20-F 1 x50024e20vf.htm FORM 20-F 20-F
Table of Contents

 
 
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
 
þ
  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the fiscal year ended December 31, 2005
 
OR
 
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the transition period from          to
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          to
                           Commission file number 0-25670
Abbey National plc
(Exact name of Registrant as specified in its charter)
England
(Jurisdiction of incorporation or organization)
Abbey National House, 2 Triton Square, Regent’s Place, London NW1 3AN, England
(Address of principal executive offices)
                           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
     
Non-cumulative Dollar-denominated Preference    
Shares of nominal value $0.01 each, Series B   New York Stock Exchange*
American Depositary Shares,    
each representing one Non-cumulative    
Dollar-denominated Preference Share    
of nominal value $0.01, Series B (ANBPRC)   New York Stock Exchange
7.25% Perpetual Subordinated Capital Securities    
(SXA)   New York Stock Exchange
7.375% Perpetual Subordinated Capital Securities    
                              (SXP)   New York Stock Exchange
Not for trading, but only in connection with the listing of related American Depositary Shares
Securities registered or to be registered pursuant to Section 12(g) of the Act. None
Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock as of the close of the period covered by the annual report.
         
Ordinary Shares of Nominal Value 10 Pence Each   None
103/8% Non-cumulative Preference Shares of nominal vale £1 each
    200,000,000  
85/8% Non-cumulative Preference Shares of nominal value £1 each
    125,000,000  
73/8% Non-cumulative Dollar-denominated Preference Shares of nominal value $0.01 each, Series B
    18,000,000  
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes þ        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 þ
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 þ        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 o        Accelerated Filer o        Non-Accelerated Filer þ
Indicate by check mark which financial statement item the registrant has elected to follow.    Item 17 o        Item 18    þ
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 þ
 
 


 

     
 
  Contents
 
   
 
   
 
  Business Review and Forward-looking Statements
 
  Chief Executive’s Review 2
 
  Forward-looking Statements 5
 
   
 
  Business and Financial Review
 
  Business Overview 6
 
  Business Review – Summary 10
 
  Business Review – Personal Financial Services 18
 
  Business Review – Portfolio Business Unit 31
 
  Other Material Items 32
 
  Balance Sheet Business Review 34
 
  Risk Management 59
 
   
 
  Report of the Directors
 
  Directors 74
 
  Directors’ Report 77
 
  Supervision and Regulation 86
 
   
 
  Financial Statements
 
  Independent Auditors’ Report to the Member of Abbey National plc 91
 
  Primary Financial Statements 92
 
  Accounting Policies 97
 
  Notes to the Financial Statements 109
 
  Selected Financial Data 195
 
   
 
  Shareholder Information
 
  Dividend and Share Information 199
 
  Risk Factors 200
 
  Taxation for US Investors 201
 
  Contact Information 202
 
   
 
  Glossary and Definitions 204
 
   
 
  Cross-reference to Form 20-F 205
 Exhibit 1.1
 Exhibit 4.1
 Exhibit 7.1
 Exhibit 8.1
 Exhibit 12.1
 Exhibit 12.2
 Exhibit 13.1
 Exhibit 14.1
(COMPANY LOGO)

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Table of Contents

Business Review and Forward-looking Statements
Chief Executive’s Review
Overview
In the first full year since the acquisition of Abbey National plc (‘Abbey’) by Banco Santander Central Hispano, S.A., Abbey has made good progress in rebuilding its business and has posted a strong set of financial results.
     At the start of 2005 we set clear targets against which Abbey’s progress would be measured:
     
stabilise Personal Financial Services (PFS) trading revenues after a
period of decline
  PFS trading revenues were up 1%
   
accelerate cost savings, with a cost reduction in 2005 of £150m
instead of the £100m originally targeted
  cost reduction of £224m
We’ve reduced costs across the business, and there are clear signs of improved sustainable revenue performance.
     Our market share of new business in mortgages and savings has improved and our initiatives to enter areas where we have significant opportunities – such as current accounts, unsecured personal loans and investments — are building momentum. In addition, we have announced our intention to set up our own credit card business, drawing upon the expertise of Santander’s global card operations. More recently we announced the sale of our Life assurance business to Resolution plc (‘Resolution’), and entered into a distribution agreement with Resolution allowing Abbey to provide products and services through our established direct and intermediary channels. Across all product lines we are focusing on our strengths to build profitable businesses, whilst maintaining good credit quality.
     Underpinning our progress are operational improvements in terms of sales capacity and productivity. The number of people holding sales authorisations in our branches has increased by 28% from the start of the year. In addition, the service issues that were hindering performance in the intermediary channel have been successfully addressed.
Key financial highlights:
     
>
  statutory profit before tax of £596m (2004: £(21)m), with a profit after tax of £420m (2004: £(54)m);
 
   
>
  statutory profit before tax for Personal Financial Services of £509m (2004: £(32)m);
 
   
>
  Personal Financial Services trading profit before tax of £775m up 34% compared to £579m in 2004, benefiting from an increase in revenues combined with lower costs resulting from the cost reduction programme;
 
   
>
  trading income in Personal Financial Services was slightly ahead of 2004, and better than originally targeted at the start of 2005. During the year trading income has benefited from increased fee income, partially offset by a modest decline in spreads;
 
   
>
  Personal Financial Services trading expenses were £224m lower than 2004, a reduction of 13%, well ahead of the original targeted savings for 2005 of £100m;
 
   
>
  a reduction in the Personal Financial Services trading cost: income ratio to 60.6% (2004: 69.9%);
 
   
>
  provision charges in relation to Personal Financial Services lending (after adjusting for 2004 write backs) were higher by £54m;
 
   
>
  reorganisation and other charges, IFRS embedded value charges and rebasing and hedging variances of £266m (2004:
 
  £546m), including the cost of compensation following remediation of £70m relating to endowment misselling;
 
   
>
  total retail customer loans of £99.3bn, up 4%, and retail deposits of £62.0bn, also up 4% compared to 2004; and
 
   
>
  capital ratios decreased due to the impact of IFRS adjustments applicable from 1 January 2005, partly offset by an increase in net attributable profit. The tier 1 ratio decreased to 10.0% and equity tier 1 ratio to 6.6%, compared with 10.4% and 7.0% in 2004 respectively.

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Business Review and Forward-looking Statements
Chief Executive’s Review continued
Strategic Outline
At the time of Abbey’s third Quarter trading update, details of Abbey’s strategic plan were announced. We have a clear vision to be the best retail bank in the UK, in terms of service and efficiency.
     Over the next three years we have plans to transform Abbey from its historical focus on mortgages and savings, to a full retail bank offering. Our aim is for Abbey to become a powerful competitor across the market, and we aim to be able to deliver strong revenue and profit growth over this period.
     There are two components to Abbey’s strategic plan:
     
>
  moving to a new operating model; and
 
   
>
  delivering revenue growth in both existing and new markets.
New operating model
We believe that the new model will significantly improve the efficiency of back-office and manufacturing operations, change the mix of front / back office staff and improve front-line sales capability.
     In the short-term one of our priorities has been cost reduction activity, and at least 4,000 jobs were taken out of the business in 2005. Abbey will continue to review headcount against the needs of the business and our future plans, with further job cuts expected, though not of the magnitude experienced in 2005. This is in line with Santander’s model of continuous efficiency and improvements through leading edge technology. These types of cost saving efforts will become business-as-usual across Abbey.
     At the same time, we are working to improve our sales capability, and are targeting significant growth across all channels in 2006.
     Our current level of sales productivity is well below the average of our peers, and is significantly lower than the best in the market. We have introduced a basic focus on sales management across all channels – looking to increase and optimise capacity, and manage performance more rigorously.
     In the medium-term, we expect the implementation of Partenon, Santander’s information technology platform, will further lower the marginal cost of new business – reducing manufacturing and IT costs as a percentage of the total cost base, and allowing greater investment in customer facing activities.
     We anticipate that Partenon will not only provide efficiency benefits, but will also improve the speed to market with new products, and provide better sales tools and processes, including a single view of our relationship with the customer. A detailed implementation plan is now in place for Partenon, with a phased rollout through 2006 and 2007 – with 2008 the first year in which a full benefit will be realised.
Revenue growth from new and existing markets
In Abbey’s core markets of mortgage and savings, we are aiming to reverse the recent trends in revenues through more aggressive balance sheet growth in a more stable margin environment than in recent years. In mortgages we are targeting new business levels above our current stock share – to maintain and then grow our position in this market. In mortgages, plans to enter higher margin segments are being developed with progress expected through 2006 and 2007. These segments are a large and growing part of the market in which Abbey has not previously competed. In savings we have to defend our strong market position and focus on growing the business profitably.
     The bank will grow aggressively in areas where it is under-represented such as current accounts, unsecured loans, investments and pensions. In addition, it will seek to develop opportunities in consumer finance and business banking. Abbey is a natural competitor to the big four clearing banks and its plan is to attack in the areas where it has significant opportunities to grow and take market share.
     In some of these initiatives, Abbey can use the strength of Santander. As an example, in the consumer finance market Abbey entered into a joint venture in August to develop the motor finance business in the UK – drawing upon Santander’s expertise and product range in this area. In January we announced the intention to set up our own credit card business. In doing so we will exit the existing arrangement with MBNA, with Abbey’s new operations able to leverage Santander’s global card operation (which currently has 49 million cards in issue) and Partenon.
Financial targets
Abbey is on track to meet the revenue and cost targets set at the time of acquisition:
     
>
  revenue synergies of £150m by 2007; and
 
   
>
  cost synergies of £300m by 2007.
As part of the strategic update in October 2005, further financial targets for 2006 – 2008 were published, including:
     
>
  revenue growth of 5 – 10% per annum over the next 3 years;
 
   
>
  a cost: income ratio of around 45% by 2008; and
 
   
>
  a return on regulatory tier 1 equity of 18% by 2008.
In addition, £300m of cost savings are expected to be achieved before the full impact of Partenon, with further efficiency benefits in 2008, that will provide further scope for increased investment in front office operations.
     After taking account of the sale of the Life businesses, these are ambitious, but realistic targets in a competitive and slowing market environment. The confidence in the targets reflects the strength of the Abbey franchise – and the potential to improve performance and move into new markets. We expect this to be underpinned by the implementation of Partenon, and the ability to leverage the strength of the Group.

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Business Review and Forward-looking Statements
Chief Executive’s Review continued
     At the same time we have been strengthening the management team. Changes include the appointment of Jorge Morán as Chief Operating Officer, who previously held senior roles in Santander and has extensive knowledge of European retail banking operations.
     In the first full year since the acquisition by Santander, we believe that Abbey has made excellent progress. We are meeting our challenges and have competitive products and the enthusiasm to succeed at all levels in the organisation. We have set ourselves clear targets, and will build on the momentum we have established in 2005. 2006 has started positively with business performance maintaining the trends reported through 2005, and we expect further improvements in customer service and business efficiency in 2006.
     We’ve made a good start towards achieving our three-year turnaround and long-term goal of becoming the best retail bank in the UK.
Francisco Gómez-Roldán
Chief Executive

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Business review and forward-looking statements
Forward-looking statements
Abbey National plc (‘Abbey’) may from time to time make written or oral forward-looking statements. Written forward-looking statements may appear in documents filed with the US Securities and Exchange Commission, including this Annual Report, reports to shareholders and other communications. The US Private Securities Litigation Reform Act of 1995 contains a safe harbour for forward-looking statements on which Abbey relies in making such disclosures. Examples of such forward-looking statements include, but are not limited to:
     
>
  projections or expectations of revenues, costs, profit (or loss), earnings (or loss) per share, dividends, capital structure or other financial items or ratios;
 
   
>
  statements of plans, objectives or goals of Abbey or its management, including those related to products or services;
 
   
>
  statements of future economic performance; and
 
   
>
  statements of assumptions underlying such statements.
Words such as ‘believes’, ‘anticipates’, ‘expects’, ‘intends’, ‘aims’, and ‘plans’ and similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements.
     By their very nature, forward-looking statements involve inherent risks and uncertainties, both general and specific, and risks exist that the predictions, forecasts, projections and other forward-looking statements will not be achieved. Abbey cautions readers that a number of important factors could cause actual results to differ materially from the plans, objectives, expectations, estimates and intentions expressed in such forward-looking statements made by Abbey or on Abbey’s behalf. These factors include:
     
>
  inflation, interest rate, exchange rate, market and monetary fluctuations;
 
   
>
  the effect of, and changes to, regulation and government policy;
 
   
>
  the effects of competition in the geographic and business areas in which Abbey conducts operations;
 
   
>
  changes in consumer spending, saving and borrowing habits in the United Kingdom and in other countries in which Abbey conducts operations;
 
   
>
  the effects of changes in laws, regulations, taxation or accounting standards or practices;
 
   
>
  the ability to increase market share and control expenses;
 
   
>
  the timely development of and acceptance of new products and services of Abbey and the perceived overall value of these products and services by users;
 
   
>
  acquisitions and disposals;
 
   
>
  technological changes;
 
   
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  the possibility of foreign exchange controls, expropriation, nationalisation or confiscation of assets in countries in which Abbey conducts operations; and
 
   
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  Abbey’s success at managing the risks of the foregoing.
Abbey cautions that the foregoing list of important factors is not exhaustive. When relying on forward-looking statements to make decisions with respect to Abbey, investors and others should carefully consider the foregoing factors and other uncertainties and events. Such forward-looking statements speak only as of the date on which they are made, and Abbey does not undertake any obligation to update or revise any of them, whether as a result of new information, future events or otherwise.

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Business and Financial Review
Business Overview
This section contains forward-looking statements that involve inherent risks and uncertainties. Actual results may differ materially from those contained in such forward-looking statements. See “Forward-looking statements” on page 5.
General
Abbey National plc (‘Abbey’) and its subsidiaries (together, the ‘Group’) operate primarily in the UK, under UK Law and Regulation and are part of the Santander group of companies. Abbey is a significant financial services provider in the UK, being the second largest residential mortgage lender and the third largest savings brand. It operates across the full range of personal financial services serving approximately 18 million customers. Founded in 1857, Santander has over 60 million customers, approximately 10,000 offices and a presence in over 40 countries. It is the largest financial services group in Spain and Latin America.
     The principal executive office and the registered office of Abbey and Abbey National Treasury Services plc is Abbey National House, 2 Triton Square, Regent’s Place, London NW1 3AN. The telephone number of Abbey is +44 (0)870-607-6000. The designated agent for service of process on Abbey in the United States is CT Corporation System, with offices at 111 Eighth Avenue, New York, NY 10011. Please see “Business and Financial review – Tangible fixed assets” for further information regarding Abbey’s properties.
Summary history of Abbey National plc
The Abbey National Building Society (‘the Society’) was formed in 1944 with the merger of two long-standing building societies. In 1988, Abbey National plc was incorporated as a bank and in 1989 the Society transferred business to Abbey National plc as part of the conversion and listing on the London Stock Exchange. In 2003, the brand name was shortened to Abbey and this is the name used in this Annual Report and Accounts. A list of Abbey’s principal subsidiaries and their country of incorporation can be found at page 129. On 12 November 2004, Abbey was acquired by Banco Santander Central Hispano, S.A.
Corporate purpose and strategy
Abbey’s ultimate purpose and goal is to maximise value for its shareholder, focusing on the provision of Personal Financial Services in the UK.
     Over the last two years, Abbey has made good progress in restructuring its business — exiting the large majority of £60bn of assets and businesses that were deemed non-core and investing in the ongoing Personal Financial Services operations. One year since the completion of the acquisition, excellent progress has been made against the stated 2005 targets: revenues have been stabilised, sales productivity has improved and significant cost savings achieved. Priorities for 2006 are to position Abbey to deliver revenue growth of between 5-10% subject to market conditions, as well as further cost savings.
Executive Responsibility
Following the completion of the acquisition of Abbey by Banco Santander Central Hispano, S.A. in November 2004, a new organisational structure was implemented with a revised set of executive responsibilities.
     Abbey’s management structure is headed by Francisco Gómez-Roldán, Chief Executive, supported by Jorge Morán, Chief Operating Officer and consists of three business divisions and three support divisions.
     The business divisions consist of:
     
>
  Retail Banking - responsible for all direct sales (branches, telephone, internet banking) and intermediary channels. Also responsible for marketing, including product design, branding and advertising. Graeme Hardie, joined Abbey and was appointed to the Board in February 2005 to head this division.
 
   
>
  Insurance and Asset Management - responsible for the long-term savings and general insurance business together with the asset management activities of the Group. This division is headed by Javier Maldonado, who was appointed on 9 February 2006.
 
   
>
  Finance and Markets - comprises Abbey Financial Markets, Finance and the Portfolio Business Unit, and is headed by Nathan Bostock. Abbey Financial Markets provides treasury services to the Group, including managing the Group’s funding, liquidity and capital; providing risk management services; as well as manufacturing retail structured products.
 
     The support divisions consist of:
 
   
>
  Human Resources - responsible for all human resources strategy and personnel support. This division is headed by Paul Lomas.
 
   
>
  Manufacturing - responsible for all information technology and operations activity (including service centres). This division is headed by Juan Olaizola.
 
   
>
  Risk - responsible for ensuring that the Board and senior management team of Abbey are provided with an appropriate risk policy and control framework, and to report any material risk issues to the Risk Committee and the Board. This division is headed by Ian Jenkins.
There are three further units that report directly to the Chief Executive – Strategy and Planning; Legal, Secretariat, Tax and Regulatory Affairs; and Communications.

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Business and Financial Review
Business Overview continued
Competition
Competitive environment and future trends
Abbey’s main competitors are established UK banks, building societies and insurance companies and other financial services providers such as supermarket chains and large retailers.
     In recent years, customer access, choice and mobility have all increased, as has the extent of regulation. The market is competitive, driven largely by market incumbents.
Competition outlook
Management is confident of Abbey’s strength and potential to improve business performance despite a slower rate of growth in some of its core personal financial services markets.
Personal Financial Services
The overview of Personal Financial Services set out below reflects the reporting structure in place during 2005 in accordance with which the segmental information in the “Business Operating Review – Personal Financial Services” section has been presented.
Retail Banking
Residential mortgages
Abbey is the second largest provider of residential mortgages in the UK, providing mortgage loans for house purchases as well as home improvement loans to new and existing mortgage customers. Mortgage loans are offered in two payment types. Repayment mortgages require both principal and interest to be repaid in monthly instalments over the life of the mortgage. Interest-only mortgages require monthly interest payments and the repayment of principal at the end of the mortgage term (which can be arranged via a number of investment products including Individual Savings Accounts and pension policies, or by the sale of the property).
     Abbey’s mortgage loans are usually secured by a first mortgage over property and are typically arranged for a 25-year term, with no minimum term. Historically, interest on mortgage loans has been charged at variable rates determined at the discretion of Abbey by reference to the general level of market interest rates and competitive forces in the UK mortgage market. Fixed rate products offer a predetermined interest rate, generally fixed for between two and five years, after which they bear interest at standard variable rates.
     In common with the market, an increasing proportion of new mortgage business in recent years has been through trackers that track the Bank of England base rate normally with an incentive period for the first 2 to 5 years, and flexible mortgages, allowing the customer to vary their monthly payments, or take payment holidays, within predetermined criteria. More recently the UK market has seen an increase in the proportion of fixed rate lending. In line with the rest of the UK market, the majority of mortgages are prepaid at the end of the fixed or incentive period.
Savings
Abbey provides a wide range of retail savings accounts, including on-demand accounts, notice accounts, investment accounts and Individual Savings Accounts. Interest rates on savings in the UK are primarily set with reference to the general level of market interest rates and the level of competition for such funds.
Banking and Consumer Credit
Abbey offers a range of personal banking services including current accounts, credit cards and unsecured loans. Credit scoring is used for initial lending decisions on these products and behavioural scoring is used for certain products for further lending.
     Abbey’s principal credit card offering is delivered through its strategic alliance with MBNA Europe Bank Limited, who are responsible for taking the credit risk and currently managing the credit card base. In February 2006, Abbey announced its intention to commence issuing credit cards directly rather than through MBNA Europe Bank Limited from 2007.
Abbey National International
Abbey National International Limited, the principal offshore company, uses the Abbey International brand. Its head office is in Jersey, with a focus on attracting deposits by offering a range of savings accounts denominated in sterling, US dollars and euro.
Cater Allen
Cater Allen Limited offers banking services under the trading name Cater Allen Private Bank. The business attracts clients by marketing to introducers, including Independent Financial Advisers.
cahoot
cahoot is Abbey’s separately branded, e-commerce retail banking and financial services provider. cahoot targets customers who wish to access banking services predominantly through the internet.
General Insurance
The range of non-life insurance products sold by Abbey includes property (buildings and contents) and payment protection. Residential home insurance remains the primary type of policy sold and is offered to customers through the branch network, internet and over the telephone, as well as being sold by mortgage intermediaries, often at the same time that a mortgage is being taken out.
     The business model currently uses Norwich Union to underwrite most property and payment protection insurances. In addition, Capita Insurance Services and Cap Gemini are responsible for the management and development of systems to support

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Business and Financial Review
Business Overview continued
the business whilst the servicing of most policies is outsourced to Capita Insurance Services and some claims administration to Aviva plc.
Insurance and Asset Management
The UK life insurance industry consists of three principal segments: protection, investment and savings, and pensions.
     
>
  Protection. The traditional form of protection policy, known as term insurance, provides a lump sum benefit payable on death within a specified term. Policies are also available to provide protection against critical illness and disability.
 
   
>
  Investment and savings. Investment bonds, with-profit bonds, structured products, unit trusts, Individual Savings Accounts and endowment life insurance policies are included in this category.
 
   
>
  Pensions. In the UK pensions are a tax-efficient way of saving to provide benefits on retirement. This is a result of the tax deductibility of contributions made and the generally tax-free growth granted to pension funds.
Abbey National Life plc, and its related subsidiary companies distribute via the marketing associate route, whereby the associate is required to recommend the most suitable products from the product range of the companies for which it acts as associate.
     Abbey National Life plc provides a wide range of products including pension, protection and investment products. The subsidiaries of Abbey National Life plc include Abbey National Unit Trust Managers Limited which manages a range of Unit Trusts and Abbey National PEP and ISA Managers Limited which manages the Personal Equity Plans and Individual Savings Accounts businesses of Abbey.
     Scottish Mutual Assurance plc and Scottish Provident Limited distribute principally via the Independent Financial Adviser route in the UK. Independent Financial Advisers provide suitable advice on the product range that exists in the market place. Scottish Mutual Assurance plc and its predecessors have been in the insurance business since 1883. It provides a broad range of products including personal pensions, single premium products such as investment bonds annuities and products to cover death, critical illness and disability. New conventional protection business sold under the Scottish Provident brand in the UK is written into Scottish Mutual Assurance plc.
Sale of Life Insurance Businesses

Abbey announced on 7 June 2006 that it has entered into an agreement to sell its entire life insurance business to Resolution plc (“Resolution”) for cash consideration of approximately £3,600m.
     Completion of the transaction is expected during the third quarter of 2006 and is conditional upon, among other things, approval from the Financial Services Authority and relevant overseas regulators and the approval of Resolution’s shareholders. The life businesses being sold are Scottish Mutual Assurance plc, Scottish Provident Limited and Abbey National Life plc, as well as the two offshore life companies, Scottish Mutual International plc and Scottish Provident International Life Assurance Limited. Abbey will retain all of its branch-based investment and asset management business, James Hay, its market-leading self-invested personal pension company, and its Wrap business.
     Separately, in order to provide continuity of product supply and service to its customers, Abbey has entered into a retail bank distribution agreement and intermediary distribution agreement with Resolution. Under the retail bank distribution agreement Abbey will distribute through its retail network Abbey-branded protection, life bonds and stakeholder pension products provided by Resolution. Under the intermediary distribution agreement Abbey will continue to be the exclusive distributor of Scottish Provident protection products to intermediaries. The distribution agreement covers Scottish Provident Self Assurance protection products, Scottish Mutual Pegasus protection products and offshore bonds issued by Scottish Provident International Life Assurance Limited. Resolution will use Abbey’s intermediary sales force to distribute Scottish Provident products to intermediaries and will reimburse Abbey’s costs, on a variable basis, in respect of this sales force. The distribution agreements have a term of ten years, subject to a review after five years. In addition, Abbey has secured exclusive access to provide retail banking products to Resolution’s estimated five million policyholders.
James Hay
James Hay provides and offers administration services for self-invested personal pension schemes and small self-administered pension schemes. Its services are provided to end customers mainly via Independent Financial Advisers and branded financial service providers.
Abbey Financial Markets
Abbey Financial Markets is structured into the following three business areas:
Asset and Liability Management
Asset and Liability Management is responsible for managing the Group’s structural liquidity. This includes Abbey’s capital management activities and medium and long-term funding, including Abbey’s structured covered bond and securitisation programmes. It manages Abbey’s product and structural exposure to interest rates and, in that role, is a link between the retail and other Abbey Financial Markets areas. Asset and Liability Management helps set and implement Board, Asset and Liability Committee and Risk Committee policies for all aspects of balance sheet management – formulating guidance for, and monitoring, the overall balance sheet shape, including maturity profile. In carrying out its financing role, it maintains many relationships in the financial world which are utilised by other parts of the organisation, including the other Retail Banking Services businesses and the two customer-facing Abbey Financial Markets businesses.
     Abbey first registered with the Securities and Exchange Commission in October 1994. Abbey National plc, Abbey National Treasury Services plc and Abbey National First Capital B.V. have registered various shelf facilities with the Securities and Exchange Commission, the most recent being in February 2001, permitting preference shares and debt securities, including medium-term notes and other subordinated securities, to be issued from the date of registration in an aggregate principal amount of approximately $7.0bn.
     Under the shelf facility registered with the Securities and Exchange Commission, Abbey National Treasury Services plc may issue senior debt securities, and Abbey National plc and Abbey National First Capital B.V. may issue subordinated debt securities. Abbey acts as guarantor on a senior basis of the debt securities issued by Abbey National Treasury Services plc, and as guarantor on a subordinated basis of the debt securities issued by Abbey National First Capital B.V. Various other entities within the Group may issue other subordinated securities under the shelf facility.
     At 31 December 2005, the aggregate amount of outstanding claims of creditors senior to the holders of subordinated debt of the following entities (and in the case of Abbey, senior to the holders of subordinated debt guaranteed by Abbey) was as follows:
         
 
Abbey and its subsidiaries
  £ 196,094m  
Abbey National plc
  £ 131,182m  
 
At 31 December 2005, the aggregate amount of outstanding claims of creditors of Abbey that will rank pari passu with the subordinated debt issued by Abbey (and with the subordinated debt guaranteed by Abbey) was as follows:
         
 
Abbey National plc
  £ 7,310m  
 

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Business and Financial Review
Business Overview continued
In December 2005 there was a further issue under Abbey’s UK Residential Mortgage Backed Securitisation programme, Holmes Financing Master Trust, bringing the total issuance under the programme to £23.9bn, (of which £15.6bn is outstanding). The terms and conditions of the underlying mortgages remain unaffected by the securitisation process.
     See also “Liquidity sources”.
Derivatives and Structured Products
Derivatives and Structured Products cover equity, fixed income, residential property and credit derivative activities including the manufacture of structured products sold to retail customers by Abbey and other financial services organisations.
Short-Term Markets
Short-Term Markets is responsible for managing Abbey’s operating liquidity. It runs Abbey’s short-term funding and liquidity management activities and the securities lending/borrowing and repo businesses. Short-Term Markets focuses on managing Abbey’s liquidity, within the overall balance sheet management framework set by Asset and Liability Management, which also creates trading opportunities. Additionally, Short-Term Markets operates in several international non-cash markets, in particular the stock borrowing and lending repo markets. It has retained a US office, to facilitate Abbey’s short-term multi-currency fund raising.
Group Infrastructure
Group Infrastructure comprises Central Services, Financial Holdings (which contains the earnings on any surplus capital), and the results of certain small businesses.
Portfolio Business Unit
The Portfolio Business Unit originally comprised a number of businesses, assets and portfolios that were deemed inconsistent with the strategy focusing on personal financial services in the UK. Of the £60.0bn of assets that existed at the start of the programme, now only £2.5bn remains, consisting mainly of Porterbrook, and the Motor Finance and Litigation Funding business. Due to the significantly reduced size of the Portfolio Business Unit the remaining assets including Porterbrook will be reported as part of Abbey Financial Markets in 2006.

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Business and Financial Review
Business Review — Summary
The results discussed below are not necessarily indicative of Abbey’s results in future periods. The following information contains certain forward-looking statements. See “Forward-looking Statements” on page 5.
   The following discussion is based on and should be read in conjunction with the Consolidated Financial Statements included elsewhere in this Annual Report and Accounts. The Consolidated Financial Statements are prepared in accordance with International Financial Reporting Standards (‘IFRS’), which vary in certain significant respects from US GAAP. A discussion of such differences can be found in the “Other Material Items” section of the Business and Financial Review and a reconciliation of certain IFRS amounts to US GAAP is included in note 58 of the Consolidated Financial Statements.
Executive summary
Abbey has prepared this Business and Financial Review in a manner consistent with the way management views Abbey’s business as a whole. As a result, Abbey presents the following key sections to the Business and Financial Review:
     
>
  Business review summary - this contains an explanation of the basis of Abbey’s results and any potential changes to that basis in the future, a summary income statement with commentary, a summary income statement analysed between Personal Financial Services and the Portfolio Business Unit, and a summary of the nature of adjustments between our statutory basis of accounting and Abbey’s management basis of accounting (known as the “trading” basis);
 
   
>
  Personal Financial Services - this contains a summary of the results, and commentary thereon, by income statement line item on a trading basis for each segment. Additional detailed information is provided for certain segments such as the Retail Banking and Insurance and Asset Management segments due to the significance of their impact on Abbey’s results;
 
   
>
  Portfolio Business Unit - this contains a summary of the results and commentary thereon on a management basis. Additional information is provided on the assets and relevant provisions;
 
   
>
  Other Material Items - this contains detailed information about the statutory to trading basis adjustments. It also contains details of the differences between IFRS and US GAAP and the movements therein; and
 
   
>
  Balance Sheet Review - this contains an analysis of Abbey’s balance sheet as a whole, including:
         
 
  >   Capital disclosures - this contains an analysis of Abbey’s capital needs and availability;
 
       
 
  >   Off-Balance Sheet disclosures - this contains a summary of Abbey’s off-balance sheet arrangements, their business purpose, and importance to Abbey; and
 
       
 
  >   Liquidity disclosures - this contains an analysis of Abbey’s sources and uses of liquidity and recent cashflows.
Basis of results presentation
In 2005, the reorganisation of Abbey following its acquisition by Banco Santander Central Hispano, S.A. resulted in a change in the way our business is managed and reported. The discussions in this Annual Report and Accounts reflect our new segments, which are:
     
>
  Retail Banking;
 
   
>
  Insurance and Asset Management;
 
   
>
  Abbey Financial Markets;
 
   
>
  Group Infrastructure; and
 
   
>
  Portfolio Business Unit
In this report, the Retail Banking, Insurance and Asset Management, Abbey Financial Markets and Group Infrastructure segments are referred to as the Personal Financial Services businesses. The analysis of our results for 2004 has also been presented on this basis. Previously, our segment reporting structure was:
     
>
  Banking and Savings;
 
   
>
  Investment and Protection;
 
   
>
  Abbey Financial Markets;
 
   
>
  General Insurance;
 
   
>
  Group Infrastructure;
 
   
>
  Wholesale Banking;
 
   
>
  Motor Finance & Litigation Funding; and
 
   
>
  Other.
   In summary, our General Insurance business has been transferred into the Banking and Savings segment, which has been renamed Retail Banking. In addition, Scottish Mutual International Limited, which was reported in the Other segment has been transferred into the Investment & Protection segment in 2005, which has been renamed Insurance and Asset Management. Finally, the Wholesale Banking businesses (which now consist principally of the Porterbrook leasing business), the Motor Finance and Litigation Funding businesses and the remaining businesses in the Other segment are now reported as the Portfolio Business Unit segment.
Critical factors affecting results
Critical accounting policies and areas of significant management judgement
The preparation of Abbey’s financial statements requires management to make estimates and judgements that affect the reported amount of assets and liabilities at the date of the financial statements and the reported amount of income and expenses during the reporting period.

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Business Review — Summary continued
Management evaluates its estimates and judgements on an ongoing basis. Management bases its estimates and judgements on historical experience and on various other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.
The following estimates and judgements are considered important to the portrayal of Abbey’s financial condition.
(a) Provisions for loans and advances
Abbey estimates provisions for loans and advances with the objective of maintaining balance sheet provisions at the level believed by management to be sufficient to absorb actual losses (“observed provisions”) and inherent losses (“incurred but not yet observed provisions”) in Abbey’s loan portfolio from homogeneous portfolios of assets and individually identified loans in connection with loans and advances to banks and loans and advances to customers. The calculation of provisions on impaired loans and advances is based on the likelihood of the asset being written off (or repossessed in the case of mortgage loans) and the estimated loss on such a write-off. These assessments are made using statistical techniques based on historic experience. These determinations are supplemented by various formulaic calculations and the application of management judgement.
     Abbey considers accounting estimates related to provisions for loans and advances “critical accounting estimates” because: (i) they are highly susceptible to change from period to period as the assumptions about future default rates and valuation of potential losses relating to impaired loans and advances are based on recent performance experience, and (ii) any significant difference between Abbey’s estimated losses (as reflected in the provisions) and actual losses will require Abbey to take provisions which, if significantly different, could have a material impact on its future income statement and its balance sheet. Abbey’s assumptions about estimated losses are based on past performance, past customer behaviour, the credit quality of recent underwritten business and general economic conditions, which are not necessarily an indication of future losses.
     Provisions for loans and advances, less amounts released and recoveries of amounts written off in previous years, are charged to the line item “Impairment losses on loans and advances” in the income statement. The provisions are deducted from the “Loans and advances to banks” and the “Loans and advances to customers” line items on the balance sheet. If Abbey believes that additions to the provisions for such credit losses are required, then Abbey records additional provisions for credit losses, which would be treated as a charge in the line item “Impairment losses on loans and advances” in the income statement.
     The financial statements for the year ended 31 December 2005 include a provision charge for loans and advances in the Retail Banking segment for an amount equal to £208m. This provision increased (in 2004 it was £20m), reflecting higher default rates in the unsecured portfolios, and a reduction of general provisions of £136m. In calculating the provisions within the Retail Banking segment, a range of outcomes was calculated based principally on management’s conclusions regarding the current economic outlook relative to historic experience. Had management used different assumptions regarding the current economic outlook, a larger or smaller provision for loans and advances would have resulted in the Retail Banking segment that could have had a material impact on Abbey’s reported operating profit in 2005. Specifically, if management’s conclusions as to the current economic outlook were different, but within the range of what management deemed to be reasonably possible economic outlooks, the provision charge for loans and advances in the Retail Banking segment could have decreased in 2005 from an actual provision charge of £208m (2004: £20m) by as much as £32m (2004: £15m), with a potential corresponding increase in Abbey’s operating profit in 2005 of up to 5% (2004: 71%), or increased by £45m (2004: £87m), with a potential corresponding decrease in Abbey’s operating profit in 2005 of up to 8% (2004: 414%). The actual provision charge of £208m (2004: £20m) in 2005 was based on what management estimated to be the most probable economic outlook within the range of reasonably possible economic outlooks.
(b) Valuation of financial instruments
Financial instruments that are classified at fair value through profit and loss (including those held for trading purposes) or available for sale, and all derivatives, are stated at fair value. The fair value of such financial instruments is the estimated amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. If a quoted market price is available for an instrument, the fair value is calculated based on the market price.
     When valuation parameters are not observable in the market or cannot be derived from observable market prices, as is the case with certain over-the-counter derivatives, the fair value is derived through analysis of other observable market data appropriate for each product and pricing models which use a mathematical methodology based on accepted financial theories. Depending on the product type and its components, the fair value of over-the-counter derivatives is modelled using one or a combination of pricing models that are widely accepted in the financial services industry. Pricing models take into account the contract terms of the securities as well as market-based valuation parameters, such as interest rates, volatility, exchange rates and the credit rating of the counterparty. Where market-based valuation parameters are not directly observable, management will make a judgement as to its best estimate of that parameter. In exercising this judgement, a variety of tools are used including proxy observable data, historical data, and extrapolation techniques.
     Abbey considers that the accounting estimate related to valuation of trading securities and derivatives where quoted market prices are not available is a “critical accounting estimate” because: (i) it is highly susceptible to change from period to period because it requires management to make assumptions about interest rates, volatility, exchange rates, the credit rating of the counterparty, valuation adjustments and specific features of the transactions and (ii) the impact that recognising a change in the valuations would have on the assets reported on its balance sheet as well as its net profit/(loss) could be material.
     Changes in the valuation of trading securities and derivatives where quoted market prices are not available are accounted for in the line item “Net trading income” in the income statement and the “Trading assets” or “Trading Liabilities” and “Derivative Financial Instruments” line items in Abbey’s balance sheet.
     Had management used different assumptions regarding the interest rates, volatility, exchange rates, the credit rating of the counterparty, and valuation adjustments, a larger or smaller change in the valuation of trading securities and derivatives where quoted market prices are not available would have resulted that could have had a material impact on Abbey’s reported

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Business Review — Summary continued
operating profit in 2005. Due to the individual nature of these contracts, Abbey does not believe it is appropriate to apply a global adjustment to management’s estimates, as it would not give a meaningful sensitivity.
     The table below summarises Abbey’s trading portfolios and other assets and liabilities held at fair value by valuation methodology at 31 December 2005:
                 
    Assets   Liabilities
    %   %
 
Fair value based on:
               
Quoted market prices
    58       36  
Internal models based on market prices
    42       64  
Internal models based on information other than market data
           
 
Total
    100       100  
 
(c) Long-term assurance business
Abbey accounts for its long-term assurance business using the embedded value basis of accounting used by banking groups, modified, as necessary, to comply with the requirements of IFRS (“IFRS embedded value”), including a consolidation on a line by line basis of the long-term assurance business into Abbey’s consolidated financial statements.
     The long-term assurance business issues insurance contracts and investment contracts. Insurance contracts are contracts which transfer significant insurance risk. As a general guideline, the Group defines as significant insurance risk the possibility of having to pay benefits on the occurrence of an insured event. Investment contracts are those contracts which carry no significant insurance risk. A number of insurance and investment contracts contain a discretionary participation feature which entitles the holder to receive, as a supplement to guaranteed benefits, additional benefits or bonuses that are likely to be a significant portion of the total contractual benefits and whose amount or timing is contractually at the discretion of the Group and based on the performance of specified assets. Contracts containing a discretionary participation feature are referred to as participating or with-profits contracts.
     The critical accounting policies set out below relate to the valuation of insurance contract liabilities and the estimated future surplus emerging. In addition, results are affected by the movement in the value of financial assets within the long-term assurance business which are recorded at fair value through income. Management do not consider the valuation of investment contract liabilities as a critical accounting policy, as the impact of market changes is borne by the policyholder.
Insurance contracts and participating contracts
Abbey accounts for insurance contracts and participating investment contracts using the IFRS embedded value basis of accounting which recognises the present value of in-force (“PVIF”) business. The PVIF is calculated by projecting future surpluses (excluding future investment margins) and other net cash flows attributable to the shareholders arising from business written at the balance sheet date and discounting the result at a rate which reflects the shareholders’ overall risk premium.
     Liabilities relating to insurance contracts, which are not unit linked, are recorded when the premium is recognised as due. The liability is calculated by estimating the future cash flows over the duration of the in-force policies and discounting them back to the valuation date allowing for probabilities of occurrence. The liability will vary with movements in interest rates and with the cost of life assurance and annuity benefits where future mortality is uncertain. Assumptions are made in respect of all material factors affecting future cash flows, including future interest rates, mortality and costs. For conventional life and pensions business, the gross premium valuation method has been used.
     Liabilities for life insurance contracts, which are unit linked, are recorded when premiums are allocated. These liabilities are increased or reduced by the change in the unit prices and are reduced by policy administration fees, mortality and surrender charges and any withdrawals and include any amounts necessary to compensate the Group for services to be performed over future periods. The mortality charges deducted in each period from the policyholders as a group are considered adequate to cover the expected total death benefits claims in excess of the contract account balances in each period and hence no additional liability is established for these claims in excess of the contract balances. Revenue consists of fees deducted for mortality, policy administration and surrender charges. Interest or changes in the unit prices credited to the account balances and excess benefit claims in excess of the account balances incurred in the period are charged as expenses in the income statement.
     Liabilities of the Group’s with-profits life funds, including guarantees and options embedded within products written by that fund, are stated at their realistic values in accordance with the Financial Services Authority’s realistic capital regime. The measurement of insurance liabilities is calculated using stochastic methods and therefore reflects both the intrinsic and time value of guarantees and options embedded within products. Economic assumptions are calibrated to observed current market prices.
     Future surpluses used to calculate the value of in-force business will depend on lapse rates, mortality, persistency, and levels of expenses. Surpluses are estimated by management through assumptions about future experience, having regard to both actual experience and current economic trends. Surpluses expected to emerge in the future are discounted at risk-adjusted discount rates after provision has been made for taxation. There is an acceptable range into which these assumptions can validly fall, and the use of different assumptions or changes to these assumptions may cause the present value of future surpluses to differ from those assumed at the balance sheet date. This could significantly affect the income recognised, and the value attributed to the in-force business, in the accounts.
     The value of the in-force business could also be affected by changes in the amounts and timing of other net cash flows, principally annual management charges and other fees levied upon the policy holders, which are reflected in the income statement using unsmoothed fund values. In addition, to the extent that actual experience is different from that assumed, the effect will be recognised in the income statement for the period. Demographic assumptions are set individually by product.

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Business and Financial Review
Business Review — Summary continued
Sensitivities to key assumption changes such as interest rates and lapses rates which impact the value of assets and liabilities are shown on page 71.
(d) Impairment of goodwill
The carrying value of goodwill is stated at cost less impairment. The carrying value of goodwill is written down by the amount of any impairment, and the loss is recognised in the income statement in the period in which this occurs. Should an external event reverse the effects of a previous impairment, the carrying value of the goodwill may be written up to a value no higher than the original amortised cost. Impairments are calculated with reference to the discounted cash flows of the entity or income-generating unit. Assumptions about expected future cash flows require management to make assumptions about interest rates, the health of the economy and operating costs. This involves significant judgement because such factors have fluctuated in the past and are expected to continue to do so.
     Abbey considers that the accounting estimate related to impairment of goodwill is a “critical accounting estimate” because: (i) it is highly susceptible to change from period to period because it requires management to make assumptions about future cash flows, interest rates, the health of the economy and operating costs, and (ii) the impact that recognising a goodwill impairment charge would have on the assets reported on its balance sheet as well as on its net profit/(loss) could be material.
     Goodwill impairment charges are accounted for in the line item “Impairment recoveries/(losses) on fixed asset investments” in the income statement and the “Intangible assets” line item in the balance sheet.
     The financial statements for the year ended 31 December 2005 do not include any impairment charges for goodwill under IFRS (2004: £nil). In determining whether or not the goodwill balances within the Retail Banking, Insurance and Asset Management and Portfolio Business Unit segments were impaired and, if so, by how much, a range of outcomes was calculated based principally on management’s conclusions regarding the current economic outlook. Had management used different assumptions regarding the current economic outlook, larger impairment charges for goodwill would have resulted in the Retail Banking, Insurance and Asset Management and Portfolio Business Unit segments that could have had a material impact on Abbey’s reported operating profit in 2005. Specifically, if management’s conclusions as to the current economic outlook were different, but within the range of what management deemed to be reasonable possible economic outlooks, the impairment charges under IFRS for goodwill in the Retail Banking and Insurance and Asset Management segments could have increased by £136m (2004: £136m), with a potential corresponding decrease in Abbey’s operating profit in 2005 of up to 23% (2004: 647%). The actual impairment charge for goodwill of £nil (2004: £nil) in 2005, was based on what management estimated to be the most probable economic outlook within the range of reasonably possible economic outlooks.
     For details of the impairment charge under US GAAP in 2005 in the Insurance and Asset Management segment refer to Note 59 of the Consolidated Financial Statements.
(e) Provisions for misselling
Abbey estimates provisions for misselling with the objective of maintaining reserve levels believed by management to be sufficient to absorb current estimated probable losses in connection with compensation and costs relating to the handling of complaints from customers who claim misselling of endowment policies and other products. The calculation of provisions for misselling is based on the estimated number of claims that will be received, of those, the number that will be upheld, and the estimated average settlement per case. These assessments are based on management’s estimate for each of these three factors.
     Abbey considers accounting estimates related to misselling provisions “critical accounting estimates” because: (i) they are highly susceptible to change from period to period in the three factors above, and (ii) any significant difference between Abbey’s estimated losses as reflected in the provisions and actual losses will require Abbey to take provisions which, if significantly different, could have a material impact on its future income statement and its balance sheet. Abbey’s assumptions about estimated losses are based on past claims uphold rates, past customer behaviour, and past average settlements, which are not necessarily an indication of future losses.
     Provisions for misselling are charged to the line item “Provisions for other liabilities and charges” in the income statement. The provision is included in the “Other Provisions” line item on the balance sheet. If Abbey believes that additions to the misselling provision are required, then Abbey records additional provisions, which would be treated as a charge in the line item “Provisions for other liabilities and charges” in the income statement.
     The financial statements for the year ended 31 December 2005 include a provision charge for misselling in the Retail Banking segment for an amount equal to £10m. In addition, claims settled of £70m have been charged to administrative expenses. The balance sheet provision increased from £153m to £189m reflecting the £10m additional provision together with the inclusion of £44m previously classified within liabilities of the long-term assurance funds. In calculating the misselling provision with the Retail Banking and Insurance and Asset Management segments, management’s best estimate of the provision was calculated based on conclusions regarding the number of claims that will be received, of those, the number that will be upheld, and the estimated average settlement per case. Had management used different assumptions regarding these factors, a larger or smaller provision for misselling would have resulted in the Retail Banking and Asset and Insurance Management segments that could have had a material impact on Abbey’s reported operating profit in 2005. Specifically, if management’s conclusions as to the number of claims that will be received, of those, the number that will be upheld, and the estimated average settlement per case were different, but within the range of what management deemed to be reasonably possible, the provision charge for misselling in the Retail Banking and Insurance and Asset Management segments could have decreased in 2005 from an actual total charge of £80m by as much as £21m, with a potential corresponding increase in Abbey’s operating profit in 2005 of up to 4%, or increased by £65m, with a potential corresponding decrease in Abbey’s operating profit in 2005 of up to 11%. The actual charge of £80m in 2005 was based on what management estimated to be the most probable number of claims that will be received, of those, the number that will be upheld, and the estimated average settlement per case within the range of reasonably possible outcomes.

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Business and Financial Review
Business Review — Summary continued
(f) Pensions
Abbey operates a number of defined benefit pension schemes as described in Note 43 to the Consolidated Financial Statements. The assets of the schemes are measured at their fair values at the balance sheet date. The liabilities of the schemes are estimated by projecting forward the growth in current accrued pension benefits to reflect inflation and salary growth to the date of pension payment, discounted to present value using the interest rate applicable to high-quality corporate bonds of the same currency and term as the scheme liabilities. Any surplus or deficit of scheme assets over liabilities is recognised in the balance sheet as an asset (surplus) or liability (deficit). An asset is only recognised to the extent that the surplus can be recovered through reduced contributions in the future or through refunds from the scheme. In determining the value of scheme liabilities, assumptions are made by management as to price inflation, discount rates, pensions increases, earnings growth and mortality.
     Abbey considers accounting estimates related to pension provisions “critical accounting estimates” because: (i) they are highly susceptible to change from period to period, and (ii) any significant difference between Abbey’s estimates of the scheme liabilities and actual liabilities could significantly alter the amount of the surplus or deficit recognised in the balance sheet and the pension cost charged to the income statement. Abbey’s assumptions about price inflation, discount rates, pensions increases, earnings growth and mortality are based on past experience and current economic trends, which are not necessarily an indication of future experience.
     Pension costs are charged to the line item “Administration expenses” in the income statement. The provision is included in the “Retirement benefit obligations” line item in the balance sheet. If Abbey believes that increases to the pensions cost are required, then Abbey records additional costs that would be treated as a charge in the line item “Administration expenses” in the income statement.
     The financial statements for the year ended 31 December 2005 include current year service costs for an amount equal to £102m. This cost was reduced (in 2004 it was £121m), reflecting reductions in scheme membership, salary reviews and changes in discount rates. In calculating the current year service cost, a range of outcomes was calculated based principally on management’s estimates regarding price inflation, discount rates, pensions increases, earnings growth and mortality. Had management used different assumptions regarding price inflation, discount rate, pensions increases, earnings growth and mortality, a larger or smaller charge for pension costs would have resulted that could have had a material impact on Abbey’s reported operating profit in 2005. Specifically, if management’s conclusions as to price inflation, discount rates, pensions increases, earnings growth and mortality were different, but within the range of what management deemed to be reasonably possible conclusions, the charge for pension costs could have decreased in 2005 from an actual pension charge of £102m (2004: £121m) by as much as £5m (2004: £5m), with a potential corresponding increase in Abbey’s operating profit in 2005 of up to 0.8% (2004: 23.8%), or increased by £23m (2004: £29m), with a potential corresponding decrease in Abbey’s operating profit in 2005 of up to 3.9% (2004: 138%). The actual current year service pension charge of £101m (2004: £121m) in 2005 was based on what management estimated to be the most probable price inflation, discount rates, pensions increases, earnings growth and mortality within the range of reasonably possible price inflation, discount rates, pensions increases, earnings growth and mortality.
Profit on disposal of Group undertakings
Profits of £62m were made in the year ended 31 December 2005 on the disposal of Group undertakings.
Significant acquisitions and disposals
The results for the year ended 31 December 2005 have not been materially impacted by disposals. There were no significant acquisitions during the year.
Current and future accounting developments
Details of current and future developments can be found in the accounting policies and notes 56 and 57 to the Consolidated Financial Statements.
Transitional exemptions permitted by IFRS 1
The Consolidated Financial Statements have, for the first time, been prepared in accordance with IFRS as approved by the International Accounting Standards Board (“IASB”), and interpretations issued by the International Financial Reporting Interpretations Committee of the IASB that, under European Regulations, are effective or available for early adoption at the Group’s first reporting date under IFRS. The date of transition to IFRS for the Group and the date of its opening IFRS balance sheet was 1 January 2004. On initial adoption of IFRS, the Group applied the following exemptions from the requirements of IFRS and from their retrospective application as permitted by IFRS 1 “First-time Adoption of International Financial Reporting Standards”.
a)   Business Combinations – the Group has applied IFRS 3 “Business Combinations” to business combinations that occurred on or after 1 January 2004. Business combinations before that date have not been restated. Under previous GAAP (“UK 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. Had this exemption not been taken, the main effects would have been to recognise additional deferred tax on fair value adjustments made at the date of acquisition and to recognise additional intangible assets, with resulting adjustments to the carrying value of goodwill and retained earnings at 1 January 2004.
 
b)   Cumulative foreign currency difference – The Group has brought forward a nil opening balance on the cumulative foreign currency translation adjustment arising from the retranslation of foreign operations, which is shown as a separate item in shareholders’ equity at the date of transition in accordance with IAS 21 “The Effects of changes in Foreign Exchange Rates”. Had this exemption not been taken, the resulting retrospective application of IAS 21 would

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    have resulted in a reallocation between retained earnings and other reserves at 1 January 2004 but would have had no impact on total equity.
 
c)   Implementation of IAS 32, IAS 39 and IFRS 4 (incorporating the adoption of FRS 27 “Life Assurance”) – As allowed by IFRS 1, the Group has not restated its 2004 consolidated income statements and balance sheets to comply with IAS 32, IAS 39 and IFRS 4.
 
d)   The Group has decided to early adopt IFRS 7 “Financial Instruments: Disclosures” and has taken advantage of the exemption therein from presenting certain comparative information.
 
e)   The Group has also decided to early adopt the amendment to IAS 19 “Employee Benefits- Actuarial Gains and Losses Group Plans and Disclosures” and has, therefore, recognised in equity at 1 January 2004 all cumulative actuarial gains and losses on post-employment benefit plans. Recognising certain actuarial gains and losses under the alternative ‘corridor approach’ would have reduced liabilities and increased retained earnings at 1 January 2004. Abbey has not elected to adopt a corridor approach going forward under IAS 19 ‘Employee Benefits’.
 
f)   The Group has adopted IFRS 5 “Non current assets held for sale and Discontinued Operations” prospectively from 1 January 2005 and has elected not to restate comparatives. Had this exemption not been taken, the retrospective application of IFRS 5 would have resulted in disclosures of an allocation of the profit for the year ended 31 December 2004 between continuing operations and discontinued operations.
Group summary
Summarised consolidated statutory income statement and selected ratios
                 
    31 December     31 December  
    2005     2004  
    £m     £m  
 
Net interest income
    1,207       1,463  
Non-interest income
    1,533       1,382  
 
Total operating income
    2,740       2,845  
Administrative expenses
    (1,724 )     (2,221 )
Depreciation and amortisation
    (199 )     (547 )
Provision for bad and doubtful debts
    (218 )     55  
Provisions for other liabilities and charges
    (3 )     (233 )
Amounts written off fixed asset investments
          80  
 
Profit/(loss) on ordinary activities before tax
    596       (21 )
 
Tax on profit/(loss) on ordinary activities
    (176 )     (33 )
 
Profit/(loss) on ordinary activities after tax
    420       (54 )
 
 
               
Tier 1 capital ratio
    10.0 %     10.4 %
Equity Tier 1 capital ratio
    6.6 %     7.0 %
Closing risk weighted assets (£m)
    55,972       56,171  
 
2005 compared to 2004
Total profit before tax of £596m compared to a loss of £21m in 2004 marks a significant improvement on 2004. Material movements by line include:
     
>
  net interest income of £1,207m (2004: £1,463m) fell due to a reduction of £99m in Portfolio Business Unit reflecting lower level of interest earning asset, the non-recurrence of £50m of gains relating to the close-out of hedges, and a 6 basis point fall in the retail banking spread.
 
   
>
  non-interest income of £1,533m (2004: £1,382m), up 11% as a result of improved fee performance in relation to mortgages, banking and unsecured personal lending. In addition, reduced losses on disposal of Portfolio Business Unit loans and securities contributed positively.
 
   
>
  administrative expenses of £1,724m (2004: £2,221m) were down 22%. Personal Financial Services expenses fell £439m to £1,686m largely reflecting the benefits of the cost reduction programme and higher costs in 2004 associated with the sale of Abbey National plc to Banco Santander Central Hispano, S.A. including costs realised post acquisition. Portfolio Business Unit expenses fell due to the reduced size of operations.
 
   
>
  Depreciation and amortisation of £199m (2004: £547m) was down 64%. 2004 included a charge of £147m in connection with an impairment of goodwill in relation to Scottish Provident Limited distribution channels and depreciation on operating lease assets of £123m (2004: £184m), down 33% reflecting the sale of leasing companies in the Portfolio Business Unit through the year.
 
   
>
  a credit provision charge in relation to bad and doubtful debts of £218m (2004: £55m release). The 2004 release included a release of general provisions of £136m together with the release of £60m of Scottish Provident Limited contingent loans not repeated in 2005. Other movements in the credit provision charge include an increase in mortgage provisions of £12m. The remaining increase relates to unsecured lending, reflecting some modest credit quality deterioration together with seasoning of the asset.
 
   
>
  provisions for other liabilities and charges decreased to £3m (2004: £233m). 2004 included a charge of £154m related to endowment misselling. Remediation costs relating to misselling of £70m in 2005 were also charged to administrative expenses.
 
   
>
  amounts written off fixed asset investments were nil in 2005 (2004: £80m release). The release reflected the disposal of Portfolio Business Unit assets for amounts in excess of their written down value.

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Business and Financial Review
Business Review — Summary continued
Summarised consolidated statutory income statement analysed between Personal Financial Services and the Portfolio Business Unit
                                                 
    31 December 2005     31 December 2004  
    PFS     PBU     Total     PFS     PBU     Total  
    £m     £m     £m     £m     £m     £m  
 
Net interest income
    1,243       (36 )     1,207       1,400       63       1,463  
Non-interest income
    1,247       286       1,533       1,224       158       1,382  
 
Total operating income
    2,490       250       2,740       2,624       221       2,845  
Administrative expenses
    (1,686 )     (38 )     (1,724 )     (2,125 )     (96 )     (2,221 )
Depreciation and amortisation
    (76 )     (123 )     (199 )     (363 )     (184 )     (547 )
Provision for bad and doubtful debts
    (208 )     (10 )     (218 )     65       (10 )     55  
Provisions for other liabilities and charges
    (11 )     8       (3 )     (233 )           (233 )
Amounts written off fixed asset investments
                            80       80  
 
Profit/(loss) on ordinary activities before tax
    509       87       596       (32 )     11       (21 )
 
Adjustments between the statutory basis and the trading basis
Abbey’s Board reviews discrete financial information for each of its segments that includes measures of operating results and assets. However, due to the differing natures of its ongoing Personal Financial Services group of reportable segments and its Portfolio Business Unit segment, which is being managed for value, these are managed differently. The Personal Financial Services group of reportable segments is managed primarily on the basis of its results, which are measured on a trading basis. The Portfolio Business Unit segment is managed both on the basis of its results, which are measured on a management basis, and on the basis of its net asset value. On a consolidated level, the trading results of the Personal Financial Services group of reportable segments are aggregated with the management results of the Portfolio Business Unit segment to give the summarised trading income statement. The trading basis for Abbey’s Personal Financial Services group of reportable segments and the management basis for its Portfolio Business Unit segment are collectively known as the “trading” basis, as presented below.
Management considers that the trading basis provides the most appropriate way of reviewing the performance of the business. The main adjustments are:
     
>
  IFRS embedded value charges and rebasing – These are unpredictable as they depend on both equity and debt market movements which do not affect the underlying performance of what is a very long-term business. The short-term market movements remain a very important factor in the management of the business but these are managed separately with a more risk-based focus.
 
   
>
  Reorganisation and other costs – Comprise implementation costs in relation to the strategic change and cost reduction process. Management needs to understand the underlying drivers of the cost base that will remain after the exercise is complete, and does not want this view to be clouded by the costs of the exercise, which are managed independently.
 
   
>
  Intangible asset charges – These charges can vary significantly year on year, and hence can materially affect the profit or loss for that year. As a result, Abbey reviews these charges separately to avoid clouding the presentation of underlying results.
 
   
>
  Hedging variances – As a consequence of the introduction of IFRS, the balance sheet and income statement are subject to volatility particularly from the accounting for elements of derivatives deemed under IFRS rules to be ineffective as hedges. Where appropriate, such volatility is separately identified to enable management to view the underlying performance of the business.
     
>
  Proforma IFRS adjustments – Due to certain IFRS standards only being applicable from 1 January 2005, the 2004 statutory results only include the impact of IFRS which are required to be applied retrospectively in the preparation of the 2005 results. As a result, management reviews the 2004 results on a proforma basis, incorporating the impact of those prospective IFRS where it can be determined what the impact would have been if the accounting changes had been effective in 2004. The impact includes the treatment of interest income and fees and the reclassification of preference shares from shareholders equity to debt, but excludes the effect of accounting for derivatives under IAS 39 as no estimate of their effect can be made.
 
   
>
  One-off statutory IFRS adjustments – The conversion to IFRS resulted in the recognition of certain one off items including impairment charges. These items have been deducted from the results to allow management to understand the underlying performance of the business.

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Business and Financial Review
Business Review — Summary continued
For a detailed explanation of these items, please refer to the “Other material items” section of the Business and Financial Review.
The adjustments applied to the Personal Financial Services group of reportable segments are:
     
>
  IFRS embedded value charges and rebasing,
 
   
>
  Reorganisation costs,
 
   
>
  Intangible asset charges,
 
   
>
  Hedging variances,
 
   
>
  Proforma IFRS adjustments, and
 
   
>
  One-off statutory IFRS adjustments.
The adjustment applied to the Portfolio Business Unit segment is Proforma IFRS adjustments.

17


Table of Contents

Business and Financial Review
Business Review — Personal Financial Services
Personal Financial Services profit before tax by segment
                                         
            Insurance     Abbey              
    Retail     and Asset     Financial     Group        
    Banking     Management     Markets     Infrastructure     Total  
31 December 2005   £m     £m     £m     £m     £m  
 
Net interest income
    1,400       55       1       (213 )     1,243  
Non-interest income
    561       267       252       197       1,277  
Depreciation of operating lease assets
                             
 
Total trading income
    1,961       322       253       (16 )     2,520  
Total trading expenses
    (1,050 )     (193 )     (105 )     (178 )     (1,526 )
Provision for bad and doubtful debts
    (208 )                       (208 )
Provisions for other liabilities and charges
    (10 )     (1 )                 (11 )
Amounts written off fixed asset investments
                             
 
Trading profit before tax
    693       128       148       (194 )     775  
Adjust for:
                                       
- IFRS embedded value charges and rebasing
          (12 )                 (12 )
- Reorganisation expenses
    (197 )     (17 )     (14 )     (5 )     (233 )
- Intangible asset charges
          (3 )                 (3 )
- Hedging Variances
    3                   (21 )     (18 )
Adjust for:
                                       
- One-off statutory IAS adjustments
                             
- Eliminating IAS proforma adjustments
                             
 
Profit/(loss) before tax
    499       96       134       (220 )     509  
 
                                         
            Insurance     Abbey              
    Retail     and Asset     Financial     Group        
    Banking     Management     Markets     Infrastructure     Total  
31 December 2004   £m     £m     £m     £m     £m  
 
Net interest income
    1,432       72       (2 )     (198 )     1,304  
Non-interest income
    477       279       291       151       1,198  
Depreciation of operating lease assets
                             
 
Total trading income
    1,909       351       289       (47 )     2,502  
Total trading expenses
    (1,153 )     (262 )     (109 )     (226 )     (1,750 )
Provision for bad and doubtful debts
    (20 )                       (20 )
Provisions for other liabilities and charges
    (155 )                 2       (153 )
Amounts written off fixed asset investments
                             
 
Trading profit before tax
    581       89       180       (271 )     579  
Adjust for:
                                       
- IFRS embedded value charges and rebasing
          21                   21  
- Reorganisation expenses
    (199 )     (57 )     (24 )     (267 )     (547 )
- Intangible asset charges
                      (20 )     (20 )
- Hedging Variances
                             
Adjust for:
                                       
- One-off statutory IAS adjustments
    (62 )     (32 )     (11 )     (134 )     (239 )
- Eliminating IAS proforma adjustments
    80       (3 )           97       174  
 
Profit/(loss) before tax
    400       18       145       (595 )     (32 )
 
     
2005 compared to 2004
 
>
  Personal Financial Services trading profit before tax of £775m was up 34% on 2004 (2004: £579m), largely due to increased revenues combined with savings from the cost reduction programme.
 
   
>
  Retail Banking trading profit before tax increased by 19% to £693m (2004: £581m). Included in the 2004 results were £92m of non-recurring revenue benefits. After adjusting for these items, the improvement was largely driven by increased fee income and the benefit of significant cost savings.
 
   
>
  Insurance and Asset Management trading profit before tax increased to £128m (2004: £89m). The main reason for the movement is the large decrease in costs, a result of the cost reduction programme, partially offset by the impact of continued lapses.
 
   
>
  Abbey Financial Markets trading profit before tax of £148m was down 18%, largely due to £65m of non-recurring revenue items in 2004, being partially offset by favourable market conditions and strong trading volumes, particularly in the second half of the year;
 
   
>
  Group Infrastructure trading loss before tax of £194m decreased by £77m (2004: loss of £271m) due largely to the reduction in costs resulting from the cost reduction programme.

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Business and Financial Review
Business Review — Personal Financial Services continued
Business flows relating to the Personal Financial Services businesses are set out below. These flows are used by management to assess the sales performance of Abbey, both absolutely and relative to its peers, and to inform management of product trends in the Personal Financial Services market.
Personal Financial Services business flows
                 
    31 December     31 December  
    2005     2004  
Retail Banking
               
Mortgages:
               
Gross mortgage lending
    £27.6bn       £25.0bn  
Capital repayments
    £24.6bn       £21.9bn  
Net mortgage lending
    £3.0bn       £3.1bn  
Mortgage stock
    £93.9bn       £90.9bn  
Of which:
               
– Abbey retail
    £89.9bn       £87.5bn  
– Housing Association
    £4.0bn       £3.4bn  
Market share – gross mortgage lending
    9.6 %     8.6 %
Market share – capital repayments
    12.5 %     11.5 %
Market share – net mortgage lending
    3.3 %     3.1 %
Market share – mortgage stock
    9.7 %     10.4 %
Retail deposits:
               
Total net deposit flows
    £2.6bn       £1.3bn  
Of which:
               
– Abbey retail
    £1.6bn       £0.3bn  
– Other
    £1.0bn       £1.0bn  
Deposit stock
    £62.0bn       £59.4bn  
Of which:
               
– Abbey retail
    £51.3bn       £49.7bn  
– Other
    £10.7bn       £9.7bn  
Banking:
               
Bank account openings:
               
– Abbey retail
    358,931       334,950  
– Other
    26,949       42,630  
 
 
    385,880       377,580  
Bank account liability:
               
– Abbey retail
    £4.8bn       £4.5bn  
– Other
    £3.2bn       £3.2bn  
 
 
    £8.0bn       £7.7bn  
Credit card openings:
               
– Abbey retail
    210,912       185,481  
– Other
    6,115       13,247  
 
 
    217,027       198,728  
Credit card stock:
               
– Abbey retail
    1,178,205       1,048,718  
– Other
    134,824       139,634  
 
 
    1,313,029       1,188,352  
 
Gross unsecured personal loan lending:
               
– Abbey retail
    £1.3bn       £1.1bn  
– Other
    £0.8bn       £1.1bn  
 
 
    £2.1bn       £2.2bn  
Unsecured lending asset – Abbey retail
    £2.3bn       £2.0bn  
– Other
    £1.5bn       £1.4bn  
 
 
    £3.8bn       £3.4bn  
 
               
*SME account openings (gross)
    36,918       30,949  
*SME account stock
    195,579       159,752  
*SME account liability
    £4.0bn       £3.7bn  
 

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Business and Financial Review
Business Review — Personal Financial Services continued
             
    31 December   31 December
    2005   2004
 
Insurance and Asset Management Investment:
           
New business premiums: Investments
  £1,010m   £479m
New business premiums: Pensions
  £250m   £292m
 
Total life assurance new business premiums
  £1,260m   £771m
Inscape
  £324m   £250m
 
Total investment new business premiums
  £1,584m   £1,021m
 
Branch and Direct – annualised equivalent
  £94m   £70m
Intermediary – annualised equivalent
  £64m   £49m
 
Total life assurance annualised equivalent
  £158m   £119m
 
Protection:
           
 
Branch and Direct
  £18m   £19m
Intermediary
  £64m   £78m
 
Total protection annualised equivalent
  £82m   £97m
 
Funds under management – life assurance
  £27bn   £26bn
 
General Insurance
           
New policy sales
    314,821     377,523
Policies in force
    1,472,954     1,672,606
 
*   Small and Medium Enterprise.
2005 compared to 2004
Retail Banking
Mortgages
Gross mortgage lending of £27.6bn (2004: £25.0bn) was 10% ahead of 2004 with an uplift in all channels and an improved average new business margin. This compared to a 1% decline in the size of the market, resulting in a market share estimated at 9.6% (2004: 8.6%). Capital repayments of £24.6bn were above natural share, as expected, reflecting high levels of incentive period maturities. Net lending of £3.0bn, was slightly ahead of 2004 and corresponds to a 3.3% market share.
Retail Deposits
Deposit inflows of £2.6bn were double the 2004 performance. Profitable new branch-based acquisition account inflows more than offset back-book attrition and helped to stabilise liability spreads. Overall, retail deposits balances of £62.0bn were up 4% on 2004.
Banking
In total, bank account openings were ahead of last year’s performance, with a stronger uplift in terms of adult Abbey bank accounts openings, up 14%. This was boosted by the “Bank and Save” campaign in the fourth quarter, which also contributed to an increase of switchers joining Abbey to 34,000.
     In total, gross unsecured lending was broadly in line with 2004, although balances grew by 12%. Abbey branded gross lending was up 18%, largely driven by improved systems capability in the branch channel.
     Credit card openings were up 9% compared to 2004, albeit with a weaker second half performance.
General Insurance
General Insurance policy sales of 314,821 were down 17% on 2004. This decline was primarily the result of a decline in household sales, but were also affected by Abbey’s exit from both the travel and motor markets in 2004.
Insurance and Asset Management
Investment
Investment sales were 33% ahead of 2004, benefiting from significant growth in sales of the Select Offshore Bond, a strong tax year-end and the successful launch of Guaranteed Growth Plan and Guaranteed Income Bond through direct channels in the first half of the year. In total, investment sales (including Inscape) through direct channels were up 50%.
     Pension sales are down on last year due to sales efforts being targeted on development activity to capture increased sales following Pensions A-Day in April 2006.
Protection
Sales of protection sales fell relative to 2004, albeit set against a declining market. Second half protection sales were up 5% compared with the first half.

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Business and Financial Review
Business Review — Personal Financial Services continued
Personal Financial Services trading income
Personal Financial Services trading income by segment by business
                 
    31 December     31 December  
    2005     2004  
    £m     £m  
 
Retail Banking
    1,961       1,909  
Insurance and Asset Management
    322       351  
Abbey Financial Markets
    253       289  
Group Infrastructure
    (16 )     (47 )
 
Total trading income
    2,520       2,502  
 
Adjust for:
               
– IFRS embedded value charges and rebasing
    (12 )     (27 )
– Reorganisation expenses – life assurance
          (20 )
– Hedging variances
    (18 )      
– Eliminating IAS proforma adjustments
          169  
 
PFS total operating income
    2,490       2,624  
 
2005 compared to 2004
Retail Banking trading income was £52m higher than the previous period at £1,961m (2004: £1,909m). 2004 included non-recurring items of £92m, excluding which the increase was £144m. The improvement is largely attributable to growth in retail banking fee income, with balance sheet growth offsetting a modest spread decline to deliver a stable net interest income result.
     Insurance and Asset Management trading income of £322m was £29m lower than the previous period (2004: £351m), largely due to lower protection new business volumes, lower earnings on the in-force policies due to the lowering of the discount rate assumption and higher internal value based management charges following a change in the assumed mix of capital support. The 2005 result includes £118m of experience variances and assumption changes compared to £83m in 2004. (These are discussed in more detail in the ‘Insurance and Asset Management Income’ section).
     Abbey Financial Markets trading income of £253m was £36m lower than the previous period (2004: £289m), largely due to £65m of non-recurring specific revenue items in 2004.
     Group Infrastructure trading income of £(16)m (2004: £(47)m) was £31m higher than last year.
Personal Financial Services net interest income and spread
Personal Financial Services net interest income by segment
                 
    31 December     31 December  
    2005     2004  
    £m     £m  
 
Retail Banking
    1,400       1,432  
Insurance and Asset Management
    55       72  
Abbey Financial Markets
    1       (2 )
Group Infrastructure
    (213 )     (198 )
 
Net interest income
    1,243       1,304  
 
2005 compared to 2004
Excluding Retail Banking (analysed below), net interest income decreased by £(29)m.
Personal Financial Services Banking spread
                 
    31 December     31 December  
    2005     2004  
 
Net interest income (£m)
    1,400       1,432  
PFS Banking spread
    1.45 %     1.51 %
PFS Average asset spread
    0.71 %     0.74 %
PFS Average liability spread
    0.74 %     0.77 %
 
(1)   Retail Banking net interest income includes income associated with the Housing Association asset, however the Personal Financial Services Banking spread excludes Social Housing.
 
(2)   Average spread is defined as interest received (mortgage, unsecured personal loans and overdraft interest less suspended interest) over average interest earning assets, less interest payable (savings, in-credit bank accounts) over interest bearing liabilities (including an element of wholesale funding).
 
(3)   Asset and liability spreads are calculated using the third party interest payments (such as mortgage interest receivable or savings interest payable) net of relevant hedging compared to an internal transfer price of average base rate plus 15 bps.
Net interest income in the Retail Bank fell from £1,432m to £1,400m. 2004 included £50m of non-recurring benefit, relating to the close out of the free-reserves hedges. The other movement reflects a strong banking performance offset by a lower mortgage contribution and continuing pressure from the decline in back book savings balances. Whilst the overall spread declined year-on-year by 6bps to 1.45% (2004: 1.51%), over the last 18 months the spread has remained stable, with the second half 2005 asset spread 2 bps better than the same point last year, reflecting increased standard variable rate balances.

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Business and Financial Review
Business Review — Personal Financial Services continued
                 
    31 December     31 December  
    2005     2004  
Mortgage asset mix (1)   £bn     £bn  
 
Incentive period
               
Incentive standard variable rate linked
    12       14  
Incentive base rate linked
    23       27  
Fixed
    24       19  
Tied in
           
 
 
    59       60  
 
Free-to-go
               
Standard variable rate linked
    14       13  
Base-rate linked
    7       6  
Flexible
    9       6  
Other
    1       2  
 
 
    31       27  
 
Total mortgage asset
    90       87  
 
(1)   Quoted mortgage asset excludes £4.0bn (2004: £3.4bn) of Housing Association lending, consistent with the methodology used to calculate the Abbey retail spread.
2005 compared to 2004
In overall terms, mortgage assets of £90bn were over 3% higher than 2004. In 2005, the free-to-go balances on standard variable rate have stabilised, with growth in flexible products and fixed rate offers.
     The free-to-go standard variable rate asset of £14bn is higher than 2004, though in percentage terms, broadly in line as a proportion of the book as a whole.
                 
    31 December     31 December  
    2005     2004  
Liability mix   £bn     £bn  
 
Bank accounts
    4.8       4.5  
Remote access
    11.2       11.0  
Tax and bonds
    15.0       15.1  
Branch-based deposits
    16.1       15.3  
 
Total Abbey branded household liability (1)
    47.1       45.9  
Other subsidiaries (1)
    14.9       13.5  
 
Total PFS liability
    62.0       59.4  
 
(1)   The split is different to that in the “Personal Financial Services business flows” section due to the treatment of Abbey Business.
2005 compared to 2004
Branch-based deposits have increased by £0.8bn at £16.1bn (December 2004: £15.3bn). The mix has changed reflecting attrition from older branch-based accounts, more than offset by positive flows into new positive margin, branch-based offerings, such as Flexible Saver and Branch Saver.
     Remote savings balances, including internet and postal, have increased to £11.2bn (December 2004: £11.0bn). Tax and bonds savings balances increased, with Individual Savings Account (ISA) inflows offsetting bond maturities.
     Growth in balances outside Abbey retail relate primarily to cahoot.

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Business and Financial Review
Business Review — Personal Financial Services continued
Trading non-interest income
                 
    31 December     31 December  
    2005     2004  
    £m     £m  
 
Mortgages:
               
Administration, survey and legal fees
    68       50  
Other
    8       39  
 
 
    76       89  
Savings:
    38       31  
Banking credit card and UPL fees:
               
Banking fees
    263       192  
Credit card fees
    18       17  
Unsecured Personal Lending (‘UPL’) fees
    52       34  
 
 
    333       243  
General Insurance:
               
Building and contents
    85       91  
Motor
    3       6  
Creditor
    25       21  
Other
    1       (4 )
 
 
    114       114  
 
Retail Banking
    561       477  
 
Insurance and Asset Management
    267       279  
 
Abbey Financial Markets
    252       291  
 
Group Infrastructure
    197       151  
 
PFS trading non-interest income
    1,277       1,198  
 
2005 compared to 2004
Total mortgage non-interest income has fallen to £76m (2004: £89m). 2004 included £42m of specific benefits relating to the release of unused reassurance reserves from high loan-to-value mortgages (included on Other above). Apart from this, mortgage non-interest income was higher, reflecting volume growth and changes to new business fees.
     Savings non-interest income of £38m is up £7m on last year (2004: £31m), largely due to an increase in commissions driven by the level of investment sales made through the branch network.
     Banking related non-interest income increased by £90m to £333m (2004: £243m) driven by volume related increases, particularly in UPL and Abbey-branded credit cards, in addition to changes to specific fee structures.
     General insurance non-interest income of £114m (2004: £114m) was unchanged on last year.
     Insurance and Asset Management trading non-interest income is analysed in the life assurance income section that follows.
     Abbey Financial Markets non-interest income decreased 13% to £252m (2004: £291m). The 2004 result included a number of specific risk management trades which generated income of £65m. Other income was stronger reflecting increased trading volumes resulting from a favourable market environment.
     In Group Infrastructure, non-interest income of £197m (2004: £151m) increased by £46m, reflecting higher capital charges allocated to the life assurance companies.
Insurance and Asset Management Income
                         
  31 December 2005  
    Retail Life     Intermediary     Total  
    £m     £m     £m  
 
New business contribution
    12       26       38  
Contribution from existing business:
                       
– expected return
    34       166       200  
– experience variances, changes in assumptions and expense loadings
    46       72       118  
 
Increase in value of long-term assurance businesses
    92       264       356  
Non-embedded value earnings:
                       
ANUTM and ANPIM contribution(1)
    43             43  
Other income (including interest income)
    22       82       104  
Capital charge
    (28 )     (153 )     (181 )
 
Trading income
    129       193       322  
Operating expenses
    (39 )     (155 )     (194 )
 
Trading profit before tax (3)
    90       38       128  
Adjust for:
                       
- IFRS embedded value charges and rebasing
    (7 )     (5 )     (12 )
- Reorganisation expenses and others
    (3 )     (17 )     (20 )
 
Profit/(loss) before tax
    80       16       96  
 
New business margin (%) (2)
    26 %     22 %     23 %
 

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Business and Financial Review
Business Review — Personal Financial Services continued
                         
    31 December 2004  
    Retail Life     Intermediary     Total  
    £m     £m     £m  
 
New business contribution
    14       31       45  
Contribution from existing business:
                       
– expected return
    37       169       206  
– experience variances, changes in assumptions and expense loadings
    20       63       83  
 
Increase in value of long-term assurance businesses
    71       263       334  
Other:
                       
ANUTM and ANPIM Contribution (1)
    38             38  
Other income (including interest income)
    15       99       114  
Capital Charge
    (21 )     (114 )     (135 )
 
Trading income
    103       248       351  
Operating expenses
    (43 )     (219 )     (262 )
 
Trading earnings from PFS life assurance businesses (3)
    60       29       89  
Adjust for:
                       
- IFRS embedded value charges and rebasing
    (5 )     26       21  
- Reorganisation expenses
    (7 )     (50 )     (57 )
- One-off statutory IAS adjustments
          (32 )     (32 )
- Eliminating IAS proforma adjustments
    (1 )     (2 )     (3 )
 
Profit/(loss) before tax
    47       (29 )     18  
 
New business margin (%)(2)
    40 %     25 %     28 %
 
(1)   ANUTM stands for Abbey National Unit Trust Managers Limited and ANPIM represents Abbey National PEP and ISA Managers Limited.
 
(2)   New business margin is calculated as new business contribution, divided by related annualised equivalent premiums for Life contracts.
 
(3)   The above tables include James Hay and Inscape (i.e. represents Insurance and Asset Management Income rather than just Life Assurance).
The above analysis is shown on a traditional embedded value for ease of comparison however with an adjustment within experience variances and changes in assumptions included to account for the impact of moving to an IFRS embedded value basis. The key impacts have been the change in the method of the tax gross up the impact of product classification and the elimination of future investment margin in determining the discounted value of future profits. The tax gross up of the embedded value results is now based upon the combined rate of tax applicable to both policyholders and shareholders, as opposed to the shareholder rate of 30% as applied previously. In accordance with IAS 12 Income Taxes, this has been applied retrospectively and comparatives have been adjusted accordingly. In addition, embedded value accounting is not permitted for certain products classified as investment contracts where they do not contain significant insurance risk, whereby the associated income and costs are now accounted for on a deferral and matching basis. The elimination of future investment margin as required under FRS 27 has been applied retrospectively, with comparatives being adjusted accordingly.
2005 compared to 2004

New business contribution
New business contribution decreased from 2004. The reductions in Retail Life were mainly attributable to a 7% decrease in protection volumes and decreased contribution from ‘future category’ sales despite increased sales volumes due to decreased profitability. The reduction in Intermediary new business contribution is mainly due to a 22% fall in Protection sales (particularly Scottish Provident Self Assurance volumes) in a competitive market.
Expected return
Expected return represents the unwind of the discount on the discounted value of future profits, together with the return on shareholders’ funds held in the long-term business fund. Overall, the expected return of £200m (2004: £206m) was down £6m. The overall decline was due to the fall in interest rates, which impacts the risk discount rate and earnings on surplus capital. In addition, earnings have reduced due to capital repatriated to and dividends paid to Abbey. This fall was partly offset by earnings on contingent loan balances in place in 2004 being recognised as part of IFRS embedded value rather than in net interest income.
Abbey National Unit Trust Managers Limited (‘ANUTM’) and Abbey National PEP and ISA Managers Limited’s (‘ANPIM’) contribution
ANUTM and ANPIM non-interest income of £43m was marginally above last year (2004: £38m) due to higher sales volumes, mainly the Guaranteed Growth Plan and Safety Plus Growth Plan.
Other Income (including interest income)
Other income (including interest income) of £104m was adverse to 2004. This is mainly due to lost earnings on capital repatriated to, and dividends paid to Abbey from the shareholder fund.
Capital charge
The capital charge of £181m has increased on 2004 reflecting a change in methodology.
Operating expenses
Operating expenses of £194m are down on 2004 following the successful implementation of Group wide cost reduction initiatives.

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Business and Financial Review
Business Review — Personal Financial Services continued
Experience variances, changes in assumptions and expense loadings
Experience variances, assumption changes and expense loadings of £118m (2004: £83m) have improved as follows:
                                                 
    31 December 2005     31 December 2004  
    Retail Life     Intermediary     Total     Retail Life     Intermediary     Total  
    £m     £m     £m     £m     £m     £m  
 
Mortality and morbidity experience
    1       7       8       3       13       16  
Lapse experience
          (49 )     (49 )     (1 )     (37 )     (38 )
Expense loadings
    23       127       150       21       141       162  
Changes to reserving and modelling methodology
    22       (13 )     9       (3 )     (54 )     (57 )
 
Total experience and assumption changes variance
    46       72       118       20       63       83  
 
Experience variances relate to the current year and changes in assumptions capture the effect both in current year, and on the discounted value of future profits, of the difference between the actual experience and the assumptions built in the models for calculating the new business contribution and the expected return. However, investment variances and other one-off items are excluded.
     Mortality and morbidity experience variances have been favourable following the assumption changes made in the Life Companies at the end of 2004.
     Adverse lapse experience continues mainly reflecting general market trends as customers continue to seek alternative investment products to with-profit products. In addition, Protection lapses have been higher than expected due to increased competition throughout the year.
     Expense loadings reflect the amount of premium income received that is allocated to cover costs of writing new business and servicing the in-force book of business. The decrease year on year is a direct result of reduced new business and higher than expected lapses. This has been offset by reduced actual expenses following the implementation of Group wide cost reduction initiatives (included in ‘operating expenses’ line). The expense over/under run, which is a measure of the efficiency of cost management within funds, improved from an expense overrun of £8m in 2004, to an expense under run of £19m in 2005, mainly as a result of decreased costs following the implementation of group wide cost reduction strategies.
     Changes to modelling and reserving assumptions and other includes the benefit from the revision of expenses and revised mortality assumptions partially offset by a change in lapse assumptions and other modelling changes including an adjustment to allow for the impact of IFRS. Excluding the impact of IFRS and expense loadings, experience variances and changes in assumptions were £22m (2004: £(55)m)
IFRS embedded value charges and rebasing
IFRS embedded value charges and rebasing were £(12)m (2004: £21m).
     The IFRS embedded value charges and rebasing are disclosed in the “Other Material Items” section. The investment assumptions and variance totals has two main drivers. Firstly, the impact of investment markets over the period differing from expectations. This includes actual less expected interest on surpluses retained in the funds and the difference between actual and expected management charges on unit funds over the period. Secondly, the impact of closing market levels being different than expected on the discounted value of future profits. This includes items such as changes in asset mix and the impact of higher or lower unit values on the stream of future management charges. Other one-off adjustments included in 2004 reflect changes in provisioning and the impacts of stabilising the with-profits funds.
Life assurance new business premiums(1)
                         
    31 December 2005  
    Retail Life     Intermediary     Total  
    £m     £m     £m  
 
Single
                       
Pension
    24       204       228  
Life and investments:
                       
– ISA and unit trusts
    536             536  
– Life and other bonds
    151       309       460  
 
 
    711       513       1,224  
 
Annual
                       
Pension
    10       12       22  
Life and investments:
                       
– ISA and unit trusts
    13             13  
– Life and other bonds
          1       1  
– Term assurance and other protection
    18       64       82  
 
 
    41       77       118  
 
Total new business premiums
    752       590       1,342  
Annualised equivalent (2)
    94       64       158  
New business margin (3)
    26 %     22 %     23 %
 
(1)   Excludes sales through James Hay and Inscape.
 
(2)   Calculated as 10% of single premium new business premiums, plus annual new business premiums.
 
(3)   New business margin is calculated as new business contribution to IFRS embedded value, divided by related annualised premiums for life contracts.

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Business and Financial Review
Business Review — Personal Financial Services continued
                         
    31 December 2004  
    Retail Life     Intermediary     Total  
    £m     £m     £m  
 
Single
                       
Pension
    17       243       260  
Life and investments:
                       
– ISA and unit trusts
    409             409  
– Life and other bonds
    4       48       52  
 
    430       291       721  
 
Annual
                       
Pension
    13       19       32  
Life and investments:
                       
– ISA and unit trusts
    14             14  
– Life and other bonds
          1       1  
– Term assurance and other protection
    19       78       97  
 
 
    46       98       144  
 
Total new business premiums
    476       389       865  
Annualised equivalent (2)
    69       49       119  
New business margin (3)
    40 %     25 %     28 %
 
(1)   Excludes sales through James Hay and Inscape.
 
(2)   Calculated as 10% of single premium new business premiums, plus annual new business premiums.
 
(3)   New business margin is calculated as new business contribution to IFRS embedded value, divided by related annualised equivalent premiums for life contracts.
2005 compared to 2004
Total Personal Financial Services life assurance new business premiums of £1,342m were 55% higher than 2004 (£865m), mainly reflecting the general improvement in the Individual Savings Account market.
A more detailed analysis of the movement includes:
>   Retail Life new business totalled £752m (2004: £476m), up 58%. This was driven by increases in single premium structured Individual Savings Account sales and investment bonds.
 
>   New business premiums in Intermediary of £590m were 51% higher than 2004, predominantly due to increased sales of SPILA Flexible Select and Choice plan.
Assets under management
The table below shows the Abbey National Asset Managers’ funds under management by company (including related Portfolio Business Unit entities), and by type of business.
                         
    31 December 2005  
    Retail Life     Intermediary(1)     Total  
    £bn     £bn     £bn  
 
Closed with-profit funds
          12.2       12.2  
Ongoing businesses
    3.4       11.3       14.7  
 
Total
    3.4       23.5       26.9  
 
(1)   Intermediary includes Scottish Mutual Assurance plc, Scottish Provident Ltd, Scottish Provident International Ltd and Scottish Mutual International plc.
 
(2)   The above excludes James Hay and Inscape.
                         
    31 December 2004  
    Retail Life     Intermediary (1)     Total  
    £bn     £bn     £bn  
 
Closed with-profits fund
          13.2       13.2  
Ongoing businesses
    4.7       8.3       13.0  
 
Total
    4.7       21.5       26.2  
 
Note: The funds under management disclosed in the table above were largely outsourced in 2004.
Total funds under management have increased by £0.7bn to £26.9bn despite continued with-profit bond lapses due to favourable market movements and new business written in 2005.

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Business and Financial Review
Business Review — Personal Financial Services continued
Personal Financial Services trading expenses
Personal Financial Services trading expenses by segment by business
                 
    31 December     31 December  
    2005     2004  
    £m     £m  
 
Retail Banking
    1,050       1,153  
Insurance and Asset Management
    193       262  
Abbey Financial Markets
    105       109  
Group Infrastructure
    178       226  
 
Total trading expenses
    1,526       1,750  
Adjust for:
               
– Reorganisation expenses
    233       479  
– Intangible asset charges
    3       20  
– IAS statutory and proforma adjustments
          239  
 
PFS expenses
    1,762       2,488  
 
2005 compared to 2004
At the time of the acquisition of Abbey by Santander, £300m of trading cost savings by 2007 were identified as potential synergies. Of these, £100m were earmarked to be achieved in 2005.
     Operating expense of £1,526m in 2005 were 13% lower than 2004. The cost reduction programme has reduced costs by £224m, with savings across all business units and is well ahead of the original target.
     In total, over 4,000 roles have been removed from the business during the year. Other cost savings have come from a detailed procurement review and other activities.
Personal Financial Services trading expenses by type
                 
    31 December     31 December  
    2005     2004  
    £m     £m  
 
Salaries and other compensation payments
    693       718  
Social security costs
    58       64  
Pension costs
    91       84  
 
Salaries and other staff costs
    842       866  
Bank, legal and professional expenses
    49       76  
Advertising and marketing
    65       109  
 
Bank, legal, marketing and professional expenses
    114       185  
Software, computer and administration expenses
    320       421  
Premises and equipment depreciation
    67       92  
Other property and equipment expenses
    183       186  
 
PFS trading expenses
    1,526       1,750  
 
2005 compared to 2004
Total employment costs were lower at £842m (2004: £866m) comprising:
>   Salaries and other compensation benefits are down on 2004 due to a reduction of 4000 roles throughout the year. A corresponding reduction in Social Security costs has been driven by these lower staffing levels;
 
>   Bank, legal, and professional expenses of £49m were down 35% on 2004, this is due to tighter cost control on discretionary spend and greater reductions through Procurement negotiations;
 
>   Advertising and marketing spend was £44m lower (2004: £109m) due to a significant reduction in advertising spend, greater procurement activity and increased costs in 2004 due to rebranding;
 
>   Computer and administration expenses of £320m (2004: £421m) were lower due to aggressive renegotiation or cancellation of contracts, along with a reduction in software purchases and descoping software maintenance contracts;
 
>   Premises and equipment depreciation expenses of £67m decreased by 27% (2004: £92m), due to asset write-offs and run-off more than offsetting increased capital investment;
 
>   Other property and equipment expenses fell 2% to £183m (2004: £186m), a result of a reduction in property running costs due to site closures and rationalisation, offset by increased utilities charges due to market rate increases;

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Business and Financial Review
Business Review — Personal Financial Services continued
Personal Financial Services trading provisions
Personal Financial Services trading provisions by type
                 
    31 December     31 December  
    2005     2004  
    £m     £m  
 
Mortgages
    8       (139 )
Unsecured personal loans
    116       73  
Credit cards
    9       7  
Banking
    64       66  
Other
    11       13  
 
PFS provisions for bad and doubtful debts
    208       20  
Provisions for other liabilities and charges
    11       153  
Amounts written off fixed-asset investments
           
 
Total PFS trading provisions
    219       173  
Adjust for:
               
- IFRS embedded value charges and rebasing
          48  
- Reorganisation expenses (1)
          (48 )
- Eliminating IAS proforma adjustments
          (5 )
 
PFS provisions
    219       168  
 
(1)   Includes empty premises provisions arising from the review of site locations and certain asset write-downs.
2005 compared to 2004
Total trading provisions of £219m were up from £173m in 2004. To understand the underlying trends, 2004 included firstly, a significant reduction in general provisions of £(136)m due to improvements in economic conditions, and secondly a charge for other liabilities relating to misselling of £153m.
     After these items the underlying trend in lending provisions is an increased charge of £52m. Of this increase, £12m related to mortgages, equivalent to approximately 1 basis point.
     Most of the remaining increase related to the unsecured book, with some modest credit quality deterioration in line with industry experience, but also attributable to growth and seasoning of the asset over the last two years.
Total Personal Financial Services non-performing loans
                 
    31 December     31 December  
    2005     2004  
    £m     £m  
 
Total non-performing loans (“NPLs”)
    746       604  
 
Total loans and advances to customers
    99,226       95,751  
Total provisions
    269       243  
NPLs as a % of loans and advances
    0.75 %     0.63 %
 
Provisions as a % of NPLs
    36.06 %     40.23 %
 
2005 compared to 2004
The value of non-performing loans increased to £746m (2004: £604m), driven by some deterioration in market conditions for unsecured lending and a modest slow down in the housing market for mortgages.
     As a percentage of loans and advances, non-performing loans have increased to 0.75% (2004: 0.63%), with provision coverage of 36.06% (2004: 40.23%). The balance sheet remains strong with secured lending constituting 96% of all customer loans.

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Business and Financial Review
Business Review — Personal Financial Services continued
Personal Financial Services mortgage arrears, properties in possession and lending mix
Mortgage arrears
                                                 
    31 December 2005     31 December 2004  
                    CML (1)                     CML (1)  
    Number of     % of total     Industry     Number of     % of total     Industry  
Cases   cases (000)     mortgages     average %     cases (000)     mortgages     average %  
 
1 — 2 months arrears
    22.5       1.85       1.48       24.6       1.88       n/a  
3 — 5 months arrears
    5.5       0.45       0.52       5.9       0.45       0.47  
6 — 11 months arrears
    2.4       0.20       0.28       1.8       0.14       0.23  
12 months + arrears
    0.4       0.03       0.12       0.3       0.02       0.10  
 
 
    31 December 2005     31 December 2004  
                    % of total                     % of total  
Value of arrears(2)         £m     mortgages           £m     mortgages  
 
1 — 2 months arrears
            16.4       0.02               16.1       0.02  
3 — 5 months arrears
            10.4       0.01               9.6       0.01  
6 — 11 months arrears
            8.3       0.01               5.2       0.01  
12 months + arrears
            2.8                     2.7        
 
Total arrears
            37.9       0.04               33.6       0.04  
 
Balance sheet provisions
            58.1                       53.1          
Coverage (times)
            1.5                       1.6          
 
Mortgage properties in possession
                                                 
    31 December 2005     31 December 2004  
                    CML (1)                     CML (1)  
    Number of             Industry     Number of             Industry  
Cases   cases (000)     % of total     average %     cases     % of total     average %  
 
No. of repossessions
    1,214       0.10       0.09       987       0.08       0.05  
No. of sales
    1,055       0.09       0.07       1,024       0.08       0.05  
Stock
    447       0.04       0.04       288       0.02       0.02  
 
(1)   The abbreviation CML stands for Council of Mortgage Lenders.
 
(2)   This represents the amount of payments outstanding rather than the total amount of loans in arrears
2005 compared to 2004
Mortgage 3-month-plus arrears cases have experienced a slight increase to 8,300 compared to 8,000 at 31 December 2004. This amounts to 0.68% of the total, compared to 0.61% at 31 December 2004, and remains significantly below 0.92% for the industry as a whole (per Council of Mortgage Lenders).
     By value, 3-month-plus arrears totalled £21.5m (December 2004: £17.5m), with provisions in place of £58.1m (December 2004: £53.1m).
     The stock of properties in possession rose by 55% to 447 (December 2004: 288), with the number of property repossessions also increasing by 227 to 1,214 (December 2004: 987). The increases in 3 months arrears and properties in possession are modest given that 2004 was the lowest experienced in a number of years.
Mortgage new business credit quality
                 
    31 December     31 December  
    2005     2004  
 
Loan-to-value analysis:
               
New business
               
> 90%
    4 %     6 %
75% — 90%
    29 %     32 %
< 75%
    67 %     62 %
Average (at inception)
    60 %     61 %
Average loan-to-value of stock (indexed)
    45 %     45 %
New business profile:
               
First-time buyers
    14 %     19 %
Home movers
    37 %     41 %
Remortgagers
    49 %     40 %
Average earnings multiple
    2.9       2.7  
 
There has been no significant deterioration of quality over the period, with most credit quality indicators remaining similar to those reported in 2004. In particular:
>   The average loan-to-value of new business has remained broadly constant in 2005 at 60%, despite remortgage business reducing as a proportion of Abbey’s new business.
 
>   The proportion of new business written with a high loan-to-value (greater than 90%) has decreased in 2005 to only 4%.
 
>   Income multiples have increased in line with the market, given the continued increase in house prices. A review of income multiples has resulted in tighter guidelines for riskier segments of business.
 
>   For niche markets such as Buy-to-Let, Abbey is under-represented and has not significantly increased its exposure.
 
>   The proportion of remortgage business taking further equity release has remained unchanged for the last 18 months.

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Business and Financial Review
Business Review — Personal Financial Services continued
Personal Financial Services banking and unsecured personal loan arrears
                 
    31 December     31 December  
    2005     2004  
    £m     £m  
 
Total banking and unsecured personal loan arrears (1,2)
    126       121  
Total banking and unsecured personal loan asset
    3,749       3,288  
Banking and unsecured personal loan arrears as a % of asset
    3.4 %     3.7 %
 
(1)   Banking arrears are defined as customers whose borrowings exceed their overdraft by over £100.
 
(2)   Unsecured personal loan arrears are defined as the balances of accounts that are three or more monthly instalments in arrears.
2005 compared to 2004
The reduction in arrears as a percentage of assets reflects faster write offs in 2005 due to increased processing efficiency.
Personal Financial Services provisions for doubtful debts analysis — balance sheet
                                 
    31 December 2005     31 December 2004  
    Provisions balance     Balance as % of     Provisions balance     Balance as % of  
    £m     loan asset     £m     loan asset  
 
Mortgages
    58       0.1       53       0.1  
Personal banking
    45       12.1       39       11.5  
Unsecured personal loans
    89       4.5       73       4.4  
Abbey Business
    4       0.3       2       0.2  
cahoot
    73       5.3       74       5.7  
 
Retail Banking
    269       0.3       241       0.3  
Insurance and Asset Management
                       
Group Infrastructure
                       
 
Total PFS
    269       0.3       241       0.3  
 
Mortgage provisions have increased in line with the modest rise in arrears and the ratio to asset reflects a stable performance on the portfolio.
     On the Abbey branded unsecured lending, the current experience of deteriorating performance on unsecured personal loans and managements view of worsening near term economic conditions affecting unsecured lending has resulted in higher provision balances on unsecured lending.
Personal Financial Services provisions for doubtful debts analysis — balance sheet reconciliation
                         
    Mortgages     Unsecured     Total  
    £m     £m     £m  
 
At 1 January 2005
    53       188       241  
Transfer (to)/from P&L account
    7       201       208  
Recoveries
    2       27       29  
Income adjustment
    1       16       17  
Irrecoverable amounts written off
    (5 )     (221 )     (226 )
 
At 31 December 2005
    58       211       269  
 

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Table of Contents

Business and Financial Review
Business Review — Portfolio Business Unit (PBU)
Portfolio Business Unit trading profit on ordinary activities before tax
                 
    31 December 2005     31 December 2004  
    £m     £m  
 
Net interest income
    (36 )     73  
Non-interest income
    286       158  
 
Total trading income
    250       231  
Total trading expenses
    (38 )     (96 )
Depreciation and impairment on operating lease assets
    (123 )     (184 )
Provision for bad and doubtful debts
    (10 )     (10 )
Provisions for other liabilities and charges
    8        
 
Amounts written off fixed asset investments
          80  
 
Trading profit on ordinary activities before tax
    87       21  
- Eliminating IAS proforma adjustments
          (10 )
 
Profit/(loss) before tax
    87       11  
 
2005 compared to 2004
Trading profit before tax for the Portfolio Business Unit of £87m was significantly higher than the £21m in 2004, reflecting the more advanced stage of the exit programme, and profits on sale of finance leasing assets in the period.
>   Net interest income decreased by £109m to £(36)m (2004: £73m) due to lower average asset balances. Net interest income includes interest expense on the funding of operating lease assets, whereas operating lease income is included in non-interest income. As a result of this, and the lower average asset balances, net interest income is negative in 2005.
 
>   Non-interest income increased £128m to £286m (2004: £158m), reflecting lower absolute levels of asset disposals and related losses.
 
>   Depreciation on operating lease assets fell £61m to £123m (2004: £184m), due to continued disposals of operating lease businesses.
 
>   Trading operating expenses fell to £38m (2004: £96m) due to reduced size of operations.
 
>   Provision for bad and doubtful debts were in line with 2004.
 
>   Amounts written off fixed asset investments were nil with 2004 being a credit of £80m, representing disposals of assets in excess of written down values.
The remaining assets in the Portfolio Business Unit will be reported as part of Abbey Financial Markets in 2006. Within the £87m of the trading profit reported above, approximately £30m relates to these ongoing businesses.
Portfolio Business Unit assets and risk-weighted assets
                                 
    At 31 December 2005     At 31 December 2004(1)  
    Assets     Risk-weighted assets     Assets     Risk-weighted assets  
    £bn     £bn     £bn     £bn  
 
Total
    2.5       2.5       4.7       3.9  
 
(1)   The table excludes the shareholder net assets of the international life assurance businesses of £208m since they do not have a risk-weighted asset equivalent.
Total Portfolio Business Unit assets of £2.5bn were 47% lower than at December 2004, with a 36% reduction in risk-weighted assets to £2.5bn (2004: £3.9bn). The remaining balance is largely made up of the Porterbrook business, with some smaller Litigation Funding and Motor Finance balances.

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Business and Financial Review
Other Material Items
Impact of IFRS embedded value charges and rebasing
                                                 
    31 December 2005     31 December 2004  
    Retail                     Retail              
    Life     Intermediary     Total     Life     Intermediary     Total  
    £m     £m     £m     £m     £m     £m  
 
Investment assumptions and variances     (7 )     (5 )     (12 )     (5 )     (12 )     (17 )
Other one-off adjustments                             38       38  
 
Total IFRS embedded value charges and rebasing     (7 )     (5 )     (12 )     (5 )     26       21  
 
Investment assumptions and variances
This variance represents the adjustment to allow for differences between actual market performance and our assumptions set out at the beginning of the year. Overall, investment assumptions and variances have improved by £5m with no significant movements in the period.
Other one-off adjustments
The 2004 results represents a release of the provisions in respect of the Scottish Provident contingent loan in the long-term fund and shareholders’ fund not repeated in 2005.
Reorganisation and other
                 
    31 December     31 December  
    2005     2004  
    £m     £m  
 
Cost reduction programme
    (158 )     (441 )
Asset write-downs
    (5 )     (106 )
Misselling remediation cost
    (70 )      
 
 
    (233 )     (547 )
 
Total reorganisation expenses of £233m are significantly lower than 2004, reflecting the cost reduction programme and ongoing restructuring of the business being at a more advanced stage and a lower proportion of regulatory change investment. During 2005, Abbey has undergone a detailed review of endowment policies in remediation. As a result, remediation costs of £70m with respect to endowment misselling were incurred.
Hedging variances
                 
    31 December     31 December  
    2005     2004  
    £m     £m  
 
Hedging variances
    (18 )      
 
As a consequence of the introduction of IAS 39 prospectively from 1 January 2005, the balance sheet and income statement are subject to a certain amount of volatility particularly from the accounting for hedges deemed under IFRS rules to be ineffective. In 2005, the impact of this volatility was £(18)m.
IFRS to US GAAP reconciliation
Profit/(loss) after tax under IFRS in each of the years ended 31 December 2005 and 2004 was £420m and £(54)m, respectively. Under US GAAP, the corresponding amounts were £253m and £(20)m. A detailed description of the principal differences between IFRS and US GAAP is included in Note 55 to the Consolidated Financial Statements. Reconciliations between the IFRS and US GAAP amounts, together with financial statements disclosures required by US GAAP, are included in Notes 58 to 61 to the Consolidated Financial Statements.
2005 compared to 2004
Net income/(loss) under US GAAP was £253m in 2005, £167m lower than the IFRS profit for the year of £420m. In 2004, the US GAAP net loss was £(20)m, lower than the IFRS loss for the year of £(54)m. The IFRS to US GAAP adjustments increased £201m from additional income of £34m in 2004 to additional expenses of £167m in 2005. The principal movements in the IFRS to US GAAP adjustments affecting net income/(loss) are as follows:
>   In 2005, a charge was recognised in the income statement under US GAAP reflecting impairment in the value of goodwill in the Insurance and Asset Management segment. This impairment was recognised due to expected lower future profitability given higher lapse rates in 2005, coupled with projected lower volumes of new business being written at lower margins in a competitive market. No impairment was recognised for IFRS purposes due to the lower level of goodwill held under IFRS.
 
>   In 2005, profits representing movements in the fair values of securities that are classified as fair value through profit and loss under IFRS were reversed for US GAAP purposes. Under US GAAP, these securities are classified as available for sale, with movements in their fair values accounted for in other comprehensive income. Prior to 1 January 2005, under IFRS these securities were accounted for at cost, subject to impairment, so there is no equivalent income statement adjustment in 2004, the relevant IFRS being prospective from 1 January 2005.

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Other Material Items continued
>   In 2005, investment properties held at market value under IFRS, and amortised cost under US GAAP, were sold. The sales proceeds significantly exceeded the amortised cost. As a result, the 2005 income statement adjustment reflects the increased profit recognised under US GAAP, which was effectively recognised as market value movements in prior periods under IFRS. Predominantly, this gain flows to the policyholder bonus fund, resulting in a corresponding increase in policy liabilities.
 
>   In 2005, there was no significant income statement adjustment relating to derivatives because under US GAAP, and IFRS from 1 January 2005, all derivatives are marked to market through the income statement. In 2004, the adjustment primarily reflects the marking to market of non-trading derivatives for US GAAP purposes that were accrual accounted under IFRS, the relevant IFRS being prospective from 1 January 2005.
 
>   In 2005, the debt securities in issue income statement adjustment for US GAAP reflects the reversal of movements in the fair value of debt securities in issue that qualify for the fair value option under IFRS, but do not qualify under the US GAAP fair value option. Prior to 1 January 2005, a fair value option did not exist under either IFRS or US GAAP, so there is no equivalent income statement adjustment for this in 2004. In addition, the US GAAP adjustment in 2005 reflects the absence of claiming hedge accounting under US GAAP and the consequent reversal of the hedge accounting claimed under IFRS, as well as the reversal of the IFRS transition adjustment under IFRS 1 for items that qualified as hedges prior to 1 January 2005 but which did not meet the requirements of IAS 39 applicable from 1 January 2005.
 
>   In 2005, a credit was recognised in the income statement under US GAAP reflecting the removal of the preference share dividends which are accounted for as interest expense in the income statement under IFRS, the relevant IFRS being prospective from 1 January 2005, but which are excluded from the income statement and accounted for as an appropriation of profit in reserves under US GAAP. In addition, the gains and losses recognised under IFRS on the retranslation of foreign currency denominated preference shares were reversed because under US GAAP those preference shares are not retranslated. In 2004, under IFRS, the preference share dividends were accounted for as an appropriation of profit and the foreign currency denominated preference shares were not retranslated. These treatments were consistent with US GAAP, so there was no adjustment in 2004.
Legal proceedings
Abbey and its subsidiaries are party to various legal proceedings in the ordinary course of business, the ultimate resolution of which is not expected to have material adverse effect on the financial position or the results of operations of Abbey.
Material contracts
Abbey and its subsidiaries are party to various contracts in the ordinary course of business. For the two years ended 31 December 2005, there have been no material contracts being contracts entered into outside the ordinary course of business. As described in Note 59(p) to the Consolidated Financial Statements, on 7 June 2006 Abbey entered into a Sale and Purchase Agreement with Resolution plc and Resolution Life Limited pursuant to which Abbey has agreed to sell its entire life assurance business to Resolution plc.
Audit fees
Please refer to Note 9 of the Consolidated Financial Statements.

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Business and Financial Review
Balance Sheet Business Review
Throughout this section, reference to UK and non-UK refer to the location of the office where the transaction is recorded.
Deposits
The following tables set forth the average balances of deposits for each of the three years ended 31 December.
                 
    Average: year ended 31 December  
    2005     2004  
    £m     £m  
 
Deposits by banks
               
UK
    26,084       30,036  
Non-UK
    677       688  
 
Total
    26,761       30,724  
 
Customers’ accounts (all interest bearing)
               
UK
    63,999       58,404  
Non-UK
    6,080       5,301  
 
Total
    70,079       63,705  
 
Customers’ accounts — by type
                 
    Average: year ended 31 December  
    2005     2004  
    £m     £m  
 
UK
               
Retail demand deposits
    52,083       40,760  
Retail time deposits
    9,076       12,177  
Wholesale deposits
    2,840       5,467  
 
 
    63,999       58,404  
 
Non-UK
               
Retail demand deposits
    1,092       1,152  
Retail time deposits
    4,875       4,149  
Wholesale deposits
    113        
 
 
    6,080       5,301  
 
Total
    70,079       63,705  
 
The tables below for 2003 contain information prepared under UK GAAP, Abbey’s previous primary GAAP, which is not comparable to information prepared under IFRS.
         
    Average: year  
    ended 31  
    December  
    2003  
    £m  
 
Deposits by banks
       
UK
    7,144  
Non-UK
    1,761  
 
Total
    8,905  
 
Customers’ accounts (all interest bearing)
       
UK
    63,154  
Non-UK
    5,501  
 
Total
    68,655  
 
Customers’ accounts — by type
         
    Average: year  
    ended 31  
    December  
    2003  
    £m  
 
UK
       
Retail demand deposits
    42,477  
Retail time deposits
    12,620  
Wholesale deposits
    8,057  
 
 
    63,154  
 
Non-UK
       
Retail demand deposits
    1,260  
Retail time deposits
    4,083  
Wholesale deposits
    158  
 
 
    5,501  
 
Total
    68,655  
 
Substantially all retail demand and time deposits are obtained either through the branch network, cahoot or remotely (such as postal accounts) and administered by the branch network, or cahoot, Abbey’s separately branded internet banking proposition.

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Business and Financial Review
Balance Sheet Business Review continued
Retail demand and time deposits are also obtained outside the UK, principally through Abbey National Offshore Holdings Limited. They are all interest bearing and interest rates are varied from time to time in response to competitive conditions.
Demand Deposits
Demand deposits largely consist of balances, which are available on demand. The category also includes Individual Savings Accounts, current accounts, instant saver savings accounts, remote access accounts, such as those serviced by post, and a number of other accounts which allow the customer a limited number of notice-free withdrawals per year depending on the balance remaining in the account. These accounts are treated as demand deposits because the entire account balance may be withdrawn on demand without penalty as one of the notice-free withdrawals.
Time Deposits
The main constituents of time deposits are notice accounts, which require customers to give notice of an intention to make a withdrawal, and bond accounts, which have a minimum deposit requirement. In each of these accounts, early withdrawal incurs an interest penalty.
Wholesale Deposits
Wholesale deposits are those, which either are obtained through the money markets or for which interest rates are quoted on request rather than being publicly advertised. These deposits are of fixed maturity and bear interest rates, which reflect the inter-bank money market rates.
Short-term borrowings
The following tables set forth certain information regarding short-term borrowings (composed of deposits by banks, commercial paper and negotiable certificates of deposit) for each of the three years ended 31 December. While deposits by banks are reported in the “deposits” section above, they are also shown under “Short-term borrowings” because of their importance as a source of funding to Abbey.
Deposits by banks
                 
    Year ended 31 December  
    2005     2004  
    £m     £m  
 
Year-end balance (1)
    27,478       18,412  
Average balance
    26,761       30,724  
Maximum balance
    35,872       25,530  
 
 
               
 
    %       %  
 
Average interest rate during year(2)
           
Year-end interest rate (2)
           
 
(1)   The year-end deposits by banks balance include non-interest bearing items in the course of transmission of £248m (2004: £161m).
 
(2)   Abbey policy is to mark to market the majority of its deposits by banks balances including interest and is recorded in net trading income banking rather than net interest income, therefore it has not been possible to calculate either the average interest rate during the year or year end interest rate.
At 31 December 2005, deposits by foreign banks amounted to £9,281m (2004: £9,538m).
The table below for 2003 contains information prepared under UK GAAP, Abbey’s previous primary GAAP, which is not comparable to information prepared under IFRS.
         
    Year ended 31  
    December  
    2003  
    £m  
 
Year-end balance (1)
    1,178  
Average balance
    8,905  
Maximum balance
    10,979  
 
 
       
 
    %  
 
Average interest rate during year
    2.78  
Year-end interest rate (2)
    2.83  
 
(1)   The year-end deposits by banks balance includes non-interest bearing items in the course of transmission of £204m.
 
(2)   Year-end interest rates are calculated on the basis of the interest earned in the year relative to the year-end balance, and are therefore not representative of actual interest rates.
At 31 December 2003, deposits by foreign banks amounted to £5,881m.

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Balance Sheet Business Review continued
Commercial Paper
                 
    Year ended 31 December  
    2005     2004  
    £m     £m  
 
Year-end balance
    6,009       1,656  
Average balance
    2,891       2,086  
Maximum balance
    6,009       3,367  
 
 
               
 
    %       %  
Average interest rate during year (1)
           
Year-end interest rate (1)
           
 
(1)   Abbey policy is to mark to market its commercial paper balances including interest paid on commercial paper and is recorded in net trading income banking rather than net interest income, therefore it has not been possible to calculate either the Average interest rate during the year or the year-end interest rate.
The table below for 2003 contains information prepared under UK GAAP, Abbey’s previous primary GAAP, which is not comparable to information prepared under IFRS.
         
    Year ended 31  
    December  
    2003  
    £m  
 
Year-end balance
    1,298  
Average balance
    4,199  
Maximum balance
    7,300  
 
 
       
 
    %  
 
Average interest rate during year
    1.60  
Year-end interest rate (1)
    5.16  
 
(1)   Interest rates are calculated on the basis of the interest earned in the year relative to the year-end balance and are therefore not representative of actual interest rates.
Commercial paper is issued by Abbey generally in denominations of not less than $50,000, with maturities of up to 365 days. Commercial paper is issued by Abbey National Treasury Services plc and Abbey National North America Corporation, a subsidiary of Abbey National Treasury Services plc.
Negotiable certificates of deposit
                 
    Year ended 31 December  
    2005     2004  
    £m     £m  
 
Year-end balance
    5,282       7,073  
Average balance (1)
    5,727       8,496  
Maximum balance
    6,670       9,901  
 
 
               
 
    %       %  
 
Average interest rate during year(2)
           
Year-end interest rate (2)
           
 
(1)   Average balances for 2005 and 2004 are based upon daily data for Abbey National Treasury Services plc and its subsidiaries and monthly data for all other operations.
 
(2)   Abbey policy is to mark to market its negotiable balances including interest paid on negotiable certificate of deposits and is recorded in net trading income banking rather than net interest income, therefore it has not been possible to calculate either the Average interest rate during the year or the year-end interest rate.
The table below for 2003 contains information prepared under UK GAAP, Abbey’s previous primary GAAP, which is not comparable to information prepared under IFRS.
         
    Year ended 31  
    December  
    2003  
    £m  
 
Year-end balance
    8,211  
Average balance (1)
    13,996  
Maximum balance
    22,429  
 
 
       
 
    %  
 
Average interest rate during year
    2.17  
Year-end interest rate (2)
    3.70  
 
(1)   Average balances for 2003 are based upon daily data for Abbey National Treasury Services plc and its subsidiaries and monthly data for all other operations.
 
(2)   Year-end interest rates are calculated on the basis of the interest earned in the year relative to the year-end balance and are therefore not representative of actual interest rates.

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Balance Sheet Business Review continued
Certificates of deposits and certain time deposits
The following table sets forth the maturities of Abbey’s certificates of deposit and other large wholesale time deposits from non-bank counterparties in excess of £50,000 (or the non-sterling equivalent of £50,000) at 31 December 2005. A proportion of Abbey’s retail time deposits also exceeds £50,000 at any given date; however, the ease of access and other terms of these accounts means that they may not have been in excess of £50,000 throughout 2005. Furthermore, the customers may withdraw their funds on demand upon payment of an interest penalty. For these reasons, no maturity analysis is presented for such deposits. See “Short-term borrowings” above for information on amounts and maturities of claims under issues of commercial paper.
                                         
            In more than                    
            three months     In more than              
            but not more     six months but              
    Not more than     than six     not more than     In more than a        
    three months     months     one year     year     Total  
    £m     £m     £m     £m     £m  
 
Certificates of deposit:
                                       
UK
    1,485       397       1,346       202       3,430  
Non-UK
    1,690       104       29       29       1,852  
Wholesale time deposits:
                                       
UK
    2,406       203       112       1,103       3,824  
Non-UK
                             
 
Total
    5,581       704       1,487       1,334       9,106  
 
At 31 December 2005, there were an additional £1,355m of wholesale deposits which were repayable on demand. All wholesale time deposits exceeded £50,000 at 31 December 2005.
Securities
The following table sets out the book and market values of securities at 31 December for each of the three years indicated. For further information, see the notes to the Consolidated Financial Statements.

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Balance Sheet Business Review continued
                                 
    2005     2004  
    Net asset     Market     Net asset     Market  
    value     value     value     value  
    £m     £m     £m     £m  
 
Trading portfolio
                               
Debt securities:
                               
UK government
    2,700       2,700       7,492       7,492  
US treasury and other US government agencies and corporations
    22       22              
Other public sector securities
    350       350       2,887       2,886  
Bank and building society certificates of deposit
    18,647       18,647       12,683       12,683  
Other issuers:
                               
Floating rate notes
    463       463       224       224  
Mortgage-backed securities
    350       350       240       240  
Other asset-backed securities
    4,626       4,626       495       495  
Other
    4,396       4,396       12,317       12,317  
Ordinary shares and similar securities
    1,539       1,539       10,762       10,762  
 
Sub Total
    33,093       33,093       47,100       47,099  
 
Investment securities
                               
Debt securities:
                               
UK government
                       
US treasury and other US government agencies and corporations
                       
Other public sector securities
                28       28  
Bank and building society certificates of deposit
                317       317  
Other issuers:
                               
Floating rate notes
                32       27  
Mortgage-backed securities
                38       42  
Other asset-backed securities
                257       310  
Other
                       
Ordinary shares and similar securities
    13       13       30       32  
 
Sub Total
    13       13       702       756  
 
Fair value through profit and loss
                               
Debt securities:
                               
UK government
    2,794       2,794              
US treasury and other US government agencies and corporations
    100       100              
Other public sector securities
    417       417              
Bank and building society certificates of deposit
    841       841              
Other issuers:
                               
Floating rate notes
                       
Mortgage-backed securities
                       
Other asset-backed securities
    343       343              
Other
    8,387       8,387              
Ordinary shares and similar securities
    11,670       11,670              
 
Sub Total
    24,552       24,552              
 
Total
    57,658       57,658       47,802       47,855  
 

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Balance Sheet Business Review continued
The table below for 2003 contains information prepared under UK GAAP, Abbey’s previous primary GAAP, which is not comparable to information prepared under IFRS.
                 
    2003  
    Net asset     Market  
    value     value (1)  
    £m     £m  
 
Investment securities
               
Debt securities:
               
UK government
    125       125  
US treasury and other US government agencies and corporations
           
Other public sector securities
    28       28  
Bank and building society certificates of deposit
    204       204  
Other issuers:
               
Floating rate notes
    330       381  
Mortgage-backed securities
    36       37  
Other asset-backed securities
    535       483  
Other
    495       583  
Ordinary shares and similar securities
    394       394  
 
Sub Total
    2,147       2,235  
 
Other securities
               
Debt securities:
               
UK government
    547       547  
Other public sector securities
    3,827       3,827  
Bank and building society certificates of deposit
    15,811       15,811  
Other issuers:
               
Floating rate notes
    244       244  
Mortgage-backed securities
    608       608  
Other asset-backed securities
    614       614  
Other
    6,924       6,924  
Ordinary shares and similar securities
    1,239       1,239  
 
Sub Total
    29,814       29,814  
 
Total
    31,961       32,049  
 
(1)   There are hedges in place in respect of certain securities where the rise or fall in their market value will be offset by a substantially equivalent reduction or increase in the value of the hedges.
UK government securities
The holdings of UK government securities (gilts) are primarily at fixed rates. Abbey’s assets and liabilities are predominantly floating rate (as described under ‘Risk management — market risk’ included elsewhere in this Annual Report and Accounts) which is used as the benchmark for risk management. Fixed-rate securities (including gilts) are generally hedged into floating-rate, on either an individual or an aggregate basis within the overall management of the appropriate book.
US treasury and other US government agencies and corporations
This category comprises US treasury securities, mortgage-backed securities issued or guaranteed by the US Government National Mortgage Association, the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation (collectively, ‘Agency Mortgage Backed Securities’).
Other public sector securities
This category comprises issues by governments other than the US and UK governments, issues by supranationals and issues by UK public sector bodies. These are a mixture of fixed-rate and floating-rate securities.
Bank and building society certificates of deposit
Bank and building society certificates of deposit are fixed-rate securities with relatively short maturities. These are managed within the overall position for the relevant book.
Other issuers: floating-rate notes
Floating-rate notes have simple risk profiles and are either managed within the overall position for the relevant book, or are hedged into one of the main currencies.
Other issuers: mortgage-backed securities
This category comprises US mortgage-backed securities (other than Agency mortgage-backed securities) and European mortgage-backed securities. The non-agency mortgage-backed securities have similar characteristics to the agency mortgage-backed securities discussed above and are managed along with the agency mortgage-backed securities for market risk purposes. European mortgage-backed securities have prepayment risks but few have cap features.
Other Issuers: other asset-backed securities
This category comprises a range of mostly floating-rate asset-backed securities including home equity loans, commercial mortgages, car dealer, lease and credit card debtors and student loans. A number of the credit card debtors incorporate cap features.

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Other issuers: other securities
This category comprised mainly synthetic floating-rate notes (which are fixed-rate bonds packaged into floating-rate by means of swaps tailored to provide a match to the characteristics of the underlying bond), along with a number of structured transactions which were hedged, as appropriate, either on an individual basis or as part of the overall management of the books. The synthetic floating-rate notes comprised bonds issued by banks, financial institutions and corporations, the latter being largely guaranteed by banks and financial institutions.
     The following table sets forth the book and market values of investment and other securities of individual counterparties where the aggregate amount of those securities exceeded 10% of Abbey’s shareholders’ funds at 31 December 2005.
                 
    Book value     Market value  
    £m     £m  
 
Royal Bank of Scotland Group plc
    3,230       3,233  
HBOS plc
    3,121       3,132  
Lloyds TSB Group plc
    2,707       2,717  
Barclays Bank plc
    1,847       1,848  
Nordea Bank AB
    1,000       1,000  
Unicredito Italiano SPA
    863       865  
Government of Germany
    823       885  
Nationwide Building Society
    617       617  
Societe Generale
    611       613  
Banco Bilbao Vizcaya Argentaria
    602       602  
Republic of Italy
    503       510  
Bank of Ireland
    500       501  
HSBC Holdings plc
    486       486  
Kingdom of Spain
    431       442  
Credit Suisse Group
    429       430  
Republic of Austria
    425       441  
BNP Paribas
    407       409  
UK Government
    403       457  
 
For the purposes of determining the above, shareholders’ funds amounted to £3,110m at 31 December 2005.
Loans and advances to banks
Loans and advances to banks includes loans to banks and building societies and balances with central banks (excluding those balances which can be withdrawn on demand).
     The geographical analysis of loans and advances presented in the following table are based on the location of the office from which the loans and advances are made.
                 
    Year ended 31 December  
    2005     2004  
    £m     £m  
 
UK
    8,060       11,081  
Non-UK
    1,036       670  
 
Total
    9,096       11,751  
 
The table below for 2003, 2002 and 2001 contains information prepared under UK GAAP, Abbey’s previous primary GAAP, which is not comparable to information prepared under IFRS.
                         
    Year ended 31 December  
    2003     2002     2001  
    £m     £m     £m  
 
UK
    6,219       6,465       9,288  
Non-UK
    936       135       586  
 
Total
    7,155       6,600       9,874  
 
The following tables set forth loans and advances to banks by maturity and interest rate sensitivity at 31 December 2005.
                                                 
                    In more than     In more than              
                  three months     one year but              
            In not more     but not more     not more              
    on     than three     than one     than five     In more than        
    demand     months     year     years     five years     Total  
    £m     £m     £m     £m     £m     £m  
 
UK
    2,072       3,930       2,057       1             8,060  
Non-UK
    47       752       236       1             1,036  
 
Total
    2,119       4,682       2,293       2             9,096  
 

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    Fixed rate     Variable rate     Total  
    £m     £m     £m  
 
Interest-bearing loans and advances to banks:
                       
UK
    3,755       4,113       7,868  
Non-UK
    78       958       1,036  
 
 
    3,833       5,071       8,904  
Items in the course of collection (non-interest bearing):
                       
UK
    n/a       n/a       192  
Non-UK
    n/a       n/a        
 
Total
    3,833       5,071       9,096  
 
Loans and Advances to Customers
Abbey provides lending facilities primarily to personal customers in the form of mortgages secured on residential properties, a limited number of lending facilities to corporate customers and also provides finance lease facilities. Purchase and resale agreements represent sale and repurchase activity with professional non-bank customers by Abbey Financial Markets short-term markets business.
     The geographical analysis of loans and advances presented in the following table are based on the location of the office from which the loans and advances are made.
                 
    Year ended 31 December   
    2005     2004  
    £m     £m  
 
UK
               
Advances secured on residential properties
    94,330       91,164  
Purchase and resale agreements
    4,789       4,520  
Other secured advances
    1,882       1,793  
Corporate advances
    334       1,030  
Unsecured personal advances
    3,845       3,517  
Finance lease debtors
    3       1,108  
 
 
    105,183       103,132  
 
Non-UK
               
Advances secured on residential properties
    26       14  
Purchase and resale agreements
    13,152       6,737  
Other secured advances
           
Unsecured personal advances
    31        
Finance lease debtors
           
 
 
    13,209       6,751  
 
Total
    118,392       109,883  
 
The table below for 2003, 2002 and 2001 contains information prepared under UK GAAP, Abbey’s previous primary GAAP, which is not comparable to information prepared under IFRS.
                         
            Year ended 31 December   
    2003     2002     2001  
    £m     £m     £m  
 
UK
                       
Advances secured on residential properties
    73,481       65,777       60,738  
Purchase and resale agreements
    2,958       742       2,704  
Other secured advances
    2,938       4,645       3,920  
Corporate advances
    3,762       9,071       9,119  
Unsecured personal advances
    3,228       5,162       4,833  
Finance lease debtors
    2,558       3,429       4,671  
 
 
    88,925       88,826       85,985  
 
Non-UK
                       
Advances secured on residential properties
    1,745       3,186       2,091  
Purchase and resale agreements
    6,414       2,358       1,507  
Other secured advances
    33       106       48  
Unsecured personal advances
    145       123       119  
Finance lease debtors
    15       18       67  
 
 
    8,352       5,791       3,832  
 
Total
    97,277       94,617       89,817  
 
No single concentration of loans and advances, with the exception of advances secured on residential properties and corporate advances in the UK, as disclosed above, accounts for more than 10% of total loans and advances and no individual country, other than the UK and US, accounts for more than 5% of total loans and advances.
     The following tables set forth loans and advances to customers by maturity and interest rate sensitivity at 31 December 2005. In the maturity analysis, overdrafts are included in the “on-demand” category. Advances secured by residential properties are included in the maturity analysis at their stated maturity; however, such advances may be repaid early. Abbey’s mortgage loans currently have an average life of six years depending on, among other factors, housing market conditions.

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                    In more than     In more than              
            In not more     three months     one year but              
    On     than three     but not more     not more than     In more than        
    demand     months     than one year     five years     five years     Total  
    £m     £m     £m     £m     £m     £m  
 
UK
                                               
Advances secured on residential properties
    1,199       1,362       1,968       10,730       79,071       94,330  
Purchase and resale agreements
          4,789                         4,789  
Other secured advances
    229       2       2       15       1,634       1,882  
Corporate advances
          67       8       169       90       334  
Unsecured personal advances
    974       165       633       1,802       271       3,845  
Finance lease debtors
                      1       2       3  
 
Total UK
    2,402       6,385       2,611       12,717       81,068       105,183  
 
Non-UK
                                               
Advances secured on residential properties
                      2       24       26  
Purchase and resale agreements
    12,655       497                         13,152  
Other secured advances
                                   
Corporate advances
                                   
Unsecured advances
          31                         31  
Finance lease debtors
                                   
 
Total non-UK
    12,655       528             2       24       13,209  
 
Total
    15,057       6,913       2,611       12,719       81,092       118,392  
 
The interest rate sensitivity table below analyses loans between fixed rate and variable rate.
                         
    Fixed rate     Variable rate     Total  
    £m     £m     £m  
 
UK
    33,420       71,763       105,183  
Non-UK
          13,209       13,209  
 
 
    33,420       84,972       118,392  
 
Abbey’s policy is to hedge all fixed-rate loans and advances to customers using derivative instruments, or by matching with other on-balance sheet interest rate exposures .
Provisions on loans and advances to customers
Abbey’s provisioning policy is in accordance with International Financial Reporting Standards. The charge for provisions on loans and advances to customers adjusts the balance sheet provisions to the level that management deems adequate to absorb actual and inherent losses in Abbey’s loan portfolio from homogeneous portfolios of assets and individually identified loans. A proportion of Abbey’s provisions on loans and advances to customers relate to loans and advances secured either by a first charge on residential property in the UK, or by other appropriate security depending on the nature of the loan.
Abbey’s provisioning policy is as follows:
>   Observed provision – an observed provision is established for all past due loans after a specified period of repayment default where it is likely that some of the capital will not be repaid or recovered through enforcement of any applicable security. The length of the default period depends on the nature of the advance and is generally no more than three months. Once a loan misses a payment (breach of contractual terms) an assessment of the likelihood of collecting the principal and overdue payments is made. This assessment is generally made using statistical techniques developed on previous experience and on management judgement of economic conditions. These techniques estimate the propensity of loans to go to write off and as a separate exercise, the loss incurred on written off debt is monitored. For advances secured on residential property the propensity of loans to reach repossession is determined, with repossessed properties assessed on an individual basis through the use of external valuation, anticipated disposal costs and the current exposure.
 
>   Incurred but not yet observed provision – an incurred but not yet observed provision is made against loans, which have not missed a payment but are known from past experience to have deteriorated since the initial decision to lend was made. Based on historical evidence, the number of accounts likely to default in the future as a result of events present at the balance sheet date are identified through use of statistical techniques. From 1 January 2005, these statistical techniques were expanded and enhanced. In particular, further detailed examination is now performed on the losses that emerge over a defined period of time after the reporting date called the emergence period. This period is determined to ensure that only those accounts which have a credit deterioration at the reporting date are captured and excludes accounts which will suffer credit deterioration after the reporting period. The emergence period is three months for unsecured lending and twelve months for secured lending. The provision methodology outlined for observed provisions is then applied to accounts identified as impaired in the performing portfolio’s.
 
>   Amounts written off – Unsecured loans are written off when all internal avenues of collecting the debt have failed and the debt is passed onto external collection agencies. On secured loans, the write off takes place on ultimate

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    realisation of collateral value, or from claiming on any mortgage indemnity guarantee or other insurance. All write offs are on a case by case basis, taking account of the exposure at the date of write off, after accounting for the value from any collateral or insurance held against the loan. The write-off policy is regularly reviewed to assist in determining the adequacy of provisions.
     Security is realised in accordance with Abbey’s internal debt management programme. Contact is made with customers at an early stage of arrears with counselling made available to achieve a realistic and sustainable repayment arrangement. Litigation and/or enforcement of security is usually carried out only when the steps described above have been undertaken without success.
     As a result of the write-off policy, the provisions will be made a significant time in advance of the related write-off on all products. The exception to this rule is the discovery of fraud, where the exposure is written off once full investigations have been completed and the probability of recovery is minimal. The time span between the discovery and write off will be a short period and may not result in a provision being raised.
Analysis of end-of-year provisions on loans and advances to customers
                 
    2005     2004  
    £m     £m  
 
Observed provision
               
Advances secured on residential properties – UK
    21       9  
Other secured advances – UK
    126       148  
Unsecured personal advances – UK
    158       133  
Corporate advances – UK
          67  
 
Total observed provisions
    305       357  
 
 
               
Incurred but not yet observed provision
               
Advances secured on residential properties – UK
    35       58  
Other secured advances – UK
          3  
Unsecured personal advances – UK
    54       35  
Corporate advances – UK
          14  
 
Total incurred but not yet observed provisions
    89       110  
 
Total provisions
    394       467  
 
 
               
Ratios
               
 
Provisions at the year end as a percentage of year-end loans and advances to customers:
    %       %  
Advances secured on residential properties – UK
    0.06       0.07  
Other secured advances – UK
    6.69       5.22  
Unsecured personal advances – UK
    5.46       4.57  
Corporate advances – UK
          9.22  
Advances secured on residential properties – non-UK
          0.75  
Total loans and advances to customers
    0.41       0.43  
Amounts written off (net of recoveries) (1)
    0.31       0.35  
 
               
Percent of loans in each category to total loans:
               
Advances secured on residential properties – UK
    93.96       82.97  
Purchase and resale agreements – UK
          4.11  
Other secured advances – UK
    1.97       2.64  
Corporate advances – UK
          0.80  
Unsecured personal advances – UK
    4.04       3.34  
Advances secured on residential properties – non-UK
    0.03       0.01  
Purchase and resale agreements – non-UK
          6.13  
 
(1)   Amounts written off (net of recoveries) ratio as a percentage of average loans and advances to customers excluding finance leases.

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The table below for 2003, 2002 and 2001 contains information prepared under UK GAAP, Abbey’s previous primary GAAP, which is not comparable to information prepared under IFRS.
                         
    2003     2002     2001  
    £m     £m     £m  
 
Specific
                       
Advances secured on residential properties – UK
    8       24       46  
Other secured advances – UK
    36       42       45  
Unsecured personal advances – UK
    171       124       152  
Corporate advances – UK
    161       204        
Advances secured on residential properties – non-UK
    17       26       16  
Other secured advances – non-UK
    26       34       27  
Unsecured personal advances – non-UK
    4       4       4  
 
Total specific provisions
    423       458       290  
 
 
                       
General
                       
Advances secured on residential properties – UK
    165       165       145  
Other secured advances – UK
    58       19       18  
Unsecured personal advances – UK
    32       32       35  
Corporate advances – UK
    173       56        
Advances secured on residential properties – non-UK
    12       9       5  
Other secured advances – non-UK
    2       4       4  
Unsecured personal advances – non-UK
          3       1  
 
Total general provisions
    442       288       208  
 
Total provisions
    865       746       498  
 
 
                       
Ratios
    %       %       %  
 
Provisions at the year end as a percentage of year-end loans and advances to customers
                       
Advances secured on residential properties – UK
    0.24       0.29       0.31  
Other secured advances – UK
    3.28       1.30       1.61  
Unsecured personal advances – UK
    6.20       3.02       3.87  
Corporate advances – UK
    13.83       2.97        
Advances secured on residential properties – non-UK
    1.70       1.10       1.00  
Other secured advances – non-UK
    68.29       80.85       64.58  
Unsecured personal advances – non-UK
    2.76       5.69       4.20  
Total loans and advances to customers
    0.93       0.82       0.59  
Amounts written off (net of recoveries) (1)
    0.40       0.33       0.37  
Percent of loans in each category to total loans
                       
Advances secured on residential properties – UK
    76.62       69.76       67.62  
Purchase and resale agreements – UK
    3.08       0.79       3.01  
Other secured advances – UK
    3.05       4.99       4.36  
Corporate advances – UK
    2.51       9.27       10.15  
Unsecured personal advances – UK
    3.40       5.47       5.38  
Finance lease debtors – UK
    2.67       3.64       5.20  
Advances secured on residential properties – non-UK
    1.78       3.38       2.33  
Purchase and resale agreements – non-UK
    6.68       2.50       1.70  
Other secured advances – non-UK
    0.04       0.05       0.05  
Unsecured advances – non-UK
    0.15       0.13       0.13  
Finance lease debtors – non-UK
    0.02       0.02       0.07  
 

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Movements in provisions for bad and doubtful debts
                 
    2005     2004  
    £m     £m  
 
Provisions at 31 December
    467        
IFRS reclassifications
    (40 )      
Provisions at the 1 January
    427       865  
Disposal of subsidiary undertakings
          (70 )
 
 
    427       795  
Amounts written off
               
Advances secured on residential properties – UK
    (8 )     (2 )
Other secured advances – UK
    (42 )     (39 )
Unsecured personal advances – UK
    (275 )     (136 )
Corporate advances – UK
          (164 )
 
 
    (325 )     (341 )
Advances secured on residential properties – non-UK
          (2 )
Other secured advances – non-UK
          (2 )
 
Total amounts written off
    (325 )     (345 )
 
Recoveries
               
Advances secured on residential properties – UK
    3       16  
Other secured advances – UK
    7       8  
Unsecured personal advances – UK
    27       28  
 
 
    37       52  
Advances secured on residential properties – non-UK
           
Other secured advances – non-UK
           
 
Total amount recovered
    37       52  
 
Observed provisions charged against profit
               
Advances secured on residential properties – UK
    12       (13 )
Other secured advances – UK
    11       147  
Unsecured personal advances – UK
    221       70  
Corporate advances – UK
          71  
 
 
    244       275  
 
Advances secured on residential properties – non-UK
    (3 )     (1 )
Other secured advances – non-UK
           
Unsecured personal advances – non-UK
          1  
 
Total observed provisions charged against profit
    241       275  
 
Incurred but not yet observed provisions charged against profit
    14       (310 )
 
Exchange and other adjustments
           
 
Provisions at the end of the year
    394       467  
 
IFRS reclassifications relate primarily to reclassification of provisions relating to certain corporate loans in the portfolio business unit segment.

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The table below for 2003, 2002 and 2001 contains information prepared under UK GAAP, Abbey’s previous primary GAAP, which is not comparable to information prepared under IFRS.
                         
    2003     2002     2001  
    £m     £m     £m  
 
Provisions at the beginning of the year
    746       498       527  
Acquisition of subsidiary undertakings
          8        
Disposal of subsidiary undertakings
    (94 )     (1 )      
 
 
    652       505       527  
Amounts written off
                       
Advances secured on residential properties – UK
    (16 )     (27 )     (41 )
Other secured advances – UK
    (45 )     (33 )     (49 )
Unsecured personal advances – UK
    (148 )     (335 )     (296 )
Corporate advances – UK
    (80 )            
 
 
    (289 )     (395 )     (386 )
Advances secured on residential properties – non-UK
    (10 )           (1 )
Other secured advances – non-UK
    (10 )           (5 )
Unsecured personal advances – non-UK
          (1 )     (1 )
 
Total amounts written off
    (309 )     (396 )     (393 )
 
Recoveries
                       
Advances secured on residential properties – UK
    4       4       9  
Other secured advances – UK
          3       8  
Unsecured personal advances – UK
    38       89       85  
 
 
    42       96       102  
 
Advances secured on residential properties – non-UK
          5        
Other secured advances – non-UK
          6        
 
Total amount recovered
    42       107       102  
 
Specific provisions charged against profit
                       
Advances secured on residential properties – UK
    5       1       27  
Other secured advances – UK
    52       25       29  
Unsecured personal advances – UK
    205       219       193  
Corporate advances – UK
    36       207        
 
 
    298       452       249  
 
Advances secured on residential properties – non-UK
    4       2       6  
Other secured advances – non-UK
          (1 )     (8 )
Unsecured personal advances – non-UK
          1       1  
 
Total specific provisions charged against profit
    302       454       248  
 
General provisions charged against profit
    172       60       15  
 
Exchange and other adjustments
    6       16       (1 )
 
Provisions at the end of the year
    865       746       498  
 
Potential credit risk elements in loans and advances
Under IFRS, interest continues to be accrued on all loans and the element of interest that is not anticipated to be recovered is derecognised through the use of an income adjustment, which effectively is the unwind of the discounting applied for calculating the provisions.
Group non-performing loans and advances
                 
    2005     2004  
    £m     £m  
 
Accruing loans and advances on which specific provision made
               
UK
    314       297  
Non-UK
           
 
 
    314       297  
 
Accruing loans and advances 90 days overdue on which no specific provision made
               
UK
    568       844  
Non-UK
           
 
 
    568       844  
 
Total non-performing loans and advances:
               
UK
    882       1,141  
Non-UK
           
 
 
    882       1,141  
 
Non-performing loans and advances as a percentage of loans and advances to customers excluding finance leases
    0.75 %     1.04 %
Provision as a percentage of total non-performing loans and advances
    44.67 %     40.93 %
 
Overall, non-performing loans and advances as a percentage of loans and advances to customers excluding finance leases have decreased from 1.04% to 0.92%. This is due to the sale of the majority of AFM’s wholesale lending book and to the run down of the Motor and Litigation businesses. Provisions as a percentage of total non-performing loans and advances have increased

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from 40.93% to 44.67% in 2005. This movement is attributable to the sale of the majority of AFM’s wholesale lending book. In 2004 AFM had only provided £81m against non-performing lending for AFM of £372m. This year AFM’s provision and non-performing lending balances are nil.
     The table below for 2003, 2002 and 2001 contains information prepared under UK GAAP, Abbey’s previous primary GAAP, which is not comparable to information prepared under IFRS.
                         
    2003     2002     2001  
    £m     £m     £m  
 
Accruing loans and advances on which a proportion of interest has been suspended and/or on which specific provision has been made:
                       
UK
    1,531       515       717  
Non-UK
    101       154       131  
 
 
    1,632       669       848  
 
Accruing loans and advances 90 days overdue on which no interest has been suspended and on which no specific provision has been made:
                       
UK
    1,110       1,364       898  
Non-UK
    4       22       19  
 
 
    1,114       1,386       917  
 
Non-accruing loans and advances:
                       
UK
                1  
Non-UK
    30       22       27  
 
 
    30       22       28  
 
Total non-performing loans and advances:
                       
UK
    2,641       1,879       1,616  
Non-UK
    135       198       177  
 
 
    2,776       2,077       1,793  
 
 
                       
 
    %       %       %  
 
Non-performing loans and advances as a percentage of loans and advances to customers excluding finance leases
    3.25       2.36       2.22  
Provision as a percentage of total non-performing loans and advances
    31.15       35.92       27.77  
 
Potential problem loans and advances
In retail banking, due to the homogenous nature of the loans, the impairment assessment is undertaken on a collective basis through the use of statistical techniques. The collective assessment takes due consideration of the time in arrears, with higher times in arrears indicating a higher probability of the loans to go to possession. Individual assessments are only undertaken when the collateral on a secured residential loan is repossessed or on commercial loans, where the loan is overdue.
     These techniques are equally used to establish the amount of provisions for bad and doubtful debts. In addition, Abbey’s policy of initiating prompt contact with customers in arrears, together with the nature of the security held, which in the case of advances secured on residential property has substantially increased in value over the life of the loans means that a significant proportion of non-performing loans will not result in a loss.
     The categories of non-performing loans and advances, which are statistically most likely to result in losses are cases from 6 months to 12 months in arrears and 12 months or more in arrears. Losses on cases for which the property securing the loan has been taken into possession are evaluated individually with the amounts expected to be lost on realisation of the security being established with a high degree of certainty. The following table sets forth the values for each of these categories included in the non-performing loans and advances table above for each of the last five years.
                 
    2005     2004  
    £m     £m  
 
6 months to 12 months in arrears
    172       105  
12 months or more in arrears
    26       15  
Properties in possession
    44       18  
 
The table below for 2003, 2002 and 2001 contains information prepared under UK GAAP, Abbey’s previous primary GAAP, which is not comparable to information prepared under IFRS.
                         
    2003     2002     2001  
    £m     £m     £m  
 
6 months to 12 months in arrears
    62       101       114  
12 months or more in arrears
    44       131       111  
Properties in possession
    7       9       14  
 
Country risk exposure
Abbey has no exposure to countries currently experiencing liquidity problems.
Cross border outstandings
The operations of Abbey involve operations in non-local currencies. These cross border outstandings are controlled through a well-developed system of country limits, which are reviewed to avoid concentrations of transfer, economic or political risks.

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Cross border outstandings, which exclude finance provided within the Group, are based on the country of domicile of the borrower or guarantor of ultimate risk and comprise loans and advances to customers and banks, finance lease debtors, interest-bearing investments and other monetary assets denominated in currencies other than the borrower’s local currency.
Cross border outstandings exceeding 1% of total assets
                                         
                                    Commercial,  
                    Banks and other             industrial and  
    As % of total             financial     Governments and     other private  
    assets     Total     institutions     official institutions     sector entities  
    %     £m     £m     £m     £m  
 
At 31 December 2005:
                                       
United States
    1.55       3,200       3,200              
 
At 31 December 2004:
                                       
United States
    5.31 (1)     7,448       7,412             36  
 
(1)   Total assets are total assets, as presented in the Consolidated Balance Sheet, excluding long-term assurance fund assets and balances arising from off-balance sheet financial instruments. On this basis, total assets amounted to £140.2bn at 31 December 2004.
The table below for 2003 contains information prepared under UK GAAP, Abbey’s previous GAAP, which is not comparable to information prepared under IFRS.
                                         
                                    Commercial,  
                    Banks and other             industrial and  
    As % of total             financial     Governments and     other private  
    assets     Total     institutions     official institutions     sector entities  
    %     £m     £m     £m     £m  
 
At 31 December 2003:
                                       
United States
    3.09 (2)     4,533       2,693       25       1,815  
Italy
    1.25 (2)     1,836       376       1,395       65  
 
(2)   Total assets are total assets, as presented in the Consolidated Balance Sheet, excluding long-term assurance fund assets and balances arising from off-balance sheet financial instruments. On this basis, total assets amounted to £146.6bn at 31 December 2003.
Cross border outstandings between 0.75% and 1% of total assets
At 31 December 2005 and 31 December 2004, Abbey had no cross border outstandings between 0.75% and 1% of total assets.
     The 2003 information is prepared under UK GAAP, Abbey’s previous GAAP, which is not comparable to information prepared under IFRS. At 31 December 2003, Abbey had aggregate cross border outstandings with France of 0.96% of total assets with aggregate outstandings of £1,408m.
Tangible fixed assets
                 
    Year ended 31 December  
    2005     2004  
    £m     £m  
 
Capital expenditure
    190       115  
 
Capital expenditure to 31 December 2005 amounted to £190m. The majority of this amount was incurred by Retail Banking and mostly related to computer infrastructure, computer software and furniture and fittings for branches. Capital expenditure to 31 December 2004 amounted to £115m. The majority of this was incurred by Retail Banking and mostly related to computer infrastructure, computer software and furniture and fittings for branches.
     Abbey had 915 unique property interests at 31 December 2005 consisting of 4 freehold leases and 911 operating lease interests, occupying a total floor space of 404,108 square meters.
     The number of unique property interests owned by Abbey is more than the number of individual properties as Abbey has more than one interest in some properties.
     The majority of Abbey’s property interests are retail branches. Included in the above total are 36 properties that were not occupied by Abbey as at 31 December 2005. Of Abbey’s individual properties, 809 are located in the UK, 13 in Europe, and 3 in the rest of the world. There are no material environmental issues associated with the use of the above properties.
     Abbey has four principal sites at Triton Square, London, Nelson Street, Bradford, St. Vincent Street, Glasgow, and Grafton Gate East, Milton Keynes. The main computer centre is Shenley Wood House in Milton Keynes. These properties are held under operating leases. The registered office of Abbey is located at Abbey National House, 2 Triton Square, Regent’s Place, London NW1 3AN.
     Management believes its existing properties and those under construction, in conjunction with the operating lease arrangements in place with Mapeley Columbus Limited, are adequate and suitable for its business as presently conducted or to meet future business needs. All properties are adequately maintained.

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Capital management and resources
Capital management and capital allocation
Capital adequacy and capital resources are monitored by Abbey on the basis of techniques developed by the Basel Committee on Banking Supervision (the ‘Basel Committee’) and subsequently implemented in the UK by the UK regulator, the Financial Services Authority (FSA). With Abbey and its subsidiaries being part of Santander, Abbey has both a local ‘host’ regulator (FSA) and a lead ‘home’ regulator, which for both Santander and Abbey is the Banco de España. Abbey is rated, and its capital is managed, on a stand-alone basis, however Abbey does take account of the requirements of both the host and home regulators in its capital management decision-making.
     The supervision of capital adequacy for banks in the European Union is governed by European Union Directives, and specifically the Banking Consolidation Directive and the Capital Adequacy Directives.
     After continuing consultation, the Basel Committee has developed a new framework to replace the 1988 Capital Accord, which the European Union has adapted and issued as Capital Adequacy Directive three. It is currently expected that the New Capital Accord will be implemented by Abbey from 1 January 2008, which is consistent with Santander group companies. Although the Basel Committee intends to deliver a more risk-sensitive methodology, including a new operational risk capital charge, its goal is that on average, the new approach should not raise nor lower regulatory capital for the banking sector. The international minimum risk asset ratio of 8% will be unchanged.
     On the basis of the developing proposals, management does not expect any material adverse change to the business of Abbey to arise from the new capital adequacy framework.
Capital adequacy requirements
Abbey adopts a centralised capital management approach, based on an assessment of both regulatory requirements and the economic capital impacts of our businesses. The various regulatory minimum capital criteria are augmented by internally assigned buffers. These ratios, buffers and restrictions, together with the relevant costs of differing capital instruments and a consideration of the various other capital management techniques are used to shape the most cost-effective structure to fulfil Abbey’s capital requirement.
     The most obvious capital management techniques considered are the issue of equity, preference and subordinated capital instruments. Other levers available include tools involving equity and retained earnings. Another obvious measure is control of the amount of assets and risk on the balance sheet and, finally, the use of asset mitigation tools designed to reduce the capital required to back certain classes of asset by disposing of part of the risk associated with them.
     Abbey’s capital allocation control process has two main determinants: the capital volumes approved to business units within the planning process, and the need to have access to a capital buffer which is sufficient to cover the capital impact of major contingent events or “capital shocks”. Capital allocation decisions will be influenced by comparison of returns earned on regulatory equity, conducted as part of planning reviews under which capital levels for operating divisions are approved or when additional capital requests are received.
Capital ratios
The following capital ratios, which exceed both the Basel Committee minimum risk asset ratio of 8% and the Financial Services Authority’s specific recommendation for Abbey, are calculated for Abbey as supervised by the Financial Services Authority. Abbey recognises the additional security inherent in Tier 1 capital, and hence also presents a Tier 1 to risk-weighted assets ratio. An equity Tier 1 ratio (Tier 1 excluding preference shares) is also presented.

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Group capital
                 
    2005     2004  
    £m     £m  
 
Balance sheet:
               
Distributable reserves and shareholders’ funds
    3,853       5,004  
Less: goodwill recognised
    (171 )     (1,069 )
 
Core equity Tier 1
    3,682       3,935  
Tier 1 capital instruments
    1,932       1,893  
 
Total Tier 1 capital
    5,614       5,828  
 
Undated subordinated debt
    2,641       2,604  
Dated subordinated debt
    2,620       2,204  
Incurred but not observed provisions and other
    85       177  
 
Total Tier 2 capital
    5,346       4,985  
 
Less:
               
PFS: investments in life assurance businesses
    (3,682 )     (3,789 )
PFS: investment in non-life assurance businesses
    (296 )     (68 )
Portfolio Business Unit
          (225 )
 
Total supervisory deductions
    (3,978 )     (4,082 )
 
Total regulatory capital
    6,982       6,731  
 
Risk-weighted assets:
               
Personal Financial Services
    53,434       52,198  
Portfolio Business Unit
    2,538       3,973  
 
Total Abbey risk-weighted assets
    55,972       56,171  
Banking book
    50,108       50,416  
Trading book
    5,864       5,755  
 
Total Abbey risk-weighted assets
    55,972       56,171  
 
 
               
Capital ratios:
               
 
Risk asset ratio (%)
    12.5 %     12.0 %
Tier 1 ratio (%)
    10.0 %     10.4 %
Equity Tier 1 ratio (%)
    6.6 %     7.0 %
 
Balance sheet
As at 31 December 2005, the Equity Tier 1 ratio and the risk asset ratio were 6.6% and 12.5% respectively.
     Tier 1 capital decreased by £214m to £5,614m, largely driven by the level of profit attributable to shareholders of £420m partly offset by IAS adjustments to reserves.
     The increase in Tier 2 capital of £361m was principally due to two subordinated debt issues in April (of which £554m was outstanding at 31 December 2005) offset by amortisation of subordinated capital and a reduction in general provisions.
     Supervisory deductions primarily represent capital invested in non-banking businesses — mainly the equity investment and retained earnings in life assurance and insurance companies. The movement in the year largely reflects the life assurance profit after tax and the unwind of special purpose vehicles in the Portfolio Business Unit.
     The 2004 figures have not been restated for the change to IFRS as the change to IFRS was only implemented for UK capital adequacy reporting from the second quarter of 2005.
Risk-weighted assets (RWAs)
Personal Financial Services risk-weighted assets increased by £1.2bn. This was principally the result of secured and unsecured loan growth.
     Risk-weighted assets in the Portfolio Business Unit have decreased by £1.4bn reflecting the continued asset disposals process.
Analysis of life assurance capital
                 
    2005     2004  
Value of long-term assurance business   £m     £m  
 
Discounted value of future profits (net of tax)
    1,421       1,540  
Net assets held by long-term assurance funds
    1,414       1,428  
 
IFRS embedded value of the long-term assurance business
    2,835       2,968  
Opening 2005 IFRS adjustment
          (166 )
 
Total value of long-term assurance business
    2,835       2,802  
Other net assets of shareholder funds
    847       805  
Subordinated debt
          200  
 
Total value of long-term assurance business
    3,682       3,807  
 
The discounted value of future profits represents the present value of the surplus expected to emerge in the future from the business in-force. The decrease in discounted value of future profits since December 2004 of £119m to £1,421m was mainly driven by the impact of IFRS 4 resulting in the removal of the future profits on investment contracts, the impact of continued

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lapses on with profits and protection business in addition to the unwind of the existing discounted value of profits. This was partially offset by an increase from new business written in 2005 and improved mortality experiences.
     Net assets of the shareholders interest in the long-term business fund of £1,414m were £14m below the December 2004 level, as a result of the recognition of the pension deficit and repayment of capital and dividends to Abbey partially offset by earnings in 2005 on the existing assets.
     Other net assets of the shareholders’ funds have increased by £42m from December 2004 representing capital retained within the shareholders’ funds.
     A reconciliation between the opening and closing IFRS embedded value of the long-term assurance business is as follows:
Movements in IFRS embedded value of the long-term assurance business
         
    £m  
 
Opening value at 1 January 2005
    2,802  
Transfers (to)/from shareholders’ funds
     
Increase in value of the long-term assurance business before tax
    194  
Tax on increase in value of the long-term assurance business
    (54 )
Dividends paid to Abbey
    (40 )
Capital repatriated to Abbey
    (67 )
 
Closing value at 31 December 2005
    2,835  
 
Life assurance cashflows
                 
    At 31 December     At 31 December  
    2005     2004  
    £m     £m  
Capital injections made from Abbey
          5  
Dividends and interest paid to Abbey
    (51 )     (21 )
Capital repaid to Abbey
    (267 )      
 
Net cashflows (to)/from Abbey
    (318 )     (16 )
 
Intercompany flows to and from Abbey incurred during the general course of business, such as interest, centrally based IT services and sales commissions for branch-based products, are excluded from the table above.
Off-Balance Sheet Arrangements
In the ordinary course of business, Abbey issues guarantees on behalf of customers. The significant types of guarantees are as follows:
>   It is normal in the UK to issue cheque guarantee cards to current account customers holding chequebooks, as retailers do not generally accept cheques without such form of guarantee. The guarantee is not automatic but depends on the retailer having sight of the cheque guarantee card at the time the purchase is made. The bank is liable to honour these cheques even where the customer doesn’t have sufficient funds in his account. The bank’s guarantee liability is in theory the number of cheques in issue multiplied by the amount guaranteed per cheque, which can be between £50 and £100. In practice most customers will only write cheques when they have funds in their account to meet the cheque, and cheques are frequently presented without the benefit of the cheque guarantee. On this basis management have assessed the risk with respect to this guarantee as highly remote and consider the risk of loss as part of the provisioning requirement on bank accounts.
 
>   Standby letters of credit also represent the taking on of credit on behalf of customers when actual funding is not required, normally because a third party is not prepared to accept the credit risk of Abbey’s customer. These are also included in the normal credit provisioning assessment alongside other forms of credit exposure.
 
>   Abbey, as is normal in such activity, gives representations, indemnities and warranties on the sale of subsidiaries. The maximum potential amount of any claims made against these is usually significantly higher than actual settlements. Appropriate provision is made with respect to management’s best estimate of the likely outcome, either at the time of sale, or subsequently if additional information becomes available.
See Note 44 to the Consolidated Financial Statements for additional information regarding Abbey’s guarantees as well as its commitments and contingencies.
     In the ordinary course of business, Abbey also enters into securitisation transactions as described in Note 21 to the Consolidated Financial Statements. The Holmes securitisation vehicles are consolidated under IFRS. The mortgage assets continue to be administered by Abbey. The Holmes securitisation vehicles provide Abbey with an important source of stable long-term funding and also a regulatory capital benefit. Under US GAAP the vehicles are deconsolidated in accordance with SFAS 140 and an interest-only strip calculated. This is a US GAAP adjustment only and does not affect the way the vehicles or underlying assets are managed.
Liquidity disclosures
Liquidity risk is the potential that, although remaining solvent, Abbey does not have sufficient liquid financial resources to enable it to meet its obligations as they fall due, or can secure them only at excessive cost.
     The Board is responsible for the liquidity management and control framework at Abbey and has approved key liquidity limits in setting Abbey’s liquidity risk appetite. Along with its internal Liquidity Risk Manual, which sets out the liquidity risk control framework and policy, Abbey abides by the “Sound Practices for Managing Liquidity in Banking Organisations” set out

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by the Basel Committee as its standard for liquidity risk management and control. Abbey also complies with the Financial Services Authority’s liquidity requirements, and has appropriate liquidity controls in place.
Analysis of cash flow movements
                 
    Year ended 31 December  
    2005     2004  
    £m     £m  
 
Net cash (outflow)/inflow from operating activities
    (5,230 )     (4,831 )
Net cash (outflow) from investing activities
    2,036       4,131  
Net cash inflow/(outflow) from financing activities
    96       (1,497 )
 
Increase/(decrease) in cash and cash equivalents
    (3,098 )     (2,197 )
 
2005 compared to 2004
Net cash movements decreased by £901m to a net cash outflow of £3,098m in 2005 as compared with a net cash outflow of £2,197m in 2004. The decrease was primarily due to a decrease in cash equivalents of £3,555m, driven by an increase in trading deposits at banks with a maturity of less than three months, partly offset by an increase in debt securities with a maturity of less than three months. The movements are due to an increase in Cater Allen International Limited (CAIL) trading activity, which was constrained in 2004 because of Abbeys strategic decision to focus on the Personal Financial Services business and to reduce the operations of the Portfolio Business Unit business.
Sources of liquidity
Abbey has both wholesale and retail sources of funding and attracts them through a variety of entities. The retail sources primarily originate from the Retail savings business, which forms part of the core Personal Financial Services activity. Although primarily callable, these funds provide a stable and predictable core of liquidity due to the nature of the retail accounts and the breadth of personal customer relationships.
     Abbey’s wholesale funding sources are diversified across funding types and geography. Through the wholesale markets, Abbey has active relationships with over 500 counterparts across a range of sectors, including banks, central banks, other financial institutions, corporates and investment funds. Other sources of funding include collateralised borrowings, mortgage securitisations and long-term debt issuance. While there is no certainty regarding money market lines of credit extended to Abbey, they are actively managed as part of the ongoing business. Currently, no guaranteed lines of credit have been purchased, as they are not common in European banking practice.
     The ability to sell assets quickly is also an important source of liquidity for Abbey. Abbey holds marketable investment securities, such as central bank, eligible government and other debt securities, which could be disposed of, either by entering into sale and repurchase agreements, or by being sold to provide additional funding should the need arise. Abbey also makes use of asset securitisation arrangements to provide alternative funding sources.
     Under Abbey’s Liquidity Risk Policy, in the calculation of liquidity ratios, Abbey only relies on 95% of retail deposits with an allowance for up to 5% of such deposits being withdrawn at any time. With respect to wholesale deposits, for a period up to and including a month, there is no reliance on external wholesale deposits being renewed. These approaches are more conservative than would be expected based on historical experience with respect to these types of deposits.
     Short-term funding is accessed through money market instruments, including time deposits, certificates of deposit and commercial paper. Medium to long-term funding is accessed primarily through the stand-alone bond markets. In addition Abbey utilises its euro and, separately, Securities and Exchange Commission-registered medium-term note programmes. The major debt issuance programmes managed by Abbey National Treasury Services on its own behalf, except for the US commercial paper programme which is managed for Abbey National North America LLC, a guaranteed subsidiary of Abbey, are set forth below:
                 
Programme   Outstanding at 31 December 2005   Markets issued in:
 
$15bn medium-term notes
  $9.5bn
  European
$7bn medium-term notes
  $3.6bn
  United States
$4bn commercial paper
  $0.3bn
  European
$20bn commercial paper
  $9.5bn
  United States
 
Uses of liquidity
The principal uses of liquidity for Abbey are the funding of Retail Banking lending and investment securities, payment of interest expense, dividends paid to shareholders, and the repayment of debt. Our ability to pay dividends depends on a number of factors, including our regulatory capital requirements, distributable reserves and financial performance.

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                            Payments due by period  
            Less than     1-3     3-5     More than 5  
    Total     1 year     years     years     years  
Contractual obligations   £m     £m     £m     £m     £m  
 
Debt securities in issue
    42,807       17,157       7,432       4,674       13,544  
Other borrowed funds
    2,244       16       303             1,925  
Subordinated liabilities
    6,205       105       204       309       5,587  
Insurance and reinsurance liabilities
    21,501       2,943       2,144       3,981       12,433  
Investment contract liabilities
    3,306       777       377       701       1,451  
Retirement benefit obligations
    1,380       34       70       74       1,202  
Operating lease obligations
    1,426       122       236       208       860  
Purchase obligations
    115       55       58       2        
 
Total
    78,984       21,209       10,824       9,949       37,002  
 
The amounts and maturities of Abbey’s contractual obligations in connection with deposits by banks, customer accounts, and guarantees are described in Notes 32, 33 and 44 to the consolidated financial statements.
     The repayment terms of the debt securities may be accelerated in line with the covenants contained within the individual loan agreements. Details of deposits by banks and customer accounts can be found in Notes 32 and 33 of the consolidated financial statements. Based on previous experience, it is Abbey’s expectation that the undated subordinated liabilities will continue to be outstanding for the foreseeable future. Abbey has entered into significant outsourcing contracts where, in some circumstances, there is no minimum specified spending requirement. In these cases, anticipated spending volumes have been included within purchase obligations.

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Average balance sheet (4, 5)
                                                 
    2005     2004  
    Average               Average       Average           Average  
    balance     Interest (1)     rate     balance     Interest (1)     rate  
    £m     £m     %     £m     £m     %  
 
Assets
                                               
Loans and advances to banks
                                               
UK
    3,694       170       4.60 %     5,175       243       4.70 %
Non-UK
    76       4       5.25 %                  
Loans and advances to customers (2)
                                               
UK
    97,251       5,282       5.43 %     97,459       5,246       5.38 %
Non-UK
    49       2       4.06 %     1,398       59       4.24 %
Debt securities
                                               
UK
                      3,255       87       2.66 %
Non-UK
                                   
 
Total average interest-earning assets and interest income – banking business
    101,070       5,458       5.40 %     107,287       5,635       5.25 %
 
Provision for loan losses
    (410 )                 (792 )            
Trading business
    53,154                   56,788              
Liabilities designated at fair value through profit and loss
    27,612                                
Non-interest-earning assets:
                                               
Long-term assurance fund assets
                      27,307              
Other
    19,146                   16,010              
 
Total average assets
    200,572                       206,600                  
 
Non-UK assets as a percentage of total
    0.06 %                     0.68 %                
 
Liabilities
                                               
 
Deposits by banks
                                               
UK
    (1,070 )     (42 )     3.93 %     (7,340 )     (243 )     3.32 %
Non-UK
                      (697 )     (10 )     1.48 %
Customer accounts – retail demand deposits (3)
                                               
UK
    (52,083 )     (1,816 )     3.49 %     (40,761 )     (1,371 )     3.36 %
Non-UK
    (1,092 )     (25 )     2.29 %     (1,152 )     (27 )     2.37 %
Customer accounts – retail time deposits (3)
                                               
UK
    (9,076 )     (355 )     3.91 %     (12,177 )     (456 )     3.75 %
Non-UK
    (4,875 )     (210 )     4.31 %     (4,149 )     (183 )     4.40 %
Customer accounts – wholesale deposits (3)
                                               
UK
    (2,840 )     (125 )     4.40 %     (5,467 )     (183 )     3.35 %
Non-UK
    (113 )                              
Bonds and medium-term notes
                                               
UK
    (23,847 )     (1,167 )     4.89 %     (24,165 )     (1,136 )     4.70 %
Non-UK
                                   
Other debt securities in issue
                                               
UK
                      (5,676 )     (148 )     2.61 %
Non-UK
                      (5,302 )     (101 )     1.91 %
Dated and undated loan capital and other subordinated liabilities
                                               
UK
    (8,868 )     (501 )     5.65 %     (6,544 )     (314 )     4.79 %
Non-UK
    (563 )     (35 )     6.21 %                  
Other interest-bearing liabilities
                                               
UK
                      (16 )     (1 )     5.87 %
Non-UK
                                   
 
Total average interest-bearing liabilities and interest expense
                                               
– banking
    (104,427 )     (4,276 )     4.09 %     (113,446 )     (4,173 )     3.68 %
 

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Business and Financial Review
Balance Sheet Business Review continued
                                                 
    2005     2004  
    Average             Average       Average           Average  
    balance     Interest (1)     rate     balance     Interest (1)     rate  
    £m     £m     %     £m     £m     %  
 
Trading business
    (43,775 )                 (44,129 )            
Liabilities designated at fair value through profit and loss
    (8,153 )                              
Non-interest-bearing liabilities Long-term assurance fund liabilities
                      (27,307 )            
Other
    (42,070 )                 (17,117 )            
Shareholders’ funds
    (2,147 )                 (4,601 )            
 
Total average liabilities, shareholders’ funds
    (200,572 )                     (206,600 )            
 
Non-UK liabilities as a percentage of total
    3.31 %                     5.47 %                
Interest income as a percentage of average interest-earning assets
                    5.40 %                     5.25 %
Interest expense as a percentage of average interest-bearing liabilities
                    4.09 %                     3.68 %
Interest spread
                    1.31 %                     1.57 %
Net interest margin
                    1.17 %                     1.36 %
 
(1)   For the purpose of the average balance sheet, interest income and interest expense have been stated after allocation of interest on instruments entered into for hedging purposes.
 
(2)   Loans and advances to customers includes non-performing loans. See “analysis of end-of-year provisions on loans and advances to customers” and “potential credit risk elements in loans and advances” above.
 
(3)   Demand deposits, time deposits and wholesale deposits are defined under “Deposits” above.
 
(4)   Abbey National Treasury Services plc prepares averages using average daily balances, whereas the remainder of Abbey uses month end averages. These averages are representative of the operations of Abbey.
 
(5)   The ratio of average interest-earning assets to interest-bearing liabilities for the year ended 31 December 2005 was 96.78% (2004: 94.57%).

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Business and Financial Review
Balance Sheet Business Review continued
The table below for 2003 contains information prepared under UK GAAP, Abbey’s previous primary GAAP, which is not comparable to information prepared under IFRS.
                         
    2003  
      Average           Average  
    balance     Interest (1)     rate  
    £m     £m     %  
 
Assets
                       
Loans and advances to banks
                       
UK
    3,685       155       4.21  
Non-UK
    289       7       2.42  
Loans and advances to customers (2)
                       
UK
    83,692       4,373       5.23  
Non-UK
    4,197       174       4.28  
Lease debtors
                       
UK
    3,098       140       4.52  
Non-UK
    59       2       3.39  
Debt securities
                       
UK
    9,284       324       3.49  
Non-UK
    2,518       69       2.74  
 
Total average interest-earning assets and interest income – banking business
    106,822       5,244       4.91  
 
Provision for loan losses
    (773 )            
Trading business
    40,883       978        
Non-interest-earning assets:
                       
Long-term assurance fund assets
    29,757              
Other
    17,430              
 
Total average assets and interest income
    194,119              
 
Non-UK assets as a percentage of total
    9.70 %            
 
Liabilities
                       
 
Deposits by banks
                       
UK
    (7,144 )     (244 )     3.42  
Non-UK
    (1,761 )     (24 )     1.36  
Customer accounts – retail demand deposits (3)
                       
UK
    (42,477 )     (1,061 )     2.50  
Non-UK
    (1,260 )     (28 )     2.22  
Customer accounts – retail time deposits (3)
                       
UK
    (12,620 )     (409 )     3.25  
Non-UK
    (4,083 )     (150 )     3.67  
Customer accounts – wholesale deposits (3)
                       
UK
    (8,057 )     (280 )     3.48  
Non-UK
    (158 )     (2 )     1.27  
Bonds and medium-term notes
                       
UK
    (14,002 )     (333 )     2.38  
Non-UK
    (395 )     (6 )     1.52  
Other debt securities in issue
                       
UK
    (6,551 )     (146 )     2.23  
Non-UK
    (11,963 )     (180 )     1.50  
Dated and undated loan capital and other subordinated liabilities
                       
UK
    (6,875 )     (311 )     4.52  
Non-UK
    (421 )     (7 )     1.66  
Other interest-bearing liabilities
                       
UK
    (19 )     (1 )     5.26  
Non-UK
    (2 )           3.25  
 
Total average interest-bearing liabilities and interest expense – banking
    (117,788 )     (3,182 )     2.70  
 
Trading business
    (24,269 )            
Non-interest-bearing liabilities
    (13,999 )            
Long-term assurance fund liabilities
    (31,763 )            
Other Shareholders’ funds
    (6,300 )            
 
Total average liabilities, shareholders’ funds and interest expense
    (194,119 )            
 
Non-UK liabilities as a percentage of total
    10.33 %                
Interest income as a percentage of average interest-earning assets
                    4.87  
Interest expense as a percentage of average interest-bearing liabilities
                    2.79  
Interest spread
                    2.21  
Net interest margin
                    1.93  
 

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Business and Financial Review
Balance Sheet Business Review continued
In 2003, interest-earning assets, interest-bearing liabilities and the associated interest reflect a “linked presentation” treatment for certain securitised assets under UK GAAP. If a linked presentation was not adopted, the interest spread and net interest margin would be as follows:
         
    2003
 
Interest spread
    1.94  
Net interest margin
    1.69  
 
(1)   For the purpose of the average balance sheet, interest income and interest expense have been stated after allocation of interest on instruments entered into for hedging purposes.
 
(2)   Loans and advances to customers includes non-performing loans. See “analysis of end-of-year provisions on loans and advances to customers” and “potential credit risk elements in loans and advances” above.
 
(3)   Demand deposits, time deposits and wholesale deposits are defined under “Deposits” above.
 
(4)   Abbey National Treasury Services prepares averages using average daily balances, whereas the remainder of Abbey uses month end averages. These averages are representative of the operations of Abbey.
 
(5)   The ratio of average interest-earning assets to interest-bearing liabilities for the year ended 31 December 2003 was 90.68%.
Interest rate sensitivity
Interest rate sensitivity refers to the relationship between interest rates and net interest income resulting from the periodic repricing of assets and liabilities. The largest single administered rate items in the Abbey balance sheet are residential mortgages and retail deposits, the majority of which bear interest at variable rates. Abbey is able to mitigate the impact of interest rate movements on net interest income in Retail Banking by repricing separately the variable rate mortgages and variable rate retail deposits, subject to competitive pressures.
     Abbey also offers fixed-rate mortgages and savings products on which the interest rate paid by or to the customer is fixed for an agreed period of time at the start of the contract. Abbey manages the margin on fixed-rate products by the use of derivatives matching the fixed-rate profiles. The risk of prepayment is reduced by imposing penalty charges if the customers terminate their contracts early.
     Abbey seeks to manage the risks associated with movements in interest rates as part of its management of the overall non-trading position. This is done within limits as described in the “Risk management” section elsewhere in this Annual Report.
Changes in net interest income – volume and rate analysis
The following table allocates changes in interest income, interest expense and net interest income between changes in volume and changes in rate for the years ended 31 December 2005 and 2004. Volume and rate variances have been calculated on the movement in the average balances and the change in the interest rates on average interest-earning assets and average interest-bearing liabilities. The variance caused by changes in both volume and rate has been allocated to rate changes.

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Business and Financial Review
Balance Sheet Business Review continued
                         
                    2005/2004  
    Total change     Changes due to increase/(decrease):  
            Volume     Rate  
Interest income   £m     £m     £m  
 
Loans and advances to banks
                       
UK
    (73 )     (46 )     (27 )
Non-UK
    4       5       (1 )
Loans and advances to customers
                       
UK
    36       (12 )     48  
Non-UK
    (57 )     (70 )     13  
Lease debtors
                       
UK
                 
Non-UK
                 
Debt securities
                       
UK
    (87 )     (117 )     30  
Non-UK
                 
Trading assets
                       
UK
                 
Non-UK
                 
Total interest income
                       
UK
    (124 )     (175 )     51  
Non-UK
    (53 )     (65 )     12  
 
 
    (177 )     (240 )     63  
Interest expense
                       
Deposits by banks
                       
UK
    (201 )     (208 )     7  
Non-UK
    (10 )     (10 )      
Customer accounts – retail demand deposits
                       
UK
    445       381       64  
Non-UK
    (2 )     (1 )     (1 )
Customer accounts – retail time deposits
                       
UK
    (101 )     (116 )     15  
Non-UK
    27       32       (5 )
Customer accounts – wholesale deposits
                       
UK
    (58 )     (88 )     30  
Non-UK
                 
Bonds and medium-term notes
                       
UK
    31       (15 )     46  
Non-UK
                 
Other debt securities in issue
                       
UK
    (148 )     (148 )      
Non-UK
    (101 )     (101 )      
Dated and undated loan capital and other subordinated liabilities
                       
UK
    187       111       76  
Non-UK
    35             35  
Other interest-bearing liabilities
                       
UK
    (1 )     (1 )      
Non-UK
                 
Trading liabilities
                       
UK
                 
Non-UK
                 
Total interest expense
                       
UK
    154       (84 )     238  
Non-UK
    (51 )     (80 )     29  
 
 
    103       (164 )     267  
 
Net interest income
    (280 )     (76 )     (204 )
 

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Business and Financial Review
Risk Management
The Risk Management report contains audited financial information except where noted.
Introduction
Abbey’s risk management focuses on the major areas of credit risk, market risk, liquidity risk, insurance risk, operational risk, financial crime and residual value risk. Authority flows from the Abbey National plc Board of Directors to the Chief Executive Officer and from him to specific individuals. Formal standing committees are maintained for effective management or oversight. Their authority is derived from the person they are intended to assist.
(FLOW CHART)
The diagram above shows the structure in operation in respect of risk management and oversight.
     The main elements of risk governance are as follows:
Board: this is the primary governing body. Its role is largely determined by legal and regulatory responsibilities and requirements. Its risk-control responsibilities include setting risk appetite, approving the risk framework and reviewing risk profile.
Audit and Risk Committee: this is a key Board committee. Its risk-control responsibilities include reviewing the effectiveness of risk controls and procedures including the identification, assessment and reporting of risks and the risk-governance structure and compliance with risk-control policies and procedures. It is the duty of the committee to review the effectiveness of the control mechanisms for the management of risk. It is not the responsibility of the committee to form a judgement about the acceptability or appropriateness of these risks. This remains the responsibility of the Board, and will be discharged through the Chief Executive Officer.
Asset and Liability Management Committee: is established under the authority of the Chief Executive Officer, comprising selected senior executives and supported by relevant experts. This committee is responsible for all matters relating to the balance sheet of the Company, specifically structural balance sheet risks, capital structure, funding and liquidity.
Risk Committee: this is a management committee established under the Chief Executive Officer’s authority and comprises senior executives and the Chief Risk Officer. The committee will consult with the Chief Risk Officer and make recommendations to ensure that the Company’s risk matters are suitably managed and understood. The committee will provide any information requested by the Executive Committee that it might require enabling it to appropriately discharge its responsibilities. The Risk Committee also receives information from, and is notified of, key decisions made by the Risk Oversight Fora for the Retail Banking, Abbey Financial Markets and Insurance and Asset Management businesses.
Chief Risk Officer: The Chief Risk Officer operates under authority delegated by the Chief Executive Officer. The Chief Risk Officer is responsible for establishing and maintaining comprehensive, accurate and effective risk reporting, and clear systems of risks limits. He is also responsible for highlighting to management all matters relevant to understanding risks being taken and to setting risk appetite.

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Business and Financial Review
Risk Management continued
Financial Instruments
By its nature the Group’s activities are principally related to the use of financial instruments including derivatives. The Group aim to lend monies predominately to retail borrowers at higher interest rates than accepting deposits from customers at both fixed and floating rates and for various periods.
     The Group also trades in financial instruments where it takes positions in traded and over the counter instruments, including derivatives, to take advantage of short-term market movements in the equity and bond markets and in currency and interest rates.
Risk Management
The financial risks affecting the Group have been addressed individually in the sections below. The risk exposure, measurement information and management policies are presented through the Group’s main operating segments being, Retail Banking (including Group Infrastructure), Abbey Financial Markets and Insurance and Asset Management.
     The risk exposure and management information relating to Retail Banking segment represents the holding company, Abbey National Plc. The other operating segments present the rest of the Abbey subsidiaries. In total the operating segments present the risk exposure and management policies of Abbey as a Group.
Risk Management in Retail Banking
Credit risk
Credit risk is the risk that counterparties will not meet their financial obligations and may result in Abbey losing the principal amount lent, the interest accrued and any unrealised gains (less any security held). Credit risk occurs mainly in Abbey’s loan and investment assets, and in derivative contracts.
Managing credit risk
This includes secured lending, banking and consumer credit and cahoot.
Secured lending. Abbey lends on many types of property but only after a credit risk assessment of the borrower and an assessment of the property is undertaken. The systems used to manage and monitor the quality of the mortgage asset are reviewed regularly to ensure they perform as expected.
     The majority of residential lending is subject to national lending policy and national lending authority levels, which are used to structure lending decisions to the same high standard across the retail network, a process further improved by mortgage credit scoring, underwriter accreditation and regular compliance reviews. Details concerning the prospective borrower and the mortgage are subject to a criteria-based decision-making process. Criteria for assessment include credit references, loan-to-value ratio, borrower status and the mortgage credit score.
     A responsible approach to lending is taken to ensure borrowers do not borrow more than they can afford. For low-risk applicants this may include the use of self-certification of income.
     The majority of loans provided by Abbey are secured on UK properties. All properties must be permanent in construction; mobile homes are not generally acceptable. Abbey can provide a mortgage for the purchase of properties outside the UK where the property is a second home and the loan is secured on the main property located in the UK.
     Prior to granting any first mortgage loan on a property, Abbey has the property valued by an approved and qualified surveyor, who is often an Abbey employee. The valuation is based on set Abbey guidelines. Normally, in the case of additional lending, when the total loan remains below 85% loan-to-value, the original property value is subject to indexation and no further survey is carried out. If the loan exceeds 85% loan-to-value, a revaluation is carried out by a qualified surveyor.
     The maximum loan-to-value ratio is usually no more than 95% where the maximum loan is £250,000. Abbey typically charges a fee to customers where the loan-to-value ratio is 90% or higher.
Mortgage credit quality
                 
    31 December     31 December  
    2005     2004  
 
Loan-to-value analysis:
               
New business
               
> 90%
    4 %     6 %
75% - 90%
    29 %     32 %
< 75%
    67 %     62 %
Average (at inception)
    60 %     61 %
Average loan-to-value of stock (indexed)
    45 %     45 %
New business profile:
               
First-time buyers
    14 %     19 %
Home movers
    37 %     41 %
Remortgagers
    49 %     40 %
 
               
Average earnings multiple
    2.9       2.7  
 
There has been no significant deterioration of quality over the period, with most credit quality indicators remaining similar to or better than those reported in 2004. In particular:
>   The average loan-to-value of new business has remained broadly constant in 2005 at 60%. Remortgage business is increasing as a proportion of Abbey’s new business in line with the overall market.

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Business and Financial Review
Risk Management continued
 
>   The proportion of new business written with a high loan-to-value (greater than 90%) has decreased slightly in 2005.
 
>   Income multiples have increased in line with the market, given the continued increase in house prices.
Mortgage indemnity guarantee insurance and high loan-to-value fee.
Mortgage indemnity guarantee insurance is an agreement between a lender and an insurance company to underwrite the amount of every mortgage advance that generally exceeds 75% loan-to-value.
     The mortgage indemnity guarantee insurance arrangements for loans originated prior to 31 December 2001 for Abbey are as follows:
>   For loans originated prior to 1993, the credit risk on the amount of every mortgage advance over 75% of the valuation at origination is fully insured with third party insurance companies. The expected insurance recovery is factored into the provision for lending losses.
 
>   For loans originated between 1993 and 2001, Abbey obtained almost all of its mortgage indemnity guarantee insurance from its insurance subsidiary Carfax Insurance Limited (‘Carfax’). Cover on all such policies was commuted effective from 14 October 2005.
      In the Consolidated Financial Statements, fees charged to the customer to compensate for the additional risk of mortgage advances are deferred and taken to “Net Interest Income” in the Income Statement using the Effective Interest rate (“EIR”) method. The effective interest rate is the rate that exactly discounts the estimated future cash payments or receipts over the expected life of the instrument or, when appropriate, a shorter period, to the net carrying amount of the financial asset and includes all amounts paid or received by the Group that are an integral part of the overall return.
      From 1 January 2002, Abbey ceased purchasing mortgage indemnity guarantee insurance from Carfax for the Retail Banking mortgage book. Abbey continues to charge customers high loan-to-value fees, which are credited to the Income Statement over the anticipated life of the loans. Mortgage indemnity guarantee insurance contracts between Carfax and the rest of Abbey were accounted for as intra-Abbey transactions and were eliminated on consolidation.
Mortgage arrears and repossessions. Debt Management Operations is responsible for all debt management initiatives on the secured portfolio for Retail Banking. Debt management strategies, which include powerdialling, negotiating repayment arrangements and concessions and debt counselling, can start as early as the day after a repayment is past due and will continue until legal action. Different collection strategies are applied to different segments of the portfolio subject to the perceived levels of risk for example, loan-to-value, collections score and account characteristics.
      If the agreed repayment arrangement is not maintained, legal proceedings may be taken and may result in the property being taken into possession. Abbey sells the repossessed property at market price and uses the sale proceeds, net of costs, to pay off the outstanding value of the mortgage. The stock of repossessed properties held by Abbey varies according to the number of new possessions and the buoyancy of the housing market.
      The following table sets forth information on UK residential mortgage arrears and properties in possession at 31 December 2005 and 2004 for Abbey compared to the industry average as provided by the Council of Mortgage Lenders.
                 
    Abbey     CML  
    (percentage of total mortgage loans by number)  
 
6 months to 11 months in arrears
               
31 December 2004
    0.14       0.23  
 
31 December 2005
    0.20       0.28  
 
12 months or more in arrears
               
31 December 2004
    0.02       0.10  
 
31 December 2005
    0.03       0.12  
 
Properties in possession
               
31 December 2004
    0.02       0.02  
31 December 2005
    0.04       0.04  
 
Banking and Consumer Credit. Abbey uses many systems and processes to manage the risks involved in providing unsecured personal loans and overdraft lending or in granting bank account facilities. These include the use of application and behavioural scoring systems to assist in the granting of credit facilities as well as regular monitoring of scorecard performance and the quality of the unsecured lending portfolios.
      Behavioural scoring examines the lending relationships that a customer has with Abbey and how the customer uses their bank account. This information generates a score that is used to assist in deciding the level of risk (in terms of overdraft facility amount, card facilities granted and preferred unsecured personal loan value) for each customer that Abbey is willing to accept. Individual customer scores are normally updated on a monthly basis.
      Abbey has successfully extended the use of behavioural scoring into other areas of the business, including the refinement of debt management strategies and bank account transaction processing.
cahoot. The processes used to manage credit risks are similar to those in the rest of Retail Banking.

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Business and Financial Review
Risk Management continued
Personal Financial Services banking and unsecured personal loan arrears
                 
    31 December 2005     31 December 2004  
    £m     £m  
 
Total banking and unsecured personal loan arrears (1,2)
    126       121  
Total banking and unsecured personal loan asset
    3,749       3,288  
Banking and unsecured personal loan arrears as a % of asset
    3.4 %     3.7 %
 
 
(1)   Banking arrears are defined as customers whose borrowings exceed their overdraft by over £100.
 
(2)   Unsecured personal loan and credit card arrears are defined as the balances of accounts that are three or more months in arrears (> 4 installments).
Abbey Business
Business Banking provides a limited range of products to assist with the finance requirements of businesses including overdrafts. Risk management policies are specific to and reflect the risks inherent in each product set. Approval processes for credit risk include the use of judgement, assisted by the use of probability of default and loss given default data, and the use of credit scoring. Business Banking operates within policies and authority levels approved by the Chief Risk Officer. Business Banking has a dedicated risk team, reflecting the desire for risk control to be close to the business needs and risks.
     Property Finance provides mortgages to borrowers on a wide variety of mainly non-residential property. Agreed credit assessment criteria includes, loan-to-value ratios, quality of tenants, rental income coverage for repayments with stress testing against interest rate movements. Concentration limits per borrower and business sector are also employed to ensure a balanced loan portfolio. The management of defaulting accounts and the repossession and sale of properties is handled by a dedicated function within the business.
Retail Banking estimated exposure
The following table present the amount that best represents Retail Banking’s estimated maximum exposure to credit risk at the reporting date without taking account of any collateral held or other credit enhancements:
         
    Year ended  
  31 December  
    2005  
    £m  
 
Loans and Advances to customers
    95,230  
Financial assets designated at fair value
    790  
Other
    517  
 
Third party exposures
    96,537  
 
In managing the gross exposures, Retail Banking uses the policies, procedures and types of collateral described above.
For further information on non-performing loans and repossessions refer to the relevant sections in the rest of the business and financial review, mainly pages 42 and 47.
Market risk
Market risk is the potential for loss of income or decrease in the value of net assets caused by movements in the levels and prices of financial instruments.
      Abbey accepts that market risk arises from the full range of activities undertaken as a provider of Personal Financial Services. Abbey actively manages and controls market risk by limiting the adverse impact of market movements whilst seeking to enhance earnings within clearly defined parameters. The Market Risk Manual, which is reviewed and approved by the Chief Risk Officer on an annual basis, sets the framework under which market risks are managed and controlled. Business area policies, risks limits and mandates are established within the context of the Market Risk Manual. The business areas are responsible for ensuring that they have sufficient expertise to manage the risks associated with their operations. The independent Risk function, under the direction of the Chief Risk Officer, ensures that risk-taking and risk control occur within the framework prescribed by the Manual. The Risk function also provides oversight of all risk-taking activities through a rigorous process of regular reviews.
      Abbey ensures that exposure to market risks is measured and reported on an accurate and timely basis to senior management. In addition to the regular reporting for the purposes of active risk management, the Board also receives reporting of all market risk exposures on a monthly basis where actual exposure levels are measured against limits. Senior management recognise that different risk measures are required to best reflect the risks faced in different types of business activities. In measuring exposure to market risk, Abbey uses a range of complementary measures, covering both value and income as appropriate. To facilitate understanding and communication of different risks, risk categories have been defined. Exposure to all market risk factors should be assigned to one of these categories. Abbey considers two categories:
Short-term market risk covers activities where exposures are subject to frequent change and could be closed out over a short-time horizon. Most of the exposure is generated by Abbey Financial Markets.
Structural market risk includes exposures arising as a result of the structure of portfolios of assets and liabilities, or where the liquidity of the market is such that the exposure could not be closed out over a short time horizon. The risk exposure is generated by features inherent in either a product or portfolio and normally presented over the life of the portfolio or product. Such exposures are a result of the decision to undertake specific business activities, can take a number of different forms, and are generally managed over a longer time horizon. Examples of structural market risk include the exposures arising out of the uncertainty of business volumes from the launch of fixed-rate and structured retail products, or from the provision of hedging

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against such risks, structural balance sheet exposures managed by the Asset and Liability Management Committee (“ALCO”) and unexpected customer prepayment of mortgage.
Non-trading market risks
In the Retail Banking business (including Group Infrastructure), market risk arise through the provision of retail and other banking products and services, as well as structural exposures arising in Abbey’s balance sheet. These risks impact Abbey’s current earnings and economic value. The most significant market risk in the Retail Banking business is yield curve risk, which arises from the timing mismatch in the repricing of fixed and variable rate assets, liabilities and off-balance sheet positions, as well as the investment of non-interest-bearing liabilities in interest-bearing assets. Abbey is also exposed to risks arising from features in retail products which give customers the right to alter the expected cashflows of a financial contract. This creates product launch risk, for example where the customers may not take up the expected volume of new fixed rate mortgages or other loans, and prepayment risk, for example where customers may prepay loans before their contractual maturity.
      Abbey is able to mitigate yield curve risk by repricing separately administered variable rate mortgages and variable rate retail deposits, subject to competitive pressures. However, to the extent that the volume of administered variable rate assets and liabilities are not precisely matched, the balance sheet is exposed to changes in the relationship between administered rates and market rates. In addition, the structure of customer deposit rates puts pressure on margins in a sustained low interest rate environment.
      Other non-trading market risks arise in Cater Allen Premier Bank, First National Motor Finance and the Abbey National International Group, as well as in Social Housing activities on the Abbey National Plc and Abbey National Treasury Services plc (“ANTS”) balance sheets. These risks are managed within specific mandates to ensure the risks remain immaterial. Within the ANTS Group, market risks also arise in Porterbrook Leasing Company Ltd and from capital markets funding activities.
Managing non-trading risks
Most non-trading market risks are transferred from the originating business to Abbey Financial Markets. Risks not transferred are managed within a series of market risk mandates, which set limits on the extent of market risk that may be retained. These limits are defined in terms of nominal amounts, sensitivity, earnings-at-risk or value-at-risk.
      ALCO is responsible for managing Abbey’s overall non-trading position. Natural offsets are used as far as possible to mitigate yield curve exposures but the overall balance sheet position is generally managed using interest rate swaps that are transacted through Financial Markets. The Treasurer is responsible for managing risks in accordance with ALCO’s direction. Risks are managed within limits approved either by the Chief Risk Officer or Grupo Santander’s Board Risk Committee. The key risk limits relate to yield curve risk. They are:
>   Net Interest Margin (NIM) sensitivity: the sensitivity of annual net interest margin to an instantaneous and unexpected adverse 100 basis point parallel shock to the yield curve.
 
>   Market Value of Equity (MVE) sensitivity: the potential change in net present value of interest rate sensitive positions from an instantaneous and unexpected adverse 100 basis point parallel shock to the yield curve.
These two measures provide complementary views of potential losses from interest rate movements. Market Value of Equity sensitivity provides a long-term view covering the present value of all future cashflows, whereas Net Interest Margin sensitivity considers only the impact on net interest income over the next year
The following table shows the results of these measures as at 31 December 2005:
         
    31 December  
    2005  
    £m  
 
Net interest margin sensitivity (100bps adverse parallel shock)
    (63 )
Market value of equity sensitivity (100bps adverse parallel shock)
    (298 )
 
NIM and MVE sensitivity measures were introduced as primary risk metrics during 2005. For comparative purposes, NIM sensitivity to an adverse 100bps parallel yield curve shock at 31 December 2004 was £54m.
      Within the ANTS Group, non-trading interest rate risk arises in Porterbrook. This exposure is managed by ALCO as part of the overall non-trading interest rate risk position. However, on a stand-alone basis its contribution to overall NIM sensitivity (to 100bps adverse yield curve shock) at 31 December 2005 was £1.5m.
      For illustrative purposes, a year-on-year analysis of non-trading market risks is shown below. This analysis uses risk measures employed by management prior to adopting NIM and MVE sensitivities as the primary risk measures during 2005. These numbers represent the potential change in theoretical market values of non-trading instruments, and do not represent the potential effects on income for a given time period. Non-trading instruments are generally held for collection in the form of cash over time, and are accounted for at amortised cost, with earnings accrued over the relevant life of the instruments.
      The actual, average, highest and lowest exposures shown below are all calculated to a 95% level of confidence and are based upon one-day market movements for short-term market risks, and market movements of between one day and three months (as appropriate to the management of each portfolio) for structural market risk positions. The apparent increase in structural interest rate risk reflects the revised approach taken to managing non-trading risks during 2005. Under this revised approach ALCO seeks to maximise natural hedges within the whole non-trading balance sheet prior to taking hedging decisions. This can result in individual portfolios that were included in the results below on a micro-hedged basis, appearing to be under or over hedged.

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    Exposure at 31                     Exposure for the year ended 31 December  
    December                            
    Actual exposure     Average exposure     Highest exposure     Lowest exposure  
    2005     2004     2005     2004     2005     2004     2005     2004  
    £m     £m     £m     £m     £m     £m     £m     £m  
 
Group non-trading instruments
                                                               
Short-term market risk
                                                               
Interest rate risks
    0.2       0.6       0.4       0.6       0.6       1.6       0.2        
Equity risks
                      0.1             0.2              
Foreign exchange risks
          0.1             0.1             0.2             0.1  
Structural market risk
                                                               
Interest rate risks
    73.8       8.5       48.3       12.9       79.1       16.0       15.6       8.5  
Equity risks
    0.3       0.4       0.4       0.6       0.6       1.2       0.2       0.3  
Foreign exchange risks
    1.4       2.9       1.9       3.1       2.4       3.7       1.4       2.6  
 
The above sensitivity exposures should not be aggregated, as no account has been taken of the correlation between risk classes.
Derivatives
Derivative financial instruments (‘derivatives’) are contracts or agreements whose value is derived from one or more underlying indices or asset values inherent in the contract or agreement.
      They include interest rate, cross-currency and equity related swaps, forward rate agreements, futures, caps, floors, options and swaptions (see table below). Derivatives are used for trading and hedging purposes. These terms are defined in “Accounting policies: Derivatives”.
Hedging derivatives
The main hedging derivatives are interest rate and cross-currency swaps, which are used to hedge certain of Abbey’s exposures, including fixed-rate lending and structured savings products within the Retail Banking segment and medium-term note issues, capital issuances and other capital markets funding.
      Derivative products that are combinations of more basic derivatives (such as swaps with embedded option features), or that have leverage features, may be used in circumstances where the underlying position being hedged contains the same risk features. In such cases the derivative used will be structured to match the risks of the underlying asset or liability. Exposure to market risk on such contracts is therefore economically hedged.
      The following table summarises non-trading activities undertaken by Abbey, the related risks associated with such activities and the types of non-trading derivatives used in managing such risks. Such risks may also be managed using on-balance sheet instruments as part of an integrated approach to risk management. Further information is contained in Note 15 of the Consolidated Financial Statements.

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Activity   Risk   Type of hedge
 
Management of the return on variable rate assets financed by shareholders’ funds and net non-interest bearing liabilities.
  Reduced profitability due to falls in interest rates.   Receive fixed interest rate swaps.
 
Fixed rate lending and investments.
  Sensitivity to increases in interest rates.   Pay fixed interest rate swaps.
 
Fixed rate retail and wholesale funding.
  Sensitivity to falls in interest rates.   Receive fixed interest rate swaps.
 
Equity-linked retail funding.
  Sensitivity to increases in equity market indices.   Receive equity swaps.
 
Management of other net interest income on retail activities.
  Sensitivity of income to changes in interest rates.   Interest rate swaps
 
Profits earned in foreign currency.
  Sensitivity to strengthening of sterling against other currencies.   Forward foreign exchange contracts.
 
Investment in foreign currency assets.
  Sensitivity to strengthening of sterling against other currencies.   Cross-currency and foreign exchange swaps.
 
Issuance of products with embedded equity options.
  Sensitivity to changes in underlying index and index volatility causing option exercise.   Interest rate swaps combined with equity options.
 
Lending, and issuance of, products with embedded interest rate options.
  Sensitivity to changes in underlying rate and rate volatility causing option exercise.   Interest rate swaps plus caps/floors, and other matched options.
 
Investment in, and issuance of, bonds with put/call features.
  Sensitivity to changes in rates causing option exercise.   Interest rate swaps combined with swaptions (1) and other matched options.
 
Firm commitments (e.g. asset purchases, issues arranged).
  Sensitivity to changes in rates between arranging a transaction and completion.   Hedges are arranged at the time of commitments if there is exposure to rate movements.
 
 
(1)   A swaption is an option on a swap which gives the holder the right but not the obligation to buy or sell a swap.
Liquidity risk
Retail Banking’s liquidity risk are managed by Abbey Financial Markets, refer relevant section below.
Operational risk
Managing operational risk
Operational risk is the risk of loss to Abbey, resulting from inadequate or failed internal processes, people and systems, or from external events. Risks are categorised by type, such as fraud, process failure, inadequate human resource management and damage to assets. They are assessed, not only in terms of their financial impact, but also in terms of their effect on business objectives, customers, regulatory responsibilities and Abbey’s reputation.
      Abbey operates a ‘hub and spokes’ model for the implementation of an operational risk management programme. An independent operational risk ‘hub’ function has responsibility for establishing the framework within which risk is managed and working with the business aligned ‘spoke’ groups to ensure its consistent implementation across Abbey. The framework incorporates industry practice and regulatory requirements, particularly those emanating from the Basel Committee, European Union Directives and the Financial Services Authority. The primary purpose of the framework, which is approved by the Risk Committee, is to define and articulate the Abbey-wide policy, processes, roles and responsibilities.
      The management of operational risk is the responsibility of business managers, who identify, assess and monitor risks, in line with the processes described in the framework. The operational risk function ensures that all key risks are regularly reported to the Risk Committee and Board.
      In line with Financial Services Authority’s guidance and industry practice, the company has crisis management and disaster recovery arrangements to ensure that critical business processes are maintained in the event of an unforeseen interruption. Insurance policies are also purchased to provide cover for a range of potential operational risk losses.
Risk Management in Abbey Financial Markets
Credit risk
Credit risk is the risk that counterparties will not meet their financial obligations resulting in Abbey Financial Markets (“AFM”) losing the monies lent or having to close out transactions prematurely, which may incur losses after realising collateral held. Credit risk arises by AFM making loans, investing in debt securities or other financial instruments or entering into financing transactions or derivative contracts.
Managing credit risk
The Risk Committee has established a set of risk appetite limits to cover different types of risk, including credit risk, arising in AFM. Abbey’s credit risk appetite is measured and controlled by a maximum Economic Capital value, which is defined as the maximum level of unexpected loss that Abbey is willing to sustain over a one year period. Within these limits, credit mandates and policies are approved to cover detailed industry, sector and product limits. All transactions falling within these mandates and policies are accommodated under credit limits approved by the appropriate credit authority. Specific approval is required by the Risk Committee for any transaction that falls outside the mandates. Analysis of credit exposures and credit risk trends are provided to the Financial Markets Risk Oversight Forum each month, and key issues escalated to the Risk Committee as required.

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Large Exposures (as defined by the Financial Services Authority) are reported quarterly to the Risk Committee and the Financial Services Authority.
      Credit risk on derivative instruments is calculated using the potential future mark-to-market exposure of the instruments at a 95% statistical confidence level and adding this value to the current mark-to-market value. The resulting “loan equivalent” or credit risk is then included against credit limits, along with other non-derivative exposures.
      In addition, there is a policy framework to enable the collateralisation of derivative instruments (including, swaps). If collateral is deemed necessary to reduce credit risk, the amount and nature of the collateral is determined by management’s credit evaluation of the counterparty.
Credit Risk Mitigation
(i) Netting arrangements
The Group restricts its credit risk by entering into transactions under industry standard agreements where possible these agreements facilitate netting of transactions with the counterparty. The netting arrangements do not generally result in an offset of balance sheet assets and liabilities for accounting purposes, as transactions are usually settled on a gross basis. However, there is scope for the credit risk associated with favourable contracts to be reduced by netting arrangements embodied in the agreements to the extent that if an event of default occurs, all amounts with the counterparty under the specific agreement can be terminated and settled on a net basis. Derivatives, repurchase and reverse repurchase transactions, stock borrowing/ lending transactions and securities financing transactions are governed by industry standard agreements that facilitate netting.
(ii) Collateralisation
The Group also mitigates its credit risk to counterparties with which it transacts significant amounts of derivatives through collateralisation, using industry standard collateral agreements. Under these agreements, net derivative exposures with counterparties are collateralised with cash, securities or equities. Also exposures and collateral are revalued daily and collateral is adjusted accordingly to reflect deficits/ surpluses.
Using credit risk methodologies explained above, exposure stands at £37,899m. The below table breaks down the net exposure down by credit rating of the issuer or counterparty:
         
    Year ended  
    31 December  
    2005  
    £m  
 
AAA
    3,961  
AA
    22,568  
A
    8,774  
BBB
    2,437  
BB
    146  
B
    13  
 
Total
    37,899  
 
In the securities financing businesses, credit risk arises on both assets and liabilities and on both on and off balance sheet transactions. Consequently, the above credit risk exposure arises not only from the on balance sheet assets, the gross value of which is detailed below, but also from a portfolio of securities financing trades classified as liabilities and off balance sheet assets.
      The following table presents the amount that best represents Abbey Financial Markets’ estimated maximum exposure to counterparties at the reporting date without taking account of any collateral held or other credit enhancements:
         
    Year ended  
    31 December  
    2005  
    £m  
 
Trading assets
    34,671  
Purchase and resell agreements
    23,578  
Derivatives
    12,212  
Other
    4,366  
 
Third party exposures
    74,827  
 
Market risk
As discussed above in the Retail Banking section, market risk-taking is performed within the framework established by the Market Risk Manual.
     A major portion of the market risk arises from exposures to changes in the levels of interest rates, equity markets and credit spreads. Interest rate exposure is generated from funding and trading activities. Exposure to equity markets is generated by the creation and risk management of structured products by Abbey Financial Markets for the Personal Financial Services market and trading activities. Credit spread exposure arises from credit risk management and trading activities within Abbey Financial Markets.

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Managing market risk
The primary risk exposures for Abbey Financial Markets are interest rate, equity, credit spread and residual exposure to property indices. Equity risks are managed via equity stock, futures and structured equity derivatives. Credit-spread risks are managed via credit derivatives (credit default swaps, total return swaps). Property Index risk is managed via insurance contracts and property derivatives.
      Abbey Financial Markets operates within a market risk framework designed to ensure that it has the capability to manage risk in a well-controlled manner. A comprehensive set of policies, procedures and processes have been developed and implemented to identify, measure, report, monitor and control risk across Abbey Financial Markets.
      Market Risk from non-trading activities is discussed in the Retail Banking section above.
      For Trading activities the standardised risk measure adopted is Value at Risk calculated at a 95% confidence level over a one-day time horizon. On a daily basis, market risk factor sensitivities, Value at Risk measures and stress tests are produced, reported and monitored against limits for each major activity and at the aggregate Abbey Financial Markets level. These limits are used to align risk appetite with the business’s risk-taking activities and are reviewed on a regular basis. Early identification and measurement of risks are important elements of the risk management processes. Measurement of risks can involve the use of complex quantitative methods and mathematical principles to model and predict the changes in instruments and portfolio valuation. These methods are essential tools to understand the risk exposures.
Trading Activities
Trading activities are undertaken by Abbey Financial Markets only. They are managed on a continuous basis, and are marked to market on a daily basis.
      Trading risk exposure arises only in the Abbey National Treasury Services group. The majority of trading risk exposure arises in Abbey National Treasury Services plc. Trading risk exposure arises in Cater Allen International Limited and Abbey National Securities Inc, where risk taking is controlled by the provisions in Risk Mandates.
      The following table shows the value at risk-based consolidated exposures for the major risk classes as at 31 December 2005, together with the highest, lowest and average exposures for the year. Exposures within each risk class reflect a range of exposures associated with movements in that financial market. For example, interest rate risks include the impact of absolute rate movements, movements between interest rate bases and movements in implied volatility on interest rate options. The range of possible statistical modelling techniques and assumptions mean these measures are not precise indicators of expected future losses, but are estimates of the potential change in the value of the portfolio over a specified time horizon and within a given confidence interval.
      From time to time, losses may exceed the amounts stated where the movements in market rates fall outside the statistical confidence interval used in the calculation of the value at risk analysis. The 95% confidence interval, used as a standard across Abbey, means that the theoretical loss at a risk factor level is likely to be exceeded in one period in twenty. Abbey address this risk by monitoring stress-testing measures across the different business areas. For trading instruments the actual, average, highest and lowest value at risk exposures shown below are all calculated to a 95% level of confidence using a simulation of actual one day market movements over a one year period. The effect of historic correlations between risk factors is additionally shown below. The use of a one-day time horizon for all risks associated with trading instruments reflects the horizon over which market movements will affect the measured profit and loss of these activities.
      The numbers below represent the potential change in market values of trading instruments. Since trading instruments are recorded at market value, these numbers also represent the potential effect on income. Trading instruments are held only in Abbey Financial Markets.
                                                                 
    Exposure at 31                     Exposure for the year ended 31  
    December                         December  
    Actual exposure     Average exposure     Highest exposure     Lowest exposure  
    2005     2004     2005     2004     2005     2004       2005     2004  
    £m     £m     £m     £m     £m     £m       £m     £m  
 
Group trading instruments
                                                               
Interest rate risks (1)
    3.4       4.8       4.1       4.3       5.2       7.1         3.4     2.8  
Equity risks
    2.7       5.0       3.5       3.3       5.2       5.6         2.0     1.3  
Spread risk
    2.1       1.5       1.7       1.8       2.1       2.4         1.4     1.1  
Other risks (2)
    0.1       0.3       0.1       0.2       0.4       0.4              
 
Correlation offsets (3)
    (1.6 )     (2.2 )     (1.8 )     (1.8 )                                
 
Total correlated one-day Value at Risk
    6.7       9.4       7.6       7.8       9.9       10.5         5.6     4.8  
 
 
(1)   Interest rate risks include property index risk.
 
(2)   Other risks include foreign exchange risk.
 
(3)   The highest and lowest exposure figures reported for each risk type did not necessarily occur on the same day as the highest and lowest total correlated one-day Value-at-Risk.