               
– Goodwill and other intangible assets
    (20,049 )     (48,492 )
– Goodwill and other intangible assets of discontinued businesses
          (3,232 )
– Unrealised losses on available-for-sale debt securities
    3,687       630  
– Reserves arising on revaluation of property and unrealised gains on available-for-sale equities
    (984 )     (3,321 )
– Reallocation of preference shares and innovative securities
    (1,813 )     (1,813 )
– Other regulatory adjustments
    (362 )     480  
Core Tier 1 capital
    47,623       27,324  
                 
Preference shares
    16,655       10,560  
Innovative Tier 1 securities
    7,383       6,480  
Tax on the excess of expected losses over provisions
    615       n/a  
Tier 1 deductions
    (2,429 )     n/a  
Total Tier 1 capital
    69,847       44,364  
                 
Tier 2:
               
Reserves arising on revaluation of property and unrealised gains on available-for-sale equities
    984       3,321  
Collective impairment allowances
    666       2,582  
Perpetual subordinated debt
    9,829       9,042  
Term subordinated debt
    23,162       18,639  
Minority and other interests in Tier 2 capital
    11       109  
Tier 2 deductions
    (2,429 )     n/a  
Total Tier 2 capital
    32,223       33,693  
                 
Tier 3
    260       200  
                 
Supervisory deductions:
               
Unconsolidated investments
    4,044       4,297  
Other deductions
    111       5,986  
Total deductions other than from Tier 1 capital
    4,155       10,283  
Total regulatory capital
    98,175       67,974  

It is the Group’s policy to maintain a strong capital base, to expand it as appropriate and to utilise it efficiently throughout its activities to optimise the return to shareholders while maintaining a prudent relationship between the capital base and the underlying risks of the business. In carrying out this policy, the Group has regard to the supervisory requirements of the FSA. The FSA uses Risk Asset Ratio (RAR) as a measure of capital adequacy for UK banks, comparing a bank’s capital resources with its risk-weighted assets (the assets and off-balance sheet exposures are ‘weighted’ to reflect the inherent credit and other risks); by international agreement, the RAR should be not less than 8% with a Tier 1 component of not less than 4%. The Group has complied with the FSAs capital requirements throughout the year.
 
A number of subsidiaries and sub-groups within the Group, principally banking and insurance entities, are subject to various individual regulatory capital requirements in the UK and overseas.
 
235

 

 
 
32           Memorandum items
Contingent liabilities and commitments
The amounts shown in the table below are intended only to provide an indication of the volume of business outstanding at 31 December. Although the Group is exposed to credit risk in the event of non-performance of the obligations undertaken by customers, the amounts shown do not, and are not intended to, provide any indication of the Group’s expectation of future losses.
 
   
Group
 
   
Less than 1 year
£m
   
More than 1 year but less than 3 years
£m
   
More than 3 years but less than 5 years
£m
   
Over 5 years
£m
      2008
£m
    2007
£m
 
Contingent liabilities:
                                       
Guarantees and assets pledged as collateral security
    29,350       7,738       2,898       9,276       49,262       46,441  
Other contingent liabilities
    9,093       6,637       2,252       4,293       22,275       15,479  
      38,443       14,375       5,150       13,569       71,537       61,920  
                                                 
Commitments:
                                               
Undrawn formal standby facilities, credit lines and other commitments to lend
                                               
– less than one year
    166,572                         166,572       181,914  
– one year and over
    22,209       70,301       62,725       30,591       185,826       150,897  
Other commitments
    6,715       309       1,210       1,092       9,326       5,368  
      195,496       70,610       63,935       31,683       361,724       338,179  

Banking commitments and contingent obligations, which have been entered into on behalf of customers and for which there are corresponding obligations from customers, are not included in assets and liabilities. The Group’s maximum exposure to credit loss, in the event of non-performance by the other party and where all counterclaims, collateral or security proves valueless, is represented by the contractual nominal amount of these instruments included in the table above. These commitments and contingent obligations are subject to the Group’s normal credit approval processes.
 
Contingent liabilities
Guarantees – the Group gives guarantees on behalf of customers. A financial guarantee represents an irrevocable undertaking that the Group will meet a customer’s obligations to third parties if the customer fails to do so. The maximum amount that the Group could be required to pay under a guarantee is its principal amount as disclosed in the table above. The Group expects most guarantees it provides to expire unused.
 
Other contingent liabilities – these include standby letters of credit, supporting customer debt issues and contingent liabilities relating to customer trading activities such as those arising from performance and customs bonds, warranties and indemnities.
 
Commitments
Commitments to lend – under a loan commitment the Group agrees to make funds available to a customer in the future. Loan commitments, which are usually for a specified term may be unconditionally cancellable or may persist, provided all conditions in the loan facility are satisfied or waived. Commitments to lend include commercial standby facilities and credit lines, liquidity facilities to commercial paper conduits and unutilised overdraft facilities.
 
Other commitments – these include documentary credits, which are commercial letters of credit providing for payment by the Group to a named beneficiary against presentation of specified documents, forward asset purchases, forward deposits placed and undrawn note issuance and revolving underwriting facilities, and other short-term trade related transactions.
 
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. The Group earned fee income of £1,442 million (2007 – £695 million; 2006 – £472 million) from these activities.
 
The Financial Services Compensation Scheme
The Financial Services Compensation Scheme (FSCS), the UK's statutory fund of last resort for customers of authorised financial services firms, pays compensation if a firm is unable to meet its obligations. The FSCS funds compensation for customers by raising management expenses levies and compensation levies on the industry. In relation to protected deposits, each deposit-taking institution contributes towards these levies in proportion to their share of total protected deposits on 31 December of the year preceding the scheme year (which runs from 1 April to 31 March), subject to annual maxima set by the Financial Services Authority (FSA). In addition, the FSCS has the power to raise levies (‘exit levies’) on firms who have ceased to participate in the scheme and are in the process of ceasing to be authorised for the amount that the firm would otherwise have been asked to pay during the relevant levy year. The FSCS also has the power to raise exit levies on such firms which look at their potential liability to pay levies in future years.
 
FSCS has borrowed from HM Treasury to fund the compensation costs associated with Bradford & Bingley, Heritable Bank, Kaupthing Singer & Friedlander, Landsbanki ‘Icesave’ and London Scottish Bank plc. These borrowings are on an interest-only basis until September 2011. The annual limit on the FSCS management expenses levy for the three years from September 2008 in relation to these institutions has been capped at £1 billion per annum.
 
The FSCS will receive funds from asset sales, surplus cash flow, or other recoveries in relation to these institutions which will be used to reduce the principal amount of the FSCS's borrowings. Only after the interest only period, which is expected to end in September 2011, will a schedule

 
 
32           Memorandum items (continued)
for repayment of any remaining principal outstanding (after recoveries) on the borrowings be agreed between the FSCS and HM Treasury. It is expected that, from that point, the FSCS will begin to raise compensation levies (principal repayments). No provision has been made for these levies as the amount is not yet known and is unlikely to be determined before 2011.
 
The Group has accrued £150 million for its share of FSCS management expenses levies for the 2008/9 and 2009/10 scheme years.
 
Investigations
The Group’s businesses and financial condition can be affected by the fiscal or other policies and other actions of various governmental and regulatory authorities in the United Kingdom, the European Union, the United States and elsewhere.
 
The Group has engaged, and will continue to engage, in discussions with relevant regulators, including in the United Kingdom and the United States, on an ongoing and regular basis informing them of operational, systems and control evaluations and issues as deemed appropriate or required and it is possible that any matters discussed or identified may result in investigatory actions by the regulators, increased costs being incurred by the Group, remediation of systems and controls, public or private censure or fines. Any of these events or circumstances could have a material adverse impact on the Group its business, reputation, results of operations or share price.
 
There is continuing political and regulatory scrutiny of the operation of the retail banking and consumer credit industries in the United Kingdom and elsewhere. The nature and impact of future changes in policies and regulatory action are not predictable and are beyond the Group’s control but could have an adverse impact on the Group’s businesses and earnings.
 
European Union
In the European Union, regulatory actions included an inquiry into retail banking in all of the then 25 member states by the European Commission’s Directorate General for Competition. The inquiry examined retail banking in Europe generally. On 31 January 2007, the European Commission announced that barriers to competition in certain areas of retail banking, payment cards and payment systems in the European Union had been identified. The European Commission indicated that it will consider using its powers to address these barriers and will encourage national competition authorities to enforce European and national competition laws where appropriate.
 
In 2007, the European Commission issued a decision that, while interchange is not illegal per se, MasterCard’s current multilateral interchange fee (MIF) arrangement for cross border payment card transactions with MasterCard and Maestro-branded consumer credit and debit cards in the European Union are in breach of competition law. MasterCard was required by the decision to withdraw the relevant cross border MIFs by 21 June 2008. MasterCard lodged an appeal against the decision with the European Court of First Instance on 1 March 2008, and on 12 June 2008 it announced that it would be temporarily withdrawing its cross border MIF, pending the outcome of the appeal. The Group has been granted leave to intervene in the appeal proceedings. Visa’s MIFs were exempted in 2002 by the European Commission for a period of five years up to 31 December 2007 subject to certain conditions. On 26 March 2008, the European Commission opened a formal inquiry into Visa’s current MIF arrangements for cross border payment card transactions with Visa-branded debit and consumer credit cards in the European Union. There is no deadline for the closure of the inquiry.
 
United Kingdom
In the United Kingdom, in September 2005, the Office of Fair Trading (OFT) received a super-complaint from the Citizens Advice Bureau relating to payment protection insurance (PPI). As a result, the OFT commenced a market study on PPI in April 2006. In October 2006, the OFT announced the outcome of the market study and, on 7 February 2007, following a period of consultation, the OFT referred the PPI market to the Competition Commission (CC) for an in-depth inquiry. The CC published its final report on 29 January 2009. It found a lack of competition in the PPI market as a result of various factors, including a lack of transparency and barriers to entry for standalone providers. The CC will therefore impose by Order a range of remedies, including a prohibition on actively selling PPI at point of sale of the credit product (and for 7 days thereafter), a ban on single premium policies and other measures to increase transparency (in order to improve customers’ ability to search and improve price competition). The deadline for implementation will be 2010.
 
The FSA has been conducting a broad industry thematic review of PPI sales practices and in September 2008 announced that it intends to escalate its level of regulatory intervention. The FSA is expected to publish a further update in 2009. Substantial numbers of customer complaints alleging the mis-selling of PPI policies have been made to banks and to the Financial Ombudsman Service (FOS) and many of these are being upheld by the FOS against the banks. Discussions continue between the FSA, the FOS and industry bodies on how best to handle these complaints. Separately, discussions are ongoing between the FSA and the Group in respect of concerns expressed by the FSA over certain categories of historic PPI sales.
 
The OFT has carried out investigations into Visa and MasterCard domestic credit card interchange rates. The decision by the OFT in the MasterCard interchange case was set aside by the Competition Appeals Tribunal in June 2006. The OFT’s investigations in the Visa interchange case and a second MasterCard interchange case are ongoing. The outcome is not known, but these investigations may have an impact on the consumer credit industry in general and, therefore, on the Group’s business in this sector. On 9 February 2007, the OFT announced that it was expanding its investigation into domestic interchange rates to include debit cards.
 
On 29 March 2007, the OFT announced that, following an initial review into bank current account charges, it had decided to conduct a market study into personal current accounts in the United Kingdom and a formal investigation into the fairness of bank current account charges.
 
 

 
 
On 16 July 2008, the OFT published the results of its market study into personal current accounts in the United Kingdom. The OFT found evidence of competition and several positive features in the personal current account market but believes that the market as a whole is not working well for consumers and that the ability of the market to function well has become distorted. The OFT is currently consulting with the banking industry, consumer groups and interested parties on its report. After this consultation the OFT will decide on next steps, which could include further discussions or agreed remedies with the industry, or possibly a reference of the market to the CC.
 
The OFT’s investigation into the fairness of bank current account charges is ongoing. On 12 August 2008, the OFT indicated to the Group and other banks that, although it had not concluded its investigation and had reached no final view, it had serious concerns that contractual terms relating to Relevant Charges in personal current account agreements were unfair under the Regulations. The OFT is currently consulting with the Group and other banks on this issue. Given the stage of the investigation, the Group cannot reliably estimate the impact of any adverse outcome of the OFT’s market study or investigation upon it, if any. However, the Group is co-operating fully with the OFT to achieve resolution of the matters under investigation.
 
On 26 January 2007, the FSA issued a Statement of Good Practice relating to Mortgage Exit Administration Fees. On 1 March 2007, the Group adopted a policy of charging all customers the fee applicable at the time the customers took out the mortgage or, if later, varied their mortgage. The Group believes that it is currently in compliance with the Statement of Good Practice and will continue to monitor its performance against those standards.
 
United States
In July 2004, ABN AMRO signed a written agreement with the US regulatory authorities concerning ABN AMRO’s dollar clearing activities in the New York branch. In addition, in December 2005, ABN AMRO agreed to a Cease and Desist Order with the Dutch Central Bank and various US federal and state regulators. This involved an agreement to pay an aggregate civil penalty of US$75 million and a voluntary endowment of US$5 million in connection with deficiencies in the US dollar clearing operations at ABN AMRO’s New York branch and OFAC compliance procedures regarding transactions originating at its Dubai branch. ABN AMRO and members of ABN AMRO’s management continue to provide information to law enforcement authorities in connection with ongoing criminal investigations relating to ABN AMRO’s dollar clearing activities, OFAC compliance procedures and other Bank Secrecy Act compliance matters. The Cease and Desist Order with the Dutch Central Bank was lifted on 26 July 2007 and the Cease and Desist Order agreed with the US authorities was lifted on 9 September 2008. Although no written agreement has yet been reached and negotiations are ongoing, ABN AMRO has reached an agreement in principle with the US Department of Justice that would resolve all presently known aspects of the ongoing investigation. Under the terms of the agreement in principle, ABN AMRO and the United States would enter into a deferred prosecution agreement in which ABN AMRO would waive indictment and agree to the filing of information in the United States District Court charging it with certain violations of federal law based on information disclosed in an agreed factual statement. ABN AMRO would also agree to continue co-operating in the United States’ ongoing investigation and to settle all known civil and criminal claims currently held by the United States for the sum of US$500 million. The precise terms of the deferred prosecution agreement are still under negotiation.
 
These compliance issues and the related sanctions and investigations have had, and will continue to have, an impact on ABN AMRO’s operations in the United States, including limitations on expansion. ABN AMRO is actively exploring all possible options to resolve these issues. The ultimate resolution of these compliance issues and related investigations and the nature and severity of possible additional sanctions cannot be predicted.
 
The New York State Attorney General has issued subpoenas to a wide array of participants in the sub-prime mortgage industry, including mortgage originators, appraisers, due diligence firms, investment banks and rating agencies, focusing on the information underwriters obtained as part of the due diligence process from the independent due diligence firms and whether that information is adequately disclosed to investors. RBS Greenwich Capital has produced documents requested by the New York State Attorney General principally related to sub-prime loans that were pooled into one securitisation transaction.
 
In addition to the above, certain of the Group’s subsidiaries have received requests for information from various US governmental agencies and self-regulatory organisations including in connection with sub-prime mortgages and securitisations, collateralised debt obligations and synthetic products related to sub-prime mortgages. In particular, during March 2008, the Group was advised by the SEC that it had commenced a non-public, formal investigation relating to the Group’s US sub-prime securities exposures and US residential mortgage exposures. The Group and its subsidiaries are co-operating with these various requests for information and investigations.
 
Litigation
United Kingdom
In common with other banks in the United Kingdom, the Royal Bank and NatWest have received claims and complaints from a large number of customers challenging unarranged overdraft charges (the ‘Charges’) as contravening the Unfair Terms in Consumer Contracts Regulations 1999 (the ‘Regulations’) or being unenforceable penalties (or both).
 
On 27 July 2007, the OFT issued proceedings in a test case against the banks which was intended to determine certain preliminary issues concerning the legal status and enforceability of contractual terms relating to the Charges. Because of the test case, most existing and new claims in the County Courts are currently stayed, the FSA temporarily waived the customer complaints-handling process and there is a standstill of Financial Ombudsman Service decisions.
 
 

 
32           Memorandum items (continued)
A High Court judgment in April 2008 addressed preliminary issues in respect of the banks’ contractual terms relating to the Charges in force in early 2008 (the ‘Current Terms’). The judgment held that the Current Terms used by the Royal Bank and NatWest (i) are not unenforceable as penalties, but (ii) are not exempt from assessment for fairness under the Regulations. The Group (in common with the other banks) has accepted that the ruling in the April judgment that the Current Terms are not exempt from assessment for fairness applies also to a sample of the Royal Bank and NatWest contractual terms relating to the Charges in force between 2001 and 2007 (the ‘Historic Terms’). The High Court made an order to this effect in October 2008.
 
The Group and the other banks have appealed against the rulings in April and October 2008 that the Current Terms and Historic Terms are not exempt from assessment for fairness under the Regulations. The hearing of the appeal in relation to Current Terms took place before the Court of Appeal in October and November 2008. The decision of the Court of Appeal is expected shortly. The appeal in relation to the Historic Terms is stayed pending the resolution of the appeal in relation to the Current Terms.
 
High Court judgments on further preliminary issues were handed down in October 2008 and January 2009. These judgments primarily addressed the question of whether certain Historic Terms were capable of being unenforceable penalties. The Judge decided that all of the Royal Bank’s and most of NatWest’s Historic Terms were not penalties, but that a term contained in a set of NatWest 2001 terms and conditions was a contractual prohibition against using a card to obtain an unarranged overdraft. The Judge did not decide whether any charge payable upon a breach of this prohibition was a penalty. The Group has not appealed that decision.
 
The issues relating to the legal status and enforceability of the Charges are complex. The Group maintains that its Charges are fair and enforceable and believes that it has a number of substantive and credible defences. The Group cannot at this stage predict with any certainty the final outcome of the customer claims and complaints, the appeals referred to above and any further stages of the test case. It is unable reliably to estimate the liability, if any, that may arise as a result of or in connection with these matters or its effect on the Group’s consolidated net assets, operating results or cash flows in any particular period.
 
United States
Proceedings, including consolidated class actions on behalf of former Enron securities holders, have been brought in the United States against a large number of defendants, including the Group, following the collapse of Enron. The claims against the Group could be significant; the class plaintiff’s position is that each defendant is responsible for an entire aggregate damage amount less settlements – they have not quantified claimed damages against the Group in particular. The Group considers that it has substantial and credible legal and factual defences to these claims and will continue to defend them vigorously. Recent decisions by the US Supreme Court and the US Federal Court for the Fifth Circuit provide further support for the Group’s position. The Group is unable reliably to estimate the liability, if any, that might arise or its effect on the Group’s consolidated net assets, operating results or cash flows in any particular period.
 
Group companies have been named as defendants in a number of purported class action and other lawsuits in the United States that relate to the sub-prime mortgage business. In general, the cases involve the issuance of sub-prime-related securities or the issuance of shares in companies with sub-prime-related exposure, where the plaintiffs have brought actions against the issuers and underwriters (including Group companies) of such securities claiming that certain disclosures made in connection with the relevant offerings of such securities were false or misleading. The Group considers that it has substantial and credible legal and factual defences to these claims and will continue to defend them vigorously. The Group does not currently expect that these lawsuits, individually or in the aggregate, will have a material impact on its consolidated net assets, operating results or cash flows in any particular period.
 
The company and a number of its subsidiaries and certain individual officers and directors have been named as defendants in a number of class action complaints filed in the United States District Court for the Southern District of New York. The complaints allege that public filings in connection with the issuance of non-cumulative dollar preference shares, ADS, including Series Q, Series R, Series S and Series T, contained false and misleading statements, and variously assert claims under Sections 11, 12 and 15 of the Securities Act 1933, Section 10 of the Securities Exchange Act of 1934 and SEC Rule 10b-5. Plaintiffs seek unquantified damages on behalf of purchasers of these shares. The proceedings are in their initial stages. The Group considers that it has substantial and credible legal and factual defences to these claims and will defend them vigorously. The Group is unable reliably to estimate the liability, if any, that might arise or its effect on the Group’s consolidated net assets, operating results or cash flows in any particular period.
 
Other disputes, legal proceedings and litigation
Members of the Group are engaged in other litigation in the United Kingdom and a number of overseas jurisdictions, including the United States, involving claims by and against them arising in the ordinary course of business. The Group has reviewed these other actual, threatened and known potential claims and proceedings and, after consulting with its legal advisers, does not expect that the outcome of these other claims and proceedings will have a material adverse effect on its consolidated net assets, operating results or cash flows in any particular period.
 

 
 
33           Net cash (outflow)/inflow from operating activities

   
Group
   
Company
 
     
2008
£m
     
2007
£m
     
2006
£m
     
2008
£m
     
2007
£m
     
2006
£m
 
Operating (loss)/profit before tax
    (40,667 )     9,832       9,186       (10,017 )     2,372       3,486  
Operating profit before tax on discontinued activities
    4,208       68                          
(Increase)/decrease in prepayments and accrued income
    (921 )     (662 )     322             (1 )      
Interest on subordinated liabilities
    2,144       1,518       1,386       499       470       520  
Increase/(decrease) in accruals and deferred income
    3,961       (818 )     515       7             (27 )
Provisions for impairment losses
    8,072       1,968       1,877                    
Loans and advances written-off net of recoveries
    (2,829 )     (1,669 )     (1,626 )                  
Unwind of discount on impairment losses
    (194 )     (164 )     (142 )                  
Profit on sale of property, plant and equipment
    (167 )     (741 )     (216 )                  
Profit on sale of subsidiaries and associates
    (943 )     (67 )     (44 )     (487 )            
Profit on sale of securities
    (342 )     (544 )     (369 )                  
Charge for defined benefit pension schemes
    490       489       580                    
Cash contribution to defined benefit pension schemes
    (810 )     (599 )     (536 )                  
Other provisions utilised
    (32 )     (211 )     (42 )                  
Depreciation and amortisation
    3,154       1,932       1,678                    
Write down of goodwill and other intangible assets
    32,581                                
Write down of investment in subsidiaries
                      14,321              
Elimination of foreign exchange differences
    (41,874 )     (10,282 )     4,516       1,778       (58 )     (22 )
Elimination of non-cash items on discontinued activities
    592       62                          
Other non-cash items
    1,998       (327 )     (1,395 )     2       2       45  
Net cash (outflow)/inflow from trading activities
    (31,579 )     (215 )     15,690       6,103       2,785       4,002  
(Increase)/decrease in loans and advances to banks and customers
    (5,469 )     (90,829 )     (44,525 )     (15,542 )     (8 )     346  
Decrease/(increase) in securities
    75,964       (26,167 )     (16,703 )                  
(Increase)/decrease in other assets
    (5,845 )     (384 )     671       (73 )           2  
(Increase)/decrease in derivative assets
    (708,607 )     (88,948 )     (18,616 )     (995 )     (173 )     55  
Changes in operating assets
    (643,957 )     (206,328 )     (79,173 )     (16,610 )     (181 )     403  
(Decrease)/increase in deposits by banks and customers
    (78,166 )     81,645       63,091       (4,064 )     4,677       (164 )
(Decrease)/increase in insurance liabilities
    (186 )     2,706       244                    
Increase/(decrease) in debt securities in issue
    27,222       59,735       (4,457 )     (1,794 )     10,936       (803 )
(Decrease)/increase in other liabilities
    (8,869 )     (1,036 )     935       32       (7 )     14  
Increase in derivative liabilities
    699,601       83,466       19,272       182       137       42  
(Decrease)/increase in settlement balances and short positions
    (37,864 )     8,073       4,068                    
Changes in operating liabilities
    601,738       234,589       83,153       (5,644 )     15,743       (911 )
Total income taxes (paid)/received
    (1,540 )     (2,442 )     (2,229 )     119       6       154  
Net cash (outflow)/inflow from operating activities
    (75,338 )     25,604       17,441       (16,032 )     18,353       3,648  
 
 
240

 


34           Analysis of the net investment in business interests and intangible assets
(a) Acquisition of ABN AMRO
On 17 October 2007, the Group, through its subsidiary RFS Holdings B.V. (RFS), acquired 99% of the ordinary shares of ABN AMRO Holding N.V., the holding company of a major European banking group based in the Netherlands with subsidiaries that undertake commercial banking operations, investment banking and other related financial activities. During 2008, RFS acquired the remaining 1 % of the ordinary shares of ABN AMRO.
 
The provisional fair values of ABN AMRO’s assets and liabilities at the date of acquisition were finalised as follows:
 
   
Pre-acquisition carrying amounts
£m
   
Disposal groups(1)
£m
   
Provisional fair value adjustments(2)
£m
   
Amendments to provisional fair value adjustments
£m
   
Recognised acquisition values(2)
£m
 
Cash and balances at central banks
    7,263       (186 )                 7,077  
Loans and advances to banks
    120,120       (3,646 )                 116,474  
Loans and advances to customers
    314,287       (26,158 )     (1,843 )     (699 )     285,587  
Treasury and other eligible bills and debt and equity securities
    166,018       (3,804 )                 162,214  
Derivatives
    86,695       (322 )                 86,373  
Intangible assets
    4,239       (3,522 )     4,282       788       5,787  
Property, plant and equipment
    2,062       (747 )     175       (5 )     1,485  
Other assets
    32,710       (7 )     1,357       (180 )     33,880  
Assets of disposal groups(1)
    2,987       38,392       787       (98 )     42,068  
                                         
Deposits by banks
    (160,906 )     2,808       (321 )     322       (158,097 )
Customer accounts
    (253,583 )     13,786       (152 )     2       (239,947 )
Debt securities in issue
    (134,630 )     5,937       776       (551 )     (128,468 )
Settlement balances and short positions
    (44,748 )     36                   (44,712 )
Derivatives
    (85,491 )     417                   (85,074 )
Subordinated liabilities
    (11,748 )     868       685       (61 )     (10,256 )
Other liabilities
    (21,268 )     271       (1,814 )     (114 )     (22,925 )
Liabilities of disposal groups (1)
    (2,377 )     (24,123 )                 (26,500 )
Net identifiable assets and liabilities
    21,630             3,932       (596 )     24,966  
Minority interests
                                    (242 )
Goodwill on acquisition
                                    23,851  
Consideration
                                    48,575  
                                         
Satisfied by:
                                       
Issue of 531 million ordinary shares of the company
                                    2,719  
Cash
                                    45,786  
Fees and expenses relating to the acquisition
                                    70  
Consideration
                                    48,575  
                                         
Net cash:
                                       
Cash consideration
                                    45,856  
Cash acquired
                                    (60,093 )
                                      14,237  
Notes:
 
(1)
Banca Antonveneta SpA. and ABN AMRO’s asset management business were identified as disposal groups on the acquisition of ABN AMRO and sold during 2008. In addition, under the terms of the Consortium and Shareholders’ Agreement, consortium members other than the Group agreed to acquire, in due course, various ABN AMRO businesses including operations in Brazil (sold 1 Juy 2008), the commercial and retail businesses in the Netherlands, the private clients business and Interbanca.
 
(2)
The initial accounting for the acquisition was determined provisionally at 31 December 2007 because of its complexity and the limited time available between the acquisition and the preparation of the 2007 financial statements. The principal adjustments, excluding reclassifications, on finalising fair values were:
 
(a)
The Group’s methodology for calculating the fair value of trading financial instruments produced values lower by £524 million than those recorded by ABN AMRO;
 
(b)
Following further work on identifying intangible assets, additional customer relationship assets and core deposit intangibles of £724 million have been recognised;
 
(c)
Net assets of the Netherlands pension scheme have been reduced by £250 million.
 
 

 
(d)
The fair value of private equity investments was reduced by £98 million based on additional evidence provided by disposals in 2008;
 
(e)
The liability for instruments issued by conduits should be increased by £366 million;
 
No material change was required to the deferred tax effect of fair value adjustments.
 
 
It is estimated that the Group would have reported total income of £37.2 billion and profit after tax of £7.7 billion from continuing operations for the year ended 31 December 2007 had all acquisitions occurred on 1 January 2007. These results would not have been materially affected by the finalisation of fair values.
 
242

 

 
(b) Other acquisitions and disposals
 
   
Group
 
     
2008
£m
     
2007
£m
     
2006
£m
 
Fair value given for businesses acquired
    (1,810 )     (280 )     (21 )
Cash and cash equivalents acquired
          5        
Non-cash consideration
    (17 )            
Net outflow of cash in respect of purchases
    (1,827 )     (275 )     (21 )
                         
Cash and cash equivalents in businesses sold
          21       229  
Other assets sold
    739       16       36  
Non-cash consideration
    (103 )     (2 )     (1 )
Profit on disposal
    943       67       44  
Net inflow of cash in respect of disposals
    1,579       102       308  
Dividends received from joint ventures
    89       11       29  
Cash expenditure on intangible assets
    2,411       (435 )     (379 )
Net outflow
    2,252       (597 )     (63 )

The Group’s reported result from continuing operations for the year would not have been materially affected had all acquisitions occurred on 1 January 2008. The profit on disposal arises on the sales of Angel Trains, Tesco Personal Finance and the European Consumer Finance business during the year.
 
35           Interest received and paid

   
Group
   
Company
 
     
2008
£m
     
2007
£m
     
2006
£m
     
2008
£m
     
2007
£m
     
2006
£m
 
Interest received
    52,393       31,552       24,381       794       457       594  
Interest paid
    (31,614 )     (18,407 )     (14,656 )     (1,325 )     (746 )     (632 )
      20,779       13,145       9,725       (531 )     (289 )     (38 )
 
 


36           Analysis of changes in financing during the year
   
Group
   
Company
 
   
Share capital, share premium, paid-in equity and merger reserve
   
Subordinated liabilities
   
Share capital, share premium, paid-in equity and merger reserve
   
Subordinated liabilities
 
     
2008
£m
     
2007
£m
     
2008
£m
     
2007
£m
     
2008
£m
     
2007
£m
     
2008
£m
     
2007
 £m
 
At 1 January
    31,806       24,178       38,043       27,654       20,925       13,297       7,743       8,194  
Issue of ordinary shares
    49       77                       49       77                  
Issue of other equity securities
          4,673                             4,673                  
Placing and open offer
    19,741                             19,741                          
Rights issue
    12,000                             12,000                          
Net proceeds from issue of subordinated liabilities
                    2,413       1,018                                
Repayment of subordinated liabilities
                    (1,727 )     (1,708 )                             (469 )
Net cash inflow/(outflow) from financing
    31,790       4,750       686       (690 )     31,790       4,750             (469 )
Acquisition of subsidiaries
          2,719             10,256             2,719              
Transfer to retained earnings
    (14,273 )                       (14,273 )                  
Currency translation and other adjustments
          159       10,425       823             159       2,571       18  
At 31 December
    49,323       31,806       49,154       38,043       38,442       20,925       10,314       7,743  

37           Analysis of cash and cash equivalents

   
Group
   
Company
 
     
2008 
£m
     
2007
£m
     
2006
£m
     
2008
£m
     
2007
£m
     
2006
£m
 
At 1 January
                                               
— cash
    52,796       28,378       25,476       5       11       30  
— cash equivalents
    96,159       43,273       27,073       1,568       646       1,096  
      148,955       71,651       52,549       1,573       657       1,126  
Acquisition of subsidiaries
          60,098                          
Disposal of subsidiaries
    (3,171 )                              
Net cash (outflow)/inflow
    (10,859 )     17,206       19,102       3,496       916       (469 )
At 31 December
    134,925       148,955       71,651       5,069       1,573       657  
                                                 
Comprising:
                                               
Cash and balances at central banks
    12,007       17,428       5,752                    
Treasury bills and debt securities
    15,623       6,818       1,596                    
Loans and advances to banks
    107,295       124,709       64,303       5,069       1,573       657  
Cash and cash equivalents
    134,925       148,955       71,651       5,069       1,573       657  

Certain subsidiary undertakings are required to maintain balances with the Bank of England which, at 31 December 2008, amounted to £393 million (2007 — £439 million). Certain subsidiary undertakings are required by law to maintain reserve balances with the Federal Reserve Bank in the US. Such reserve balances were nil at 31 December 2008 (2007 — US$1 million). ABN AMRO had mandatory reserve deposits of €3 million at 31 December 2008 (2007 — €6 million).
 
244

 



38           Segmental analysis
(a) Divisions
The directors manage the Group primarily by class of business and present the segmental analysis on that basis. The Group’s activities are organised as follows:
 
Global Markets is focused on the provision of debt and equity financing, risk management and transaction banking services to large businesses and financial institutions in the United Kingdom and around the world. Its activities have been organised into two divisions, Global Banking & Markets (GBM) and Global Transaction Services (GTS), in order best to serve the Group’s customers whose financial needs are global.
 
GBM is a leading banking partner to major corporations and financial institutions around the world, providing an extensive range of debt and equity financing, risk management and investment services to its customers.
 
GTS ranks among the top five global transaction services providers, offering global payments, cash and liquidity management, as well as trade finance, UK and international merchant acquiring and commercial card products and services. It includes the Group’s corporate money transmission activities in the United Kingdom and the United States.
 
Regional Markets is organised around the provision of retail and commercial banking to customers in four regions: the United Kingdom, the United States, Europe and the Middle East and Asia. This includes the provision of wealth management services both in the United Kingdom and internationally.
 
UK Retail & Commercial Banking comprises retail, commercial and corporate banking, and wealth management services in the United Kingdom. It supplies financial services through both the Royal Bank and NatWest brands.
 
US Retail & Commercial Banking comprises Citizens which is engaged in retail and corporate banking activities through its branch network in 13 states in the United States and through non-branch offices in other states.
 
Citizens Financial Group provides financial services through the Citizens and Charter One brands.
 
Europe & Middle East Retail & Commercial Banking comprises Ulster Bank and the Group’s combined retail and commercial businesses in Europe and the Middle East.
 
Ulster Bank provides a comprehensive range of financial services across the island of Ireland. Its retail banking arm has a network of branches and operates in the personal, commercial and wealth management sectors, while its corporate markets operations provide services in the corporate and institutional markets.
 
Asia Retail & Commercial Banking holds prominent market positions in India, Pakistan, China and Taiwan, as well as presences in Hong Kong, Indonesia, Malaysia and Singapore. It provides financial services across four segments: affluent banking, cards and consumer finance, business banking and international wealth management, which offers private banking and investment services to clients in selected markets through the RBS Coutts brand.
 
RBS Insurance sells and underwrites retail and SME insurance over the telephone and internet, as well as through brokers and partnerships. Its brands include Direct Line, Churchill, Privilege, Green Flag and NIG. Direct Line, Churchill and Privilege sell general insurance products direct to the customer. Through its international division, RBS Insurance sells general insurance, mainly motor, in Spain, Germany and Italy. The Intermediary and Broker division sells general insurance products through independent brokers.
 
Group Manufacturing comprises the Group’s worldwide manufacturing operations. It supports the Group’s customer-facing businesses and provides operational technology, customer support in telephony, account management, lending and money transmission, global purchasing, property and other services.
 
The Centre comprises group and corporate functions, such as capital raising, finance, risk management, legal, communications and human resources. The Centre manages the Group’s capital resources and Group-wide regulatory projects and provides services to the operating divisions.
 
RFS Holdings minority interest comprises those activities of ABN AMRO that are attributable to the other consortium members.
 
Share of shared assets comprises the Group’s share of the unallocated assets of ABN AMRO.
 
Segments charge market prices for services rendered to other parts of the Group with the exception of Group Manufacturing and central items. The expenditure incurred by Group Manufacturing relates to costs principally in respect of the Group’s banking and insurance operations in the UK and Ireland. These costs reflect activities that are shared between the various customer-facing divisions. These shared costs and related assets and liabilities are not allocated to divisions in the day-to-day management of the businesses and the results below reflect this. Funding charges between segments are determined by Group Treasury, having regard to commercial demands. The results of each division before amortisation of purchased intangible assets, integration costs and net gain on sale of strategic investments and subsidiaries (‘Contribution’) are shown in the following table.
 
 

 
38 Segmental analysis (continued)
   
Group
 
2008
 
Net interest income
£m
   
Non-interest income
£m
   
Total
£m
   
Operating expenses
and insurance claims
£m
   
Depreciation and amortisation
£m
   
Impairment losses
£m
   
Contribution
£m
 
Global Markets
                                         
— Global Banking & Markets
    3,490       (6,010 )     (2,520 )     (3,833 )     (519 )     (3,643 )     (10,515 )
— Global Transaction Services
    909       1,563       2,472       (585 )     (9 )     (60 )     1,818  
Regional Markets
                                                       
— UK Retail & Commercial Banking
    6,999       3,999       10,998       (2,942 )     (413 )     (1,964 )     5,679  
— US Retail & Commercial Banking
    2,106       904       3,010       (942 )     (144 )     (1,041 )     883  
— Europe & Middle East Retail & Commercial Banking
    1,087       431       1,518       (563 )           (526 )     429  
— Asia Retail & Commercial Banking
    379       402       781       (475 )     (8 )     (171 )     127  
RBS Insurance
    647       4,919       5,566       (4,464 )     (40 )     (42 )     1,020  
Group Manufacturing
    (202 )     (11 )     (213 )     (3,867 )     (713 )           (4,793 )
Central Items
    524       (902 )     (378 )     (371 )     55       19       (675 )
Share of shared assets
    (175 )     (18 )     (193 )     (62 )     (41 )     (4 )     (300 )
      15,764       5,277       21,041       (18,104 )     (1,832 )     (7,432 )     (6,327 )
RFS Holdings minority interest
    2,911       1,916       4,827       (3,303 )     (843 )     (640 )     41  
      18,675       7,193       25,868       (21,407 )     (2,675 )     (8,072 )     (6,286 )
Amortisation of intangibles
                            (443 )           (443 )
Integration and restructuring costs
                      (1,321 )  
(36
)           (1,357 )
Goodwill and other intangibles write-downs
                      (32,581 )                 (32,581 )
      18,675       7,193       25,868       (55,309 )     (3,154 )     (8,072 )     (40,667 )
2007
                                                       
Global Markets
                                                       
— Global Banking & Markets
    808       6,011       6,819       (2,613 )     (486 )     (67 )     3,653  
— Global Transaction Services
    595       1,183       1,778       (443 )     (6 )     (14 )     1,315  
Regional Markets
                                                       
— UK Retail & Commercial Banking
    6,602       4,504       11,106       (3,173 )     (340 )     (1,368 )     6,225  
— US Retail & Commercial Banking
    1,935       846       2,781       (844 )     (118 )     (340 )     1,479  
— Europe & Middle East Retail & Commercial Banking
    958       388       1,346       (453 )     (6 )     (118 )     769  
— Asia Retail & Commercial Banking
    123       232       355       (235 )     (5 )     (24 )     91  
RBS Insurance
    611       5,045       5,656       (4,706 )     (45 )           905  
Group Manufacturing
    (192 )     (4 )     (196 )     (2,983 )     (594 )           (3,773 )
Central Items
    69       (141 )     (72 )     (486 )     8       (2 )     (552 )
Share of shared assets
    15       (54 )     (39 )     (37 )           3       (73 )
      11,524       18,010       29,534       (15,973 )     (1,592 )     (1,930 )     10,039  
RFS Holdings minority interest
    545       287       832       (573 )     (58 )     (38 )     163  
      12,069       18,297       30,366       (16,546 )     (1,650 )     (1,968 )     10,202  
Amortisation of intangibles
                      (40 )     (222 )           (262 )
Integration costs
                      (48 )     (60 )           (108 )
      12,069       18,297       30,366       (16,634 )     (1,932 )     (1,968 )     9,832  
2006
                                                       
Global Markets
                                                       
— Global Banking & Markets
    1,028       5,676       6,704       (2,343 )     (465 )     (85 )     3,811  
— Global Transaction Services
    449       1,081       1,530       (334 )     (6 )     (4 )     1,186  
Regional Markets
                                                       
— UK Retail & Commercial Banking
    6,350       4,223       10,573       (3,011 )     (347 )     (1,497 )     5,718  
— US Retail & Commercial Banking
    2,041       949       2,990       (910 )     (156 )     (180 )     1,744  
— Europe & Middle East Retail & Commercial Banking
    824       320       1,144       (360 )     (5 )     (104 )     675  
— Asia Retail & Commercial Banking
    52       159       211       (140 )     (5 )     1       67  
RBS Insurance
    511       5,168       5,679       (4,669 )     (43 )           967  
Group Manufacturing
    (189 )     9       (180 )     (2,784 )     (559 )           (3,523 )
Central Items
    (470 )     (179 )     (649 )     (591 )     18       (9 )     (1,231 )
      10,596       17,406       28,002       (15,142 )     (1,568 )     (1,878 )     9,414  
Amortisation of intangibles
                            (94 )           (94 )
Integration costs
                      (118 )     (16 )           (134 )
      10,596       17,406       28,002       (15,260 )     (1,678 )     (1,878 )     9,186  
 
246

 


   
2008
   
2007
   
2006
 
Total revenue
 
External
£m
   
Inter
segment
£m
   
Total
£m
   
External
£m
   
Inter
segment
£m
   
Total
£m
   
External
£m
   
Inter
segment
£m
   
Total
£m
 
Global Markets
                                                     
— Global Banking & Markets
    10,324       13,135       23,459       13,338       9,544       22,882       11,246       7,638       18,884  
— Global Transaction Services
    3,087       80       3,167       2,959       77       3,036       2,073       4       2,077  
Regional Markets
                                                                       
— UK Retail & Commercial Banking
    18,690       3,718       22,408       18,222       3,820       22,042       16,207       2,804       19,011  
— US Retail & Commercial Banking
    5,031             5,031       5,184             5,184       5,456       2       5,458  
— Europe & Middle East Retail & Commercial Banking
    3,572       738       4,310       2,940       197       3,137       2,373       196       2,569  
— Asia Retail & Commercial Banking
    823       350       1,173       563       330       893       218       252       470  
RBS Insurance
    6,177       33       6,210       6,333       89       6,422       6,365       82       6,447  
Group Manufacturing
    37             37       44       1       45       52       5       57  
Central Items
    1,700       13,405       15,105       1,650       9,972       11,622       296       7,985       8,281  
Share of shared assets
    257             257       264             264                    
      49,698       31,459       81,157       51,497       24,030       75,527       44,286       18,968       63,254  
RFS Holdings minority interest
    9,703       (24 )     9,679       1,534       (255 )     1,279                    
Eliminations
          (31,435 )     (31,435 )           (23,775 )     (23,775 )           (18,968 )     (18,968 )
      59,401             59,401       53,031             53,031       44,286             44,286  

   
2008
   
2007
   
2006
 
Total income
 
External
£m
   
Inter
segment
£m
   
Total
£m
   
External
£m
   
Inter
segment
£m
   
Total
£m
   
External
£m
   
Inter
segment
£m
   
Total
£m
 
Global Markets
                                                     
— Global Banking & Markets
    (99 )     (2,421 )     (2,520 )     8,457       (1,638 )     6,819       8,375       (1,671 )     6,704  
— Global Transaction Services
    2,000       472       2,472       2,134       (356 )     1,778       1,528       2       1,530  
Regional Markets
                                                                       
— UK Retail & Commercial Banking
    12,445       (1,447 )     10,998       11,959       (853 )     11,106       11,495       (922 )     10,573  
— US Retail & Commercial Banking
    3,049       (39 )     3,010       2,837       (56 )     2,781       3,072       (82 )     2,990  
— Europe & Middle East Retail & Commercial Banking
    2,071       (553 )     1,518       1,823       (477 )     1,346       1,297       (153 )     1,144  
— Asia Retail & Commercial Banking
    434       347       781       83       272       355       1       210       211  
RBS Insurance
    5,549       17       5,566       5,649       7       5,656       5,662       17       5,679  
Group Manufacturing
    (204 )     (9 )     (213 )     (192 )     (4 )     (196 )     (159 )     (21 )     (180 )
Central Items
    (4,798 )     4,420       (378 )     (3,576 )     3,504       (72 )     (3,269 )     2,620       (649 )
Share of shared assets
    56       (249 )     (193 )     (39 )           (39 )                  
      20,503       538       21,041       29,135       399       29,534       28,002             28,002  
RFS Holdings minority interest
    5,365       (538 )     4,827       1,231       (399 )     832                    
      25,868             25,868       30,366             30,366       28,002             28,002  
 
Note:
 
(1)
Segmental results for 2007 and 2006 have been restated to reflect transfers of businesses between segments in 2008.
 

   
Group
 
   
2008
   
2007
 
   
Assets
£m
   
Liabilities
£m
   
Cost to
acquire
fixed assets
and intangible
assets
£m
   
Assets
£m
   
Liabilities
£m
   
Cost to
acquire
fixed assets
and intangible
assets
£m
 
Global Markets
                                   
— Global Banking & Markets
    1,672,158       1,580,651       3,105       1,147,384       1,043,060       2,061  
— Global Transaction Services
    23,962       54,109       4       22,730       58,905       15  
Regional Markets
                                               
— UK Retail & Commercial Banking
    249,385       193,101       1,447       232,821       196,674       1,497  
— US Retail & Commercial Banking
    103,940       91,834       204       79,078       67,814       171  
— Europe & Middle East Retail & Commercial Banking
    66,382       48,397       2       56,087       44,772       35  
— Asia Retail & Commercial Banking
    8,284       15,700       18       7,562       11,629       14  
RBS Insurance
    12,855       9,086       61       12,459       8,935       92  
Group Manufacturing
    6,105       2,469       1,235       5,658       2,139       1,001  
Central Items
    73,575       156,984             4,065       75,487        
Share of shared assets
    2,047       2,047             27,222       27,222        
      2,218,693       2,154,378       6,076       1,595,066       1,536,637       4,886  
RFS Holdings minority interest
    182,959       166,776       174       245,763       212,766       675  
    2,401,652       2,321,154       6,250       1,840,829       1,749,403       5,561  
 

247

 

 
 
38 Segmental analysis (continued)
Owners’ equity
   
2008
£m
     
2007
£m
 
Global Markets
               
— Global Banking & Markets
    17,100       9,076  
— Global Transaction Services
    1,202       567  
Regional Markets
               
— UK Retail & Commercial Banking
    9,928       8,696  
— US Retail & Commercial Banking
    10,035       10,865  
— Europe & Middle East Retail & Commercial Banking
    1,894       1,652  
— Asia Retail & Commercial Banking
    396       149  
RBS Insurance
    3,048       2,646  
Group Manufacturing
    257       149  
Central Items
    15,019       19,238  
      58,879       53,038  
 
Note:
 
(1)
Segmental results for 2007 have been restated to reflect transfers of businesses between segments in 2008.
 
 
Segmental analysis of goodwill is as follows:
 
   
Global Banking & Markets
£m
   
Global Transaction Services
£m
   
UK Retail & Commercial Banking
£m
   
US Retail & Commercial Banking
£m
   
Europe & Middle East Retail & Commercial Banking
£m
   
Asia Retail & Commercial Banking
£m
   
RBS Insurance
£m
   
RFS Holdings minority interest
£m
   
Total
£m
 
At 1 January 2007
    2,281       1,742       6,172       5,429       903       298       1,064             17,889  
Currency translation and other adjustments
    227       24             (103 )     48       34             957       1,187  
Acquisitions
    4,834       865             66       118       570             17,464       23,917  
Goodwill written off
          (40 )                                         (40 )
At 1 January 2008
    7,342       2,591       6,172       5,392       1,069       902       1,064       18,421       42,953  
Transfers to disposal groups
                                              (3,692 )     (3,692 )
Currency translation and other adjustments
    1,475       678       (2 )     2,013       173       225       7       4,336       8,905  
Acquisitions
    448       42                   6       28                   524  
Disposals
    (2 )                       (47 )                 (3,017 )     (3,066 )
Write-down of goodwill
    (8,946 )     (44 )     (46 )     (4,382 )     (1,201 )     (863 )     (42 )     (14,538 )     (30,062 )
At 31 December 2008
    317       3,267       6,124       3,023             292       1,029       1,510       15,562  
 
 
 



(b) Geographical segments
The geographical analyses in the tables below have been compiled on the basis of location of office where the transactions are recorded.
 
   
Group
 
   
UK
   
USA
   
Europe
   
Rest of the World
   
Total
   
Less: RFS Holdings minority interest
   
Group
 
2008
    £m       £m       £m       £m       £m       £m       £m  
Total revenue
    23,748       8,518       21,112       6,023       59,401       9,679       49,722  
                                                         
Net interest income
    9,853       2,790       5,018       1,014       18,675       2,911       15,764  
Net fees and commissions
    3,728       1,492       1,648       577       7,445       1,011       6,434  
Income from trading activities
    (7,103 )     (1,604 )     (552 )     782       (8,477 )     352       (8,829 )
Other operating income
    2,337       49       (528 )     41       1,899       (64 )     1,963  
Insurance premium income (net of reinsurers’ share)
    5,190             1,136             6,326       617       5,709  
Total income
    14,005       2,727       6,722       2,414       25,868       4,827       21,041  
                                                         
Operating (loss)/profit before tax
    (7,989 )     (5,809 )     (26,883 )     14       (40,667 )     (15,629 )     (25,038 )
                                                         
Total assets
    1,304,714       607,511       368,290       121,137       2,401,652       182,959       2,218,693  
                                                         
Total liabilities
    1,253,814       592,272       361,590       113,478       2,321,154       166,776       2,154,378  
                                                         
Net assets attributable to equity owners and minority interests
    50,900       15,239       6,700       7,659       80,498       16,183       64,315  
                                                         
Contingent liabilities and commitments
    200,763       131,435       79,941       21,122       433,261       9,272       423,989  
                                                         
Cost to acquire property, plant and equipment and intangible assets
    3,415       445       2,204       186       6,250       174       6,076  
                                                         
2007
                                                       
Total revenue
    33,743       8,570       8,140       2,578       53,031       1,678       51,353  
                                                         
Net interest income
    8,350       2,054       1,510       155       12,069       545       11,524  
Net fees and commissions
    3,933       1,176       560       416       6,085       224       5,861  
Income from trading activities
    1,252       (486 )     348       178       1,292       (139 )     1,431  
Other operating income
    3,844       260       587       142       4,833       96       4,737  
Insurance premium income (net of reinsurers’ share)
    5,562             525             6,087       106       5,981  
Total income
    22,941       3,004       3,530       891       30,366       832       29,534  
                                                         
Operating profit before tax
    7,761       719       1,136       216       9,832       163       9,669  
                                                         
Total assets
    938,064       340,170       422,058       140,537       1,840,829       245,763       1,595,066  
                                                         
Total liabilities
    902,340       326,499       392,362       128,202       1,749,403       212,766       1,536,637  
                                                         
Net assets attributable to equity owners and minority interests
    35,724       13,671       29,696       12,335       91,426       32,997       58,429  
Contingent liabilities and commitments
    197,637       95,547       82,316       24,599       400,099       21,000       379,099  
Cost to acquire property, plant and equipment and intangible assets
    3,305       238       1,793       225       5,561       675       4,886  
 
249

 


38 Segmental analysis (continued)
   
Group
 
   
UK
   
USA
   
Europe
   
Rest of the World
   
Total
 
2006
    £m       £m       £m       £m       £m  
Total revenue
    29,162       9,411       4,683       1,030       44,286  
Net interest income
    7,541       2,278       709       68       10,596  
Net fees and commissions
    3,443       1,245       412       94       5,194  
Income from trading activities
    1,585       939       108       43       2,675  
Other operating income
    2,766       295       491       12       3,564  
Insurance premium income (net of reinsurers’ share)
    5,604             369             5,973  
Total income
    20,939       4,757       2,089       217       28,002  
                                         
Operating profit before tax
    6,038       2,334       785       29       9,186  
                                         
Total assets
    579,075       197,421       60,759       19,577       856,832  
                                         
Total liabilities
    557,605       183,430       56,662       13,645       811,342  
                                         
Net assets attributable to equity owners and minority interests
    21,470       13,991       4,097       5,932       45,490  
                                         
Contingent liabilities and commitments
    186,627       57,873       13,244       7,159       264,903  
                                         
Cost to acquire property, plant and equipment and intangible assets
    3,040       254       1,427       19       4,740  

 
39           Directors’ and key management remuneration
   
Group
 
   
2008
   
2007
 
Directors’ remuneration
    £000       £000  
Non-executive directors — emoluments
    1,408       1,081  
Chairman and executive directors — emoluments
    7,132       16,461  
— contributions and allowances in respect of defined contribution pension schemes
    3       30  
      8,543       17,572  
— amounts receivable under long-term incentive plans
    646       1,839  
— gains on exercise of share options
    77       1,474  
      9,266       20,885  

 
Retirement benefits are accruing to one director (2007 — five) under defined benefit schemes. No directors (2007 — one) are accruing benefits under defined contribution schemes.
 
The executive directors may also participate in the company’s executive share option and sharesave schemes and details of their interests in the company’s shares arising from their participation are given on page 148. Details of the remuneration received by each director during the year and each director’s pension arrangements are given on pages 147 to 152.
 
Compensation of key management
The aggregate remuneration of directors and other members of key management during the year was as follows:
   
Group
 
   
2008
   
2007
 
      £000       £000  
Short-term benefits
    16,813       37,763  
Post-employment benefits
    13,174       10,051  
Other long-term
    496       708  
Termination benefits
    345        
Share-based payments
    2,078       5,165  
      32,906       53,687  
 
 
250

 


40           Transactions with directors, officers and others
(a)
At 31 December 2008, the amounts outstanding in relation to transactions, arrangements and agreements entered into by authorised institutions in the Group, as defined in UK legislation, were £117,847 in respect of loans to 27 persons who were directors of the company (or persons connected with them) at any time during the financial period.
 
(b)
For the purposes of IAS 24 ‘Related Party Disclosures’, key management comprise directors of the company and members of the Group Executive Management Committee. The captions in the Group’s primary financial statements include the following amounts attributable, in aggregate, to key management:
 
   
2008
   
2007
 
      £000       £000  
Loans and advances to customers
    4,217       2,023  
Customer accounts
    9,572       13,309  

Key management have banking relationships with Group entities which are entered into in the normal course of business and on substantially the same terms, including interest rates and security, as for comparable transactions with other persons of a similar standing or, where applicable, with other employees. These transactions did not involve more than the normal risk of repayment or present other unfavourable features.
 
Key management had no reportable transactions or balances with the company except for dividends.
 
41           Related parties
(a)
In their roles as providers of finance, Group companies provide development and other types of capital support to businesses. These investments are made in the normal course of business and on arm’s-length terms. In some instances, the investment may extend to ownership or control over 20% or more of the voting rights of the investee company. However, these investments are not considered to give rise to transactions of a materiality requiring disclosure under IAS 24.
 
(b)
The Group recharges The Royal Bank of Scotland Group Pension Fund with the cost of administration services incurred by it. The amounts involved are not material to the Group.
 
(c)
In accordance with IAS 24, transactions or balances between Group entities that have been eliminated on consolidation are not reported.
 
(d)
The captions in the primary financial statements of the parent company include amounts attributable to subsidiaries. These amounts have been disclosed in aggregate in the relevant notes to the financial statements.
 
(e)
On 1 December 2008, the UK Government through HM Treasury became the ultimate controlling party of The Royal Bank of Scotland Group plc. The UK Government’s shareholding is managed by UK Financial Investments Limited, a company wholly owned by the UK Government. As a result the UK Government and UK Government controlled bodies became related parties of the Group. The Group enters into transactions with many of these bodies on an arms' length basis. The volume and diversity of such transaction are such that disclosure of their amounts in the period 1 December 2008 to 31 December 2008 is impractical.
 
As at 31 December 2008 balances with the UK Government and UK Government controlled bodies were:
 
   
Central government (including the Bank of England)
   
Local
government
   
Banks, financial corporations and public corporations
   
2008
Total
 
      £m       £m       £m       £m  
Assets
                               
Balances at central banks
    393                   393  
Loans and advances to banks
                1,081       1,081  
Loans and advances to customers
    5       721       468       1,194  
Debt securities
    21,628             113       21,741  
Derivatives
    1,286       64       17       1,367  
Other
    249                   249  
                                 
Liabilities
                               
Deposits by banks
    26,541             633       27,174  
Customer accounts
    1,536       3,320       598       5,454  
Derivatives
    276       78       29       383  
Other
    176                   176  
 
Notes:
 
(1)
In addition to UK Government’s shareholding in the Group, the UK Government and UK Government controlled bodies may hold debt securities, subordinated liabilities and other liabilities or shares issued by the Group in the normal course of their business. It is not practicable to ascertain and disclose these amounts.
 
(2)
Certain of the liability balances are secured.
 

 
 
41 Related parties (continued)
 
No impairment losses were recognised by the Group in 2008 in respect of balances with UK Government and UK Government controlled bodies.
 
The Group participates in a number of schemes operated by the Bank of England and the UK Government and made available to eligible banks and building societies.
 
Bank of England facilities include:
 
· 
Open market operations — these provide market participants with funding at market rates on a tender basis in the form of short and long-term repos on a wide range of collateral and outright purchases of high-quality bonds to enable them to meet the reserves that they must hold at the Bank of England.
 
· 
US dollar repo operations — these commenced in September 2008 taking the form of an auction. Eligible collateral consists of securities routinely eligible in the Bank's short-term repo open market operations together with conventional US Treasuries.
 
· 
The special liquidity scheme — this was launched in April 2008 to allow financial institutions to swap temporarily illiquid assets for treasury bills, with fees charged based on the spread between 3-month LIBOR and the 3-month gilt repo rate.
 
As at 31 December 2008, the Group’s utilisation of these facilities amounted to £41.8 billion.
 
Government credit guarantee scheme — this was announced in October 2008. The Government, in return for a fee (50 basis points plus the bank’s median five-year credit default spread during the twelve months to 7 October 2008), guarantees new unsecured borrowing.
 
As at 31 December 2008, the Group had obtained funding from the Bank of England and issued debt guaranteed by the government totalling £32.2 billion.
 
42           Post balance sheet events
There have been no significant events between the year end and the date of approval of these accounts which would require a change to or disclosure in the accounts.
 
 
 
 
Additional information

 
 
254
Financial Summary
254
Amounts in accordance with IFRS
263
Exchange rates
264
Economic and monetary environment
265
Supervision
266
Regulatory reviews and developments
267
Description of property and equipment
267
Major shareholders
267
Material contracts
272
FSA Listing Rules disclosure
 


 
Financial Summary
The Group’s financial statements are prepared in accordance with IFRS as issued by the IASB. Selected data under IFRS for each of the five years ended 31 December 2008 are presented on pages 254 to 262.
 
The dollar financial information included below has been converted from sterling at a rate of £1.00 to US$1.4619, being the Noon Buying Rate on 31 December 2008.
 
Amounts in accordance with IFRS
   
2008
   
2008
   
2007
   
2006
   
2005
   
2004
 
Summary consolidated income statement — IFRS
    $m       £m       £m       £m       £m       £m  
Net interest income
    27,301       18,675       12,069       10,596       9,918       9,071  
Non-interest income (1)
    10,515       7,193       18,297       17,406       15,984       14,320  
Total income
    37,816       25,868       30,366       28,002       25,902       23,391  
Operating expenses (2, 3, 4, 5, 6)
    78,991       54,033       13,942       12,480       11,946       10,362  
(Loss)/profit before other operating charges and impairment losses
    (41,175 )     (28,165 )     16,424       15,522       13,956       13,029  
Insurance net claims
    6,476       4,430       4,624       4,458       4,313       4,260  
Impairment
    11,800       8,072       1,968       1,878       1,707       1,485  
Operating (loss)/profit before tax
    (59,451 )     (40,667 )     9,832       9,186       7,936       7,284  
Tax
    (3,396 )     (2,323 )     2,044       2,689       2,378       1,995  
(Loss)/profit from continuing operations
    (56,055 )     (38,344 )     7,788       6,497       5,558       5,289  
Profit/(loss) from discontinued operations, net of tax
    5,805       3,971       (76 )                  
(Loss)/profit for the year
    (50,250 )     (34,373 )     7,712       6,497       5,558       5,289  
                                                 
(Loss)/profit attributable to:
                                               
Minority interests
    (15,835 )     (10,832 )     163       104       57       177  
Other owners
    871       596       246       191       109       256  
Ordinary shareholders
    (35,286 )     (24,137 )     7,303       6,202       5,392       4,856  

Notes:
 
(1)
Includes gain on sale of strategic investment of £333 million in 2005.
 
(2)
Includes loss on sale of subsidiaries of £93 million in 2005.
 
(3)
Includes integration expenditure of £1,050 million in 2008 (2007 — £108 million; 2006 — £134 million; 2005 — £458 million; 2004 —£520 million).
 
(4)
Includes purchased intangibles amortisation of £919 million in 2008 (2007 — £234 million; 2006 — £94 million; 2005 — £97 million; 2004 —£45 million).
 
(5)
Includes restructuring expenditure of £307 million in 2008.
 
(6)
Includes write-down of goodwill and other intangibles assets of £32,581 million in 2008.
 

   
2008
   
2008
   
2007
   
2006
   
2005
   
2004
 
Summary consolidated balance sheet — IFRS
    $m       £m       £m       £m       £m       £m  
Loans and advances (1)
    1,480,786       1,012,919       1,047,998       549,499       487,813       408,324  
Debt securities and equity shares
    429,622       293,879       347,682       146,246       135,804       104,741  
Derivatives and settlement balances (2)
    1,477,091       1,010,391       293,991       109,506       89,470       15,193  
Other assets (1)
    123,476       84,463       151,158       51,581       51,542       51,575  
Total assets
    3,510,975       2,401,652       1,840,829       856,832       764,629       579,833  
                                                 
Owners’ equity
    86,075       58,879       53,038       40,227       35,435       33,905  
Minority interests
    31,605       21,619       38,388       5,263       2,109       3,492  
Subordinated liabilities (1)
    71,858       49,154       38,043       27,654       28,274       20,366  
Deposits (1)
    1,312,137       897,556       994,657       516,365       453,274       383,198  
Derivatives, settlement balances and short positions (2)
    1,499,385       1,025,641       363,073       152,988       128,228       43,577  
Other liabilities (1)
    509,915       348,803       353,630       114,335       117,309       95,295  
Total liabilities and equity
    3,510,975       2,401,652       1,840,829       856,832       764,629       579,833  
 
Notes:
 
(1)
2007 comparative data have been restated following finalisation of the ABN AMRO acquisition accounting.
 
(2)
2007 to 2004 comparative amounts have been restated for the netting of certain derivative asset and derivative liability balances with the London Clearing House.
 


 
The per share data in the table below have been restated for the effect of the rights issue in June 2008 and the capitalisation issue in September 2008.
 
Other financial data based upon IFRS
 
2008
   
2007
   
2006
   
2005
   
2004
 
Earnings per ordinary share — pence
    (145.7 )     64.0       54.4       47.3       43.9  
Diluted earnings per ordinary share — pence (1)
    (145.7 )     63.4       53.9       47.0       43.5  
Dividends per ordinary share — pence
    19.3       27.0       21.6       17.0       14.7  
Dividend payout ratio (2)
          45%       46%       43%       38%  
Share price per ordinary share at year end — £
    0.494       3.72       5.56       4.90       4.89  
Market capitalisation at year end — £bn
    19.5       44.4       62.8       56.1       55.6  
Net asset value per ordinary share — £
    1.15       3.74       3.24       2.83       2.59  
Return on average total assets (3)
    (1.18% )     0.65%       0.74%       0.73%       0.94%  
Return on average ordinary shareholders’ equity (4)
    (50.0% )     18.8%       18.5%       17.5%       18.3%  
Average owners’ equity as a percentage of average total assets
    2.9%       3.9%       4.4%       4.5%       5.9%  
Risk asset ratio — Tier 1
    10.0%       7.3%       7.5%       7.6%       7.0%  
Risk asset ratio — Total
    14.1%       11.2%       11.7%       11.7%       11.7%  
Ratio of earnings to combined fixed charges and preference share dividends (5)
                   
— including interest on deposits
    (0.29 )     1.45       1.62       1.67       1.88  
— excluding interest on deposits
    (11.96 )     5.73       6.12       6.05       7.43  
Ratio of earnings to fixed charges only (5)
                                       
— including interest on deposits
    (0.30 )     1.47       1.64       1.69       1.94  
— excluding interest on deposits
    (14.71 )     6.53       6.87       6.50       9.70  
 
Notes:
 
(1)
None of the convertible preference shares had a dilutive effect in 2008. All the convertible preference shares had a dilutive effect in 2007, 2006 and 2005 and as such were included in the computation of diluted earnings per share. In 2004, $1,500 million of convertible preference shares was not included in the computation of diluted earnings per share as their effect was anti-dilutive.
 
(2)
Dividend payout ratio represents the interim dividend paid and current year final dividend proposed as a percentage of profit attributable to ordinary shareholders.
 
(3)
Return on average total assets represents profit attributable to ordinary shareholders as a percentage of average total assets.
 
(4)
Return on average ordinary shareholders’ equity represents profit attributable to ordinary shareholders expressed as a percentage of average ordinary shareholders’ equity.
 
(5)
For this purpose, earnings consist of income before tax and minority interests, plus fixed charges less the unremitted income of associated undertakings (share of profits less dividends received). Fixed charges consist of total interest expense, including or excluding interest on deposits and debt securities in issue, as appropriate, and the proportion of rental expense deemed representative of the interest factor (one third of total rental expenses).
 

 
 
Amounts in accordance with IFRS (continued)
Analysis of loans and advances to customers — IFRS
The following table analyses loans and advances to customers before provisions by remaining maturity, geographical area and type of customer.
 
   
Within
1 year
   
After 1
but within
5 years
   
After
5 years
   
2008
Total
   
2007
   
2006
   
2005
   
2004
 
      £m       £m       £m       £m       £m       £m       £m       £m  
UK
                                                               
Central and local government
    2,760       27       304       3,091       3,135       6,732       3,340       1,866  
Manufacturing
    8,615       4,552       1,907       15,074       13,452       11,051       11,615       6,292  
Construction
    6,465       2,482       1,224       10,171       10,202       8,251       7,274       5,024  
Finance
    35,055       3,547       3,830       42,432       70,006       25,017       27,091       24,638  
Service industries and business activities
    25,763       13,076       19,799       58,638       53,965       43,887       40,687       30,867  
Agriculture, forestry and fishing
    1,361       302       1,309       2,972       2,473       2,767       2,645       2,481  
Property
    19,231       15,251       17,645       52,127       50,051       39,296       32,899       26,448  
Individuals — home mortgages
    19,005       1,672       60,290       80,967       73,916       70,884       65,286       57,535  
— other
    20,027       3,337       3,625       26,989       28,186       27,922       26,323       26,459  
Finance leases and instalment credit
    2,705       6,666       7,992       17,363       15,632       14,218       13,909       13,044  
Accrued interest
    2,348       29       86       2,463       2,344       1,497       1,250        
Total domestic
    143,335       50,941       118,011       312,287       323,362       251,522       232,319       194,654  
Overseas residents
    60,415       36,570       22,671       119,656       98,845       69,242       52,234       48,183  
Total UK offices
    203,750       87,511       140,682       431,943       422,207       320,764       284,553       242,837  
                                                                 
Overseas
                                                               
US
    38,706       42,123       45,448       126,277       135,059       92,166       90,606       74,027  
Rest of the World
    107,184       66,794       153,413       327,391       277,721       57,896       45,951       34,555  
Total Overseas offices
    145,890       108,917       198,861       453,668       412,780       150,062       136,557       108,582  
Loans and advances to customers — gross
    349,640       196,428       339,543       885,611       834,987       470,826       421,110       351,419  
Loan impairment provisions
                            (10,889 )     (6,449 )     (3,933 )     (3,884 )     (4,168 )
Loans and advances to customers — net
                            874,722       828,538       466,893       417,226       347,251  
                                                                 
Fixed rate
    57,671       46,487       79,536       183,693       351,336       115,240       100,748       101,227  
Variable rate
    291,969       149,941       260,007       701,918       483,651       355,586       320,362       250,192  
Loans and advances to customers — gross
    349,640       196,428       339,543       885,611       834,987       470,826       421,110       351,419  

Cross border exposures
Cross border exposures are defined as loans to banks and customers (including finance lease and instalment credit receivables) and other monetary assets, including non-local currency claims of overseas offices on local residents.
 
The Group monitors the geographical breakdown of these exposures based on the country of domicile of the borrower or guarantor of ultimate risk.
 
The table below sets out the Group’s cross border outstandings in excess of 0.75% of Group total assets (including acceptances), which totalled £2,401.7 billion at 31 December 2008 (2007 — £1,840.8 billion; 2006 — £856.8 billion). None of these countries has experienced repayment difficulties that have required refinancing of outstanding debt.
 
   
2008
   
2007
   
2006
 
      £m       £m       £m  
United States
    91,544       91,653       43,718  
France
    58,251       65,430       18,136  
Germany
    40,812       51,123       20,130  
Spain
    36,441       31,651       9,341  
Netherlands
    34,283       27,707       12,407  
Republic of Ireland
    18,662       17,736       8,530  
Cayman Islands
    18,126       17,099       9,063  
Japan
    *       31,922       7,725  
Italy
    *       23,925       7,506  
Norway
    *       *       7,768  
Switzerland
    *       *       7,262  
China
    *       *       6,574  
 
*
Less than 0.75% of Group total assets.
 


Loan impairment provisions
For a discussion of the factors considered in determining the amount of the provisions, see ‘Impairment’ on page 78 and ‘Critical accounting policies — Loan impairment provisions’ on pages 169 and 170.
 
The following table shows the elements of loan impairment provisions.
 
   
IFRS
 
   
2008
   
2007
   
2006
   
2005
   
2004
 
      £m       £m       £m       £m       £m  
Provisions at the beginning of the year
                                       
Domestic
    3,258       3,037       2,759       2,675       2,408  
Foreign
    3,194       898       1,128       1,470       1,477  
      6,452       3,935       3,887       4,145       3,885  
Transfer to disposal groups
                                       
Domestic
                             
Foreign
    (767 )                        
      (767 )                        
Currency translation and other adjustments
                                       
Domestic
    107       5       (17 )     (7 )     (8 )
Foreign
    1,334       178       (44 )     58       (90 )
      1,441       183       (61 )     51       (98 )
(Disposals)/acquisitions of businesses
                                       
Domestic
    (108 )     10                   2  
Foreign
    (70 )     2,211                   288  
      (178 )     2,221                   290  
Amounts written-off
                                       
Domestic
    (1,446 )     (1,222 )     (1,360 )     (1,252 )     (901 )
Foreign
    (1,702 )     (789 )     (481 )     (788 )     (548 )
      (3,148 )     (2,011 )     (1,841 )     (2,040 )     (1,449 )
Recoveries of amounts written-off in previous years
                                       
Domestic
    116       158       119       97       85  
Foreign
    203       184       96       75       59  
      319       342       215       172       144  
Charged to income statement
                                       
Domestic
    2,698       1,420       1,663       1,376       960  
Foreign
    4,393       526       214       327       442  
      7,091       1,946       1,877       1,703       1,402  
Unwind of discount
                                       
Domestic
    (151 )     (150 )     (127 )     (130 )      
Foreign
    (43 )     (14 )     (15 )     (14 )      
      (194 )     (164 )     (142 )     (144 )      
Provisions at the end of the year (1)
                                       
Domestic
    4,474       3,258       3,037       2,759       2,546  
Foreign
    6,542       3,194       898       1,128       1,628  
      11,016       6,452       3,935       3,887       4,174  
                                         
Gross loans and advances to customers
                                       
Domestic
    312,287       323,362       251,522       232,319       194,654  
Foreign
    573,324       511,625       219,304       188,791       156,765  
      885,611       834,987       470,826       421,110       351,419  
                                         
Closing customer provisions as a % of gross loans and advances to customers (2)
                                       
Domestic
    1.43 %     1.01 %     1.21 %     1.19 %     1.31 %
Foreign
    1.12 %     0.62 %     0.41 %     0.60 %     1.04 %
Total
    1.23 %     0.77 %     0.84 %     0.92 %     1.19 %
                                         
Customer charge to income statement as a % of gross loans and advances to customers
                                       
Domestic
    0.86 %     0.44 %     0.66 %     0.59 %     0.49 %
Foreign
    0.75 %     0.10 %     0.10 %     0.17 %     0.28 %
Total
    0.79 %     0.23 %     0.40 %     0.40 %     0.40 %
 
Notes:
 
(1)
Includes closing provisions against loans and advances to banks of £127 million (2007 — £3 million; 2006 — £2 million; 2005 — £3 million; 2004 —£6 million).
 
(2)
Closing customer provisions exclude closing provisions against loans and advances to banks.
 

 
 
Amounts in accordance with IFRS (continued)
Loan impairment provisions (continued)
The following table shows additional information in respect of the loan impairment provisions.
 
   
IFRS
 
   
2008
   
2007
   
2006
   
2005
   
2004
 
      £m       £m       £m       £m       £m  
Loan impairment provisions at end of year:
                                       
– customers
    10,889       6,449       3,933       3,884          
– banks
    127       3       2       3          
Specific provisions
                                       
– customers
                                    3,607  
– banks
                                    6  
General provision
                                    561  
      11,016       6,452       3,935       3,887       4,174  
                                         
Average loans and advances to customers (gross)
    858,333       567,900       445,766       402,473       299,430  
                                         
As a % of average loans and advances to customers during the year:
                                       
Total customer provisions charged to income statement
    0.81 %     0.34 %     0.42 %     0.42 %     0.47 %
                                         
Amounts written-off (net of recoveries) – customers
    0.33 %     0.29 %     0.36 %     0.46 %     0.44 %

Analysis of closing loan impairment provisions
The following table analyses customer loan impairment provisions by geographical area and type of domestic customer.
 
   
IFRS
 
   
2008
   
2007
   
2006
   
2005
   
2004
 
   
Closing provision
   
% of loans to total loans
   
Closing provision
   
% of loans to total loans
   
Closing provision
   
% of loans to total loans
   
Closing provision
   
% of loans to total loans
   
Closing provision
   
% of loans to total loans
 
      £m    
%
      £m    
%
      £m    
%
      £m    
%
      £m    
%
 
Domestic
                                                                     
Central and local government
          0.3             0.4             1.4             0.8             0.6  
Manufacturing
    127       1.7       93       1.6       94       2.4       138       2.8       127       1.8  
Construction
    254       1.1       75       1.2       63       1.8       74       1.7       71       1.4  
Finance
    67       4.8       52       8.4       33       5.3       104       6.4       54       7.0  
Service industries and business activities
    778       6.6       562       6.5       647       9.3       647       9.7       516       8.8  
Agriculture, forestry and fishing
    19       0.3       21       0.3       25       0.6       26       0.6       23       0.7  
Property
    490       5.9       85       6.0       70       8.3       63       7.8       64       7.5  
Individuals — home mortgages
    36       9.1       36       8.8       37       15.1       36       15.5       32       16.4  
— other
    2,235       3.0       2,054       3.4       1,826       5.9       1,513       6.3       1,277       7.5  
Finance leases and instalment credit
    194       2.0       132       1.9       103       3.0       88       3.3       122       3.7  
Accrued interest
          0.3             0.3             0.3             0.3                  
Total domestic
    4,200       35.1       3,110       38.8       2,898       53.4       2,689       55.2       2,286       55.4  
Foreign
    4,745       64.9       2,289       61.2       442       46.6       652       44.8       1,321       44.6  
Impaired book provisions
    8,945       100.0       5,399       100.0       3,340       100.0       3,341       100.0               100.0  
Latent book provisions
    1,944               1,050               593               543                          
Specific provisions
                                                                    3,607          
General provision
                                                                    561          
Total provisions
    10,889               6,449               3,933               3,884               4,168          
 

 

Analysis of write-offs
The following table analyses amounts written-off by geographical area and type of domestic customer.
 
   
IFRS
 
   
2008
   
2007
   
2006
   
2005
   
2004
 
      £m       £m       £m       £m       £m  
Domestic
                                       
Manufacturing
    61       29       41       40       55  
Construction
    51       21       29       17       12  
Finance
    31       47       17       21       19  
Service industries and business activities
    299       190       212       176       163  
Agriculture, forestry and fishing
    5       4       5       4       9  
Property
    34       9       6       25       33  
Individuals — home mortgages
    1             5       4       4  
— others
    938       909       1,021       950       516  
Finance leases and instalment credit
    26       13       24       15       90  
Total domestic
    1,446       1,222       1,360       1,252       901  
Foreign
    1,702       789       481       788       548  
Total write-offs (1)
    3,148       2,011       1,841       2,040       1,449  
 
Note:
 
(1)  Excludes £2 million written-off in respect of loans and advances to banks in 2005.

 
Analysis of recoveries
The following table analyses recoveries of amounts written-off by geographical area and type of domestic customer.
 
   
IFRS
 
   
2008
   
2007
   
2006
   
2005
   
2004
 
        £m       £m       £m       £m       £m  
Domestic
                                       
Manufacturing
    2                   1       1  
Construction
                      1        
Finance
    2                         2  
Service industries and business activities
    12       7       5       2       1  
Property
                1       2        
Individuals — home mortgages
                            1  
— others
    96       143       101       84       78  
Finance leases and instalment credit
    4       8       12       7       2  
Total domestic
    116       158       119       97       85  
Foreign
    203       184       96       75       59  
Total recoveries
    319       342       215       172       144  
 


Amounts in accordance with IFRS (continued)
Risk elements in lending and potential problem loans
The Group’s loan control and review procedures do not include the classification of loans as non-accrual, accruing past due, restructured and potential problem loans, as defined by the SEC in the US. The following table shows the estimated amount of loans that would be reported using the SEC’s classifications. The figures are stated before deducting the value of security held or related provisions.
 
IFRS require interest to be recognised on a financial asset (or a group of financial assets) after impairment at the rate of interest used to discount recoveries when measuring the impairment loss. Thus, interest on impaired financial assets is credited to profit or loss as the discount on expected recoveries unwinds. Despite this, such assets are not considered performing. All loans that have an impairment provision are classified as non-accrual. This is a change from practice in 2004 and earlier years where certain loans with provisions were classified as past due 90 days or potential problem loans (and interest accrued on them).
 
   
IFRS
 
   
2008
   
2007
   
2006
   
2005
   
2004
 
     
£m
     
£m
     
£m
     
£m
     
£m
 
Loans accounted for on a non-accrual basis (2):
                                       
Domestic
    8,588       5,599       5,420       4,977       3,658  
Foreign
    10,891       4,763       812       949       1,075  
Total
    19,479       10,362       6,232       5,926       4,733  
Accruing loans which are contractually overdue
                                       
90 days or more as to principal or interest (3):
                                       
Domestic
    1,201       217       81       2       634  
Foreign
    581       152       24       7       79  
Total
    1,782       369       105       9       713  
Loans not included above which are classified as
                                       
‘troubled debt restructurings’ by the SEC:
                                       
Domestic
                      2       14  
Foreign
                            10  
Total
                      2       24  
Total risk elements in lending
    21,261       10,731       6,337       5,937       5,470  
                                         
Potential problem loans (4)
                                       
Domestic
    218       63       47       14       173  
Foreign
    8       608       5       5       107  
Total potential problem loans
    226       671       52       19       280  
Closing provisions for impairment as a % of total risk elements in lending
    52 %     60 %     62 %     65 %     76 %
Closing provisions for impairment as a % of total risk elements in lending and potential problem loans
    51 %     57 %     62 %     65 %     72 %
Risk elements in lending as a % of gross lending to customers excluding reverse repos
    2.51 %     1.55 %     1.55 %     1.60 %     1.83 %

Notes:
 
(1)
For the analysis above, ‘Domestic’ consists of the United Kingdom domestic transactions of the Group. ‘Foreign’ comprises the Group’s transactions conducted through offices outside the UK and through those offices in the UK specifically organised to service international banking transactions.
 
(2)
All loans against which an impairment provision is held are reported in the non-accrual category.
 
(3)
Loans where an impairment event has taken place but no impairment recognised. This category is used for fully collateralised non-revolving credit facilities.
 
(4)
Loans for which an impairment event has occurred but no impairment provision is necessary. This category is used for fully collateralised advances and revolving credit facilities where identification as 90 days overdue is not feasible.
 
   
IFRS
 
   
2008
   
2007
   
2006
   
2005
   
2004
 
     
£m
     
£m
     
£m
     
£m
     
£m
 
Gross income not recognised but which would have been recognised under the original terms of non-accrual and restructured loans:
                                       
Domestic
    393       390       370       334       235  
Foreign
    342       155       77       62       58  
      735       545       447       396       293  
Interest on non-accrual and restructured loans included in net interest income:
                                       
Domestic
    150       165       142       130       58  
Foreign
    43       16       15       14       7  
      193       181       157       144       65  
 
260

 

 
 
Analysis of deposits — product analysis
The following table shows the distribution of the Group’s deposits by type and geographical area.
 
   
IFRS
 
   
2008
   
2007
   
2006
 
     
£m
     
£m
     
£m
 
UK
Domestic:
                       
Demand deposits – interest-free
    43,376       43,721       39,149  
– interest-bearing
    107,159       121,343       118,315  
Time deposits – savings
    88,434       41,185       31,656  
– other
    130,951       207,263       80,496  
Overseas residents:
                       
Demand deposits – interest-free
    907       563       573  
– interest-bearing
    16,320       25,129       37,729  
Time deposits – savings
    1,819       605       1,122  
– other
    67,477       87,437       51,568  
Total UK offices
    456,443       527,246       360,608  
Overseas
                       
Demand deposits – interest-free
    29,253       27,959       12,173  
– interest-bearing
    92,354       70,758       27,441  
Time deposits – savings
    68,014       52,381       19,049  
– other
    251,492       316,313       97,094  
Total overseas offices
    441,113       467,411       155,757  
Total deposits
    897,556       994,657       516,365  
                         
Held-for-trading
    137,080       125,917       104,249  
Designated as at fair value through profit or loss
    8,054       7,505       3,922  
Amortised cost
    752,422       861,235       408,194  
Total deposits
    897,556       994,657       516,365  
                         
Overseas
                       
US
    153,163       152,324       115,121  
Rest of the World
    287,950       315,087       40,636  
Total overseas offices
    441,113       467,411       155,757  
 

 
 
Amounts in accordance with IFRS (continued)
Short term borrowings
 
   
IFRS
 
   
2008
   
2007
   
2006
 
     
£m
     
£m
     
£m
 
Commercial paper
                       
Outstanding at year end
    78,581       78,612       12,675  
Maximum outstanding at any month end during the year
    111,108       81,187       14,402  
Approximate average amount during the year
    98,150       32,498       13,225  
Approximate weighted average interest rate during the year
    3.3%       4.8%       4.9%  
Approximate weighted average interest rate at year end
    3.0%       5.5%       5.0%  
                         
Other short term borrowings
                       
Outstanding at year end
    194,346       280,526       122,576  
Maximum outstanding at any month end during the year
    395,132       312,557       130,867  
Approximate average amount during the year
    299,513       188,326       112,008  
Approximate weighted average interest rate during the year
    3.2%       4.6%       4.5%  
Approximate weighted average interest rate at year end
    2.5%       4.1%       4.5%  

 
Average interest rates during the year are computed by dividing total interest expense by the average amount borrowed. Average interest rates at year end are average rates for a single day and as such may reflect one-day market distortions which may not be indicative of generally prevailing rates. Original maturities of commercial paper are not in excess of one year. ‘Other short-term borrowings’ consist principally of borrowings in the money markets included within ‘Deposits by banks’ and ‘Customer accounts’ in the financial statements, and generally have original maturities of one year or less.
 
Certificates of deposit and other time deposits
The following table shows details of the Group’s certificates of deposit and other time deposits over $100,000 or equivalent by remaining maturity.
 
   
Within
3 months
   
Over 3 months but within
6 months
   
Over 6 months but within
12 months
   
Over
12 months
   
2008 Total
 
     
£m
     
£m
     
£m
     
£m
     
£m
 
UK based companies and branches
                                       
Certificates of deposit
    23,076       7,475       9,236       13       39,800  
Other time deposits
    62,623       7,665       5,939       12,359       88,586  
                                         
Overseas based companies and branches
                                       
Certificates of deposit
    32,263       1,666       1,316             35,245  
Other time deposits
    111,542       13,498       7,983       15,641       148,664  
      229,504       30,304       24,474       28,013       312,295  
 


 
Other contractual cash obligations
The table below summarises the Group’s other contractual cash obligations by payment date.
 
   
Group
 
   
0-3 months
   
3-12
months
   
1-3 years
   
3-5 years
   
5-10 years
   
10-20 years
 
2008
   
£m
     
£m
     
£m
     
£m
     
£m
     
£m
 
Operating leases
    146       433       976       751       1,448       1,851  
Contractual obligations to purchase goods or services
    237       892       486       208       303       1  
      383       1,325       1,462       959       1,751       1,852  
2007
                                               
Operating leases
    90       268       655       569       1,060       1,958  
Contractual obligations to purchase goods or services
    441       1,007       748       199       5       2  
      531       1,275       1,403       768       1,065       1,960  

The Group’s undrawn formal facilities, credit lines and other commitments to lend were £352,398 million (2007 — £332,811 million). While the Group has given commitments to provide these funds, some facilities may be subject to certain conditions being met by the counterparty. The Group does not expect all facilities to be drawn, and some may lapse before drawdown.
 
Exchange rates
Except as stated, the following tables show, for the dates or periods indicated, the Noon Buying Rate in New York for cable transfers in sterling as certified for customs purposes by the Federal Reserve Bank of New York.
 
 
March
 
February
   
January
   
December
   
November
   
October
 
US dollars per £1
2009
 
2009
   
2009
   
2008
   
2008
   
2008
 
Noon Buying Rate
                               
High
 1.4730
    1.4936       1.5254       1.5457       1.6156       1.7804  
Low
  1.3757
    1.4224       1.3658       1.4395       1.4789       1.5472  
                                           
     
2008
   
2007
   
2006
   
2005
   
2004
 
Noon Buying Rate
                                         
Period end rate
      1.4619       1.9843       1.9586       1.7188       1.9160  
Average rate for the period (1)
      1.8424       2.0073       1.8582       1.8147       1.8356  
                                           
Consolidation rate (2)
                                         
Period end rate
      1.4604       2.0043       1.9651       1.7214       1.9346  
Average rate for the period
      1.8528       2.0015       1.8436       1.8198       1.8325  
 
Notes:
 
(1)
The average of the Noon Buying Rates on the last business day of each month during the period.
 
(2)
The rates used by the Group for translating US dollars into sterling in the preparation of its financial statements.
 
(3)
On 24 April 2009, the Noon Buying Rate was £1.00 = US$1.4697.
 


 
Economic and monetary environment
The world economy entered its most difficult period in a generation in the second half of 2008. The failure of a large financial institution in September coincided with the near-seizure of already fragile interbank funding markets. Heightened risk aversion among investors led to unprecedented volatility across global financial markets including equities, fixed income and foreign exchange. Many asset prices tumbled, with global real estate and equity markets the worst hit, while a ‘flight to quality’ prompted an historic rally in government bond markets that pushed long-term risk free interest rates towards all time lows in many developed economies.
 
The pronounced increase in commodity prices in the first half of 2008, together with the intensifying financial crisis led to a further sharp deterioration in private sector confidence in all major economies. Private spending weakened significantly. Softer demand conditions adversely affected prospects for profitability and employment. Policymakers responded aggressively. Since September, governments have either proposed or implemented measures that include the recapitalisation of the banking sector, tax cuts and/or new infrastructure spending. Central banks provided support through rate cuts and increased liquidity provision. Despite these supportive actions, the global economy remained on a downward trajectory at the beginning of 2009, with many industrialised economies in recession.
 
In the UK, the Bank Rate fell from 5.5% at the beginning of 2008 to 1.0% in February 2009. The Bank of England remained cautious in the first half of 2008, lowering policy rates a modest 25bps twice. Mounting inflationary pressures were a major constraint, with the annual inflation rate climbing as high as 5.2% in September, the highest reading since the Bank of England’s operational independence in 1997, and some way above the official target of 2%. Before October, the Bank focused on liquidity measures to support the financial system. When it became clear in the final quarter of 2008 that the confidence in the wider economy had fallen to levels consistent with a deep contraction, policy became more aggressive. The government assisted the recapitalisation of the banking sector, while the Bank of England reduced rates rapidly, from 5.0% in October to 1.0% in February 2009 and then to 0.5% in March 2009.
 
However, the economy had already gathered too much negative momentum to stop an official recession — GDP declined by 2.1 % in the second half of 2008, and is widely expected to fall further in 2009. One reason is lower policy rates have failed to translate effectively into looser monetary conditions for the private sector. Three-month sterling LIBOR, a key determinant of borrowing costs for households and firms, remained on average almost 100bps above the prevailing Bank Rate, well above its long-term average of 20bps. Sterling’s 17% depreciation on a trade-weighted basis did not deliver a significant offset to weakening domestic demand due to the difficult economic conditions prevailing in the UK’s main trading partners.
 
US policy rates also declined substantially in 2008, from 4.25% in January to effectively zero in December. With no room to cut interest rates further, the Federal Reserve has since started to target longer term market interest rates to directly lower the cost of funds for households and firms, for example by purchasing mortgage-backed securities and corporate commercial paper. More unorthodox policy measures are likely this year. Similar to the UK, monetary policy failed to gain much traction in the wider economy. Three-month US$ LIBOR averaged close to 100bps higher than the prevailing policy rate.
 
The US officially entered recession in December 2007 and, in spite of a fiscal stimulus in the first half of the year, activity continued to fall through 2008 and is forecast to decline markedly in 2009. The effects were acutely felt in employment, with US non-farm businesses shedding 2.6 million jobs in the twelve months to December. The dollar’s 11% depreciation in 2007 helped to boost net exports, making trade the single biggest contributor to GDP growth in 2008. However, this support was fading in early 2009, due to slumping overseas demand.
 
The Eurozone started 2008 on a strong footing, with some member countries experiencing above-trend growth in the first quarter. However, for reasons that varied across countries, conditions worsened markedly throughout the remainder of the year, and the region officially entered recession in the second quarter. Growth in Germany, the region’s largest economy and the world’s largest exporter, was hit hard by the slowdown in global trade. Many of the more peripheral economies, like Ireland and Spain, with higher debt levels were hit hard by the turbulence in credit markets and falling asset prices. Economic activity in the entire region is forecast to continue to contract in 2009.
 
Policy in the Eurozone was on average less supportive than in the UK or the US, with the Repo Rate on hold at 4% in the first half of 2008. In July 2008, the ECB raised rates by 25bps to fend off the dangers of spiralling inflation. Official rates finally started to fall in October, when the ECB participated in a globally co-ordinated rate cut to calm investors’ fears amid intensifying strains in the global financial system. The euro’s strong appreciation against the dollar also reduced the competitiveness of the region’s exporters.
 
Initially, Asia Pacific appeared insulated from economic difficulties elsewhere as China and India continued to grow strongly in the first half of 2008. In fact, surging inflation reinforced concerns about overheating, and prompted a series of policy measures aimed at cooling monetary conditions. But this perception changed towards the end of 2008, when recession in the major industrialised countries highlighted the region’s exposure to a retrenchment in global trade. Growth forecasts have been cut substantially, with 2009 growth in China and India potentially falling to half its level from a year earlier. Increasing risk aversion of international investors also led to large capital outflows, putting downward pressure on floating currencies and local equity markets.
 
Exchange rates affect earnings and costs reported by the Group’s non-UK subsidiaries, and the value of non-sterling denominated assets and liabilities. Sterling weakened significantly during 2008, losing 28% against the dollar and 30% against the euro, respectively. These movements increase the sterling-value of non-sterling earnings, costs, assets and liabilities. As a result, the Group recognises translation benefits if it reports profits and/or has a positive net asset position denominated in foreign currency.
 


 
Supervision
United Kingdom
The UK Financial Services Authority (FSA) is the consolidated supervisor of the Group. As at 31 December 2008, 31 companies in the Group (excluding subsidiaries of ABN AMRO), spanning a range of financial services sectors (banking, insurance and investment business), were authorised to conduct financial activities regulated by the FSA.
 
The UK authorised banks in the Group include the Royal Bank, NatWest, Coutts & Co and Ulster Bank Limited. Wholesale activities, other than Group Treasury activities, are concentrated in the Group’s Global Markets division and are undertaken under the names of the Royal Bank and NatWest. UK retail banking activities are managed by Regional Markets, RBS UK. The exception is Ulster Bank Limited, which is run as a separate division within the Group. Ulster Bank Group will move to a single brand in the Republic of Ireland, with First Active merging with Ulster Bank. Ulster Bank Limited provides banking services in Northern Ireland while the banking service in the Republic of Ireland is provided by Ulster Bank Ireland Limited which is primarily supervised by the Irish Financial Services Regulatory Authority.
 
Investment management business is principally undertaken by companies in the Regional Markets division, including Coutts & Co, Adam & Company Investment Management Limited, and in the Global Markets division through RBS Asset Management Limited.
 
General insurance business is principally undertaken by Direct Line Insurance plc and Churchill Insurance Company Limited. Life assurance business is principally undertaken by Royal Scottish Assurance plc and National Westminster Life Assurance Limited (in partnership with Aviva plc).
 
United States
The Group is both a bank holding company and a financial holding company within the meaning of the US Bank Holding Company Act of 1956. As such, it is subject to the regulation and supervision of the Board of Governors of the Federal Reserve System (the “Federal Reserve”). Among other things, the Group’s direct and indirect activities and investments in the United States are limited to those that are ‘financial in nature’ or ‘incidental’ or ‘complementary’ to a financial activity, as determined by the Federal Reserve. The Group is also required to obtain the prior approval of the Federal Reserve before acquiring directly or indirectly, the ownership or control of more than 5% of any class of the voting shares of any US bank or holding company.
 
Under current Federal Reserve policy, the Group is required to act as a source of financial strength for its US bank subsidiaries. Among other things, this source of strength obligation could require the Group to inject capital into any of its US bank subsidiaries if any of them became undercapitalised.
 
The Group’s US bank and non-bank subsidiaries and the Royal Bank’s US branches are also subject to supervision and regulation by a variety of other US regulatory agencies. RBS Citizens, NA is supervised by the Office of the Comptroller of the Currency, which is charged with the regulation and supervision of nationally chartered banks. Citizens Financial Group is under the supervision of the Federal Reserve as a bank holding company. Citizens Bank of Pennsylvania is subject to the regulation and supervision of the Pennsylvania Department of Banking and the US Federal Deposit Insurance Corporation. The Royal Bank’s New York branch is supervised by the New York State Banking Department, and its Connecticut branch is supervised by the Connecticut Department of Banking. Both branches are also subject to supervisory oversight by the Federal Reserve, through the Federal Reserve Bank of Boston.
 
The Group’s US insurance agencies are regulated by state insurance authorities. The Group’s US broker dealer, Greenwich Capital Markets, Inc., is subject to regulation and supervision by the US Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) with respect to its securities activities. The futures activities of Greenwich Capital Markets, Inc. are subject to regulation and oversight by the US Commodity Futures Trading Commission (CFTC) and the Chicago Board of Trade (CBOT). The Group's US commodities business, RBS Sempra Commodities, is primarily regulated by the Federal Energy Regulatory Commission (FERC) and CFTC.
 
The Group is subject to extensive regulations that impose obligations on financial institutions to maintain appropriate policies, procedures and controls to insure compliance with the rules and regulations to which they are subject, in particular to detect, prevent and report money laundering and terrorist financing and to ensure compliance with economic sanctions against designated foreign countries, nationals and others. Anti-money laundering, anti-terrorism and economic sanctions regulations have become a major focus of US government policy relating to financial institutions and are rigorously enforced by US government agencies.
 
Netherlands
The consolidated supervisor of ABN AMRO is the Dutch Central Bank, De Nederlandsche Bank (DNB). The DNB operates as prudential supervisor of banks and insurance companies and also as part of the European System of Central Banks.
 
Other jurisdictions
The Group operates in over 50 countries through a network of branches, local banks and non-bank subsidiaries.
 


Regulatory reviews and developments
The Group works with domestic and international trade associations and proactively engages with regulators and other authorities such as the Basel Committee, the Committee of European Banking Supervisors and the EU Commission in order to understand the implications of proposed regulatory change and to contribute to the development of regulatory policy.
 
The Group and its subsidiaries have co-operated fully with various regulatory reviews and developments in the UK and internationally, including enquiries or investigations into alleged or possible breaches of regulations.
 
United Kingdom
The Group successfully implemented the Markets in Financial Instruments Directive (MiFID) by the implementation date of 1 November 2007. MiFID established a comprehensive legislative framework at the European level, which is now implemented in the UK, for the establishment and conduct of investment firms, multilateral trading facilities and regulated markets.
 
FSA authorised firms must also comply with rules designed to reduce the scope for firms to be used for financial crime and in particular money laundering. Revised Joint Money Laundering Steering Group Guidance Notes were issued on 13 November 2007 to take into account the new Money Laundering Regulations 2007. These Regulations came into force on 15 December 2007 and implemented the EU’s Third Money Laundering Directive. Amongst their other provisions, the Regulations endorse a risk based approach to combating money laundering, while also prescribing ‘enhanced due diligence’ for non face to face customers, ‘politically exposed persons’ (PEPs) and correspondent banking. Whilst for all material purposes the Group is already compliant — these provisions having been anticipated in industry guidance for some time — internal processes are continually reviewed to ensure best practice standards are met. In particular, the Group has issued new internal policy guidelines based on the regulations and supporting industry guidance against which all divisions have undertaken a gap analysis as a basis for further action plans where necessary.
 
In the UK, the Group has engaged proactively with a variety of legislative and regulatory consultations. Financial stability and depositor protection have been a key focus for the UK regulatory authorities. The Group participated fully in the consultation process on the Banking Reform Bill. In addition, the Group continues to comment on regulatory and legal changes that impact its business. Examples include the Department for Business, Enterprise and Regulatory Reform (BERR) transposition of the Consumer Credit Directive and Consumer Law Review; HM Treasury’s Dormant Bank and Building Society Accounts Bill; Lord Hunt’s Review of the Financial Ombudsman Service and the review of the Banking Codes and the FSA’s consultations on liquidity and regulatory capital.
 
A review by the Competition Commission and the FSA into Payment Protection Insurance is ongoing, with the Competition Commission drafting the implementation order following finalisation of its remedies.
 
In July 2008, the Office of Fair Trading (OFT) published the results of its market study into personal current accounts and is now consulting on remedial action in the three key areas of transparency, complexity of charging structure and switching. The OFT is also continuing its inquiry into credit and debit card interchange fees.
 
UK regulated firms within the Group are members of the Financial Services Compensation Scheme (FSCS), which provides compensation to eligible customers of authorised financial services firms that are unable to meet their obligations. The FSCS is funded through annual levies charged to UK regulated firms. These levies are apportioned between firms on the basis of their shares of the FSCS tariff base: in the case of deposit takers, this means that levies are determined by their share of protected deposits. As a result of FSCS involvement in a number of bank failures in 2008, there will be a significant impact on levies charged to deposit takers, starting with those for 2008-09. These impacts are reflected in the accounts.
 
The FSA, in their 2008/09 Business Plan, emphasised the continued focus on ‘Treating Customers Fairly’ in line with their view that the area of greatest structural concern remains the retail market. The Group has undertaken a process of continuous improvement of management information and root cause analysis of customer issues in order to ensure that it can demonstrate that it is consistently treating customers fairly throughout the product lifecycle.
 
The Group also continues to co-operate with the Information Commissioner’s Office, the UK’s independent public body set up to promote access to official information and to protect personal information. The Group continues to improve its processes in line with changing guidelines in order to meet information security requirements.
 
European Union
In the EU, the Group has also responded to a number of proposals for regulatory and legislative change, including proposed amendments to the Capital Requirements Directive and the establishment of Colleges of Supervisors to enhance cross border cooperation between supervisors. The Group also follows closely the work (and recommendations) of the G7 and G10.
 
United States
In the US the Group also engages constructively with regulators and other bodies on regulatory and legislative change and seeks to ensure proper implementation and compliance. Current issues include mortgage reform and student lending.
 
 
 
Department of Justice investigation
As previously disclosed by ABN AMRO, the United States Department of Justice has been conducting a criminal investigation into ABN AMRO’s dollar clearing activities, Office of Foreign Assets Control compliance procedures and other Bank Secrecy Act compliance matters. ABN AMRO has cooperated and continues to cooperate fully with the investigation. Prior to the acquisition by the Group, ABN AMRO had reached an agreement in principle with the Department of Justice that would resolve all presently known aspects of the ongoing investigation by way of a Deferred Prosecution Agreement in return for a settlement payment by ABN AMRO of US$500 million (accrued by ABN AMRO in its interim financial statements for the six months ended 30 June 2007). Negotiations are continuing to enable a written agreement to be concluded.
 
Sub-prime exposures
Certain of the Group’s subsidiaries have received requests for information from various US governmental agencies and self-regulatory organisations including in connection with sub-prime mortgages and securitisations, collateralised debt obligations and synthetic products related to sub-prime mortgages. In particular, during March 2008, the Group was advised by the SEC that it had commenced a non-public, formal investigation relating to the Group’s US sub-prime securities exposures and US residential mortgage exposures. The Group and its subsidiaries are cooperating with these various requests for information and investigations.
 
The outcome of these reviews is outside the Group’s control and it is not possible to predict the effect, if any, on the Group’s operations of future regulatory actions or policy changes.
 
Other jurisdictions
The Group is active in monitoring regulatory developments in each country in which it operates to ensure internal policies are sufficient to ensure the effective management of regulatory risk.
 
Description of property and equipment
The Group operates from a number of locations worldwide, principally in the UK. At 31 December 2008, the Royal Bank and NatWest had 651 and 1,628 retail branches, respectively, in the UK. Ulster Bank and First Active had a network of 295 branches and business centres in Northern Ireland and the Republic of Ireland. Citizens had 1,606 retail banking offices (including in-store branches) covering Connecticut, Delaware, Illinois, Indiana, Massachusetts, Michigan, New Hampshire, New Jersey, New York, Ohio, Pennsylvania, Rhode Island and Vermont. A substantial majority of the UK branches are owned by the Royal Bank, NatWest and their subsidiaries or are held under leases with unexpired terms of over 50 years. The Group’s principal properties include its headquarters at Gogarburn, Edinburgh, its principal offices in London at 135 and 280 Bishopsgate and the Drummond House administration centre located at South Gyle, Edinburgh.
 
Total capital expenditure on premises (excluding investment properties), computers and other equipment in the year ended 31 December 2008 was £1,406 million (2007 — £1,792 million; 2006 — £1,140 million).
 
Major shareholders
Details of major shareholders of the company’s ordinary and preference shares are given on page 132.
 
In December 2008, The Solicitor for the Affairs of Her Majesty’s Treasury acquired 22,854 million ordinary shares representing 57.92% of the company’s issued ordinary share capital and in April 2009, acquired a further 16,791 million ordinary shares taking its shareholding to 70.33% of the company's enlarged issued ordinary share capital. The ordinary shareholding of Legal & General Group plc decreased from 5.04% in December 2007 to below 3% in December 2008.
 
Other than detailed above, there have been no significant changes in the percentage ownership of major shareholders of the company’s ordinary and preference shares during the three years ended 25 February 2009. All shareholders within a class of the company’s shares have the same voting rights.
 
At 25 February 2009, the directors of the company had options to purchase a total of 3,073,445 ordinary shares of the company.
 
As at 31 December 2008, almost all of the company’s US$ denominated preference shares and American Depositary Shares representing ordinary shares were held by shareholders registered in the US. All other shares were predominantly held by shareholders registered outside the US.
 
Material contracts
The company and its subsidiaries are party to various contracts in the ordinary course of business. Material contracts include the following:
 
Consortium and Shareholders Agreement (CSA)
On 28 May 2007, Fortis, the company, Santander and RFS Holdings entered into the CSA. Fortis Bank Nederland acceded to the CSA on 26 July 2007. On 3 October 2008, the State of the Netherlands acquired Fortis Bank Nederland. On 24 December 2008 the State of the Netherlands acceded to the CSA following its acquisition of the shares held by Fortis Bank Nederland in RFS Holdings pursuant to a Deed of Accession entered into between RFS Holdings, the company, Fortis Bank Nederland, Santander and the State of the Netherlands. The CSA governs the relationships amongst the parties thereto in relation to the acquisition by RFS Holdings of ABN AMRO. The CSA details, inter alia, the funding of RFS Holdings in connection with the acquisition of ABN AMRO, the equity interests in RFS Holdings, the governance of RFS Holdings both before and after the acquisition of ABN AMRO, the arrangements for the transfer of certain ABN AMRO businesses, assets and liabilities to the State of the Netherlands (previously Fortis Bank Nederland), the company and Santander post-acquisition of ABN AMRO, further funding obligations of the State of the Netherlands (previously Fortis Bank Nederland), the company and Santander after the acquisition of ABN AMRO where funding is required by regulatory authorities in connection with the ABN AMRO businesses, the allocation of Core Tier 1 capital and the allocation of taxes and conduct of tax affairs.
 
 

 
 
Standby underwriting commitment letter
On 28 May 2007, the company and Merrill Lynch International entered into a standby underwriting commitment letter, pursuant to which Merrill Lynch International undertook to underwrite one or more issues by the company of securities eligible to be treated as part of its innovative or non-innovative Tier 1 capital and/or convertible securities convertible into Ordinary Shares, the proceeds of which would be used to finance part of the cash portion of consideration payable to ABN AMRO shareholders upon settlement of the offers for shares in ABN AMRO. The aggregate amount of Merrill Lynch International’s standby underwriting commitment was €6.2 billion. Pursuant to the letter, the company agreed to pay certain fees and expenses to Merrill Lynch International in consideration for its standby commitment.
 
Agreement with Bank of America for the sale of LaSalle
On 22 April 2007, ABN AMRO Bank and Bank of America entered into an agreement for the sale by ABN AMRO Bank to Bank of America of all of the outstanding shares of common stock of ABN AMRO North America Holding Company (ABN AMRO North America), a Delaware corporation whose subsidiaries include LaSalle. The consideration for the shares was US$21 billion, subject to a potential purchase price adjustment if ABN AMRO Bank’s estimate of the net income of ABN AMRO North America for the pre-closing period was less than a specified income threshold. The agreement also provided for approximately US$6 billion owed by ABN AMRO North America to other members of the ABN AMRO group to be converted into common stock of ABN AMRO North America. ABN AMRO Bank gave certain representations and warranties to Bank of America, including, inter alia, as to title to the shares, authority and capacity to enter into the agreement, financial statements, tax and employee benefits. The warranties given by ABN AMRO Bank were repeated on closing of the agreement. ABN AMRO Bank is liable to indemnify and hold harmless Bank of America for damages arising out of certain specified events, including breach of any covenant that survives closing.
 
Underwriting agreement
On 22 April 2008, the company, Goldman Sachs International, Merrill Lynch International, UBS and the Royal Bank entered into an underwriting agreement, pursuant to which Merrill Lynch International, Goldman Sachs International and UBS agreed to procure subscribers for, or failing which themselves to subscribe for, Ordinary Shares not taken up under the Rights Issue, in each case at the relevant issue price. Pursuant to the underwriting agreement, the company agreed to pay certain fees and expenses to Merrill Lynch International, Goldman Sachs International and UBS in consideration for their underwriting commitment. The company gave certain representations and warranties and indemnities to those persons defined as underwriters in the Underwriting Agreement. The liabilities of the company were uncapped as to time and amount.
 
Sale of Angel Trains
On 6 August 2008, the company completed the sale of Angel Trains Group to a consortium advised by Babcock & Brown for an enterprise value of £3.6 billion.
 
Sale of Tesco Personal Finance
On 28 July 2008, the company announced that it had agreed to sell its 50 per cent. shareholding in Tesco Personal Finance to its joint venture partner Tesco plc for a cash consideration of £950 million, subject to transaction adjustments. As part of this transaction, the Group will continue to provide certain commercial services to Tesco Personal Finance post-completion. The sale completed on 19 December 2008.
 
First Placing and Open Offer Agreement
Pursuant to a placing and open offer agreement effective as of 13 October 2008 entered into between the company, UBS, Merrill Lynch International and HM Treasury, (i) the company agreed to invite qualifying shareholders to apply to acquire new Shares at the issue price of 65.5 pence by way of the First Open Offer, (ii) UBS and Merrill Lynch International were appointed as joint sponsors, joint bookrunners and joint placing agents and agreed to use reasonable endeavours to procure placees to acquire the new Shares at not less than the issue price of 65.5 pence on such terms as agreed by HM Treasury on the basis that the new Shares placed were subject to clawback to the extent they were taken up under the Open Offer and (iii) HM Treasury agreed that, to the extent not placed or taken up under the First Open Offer and subject to the terms and conditions set out in the First Placing and Open Offer Agreement, HM Treasury would acquire such new Shares itself at the issue price of 65.5 pence.
 
In consideration of its services under the First Placing and Open Offer Agreement, HM Treasury was paid (i) a commission of 0.5 per cent. of the aggregate value of the new Shares at the issue price of 65.5 pence per new Share payable on Admission (as defined in the First Placing and Open Offer Agreement) and the second business day after the day on which the First Placing and Open Offer Agreement terminated and (ii) a further commission of 1 per cent. of the aggregate value of the new Shares acquired by placees (including HM Treasury) at the issue price of 65.5 pence per new Share payable on Admission (as defined in the First Placing and Open Offer Agreement). The company paid all legal and other costs and expenses of HM Treasury, those of UBS and Merrill Lynch International properly incurred and the costs and expenses of HM Treasury’s financial advisers incurred in connection with the First Placing and Open Offer and the Preference Share Issue.
 
The company also bore all costs and expenses relating to the First Placing and Open Offer and the Preference Share Issue, including (but not limited to) the fees and expenses of its professional advisers, the cost of preparation, advertising, printing and distribution of the First Placing and Open Offer prospectus and all other documents connected with the First Placing and Open Offer and the Preference Share Issue, the listing fees of the FSA, any charges by CREST and the fees of the London Stock Exchange and Euronext.
 
The company gave certain undertakings to HM Treasury in relation to such matters as mortgage lending, lending to SMEs and Board remuneration. These undertakings were aimed at ensuring that any state aid involved in the potential acquisition of new Shares and the company’s potential participation in the guarantee scheme to be promoted by HM Treasury as part of its support for the UK banking industry was compatible with the common market under EU law. These constraints will cease to apply when, broadly, it is determined that the company is no longer in receipt of state aid.
 
 

 
 
The undertakings the company gave to HM Treasury included the following:
 
·  
no bonus will be awarded to any director for 2008 and any bonuses earned by directors in respect of 2009 will be paid in restricted shares, remuneration will seek to reward long term value creation and not encourage excessive risk taking (short term indicators will be taken into account only where fully consistent with long term value creation and not encouraging excessive risk taking) and Directors who are dismissed will receive a severance package which is reasonable and perceived as fair;
 
·  
to work with HM Treasury on the appointment of up to three new independent non-executive directors;
 
·  
to maintain its SME and mortgage lending availability to at least 2007 levels until the end of 2011 with the active marketing of competitively priced loan products;
 
·  
to increase its support to shared equity projects until the end of 2009 in order to assist those in difficulties with their mortgage payments to stay in their homes, either through individual bank schemes or paid into a central fund run by industry; and
 
·  
to publish an annual report, for each year until 2011, on its lending to SMEs and establish transparent public reporting on both SME and mortgage lending as agreed with HM Treasury.
 
In addition, the company agreed to limit its activities to the higher of: (i) the annual rate of growth of UK nominal GDP in the preceding year; and (ii) the average historical growth of the balance sheets in the UK banking sector during the period 1987-2007, unless there is evidence that the thresholds are exceeded for reasons unrelated to the provision of the aid. HM Treasury agreed, in certain circumstances, to consult with the company with a view to making submissions to the European Commission to obtain clarity as to the duration of the conditions and/or seek their disapplication.
 
Second Placing and Open Offer Agreement
Pursuant to a placing and open offer agreement dated 19 January 2009 entered into between the company, UBS, Merrill Lynch International and HM Treasury, (i) the company agreed to invite qualifying shareholders to apply to subscribe for new shares at the issue price by way of the open offer, (ii) UBS and Merrill Lynch International were appointed as joint sponsors, joint bookrunners and joint placing agents and agreed to use reasonable endeavours to procure placees to subscribe for the new shares on such terms as may be agreed by the Company and HM Treasury at not less than the issue price on the basis that the new shares placed will be subject to clawback to the extent they are taken up under the open offer and (iii) HM Treasury agreed that, to the extent not placed or taken up under the open offer and subject to the terms and conditions set out in the Placing and Open Offer Agreement, HM Treasury will subscribe for such new shares itself at the issue price.
 
Pursuant to the terms of the Second Placing and Open Offer Agreement, the aggregate proceeds of the Second Placing and Open Offer were used in full to fund the redemption on Admission of the preference shares held by HM Treasury at 101 per cent. of their issue price (£5,050,000,000) together with the accrued dividend on the preference shares (from and including 1 December 2008 to but excluding the date of Admission) and the commissions payable to HM Treasury under the Second Placing and Open Offer Agreement.
 
In consideration of the provision of its services under the Second Placing and Open Offer Agreement, HM Treasury was paid (i) a commission of 0.5 per cent. of the aggregate value of the new shares at the issue price per new share payable on Admission and (ii) a further commission of 1 per cent. of the aggregate value of the new shares subscribed for by placees at the issue price per new share payable on Admission.
 
The company paid to each of HM Treasury, UBS and Merrill Lynch International all legal and other costs and expenses (properly incurred in the case of UBS and Merrill Lynch International) and those of HM Treasury’s financial advisers, incurred in connection with the Placing and Open Offer, the redemption of the preference shares or any arrangements referred to in the Second Placing and Open Offer Agreement.
 
The company also bore all costs and expenses relating to the Placing and Open Offer and the Preference Share Redemption, including (but not limited to) the fees and expenses of its professional advisers, the cost of preparation, advertising, printing and distribution of all documents connected with the Placing and Open Offer and the Preference Share Redemption, the listing fees of the FSA, any charges by CREST and the fees of the London Stock Exchange and Euronext.
 

 
 
On termination of appointment by UBS or Merrill Lynch International, the Second Placing and Open Offer Agreement will continue to be in force as between the non-terminating parties.
 
HM Treasury is entitled to novate its rights under the Second Placing and Open Offer Agreement to any entity that is owned, directly or indirectly, by HM Treasury.
 
The company has given certain representations and warranties and indemnities to each of HM Treasury, UBS and Merrill Lynch International under the Second Placing and Open Offer Agreement. The liabilities of the company are unlimited as to time and amount.
 
The company also gave HM Treasury the following undertakings:
 
·  
to extend the lending commitments made to HM Treasury in the First Placing and Open Offer Agreement in respect of the UK mortgage and SME lending markets. These commitments will now also apply to the company’s lending to larger commercial and industrial companies in the United Kingdom; and
 
·  
a commitment to increase the level at which competitively priced lending is made available and actively marketed by the Group in the United Kingdom by £6 billion.
 
RBS's commitments described above have been superseded by the Lending Commitments Letter pursuant to which RBS has agreed, among other things, to lend £16 billion above the amount RBS has budgeted to lend to UK businesses and £9 billion above the amount RBS has budgeted to lend to UK homeowners in the year commencing 1 March 2009, with a commitment to lend a similar levels in the year commencing 1 March 2010. Further information is set forth below.
 
Preference Share Subscription Agreement
Pursuant to a preference share subscription agreement effective as of 13 October 2008 between the company and HM Treasury, HM Treasury subscribed for, and the company allotted and issued to HM Treasury, the preference shares for a total consideration of £5 billion. The company and HM Treasury agreed that applications would be made to the UKLA for the preference shares to be admitted to the Official List and to the London Stock Exchange for the preference shares to be admitted to trading on the London Stock Exchange. Pursuant to the Preference Share Subscription Agreement, the company agreed to pay the costs and expenses of both parties in relation to the negotiation of the Preference Share Subscription Agreement and the subscription for, and allotment and issue of, the preference shares (including, without limitation, any stamp duty or stamp duty reserve tax). HM Treasury was entitled to novate its rights under the Preference Share Subscription Agreement to any entity that is owned, directly or indirectly, by HM Treasury.
 
The Preference Share Subscription Agreement was conditional on the First Placing and Open Offer Agreement becoming unconditional in accordance with its terms.
 
Subscription and Transfer Agreements
In connection with the First Placing and Open Offer, the company, Merrill Lynch International, UBS, Computershare and Encuentro Limited entered into several agreements dated 4 November 2008, in respect of the subscription and transfer of ordinary shares and redeemable preference shares in Encuentro Limited. Under the terms of these agreements:
 
·  
the company and UBS and/or Merrill Lynch International agreed to acquire ordinary shares in Encuentro Limited and enter into put and call options in respect of the ordinary shares in Encuentro Limited subscribed for by UBS and/or Merrill Lynch that were exercisable if the Placing and Open Offer did not proceed;
 
·  
Merrill Lynch International or UBS, as applicable, agreed to apply monies received from qualifying shareholders, placees or HM Treasury under the First Placing and Open Offer to subscribe for redeemable preference shares in Encuentro Limited to an aggregate value equal to such monies, after deduction of the amount of certain commissions and expenses; and
 
·  
the company agreed to allot and issue the new shares to those persons entitled thereto in consideration of Merrill Lynch International or UBS, as applicable, transferring its holding of redeemable preference shares and ordinary shares in Encuentro Limited to the company.
 
Accordingly, instead of receiving cash as consideration for the issue of the new shares, at the conclusion of the First Placing and Open Offer the company owned the entire issued ordinary and redeemable preference share capital of Encuentro Limited whose only assets were its cash reserves, which represented an amount equivalent to the net proceeds of the First Placing and Open Offer. The company was able to utilise this amount equivalent to the First Placing and Open Offer net proceeds by exercising its right of redemption over the redeemable preference shares it held in Encuentro Limited.
 
Qualifying shareholders were not party to these arrangements and so did not acquire any direct right against Merrill Lynch International, UBS and Computershare pursuant to these arrangements. The company was responsible for enforcing the other parties’ obligations thereunder.
 
Pre-accession Commitments Letter
 
On 26 February 2009, the Royal Bank entered into a deed poll in favour of HM Treasury, pursuant to which the Royal Bank gave a series of undertakings, with immediate effect unless otherwise agreed, in relation to the provision of information and the management of the Proposed Assets in the period prior to the Royal Bank’s proposed accession to the APS.
 
The Royal Bank has undertaken to HM Treasury, among other things, to:
 
 
 
(i)           provide all such assistance and information and data as is reasonably requested which is pertinent to the implementation of the APS and the Royal Bank’s potential participation in the APS;
 
(ii)           provide, as soon as practicable, an indicative list of the Proposed Assets with a view to agreeing such list by 30 April 2009;
 
(iii)           provide, as promptly as practicable, information and data relating to the Proposed Assets reasonably requested for due diligence purposes and to provide certain other information concerning the RBS Group’s business and the financial performance and risk of the Proposed Assets;
 
(iv)           provide access to the RBS Group’s premises, books, records, senior executives, relevant personnel and professional advisers on reasonable terms;
 
(v)           consult with HM Treasury regarding the management and operations of the Proposed Assets and to ensure that the management of the Proposed Assets is in accordance with usual business practices and also without regard to the possible benefits under the APS;
 
(vi)           develop and, subject to market conditions, implement a liability management plan which is designed to enable the RBS Group to meet certain Core Tier 1 capital targets for 2009; and
 
(vii)           use best endeavours (giving regard to reasonable operational requirements) to maintain regular, adequate and effective monitoring, reporting, risk management and audit controls and procedures in order, among other things, to ensure that risks relating to key business processes which affect the Proposed Assets are identified, assessed and reported and are managed and mitigated appropriately.
 
In addition, the Royal Bank has agreed in principle that, if and only if the Royal Bank accedes to the APS, it will not claim, and will disclaim, certain UK tax losses and allowances arising to members of the RBS Group in respect of any accounting period ending on or after 31 December 2008, provided that this undertaking will not apply in respect of any such tax benefits arising in the earlier of (a) the first accounting period beginning more than five years after the relevant accession date and (b) the first accounting period beginning after the relevant accession date in which the RBS Group becomes profitable.
 
The Royal Bank has acknowledged that HM Treasury and the FSA propose to commence a consultation in relation to a Code of Remuneration Practice for banking institutions and has confirmed that it will comply with any such Code, and any other legal or regulatory requirements relating to remuneration policies, to which it becomes subject from time to time.
 
Lending Commitments Letter
 
On 26 February 2009, the Group entered into a deed poll in favour of certain UK Government departments under which it undertook to support lending to creditworthy borrowers in the UK in a commercial manner with effect from 1 March 2009. This lending commitment is a pre-requisite to the Group’s proposed participation in the APS and other Government backed schemes the objective of which is to reinforce the stability of the financial system and support the recovery of the economy.
 
Pursuant to this lending commitment, the Group has agreed to increase its lending in the 12 months commencing 1 March 2009 from its UK banking operations to UK businesses by £16 billion above the amount previously budgeted and to maintain in the 12 months commencing 1 March 2010 similar levels of lending to UK businesses as in the 12 months commencing 1 March 2009. Such additional lending is subject to the Group’s ordinary course pricing and other terms, and certain commercial, risk, credit and regulatory considerations.
 
The Group has also made a commitment to increase lending to homeowners, including first time buyers, in the United Kingdom. The Group has undertaken to increase its residential mortgage lending by at least £9 billion above the amount previously budgeted in the 12 months commencing 1 March 2009 and to maintain in the 12 months commencing 1 March 2010 similar levels of residential mortgage lending as in the 12 months commencing 1 March 2009 subject to adjustment of the commitments by the UK Government departments from time to time.
 
The Group’s compliance with its lending commitments will be subject to a monthly reporting process to the UK Government.
 
The Group has also made certain undertakings as regards marketing in support of its lending commitments and certain other matters relating to its business and residential lending practices and policies. The lending commitments made in the deed poll supersede the commitments given by the Group in the First Placing and Open Offer Agreement and the Second Placing and Open Offer Agreement.
 
These lending commitments will cease if the Group does not participate in the APS and Credit Guarantee Scheme by 1 June 2009 or will reduce if it participates in only one of the APS or Credit Guarantee Scheme prior to 1 June 2009.
 
 

 
 
FSA Listing Rules disclosure
With effect from 1 July 2008, the Group sold to Santander (a related party for the purposes of the FSA Listing Rules) its interests in the European Consumer Finance businesses in Germany and Austria for €306 million.
 
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290
 
273

 
Shareholder information


Financial calendar
 
Annual General Meeting
3 April 2009 at 1 pm
Edinburgh International Conference Centre,
The Exchange, Morrison Street,
Edinburgh
   
Interim results
7 August 2009
 
Dividends
Payment dates:
Cumulative preference shares
29 May and 31 December 2009
   
Non-cumulative preference shares
31 March, 30 June,
30 September and
31 December 2009
 
Ex-dividend dates:
Cumulative preference shares
29 April 2009
 
Record dates:
Cumulative preference shares
1 May 2009
 
Shareholder enquiries
Shareholdings in the company may be checked by visiting our website (www.rbs.com/shareholder). You will need the shareholder reference number printed on your share certificate or tax voucher to gain access to this information.
 
Dividend payments
The company pays its dividends in pounds sterling although shareholders may choose to receive payment in US dollars or euros. Shareholders wishing to receive payment in either US dollars or euros should request an instruction form from the Company’s Registrar:
 
Computershare Investor Services PLC
The Pavilions
Bridgwater Road
Bristol BS99 6ZZ
Telephone: 0870 702 0135
Fax: 0870 703 6009
Email: web.queries@computershare.co.uk
 
Shareholders may also download an instruction form via our website (www.rbs.com/shareholder). Completed instruction forms must be returned to the registrar no later than 15 working days before the relevant dividend payment date.
 
Braille and audio Annual Review and Summary Financial Statement
Shareholders requiring a Braille or audio version of the Annual Review and Summary Financial Statement should contact the Registrar on 0870 702 0135.
 
ShareGift
The company is aware that shareholders who hold a small number of shares may be retaining these shares because dealing costs make it uneconomical to dispose of them. ShareGift, the charity share donation scheme is a free service operated by The Orr Mackintosh Foundation (registered charity 1052686) to enable shareholders to donate shares to charity.
 
Should you wish to donate your shares to charity in this way you should contact ShareGift for further information:
 
ShareGift, The Orr Mackintosh Foundation,
17 Carlton House Terrace, London SW1Y 5AH
Tel: 020 7930 3737
www.sharegift.org
 
Donating your shares in this way will not give rise to either a gain or a loss for UK capital gains tax purposes and you may be able to reclaim UK income tax on gifted shares. Further information can be obtained from HM Revenue & Customs.
 
Warning to shareholders — boiler room scams
Over the last year, many companies have become aware that their shareholders have received unsolicited phone calls or correspondence concerning investment matters. These are typically from overseas based ‘brokers’ who target UK shareholders, offering to sell them what often turn out to be worthless or high risk shares in US or UK investments. These operations are commonly known as ‘boiler rooms’. These ‘brokers’ can be very persistent and extremely persuasive, and a 2006 survey by the Financial Services Authority (FSA) has reported that the average amount lost by investors is around £20,000.
 
It is not just the novice investor that has been duped in this way; many of the victims had been successfully investing for several years. Shareholders are advised to be very wary of any unsolicited advice, offers to buy shares at a discount or offers of free company reports. If you receive any unsolicited investment advice:
 
·  
Make sure you get the correct name of the person and organisation;
 
·  
Check that they are properly authorised by the FSA before getting involved by visiting www.fsa.gov.uk/register;
 
·  
Report the matter to the FSA either by calling 0845 606 1234 or visiting www.moneymadeclear.fsa.gov.uk; and
 
·  
If the calls persist, hang up.
 
 
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Shareholder information continued

 
 
If you deal with an unauthorised firm, you will not be eligible to receive payment under the Financial Services Compensation Scheme. The FSA can be contacted by completing an online form at www.fsa.gov.uk/pages/doing/regulated/law/alerts/overseas.shtml

Details of any share dealing facilities that the company endorses will be included in company mailings.
 
More detailed information on this or similar activity can be found on the FSA website www.moneymadeclear.fsa.gov.uk
 
 
 
 
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Shareholder information continued

 
 
Capital gains tax
For shareholders who held RBS ordinary shares at 31 March 1982, the market value of one ordinary share held was 103p. After adjusting for the following:
 
·  
the 1 March 1985 rights issue;
 
·  
the 1 September 1989 capitalisation issue;
 
·  
the 12 July 2000 bonus issue of Additional Value Shares;
 
·  
the 8 May 2007 bonus issue;
 
·  
the 6 June 2008 rights issue;
 
·  
the 15 September 2008 capitalisation issue; and
 
·  
the basic entitlement under the 1 December 2008 open offer,
 
the adjusted 31 March 1982 base value of one ordinary share held currently is 73p.
 
For shareholders who held NatWest ordinary shares at 31 March 1982, the market value of one ordinary share held was 76.3p for shareholders who accepted the basic terms of the RBS offer. This takes account of the following:
 
·  
the August 1984 rights issue of NatWest ordinary shares;
 
·  
the June 1986 rights issue of NatWest ordinary shares;
 
·  
the June 1989 bonus issue of NatWest ordinary shares;
 
·  
the 12 July 2000 bonus issue of Additional Value Shares;
 
·  
the 8 May 2007 bonus issue;
 
·  
the 6 June 2008 rights issue;
 
·  
the 15 September 2008 capitalisation issue; and
 
·  
the basic entitlement under the 1 December 2008 open offer.
 
The information set out above is intended as a general guide only and is based on current United Kingdom legislation and HM Revenue & Customs practice as at this date. This information deals only with the position of individual shareholders who are resident in the United Kingdom for tax purposes, who are the beneficial owners of their shares and who hold their shares as an investment. It does not deal with the position of shareholders other than individual shareholders, shareholders who are resident outside the United Kingdom for tax purposes or certain types of shareholders, such as dealers in securities.
 
Analyses of ordinary shareholders at 31 December 2008

     
Shareholdings
   
Number of shares — millions
   
%
 
Individuals
      195,459       982.9       2.5  
Banks and nominee companies
      28,242       37,496.0       95.0  
Investment trusts
      179       7.0        
Insurance companies
      283       7.8        
Other companies
      2,131       893.6       2.3  
Pension trusts
      46       30.2       0.1  
Other corporate bodies
      88       38.5       0.1  
        226,428       39,456.0       100.0  
                           
Range of shareholdings:
                         
 
1 — 1,000
      75,566       31.9       0.1  
 
1,001 — 10,000
      123,493       441.6       1.1  
 
10,001 — 100,000
      25,347       557.7       1.4  
 
100,001 — 1,000,000
      1,192       385.8       1.0  
 
1,000,001 — 10,000,000
      613       2,106.5       5.3  
10,000,001 and over
      217       35,932.5       91.1  
          226,428       39,456.0       100.0  
 

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Shareholder information continued

 
 
Trading market
 
Non-cumulative dollar preference shares
On 26 March 1997, 8 February 1999, 30 September 2004, 26 August 2004, 19 May 2005, 9 November 2005, 25 May 2006, 27 December 2006, 28 June 2007, 27 September 2007 and 4 October 2007 the company issued the following American Depository Shares (ADSs) representing non-cumulative dollar preference shares of the company, in the United States, which were outstanding at 31 December 2008:
 
8,000,000 Series F (“Series F ADSs”) representing 8,000,000 non-cumulative dollar preference shares, Series F;
 
12,000,000 Series H (“Series H ADSs”) representing 12,000,000 non-cumulative dollar preference shares, Series H;
 
34,000,000 Series L (“Series L ADSs”) representing 34,000,000 non-cumulative dollar preference shares, Series L;
 
37,000,000 Series M (“Series M ADSs”) representing 37,000,000 non-cumulative dollar preference shares, Series M;
 
40,000,000 Series N (“Series N ADSs”) representing 40,000,000 non-cumulative dollar preference shares, Series N;
 
22,000,000 Series P (“Series P ADSs”) representing 22,000,000 non-cumulative dollar preference shares, Series P;
 
27,000,000 Series Q (“Series Q ADSs”) representing 27,000,000 non-cumulative dollar preference shares, Series Q;
 
26,000,000 Series R (“Series R ADSs”) representing 26,000,000 non-cumulative dollar preference shares, Series R;
 
38,000,000 Series S (“Series S ADSs”) representing 38,000,000 non-cumulative dollar preference shares, Series S;
 
64,000,000 Series T (“Series T ADSs”) representing 64,000,000 non-cumulative dollar preference shares, Series T; and
 
15,000 Series U (“Series U ADSs”) representing 15,000 non-cumulative dollar preference shares, Series U.
 
Each of the respective ADSs set out above represents the right to receive one corresponding preference share, and is evidenced by an American Depository Receipt (ADR) and is listed on the New York Stock Exchange, a subsidiary of NYSE Euronext (NYSE).
 
The ADRs evidencing the ADSs above were issued pursuant to Deposit Agreements, among the company, The Bank of New York, as depository, and all holders from time-to-time of ADRs issued thereunder. Currently, there is no non-United States trading market for any of the non- cumulative dollar preference shares. All of the non-cumulative dollar preference shares are held by the depository, as custodian, in bearer form.
 
At 31 December 2008, there were 106 registered shareholders of Series F ADSs, 68 registered shareholders of Series H ADSs, 30 registered shareholders of Series L ADSs, 7 registered shareholders of Series M ADSs, 39 registered shareholders of Series N ADSs, 50 registered shareholders of Series P ADSs, 15 registered shareholders of Series Q ADSs, 2 registered shareholders of Series R ADSs, 3 registered shareholders of Series S ADSs, 29 registered shareholders of Series T ADSs and 1 registered shareholder of Series U ADSs.
 
PROs
In August 2001, the company issued US$1.2 billion of perpetual regulatory tier one securities (PROs) in connection with a public offering in the United States. The PROs are listed on the NYSE.
 
ADSs representing ordinary shares
In October 2007, the company listed ADSs, each representing one ordinary share, nominal value 25p each (or a right to receive one ordinary share), and evidenced by an ADR or uncertificated securities, on the NYSE. With effect from 7 November 2008, the ratio of one ADS representing one ordinary share changed to one ADS representing 20 ordinary shares. As of 31 December 2008, 12.9 million ADSs were outstanding. The ADSs were issued in connection with the company’s bid for the outstanding share capital of ABN AMRO Holding N.V.
 
The ADSs described in the above paragraph were issued pursuant to a Deposit Agreement, among the company, The Bank of New York Mellon, as Depository, and all owners and holders from time to time of ADSs issued thereunder. The ordinary shares of the company are listed and traded on the London Stock Exchange. All ordinary shares are deposited with the principal London office of The Bank of New York Mellon, as custodian for the Depository.
 
 

 
 
The following table shows, for the periods indicated, the high and low sales prices for each of the outstanding ADSs representing non-cumulative dollar preference shares and PROs, as reported on the NYSE composite tape:
 
   
Series F
Series H
Series L
Series M
Series N
Series P
Series Q
Series R
Series S
Series T
Series U
 
Figures in US$
 
ADSs
ADSs
ADSs
ADSs
ADSs
ADSs
ADSs
ADSs
ADSs
ADSs
ADSs
PROs(1)
By month
                         
March 2009
High
7.35
6.31
5.97
6.00
5.85
6.00
6.18
6.00
6.00
6.34
22.50
  28.00
 
Low
3.00
2.77
2.21
2.63
2.55
2.43
2.64
2.37
2.58
2.78
10.50
  21.00
February 2009
High
5.78
5.25
4.37
4.53
4.68
4.51
4.80
4.45
4.67
5.75
16.45
30.13
 
Low
3.59
3.25
2.64
2.70
2.73
2.80
2.88
2.55
2.95
3.02
8.98
20.00
January 2009
High
14.19
12.99
10.89
12.25
11.75
11.50
12.18
11.30
11.84
13.51
43.96
56.03
 
Low
3.35
3.17
2.51
2.73
2.80
2.68
3.00
2.67
2.94
3.80
12.49
25.00
December 2008
High
11.33
10.55
8.80
9.45
9.29
8.97
9.74
8.97
9.55
11.07
48.92
56.25
 
Low
8.51
8.03
6.67
7.05
7.19
6.95
7.47
6.96
7.32
8.42
39.84
53.60
November 2008
High
13.34
13.40
10.37
10.84
11.30
10.71
11.34
10.32
11.15
12.36
52.91
69.74
 
Low
8.60
6.75
5.50
6.00
6.48
5.70
5.64
5.50
6.00
6.40
46.89
55.25
October 2008
High
14.10
12.78
10.94
11.36
11.70
11.10
12.20
11.16
11.98
13.09
74.78
84.10
 
Low
5.10
5.00
4.37
4.51
4.20
4.50
4.34
4.16
4.36
5.43
44.62
68.63
                           
By quarter
                         
2009: First  quarter
High
14.19
12.99
10.89
12.25
11.75
11.50
12.18
11.30
11.84
13.51
43.96
  56.03
 
Low
3.00
2.77
2.21
2.63
2.55
2.43
2.64
2.37
2.58
2.78
8.98
  20.00
2008: Fourth quarter
High
14.10
13.40
10.94
11.36
11.70
11.10
12.20
11.16
11.98
13.09
74.78
84.10
 
Low
5.10
5.00
4.37
4.51
4.20
4.50
4.34
4.16
4.36
5.43
39.84
53.60
2008: Third quarter
High
24.00
22.11
17.31
19.36
19.29
18.76
20.49
18.32
20.06
22.42
92.03
96.30
 
Low
8.39
7.00
4.74
8.49
5.98
5.24
5.80
5.40
6.25
8.00
74.34
83.82
2008: Second quarter
High
25.74
24.95
20.22
22.64
22.73
22.01
23.74
21.57
22.99
24.73
96.63
93.76
 
Low
21.50
20.15
16.12
17.90
18.10
17.34
18.78
17.08
18.62
20.40
85.25
89.23
2008: First quarter
High
25.59
25.30
22.27
24.12
24.01
23.85
24.95
23.52
24.66
25.66
105.61
107.55
 
Low
24.50
24.00
18.05
20.60
19.78
20.05
21.80
19.79
20.77
23.95
86.13
93.76
2007: Fourth quarter
High
25.85
25.50
21.34
23.23
23.10
22.89
24.80
22.54
24.11
25.48
107.98
109.95
 
Low
23.60
22.70
17.90
19.68
19.50
19.25
20.71
18.96
20.26
22.61
98.34
100.49
2007: Third quarter
High
26.23
25.60
22.23
24.60
24.30
24.14
25.88
23.55
25.20
25.10
112.88
 
Low
25.25
24.95
20.30
22.22
21.98
21.76
23.49
21.20
22.77
24.95
104.94
2007: Second quarter
High
26.50
25.78
24.36
25.88
25.67
25.78
26.40
25.35
25.00
118.15
 
Low
25.39
25.10
21.80
24.10
23.81
23.51
24.95
23.30
24.75
110.17
2007: First quarter
High
25.76
25.85
24.75
25.99
25.75
25.83
26.91
25.50
122.07
 
Low
25.26
25.21
24.02
25.50
25.35
25.25
26.08
24.79
115.81
                           
By year
                         
2008
High
25.74
25.30
22.27
24.12
24.01
23.85
24.95
23.52
24.66
25.66
105.61
107.55
 
Low
5.10
5.00
4.37
4.51
4.20
4.50
4.34
4.16
4.36
5.43
39.84
53.60
2007
High
26.50
25.85
24.75
25.99
25.75
25.83
26.91
25.50
25.20
25.48
107.98
122.07
 
Low
23.60
22.70
17.90
19.68
19.50
19.25
20.71
18.96
20.26
22.61
98.34
100.49
2006
High
27.25
25.95
24.62
26.08
25.96
26.07
26.76
122.23
 
Low
25.29
25.01
21.15
23.58
23.32
22.76
24.67
106.06
2005
High
28.00
26.19
24.99
26.75
26.23
25.50
129.57
 
Low
26.02
25.20
22.67
24.77
24.70
24.60
116.70
2004
High
28.45
25.87
24.68
26.16
125.14
 
Low
25.65
24.45
23.51
25.13
110.58
 
Note:
 
(1)
Price quoted as a % of US$1,000 nominal.
 
 
Shareholder information continued

 
 
Ordinary shares
The following table shows, for the periods indicated, the high and low sales prices for the company’s ordinary shares on the London Stock Exchange, as derived from the Daily Official List of the UK Listing Authority and restated for the effect of the rights issue in June 2008 and the capitalisation issue in September 2008.
 
By month
 
£
 
By quarter
 
£
 
By year
 
£
March 2009
High
0.2660
 
2009: First quarter
High
0.5500
 
2008
High
3.7054
 
Low
0.1900
   
Low
0.1030
   
Low
0.4140
February 2009
High
0.2900
 
2008: Fourth quarter
High
1.8620
 
2007
High
6.0208
 
Low
0.1810
   
Low
0.4140
   
Low
3.3265
January 2009
High
0.5500
 
2008: Third quarter
High
2.4293
 
2006
High
5.5770
 
Low
0.1030
   
Low
1.6098
   
Low
4.6559
December 2008
High
0.7010
 
2008: Second quarter
High
3.2156
 
2005
High
5.1081
 
Low
0.4140
   
Low
2.0707
   
Low
4.2456
November 2008
High
0.6900
 
2008: First quarter
High
3.7054
 
2004
High
4.9155
 
Low
0.4170
   
Low
2.5540
   
Low
4.0865
October 2008
High
1.8620
 
2007: Fourth quarter
High
4.7689
       
 
Low
0.5680
   
Low
3.3265
       
       
2007: Third quarter
High
5.3802
       
         
Low
4.2581
       
       
2007: Second quarter
High
5.7780
       
         
Low
5.2169
       
       
2007: First quarter
High
6.0208
       
         
Low
5.4514
       

On 24 April 2009, the closing price of the ordinary shares on the London Stock Exchange was £0.3330, equivalent to $0.4894 per share translated at the Noon Buying Rate of $1.4697 per £1.00 on 24 April 2009.
 
ADSs
The following table shows, for the periods indicated, the high and low sales prices for the company’s ordinary ADSs, as reported on the NYSE composite tape and restated for the effect of the rights issue in June 2008 and the capitalisation issue in September 2008.
 
By month
 
US$
 
By quarter
 
US$
 
By year
 
US$
March 2009
High
7.69
 
2009: First quarter
High
16.70
 
2008
High
149.05
 
Low
5.13
   
Low
3.33
   
Low
12.20
February 2009
High
7.83
 
2008: Fourth quarter
High
66.00
 
2007
High
189.25
 
Low
5.10
   
Low
12.20
   
Low
141.18
January 2009
High
16.70
 
2008: Third quarter
High
93.85
       
 
Low
3.33
   
Low
55.00
       
December 2008
High
20.75
 
2008: Second quarter
High
129.96
       
 
Low
12.66
   
Low
83.71
       
November 2008
High
22.80
 
2008: First quarter
High
149.05
       
 
Low
12.20
   
Low
105.18
       
October 2008
High
66.00
 
2007: Fourth quarter
High
189.25
       
 
Low
18.00
   
Low
141.18
       
                     
                     

 
With effect from 7 November 2008, the ratio of one ADS representing one ordinary share changed to one ADS representing 20 ordinary shares. The prices in the table have been adjusted accordingly.
 
On 24 April 2009, the closing price of the ordinary ADSs on the New York Stock Exchange was $9.99.
 
279

 

 
 
Dividend history
 
Preference and other non-equity dividends
 
   
IFRS
2008
   
IFRS
2007
   
IFRS
2006
   
IFRS
2005
 
   
Subordinated
liabilities
   
Equity
   
Subordinated liabilities
   
Equity
   
Subordinated liabilities
   
Equity
   
Subordinated liabilities
   
Equity
 
Amount per share
    $       £       $       £       £       £       £       £       £       £  
Non-cumulative preference shares of US$0.01
                                                                               
– Series D (redeemed March 2006)
                                              0.21               1.13          
– Series E (redeemed January 2007)
                                0.04               1.10               1.12          
– Series F
    1.91       1.04                       0.96               1.03               1.06          
– Series G (redeemed January 2007)
                                0.04               1.00               1.02          
– Series H
    1.81       0.99                       0.91               0.98               1.00          
– Series I (redeemed March 2006)
                                              0.20               1.10          
– Series J (redeemed November 2005)
                                                            1.06          
– Series K (redeemed January 2007)
                                0.04               1.06               1.09          
– Series L
    1.44       0.78                       0.72               0.78               0.79          
– Series M
                    1.60       0.89               0.80               0.87               0.88  
– Series N
                    1.59       0.88               0.79               0.86               0.55  
– Series P
                    1.56       0.87               0.78               0.85               0.13  
– Series Q
                    1.69       0.94               0.84               0.53                
– Series R
                    1.53       0.85               0.77                              
– Series S
                    1.65       0.92               0.41                              
– Series T
                    1.81       1.01               0.23                              
– Series U
                    7,555       3,935                                            
Non-cumulative convertible preference shares of US$0.01
                                                                               
– Series 1
    91.18       49.66                       45.58               50.26               50.33          
– Series 2 (redeemed March 2005)
                                                            11.60          
– Series 3 (redeemed December 2005)
                                                            43.03          
Non-cumulative convertible preference shares of €0.01
                                                                               
– Series 1 (redeemed March 2005)
                                                            11.54          
Non-cumulative preference shares of €0.01
                                                                               
– Series 1
                    67.95       46.53               39.63               37.18               41.14  
– Series 2
                    61.03       41.79               35.52               36.22                
Non-cumulative convertible preference shares of £0.01
                                                                               
– Series 1
    107.88       73.87                       73.87               73.87               73.87          
 

 
UK
GAAP
2004
Amount per share
£
Non-cumulative preference shares of US$0.01
 
– Series D (redeemed March 2006)
1.11
– Series E (redeemed January 2007)
1.10
– Series F
1.04
– Series G (redeemed January 2007)
1.00
– Series H
0.98
– Series I (redeemed March 2006)
1.08
– Series J (redeemed November 2005)
1.15
– Series K (redeemed January 2007)
1.07
– Series L
0.19
– Series M
0.30
Non-cumulative convertible preference shares of US$0.01
 
– Series 1
49.05
– Series 2 (redeemed March 2005)
47.43
– Series 3 (redeemed December 2005)
41.74
Non-cumulative convertible preference shares of €0.01
 
– Series 1 (redeemed March 2005)
44.19
Non-cumulative preference shares of €0.01
 
– Series 1
3.45
Non-cumulative convertible preference shares of £0.01
 
– Series 1
73.87
 
 
 
Ordinary dividends
Ordinary dividends per share for prior years in the table below have been restated for the effect of the rights issue in June 2008 and the capitalisation issue in September 2008.
 
   
IFRS
2007
   
IFRS
2006
   
IFRS
2005
 
Amount per share and American Depository Shares (1)
 
pence
   
pence
   
pence
 
Interim
    8.5       6.8       5.4  
Final (2)
    19.3       18.5       14.8  
Total dividends on equity shares
    27.8       25.3       20.2  

 
   
UK GAAP
2004
 
Amount per share and American Depository Shares (1)
 
pence
 
Interim
    4.7  
Final (2)
    11.5  
Total dividends on equity shares
    16.2  
 
Notes:
 
(1)
Each American Depository Share represents 20 ordinary shares. The historical amounts listed in the table apply to the ordinary shares, as the American Depositary Shares were not issued until October 2007 as described above under Trading Market.
 
(2)
Final dividends for each year were proposed in the indicated year and paid in the following year.
 
In September 2008, the company issued new ordinary shares by way of a capitalisation issue rather than paying an interim dividend.
 
In December 2008, the company issued Series 2 non-cumulative preference shares of £1 each to HM Treasury, with an attached condition that no dividend is paid to ordinary shareholders until those preference shares are no longer in issue, unless otherwise agreed by HM Treasury. The company has reached agreement with HM Treasury to replace the Series 2 non-cumulative preference shares held by HM Treasury with new ordinary shares. Following redemption, the dividend restriction on ordinary shares will be removed. However, it is currently the Board’s intention not to pay any ordinary dividends for 2009.
 
For further information, see Notes 7 and 8 on the accounts.
 
 

 
 
Taxation for US Holders
The following discussion summarises certain US federal and UK tax consequences of the acquisition, ownership and disposition of ordinary shares, non-cumulative dollar preference shares, ADSs representing ordinary shares (ordinary ADSs), ADSs representing non-cumulative dollar preference shares (preference ADSs) or PROs by a beneficial owner that is a citizen or resident of the United States or that otherwise will be subject to US federal income tax on a net income basis in respect of the ordinary shares, non-cumulative dollar preference shares, ordinary ADSs, preference ADSs or PROs (a US Holder). This summary assumes that a US Holder is holding ordinary shares, non-cumulative dollar preference shares, ordinary ADSs, preference ADSs or PROs, as applicable, as capital assets. This summary does not address the tax consequences to a US Holder (i) that is resident (or, in the case of an individual, ordinarily resident) in the UK for UK tax purposes or (ii) generally, that is a corporation which alone or together with one or more associated companies, controls, directly or indirectly, 10% or more of the voting stock of the company.
 
The statements and practices set forth below regarding US and UK tax laws, including the US/UK double taxation convention relating to income and capital gains which entered into force on 31 March 2003 (the Treaty), and the US/UK double taxation convention relating to estate and gift taxes (the Estate Tax Treaty), are based on those laws and practices as in force and as applied in practice on the date of this report. This summary is not exhaustive of all possible tax considerations and holders are advised to satisfy themselves as to the overall tax consequences, including specifically the consequences under US federal, state, local and other laws, and possible changes in taxation law, of the acquisition, ownership and disposition of ordinary shares, non-cumulative dollar preference shares, ordinary ADSs, preference ADSs or PROs by consulting their own tax advisers.
 
The following discussion assumes that the company is not, and will not become, a passive foreign investment company (PFIC) — see ‘Passive Foreign Investment Company Considerations’ on page 285.
 
Ordinary shares, preference shares, ordinary ADSs and preference ADSs
 
Taxation of dividends
For the purposes of the Treaty, the Estate Tax Treaty and the US Internal Revenue Code of 1986, as amended (the Code), US Holders of ordinary ADSs and preference ADSs should be treated as owners of the ordinary shares and the non-cumulative dollar preference shares underlying such ADSs.
 
The US Treasury has expressed concerns that parties to whom depositary receipts are released before shares are delivered to the depositary, or intermediaries, in the chain of ownership between US holders and the issuer of the security underlying the depositary receipts may be taking actions that are inconsistent with the claiming of foreign tax credits for US holders of depositary receipts. Such actions in connection with pre-release activity would also be inconsistent with the claiming of the reduced rate of US tax applicable to dividends received by certain non-corporate US holders. Accordingly, availability of the reduced tax rate for dividends received by certain non-corporate US holders of ordinary ADSs could be affected by actions taken by such parties or intermediaries.
 
The company is not required to withhold UK tax at source from dividend payments it makes or from any amount (including any amounts in respect of accrued dividends) distributed by the company. US Holders who are not resident or ordinarily resident in the UK and who do not carry on a trade, profession or vocation in the UK through a branch, agency or permanent establishment in connection with which their ordinary shares, non-cumulative preference shares, ordinary ADSs or preference ADSs are held, used or acquired will not be subject to UK tax in respect of any dividends received on the relevant shares or ADSs.
 
Distributions by the company will constitute foreign source dividend income for US federal income tax purposes to the extent paid out of the current or accumulated earnings and profits of the company, as determined for US federal income tax purposes. Because the company does not maintain calculations of its earnings and profits under US federal income tax principles, it is expected that distributions will be reported to US Holders as dividends. Payments will not be eligible for the dividends-received deduction generally allowed to corporate US holders.
 
Subject to applicable limitations that may vary depending upon a holder’s individual circumstances, dividends paid to certain non- corporate US Holders in taxable years beginning before 1 January 2011 will be taxable at a maximum tax rate of 15%. Non-corporate US Holders should consult their own tax advisers to determine whether they are subject to any special rules that limit their ability to be taxed at this favourable rate.
 
Dividends will be included in a US Holder’s income on the date of the US Holder’s (or in the case of ADSs, the Depositary’s) receipt of the dividend. The amount of any dividend income paid in pounds sterling or euros will be a US dollar amount calculated by reference to the relevant exchange rate in effect on the date of such receipt regardless of whether the payment is in fact converted into US dollars. If the dividend is converted into US dollars on the date of receipt, the US Holder generally should not be required to recognise foreign currency gain or loss in respect of the dividend income. If the amount of such dividend is not converted into US dollars on the date of receipt, the US Holder may have foreign currency gain or loss.
 
Taxation of capital gains
A US Holder that is not resident (or, in the case of an individual, ordinarily resident) in the UK will not normally be liable for UK tax on capital gains realised on the disposition of an ordinary share, a non-cumulative dollar preference share, an ordinary ADS or a preference ADS unless at the time of the disposal, in the case of a corporate US Holder, such US Holder carries on a trade in the UK through a permanent establishment or, in the case of any other US Holder, such US Holder carries on a trade, profession or vocation in the UK through a UK branch or agency and such ordinary share, non-cumulative dollar preference share, ordinary ADS or preference ADS is or has been used, held or acquired by or for the purposes of such trade (or profession or vocation), permanent establishment, branch or agency. Special rules apply to individuals who are temporarily not resident or ordinarily resident in the UK.
 
 
Shareholder information continued

 
 
A US Holder will, upon the sale or other disposition of an ordinary share, a non-cumulative dollar preference share, an ordinary ADS or a preference ADS, or upon the redemption of a non-cumulative dollar preference share or preference ADS, generally recognise capital gain or loss for US federal income tax purposes (assuming that in the case of a redemption of a non-cumulative dollar preference share or a preference ADS, such US Holder does not own, and is not deemed to own, any ordinary shares or ordinary ADSs of the company) in an amount equal to the difference between the amount realised (excluding in the case of a redemption any amount treated as a dividend for US federal income tax purposes, which will be taxed accordingly) and the US Holder’s tax basis in such share or ADS. This capital gain or loss will be long-term capital gain or loss if the US Holder held the share or ADS so sold, disposed or redeemed for more than one year.
 
A US Holder who is liable for both UK and US tax on a gain recognised on the disposal of an ordinary share, a non-cumulative dollar preference share, an ordinary ADS or a preference ADS will generally be entitled, subject to certain limitations, to credit the UK tax against its US federal income tax liability in respect of such gain.
 
If a corporate US Holder is subject to UK corporation tax by reason of carrying on a trade in the UK through a permanent establishment and its non-cumulative dollar preference share or preference ADS is, or has been, used, held or acquired for the purposes of that permanent establishment, certain provisions introduced by the Finance (No. 2) Act 2005 will apply if the US Holder holds its non-cumulative dollar preference share or preference ADS for a ‘tax avoidance purpose’. If these provisions apply, dividends on the non-cumulative dollar preference share or preference ADS, as well as certain fair value credits and debits arising in respect of such share or ADS, will be brought within the charge to UK corporation tax on income and the UK tax position outlined in the preceding paragraphs will not apply in relation to such US Holder.
 
Estate and gift tax
Subject to the discussion of the Estate Tax Treaty in the next paragraph, ordinary shares, non-cumulative dollar preference shares, ordinary ADSs or preference ADSs beneficially owned by an individual may be subject to UK inheritance tax (subject to exemptions and reliefs) on the death of the individual or in certain circumstances, if such shares or ADSs are the subject of a gift (including a transfer at less than market value) by such individual. (Inheritance tax is not generally chargeable on gifts to individuals made more than seven years before the death of the donor). Ordinary shares, non-cumulative dollar preference shares, ordinary ADSs or preference ADSs held by the trustees of a settlement will also be subject to UK inheritance tax. Special rules apply to such settlements.
 
An ordinary share, a non-cumulative dollar preference share, an ordinary ADS or a preference ADS beneficially owned by an individual, whose domicile is determined to be the United States for purposes of the Estate Tax Treaty and who is not a national of the UK, will not be subject to UK inheritance tax on the individual’s death or on a lifetime transfer of such share or ADS, except in certain cases where the share or ADS (i) is comprised in a settlement (unless, at the time of the settlement, the settlor was domiciled in the United States and was not a national of the UK); (ii) is part of the business property of a UK permanent establishment of an enterprise; or (iii) pertains to a UK fixed base of an individual used for the performance of independent personal services. The Estate Tax Treaty generally provides a credit against US federal estate or gift tax liability for the amount of any tax paid in the UK in a case where the ordinary share, non-cumulative dollar preference share, ordinary ADS or preference ADS is subject to both UK inheritance tax and US federal estate or gift tax.
 
UK stamp duty and stamp duty reserve tax (SDRT)
The following is a summary of the UK stamp duty and SDRT consequences of transferring an ADS or ADR in registered form (otherwise than to the custodian on cancellation of the ADS) or of transferring an ordinary share or a non-cumulative dollar preference share. A transfer of a registered ADS or ADR executed and retained in the United States will not give rise to stamp duty and an agreement to transfer a registered ADS or ADR will not give rise to SDRT. Stamp duty or SDRT will normally be payable on or in respect of transfers of ordinary shares or non-cumulative dollar preference shares and accordingly any holder who acquires or intends to acquire ordinary shares or non-cumulative dollar preference shares is advised to consult its own tax advisers in relation to stamp duty and SDRT.
 
PROs
United States
Payments of interest on a PRO (including any UK withholding tax, as to which see below) will constitute foreign source dividend income for US federal income tax purposes to the extent paid out of the current or accumulated earnings and profits of the company, as determined for US federal income tax purposes. Payments will not be eligible for the dividends-received deduction generally allowed to corporate US holders. A US Holder who is entitled under the Treaty to a refund of UK tax, if any, withheld on a payment will not be entitled to claim a foreign tax credit with respect to such tax.
 
Subject to applicable limitations that may vary depending upon a holder’s individual circumstances, dividends paid to certain non- corporate US Holders in taxable years beginning before 1 January 2011 will be taxable at a maximum tax rate of 15%. Non-corporate US Holders should consult their own tax advisers to determine whether they are subject to any special rules that limit their ability to be taxed at this favourable rate.
 
In addition, bills have been introduced in both the US House and the US Senate which would have denied the favourable tax rates described in the preceding paragraph for dividends paid in respect of certain securities, including securities such as PROs, where the issuer of the securities is allowed a deduction under the tax laws of a foreign country with respect to such dividend. The proposed legislation would have applied to dividends received after the date of its enactment. It is not possible to predict whether similar legislation might be reintroduced and enacted in the future. Non-corporate US Holders should consult their tax advisers with respect to the potential enactment of proposed legislation and its application in their particular circumstances.
 
A US Holder will, upon the sale, exchange or redemption of a PRO, generally recognise capital gain or loss for US federal income tax purposes (assuming that in the case of a redemption, such US Holder does not own, and is not deemed to own, any ordinary shares or ordinary ADSs of the company) in an amount equal to the difference between the amount realised (excluding any amount in respect of mandatory interest and any missed payments which are to be satisfied on a missed payment satisfaction date, which would be treated as ordinary income) and the US Holder’s tax basis in the PRO.
 
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Shareholder information continued

 
 
A US Holder who is liable for both UK and US tax on gain recognised on the disposal of PROs will generally be entitled, subject to certain limitations, to credit the UK tax against its US federal income tax liability in respect of such gain.
 
United Kingdom
Taxation of payments on the PROs
Payments on the PROs will constitute interest rather than dividends for UK withholding tax purposes. However, the PROs will constitute ‘quoted eurobonds’ within the meaning of section 987 of the Income Tax Act 2007 and therefore payments of interest will not be subject to withholding or deduction for or on account of UK taxation as long as the PROs remain at all times listed on a ‘recognised stock exchange’ within the meaning of section 1005 of the Income Tax Act 2007. In all other cases, an amount must be withheld on account of UK income tax at the basic rate (currently 20%) subject to any direction to the contrary by HM Revenue & Customs under the Treaty and except that the withholding obligation is disapplied in respect of payments to persons who the company reasonably believes are within the charge to corporation tax or fall within various categories enjoying a special tax status (including charities and pension funds), or are partnerships consisting of such persons (unless HM Revenue & Customs directs otherwise). Where interest has been paid under deduction of UK withholding tax, US Holders may be able to recover the tax deducted under the Treaty.
 
Any paying agent or other person by or through whom interest is paid to, or by whom interest is received on behalf of an individual, may be required to provide information in relation to the payment and the individual concerned to HM Revenue & Customs. HM Revenue & Customs may communicate this information to the tax authorities of other jurisdictions.
 
HM Revenue & Customs confirmed at around the time of the issue of the PROs that interest payments would not be treated as distributions for UK tax purposes by reason of (i) the fact that interest may be deferred under the terms of issue; or (ii) the undated nature of the PROs, provided that at the time an interest payment is made, the PROs are not held by a company which is ‘associated’ with the company or by a ‘funded company’. A company will be associated with the company if, broadly speaking, it is part of the same group as the company. A company will be a ‘funded company’ for these purposes if there are arrangements involving that company being put in funds (directly or indirectly) by the company, or an entity associated with the company. In this respect, HM Revenue & Customs has confirmed that a company holding an interest in the PROs which incidentally has banking facilities with any company associated with the company will not be a ‘funded company’ by virtue of such facilities. Interest on the PROs constitutes UK source income for UK tax purposes and, as such, may be subject to income tax by direct assessment even where paid without withholding. However, interest with a UK source received without deduction or withholding on account of UK tax will not be chargeable to UK tax in the hands of a US Holder unless, in the case of a corporate US Holder, such US Holder carries on a trade in the UK through a UK permanent establishment or in the case of other US Holders, such persons carry on a trade, profession or vocation in the UK through a UK branch or agency in connection with which the interest is received or to which the PROs are attributable. There are exemptions for interest received by certain categories of agents (such as some brokers and investment managers).
 
EU Directive on taxation of savings income
The European Union has adopted a directive regarding the taxation of savings income. The Directive requires member states of the European Union to provide to the tax authorities of other member states details of payments of interest and other similar income paid by a person to an individual or certain other persons resident in another member state, except that Belgium, Luxembourg and Austria may instead impose a withholding system for a transitional period unless during such period they elect otherwise.
 
Disposal (including redemption)
A disposal (including redemption) of PROs by a non-corporate US Holder will not give rise to any liability to UK taxation on capital gains unless the US Holder carries on a trade (which for this purpose includes a profession or a vocation) in the UK through a branch or agency and the PROs are, or have been, held or acquired for the purposes of that trade, branch or agency.
 
A transfer of PROs by a US Holder will not give rise to a charge to UK tax on accrued but unpaid interest payments, unless the US Holder is an individual or other non-corporate taxpayer and at any time in the relevant year of assessment or accounting period carries on a trade in the UK through a branch or agency to which the PROs are attributable.
 
Annual tax charges
Corporate US Holders of PROs may be subject to annual UK tax charges (or relief) by reference to fluctuations in exchange rates and in respect of profits, gains and losses arising from the PROs, but only if such corporate US Holders carry on a trade, profession or vocation in the UK through a UK permanent establishment to which the PROs are attributable.
 
Inheritance tax
In relation to PROs held through DTC (or any other clearing system), the UK inheritance tax position is not free from doubt in respect of a lifetime transfer, or death of, a US Holder who is not domiciled nor deemed to be domiciled in the UK for inheritance tax purposes; HM Revenue & Customs is known to consider that the situs of securities held in this manner is not necessarily determined by the place where the securities are registered. In appropriate circumstances, there may be a charge to UK inheritance tax as a result of a lifetime transfer at less than market value by, or on the death of, such US Holder. Inheritance tax is not generally chargeable on gifts to individuals made more than seven years before the death of the donor. However, exemption from, or a reduction of, any such UK tax liability may be available under the Estate Tax Treaty (see below). US Holders should consult their professional advisers in relation to such potential liability.
 
 

 
 
PROs beneficially owned by an individual, whose domicile is determined to be the United States for the purposes of the Estate Tax Treaty and who is not a national of the UK, will not be subject to UK inheritance tax on the individual’s death or on a lifetime transfer of the PRO, except in certain cases where the PRO (i) is comprised in a settlement (unless, at the time of the settlement, the settlor was domiciled in the United States and was not a national of the UK); (ii) is part of the business property of a UK permanent establishment of an enterprise; or (iii) pertains to a UK fixed base of an individual used for the performance of independent personal services. The Estate Tax Treaty generally provides a credit against US federal estate or gift tax liability for the amount of any tax paid in the UK in a case where the PRO is subject to both UK inheritance tax and US federal estate or gift tax.
 
Stamp duty and SDRT
No stamp duty, SDRT or similar tax is imposed in the UK on the issue, transfer or redemption of the PROs.
 
Passive Foreign Investment Company considerations
A foreign corporation will be a PFIC in any taxable year in which, after taking into account the income and assets of the corporation and certain subsidiaries pursuant to applicable ‘look-through rules’, either (i) at least 75% of its gross income is ‘passive income’ or (ii) at least 50% of the average value of its assets is attributable to assets which produce passive income or are held for the production of passive income. The company does not believe that it was as a PFIC for its 2008 taxable year. Although interest income is generally passive income, a special rule allows banks to treat their banking business income as non-passive. To qualify for this rule, a bank must satisfy certain requirements regarding its licensing and activities. The company believes that it currently meets these requirements. The company’s possible status as a PFIC must be determined annually, however, and may be subject to change if the company fails to qualify under this special rule for any year in which a US Holder holds ordinary shares, non-cumulative dollar preference shares, ordinary ADSs, preference ADSs or PROs. If the company were to be treated as a PFIC in any year during which a US Holder holds ordinary shares, non-cumulative dollar preference shares, ordinary ADSs, preference ADSs or PROs, US Holders would generally be subject to adverse US federal income tax consequences. Holders should consult their own tax advisers as to the potential application of the PFIC rules to the ownership and disposition of the company’s ordinary shares, non-cumulative dollar preference shares, ordinary ADSs, preference ADSs or PROs.
 
Exchange controls
The company has been advised that there are currently no UK laws, decrees or regulations which would prevent the import or export of capital, including the availability of cash or cash equivalents for use by the Group, or the remittance of dividends, interest or other payments to non-UK resident holders of the company’s securities.
 
There are no restrictions under the Articles of Association of the company or under UK law, as currently in effect, which limit the right of non-UK resident owners to hold or, when entitled to vote, freely to vote the company’s securities.
 
Memorandum and Articles of Association
The following information is a summary of certain terms of the company’s Memorandum of Association (the “Memorandum”) and Articles of Association (the “Articles”) as in effect at the date of this Annual Report and certain relevant provisions of the Companies Act 1985, as amended (the “ 1985 Act”) and the Companies Act 2006 (the “2006 Act”) where appropriate and as relevant to the holders of any class of share. The Articles were last amended on 3 April 2009. The amendments to the Articles were designed to vary the class rights of HM Treasury in its capacity as the holder of non-cumulative sterling preference shares. The following summary description is qualified in its entirety by reference to the terms and provisions of the Memorandum and Articles. The Memorandum and Articles are registered with the Registrar of Companies of Scotland. Holders of any class of share are encouraged to read the full Memorandum and Articles, which have been filed as an exhibit to this annual report on Form 20-F.
 
Incorporation and registration
The company was incorporated and registered in Scotland under the Companies Act 1948 as a limited company on 25 March 1968 under the name National and Commercial Banking Group Limited. On 10 March 1982, it changed its name to its present name and was registered under the Companies Acts 1948 to 1980 as a public company with limited liability. The company is registered under Company No. SC 45551.
 
Purpose and objects
The Memorandum provides, amongst other things, that its objects are to carry on the business of banking in all or any of its aspects and to carry on the business of a holding company. The company’s objects are set out in full in clause 4 of the Memorandum.
 
Directors
At each annual general meeting of the company, any Director appointed since the last annual general meeting and any Directors who were not appointed at one of the preceeding two annual general meetings shall retire from office and may offer themselves for re-election by the members. Directors who have attained the age of 16 may be appointed to or remain on the Board if that appointment is or was made or approved by the company in a general meeting.
 
Directors may be appointed by the company by ordinary resolution or by the Board. A director appointed by the Board holds office only until the next annual general meeting, whereupon he will be eligible for re-election. Unless and until otherwise determined by ordinary resolution, the directors (other than alternate directors) shall be not more than twenty five. There is no stipulation in the Articles regarding a minimum number of directors; under the 2006 Act, and in the absence of express provision, the minimum number is two.
 
Directors’ interests
A director shall not vote at a meeting of the Board or a committee of the Board on any resolution of the Board concerning a matter in which he has an interest (otherwise than by virtue of his interest in shares, debentures or other securities of, or otherwise in or through, the company) which (together with any interest of any person connected with him) is, to his knowledge, material unless his interests arises only because the resolution relates to one or more of the following matters:
 
 
i.
the giving of any security or indemnity to him pursuant to the Articles or in respect of money lent, or obligations incurred, by him at the request of, or for the benefit of, the company or any of its subsidiary undertakings;
 
 
ii.
the giving of any security or indemnity to a third party in respect of a debt or obligation of the company or any of its subsidiary undertakings for which he has assumed responsibility (in whole or in part) under a guarantee or indemnity or by the giving of security;
 
 
iii.
a proposal concerning an offer of shares, debentures or other securities of the company, or any of its subsidiary undertakings, for subscription or purchase, in which offer he is, or may be, entitled to participate as a holder of securities or in the underwriting or sub-underwriting of which he is to participate;
 
 
 
 
Shareholder information continued

 
 
 
iv.
any proposal concerning any other body corporate in which he is interested, directly or indirectly, whether as an officer or shareholder or otherwise, provided that he is not the holder of shares representing one per cent or more of any class of the equity share capital of such body corporate;
 
 
v.
any proposal concerning the adoption, modification or operation of a pension fund or retirement, death or disability benefits scheme or employees’ share scheme which relates both to directors and employees of the company or a subsidiary of the company and does not provide any privilege or advantage in respect of any director which it does not accord to the employees to which the fund or scheme relates;
 
 
vi.
a contract or arrangement for the benefit of the employees of the company or any of its subsidiary undertakings which does not accord him any privilege or advantage not generally accorded to the employees to whom the contract or arrangement relates; and
 
 
vii.
a proposal concerning any insurance which the company proposes to purchase and/or maintain for the benefit of any directors or for persons who include directors of the company.
 
Under the 2006 Act, from 1 October 2008 a director must avoid a situation where he has, or can have, a direct or indirect interest that conflicts, or possibly may conflict, with the company’s interests. The 2006 Act allows directors of public companies, where appropriate, to authorise conflicts and potential conflicts where the articles of association contain a provision to this effect. The 2006 Act also allows the articles of association to contain other provisions for dealing with directors’ conflicts of interest to avoid a breach of duty.
 
Clause 100 of the Articles, to take effect from 1 October 2008, gives the directors authority to authorise any matter which would or might otherwise constitute or give rise to a breach of the duty of a director under the 2006 Act to avoid a situation in which he has, or can have, a direct or indirect interest that conflicts, or possibly may conflict with the company.
 
Authorisation of any matter pursuant to Clause 100 must be approved in accordance with normal board procedures by directors who have no interest in the matter being considered. In taking the decision, the directors must act in a way they consider, in good faith, will be most likely to promote the company’s success. Any authorisation of a matter may be given on or subject to such conditions or limitations as the directors determine, whether at the time of authorisation or subsequently, including providing for the exclusion of the interested directors from the receipt of information or participation in discussion relating to the matter authorised by the directors and providing that interested directors in receipt of confidential information from a third party are not obliged to disclose such information to the company or use the information in relation to the company’s affairs. Any authorization may be terminated by the directors at any time.
 
A director is not, except as otherwise agreed by him, accountable to the company for any benefit which he, or a person connected with him, derives from any matter authorised by the directors and any contract, transaction or arrangement relating to such matter is not liable to be avoided on the grounds of such benefit.
 
Borrowing powers
The directors may exercise all the powers of the company to borrow money and to mortgage or charge its undertaking, property and uncalled capital and to issue debentures and other securities, whether outright or as collateral security for any debt, guarantee, liability or obligation of the company, or of any third party.
 
Qualifying shareholding
Directors are not required to hold any shares of the company by way of qualification.
 
Classes of shares
The company has issued and outstanding the following 3 general classes of shares, namely ordinary shares, preference shares and non-voting deferred shares to which the provisions set forth below apply. In addition, the company has authorized as part of its share capital Additional Value Shares (“AVSs”). All of the issued AVSs were converted into non-voting deferred shares in December 2003. The terms of those AVSs are set out in Schedule 4 to the Articles.
 
Dividends
General
Subject to the provisions of the 1985 Act and clause 133 of the Articles, the company may, by ordinary resolution, declare dividends on ordinary shares save that no dividend shall be payable except out of profits available for distribution, or in excess of the amount recommended by the Board or in contravention of the special rights attaching to any share. Any dividend which has remained unclaimed for 12 years from the date of declaration shall be forfeited and shall revert to the company. The company may cease sending dividend warrants and cheques by post or otherwise to a member if such instruments have been returned undelivered to, or left uncashed by, that member on at least two consecutive occasions, or, following one such occasion, reasonable enquiries have failed to establish any new address or account of the registered holder. The company may resume sending warrants and cheques if the holder requests such recommencement in writing.
 
Preference shares
Each cumulative preference share confers the right to a fixed cumulative preferential dividend payable half-yearly. Each non-cumulative preference share confers the right to a preferential dividend (not exceeding a specified amount) payable in the currency of the relevant share. The rate of such dividend and the date of payment thereof, together with the terms and conditions of the dividend, are as may be determined by the directors prior to allotment. Cumulative preference share dividends are paid in priority to any dividend on any other class of share.
 
The non-cumulative preference shares rank for dividend after the cumulative preference shares but rank pari passu with each other and any shares expressed to rank, in terms of participation in the profits of the company, in some or all respects pari passu therewith and otherwise in priority to dividends payable on the ordinary shares and any other share capital in the company.
 
The directors may resolve prior to the issue and allotment of any series of non-cumulative preference shares that full dividends in respect of a particular dividend payment date will not be declared and paid if, (i) in its sole and absolute discretion, the directors resolve prior to the relevant dividend payment date that such dividend (or part thereof) shall not be paid and/or (ii) in the opinion of the directors, payment of a dividend would cause a breach of the UK Financial Services Authority’s capital adequacy requirements applicable to the company or its subsidiaries, or subject to the next following paragraph, insufficient distributable profits of the company are available to cover the payment in full of all dividends after having paid any dividends payable on any of the cumulative preference shares.
 
 
 
 
 
Shareholder information continued

 
 
If dividends will be paid but, in the opinion of the directors, insufficient distributable profits of the company are available to cover the payment in full of dividends after having paid any dividends payable on any of the cumulative preference shares, dividends will be declared by the directors, pro rata on the non-cumulative preference shares to the extent of the available distributable profits.
 
The non-cumulative preference shares will carry no further rights to participate in the profits of the company and if, and to the extent, any dividend or part of any dividend is on any occasion not paid for any of the reasons described above, holders of non-cumulative preference shares will have no claim in respect of such non-payment.
 
If any dividend is not payable for the reasons described in clause (ii) of this subsection, the directors may pay a special dividend not exceeding US$0.01, £0.01 or €0.01 (depending on the currency of the relevant preference share) per share.
 
If the dividend payable on any series of non-cumulative preference shares on the most recent payment date is not paid in full, or if a sum is not set aside to provide for such payment in full, in either case for the reasons set forth in clause (ii) of this subsection, no dividends may be declared on any other share capital of the company and no sum may be set aside for the payment of a dividend on any other share capital (in each case other than the cumulative preference shares), unless, on the date of declaration, an amount equal to the dividend payable in respect of the then current dividend period for such series of non-cumulative preference shares is set aside for payment in full on the next dividend payment date.
 
If any dividend payable on the non-cumulative preference shares is not paid in full or if a sum is not set aside to provide for such payment in full (in either case for the reasons set forth in clause (ii) of this subsection), the company may not redeem or purchase or otherwise acquire any other share capital of the company and may not set aside any sum nor establish any sinking fund for its redemption, purchase or other such acquisition, until such time as dividends have been declared and paid in full in respect of successive dividend periods together aggregating not less than twelve months.
 
The non-payment of any dividend (in full or in part) by reason of the exercise of the directors’ discretion referred to in clause (i) of this subsection, shall not prevent or restrict (a) the declaration and payment of dividends on any other series of non-cumulative preference shares or on any non-cumulative preference shares expressed to rank pari passu with the non-cumulative preference shares, (b) the setting aside of sums for the payment of such dividends, (c) except as set forth in the following paragraph, the redemption, purchase or other acquisition of shares in the company by the company, or (d) except as set forth in the following paragraph, the setting aside of sums, or the establishment of sinking funds, for any such redemption, purchase or other acquisition by the company.
 
If dividends are not declared and paid in full on any series of non-cumulative preference shares as a result of the directors’ discretion referred to in clause (i) of this subsection, then the company may not redeem, purchase or otherwise acquire for any consideration any share capital ranking after such preference shares, and may not set aside any sum nor establish any sinking fund for the redemption, purchase or other acquisition thereof, until such time as the company has declared and paid in full dividends on such series of non-cumulative preference shares in respect of successive dividend periods together aggregating no less than twelve months. In addition, no dividend may be declared or paid on any of the company’s share capital ranking after such preference shares until the dividend in respect of a particular dividend payment date payable on the preference shares to which the directors’ discretion in clause (i) of this subsection applies has been declared and paid in full.
 
Non-voting deferred shares
The holders of non-voting deferred shares are not entitled to the payment of any dividend or other distribution.
 
Distribution of assets on liquidation
Cumulative preference shares
In the event of a return of capital on a winding-up or otherwise, the holders of cumulative preference shares are entitled to receive out of the surplus assets of the company available for distribution amongst the members (i) in priority to the holders of the non-cumulative preference shares and any other shares ranking pari passu therewith, the arrears of any fixed dividends including the amount of any dividend due for a payment after the date of commencement of any winding-up or liquidation but which is payable in respect of a half-year period ending on or before such date and (ii) pari passu with the holders of the non-cumulative preference shares and any other shares ranking pari passu therewith, the amount paid up or credited as paid up on such shares together with any premium.
 
Non-cumulative preference shares
Each non-cumulative preference share will confer on a winding up or liquidation (except (unless otherwise provided by the terms of issue) a redemption or purchase by the company of any shares in the capital of the company), the right to receive out of surplus assets of the company available for distribution amongst the members after payment of the arrears (if any) of the cumulative dividend on the cumulative preference shares and in priority to the holders of the ordinary shares, repayment of the amount paid up or credited as paid up on the non-cumulative preference shares together with any premium paid on issue pari passu with the holders of the cumulative preference shares and together with an amount equal to accrued and unpaid dividends.
 
Non-voting deferred shares
On a winding-up or other return of capital of the company, holders of non-voting deferred shares are entitled only to payment of the amounts paid up on the non-voting deferred shares, after repayment to the holders of ordinary shares of the nominal amount paid up on the ordinary shares held by them and payment of £100,000 on each ordinary share.
 
General
On a winding-up of the company, the liquidator may, with the authority of any extraordinary resolution and any other sanction required by the Insolvency Act 1986 and subject to the rights attaching to any class of shares after payment of all liabilities, including the payment to holders of preference shares, divide amongst the members in specie or kind the whole or any part of the assets of the company or vest the whole or any part of the assets in trustees upon such trusts for the benefit of the members and may determine the scope and terms of those trusts. No member shall be compelled to accept any assets on which there is a liability.
 
Voting Rights
General
Subject to any rights or restrictions as to voting attaching to any shares or class of shares, on a show of hands every member who is present in person or by proxy at a general meeting shall have one vote and on a poll every member present in person or by proxy shall have one vote for each 25 pence in nominal amount of shares held by him. No member shall, unless the directors otherwise determine, be entitled to vote at a general meeting or at a separate meeting of the holders of shares in the capital of the company, either in person or by proxy, in respect of any share held by him unless all monies presently payable by him in respect of that share have been paid.
 
 
 
 
 
Shareholder information continued

 
 
The quorum required for a meeting of members is not less than five members present in person and entitled to vote. If a meeting is adjourned because of the lack of a quorum, the members present in person or by proxy and entitled to vote will constitute a quorum at the adjourned meeting.
 
Meetings are convened upon written notice of not less than 21 days in respect of annual general meetings of members and not less than 14 days in respect of other meetings of members.
 
Cumulative preference shares
At a general meeting of the company, every holder of a cumulative preference share who is present in person or by proxy shall be entitled to one vote on a show of hands and, on a poll, every person who is present in person or by proxy shall have one vote for each 25 pence in nominal amount of shares held. No member shall be entitled to vote any share in person or by proxy unless all moneys owed in respect of that share have been paid.
 
Non-cumulative preference shares
Holders of non-cumulative preference shares are not entitled to attend or vote at any general meeting unless the business of the meeting includes the consideration of a resolution for the winding-up of the company or any resolution directly varying or abrogating the rights attached to any such shares and then in such case only to speak to and vote upon any such resolution.
 
However, holders have the right to vote in respect of any matter when the dividend payable on their shares has not been declared in full for such number of dividend periods as the directors shall determine prior to the allotment thereof.
 
Whenever a holder is entitled to vote at a general meeting, on a show of hands every shareholder who is present in person has one vote and, on a poll, every such holder who is present in person or by proxy shall have such number of votes as may be determined by the directors prior to allotment.
 
Non-voting deferred shares
The holders of non-voting deferred shares are not entitled to receive notice of or to attend or vote at any general meeting of the company or otherwise receive any shareholder communication.
 
Redemption
Except as set forth in the following paragraph, unless the directors determine, prior to allotment of any particular series of non-cumulative preference shares, that such series shall be non-redeemable, the preference shares will be redeemable at the option of the company on any date (a “Redemption Date”) which (subject to certain exceptions described in the terms of such shares) falls no earlier than such date (if any) as may be fixed by the directors, prior to allotment of such shares.   Except as set forth in the following paragraph, on  redemption, there shall be paid on each non-cumulative preference share the aggregate of its nominal amount together with any premium paid on issue, where applicable a redemption premium and accruals of dividend.
 
Series 2 of the non-cumulative sterling preference shares may be redeemed at any time provided that the redemption is financed wholly by the proceeds of the issue of new ordinary shares pursuant to the placing and open offer agreement dated 19 January 2009 between the company and HM Treasury.  In such case, on redemption, there shall be paid on each non-cumulative sterling preference share the aggregate of 101 per cent of its liquidation preference amount and any dividend accrued thereon.  
 
Purchase
General
Subject to the 1985 Act, the company may, by special resolution, reduce its share capital, any capital redemption reserve and any share premium account or other undistributable reserve and may also, subject to the 1985 Act, the requirements of the London Stock Exchange and the rights attached to any class of shares, purchase its own shares (including redeemable shares).
 
Non-cumulative preference shares and convertible preference shares
Subject to the 1985 Act, the company may purchase any non-cumulative preference shares and convertible preference shares upon such terms as the directors shall determine provided that, where the shares being purchased are listed on the London Stock Exchange, the purchase price payable, exclusive of expenses and accrued dividends, shall not exceed (a) in the case of a purchase in the open market, or by tender, the average of the closing middle market quotations of such shares for the 10 dealing days preceding the date of the purchase of (if higher), in the case of a purchase in the open market only, the market price on the date of purchase provided that such market price is not more than 105 per cent of such average and (b) in the case of a purchase by private treaty, 120 per cent of the closing middle market quotation of such shares for the last dealing day preceding the date of purchase; but so that this proviso shall not apply to any purchase of such shares made in the ordinary course of a business of dealing in securities. Upon the purchase of any such shares, the nominal amount of such shares shall thereafter be divided into, and reclassified as, ordinary shares.
 
Conversion rights
Convertible preference shares carry the right to convert into ordinary shares if they have not been the subject of a notice of redemption from the company, on or before a specified date determined by the directors. The right to convert will be exercisable by service of a conversion notice on the company within a specified period. The company will use reasonable endeavours to arrange the sale, on behalf of convertible preference shareholders who have submitted a conversion notice, of the ordinary shares which result from such conversion and to pay to them the proceeds of such sale so that they receive net proceeds equal to the nominal value of the convertible preference shares which were the subject of the conversion notice and any premium at which such shares were issued, provided that ordinary shares will not be sold at below a benchmark price (as determined prior to the issue of the relevant convertible preference shares by the directors).
 
In December 2003, following the payment of aggregate dividends of £1 in respect of each AVS, all issued and outstanding AVSs were de-listed from the Official List and from trading on the London Stock Exchange’s market for listed securities and converted into non-voting deferred shares of £0.01 each.
 
Changes in share capital and variation of rights
Subject to the provisions of the 1985 Act and without prejudice to any rights attached to any existing shares or class of shares, any share may be issued with such rights or restrictions as the company may by ordinary resolution determine or, subject to and in default of such determination, as the Board shall determine. Subject to the provisions of the 1985 Act, the company may issue shares which are, or at the option of the company or the holder are liable, to be redeemed. Subject to the provisions of the 1985 Act and the Articles, unissued shares are at the disposal of the Board.
 
The company may by ordinary resolution: increase its share capital; consolidate and divide all or any of its share capital into shares of larger amount than its existing shares; subject to the provisions of the 1985 Act, subdivide its shares, or any of them, into shares of smaller amount than is fixed by
 
 
 

 
 
the Memorandum; or cancel any shares which have not been taken or agreed to be taken by any person and diminish the amount of its share capital by the amount of the shares so cancelled.
 
Subject to the provisions of the 1985 Act, if at any time the capital of the company is divided into different classes of shares, the rights attached to any class of shares may (unless further conditions are provided by the terms of issue of the shares of that class) be varied or abrogated, whether or not the company is being wound up, either with the consent in writing of the holders of three-quarters in-nominal value of the issued shares of the class or with the sanction of an extraordinary resolution passed at a separate general meeting of holders of the shares of the class (but not otherwise).
 
To any such separate general meeting the provision of the Articles relating to general meetings will apply, save that:
 
 
(i)
if at any adjourned meeting of such holders a quorum as defined above is not present, two people who hold shares of the class, or their proxies. are a quorum; and
 
 
(ii)
any such holder present in person or by proxy may demand a poll.
 
The rights attaching to any class of shares having preferential rights are not, unless otherwise expressly provided by the terms of issue thereof, deemed to be varied by the creation or issue of further shares ranking, as regards participation in the profits or assets of the company, pari passu therewith, but in no respect in priority thereto.
 
Disclosure of interests in shares
The 2006 Act gives the company the power to require persons who it believes to be, or have been within the previous three years, interested in its shares, to disclose prescribed particulars of those interests. Failure to supply the information or supplying a statement which is materially false may lead to the Board imposing restrictions upon the relevant shares. The restrictions available are the suspension of voting or other rights conferred by membership in relation to meetings of the company in respect of the relevant shares and, additionally, in the case of a shareholding representing at least 0.25 per cent of the class of shares concerned, the withholding of payment of dividends on, and the restriction of transfers of, the relevant shares.
 
Limitations on rights to own share
There are no limitations imposed by UK law or the Memorandum and Articles on the right of non-residents or foreign persons to hold or vote the company's shares other than the limitations that would generally apply to all of the company's shareholders.
 
Members resident abroad
Members with registered addresses outside the United Kingdom are not entitled to receive notices from the company unless they have given the company an address within the United Kingdom at which such notices may be served.
 
Incorporation and registration
The company was incorporated and registered in Scotland under the Companies Act 1948 as a limited company on 25 March 1968 under the name National and Commercial Banking Group Limited. On 10 March 1982, it changed its name to its present name and was registered under the Companies Acts 1948 to 1980 as a public company with limited liability. The company is registered under Company No. SC 45551.
 
Code of ethics
As discussed on page 128, the Group has adopted a code of conduct applicable to all Group employees, which will be provided to any person without charge, upon request, by contacting Group Secretariat at the telephone number listed on page 290.
 
Documents on display
Documents concerning the company may be inspected at 36 St Andrew Square, Edinburgh, EH2 2YB.

Executive directors’ service contracts and copies of directors’ indemnities granted by the company in terms of section 309C of the Companies Act 1985 may be inspected at the company’s office at Gogarburn, Edinburgh, EH12 1HQ (telephone 0131 626 4114).

In addition, we file reports and other information with the SEC. You can read and copy these reports and other information at the SEC’s Public Reference Room at 100 F Street, N.E., Room 1580, Washington, D.C. 20549. You can call the SEC at 1-800-SEC-0330 for further information on the Public Reference Room or contact the offices of The New York Stock Exchange, on which certain of our securities are listed, at 20 Broad Street, New York, New York 10005.  The SEC also maintains a website at www.sec.gov which contains in electronic form each of the reports and other information that we have filed electronically with the SEC.
 
 
289

 
Shareholder information continued

 
 
Important addresses
 
Shareholder enquiries
Registrar
Computershare Investor Services PLC
The Pavilions
Bridgwater Road
Bristol BS99 6ZZ
Telephone: 0870 702 0135
Facsimile: 0870 703 6009
Email: web.queries@computershare.co.uk
 
ADR Depositary Bank
BNY Mellon Shareowner Services
PO Box 358516
Pittsburgh, PA 15252-8516
Telephone: 866 241 9317 (US callers)
Telephone: 201 680 6825 (International)
Email: shrrelations@bnymellon.com
Website: www.bnymellon.com/shareowner
 
Group Secretariat
The Royal Bank of Scotland Group plc
PO Box 1000
Business House F
Gogarburn
Edinburgh EH12 1HQ
Telephone: 0131 556 8555
Facsimile: 0131 626 3081
 
Investor Relations
280 Bishopsgate
London EC2M 4RB
Telephone: +44 (0)207 672 1758
Facsimile: +44 (0)207 672 1801
Email: investor.relations@rbs.com
 
Registered office
36 St Andrew Square
Edinburgh EH2 2YB
Telephone: 0131 556 8555
Registered in Scotland No. 45551
 
Website
www.rbs.com
 
Principal offices
 
The Royal Bank of Scotland Group plc
PO Box 1000 Gogarburn Edinburgh EH12 1HQ
Telephone: 0131 626 0000
 
The Royal Bank of Scotland plc
PO Box 1000 Gogarburn Edinburgh EH12 1HQ
280 Bishopsgate London EC2M 4RB
 
National Westminster Bank Plc
135 Bishopsgate London EC2M 3UR
 
Citizens
Citizens Financial Group, Inc.
One Citizens Plaza Providence Rhode Island 02903 USA
 
Ulster Bank
11-16 Donegall Square East Belfast BT1 5UB
George’s Quay Dublin 2
 
RBS Insurance
Direct Line House 3 Edridge Road Croydon Surrey CR9 1AG
Churchill Court Westmoreland Road Bromley Kent BR1 1DP
 
RBS Greenwich Capital
600 Steamboat Road
Greenwich Connecticut 06830 USA
 
Coutts Group
440 Strand London WC2R 0QS
 
 
 
Shareholder information continued

 
 
The Royal Bank of Scotland International Limited
Royal Bank House 71 Bath Street
St Helier Jersey Channel Islands JE4 8PJ
 
NatWest Offshore
23/25 Broad Street
St Helier Jersey Channel Islands JE4 8QJ
 
ABN AMRO Holding N.V.
Gustav Mahlerlaan 10
1082 PP Amsterdam The Netherlands
 
 
291

 
Exhibit Index
 

Exhibit Number
 
Description
     
1.1
 
Memorandum and Articles of Association of The Royal Bank of Scotland Group plc
     
2.1
 
Form of Deposit Agreement among The Royal Bank of Scotland Group plc, The Bank of New York as Depositary, and all Owners and Holders from time to time of American Depositary Receipts issued thereunder, incorporated by reference to Exhibit 1 to the Registration Statement on Form F-6 (Registration No. 333-144756) (filed on 20 July 2007)
     
2.2
 
Form of American Depositary Receipt for ordinary shares of the par value of £0.25 each incorporated by reference to Exhibit A of Exhibit 1 to the Registration Statement on Form F-6 (Registration No. 333-144756) (filed on 20 July 2007)
     
2.3
 
Letter dated May 12, 2008 from The Bank of New York Mellon as Depository to The Royal Bank of Scotland Group plc relating to the Prerelease of American Depository Receipts, incorporated by reference to Exhibit 2.3 to the Groups Annual Report on Form 20-F for the fiscal year ended 31 December 2007 (File No. 1-10306)
     
4.1
 
Service agreement for Stephen Hester
     
4.2
 
Service agreement amendment for Stephen Hester
     
4.3**   Service contract for Gordon Pell
     
4.4**   Service contract for Guy Whittaker
     
4.5***   Form of Deed of Indemnity for Directors
     
4.6
 
Consortium and Shareholders' Agreement, dated 28 May 2007, among The Royal Bank of Scotland Group plc, Banco Santander Central Hispano, S.A., Fortis N.V., Fortis SA/NV and RFS Holdings B.V. incorporated by reference to Exhibit 10.1 to the Registration Statement on Form F-4 (Registration No. 333-144752) (filed on July 20, 2007)
     
4.7
 
Supplemental Consortium and Shareholders' Agreement dated 17 September 2007, supplementing the Consortium and Shareholders' Agreement dated 28 May 2007, among The Royal Bank of Scotland Group plc, Banco Santander, S.A., Fortis N.V., Fortis SA/NV and RFS Holdings B.V. incorporated by reference to Exhibit 99.(A)(5)(XXVI) to Amendment No. 9 to the Tender Offer Statement on Schedule TO filed on 18 September 2007
 
4.8
 
Amendment Agreement dated August 2008, relating to the Consortium and Shareholders' Agreement dated 28 May 2007, among The Royal Bank of Scotland Group plc, Banco Santander, S.A., Fortis N.V., Fortis SA/NV and, by accession, Fortis Nederland (Holding) N.V., and RFS Holdings B.V. (as supplemented and amended by a Supplemental Consortium and Shareholders’ Agreement dated 17 September 2007)
     
4.9
 
Deed of Accession dated December 2008 among The Royal Bank of Scotland Group plc, Banco Santander, S.A., Fortis Bank Nederland (Holding) N.V., The State of the Netherlands and RFS Holdings B.V.
     
4.10
 
Letter dated 28 May 2007 from Merrill Lynch International to The Royal Bank of Scotland plc incorporated by reference to Exhibit 10.3 to the Registration Statement on Form F-4 (Registration No. 333-144752) (filed on July 20, 2007)
     
4.11
 
Purchase and Sale Agreement dated 22 April 2007 among ABN Amro Bank N.V. and Bank of America Corporation incorporated by reference to the Form 6-K filed by ABN Amro Holdings N.V. (Registration No. 001-14624) (filed on April 24, 2007)
     
4.12
 
Underwriting Agreement dated 22 April 2008 among The Royal Bank of Scotland Group plc, Goldman Sachs International, Merrill Lynch International, UBS Limited and The Royal Bank of Scotland plc
     
4.13
 
Share Purchase Agreement dated 13 June 2008 among The Royal Bank of Scotland Group plc and Willow Bidco Limited
     
4.14
 
Share Purchase Agreement dated 28 July 2008 among The Royal Bank of Scotland Group plc and Tesco plc relating to the sale and purchase of part of the issued share capital of Tesco Personal Finance Group Limited
 
 
 
Exhibit Number
 
Description
     
4.15
 
Placing and Open Offer Agreement dated 13 October 2008 among The Royal Bank of Scotland Group plc, UBS Limited, Merrill Lynch International and The Commissioners of Her Majesty’s Treasury
     
4.16
 
Preference Share Acquisition Agreement dated 13 October 2008 among The Commissioners of Her Majesty’s Treasury, The Royal Bank of Scotland Group plc and UBS Limited
     
4.17   Amendment Agreement dated 13 October 2008 among The Royal Bank of Scotland Group plc, UBS Limited, Merrill Lynch International and The Commissioners of Her Majestys Treasury
     
4.18
 
First Subscription and Transfer Agreement dated 4 November 2008 among UBS Limited, Merrill Lynch International, Encuentro Limited and The Royal Bank of Scotland Group plc
     
4.19
 
Second Subscription and Transfer Agreement dated 4 November 2008 among UBS Limited, Merrill Lynch International, Encuentro Limited and The Royal Bank of Scotland Group plc
     
4.20   Amendment Deed dated 28 November 2009 among UBS Limited, Merrill Lynch International, Encuentro Limited and The Royal Bank of Scotland Group plc
     
4.21
 
Second Placing and Open Offer Agreement dated 19 January 2009 among The Royal Bank of Scotland Group plc, UBS Limited, Merrill Lynch International and The Commissioners of Her Majesty’s Treasury
     
4.22
 
Pre-accession Commitments Deed poll dated 26 February 2009 by The Royal Bank of Scotland plc
     
4.23*
 
Lending Commitments Deed poll dated 26 February 2009 by The Royal Bank of Scotland plc
     
7.1   Explanation of ratio calculations
     
8.1
 
Principal subsidiaries of The Royal Bank of Scotland Group plc
 
12.1
 
CEO certification required by Rule 13a-14(a)
     
12.2
 
CFO certification required by Rule 13a-14(a)
     
13.1
 
Certification required by Rule 13a-14(b)
     
15.1
 
Consent of independent registered public accounting firm

 
*
Confidential treatment has been requested.  Confidential materials have been redacted and separately filed with the SEC.
 
**
Previously filed and incorporated by reference to Exhibits 4.4 and 4.6, respectively to the Groups Annual Report on Form 20-F for the fiscal year ended 31 December 2005 (file No. 1-10306).
 
***
Previously filed and incorporated by reference to Exhibit 4.11 to the Groups Annual Report on Form 20-F for the fiscal year ended 31 December 2006 (File No. 1-10306) except that the sentence “PROVIDED THAT this Indemnity is given subject to the provisions of Section 309A Company Act 1985” has been replaced with “PROVIDED THAT this Indemnity is given subject to the provisions of Section 234 Companies Act 2001”.
 
 
 
 

 
 
SIGNATURE

     The registrant hereby certifies that it meets all of the requirements for filing on Form 20-F and that it has duly caused and authorized the undersigned to sign this annual report on its behalf.

The Royal Bank of Scotland Group plc


Registrant


/s/ Guy Robert Whittaker

Guy Robert Whittaker
Group Finance Director


29 April 2009
 
 
Exhibit Index
 

Exhibit Number
 
Description
     
1.1
 
Memorandum and Articles of Association of The Royal Bank of Scotland Group plc
     
2.1
 
Form of Deposit Agreement among The Royal Bank of Scotland Group plc, The Bank of New York as Depositary, and all Owners and Holders from time to time of American Depositary Receipts issued thereunder, incorporated by reference to Exhibit 1 to the Registration Statement on Form F-6 (Registration No. 333-144756) (filed on 20 July 2007)
     
2.2
 
Form of American Depositary Receipt for ordinary shares of the par value of £0.25 each incorporated by reference to Exhibit A of Exhibit 1 to the Registration Statement on Form F-6 (Registration No. 333-144756) (filed on 20 July 2007)
     
2.3
 
Letter dated May 12, 2008 from The Bank of New York Mellon as Depository to The Royal Bank of Scotland Group plc relating to the Prerelease of American Depository Receipts, incorporated by reference to Exhibit 2.3 to the Groups Annual Report on Form 20-F for the fiscal year ended 31 December 2007 (File No. 1-10306)
     
4.1
 
Service agreement for Stephen Hester
     
4.2
 
Service agreement amendment for Stephen Hester
     
4.3**   Service contract for Gordon Pell
     
4.4**   Service contract for Guy Whittaker
     
4.5***   Form of Deed of Indemnity for Directors
     
4.6
 
Consortium and Shareholders' Agreement, dated 28 May 2007, among The Royal Bank of Scotland Group plc, Banco Santander Central Hispano, S.A., Fortis N.V., Fortis SA/NV and RFS Holdings B.V. incorporated by reference to Exhibit 10.1 to the Registration Statement on Form F-4 (Registration No. 333-144752) (filed on July 20, 2007)
     
4.7
 
Supplemental Consortium and Shareholders' Agreement dated 17 September 2007, supplementing the Consortium and Shareholders' Agreement dated 28 May 2007, among The Royal Bank of Scotland Group plc, Banco Santander, S.A., Fortis N.V., Fortis SA/NV and RFS Holdings B.V. incorporated by reference to Exhibit 99.(A)(5)(XXVI) to Amendment No. 9 to the Tender Offer Statement on Schedule TO filed on 18 September 2007
 
4.8
 
Amendment Agreement dated August 2008, relating to the Consortium and Shareholders' Agreement dated 28 May 2007, among The Royal Bank of Scotland Group plc, Banco Santander, S.A., Fortis N.V., Fortis SA/NV and, by accession, Fortis Nederland (Holding) N.V., and RFS Holdings B.V. (as supplemented and amended by a Supplemental Consortium and Shareholders’ Agreement dated 17 September 2007)
     
4.9
 
Deed of Accession dated December 2008 among The Royal Bank of Scotland Group plc, Banco Santander, S.A., Fortis Bank Nederland (Holding) N.V., The State of the Netherlands and RFS Holdings B.V.
     
4.10
 
Letter dated 28 May 2007 from Merrill Lynch International to The Royal Bank of Scotland plc incorporated by reference to Exhibit 10.3 to the Registration Statement on Form F-4 (Registration No. 333-144752) (filed on July 20, 2007)
     
4.11
 
Purchase and Sale Agreement dated 22 April 2007 among ABN Amro Bank N.V. and Bank of America Corporation incorporated by reference to the Form 6-K filed by ABN Amro Holdings N.V. (Registration No. 001-14624) (filed on April 24, 2007)
     
4.12
 
Underwriting Agreement dated 22 April 2008 among The Royal Bank of Scotland Group plc, Goldman Sachs International, Merrill Lynch International, UBS Limited and The Royal Bank of Scotland plc
     
4.13
 
Share Purchase Agreement dated 13 June 2008 among The Royal Bank of Scotland Group plc and Willow Bidco Limited
     
4.14
 
Share Purchase Agreement dated 28 July 2008 among The Royal Bank of Scotland Group plc and Tesco plc relating to the sale and purchase of part of the issued share capital of Tesco Personal Finance Group Limited
 
 
 
Exhibit Number
 
Description
     
4.15
 
Placing and Open Offer Agreement dated 13 October 2008 among The Royal Bank of Scotland Group plc, UBS Limited, Merrill Lynch International and The Commissioners of Her Majesty’s Treasury
     
4.16
 
Preference Share Acquisition Agreement dated 13 October 2008 among The Commissioners of Her Majesty’s Treasury, The Royal Bank of Scotland Group plc and UBS Limited
     
4.17   Amendment Agreement dated 13 October 2008 among The Royal Bank of Scotland Group plc, UBS Limited, Merrill Lynch International and The Commissioners of Her Majestys Treasury
     
4.18
 
First Subscription and Transfer Agreement dated 4 November 2008 among UBS Limited, Merrill Lynch International, Encuentro Limited and The Royal Bank of Scotland Group plc
     
4.19
 
Second Subscription and Transfer Agreement dated 4 November 2008 among UBS Limited, Merrill Lynch International, Encuentro Limited and The Royal Bank of Scotland Group plc
     
4.20   Amendment Deed dated 28 November 2009 among UBS Limited, Merrill Lynch International, Encuentro Limited and The Royal Bank of Scotland Group plc
     
4.21
 
Second Placing and Open Offer Agreement dated 19 January 2009 among The Royal Bank of Scotland Group plc, UBS Limited, Merrill Lynch International and The Commissioners of Her Majesty’s Treasury
     
4.22
 
Pre-accession Commitments Deed poll dated 26 February 2009 by The Royal Bank of Scotland plc
     
4.23*
 
Lending Commitments Deed poll dated 26 February 2009 by The Royal Bank of Scotland plc
     
7.1   Explanation of ratio calculations
     
8.1
 
Principal subsidiaries of The Royal Bank of Scotland Group plc
 
12.1
 
CEO certification required by Rule 13a-14(a)
     
12.2
 
CFO certification required by Rule 13a-14(a)
     
13.1
 
Certification required by Rule 13a-14(b)
     
15.1
 
Consent of independent registered public accounting firm

 
*
Confidential treatment has been requested.  Confidential materials have been redacted and separately filed with the SEC.
 
**
Previously filed and incorporated by reference to Exhibits 4.4 and 4.6, respectively to the Groups Annual Report on Form 20-F for the fiscal year ended 31 December 2005 (file No. 1-10306).
 
***
Previously filed and incorporated by reference to Exhibit 4.11 to the Groups Annual Report on Form 20-F for the fiscal year ended 31 December 2006 (File No. 1-10306) except that the sentence “PROVIDED THAT this Indemnity is given subject to the provisions of Section 309A Company Act 1985” has been replaced with “PROVIDED THAT this Indemnity is given subject to the provisions of Section 234 Companies Act 2001”.