20-F 1 dp02645_20f.htm

FORM 20-F

(Mark one) o REGISTRATION STATEMENT PURSUANT TO SECTION 12(b) or (g) OF THE SECURITIES EXCHANGE ACT OF 1934  
         
OR x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934  
         
OR o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934  
         
OR o SHELL COMPANY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934  
     
  Date of event requiring shell company report ______________________  
     
For the fiscal year ended                                                                                     31 December 2005  
   
 

Commission file number                                                                       1 – 9266    
 
 

NATIONAL WESTMINSTER BANK Plc
ENGLAND
135 Bishopsgate, London, EC2M 3UR, England

Securities registered or to be registered pursuant to Section 12 (b) of the Act.
    Title of each class   Name of each exchange on which registered
-   American Depositary Shares, each representing one Non-Cumulative    
    Dollar Preference Share of $25 each, Series B   New York Stock Exchange
-   American Depositary Shares, each representing one Non-Cumulative    
    Dollar Preference Share of $25 each, Series C   New York Stock Exchange
-   Exchangeable Capital Securities, Series A*   New York Stock Exchange
    *redeemed on 16 January 2006    

Securities registered or to be registered pursuant to Section 12(g) of the Act.
None

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

Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock as of December 31, 2005, the close of the period covered by the annual report.

  - £1 Ordinary shares 1,678,176,558  
  - Non-Cumulative Dollar Preference Shares of $25 each, Series B 10,000,000  
  - Non-Cumulative Dollar Preference Shares of $25 each, Series C 12,000,000  
  - 9% Non-Cumulative Preference Shares of £1 each, Series A 140,000,000  


Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
  o   YES   x NO
             
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.
  o   YES   x NO
             
Note: Checking the box above will not relieve any registrant required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 from their obligations under those Sections.
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

 

x   YES   o NO
             
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           x
             
Indicate by check mark which financial statement item the registrant has elected to follow.
  o   Item 17   x Item 18
             
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).
  o   Yes   x No
             

(APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PAST FIVE YEARS)

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court.

  o   Yes   o No
             

As a wholly-owned subsidiary of The Royal Bank of Scotland plc, which in turn is a wholly-owned direct subsidiary of The Royal Bank of Scotland Group plc, a public company with limited liability incorporated in Great Britain and which has its registered office in Scotland, National Westminster Bank Plc meets the conditions set forth in General Instruction (I)(1)(a) and (b) of Form 10-K, as applied to reports on Form 20-F, and is therefore filing its Form 20-F with a reduced disclosure format.

1






NATIONAL WESTMINSTER BANK Plc

ANNUAL REPORT ON FORM 20-F
FOR THE YEAR ENDED 31 DECEMBER 2005
CONTENTS

Item   Item Caption   Page
     
  Presentation of Information   4
PART I  
1   Identity of Directors, Senior Management and Advisers   *
2   Offer Statistics and Expected Timetable   *
3   Key Information   6
       Selected financial data   *
       Capitalisation and indebtedness   *
       Reasons for the offer and use of proceeds   *
       Risk factors   9
4   Information on the Bank   10
       History and development of the Bank   10
       Business overview   10
       Organisational structure   10
       Property, plant and equipment   10
5   Operating and Financial Review and Prospects   11
       Operating results   11
       Liquidity and capital resources   37
       Research and development, patents, licences etc   *
       Trend information   *
       Off balance sheet arrangements   *
       Contractual obligations   *
6   Directors, Senior Management and Employees   38
       Directors and senior management   *
       Compensation   *
       Board practices   38
       Employees   *
       Share ownership   39
7   Major Shareholders and Related Party Transactions   *
       Major shareholders   *
       Related party transactions   *
       Interests of experts and counsel   *
8   Financial Information   41
       Consolidated statements and other financial information   41
       Significant changes   41
   
*      Not required because this Form 20-F is filed as an Annual Report, is not applicable to National Westminster Bank Plc, is omitted on the basis of General Instruction I to Form 10-K or is otherwise not included herein.

2






9     The Offer and Listing   42
       Offer and listing details   42
       Plan of distribution   *
       Markets   43
       Selling shareholders   *
       Dilution   *
       Expenses of the issue   *
10     Additional Information   44
       Share capital   *
       Memorandum and articles of association   44
       Material contracts   44
       Exchange controls   44
       Taxation   44
       Dividends and paying agents   *
       Statement of experts   *
       Documents on display   *
       Subsidiary information   *
11     Quantitative and Qualitative Disclosure about Market Risk   49
12     Description of Securities other than Equity Securities   *
PART II  
13     Defaults, Dividend Arrearages and Delinquencies   *
14     Material Modifications to the Rights of Security Holders and Use of Proceeds   *
15     Controls and Procedures   50
16     Reserved   *
16     A     Audit Committee financial expert   *
    B     Code of ethics   *
    C     Principal Accountant Fees and Services   70
    D     Exemptions from the Listing Standards for Audit Committee   *
      E     Purchases of Equity Securities by the Issuer and Affiliated Purchasers   *
PART III  
17     Financial Statements   *
18     Financial Statements   51
19     Exhibits   136  
    Signatures   137  

* Not required because this Form 20-F is filed as an Annual Report, is not applicable to National Westminster Bank Plc, is omitted on the basis of General Instruction I to Form 10-K or is otherwise not included herein.
 

3






PRESENTATION OF INFORMATION

In this report, the term ‘Bank’ or ‘Company’ means National Westminster Bank Plc and ‘NatWest Group’ means the Bank and its subsidiary and associated undertakings.

National Westminster Bank Plc is a wholly-owned direct subsidiary of The Royal Bank of Scotland plc, which in turn is a wholly-owned direct subsidiary of The Royal Bank of Scotland Group plc. For the purpose of this report, the term ‘RBS Group’ means The Royal Bank of Scotland Group plc and its subsidiary and associated undertakings, including the Bank, and the term the ‘Royal Bank’ refers to The Royal Bank of Scotland plc.

The Bank publishes its financial statements in pounds sterling (“£” or “sterling”). The abbreviations ‘£m’ and ‘£bn’ represent millions and thousands of millions of pounds sterling, respectively, and references to ‘pence’ represent pence in the United Kingdom (“UK”). Reference to ‘dollars’ or ‘$’ are to United States of America (“US”) dollars. The abbreviations ‘$m’ and ‘$bn’ represent millions and thousands of millions of dollars, respectively, and references to ‘cents’ represent cents in the US. The abbreviation ‘€’ represents the ‘euro’, the European single currency and the abbreviations ‘€m’ and ‘€bn’ represent millions and thousands of millions of euros, respectively.

Certain information in this report is presented separately for domestic and foreign activities. Domestic activities primarily consist of UK domestic transactions of NatWest Group. Foreign activities comprise NatWest Group’s transactions conducted through those offices in the UK specifically organised to service international banking transactions and transactions conducted through offices outside the UK.

The geographic analysis in the average balance sheet and interest rates, changes in net interest income and average interest rates, yields, spreads and margins in this report have been compiled on the basis of location of office – UK and Overseas. Management believes that presentation on this basis provides more useful information on the yields, spreads and margins of NatWest Group’s activities than would be provided by presentation on the basis of the domestic and foreign activities analysis used elsewhere in this report as it more closely reflects the basis on which NatWest Group is managed. ‘UK’ in this context includes domestic transactions and transactions conducted through the offices in the UK which service international banking transactions.

NatWest Group distinguishes its trading from non-trading activities by determining whether a business unit’s principal activity is trading or non-trading and then attributing all of that unit’s activities to one portfolio or the other. Although this method may result in some non-trading activity being classified as trading, and vice versa, NatWest Group believes that any resulting misclassification is not material.

International Financial Reporting Standards

As required by the Companies Act 1985 and Article 4 of the European Union IAS Regulation, the consolidated financial statements of NatWest Group have been prepared, for the first time, in accordance with International Financial Reporting Standards adopted by the International Accounting Standards Board (IASB) and interpretations issued by the International Financial Reporting Interpretations Committee of the IASB (together “IFRS”) as endorsed by the European Union. NatWest Group, however, has taken advantage of the option in IFRS 1 ‘First-time Adoption of International Financial Reporting Standards’ to implement IAS 39 ‘Financial Instruments: Recognition and Measurement’ (IAS 39) and IAS 32 ‘Financial Instruments: Disclosure and Presentation’ (IAS 32) from 1 January 2005 without restating its 2004 income statement and balance sheet. The implementation of IAS 32 and IAS 39 on 1 January 2005 had a significant effect on NatWest Group’s balance sheet. To facilitate comparison, a balance sheet as at 1 January 2005 and a reconciliation of shareholders’ funds as at 31 December 2004 are shown on pages 126 and 128 respectively. For a further discussion of NatWest Group’s adoption of IFRS, see ‘Accounting Policies – Adoption of International Financial Reporting Standards’ on page 54.

NatWest Group’s 2004 financial statements were prepared in accordance with then current UK generally accepted accounting principles (“UK GAAP” or “previous GAAP”) comprising standards issued by the UK Accounting Standards Board, pronouncements of the Urgent Issues Task Force, relevant Statements of Recommended Accounting Practice and provisions of the Companies Act 1985.

NatWest Group also presents information under generally accepted accounting principles in the US (“US GAAP”).

4






Forward-looking statements

Certain sections in this document contain ‘forward-looking statements’ as that term is defined in the United States Private Securities Litigation Reform Act of 1995, such as statements that include the words ‘expect’, ‘estimate’, ‘project’, ‘anticipate’, ‘believes’, ‘should’, ‘intend’, ‘plan’, ‘probability’, ‘risk’, ‘Value-at-Risk (“VaR”)’, ‘target’, ‘goal’, ‘objective’, ‘will’, ‘endeavour’, ‘outlook’, ‘optimistic’, ‘prospects’ and similar expressions or variations on such expressions.

In particular, this document includes forward-looking statements relating, but not limited, to NatWest Group’s potential exposures to various types of market risks, such as interest rate risk, foreign exchange rate risk and commodity and equity price risk. Such statements are subject to risks and uncertainties. For example, certain of the market risk disclosures are dependent on choices about key model characteristics and assumptions and are subject to various limitations. By their nature, certain of the market risk disclosures are only estimates and, as a result, actual future gains and losses could differ materially from those that have been estimated.

Other factors that could cause actual results to differ materially from those estimated by the forward-looking statements contained in this document include, but are not limited to: general economic conditions in the UK and in other countries in which NatWest Group has significant business activities or investments, including the United States; the monetary and interest rate policies of the Bank of England, the Board of Governors of the Federal Reserve System and other G-7 central banks; inflation; deflation; unanticipated fluctuations in interest rates, foreign currency exchange rates, commodity prices and equity prices; changes in UK and foreign laws, regulations and taxes; changes in competition and pricing environments; natural and other disasters; the inability to hedge certain risks economically; the adequacy of loss reserves; acquisitions or restructurings; technological changes; changes in consumer spending and saving habits; and the success of NatWest Group in managing the risks involved in the foregoing.

The forward-looking statements contained in this report speak only as of the date of this report, and NatWest Group does not undertake to update any forward-looking statement to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

For a further discussion on certain risks faced by NatWest Group, see Risk Factors on page 9.

5






ITEM 3. KEY INFORMATION

The Company has omitted portions of this item on the basis of General Instruction I(2)(a) to Form 10-K.

As discussed on page 4, the consolidated financial statements of NatWest Group have been prepared in accordance with International Financial Reporting Standards. NatWest Group, however, has taken advantage of the option in IFRS 1 to implement IAS 32 and IAS 39 from 1 January 2005 without restating its 2004 income statement and balance sheet. The implementation of IAS 32 and IAS 39 on 1 January 2005 had a significant effect on NatWest Group's balance sheet. Therefore the income statements for 2005 and 2004 and the balance sheets at 31 December 2005 and 31 December 2004 discussed in the Operating and financial review are not directly comparable.

Financial data based upon IFRS:   2005      2004             
   
   
           
Return on average total assets (1)    0.99 %   1.21 %            
                         
Return on average ordinary shareholders' equity (2)    29.6 %   30.7 %            
                         
Average shareholders’ equity as a percentage of average
   total assets
  3.3 %   4.2 %            
Risk asset ratio                      
     Tier 1   10.1 %   n/a            
     Total   14.1 %   n/a            
                       
Ratio of earnings to combined fixed charges and
   preference share dividends(3)
     Including interest on deposits
     Excluding interest on deposits
  1.84
4.02
    2.11
5.62
           
                       
Ratio of earnings to fixed charges only(3)
     Including interest on deposits
     Excluding interest on deposits
  1.84
4.02
    2.14
5.92
           
                       
Financial data based upon US GAAP:   2005     2004   2003   2002   2001
   
   
   
   
   
 
Return on average total assets (1)   0.90 %   1.02 %   1.18 %   1.18 %   1.11 %
Return on average ordinary shareholders' equity (2)   22.3 %   23.7 %   25.7 %   27.5 %   30.5 %
Average shareholders' equity as a percentage of average              
 total assets   4.2 %   4.5 %   4.9 %   4.6 %   3.9 %
Ratio of earnings to combined fixed charges and            
 preference share dividends (3)            
     Including interest on deposits   1.74     1.99   2.50   2.28   1.73
     Excluding interest on deposits   3.66     5.19   6.82   4.48   5.12
Ratio of earnings to fixed charges only (3)            
     Including interest on deposits   1.75     2.01   2.55   2.32   1.75
     Excluding interest on deposits   3.78     5.48   7.37   4.69   5.42

6






Financial data based upon UK GAAP:   2004   2003   2002   2001
   
   
   
   
 
Return on average total assets (1)   1.30 %   1.21 %   1.02 %   0.95 %
Return on average ordinary shareholders' equity (2)   28.8 %   25.6 %   21.9 %   24.3 %
Average shareholders' equity as a percentage of average          
   total assets   4.8 %   5.0 %   5.0 %   4.2 %
Risk asset ratio        
     Tier 1   8.0 %   9.2 %   8.9 %   7.9 %
     Total   11.6 %   13.3 %   13.0 %   12.3 %
Ratio of earnings to combined fixed charges and        
   preference share dividends (3)        
     Including interest on deposits   2.20   2.52   2.04   1.58
     Excluding interest on deposits   6.10   6.92   3.82   4.30
Ratio of earnings to fixed charges only (3)        
     Including interest on deposits   2.23   2.57   2.07   1.60
     Excluding interest on deposits   6.44   7.48   4.00   4.56
 
 
 
 
 

Notes:
(1) Return on average total assets represents profit attributable to ordinary shareholders as a percentage of average total assets.
(2) Return on average ordinary shareholders' equity represents profit attributable to ordinary shareholders expressed as a percentage of average ordinary shareholders' equity.
(3) For this purpose, earnings consist of income before taxes and minority interests, plus fixed charges less the unremitted income of associated undertakings (share of profits less dividends received). Fixed charges consist of total interest expense, including or excluding interest on deposits and debt securities in issue, as appropriate, and the proportion of rental expense deemed representative of the interest factor (one third of total rental expenses).
 

7






Exchange rates

Except as stated, the following tables show, for the dates or periods indicated, the Noon Buying Rate in New York for cable transfers in sterling as certified for customs purposes by the Federal Reserve Bank of New York (the ‘Noon Buying Rate’):

US dollars per £1   May   April   March   February   January   December
  2006   2006   2006    2006   2006   2005
Noon buying rate  
 
 
 
 
 
High   1.8911   1.8220   1.7567   1.7807   1.7885   1.7740
Low   1.8286   1.7389   1.7256   1.7343   1.7404   1.7188

    31 December
US dollars per £1  








  2005   2004   2003   2002   2001
Noon buying rate  
 
 
 
 
Year end rate   1.7188   1.9160   1.7842   1.6095   1.4543
Average rate for the year (1)   1.8147   1.8356   1.6450   1.5043   1.4396
Consolidation rate (2)          
Year end rate   1.7214   1.9346   1.7857   1.6128   1.4498
Average rate for the year   1.8198   1.8325   1.6354   1.5032   1.4401

Notes:
(1) The average of the Noon Buying Rates on the last business day of each month during the year.
(2) The rates used by NatWest Group for translating dollars into sterling in the preparation of its consolidated financial statements.
(3) On 20 June 2006, the Noon Buying Rate was £1.00 = $1.8399.
 

8






RISK FACTORS

Set out below are certain risk factors which could affect NatWest Group’s future results and cause them to be materially different from expected results. NatWest Group’s results are also affected by competition and other factors. The factors discussed in this report should not be regarded as a complete and comprehensive statement of all potential risks and uncertainties.

The financial performance of NatWest Group is affected by borrower credit quality and general economic conditions, in particular in the UK. Risks arising from changes in credit quality and the recoverability of loans and amounts due from counterparties are inherent in a wide range of NatWest Group’s businesses. Adverse changes in the credit quality of NatWest Group’s borrowers and counterparties or a general deterioration in UK, or global economic conditions, or arising from systemic risks in the financial systems, could affect the recoverability and value of NatWest Group’s assets and require an increase in the provision for impairment losses and other provisions.

Changes in interest rates, foreign exchange rates, equity prices and other market factors affect NatWest Group’s business. The most significant market risks NatWest Group faces are interest rate, foreign exchange and bond and equity price risks. Changes in interest rate levels, yield curves and spreads may affect the interest rate margin realised between lending and borrowing costs. Changes in currency rates, particularly in the sterling-dollar and sterling-euro exchange rates, affect the value of assets and liabilities denominated in foreign currencies and affect earnings reported by NatWest Group’s non-UK subsidiaries, mainly RBS Greenwich Capital and Ulster Bank, and may affect income from foreign exchange dealing. The performance of financial markets may cause changes in the value of NatWest Group’s investment and trading portfolios. NatWest Group has implemented risk management methods to mitigate and control these and other market risks to which NatWest Group is exposed. However, it is difficult to predict with accuracy changes in economic or market conditions and to anticipate the effects that such changes could have on NatWest Group’s financial performance and business operations.

Operational risks are inherent in NatWest Group’s business. NatWest Group’s businesses are dependent on the ability to process a very large number of transactions efficiently and accurately. Operational losses can result from fraud, errors by employees, failure to document transactions properly or to obtain proper authorisation, failure to comply with regulatory requirements and Conduct of Business rules, equipment failures, natural disasters or the failure of external systems, for example, NatWest Group’s suppliers or counterparties. Although NatWest Group has implemented risk controls and loss mitigation actions, and substantial resources are devoted to developing efficient procedures and to staff training, it is only possible to be reasonably, but not absolutely, certain that such procedures will be effective in controlling each of the operational risks faced by NatWest Group.

Each of NatWest Group’s businesses is subject to substantial regulation and regulatory oversight. Any significant regulatory developments could have an effect on how NatWest Group conducts its business and on NatWest Group’s results of operations. NatWest Group is subject to financial services laws, regulations, administrative actions and policies in each location in which NatWest Group operates. This supervision and regulation, in particular in the UK, if changed could materially affect NatWest Group’s business, the products and services offered or the value of assets.

Future growth in NatWest Group’s earnings and shareholder value depends on strategic decisions regarding organic growth and potential acquisitions. NatWest Group devotes substantial management and planning resources to the development of strategic plans for organic growth and identification of possible acquisitions, supported by substantial expenditure to generate growth in customer business. If these strategic plans do not meet with success, NatWest Group’s earnings could grow more slowly or decline.

The risk of litigation is inherent in NatWest Group’s operations In the ordinary course of NatWest Group’s business, legal actions, claims against and by NatWest Group and arbitrations arise; the outcome of such legal proceedings could affect the financial performance of NatWest Group.

NatWest Group is exposed to the risk of changes in tax legislation and its interpretation and to increases in the rate of corporate and other taxes in the jurisdictions in which in operates NatWest Group’s activities are subject to tax at various rates around the world computed in accordance with local legislation and practice. Action by governments to increase tax rates or to impose additional taxes would reduce the profitability of NatWest Group. Revisions to tax legislation or to its interpretation might also affect NatWest Group's results in the future.

9






ITEM 4. INFORMATION ON THE BANK

The Company has omitted portions of this item on the basis of General Instructions I(2)(a) and (d) to Form 10-K.

HISTORY AND DEVELOPMENT OF THE BANK

National Westminster Bank Plc is a public limited company registered in England and Wales No. 929027. The registered office and principal office of the Bank is 135 Bishopsgate, London, EC2M 3UR (telephone 020-7375-5000). The Bank's website address is www.natwest.com.

NatWest Group is a diversified financial services group engaged in a wide range of banking, financial and finance-related activities in the UK and internationally. NatWest Group's operations are principally centred in the UK.

National Westminster Bank Plc is a major UK clearing bank. The Bank was incorporated in England in 1968 and was formed from the merger of National Provincial Bank Limited and Westminster Bank Limited, which had themselves been formed through a series of mergers involving banks with origins dating back to the 17th century.

National Westminster Bank Plc was acquired by The Royal Bank of Scotland Group plc on 6 March 2000 and was its wholly-owned direct subsidiary until 31 January 2003 when ownership of the entire issued ordinary share capital was transferred to the Royal Bank.

BUSINESS OVERVIEW

Since being acquired by The Royal Bank of Scotland Group plc in 2000, NatWest Group has operated and been managed as a member of the overall RBS Group. As part of the integration of NatWest Group to the RBS Group a number of businesses and assets have been transferred between NatWest Group and the Royal Bank to bring together similar operations and functions. In the RBS Group, all new large corporate relationships are domiciled in the Royal Bank. In the retail banking division in the UK, RBS Group has retained and promotes both the NatWest and the Royal Bank brands, which compete with each other.

A central Manufacturing function provides services to entities in the RBS Group. Allocations of manufacturing costs are made on appropriate bases to individual legal entities, including NatWest.

At 31 December 2005, NatWest Group had total assets of £260.6 billion and shareholders’ equity of £9.4 billion.

The RBS Group operates on an integrated basis through a divisional structure. The divisions relevant to NatWest Group are Corporate Markets (formerly Corporate Banking & Financial Markets), Retail Markets (comprising Retail Banking, Retail Direct and Wealth Management), Ulster Bank and Manufacturing.

ORGANISATIONAL STRUCTURE

The company is a wholly-owned subsidiary of the Royal Bank. The ultimate holding company is The Royal Bank of Scotland Group plc, which is incorporated in Great Britain and has its registered office at 36 St Andrew Square, Edinburgh EH2 2YB. The principal subsidiary undertakings of NatWest Group and their activities are detailed in Note 14 to the Consolidated Financial Statements.

The ownership of National Westminster Home Loans Limited, a home mortgage finance business, was transferred to the Royal Bank on 31 December 2005.

DESCRIPTION OF PROPERTY AND EQUIPMENT

NatWest Group operates from a number of locations worldwide, principally in the UK. At 31 December 2005, NatWest had 1,631 retail branches in the UK. Ulster Bank including First Active had a network of 272 branches in Northern Ireland and the Republic of Ireland. A substantial majority of the UK branches are owned by NatWest and its subsidiaries or are held under leases with unexpired terms of over 50 years. NatWest Group’s properties include its principal office in London at 135 Bishopsgate.

Total capital expenditure on premises, computers and other equipment for the year ended 31 December 2005 was £270 million (2004 – £226 million).

10






ITEM 5. OPERATING AND FINANCIAL REVIEW AND PROSPECTS

The Company has omitted portions of this item on the basis of General Instruction I(2)(a) to Form 10-K. For a discussion of critical accounting policies that are considered by the directors to be the most important to the portrayal of its financial condition, see pages 54 to 62. In addition, for a discussion of accounting developments, see page 62.

OPERATING RESULTS

As discussed on page 4, the consolidated financial statements of NatWest Group have been prepared in accordance with International Financial Reporting Standards. NatWest Group has taken advantage of the option in IFRS 1 to implement IAS 32 and IAS 39 from 1 January 2005 without restating its 2004 income statement and balance sheet. The implementation of IAS 32 and IAS 39 on 1 January 2005 had a significant effect on NatWest Group's balance sheet. Therefore the income statements for 2005 and 2004 and the balance sheets at 31 December 2005 and 31 December 2004 are not directly comparable.

Overview of results

The following table summarises NatWest Group's results for each of the two years ended 31 December 2005:

Consolidated income statement   Discontinued*     Continuing     Discontinued*   Continuing
  2005   2005   2004   2004


 

 

 

  £m   £m   £m   £m
Net interest income   212   4,249   265   4,118











Fees and commissions receivable   43   3,663   51   3,384
Fees and commissions payable   (34 )   (926 )   (38 )   (845 )
Income from trading activities   -   808   -   887
Other operating income   -   635   -   201











Non-interest income   9   4,180   13   3,627











Total income   221   8,429   278   7,745











Administrative expenses        
   - staff costs**   -   1,477   -   1,326
   - premises and equipment**   -   114   -   197
   - other**   70   2,440   52   2,131
Depreciation and amortisation   -   382   1   461











Operating expenses   70   4,413   53   4,115











Operating profit before impairment losses   151   4,016   225   3,630
Impairment losses   4   752   (5 )   630











Operating profit before tax   147   3,264   230   3,000
Tax   44   904   69   797











Operating profit after tax   103   2,360   161   2,203


       
       
Discontinued operations     103     161




Profit for the year     2,463     2,364




* NatWest Group transferred its home mortgage finance business, National Westminster Home Loans Limited, to the Royal Bank on 31 December 2005 at neither a profit nor a loss.

**Includes integration expenditure.

2005 compared with 2004

Profit

The implementation of IAS 32 and IAS 39 on 1 January 2005 affected the timing of recognition of income and costs, classification of debt and equity and impairment provisions in 2005.

Operating profit before tax was up 6%, from £3,230 million to £3,411 million. Good underlying organic income growth was partially offset by the adverse impact on income of implementing IAS 32 and IAS 39 on 1 January 2005.

11






Total income

Total income was up 8% or £627 million to £8,650 million. This reflected growth across the NatWest Group and also included net gain of £332 million on sale of strategic investments. The effect of implementing the requirements of IAS 32 and IAS 39 on 1 January 2005 was to reduce total income. Under IFRS, certain lending fees are deferred over the life of the financial asset and interest is recognised on a constant yield basis. The implementation of IAS 32 also resulted in NatWest Group’s preference shares being reclassified as debt; accordingly the interest thereon is included in interest payable.

Net interest income increased by 2% to £4,461 million. Average loans and advances to customers and average customer deposits grew by 19% and 14% respectively. The implementation of IAS 32 and IAS 39 on 1 January 2005 led to a reduction in net interest income. Interest income is recognised on a constant yield basis under IFRS; under UK GAAP interest was recognised on an accrual basis. Interest payable also increased due to the reclassification of NatWest Group’s preference shares.

Non-interest income increased by 15% to £4,189 million with good growth in banking fee income and financial markets income. The effect of implementing the requirements of IAS 39 on 1 January 2005 was to reduce non-interest income, principally due to the deferral of certain lending fees.

Operating expenses

Operating expenses rose by 8% to £4,483 million, partly due to the implementation of IAS 39 on 1 January 2005.

Integration costs

Integration costs were £163 million compared with £297 million in 2004. Included are software costs relating to the integration of NatWest with RBS Group which were written-off as incurred under UK GAAP but on transition to IFRS were capitalised and amortised. All such software is now fully amortised.

Impairment losses

Impairment losses were £756 million compared with £625 million in 2004. Overall credit quality remained strong in 2005. The effect of implementing the requirements of IAS 39 on 1 January 2005 was to increase loan impairment losses.

Risk elements in lending and potential problem loans represented 2.19% of gross loans and advances to customers excluding reverse repos at 31 December 2005 (31 December 2004 – 2.61%).

Provision coverage of risk elements in lending and potential problem loans was 63% compared with 64% at 31 December 2004.

Balance sheet

Total assets of £260.6 billion at 31 December 2005 were up £63.4 billion, 32%, compared with 31 December 2004, with £35.8 billion of this increase arising from grossing-up following the implementation of IAS 32 and IAS 39 on 1 January 2005, and the balance reflecting business growth.

Loans and advances to customers (excluding £26.9 billion relating to NatWest Home Loans which was sold on 31 December 2005) were up 53%, £55.2 billion to £159.9 billion and loans and advances to banks increased by £26.0 billion to £56.0 billion, reflecting the implementation of IAS 32 and IAS 39 on 1 January 2005 and business growth.

Customer accounts were up £31.8 billion, 25% to £157.9 billion with £20.0 billion arising from the implementation of IAS 32 and IAS 39, largely reflecting the grossing up of previously netted deposits. Excluding this and repos, which decreased £3.7 billion, 15% to £20.7 billion, deposits rose by £15.5 billion, 13%, to £137.3 billion with good growth in all divisions.

Capital ratios at 31 December 2005 were 10.1% (Tier 1) and 14.1% (Total).

12






Net interest income    
  2005   2004
 
 
  £m   £m
         
Interest receivable   8,492   7,180
Interest payable   (4,031 )   (2,797 )




 
Net interest income   4,461   4,383




 
         
    %   %
Gross yield on interest-earning assets of banking business   5.73   5.66
Cost of interest-bearing liabilities of banking business   (3.22 )   (2.72 )




 
Interest spread of banking business   2.51   2.94
Benefit from interest-free funds   0.50   0.52




 
Net interest margin of banking business   3.01   3.46




 

The following table gives average interest rates, yields and margins.

  2005     2004  
 
   
 
  %     %  
Yields, spreads and margins of the banking business:        
Gross yield (1)      
   Group   5.73     5.66  
   UK   6.11     5.97  
   Overseas   4.55     4.43  
Interest spread (2)      
   Group   2.51     2.94  
   UK   2.89     3.21  
   Overseas   1.32     1.89  
Net interest margin (3)      
   Group   3.01     3.46  
   UK   3.32     3.65  
   Overseas   2.03     2.69  
The Bank’s base rate   4.65     4.38  
London inter-bank three month offered rate:        
   Sterling   4.76     4.64  
   Eurodollar   3.56     1.62  
   Euro   2.18     2.11  

Notes:
(1) Gross yield is the interest rate earned on average interest-earning assets of the banking business.
(2) Interest spread is the difference between the gross yield and the interest rate paid on average interest-bearing liabilities of the banking business.
(3) Net interest margin is net interest income of the banking business as a percentage of average interest-earning assets of the banking business.
 

13






Average balance sheets and interest rates

The following table shows average balances and interest rates for each of the past two years.

        2005             2004      
   






 







 
    Average
balance
  Interest   Average
rate
    Average
balance
  Interest   Average
rate
 
   






 







 
ASSETS   £m   £m   %     £m   £m   %  
Loans and advances to banks              
     UK   18,461   762   4.13     17,652   733   4.15  
     Overseas   7,127   234   3.28     5,743   170   2.96  
Loans and advances to customers (1)              
     UK   93,135   6,066   6.51     82,335   5,273   6.40  
     Overseas   26,977   1,332   4.94     18,770   922   4.91  
Debt securities              
     UK   769   35   4.55     1,242   42   3.38  
     Overseas   1,689   63   3.73     1,023   40   3.91  








Total interest-earning assets – Banking business   148,158   8,492   5.73     126,765   7,180   5.66  




Total interest-earning assets – Trading business (2)   68,521         48,289    




Total interest-earning assets   216,679         175,054    
Non-interest-earning assets   30,077         16,303    




Total assets   246,756         191,357    




Percentage of assets applicable to overseas operations   46.7%         43.2%    
               
LIABILITIES AND SHAREHOLDERS' EQUITY              
Deposits by banks              
     UK   4,669   183   3.92     3,820   142   3.72  
     Overseas   11,251   374   3.32     6,924   167   2.41  
Customer accounts              
     - demand deposits              
     UK   46,585   1,156   2.48     39,899   808   2.03  
     Overseas   4,361   86   1.97     3,651   69   1.89  
     - savings deposits              
     UK   17,733   517   2.92     14,781   390   2.64  
     Overseas   1,078   26   2.41     969   23   2.37  
     - other time deposits              
     UK   21,531   921   4.28     20,285   753   3.71  
     Overseas   7,125   244   3.42     4,841   139   2.87  
Debt securities in issue              
     UK   1,650   75   4.55     844   42   4.98  
     Overseas   3,692   146   3.95     1,023   40   3.91  
Loan capital              
     UK   5,440   290   5.33     5,802   222   3.83  
     Overseas   488   28   5.74     133   8   6.02  
Internal funding of trading business   (509 )   (15 )   2.95     (211 )   (6 )   2.84  








Total interest-bearing liabilities – Banking business   125,094   4,031   3.22     102,761   2,797   2.72  




Total interest-bearing liabilities – Trading business (2)   67,726         47,659    




Total interest-bearing liabilities   192,820         150,420    
Non-interest bearing liabilities              
 Demand deposits              
     UK   13,855         13,732    
     Overseas   3,154         3,273    
 Other liabilities   28,670         15,947    
Shareholders' equity   8,257         7,985    




Total liabilities and shareholders' equity   246,756         191,357    




Percentage of liabilities applicable to overseas operations   45.3%         41.9%    
             
Notes:
(1) The analysis into UK and Overseas has been compiled on the basis of location of office.
(2) Interest receivable and interest payable on trading assets and liabilities are included in income from trading activities.

14




Changes in net interest income - volume and rate analysis

Volume and rate variances have been calculated based on movements in average balances over the year and changes in interest rates on average interest-earning assets and average interest-bearing liabilities. Changes due to a combination of volume and rate are allocated pro rata to volume and rate movements.      

  2005 compared with 2004
 






  Increase/(decrease) due to changes in:
 






  Average volume   Average rate   Net change
 






  £m   £m   £m
                   
INTEREST-EARNING ASSETS                  
Loans and advances to banks                  
     UK   33     (4 )   29  
     Overseas   44     20     64  
Loans and advances to customers                  
     UK   701     92     793  
     Overseas   404     6     410  
Debt securities                  
     UK   (19 )   12     (7 )
     Overseas   25     (2 )   23  
   







Total interest receivable of banking business                  
     UK   715     100     815  
     Overseas   473     24     497  
   







    1,188     124     1,312  
   







INTEREST-BEARING LIABILITIES                  
Deposits by banks                  
     UK   (33 )   (8 )   (41 )
     Overseas   (129 )   (78 )   (207 )
Customer accounts                  
     - demand deposits   (150 )   (198 )   (348 )
     UK   (14 )   (3 )   (17 )
     Overseas                  
     - savings deposits   (83 )   (44 )   (127 )
     UK   (3 )   -     (3 )
     Overseas                  
     - other time deposits   (48 )   (120 )   (168 )
     UK   (75 )   (30 )   (105 )
     Overseas                  
Debt securities in issue                  
     UK   (37 )   4     (33 )
     Overseas   (106 )   -     (106 )
Loan capital                  
     UK   15     (83 )   (68 )
     Overseas   (20 )   -     (20 )
Internal funding of trading business   9     -     9  
   







Total interest payable of banking business                  
     UK   (327 )   (449 )   (776 )
     Overseas   (347 )   (111 )   (458 )
   







    (674 )   (560 )   (1,234 )
   







Movement in net interest income                  
     UK   388     (349 )    39  
     Overseas   126     (87 )    39  
   







    514     (436 )    78  








15

 






Net interest income

As discussed on page 4, the Group implemented IFRS with effect from 1 January 2004. The average balance sheet and related data presented for 2003 on pages 16 to 18 are based on UK GAAP and are therefore not directly comparable with the average balance sheet and related data for 2004 or 2005, each of which is based on IFRS. For a more complete discussion of the Group’s adoption of IFRS, see ‘Accounting Policies – Adoption of International Financial Reporting Standards’ on page 54.

  UK GAAP
  2003
 
  £m
     
Interest receivable   5,979
Interest payable   (1,947 )


Net interest income   4,032


  %
Gross yield on interest-earning assets of banking business   5.35
Cost of interest-bearing liabilities of banking business   (2.21 )


Interest spread of banking business   3.14
Benefit from interest-free funds   0.47


Net interest margin of banking business   3.61


The following table gives average interest rates, yields and margins.

  UK GAAP  
  2003  
 
 
  %  
Yields, spreads and margins of the banking business:      
Gross yield (1)  
     Group   5.35  
     UK   5.50  
     Overseas   4.35  
Interest spread (2)  
     Group   3.14  
     UK   3.26  
     Overseas   2.40  
Net interest margin (3)  
     Group   3.61  
     UK   3.70  
     Overseas   2.99  
The Bank’s base rate   3.74  
London inter-bank three month offered rate:      
     Sterling   3.74  
     Eurodollar   1.22  
     Euro   2.33  

Notes:
(1) Gross yield is the interest rate earned on average interest-earning assets of the banking business.
(2) Interest spread is the difference between the gross yield and the interest rate paid on average interest-bearing liabilities of the banking business.
(3) Net interest margin is net interest income of the banking business as a percentage of average interest-earning assets of the banking business.
 

16






Average balance sheets and interest rates

The following table shows average balances and interest rates for the year ended 31 December 2003 under UK GAAP.

    UK GAAP
2003
 
   






 
    Average           Average  
    balance     Interest     rate  
   






 
ASSETS   £m     £m     %  
Loans and advances to banks                
     UK   17,576     590     3.36  
     Overseas   4,708     113     2.40  
Loans and advances to customers (1)                
     UK   78,053     4,695     6.02  
     Overseas   9,972     527     5.28  
Debt securities                
     UK   1,228     44     3.58  
     Overseas   247     10     4.05  
   




   
Total interest-earning assets – Banking business   111,784     5,979     5.35  
         

   
Total interest-earning assets – Trading business (2)   48,794            
   

         
Total interest-earning assets   160,578            
Non-interest-earning assets   16,514            
   

         
Total assets   177,092            
   

         
Percentage of assets applicable to overseas operations   41.3 %          
                 
LIABILITIES AND SHAREHOLDERS’ EQUITY                
Deposits by banks                
     UK   4,634     149     3.22  
     Overseas   2,725     60     2.20  
Customer accounts                
     - demand deposits                
     UK   38,161     518     1.36  
     Overseas   2,554     21     0.82  
     - savings deposits                
     UK   10,196     253     2.48  
     Overseas   369     5     1.36  
     - other time deposits                
     UK   20,321     638     3.14  
     Overseas   4,508     108     2.40  
Debt securities in issue                
     UK   263     8     3.04  
     Overseas   241     8     3.32  
Loan capital                
     UK   5,844     213     3.64  
     Overseas   30     1     3.33  
Internal funding of trading business   (1,621 )   (35 )   2.16  
   




   
Total interest-bearing liabilities – Banking business   88,225     1,947     2.21  
         

   
Total interest-bearing liabilities – Trading business (2)   48,241            
   

         
Total interest-bearing liabilities   136,466            
Non-interest bearing liabilities                
 Demand deposits                
     UK   13,577            
     Overseas   2,370            
 Other liabilities   15,865            
Shareholders’ funds   8,814            
   

         
Total liabilities and shareholders’ equity   177,092            
   

         
Percentage of liabilities applicable to overseas operations   40.0 %          
                   
Notes:
(1) The analysis into UK and Overseas has been compiled on the basis of location of office.
(2) Interest receivable and interest payable on trading assets and liabilities are included in income from trading activities.
 

17






Changes in net interest income - volume and rate analysis

Volume and rate variances have been calculated based on movements in average balances over the year and changes in interest rates on average interest-earning assets and average interest-bearing liabilities. Changes due to a combination of volume and rate are allocated pro rata to volume and rate movements.

  2004 compared with 2003
 
  Increase/(decrease) due to changes in








  Average   Average   Net
  volume   rate   change








  £m   £m   £m
INTEREST-EARNING ASSETS      
Loans and advances to banks      
     UK   3   140   143
     Overseas   28   29   57
Loans and advances to customers      
     UK   269   309   578
     Overseas   434   (39 )   395
Debt securities      
     UK   -   (2 )   (2 )
     Overseas   30   -   30








Total interest receivable of banking business      
     UK   272   447   719
     Overseas   492   (10 )   482








  764   437   1,201








INTEREST-BEARING LIABILITIES      
Deposits by banks      
     UK   28   (21 )   7
     Overseas   (101 )   (6 )   (107 )
Customer accounts      
     - demand deposits      
     UK   (25 )   (265 )   (290 )
     Overseas   (12 )   (36 )   (48 )
     - savings deposits      
     UK   (120 )   (17 )   (137 )
     Overseas   (12 )   (6 )   (18 )
     - other time deposits      
     UK   1   (116 )   (115 )
     Overseas   (8 )   (23 )   (31 )
Debt securities in issue      
     UK   (26 )   (8 )   (34 )
     Overseas   (30 )   (2 )   (32 )
Loan capital      
     UK   2   (11 )   (9 )
     Overseas   (6 )   (1 )   (7 )
Internal funding of trading business   (37 )   8   (29 )








Total interest payable of banking business      
     UK   (177 )   (430 )   (607 )
     Overseas   (169 )   (74 )   (243 )








  (346 )   (504 )   (850 )








Movement in net interest income      
     UK   95   17   112
     Overseas   323   (84 )   239








  418   (67 )   351








18






Overview of balance sheet
Summary consolidated balance sheet
  2005   2004  
 
 
 
  £m   £m  
Assets    
Cash and balances at central banks   1,568   1,589  
Treasury bills and other eligible bills   770   172  
Loans and advances to banks   55,995   29,982  
Loans and advances to customers   159,943   131,679  
Debt securities and equity shares   29,568   23,764  
Other assets   12,759   10,035  



 
Total assets   260,603   197,221  



 
Liabilities    
Deposits by banks   46,001   23,873  
Customer accounts   157,924   126,119  
Debt securities in issue   10,801   3,597  
Other liabilities   29,045   29,407  
Subordinated liabilities   6,648   5,808  
Minority interests   744   408  
Shareholders’ equity   9,440   8,009  



 
Total liabilities and equity   260,603   197,221  



 

Analysis of repurchase agreements

  2005   2004  
 
 
 
  £m   £m  
Reverse repurchase agreements and stock borrowing      
Loans and advances to banks   13,135   6,858  
Loans and advances to customers   15,036   17,596  



 
  28,171   24,454  



 
Repurchase agreements and stock lending    
Deposits by banks   19,569   14,855  
Customer accounts   20,664   15,486  



 
  40,233   30,341  



 

19






Overview – summary consolidated balance sheet

31 December 2005 compared with 31 December 2004

Total assets of £260.6 billion at 31 December 2005 were up £63.4 billion, 32%, compared with 31 December 2004, with £35.8 billion of this increase arising from the implementation of IAS 32 and IAS 39 on 1 January 2005, and the balance reflecting business growth.

Loans and advances to banks rose £26.0 billion to £56.0 billion. Excluding the effects of implementing IAS 32 and IAS 39, they increased £13.8 billion, 33%, with growth in reverse repurchase agreements and stock borrowing (“reverse repos”), which increased by £5.9 billion, 83%, to £13.1 billion, and bank placings up £7.8 billion, 22%, to £42.9 billion.

Loans and advances to customers were up £28.3 billion, 21%, at £159.9 billion of which £21.3 billion resulted from the implementation of IAS 32 and IAS 39, mainly due to the grossing up of previously netted customer balances. Excluding this and a decrease in reverse repos, down 43%, £11.4 billion to £15.0 billion, customer lending was up £18.4 billion, 15%, reflecting organic growth across all divisions.

Debt securities and equity shares increased by £5.8 billion, 24%, to £29.6 billion, principally due to increased holdings in Corporate Markets.

Other assets increased by £2.7 billion, 27% to £12.8 billion, largely due to the increase in derivatives at fair value resulting from the implementation of IAS 32 and IAS 39, with £2.0 billion arising from the grossing up of previously netted balances.

Deposits by banks increased by £22.1 billion, 93%, to £46.0 billion, of which £12.2 billion arose from the implementation of IAS 32 and IAS 39. The remaining £9.9 billion was raised to fund business growth both through higher inter-bank deposits, up £5.5 billion, 26%, to £26.4 billion and increased repurchase agreements and stock lending (“repos”), up 29%, from £15.2 billion to £19.6 billion.

Customer accounts were up £31.8 billion, 25% at £157.9 billion with £20.0 billion arising from the implementation of IAS 32 and IAS 39, largely reflecting the grossing up of previously netted deposits. Excluding this and repos, which decreased £3.7 billion, 15%, to £20.7 billion, deposits rose by £15.5 billion, 13%, to £137.3 billion with good growth in all divisions.

Debt securities in issue increased by £7.2 billion to £10.8 billion, with £1.5 billion resulting from the implementation of IAS 39, and £5.7 billion raised primarily to meet the NatWest Group’s funding requirements.

Subordinated liabilities were up £0.8 billion, 14%, to £6.6 billion, including £0.5 billion due to the reclassification as debt of NatWest Group’s existing preference share capital following the implementation of IAS 32. The balance, £0.3 billion, reflected the issue of £0.3 billion dated loan capital and exchange rate movements of £0.2 billion which were partially offset by the redemption of £0.2 billion dated loan capital.

Shareholders’ equity increased by £1.4 billion, 18%, to £9.4 billion. The implementation of IAS 32 and IAS 39 reduced shareholders’ equity by £0.6 billion, largely as a result of the reclassification as debt of NatWest Group’s preference share capital. Excluding this, shareholders’ equity was up by £2.1 billion, 28%, primarily reflecting the profit for the period of £2.4 billion, partly offset by the payment of ordinary dividends, £0.3 billion.

20






Description of assets and liabilities

Assets

Loan portfolio

NatWest Group’s loan portfolio consists of loans (including overdraft facilities) and finance leases and instalment credit.

Overdraft facilities provide the customer with a demand deposit account and demand credit facility combined in a single checking (current) account. An overdraft is effected whenever a customer’s drawings on a demand deposit account exceed the credit balance of the account, the balance of which may alternate between debit and credit. While overdrafts are contractually repayable on demand, unless a fixed term has been agreed, in practice customers will from time to time make deposits into the account thereby reducing indebtedness or increasing a credit balance in accordance with their requirements. Borrowing limits on the overdraft facility are established and full repayment is normally only required if the customer fails to honour the conditions on which the limit was granted or their financial position has so deteriorated such that it is necessary to take protective action. Overdraft facilities are usually reviewed at least annually. Interest is generally calculated on the daily outstanding balance by reference to NatWest Group’s base rate and is typically charged monthly.

Analysis of loans to customers by geographical area and type of customer - IFRS

The following table analyses loans and advances to customers before provisions by remaining maturity, geographical area and type of customer. Overdrafts are included within the ‘within 1 year’ category.

Within
1 year
After
1 but within
5 years
After 5
years
IFRS 2005
Total
 
  IFRS
2004
 







  £m   £m   £m   £m
 
  £m
UK        
 
 
Central and local government   1,667   -   1   1,668
 
  128
Manufacturing   4,476   441   463   5,380
 
  2,742
Construction   2,818   711   744   4,273
 
  2,811
Finance   33,163   1,323   341   34,827
 
  1,597
Service industries and business activities   11,378   3,472   4,853   19,703
 
  13,876
Agriculture, forestry and fishing   859   393   597   1,849
 
  1,739
Property   3,697   2,859   4,143   10,699
 
  8,581
Individuals - home mortgages   1,297   584   865   2,746
 
  29,434
Individuals - other   7,326   4,703   2,623   14,652
 
  14,051
Finance leases and instalment credit   10   169   141   320
 
  356
Accrued interest   202   -   -   202
 
  -











Total domestic   66,893   14,655   14,771   96,319
 
  75,315
Overseas residents   9,617   525   2,307   12,449
 
  11,413











Total UK offices   76,510   15,180   17,078   108,768
 
  86,728











Overseas        
 
 
United States   15,261   857   7,821   23,939
 
  24,662
Rest of the World   14,814   3,540   10,910   29,264
 
  22,223











Total overseas offices   30,075   4,397   18,731   53,203
 
  46,885











Loans and advances to customers – gross   106,585   19,577   35,809   161,971
 
  133,613





 
Loan impairment provisions         (2,028 )   (1,934 )





Loans and advances to customers – net         159,943
 
  131,679





Fixed rate   17,853   6,322   7,648   31,823
 
  40,861
Variable rate   88,732   13,255   28,161   130,148
 
  92,752











Loans and advances to customers – gross   106,585   19,577   35,809   161,971
 
  133,613











For further information regarding NatWest Group’s operations by geographical area, see Note 40 to the Consolidated Financial Statements.

21




Loan impairment provisions

Provisioning policy

NatWest Group’s approach to managing credit risk is discussed in note 32 to the Consolidated Financial Statements and its accounting policy for impairment of financial assets is set out on page 58.

Loan impairment provisions - IFRS

For a discussion of the factors considered in determining the amount of the provisions, see ‘Provision analysis’ and ‘Provision methodology’ on page 98. The following table shows the elements of loan impairment provisions.

  2005   2004
 

 

  £m   £m
Provisions at beginning of year    
     Domestic   1,654   1,358
     Foreign   471   547





  2,125   1,905





Currency translation and other adjustments    
     Domestic   7     -
     Foreign   (9 )   (27 )
Acquisition/(disposal) of subsidiaries        
     Domestic   (23 )   -
     Foreign   16     35
Amounts written-off    
     Domestic   (639 )   (425 )
     Foreign   (179 )   (170 )
Recoveries of amounts written-off in previous years      
     Domestic   44   41
     Foreign   12   4
Transfers to immediate parent company    
     Domestic   -   (48 )
     Foreign   -   -
Charge to income statement    
     Domestic   704   470
     Foreign   49   155
Discount unwind    
     Domestic   (67 )  
     Foreign   (9 )  
Provisions at end of year    
     Domestic   1,680   1,396
     Foreign   351   544





  2,031   1,940





Gross loans and advances to customers    
Domestic   96,319   75,315
Foreign   65,652   58,298





  161,971   133,613





Closing customer provisions as a % of gross loans and advances to customers      
Domestic   1.74 %   1.85 %
Foreign   0.53 %   0.92 %





  1.25 %   1.45 %





Customer charge to income statement as a % of gross loans and advances to customers      
Domestic   0.73 %   0.62 %
Foreign   0.07 %   0.27 %





  0.46 %   0.47 %





22




The following table presents additional information with respect to loan impairment provisions.

  2005
  2004

   

£m     £m  
Loans and advances to customers (gross)   161,971   133,613





Loan impairment provisions at end of year:    
     Customers   2,028  
     Banks   3  
     Specific provisions – customers     1,651
     Specific provisions – banks     6
     General provision     283





  2,031   1,940





Customer provision at end of year as a % of loans and advances to customers at end of year:      
     Specific provisions     1.24 %
     General provision     0.21 %
   

    1.45 %
   

Average loans and advances to customers (gross)   162,733   117,249





As a % of average loans and advances to customers during the year:      
 Total customer provisions charged to income statement   0.46 %   0.53 %





 Amounts written-off (net of recoveries) – customers   0.47 %   0.47 %






Analysis of closing loan impairment provisions - IFRS

The following table analyses customer loan impairment provisions by geographical area and type of domestic customer.

    2005   2004
   
 
    Closing
provision
  % of
loans to
total
loans
  Closing
provision
  % of
loans to
total
loans
   
 
 
 
    £m   %   £m   %
Domestic        
Central and local government   -   1.0     0.1
Manufacturing   70   3.3   80   2.1
Construction   48   2.7   50   2.1
Finance   17   21.5   16   1.2
Service industries and business activities   411   12.2   299   10.4
Agriculture, forestry and fishing   20   1.1   17   1.3
Property   38   6.6   27   6.4
Individuals        
 - home mortgages   3   1.7   9   22.0
 - other   921   9.1   716   10.5
Finance leases and instalment credit   -   0.2   45   0.3
Accrued interest   -   0.1    







Total domestic   1,528   59.5   1,259   56.4
Foreign   298   40.5   392   43.6







Impaired book provisions   1,826   100.0     100.0


Latent book provisions   202      
Specific provisions       1,651  
General provision       283  


Total provisions   2,028     1,934  



23




Write-offs - IFRS

The following table analyses amounts written-off by geographical area and type of domestic customer:

  2005   2004
 
 
  £m   £m
Domestic    
Manufacturing   26   25
Construction   13   9
Finance   2   1
Service industries and business activities   82   78
Agriculture, forestry and fishing   3   3
Property   7   12
Individuals - home mortgages   1   -
Individuals - others   503   296



Total domestic   637   424
Foreign   179   171



Total write-offs   816   595



Recoveries - IFRS

The following table analyses recoveries of amounts written-off by geographical area and type of domestic customer:

  2005   2004
 
 
  £m   £m
Domestic    
Manufacturing   1   -
Service industries and business activities   1   1
Individuals - others   41   39



Total domestic   43   40
Foreign   -   5



Total recoveries   43   45




24





Risk elements in lending and potential problem loans - IFRS

NatWest Group’s loan control and review procedures do not include the classification of loans as non-accrual, accruing past due, restructured and potential problem loans, as defined by the SEC in the US. The following table shows the estimated amount of loans that would be reported using the SEC’s classifications. The figures are stated before deducting the value of security held or related provisions.

IAS 39 requires interest to be recognised on a financial asset (or a group of financial assets) after impairment at the rate of interest used to discount recoveries when measuring the impairment loss. Thus, interest on impaired financial assets is credited to profit or loss as the discount on expected recoveries unwinds. Despite this, such assets are not considered performing. All loans that have an impairment provision are classified as non-accrual. This is a change from past practice where certain loans with provisions were classified as past due 90 days or potential problem loans (and interest accrued on them).

  2005   2004
 
 
  £m   £m
Loans accounted for on a non-accrual basis (2):    
     Domestic   2,700   1,966
     Foreign   487   565





     Total   3,187   2,531





Accruing loans which are contractually past due    
 90 days or more as to principal or interest (3):    
     Domestic   2   342
     Foreign   7   60





     Total   9   402





Loans not included above which are classified as    
 “troubled debt restructurings” by the SEC:    
     Domestic   -   -
     Foreign   -   -





     Total   -   -





Total risk elements in lending   3,196   2,933





Potential problem loans (4)    
     Domestic   11   13
     Foreign   5   83





     Total   16   96





Closing provisions for impairment as a % of total risk elements in lending   63 %   66 %





Closing provisions for impairment as a % of total risk elements in lending    
and potential problem loans   63 %   64 %





Risk elements in lending as a % of gross lending to customers excluding reverse repos   2.18 %   2.53 %





Notes:  
(1) For the analysis above, “Domestic” consists of the United Kingdom domestic transactions of NatWest Group. “Foreign” comprises NatWest Group’s transactions conducted through offices outside the UK and through those offices in the UK specifically organised to service international banking transactions.
(2) All loans against which an impairment provision is held are reported in the non-accrual category.
(3) Loans where an impairment event has taken place but no impairment recognised. This category is used for over-collateralised non-revolving credit facilities.
(4) Loans for which an impairment event has occurred but no impairment provision is necessary. This category is used for over-collateralised advances and revolving credit facilities where identification as 90 days overdue is not feasible.

25






  2005   2004
 
 
  £m   £m
Gross income not recognised but which would have been recognised under the original terms of      
 non-accrual and restructured loans      
     Domestic   99   130
     Foreign   21   31



  120   161



Interest on non-accrual and restructured loans included in net interest income      
     Domestic   67   41
     Foreign   9   -



  76   41



Cross border outstandings in excess of 0.75% of total assets

Cross border outstandings consist of loans to banks and customers (including instalment credit and finance lease receivables), acceptances and other monetary assets, including non-local currency claims of overseas offices on local residents. NatWest Group monitors the geographical breakdown of outstandings based on the country of domicile of the borrower or guarantor of ultimate risk.

At 31 December 2005 and 2004, NatWest Group had no cross border outstandings in excess of 0.75% of total assets (including acceptances).

26






Liabilities

Analysis of deposits - IFRS

Analysis of deposits by product type and geographical area - IFRS

The following table shows the distribution of NatWest Group's deposits by product type and geographical area.

  2005   2004

 
  £m   £m
UK    
Domestic:    
Demand deposits - interest-free   23,825   17,579
                           - interest-bearing   54,048   42,621
Time deposits - savings   17,234   13,506
                      - other   25,011   21,039
Overseas residents:    
Demand deposits - interest-free   329   221
                           - interest-bearing   4,326   1,773
Time deposits - savings   892   971
                      - other   873   3,588



Total UK offices   126,538   101,298



Overseas    
Demand deposits - interest-free   3,629   3,038
                           - interest-bearing   9,244   4,032
Time deposits - savings   1,097   1,064
                      - other   63,417   40,560



Total overseas offices (see below)   77,387   48,694



Total deposits   203,925   149,992



Held for trading   16,961  
Fair value through profit or loss   1,339  
Amortised cost   185,625  
       
Banking business     119,848
Trading business     30,144



Total deposits   203,925   149,992



Overseas offices    
United States   43,432   28,080
Rest of the World   33,955   20,614



Total overseas offices   77,387   48,694




Note:
(1) Presentation of product analysis data has been refined and 2004 has been restated onto a basis consistent with 2005.

27






Short-term borrowings - IFRS

The following table shows details of NatWest Group’s short-term borrowings.

  2005   2004
 
 
  £m   £m
Commercial paper:    
     Outstanding at 31 December   2,343   1,760
     Maximum amount outstanding at any month-end during the year   3,326   2,211
     Approximate average amount outstanding during the year   2,863   1,495
     Approximate weighted average interest rate during the year   3.0 %   2.4 %
     Approximate weighted average interest rate at 31 December   4.4 %   2.4 %
Other short-term borrowings:    
     Outstanding at 31 December   37,513   29,250
     Maximum amount outstanding at any month-end during the year   44,172   30,868
     Approximate average amount outstanding during the year   37,147   27,859
     Approximate weighted average interest rate during the year   3.9 %   2.1 %
     Approximate weighted average interest rate at 31 December   4.1 %   2.2 %

Average interest rates during the year are computed by dividing total interest expense by the average amount borrowed. Average interest rates at year end are average rates for a single day and as such may reflect one-day market distortions which may not be indicative of generally prevailing rates. Original maturities of commercial paper are not in excess of one year. “Other short-term borrowings” consist principally of borrowings in the money markets included within “Deposits by banks” and “Customer accounts” in the Consolidated Financial Statements, and generally have original maturities of one year or less.

Certificates of deposit and other time deposits - IFRS

The following table shows details of NatWest Group's certificates of deposit issued and other time deposits over £50,000 (or the equivalent of $100,000 for currencies other than sterling) at 31 December 2005, by time remaining until maturity:

  Within
3 months
  Over 3
but within
6 months
  Over 6
but within
12 months
   
Over
12 months
2005
Total
 
 
 
 
 
  £m   £m   £m   £m   £m
UK based companies and branches          
     Certificates of deposit   1,517   140   58   -   1,715
     Other time deposits   18,015   356   52   37   18,460
           
Overseas based companies and branches          
     Certificates of deposit   1,222   956   747   -   2,925
     Other time deposits   45,729   2,874   372   917   49,892









Total   66,483   4,326   1,229   954   72,992










28






Amounts in accordance with UK GAAP

Analysis of loans to customers by geographical area and type of customer – UK GAAP

The following table analyses loans and advances to customers before provisions by remaining maturity, geographical area and type of customer. Overdrafts are included within the ‘within 1 year’ category.

    2004   2003   2002   2001
   
 
 
 
    £m   £m   £m   £m
UK        
Central and local government   128   127   215   95
Manufacturing   2,742   2,896   3,751   3,421
Construction   2,811   2,356   2,088   1,857
Finance   1,278   742   1,091   1,159
Service industries and business activities   13,855   12,680   11,531   12,263
Agriculture, forestry and fishing   1,739   1,731   1,689   1,647
Property   8,581   6,964   5,486   4,694
Individuals - home mortgages   29,434   24,545   22,286   20,425
Individuals - other   14,051   12,760   11,690   10,287
Finance leases and instalment credit   356   1,961   11,456   11,092











Total domestic   74,975   66,762   71,283   66,940
Overseas residents   11,413   13,263   15,448   17,694











Total UK offices   86,388   80,025   86,731   84,634











Overseas        
United States   24,676   12,034   16,868   8,157
Rest of the World   22,223   12,411   10,618   9,950











Total overseas offices   46,899   24,445   27,486   18,107











Loans and advances to customers – gross   133,287   104,470   114,217   102,741
Provisions for bad and doubtful debts   (1,934 )   (1,898 )   (2,095 )   (2,123 )











Loans and advances to customers – net   131,353   102,572   112,122   100,618











Fixed rate   40,761   25,573   37,143   25,224
Variable rate   92,526   78,897   77,074   77,517











Gross loans and advances to customers – by maturity          
  133,287   104,470   114,217   102,741











For further information regarding NatWest Group's operations by geographical area, see Note 40 to the Consolidated Financial Statements.

29






Provision for bad and doubtful debts – UK GAAP

The following table shows the elements of provisions for bad and doubtful debts under UK GAAP:

  2004     2003     2002     2001

   
   
   
 
  £m     £m     £m     £m
Provisions at beginning of year                        
     Domestic   1,358     1,559     1,656     1,723  
     Foreign   547     543     475     375  
   

 

 

 

    1,905     2,102     2,131     2,098  
   

 

 

 

Currency translation and other adjustments                        
     Domestic   -     -     5     (15 )
     Foreign   (27 )   -     (15 )   13  
Acquisition/(disposal) of subsidiaries                        
     Domestic   -     (156 )   -     (28 )
     Foreign   35     4     -     (10 )
Amounts written-off                        
     Domestic   (425 )   (467 )   (418 )   (372 )
     Foreign   (170 )   (139 )   (126 )   (84 )
Recoveries of amounts written-off in previous years                        
     Domestic   41     8     13     10  
     Foreign   4     4     4     9  
Transfers to immediate parent company                        
     Domestic   (48 )   -     -     -  
     Foreign   -     -     -     -  
Charge to profit and loss account                        
     Domestic   470     414     303     338  
     Foreign   155     135     205     172  
Provisions at end of year                        
     Domestic   1,396     1,358     1,559     1,656  
     Foreign   544     547     543     475  
   

 

 

 

    1,940     1,905     2,102     2,131  
   

 

 

 

Gross loans and advances to customers                        
Domestic   74,975     66,762     71,283     66,940  
Foreign   58,312     37,708     42,934     35,801  
   

 

 

 

    133,287     104,470     114,217     102,741  
   

 

 

 

Closing customer provisions as a % of gross loans                        
     and advances to customers                        
Domestic   1.86 %   2.03 %   2.19 %   2.47 %
Foreign   0.93 %   1.45 %   1.25 %   1.30 %
   

 

 

 

    1.46 %   1.82 %   1.83 %   2.07 %
   

 

 

 

Customer charge against profit as a % of gross loans                        
     and advances to customers                        
Domestic   0.63 %   0.62 %   0.43 %   0.50 %
Foreign   0.27 %   0.36 %   0.48 %   0.48 %
   

 

 

 

    0.47 %   0.53 %   0.44 %   0.50 %
   

 

 

 


30






The following table presents additional information with respect to provisions for bad and doubtful debts.

  2004   2003   2002   2001
 
 
 
 
  £m   £m   £m   £m
                 
Loans and advances to customers (gross)   133,287   104,470   114,217   102,741











Provisions at end of year:        
     Specific provisions – customers   1,651   1,528   1,727   1,725
     Specific provisions – banks   6   7   7   8
     General provision   283   370   368   398











  1,940   1,905   2,102   2,131











Customer provision at end of year as a % of loans and        
 advances to customers at end of year:        
     Specific provisions   1.24 %   1.46 %   1.51 %   1.68 %
     General provision   0.21 %   0.36 %   0.32 %   0.39 %











  1.45 %   1.82 %   1.83 %   2.07 %











Average loans and advances to customers (gross)   116,917   106,967   110,874   103,585











As a % of average loans and advances to customers        
during the year:        
 Total customer provisions charged to profit and loss   0.53 %   0.51 %   0.46 %   0.49 %











 Amounts written-off (net of recoveries) – customers   0.47 %   0.56 %   0.47 %   0.42 %











Analysis of closing provisions for bad and doubtful debts – UK GAAP

The following table analyses customer provisions for bad and doubtful debts by geographical area and type of domestic customer.

    2004   2003   2002   2001
   


 


 


 


    Closing
provision
  % of
loans to
total
loans
  Closing
provision
  % of
loans to
total
loans
  Closing
provision
  % of
loans to
total
loans
  Closing
provision
  % of
loans to
total
loans
   
 
 
 
 
 
 
 
    £m   %   £m   %   £m   %   £m   %
Domestic                
Central and local government   -   0.1   -   0.1   -   0.2   -   0.2
Manufacturing   80   2.1   84   2.8   112   3.3   129   3.3
Construction   50   2.1   46   2.2   52   1.8   59   1.8
Finance   16   1.0   14   0.7   43   1.0   54   1.1
Service industries and business                
activities   299   10.4   326   12.1   389   10.1   430   11.9
Agriculture, forestry and fishing   17   1.3   16   1.7   24   1.5   21   1.6
Property   27   6.4   29   6.7   32   4.8   30   4.6
Individuals                
 - home mortgages   9   22.1   13   23.5   15   19.5   17   19.9
 - other   716   10.5   548   12.2   444   10.2   487   10.0
Finance leases and                
   instalment credit   45   0.3   45   1.9   208   10.0   164   10.8















Total domestic   1,259   56.3   1,121   63.9   1,319   62.4   1,391   65.2
Foreign   392   43.7   407   36.1   408   37.6   334   34.8















Specific provisions   1,651   100.0   1,528   100.0   1,727   100.0   1,725   100.0




General provision   283     370     368     398  




Total provisions   1,934     1,898     2,095     2,123  





31






Write-offs – UK GAAP

The following table analyses amounts written-off by geographical area and type of domestic customer:

  2004   2003   2002   2001
 
 
 
 
  £m   £m   £m   £m
Domestic        
Manufacturing   25   57   76   37
Construction   9   16   15   11
Finance   1   30   28   2
Service industries and business activities   78   150   123   109
Agriculture, forestry and fishing   3   3   3   4
Property   12   5   5   9
Individuals - home mortgages   -   -   1   1
Individuals - others   296   169   122   136
Finance leases and instalment credit   -   37   45   63







Total domestic   424   467   418   372
Foreign   171   139   126   84







Total write-offs*   595   606   544   456







* Includes amounts relating to loans and advances to banks of nil in 2004 (2003 – nil; 2002 - £1 million; 2001 - £6 million).

Recoveries – UK GAAP

The following table analyses recoveries of amounts written-off by geographical area and type of domestic customer:

  2004   2003   2002   2001
 
 
 
 
  £m   £m   £m   £m
Domestic        
Construction   -   -   -   1
Service industries and business activities   1   1   1   1
Property   -   -   1   -
Individuals - others   39   6   4   5
Finance leases and instalment credit   -   1   7   3







Total domestic   40   8   13   10
Foreign   5   4   4   9







Total recoveries   45   12   17   19








32






Risk elements in lending and potential problem loans – UK GAAP

  2004   2003   2002   2001
 
 
 
 
  £m   £m   £m   £m
Loans accounted for on a non-accrual basis (3):        
     Domestic   1,966   1,950   1,781   2,238
     Foreign   565   537   531   360











     Total   2,531   2,487   2,312   2,598











Accruing loans which are contractually past due        
90 days or more as to principal or interest (4):        
     Domestic   342   276   195   237
     Foreign   60   48   34   19











     Total   402   324   229   256











Loans not included above which are classified as        
 “troubled debt restructurings” by the SEC:        
     Domestic   -   16   7   24
     Foreign   -   -   1   7











     Total   -   16   8   31











Total risk elements in lending   2,933   2,827   2,549   2,885











Potential problem loans (5)        
     Domestic   13   276   523   765
     Foreign   83   50   70   218











     Total   96   326   593   983











Closing provisions for bad and doubtful debts as a % of total risk          
elements in lending   66 %   67 %   82 %   74 %











Closing provisions for bad and doubtful debts as a % of total risk          
elements in lending and potential problem loans   64 %   60 %   67 %   55 %











Risk elements in lending as a % of gross loans and advances to          
customers excluding reverse repos   2.54 %   2.96 %   2.59 %   3.04 %












Notes:
(1) For the analysis above, ‘Domestic’ consists of the UK domestic transactions of NatWest Group. ‘Foreign’ comprises NatWest Group’s transactions conducted through offices outside the UK and through those offices in the UK specifically organised to service international banking transactions.
(2) The classification of a loan as non-accrual, past due 90 days or troubled debt restructuring does not necessarily indicate that the principal of the loan is uncollectable in whole or in part. Collection depends in each case on the individual circumstances of the loan, including the adequacy of any collateral securing the loan and therefore classification of a loan as non-accrual, past due 90 days or troubled debt restructuring does not always require that a provision be made against such a loan. In accordance with NatWest Group’s provisioning policy for bad and doubtful debts, it is considered that adequate provisions for the above risk elements in lending have been made.
(3) NatWest Group’s UK banking subsidiary undertakings account for loans on a non-accrual basis from the point in time at which the collectability of interest is in significant doubt.
(4) Overdrafts generally have no fixed repayment schedule and consequently are not included in this category.
(5) Loans that are current as to the payment of principal and interest but in respect of which management has serious doubts about the ability of the borrower to comply with contractual repayment terms. Substantial security is held in respect of these loans and appropriate provisions have already been made in accordance with NatWest Group’s provisioning policy for bad and doubtful debts.

33






  2004   2003   2002
 
 
 
  £m   £m   £m
Gross income not recognised but which would have been recognised under the        
 original terms of non-accrual and restructured loans        
     Domestic   130   134   171
     Foreign   31   31   32





  161   165   203





Interest on non-accrual and restructured loans included in net interest income        
     Domestic   41   43   36
     Foreign   -   -   5





  41   43   41





Cross border outstandings in excess of 0.75% of total assets – UK GAAP

Cross border outstandings consist of loans to banks and customers (including instalment credit and finance lease receivables), acceptances and other monetary assets, including non-local currency claims of overseas offices on local residents. NatWest Group monitors the geographical breakdown of outstandings based on the country of domicile of the borrower or guarantor of ultimate risk.

At 31 December 2004 and 2003, NatWest Group had no cross border outstandings in excess of 0.75% of total assets (including acceptances) of £196.5 billion and £173.1 billion, respectively.

34






Analysis of deposits – UK GAAP

Analysis of deposits by product type and geographical area – UK GAAP

The following table shows the distribution of NatWest Group's deposits by product type and geographical area.

  2004   2003
 
 
  £m   £m
UK    
Domestic:    
Demand deposits - interest-free   16,799   15,739
Demand deposits - interest-bearing   48,165   43,351
Time deposits - savings   7,962   6,992
Time deposits - other   21,039   18,934
Overseas residents:    
Demand deposits - interest-free   210   706
Demand deposits - interest-bearing   2,165   2,013
Time deposits - savings   579   810
Time deposits - other   3,588   3,364



Total UK offices   100,507   91,909



Overseas    
Demand deposits - interest-free   3,038   2,973
                           - interest-bearing   4,032   2,469
Time deposits      - savings   1,064   415
                           - other   40,560   36,361



Total overseas offices (see below)   48,694   42,218



Total deposits   149,201   134,127



Banking business   119,057   105,336
Trading business   30,144   28,791



Total deposits   149,201   134,127



Overseas offices    
United States   28,080   28,678
Rest of the World   20,614   13,540



Total overseas offices   48,694   42,218



The following table shows the distribution of deposits by banks and customer accounts by sterling and other currencies.

  2004   2003
 
 
  £m   £m
Deposits by banks    
 Sterling   3,202   1,827
 Other currencies   19,880   15,731



Total deposits by banks   23,082   17,558



Customer accounts    
 Sterling   92,797   84,692
 Other currencies   33,322   31,877



Total customer accounts   126,119   116,569



Total deposits   149,201   134,127



35






Short-term borrowings – UK GAAP

  2004   2003
 
 
  £m   £m
Commercial paper:    
     Outstanding at 31 December   1,760   2,060
     Maximum amount outstanding at any month-end during the year   2,211   2,060
     Approximate average amount outstanding during the year   1,495   672
     Approximate weighted average interest rate during the year   2.4 %   1.3 %
     Approximate weighted average interest rate at 31 December   2.4 %   1.4 %
     
Other short-term borrowings:    
     Outstanding at 31 December   29,250   29,302
     Maximum amount outstanding at any month-end during the year   30,868   29,302
     Approximate average amount outstanding during the year   27,859   24,982
     Approximate weighted average interest rate during the year   2.1 %   2.0 %
     Approximate weighted average interest rate at 31 December   2.2 %   1.3 %

Average interest rates during the year are computed by dividing total interest expense by the average amount borrowed. Average interest rates at year end are average rates for a single day and as such may reflect one-day market distortions which may not be indicative of generally prevailing rates. Original maturities of commercial paper are not in excess of one year. “Other short-term borrowings” consist principally of borrowings in the money markets included within “Deposits by banks” and “Customer accounts” in the Consolidated Financial Statements, and generally have original maturities of one year or less.

36






LIQUIDITY AND CAPITAL RESOURCES

In the management of capital resources, NatWest Group is governed by RBS Group’s policy which is to maintain a strong capital base, to expand it as appropriate and to utilise it efficiently throughout its activities to optimise the return to shareholders while maintaining a prudent relationship between the capital base and the underlying risks of the business. In carrying out this policy, NatWest Group has regard to the supervisory requirements of the Financial Services Authority (“FSA”). The FSA uses Risk Asset Ratio (“RAR”) as a measure of capital adequacy in the UK banking sector, comparing a bank’s capital resources with its weighted risk assets (the assets and off-balance sheet exposures are ‘weighted’ to reflect the inherent credit and other risks); by international agreement, the RAR should be not less than 8% with a tier 1 component of not less than 4%. At 31 December 2005, NatWest Group’s total RAR ratio was 14.1% and the tier 1 RAR was 10.1%.

Upon the adoption of IFRS by listed banks in the UK on 1 January 2005, the FSA changed its regulatory requirements such that the measurement of capital adequacy was based on IFRS subject to a number of prudential filters. The data as at 31 December 2005 set out below have been presented in compliance with these revised FSA requirements.

  2005
 
  £m
Capital base  
Tier 1 capital   10,359
Tier 2 capital   6,043


 
Total   16,402
Less investments in insurance subsidiaries, associated undertakings and    
other supervisory deductions   (1,911 )  


 
Total capital   14,491


 
Weighted risk assets  
Banking book:  
 On-balance sheet   88,600
 Off-balance sheet   9,300
Trading book   4,600


 
  102,500


 
Risk asset ratios  
Tier 1   10.1 %  
Total   14.1 %  

The data set forth below are in accordance with the FSA regulations in force at the time and are based on UK GAAP.

  2004   2003
 
 
  £m   £m
Capital base    
Tier 1 capital   8,814   8,737
Tier 2 capital   5,640   5,652





Total   14,454   14,389
Less investments in insurance subsidiaries, associated undertakings and      
other supervisory deductions   (1,772 )   (1,702 )





Total capital   12,682   12,687





Weighted risk assets    
Banking book:    
 On-balance sheet   90,400   79,200
 Off-balance sheet   10,200   9,600
Trading book   9,200   6,500





  109,800   95,300





Risk asset ratios   %   %
Tier 1   8.0   9.2
Total   11.6   13.3

37






ITEM 6. DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES

The Company has omitted portions of this item on the basis of General Instructions I(2)(c) and (d) to Form 10-K.

BOARD PRACTICES

The company is committed to high standards of corporate governance, business integrity and professionalism in all its activities.

Under the US Sarbanes-Oxley Act of 2002, enhanced standards of corporate governance and business and financial disclosure apply to companies, including the company, with securities registered in the US. NatWest Group complies with all currently applicable sections of the Act.

Board of directors

The Board is the principal decision making forum for the company. It has overall responsibility for leading and controlling the company and is accountable to shareholders for financial and operational performance. The Board approves Group strategy and monitors performance. The Board has adopted a formal schedule of matters detailing key aspects of the company’s affairs reserved to it for its decision. This schedule is reviewed annually.

The roles of the Chairman and Group Chief Executive are distinct and separate, with a clear division of responsibilities. The Chairman leads the Board and ensures the effective engagement and contribution of all non-executive and executive directors. The Group Chief Executive has responsibility for all Group businesses and acts in accordance with the authority delegated from the Board. Responsibility for the development of policy and strategy and operational management is delegated to the Group Chief Executive and other executive directors.

All directors participate in discussing strategy, performance and financial and risk management of the company. Meetings of the Board are structured to allow open discussion. The Board met nine times during 2005 and was supplied with comprehensive papers in advance of each Board meeting covering the Group’s principal business activities. Members of the executive management attend and make regular presentations as appropriate at meetings of the Board.

Board Committees

In order to provide effective oversight and leadership, the Board has established a number of Board Committees with particular responsibilities. The Committee chairmanship and membership are reviewed on a regular basis.

Audit Committee

All members of the Audit Committee are independent non-executive directors. The Audit Committee holds at least five meetings each year. This core agenda is supplemented by additional meetings as required, four being added in 2005. Audit Committee meetings are attended by relevant executive directors, the internal and external auditors and risk management executives. At least twice per annum the Committee meets privately with the external auditors. The Audit Committee also visits business divisions and certain Group functions under a programme set at the beginning of each year.

The Audit Committee is responsible for:
  • assisting the Board in discharging its responsibilities and in making all relevant disclosures in relation to the financial affairs of the Group;

  • reviewing accounting and financial reporting and regulatory compliance;

  • reviewing the Group’s systems of internal control; and

  • monitoring the Group’s processes for internal audit, risk management and external audit.

The Audit Committee has adopted a policy on the engagement of the external auditors to supply audit and non-audit services, which takes into account relevant legislation regarding the provision of such services by an external audit firm. The Audit Committee reviews the policy annually and prospectively approves the provision of audit services and certain non-audit services by the external auditors. The Audit Committee approves all other permitted non-audit services on a case by case basis. The relevant submissions by management outline the service required and confirm that the external auditor’s independence will not be compromised. In addition, the Audit Committee reviews and monitors the independence and objectivity of the external auditors when it approves non-audit work to be carried out by them, taking into consideration relevant legislation and ethical guidance.

Information on the audit and non-audit services carried out by the external auditors is detailed in Note 4 to the Group’s accounts.

38






The Audit Committee undertakes an annual evaluation to assess the independence and objectivity of the external auditors and the effectiveness of the audit process, taking into consideration relevant professional and regulatory requirements. The results of this evaluation are reported to the Board. The Audit Committee makes recommendations to the Board for it to put to the Shareholders for their approval at the Annual General Meeting, in relation to the appointment, re-appointment and removal of Deloitte & Touche LLP as the external auditors and to approve the remuneration and terms of engagement of the external auditors.

Remuneration Committee

The Remuneration Committee is responsible for assisting the Board in discharging its responsibilities and making all relevant disclosures in relation to the formulation and review of the Group’s executive remuneration policy. The Remuneration Committee makes recommendations to the Board on the remuneration arrangements for its executive directors and the Chairman. All members of the Remuneration Committee are independent non-executive directors. No director is involved in decisions regarding his or her own remuneration.

Nominations Committee

The Nominations Committee comprises independent non-executive directors, under the chairmanship of the Chairman of the Board. The Nominations Committee is responsible for assisting the Board in the formal selection and appointment of directors. It considers potential candidates and recommends appointments of new directors to the Board. The appointments are based on merit and against objective criteria including the time available, and commitment which will be required of, the potential director.

In addition, the Nominations Committee considers succession planning for the Chairman, Group Chief Executive and non-executive directors.

The Board is aware of the other commitments of its directors and is satisfied that these do not conflict with their duties as non-executive directors of the company.

Corporate responsibility

Business excellence requires that the RBS Group meets changing customer, shareholder, investor, employee and supplier expectations. The RBS Group believes that meeting high standards of environmental, social and ethical responsibility is key to the way it does business.

Further details of the RBS Group’s corporate responsibility policies will be contained in the 2005 Corporate Responsibility Report.

SHARE OWNERSHIP

The Bank is a wholly-owned direct subsidiary of The Royal Bank of Scotland plc which in turn is a wholly owned direct subsidiary of The Royal Bank of Scotland Group plc.

No director had an interest in NatWest Group’s preference shares or loan notes during the year.

39






ITEM 7. MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS

The Company has omitted this item on the basis of General Instruction I(2)(c) to Form 10-K.

40






ITEM 8. FINANCIAL INFORMATION

CONSOLIDATED STATEMENTS AND OTHER FINANCIAL INFORMATION

The Consolidated Financial Statements are included in Item 18 of this Annual Report.

Legal proceedings

Proceedings, including a consolidated class action, have been brought in the United States against a large number of defendants, including the RBS Group, following the collapse of Enron. The claims against the RBS Group could be significant but are largely unquantified. The RBS Group considers that it has substantial and credible legal and factual defences to these claims and it continues to defend them vigorously. A court ordered mediation commenced in September 2003 but no material progress has been made towards a resolution of the claims, although a number of other defendants have reached settlements in the principal class action. The RBS Group is unable reliably to estimate the possible loss in relation to these matters or the effect that the possible loss might have on the RBS Group’s consolidated net assets or its operating results or cash flows in any particular period. In addition, pursuant to requests received from the US Securities and Exchange Commission and the Department of Justice, the RBS Group has provided copies of Enron-related materials to these authorities and has co-operated fully with them.

Members of NatWest Group are engaged in other litigation in the United Kingdom and a number of overseas jurisdictions, including the United States, involving claims by and against them arising in the ordinary course of business. NatWest Group has reviewed these other actual, threatened and known potential claims and proceedings and, after consulting with its legal advisers, is satisfied that the outcome of these other claims and proceedings will not have a material adverse effect on its consolidated net assets, operating results or cash flows in any particular period.

SIGNIFICANT CHANGES

Post balance sheet events

There have been no significant events between the year end and the date of approval of these accounts which would require a change to or disclosure in the accounts.

41






ITEM 9. THE OFFER AND LISTING

OFFER AND LISTING DETAILS

Nature of trading market

On 10 April 2000, following the acquisition by The Royal Bank of Scotland Group plc, the Bank’s ordinary shares were delisted from the London Stock Exchange and the ordinary shares represented by American Depository Shares were delisted from the New York Stock Exchange. All of the Bank’s ordinary share capital is ultimately held by The Royal Bank of Scotland Group plc.

On 9 June 1993 and 8 April 1997, the Bank issued respectively the following American Depository Shares (“ADSs”), each in connection with a public offering in the United States:

10,000,000 Series B (“Series B ADSs”) representing 10,000,000 non-cumulative dollar preference shares, Series B; and
12,000,000 Series C (“Series C ADSs”) representing 12,000,000 non-cumulative dollar preference shares, Series C.

Each of the respective ADSs represents the right to receive one corresponding preference share, is evidenced by an American Depository Receipt (“ADR”) and is listed on the New York Stock Exchange (“NYSE”).

The ADRs evidencing the ADSs above were issued pursuant to a Deposit Agreement dated as of 25 September 1991, covering both the Series B ADSs and the Series C ADSs, among the Bank, Morgan Guaranty Trust Company of New York as the depository, and all holders from time to time of ADRs issued thereunder. Currently, there is no non-United States trading market for any of the non-cumulative dollar preference shares although Series B dollar preference shares are listed on the London Stock Exchange. All of the non-cumulative dollar preference shares are held by the depository, as custodian, in bearer form.

On 4 November 1993, the Bank issued $500 million 7.875% Exchangeable Capital Securities, $25 each, Series A (“Capital Securities”) in connection with a public offering in the United States. The Capital Securities were listed on the New York Stock Exchange and all of the Capital Securities were redeemed on 16 January 2006.

42






The following table shows the high and low sales prices for each of the ADSs for the period indicated, as reported on the NYSE composite tape:

    Series B
ADSs
  Series C
ADSs



    $   $
By month      
May 2006   High   25.55   25.64
  Low   25.41   25.45
April 2006   High   25.58   25.52
  Low   25.45   25.39
March 2006   High   25.96   26.00
  Low   25.40   25.46
February 2006   High   25.75   25.95
  Low   25.54   25.75
January 2006   High   25.72   25.87
  Low   25.40   25.68
December 2005   High   25.82   25.90
  Low   25.39   25.42
By quarter      
2006 : First quarter   High   25.96   26.00
  Low   25.40   25.46
2005 : Fourth quarter   High   25.83   26.05
  Low   25.39   25.42
2005 : Third quarter   High   25.96   26.30
  Low   25.56   25.58
2005 : Second quarter   High   25.91   26.30
  Low   25.40   25.56
2005 : First quarter   High   25.94   26.23
  Low   25.35   25.80
2004 : Fourth quarter   High   25.85   26.61
  Low   25.38   25.86
2004 : Third quarter   High   26.00   26.52
  Low   25.37   25.65
2004 : Second quarter   High   25.67   26.45
  Low   24.94   25.40
2004: First quarter   High   26.00   26.55
  Low   25.41   25.94
By year      
2005   High   25.96   26.30
  Low   25.35   25.42
2004   High   26.00   26.61
  Low   24.94   25.40
2003   High   25.88   26.83
  Low   25.17   26.00
2002   High   25.90   26.63
  Low   25.00   25.45
2001   High   26.15   27.10
  Low   24.44   24.31

MARKETS

The Series B ADSs, each representing one non-cumulative dollar preference share and the, Series C ADSs, each representing one non-cumulative dollar preference share, are listed on the New York Stock Exchange. The Series B non-cumulative dollar preference shares are also listed on the London Stock Exchange.

43






ITEM 10. ADDITIONAL INFORMATION

MEMORANDUM AND ARTICLES OF ASSOCIATION

A summary of certain terms of the company’s Memorandum of Association (the “Memorandum”) and Articles of Association (the “Articles”) as in effect at the date of this annual report and certain relevant provisions of the Companies Act 1985, as amended (the “Act”) as relevant to the holders of any class of share is contained in the company’s Annual Report on Form 20-F for the year ended 31 December 2002, which summary is incorporated by reference into this annual report. The summary description is qualified in its entirety by reference to the terms and provisions of the Memorandum and Articles. The Memorandum and Articles are registered with the Registrar of Companies of England and Wales. Holders of any class of share are encouraged to read the full Memorandum and Articles, which have been filed with the SEC.

MATERIAL CONTRACTS

The Bank and its subsidiaries are party to various contracts in the ordinary course of business. In the year ended 31 December 2005, there have been no material contracts entered into outside the ordinary course of business.

EXCHANGE CONTROLS

The Bank has been advised that there are currently no UK laws, decrees or regulations which would prevent the remittance of dividends or other payments to non-UK resident holders of the Bank's non-cumulative dollar preference shares.

There are no restrictions under the Articles of Association of the Bank or under UK law, as currently in effect, which limit the right of non-UK resident owners to hold or, when entitled to vote, freely to vote the Bank's non-cumulative dollar preference shares.

TAXATION

The following discussion summarises certain US federal and UK tax consequences of the acquisition, ownership and disposition of non-cumulative dollar preference shares, ADSs or Capital Securities by a beneficial owner of non-cumulative dollar preference shares, ADSs or Capital Securities that is for US federal income tax purposes (i) a citizen or resident of the United States, (ii) a corporation, or other entity taxable as a corporation, created or organised under the laws of the United States or any State thereof, or (iii) a trust or an estate the income of which is subject to US federal income tax without regard to its source and that holds such non-cumulative dollar preference shares, ADSs or Capital Securities as capital assets (a “US Holder”).

This summary does not address the tax consequences to a US Holder (i) that is resident (or, in the case of an individual, ordinarily resident) in the UK for UK tax purposes or, generally, (ii) that is a corporation which alone or together with one or more associated companies, controls, directly or indirectly, 10% or more of the voting stock of the Bank.

The statements and practices set forth below regarding US and UK tax laws (including the US/UK double taxation convention relating to income and capital gains which entered into force on 31 March 2003 (the “Treaty”) and the US/UK double taxation convention relating to estate and gift taxes (the “Estate Tax Treaty”) are based on those laws and practices as in force and as applied in practice on the date of this Report, which are subject to change, possibly with retroactive effect. This summary is not exhaustive of all possible tax considerations and holders are advised to satisfy themselves as to the overall tax consequences, including specifically the consequences under US state, local and other laws, of the acquisition, ownership and disposition of non-cumulative dollar preference shares, ADSs or Capital Securities by consulting their own tax advisers.

For the purposes of the Treaty and the Estate Tax Treaty and for purposes of the US Internal Revenue Code of 1986, as amended (the “Code”), US Holders of ADSs will be treated as owners of the non-cumulative dollar preference shares underlying such ADSs.

44






Preference shares or ADSs
Taxation of dividends

The Bank is not required to withhold tax at source from dividend payments it makes or from any amount (including any amounts in respect of accrued dividends) distributed by the Bank on a redemption or winding-up.

Distributions will constitute foreign source dividend income to the extent paid out of the Bank’s current or accumulated earnings and profits, as determined for US federal income tax purposes. Distributions will not be eligible for the dividends-received deduction generally allowed to corporate US Holders.

Subject to applicable limitations that may vary depending on a holder’s individual circumstances, dividends paid to certain non-corporate US Holders in taxable years beginning before 1 January 2011 will be taxable at a maximum rate of 15%. on-corporate US Holders should consult their own tax advisers to determine whether they are subject to any special rules that limit their ability to be taxed at this favourable rate.

Taxation of capital gains

Subject to the provisions set out in the next paragraph in relation to temporary non-residents, a US Holder that is not resident (or, in the case of an individual, ordinarily resident) in the UK will not normally be liable for UK tax on gains realized on the disposal of such holder's non-cumulative dollar preference share or ADS unless at the time of the disposal, in the case of a corporate US Holder, such US Holder carries on a trade in the UK through a permanent establishment or, in the case of any other US Holder, such US Holder carries on a trade, profession or vocation in the UK through a branch or agency and such non-cumulative dollar preference share or ADS is or has been used, held or acquired by or for the purposes of such trade (or profession or vocation), permanent establishment, branch or agency, in which case such US Holder might, depending on the circumstances, be liable to UK tax on gain realized on disposal of such holder’s non-cumulative dollar preference share or ADS.

An individual US Holder who has ceased to be resident or ordinarily resident for UK tax purposes in the UK for a period of less than five years of assessment and who disposes of a non-cumulative dollar preference share or ADS during that period may, for the year of assessment when that individual returns to the UK, be liable to UK taxation on chargeable gains arising during the period of absence, subject to any available exemption or relief.

A US Holder will, upon the sale, exchange or redemption of a non-cumulative dollar preference share or ADS representing preference shares, generally recognise capital gain or loss for US federal income tax purposes (assuming in the case of a redemption, that such US Holder does not own, and is not deemed to own, any ordinary shares of the Bank) in an amount equal to the difference between the amount realised (excluding any declared but unpaid dividends, which will be treated as a dividend for US federal income tax purposes) and the US Holder's tax basis in the non-cumulative dollar preference share or ADS. Gain or loss will generally be US source.

A US Holder who is liable for both UK and US tax on a gain recognised on the disposal of a non-cumulative dollar preference share or ADS will generally be entitled, subject to certain limitations, to credit the UK tax against its US federal income tax liability in respect of such gain.

US Holders should consult their tax advisers regarding the US federal income tax treatment of capital gains (which may be taxed at lower rates than ordinary income for certain non-corporate taxpayers) and losses (the deductibility of which is subject to limitations).

Finance (No. 2) Act 2005

If a corporate US Holder is subject to UK corporation tax by reason of carrying on a trade in the UK through a permanent establishment and such US Holder’s non-cumulative dollar preference share or ADS is, or has been, used, held or acquired for the purpose of that permanent establishment, certain provisions introduced by the Finance (No. 2) Act 2005 may apply if the US Holder holds its non-cumulative dollar preference share or ADS, as well as certain fair value credits and debits arising in respect of such non-cumulative dollar preference share or ADS, may be brought within the charge to UK corporation tax on income and the UK tax position outlined in the proceeding paragraphs under the sub-heading “Taxation of Capital Gains” in relation to such US Holder will not apply.

45






Estate and gift tax

A non-cumulative dollar preference share or ADS beneficially owned by an individual, whose domicile is determined to be the United States for the purposes of the Estate Tax Treaty and who is not a national of the UK, will not be subject to UK inheritance tax on the individual's death or on a lifetime transfer of the non-cumulative dollar preference share or ADS, except in certain cases where the non-cumulative dollar preference share or ADS (i) is comprised in a settlement (unless, at the time of the settlement, the settlor was domiciled in the United States and was not a national of the UK); (ii) is part of the business property of a UK permanent establishment of an enterprise; or (iii) pertains to a UK fixed base of an individual used for the performance of independent personal services. The Estate Tax Treaty generally provides a credit against US federal estate or gift tax liability for the amount of any tax paid in the UK in a case where a non-cumulative dollar preference share or ADS is subject both to UK inheritance tax and to US federal estate or gift tax.

UK stamp duty and stamp duty reserve tax (“SDRT”)

The following is a summary of the UK stamp duty and SDRT consequences of transferring an ADS in registered form (otherwise than to the custodian on cancellation of the ADS). It does not set out the UK stamp duty or SDRT consequences of transferring, or agreeing to transfer, non-cumulative dollar preference shares or any interest therein or right thereto (other than interests in ADSs) on which investors should consult their own tax advisers.

A transfer of an ADS in registered form executed and retained in the US will not give rise to stamp duty and an agreement to transfer an ADS in registered form will not give rise to SDRT.

Capital Securities

United States

Because the Capital Securities have no stated maturity, can be exchanged for preference shares or ADSs at the option of the Bank and would be treated as if they were preference shares in a winding-up of the Bank, and because the Bank may elect not to make payments on the Capital Securities, the Capital Securities will be treated as equity for US federal income tax purposes.

Payments (including any UK withholding tax, as to which see below) will constitute foreign source dividend income for US federal income tax purposes to the extent paid out of the Bank’s current or accumulated earnings and profits, as determined for US federal income tax purposes. Payments will not be eligible for the dividends-received deduction allowed to corporate US Holders.

Subject to applicable limitations that may vary depending on a holder’s individual circumstances, dividends paid to certain non-corporate US Holders in taxable years beginning before 1 January 2011 will be taxable at a maximum rate of 15%. Non-corporate US Holders should consult their own tax advisers to determine whether they are subject to any special rules that limit their ability to be taxed at this favourable rate.

A US Holder will, upon the sale, exchange or redemption of Capital Securities, generally recognise capital gain or loss for US federal income tax purposes in an amount equal to the difference between the amount realised and the US Holder’s tax basis in the Capital Securities (assuming, in the case of a redemption, that such US Holder does not own, and is not deemed to own, any ordinary shares of the Bank).

Gain or loss will not be recognised by a US Holder upon the exchange of Capital Securities for preference shares or ADSs pursuant to the Bank’s exercise of its exchange right. A US Holder's basis in the preference shares or ADSs received in exchange for its Capital Securities will be the same as the US Holder’s basis in the Capital Securities at the time of the exchange and the US Holder's holding period for the preference shares or ADSs received in the exchange will include the holding period of the Capital Securities exchanged.

United Kingdom
Taxation of payments of interest

Payments on the Capital Securities will constitute interest rather than dividends for UK withholding tax purposes. However, the Capital Securities will constitute “quoted eurobonds” within the meaning of section 349 of the Income and Corporation Taxes Act 1988 and therefore payments of interest will not be subject to withholding or deduction for or on account of UK taxation as long as Capital Securities are and remain at all times listed on a ‘recognised stock exchange’ within the meaning of section 841 of the Income and Corporation Taxes Act 1988 (the New York Stock Exchange is so recognised). In all other cases an amount must be withheld on account of UK income tax at the lower rate (currently 20%) subject to any direction to the contrary by HM Revenue & Customs under the Treaty and subject to an entitlement to pay without withholding to US Holders within the charge to UK corporation tax.

46






If interest were paid under deduction of United Kingdom income tax (e.g., if the Capital Securities lost their listing), US Holders may be able to claim a refund of the tax deducted under the Treaty.

Any paying agent or other person through whom interest is paid to, or by whom interest is received on behalf of, an individual, may be required to provide information in relation to the payment and the individual concerned to HM Revenue & Customs. HM Revenue & Customs may communicate this information to the tax authorities of other jurisdictions.

The interest has a United Kingdom source and accordingly may be chargeable to United Kingdom tax by direct assessment. Where the interest is paid without withholding or deduction, the interest will not be assessed to United Kingdom tax in the hands of holders of the Capital Securities who are not resident in the United Kingdom, except where, in the case of a corporate US Holder, such US Holder carries on a trade in the UK through a permanent establishment or, in the case of other US Holders, such persons carry on a trade, profession or vocation in the United Kingdom through a United Kingdom branch or agency in connection with which the interest is received or to which the Capital Securities are attributable, in which case (subject to exemptions for interest received by certain categories of agent) tax may be levied on the United Kingdom permanent establishment, branch or agency.

HM Revenue & Customs has confirmed that interest payments should not be treated as distributions for UK tax purposes (i) by reason of the fact that interest may be deferred under the terms of issue or (ii) by reason of the undated nature of the Capital Securities, provided that at the time an interest payment is made, the Capital Securities are not held by a company which is 'associated' with the Bank or by a 'funded company'. A company will be associated with the Bank if, broadly speaking, it is in the same group as the Bank. A company will be a 'funded company' for these purposes if there are arrangements involving that company being put in funds (directly or indirectly) by the Bank, or an entity associated with the Bank. In this respect, HM Revenue & Customs has confirmed that a bank holding an interest in Capital Securities which incidentally has banking facilities with the Bank will not be a 'funded company' by virtue of such facilities.

EU Directive on the Taxation of Savings Income

The EU has adopted a Directive regarding the taxation of savings income. The Directive requires Member States to provide to the tax authorities of other Member State details of payments of interest (or other similar income) paid by a person within its jurisdiction to an individual resident in another Member State, except that Belgium, Luxembourg and Austria will instead operate a withholding system for a transitional period unless during such period they elect otherwise.

Disposal (including Redemption)

Subject to the provisions set out in the next paragraph in relation to temporary non-residents, a non-corporate US Holder will not normally be liable for UK tax on gains realized on the disposal of such holder's Capital Securities unless at the time of the disposal such US Holder carries on a trade, profession or vocation in the UK through a branch or agency and such Capital Securities are or have been used, held or acquired by or for the purposes of such trade (or profession or vocation), branch or agency in which case such US Holder might, depending on the circumstances, be liable to UK tax on a gain realized on a disposal of Capital Securities.

A US Holder who is an individual and who has ceased to be resident or ordinarily resident for tax purposes in the UK for a period of less than five years of assessment and who disposes of Capital Securities during that period may, for the year of assessment when that individual returns to the UK, be liable to UK taxation on capital gains arising during the period of absence, subject to any available exemption or relief.

Subject to certain conditions being met, an exchange by a US Holder of Capital Securities for non-cumulative dollar preference shares or ADSs pursuant to the Bank's exercise of its exchange right will not give rise to a charge to UK tax on capital gains even if such US Holder would be subject to tax on a disposal of such holder’s Capital Securities in accordance with the tax treatment referred to in the preceding paragraphs.

A transfer of Capital Securities by a non-corporate US Holder will not give rise to a charge to UK tax on accrued but unpaid interest payments, unless the US Holder at any time in the relevant year of assessment or accounting period carries on a trade in the UK through a branch or agency to which the Capital Securities are attributable.

Corporate holders - Annual tax charges

A transfer of Capital Securities by a corporate US Holder that is not resident in the UK should not give rise to any UK tax charge unless such US Holder carries on a trade, profession or vocation in the UK through a permanent establishment to which the Capital Securities are attributable, in which case it may be subject to UK tax charges (or relief) by reference to fluctuations in exchange rates and in respect of profits, gains and losses arising from the Capital Securities.

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Inheritance tax

Capital Securities in bearer form physically held outside the UK should not be subject to UK inheritance tax in respect of a lifetime transfer by, or the death of, a US Holder who is neither domiciled nor deemed to be domiciled in the UK for inheritance tax purposes. However, in relation to Capital Securities held through DTC (or any other clearing system), the position is not free from doubt and HM Revenue & Customs are known to consider that the situs of securities held in this manner is not necessarily determined by the place in which the securities are physically held. If Capital Securities in bearer form are or become situated in the UK, or if Capital Securities are held in registered form, there may be a charge to UK inheritance tax as a result of a lifetime transfer at less than fair market value by, or on the death of, such a US Holder. However, exemption from, or a reduction of, any such UK tax liability may be available under the Estate Tax Treaty in the same manner as for non-cumulative dollar preference shares. US Holders should consult their professional advisers in relation to such potential liability.

Stamp duty and SDRT

No UK stamp duty or SDRT is payable on the transfer or redemption of Capital Securities, whether in definitive bearer form or in the form of one or more bearer global Capital Securities or in registered form.

No UK stamp duty or SDRT will be payable on issue of ADSs in exchange for Capital Securities pursuant to the Bank’s exercise of its exchange rights. As a result of a change in law since the Capital Securities were issued, the SDRT consequences of the issue of the non-cumulative dollar preference shares represented by the ADSs into the depository receipt system are not entirely clear and it is possible that a charge to SDRT at the rate of 1.5% could arise.

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ITEM 11. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

Risk management is conducted on an overall basis within the RBS Group. The financial risk management objectives and policies of the RBS Group and information on NatWest Group’s exposure to price, credit, liquidity and cash flow risk are contained in Note 32 on the financial statements, included in Item 18 of this Annual Report on Form 20-F.

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ITEM 15. CONTROLS AND PROCEDURES

Disclosure controls and procedures
As required by US regulations, the Group Chief Executive and the Group Finance Director have evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in the rules under the US Securities Exchange Act of 1934). This evaluation has been considered and approved by the Board which has authorised the Group Chief Executive and the Group Finance Director to certify that as at 31 December 2005, the Company’s disclosure controls and procedures were adequate and effective and designed to ensure that material information relating to the Company and its consolidated subsidiaries would be made known to them by others within those entities.

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

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ITEM 18. CONSOLIDATED FINANCIAL STATEMENTS

CONTENTS

  Page
     
Statement of directors’ responsibilities   52
     
Report of independent registered public accounting firm   53
   
Accounting policies   54
   
Consolidated income statement for the year ended 31 December 2005   63
     
Balance sheets at 31 December 2005   64
   
Statements of recognised income and expense for the year ended  
31 December 2005   65
   
Cash flow statements for the year ended 31 December 2005   66
     
Notes on the accounts   67

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Statement of directors’ responsibilities

The Directors are required by Article 4 of the IAS Regulation (European Commission Regulation No 1606/2002) to prepare Group accounts and, as permitted by the Companies Act 1985 have elected to prepare Bank accounts for each financial year and have elected to prepare them in accordance with International Financial Reporting Standards. They are responsible for preparing accounts that present fairly the financial position, financial performance and cash flows of the Group and the Bank. In preparing those accounts, the directors are required to:

  • select suitable accounting policies and then apply them consistently;

  • make judgements and estimates that are reasonable and prudent;

  • state whether applicable accounting standards have been followed, subject to any material departures disclosed and explained in the accounts; and

  • prepare the accounts on the going concern basis unless it is inappropriate to presume that the Bank will continue in business.

The directors are responsible for keeping proper accounting records which disclose with reasonable accuracy at any time the financial position of the Bank and to enable them to ensure that the Annual report and accounts complies with the Companies Act 1985. They are also responsible for safeguarding the assets of the Bank and the Group and hence for taking reasonable steps for the prevention and detection of fraud and other irregularities.


By order of the Board.

 

Miller McLean
Secretary
29 March 2006

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Report of independent registered public accounting firm to the members of National Westminster Bank Plc


We have audited the accompanying consolidated balance sheets of National Westminster Bank Plc (the “Bank”) and its subsidiary undertakings (together “the Group”) as at 31 December 2005 and 2004, and the related consolidated income statements, the statements of recognised income and expense and the consolidated cash flow statements for each of the years then ended. These financial statements are the responsibility of the directors. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Group is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Group’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of National Westminster Bank Plc and subsidiaries as at 31 December 2005 and 2004, and the results of their operations and their cash flows for each of the years then ended in conformity with International Financial Reporting Standards (“IFRS”).

IFRS vary in certain significant respects from accounting principles generally accepted in the United States of America. Information relating to the nature and effect of such differences is presented in Note 46 to the consolidated financial statements.

Deloitte & Touche LLP
Chartered Accountants and Registered Auditors
Edinburgh, United Kingdom

22 June 2006

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Accounting policies


1. Adoption of International Financial Reporting Standards

The annual accounts have, for the first time, been prepared in accordance with International Financial Reporting Standards adopted by the International Accounting Standards Board (“IASB”), and interpretations issued by the International Financial Reporting Interpretations Committee of the IASB (together “IFRS”) as endorsed by the European Union (“EU”). The EU has not endorsed the complete text of IAS 39 ‘Financial Instruments: Recognition and Measurement’; it has relaxed some of the standard’s hedging requirements. The Group has not taken advantage of this relaxation and has adopted IAS 39 as issued by the IASB. The date of transition to IFRS for the Group and the Bank and the date of their opening IFRS balance sheets was 1 January 2004. The Bank accounts have been presented in accordance with the Companies Act 1985.

The main differences between IFRS and previously applied generally accepted accounting principles in the United Kingdom (“UK GAAP”) and the effect of implementing IFRS on the Group and Bank balance sheets and shareholders’ funds as at 1 January and 31 December 2004 and on the Group’s 2004 consolidated income statement are set out on pages 117 to 125.

On initial adoption of IFRS, the Group (and the Bank where relevant) 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’:

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 UK GAAP, goodwill arising on acquisitions was capitalised and amortised over its estimated useful economic life. The carrying amount of goodwill in the Group’s opening IFRS balance sheet was £273 million, its carrying value under UK GAAP as at 31 December 2003.

Fair value or revaluation as deemed cost – under UK GAAP, the Group’s freehold and long leasehold property occupied for its own use was recorded at valuation on the basis of existing use value. The Group has elected to use this valuation as at 31 December 2003 as deemed cost for its opening IFRS balance sheet. At this date, the carrying value under UK GAAP of freehold and long leasehold property occupied for own use was £1,334 million.

Compound financial instruments – the Group has not separated compound instruments between liability and equity components, as required by IAS 32 ‘Financial Instruments: Disclosure and Presentation’, where the liability component was not outstanding at 1 January 2004. UK GAAP did not permit compound instruments to be separated between liability and equity components on issue.

Derecognition – the Group has applied the derecognition requirements of IAS 39 to transactions occurring on or after 1 January 1992.

Implementation of IAS 32 and IAS 39 – as allowed by IFRS 1, the Group and the Bank implemented IAS 32 and IAS 39 with effect from 1 January 2005 without restating the income statement, balance sheet and notes for 2004. The Group has adopted the Amendment to IAS 39 ‘The Fair Value Option’ issued by the IASB in June 2005 also from 1 January 2005. The effect of implementing IAS 32 and IAS 39 on the Group and Bank balance sheets and shareholders’ funds as at 1 January 2005 is set out on pages 126 to 128. In preparing the 2004 comparatives, UK GAAP principles then current have been applied to financial instruments. The main differences between UK GAAP and IFRS on financial instruments are summarised on pages 119 to 121.

IFRS 1 prohibits retrospective application of some aspects of IFRS:

 

Derecognition of financial assets and liabilities – non-derivative financial assets and liabilities derecognised before 1 January 1992 (the date from which the derecognition requirements of IAS 39 have been implemented) under the Group’s previous GAAP have not been recognised in its opening IFRS balance sheet.

   
  Hedge accounting – hedging relationships of a type that does not qualify for hedge accounting under IAS 39 are not reflected in the Group’s opening IFRS balance sheet.
   
  Discontinued operations and assets classified as held for sale – the Group has applied IFRS 5 ‘Non-current Assets Held for Sale and Discontinued Operations’ from 1 January 2005.

The Group has adopted the Amendment ‘Actuarial Gains and Losses, Group Plans and Disclosures’ to IAS 19 ‘Employee Benefits’ from 1 January 2004.

2. Accounting convention

The Bank is incorporated in the UK and registered in England. The financial statements have been prepared on the historical cost basis except that the following assets and liabilities are stated at their fair value: derivative financial instruments, held-for-trading financial assets and financial liabilities, financial assets and financial liabilities that are designated as at fair value through profit or loss, available-for-sale financial assets and investment property. Recognised financial assets and financial liabilities in fair value hedges are adjusted for changes in fair value in respect of the risk that is hedged.

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Accounting policies continued

3. Basis of consolidation

The consolidated financial statements incorporate the financial statements of the Bank and entities (including certain special purpose entities) controlled by the Group (its subsidiaries). Control exists where the Group has the power to govern the financial and operating policies of the entity; generally conferred by holding a majority of voting rights. On acquisition of a subsidiary, its identifiable assets, liabilities and contingent liabilities are included in the consolidated accounts at their fair value. Any excess of the cost (the fair value of assets given, liabilities incurred or assumed and equity instruments issued by the Group plus any directly attributable costs) of an acquisition over the fair value of the net assets acquired is recognised as goodwill. The interest of minority shareholders is stated at their share of the fair value of the subsidiary’s net assets.

The results of subsidiaries acquired are included in the consolidated income statement from the date control passes to the Group. The results of subsidiaries sold are included up until the Group ceases to control them.

All intra-group balances, transactions, income and expenses are eliminated on consolidation. The consolidated accounts are prepared using uniform accounting policies.

4. Revenue recognition

Interest income on financial assets that are classified as loans and receivables, available-for-sale or held-to-maturity and interest expense on financial liabilities other than those at fair value through profit or loss are determined using the effective interest rate method. The effective interest rate method is a method of calculating the amortised cost of a financial asset or financial liability (or group of financial assets or liabilities) and of allocating the interest income or interest expense over the expected life of the asset or liability. The effective interest rate is the rate that exactly discounts estimated future cash flows to the instrument’s initial carrying amount. Calculation of the effective interest rate takes into account fees receivable, that are an integral part of the instrument’s yield, premiums or discounts on acquisition or issue, early redemption fees and transaction costs. All contractual terms of a financial instrument are considered when estimating future cash flows.

Financial assets and financial liabilities held-for-trading or designated as at fair value through profit or loss are recorded at fair value. Changes in fair value are recognised in profit or loss together with dividends and interest receivable and payable.

Commitment and utilisation fees are determined as a percentage of the outstanding facility. If it is unlikely that a specific lending arrangement will be entered into, such fees are taken to profit or loss over the life of the facility otherwise they are deferred and included in the effective interest rate on the advance.

Fees in respect of services are recognised as the right to consideration accrues through the provision of the service to the customer. The arrangements are generally contractual and the cost of providing the service is incurred as the service is rendered. The price is usually fixed and always determinable. The application of this policy to significant fee types is outlined below.

Payment services: this comprises income received for payment services including cheques cashed, direct debits, Clearing House Automated Payments (the UK electronic settlement system) and BACS payments (the automated clearing house that processes direct debits and direct credits). These are generally charged on a per transaction basis. The income is earned when the payment or transaction occurs. Payment services income is usually charged to the customer’s account, monthly or quarterly in arrears. Accruals are raised for services provided but not charged at period end.

Card related services: fees from credit card business include:

 

Commission received from retailers for processing credit and debit card transactions: income is accrued to the income statement as the service is performed.

   
  Interchange received: as issuer, the Group receives a fee (interchange) each time a cardholder purchases goods and services. The Group also receives interchange fees from other card issuers for providing cash advances through its branch and Automated Teller Machine networks. These fees are accrued once the transaction has taken place.
   
  An annual fee payable by a credit card holder is deferred and taken to profit or loss over the period of the service i.e. 12 months.

Insurance brokerage: this is made up of fees and commissions received from the agency sale of insurance. Commission on the sale of an insurance contract is earned at the inception of the policy as the insurance has been arranged and placed. However, provision is made where commission is refundable in the event of policy cancellation in line with estimated cancellations.

Investment management fees: fees charged for managing investments are recognised as revenue as the services are provided. Incremental costs that are directly attributable to securing an investment management contract are deferred and charged as expense as the related revenue is recognised.

5. Pensions and other post-retirement benefits

The Group provides post-retirement benefits in the form of pensions and healthcare plans to eligible employees.

For defined benefit schemes, scheme liabilities are measured on an actuarial basis using the projected unit credit method and discounted at a rate that reflects the current rate of return on a high quality corporate bond of equivalent term and currency to the scheme liabilities. Scheme assets are measured at their fair value. Cumulative actuarial gains or losses that exceed 10 per cent of the greater of the assets or

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the obligations of the scheme are amortised to the income statement over the expected average remaining lives of participating employees. Past service costs are recognised immediately to the extent that benefits have vested; otherwise they are amortised over the period until the benefits become vested.

Any surplus or deficit of scheme assets over liabilities adjusted for unrecognised actuarial gains and losses and past service costs is recognised in the balance sheet as an asset (surplus) or liability (deficit).

Contributions to defined contribution pension schemes are recognised in the income statement when payable.

6. Intangible assets and goodwill

Intangible assets that are acquired by the Group are stated at cost less accumulated amortisation and impairment losses. Amortisation is charged to profit or loss using methods that best reflect the economic benefits over their estimated useful economic lives and is included in Depreciation and amortisation. The estimated useful economic lives are as follows:

  Core deposit intangibles   up to 8 years
  Other acquired intangibles   5-10 years
  Computer software   3-5 years

Expenditure on internally generated goodwill and brands is written-off as incurred. Acquired goodwill being the excess of the cost of an acquisition over the Group’s interest in the net fair value of the identifiable assets, liabilities and contingent liabilities of the subsidiary, associate or joint venture acquired is initially recognised at cost and subsequently at cost less any accumulated impairment losses. Goodwill arising on the acquisition of subsidiaries and joint ventures is included in the balance sheet caption ‘Intangible assets’ and that on associates within their carrying amounts. The gain or loss on the disposal of a subsidiary, associate or joint venture includes the carrying value of any related goodwill.

7. Property, plant and equipment

Items of property, plant and equipment are stated at cost less accumulated depreciation (see below) and impairment losses. Where an item of property, plant and equipment comprises major components having different useful lives, they are accounted for separately. Property that is being constructed or developed for future use as investment property is classified as property, plant and equipment and stated at cost until construction or development is complete, at which time it is reclassified as investment property.

Depreciation is charged to profit or loss on a straight-line basis so as to write-off the depreciable amount of property, plant and equipment (including assets owned and let on operating leases (except investment property – see note 18 below)) over their estimated useful lives. The depreciable amount is the cost of an asset less its residual value. Land is not depreciated.

Estimated useful lives are as follows:

  Freehold and long leasehold buildings   50 years
  Short leaseholds   unexpired period
      of the lease
  Property adaptation costs   10 to 15 years
  Computer equipment   up to 5 years
  Other equipment   4 to 15 years

8. Impairment of intangible assets and property, plant and equipment

At each reporting date, the Group assesses whether there is any indication that its intangible assets, or property, plant and equipment are impaired. If any such indication exists, the Group estimates the recoverable amount of the asset and the impairment loss if any. Goodwill is tested for impairment annually or more frequently if events or changes in circumstances indicate that it might be impaired. If an asset does not generate cash flows that are independent from those of other assets or groups of assets, recoverable amount is determined for the cash-generating unit to which the asset belongs. The recoverable amount of an asset is the higher of its fair value less costs to sell and its value in use. Value in use is the present value of future cash flows from the asset or cash-generating unit discounted at a rate that reflects market interest rates adjusted for risks specific to the asset or cash generating unit that have not been reflected in the estimation of future cash flows. If the recoverable amount of an intangible or tangible asset is less than its carrying value, an impairment loss is recognised immediately in profit or loss and the carrying value of the asset reduced by the amount of the loss. A reversal of an impairment loss on intangible assets (excluding goodwill) or property, plant and equipment is recognised as it arises provided the increased carrying value does not exceed that which it would have been had no impairment loss been recognised. Impairment losses on goodwill are not reversed.

9. Foreign currencies

The Group’s consolidated financial statements are presented in sterling which is the functional currency of the Bank.

Transactions in foreign currencies are translated into sterling at the foreign exchange rate ruling at the date of the transaction. Monetary assets and liabilities denominated in foreign currencies are translated into sterling at the rates of exchange ruling at the balance sheet date. Foreign exchange differences arising on translation are recognised in profit or loss except for differences arising on cash flow hedges and hedges of net investments in foreign operations. Non-monetary items denominated in foreign currencies that are stated at fair value are translated into sterling at foreign exchange rates ruling at the dates the values were determined. Translation differences arising on non-monetary items measured at fair value are recognised in profit or loss except for differences arising on available-for-sale non-monetary financial assets, for example equity shares, which are included in the available-for-sale reserve in equity unless the asset is the hedged item in a fair value hedge.

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Accounting policies continued

The assets and liabilities of foreign operations, including goodwill and fair value adjustments arising on acquisition, are translated into sterling at foreign exchange rates ruling at the balance sheet date. The revenues and expenses of foreign operations are translated into sterling at average exchange rates unless these do not approximate to the foreign exchange rates ruling at the dates of the transactions. Foreign exchange differences arising on the translation of foreign operations are recognised directly in equity.

10. Leases

Contracts to lease assets are classified as finance leases if they transfer substantially all the risks and rewards of ownership of the asset to the customer. Other contracts to lease assets are classified as operating leases.

Finance lease receivables are stated in the balance sheet at the amount of the net investment in the lease being the minimum lease payments and any unguaranteed residual value discounted at the interest rate implicit in the lease. Finance lease income is allocated to accounting periods so as to give a constant periodic rate of return before tax on the net investment. Unguaranteed residual values are subject to regular review to identify potential impairment. If there has been a reduction in the estimated unguaranteed residual value, the income allocation is revised and any reduction in respect of amounts accrued is recognised immediately.

Rental income from operating leases is credited to the income statement on a receivable basis over the term of the lease. Operating lease assets are included within Property, plant and equipment and depreciated over their useful lives (see note 7 above).

11. Taxation

Provision is made for taxation at current enacted rates on taxable profits, arising in income or in equity, taking into account relief for overseas taxation where appropriate. Deferred taxation is accounted for in full for all temporary differences between the carrying amount of an asset or liability for accounting purposes and its carrying amount for tax purposes, except in relation to overseas earnings where remittance is controlled by the Group, and goodwill.

Deferred tax assets are only recognised to the extent that it is probable that they will be recovered.

12. Financial assets

Financial assets are classified into held-to-maturity investments; available-for-sale financial assets; held-for-trading; designated as at fair value through profit or loss; or loans and receivables.

Held-to-maturity investments – a financial asset is classified as a held-to-maturity investment only if it has fixed or determinable payments, a fixed maturity and the Group has the positive intention and ability to hold to maturity. Held-to-maturity investments are initially recognised at fair value plus directly related transaction costs. They are subsequently measured at amortised cost using the effective interest method (see note 4 above) less any impairment losses.

Held-for-trading – a financial asset is classified as held-for-trading if it is acquired principally for the purpose of selling in the near term, or forms part of a portfolio of financial instruments that are managed together and for which there is evidence of short-term profit taking, or it is a derivative (not in a qualifying hedge relationship). Held-for-trading financial assets are recognised at fair value with transaction costs being recognised in profit or loss. Subsequently they are measured at fair value. Gains and losses on held-for-trading financial assets are recognised in profit or loss as they arise.

Designated as at fair value through profit or loss – financial assets that the Group designates on initial recognition as being at fair value through profit or loss are recognised at fair value, with transaction costs being recognised in profit or loss and are subsequently measured at fair value. Gains and losses on financial assets that are designated as at fair value through profit or loss are recognised in profit or loss as they arise.

Financial assets may be designated as at fair value through profit or loss only if such designation (a) eliminates or significantly reduces a measurement or recognition inconsistency; or (b) applies to a group of financial assets, financial liabilities or both that the Group manages and evaluates on a fair value basis; or (c) relates to an instrument that contains an embedded derivative which is not evidently closely related to the host contract.

Loans and receivables – non-derivative financial assets with fixed or determinable repayments that are not quoted in an active market are classified as loans and receivables except those that are classified as available-for-sale or as held-for-trading, or designated as at fair value through profit or loss. Loans and receivables are initially recognised at fair value plus directly related transaction costs. They are subsequently measured at adjusted cost using the effective interest method (see note 4 above) less any impairment losses.

Available-for-sale – financial assets that are not classified as held-to-maturity; held-for-trading; designated at fair value through profit or loss; or loans and receivables are classified as available-for-sale. Financial assets can be designated as available-for-sale on initial recognition. Available-for-sale financial assets are initially recognised at fair value plus directly related transaction costs. They are subsequently measured at fair value. Impairment losses and exchange differences resulting from retranslating the amortised cost of currency monetary available-for-sale financial assets are recognised in profit or loss together with interest calculated using the effective interest rate (see note 4 above). Other changes in the fair value of available-for-sale financial assets are reported in a separate component of shareholders’ equity until disposal, when the cumulative gain or loss is recognised in profit or loss.

Regular way purchases of financial assets classified as loans and receivables are recognised on settlement date; all other regular way purchases are recognised on trade date.

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Fair value for a net open position in a financial asset that is quoted in an active market is the current bid price times the number of units of the instrument held. Fair values for financial assets not quoted in an active market are determined using appropriate valuation techniques including discounting future cash flows, option pricing models and other methods that are consistent with accepted economic methodologies for pricing financial assets.

13. Impairment of financial assets

The Group assesses at each balance sheet date whether there is any objective evidence that a financial asset or group of financial assets classified as held-to-maturity, available-for-sale or loans and receivables is impaired. A financial asset or portfolio of financial assets is impaired and an impairment loss incurred if there is objective evidence that an event or events since initial recognition of the asset have adversely affected the amount or timing of future cash flows from the asset.

Financial assets carried at amortised cost – if there is objective evidence that an impairment loss on a financial asset or group of financial assets classified as loans and receivables or as held-to-maturity investments has been incurred, the Group measures the amount of the loss as the difference between the carrying amount of the asset or group of assets and the present value of estimated future cash flows from the asset or group of assets discounted at the effective interest rate of the instrument at initial recognition. Impairment losses are assessed individually for financial assets that are individually significant and individually or collectively for assets that are not individually significant. In making collective assessment of impairment, financial assets are grouped into portfolios on the basis of similar risk characteristics. Future cash flows from these portfolios are estimated on the basis of the contractual cash flows and historical loss experience for assets with similar credit risk characteristics. Historical loss experience is adjusted, on the basis of current observable data, to reflect the effects of current conditions not affecting the period of historical experience.

Impairment losses are recognised in profit or loss and the carrying amount of the financial asset or group of financial assets reduced by establishing an allowance for impairment losses. If in a subsequent period the amount of the impairment loss reduces and the reduction can be ascribed to an event after the impairment was recognised, the previously recognised loss is reversed by adjusting the allowance. Once an impairment loss has been recognised on a financial asset or group of financial assets, interest income is recognised on the carrying amount using the rate of interest at which estimated future cash flows were discounted in measuring impairment.

Financial assets carried at fair value – when a decline in the fair value of a financial asset classified as available-for-sale has been recognised directly in equity and there is objective evidence that the asset is impaired, the cumulative loss is removed from equity and recognised in profit or loss. The loss is measured as the difference between the amortised cost of the financial asset and its current fair value. Impairment losses on available-for-sale equity instruments are not reversed through profit or loss, but those on available-for-sale debt instruments are reversed, if there is an increase in fair value that is objectively related to a subsequent event.

14. Financial liabilities

A financial liability is classified as held-for-trading if it is incurred principally for the purpose of selling in the near term, or forms part of a portfolio of financial instruments that are managed together and for which there is evidence of short-term profit taking, or it is a derivative (not in a qualifying hedge relationship). Held-for-trading financial liabilities are recognised at fair value with transaction costs being recognised in profit or loss. Subsequently they are measured at fair value. Gains and losses are recognised in profit or loss as they arise. Financial liabilities that the Group designates on initial recognition as being at fair value through profit or loss are recognised at fair value, with transaction costs being recognised in profit or loss and are subsequently measured at fair value. Gains and losses on financial liabilities that are designated as at fair value through profit or loss are recognised in profit or loss as they arise.

Financial liabilities may be designated as at fair value through profit or loss only if such designation (a) eliminates or significantly reduces a measurement or recognition inconsistency; or (b) applies to a group of financial assets, financial liabilities or both that the Group manages and evaluates on a fair value basis; or (c) relates to an instrument that contains an embedded derivative which is not evidently closely related to the host contract.

The principal category of financial liabilities designated as at fair value through profit or loss is structured liabilities issued by the Group: designation significantly reduces the measurement inconsistency between these liabilities and the related derivatives carried at fair value.

All other financial liabilities are measured at amortised cost using the effective interest method (see note 4 above).

58






Fair value for a net open position in a financial liability that is quoted in an active market is the current offer price times the number of units of the instrument held or issued. Fair values for financial liabilities not quoted in an active market are determined using appropriate valuation techniques including discounting future cash flows, option pricing models and other methods that are consistent with accepted economic methodologies for pricing financial liabilities.

15. Derecognition

A financial asset is derecognised when it has been transferred and the transfer qualifies for derecognition. A transfer requires that the Group either: (a) transfers the contractual rights to receive the asset’s cash flows; or (b) retains the right to the asset’s cash flows but assumes a contractual obligation to pay those cash flows to a third party. After a transfer, the Group assesses the extent to which it has retained the risks and rewards of ownership of the transferred asset. If substantially all the risks and rewards have been retained, the asset remains on the balance sheet. If substantially all of the risks and rewards have been transferred, the asset is derecognised. If substantially all the risks and rewards have been neither retained nor transferred, the Group assesses whether or not it has retained control of the asset. If it has not retained control, the asset is derecognised. Where the Group has retained control of the asset, it continues to recognise the asset to the extent of its continuing involvement.

A financial liability is removed from the balance sheet when the obligation is discharged, or cancelled, or expires.

16. Capital instruments

The Group classifies a financial instrument that it issues as a financial asset, financial liability or an equity instrument in accordance with the substance of the contractual arrangement. An instrument is classified as a liability if it is a contractual obligation to deliver cash or another financial asset, or to exchange financial assets or financial liabilities on potentially unfavourable terms. An instrument is classified as equity if it evidences a residual interest in the assets of the Group after the deduction of liabilities. The components of a compound financial instrument issued by the Group are classified and accounted for separately as financial assets, financial liabilities or equity as appropriate.

17. Derivatives and hedging

Derivative financial instruments are recognised initially, and subsequently measured, at fair value. Derivative fair values are determined from quoted prices in active markets where available. Where there is no active market for an instrument, fair value is derived from prices for the derivative’s components using appropriate pricing or valuation models.

A derivative embedded in a contract is accounted for as stand-alone derivative if its economic characteristics are not closely related to the economic characteristics of the host contract; unless the entire contract is carried at fair value through profit or loss.

Gains and losses arising from changes in fair value of a derivative are recognised as they arise in profit or loss unless the derivative is the hedging instrument in a qualifying hedge. There are three types of hedge relationship: hedges of changes in the fair value of a recognised asset or liability or firm commitment (fair value hedges); hedges of the variability in cash flows from a recognised asset or liability or a forecast transaction (cash flow hedges); and hedges of the net investment in a foreign entity.

Hedge relationships are formally documented at inception. The documentation includes identification of the hedged item and the hedging instrument, details the risk that is being hedged and the way in which effectiveness will be assessed at inception and during the period of the hedge. If the hedge is not highly effective in offsetting changes in fair values or cash flows attributable to the hedged risk, consistent with the documented risk management strategy, hedge accounting is discontinued.

Fair value hedge – in a fair value hedge, the gain or loss on the hedging instrument is recognised in profit or loss. The gain or loss on the hedged item attributable to the hedged risk is recognised in profit or loss and adjusts the carrying amount of the hedged item. Hedge accounting is discontinued if the hedge no longer meets the criteria for hedge accounting or if the hedging instrument expires or is sold, terminated or exercised or if hedge designation is revoked. If the hedged item is one for which the effective interest rate method is used, any cumulative adjustment is amortised to profit or loss over the life of the hedged item using a recalculated effective interest rate.

Cash flow hedge – where a derivative financial instrument is designated as a hedge of the variability in cash flows of a recognised asset or liability or a highly probable forecast transaction, the effective portion of the gain or loss on the hedging instrument is recognised directly in equity. The ineffective portion is recognised in profit or loss. When the forecast transaction results in the recognition of a financial asset or financial liability, the cumulative gain or loss is reclassified from equity in the same periods in which the asset or liability affects profit or loss. Otherwise the cumulative gain or loss is removed from equity and recognised in profit or loss at the same time as the hedged transaction. Hedge accounting is discontinued if the hedge no longer meets the criteria for hedge accounting; if the hedging instrument expires or is sold, terminated or exercised; if the forecast transaction is no longer expected to occur; or if hedge designation is revoked. On the discontinuance of hedge accounting (except where a forecast transaction is no longer expected to occur), the cumulative unrealised gain or loss recognised in equity is recognised in profit or loss when the hedged cash flow occurs or, if the forecast transaction results in the recognition of a financial asset or financial liability, in the same periods during which the asset or liability affects profit or loss. Where a forecast transaction is no longer expected to occur, the cumulative unrealised gain or loss is recognised in profit or loss immediately.

59






Hedge of net investment in a foreign operation – where a foreign currency liability hedges a net investment in a foreign operation, the portion of foreign exchange differences arising on translation of the liability determined to be an effective hedge is recognised directly in equity. Any ineffective portion is recognised in profit or loss.

18. Investment property

Investment property comprises freehold and leasehold properties that are held to earn rentals or for capital appreciation or both. It is not depreciated but is stated at fair value based on valuations by independent registered valuers. Fair value is based on current prices in an active market for similar properties in the same location and condition. Any gain or loss arising from a change in fair value is recognised in profit or loss. Rental income from investment property is recognised on a straight-line basis over the term of the lease. Lease incentives granted are recognised as an integral part of the total rental income.

19. Cash and cash equivalents

Cash and cash equivalents comprises cash and demand deposits with banks together with short-term highly liquid investments that are readily convertible to known amounts of cash and subject to insignificant risk of change in value.

20. Shares in Group entities

The Bank’s investments in its subsidiaries are stated at cost less any impairment.

Critical accounting policies and key sources of estimation uncertainty

The reported results of the Group are sensitive to the accounting policies, assumptions and estimates that underlie the preparation of its financial statements. UK company law and IFRS require the directors, in preparing the Group's financial statements, to select suitable accounting policies, apply them consistently and make judgements and estimates that are reasonable and prudent. In the absence of an applicable standard or interpretation, IAS 8 ‘Accounting Policies, Changes in Accounting Estimates and Errors’, requires management to develop and apply an accounting policy that results in relevant and reliable information in the light of the requirements and guidance in IFRS dealing with similar and related issues and the IASB’s Framework for the Preparation and Presentation of Financial Statements.

The judgements and assumptions involved in the Group’s accounting policies that are considered by the Board to be the most important to the portrayal of its financial condition are discussed below. The use of estimates, assumptions or models that differ from those adopted by the Group would affect its reported results.

Loan impairment provisions

The Group’s loan impairment provisions are established to recognise incurred impairment losses in its portfolio of loans classified as loans and receivables and carried at amortised cost. A loan is impaired when there is objective evidence that events since the loan was granted have affected expected cash flows from the loan. The impairment loss is the difference between the carrying value of the loan and the present value of estimated future cash flows at the loan's original effective interest rate.

At 31 December 2005, gross loans and advances to customers totalled £161,974 million (2004 – £133,619 million) and customer loan impairment provisions amounted to £2,031 million (2004 – £1,940 million).

There are two components to the Group’s loan impairment provisions: individual and collective.

Individual component – all impaired loans that exceed specific thresholds are individually assessed for impairment.
Individually assessed loans principally comprise the Group's portfolio of commercial loans to medium and large businesses. Impairment losses are recognised as the difference between the carrying value of the loan and the discounted value of management’s best estimate of future cash repayments and proceeds from any security held. These estimates take into account the customer’s debt capacity and financial flexibility; the level and quality of its earnings; the amount and sources of cash flows; the industry in which the counterparty operates; and the realisable value of any security held. Estimating the quantum and timing of future recoveries involves significant judgement. The size of receipts will depend on the future performance of the borrower and the value of security, both of which will be affected by future economic conditions; additionally, collateral may not be readily marketable. The actual amount of future cash flows and the date they are received may differ from these estimates and consequently actual losses incurred may differ from those recognised in these financial statements.

Collective component – this is made up of two elements: loan impairment provisions for impaired loans that are below individual assessment thresholds (collective impaired loan provisions) and for loan losses that have been incurred but have not been separately identified at the balance sheet date (latent loss provisions). These are established on a portfolio basis taking into account the level of arrears, security, past loss experience, credit scores and defaults based on portfolio trends. The most significant factors in establishing these provisions are the expected loss rates and the related average life. These portfolios include credit card receivables and other personal advances including mortgages. The future credit quality of these portfolios is subject to uncertainties that could cause actual credit losses to differ materially from reported loan impairment provisions. These uncertainties include the economic environment, notably interest rates and their effect on customer spending, the unemployment level, payment behaviour and bankruptcy trends.

Pensions

The Group operates a number of defined benefit pension schemes as described in Note 3 on the financial statements. The assets of the schemes are measured at their fair value at

60




 


Accounting policies continued


the balance sheet date. Scheme liabilities are measured using the projected unit method, which takes account of projected earnings increases, using actuarial assumptions that give the best estimate of the future cash flows that will arise under the scheme liabilities. These cash flows are discounted at the interest rate applicable to high-quality corporate bonds of the same currency and term as the liabilities. Any surplus or deficit in excess of 10% of the greater of scheme assets and scheme liabilities is recognised in the balance sheet as an asset (surplus) or liability (deficit). In determining the value of scheme liabilities, assumptions are made as to price inflation, dividend growth, pension increases, earnings growth and employees. There is a range of assumptions that could be adopted in valuing the schemes’ liabilities. Different assumptions could significantly alter the amount of the deficit recognised in the balance sheet and the pension cost charged to the income statement. The assumptions adopted for the Group’s pension schemes are set out in Note 3 on the financial statements. The pension deficit recognised in the balance sheet at 31 December 2005 was £1,235 million (2004 – £2,093 million).

Fair value

Financial instruments classified as held-for-trading or designated as at fair value through profit or loss and financial assets classified as available-for-sale are recognised in the financial statements at fair value. All derivatives are measured at fair value. In the balance sheet, financial assets carried at fair value are included within Treasury and other eligible bills, Loans and advances to banks, Loans and advances to customers, Debt securities and Equity shares as appropriate. Financial liabilities carried at fair value are included within the captions Deposits by banks, Customer accounts, Debt securities in issue and Subordinated liabilities. Derivative assets and Derivative liabilities are shown separately on the face of the balance sheets. Gains or losses arising from changes in fair value of financial instruments classified as held-for-trading or designated as at fair value through profit or loss are included in the income statement. Unrealised gains and losses on available-for-sale financial assets are recognised directly in equity unless an impairment loss is recognised. The carrying value of a financial asset or a financial liability carried at cost or amortised cost that is the hedged item in a qualifying hedge relationship is adjusted by the gain or loss attributable to the hedged risk.

Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction. Fair values are determined by reference to observable market prices where available and reliable. Where representative market prices for an instrument are not available or are unreliable because of poor liquidity, the fair value is derived from prices for its components using appropriate pricing or valuation models that are based on independently sourced market parameters, including interest rate yield curves, option volatilities and currency rates.

Financial assets carried at fair value include government, asset backed and corporate debt securities, reverse repos, loans, corporate equity shares and derivatives. Financial liabilities carried at fair value include deposits, repos and short positions in securities. Fair value for a substantial proportion of these instruments is based on observable market prices or derived from observable market parameters. Where observable prices are not available, fair value is based on appropriate valuation techniques or management estimates.

The Group’s derivative products include swaps, forwards, futures and options. Exchange traded instruments are valued using quoted prices. The fair value of over-the-counter instruments is derived from pricing models which take account of contract terms, including maturity, as well as quoted market parameters such as interest rates and volatilities. Most of the Group’s pricing models do not entail material subjectivity because the methodologies utilised do not incorporate significant judgement and the parameters included in the models can be calibrated to actively quoted market prices. Values established from pricing models are adjusted for credit risk, liquidity risk and future operational costs.

A negligible proportion of the Group’s trading derivatives are valued directly from quoted prices, the majority being valued using appropriate valuation techniques. The fair value of substantially all securities positions carried at fair value is determined directly from quoted prices.

Details of financial instruments carried at fair value are given in Note 32 on the financial statements.

Goodwill

The Group capitalises goodwill arising on the acquisition of businesses, as disclosed in the Accounting policies. The carrying value of goodwill as at 31 December 2005 was £760 million (2004 – £739 million).

Goodwill is the excess of the cost of an acquisition over the fair value of its net assets. The determination of the fair value of assets and liabilities of businesses acquired requires the exercise of management judgement; for example those financial assets and liabilities for which there are no quoted prices, and those non-financial assets where valuations reflect estimates of market conditions such as property. Different fair values would result in changes to the goodwill arising and to the post-acquisition performance of the acquisition. Goodwill is not amortised but is tested for impairment annually or more frequently if events or changes in circumstances indicate that it might be impaired.

For the purposes of impairment testing goodwill acquired in a business combination is allocated to each of the Group’s cash-generating units or groups of cash-generating units expected to benefit from the combination. Goodwill impairment testing involves the comparison of the carrying value of a cash-

61






generating unit or group of cash generating units with its recoverable amount. The recoverable amount is the higher of the unit's fair value and its value in use. Value in use is the present value of expected future cash flows from the cash-generating unit or group of cash-generating units. Fair value is the amount obtainable for the sale of the cash-generating unit in an arm’s length transaction between knowledgeable, willing parties.

Impairment testing inherently involves a number of judgmental areas: the preparation of cash flow forecasts for periods that are beyond the normal requirements of management reporting; the assessment of the discount rate appropriate to the business; estimation of the fair value of cash-generating units; and the valuation of the separable assets of each business whose goodwill is being reviewed.

Accounting developments

The International Accounting Standards Board (“IASB”) issued IFRS 7 ‘Financial Instruments: Disclosures’ in August 2005. The standard replaces IAS 30 ‘Disclosures in the Financial Statements of Banks and Similar Financial Institutions’ and the disclosure provisions in IAS 32 ‘Financial Instruments: Disclosure and Presentation’. IFRS 7 requires disclosure of the significance of financial instruments for an entity’s financial position and performance and of qualitative and quantitative information about exposure to risks arising from financial instruments. The standard is effective for annual periods beginning on or after 1 January 2007. Earlier application is encouraged.

At the same time the IASB issued an amendment ‘Capital Disclosures’ to IAS 1 ‘Presentation of Financial Statements’. It requires disclosures about an entity's capital and the way it is managed. This amendment is also effective for annual periods beginning on or after 1 January 2007. Earlier application is encouraged.

The IASB has also issued three amendments to IAS 39 ‘Financial Instruments: Recognition and Measurement’. The first, ‘Cash Flow Hedge Accounting of Forecast Intragroup Transactions’, published in April 2005, amends IAS 39 to permit the foreign currency risk of a highly probable forecast intragroup transaction to qualify as a hedged item in consolidated financial statements. The amendment is effective for annual periods beginning on or after 1 January 2006.

The second, ‘The Fair Value Option’, published in June 2005, places conditions on the option in IAS 39 to designate on initial recognition a financial asset or financial liability as at fair value through profit or loss. The amendment is effective for annual periods beginning on or after 1 January 2006. Earlier application is encouraged. The Group has adopted this amendment from 1 January 2005 (see accounting policies on page 54).

The third, ‘Financial Guarantee Contracts’, published in August 2005, amends IAS 39 and IFRS 4 ‘Insurance Contracts’. The amendments define a financial guarantee contract. They require such contracts to be recorded initially at fair value and subsequently at the higher of the provision determined in accordance with IAS 37 ‘Provisions, Contingent Liabilities and Contingent Assets’ and the amount initially recognised less amortisation. The amendments are effective for annual periods beginning on or after 1 January 2006.

In December 2005, the IASB issued amendments to IAS 21 ‘The Effects of Changes in Foreign Exchange Rates’ to clarify that a monetary item can form part of the net investment in overseas operations regardless of the currency in which it is denominated and that the net investment in a foreign operation can include a loan from a fellow subsidiary. The amendments are effective immediately but have not been endorsed by the EU.

The Group is reviewing IFRS 7 and the amendments to IAS 1 and IAS 21 and those to IAS 39 that it has not implemented, to determine their effect on its financial reporting.

62






Consolidated income statement
for the year ended 31 December 2005


        2005     2004  
       



   



 
        Discontinued*     Continuing     Discontinued     Continuing  
    Note   £m     £m     £m     £m  















Interest receivable       203     8,289     251     6,929  
Interest payable       9     (4,040 )   14     (2,811 )















Net interest income       212     4,249     265     4,118  















Fees and commissions receivable       43     3,663     51     3,384  
Fees and commissions payable       (34 )   (926 )   (38 )   (845 )
Income from trading activities   1       808         887  
Other operating income           635         201  















Non-interest income       9     4,180     13     3,627  















Total income       221     8,429     278     7,745  















Staff costs           1,477         1,326  
Premises and equipment           114         197  
Other administrative expenses       70     2,440     52     2,131  
Depreciation and amortisation           382     1     461  















Operating expenses**   2   70     4,413     53     4,115  















Operating profit before impairment losses       151     4,016     225     3,630  
Impairment losses       4     752     (5 )   630  















Operating profit before tax   4   147     3,264     230     3,000  
Tax   5   44     904     69     797  















Operating profit after tax       103     2,360     161     2,203  




Discontinued operations             103           161  











Profit for the year             2,463           2,364  




 
Profit attributable to:                            
Minority interests             17           12  
Preference dividends – non equity                       36  
Ordinary shareholders             2,446           2,316  















              2,463           2,364  





*      the Group transferred its home mortgage finance business, National Westminster Home Loans Limited, to The Royal Bank of Scotland plc on 31 December 2005 at neither a profit nor a loss.
   
**      includes integration expenditure (see Note 4).

63






Balance sheets
at 31 December 2005


        Group   Bank
       
 
        2005   2004   2005   2004
    Note   £m   £m   £m   £m











Assets                    
Cash and balances at central banks       1,568   1,589   894   956
Treasury bills and other eligible bills   9   770   172    
Loans and advances to banks   10   55,995   29,982   20,829   15,994
Loans and advances to customers   11   159,943   131,679   97,569   77,619
Debt securities   12   28,745   22,426   51   39
Equity shares   13   823   1,338     587
Investment in Group undertakings   14       6,633   6,253
Intangible assets   16   1,198   1,244   347   434
Property, plant and equipment   17   1,531   1,542   1,044   1,247
Settlement balances       3,931   3,538    
Derivatives at fair value   18   2,976   1,366   1,203   704
Prepayments, accrued income and other assets   19   3,123   2,345   1,564   1,834











Total assets       260,603   197,221   130,134   105,667







                     
Liabilities                    
Deposits by banks   20   46,001   23,873   5,310   3,480
Customer accounts   21   157,924   126,119   109,942   87,925
Debt securities in issue   22   10,801   3,597   38   39
Settlement balances and short positions   23   21,574   21,670    
Derivatives at fair value   18   2,657   1,105   1,129   283
Accruals, deferred income and other liabilities   24   3,579   4,539   1,464   2,171
Retirement benefit liabilities   3   1,235   2,093   1,041   1,920
Subordinated liabilities   26   6,648   5,808   5,501   4,747











Total liabilities       250,419   188,804   124,425   100,565
                     
 
Equity*                    
Minority interests   27   744   408    
Shareholders’ equity                    
    Called up share capital   28   1,678   2,102   1,678   2,102
    Reserves   29   7,762   5,907   4,031   3,000
 
Total equity       10,184   8,417   5,709   5,102











                     
Total liabilities and equity       260,603   197,221   130,134   105,667







*      includes non-equity minority interests and preference shares in 2004.
   
  The accounts were approved by the Board of directors on 29 March 2006 and signed on its behalf by:


Sir George Mathewson   Sir Fred Goodwin   Guy Whittaker
Chairman   Group Chief Executive   Group Finance Director

64






Statements of recognised income and expense
for the year ended 31 December 2005


    Group     Bank  
   
   
 
    2005     2004     2005     2004  
    £m     £m     £m     £m  













Available-for-sale investments                        
Net valuation gains taken direct to equity   38           33        
Net profit taken to income on sales   (324 )         (320 )      
                         
Cash flow hedges                        
Net losses taken direct to equity   (28 )         (52 )      
                         
Exchange differences on translation of foreign operations   180     8     (5 )    













(Expense)/income before tax on items recognised direct in equity   (134 )   8     (344 )    
Tax on items recognised direct in equity   106         110      













Net (expense)/income recognised direct in equity   (28 )   8     (234 )    
Profit for the year   2,463     2,364     1,774     1,901  













Total recognised income and expense for the year   2,435     2,372     1,540     1,901  











                         
Attributable to:                        
Equity holders of the parent   2,420     2,360     1,540     1,901  
Minority interests   15     12          













    2,435     2,372     1,540     1,901  











                         
Effect of changes in accounting policies on the implementation of IFRS                        
Equity holders of the parent   (1,768 )   (1,029 )   (4,619 )   (3,567 )
Minority interests   (6 )            













    (1,774 )   (1,029 )   (4,619 )   (3,567 )











65






Cash flow statements
for the year ended 31 December 2005


        Group     Bank  
       
   
 
        2005     2004     2005     2004  
    Note   £m     £m     £m     £m  














 
Operating activities                            
Operating profit before tax       3,411     3,230     2,315     2,382  
                             
Adjustments for:                            
Depreciation and amortisation       382     462     326     402  
Interest on subordinated liabilities       304     202     283     193  
Charge for defined benefit pension schemes       149     133     97     96  
Cash contribution to defined benefit pension schemes       (1,007 )   (53 )   (976 )   (30 )
Other non-cash items       4,227     (3,099 )   (499 )   (149 )














 
Net cash inflow from operating activities       7,466     875     1,546     2,894  
Changes in operating assets and liabilities       24,173     (4,688 )   6,010     137  














 
Net cash flows from operating activities before tax       31,639     (3,813 )   7,556     3,031  
Income taxes paid       (1,170 )   (1,051 )   (662 )   (546 )














 
Net cash flows from operating activities   34   30,469     (4,864 )   6,894     2,485  














 
                             
Investing activities                            
Sale and maturity of securities       1,600     771     951     152  
Purchase of securities       (1,322 )   (1,338 )   (80 )   (306 )
Sale of property, plant and equipment       333     106     302     21  
Purchase of property, plant and equipment       (281 )   (226 )   (119 )   (153 )
Net investment in business interests and intangible assets   35   (168 )   (871 )   (167 )   (407 )














 
Net cash flows from investing activities       162     (1,558 )   887     (693 )














 
                             
Financing activities                            
Issue of subordinated liabilities       291     559          
Proceeds of minority interests acquired       463     405          
Costs of minority interests redeemed       (121 )   (2 )        
Repayments of subordinated liabilities       (210 )   (455 )   (210 )   (455 )
Dividends paid       (365 )   (2,346 )   (350 )   (2,336 )
Interest paid on subordinated liabilities       (319 )   (196 )   (297 )   (174 )














 
Net cash flows from financing activities       (261 )   (2,035 )   (857 )   (2,965 )














 
Effects of exchange rate changes on cash and cash equivalents       (4,791 )   2,484     (247 )   139  














 
Net increase/(decrease) in cash and cash equivalents       25,579     (5,973 )   6,677     (1,034 )
Cash and cash equivalents 1 January       22,845     28,818     11,911     12,945  














 
Cash and cash equivalents 31 December       48,424     22,845     18,588     11,911  










 

66






Notes on the accounts

Introduction

IAS 32 ‘Financial Instruments: Disclosure and Presentation’ and IAS 39 ‘Financial Instruments: Recognition and Measurement’ were implemented by the Group on 1 January 2005 and applied prospectively from that date and, as permitted by IFRS, without restating comparatives. Consequently, in the notes on the accounts affected by these standards, comparative data for 2004 in accordance with previous GAAP have been presented.

1 Income from trading activities   Group

    2005     2004
    £m     £m

   Foreign exchange (1)   (45 )   93
   Securities          
           – equities (2)       2
           – debt (3)   773     690
   Interest rate derivatives (4)   80     102






    808     887

  Notes:
(1)      Includes spot and forward foreign exchange contracts and currency swaps, futures and options and related hedges and funding.
(2)      Includes equities and equity derivatives and related hedges and funding.
(3)      Includes debt securities and related hedges and funding.
(4)      Includes interest rate swaps, forward rate agreements, interest rate options, interest rate futures and credit derivatives and related hedges and funding.

2 Operating expenses   Group

    2005   2004
    £m   £m

   Administrative expenses        
   Staff costs        
   Wages, salaries and other staff costs   1,246   1,116
   Social security costs   70   68
   Pension costs (see Note 3)        
       – defined benefit schemes   149   133
       – defined contribution schemes   12   9





    1,477   1,326
   Premises and equipment   114   197
   Other   2,510   2,183





    4,101   3,706
   Depreciation and amortisation        
   Property, plant and equipment (see note 17)   105   85
   Intangible assets (see note 16)   277   377





    4,483   4,168

The average number of persons employed by the Group during the year, excluding temporary staff, was 34,600 (2004 – 33,300).

    Bank

    2005   2004
    £m   £m





Staff costs        
Wages, salaries and other staff costs   380   333
Social security costs   27   28
Pension costs (see Note 3)        
   – defined benefit schemes   97   96
   – defined contribution schemes   4  





    508   457

The average number of persons employed by the Bank during the year, excluding temporary staff, was 18,200 (2004 – 17,600).

67






3 Pension costs

The Group operates a number of pension schemes which are predominantly defined benefit schemes whose assets are independent of the Group’s finances. The Bank is legally the sponsoring employer of The Royal Bank of Scotland Group Pension Scheme (‘Main Scheme’). This scheme operates on the basis that other members of the Group are required to remit contributions to the scheme based on a level of contributions agreed annually with the scheme’s actuaries.

In addition to the Main Scheme, the Group operates a number of other UK and overseas pension schemes. It also provides other post-retirement benefits, principally through subscriptions to private heathcare schemes in the UK and the Republic of Ireland and unfunded post-retirement benefit plans. Provision for the costs of these benefits is charged to the income statement over the average remaining future service lives of the eligible employees. The amounts are not material.

The corridor method of accounting permits the Bank to defer recognition of actuarial gains and losses that are within 10% of the larger of the fair value of plan assets and present value of defined benefit obligations of the schemes, on an individual scheme basis, at the reporting date. Any excess variations are amortised prospectively over the average remaining service lives of current members of the schemes.

Interim valuations of the Group’s schemes were prepared to 31 December by independent actuaries, using the following assumptions:

    Group     Bank  





 




Principal actuarial assumptions at 31 December (weighted average)   2005     2004     2005     2004  













Discount rate   4.8 %   5.4 %   4.8 %   5.4 %
Expected return on plan assets   6.5 %   6.7 %   6.5 %   6.7 %
Rate of increase in salaries   3.9 %   3.9 %   3.9 %   3.9 %
Rate of increase in pensions in payment   2.7 %   2.7 %   2.7 %   2.7 %
Inflation assumption   2.7 %   2.7 %   2.7 %   2.7 %













                         
The expected return on plan assets at 31 December 2005 is based upon the weighted average of the following assumptions of the returns on the major classes of plan assets:
                         
    Group     Bank  





 




    2005     2004     2005     2004  













Equities   7.7 %   8.1 %   7.7 %   8.1 %
Index-linked bonds   4.1 %   4.5 %   4.1 %   4.5 %
Government fixed interest bonds   4.0 %   4.5 %   4.1 %   4.5 %
Corporate and other bonds   4.8 %   5.4 %   4.8 %   5.4 %
Property   5.9 %   6.3 %   5.9 %   6.3 %
Cash and other assets   4.1 %   4.6 %   4.2 %   4.6 %













                         
Post-retirement mortality assumptions (Main Scheme)         2005     2004     2003  













Longevity at age 60 for current pensioners (years)                        
Males         25.4     25.4     23.5  
Females         28.2     28.2     25.3  
                         
Longevity at age 60 for future pensioners (years)                        
Males         26.2     26.2     24.8  
Females         29.0     29.0     26.5  













68




 

Notes on the accounts continued

3 Pension costs (continued)         Group                 Bank        








 







   Changes in value of net pension liability   Fair value
of plan
assets
£m
    Present
value of
defined
benefit
obligations
£m
    Net
pension
liability
£m
    Fair value
of plan
assets
£m
    Present
value of
defined
benefit
obligations
£m
    Net
pension
liability
£m
 



















   At 1 January 2004   12,358     14,354     1,996     11,797     13,651     1,854  
   Currency translation and other adjustments   4     8     4              
   Income statement:                                    
 
         Expected return   880           (880 )   838           (838 )
         Interest cost         800     800           759     759  
         Current service cost         430     430           401     401  
         Less: direct contributions from other scheme members         (226 )   (226 )         (226 )   (226 )
         Past service cost         9     9                
 
    880     1,013     133     838     934     96  
   Statement of recognised income and expense:                                    
         Actuarial gains and losses   403     1,964     1,561     392     1,825     1,433  
   Acquisitions of subsidiaries   45     62     17              
   Contributions by employer   53           (53 )   30           (30 )
   Contributions by other scheme members   290     290           289     289        
   Advances of contributions by other scheme members   750     750           750     750        
   Contributions by plan participants   3     3                      
   Benefits paid   (516 )   (516 )         (494 )   (494 )      
   Expenses included in service cost   (34 )   (34 )         (33 )   (33 )      



















   At 31 December 2004   14,236     17,894     3,658     13,569     16,922     3,353  










                                     
   Unrecognised actuarial losses               1,565                 1,433  



















   Post-retirement benefit liabilities at 31 December 2004               2,093                 1,920  




                                     
   Unfunded schemes liabilities included in post-retirement benefit liabilities               18                 8  























   At 1 January 2005   14,236     17,894     3,658     13,569     16,922     3,353  
   Currency translation and other adjustments   (9 )   (14 )   (5 )            
   Income statement:                                    
 
           Expected return   972           (972 )   930           (930 )
           Interest cost         912     912           865     865  
           Current service cost         484     484           448     448  
           Less: direct contributions from other scheme members         (280 )   (280 )         (289 )   (289 )
           Past service cost         3     3           3     3  
           Amortisation of net unrecognised actuarial losses         2     2                
 
    972     1,121     149     930     1,027     97  
   Statement of recognised income and expense:                                    
         Actuarial gains and losses   1,639     2,321     682     1,556     2,273     717  
   Acquisitions of subsidiaries       2     2              
   Contributions by employer   1,007           (1,007 )   976           (976 )
   Contributions by other scheme members   145     145           154     154        
   Advances of contributions by other scheme members   (750 )   (750 )         (750 )   (750 )      
   Contributions by plan participants   3     3                      
   Benefits paid   (528 )   (528 )         (504 )   (504 )      
   Expenses included in service cost   (18 )   (18 )         (17 )   (17 )      
   Amortisation of net unrecognised actuarial losses         (2 )   (2 )              



















   At 31 December 2005   16,697     20,174     3,477     15,914     19,105     3,191  










                                     
   Unrecognised actuarial losses               2,242                 2,150  



















   Post-retirement benefit liabilities at 31 December 2005               1,235                 1,041  




                                     
   Unfunded schemes liabilities included in post-retirement benefit liabilities               21                 11  




The Group expects to contribute £417 million (Bank – £386 million) to its defined benefit pension schemes in 2006.

    Group           Bank        










Major plan assets as a percentage of total plan assets   2005     2004     2005     2004  













Equities   61.4 %   57.0 %   61.3 %   56.7 %
Index-linked bonds   17.5 %   15.9 %   18.1 %   16.5 %
Government fixed interest bonds   2.3 %   2.6 %   1.8 %   2.1 %
Corporate and other bonds   14.4 %   12.4 %   14.6 %   12.5 %
Property   3.8 %   3.3 %   3.6 %   3.1 %
Cash and other assets   0.6 %   8.8 %   0.6 %   9.1 %













69






The pension plan assets of the Group and Bank include a holding of The Royal Bank of Scotland Group plc’s ordinary shares with a fair value of £76 million (2004 – £71 million) and holdings of financial instruments of the Group with a value of £299 million (2004 – £726 million).

          Group                  Bank      















History of defined benefits schemes   2005
£m
    2004
£m
    2003
£m
    2005
£m
    2004
£m
    2003
£m


















Present value of defined benefit obligations   20,174     17,894     14,354     19,105     16,922     13,651
Fair value of plan assets   16,697     14,236     12,358     15,914     13,569     11,797


















Net deficit   3,477     3,658     1,996     3,191     3,353     1,854
















                                   
Experience losses on plan liabilities   (55 )   (611 )         (41 )   (624 )    
Experience gains on plan assets   1,639     403           1,556     392      
Actual return on pension scheme assets   2,611     1,283           2,486     1,230      
















   
             
4 Operating profit before tax            
       
   Operating profit before tax is stated after taking account of the following:   Group        





        2005
£m
    2004
£m
 









   Income   Sales of available-for-sale securities            
           – Gross gains   328        
           – Gross losses   (1 )      
   



     
           – Net profit   327        


    Sales of investment securities            
           – Gross gains         13  
           – Gross losses         (1 )
   






           – Net profit         12  
   

                 
    Dividend income   48     50  
    Share of associated undertakings’ net profit   17     2  
    Net gains on financial assets and liabilities designated            
           as at fair value through profit or loss   26        
                 
   Expenses   Interest on subordinated liabilities   304     202  
    Integration expenditure*   163     297  









                 
* Integration and restructuring costs comprise            
    Staff costs   17     15  
    Premises and equipment   1     1  
    Other administrative expenses   14     10  
    Depreciation and amortisation   131     271  









        163     297  





                 
   Auditors’ remuneration            
   Amounts paid to the auditors for statutory audit and other services were as follows:   Group        





        2005
£m
    2004
£m
 









   Audit services            
           – Statutory audit   2.0     1.8  
           – Audit related including regulatory reporting*   1.2     0.3  









        3.2     2.1  
   Further assurance services   1.5     0.8  
   Other services       0.1  









   Total       4.7     3.0  





* includes fees relating to the transition to IFRS and work in respect of US Sarbanes-Oxley Act Section 404 reporting requirements.

The auditors’ remuneration for statutory audit work for the Bank was £0.6 million (2004 – £0.6 million). Non-audit fees paid to the auditors and their associates in the UK was £1.3 million (2004 – £0.2 million).

70





Notes on the accounts continued


5 Tax   Group        





    2005
£m
    2004
£m
 







   Current taxation:            
   UK corporation tax charge for the year at 30%   1,142     1,063  
   Over provision in respect of prior periods   (68 )   (70 )
   Relief for overseas taxation   (24 )   (33 )







    1,050     960  
   Deferred taxation:            
   Credit for the year   (81 )   (51 )
   Over provision in respect of prior periods   (21 )   (43 )







    948     866  





             
   The actual tax charge differs from the expected tax charge computed by applying the standard rate of UK corporation
   tax of 30% as follows:            
    2005
£m
    2004
£m
 







   Expected tax charge   1,023     969  
   Non-deductible items   70     54  
   Non-taxable items   (71 )   (27 )
   Taxable foreign exchange movements   35     (1 )
   Foreign profits taxed at other rates   (21 )   (12 )
   Unutilised losses brought forward and carried forward   1     (4 )
   Adjustments in respect of prior periods   (89 )   (113 )







   Actual tax charge   948     866  





 
Deferred tax assets of £5 million (2004 – £67 million) resulting from tax losses carried forward have not been recognised as there is insufficient evidence that the asset will be recoverable. These assets may be recoverable if the losses can be offset against suitable future taxable profits arising in the same tax jurisdiction.
 
6 Profit attributable to preference shareholders   Group      






    Finance cost
included in
interest payable
2005
£m
    Finance cost
of non-equity
shares
2004
£m
 







   9% non-cumulative sterling preference shares, Series A   13     13  
   Non-cumulative dollar preference shares, Series B   11     11  
   Non-cumulative dollar preference shares, Series C   12     12  







   Total   36     36  





  Notes:
 
(1)      Following the implementation of IAS 32 on 1 January 2005, the Group’s preference shares are now included in subordinated liabilities and the finance cost thereon is included in interest payable.
 
7 Ordinary dividends       Group        







    2005
p per share
  2004
p per share
  2005
£m
  2004
£m









   Dividends paid on ordinary equity shares   20.9   137.1   350   2,300







8 Profit dealt with in the accounts of the company

As permitted by section 230(3) of the Companies Act 1985, no income statement for the Bank has been presented as a primary financial statement. Of the profit attributable to ordinary shareholders £1,774 million (2004 – £1,865 million) has been dealt with in the accounts of the Bank.

71






9 Treasury bills and other eligible bills   Group   Bank



 


    2005
£m
  2004
£m
  2005
£m
  2004
£m









Treasury bills and similar securities   634   16    
Other eligible bills   136   156    









    770   172    







                 
Held-for-trading   724          
Available-for-sale   46          



     
   
    770          

     
   
                 
10 Loans and advances to banks                
    Group   Bank
 


 


    2005
£m
  2004
£m
  2005
£m
  2004
£m









Held-for-trading   17,411       110    
Designated as at fair value through profit and loss   825          
Loans and receivables   37,759       20,719    









    55,995   29,982   20,829   15,994







Amounts above include:                
Items in the course of collection from other banks   2,071   2,308   1,929   2,161
Due from holding company   35,714   17,293   16,617   11,903
Due from fellow subsidiaries   10     7  
Due from subsidiaries       1,027   1,112









                 
11 Loans and advances to customers                
    Group   Bank
 


 


    2005
£m
  2004
£m
  2005
£m
  2004
£m









Held-for-trading   15,897       30    
Loans and receivables   143,235       97,539    
Finance leases   811      









    159,943   131,679   97,569   77,619







                 
Amounts above include:                
Due from ultimate holding company   842     842  
Due from holding company   1,432     707  
Due from fellow subsidiaries   30,406   35   28,620   183
Due from subsidiaries       1,878   26,851









72






Notes on the accounts continued

11 Loans and advances to customers (continued)

Securitisations

The Group engages in securitisation transactions of its financial assets including commercial and residential mortgage loans, commercial and residential mortgage related securities, US Government agency collateralised mortgage obligations, and other types of financial assets. In such transactions, the assets, or interests in the assets, are transferred generally to a special purpose entity which then issues liabilities to third party investors.

Securitisations may, depending on the individual arrangement, result in continued recognition of the securitised assets; continued recognition of the assets to the extent of the Group’s continuing involvement in those assets; or derecognition of the assets and the separate recognition, as assets or liabilities, of any rights and obligations created or retained in the transfer. The Group has securitisations in each of these categories:

Continued recognition – The table below sets out the asset categories together with the carrying amounts of the assets and associated liabilities.

        Group        







        2005       2004



 


Asset type   Assets
£m
  Liabilities
£m
  Assets
£m
  Liabilities
£m









Residential mortgages (1, 2)   2,388   2,366   1,519   1,479
Credit card receivables (3, 4)   1,232   1,232    









   
(1)      At 31 December 2004, in accordance with previous GAAP, the financial assets in these categories were derecognised to the extent of non-recourse finance as the arrangements qualified for the linked presentation.
   
(2)      Mortgages have been transferred to special purpose vehicles, held ultimately by charitable trusts, funded principally through the issue of floating rate notes. The Group has entered into arm’s length fixed/floating interest rate swaps with the securitisation vehicles and provides mortgage management and agency services to the vehicles. On repayment of the financing, any further amounts generated by the mortgages will be paid to the Group. In 2004, the Group recognised net income of £26 million.
   
(3)      Credit card receivables in the UK have been securitised. Notes have been issued by a special purpose vehicle. The note holders have a proportionate interest in a pool of credit card receivables that have been equitably assigned by the Group to a receivables trust. The Group continues to be exposed to the risks and rewards of the transferred receivables through its right to excess spread (after charge offs).
   
(4)      Bank and Group.
   

Continuing involvement – In certain US securitisations of residential mortgages substantially all the risks and rewards have been neither tranferred nor retained, but the Group has retained control, of the assets and continues to recognise the assets to the extent of its continuing involvement. Securitised assets were £39.8 billion; retained interests £863 million; subordination assets £609 million and related liabilities £609 million.

Derecognition

Other securitisations of the Group’s financial assets in the US qualify for derecognition as substantially all the risks and rewards of the assets have been transferred. The Group continues to recognise any retained interests in the securitisation vehicles.

Disclosures are given below about those securitisations of financial assets undertaken by the Group that resulted in derecognition or recognition to the extent of continuing involvement. The Group has classified these securitisations into three broad categories: US Agency, consumer, and commercial securitisations. During 2005, the Group received proceeds of approximately £46.3 billion from securitisation trusts in connection with new securitisations of Group assets and £9.6 billion in connection with securitisation of third-party assets.

The Group recognised net pre-tax gains of approximately £182 million (2004 – £111 million) relating to these securitisations. Net pre-tax gains are based on the difference between the sales prices and previous carrying values of assets prior to date of sale, are net of transaction costs, and exclude any results attributable to hedging activities, interest income, funding costs, and changes in asset values prior to, and in retained interest values subsequent to, the securitisation date.

At 31 December 2005, the fair value of the Group’s retained interests was approximately £2.1 billion (2004 – £1.4 billion). These retained interests comprise approximately £1,179 million in US Agency based retained interests, £764 million in consumer based retained interests and £128 million in commercial based retained interests. These retained interests primarily relate to mortgage loans and securities and arose from securitisations that have taken place in current and prior years. Cash flows received in 2005 from retained interests held at 31 December 2005 in connection with securitisations that took place in current and prior years amounted to approximately £481 million (2004 – £383 million).

 

73






11 Loans and advances to customers (continued)

Key economic assumptions used in measuring the value of retained interests at the date of securitisation resulting from securitisations completed during the year were as follows:

Assumptions U.S. Agency
retained interests
  Consumer
retained interests
  Commercial
retained interests







Prepayment speed 139 – 690 PSA   16 – 44% CPR (1) 0 – 100 CPY(1)
Weighted average life 1 – 20 years 1 – 10 years   1 – 20 years
Cash flow discount rate 0 – 26%   4 – 90%   5 – 81%  
Credit losses   N/A (3) 0 – 2% CDR (4) N/A (5)








Key economic assumptions and the sensitivity of the current fair value of retained interests at 31 December 2005 to immediate adverse changes, as indicated below, in those assumptions are as follows:

Assumptions/impact on fair value   U.S. Agency
retained interests
Consumer
retained interests
Commercial
retained interests







Fair value of retained interests at 31 December 2004   £1,179 million £764 million £128 million
Prepayment speed(6) 9 – 25% CPR (1) 16 – 80% CPR (1) 0 – 75 CPY (2)
Impact on fair value of 10% adverse change   £0.5 million £26.1 million
Impact on fair value of 20% adverse change   £0.6 million £47.1 million
Weighted average life 0 – 19 years 1 – 10 years 1 – 20 years
Cash flow discount rate   0 – 26% 4 – 96% 5 – 81%
Impact on fair value of 10% adverse change   £33.5 million £23.8 million £4.7 million
Impact on fair value of 20% adverse change   £65.1 million £46.0 million £9.1 million
Credit losses N/A (3) 0 – 2% CDR (4) N/A (5)
Impact on fair value of 10% adverse change   N/A £10.9 million N/A
Impact on fair value of 20% adverse change   N/A £19.8 million N/A








Notes:

(1)      Constant prepayment rate – the CPR range represents the low and high points of a dynamic CPR curve.
 
(2)      CPR with yield maintenance provision and thus prepayment risk is limited.
 
(3)      Population consists of securities whose collateral is guaranteed by US Government sponsored entities and therefore, no credit loss has been assumed.
 
(4)      Constant default rate.
 
(5)      Population consists of only investment grade senior tranches; therefore, no credit losses are included in the assumptions.
 
(6)      Prepayment speed has been stressed on an overall portfolio basis for US Agency retained interests due to the overall homogeneous nature of the collateral. Consumer and commercial retained interests have been stressed on a security level basis.

The sensitivities depicted in the preceding table are hypothetical and should be used with caution. The likelihood of those percent variations selected for sensitivity testing is not necessarily indicative of expected market movements because the relationship of the change in the assumptions to the change in fair value may not be linear. Also, the effect of a variation in a particular assumption on the fair value of a retained interest is calculated without changing any other assumptions. This might not be the case in actual market conditions since changes in one factor might result in changes to other factors. Further, the sensitivities depicted above do not consider any corrective actions that the Group might take to mitigate the effect of any adverse changes in one or more key assumptions.

74






12 Debt securities   Group  
   
















    UK
government
    Other
government
    Other public
sector body
    Bank and
building
society
    Other
issuers
    Total
 
2005   £m     £m     £m     £m     £m     £m  



















Held-for-trading       5,829     50         19,595     25,474  
Designated as at fair value through profit or loss   4             5     394     403  
Available-for-sale       869         1,105     894     2,868  



















At 31 December 2005   4     6,698     50     1,110     20,883     28,745  

















                                     
Available-for-sale                                    
   Gross unrealised gains       2         2         4  
   Gross unrealised losses       (8 )       (3 )       (11 )



















                                     
2004                                    



















Investment securities       440         60     1,299     1,799  
Other securities   4     6,177     37     363     14,046     20,627  



















At 31 December 2004   4     6,617     37     423     15,345     22,426  

















                                     
Investment securities                                    
   Book value       440         60     1,299     1,799  
   Gross unrecognised gains       1             1     2  
   Gross unrecognised losses       (1 )           (2 )   (3 )



















   Valuation 31 December 2004       440         60     1,298     1,798  

















                                     
                            Group        
 







2005                     Listed
£m
    Unlisted
£m
    Total
£m
 



















Held-for-trading                         25,474     25,474  
Designated as at fair value through profit or loss                     403         403  
Available-for-sale                     2,712     156     2,868  



















At 31 December 2005                     3,115     25,630     28,745  
 







                                     
2004                     Listed
£m
    Unlisted
£m
    Total
£m
 



















Investment securities                     1,650     149     1,799  
Other securities                     502     20,125     20,627  



















At 31 December 2004                     2,152     20,274     22,426  
 







The following table shows the Group’s available-for-sale debt securities by remaining maturity and the related yield (based on weighted averages) as at 31 December 2005.

    Within 1 year   After 1 but
within 5 years
  After 5 but
within 10 years
  After 10 years   Total
 



 


 


 


 


    Amount
£m
  Yield
%
  Amount
£m
  Yield
%
  Amount
£m
  Yield
%
  Amount
£m
  Yield
%
  Amount
£m
  Yield
%





















Other government   78   4.4   789   4.0   1   4.2   -   -   868   4.1
Corporate debt securities   -   -   -   -   5   4.4   -   -   5   4.4
Mortgage-backed securities   23   5.3   5   4.8   -   -   81   4.8   109   4.9
Bank and building society   291   3.5   791   3.3   22   3.0   -   -   1,104   3.4
Other   765   3.2   13   5.4   3   6.8   1   4.6   782   3.3





















Total fair value   1,157   3.4   1,598   3.7   31   3.6   82   4.8   2,868   3.6




















75






    Bank



2005   Other
issuers
£m
  Total
£m





Held-for-trading   3   3
Available-for-sale   48   48





At 31 December 2005   51   51



         
2004        





Investment securities   36   36
Other securities   3   3





At 31 December 2004   39   39



         
Investment securities        
   Book value and valuation at 31 December 2004   36   36





    Bank



2005   Unlisted
£m
  Total
£m





Held-for-trading   3   3
Available-for-sale   48   48





At 31 December 2005   51   51



         
2004   Unlisted
£m
  Total
£m





Investment securities   36   36
Other securities   3   3





At 31 December 2004   39   39



76






13 Equity shares   Group
 










    2005   2004
 










    Listed
£m
  Unlisted
£m
  Total
£m
  Listed
£m
  Unlisted
£m
  Total
£m













Held-for-trading   25   1   26            
Designated as at fair value through profit or loss   39     39            
Available-for-sale   17   741   758            







     
    81   742   823            
 




     
Investment securities               583   698   1,281
Other securities               56   1   57













At 31 December               639   699   1,338
       




Available-for-sale                        
   Gross unrealised gains   1   11   12            
 




     
                         
Investment securities                        
Book value               583   698   1,281
   Gross unrecognised gains               287     287
       




                870   698   1,568
       




The Group’s unquoted equity investments at cost include an investment in a fellow subsidiary of £634 million. The remaining investments at cost cannot be measured reliably and comprised numerous shareholdings. Disposals in the year generated gains of £4 million.

    Bank
   




2004   Listed
£m
  Unlisted
£m
  2004
Total
£m







Investment securities   582   4   586
Other securities     1   1







    582   5   587
 




Investment securities            
   Book value   582   4   586
   Gross unrecognised gains   287     287







    869   4   873
 




The unlisted equity shares are held at cost.

77






14 Investment in Group undertakings            
       
Movements in investment in Group undertakings during the year were as follows:   Bank        





    2005
£m
    2004
£m
 







At 1 January   6,253     6,180  
Implementation of IAS 32 and IAS 39 on 1 January 2005   31      
Currency translation and other adjustments   140     (150 )
Additions   218     239  
Disposals   (9 )   (16 )







At 31 December   6,633     6,253  





The principal subsidiary undertakings of the Bank are shown below. Their capital consists of ordinary and preference shares, which are unlisted. All of the subsidiary undertakings are owned directly or indirectly through intermediate holding companies and are all wholly-owned. All of these subsidiary undertakings are included in the Group’s consolidated financial statements and have an accounting reference date of 31 December.

    Nature of
business
  Country of
incorporation
and principal area
of operations





Coutts & Co (1)   Private banking   Great Britain
Greenwich Capital Markets, Inc. (2)   Broker dealer   US
Ulster Bank Limited (3)   Banking   Northern Ireland





   
  Notes:
(1)      Coutts & Co is incorporated with unlimited liability. Its registered office is 440 Strand, London WC2R 0QS.
(2)      Shares are not directly held by the Bank.
(3)      Ulster Bank Limited and its subsidiary undertakings also operate in the Republic of Ireland.
   

The above information is provided in relation to the principal related undertakings as permitted by section 231(5) of the Companies Act 1985. Full information on all related undertakings will be included in the Annual Return filed with the UK Companies House.

78






15 Impaired and past-due financial assets   Group





2005   Cost
£m
  Provision
£m
  Net book
value
£m







Impaired financial assets            
Loans and receivables and finance leases   2,798   1,829   969
Available-for-sale   10   4   6







    2,808   1,833   975





             
        Group



        2005
£m
  2004
£m







Impairment losses charged to the income statement            
Loans and receivables and finance leases (see table below)       753    
Available-for-sale       3    
Loans and advances (see table below)           625







Total       756   625



The following table shows impairment losses for loans and receivables and finance leases (2004 – loans and advances).

          Group              











    2005
£m
    Specific
£m
    General
£m
    2004
Total
£m
 













At 1 January   1,940     1,535     370     1,905  
Implementation of IAS 39   185                    
Currency translation and other adjustments   (2 )   75     (102 )   (27 )
(Disposals)/acquisitions of subsidiaries   (7 )   19     16     35  
Amounts written-off   (818 )   (595 )       (595 )
Recoveries of amounts previously written-off   56     45         45  
Transfer to immediate parent company       (47 )   (1 )   (48 )
Charged to the income statement   753     625         625  
Unwind of discount   (76 )                  













At 31 December   2,031     1,657     283     1,940  











                         
          Bank  








2005         Cost
£m
    Provision
£m
    Net book
value
£m
 













Impaired financial assets                        
Loans and receivables and finance leases         2,311     1,537     774  








                         
                Bank  
     




                2005     2004  
                £m     £m  













Impairment losses charged to the income statement                        
Loans and receivables and finance leases (see table below)               651        
Loans and advances (see table below)                     531  













Total               651     531  
   





The following table shows impairment losses for loans and receivables and finance leases (2004 – loans and advances).

    Bank  











          2004  








    2005
£m
    Specific
£m
    General
£m
      Total
£m
 













At 1 January   1,633     1,295     323     1,618  
Implementation of IAS 39   177                    
Currency translation and other adjustments   5     76     (103 )   (27 )
Disposals of subsidiaries   (17 )            
Amounts written-off   (758 )   (528 )       (528 )
Recoveries of amounts previously written-off   43     39         39  
Charged to the income statement   651     531         531  
Unwind of discount   (61 )                  













At 31 December   1,673     1,413     220     1,633  











79






Notes on the accounts continued

16 Intangible assets   Group  














2005   Goodwill
£m
    Core
deposit
intangibles
£m
    Other
purchased
intangibles
£m
    Internally
generated
software
£m
    Total
£m
 
















Cost:                              
At 1 January 2005   739     24     30     1,472     2,265  
Currency translation and other adjustments   (7 )   1     (1 )       (7 )
Acquisitions of subsidiaries   40                 40  
Additions               227     227  
Disposals and write-off of fully amortised assets   (12 )           (17 )   (29 )
















At 31 December 2005   760     25     29     1,682     2,496  














                               
Accumulated amortisation:                              
At 1 January 2005       3     3     1,015     1,021  
Currency translation and other adjustments       1     (1 )        
Charge for the year       3     3     271     277  
















At 31 December 2005       7     5     1,286     1,298  














                               
Net book value at 31 December 2005   760     18     24     396     1,198  














                               
2004                              
















Cost:                              
At 1 January 2004   257             1,303     1,560  
Currency translation and other adjustments   (2 )               (2 )
Acquisition of subsidiaries   484     24     30         538  
Additions               184     184  
Disposals and write-off of fully amortised assets               (15 )   (15 )
















At 31 December 2004   739     24     30     1,472     2,265  














                               
Accumulated amortisation:                              
At 1 January 2004               657     657  
Currency translation and other adjustments           1         1  
Disposals and write-off of fully amortised assets               (14 )   (14 )
Charge for the year       3     2     372     377  
















At 31 December 2004       3     3     1,015     1,021  














                               
Net book value at 31 December 2004   739     21     27     457     1,244  














80






    Bank

Software   2005
£m



Cost:    
At 1 January 2005   1,442
Additions   180



At 31 December 2005   1,622

     
Accumulated amortisation:    
At 1 January 2005   1,008
Depreciation charge for the year   267



At 31 December 2005   1,275

     
Net book value at 31 December 2005   347

     
    2004
£m



Cost:    
At 1 January 2004   1,259
Additions   183



At 31 December 2004   1,442

     
Accumulated amortisation:    
At 1 January 2004   655
Depreciation charge for the year   353



At 31 December 2004   1,008

     
Net book value at 31 December 2004   434

The weighted average amortisation period of purchased intangible assets, other than goodwill, subject to amortisation are:

    Years



Core deposit intangibles   8
Other purchased intangibles   10



The amortisation expense for each of the next five years is currently estimated to be:

    £m



2006   6
2007   6
2008   6
2009   6
2010   6



Impairment review

        Goodwill        





        2005 (1)   2004 (2)   Basis of   Key
Significant Business Unit   Acquisition and cash generating unit   £m     £m     valuation   assumptions













Ulster Bank   First Active   406         Value-in-use:   Terminal growth
                    cash flow   after year 8













Wealth Management   Bank Von Ernst   142     144     Sales value   Sales of banks
                    of business   in same market













NatWest   Greenwich   106     105     Earnings    













(1)     As at 30 September.

(2)     As at 1 January.

*        The key valuation parameters are the same as those used to support the Group’s decision to purchase the business.

81






Notes on the accounts continued

17 Property, plant and equipment   Group  


















2005   Investment
properties
£m
  Freehold
premises
£m
    Long
leasehold
premises
£m
    Short
leasehold
premises
£m
    Computers
and other
equipment
£m
    Operating
lease
assets
£m
  Total
£m
 




















Cost or valuation:                                      
At 1 January 2005     1,209     301     351     264       2,125  
Currency translation and other adjustments     (15 )   11     1     1       (2 )
Additions   69   28     6     127     40     11   281  
Disposals and write-off of fully depreciated assets     (276 )   (49 )   (31 )   (25 )     (381 )
Transfer from fellow subsidiary     162                   162  




















At 31 December 2005   69   1,108     269     448     280     11   2,185  


















                                       
Accumulated depreciation and amortisation:                                      
At 1 January 2005     183     101     131     168       583  
Disposals and write-off of fully depreciated assets     (43 )   (10 )   (16 )   (30 )     (99 )
Currency translation and other adjustments     2     2         5       9  
Transfer from fellow subsidiary     56                   56  
Depreciation charge for the year     34     5     27     38     1   105  




















At 31 December 2005     232     98     142     181     1   654  


















                                       
Net book value at 31 December 2005   69   876     171     306     99     10   1,531  


















                                       
2004                                      




















Cost or valuation:                                      
At 1 January 2004     1,194     274     268     257       1,993  
Currency translation and other adjustments     (1 )           (1 )     (2 )
Reclassifications     4     (3 )       (1 )      
Acquisition of subsidiaries     1     32     8     12       53  
Additions     95     13     77     41       226  
Disposals and write-off of fully depreciated assets     (84 )   (15 )   (2 )   (39 )     (140 )
Transfer to fellow subsidiary                 (5 )     (5 )




















At 31 December 2004     1,209     301     351     264       2,125  


















                                       
Accumulated depreciation and amortisation:                                      
At 1 January 2004     163     88     113     165       529  
Currency translation and other adjustments         4         (1 )     3  
Reclassifications     1             (1 )      
Acquisition of subsidiaries         5         11       16  
Disposals and write-off of fully depreciated assets     (15 )   (2 )   (1 )   (27 )     (45 )
Transfer to fellow subsidiary                 (5 )     (5 )
Depreciation charge for the year     34     6     19     26       85  




















At 31 December 2004     183     101     131     168       583  


















                                       
Net book value at 31 December 2004     1,026     200     220     96       1,542  


















Investment properties are valued to reflect fair market value. Valuations are carried out by qualified surveyors who are members of the Royal Institution of Chartered Surveyors, or an equivalent overseas body. The 31 December 2005 valuation for a significant majority of the Group’s investment properties was undertaken by external valuers.

The fair value of investment properties does not include any appreciation since purchase. Premises include £51 million (2004 – £105 million) assets in the course of construction.

82






    Bank














    Freehold
premises
    Long
leasehold
premises
    Short
leasehold
premises
    Computers
and other
equipment
    Total  
2005   £m     £m     £m     £m     £m  
















Cost or valuation:                              
At 1 January 2005   1,186     137     297     10     1,630  
Additions   10     2     107         119  
Disposals and write-off of fully depreciated assets   (266 )   (34 )   (21 )   (3 )   (324 )
















At 31 December 2005   930     105     383     7     1,425  














                               
Accumulated depreciation and amortisation:                              
At 1 January 2005   228     48     104     3     383  
Disposals and write-off of fully depreciated assets   (42 )   (6 )   (10 )   (3 )   (61 )
Charge for year   31     3     22     3     59  
















At 31 December 2005   217     45     116     3     381  














                               
Net book value at 31 December 2005   713     60     267     4     1,044  














                               
2004                              
















Cost or valuation:                              
At 1 January 2004   1,125     131     226     15     1,497  
Currency translation and other adjustments               (1 )   (1 )
Additions   70     9     73     1     153  
Disposals and write-off of fully depreciated assets   (9 )   (3 )   (2 )   (5 )   (19 )
















At 31 December 2004   1,186     137     297     10     1,630  














                               
Accumulated depreciation and amortisation:                              
At 1 January 2004   199     45     91     7     342  
Disposals and write-off of fully depreciated assets   (1 )       (2 )   (5 )   (8 )
Charge for year   30     3     15     1     49  
















At 31 December 2004   228     48     104     3     383  














 
Net book value at 31 December 2004   958     89     193     7     1,247  














83






Notes on the accounts continued

18 Derivatives at fair value

Companies in the Group enter into various off-balance sheet financial instruments (derivatives) as principal either as a trading activity or to manage balance sheet foreign exchange and interest rate risk. Derivatives include swaps, forwards, futures and options. They may be traded on an organised exchange (exchange-traded) or over-the-counter (OTC). Holders of exchange traded derivatives are generally required to provide margin daily in the form of cash or other collateral.

Swaps include currency swaps, interest rate swaps, credit default swaps, total return swaps and equity and equity index swaps. A swap is an agreement to exchange cash flows in the future in accordance with a pre-arranged formula. In currency swap transactions, interest payment obligations are exchanged on assets and liabilities denominated in different currencies; the exchange of principal may be notional or actual. Interest rate swap contracts generally involve exchange of fixed and floating interest payment obligations without the exchange of the underlying principal amounts.

Forwards include forward foreign exchange contracts and forward rate agreements. A forward contract is a contract to buy (or sell) a specified amount of a physical or financial commodity, at agreed price, on an agreed future date. Forward foreign exchange contracts are contracts for the delayed delivery of currency on a specified future date. Forward rate agreements are contracts under which two counterparties agree on the interest to be paid on a notional deposit of a specified maturity at a specific future date; there is no exchange of principal.

Futures are exchange-traded forward contracts to buy (or sell) standardised amounts of underlying physical or financial commodities. The Group buys and sells currency, interest rate and equity futures.

Options include exchange-traded options on currencies, interest rates and equities and equity indices and OTC currency and equity options, interest rate caps and floors and swaptions. They are contracts that give the holder the right but not the obligation to buy (or sell) a specified amount of the underlying physical or financial commodity at an agreed price on an agreed date or over an agreed period.

        Group    





    Total derivatives   





    Notional
amounts
  Assets   Liabilities
2005   £bn   £m   £m







Exchange rate contracts            
Spot, forwards and futures   14   238   220
Currency swaps   9   225   217
Options purchased   4   128  
Options written   3     83
             
Interest rate contracts            
Interest rate swaps   340   1,871   1,729
Options purchased   66   420  
Options written   71     392
Futures and forwards   157    
             
Credit derivatives   4   6   15
             
Equity and commodity contracts   1   88   1







        2,976   2,657



Amounts above include:            
Due from/to fellow subsidiaries       728   751
Due from/to holding company       630   626







84






    Bank
   







    Total derivatives
   







    Notional
amounts
    Assets     Liabilities  
2005   £bn     £m     £m  










Exchange rate contracts                  
Spot, forwards and futures   10     138     141  
Currency swaps   1     115     21  
Options purchased   3     80      
Options written   2         80  
                   
Interest rate contracts                  
Interest rate swaps   63     840     877  
Options purchased   2     29      
Options written   2         10  
                   
Credit derivatives   1     1      










          1,203     1,129  





Included in the above are cash flow hedging derivatives as follows                  
Interest rate swaps             42  
                   
Amounts above include:                  
Due from/to holding company         626     626  
Due from/to subsidiaries         54     262  










 
         Group        
   







          Trading derivatives
Fair value
     

    Notional
amounts
    Assets     Liabilities  
2004   £bn     £m     £m  







Exchange rate contracts                  
Spot, forwards and futures   16     433     538  
Currency swaps   8     331     187  
Options purchased         85      
Options written             84  
 
Interest rate contracts                  
Interest rate swaps   165     2,099     1,920  
Options purchased   55     308      
Options written   45         247  
Futures and forwards   291     110     125  
 
Credit derivatives   2     3     7  










          3,369     3,108  
Effect of netting         (2,003 )   (2,003 )





          1,366     1,105  





Non-trading derivatives

Under previous GAAP, hedging derivatives were accounted for in accordance with the treatment of the hedged transaction. As a result any gains or losses on the hedging instrument arising from changes in fair values were not recognised in the profit and loss account immediately but accounted for in the same manner as the hedged item. The Group established such non-trading derivative positions externally with third party and also internally. The tables below include the components of the internal hedging programme that transferred risks to the trading portfolio or to external third party participants in the derivatives market.

The following table summarises the fair values and book values of derivatives held for non-trading activities and includes internal trades.

            Group        
 








        Fair value       Book value
 




 


    Notional
amounts
  Positive   Negative   Assets   Liabilities
2004   £bn   £m   £m   £m   £m











Exchange rate contracts                    
Spot, forwards and futures   1.5     54    
Currency swaps and options   0.3   4   10     3
 
Interest rate contracts                    
Interest rate swaps   12.0   351   299   80   60
Futures, forwards and options   0.2   3   4    











        358   367   80   63








85






Notes on the accounts continued

18 Derivatives at fair value (continued)

    Group      
 




    Unrecognised
gains and
losses
    Deferred
gains and
losses
 
2004   £m     £m  







As at 1 January 2004 – gains   889     109  
As at 1 January 2004 – losses   (601 )   (5 )







    288     104  
Recognised gains that arose in previous periods   (229 )   (42 )
Recognised losses that arose in previous periods   123     4  
Unrecognised gains and losses arising in the year   (7 )    
Unrecognised gains and losses deferred in the year   (201 )   201  
Unrecognised gains and losses deferred and taken to profit or loss in the year       (50 )







At 31 December 2004   (26 )   217  





 
Of which – gains   351     272  
               – losses   (377 )   (55 )







    (26 )   217  





Maturity of replacement cost of over-the-counter contracts (trading and non-trading)

Replacement cost indicates the Group's derivatives credit exposure. The following table sets forth the gross positive fair values by maturity. The replacement cost of internal trades is not included as there is no credit risk associated with them.

    Group
 






    Within
one year
  One to
five years
  Over
five years
  Total
2004   £m   £m   £m   £m









Before netting                
Exchange rate contracts   448   237   165   850
Interest rate contracts   275   813   1,476   2,564
Credit derivatives     2     2









    723   1,052   1,641   3,416







 
Financial institutions               2,731
Others               685









                3,416


86






19 Prepayments, accrued income and other assets

    Group   Bank    



 


    2005   2004   2005   2004
    £m   £m   £m   £m









Prepayments   76   134   45   77
Accrued income   366   1,292   275   799
Deferred taxation (see Note 25)   393   322   318   365
Deferred expenses   5   34     33
Other assets   2,283   563   926   560









    3,123   2,345   1,564   1,834







Amounts above include:                
Due from fellow subsidiaries   25   17    









 
20 Deposits by banks                
    Group   Bank    



 


    2005   2004   2005   2004
    £m   £m   £m   £m









Held-for-trading   6,589       1,237    
Amortised cost   39,412       4,073    









    46,001   23,873   5,310   3,480







Amounts above include:                
Items in the course of transmission to other banks   705   791   761   852
Due to holding company   18,885   2,218   1,865   537
Due to fellow subsidiaries   35     9  
Due to subsidiaries           950   874









 
21 Customer accounts                
    Group   Bank    



 


    2005   2004   2005   2004
    £m   £m   £m   £m









Held-for-trading   10,372       1,560    
Designated as at fair value through profit or loss   1,339       63    
Amortised cost   146,213       108,319    









    157,924   126,119   109,942   87,925







Amounts above include:                
Due to ultimate holding company   3      
Due to holding company   668     487  
Due to fellow subsidiaries   4,086   664   3,912   794
Due to subsidiaries       5,696   3,928









 
22 Debt securities in issue                
    Group   Bank    



 


    2005   2004   2005   2004
    £m   £m   £m   £m









Amortised cost   10,801       38    









    10,801   3,597   38   39







Amounts above include:                
Bonds and medium term notes   1,070   344   38   39
Certificates of deposit and other commercial paper   9,731   3,253    









 
23 Settlement balances and short positions                
            Group  



            2005   2004
            £m   £m









Settlement balances – Amortised cost           3,075   2,103
Short positions – held-for-trading:                
       Debt securities – Government           16,846   18,508
                                  – Other issuers           1,347   968
       Treasury bills and other eligible bills           288   91
       Equity shares           18  









            21,574   21,670



87






Notes on the accounts continued


24 Accruals, deferred income and other liabilities

                Group    Bank


 




                2005     2004     2005     2004  
                £m     £m     £m     £m  



















Notes in circulation               376     346          
Current taxation               393     481     289     357  
Accruals               888     1,846     260     914  
Deferred income               131     462     105     309  
Provisions for liabilities and charges (see table below)               108     122     83     94  
Deferred tax liability (see Note 25)               33              
Other liabilities               1,650     1,282     727     497  



















                3,579     4,539     1,464     2,171  











Amounts above include:                                    
Due to fellow subsidiaries               15     23          



















 
          Group                 Bank        
   







 







    Property(1)     Other(2 )   Total     Property(1)     Other(2 )   Total  
Provisions for liabilities and charges   £m     £m     £m     £m     £m     £m  



















At 1 January   91     31     122     91     3     94  
Currency translation and other movements   1     (2 )   (1 )   1         1  
Charge to income statement   9     4     13     9     2     11  
Unused provisions credited to income statement   (7 )   (1 )   (8 )   (7 )       (7 )
Provisions utilised   (14 )   (4 )   (18 )   (14 )   (2 )   (16 )



















At 31 December 2005   80     28     108     80     3     83  


















  Notes:
 
(1)      The Group has a number of leasehold properties where rents payable and other unavoidable costs exceed the value to the Group. Such costs arise over the period of the lease or to the expected termination date, and the provision has been discounted due to the long-term nature of certain of these obligations.
   
(2)      Other provisions arise in the normal course of business.

88






25 Deferred taxation        
         
Provision for deferred taxation has been made as follows:        
  Group     Bank  


 


 
  2005
£m
    2004
£m
    2005
£m
    2004
£m
 

 
Deferred tax liability (included in Accruals, deferred income and other liabilities, Note 24)   33      
Deferred tax asset (included in Prepayments, accrued income and other assets, Note 19)   (393 )   (322 )   (318 )   (365 )













Net deferred tax   (360 )   (322 )   (318 )   (365 )


  Group
 
  Pension
£m
    Accelerated
capital
allowances
£m
    Provisions
£m
    Deferred
gains
£m
    Other
transition
£m
    Fair
value on
financial
instruments
£m
    Intangibles
£m
    Hedging
£m
    Other
£m
    Total
£m

At 1 January 2004 under UK GAAP 2   264   (200 )             10   76
Implementation of IFRS                  
(excluding IAS 32 and IAS 39) (582 )   (7 )     120       176       (293 )

At 1 January 2004 restated (580 )   257   (200 )   120       176     10   (217 )
Charge to income statement (14 )   (24 )   24         (73 )     (7 )   (94 )
Charge to equity directly   (1 )                 (1 )
Acquisitions/(disposals) of subsidiaries 2     (1 )             8   9
Other (9 )   (14 )               4   (19 )

At 1 January 2005 (601 )   218   (177 )   120       103     15   (322 )
Implementation of IAS 32 and IAS 39     (55 )     (131 )   86     50     (50 )


At 1 January 2005 restated (601 )   218   (232 )   120   (131 )   86   103   50   15   (372 )
Charge to income statement (5 )   (18 )   20   (28 )   4   (1 )   (72 )     (2 )   (102 )
Charge to equity directly           (78 )     (20 )     (98 )
Acquisitions/(disposals) of subsidiaries         (7 )           (7 )
Other 266   2   (8 )             (41 )   219


At 31 December 2005 (340 )   202   (220 )   92   (134 )   7   31   30   (28 )   (360 )
 

  Bank
 
  Pension
£m
    Accelerated
capital
allowances
£m
    Provisions
£m
    Deferred
gains
£m
    Other
transition
£m
    Fair
value on
financial
instruments
£m
    Intangibles
£m
    Hedging
£m
    Other
£m
    Total
£m

At 1 January 2004 under UK GAAP   113   (162 )               1   (48 )
Implementation of IFRS                    
   (excluding IAS 32 and IAS 39) (552 )       66         181       (305 )

At 1 January 2004 restated (552 )   113   (162 )   66         181     1   (353 )
Charge to income statement (20 )   9   49           (68 )       (30 )
Currency translation and other adjustments   (1 )             20     (1 )   18

At 1 January 2005 (572 )   121   (113 )   66         133       (365 )
Implementation of IAS 32 and IAS 39     (23 )       (134 )   86     34     (37 )


At 1 January 2005 restated (572 )   121   (136 )   66     (134 )   86   133   34     (402 )
Charge to income statement 4   (1 )   17   10         (67 )       (37 )
Charge to equity directly             (86 )     (24 )     (110 )
Other 266               (35 )       231


At 31 December 2005 (302 )   120   (119 )   76     (134 )     31   10     (318 )
 


89



Notes on the accounts continued

26 Subordinated liabilities        
  Group   Bank

 
  2005
£m
  2004
£m
  2005
£m
  2004
£m

Amortised cost   6,648     5,501  









  6,648   5,808   5,501   4,747
   






Dated loan capital   3,418   3,074   2,414   2,383
Undated loan capital   2,765   2,734   2,622   2,364
Preference shares   465     465  









  6,648   5,808   5,501   4,747
   






Amounts above include:        
Due to holding company   277   550    
Due to fellow subsidiaries   369      

On implementation of IAS 32, all of the Group’s preference shares were re-classified as liabilities; these securities remain subject to the capital maintenance rules of the Companies Act 1985.

The following tables analyse the remaining maturity of subordinated liabilities by (1) the final redemption date; and (2) the next callable date.

  Group

2005 – final redemption   2006
£m
  2007
£m
  2008-2010
£m
  2011-2015
£m
  thereafter
£m
  perpetual
£m
  Total
£m

– Sterling   14     37   597   461     1,109
– US$   364     579   121   276     1,340
– Euro   32     410   340   187     969



Dated loan capital   410     1,026   1,058   924     3,418



– Sterling             792   792
– US$             1,483   1,483
– Euro             490   490



Undated loan capital             2,765   2,765



– Sterling             140   140
– US$             325   325



Preference shares             465   465



  410     1,026   1,058   924   3,230   6,648


  Group

2005 – call date   Currently
£m
  2006
£m
  2007
£m
  2008 – 2010
£m
  2011– 2015
£m
  thereafter
£m
  perpetual
£m
  Total
£m

– Sterling     14     37   762   296     1,109
– US$     596     601   143       1,340
– Euro     32     410   464   63     969



Dated loan capital     642     1,048   1,369   359     3,418



– Sterling     28     539     118   107   792
– US$   1,160   17   290       16     1,483
– Euro     5     366     82   37   490



Undated loan capital   1,160   50   290   905     216   144   2,765



– Sterling   140               140
– US$   146   5   174           325



Preference shares   286   5   174           465



  1,446   697   464   1,953   1,369   575   144   6,648


90

 




  Group

2004 – final redemption   2005
£m
  2006
£m
  2007-2009
£m
  2010-2014
£m
  thereafter
£m
  perpetual
£m
  Total
£m

– Sterling         299   758     1,057
– US$   207   54   514   22   285     1,082
– Euro         770   165     935

Dated loan capital   207   54   514   1,091   1,208     3,074

– Sterling             748   748
– US$             1,290   1,290
– Euro             658   658
– Other             38   38

Undated loan capital             2,734   2,734

  207   54   514   1,091   1,208   2,734   5,808


  Group

2004 – call date   Currently
£m
  2005
£m
  2006
£m
  2007– 2009
£m
  2010– 2014
£m
  thereafter
£m
  perpetual
£m
  Total
£m

– Sterling       299   100   65   593     1,057
– US$   207   207   54   614         1,082
– Euro         99   770   66     935

Dated loan capital   207   207   353   813   835   659     3,074

– Sterling           324   398   26   748
– US$   1,032       258         1,290
– Euro         352       306   658
– Other               38   38

Undated loan capital   1,032       610   324   398   370   2,734

  1,239   207   353   1,423   1,159   1,057   370   5,808


Bank













2005 – final redemption   2006
£m
  2007
£m
  2008-2010
£m
  2011-2015
£m
  thereafter
£m
  perpetual
£m
  Total
£m

– Sterling   14     37   597   296     944
– US$   10     579   99       688
– Euro   32     410   340       782



Dated loan capital   56     1,026   1,036   296     2,414



– Sterling             767   767
– US$             1,484   1,484
– Euro             371   371



Undated loan capital             2,622   2,622



– Sterling             140   140
– US$             325   325



Preference shares             465   465



  56     1,026   1,036   296   3,087   5,501


  Bank

2005– call date   Currently
£m
  2006
£m
  2007
£m
  2008– 2010
£m
  2011– 2015
£m
  thereafter
£m
  perpetual
£m
  Total
£m

– Sterling     14     37   597   296     944
– US$     10     579   99       688
– Euro     32     410   340       782

















Dated loan capital     56     1,026   1,036   296     2,414

















– Sterling     28     539     200     767
– US$   1,160   17   290       17     1,484
– Euro     5     366         371

















Undated loan capital   1,160   50   290   905     217     2,622

















– Sterling   140               140
– US$   146   5   174           325

















Preference shares   286   5   174           465

















  1,446   111   464   1,931   1,036   513     5,501


91


 

Notes on the accounts continued

26 Subordinated liabilities (continued)                  
      Bank
   
2004 – final redemption       2005
£m
  2006
£m
  2007-2009
£m
  2010-2014
£m
  thereafter
£m
  perpetual
£m
  Total
£m

– Sterling           299   593     892
– US$     207     514         721
– Euro           770       770

Dated loan capital     207     514   1,069   593     2,383

– Sterling               722   722
– US$               1,290   1,290
– Euro               352   352

Undated loan capital               2,364   2,364

    207     514   1,069   593   2,364   4,747

                 
  Bank

  Currently   2005   2006   2007– 2009   2010– 2014   thereafter   perpetual   Total
2004 – call date   £m   £m   £m   £m   £m   £m   £m   £m

– Sterling       299       593     892
– US$     207     514         721
– Euro           770       770

Dated loan capital     207   299   514   770   593     2,383

– Sterling           324   398     722
– US$   1,032       258         1,290
– Euro         352         352

Undated loan capital   1,032       610   324   398     2,364

  1,032   207   299   1,124   1,094   991     4,747


  Notes:
   
(1) In the event of certain changes in tax laws, dated and undated loan capital issues may be redeemed in whole, but not in part, at the option of the Group, at the principal amount thereof plus accrued interest, subject to prior regulatory approval.
   
(2) At 31 December 2004 the principal amounts payable to dated and undated loan note holders would not have been materially different from the carrying amount.
   
(3) On 15 December 2005, the Bank gave notice of redemption of 20 million Exchangeble Capital Securities, Series A, of US$25 each on 16 January 2006.
   
27 Minority interests    
  Group

 
  2005
£m
    2004
£m

 
At 1 January   408   3
Implementation of IAS 32 and IAS 39 on 1 January 2005   (6 )  
Currency translation adjustments and other movements   (2 )  
Profit attributable to minority interests   17   12
Dividends paid   (15 )   (10 )
Equity raised   463   405
Equity withdrawn   (121 )   (2 )






 
At 31 December   744   408

 

92





28 Share capital        
  Group and Bank

  Allotted, called up
and fully paid
  Authorised

 
  2005   2004   2005   2004
  £m   £m   £m   £m

Equity shares        
Ordinary shares of £1 each   1,678   1,678   2,250   2,250









Total equity share capital   1,678   1,678   2,250   2,250









Non-equity shares        
Non-cumulative preference shares of US$25   320   284   1,162   1,034
Non-cumulative preference shares of £1   140   140   1,000   1,000









Total non-equity share capital   460   424   2,162   2,034









Total share capital   2,138   2,102   4,412   4,284

               
  Allotted, called up
and fully paid
  Authorised


Number of shares – millions   2005   2004   2005   2004

Equity shares        
Ordinary shares of £1 each   1,678   1,678   2,250   2,250









Non-equity shares        
Non-cumulative preference shares of US$25   22   22   80   80
Non-cumulative preference shares of £1   140   140   1,000   1,000

The non-cumulative preference shares, Series B, of US$25 each which carry the right to a gross dividend of 8.75% inclusive of associated tax credit, are redeemable at the option of the Bank at US$25 per share.

The non-cumulative preference shares, Series C, of US$25 each carry the right to a gross dividend of 8.625% inclusive of associated tax credit. They are redeemable at the option of the Bank from 9 April 2002 to 8 April 2008 inclusive, at a premium per share of US$0.60 until 8 April 2006 and US$0.30 from 9 April 2006 until 8 April 2007. There is no redemption premium if the date of redemption falls after 8 April 2007.

The 9% non-cumulative preference shares, Series A, of £1 each are non-redeemable.

The holders of sterling and dollar preference shares are entitled, on the winding-up of the Bank, to priority over the ordinary shareholders as regards payment of capital. Otherwise the holders of preference shares are not entitled to any further participation in the profits or assets of the Bank and accordingly these shares are classified as non-equity shares.

The holders of sterling and dollar preference shares are not entitled to receive notice of, attend, or vote at any general meeting unless the business of the meeting includes the consideration of a resolution for the winding-up of the Bank or the sale of the whole of the business of the Bank or any resolution directly affecting any of the special rights or privileges attached to any of the classes of preference shares.

Under IFRS, the Group’s preference shares are classified as debt and are now included in subordinated liabilities on the balance sheet (see Note 26).

93





Notes on the accounts continued

29 Reserves        
  Group     Bank

   
 
  2005     2004     2005     2004
  £m     £m     £m     £m

 
Share premium account        
At 1 January   1,286   1,286   1,286   1,286
Reclassification of preference shares on implementation of IAS 32 on 1 January 2005   5     5  












 
At 31 December   1,291   1,286   1,291   1,286










 
Available-for-sale reserve        
Implementation of IAS 32 and IAS 39 on 1 January 2005   200     201  
Unrealised gains in the year   38     33  
Realised gains in the year   (324 )     (320 )  
Taxation   86     86  










     
At 31 December        

 
 
Cash flow hedging reserve        
Implementation of IAS 32 and IAS 39 on 1 January 2005   156     122  
Unrealised losses in the year   (28 )     (52 )  
Taxation   20     24  










     
At 31 December   148     94  

 
 
Foreign exchange reserve        
At 1 January   (19 )   (33 )    
Implementation of IAS 32 and IAS 39 on 1 January 2005   6      
Retranslation of net assets   182   14   (5 )  












 
At 31 December   169   (19 )   (5 )  










 
Other reserves        
At 1 January and 31 December   298   298   298   298










 
Retained earnings        
At 1 January   4,342   4,332   1,416   1,851
Implementation of IAS 32 and IAS 39 on 1 January 2005   (582 )     (487 )  
Currency translation adjustments and other movements     (6 )    
Profit attributable to ordinary and equity preference shareholders   2,446   2,352   1,774   1,901
Ordinary dividends paid   (350 )   (2,300 )   (350 )   (2,300 )
Preference dividends – non-equity     (36 )     (36 )












 
At 31 December   5,856   4,342   2,353   1,416










 
Reserves at 31 December   7,762   5,907   4,031   3,000










 

UK law prescribes that only reserves of the Bank are taken into account for the purpose of making distributions and the permissible applications of the share premium account.

The Group optimises capital efficiency by maintaining reserves in subsidiaries, including regulated entities. Certain preference shares and subordinated debt are also included within regulatory capital. The remittance of reserves to the parent or the redemption of shares or subordinated capital by regulated entities may be subject to maintaining the capital resources required by the relevant regulator.

94




30 Leases                
         
Minimum amounts receivable and payable under non-cancellable leases        
  2005     2004

   
 
  Year in which receipt or payment will occur     Year in which receipt or payment will occur

   
 
Group   Within 1
year
£m
    After 1 year
but within
5 years
£m
    After 5
years
£m
    Total
£m
    Within 1
year
£m
    After 1 year
but within
5 years
£m
    After 5
years
£m
    Total
£m
























 
Finance lease assets:                
Amounts receivable   99   605   381   1,085   78   424   634   1,136
Present value adjustment   (27 )   (136 )   (110 )   (273 )   (31 )   (159 )   (261 )   (451 )
Other movements   (3 )   (60 )   (25 )   (88 )   (1 )   (34 )   (10 )   (45 )
























 
Present value amounts receivable   69   409   246   724   46   231   363   640












Operating lease obligations:                
Amounts payable:                
Premises   84   302   655   1,041   98   358   788   1,244
Equipment   2   1     3   2   1     3

























  86   303   655   1,044   100   359   788   1,247

 
Bank                
























 
Operating lease obligations:                
Amounts payable:                
Premises   66   242   452   760   72   271   562   905
























 
          Group   Bank

 
 
          2005   2004   2005   2004
Amounts recognised as income and expense             £m   £m   £m   £m
























 
Operating lease payables – minimum payments         100   106   75   83
Finance lease receivables – unearned finance income         273   451    
























 

95






Notes on the accounts continued

31 Collateral

Securities repurchase agreements and lending transactions

The Group enters into securities repurchase agreements as securities lending transactions under which it receives or transfers cash or securities as collateral in accordance with normal market practice. Under standard terms for repurchase transactions in the UK and US markets, the recipient of collateral has an unrestricted right to sell or repledge it, subject to returning equivalent securities on settlement of the transaction.

Securities transferred under repurchase transactions included within securities on the balance sheet were as follows:

Group


2005
£m
  2004
£m




Treasury and other eligible bills 724   133
Debt securities 26,607   20,202




27,331   20,335



All of the above securities could be sold or repledged by the holder. Securities received as collateral under reverse repurchase agreements amounted to £34.8 billion (2004 – £34.3 billion), of which £33.1 billion (2004 – £31.7 billion) has been resold or repledged as collateral for the Group’s own transactions.

Other collateral given   Group   Bank


 

Assets charged as security for liabilities   2005
£m
  2004
£m
  2005
£m
  2004
£m









Loans and advances to customers   351   342    
Other   11   4    









  362   346    







Liabilities secured by charges to assets   2005
£m
  2004
£m
  2005
£m
  2004
£m









Customer accounts   8     9  
Debt securities in issue   349   342    
Other liabilities   17      









  374   342   9  


32 Financial instruments

Risk management

Risk Management is conducted on an overall basis within the RBS Group. Therefore in the discussion on risk management (pages 96 to 101) references to “the Group” or “Group” Board and committees are to the RBS Group.

Governance framework

The Board sets the overall risk appetite and philosophy for the Group. Various Board sub-committees support these goals, as follows:

  • Group Audit Committee is a non-executive committee that supports the Board in carrying out its responsibilities for financial reporting including accounting policies and in respect of internal control and risk assessment. The Group Audit Committee monitors the ongoing process of the identification, evaluation and management of all significant risks throughout the Group. The Committee is supported by Group Internal Audit which provides an independent assessment of the design, adequacy and effectiveness of the Group’s internal controls.

  • Advances Committee is an executive committee that deals with all transactions that exceed the Group Credit Committee's delegated authority.

In addition to the responsibilities at Board level, operational authority and oversight is delegated to the Group Executive Management Committee (“GEMC”), which is responsible for implementing a risk management framework consistent with the Board's risk appetite. The GEMC, in turn, is supported by the following committees:

  • Group Risk Committee (“GRC”) is an executive risk governance committee which recommends and approves limits, processes and policies in respect of the effective management of all material non-balance sheet risks across the Group.

  • Group Credit Committee (“GCC”) is a credit approval committee which deals with all transactions that exceed the delegated authority of divisional credit committees.

  • Group Asset and Liability Management Committee (“GALCO”), is an executive committee which is responsible for reviewing the balance sheet, funding, liquidity, structural forex, intra-group limits, capital adequacy and capital raising across the Group as well as interest rate risk in the banking book. In addition, GALCO monitors and reviews external, economic and environmental changes affecting such risks.

These Committees are further supported by two dedicated group level functions, Group Risk Management, which has responsibility for credit, market, regulatory and enterprise risk

96




and Group Treasury which is responsible for the management of the Group's balance sheet, capital raising, intra group credit exposure, liquidity and hedging policies. Both functions report to GEMC and the Group Board through the Group Finance Director and play an active role in assessing and monitoring the effectiveness of the divisional risk management functions.

Financial risk management policies and objectives

The Board establishes the overall governance framework for risk management and sets the risk appetite and philosophy for the Group.

The principal financial risks that the Group manages are as follows:

  • Credit risk: credit risk is the risk arising from the possibility that the Group will incur losses from the failure of customers to meet their obligations.

  • Liquidity risk: the risk that the Group is unable to meet its’ obligations as they fall due.

  • Market risk: the Group is exposed to market risk because of positions held in its trading portfolios and its non-trading businesses.

  • Insurance underwriting risk: the Group is exposed to insurance risk through using insurance as a tool to mitigate other risk exposures.

Credit risk

The objective of credit risk management is to enable the Group to achieve sustainable and superior risk versus reward performance whilst maintaining credit risk exposure in line with approved risk appetite.

The key principles for credit risk management are set out in the Group’s Credit Risk Management Framework and include:

  • Approval of all credit exposure must be granted prior to any advance or extension of credit.

  • An appropriate credit risk assessment of the customer and related credit facilities must be undertaken prior to approval of credit exposure. This must include an assessment of, amongst others, the purpose of the credit and sources of repayment, compliance with affordability tests, repayment history, capacity to repay, sensitivity to economic and market developments and risk-adjusted return.

  • The Board delegates authority to Executive Advances Committee, Group Credit Committee and divisional credit committees. A divisional CEO may delegate a subset of the divisional credit risk authority to sub-committees or to individuals.

  • Credit risk authority must be specifically granted in writing to all individuals involved in the granting of credit approval, whether this is exercised personally or collectively as part of a credit committee. These individuals must act independently and with balanced commercial judgement in exercising credit authority.

  • Where credit authority is exercised personally, the individual must not have any responsibility or accountability for business revenue origination.

  • All credit exposures, once approved, must be effectively monitored and managed and reviewed periodically against approved limits. Review occurs at least annually, with lower quality exposures being subject to a greater frequency of analysis and assessment.

  • Customers with emerging credit problems must be identified early and classified accordingly. Remedial actions must be implemented promptly to minimise the potential loss to the Group and consideration should be given whether to transfer customers with credit problems to a specialised problem management or recovery unit.

  • Portfolio analysis and reporting must be used to identify and manage credit risk concentrations and credit risk quality migration.

Credit grading models

In order to support the analytical elements of the credit risk management framework, in particular the risk assessment part of the credit approval process, ongoing monitoring and portfolio analysis, the Group employs a range of credit risk models. These models can be broadly grouped into four categories.

  • Probability of default (“PD”)/customer credit grade – these models assess the probability that the customer will fail to make full and timely repayment of credit obligations over a one year time horizon. Each customer is assigned an internal credit grade which corresponds to a probability of default. There are a number of different credit grading models in use across the Group, each of which considers particular characteristics of customer types in that portfolio. The credit grading models use a combination of quantitative inputs, such as recent financial performance and customer behaviour, and qualitative inputs, such as company management performance or sector outlook.

Every customer credit grade across all grading scales in the Group can be mapped to a Group level credit grade which uses a five band scale from AQ1 to AQ5.

  • Loss given default (“LGD”) – these models estimate the economic loss that may be suffered by the Group on a credit facility in the event of default. The LGD of a facility represents the amount of debt which cannot be recovered and is typically expressed as a percentage of the EAD. The Group's LGD models take into account the type of borrower, facility and any risk mitigation such as the presence of any security or collateral held. The LGD may also be affected by the industry sector of the borrower, the legal jurisdiction in which the borrower operates as well as general economic conditions which may impact the value of any assets held as security.

97





Notes on the accounts continued


32 Financial instruments
(continued)

  • Exposure at default (“EAD”) – these models estimate the expected level of utilisation of a credit facility at the time of a borrower’s default. The EAD will typically be higher than the current utilisation (e.g. in the case where further drawings are made on a revolving credit facility prior to default) but will not typically exceed the total facility limit. The methodologies used in EAD modelling recognise that customers may make more use of their existing credit facilities in the run up to a default.

  • Credit risk exposure measurement – these models calculate the credit risk exposure for products where the exposure is not 100% of the gross nominal amount of the credit obligation. These models are most commonly used for derivative and other traded instruments where the amount of credit risk exposure may be dependent on external variables such as interest rates or foreign exchange rates.

Risk assets

The Group’s portfolio consists of loans (including overdraft facilities), instalment credit, finance lease receivables, debt securities and other traded instruments. In order to encompass the entire range of products in the Group’s credit portfolios exposure is monitored using risk assets, which cover exposures to all these asset and customer types.

Risk asset quality

Internal reporting and oversight of risk assets is principally differentiated by credit ratings. Internal ratings are used to assess the credit quality of borrowers. Customers are assigned credit ratings, based on various credit grading models that reflect the probability of default. All credit ratings across the Group map to a Group level asset quality scale.

Provision analysis

The Group’s consumer portfolios, which consist of small value, high volume credits, have highly efficient largely automated processes for identifying problem credits and very short timescales, typically three months, before resolution or adoption of various recovery methods.

Corporate portfolios consist of higher value, lower volume credits, which tend to be structured to meet individual customer requirements. Provisions are assessed on a case by case basis.

Early and proactive management of problem exposures ensures that credit losses are minimised. Specialised units are used for different customer types to ensure that the appropriate risk mitigation is taken in a timely manner.

Portfolio provisions are reassessed regularly as part of the Group’s ongoing monitoring process.

Provisions methodology

Under IAS 39 provisions are assessed under three categories as described below:

Individually assessed provisions are the provisions required for individually significant impaired assets which are assessed on a case by case basis, taking into account the financial condition of the counterparty and any guarantor. This incorporates an estimate of the discounted value of any recoveries and realisation of security or collateral. The asset continues to be assessed on an individual basis until it is repaid in full, transferred to the performing portfolio or written off.

Collectively assessed provisions are the provisions on impaired credits below an agreed value threshold which are assessed on a portfolio basis, to reflect the homogenous nature of the assets, such as credit cards or personal loans. The provision is determined from a quantitative review of the relevant portfolio, taking account of the level of arrears, security and average loss experience over the recovery period.

Latent loss provisions are the provisions held against the estimated impairment in the performing portfolio which has yet to be identified and reported as at the balance sheet date. To assess the latent loss within the portfolio, the Group has developed methodologies to estimate the time that an asset can remain impaired within a performing portfolio before it is identified and reported as such.

Liquidity risk

Liquidity management within the Group focuses on both overall balance sheet structure and the control, within prudent limits, of risk arising from the mismatch of maturities across the balance sheet and from undrawn commitments and other contingent obligations. It is undertaken within limits and other policy parameters set by Group Asset and Liability Management Committee (GALCO).

The structure of the Group’s balance sheet is managed to maintain substantial diversification, to minimise concentration across its various deposit sources, and to contain the level of reliance on total and net short-term wholesale sources of funds within prudent levels.

The degree of maturity mismatch within the overall long-term structure of the Group’s assets and liabilities is also managed within internal policy limits, to ensure that term asset commitments may be funded on an economic basis over their life. In managing its overall term structure, the Group analyses and takes into account the effect of retail and corporate customer behaviour on actual asset and liability maturities where they differ materially from the underlying contractual maturities. The short-term maturity structure of the Group’s assets and liabilities is managed on a daily basis to ensure that contractual cash flow obligations, and potential cash flows arising from undrawn commitments and other contingent obligations, can be met as they arise from day to day, either from cash inflows from maturing assets, new borrowing or the sale or repurchase of debt securities held.

98




Short-term liquidity risk is managed on a consolidated basis for the whole Group excluding the activities of Citizens and insurance businesses, which are subject to regulatory regimes that necessitate local management of liquidity.

Internal liquidity mismatch limits are set for all other subsidiaries and non-UK branches which have material local treasury activities in external markets, to ensure those activities do not compromise daily maintenance of the Group’s overall liquidity risk position within the Group’s policy parameters.

The level of large deposits taken from banks, corporate customers, non-bank financial institutions and other customers and significant cash outflows therefrom are also reviewed to monitor concentrations and identify any adverse trends.

Market risk

The Group is exposed to market risk because of positions held in its trading portfolios and its non-trading business including the Group’s treasury operations. The Group manages the market risk in its trading and treasury portfolios through its market risk management framework, which is based on value-at-risk (“VaR”) limits, together with, but not limited to, stress testing, scenario analysis, and position and sensitivity limits. Stress testing measures the impact of abnormal changes in market rates and prices on the fair value of the Group’s trading portfolios. GEMC approves the high-level VaR and stress limits for the Group. The Group Market Risk function, independent from the Group’s trading businesses, is responsible for setting and monitoring the adequacy and effectiveness of the Group’s market risk management processes.

Value-at-risk (“VaR”)

VaR is a technique that produces estimates of the potential negative change in the market value of a portfolio over a specified time horizon at given confidence levels. For internal risk management purposes, the Group’s VaR assumes a time horizon of one day and a confidence level of 95%. The Group uses historical simulation models in computing VaR. This approach, in common with many other VaR models, assumes that risk factor changes observed in the past are a good estimate of those likely to occur in the future and is, therefore, limited by the relevance of the historical data used. The Group’s method, however, does not make any assumption about the nature or type of underlying loss distribution.

The Group typically uses the previous two years of market data. The Group’s VaR should be interpreted in light of the limitations of the methodology used. These limitations include:

  • Historical data may not provide the best estimate of the joint distribution of risk factor changes in the future and may fail to capture the risk of possible extreme adverse market movements which have not occurred in the historical window used in the calculations.

  • VaR using a one-day time horizon does not fully capture the market risk of positions that cannot be liquidated or hedged within one day.

  • VaR using a 95% confidence level does not reflect the extent of potential losses beyond that percentile.

The Group largely computes the VaR of trading portfolios at the close of business and positions may change substantially during the course of the trading day. Controls are in place to limit the Group’s intra-day exposure; such as the calculation of the VaR for selected portfolios. These limitations and the nature of the VaR measure mean that the Group cannot guarantee that losses will not exceed the VaR amounts indicated.

Trading

The principal focus of the Group’s trading activities is client facilitation – providing products to the Group’s client base at competitive prices. The Group also undertakes: market making –quoting firm bid (buy) and offer (sell) prices with the intention of profiting from the spread between the quotes; arbitrage –entering into offsetting positions in different but closely related markets in order to profit from market imperfections; and proprietary activity – taking positions in financial instruments as principal in order to take advantage of anticipated market conditions. The main risk factors are interest rates, credit spreads and foreign exchange. Financial instruments held in the Group’s trading portfolios include, but are not limited to, debt securities, loans, deposits, securities sale and repurchase agreements and derivative financial instruments (futures, forwards, swaps and options). For a discussion of the Group’s accounting policies for derivative financial instruments, see Accounting policies.

The VaR for the Group’s trading portfolios segregated by type of market risk exposure, including idiosyncratic risk, is presented in the table below.

  2005   2004








 







  Average   Period end     Maximum   Minimum   Average   Period end     Maximum   Minimum
  £m   £m     £m   £m   £m   £m     £m   £m



















Trading                
Interest rate   6.0   5.5   10.8   4.1   5.5   5.0   8.5   4.0
Credit spread   6.0   5.2   8.6   3.6   3.8   4.9   6.6   1.5
Currency   0.4   0.4   0.8     0.4   0.8   1.2   0.1
Equity and commodity   0.2   0.3   1.3       0.3   0.6  
Diversification     (3.5 )         (4.4 )    




Total trading VaR   8.1   7.9   12.3   5.5   7.0   6.6   10.3   4.8


99



Notes on the accounts continued

32 Financial instruments (continued)

Non-trading

The principal market risks arising from the Group’s non-trading activities are interest rate risk, currency risk and equity risk. Treasury activity and mismatches between the repricing of assets and liabilities in its retail and corporate banking operations account for most of the non-trading interest rate risk. Non-trading currency risk derives from the Group’s investments in overseas subsidiaries, associates and branches. The Group’s venture capital portfolio and investments held by its general insurance business are the principal sources of non-trading equity price risk. The Group’s portfolios of non-trading financial instruments mainly comprise loans (including finance leases), debt securities, equity shares, deposits, certificates of deposits and other debt securities issued, loan capital and derivatives. To reflect their distinct nature, the Group’s long-term assurance assets and liabilities attributable to policyholders have been excluded from these market risk disclosures.

• Interest rate risk

Non-trading interest rate risk arises from the Group’s treasury activities and retail and corporate banking businesses.

Treasury

The Group’s treasury activities include its money market business and the management of internal funds flow within the Group’s businesses. Money market portfolios include cash instruments (principally debt securities, loans and deposits) and related hedging derivatives.

Retail and corporate banking

Structural interest rate risk arises in these activities where assets and liabilities have different repricing dates. It is the Group’s policy to minimise the sensitivity of net interest income to changes in interest rates and where interest rate risk is retained to ensure that appropriate resources, measures and limits are applied.

Structural interest rate risk is calculated in each division on the basis of establishing the repricing behaviour of each asset and liability product. For many products, the actual interest rate repricing characteristics differ from the contractual repricing. In most cases, the repricing maturity is determined by the market interest rate that most closely fits the historical behaviour of the product interest rate. For non-interest bearing current accounts, the repricing maturity is determined by the stability of the portfolio. The repricing maturities used are approved by Group Treasury and divisional asset and liability committees at least annually. Key conventions are reviewed annually by GALCO.

A static maturity gap report is produced as at the month-end for each division, in each functional currency based on the behaviouralised repricing for each product. It is Group policy to include in the gap report, non-financial assets and liabilities, mainly property, plant and equipment and the Group’s capital and reserves, spread over medium and longer term maturities. This report also includes hedge transactions, principally derivatives.

Any residual non-trading interest rate exposures are controlled by limiting repricing mismatches in the individual balance sheets. Potential exposures to interest rate movements in the medium to long term are measured and controlled using a version of the same VaR methodology that is used for the Group’s trading portfolios but without discount factors. Net accrual income exposures are measured and controlled in terms of sensitivity over time to movements in interest rates.

Risk is managed within limits approved by GALCO through the execution of cash and derivative instruments. Execution of the hedging is carried out by the relevant division through the Group’s treasury function. The residual risk position is reported to divisional asset and liability committees, GALCO and Board.

• Currency risk

The Group does not maintain material non-trading open currency positions other than the structural foreign currency translation exposures arising from its investments in foreign subsidiaries and associated undertakings and their related currency funding. The Group’s policy in relation to structural positions is to match fund the structural foreign currency exposure arising from net asset value, including goodwill, in foreign subsidiaries, equity accounted investments and branches, except where doing so would materially increase the sensitivity of either the Group’s or the subsidiary’s regulatory capital ratios to currency movements. The policy requires structural foreign exchange positions to be reviewed regularly by GALCO. Gains or losses on foreign currency investments net of any gains or losses on related foreign currency funding or hedges are recognised in the statement of recognised income and expense.

100





The tables below set out the Group’s structural foreign currency exposures.        
2005   Net investments
in foreign
operations
£m
  Foreign
currency
borrowings
hedging net
investments
£m
  Structural
foreign
currency
exposures
£m







US dollar   3,022   2,806   216
Euro   1,934   284   1,650
Swiss franc   431   430   1
Other non-sterling   4   4  







  5,391   3,524   1,867

2004      







US dollar   2,142   2,092   50
Euro   1,822   1,125   697
Swiss franc   392   388   4
Other non-sterling   4   4  







  4,360   3,609   751


The structural foreign currency exposure in euros is principally due to Ulster Bank running an open structural foreign exchange position to minimise the sensitivity of its capital ratios to possible movements in the Euro exchange rate against Sterling and the exclusion from the table of preference shares classified as equity under IFRS. These instruments continue to be considered part of the currency funding of foreign operations for asset and liability management purposes.

101




Notes on the accounts continued

32 Financial instruments (continued)              
     
Remaining maturity   Group

2005   1 month
or less
£m
  Within
3 months
£m
  3-12
months
£m
  1-5
years
£m
  Over 5
years
£m
  Equity
shares
£m
  Total
£m

Assets              
Cash and balances at central banks   1,568             1,568
Treasury bills and other eligible bills   23   39   708         770
Loans and advances to banks   47,521   6,001   1,400   780   293     55,995
Loans and advances to customers   73,218   12,591   17,165   21,447   35,522     159,943
Debt securities   399   179   1,323   6,894   19,950     28,745
Equity shares             823   823
Settlement balances   3,931             3,931
Derivatives at fair value   213   210   368   875   1,310     2,976
               
Liabilities              
Deposits by banks   29,351   5,147   7,915   2,784   804     46,001
Customer accounts   141,464   10,170   2,795   3,110   385     157,924
Debt securities in issue   3,040   2,277   4,949   141   394     10,801
Settlement balances and short positions   3,061   223   705   15,079   2,506     21,574
Derivatives at fair value   251   192   289   652   1,273     2,657
Subordinated liabilities   326   6   1,811   2,417   2,088     6,648

               
2004              

Assets              
Cash and balances at central banks   1,589             1,589
Treasury bills and other eligible bills   74   84   14         172
Loans and advances to banks   19,404   7,750   1,477   561   790     29,982
Loans and advances to customers   30,101   14,927   11,163   21,953   53,535     131,679
Debt securities   272   298   395   5,381   16,080     22,426
Equity shares             1,338   1,338
Settlement balances   3,538             3,538
Derivatives at fair value   29   15   243   423   656     1,366
               
Liabilities              
Deposits by banks   14,412   7,195   2,038   185   43     23,873
Customer accounts   103,462   18,741   2,121   1,655   140     126,119
Debt securities in issue   892   1,784   443   102   376     3,597
Settlement balances and short positions   3,112   379   185   12,800   5,194     21,670
Derivatives at fair value   16   21   195   342   531     1,105
Subordinated liabilities   207   1,032   207   1,776   2,586     5,808


102




Remaining maturity   Bank

2005   1 month
or less
£m
  Within
3 months
£m
  3-12
months
£m
  1-5
years
£m
  Over 5
years
£m
  Equity
shares
£m
  Total
£m

Assets              
Cash and balances at central banks   894             894
Loans and advances to banks   18,112   1,733   754   190   40     20,829
Loans and advances to customers   52,290   6,921   9,680   13,530   15,148     97,569
Debt securities   8   11   17   12   3     51
Derivatives at fair value   43   61   128   424   547     1,203
               
Liabilities              
Deposits by banks   3,413   808   604   261   224     5,310
Customer accounts   98,683   7,005   1,755   1,923   576     109,942
Debt securities in issue       5   33       38
Derivatives at fair value   42   55   117   208   707     1,129
Subordinated liabilities   326   6   1,225   2,395   1,549     5,501

2004              

Assets              
Cash and balances at central banks   956             956
Loans and advances to banks   12,136   1,964   1,193   20   681     15,994
Loans and advances to customers   28,215   8,052   10,688   15,581   15,083     77,619
Debt securities       26   13       39
Equity shares             587   587
Derivatives at fair value     14   133   218   339     704
               
Liabilities              
Deposits by banks   2,513   881   74   12       3,480
Customer accounts   76,103   8,862   1,040   1,391   529     87,925
Debt securities in issue         5   34     39
Derivatives at fair value   3   6   50   88   136     283
Subordinated liabilities     1,032   207   1,423   2,085     4,747


103



Notes on the accounts continued

32 Financial instruments (continued)

Interest rate sensitivity

The tables below summarise the interest rate sensitivity gap for the Group and the Bank at 31 December 2005 and the Group at 31 December 2004. The tables show the contractual repricing for each category of asset, liability and off-balance sheet items in the banking book. A liability (or negative) gap position exists when liabilities reprice more quickly or in greater proportion than assets during a given period and tends to benefit net interest income in a declining interest rate environment. An asset (or positive) gap position exists when assets reprice more quickly or in greater proportion than liabilities during a given period and tends to benefit net interest income in a rising interest rate environment. Contractual repricing terms do not reflect the potential impact of early repayment or withdrawal. Positions may not be reflective of those in subsequent periods. Major changes in positions can be made promptly as market outlooks change. In addition, significant variations in interest rate sensitivity may exist within the re-pricing periods presented and among the currencies in which the Group has interest rate positions.

    Group

2005   3 months
or less
£m
    After 3
months
but less
than
6 months
£m
    After 6
months
but less
than
1 year
£m
    After 1
year
but less
than
5 years
£m
  Over 5
years
£m
  Total
interest
earning
/bearing
£m
    Yield
%
  Non
interest
earning
/bearing
£m
    Fair value
through
profit
or loss
£m
  Banking
book
£m
    Trading
book
£m
  Total
£m

Assets                        
Loans and advances to banks   38,052   580   884   521   25   40,062   2.19   2,467   825   43,354   12,641   55,995
Loans and advances                        
   to customers   99,057   2,624   2,492   12,027   4,650   120,850   4.26   16,253     137,103   22,840   159,943
Debt securities and                        
   treasury bills   2,290   155   152   238   82   2,917   3.39     403   3,320   26,195   29,515
Other assets                 8,421   39   8,460   6,690   15,150































Total assets   139,399   3,359   3,528   12,786   4,757   163,829   3.74   27,141   1,267   192,237   68,366   260,603





























Liabilities and equity                        
Deposits by banks   18,486   4,007   1,517   2,470   517   26,997   1.60   2,040     29,037   16,964   46,001
Customer accounts   113,329   1,153   1,369   1,588   367   117,806   2.09   18,012   1,339   137,157   20,767   157,924
Debt securities in issue   4,090   2,221   1,025   140   394   7,870   1.77   6     7,876   2,925   10,801
Subordinated liabilities   2,146       2,535   1,614   6,295   5.83       6,295   353   6,648
Other liabilites                 5,202     5,202   24,587   29,789
Shareholders’ equity                 7,825     7,825   1,615   9,440
Internal funding of trading book   (1,268 )           (1,268 )   3.71   113     (1,155 )   1,155  































Total liabilities and equity   136,783   7,381   3,911   6,733   2,892   157,700   2.12   33,198   1,339   192,237   68,366   260,603





























Off-balance sheet items   (1,231 )   147   194   264   626              






















     
Interest rate sensitivity gap   1,385   (3,875 )   (189 )   6,317   2,491   6,129     (6,057 )   (72 )        






















     
Cumulative interest rate                        
   sensitivity gap   1,385   (2,490 )   (2,679 )   3,638   6,129   6,129     72        

 

Trading book

The table below sets out by time band the net effect on the profit or loss of a basis point (0.01%) increase in interest rates, assuming all trading positions remain unchanged.

  2005

Group   3 months
or less
£000
  After 3
months but
less than
6 months
£000
    After 6
months but
less than
1 year
£000
  After 1
year but
less than
5 years
£000
    Over 5
years
£000
    Total
£000

Gain/(loss) per basis point increase   51   (14 )   471   (959 )   499   48

Bank            

Gain/(loss) per bonus point increase   4   (61 )   16   106   (13 )   52


104




    Group
   




















2004   3 months
or less
£m
    After 3
months
but less
than
6 months
£m
  After 6
months
but less
than
1 year
£m
  After 1
year
but less
than
5 years
£m
  Over 5
years
£m
    Non
interest
earning
/bearing
£m
    Banking
book
£m
    Trading
book
£m
  Total
£m























Assets                    
Loans and advances to banks   18,086   503   697   490   523   2,362     22,661   7,321   29,982
Loans and advances to customers   77,730   3,411   4,293   12,681   9,021   215     107,351   24,328   131,679
Debt securities and treasury bills   887   268   145   1,216   11   134     2,661   19,937   22,598
Other assets             7,682     7,682   5,280   12,962























Total assets   96,703   4,182   5,135   14,387   9,555   10,393     140,355   56,866   197,221
   




















Liabilities and equity                    
Deposits by banks   7,658   613   129   72   17   861     9,350   14,523   23,873
Customer accounts   87,614   1,100   887   1,667   140   19,090     110,498   15,621   126,119
Debt securities in issue   1,243   175   14   63   342       1,837   1,760   3,597
Subordinated liabilities   1,701   208   258   1,070   2,517       5,754   54   5,808
Other liabilites         4     6,103     6,107   23,708   29,815
Shareholders’ equity             6,931     6,931   1,078   8,009
Internal funding of trading book   (122 )               (122 )   122  























Total liabilities and equity   98,094   2,096   1,288   2,876   3,016   32,985     140,355   56,866   197,221
   




















Off-balance sheet items   (10 )   103   246   115   (454 )          
   













             
Interest rate sensitivity gap   (1,401 )   2,189   4,093   11,626   6,085   (22,592 )          
   













             
Cumulative interest rate sensitivity gap   (1,401 )   788   4,881   16,507   22,592          
   










                   

    Bank
   
2005   3 months
or less
£m
    After 3
months
but less
than
6 months
£m
    After 6
months
but less
than
1 year
£m
    After 1
year
but less
than
5 years
£m
    Over 5
years
£m
  Total
interest
earning
/bearing
£m
    Yield
%
  Non
interest
earning
/bearing
£m
    Fair value
through
profit
or loss
£m
    Banking
book
£m
    Trading
book
£m
    Total
£m

Assets                                
Loans and advances to banks   17,593   102     628     191       18,514   4.17   2,302     20,816   13     20,829
Loans and advances                                
   to customers   67,487   1,320     1,163     9,078     2,866   81,914   4.43   15,624     97,538   31     97,569
Debt securities and                                
   treasury bills   19   14     3     9     6   51   5.88       51       51
Other assets                       11,163     11,163   522     11,685


































Total assets   85,099   1,436     1,794     9,278     2,872   100,479   4.38   29,089     129,568   566     130,134
   































Liabilities and equity                                
Deposits by banks   3,534   282     164     249       4,229   2.22   1,081     5,310       5,310
Customer accounts   88,425   517     1,064     399     132   90,537   2.09   19,285   63   109,885   57     109,942
Debt securities in issue         5     33       38   2.63       38       38
Subordinated liabilities   1,501           2,535     1,465   5,501   6.45       5,501       5,501
Other liabilites                       3,390     3,390   244     3,634
Shareholders’ equity                       5,710     5,710   (1 )   5,709
Internal funding of trading book   (312 )                 (312 )   0.32   46     (266 )   266    


































Total liabilities and equity   93,148   799     1,233     3,216     1,597   99,993   2.33   29,512   63   129,568   566     130,134
   































Off-balance sheet items   (1,231 )   147     194     264     626                
























Interest rate sensitivity gap   (9,280 )   784     755     6,326     1,901   486     (423 )   (63 )        
























Cumulative interest rate                                
   sensitivity gap   (9,280 )   (8,496 )   (7,741 )   (1,415 )   486   486     63          






















105




Notes on the accounts continued

32 Financial instruments (continued)

The following table shows the carrying values and the fair values of financial instruments on the balance sheet.

  Group   Bank

 
  2005
Carrying
value
£m
  2005
Fair
value
£m
  2004
Carrying
value
£m
  2004
Fair
value
£m
  2005
Carrying
value
£m
  2005
Fair
value
£m
  2004
Carrying
value
£m
  2004
Fair
value
£m

















Financial assets                
Cash and balances at central banks   1,568   1,568   1,589   1,589   894   894   956   956
   














Treasury bills and other eligible bills                
   Held-for-trading   724   724            
   Available-for-sale   46   46            
   Banking business       38   38        
   Trading business       134   134        
   














  770   770   172   172        
   














Loans and advance to banks                
   Held-for-trading   17,411   17,411       110   110    
   Designated as at fair value through profit or loss   825   825            
   Loans and receivables   37,759   37,761       20,719   20,719    
   Banking business       22,661   22,662       15,901   15,901
   Trading business       7,321   7,321       93   93
   














  55,995   55,997   29,982   29,983   20,829   20,829   15,994   15,994
   














Loans and advance to customers                
   Held-for-trading   15,896   15,896       30   30    
   Loans and receivables   144,047   144,628       97,539   98,006    
   Banking business       107,351   107,447       77,587   77,837
   Trading business       24,328   24,328       32   32
   














  159,943   160,524   131,679   131,775   97,569   98,036   77,619   77,869
   














Debt securities                
   Held-for-trading   25,474   25,474       3   3    
   Designated as at fair value through profit or loss   403   403            
   Available-for-sale   2,868   2,868       48   48    
   Banking business       2,623   2,622       39   39
   Trading business       19,803   19,803        
   














  28,745   28,745   22,426   22,425   51   51   39   39
   














Equity shares                
   Held-for-trading   26   26            
   Designated as at fair value through profit or loss   39   39            
   Available-for-sale   758   758            
   Banking business       1,323   1,610       574   861
   Trading business       15   15       13   13
   














  823   823   1,338   1,625       587   874
   














Settlement balances   3,931   3,931   3,538   3,538        
   














Derivatives at fair value   2,976   2,976   1,366   1,366   1,203   1,203   704   704


















106




  Group   Bank

 
  2005
Carrying
value
£m
  2005
Fair
value
£m
  2004
Carrying
value
£m
  2004
Fair
value
£m
  2005
Carrying
value
£m
  2005
Fair
value
£m
  2004
Carrying
value
£m
  2004
Fair
value
£m

















Financial liabilities                
Deposits by banks                
      Held-for-trading   6,589   6,589       1,237   1,237    
      Amortised cost   39,412   39,417       4,073   4,073    
      Banking business       9,350   9,360       3,076   3,076
      Trading business       14,523   14,523       404   404
   














  46,001   46,006   23,873   23,883   5,310   5,310   3,480   3,480
   














Customer accounts                
      Held-for-trading   10,372   10,372       1,560   1,560    
      Designated as at fair value through profit or loss   1,339   1,339       63   63    
      Amortised cost   146,213   147,313       108,319   108,541    
      Banking business       110,498   110,504       87,910   87,912
      Trading business       15,621   15,621       15   15
   














  157,924   159,024   126,119   126,125   109,942   110,164   87,925   87,927
   














Debt securities in issue                
      Amortised cost   10,801   10,872       38   38    
      Banking business       1,837   1,836       39   39
      Trading business       1,760   1,760        
   














  10,801   10,872   3,597   3,596   38   38   39   39
   














Subordinated liabilities                
      Amortised cost   6,648   6,773       5,501   5,626    
      Banking business       5,754   6,020       4,747   5,276
      Trading business       54   54        
   














  6,648   6,773   5,808   6,074   5,501   5,626   4,747   5,276
   














Settlement balances and short positions   21,574   21,574   21,670   21,670        

















Derivatives at fair value   2,657   2,657   1,105   1,105   1,129   1,129   283   283


















107




Notes on the accounts continued

32 Financial instruments (continued)

Industry risk – geographical analysis

    Group
   










2005   Loans and
advances
to banks and
customers
£m
  Treasury bills,
debt securities
and equity
shares
£m
  Derivatives
£m
  Settlement
balances
£m
  Total
£m
  Netting(1)
offset
£m













UK                        
Central and local government   1,690   4   7     1,701   1,137
Manufacturing   6,887   1   78     6,966   2,406
Construction   4,479     28     4,507   1,258
Finance   74,742   1,671   1,428     77,841   6,250
Service industry and business activities   24,031   135   249     24,415   4,356
Agriculture, forestry and fishing   1,884     2     1,886   209
Property   15,316   10   96     15,422   1,613
Individuals                        
      Home mortgages   2,746     1     2,747   1,178
      Other   15,283         15,283   506
Finance leases and instalment credit   319         319  
Interest accruals   208         208  













Total UK   147,585   1,821   1,889     151,295   18,913













US                        
Central and local government     7,599     112   7,711  
Manufacturing   44   84       128  
Construction   5   27       32  
Finance   28,258   18,121   609   3,809   50,797   4,323
Service industry and business activities   484   302       786  
Agriculture, forestry and fishing   13         13  
Property   2,252         2,252  
Individuals                        
      Home mortgages   5,107         5,107  
      Other   9         9  
Finance leases and instalment credit   439         439  
Interest accruals   79   160       239   2













Total US   36,690   26,293   609   3,921   67,513   4,325













Europe                        
Central and local government   287   234       521   111
Manufacturing   3,060         3,060   889
Construction   2,257         2,257   1,931
Finance   6,776   1,802   450   8   9,036   4,986
Service industry and business activities   4,758   10   11     4,779   3,726
Agriculture, forestry and fishing   513         513   577
Property   2,576   49       2,625   2,670
Individuals                        
      Home mortgages   8,802         8,802   11,264
      Other   3,412   105       3,517   1,577
Finance leases and instalment credit   96         96  
Interest accruals   110   26       136  













Total Europe   32,647   2,226   461   8   35,342   27,731













Rest of the World                        
Central and local government     2       2  
Finance   169     3   2   174  
Service industry and business activities       14     14  
Property   2         2  
Individuals                        
      Home mortgages   75         75  
      Other   792         792  
Interest accruals   9         9  













Total Rest of the World   1,047   2   17   2   1,068  














(1)      This column shows the amount by which exposures to counterparties are reduced by the existence of a legal right of set off (on the basis that the financial asset will be collected in accordance with its terms) and under master netting arrangements. The credit risk of financial assets subject to a master netting arrangement is eliminated only to the extent that financial liabilities due to the same counterparty will be settled after the assets are realised. The extent to which the Group’s credit risk is reduced throught a master netting arrangement may change substantially within a short period following the balance sheet date because the exposure is affected by each transaction subject to the arrangement.
 

108






    Group
   










2005   Loans and
advances
to banks and
customers
£m
  Treasury bills,
debt securities
and equity
shares
£m
  Derivatives
£m
  Settlement
balances
£m
  Total
£m
  Netting(1)
offset
£m













Total                        
Central and local government   1,977   7,839   7   112   9,935   1,248
Manufacturing   9,991   85   78     10,154   3,295
Construction   6,741   27   28     6,796   3,189
Finance   109,945   21,594   2,490   3,819   137,848   15,559
Service industry and business activities   29,273   447   274     29,994   8,082
Agriculture, forestry and fishing   2,410     2     2,412   786
Property   20,146   59   96     20,301   4,283
Individuals                        
      Home mortgages   16,730     1     16,731   12,442
      Other   19,496   105       19,601   2,083
Finance leases and instalment credit   854         854  
Interest accruals   406   186       592   2













    217,969   30,342   2,976   3,931   255,218   50,969












(1)      This column shows the amount by which exposures to counterparties are reduced by the existence of a legal right of set off (on the basis that the financial asset will be collected in accordance with its terms) and under master netting arrangements. The credit risk of financial assets subject to a master netting arrangement is eliminated only to the extent that financial liabilities due to the same counterparty will be settled after the assets are realised. The extent to which the Group’s credit risk is reduced throught a master netting arrangement may change substantially within a short period following the balance sheet date because the exposure is affected by each transaction subject to the arrangement.
 

109






Notes on the accounts continued

32 Financial instruments (continued)

Industry risk – geographical analysis (continued)

    Bank









2005   Loans and
advances
to banks and
customers
£m
  Treasury bills,
debt securities
and equity
shares
£m
  Derivatives
£m
  Total
£m
  Netting(1)
offset
£m











UK                    
Central and local government   1,689     7   1,696   1,137
Manufacturing   6,737     78   6,815   2,249
Construction   4,108     28   4,136   842
Finance   53,440   48   742   54,230   219
Service industry and business activities   23,140     249   23,389   3,626
Agriculture, forestry and fishing   1,700     2   1,702   12
Property   14,397     96   14,493   981
    Individuals                    
    Home mortgages   40     1   41  
Other   13,434       13,434   2
Interest accruals   172       172  











Total UK   118,857   48   1,203   120,108   9,068









US                    
Finance   54       54  
Service industry and business activities     3     3  
Interest accruals   21       21  











Total US   75   3     78  









Europe                    
Finance   1,133       1,133  
Interest accruals   6       6  











Total Europe   1,139       1,139  









Total                    
Central and local government   1,689     7   1,696   1,137
Manufacturing   6,737     78   6,815   2,249
Construction   4,108     28   4,136   842
Finance   54,627   48   742   55,417   219
Service industry and business activities   23,140   3   249   23,392   3,626
Agriculture, forestry and fishing   1,700     2   1,702   12
Property   14,397     96   14,493   981
    Individuals                    
    Home mortgages   40     1   41  
Other   13,434       13,434   2
Interest accruals   199       199  











    120,071   51   1,203   121,325   9,068










(1)      This column shows the amount by which exposures to counterparties are reduced by the existence of a legal right of set off (on the basis that the financial asset will be collected in accordance with its terms) and under master netting arrangements. The credit risk of financial assets subject to a master netting arrangement is eliminated only to the extent that financial liabilities due to the same counterparty will be settled after the assets are realised. The extent to which the Group’s credit risk is reduced throught a master netting arrangement may change substantially within a short period following the balance sheet date because the exposure is affected by each transaction subject to the arrangement.
 

110






33 Memorandum items

Contingent liabilities and commitments

The amounts shown in the table below are intended only to provide an indication of the volume of business outstanding at 31 December. Although the Group is exposed to credit risk in the event of non-performance of the obligations undertaken by customers, the amounts shown do not, and are not intended to, provide any indication of the Group’s expectation of future losses.

    Group   Bank






    2005
£m
  2004
£m
  2005
£m
  2004
£m









Contingent liabilities:                
Guarantees and assets pledged as collateral security   2,768   2,800   2,295   2,437
Other contingent liabilities   2,967   2,900   2,248   2,445









    5,735   5,700   4,543   4,882







Commitments:                
Undrawn formal standby facilities, credit lines and other commitments to lend                
      – less than one year   55,973   53,238   38,604   40,014
      – one year and over   11,543   13,212   10,509   11,525
Other commitments   182   137   100   96









    67,698   66,587   49,213   51,635








Banking commitments and contingent obligations, which have been entered into on behalf of customers and for which there are corresponding obligations from customers, are not included in assets and liabilities. The Group’s maximum exposure to credit loss, in the event of non-performance by the other party and where all counterclaims, collateral or security proves valueless, is represented by the contractual nominal amount of these instruments included in the table above. These commitments and contingent obligations are subject to the Group’s normal credit approval processes and any potential loss is taken into account in assessing provisions for bad and doubtful debts in accordance with the Group’s provisioning policy.

Contingent liabilities

Guarantees – the Group gives guarantees on behalf of customers. A financial guarantee represents an irrevocable undertaking that the Group will meet a customer’s obligations to third parties if the customer fails to do so. The maximum amount that the Group could be required to pay under a guarantee is its principal amount as disclosed in the table above. The Group expects most guarantees it provides to expire unused.

Other contingent liabilities – these include standby letters of credit, supporting customer debt issues and contingent liabilities relating to customer trading activities such as those arising from performance and customs bonds, warranties, indemnities and acceptances.

Commitments

Commitments to lend – under a loan commitment the Group agrees to make funds available to a customer in the future. Loan commitments, which are usually for a specified term may be unconditionally cancellable or may persist, provided all conditions in the loan facility are satisfied or waived. Commitments to lend include commercial standby facilities and credit lines, liquidity facilities to commercial paper conduits and unutilised overdraft facilities.

Other commitments – these include forward asset purchases, forward forward deposits placed and undrawn note issuance, revolving underwriting facilities, documentary credits and other short-term trade related transactions.

Regulatory enquiries and investigations – in the normal course of business the Group and its subsidiaries co-operate with regulatory authorities in various jurisdictions in their enquiries or investigations into alleged or possible breaches of regulations.

Additional contingent liabilities arise in the normal course of the Group’s business. It is not anticipated that any material loss will arise from these transactions.

Litigation

Proceedings, including a consolidated class action, have been brought in the United States against a large number of defendants, including the Group, following the collapse of Enron. The claims against the Group could be significant but are largely unquantified. The Group considers that it has substantial and credible legal and factual defences to these claims and it continues to defend them vigorously. A court ordered mediation commenced in September 2003 but no material progress has been made towards a resolution of the claims, although a number of other defendants have reached settlements in the principal class action. The Group is unable reliably to estimate the possible loss in relation to these matters or the effect that the possible loss might have on the Group’s consolidated net assets or its operating results or cash flows in any particular period. In addition, pursuant to requests received from the US Securities and Exchange Commission and the Department of Justice, the Group has provided copies of Enron-related materials to these authorities and has co-operated fully with them.

Members of the Group are engaged in other litigation in the United Kingdom and a number of overseas jurisdictions, including the United States, involving claims by and against them arising in the ordinary course of business. The Group has reviewed these other actual, threatened and known potential claims and proceedings and, after consulting with its legal advisers, is satisfied that the outcome of these other claims and proceedings will not have a material adverse effect on its consolidated net assets, operating results or cash flows in any particular period.

Trustee and other fiduciary activities

In its capacity as trustee or other fiduciary role, the Group may hold or place assets on behalf of individuals, trusts, companies, pension schemes and others. The assets and their income are not included in the Group’s financial statements.

111






Notes on the accounts continued

34 Net cash flows from operating activities

    Group   Bank
 









    2005
£m
    2004
£m
    2005
£m
    2004
£m
 













Profit for the year   3,411     3,230     2,315     2,382  
Decrease/(increase) in prepayments and accrued income   988     (11 )   557     (184 )
Interest on subordinated liabilities   304     202     283     193  
(Decrease)/increase in accruals and deferred income   (1,278 )   (776 )   (846 )   261  
Provisions for impairment losses   756     625     651     531  
Unwind of discount on impairment losses   (76 )       (61 )    
Loans and advances written-off net of recoveries   (762 )   (550 )   (715 )   (489 )
Profit on sale of property, plant and equipment   (51 )   (11 )   (39 )   (10 )
Profit on sale of subsidiaries and associates   (12 )       (221 )    
Profit on sale of investment securities   (327 )   (12 )   (320 )   (1 )
Charge for pensions   149     133     97     96  
Pension contributions   (1,007 )   (53 )   (976 )   (30 )
Provisions utilised   (18 )   (25 )   (16 )   (19 )
Depreciation and amortisation   382     462     326     402  
Other non-cash items   5,007     (2,339 )   511     (238 )













Net cash inflow from trading activities   7,466     875     1,546     2,894  













Increase in loans and advances to banks and customers   (24,532 )   (22,788 )   (4,182 )   (5,414 )
(Increase)/decrease in securities   (5,565 )   44     1     329  
(Increase)/decrease in other assets   (1,469 )   72     (625 )   (349 )
Decrease in derivative assets   797     986     335     257  













Changes in operating assets   (30,769 )   (21,686 )   (4,471 )   (5,177 )













Increase in deposits by banks and customers   49,683     10,497     9,815     6,244  
Increase/(decrease) in debt securities in issue   5,724     450     (1 )   (9 )
Increase/(decrease) in other liabilities   1,138     1,378     953     (630 )
Decrease in derivative liabilities   (951 )   (1,131 )   (286 )   (291 )
(Decrease)/increase in settlement balances and short positions   (652 )   5,804          













Changes in operating liabilities   54,942     16,998     10,481     5,314  













Total income taxes paid   (1,170 )   (1,051 )   (662 )   (546 )













Net cash inflow/(outflow) from operating activities   30,469     (4,864 )   6,894     2,485  











35 Analysis of the net outflow of cash in respect of the purchase and sales of business interests and intangible assets

    Group   Bank
 









    2005
£m
    2004
£m
    2005
£m
    2004
£m
 













Fair value given for business acquired   (238 )   (739 )   (217 )   (239 )
Cash and cash equivalents acquired   25     15          
Non-cash consideration   3              













Net outflow of cash in respect of purchases   (210 )   (724 )   (217 )   (239 )













Cash and cash equivalents in businesses sold   (2 )            
Other assets sold   260     37     9     16  
Non-cash consideration   (25 )            
Profit on disposal   12         221      













Net cash inflow on disposals   245     37     230     16  













Dividends received from joint ventures   7              
Net cash expenditure on other intangible assets   (210 )   (184 )   (180 )   (184 )













Net outflow   (168 )   (871 )   (167 )   (407 )












112






36 Interest received and paid

  Group     Bank  
 
   
 
  2005
£m
    2004
£m
    2005
£m
    2004
£m
 












Interest received 8,475     7,322     5,621     5,265  
Interest paid (4,164 )   (2,970 )   (2,683 )   (2,313 )












  4,311     4,352     2,938     2,952  











37 Analysis of changes in financing during the year

  Group     Bank
 
   
  Share capital     Subordinated
liabilities
    Share capital     Subordinated
liabilities
 
 
   
   
   

  2005
£m
    2004
£m
    2005
£m
    2004
£m
    2005
£m
    2004
£m
    2005
£m
    2004
£m
 
























At 1 January 3,388     3,412     5,808     5,743     3,388     3,412     4,747     5,376  
Implementation of IAS 32 (419 )       530         (419 )       530      
























At 1 January restated 2,969     3,412     6,338     5,743     2,969     3,412     5,277     5,376  
























Net proceeds from issue of                                              
      subordinated liabilities         291     559                  
Repayment of subordinated liabilities         (210 )   (455 )           (210 )   (455 )
























Net cash (outflow)/inflow from financing         81     104             (210 )   (455 )
























Acquisitions of subsidiaries             153                  
Currency translation and other movements     (24 )   229     (192 )       (24 )   434     (174 )
























At 31 December 2,969     3,388     6,648     5,808     2,969     3,388     5,501     4,747  























38 Analysis of cash and cash equivalents

  Group     Bank
 
   
  2005
£m
  2004
£m
    2005
£m
  2004
£m
 










At 1 January                  
   – cash 14,816   17,779     9,952   9,777  
   – cash equivalents 8,029   11,039     1,959   3,168  
Net cash inflow/(outflow) 25,579   (5,973 )   6,677   (1,034 )










At 31 December 48,424   22,845     18,588   11,911  









Comprising:                  
Cash and balances at central banks 1,446   1,480     779   853  
Treasury bills and debt securities 1          
Loans and advances to banks repayable on demand 46,977   21,365     17,809   11,058  










Cash and cash equivalents 48,424   22,845     18,588   11,911  










The Bank and certain subsidiary undertakings are required to maintain balances with the Central banks which, at 31 December 2005, amounted to £122 million (2004 – £111 million).

39 Net cashflow on discontinued operations

  Group
 
  2005
£m
    2004
£m
 






Net cashflow from operating activities 194     (66 )
Net cashflow from investing activities     (1 )
Net cashflow from financing activities (194 )   67  






Cash and cash equivalents at 1 January and 31 December      






113




Notes on the accounts continued

40 Segmental analysis

The directors manage the Group primarily by class of business and present the segmental analysis on that basis. Segments charge market prices for services rendered to other parts of the Group with the exception of Manufacturing and central resources. The expenditure incurred by Manufacturing relates to shared costs principally in respect of the Group's UK and Ireland banking operations. These costs reflect activities that are shared between the various customer-facing divisions and consequently cannot be directly attributed to individual divisions. Funding charges between segments are determined by Group Treasury, having regard to commercial demands.

(a) Classes of business

  Group  
 




























  Revenue     Total Income                          
 
   
                         
2005 External
£m
    Inter
segment
£m
    Total
£m
    External
£m
    Inter
segment
£m
    Total
£m
    Operating
expenses
£m
    Depreciation
and
amortisation
£m
    Provisions
£m
    Operating
profit
before tax
£m
 






























Corporate Markets 4,135     1,003     5,138     3,124     (259 )   2,865     (797 )   (7 )   (8 )   2,053  
Retail Banking 4,038     1,301     5,339     3,243     (40 )   3,203     (580 )   (5 )   (452 )   2,166  
Retail Direct 1,916         1,916     982     (22 )   960     (296 )   (2 )   (209 )   453  
Wealth Management 1,102     2     1,104     508     (1 )   507     (276 )   (13 )   (6 )   212  
Ulster Bank 1,763     25     1,788     860     (2 )   858     (246 )   (24 )   (58 )   530  
Manufacturing 45     6     51     26     (30 )   (4 )   (1,550 )   (57 )       (1,611 )
Central items 64     438     502     (646 )   354     (292 )   (254 )   (137 )   (19 )   (702 )
Eliminations     (2,775 )   (2,775 )                            






























Continuing operations 13,063         13,063     8,097         8,097     (3,999 )   (245 )   (752 )   3,101  
Discontinued operations 246         246     221         221     (70 )       (4 )   147  
Amortisation of                                                          
    intangibles                             (6 )       (6 )
Integration costs                         (32 )   (131 )       (163 )
Net gain on sale of                                                          
    strategic investments 332         332     332         332                 332  






























Operating profit before tax 13,641         13,641     8,650         8,650     (4,101 )   (382 )   (756 )   3,411  
 
2004                                                          






























Corporate Markets 3,822     913     4,735     2,949     (366 )   2,583     (647 )   (5 )   (140 )   1,791  
Retail Banking 3,457     1,263     4,720     2,805     136     2,941     (627 )   (3 )   (287 )   2,024  
Retail Direct 1,817     1     1,818     962     (19 )   943     (257 )   (1 )   (160 )   525  
Wealth Management 865     1     866     465     (2 )   463     (268 )   (29 )   (2 )   164  
Ulster Bank 1,315     19     1,334     747     (4 )   743     (207 )   (22 )   (40 )   474  
Manufacturing 16     8     24     22     (25 )   (3 )   (1,401 )   (119 )       (1,523 )
Central items 109     356     465     (205 )   280     75     (221 )   (6 )   (1 )   (153 )
Eliminations     (2,561 )   (2,561 )                            






























Continuing operations 11,401         11,401     7,745         7,745     (3,628 )   (185 )   (630 )   3,302  
Discontinued operations 302         302     278         278     (52 )   (1 )   5     230  
Amortisation of intangibles                             (5 )       (5 )
Integration costs                         (26 )   (271 )       (297 )






























Operating profit before tax 11,703         11,703     8,023         8,023     (3,706 )   (462 )   (625 )   3,230  
 

  2005   2004  
 
 

Group Assets
£m
  Liabilities
£m
  Cost to
acquire fixed
assets and
intangible
assets
£m
  Assets
£m
  Liabilities
£m
  Cost to
acquire fixed
assets and
intangible
assets
£m
 













Corporate Markets 143,814   128,214   80   101,948   88,541   8  
Retail Banking 48,282   56,967     46,619   51,649   1  
Retail Direct 5,551   749   46   4,974   958   63  
Wealth Management 19,585   18,802   17   12,219   15,787   9  
Ulster Bank 39,249   37,026   77   28,273   26,831   564  
Manufacturing 1,876   509   328   1,915   202   356  
Central items 2,246   8,152     1,273   4,836    













Group 260,603   250,419   548   197,221   188,804   1,001  












Segmental analysis of goodwill is as follows:

    Group
 










    Corporate
Markets
£m
Retail Direct
£m
Wealth
Management
£m
Ulster Bank
£m
Total
£m












At 1 January 2005   98   69   147   425   739  
Currency translation and other adjustments   10   (2 ) (4 ) (11 ) (7 )
Arising on acquisitions during the year   -   40   -   -   40  
Disposals   -   -   (12 ) -   (12 )












At 31 December 2005   108   107   131   414   760  
   









                       
                       
Note: Accumulated amortisation and impairment at 31 December 2005 and 2004 was nil.  

114





(b) Geographical segments

The geographical analyses in the tables below have been compiled on the basis of location of office where the transactions are recorded

  Group
 
2005 UK
£m
    USA
£m
  Europe
£m
  Rest of
the world
£m
  Total
£m











Net interest income 3,858     12   578   13   4,461
Fees and commissions (net) 2,308     157   208   73   2,746
Income from trading activities (5 )   777   33   3   808
Other operating income 493     45   97     635











Total income 6,654     991   916   89   8,650

Operating profit before tax 2,522     560   297   32   3,411

Total assets 138,574     74,162   44,673   3,194   260,603

Total liabilities 133,341     72,218   41,787   3,073   250,419

Net assets attributable to equity shareholders and minority interests 5,233     1,944   2,886   121   10,184

Contingent liabilities and commitments 58,025     6,231   9,177     73,433

Cost to acquire property, plant and equipment and intangible assets 368     29   144   7   548

2004                    











Net interest income 3,790     12   568   13   4,383
Fees and commissions (net) 2,175     94   225   58   2,552
Income from trading activities 148     720   15   4   887
Other operating income 149     29   22   1   201











Total income 6,262     855   830   76   8,023

Operating profit before tax 2,443     450   309   28   3,230

Total assets 107,089     58,481   29,722   1,929   197,221

Total liabilities 101,451     57,369   28,069   1,915   188,804

Net assets attributable to equity shareholders and minority interests 5,638     1,112   1,653   14   8,417

Contingent liabilities and commitments 60,174     4,190   7,923     72,287

Cost to acquire property, plant and equipment and intangible assets 367     8   626     1,001


115




Notes on the accounts continued

41 Directors’ and key management remuneration

The current directors of the Bank are also directors of the ultimate holding company and are remunerated for their services to the RBS Group as a whole. The remuneration of the directors is disclosed in the Report and Accounts of the RBS Group. Pensions paid to former directors of the Bank and their dependents amounted to £308,000 (2004 – £294,000).

Compensation of key management

The aggregate remuneration of directors and other members of key management during the year was as follows:

  RBS Group
 


  2005
£000
  2004
£000




Short-term benefits 26,180   23,652
Post-employment benefits 9,383   5,298
Other long-term 4,215  
Share-based payments 1,568   5,200




  41,346   34,150



42 Transactions with directors, officers and others

(a)

At 31 December 2005, the amounts outstanding in relation to transactions, arrangements and agreements entered into by authorised institutions in the Group, as defined by UK Law, were £17,917 in respect of loans to five persons who were directors of the company (or persons connected with them) at any time during the financial period and £9,549,650 to 48 people who were officers of the company at any time during the financial period.
   
(b)  For the purposes of IAS 24 ‘Related Party Disclosures’, key management comprise directors of the Bank and members of the RBS Group’s Group Executive Management Committee. The captions in the primary financial statements include the following amounts attributable, in aggregate, to key management:
       
  2005
£000
  2004
£000




Loans and advances to customers 1,035   899
Customer accounts 378   493





Key management have banking relationships with Group entities which are entered into in the normal course of business.
 
Key management had no reportable transactions or balances with the company except for dividends.

43 Related parties

(a) Group companies provide development and other types of capital support to businesses in their roles as providers of finance. These investments are made in the normal course of business and on arm’s-length terms. In some instances, the investment may extend to ownership or control over 20% or more of the voting rights of the investee company. However, these investments are not considered to give rise to transactions of a materiality requiring disclosure under IAS 24.
 
(b) The Group recharges The Royal Bank of Scotland Group Pension Fund with the cost of administration services incurred by it. The amounts involved are not material to the Group.
 
(c) In accordance with IAS 24, transactions or balances between Group entities that have been eliminated on consolidation are not reported.
 
(d) The captions in the primary financial statements of the Bank include amounts attributable to subsidiaries. These amounts have been disclosed in aggregate in the relevant notes to the financial statements. The table below discloses items included in income and operating expenses on transactions between the Group and fellow subsidiaries of the RBS Group.
 
  2005
£000
  2004
£000




Income      
Interest receivable 1,112   901
Interest payable 367   248
Fees and commissions receivable 94   102
Fees and commissions payable 100   76
Expenses      
Other administrative expenses 1,529   1,384





116




44 Transition to IFRS

(1) Significant differences between the Group’s UK GAAP accounting policies applied in its 2004 financial statements and its IFRS accounting policies

UK GAAP   IFRS

(a) Goodwill    
Goodwill arising on acquisitions is capitalised and amortised over its estimated useful economic life. Goodwill is reviewed for impairment at the end of the first full year following an acquisition and subsequently if events or changes in circumstances indicated that its carrying value might not be recoverable,  

Goodwill is recorded at cost less any accumulated impairment losses. Goodwill is tested annually for impairment or more frequently if events or changes in circumstances indicate that it might be impaired.

The carrying amount of goodwill in the Group's opening IFRS balance sheet (as at 1 January 2004) was £273 million, its carrying value under UK GAAP as at 31 December 2003.


(b) Intangibles other than goodwill    
Computer software development costs    
Most computer software development costs are written off as incurred.   Computer software development costs are capitalised if they create an identifiable intangible asset. They are amortised over their estimated useful life of three years. Net computer software development costs of £587 million were recognised on transition to IFRS.
     
Other intangibles    
An intangible asset acquired in a business combination is capitalised separately from goodwill only if it can be disposed of separately from the revenue-earning activity to which it contributes and its value can be measured reliably.  

An intangible asset is recognised as an asset separately from goodwill if it is separable or if it arises from contractual or other legal rights regardless of whether these rights are transferable or separable.

Core deposit intangibles of £24 million and other intangibles of £30 million were recognised in business combinations that took place in 2004.


(c) Leasing    
Finance lease income is recognised so as to give a level rate of return on the net cash investment in the lease; tax cash flows are taken into account in allocating income.   IFRS requires a level rate of return on the net investment in the lease. Tax cash flows are not reflected in the pattern of income recognition.
     
Assets held under operating leases are depreciated on a straight-line or reverse-annuity basis.   Assets held on operating leases are depreciated on a straight-line basis.

(d) Dividends    
Dividends payable on ordinary shares are recorded in the period to which they relate.   Dividends are recorded in the period in which they are declared.



(e) Consolidation    
UK GAAP requires consolidation of entities controlled by the reporting entity. Control is the ability to direct the financial and operating policies of an entity.   All entities controlled by the Group are consolidated together with special purpose entities (SPEs) where the substance of the relationship between the reporting entity and the SPE indicates that it is controlled by the reporting entity.

117




Notes on the accounts continued


44 Transition to IFRS
(continued)

UK GAAP   IFRS

(f) Associates and joint ventures    
An associate is an entity in which the reporting entity holds a participating interest and over whose operating and financial policies it exercises a significant influence in practice. A joint venture is an entity in which the reporting entity in practice shares control with other investors. Associates are accounted for using the equity method and joint ventures using the gross equity method.   The definitions of associate and joint venture are similar to those in UK GAAP. However, significant influence is defined as the power to participate in the financial and operating policies of the associate. A joint venture is an entity where the strategic financial and operating decisions require the unanimous consent of the parties sharing control. Associates are accounted for using the equity method. The Group proportionately consolidates its joint ventures.

(g) Property, plant and equipment    
The Group's freehold and long leasehold property occupied for its own use is recorded at valuation on the basis of existing use value.   The Group's freehold and long leasehold property occupied for its own use is recorded at cost less depreciation.
     
    The Group has elected to use the UK GAAP valuation as at 31 December 2003 as deemed cost for freehold and long leasehold property occupied for its own use in its opening IFRS balance sheet (1 January 2004).

(h) Investment property    
Investment property is revalued annually to open market value and changes in market value reflected in the Statement of total recognised gains and losses.   Investment property is stated at fair value. Any gain or loss arising from a change in fair value is recognised in profit or loss.

(i) Pensions    
Pension scheme assets are measured at fair value using mid-market prices.   Pension scheme assets are measured at fair value using bid prices.
     
The profit and loss account reflects the current and past service costs, and the interest or discount unwind attributable to the assets and liabilities of the fund.   The income statement reflects the current and past service costs, and the cumulative excess actuarial gains and losses amortised over the expected average remaining lives of participating employees. Excess gains and losses are those exceeding 10% of the higher of the gross assets or liabilities of the scheme.
     
Actuarial gains and losses representing other movements in the net pension asset or liability are recognised in the statement of total recognised gains and losses.   Any surplus or deficit of scheme assets over liabilities adjusted for unrecognised actuarial gains and losses and past service costs is recognised in the balance sheet as an asset (surplus) or liability (deficit).



(j) Income tax    
Deferred tax is not accounted for in relation to revaluations of fixed assets where there is no commitment to dispose of the asset or in relation to taxable gains or losses on sales of fixed assets that are rolled over into the tax cost of replacement fixed assets.   Deferred tax is provided on fixed asset revaluations and on taxable gains and losses on fixed asset sales rolled over into the tax cost of replacement assets.

118




UK GAAP   IFRS

(k) Cash flow statements    
Cash comprises cash and balances with central banks and loans and advances to banks repayable on demand.   Cash and cash equivalents comprise cash on hand and demand deposits with banks together with short-term highly liquid investments that are readily convertible to known amounts of cash and subject to insignificant risk of changes in value.
     
Under UK GAAP, cash flows are classified under the following headings:
• operating activities
• dividends from joint ventures and associates
• returns on investments and servicing of finance
• taxation
• capital expenditure and financial investment
• acquisitions and disposals
• ordinary equity dividends paid
• financing
  Under IFRS cash flows are classified into operating, investing and financing activities.

     
Implementation of IAS 32, IAS 39 and IFRS 4    
     
UK GAAP   IFRS

(l) Financial instruments: financial assets    

Loans are measured at cost less provisions for bad and doubtful debts, derivatives held for trading are carried at fair value and hedging derivatives are accounted for in accordance with the treatment of the item being hedged (see Derivatives and hedging below).

Debt securities and equity shares intended for use on a continuing basis in the Group's activities are classified as investment securities and are stated at cost less provision for any permanent diminution in value. The cost of dated investment securities is adjusted for the amortisation of premiums or discounts. Other debt securities and equity shares are carried at fair value.

  Under IAS 39, financial assets are classified into held-to-maturity; available-for-sale; held for trading; designated as at fair value through profit or loss; and loans and receivables. Financial assets classified as held-to-maturity or as loans and receivables are carried at amortised cost. Other financial assets are measured at fair value. Changes in the fair value of available-for-sale financial assets are reported in a separate component of shareholders' equity. Changes in the fair value of financial assets held-for-trading or designated as at fair value are taken to profit or loss. Financial assets can be classified as held-to-maturity only if they have a fixed maturity and the reporting entity has the positive intention and ability to hold to maturity. Trading financial assets are held for the purpose of selling in the near term. IFRS allows any financial asset to be designated as at fair value through profit or loss on initial recognition. Unquoted debt financial assets that are not classified as held-to-maturity, held for trading or designated as fair value through profit or loss are categorised as loans and receivables. All other financial assets are classified as available-for-sale.

(m) Financial instruments: financial liabilities    
Under UK GAAP, short positions in securities and trading derivatives are carried at fair value; all other financial liabilities are recorded at amortised cost.   IAS 39 requires all financial liabilities to be measured at amortised cost except those held for trading and those that were designated as at fair value through profit or loss on initial recognition.

119



Notes on the accounts continued

44 Transition to IFRS (continued)

UK GAAP   IFRS

(n) Liabilities and equity    
Under UK GAAP, all shares are classified as shareholders' funds. An analysis of shareholders' funds between equity and non-equity interests is given.     There is no concept of non-equity shares in IFRS. Instruments are classified between equity and liabilities in accordance with the substance of the contractual arrangements. A non-derivative instrument is classified as equity if it does not include a contractual obligation either to deliver cash or to exchange financial instruments with another entity under potentially unfavourable conditions, and, if the instrument will or may be settled by the issue of equity, settlement does not involve the issue of a variable number of shares. On implementation of IAS 32, non-equity shares with a balance sheet value of £419 million were reclassified as liabilities.

(o) Effective interest rate and lending fees    
Under UK GAAP, loan origination fees are recognised when received unless they are charged in lieu of interest.  

IAS 39 requires the amortised cost of a financial instrument to be calculated using the effective interest method. The effective interest rate is the rate that discounts estimated future cash flows over an instrument's expected life to its net carrying value. It takes into account all fees and points paid that are an integral part of the yield, transaction costs and all other premiums and discounts.

On implementation of IAS 39, the carrying value of financial assets was reduced by £256 million and financial liabilities increased by £81 million, deferred tax was reduced by £101 million and shareholder's equity reduced by £236 million.


(p) Derivatives and hedging    
Under UK GAAP non-trading derivatives are accounted for on an accruals basis in accordance with the accounting treatment of the underlying transaction or transactions being hedged. If a non-trading derivative transaction is terminated or ceases to be an effective hedge, it is re-measured at fair value and any gain or loss amortised over the remaining life of the underlying transaction or transactions being hedged. If a hedged item is derecognised the related non-trading derivative is remeasured at fair value and any gain or loss taken to the income statement.   Under IAS 39, all derivatives are measured at fair value. Hedge accounting is permitted for three types of hedge relationship: fair value hedge - the hedge of changes in the fair value of a recognised asset or liability or firm commitment; cash flow hedge - the hedge of variability in cash flows from a recognised asset or liability or a forecasted transaction; and the hedge of a net investment in a foreign entity. In a fair value hedge the gain or loss on the derivative is recognised in profit or loss as it arises offset by the corresponding gain or loss on the hedged item attributable to the risk hedged. In a cash flow hedge and in the hedge of a net investment in a foreign entity, the element of the derivative's gain or loss that is an effective hedge is recognised directly in equity. The ineffective element is taken to the income statement. Certain conditions must be met for a relationship to qualify for hedge accounting. These include designation, documentation and prospective and actual hedge effectiveness. On implementation of IAS 39, non-trading derivatives were remeasured at fair value.
     
Embedded derivatives are not bifurcated from the host contract.   A derivative embedded in a contract is accounted for as a stand-alone derivative if its economic characteristics are not closely related to the economic characteristics of the host contract, unless the entire contract is carried at fair value through profit or loss.

120




UK GAAP   IFRS

(q) Loan impairment    
Under UK GAAP provisions for bad and doubtful debts are made so as to record impaired loans at their ultimate net realisable value. Specific provisions are established against individual advances or portfolios of smaller balance homogeneous advances and the general provision covers advances impaired at the balance sheet date but which have not been identified as such. Interest receivable from loans and advances is credited to the income statement as it accrues unless there is significant doubt that it can be collected.   IFRS require impairment losses on financial assets carried at amortised cost to be measured as the difference between the asset's carrying amount and the present value of estimated future cash flows discounted at the asset's original effective interest rate. There is no concept of specific and general provision - under IFRS impairment is assessed individually for individually significant assets but can be assessed collectively for other assets. Once an impairment loss has been recognised on a financial asset or group of financial assets, interest income is recognised on the carrying amount using the rate of interest at which estimated future cash flows were discounted in measuring impairment.

(r) Offset    
Under UK GAAP an intention to settle net is not a requirement for set off; the entity must have the ability to insist on net settlement and that ability is assured beyond doubt.  

For a financial asset and a financial liability to be offset, IFRS require that an entity must intend to settle on a net basis or to realise the asset and settle the liability simultaneously.

On implementation of IAS 32, the balance sheet value of financial assets and financial liabilities increased by £34 billion.


(s) Linked presentation    
FRS 5 'Reporting the Substance of Transactions' allows qualifying transactions to be presented using the linked presentation.   There is no linked presentation under IFRS. If substantially all the risks and rewards have been retained, the gross assets and related funding are presented separately.

(t) Extinguishment of liabilities    
Under UK GAAP, recognition of a financial liability ceases once any transfer of economic benefits to the creditor is no longer likely.   A financial liability is removed from the balance sheet when, and only when, it is extinguished i.e. when the obligation specified in the contract is discharged or cancelled or expires.

121




Notes on the accounts continued

44 Transition to IFRS (continued)

(2) Analysis of IFRS adjustments, excluding IAS 32, IAS 39 and IFRS 4

Opening balance sheet at 1 January 2004 – Group

    UK GAAP
£m
  Income tax
£m
    Leases
£m
    Consolidation
£m
  Software
development
costs
£m
    Employee
benefits
£m
    Banc-
assurance
£m
    Goodwill
£m
    Other
£m
  Total
adjustments
£m
    IFRS
£m






























Assets                                                          
Cash and balances at                                                          
   central banks   1,112                                   1,112
Treasury bills and other                                                          
   eligible bills   541                                   541
Loans and advances                                                          
   to banks   37,667                                   37,667
Loans and advances                                                          
   to customers   102,572       (29 )   343                     314     102,886
Debt securities   21,727                     21           21     21,748
Equity shares   1,072                     44           44     1,116
Intangible assets   273             646             (16 )     630     903
Property, plant and                                                          
   equipment   1,523             (59 )                 (59 )   1,464
Settlement balances   2,136                                   2,136
Derivatives at fair value   2,352                                   2,352
Prepayments, accrued                                                          
   income and other assets   1,898           5       14     (65 )       194   148     2,046






























Total assets   172,873       (29 )   348   587     14         (16 )   194   1,098     173,971




























                                                           
Liabilities                                                          
Deposits by banks   18,501                                   18,501
Customer accounts   116,569                                   116,569
Debt securities in issue   2,112           344                     344     2,456
Settlement balances and                                                          
   short positions   14,464                                   14,464
Derivatives at fair value   2,236                                   2,236
Accruals, deferred income                                                          
   and other liabilities   3,990       (1 )   4       1               4     3,994
Retirement benefit liabilities   118                 1,878               1,878     1,996
Deferred taxation liabilities   99   120     (7 )     176     (582 )           194   (99 )  
Subordinated liabilities   5,743                                   5,743
Minority interests   3                                   3
Shareholders' equity   9,038   (120 )   (21 )     411     (1,283 )       (16 )     (1,029 )   8,009






























Total liabilities and equity   172,873       (29 )   348   587     14         (16 )   194   1,098     173,971





























122






Opening balance sheet at 1 January 2004 – Bank

    UK GAAP
£m
  Dividends
£m
    Income tax
£m
    Software
development
costs
£m
  Employee
benefits
£m
    Other
£m
    Total
adjustments
£m
    IFRS
£m
 























Assets                                            
Cash and balances at central banks   901                         901  
Treasury bills and other eligible bills   95                         95  
Loans and advances to banks   17,517                         17,517  
Loans and advances to customers   71,927                         71,927  
Debt securities   446                         446  
Equity shares   353                         353  
Investment in Group undertakings   8,587                 (2,407 )   (2,407 )   6,180  
Intangible assets             604           604     604  
Property, plant and equipment   1,155                         1,155  
Derivatives at fair value   961                         961  
Prepayments, accrued income and other assets   1,074   (231 )         14     300     83     1,157  























Total assets   103,016   (231 )       604   14     (2,107 )   (1,720)     101,296  





















                                             
Liabilities                                            
Deposits by banks   3,378                         3,378  
Customer accounts   81,932                         81,932  
Debt securities in issue   48                         48  
Derivatives at fair value   574                         574  
Accruals, deferred income and other liabilities   2,580             (6 )   (1 )   (7 )   2,573  
Retirement benefit liabilities               1,854         1,854     1,854  
Deferred taxation liabilities         66     181   (552 )   305          
Subordinated liabilities   5,376                         5,376  
Shareholders' equity   9,128   (231 )   (66 )   423   (1,282 )   (2,411 )   (3,567 )   5,561  























Total liabilities and equity   103,016   (231 )       604   14     (2,107 )   (1,720)     101,296  





















                                             
                                             
Reconciliation of shareholders’ funds as at 1 January 2004     Group
£m
    Bank
£m
 























UK GAAP shareholders' funds                                   9,038     9,128  
Standards applicable to all periods:                                            
Valuation of subsidiaries and associates                                       (2,411 )
Proposed dividends                                       (231 )
Employee benefits                                   (1,833 )   (1,832 )
Software development costs                                   587     604  
Other                                   (44 )    
Tax effect on adjustments                                   381     369  
Deferred tax                                   (120 )   (66 )























Shareholders' funds under IFRS                                   8,009     5,561  
   






123






Notes on the accounts continued

44 Transition to IFRS (continued)

Balance sheet at 31 December 2004 – Group

    UK GAAP
£m
  Income tax
£m
    Property
plant and
equipment
£m
    Leases
£m
    Consolidation
  £m
  Software
development
costs
£m
    Employee
benefits
£m
    Banc-
assurance
£m
    Goodwill
£m
  Other
£m
  Total
adjustments
£m
    IFRS
£m
































Assets                                                              
Cash and balances at central banks   1,589                                     1,589
Treasury bills and other eligible bills   172                                     172
Loans and advances to banks   29,982                                     29,982
Loans and advances to customers   131,353           (16 )   342                   326     131,679
Debt securities   22,407                         19         19     22,426
Equity shares   1,300                         38         38     1,338
Intangible assets   766                 458             20     478     1,244
Property, plant and equipment   1,694       (35 )   (3 )     (114 )               (152 )   1,542
Settlement balances   3,538                                     3,538
Derivatives at fair value   1,366                                     1,366
Prepayments, accrued income                                                              
    and other assets   2,098           3     4       20     (57 )     277   247     2,345
































Total assets   196,265       (35 )   (16 )   346   344     20         20   277   956     197,221






























                                                               
Liabilities                                                              
Deposits by banks   23,873                                     23,873
Customer accounts   126,119                                     126,119
Debt securities in issue   3,255               342                   342     3,597
Settlement balances and                                                              
    short positions   21,670                                     21,670
Derivatives at fair value   1,105                                     1,105
Accruals, deferred income                                                              
    and other liabilities   4,535               4                   4     4,539
Retirement benefit liabilities   243                     1,850             1,850     2,093
Deferred taxation liabilities   111   120         (4 )     103     (607 )         277   (111 )  
Subordinated liabilities   5,808                                     5,808
Minority interests   408                                     408
Shareholders' equity   9,138   (120 )   (35 )   (12 )     241     (1,223 )       20     (1,129 )   8,009
































Total liabilities and equity   196,265       (35 )   (16 )   346   344     20         20   277   956     197,221































124






Balance sheet at 31 December 2004 – Bank

    UK GAAP
£m
  Dividends
£m
    Income
Tax
£m
    Property
plant and
equipment
£m
    Software
development
costs
£m
  Employee
benefits
£m
    Other
£m
    Total
adjustments
£m
    IFRS
£m

























Assets                                                
Cash and balances at central banks   956                             956
Loans and advances to banks   15,994                             15,994
Loans and advances to customers   77,619                             77,619
Debt securities   39                             39
Equity shares   587                             587
Investment in Group undertakings   9,076                     (2,823 )   (2,823 )   6,253
Intangible assets                 434           434     434
Property, plant and equipment   1,284           (37 )             (37 )   1,247
Derivatives at fair value   704                             704
Prepayments, accrued income and other assets   1,542   (81 )             14     359     292     1,834

























Total assets   107,801   (81 )       (37 )   434   14     (2,464 )   (2,134)     105,667























                                                 
Liabilities                                                
Deposits by banks   3,480                             3,480
Customer accounts   87,925                             87,925
Debt securities in issue   39                             39
Derivatives at fair value   283                             283
Accruals, deferred income and other liabilities   2,178                 (6 )   (1 )   (7 )   2,171
Retirement benefit liabilities                   1,920         1,920     1,920
Deferred taxation liabilities   11       66         130   (572 )   365     (11 )  
Subordinated liabilities   4,747                             4,747
Shareholders' equity   9,138   (81 )   (66 )   (37 )   304   (1,328 )   (2,828 )   (4,036 )   5,102

























Total liabilities and equity   107,801   (81 )       (37 )   434   14     (2,464 )   (2,134)     105,667
























Consolidated income statement for the year ended 31 December 2004

  UK GAAP
£m
  Leases
£m
  Software
development
costs
£m
  Employee
benefits
£m
  Goodwill
£m
  Discounted
operations
£m
    Total
adjustments
£m
    IFRS
£m






















Net interest income   4,360   13   10             (265 )   (242 )   4,118
Non-interest income   3,641         (1 )       (13 )   (14 )   3,627






















Total income   8,001   13   10     (1 )       (278 )   (256 )   7,745
Operating expenses   3,893     253     65     (43 )   (53 )   222     4,115






















Operating profit before impairment losses   4,108   13   (243 )   (66 )   43     (225 )   (478 )   3,630
Impairment losses   625                 5     5     630






















Profit before tax   3,483   13   (243 )   (66 )   43     (230 )   (483 )   3,000
Tax   955   4   (73 )   (20 )       (69 )   (158 )   797
Discontinued operations                   161     161     161






















Profit for the year   2,528   9   (170 )   (46 )   43         (164 )   2,364




















                                           
                                           
Bank income statement for the year ended 31 December 2004
                                           
            UK GAAP
£m
    Dividends
£m
    Software
development
costs
£m
  Employee
benefits
£m
    Total
adjustments
£m
    IFRS
£m






















Profit for the year           1,915     150     (119 )   (45 )   (14 )   1,901
   
















125






Notes on the accounts continued

44 Transition to IFRS (continued)

(3) Analysis of IAS 32, IAS 39 and IFRS 4 adjustments

Balance sheet at 1 January 2005 – Group

    IFRS prospective adjustments



































    IFRS
31 December
2004
£m
  Offset
£m
  Other
IAS 39
£m
    Debt
equity
£m
    Classification
measurement
£m
    Embedded
derivatives
£m
    Provisioning
and
impairment
£m
    Hedging/
measurement
£m
    Derecognition
£m
    Revenue
recognition
£m
    Other
£m
    Total
adjustments
£m
    IFRS
1 January
2005
£m





































Assets                                                                        
Cash and balances at                                                                        
   central banks   1,589                                             1,589
Treasury bills and                                                                        
   other eligible bills   172                                             172
Loans and advances                                                                        
   to banks   29,982   12,209   4                     28             1     12,242     42,224
Loans and advances                                                                        
   to customers   131,679   19,588   551         (1 )       (218 )   133     1,479     (254 )   (2 )   21,276     152,955
Debt securities   22,426     138         (2 )                           136     22,562
Equity shares   1,338             289                             289     1,627
Intangible assets   1,244                                             1,244
Property, plant and                                                                        
   equipment   1,542                                             1,542
Settlement balances   3,538                                             3,538
Derivatives at fair value   1,366   1,983           3     60         366             (1 )   2,411     3,777
Prepayments,                                                                        
   accrued income                                                                        
   and other assets   2,345     (693 )       (2 )   (15 )       (202 )   295     (2 )   52     (567 )   1,778





































Total assets   197,221   33,780           287     45     (218 )   325     1,774     (256 )   50     35,787     233,008



































                                                                         
Liabilities                                                                        
Deposits by banks   23,873   12,209   8                     10                 12,227     36,100
Customer accounts   126,119   19,588   349         (2 )   (15 )         (18 )   99             20,001     146,120
Debt securities in issue   3,597                             1,479         1     1,480     5,077
Settlement balances                                                                        
   and short positions   21,670     163                                     163     21,833
Derivatives at fair value   1,105   1,983           3     60         457                 2,503     3,608
Accruals, deferred                                                                        
   income and other                                                                        
   liabilities   4,539     (623 )   (7 )   76     (3 )       (291 )   295     81         (472 )   4,067
Retirement benefit                                                                        
   liabilities   2,093                                             2,093
Deferred taxation                                                                        
   liabilities               86     1     (55 )   50     (30 )   (101 )   49        
Subordinated liabilities   5,808     103     426                             1     530     6,338
Minority interests   408         (6 )                               (6 )   402
Shareholders’ equity   8,009         (413 )   124     2     (163 )   117     (69 )   (236 )   (1 )   (639 )   7,370





































Total liabilities and equity   197,221   33,780           287     45     (218 )   325     1,774     (256 )   50     35,787     233,008




































126






Balance sheet at 1 January 2005 – Bank

    IFRS prospective adjustments

    IFRS
31 December
2004
£m
  Offset
£m
  Other
IAS 39
£m
    Debt
equity
£m
    Classification
measurement
£m
  Embedded
derivatives
£m
    Provisioning
and
impairment
£m
    Hedging
measurement
£m
    Derecognition
£m
    Revenue
recognition
£m
    Other
£m
    Total
adjustments
£m
    IFRS
1 January
2005
£m



































Assets                                                                      
Cash and balances at                                                                      
   central banks   956                                           956
Loans and advances                                                                      
   to banks   15,994   2,885                     25                 2,910     18,904
Loans and advances                                                                      
   to customers   77,619   10,880   409     (33 )         (207 )   133         (272 )   1     10,911     88,530
Debt securities   39                                           39
Equity shares   587             288                           288     875
Investment in Group                                                                      
   undertakings   6,253         31                               31     6,284
Intangible assets   434                                           434
Property, plant and                                                                      
   equipment   1,247                                           1,247
Derivatives at fair value   704   706             7         121                 834     1,538
Prepayments,                                                                      
   accrued income                                                                      
   and other assets   1,834     (409 )         (7 )       38             36     (342 )   1,492




































Total assets   105,667   14,471       (2 )   288       (207 )   317         (272 )   37     14,632     120,299


































                                                                       
Liabilities                                                                      
Deposits by banks   3,480   2,885   3                               (1 )   2,887     6,367
Customer accounts   87,925   10,880   264           (7 )             99             11,236     99,161
Debt securities in issue   39                                           39
Derivatives at fair value   283   706             7         419                 1,132     1,415
Accruals, deferred                                                                      
   income and other                                                                      
   liabilities   2,171     (370 )   (6 )   1           (270 )       78     (3 )   (570 )   1,601
Retirement benefit                                                                      
   liabilities   1,920                                           1,920
Deferred tax               86       (36 )   46     (30 )   (105 )   39        
Subordinated liabilities   4,747     103     426                           1     530     5,277
Shareholders’ equity   5,102         (422 )   201       (171 )   122     (69 )   (245 )   1     (583 )   4,519




































Total liabilities and equity   105,667   14,471       (2 )   288       (207 )   317         (272 )   37     14,632     120,299



































127






Notes on the accounts continued

44 Transition to IFRS (continued)

Reconciliation of shareholders’ funds            
    Group
£m
    Bank
£m
 







UK GAAP shareholders' funds at 31 December 2004   9,138     9,138  
Standards applicable to all periods:            
Valuation of subsidiaries and associates       (2,828 )
Proposed dividend       (81 )
Employee benefits   (1,767 )   (1,898 )
Software development costs   344     434  
Other   (31 )   (37 )
Tax effect on adjustments   445     440  
Deferred tax   (120 )   (66 )







Shareholders' funds under IFRS at 31 December 2004   8,009     5,102  
Standards applicable from 1 January 2005:            
Non-equity shares reclassified to debt   (419 )   (419 )
Revenue recognition   (337 )   (350 )
Derecognition   (99 )   (99 )
Securities   210     287  
Other   (43 )   (2 )
Tax effect on adjustments   49      







Shareholders' funds under IFRS at 1 January 2005   7,370     4,519  
Equity – minority interests   402      







Equity under IFRS at 1 January 2005   7,772     4,519  






    Group   Bank






As at 1 January 2005   Fair value on
implementation of IAS 39
£m
  Carrying value
under UK GAAP
£m
  Fair value on
implementation of IAS 39
£m
  Carrying value
under UK GAAP
£m









Financial assets                
– designated as at fair value through profit or loss   1,137   1,062   60   60
– available-for-sale   3,851   3,562   911   624
                 
Financial liabilities                
– designated as at fair value through profit or loss   1,326   1,259   60   60










45 Ultimate holding company

The Group’s ultimate holding company and ultimate controlling party is The Royal Bank of Scotland Group plc and its immediate parent company is The Royal Bank of Scotland plc. Both companies are incorporated in Great Britain and registered in Scotland. As at 31 December 2005, The Royal Bank of Scotland Group plc heads the largest group in which the Group is consolidated and The Royal Bank of Scotland plc heads the smallest group in which the Group is consolidated. Copies of the consolidated accounts of both companies may be obtained from The Secretary, The Royal Bank of Scotland Group plc, Gogarburn, PO Box 1000, Edinburgh EH12 1HQ.

128






46 Significant differences between IFRS and US GAAP

The consolidated accounts of the Group have been prepared in accordance with IFRS issued and extant at 31 December 2005 which differ in certain significant respects from US GAAP. The significant differences which affect the Group are summarised below in three separate sections:

Section (1) covers significant differences between US GAAP and IFRS for the income statement for the year ended 31 December 2005 and the balance sheet at 31 December 2005. These differences include those between US GAAP and IAS 32 and IAS 39. As permitted by IFRS 1, the Group implemented IAS 32 and IAS 39 from 1 January 2005 without restating comparatives.

Section (2) sets out the significant differences between US GAAP and IFRS for 2004.

Section (3) summarises those areas where, though the recognition and measurement principles in US GAAP and IFRS are the same, adjustments to IFRS amounts are required due to differing implementation dates for the Group.

(1) For 31 December 2005

  IFRS   US GAAP



       
(a) Property revaluation and depreciation    
 

Freehold and long leasehold property occupied for the Group's use is carried at cost less accumulated depreciation. Depreciation is charged based on an estimated useful life of 50 years. As permitted by IFRS 1, valuation as at 31 December 2003 is its deemed cost.

Investment properties are carried at fair value; changes in fair value are included in the income statement.

  Under US GAAP, revaluations of property are not permitted. Depreciation is charged, and gains or losses on disposal are based on the historical cost for both own-use and investment properties.



       
(b) Leasehold property provisions    
  Provisions are recognised on leasehold properties when there is a commitment to vacate the property.   Provisions are recognised on leasehold properties at the time the property is vacated.



       
(c) Loan origination    
  Only costs that are incremental and directly attributable to the origination of a loan are deferred over the period of the related loan or facility.   Certain direct (but not necessarily incremental) costs are deferred and recognised over the period of the related loan or facility.



       
(d)  Pension costs    

The main scheme is deemed a defined benefit scheme that shares risk between various entities of the RBS Group.  There is no contractual agreement or stated policy for charging the net defined benefit cost for the plan as a whole to individual group entities.  Consequently, pursuant to IAS 19, the net defined benefit cost has been recognised in the financial statements of the Group, the entity that is considered legally the sponsoring employer for the scheme.

The income statement reflects the current and past service cost and the cumulative excess actuarial gains and losses amortised over the expected average remaining lives of participating employees. Excess gains and losses are those exceeding 10% of the higher of the gross assets or liabilities of the scheme.

Pension scheme assets are measured at their fair value. Scheme liabilities are measured on an actuarial basis using the projected unit method and discounted at the current rate of return on a high quality corporate bond of equivalent term and currency. Any surplus or deficit of scheme assets over liabilities adjusted for unrecognised actuarial gains and losses and past service costs is recognised in the balance sheet as an asset (surplus) or liability (deficit).

 

Under US GAAP, the main scheme is considered a single-employer plan.  Each subsidiary of The Royal Bank of Scotland Group plc accounts for its participation as a participation in a multi-employer pension plan pursuant to SFAS 87.  For US GAAP reporting purposes, The Royal Bank of Scotland Group plc is designated as the scheme sponsor and consequently follows defined benefit plan accounting in its consolidated financial statements.  Accordingly, the Group has accounted for its for its participation in the main scheme in accordance with the amount allocated by The Royal Bank of Scotland Group plc.





129






Notes on the accounts continued

46 Significant differences between IFRS and US GAAP (continued)

  IFRS   US GAAP



       
(e)  Financial instruments    
  Financial assets designated as at fair value through profit or loss    
Under IFRS, a financial asset may be designated as at fair value through profit or loss on initial recognition. Such designation is not allowed under US GAAP.
       
  Debt securities classified as loans and receivables    
  Non-derivative financial assets with fixed or determinable repayments that are not quoted in an active market are classified as loans and receivables except those that are classified as held-to-maturity, held-for-trading, available-for-sale or designated as at fair value through profit or loss. Loans and receivables are initially recognised at fair value plus directly related transaction costs. They are subsequently measured at adjusted cost using the effective interest method less any impairment losses.   Under US GAAP, these debt securities are classified as available-for-sale securities with unrealised gains and losses reported in a separate component of equity, except when the unrealised loss is considered other than temporary in which case the loss is included in net income.
       
  Financial assets other than debt securities and equity shares    
  classified as available-for-sale    
  Under IAS 39 financial assets classified as available-for-sale may take any legal form.   Under US GAAP, only debt and equity securities can be classified as available-for-sale. (Such securities are measured at fair value with unrealised gains and losses reported in a separate component of equity).
       
  Foreign exchange gains and losses on monetary available-for-sale financial assets    
  For the purposes of recognising foreign exchange gains and losses, a monetary available-for-sale financial asset is treated as if it were carried at amortised cost in the foreign currency. Accordingly, for such financial assets, exchange differences resulting from retranslating amortised cost are recognised in profit or loss.   Such differences are included with other unrealised gains and losses and reported in a separate component of equity.
       
  Financial liabilities    
  All financial liabilities held-for-trading are classified as such and carried at fair value with changes in fair value recognised in net income. A financial liability may be designated as at fair value through profit or loss.   Only financial liabilities that are derivatives and short positions are carried at fair value with changes in fair value recognised in net income.
 



130






  IFRS   US GAAP



       
(f)  Derivatives and hedging activities    
  Gains and losses arising from changes in fair value of a derivative are recognised as they arise in profit or loss unless the derivative is the hedging instrument in a qualifying hedge. The Group enters into three types of hedge relationship: hedges of changes in the fair value of a recognised asset or liability or firm commitment (fair value hedges); hedges of the variability in cash flows from a recognised asset or liability or a forecast transaction (cash flow hedges); and hedges of the net investment in a foreign entity.   US GAAP principles are similar to IFRS. There are however differences in their detailed application. The Group has not recognised any hedge relationships for US GAAP purposes. All derivatives are measured at fair value with changes in fair value recognised in net income.



       
(g)  Liabilities and equity    
  The Group classifies a financial instrument that it issues as a financial asset, financial liability or an equity instrument in accordance with the substance of the contractual arrangement. An instrument is classified as a liability if there is a contractual obligation to deliver cash or another financial asset, or to exchange financial assets or financial liabilities on potentially unfavourable terms. An instrument is classified as equity if it evidences a residual interest in the assets of the Group after the deduction of liabilities.  

Under US GAAP, preference shares issued by the Group are classified as equity as they are perpetual and redeemable only at the option of the Group.




       
(h) Offset arrangements    
 

A financial asset and a financial liability are offset and the net amount reported in the balance sheet when, and only when, the reporting entity currently has a legally enforceable right to set off the recognised amounts; and intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously.

Arrangements such as master netting arrangements do not generally provide a basis for offsetting.

 

Under US GAAP, debit and credit balances with the same counterparty may be offset only where there is a legally enforceable right of set-off and the intention to settle on a net basis. However, fair value amounts for forward, interest rate swap, currency swap, option, and other conditional or exchange contracts executed with the same counterparty under a master netting agreement may be offset as may repurchase and reverse repurchase agreements that are executed under a master netting agreement with the same counterparty and have the same settlement date.

This GAAP difference has no effect on net income or shareholders’ equity.





131






Notes on the accounts continued

46 Significant differences between IFRS and US GAAP (continued)

(2) For 2004

As indicated above, as permitted by IFRS 1, in the preparation of the Group's 2004 consolidated income statements and balance sheets, all IFRS have been applied except those relating to financial instruments where UK GAAP principles then current have been applied.

  IFRS or relevant UK GAAP   US GAAP



       
(a)  Property revaluation and depreciation    
 

Freehold and long leasehold property occupied for the Group's use is carried at cost less accumulated depreciation. Depreciation is charged based on an estimated useful life of 50 years. As permitted by IFRS 1, valuation as at 31 December 2003 is its deemed cost.

Investment properties are carried at fair value; changes in fair value are included in the income statement.

  Under US GAAP, revaluations of property are not permitted. Depreciation is charged, and gains or losses on disposal are based on the historical cost for both own-use and investment properties.



       
(b) Leasehold property provisions    
  Provisions are raised on leasehold properties when there is a commitment to vacate the property.   Provisions are recognised on leasehold properties at the time the property is vacated.



       
(c) Loan origination fees    
  Certain loan fees, together with related costs, are recognised in the income statement as received or incurred.   Applicable non-refundable loan fees and certain direct costs are deferred and recognised over the period of the related loan or facility.



       
(d) Pension costs    
 

The main scheme is deemed a defined benefit scheme that shares risk between various entities of the RBS Group. There is no contractual agreement or stated policy for charging the net defined benefit cost for the plan as a whole to individual group entities. Consequently, pursuant to IAS 19, the net defined benefit cost has been recognised in the financial statements of the Group, the entity that is considered legally the sponsoring employer for the scheme.

The income statement reflects the current and past service cost and the cumulative excess actuarial gains and losses amortised over the expected average remaining lives of participating employees. Excess gains and losses are those exceeding 10% of the higher of the gross assets or liabilities of the scheme.

Pension scheme assets are measured at their fair value. Scheme liabilities are measured on an actuarial basis using the projected unit method and discounted at the current rate of return on a high quality corporate bond of equivalent term and currency. Any surplus or deficit of scheme assets over liabilities adjusted for unrecognised actuarial gains and losses and past service costs is recognised in the balance sheet as an asset (surplus) or liability (deficit).

 

Under US GAAP, the main scheme is considered a single-employer plan. Each subsidiary of The Royal Bank of Scotland Group plc accounts for its participation as a participation in a multi-employer pension plan pursuant to SFAS 87. For US GAAP reporting purposes, The Royal Bank of Scotland Group plc is designated as the scheme sponsor and consequently follows defined benefit plan accounting in its consolidated financial statements. Accordingly, the Group has accounted for its for its participation in the main scheme in accordance with the amount allocated by The Royal Bank of Scotland Group plc.




       
(e) Extinguishment of liabilities    
  Recognition of a financial liability ceases once any transfer of economic benefits to the creditor is no longer likely.   A financial liability is derecognised only when the creditor is paid or the debtor is legally released from being the primary obligator under the liability, either judicially or by the creditor.




132






  IFRS or relevant UK GAAP   US GAAP



       
(f)  Securities    
  The Group’s debt and equity securities are classified as being held as investment securities or for trading purposes. Investment securities are stated at cost less provision for any permanent diminution in value. Premiums and discounts on dated debt securities are amortised to interest income over the period to maturity. Securities held for trading purposes are carried at fair value with changes in fair value recognised in profit or loss.   The Group’s investment debt securities and marketable investment equity shares are classified as available- for-sale securities and measured at fair value with unrealised gains and losses reported in a separate component of equity, except when the unrealised loss is considered other-than- temporary in which case the loss is included in net income. The Group recognises an other-than-temporary impairment on an available-for-sale equity share when its carrying value has exceeded its market value for a period of more than twelve months.



       
(g)  Derivatives and hedging activities    
  Non-trading derivatives are entered into by the Group to hedge exposures arising from transactions entered into in the normal course of banking activities. They are recognised in the accounts in accordance with the accounting treatment of the underlying transaction or transactions being hedged. To be classified as non- trading, a derivative must match or eliminate the risk inherent in the hedged item from potential movements in interest rates, exchange rates and market values. In addition, there must be a demonstrable link to an underlying transaction, pool of transactions or specified future transaction or transactions. Specified future transactions must be reasonably certain to arise for the derivative to be accounted for as a hedge. In the event that a non-trading derivative transaction is terminated or ceases to be an effective hedge, the derivative is remeasured at fair value and any resulting profit or loss amortised over the remaining life of the underlying transaction or transactions being hedged. If a hedged item is derecognised, or a specified future transaction is no longer likely to occur, the related non-trading derivative is remeasured at fair value and the resulting profit or loss taken to the income statement.   The Group has not made changes in its use of non-trading derivatives to meet the hedge criteria in SFAS 133 ‘Accounting for Derivative Instruments and Hedging Activities’. For US GAAP purposes, its portfolio of non-trading derivatives is remeasured to fair value and changes in fair value reflected in net income.
       
  Monetary assets denominated in a foreign currency are retranslated at closing rates with exchange differences taken to profit or loss. Equity shares financed by foreign currency borrowings are retranslated at closing rates with exchange differences taken to reserves along with differences on the related borrowings.   SFAS 133 does not permit a non-derivative financial instrument to be designated as the hedging instrument in a fair value hedge of the foreign exchange exposure of available-for-sale securities.
       
  Embedded derivatives are not bifurcated from the host contract.   SFAS 133 requires derivatives embedded in other financial instruments to be accounted for on a stand-alone basis if they have economic characteristics and risks that differ from those of the host instrument.



       
(h) Consolidation    
  All entities controlled by the Group are consolidated together with special purpose entities (SPEs) where the substance of the relationship between the reporting entity and the SPE indicates that it is controlled by the reporting entity.  

US GAAP requires consolidation by the primary beneficiary of a variable interest entity (VIE). An enterprise is the primary beneficiary of a VIE if it will absorb a majority of the entity’s expected losses, receive a majority of the entity's expected residual returns, or both.

 



133






Notes on the accounts continued

46  Significant differences between IFRS and US GAAP (continued)
  IFRS or relevant UK GAAP   US GAAP



       
(i)  Offset arrangements    
  Debit and credit balances with the same counterparty are aggregated into a single item where there is a right to insist on net settlement and the debit balance matures no later than the credit balance.   Under US GAAP, debit and credit balances with the same counterparty may be offset only where there is a legally enforceable right of set-off and the intention to settle on a net basis. However, fair value amounts for forward, interest rate swap, currency swap, option, and other conditional or exchange contracts executed with the same counterparty under a master netting agreement may be offset as may repurchase and reverse repurchase agreements that are executed under a master netting agreement with the same counterparty and have the same settlement date.



       
(3) Implementation timing differences    
  This section sets out the areas where differences in amounts reported under IFRS and US GAAP arise because the effective dates of standards are different although the recognition and measurement principles are the same.
 
       
  IFRS   US GAAP



       
  Intangible assets    
  Purchased goodwill    
  Purchased goodwill is recorded at cost less any accumulated impairment losses. Goodwill is tested annually (at 30 September) for impairment or more frequently if events or changes in circumstances indicate that it might be impaired.   US GAAP requires the same treatment of purchased goodwill. This was adopted by the Group from 1 July 2001. Prior to this goodwill was recognised as an asset and amortised over periods of up to 25 years. No amortisation was written back on this change of policy. During 2005, the Group changed the date for performing its annual goodwill impairment test from 1 January to 30 September for certain of its reporting units in order to conform to the date selected by the Group upon adoption of IFRS.
       
  Goodwill arising on acquisitions after 1 October 1998 was capitalised and amortised over its estimated useful economic life. Goodwill arising on acquisitions before 1 October 1998 was deducted from equity. The carrying amount of goodwill in the Group's opening IFRS balance sheet was its carrying value under UK GAAP as at 31 December 2003.    
       
  There was no restatement of previous acquisitions in 1998.    
  In 2004 no amortisation was written back.    
       
  Other intangibles    
  Until 2004 intangible assets acquired in a business combination were recognised separately from goodwill only if they were separable and reliably measurable. Thereafter intangibles have been recognised if they are separable or arise from contractual or other legal rights. All intangibles are amortised over their useful economic lives.   The same treatment was adopted for US GAAP purposes from 1 July 2001.
 


Other adjustments in the reconciliation of net income for the year ended 31 December 2005 from IFRS to US GAAP include refinements to estimates, primarily loan impairment provisions, arising from the implementation of IFRS.

Recent developments in US GAAP
In May 2005, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards 154 ‘Accounting Changes and Error Corrections’. The standard replaces APB 20 and SFAS 3 and amends the treatment of changes of accounting principle and the correction of errors. It is effective for accounting changes and corrections of errors made in fiscal years beginning after 15 December 2005.

In February 2006, the FASB published SFAS 155 ‘Accounting for Certain Hybrid Financial Instruments – an amendment of FASB Statements No 133 and 140’ (SFAS 155) which is effective for all financial instruments acquired or issued by the Group after 1 January 2007. The statement allows any hybrid financial instrument that contains an embedded derivative that would otherwise require bifurcation to be measured at fair value. The statement also eliminates the exemption from applying SFAS 133 to interests in securitised financial assets.

The FASB issued SFAS 156 ‘Accounting for Servicing of Financial Assets - an amendment of FASB Statement No. 140’ in March 2006. SFAS 156 addresses the recognition and measurement of separately recognised servicing assets and liabilities and provides an approach to obtain hedge-like (offset) accounting. The standard also: clarifies when an obligation to service financial assets should be separately recognised as a servicing asset or liability; requires fair value measurement for these assets and liabilities, if practicable; permits fair value or amortisation for subsequent measurement of these assets and liabilities; and permits a servicer using derivatives to offset servicing risk to measure both the derivative and related servicing asset or liability at fair value.

134






Selected figures in accordance with US GAAP

The following tables summarise the significant adjustments to consolidated net income available for ordinary shareholders and shareholders’ equity which would result from the application of US GAAP instead of IFRS. Where applicable, the adjustments are stated gross of tax with the tax effect shown separately in total.

Consolidated statement of income   2005
£m
    2004
£m
 







Profit attributable to ordinary shareholders – IFRS   2,446     2,316  
Adjustments in respect of:            
       Property revaluation and depreciation   4     4  
       Leasehold property provisions   (17 )   (20 )
       Loan origination   42     (17 )
       Pension costs   (89 )   (119 )
       Extinguishment of liabilities   -     (49 )
       Financial instruments   (10 )   21  
       Derivatives and hedging   (115 )   (248 )
       Liabilities and equity   47     -  
       Timing differences and other   (234 )   66  
       Taxation   68     118  







Net income available for ordinary shareholders – US GAAP   2,142     2,072  





             
             
Consolidated shareholders’ equity   2005
£m
    2004
£m
 







Shareholders’ equity – IFRS   9,440     8,009  
Adjustments in respect of:            
       Property revaluation and depreciation   (573 )   (577 )
       Leasehold property provisions   21     38  
       Loan origination   247     (132 )
       Pension costs   2,030     2,119  
       Extinguishment of liabilities   -     (109 )
       Financial instruments   (18 )   271  
       Derivatives and hedging   (30 )   195  
       Liabilities and equity   460     -  
       Timing differences   67     83  
       Taxation   (700 )   (707 )







Shareholders’ equity – US GAAP   10,944     9,190  





Total assets under US GAAP of £257.0 billion (2004 – £222.3 billion) primarily reflects the effect of certain arrangements that can be netted under US GAAP, together with the effect of adjustments made to shareholders’ equity.

47 Post balance sheet events
There have been no significant events between the year end and the date of approval of these accounts which would require a change to or disclosure in the accounts.

135






ITEM 19. EXHIBIT INDEX

   
Exhibit number   Description  
         
1.1 *   Memorandum and Articles of Association of National Westminster Bank Plc  
     
7.1   Explanation of ratio calculations
     
8.1   Omitted pursuant to General Instruction I of Form 10-K as applied to reports on Form 20-F
     
12.1   CEO certifications required by Rule 13a-14(a)
     
12.2   CFO certifications required by Rule 13a-14(a)
     
13.1   Certifications required by Rule 13a-14(b)

* Incorporated by reference to Exhibit 1.1 to the National Westminster Bank Plc Annual Report on Form 20-F for the fiscal year ended 31 December 2002 (File No. 1-9266).

 

136






Signatures

Pursuant to the requirements of Section 12 of the Securities Exchange Act of 1934, the registrant certifies that it meets all of the requirements for filing on Form 20-F and has duly caused this annual report to be signed on its behalf by the undersigned, thereunto duly authorised.

National Westminster Bank Plc
Registrant

/s/ Guy Robert Whittaker

Guy Robert Whittaker
Group Finance Director

22 June 2006

137






   
Exhibit number   Description  
         
1.1 *   Memorandum and Articles of Association of National Westminster Bank Plc  
     
7.1   Explanation of ratio calculations
     
8.1   Omitted pursuant to General Instruction I of Form 10-K as applied to reports on Form 20-F
     
12.1   CEO certifications required by Rule 13a-14(a)
     
12.2   CFO certifications required by Rule 13a-14(a)
     
13.1   Certifications required by Rule 13a-14(b)

* Incorporated by reference to Exhibit 1.1 to the National Westminster Bank Plc Annual Report on Form 20-F for the fiscal year ended 31 December 2002 (File No. 1-9266).