20-F 1 dp02253_20f.htm
 
As filed with the Securities and Exchange Commission on April 26, 2006


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

 
FORM 20-F

(Mark One)  
o REGISTRATION STATEMENT PURSUANT TO SECTION 12(b) OR (g) OF THE SECURITIES EXCHANGE ACT OF 1934
  OR
x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
  For the fiscal year ended December 31, 2005
  OR
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
  OR
o SHELL COMPANY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Date of event requiring this shell company report ___________
For the transition period from ___________ to ___________
 
Commission file number 0001-10306
 
THE ROYAL BANK OF SCOTLAND GROUP plc
(Exact name of Registrant as specified in its charter)
 
United Kingdom
(Jurisdiction of incorporation or organization)
 
RBS Gogarburn, PO Box 1000, Edinburgh EH12 1HQ
(Address of principal executive offices)
 
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 Series D**, E, F, G, H, I**, K, L, M, N and P each   New York Stock Exchange
     representing one Non-Cumulative Dollar Preference Share, Series D, E, F, G, H, I,    
     K, L, M, N and P, respectively    
Exchangeable Capital Securities, Series A***   New York Stock Exchange
Non-Cumulative Dollar Preference Shares*   New York Stock Exchange
Dollar Perpetual Regulatory tier one securities, Series 1   New York Stock Exchange

* Issuable upon exchange of the Exchangeable Capital Securities    
** Redeemed on March 6, 2006    
*** Redeemed on December 31, 2005    

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:

Ordinary shares of 25 pence each   3,196,543,671   Non-cumulative dollar preference shares, Series D to P   206,000,000
Non-voting Deferred Shares   2,660,556,304   Non-cumulative convertible dollar preference shares, Series 1   1,000,000
11% cumulative preference shares   500,000   Non-cumulative euro preference shares, Series 1 and 2   2,500,000
5½% cumulative preference shares   400,000        

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act
Yes x No o
 
If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.
Yes o No x
 
Note — checking the box above will not relieve any registrant required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 from their obligations under those Sections.
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes x No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

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






SEC Form 20-F cross reference guide


Item   Item Caption   Pages
         
PART I      
1   Identity of Directors, Senior Management and Advisers   Not applicable
2   Offer Statistics and Expected Timetable   Not applicable
3   Key Information    
         Selected financial data   129-131, 184-185, 193-195, 202, 215
         Capitalisation and indebtedness   Not applicable
         Reasons for the offer and use of proceeds   Not applicable
         Risk factors   6
4   Information on the Company   11-16, 42-47, 111-112, 185-193, 195-202
         History and development of the Company   4-5, 62, 116-117, 209, 220-221
         Business overview   4-5, 62, 157-159, 205-208
         Organisational structure   4, 113
         Property, plant and equipment   116-117, 209
5   Operating and Financial Review and Prospects    
         Operating results   7-37, 54-55, 118-120, 139-140, 205-208
         Liquidity and capital resources   36-37, 48-51, 62, 117-120, 133-134, 136-153, 155-156, 158, 192
         Research and development, patents, licences etc   Not applicable
         Trend information   6, 205-208
         Off balance sheet arrangements   118-120, 203-204
         Contractual obligations   204
6   Directors, Senior Management and Employees    
         Directors and senior management   60-61
         Compensation   73-81, 103
         Board practices   61, 67-69, 71-73, 76-77
         Employees   33
         Share ownership   64, 79-80, 82
7   Major Shareholders and Related Party Transactions    
         Major shareholders   63, 209
         Related party transactions   161
         Interests of experts and counsel   Not applicable
8   Financial Information    
         Consolidated statements and other financial information   86-182, 207
         Significant changes   181
         

i






Item   Item Caption   Pages
         
9   The Offer and Listing    
         Offer and listing details   214
         Plan of distribution   Not applicable
         Markets   213
         Selling shareholders   Not applicable
         Dilution   Not applicable
         Expenses of the issue   Not applicable
10   Additional Information    
         Share capital   Not applicable
         Memorandum and articles of association   220
         Material contracts   209
         Exchange controls   220
         Taxation   216-220
         Dividends and paying agents   Not applicable
         Statement of experts   Not applicable
         Documents on display   220
         Subsidiary information   Not applicable
11   Quantitative and Qualitative Disclosure about Market Risk   38-58, 118-120, 136-153
12   Description of Securities other than Equity Securities   Not applicable
PART II        
13   Defaults, Dividend Arrearages and Delinquencies   Not applicable
14   Material Modifications to the Rights of Security Holders and Use of Proceeds   Not applicable
15   Controls and Procedures   69-70
16   [Reserved]    
16   A      Audit Committee financial expert   71
    B      Code of ethics   65, 220
    C      Principal Accountant Fees and services   72, 105
    D      Exemptions from the Listing Standards for Audit Committees   Not applicable
    E      Purchases of Equity Securities by the Issuer and Affiliated Purchasers   62, 220
PART III        
17   Financial Statements   Not applicable
18   Financial Statements   86-181
19   Exhibits   222
    Signature   223
         
         
         
         
         
         
         

ii






Operating and financial review

Contents
     
2   Presentation of information
3   Forward-looking statements
4   Description of business
6   Risk factors
7   Financial highlights
8   Summary consolidated
  income statement
11   Analysis of results
21   Divisional performance
34   Consolidated balance sheet
36   Cash flow
37   IFRS compared
    with US GAAP
37   Capital resources
38   Risk management
     

     
       
 
   
 

Annual Report and Accounts 2005





Presentation of information

In the Form 20-F, and unless specified otherwise, the term ‘company’ means The Royal Bank of Scotland Group plc, ‘RBS’ or the ‘Group’ means the company and its subsidiary undertakings, ‘the Royal Bank’ means The Royal Bank of Scotland plc and ‘NatWest’ means National Westminster Bank Plc.

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

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

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

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

International Financial Reporting Standards

As required by the Companies Act 1985 and Article 4 of the European Union IAS Regulation, the consolidated financial statements of the Group 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. The 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), IAS 32 ‘Financial Instruments: Disclosure and Presentation’ (IAS 32) and IFRS 4 ‘Insurance Contracts’ (IFRS 4) from 1 January 2005 without restating its 2004 income statement and balance sheet. The implementation of IAS 32, IAS 39 and IFRS 4 on 1 January 2005 had a significant effect on the 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 171 and 172 respectively. For a further discussion of the Group's adoption of IFRS, see ’Accounting Policies–Adoption of International Financial Reporting Standards’ on page 88.

The 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.

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

2






Forward-looking statements

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

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

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

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

For a further discussion of certain risks faced by the Group, see Risk factors on page 6.

3






Operating and financial review

Description of business

Introduction

The Royal Bank of Scotland Group plc is the holding company of one of the world’s largest banking and financial services groups, with a market capitalisation of £56 billion at the end of 2005. Headquartered in Edinburgh, the Group operates in the UK, US and internationally through its two principal subsidiaries, the Royal Bank and NatWest, which are major UK clearing banks whose origins go back over 275 years. In the US, the Group’s subsidiary Citizens Financial Group, Inc. (“Citizens”) is ranked the eighth largest commercial banking organisation by deposits. The Group has a large and diversified customer base and provides a wide range of products and services to personal, commercial and large corporate and institutional customers.

The Group had total assets of £776.8 billion and shareholders’ equity of £35.4 billion at 31 December 2005. It is strongly capitalised with a total capital ratio of 11.7% and tier 1 capital ratio of 7.6% as at 31 December 2005.

Organisational structure and business overview

The Group’s activities are organised in the following business divisions: Corporate Markets (formerly Corporate Banking & Financial Markets), Retail Markets (comprising Retail Banking, Retail Direct and Wealth Management), Ulster Bank, Citizens, RBS Insurance and Manufacturing. A description of each of the divisions is given below.

Corporate Markets is focused on the provision of debt and risk management services to medium and large businesses and financial institutions in the UK and around the world. Corporate Banking & Financial Markets was renamed Corporate Markets on 1 January 2006 when its activities were reorganised into two businesses, UK Corporate Banking and Global Banking & Markets, in order to enhance our focus on the distinct needs of these two customer segments. These two divisions broadly correspond to the analysis of Corporate Markets by customer grouping presented in this review.

Corporate Markets provides an integrated range of core banking, structured finance and financial markets products and services, including acquisition finance, trade finance, leasing, factoring, treasury services, money markets, foreign exchange, derivatives, bond origination and trading, sovereign debt trading, futures brokerage and interest rate risk management services.

Corporate Markets is the largest provider of banking, finance and risk management services to Mid-Corporate and Commercial customers in the UK. Through its network of relationship managers across the country it provides the full range of Corporate Markets products and services to small, medium and large companies.

Corporate Markets is a leading banking partner to major corporations and financial institutions around the world, providing a full range of debt financing, risk management and investment services to its Global Banking & Markets customers.

Retail Markets was established in June 2005 to strengthen co-ordination and delivery of our multi-brand retail strategy. Retail Markets comprises Retail Banking, Retail Direct and Wealth Management.

Retail Banking is one of the leading retail banks in the UK. The division comprises both the Royal Bank and NatWest retail brands. It offers a full range of banking products and related financial services to the personal, premium and small business markets.

In the personal banking market, Retail Banking offers a comprehensive product range: money transmission, savings, loans, mortgages and insurance. In the small business market, Retail Banking provides a full range of services which include money transmission and cash management, short, medium and long-term financing, deposit products and insurance.

Customer choice and product flexibility are central to the Retail Banking proposition and customers are able to access services through a full range of channels: branches, ATMs, the internet and the telephone.

Retail Direct consists of the Group’s non-branch based retail businesses. Retail Direct issues a comprehensive range of credit and charge cards to personal and corporate customers and provides card processing services for retail businesses. It also includes Tesco Personal Finance, The One account, First Active UK, Direct Line Financial Services and Lombard Direct, all of which offer products to customers through direct channels principally in the UK. In continental Europe, Retail Direct offers a similar range of products through the RBS and Comfort Card brands.

Wealth Management provides private banking and investment services to its clients through a number of leading UK and overseas private banking subsidiaries and offshore banking businesses. Coutts is one of the world’s leading international wealth managers with over 20 offices worldwide, including Switzerland, Dubai, Monaco, Hong Kong and Singapore, as well as its premier position in the UK. Adam & Company is the major private bank in Scotland. The offshore banking businesses – The Royal Bank of Scotland International and NatWest Offshore – deliver retail banking services to local and expatriate customers, principally in the Channel Islands, the Isle of Man and Gibraltar.

Ulster Bank brings together Ulster Bank and First Active to provide a highly effective challenger to the larger competitors in the Irish banking market. Serving personal and small business customers, Ulster Bank Retail Banking provides branch banking, wealth management and direct banking throughout the Republic of Ireland and Northern Ireland. With a continued focus on providing customer choice and value, First Active serves personal and small business customers through its separately branded product offerings and branch network throughout the Republic of Ireland. Both First Active and Ulster Bank retain their own brands, branch networks and distinctive customer propositions and benefits are achieved by selling more mortgage and savings products to Ulster Bank’s customers and a broader range of banking products to First Active’s customers.

4






Ulster Bank Corporate Banking & Financial Markets caters for the banking needs of business and corporate customers, including treasury and money market activities, asset finance, ebanking and international services.

Citizens is the second largest commercial banking organisation in New England and the eighth largest commercial banking organisation in the US measured by deposits. Citizens provides retail and corporate banking services under the Citizens brand in Connecticut, Delaware, Massachusetts, New Hampshire, New Jersey, New York state, Pennsylvania, Rhode Island and Vermont and the Charter One brand in Illinois, Indiana, Michigan and Ohio. Through its branch network Citizens provides a full range of retail and corporate banking services, including personal banking, residential mortgages and cash management. In addition, Citizens engages in a wide variety of commercial lending, consumer lending, commercial and consumer deposit products, merchant credit card services, insurance products, trust services and retail investment services.

RBS Insurance is the second largest general insurer in the UK, by gross earned premiums. Through the Direct Line, Churchill and Privilege brands it sells and underwrites personal insurance over the telephone and the internet in the UK. Through the Direct Line brand, RBS Insurance also sells and underwrites personal insurance in Spain, Italy and Germany. Through UKI Partnerships, our partnership business, we operate insurance schemes on behalf of third parties who in turn sell insurance products to their customers. NIG sells personal and commercial products through a network of intermediaries, while Inter Group acts as an insurance administrator and Devitt Insurance Services operates as a specialist broker administrator.

Manufacturing supports the customer facing businesses in the UK and Ireland and manages the Group’s telephony, account management and money transmission operations. It is also responsible for information technology operations and development, global purchasing, property and other services.

Manufacturing drives optimum efficiencies in high volume processing activities, leverages the Group’s purchasing power and has become a centre of excellence for managing large scale and complex change programmes such as integration.

Competition

The Group faces intense competition in all the markets it serves. In the UK, the Group’s principal competitors are the other UK retail and commercial banks, building societies and the other major international banks represented in London.

Competition for corporate and institutional customers in the UK is from UK banks and from large foreign financial institutions who are also active and offer combined investment and commercial banking capabilities. In asset finance, the Group competes with banks and specialised asset finance providers, both captive and non-captive.

In the small business banking market, the Group competes with other UK clearing banks, specialist finance providers and, for smaller businesses, building societies.

In the personal banking segment the Group competes with UK banks and building societies, major retailers, life assurance companies and internet-only players. In the mortgage market the Group competes with UK banks and building societies. NatWest Life and Royal Scottish Assurance compete with Independent Financial Advisors and life assurance companies. The competitive situation in the long-term savings market is dynamic due to the uncertainties created by regulatory change and the continued evolution of institutions, particularly in the mutual sector.

In the UK credit card market large retailers and specialist card issuers, including major US operators, are active in addition to the UK banks. Competitive activity is across a number of dimensions including introductory and longer term pricing, loyalty and reward schemes, and packaged benefits. Whilst competition remains intense, pricing of introductory interest rate offers has become less aggressive. In addition to physical distribution channels, providers compete through direct marketing activity and the internet.

In Wealth Management, The Royal Bank of Scotland International competes with other UK and international banks to offer offshore banking services. Coutts and Adam & Company compete as private banks with UK clearing and private banks, and with international private banks.

RBS Insurance competes in personal lines insurance and to a limited extent in commercial insurance. There is strong competition from a range of insurance companies which now operate telephone and internet direct sales businesses. RBS Insurance also competes with local insurance companies in the direct motor insurance markets in Spain, Italy and Germany.

In Ireland, Ulster Bank and First Active compete in retail and commercial banking with the major Irish banks and building societies, and with other UK and international banks and building societies active in the market. Competition is intensifying as UK, Irish and other European institutions seek to expand their businesses.

In the United States, where competition is intense, Citizens competes in the New England, Mid-Atlantic and Mid-West retail and mid-corporate banking markets with local and regional banks and other financial institutions. The Group also competes in the US in large corporate lending and specialised finance markets, and in fixed-income trading and sales. Competition is principally with the large US commercial and investment banks and international banks active in the US.

In other international markets, principally in continental Europe, the Group faces competition from the leading domestic and international institutions active in the relevant national markets.

5






Operating and financial review continued

Risk factors

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

The financial performance of the Group is affected by borrower credit quality and general economic conditions, in particular in the UK, US and Europe

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

Changes in interest rates, foreign exchange rates, equity prices and other market factors affect the Group’s business

The most significant market risks the 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 the Group’s non-UK subsidiaries, mainly Citizens, 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 the Group’s investment and trading portfolios. The Group has implemented risk management methods to mitigate and control these and other market risks to which the 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 the Group’s financial performance and business operations.

The Group’s insurance businesses are subject to inherent risks involving claims

Future claims in the Group’s general and life assurance business may be higher than expected as a result of changing trends in claims experience resulting from catastrophic weather conditions, demographic developments, changes in mortality and other causes outside the Group’s control. Such changes would affect the profitability of current and future insurance products and services. The Group re-insures some of the risks it has assumed.

Operational risks are inherent in the Group’s business

The 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, the Group’s suppliers or counterparties. Although the Group has implemented risk controls and loss mitigation actions, and substantial resources are devoted to developing efficient procedures 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 the Group.

Each of the Group’s businesses is subject to substantial regulation and regulatory oversight. Any significant regulatory developments could have an effect on how the Group conducts its business and on the results of operations

The Group is subject to financial services laws, regulations, administrative actions and policies in each location in which the Group operates. This supervision and regulation, in particular in the UK and US, if changed could materially affect the Group’s business, the products and services offered or the value of assets.

Future growth in the Group’s earnings and shareholder value depends on strategic decisions regarding organic growth and potential acquisitions

The 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, the Group’s earnings could grow more slowly or decline.

The risk of litigation is inherent in the Group’s operations

In the ordinary course of the Group’s business, legal actions, claims against and by the Group and arbitrations arise; the outcome of such legal proceedings could affect the financial performance of the Group.

The Group is exposed to the risk of changes in tax legislation and its interpretation and to increases in the rate of corporate and other taxes in the jurisdictions in which in operates

The Group’s activities are subject to tax at various rates around the world computed in accordance with local legislation and practice. Action by governments to increase tax rates or to impose additional taxes would reduce the profitability of the Group. Revisions to tax legislation or to its interpretation might also affect the Group's results in the future.

6





As discussed on page 2, the consolidated financial statements of the Group have been prepared in accordance with International Financial Reporting Standards. The Group, however, has taken advantage of the option in IFRS 1 to implement IAS 32, IAS 39 and IFRS 4 from 1 January 2005 without restating its 2004 income statement and balance sheet. The implementation of IAS 32, IAS 39 and IFRS on 1 January 2005 had a significant effect on the 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 highlights

for the year ended 31 December   2005
£m
  2004
£m
   





     
Total income   25,902   23,391    
Profit before tax   7,936   7,284    
Profit attributable to ordinary shareholders   5,392   4,856    
Cost:income ratio (%) (1)   46.1%   44.3%    
Basic earnings per share (pence)   169.4   157.4    
Return on equity (%) (2)   17.5%   18.3%    





     
         
at 31 December 2005
£m

2004
£m
1 January
2005
£m
 








Total assets 776,827 588,122 696,510  
Loans and advances to customers 417,226 347,251 381,162  
Deposits 453,274 383,198 421,072  
Shareholders’ equity 35,435 33,905 30,022  
Risk asset ratio – tier 1 (%) 7.6 7.0 6.7  
Risk asset ratio – total (%) 11.7 11.7 11.6  








  Notes:
(1) Cost:income ratio represents operating expenses expressed as a percentage of total income.
(2) Return on equity represents profit attributable to ordinary shareholders expressed as a percentage of average ordinary shareholders’ equity.

 

7






Operating and financial review continued

Summary consolidated income statement for the year ended 31 December 2005

  2005
£m
2004
£m
 







     
Net interest income   9,918 9,071  







     
Fees and commissions receivable   6,750 6,473    
Fees and commissions payable   (1,841 ) (1,926 )      
Other non-interest income   5,296 4,126    
Insurance premium income   6,076 6,146    
Reinsurers’ share   (297 ) (499 )      







     
Non-interest income   15,984 14,320    







     
Total income   25,902 23,391    
Operating expenses   11,946 10,362    







     
Profit before other operating charges   13,956 13,029    
Insurance claims   4,413 4,565    
Reinsurers’ share   (100 ) (305 )      







     
Operating profit before impairment losses   9,643 8,769    
Impairment losses   1,707 1,485    







     
Profit before tax   7,936 7,284    
Tax on profit   2,378 1,995    







     
Profit for the year   5,558 5,289    
Minority interests   57 177    
Preference dividends   109 256    







     
Profit attributable to ordinary shareholders   5,392 4,856    





     
Basic earnings per ordinary share   169.4 p 157.4 p      





     

8






2005 compared with 2004

Profit

The implementation of IAS 32, IAS 39 and IFRS 4 on 1 January 2005 affected the timing of recognition of income and costs, classification of debt and equity, impairment provisions and accounting for insurance contracts in 2005.

Profit before tax was up 9%, from £7,284 million to £7,936 million. Strong underlying organic income growth in all divisions and a full year’s contribution from acquisitions made during 2004 were partially offset by the adverse impact on income of implementing IAS 32, IAS 39 and IFRS 4 on 1 January 2005.

Total income

Total income was up 11% or £2,511 million to £25,902 million. This reflected growth in all divisions particularly Corporate Markets, Citizens and Ulster Bank and also included gain of £333 million on sale of strategic investments. The effect of implementing the requirements of IAS 32, IAS 39 and IFRS 4 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 most of the Group’s preference shares and minority interests being reclassified as debt and the interest thereon included in interest payable.

Net interest income increased by 9% to £9,918 million. Average loans and advances to customers and average customer deposits grew by 24% and 17% respectively. The effect of implementing the requirements of IAS 32, IAS 39 and IFRS 4 on 1 January 2005 was to reduce 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 the Group’s preference shares and minority interests.

Non-interest income increased by 12% to £15,984 million with good growth in banking fee income, financial markets income and insurance premium income. Non-interest income represents 62% of total income. The effect of implementing the requirements of IAS 39 and IFRS 4 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 15% to £11,946 million, partly due to the implementation of IAS 39 and IFRS 4 on 1 January 2005. Operating expenses included loss on sale of subsidiaries of £93 million.

Integration

Integration costs were £458 million compared with £520 million in 2004. Included are software costs relating to the integration of NatWest 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. The balance principally relates to the integration of Churchill, First Active and Citizens’ acquisitions, including Charter One which was acquired in August 2004.

Cost:income ratio

The Group’s cost:income ratio in 2005 was 46.1% (2004 – 44.3%), reflecting the impact on income in 2005 of IAS 32, IAS 39 and IFRS 4 and the first full year of acquisitions, particularly Charter One.

Net insurance claims

Bancassurance and general insurance claims after reinsurance, which under IFRS include maturities and surrenders, increased by 1% to £4,313 million.

Impairment losses

Impairment losses were £1,707 million compared with £1,485 million in 2004. Overall credit quality remained strong in 2005, with improvements in Corporate Markets partly offsetting

9






Operating and financial review continued

higher impairment losses in Retail Markets. 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 1.60% of gross loans and advances to customers excluding reverse repos at 31 December 2005 (31 December 2004 – 1.92%).

Provision coverage of risk elements in lending and potential problem loans was 65% compared with 72% at 31 December 2004. This reflects amounts written-off and the changing mix from unsecured to secured exposures.

Earnings and dividends

Basic earnings per ordinary share increased by 8% from 157.4p to 169.4p.

A final dividend of 53.1p per ordinary share, up 29% is recommended, giving a total dividend for the year of 72.5p, an increase of 25%. If approved, the final dividend will be paid on 9 June 2006 to shareholders registered on 10 March 2006.

Balance sheet

Total assets of £776.8 billion at 31 December 2005 were up £188.7 billion, 32%, compared with 31 December 2004, with £108.4 billion of this increase arising from the implementation of IAS 32, IAS 39 and IFRS 4 on 1 January 2005, and the balance reflecting business growth.

Loans and advances to customers were up £70.0 billion, 20%, at £417.2 billion of which £33.9 billion resulted from the implementation of IAS 32 and IAS 39, mainly as a result of the grossing up of previously netted customer balances. Excluding this and a decrease in reverse repos, down 24%, £15.7 billion to £48.9 billion, customer lending was up £51.8 billion, 16%, reflecting organic growth across all divisions.

Customer accounts were up £59.5 billion, 21% at £342.9 billion with £31.7 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 £5.7 billion, 11% to £48.8 billion, deposits rose by £33.5 billion, 13%, to £294.1 billion with good growth in all divisions.

Capital ratios at 31 December 2005 were 7.6% (Tier 1) and 11.7% (Total).

Profitability

The after-tax return on ordinary equity, which is based on profit attributable to ordinary shareholders and average ordinary equity was 17.5%.

 

10






Analysis of results

Net interest income

  2005
£m
2004
£m







Interest receivable   21,331   16,632
Interest payable   (11,413 )   (7,561 )







Net interest income   9,918   9,071





  %   %







Gross yield on interest-earning assets of the banking business   5.59   5.21
Cost of interest-bearing liabilities of the banking business   (3.36 )   (2.70 )







Interest spread of the banking business   2.23   2.51
Benefit from interest-free funds   0.37   0.33







Net interest margin of the banking business   2.60   2.84





         
Yields, spreads and margins of the banking business   %   %







Gross yield (1)    
       Group   5.59   5.21
       UK   6.06   5.58
       Overseas   4.74   4.38
Interest spread (2)    
       Group   2.23   2.51
       UK   2.45   2.56
       Overseas   1.87   2.48
Net interest margin (3)    
       Group   2.60   2.84
       UK   2.75   2.85
       Overseas   2.32   2.83
         
The Royal Bank of Scotland plc base rate (average)   4.65   4.38
London inter-bank three month offered rates (average):    
       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.

2005 compared with 2004

The net interest margin at 2.60% was down 24 basis points from 2.84% in 2004. The major contributors to the decline were product mix changes, driven by organic growth in lower margin mortgage lending and large corporate loans, and in rental assets as well as a change in deposit mix. The flattening of the US dollar yield curve also contributed to the reduction: the remainder was due to price re-positioning of some of our products. The implementation of IAS 32, IAS 39 and IFRS 4 on 1 January 2005 adversely impacted the net interest margin.

11






Operating and financial review continued

Average balance sheet and related interest

      2005           2004    
   






 






 
  Average
balance
£m
  Interest
£m
    Rate
%
  Average
balance
£m
  Interest
£m
    Rate
%
 









 






 
Assets                
Treasury bills and other eligible bills – UK   3,160     138     4.37   835     34     4.07  
Treasury bills and other eligible bills – Overseas   55     2     3.64   62     1     1.61  
Loans and advances to banks – UK   15,477     649     4.19   13,696     529     3.86  
Loans and advances to banks – Overseas   9,422     259     2.75   9,189     264     2.87  
Loans and advances to customers – UK   212,156     13,453     6.34   186,117     11,116     5.97  
Loans and advances to customers – Overseas   104,579     5,206     4.98   69,118     3,201     4.63  
Debt securities – UK   14,731     630     4.28   21,859     726     3.32  
Debt securities – Overseas   22,299     994     4.46   18,132     761     4.20  







     




     
Total interest-earning assets – banking business   381,879     21,331     5.59   319,008     16,632     5.21  
   

   

Total interest-earning assets      – trading business (2)   172,990               133,353            




 

Total interest-earning assets   554,869               452,361            
Non-interest-earning assets   182,179               70,446            




 

Total assets   737,048               522,807            


 

Percentage of assets applicable to overseas operations   35.3%               32.9%            


 

       
Liabilities and shareholders’ equity                          
                           
Deposits by banks – UK   34,742     1,192     3.43   35,059     1,073     3.06  
Deposits by banks – Overseas   27,383     891     3.25   16,425     398     2.42  
Customer accounts: demand deposits – UK   73,653     2,057     2.79   67,519     1,568     2.32  
Customer accounts: demand deposits – Overseas   13,823     299     2.16   11,580     147     1.27  
Customer accounts: savings deposits – UK   26,727     778     2.91   23,149     625     2.70  
Customer accounts: savings deposits – Overseas   21,700     381     1.76   18,349     252     1.37  
Customer accounts: other time deposits – UK   60,350     2,325     3.85   51,591     1,699     3.29  
Customer accounts: other time deposits – Overseas   32,024     979     3.06   20,725     479     2.31  
Debt securities in issue – UK   42,745     1,771     4.14   41,058     1,351     3.29  
                                 – Overseas   19,621     633     3.23   12,320     229     1.86  
Subordinated liabilities – UK   23,948     1,117     4.66   17,959     665     3.70  
                                 – Overseas   2,642     154     5.83   235     15     6.38  
Internal funding of trading business – UK   (37,628)     (1,125)     2.99   (35,317)     (920)     2.60  
Internal funding of trading business – Overseas   (2,186)     (39)     1.78   (758)     (20)     2.64  







 




Total interest-bearing liabilities – banking business   339,544     11,413     3.36   279,894     7,561     2.70  
   

   

     liabilities                                      – trading business (2)   172,744               131,743            




 

Total interest-bearing liabilities   512,288               411,637            
Non-interest-bearing liabilities                                
Demand deposits – UK   17,484               17,157            
Demand deposits – Overseas   11,181               9,101            
Other liabilities   163,147               53,827            
Shareholders’ equity   32,948               31,085            




 

Total liabilities and shareholders’ equity   737,048               522,807            




Percentage of liabilities applicable to overseas operations   33.5%       30.5%    





  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.
(3) Interest-earning assets and interest-bearing liabilities include the Retail bancassurance long-term assets and liabilities attributable to policyholders.
(4) Interest income and interest expense do not include interest on financial assets and liabilities designated as at fair value through profit or loss. Interest-earning assets and interest-bearing liabilities do not include the related balances.

12






Operating and financial review continued

Analysis of change in net interest income – volume and rate analysis

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

      2005 over 2004      
 






 
    Increase/(decrease) due to changes in:  
  Average
volume
£m
    Average
rate
£m
    Net
change
£m
 










Interest- earning assets      

Treasury bills and other eligible bills

       
       UK   101     3     104
       Overseas   -     1     1
Loans and advances to banks                
       UK   72     48     120
       Overseas   6     (11 )   (5 )
Loans and advances to customers                
       UK   1,620     717     2,337
       Overseas   1,748     257     2,005
Debt securities                
       UK   (273 )   177     (96 )
       Overseas   184     49     233










Total interest receivable of the banking business                
       UK   1,520     945     2,465
       Overseas   1,938     296     2,234










  3,458     1,241     4,699








Interest-bearing liabilities        
Deposits by banks      
       UK   10     (129 )   (119 )
       Overseas   (326 )   (167 )   (493 )
Customer accounts: demand deposits                  
       UK   (151 )   (338 )   (489 )
       Overseas   (33 )   (119 )   (152 )
Customer accounts: savings deposits                  
       UK   (102 )   (51 )   (153 )
       Overseas   (50 )   (79 )   (129 )
Customer accounts: other time deposits                  
       UK   (313 )   (313 )   (626 )
       Overseas   (313 )   (187 )   (500 )
Debt securities in issue                  
       UK   (58 )   (362 )   (420 )
       Overseas   (180 )   (224 )   (404 )
Subordinated liabilities                  
       UK   (254 )   (198 )   (452 )
       Overseas   (140 )   1     (139 )
Internal funding of trading business                  
       UK   62     143     205  
       Overseas   27     (8 )   19  










Total interest payable of the banking business        
       UK   (806 )   (1,248 )   (2,054 )
       Overseas   (1,015 )   (783 )   (1,798 )










  (1,821 )   (2,031 )   (3,852 )








Movement in net interest income                  
       UK   714     (303 )   411  
       Overseas   923     (487 )   436  










  1,637     (790 )   847  









13







Operating and financial review continued

Analysis of results

Net interest income

As discussed on page 2, the Group implemented IFRS with effect from 1 January 2004. The average balance sheet and related data presented for 2003 on pages 14 to 16 are based on UK GAAP and 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 88.

  2003 - UK GAAP
£m




Interest receivable   13,998
Interest payable   (5,697 )




Net interest income   8,301


  %




Gross yield on interest-earning assets of the banking business   5.00
Cost of interest-bearing liabilities of the banking business   (2.32 )




Interest spread of the banking business   2.68
Benefit from interest-free funds   0.29



 
Net interest margin of the banking business   2.97


     
Yields, spreads and margins of the banking business   %




Gross yield (1)  
       Group   5.00
       UK   5.20
       Overseas   4.44
Interest spread (2)  
       Group   2.68
       UK   2.68
       Overseas   2.71
Net interest margin (3)  
       Group   2.97
       UK   2.95
       Overseas   3.02
     
The Royal Bank of Scotland plc base rate (average)   3.69
London inter-bank three month offered rates (average):  
       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.

 

14






Average balance sheet and related interest

  2003 - UK GAAP
 







    Average
balance
£m
    Interest
£m
    Rate
%









Assets                
Treasury bills and other eligible bills – UK   1,378     48     3.48
                                                          – Overseas   64     1     1.56
Loans and advances to banks – UK   13,724     459     3.34
                                                  – Overseas   9,559     212     2.22
Loans and advances to customers – UK   168,390     9,519     5.65
                                                         – Overseas   44,862     2,240     4.99
Debt securities – UK   23,810     754     3.17
                         – Overseas   17,927     765     4.27







 
Total interest-earning assets – banking business   279,714     13,998     5.00


                                                     – trading business (2)   96,648            




 
Total interest-earning assets   376,362            
Non-interest-earning assets   66,060            




 
Total assets   442,422            


 
Percentage of assets applicable to overseas operations   32.4 %          


 
Liabilities and shareholders’ equity                
 
Deposits by banks – UK   28,220     703     2.49
                               – Overseas   9,565     218     2.28
Customer accounts: demand deposits – UK   64,469     1,028     1.59
                                                                – Overseas   9,166     70     0.76
Customer accounts: savings deposits – UK   18,653     503     2.70
                                                               – Overseas   16,310     260     1.59
Customer accounts: other time deposits – UK   49,880     1,478     2.96
                                                                   – Overseas   16,642     374     2.25
Debt securities in issue – UK   29,977     914     3.05
                                       – Overseas   9,630     119     1.24
Subordinated liabilities – UK   15,342     534     3.48
                                     – Overseas   154     16     10.39
Internal funding of trading business – UK   (21,258 )   (497 )   2.34
                                                          – Overseas   (1,651 )   (23 )   1.39







 
Total interest-bearing liabilities – banking business   245,099     5,697     2.32


 
Total interest-bearing liabilities – trading business (2)   93,466            




 
Total interest-bearing liabilities   338,565            
Non-interest-bearing liabilities                
Demand deposits – UK   17,589            
                              – Overseas   7,330            
Other liabilities   52,810            
Shareholders’ funds   26,128            




 
Total liabilities and shareholders’ equity   442,422            


 
Percentage of liabilities applicable to overseas operations   30.6 %          



  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 dealing profits.

15






Operating and financial review continued

Analysis of change in net interest income – volume and rate analysis

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

      2004 over 2003      
 







    Increase/(decrease) due to changes in:  
  Average
volume
£m
    Average
rate
£m
    Net
change
£m
 










Interest- earning assets      

Treasury bills and other eligible bills

       
       UK   (21 )   7     (14 )
       Overseas   -     -     -  
Loans and advances to banks                  
       UK   (1 )   71     70  
       Overseas   (8 )   60     52  
Loans and advances to customers                  
       UK   1,038     559     1,597  
       Overseas   1,133     (172 )   961  
Debt securities                  
       UK   (63 )   35     (28 )
       Overseas   9     (13 )   (4 )










Total interest receivable of the banking business                  
       UK   953     672     1,625  
       Overseas   1,134     (125 )   1,009  










  2,087     547     2,634  








Interest-bearing liabilities        
Deposits by banks      
       UK   (190 )   (180 )   (370 )
       Overseas   (166 )   (14 )   (180 )
Customer accounts: demand deposits                  
       UK   (50 )   (490 )   (540 )
       Overseas   (22 )   (55 )   (77 )
Customer accounts: savings deposits                  
       UK   (122 )   -     (122 )
       Overseas   (30 )   38     8  
Customer accounts: other time deposits                  
       UK   (52 )   (169 )   (221 )
       Overseas   (95 )   (10 )   (105 )
Debt securities in issue                  
       UK   (360 )   (77 )   (437 )
       Overseas   (39 )   (71 )   (110 )
Subordinated liabilities                  
       UK   (96 )   (35 )   (131 )
       Overseas   (7 )   8     1  
Internal funding of trading business                  
       UK   362     61     423  
       Overseas   (17 )   14     (3 )










Total interest payable of the banking business        
       UK   (508 )   (890 )   (1,398 )
       Overseas   (376 )   (90 )   (466 )










  (884 )   (980 )   (1,864 )








Movement in net interest income                  
       UK   445     (218 )   227  
       Overseas   758     (215 )   543  










  1,203     (433 )   770  









16






Non-interest income

  2005
£m
    2004
£m
     







     
Fees and commissions receivable   6,750   6,473    
Fees and commissions payable   (1,841 )   (1,926 )      
Income from trading activities   2,343   1,988    
Other operating income   2,953   2,138    







     
  10,205   8,673    







     
Insurance premium income   6,076   6,146    
Reinsurers’ share   (297 )   (499 )      







     
  5,779   5,647    







     
  15,984   14,320    





     

2005 compared with 2004

Non-interest income increased by £1,664 million, 12% to £15,984 million reflecting strong performances in Corporate Markets and Citizens, and good growth in banking fee income, financial markets income and insurance premium income. The effect of implementing IAS 39 and IFRS 4 on 1 January 2005 was to reduce non-interest income.

Within non-interest income, fees and commissions receivable increased by 4% or £277 million, to £6,750 million, while fees and commissions payable decreased by £85 million to £1,841 million. Under IFRS, certain lending fees are deferred over the life of the financial asset.

Income from trading activities, which primarily arises from providing customers with debt and risk management products in interest rate, currency and credit, was up £355 million, 18%. The increase on 2004 reflected higher customer volumes.

Other operating income increased by 38%, £815 million to £2,953 million. This was principally due to higher income from rental assets, increased bancassurance income, realised investment securities gains and the gain on sale of strategic investments.

General insurance premium income, after reinsurance, rose by 2%, or £132 million to £5,779 million reflecting volume growth in motor and home insurance products.

17





Operating and financial review continued

Operating expenses

  2005
£m
    2004
£m
     







     
Administrative expenses:          
Staff costs   5,992     5,188        
Premises and equipment   1,313     1,177        
Other administrative expenses   2,816     2,323        







     
Total administrative expenses   10,121     8,688        
Depreciation and amortisation   1,825     1,674        







     
  11,946     10,362        





     

2005 compared with 2004

Operating expenses rose by 15% to £11,946 million to support growth in business volumes and included the loss on sale of subsidiaries.

Staff costs were up £804 million, 15% to £5,922 million reflecting business growth. The number of staff increased by 400 to 137,000.

Premises and equipment expenses increased by £136 million, 12% to £1,313 million reflecting our programme of investment both in the branch networks and in our major operational centres.

Other administrative expenses, up 21%, £493 million reflected business volume growth and ongoing expenditure on regulatory projects.

The Group’s ratio of operating expenses to total income was 46.1% compared with 44.3% in 2004, partly due to the full year effect of acquisitions and the impact of implementing IAS 32, IAS 39 and IFRS 4 on 1 January 2005.

18






Integration costs

  2005
£m
    2004
£m
     







     
Staff costs   148     83        
Premises and equipment   39     35        
Other administrative expenses   131     149        
Depreciation and amortisation   140     253        







     
    458     520        
   




     

Integration costs were £458 million compared with £520 million in 2004 comprising amortisation of internally developed software and other expenditure. Software costs were previously written off as incurred under UK GAAP but under IFRS are now amortised over 3-5 years. All software relating to the NatWest integration was fully amortised by the end of 2005. The balance of integration costs principally relates to the integration of Churchill, First Active and Citizens’ acquisitions, including Charter One which was acquired in August 2004.

Accruals in relation to integration costs are set out below.

  At 31 December
2004
£m
  Currency translation
adjustments
£m
  Charge to
income statement
£m
  Utilised during
the year
£m
  At 31 December
2005
£m












Staff costs – redundancy   11   1   23   (18 )   17
Staff costs – other   29   1   125   (140 )   15
Premises and equipment   13   2   39   (40 )   14
Other   44   2   271   (291 )   26












    97   6   458   (489 )   72
   









19






Operating and financial review continued

Impairment losses

IAS 39 impacted the way in which loan impairment losses are calculated and was implemented on 1 January 2005 without restatement of comparatives. Consequently, the data in the following tables for 2005 and 2004 are not directly comparable.

  2005
£m
    2004
£m
     







     
New impairment losses   1,879   1,629    
less: recoveries of amounts previously written-off   (172 )   (144 )      







     
Charge to income statement   1,707   1,485    





     
Comprising:      
Loan impairment losses   1,703   1,402    
Other impairment losses   4   83    







     
Charge to income statement   1,707   1,485    





     

2005 compared with 2004

Impairment losses were £1,707 million compared with £1,485 million in 2004 with higher provisions in Retail Markets partly offset by improvements in Corporate Markets. Following the implementation of IAS 39 on 1 January 2005, loan impairment losses are based on the discounted value of expected recoveries. As a result, provisions are higher initially but the difference between the discounted and undiscounted amounts emerges as interest income over the recovery period.

New impairment losses were up 15%, £250 million to £1,879 million. Recoveries of amounts previously written off were up £28 million, 19% to £172 million. Consequently the net charge to the income statement was up £222 million, 15% to £1,707 million.

Total balance sheet provisions for impairment amounted to £3,887 million compared with £4,174 million at 31 December 2004. Total provision coverage (the ratio of total balance sheet provisions for impairment to total risk elements in lending) decreased from 76% to 65%.

The ratio of total balance sheet provisions for impairment to total risk elements in lending and potential problem loans decreased to 65% compared with 72% at 31 December 2004. This reflects amounts written-off and the changing mix from unsecured to secured exposure.

Other impairment losses were £4 million compared with £83 million in 2004.

Taxation

  2005
£m
    2004
£m
     







     
Tax   2,378     1,995        





     
  %     %        







     
UK corporation tax rate   30.0     30.0        
Effective tax rate   30.0     27.4        







     

The actual tax charge differs from the expected tax charge computed by applying the standard rate of UK corporation tax as follows:

  2005
£m
    2004
£m
     







     
Expected tax charge   2,381   2,185    
Interest on subordinated debt not allowable for tax   79      
Non-deductible items   230   110    
Non-taxable items   (166 )   (128 )      
Taxable foreign exchange movements   (10 )   (10 )      
Foreign profits taxed at other rates   77   49    
Unutilised losses – brought forward and carried forward   (5 )   6    
Adjustments in respect of prior periods   (208 )   (217 )      







     
Actual tax charge   2,378   1,995    





     

20






Divisional performance

The contribution of each division before amortisation of purchased intangible assets, integration costs and net gain on sale of strategic investments and subsidiaries and, where appropriate, Manufacturing costs is detailed below.

  2005
£m
  2004
£m







Corporate Markets   5,224     4,226  
Retail Markets            
   Retail Banking   3,009     3,212  
   Retail Direct   790     885  
   Wealth Management   408     357  
Total Retail Markets   4,207     4,454  
Ulster Bank   530     452  
Citizens   1,575     1,071  
RBS Insurance   926     863  
Manufacturing   (2,743 )   (2,552 )
Central items   (1,468 )   (665 )







Profit before amortisation of purchased intangible assets, integration costs and net gain            
on sale of strategic investments and subsidiaries   8,251     7,849  
Amortisation of purchased intangible assets   97     45  
Integration costs   458     520  
Net gain on sale of strategic investments and subsidiaries   240      







Profit before tax   7,936     7,284  
   




The performance of each of the divisions is reviewed on pages 22 to 33.

21






Operating and financial review continued

Corporate Markets

 
2005
£m
  2004
£m
 






Net interest income   2,960   2,561  
Non-interest income   5,855   5,090  






Total income   8,815   7,651  






Direct expenses        
       – staff costs   2,000   1,705  
       – other   523   459  
       – operating lease depreciation   733   680  






    3,256   2,844  






Contribution before impairment losses   5,559   4,807  
Impairment losses   335   581  






Contribution   5,224   4,226  





         
  31 December
2005
£bn
  1 January
2005
£bn
 






Total assets*   409.2   359.4  
Loans and advances to customers – gross*        
       – banking book   158.7   136.9  
       – trading book   11.8   10.1  
Rental assets   13.2   11.5  
Customer deposits*   111.1   100.8  
Weighted risk assets   202.6   178.4  






* excluding repos and reverse repos

Corporate Markets achieved excellent results in 2005, with total income up 15% to £8,815 million and contribution up 24% to £5,224 million, reflecting very good performances across our businesses.

RBS remains the number 1 corporate bank in the UK and we have significantly expanded our franchise in Europe and North America, where we are also focussing on the opportunities for increased co-operation between Corporate Markets and Citizens. In Asia, our profile has benefited from the announcement of the Group’s strategic partnership with Bank of China.

Our businesses continue to deliver good returns. Weighted risk assets rose by 14% over the course of the year to £202.6 billion, with much slower growth in the second half following the above-trend spike at 30 June 2005. The ratio of income to average weighted risk assets for 2005 was broadly stable, while the ratio of contribution to average weighted risk assets improved slightly.

22






Corporate Markets – Mid-Corporate and Commercial

  2005
£m
  2004
£m
 





 
Net interest income   1,760   1,477  
Non-interest income   1,257   1,333  





 
Total income   3,017   2,810  





 
Direct expenses    
       – staff costs   529   489  
       – other   132   123  
       – operating lease depreciation   335   322  





 
  996   934  





 
Contribution before impairment losses   2,021   1,876  
Impairment losses   218   270  





 
Contribution   1,803   1,606  
 


 
       
  31 December
2005
£bn
  1 January
2005
£bn
 





 
Total assets*   70.4   61.6  
Loans and advances to customers – gross*   67.9   59.4  
Customer deposits*   60.0   51.8  
Weighted risk assets   74.2   65.6  





 
* excluding repos and reverse repos

Corporate Markets generated good results in the Mid-Corporate & Commercial customer segment in 2005, building on the strength of its UK franchise. We maintained our market-leading positions in corporate and commercial banking, asset finance and invoice finance. Total income rose by 7% to £3,017 million, whilst contribution rose by 12% to £1,803 million.

Net interest income increased 19% to £1,760 million as a result of strong growth in average lending and in average customer deposits.

Non-interest income declined by 6% to £1,257 million, reflecting the effect of IAS 39 on recognition of fee income being partially offset by our continued success in cross-selling our full range of products and services to customers. Our business has benefited from the co-location of our asset finance and invoice finance managers with our corporate and commercial banking operations.

Expense growth was 7% which included a further investment in customer-facing staff.

Impairment losses were 19% lower than in 2004 at £218 million, reflecting a further improvement in our credit metrics.

23






Operating and financial review continued

Corporate Markets – Global Banking & Markets          
       
  2005
£m
  2004
£m
 






Net interest income excluding funding cost of rental assets 1,652     1,454  
Funding cost of rental assets (452 )   (370 )






Net interest income 1,200     1,084  






Fees and commissions receivable 1,060     969  
Fees and commissions payable (252 )   (217 )
Income from trading activities 1,964     1,751  
Income on rental assets 1,074     924  
Other operating income 752     330  






Non-interest income 4,598     3,757  






Total income 5,798     4,841  






Direct expenses          
       – staff costs 1,471     1,216  
       – other 391     336  
       – operating lease depreciation 398     358  






  2,260     1,910  






Contribution before impairment losses 3,538     2,931  
Impairment losses 117     311  






Contribution 3,421     2,620  






  31 December
2005
£bn
    1 January
2005
£bn
 






 Total assets* 338.8     297.8  
 Loans and advances to customers – gross*          
           – banking book 90.8     77.5  
           – trading book 11.8     10.1  
 Rental assets 11.9     10.3  
 Customer deposits* 51.1     49.0  
 Weighted risk assets 128.4     112.8  






* excluding repos and reverse repos          

An excellent performance from our Global Banking & Markets customer segment in 2005 shows the fruits of the global platform we have built over the last five years, with good growth in all major geographies and across-the-board success in income generation from our core banking, structured finance and financial markets activities.

Total income rose by 20% to £5,798 million, with contribution up 31% to £3,421 million, benefiting from cost discipline and continuing benign credit conditions.

Debt underwriting volumes remained strong throughout the course of the year, reflecting our involvement in many of the largest financings in the UK and Europe for both large corporates and private equity sponsors. We were the fourth most active bank worldwide in arranging and underwriting bank lending in 2005. A strong distribution performance brought weighted risk assets to £128.4 billion at year-end, up 14% over the year and back to a more consistent trend level than the amount at 30 June 2005.

Non-interest income grew by 22% to £4,598 million and now accounts for 79% of Global Banking & Markets revenues.

We recorded good growth in fees earned from customer services in risk management, financial structuring and debt-raising. A strong performance from RBS Greenwich Capital, which has been brought together with other Corporate Markets activities in North America, contributed to steady growth in income from trading activities. Customer volumes were higher across all products and particularly good in our credit markets businesses. Average trading Value at Risk was held steady at a very conservative level, £12 million.

Our continuing success in aircraft, train, ship and hotel leasing delivered good growth in net income from rental assets. Other operating income grew strongly, with our structured finance investment portfolio producing good realised gains, notably in the second half of the year.

Growth in expenses was 18%, reflecting variable performance-related costs.

24




Retail Markets

Retail Markets was established in June 2005 to strengthen co-ordination and delivery of our multi-brand retail strategy across our product range, and comprises Retail Banking, Retail Direct and Wealth Management. The performance of each of these divisions is discussed on pages 26, 27 and 28, respectively.

  2005
£m
  2004
£m




Net interest income 4,499   4,261
Non-interest income 3,714   3,869




Total income 8,213   8,130




Direct expenses      
       – staff costs 1,514   1,446
       – other 821   808




  2,335   2,254




Insurance net claims 486   702




Contribution before impairment losses 5,392   5,174
Impairment losses 1,185   720




Contribution 4,207   4,454



31 December   1 January
  31 December
2005
£bn
  1 January
2005
£bn




Total banking assets 114.4   104.9
Loans and advances to customers      
   – mortgages 64.6   56.9
   – personal 21.5   20.2
   – cards 9.6   9.4
   – business 16.7   15.9
Customer deposits 105.9   97.0
Investment management assets – excluding deposits 31.4   26.6
Weighted risk assets 80.6   76.5





Total income increased by 1% to £8,213 million and contribution decreased by 6% to £4,207 million, with good discipline on costs helping to partially offset increased impairment losses on unsecured lending.

At the end of 2004 we referred to the changes being seen in the retail markets with the consumer transitioning from an environment which had seen several years of very fast growth in consumer lending to an increased emphasis on savings and investment.

As a consequence, we planned to refocus our strategy to grow our sales of deposit and bancassurance products faster than the market, to exploit our potential for building profitable market share in the mortgage market and to concentrate more on the development of our branch franchise, building on our strong service proposition. During 2005 this transition has gathered momentum and we have achieved good progress in our strategies.

Branch deposit balances outgrew the market and our bancassurance sales accelerated strongly, with annual premium equivalent sales 25% higher than in 2004. Our share of net mortgage lending, assisted by the launch of the First Active brand, reached 8% in 2005. Our credit card business, meanwhile, made excellent headway in marketing through branch channels; we gained 60% more credit card customers in our core NatWest and RBS brands in the second half than in the same period of 2004.

25




Operating and financial review continued

Retail Banking

  2005
£m
  2004
£m




Net interest income 3,175   3,076
Non-interest income 2,258   2,504




Total income 5,433   5,580




Direct expenses      
       – staff costs 1,026   964
       – other 311   313




  1,337   1,277




Insurance net claims 486   702




Contribution before impairment losses 3,610   3,601
Impairment losses 601   389




Contribution 3,009   3,212



       
  31 December
2005
£bn
  1 January
2005
£bn




Total banking assets 77.1   72.8
Loans and advances to customers – gross      
       – mortgages 47.3   44.1
       – personal 13.7   13.2
       – business 16.3   15.3
Customer deposits 77.7   71.9
Weighted risk assets 54.0   51.1





Retail Banking total income for 2005 of £5,433 million and contribution of £3,009 million were adversely affected by the implementation of IAS 32, IAS 39 and IFRS 4 on 1 January 2005. Contribution before impairment losses increased to £3,610 million.

Overall customer numbers have increased since December 2004 with personal customers up 274,000 (2%) and registered internet customers up 30%. During 2005 we continued to demonstrate our commitment to customer service, with significant progress in terms of the proportion of our customers who are “extremely’’ satisfied and we are making pleasing progress in the current account switcher market. Among the high street banks, Royal Bank of Scotland ranks first for customer satisfaction with NatWest now in joint second place. NatWest remains the number one bank for students. In 2005, 44% of first year students in England and Wales chose to open new accounts with us compared with 42% in 2004.

Against the backdrop of a slower rate of growth in consumer borrowing, we have delivered robust business growth in average loans and advances, especially mortgage lending with particularly good growth in higher margin products such as the offset mortgage. Average unsecured personal lending, where we took further steps to enhance our focus on high quality new business, was also up. Average customer deposits grew, with particularly good inflows into savings products.

Net interest income was £3,175 million. Net interest margin was lower in 2005 than in 2004 with increased product margins offsetting mix effects. Spreads in mortgages and some savings products improved in the latter part of the year.

Non-interest income fell by 10% to £2,258 million. Growth in income from core personal and small business banking services, and good progress in our private banking and investment businesses were more than offset by the affect of IAS 39 and IFRS 4 on recognition of fee income and bancassurance income.

Direct expense grew by 5%, partly due to investment in future income initiatives in the second half. Staff costs increased by 6% to £1,026 million as a result of continued investment in customer-facing staff with over 500 additional customer advisors in branches, an increase in telephone banking advisors, and continued expansion of our bancassurance and investment businesses. We continue to make efficiency gains in other areas resulting in a decrease in other costs to £311 million.

Net claims in bancassurance, which under IFRS include maturities, surrenders and liabilities to policyholders, were £486 million compared with £702 million in 2004.

Impairment losses increased by 54% or £212 million to £601 million. The increased charge principally reflects the implementation of IAS 39 from 1 January 2005 and the growth in lending over recent years, including 17% growth in 2004. We have taken further steps to refine our credit policy and improved our recoveries process. Mortgage arrears remain very low. The average loan-to-value ratio on new mortgages written in 2005 was 62% and on the stock of mortgages was 46%. Small business credit quality remains stable.

26




Retail Direct

  2005
£m
  2004
£m




Net interest income 882   782
Non-interest income 1,084   995




Total income 1,966   1,777




Direct expenses      
       – staff costs 230   220
       – other 375   359




  605   579




Contribution before impairment losses 1,361   1,198
Impairment losses 571   313




Contribution 790   885



       
  31 December
2005
£bn
  1 January
2005
£bn




Total assets 27.2   23.0
Loans and advances to customers – gross      
       – mortgages 13.8   9.4
       – cards 9.5   9.3
       – other 4.0   3.8
Customer deposits 2.7   2.8
Weighted risk assets 20.5   19.4





Total income rose by 11% to £1,966 million and contribution before impairment losses by 14% to £1,361 million, a strong performance in the context of slower growth in demand for unsecured credit. This performance reflected disciplined pricing, tight cost control and stringent credit assessment. Contribution after impairment losses decreased by 11% to £790 million.

During the year, the number of customer accounts increased by 734,000, 4%. In the light of changing market conditions we have focussed our marketing efforts on existing customers, and this has resulted in very strong growth in our core NatWest and RBS brands. We gained 336,000 credit card accounts in these brands in the second half of 2005, 60% more than in the equivalent period of 2004.

Net interest income increased by 13% to £882 million, reflecting the success of the First Active brand in the UK mortgage market and the maturing of the MINT portfolio. Average loans and advances rose strongly with the fastest growth coming in mortgages. Personal loan growth slowed, reflecting strategic decisions taken over the last 18 months to reposition pricing and tighten lending criteria for personal loans sold directly.

Net interest margin was only slightly lower than in 2004, as wider margins on our cards portfolio balanced the effects of the increasing weight of mortgage assets in our loan book.

Non-interest income was up 9% to £1,084 million, benefiting from higher volumes in both domestic and international card acquiring, strong sales through Tesco Personal Finance, the introduction of balance transfer fees and good growth in Europe.

Expenses increased by 4% to £605 million, with stringent cost control across all activities, including reduced marketing costs on personal loans. This was consistent with our more cautious approach to direct lending and with our successful focus on recruitment of customers through branches.

Impairment losses rose by 82% to £571 million, reflecting higher lending volumes, the increase in personal arrears signalled at the end of 2004 and the effect of implementing IAS 39 from 1 January 2005. There are some signs of a stabilisation of credit quality, assisted by the tightening of lending criteria. Mortgage arrears remain very low. The average loan-to-value ratio on new mortgages written in 2005 was 51% and on the stock of mortgages was 44%.

27




Operating and financial review continued

Wealth Management

  2005
£m
  2004
£m




Net interest income 442   403
Non-interest income 372   370




Total income 814   773




Expenses      
       – staff costs 258   262
       – other 135   136




  393   398




Contribution before impairment losses 421   375
Impairment losses 13   18




Contribution 408   357



       
  31 December
2005
£bn
  1 January
2005
£bn




Loans and advances to customers – gross 7.8   7.1
Investment management assets – excluding deposits 25.4   21.6
Customer deposits 25.5   22.3
Weighted risk assets 6.1   6.0




Total income rose by 5% to £814 million, reflecting good growth across all our businesses, and contribution was 14% higher at £408 million. Coutts UK and Adam & Co both gained good numbers of customers, with Coutts up 7% and Adam up 11%. 2005 also saw the continuation of rapid growth in Asia, where the number of private bankers increased by 20%, with particular emphasis placed on recruitment for the Chinese and Indian markets.

Net interest income increased by 10% to £442 million. Strong growth in average customer loans and deposits was partiallly offset by lower net interest margin due to a change in the mix of business.

Non-interest income was steady at £372 million. Average assets under management rose 9% to £23.1 billion as a result of good new business volumes in Coutts UK and the rise in equity markets. Assets under management at the year end were £25.4 billion, an increase of 18%.

Expenses decreased by 1% to £393 million, reflecting a continued focus on efficiency. Despite continued investment in growth markets in both the UK and overseas, staff costs were 2% lower than in 2004. Other costs reduced to £135 million.

Impairment losses amounted to £13 million, down £5 million.

28




Ulster Bank

  2005
£m
  2004
£m




Net interest income 655   550
Non-interest income 203   193




Total income 858   743




Expenses      
       – staff costs 191   172
       – other 79   79




  270   251




Contribution before impairment losses 588   492
Impairment losses 58   40




Contribution 530   452



       
  31 December
2005
£bn
  1 January
2005
£bn




Total assets 35.9   28.7
Loans and advances to customers – gross      
       – mortgages 13.2   10.1
       – other 15.0   12.9
Customer deposits 15.9   13.6
Weighted risk assets 22.4   18.6
Average exchange rate – 1.463   1.474
Spot exchange rate – 1.457   1.418





Total income increased by 15% to £858 million, with contribution up 17% to £530 million, as Ulster Bank achieved another year of strong growth, with excellent customer recruitment, robust lending volumes and very good growth in deposits. First Active continues to perform well and in line with our integration plan. It led the Republic of Ireland market with the introduction of new mortgage products, as well as launching new credit card and direct loan products.

The number of personal and business customers increased by 68,000 in the year. Ulster Bank personal customer numbers rose by 9% in the Republic of Ireland, where our switcher mortgage product has helped us to gain market share. In Northern Ireland, Ulster Bank significantly enhanced its personal current account offering in the fourth quarter to provide free banking to all customers.

Net interest income rose by 19% to £655 million. Average loans and advances and average customer deposits both grew strongly. However, the continuing strong growth in mortgages and business loans led to a decline in net interest margin.

Non-interest income increased by £10 million or 5% to £203 million. This reflected increased volumes of customer transactions and good growth in income from financial markets services.

Expenses increased by 8% to £270 million, as a result of investment to support the growth of the business. This investment will continue into 2006. We have continued with our branch improvement programme, upgrading 50 branches in the Republic of Ireland and 39 in Northern Ireland.

Impairment losses increased by £18 million to £58 million, reflecting the growth in lending.

29






Operating and financial review continued

Citizens

  2005
£m
  2004
£m




Net interest income 2,122   1,609
Non-interest income 1,142   659




Total income 3,264   2,268




Expenses      
       – staff costs 819   580
       – other 739   500




  1,558   1,080




Contribution before impairment losses 1,706   1,188
Impairment losses 131   117




Contribution 1,575   1,071



       
  31 December
2005
US$bn
  1 January
2005
US$bn




Total assets 158.8   141.7
Loans and advances to customers – gross 104.6   91.7
Customer deposits 106.3   99.2
Weighted risk assets 106.4   93.5
Average exchange rate – US$/£ 1.820   1.832
Spot exchange rate – US$/£ 1.721   1.935





Citizens performed well in 2005, delivering a strong underlying performance in challenging market conditions both from the old Citizens franchise and from Charter One. Total income, in US dollars, rose by 43% to $5,940 million and contribution by 46% to $2,867 million, including a full year’s contribution from Charter One. Excluding Charter One and other acquisitions, income rose by 7% and contribution by 10%, despite the impact of the flattening of the yield curve, which reduced net interest margin and the rate of growth in net interest income.

We have grown our customer numbers in both personal and business segments, with Charter One increasing its small business and corporate customer base by 10%. Co-operation between Citizens and RBS Corporate Markets is yielding good results. Citizens’ new international cash management service has already won nearly 300 new accounts with existing RBS customers, bringing in more than $80 million of new core deposits.

Our cards businesses, which are only active in the prime and superprime segments, have made good progress. Credit card balances increased by 19% to $2.5 billion, as RBS National launched into a number of new channels such as Charter One branches. RBS Lynk, our merchant acquiring business, increased its customer base by 24%.

The integration of Charter One progressed well and all phases of the IT conversion were completed in July 2005, five months ahead of schedule. This involved the conversion to Citizens’ systems of over 750 branches and three million customer accounts spread over a wide geography. Despite the focus on the integration process, Charter One achieved good growth in business volumes, with loans and advances up 18% over the course of the year and customers deposits up 10%.

Net interest income increased by 31% to $3,861 million. This reflected strong growth in both lending and deposits. Excluding acquisitions, average lending increased by 13% or $6.7 billion, with robust growth in secured consumer lending, and average customer deposits by 9% or $5.7 billion. However, as a consequence of the flattening yield curve, net interest income excluding acquisitions was only 4% higher at $2,534 million.

Non-interest income was up 72% to $2,079 million. Excluding acquisitions, non-interest income grew by 15% to $1,004 million, benefiting from higher fee income, increased student loan and leasing activities, and investment gains.

Expenses were up 43% to $2,834 million. Expense growth, excluding acquisitions, was contained to 6%.

Impairment losses, including acquisitions, were up $25 million to $239 million. Credit quality overall remained stable. More than 90% of our personal sector lending is secured, and as a result there was minimal impact from the change in US bankruptcy laws in 2005.

30






RBS Insurance

  2005
£m
    2004
£m
 






Earned premiums 5,641     5,507  
Reinsurers’ share (246 )   (454 )






Insurance premium income 5,395     5,053  
Net fees and commissions (449 )   (481 )
Other income 543     467  






Total income 5,489     5,039  






Expenses          
       – staff costs 323     304  
       – other 413     314  






  736     618  






Gross claims 3,903     3,826  
Reinsurers’ share (76 )   (268 )






Net claims 3,827     3,558  






Contribution 926     863  





           
  31 December
2005
    31 December
2004
 






In-force policies (000’s)          
       – Motor: UK 8,687     8,338  
       – Motor: Continental Europe 1,862     1,639  
       – Non-motor (including home, rescue, pet, HR24): UK 10,898     10,464  
General insurance reserves – total (£m) 7,776     7,379  







RBS Insurance produced a good performance in 2005, with total income increasing by 9% to £5,489 million and contribution by 7% to £926 million. The integration of Churchill was completed in September 2005, ahead of plan, and Churchill delivered greater transaction benefits than anticipated at the time of the acquisition. Following the integration of Churchill, all our direct general insurance businesses in the UK now operate on a common platform.

RBS Insurance achieved 4% growth in UK motor policies in force. In achieving this against a background of very strong competition in UK motor insurance, we benefited from the strength of our brands and the diversity of our distribution channels. Growth came through our direct brands, through our partnership business, where we operate insurance schemes on behalf of third parties who in turn sell insurance products to their customers, and through NIG, our intermediary business acquired as part of Churchill. Our businesses in Spain, Germany and Italy together delivered 14% growth in motor policies in force. Linea Directa, our joint venture with Bankinter, increased its customer base by 17% and, with more than 1 million policies, is the largest direct motor insurer and sixth largest motor insurer in Spain.

Total home insurance policies declined by 1%. Within this total, we continued to expand through our direct brands but there was attrition of some partner-branded books.

In addition to expanding its intermediary business in motor and home insurance, NIG achieved 10% growth in commercial policies sold to SMEs.

Expenses rose by 19%. Excluding the impact of a change in reinsurance arrangements, total income rose by 6% and expenses by 9%. Net insurance claims on the same basis were up by 5%, reflecting increased volumes, claims inflation in motor and an increase in home claims following severe storms in the UK in January 2005.

The UK combined operating ratio for 2005 was 93.6%.

31






Operating and financial review continued

Manufacturing

  2005
£m
  2004
£m




Staff costs 740   753
Other costs 2,003   1,799




Total manufacturing costs 2,743   2,552



Analysis:      
Group Technology 945   852
Group Purchasing and Property Operations 1,013   927
Customer Support and other operations 785   773




Total manufacturing costs 2,743   2,552




Manufacturing’s costs increased by 7% to £2,743 million. Excluding software amortisation, costs rose by 4%. Costs relating to internal software development, which under UK GAAP were written off as incurred, are now under IFRS capitalised and amortised.

Group Technology costs increased by 11% to £945 million. Excluding software amortisation, costs were up 2%, with support for increased business volumes offset by efficiency improvements. The Group Efficiency Programme was substantially completed during the year, with major implementations such as a new system for handling customer queries and a new customer account-opening platform. The Churchill systems integration was completed in September 2005.

Group Purchasing and Property Operations costs increased by 9% to £1,013 million. We improved the efficiency of our property utilisation in 2005 while continuing our programme of investment both in the branch networks and in our major operational centres, including Birmingham, Manchester and our new headquarters in Edinburgh.

Customer Support and other operations costs rose by just 2%, despite a much greater increase in the business volumes supported. Cash withdrawals from ATMs, for example, rose by 13%, while we handled 10% more mortgage applications and 7% more personal loan volumes. These increases were absorbed by improved efficiency through the delivery of new systems and ways of working.

32






Central items

  2005
£m
  2004
£m




Funding costs 810   274
Departmental and corporate costs 658   391




Total Central items 1,468   665




Total central items increased by £803 million to £1,468 million.

Funding costs at £810 million, were up £536 million largely because of the full year funding cost of the acquisition of Charter One in August 2004 and the effect of implementing IAS 32 (reclassification of funding costs on preference shares and trust preferred securities from dividends payable and minority interests respectively to interest payable). The Group’s primary objective is to hedge its economic risks. So as not to distort divisional results, volatility attributable to derivatives in economic hedges that do not meet the criteria in IFRS for hedge accounting is transferred to the Group’s central treasury function. This resulted in a charge of £45 million, in addition to a charge for £14 million for hedge ineffectiveness under IFRS.

Central departmental costs and other corporate items at £658 million were £267 million higher than 2004. This was principally due to higher pension costs and the centralisation of certain functions, and includes ongoing expenditure on regulatory projects such as Basel II and Sarbanes-Oxley Section 404.

Employee numbers at 31 December      
  2005   2004




Corporate Markets 15,700   16,800
Retail Banking 33,100   32,200
Retail Direct 6,800   7,000
Wealth Management 4,200   4,100
Ulster Bank 4,400   4,100
Citizens 24,400   24,000
RBS Insurance 19,400   19,500
Manufacturing 26,800   26,900
Centre 2,200   2,000




Group total 137,000   136,600




2005 compared with 2004

The number of employees increased by 400 to 137,000, with increases in Retail Banking, Citizens and Ulster Bank partly offset by a reduction in Corporate Markets.

33






Operating and financial review continued

Consolidated balance sheet at 31 December 2005

  31 December
2005
£m
  1 January
2005
£m
  31 December
2004
£m






Assets          
Cash and balances at central banks 4,759   4,293   4,293
Treasury bills and other eligible bills 5,538   6,109   6,110
Loans and advances to banks 70,587   65,691   61,073
Loans and advances to customers 417,226   381,162   347,251
Debt securities 120,965   93,915   93,908
Equity shares 9,301   5,231   4,723
Intangible assets 19,932   19,242   19,242
Property, plant and equipment 18,053   16,425   16,428
Settlement balances 6,005   5,682   5,682
Derivatives at fair value 95,663   89,905   17,800
Prepayments, accrued income and other assets 8,798   8,855   11,612






Total assets 776,827   696,510   588,122





Liabilities          
Deposits by banks 110,407   106,026   99,883
Customer accounts 342,867   315,046   283,315
Debt securities in issue 90,420   66,245   63,999
Settlement balances and short positions 43,988   33,339   32,990
Derivatives at fair value 96,438   91,277   18,876
Accruals, deferred income and other liabilities 14,247   14,720   17,648
Retirement benefit liabilities 3,735   2,940   2,940
Deferred taxation liabilities 1,695   1,826   2,061
Insurance liabilities 7,212   6,592   8,647
Subordinated liabilities 28,274   27,526   20,366






Total liabilities 739,283   665,537   550,725
           
Equity          
Minority interests 2,109   951   3,492
Shareholders’ equity          
    Called up share capital 826   822   822
    Reserves 34,609   29,200     33,083
Total equity 37,544   30,973   37,397
           






Total liabilities and equity    776,827   696,510   588,122





Analysis of repurchase agreements included above          
           
Reverse repurchase agreements and stock borrowing          






Loans and advances to banks 41,804   34,475   29,975
Loans and advances to customers 48,887   64,599   52,184






  90,691   99,074   82,159





Repurchase agreements and stock lending          






Deposits by banks 47,905   47,841   43,342
Customer accounts 48,754   54,485   42,134






  96,659   102,326   85,476





34





Overview of consolidated balance sheet

31 December 2005 compared with 31 December 2004

Total assets of £776.8 billion at 31 December 2005 were up £188.7 billion, 32%, compared with 31 December 2004, with £108.4 billion of this increase arising from the implementation of IAS 32, IAS 39 and IFRS 4 on 1 January 2005, and the balance reflecting business growth.

Treasury bills and other eligible bills decreased by £0.6 billion, 9%, to £5.5 billion, reflecting trading activity.

Loans and advances to banks rose £9.5 billion, 16%, to £70.6 billion. Of the increase, £4.6 billion was due to the implementation of IAS 32 and IAS 39, and the balance reflected growth in reverse repurchase agreements and stock borrowing (“reverse repos”), which increased by £7.3 billion, 21%, to £41.8 billion. This was partially offset by a decrease in bank placings, down £2.4 billion, 8% to £28.8 billion.

Loans and advances to customers were up £70.0 billion, 20%, at £417.2 billion of which £33.9 billion resulted from the implementation of IAS 32 and IAS 39, mainly due to the grossing up of previously netted customer balances. Customer lending was up £51.8 billion, 16%, reflecting organic growth across all divisions while reverse repos were down 24%, £15.7 billion to £48.9 billion.

Debt securities increased by £27.1 billion, 29%, to £121.0 billion, principally due to increased holdings in Corporate Markets.

Equity shares rose £4.6 billion, 97%, to £9.3 billion with most of the increase, £4.1 billion, 78%, mainly due to increased activity in Corporate Markets. Implementation of IAS 39 added £0.5 billion.

Intangible assets increased by £0.7 billion, 4% to £19.9 billion largely due to exchange rate movements.

Property, plant and equipment were up £1.6 billion, 10% to £18.1 billion, principally as a result of growth in operating lease assets.

Derivatives at fair value were higher by £77.9 billion at £95.7 billion, including £72.1 billion resulting from the implementation of IAS 32 and IAS 39, with £71.5 billion arising from the grossing up of previously netted balances. The remainder of the increase, £5.8 billion, 6%, primarily reflected higher trading volumes and movements in interest and exchange rates.

Prepayments, accrued income and other assets decreased by £2.8 billion, 24% to £8.8 billion, mainly due to the implementation of IAS 32 and IAS 39.

Deposits by banks increased by £10.5 billion, 11% to £110.4 billion, of which £6.1 billion arose from the implementation of IAS 32 and IAS 39. The remaining £4.4 billion was raised to fund business growth mainly higher inter-bank deposits, up £4.3 billion, 7% to £62.5 billion. Repurchase agreements and stock lending (‘’repos’’) were largely flat at £47.9 billion.

Customer accounts were up £59.6 billion, 21% at £342.9 billion with £31.7 billion arising from the implementation of IAS 32 and IAS 39, largely reflecting the grossing up of previously netted deposits. Deposits rose by £33.5 billion, 13%, to £294.1 billion with good growth in all divisions. Repos decreased by £5.7 billion, 11% to £48.8 billion.

Debt securities in issue increased by £26.4 billion, 41%, to £90.4 billion, with £2.2 billion resulting from the implementation of IAS 39, and £24.2 billion raised primarily to meet the Group's funding requirements.

The increase in settlement balances and short positions, up £11.0 billion, 33%, largely reflected growth in customer activity.

Derivatives at fair value were up £77.6 billion to £96.4 billion, including £72.4 billion resulting from the implementation of IAS 32 and IAS 39, with £71.5 billion arising from the grossing up of previously netted balances. The remainder of the increase, £5.2 billion, 6% primarily reflected higher trading volumes and movements in interest and exchange rates.

Accruals, deferred income and other liabilities decreased by £3.4 billion, 19% to £14.2 billion, largely due to the implementation of IAS 32 and IAS 39.

Subordinated liabilities were up £7.9 billion, 39% to £28.3 billion, including £7.2 billion due to the reclassification as debt of the majority of the Group’s existing preference share capital and non-equity minority interests following the implementation of IAS 32 and IAS 39. The balance, £0.7 billion, reflected the issue of £1.2 billion dated loan capital and exchange rate movements of £1.3 billion which were partially offset by the redemption of £1.6 billion non-cumulative preference shares and dated loan capital.

Minority interests decreased £1.4 billion, 40% to £2.1 billion, due to the reclassification of £2.6 billion as debt following the implementation of IAS 32 and IAS 39. This more than offset the increase in minority interests of £1.2 billion to £2.1 billion principally due to the co-investors interest in the Group’s subsidiary that invested in Bank of China and the issuance of preferred securities.

Shareholders’ equity increased by £1.5 billion, 5%, to £35.4 billion. The implementation of IAS 32 and IAS 39 reduced shareholders’ equity by £3.9 billion, largely as a result of the reclassification as debt of the majority of the Group’s preference share capital, £3.3 billion. The profit for the period of £5.5 billion, issue of £1.6 billion non-cumulative equity preference shares and £0.3 billion of ordinary shares in respect of scrip dividends and the exercise of share options, were partly offset by the payment of the 2004 final ordinary dividend, £1.3 billion, and the 2005 interim ordinary dividend, £0.6 billion, preference dividends of £0.1 billion and £0.6 billion actuarial losses, net of tax, recognised in post-retirement benefit schemes.

The fair value of the assets of the Group’s post-retirement benefit schemes was £17.4 billion (2004 - £14.8 billion) and the present value of defined benefit obligations was £21.1 billion (2004 - £17.7 billion). The increase in net pension liability (after tax) to £2.7 billion from £2.1 billion is principally due to movements in interest rates. The mortality assumptions used in the valuation of liabilities were updated at the end of 2004 and have not been changed.

35






Operating and financial review continued

Cash flow

  2005
£m
    2004
£m
 






Net cash flows from operating activities 8,950     2,493  
Net cash flows from investing activities (2,612 )   (9,398 )
Net cash flows from financing activities (703 )   7,119  
Effects of exchange rate changes on cash and cash equivalents (3,107 )   1,686  






Net increase in cash and cash equivalents 2,528     1,900  





2005

The major factors contributing to the net cash inflow of £8,950 million from operating activities in 2005 were the profit before tax of £7,936 million, increases in deposits and debt securities in issue of £56,571 million, and increases in short positions and settlement balances of £10,326 million, partially offset by increases in securities of £28,842 million and in loans and advances of £36,778 million.

Net purchases of fixed assets, including operating lease assets and computer and other equipment, of £2,592 million were the main contributor to the net cash outflow from investing activities of £2,612 million.

The issue of £1,649 million preference shares and £1,234 million subordinated debt were more than offset by dividend payments of £2,007 million and the repayment of £1,553 million of subordinated liabilities, resulting in a net cash outflow from financing activities of £703 million.

2004

The major factors contributing to the net cash inflow of £2,493 million from operating activities in 2004 were the profit before tax of £7,284 million, increases in deposits and debt securities in issue of £72,146 million, and in short positions and settlement balances of £8,796 million, partially offset by increases in securities of £11,883 million and in loans and advances of £72,955 million.

Net purchases of fixed assets, including operating lease assets and computer and other equipment, of £2,662 million and net investment in business interests and intangible assets of £7,968 million led to the net cash outflow from investing activities of £9,398 million.

The issue of £1,358 million preference shares and £2,845 million ordinary shares, and £4,624 million subordinated liabilities, partly offset by the payment of £1,635 million of dividends, were the main contributors to the net cash inflow from financing activities of £7,119 million.

36






IFRS compared with US GAAP

The Group’s financial statements are prepared in accordance with IFRS, which differ in certain material respects from US GAAP as described on pages 173 to 178.

The net income available for ordinary shareholders under US GAAP was £4,475 million, £917 million lower than profit attributable to ordinary shareholders under IFRS of £5,392 million. The principal reasons for the decrease are:

  • a reduction of £556 million relating to financial instruments principally foreign exchange gains on available-for-sale securities recognised in net income under IFRS but included directly in equity under US GAAP together with the adjustment for financial assets and liabilities designated as at fair value through profit or loss; US GAAP does not permit such designation.

  • higher pension costs under US GAAP compared with IFRS reflecting the deferral of actuarial gains and losses over the remaining service lives of current employees under US GAAP; such gains and losses are recognised in full in equity under IFRS.

US GAAP shareholders’ equity at £40,229 million is £4,794 million higher than IFRS equity of £35,435 million principally due to the inclusion of certain preference shares, classified as debt under IFRS, equity under US GAAP, the reinstatement of goodwill deducted from equity under previous GAAP, and the effect of deferring and amortising loan origination costs.

Capital resources

It is the Group’s policy to maintain a strong capital base, to expand it as appropriate and to utilise it efficiently throughout its activities to optimise the return to shareholders while maintaining a prudent relationship between the capital base and the underlying risks of the business. In carrying out this policy, the Group has regard to the supervisory requirements of the FSA. The FSA uses Risk Asset Ratio (“RAR”) as a measure of capital adequacy 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, the Group’s total RAR was 11.7% and the tier 1 RAR was 7.6%.

Upon the adoption of IFRS by listed banks in the UK on 1 January 2005, the Financial Services Authority ("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 has been presented in compliance with these revised FSA requirements.

                        2005 - IFRS
£m
 














Capital base                          
Tier 1 capital                       28,218  
Tier 2 capital                       22,437  



                        50,655  
Less: investments in insurance subsidiaries, associated                          
       undertakings and other supervisory deductions                       (7,282 )



Total capital                       43,373  
                     

Weighted risk assets                          
Banking book:                          
       On-balance sheet                       303,300  
       Off-balance sheet                       51,500  
Trading book                       16,200  



                        371,000  
                     

                           
Risk asset ratios                       %  



Tier 1                       7.6  
Total                       11.7  














                           
The data set forth below are in accordance with the FSA regulations in force at the time and are based on UK GAAP.
                           
      2004 - UK GAAP
£m
    2003 - UK GAAP
£m
    2002 - UK GAAP
£m
    2001 - UK GAAP
£m
 














Capital base                          
Tier 1 capital     22,694     19,399     17,155     15,052  
Tier 2 capital     20,229     16,439     13,271     11,734  
Tier 3 capital     ––             172  














      42,923     35,838     30,426     26,958  
Less: investments in insurance subsidiaries, associated                          
       undertakings and other supervisory deductions     (5,165 )   (4,618 )   (3,146 )   (2,698 )














Total capital     37,758     31,220     27,280     24,260  
 
Weighted risk assets                          
Banking book:                          
       On-balance sheet     261,800     214,400     193,800     176,000  
       Off-balance sheet     44,900     36,400     28,700     22,000  
Trading book     17,100     12,900     11,500     12,500  














      323,800     263,700     234,000     210,500  
 
                           
Risk asset ratios     %     %     %     %  














Tier 1     7.0     7.4     7.3     7.1  
Total     11.7     11.8     11.7     11.5  














 

37






Operating and financial review continued

Risk management

Governance framework

The Board sets the overall risk appetite and philosophy for the Group. Various Board and executive 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 a board 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 foreign exchange, intra-group limits, capital adequacy and capital raising across the Group as well as interest rate risk in the banking book. In addition, GALCO monitors and reviews external, economic and environmental changes affecting such risks.

These Committees are supported by two dedicated group level functions, Group Risk Management (“GRM”), which has responsibility for credit, market, regulatory and enterprise risk 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. Heads of Group Risk Mangement and Internal Audit have direct access to the Group Chief Executive and the Chairman of the Group Audit Committee.

38






Risk management

The principal risks that the Group manages are as follows:

  • 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: is 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 risk: the Group is exposed to insurance risk, either directly through its businesses or through using insurance as a tool to mitigate other risk exposures.

  • Enterprise risk: the Group separately defines operational and external risk. Operational risk is defined as the risk arising from the Group’s people, processes, systems and assets. External risk comprises business, political and environmental risk.

  • Regulatory risk: is the risk arising from failing to meet the requirements and expectations of our many regulators, or from a failure to address or implement any change in these requirements or expectations.

Principal risk types

Regulatory risk    
Credit risk Liquidity risk Market risk Insurance risk
Enterprise risk    

Risk appetite

Risk management across the Group is based on the risk appetite and philosophy set by the Board and the associated risk committees. The Board establishes the parameters for risk appetite for the Group through:

  • Setting strategic direction.
  • Contributing to, and ultimately approving annual plans for each division.
  • Regularly reviewing and monitoring the Group’s performance in relation to risk through monthly Board Reports.

The Board delegates the articulation of risk appetite to GEMC and ensures that this is in line with the strategy and the desired risk reward trade off for the Group. Risk appetite is an expression of the maximum level of residual risk that the Group is prepared to accept in order to deliver its business objectives and is assessed against regular (often daily) controls and stress testing to ensure that the limits are not compromised in abnormal circumstances.

Risk appetite is usually defined in both quantitative and qualitative terms. Whilst different techniques are used to ensure that the Group’s risk appetite is achieved, generically they can be classified as follows:

  • Quantitative: encompassing stress testing, risk concentration, value at risk and credit related metrics, including the probability, loss and exposure at default.

  • Qualitative: focuses on ensuring that the Group applies the correct principles, policies and procedures.

The annual business planning and performance management process and associated activities ensure the expression of risk appetite remains appropriate. GRC and GALCO support this work.

Qualitative and quantitative elements of risk management

39




Operating and financial review continued

Risk organisation

Divisional CEOs are specifically responsible for the management of risk within their divisions. As such, they are responsible for ensuring that they have appropriate risk management frameworks that are adequate in design, effective in operation and meet minimum Group standards.

Divisional CEOs are supported by divisional Chief Risk Officers (CROs) and Chief Financial Officers (CFOs). An important element that underpins the Group’s approach to the management of all risk is independence. In the case of CROs, it is enforced by joint reporting lines, both operationally to the divisional CEO and functionally to the Group Chief Risk Officer.

Credit risk

Key principles of credit risk management

The objective of credit risk management is to enable the Group to achieve sustainable and superior risk versus reward performance whilst maintaining credit risk exposure in line with approved risk appetite.

Group Risk Management is responsible for setting standards for maintaining and developing credit risk management throughout the Group. This is achieved via a combination of governance structures, credit risk policies, control processes and credit systems collectively known as the Group’s Credit Risk Management Framework (“CRMF”). The framework is defined in detail in the Group’s ‘Principles for Managing Credit Risk’.

The key principles for credit risk management as defined in the CRMF 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 a review of, amongst other things, 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.

  • Credit risk authority must be specifically granted in writing to all individuals involved in the granting of credit approval, whether this is exercised personally or collectively as part of a credit committee. In exercising credit authority, the individuals must act independently and with balanced commercial judgement.

  • Where credit authority is exercised personally, the individual must not have any responsibility or accountability for business revenue generation.

  • All credit exposures, once approved, must be effectively monitored and managed and reviewed periodically against approved limits. Lower quality exposures are 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.

  • Portfolio analysis and reporting must be used to identify and manage credit risk concentrations and credit risk quality migration.

Each Division must establish its own CRMF consistent with the Group CRMF. Divisional credit departments are responsible for maintaining the CRMF and ensuring that asset quality is within specified parameters. Divisional credit departments are independent of business management and have no direct responsibility or accountability for revenue generation. This independence is supported by the divisional head of credit having dual reporting lines to the both the divisional CEO (via the divisional Chief Risk Officer) and to the Head of Group Credit Risk.

GRM undertakes regular assessment of the effectiveness of each divisional CRMF to ensure it complies with Group standards and is appropriate for the business being undertaken. GRC and the GEMC review reports on the Group’s portfolio of credit risks on a monthly basis.

Credit approval process

Different credit approval processes exist for each customer type in order to ensure appropriate skills and resources are employed in credit assessment and approval whilst following the key principles relating to credit approval.

Wholesale risk exposures are aggregated to determine the appropriate level of credit approval required and to facilitate consolidated credit risk management.

40






Credit authority is not extended to relationship managers:

  • Assessments of corporate borrower and transaction risk are undertaken using a range of credit risk models supplemented, where appropriate, by management judgement. Specialist internal credit risk departments independently oversee the credit process and make credit decisions or recommendations to the appropriate credit committee.

  • Financial Markets counterparties are subject to similar modelling techniques but are approved by a dedicated credit function which specialises in traded market product risk.

Consumer lending and personal businesses employ best practice credit scoring techniques to process small scale, large volume credit decisions. Scores from such systems are combined with management judgement to ensure an effective ongoing process of approval, review and enhancement. Credit decisions for loans above specified thresholds are individually assessed.

Credit risk models

Credit risk models are used throughout the Group to support the analytical elements of the credit risk management framework, in particular the quantitative risk assessment part of the credit approval process, ongoing credit monitoring as well as portfolio level analysis and reporting.

Credit risk modelling governance

The Group’s ‘Principles for Managing Credit Risk’ outline the governance structure under which all credit risk models must be developed, reviewed and approved. GRM is responsible for:

  • Establishing high level standards to which all credit risk models across the Group must adhere and thus ensuring a consistency of approach to credit risk modelling across the Group.

  • Approving all credit risk models prior to implementation and reviewing existing models on at least an annual basis.

Divisional credit risk departments own the particular models and are responsible for:

  • Developing credit risk models appropriate for the types of borrower and facilities in their credit portfolios and obtaining approval from GRM for their implementation.

  • Validating the models on at least an annual basis (every two years for credit risk exposure measurements models) and submitting documentation of these validations to GRM with appropriate recommendations on recalibration, where applicable.

  • Obtaining approval from GRM for any new methodology or parameter estimates used in existing credit risk models prior to implementation.

Credit risk models used by the Group can be broadly grouped into four categories.

  • 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 probability of default. There are a number of different credit grading models in use across the Group, each of which considers particular customer characteristics 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 (see page 42).

  • Exposure at default (“EAD”) – these models estimate the expected level of utilisation of a credit facility at the time of a borrower’s default. The EAD will typically be higher than the current utilisation (e.g. in the case where further drawings are made on a revolving credit facility prior to default) but will not typically exceed the total facility limit. The methodologies used in EAD modelling recognise that customers may make more use of their existing credit facilities in the run up to a default.

  • Loss given default (“LGD”) – these models estimate the economic loss that may be suffered by the Group on a credit facility in the event of default. The LGD of a facility represents the amount of debt which cannot be recovered and is typically expressed as a percentage of the EAD. The Group’s LGD models take into account the type of borrower, facility and any risk mitigation such as the presence of any security or collateral held. The LGD may also be affected by the industry sector of the borrower, the legal jurisdiction in which the borrower operates as well as general economic conditions which may impact the value of any assets held as security.

  • Credit risk 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.
41




Operating and financial review continued

Credit risk assets

Credit risk assets measure the exposure to all products in the Group’s credit portfolios which consist of loans and advances (including overdraft facilities), instalment credit, finance lease receivables, debt securities and other traded instruments across all customer types.

Credit risk assets are typically analysed excluding reverse repurchase agreements due to the short-term nature and low credit risk associated with this product. A breakdown of credit risk assets by division is shown below.

Credit risk assets 2005
£bn
  2004
£bn




   Corporate Markets 273.0   235.2
   Retail Banking 78.0   72.2
   Retail Direct 26.6   21.7
   Wealth Management 8.9   10.7
   Citizens 74.5   59.4
   RBS Insurance 6.7   6.1
   Ulster Bank 30.5   22.3




  498.2   427.6




Excluding reverse repurchase agreements, credit risk assets at 31 December 2005 were £498.2 billion (2004 – £427.6 billion), an increase of £70.6 billion (17%) during the year.

An analysis of reverse repurchase agreements is shown below.

Reverse repurchase agreements 31 December
2005
£bn
  1 January
2005

£bn




   Banks 41.8   34.5
   Customers 48.9   64.6




  90.7   99.1



Reverse repurchase agreements as at 31 December 2005 were £90.7 billion (1 January 2005 – £99.1 billion), a decrease of £8.4 billion (8%) during the year.

Credit risk asset quality

Internal reporting and oversight of risk assets is principally differentiated by credit ratings. Internal ratings are used to assess the credit quality of borrowers. Customers are assigned credit ratings, based on various credit grading models that reflect the probability of default. All credit ratings across the Group map to a Group level asset quality scale.

Expressed as an annual probability of default, the upper and lower boundaries and the midpoint for each of these Group level asset quality grades are as follows:

    Annual probability of default         
Asset quality grade   Minimum %   Midpoint %   Maximum %   S&P equivalent









AQ1   0.02   0.10   0.20   AAA to BBB-
AQ2   0.21   0.40   0.60   BB+ to BB
AQ3   0.61   1.05   1.50   BB- to B+
AQ4   1.51   3.25   5.00   B+ to B
AQ5   5.01   15.00     B and below










Distribution of credit risk assets by asset quality

Overall credit asset quality remained stable during 2005. As at 31 December 2005, exposure to investment grade counterparties (AQ1) accounted for 47% (2004 – 49%) of credit risk assets and 98% (2004 – 97%) of exposures were to counterparties rated AQ4 or higher. The exposure to the lowest asset quality (AQ5) reduced from 2.6% at 31 December 2004 to 2.2% at 31 December 2005.

Note: Graph data are shown net of provisions and reverse repurchase agreements.

42






Distribution of credit risk assets by industry sector

Industry analysis plays an important part in assessing potential concentration risk from within the loan portfolio. Particular attention is given to industry sectors where the Group believes there is a high degree of risk or potential for volatility in the future.

The Group also uses scenario analysis and stress testing in order to monitor the risk to clusters of correlated industry sectors.

Note: Graph data are shown net of provisions and reverse repurchase agreements.


As at 31 December 2005, 30% of credit risk assets (2004 – 30%) relate to individuals (personal and retail customers) and include mortgage lending and other smaller loans that are intrinsically well-diversified. Corporate industry sectors, including public sector and quasi government, account for 48% (2004 – 46%) of credit risk assets, with banks and other financial institutions representing the remaining 22% (2004 – 24%) of credit risk assets.

43






Operating and financial review continued

Distribution of credit risk assets by geography

The Group is currently active in 27 countries, with its principal focus on the UK, North America and Europe.

During 2005 there was further geographic diversification of credit risk assets away from the UK and into the rest of Europe and North America. As at 31 December 2005, 49.3% of credit risk assets were within the UK. North America and Europe account for 45.5% of credit risk assets with the remaining 5.2% in the rest of the world.

Distribution of credit risk assets by product and customer type

The Group also monitors the breakdown of the credit portfolio by customer type and product type. The Group’s largest exposure by credit risk assets is corporate customer lending products which represent 31% of credit risk assets as at 31 December 2005 (2004 – 30%). As illustrated in the industry analysis this exposure is well diversified across industry sectors.

44






Loan impairment

The Group classifies impaired assets as either Risk Elements in Lending (“REIL”) or Potential Problem Loans (“PPL”). REIL represents non-accrual loans, loans that are accruing but are past due 90 days and restructured loans. PPL represent impaired assets which are not included in REIL but where known information about possible credit problems causes management to have serious doubts about the future ability of the borrower to comply with loan repayment terms.

Both REIL and PPL are reported gross of the value of any security held, which could reduce the eventual loss should it occur, and gross of any provision marked. Therefore impaired assets which are highly collateralised, such as mortgages, will have a low coverage ratio of provisions held against reported impaired balance.

The adoption of IAS 39 under IFRS at the start of 2005 resulted in changes to the methodology used to identify impaired assets and therefore the way that REIL is calculated. Comparative financial information is given in the following tables for both 1 January 2005 and 31 December 2004. Commentary is based on comparison with information at 1 January 2005, which reflects the impact of IAS 32, IAS 39 and IFRS 4.

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

REIL and PPL 31 December
2005
£m
  1 January
2005
£m
  31 December
2004
£m






Non-accrual loans(1) 5,926   5,836   4,733
Accrual loans past due 90 days(2) 9   52   713
Troubled debt restructurings(3) 2     24






Total REIL 5,937   5,888   5,470
           
PPL(4) 19   11   280






Total REIL and PPL 5,956   5,899   5,750





REIL and PPL as % of lending to customers loans and advances – gross(5) 1.60%   1.84%   1.92%






* following the implementation of IAS 39, the sub-categories of REIL and PPL are calculated as per notes 1 to 4 below.

(1) All loans against which an impairment provision is held are reported in the non-accrual category.
(2) Loans where an impairment event has taken place but no impairment recognised. This category is used for over-collateralised non-revolving credit facilities.
(3) Troubled debt restructurings represent loans that have been restructured following the granting of a concession by the Group to the borrower.
(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.
(5) Gross of provisions and excluding reverse repurchase agreements.

REIL as at 31 December 2005 was £5,937 million (1 January 2005 – £5,888 million), an increase of £49 million (1%) during the year. As a % of customer lending, REIL and PPL in aggregate show an improving trend, amounting to 1.60% of customer loans and advances at 31 December 2005 (1 January 2005 – 1.84%).

REIL by division

The table below shows REIL by division.

REIL 31 December
2005
£m
  1 January
2005
£m
  31 December
2004
£m






   Corporate Markets 1,465   2,098   1,892
   Retail Banking 2,988   2,526   2,399
   Retail Direct 889   671   601
   Wealth Management 58   65   99
   Ulster Bank 342   389   341
   Citizens 195   136   135
   RBS Insurance   3   3






Total REIL 5,937   5,888   5,470

During 2005 REIL in Corporate Markets reduced by £633 million reflecting continued favourable conditions in the corporate environment in UK, Europe and the US. This was offset by a combined increase in REIL in Retail Banking and Retail Direct of £680 million (21%) due to the weakening of the consumer environment in the UK.

45




Operating and financial review continued

Impairment loss provision methodology

Provisions for impairment losses 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 provisions on impaired credits below an agreed threshold which are assessed on a portfolio basis, to reflect the homogeneous nature of the assets, such as credit cards or personal loans. The provision is determined from a quantitative review of the relevant portfolio, taking account of the level of arrears, security and average loss experience over the recovery period.

Latent loss provisions are provisions held against the estimated impairment in the performing portfolio which have yet to be identified as at the balance sheet date. To assess the latent loss within the portfolios, the Group has developed methodologies to estimate the time that an asset can remain impaired within a performing portfolio before it is identified and reported as such.

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 by experienced specialists, as well as professional valuations of collateral and the expert judgement of accountants. The Group operates a clear provisions governance framework which sets thresholds whereby suitable oversight and challenge is undertaken. These opinions and levels of provision are overseen by the division’s Provision Committee chaired by its Chief Executive, with representation from Group Risk Management. In addition, significant cases are presented to, and challenged by, the Group Problem Exposure Review Forum chaired by the Group Chief Executive or the Group Finance Director.

Early and active 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.

The adoption of IAS 39 under IFRS at the start of 2005 resulted in changes to the methodology used to identify impaired assets and to calculate required provisions.

Loan impairment charge 2005
£m
  2004
£m




Latent loss provisions charge 14    
Collectively assessed provisions charge 1,399    
Individually assessed provisions charge 290    
Specific provision charge     1,386
General provision charge     16




Total charge to income statement 1,703   1,402


Charge as a % of customer loans and advances – gross(1) 0.46%   0.47%




  Notes:
(1) Gross of provisions and excluding reverse repurchase agreements.

Provisions for loan impairment charged to the income statement in 2005 were £1,703 million, up £301 million (21%) from 2004. As a percentage of customer lending, the impairment charge improved slightly from 0.47% to 0.46%.

46






Summary of loan impairment provisions

A summary of the total customer provisions balance is shown in the table below.

Loan impairment provisions(1) 31 December
2005
£m
  1 January
2005
£m
  31 December
2004
£m






Latent loss provisions 543   570    
Collectively assessed provisions 2,587   2,484    
Individually assessed provisions 754   1,086    
Specific provisions         3,607
General provision         561






Total provisions 3,884   4,140   4,168





Total provision as a % of customer loans and advances – gross(2) 1.0%   1.3%   1.4%






  Notes:
(1) Excludes provisions against loans and advances to banks of £3 million (1 January 2005 – £5 million; 31 December 2004 – £6 million).
(2) Gross of provisions and excluding reverse repurchase agreements.

As at 31 December 2005 total customer provisions were £3,884 million, down £256 million (6%) from 1 January 2005. The movement in provisions balance is shown at the bottom of the page.

Provisions coverage

The Group’s provision coverage ratios are shown in the table below.

  31 December
2005
  1 January
2005
  31 December
2004






Total provision expressed as a:          
% of REIL 65%   70%   76%
% of REIL and PPL 65%   70%   72%







The coverage ratio of closing provisions to REIL and PPL decreased from 70% to 65% during 2005. The lower coverage ratio reflects a change of mix in the portfolios to more secured assets (e.g. residential mortgages) which, due to the level of collateral held, require a much lower level of provision.

Movement in loan impairment provisions balance

The movement in provisions balance during 2005 is shown in the table below.

  £m  



Balance as at 1 January 2005 4,145  
Currency and other adjustments 51  
Amounts written-off (2,040 )
Recoveries of amounts previously written-off 172  
Charge to income statement 1,703  
Discount unwind(1) (144 )



Balance as at 31 December 2005(2) 3,887  


  Notes:
(1) The impact of discounting inherent within the provisions balance is unwound as the time to receiving the expected recovery cash flows draws nearer.
(2) Includes provisions against loans and advances to banks of £3 million (1 January 2005 – £5 million).

An impairment provision calculated using the effective interest rate method leaves a discounted asset; the discount unwinds at a constant effective rate until the outstanding asset is completely realised.

47






Operating and financial review continued

Liquidity risk

Liquidity risk management within the Group focuses on both overall balance sheet structure and the day-to-day control, within prudent limits, of risk arising from the mismatch of maturities across the balance sheet and from undrawn commitments and other contingent obligations.

The management of liquidity risk within the Group is undertaken within limits and other policy parameters set by GALCO, which reviews monthly, and receives on an exception basis, reports detailing compliance with those policy parameters. A weekly report is also provided to the Group’s executive management. Compliance is monitored and coordinated daily under the stewardship of the Group Treasury function, both in respect of internal policy and the regulatory requirements of the Financial Services Authority.

Detailed liquidity position reports are compiled each day by Group Treasury and reviewed daily and weekly with Financial Markets, who manage day-to-day and intra-day market execution within the policy parameters set.

In addition to their consolidation within the Group’s daily liquidity management process, it is also the responsibility of all Group subsidiaries and branches outside the UK to ensure compliance with any separate local regulatory liquidity requirements where applicable, subject to Group Treasury oversight.

Diversification of funding sources

The structure of the Group’s balance sheet is managed to maintain substantial diversification, to minimise concentration across its various deposit sources, and to contain the level of reliance on total and net short-term wholesale sources of funds within prudent levels. As part of the Group’s planning process, the forecast structure of the balance sheet is regularly reviewed over the plan horizon and funding strategies and options are developed by Group Treasury and implemented after review and approval by GALCO.

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 regularly to monitor concentration and identify any adverse trends. During 2005 the composition of the Group’s funding sources remained well diversified by counterparty, instrument, market and maturity.

Sources of funding 2005
£m
  %   2004
£m
  %








Customer accounts (excluding repos)              
       Repayable on demand 172,853   27   169,016   32
       Time deposits 121,260   19   72,165   14








Total customer accounts (excluding repos) 294,113   46   241,181   46
Debt securities over 1 year remaining maturity 22,293   3   9,931   2
Subordinated liabilities 28,274   4   20,366   4
Shareholders’ equity 35,435   6   33,905   6








  380,115   59   305,383   58
Debt securities up to 1 year remaining maturity 68,127   11   54,068   10
Repo agreements with customers 48,754   7   42,134   8
Deposits by banks (excluding repos) 62,502   10   56,541   11
Repo agreements with banks 47,905   7   43,342   8
Short positions 37,427   6   28,923   5








Total 644,830   100   530,391   100








Customer accounts (excluding repos), term debt securities of over 1 year remaining maturity, subordinated liabilities and capital continue to represent the core of the Group’s funding. These core funds in total increased by £74,732 million (24%) over the course of 2005 to represent 59% of total funding excluding other liabilities at 31 December 2005.

Customer accounts continue to provide a substantial proportion of the Group’s funding and comprise a well diversified and stable source of funds from a wide range of retail, corporate and non-bank institutional customers. Excluding repo agreements, customer accounts grew by £52,932 million (22%), to maintain 46% of total funding excluding other liabilities at 31 December 2005.

Term debt securities with an outstanding term of over 1 year increased £12,362 million (124%) to represent 3% of the Group’s funding at 31 December 2005, reflecting the activity of the Group in raising term funds through its Euro and US Medium Term Note and securitisation programmes.

Capital (shareholders’ equity and subordinated debt) increased by £9,438 million (17%) and provides around 10% of total funding excluding other liabilities.

48






Short term wholesale deposits are taken from a wide range of counterparties, with the largest single depositor continuing to represent less than 1% of the Group’s total funding. The level of funding from short term unsecured debt issuance and bank deposits, excluding repos and short positions, has increased by £20,020 million (18%) to represent 20% of total funding excluding other liabilities at 31 December 2005, reflecting the higher rate of growth in customer loans and advances (see ‘net customer activity’ below).

Short positions and repos with corporate, institutional customers and banks are undertaken primarily by RBS Greenwich Capital in the US and by Financial Markets. Repo and short positions increased by £19,687 million (17%) to represent 21% of total funding excluding other liabilities at 31 December 2005.

The Group remains well placed to access various wholesale funding sources from a wide range of counterparties and markets. The changing mix evident between customer repo, deposits by banks, debt securities in issue, and shorts primarily reflects comparative pricing, maturity considerations and investor/counterparty demand rather than a material perceived trend.

Net customer activity

Net customer lending, excluding repos, rose by £20,056 million as the growth in loans and advances to customers continued to exceed the growth in customer accounts, thus increasing the degree of reliance on wholesale market funding to support loan growth.

Net customer activity 2005
£m
  2004
£m




Loans and advances to customers (gross, excluding reverse repos) 372,223   299,235
Customer accounts (excluding repos) 294,113   241,181




Customer lending less customer accounts 78,110   58,054



Loans and advances to customers as a % of customer accounts (excluding repos) 126.6%   124.1%





In prevailing economic conditions and with interest rates at relatively low historical levels in the UK, US and Europe, it is anticipated that the growth in demand for further borrowing by customers is likely, in the medium term, to continue to exceed that for customer deposits received, thus increasing net customer lending further and increasing gradually over time the Group’s dependence on the wholesale market for funding.

The Group evaluates on a regular basis a range of balance sheet management and term funding strategies to address the consequent potential impact on its structural liquidity risk position and maintain that within its normal policy parameters.

Management of term structure

The degree of maturity mismatch within the overall long-term structure of the Group’s assets and liabilities is also managed within internal policy limits, to ensure that term asset commitments may be funded on an economic basis over their life. In managing its overall term structure, the Group analyses and takes into account the effect of retail and corporate customer behaviour on actual asset and liability maturities where they differ materially from the underlying contractual maturities.

Stress testing

The maintenance of high quality credit ratings is recognised as an important component in the management of the Group’s liquidity risk. Credit ratings affect the Group’s ability to raise, and the cost of raising, funds from the wholesale market and the need to provide collateral in respect of, for example, changes in the mark-to-market value of derivative transactions.

Given its strong credit ratings, the impact of a single notch downgrade would, if it occurred, be expected to have a relatively small impact on the Group’s economic access to liquidity. More severe downgrades would have a progressively greater impact but have an increasingly lower probability of occurrence.

As part of its stress testing of its access to sufficient liquidity, the Group regularly evaluates the potential impact of a range of levels of downgrade in its credit ratings and carries out stress tests of other relevant scenarios and sensitivity analyses.

Contingency funding plans are maintained to anticipate and respond to any approaching or actual material deterioration in market conditions or in the Group’s credit ratings, and the Group remains confident of its ability to manage its liquidity requirements effectively in all such circumstances.

Daily risk management

The primary focus of the Group’s day to day risk management activity is to ensure access to sufficient liquidity to meet its cashflow obligations within key time horizons out to one month ahead. The short-term maturity structure of the Group’s liabilities and assets is managed on a daily basis to ensure that all material cashflow obligations, and potential cashflows arising from undrawn commitments and other contingent obligations, can be met as they arise from day to day, either from cash inflows, from maturing assets, new borrowing or the sale or repurchase of various debt securities held (after allowing for appropriate haircuts).

49






Operating and financial review continued

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.

Net short-term wholesale market activity 2005
£m
    2004
£m
 






Debt securities, treasury bills and other eligible bills 126,503     100,018  
Reverse repo agreements with banks and customers 90,691     82,159  
Less: repos with banks and customers (96,659 )   (85,476 )
Short positions (37,427 )   (28,923 )
Insurance Companies’ debt securities held (5,724 )   (5,029 )
Debt securities charged as security for liabilities (9,578 )   (4,852 )






Net marketable assets 67,806     57,897  






By remaining maturity up to 1 month:          
Deposits by banks (excluding repos) 35,153     34,041  
Less: loans and advances to banks (gross, excluding reverse repos) (16,381 )   (17,067 )
Debt securities in issue 20,577     15,505  






Net wholesale liabilities due within 1 month 39,349     32,479  






           
Net surplus of marketable assets over wholesale liabilities due within 1 month 28,457     25,418  






The Group’s net surplus of marketable assets over net short-term wholesale liabilities due within one month increased by £3,039 million to £28,457 million at 31 December 2005. Overall access to liquidity to meet all foreseen needs remains comfortably within the Group’s policy parameters.

Sterling liquidity

Over 42% of the Group’s total assets are denominated in sterling. For its sterling activity the FSA requires the Group on a consolidated basis to maintain daily a minimum ratio of 100% between:

1.

a stock of qualifying high quality liquid assets (primarily UK and EU government securities, treasury bills, and cash held in branches) and
   
2. the sum of:
   
 
  • sterling wholesale net outflows contractually due within five working days (offset up to a limit of 50%, by 85% of sterling certificates of deposit held which mature beyond five working days); and
  • 5% of retail deposits with a residual contractual maturity of five working days or less.

The Group exceeded the minimum ratio requirement throughout 2005.

The FSA also set an absolute minimum level for the stock of qualifying liquid assets that the Group is required to maintain each day. The Group has exceeded that minimum stock requirement at all times during 2005.

The Group’s operational processes are actively managed to ensure that both the minimum sterling liquidity ratio and the minimum stock requirement are achieved or exceeded at all times.

Liquidity in non-sterling currencies

For non-sterling currencies, no specific regulatory liquidity requirement is currently set for the Group by the FSA. However, the importance of managing prudently the liquidity risk in its non-sterling activities is recognised and the Group manages its non-sterling liquidity risk daily within net mismatch limits set for the 0-8 calendar day and 0-1 month periods as a percentage of the Group’s total deposit and debt liabilities.

In measuring its non-sterling liquidity risk, due account is taken of the marketability within a short period of the wide range of debt securities held. Appropriate adjustments are applied in each case, dependent on various parameters, to determine the Group’s ability to realise cash at short notice via the sale or repo of such marketable assets if required to meet unexpected outflows.

The level of contingent risk from the potential drawing of undrawn or partially drawn commitments, back-up lines, standby lines and other similar facilities is also actively monitored and reflected in the measures of the Group’s non-sterling liquidity risk. Particular attention is given to the US$ commercial paper market and the propensity of the Group’s corporate counterparties who are active in raising funds from that market to switch to utilising facilities offered by the Group in the event of either counterparty specific difficulties or a significant widening of interest spreads generally in the commercial paper market.

50






The Group also provides liquidity back-up facilities to both its own conduits and certain other conduits which take funding from the US$ commercial paper market. Limits sanctioned for such facilities totalled less than £11 billion at 31 December 2005. The short-term contingent liquidity risk in providing such back-up facilities is also mitigated by the spread of maturity dates of the commercial paper taken by the conduits.

The Group has operated within its non-sterling liquidity policy mismatch limits at all times during 2005 and operational processes are actively managed to ensure that is the case going forward.

Developments in liquidity risk management regulation

Following the Basel Committee’s publication of Sound Practices for Managing Liquidity in Banking Organisations in February 2000, a number of regulatory bodies internationally began reviewing their regulatory liquidity frameworks.

In the UK, the FSA published a discussion document – DP24 –in October 2003 setting out draft proposals for a new quantitative framework to operate in the UK. Comments made to the FSA, by the Group and other banks collectively, in response to these proposals, made clear the desirability of an internationally coordinated approach to the regulation of liquidity. An international forum of regulators, chaired jointly by the FSA and the US Federal Reserve Bank, was also established in 2004 to review regulation across the OECD. Their report is awaited. In 2005, the European Commission has also begun to consider the subject.

Following earlier consultation, the FSA also introduced in January 2005, new requirements for liquidity management systems and controls, particularly in respect of stress testing, contingency funding plans and related documentation. The Group has complied with these requirements and will continue to do so going forward.

The Group has been, and continues to be, actively involved in working with the various regulatory bodies to assist the development of an appropriate future regulatory liquidity regime which takes into account local national considerations but also gives due recognition to the integrated cross-border approach to the management of liquidity risk within most international banking groups.

Taking account of the indicative future regulatory requirements published to date, the Group continues to develop its liquidity risk reporting, management and stress testing capabilities.

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 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, and information with respect to, its exposures to derivative financial instruments, see Accounting policies and Note 19 on the accounts.

51






Operating and financial review continued

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
 
 
Trading Average
£m
  Period end
£m
    Maximum
£m
  Minimum
£m
  Average
£m
  Period end
£m
    Maximum
£m
  Minimum
£m

Interest rate 7.3   7.4     10.9   5.1   6.0   5.4     8.5   4.1
Credit spread 11.4   11.8     14.4   8.8   8.6   10.4     12.0   5.1
Currency 1.8   1.4     10.7   0.5   1.1   1.2     2.7   0.5
Equity and commodity 0.5   0.7     1.1   0.2   0.8   0.4     2.1   0.3
Diversification     (8.5 )               (6.5 )        




Total trading VaR 13.0   12.8     16.5   9.9   10.6   10.9     16.0   6.3

The Group’s trading activities are carried out principally by Global Banking & Markets. The charts below depict the number of days on which Global Banking & Markets’ trading income fell within the stated ranges.

2005


2004


52




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. VaR for the Group’s treasury portfolios, which relates mainly to interest rate risk including credit spreads, was £3.5 million at 31 December 2005 (2004 –£5.7 million). During the year the maximum VaR was £5.8 million (2004 – £9.3 million), the minimum £2.8 million (2004 –£5.7 million) and the average £4.0 million (2004 – £7.3 million).

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 functions. The residual risk position is reported to divisional asset and liability committees, GALCO and the Board.

Non-trading interest rate VaR

Non-trading interest rate VaR for the Group’s treasury and retail and corporate banking activities was £81.5 million at 31 December 2005 (2004 – £72.4 million) with the major exposure being to changes in longer term US dollar interest rates. During the year, the maximum VaR was £104.2 million (2004 –£89.7 million), the minimum £10.8 million (2004 – £51.5 million) and the average £65.5 million (2004 – £71.2 million).

Citizens was the main contributor to the Group’s non-trading interest rate VaR. It invests in a portfolio of highly rated and liquid investments, principally mortgage-backed securities. This balance sheet management approach is common for US retail banks where mortgages are originated and then sold to Federal agencies for funding through the capital markets. VaR, like all interest rate risk measures, has its limitations when applied to retail banking books and the management of Citizens’ interest rate exposures involves a number of other interest rate risk measures and related limits. Two measures that are reported both to Citizens ALCO and the Board are:

  • the sensitivity of net accrual earnings to a series of parallel movements in interest rates; and

  • economic value of equity (“EVE”) sensitivity to a series of parallel movements in interest rates.

 

53




Operating and financial review continued

The limits applied to these measures are set to parallel movements of +/-1% and +/-2%. The EVE methodology captures deposit repricing strategies and the embedded option risks that exist within both the investment portfolio of mortgage-backed securities and the consumer loan portfolio. EVE is the present value of the cash flows generated by the current balance sheet. EVE sensitivity to a 2% parallel movement upwards and downwards in US interest rates is shown below.

  Percent increase/(decrease) in Citizens EVE    

2005 2% parallel upward
movement in
US interest rates
%
    2% parallel downward
movement in US interest rates
(no negative rates allowed)
%
 






Period end (9.1 )   (8.2 )
Maximum (10.1 )   (9.8 )
Minimum (7.1 )   (4.4 )
Average (9.2 )   (7.9 )






           
2004          






Period end (9.2 )   (4.4 )
Maximum (12.6 )   (18.5 )
Minimum (5.2 )   (4.4 )
Average (9.3 )   (9.2 )







For the Group, the other major structural interest rate risk arises from a low interest rate environment, particularly in sterling, sustained for a number of years. In such a scenario, deposit pricing may reach effective floors below which it is not practical to reduce rates further whilst variable rate asset pricing continues to decline. A sustained low rate scenario would also generate progressively reduced income from the medium and long term hedging of non-interest bearing liabilities. GALCO regularly reviews the impact of stress scenarios including the impact of substantial declines in rates to ensure that appropriate risk management strategies are employed. Resulting action may involve execution of derivatives, product development and tactical pricing changes.

Note 34 on the accounts includes, on pages 147 and 148, tables that summarise the Group’s interest rate sensitivity gap for its non-trading book at 31 December 2005 and 31 December 2004. The tables show the contractual re-pricing for each category of asset, liability and for off-balance sheet items and do not reflect the behaviouralised repricing used in the Group’s asset and liability management methodology and the non-trading interest rate VaR presented above.

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. Foreign exchange differences arising on the translation of foreign operations are recognised directly in equity together with the effective portion of foreign exchange differences arising on hedging liabilities.

54






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 15,452   6,637   8,815
Euro 2,285   139   2,146
Swiss franc 431   430   1
Chinese RMB 914     914
Other non-sterling 76   72   4






  19,158   7,278   11,880





2004          






US dollar 12,367   6,580   5,787
Euro 2,086   1,349   737
Swiss franc 398   392   6
Other non-sterling 116   112   4






  14,967   8,433   6,534






The US dollar open structural foreign currency exposure reflects the action taken to mitigate the effect of the acquisition in 2004 of Charter One on the Group’s capital ratios. However, the increase in this position and the Euro structural exposure over 2004 is largely a result of 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. The exposure in Chinese RMB arises from the Group’s strategic investment in Bank of China.

Equity risk

Non-trading equity risk arises principally from the Group’s strategic investments, its venture capital activities and its general insurance business. General insurance investment strategy is discussed below under insurance risk.

VaR is not an appropriate risk measure for the Group’s venture capital investments, which comprise a mix of quoted and unquoted investments, or its portfolio of strategic investments. These investments are carried at fair value with changes in fair value recorded in profit or loss, or in equity.

Insurance risk

The Group is exposed to insurance risk, either directly through its businesses or through using insurance as a tool to reduce other risk exposures.

An insurance contract transfers risk from the policyholder to the insurer, whereby, in return for a premium paid, the insurer indemnifies the policyholder on the occurrence of specified events.

Insurance risk is the risk of fluctuations in the timing, frequency and severity of insured events, relative to the expectations of the Group at the time of underwriting. This risk is managed according to the following separate components:

  • Underwriting and pricing risk
  • Claims management risk
  • Reinsurance risk
  • Reserving risk

Insurance risk is predictable, especially with the analysis of large volumes of data over time. There is, however, uncertainty around the predictions from various sources, for example, volatility of the weather. However, the Group has documented risk policies, coupled with governance frameworks to oversee and control and hence minimise the risks.

Underwriting and pricing risk

The Group manages underwriting and pricing risk through a wide range of processes and forums, which include:

  • Underwriting guidelines which exist for all business transacted restricting the types and classes of business that may be accepted;

  • Pricing policies which are set by pricing committees, by product line and by brand;

  • Centralised control of policy wordings and any subsequent changes

Reinsurance and insurance of Group assets are centrally controlled in the same department as insurance risk and both have a similar framework of robust controls and processes.

55






Operating and financial review continued

Claims management risk

Claims management risk is the risk that claims are paid inappropriately. Claims are managed using a range of IT system controls and manual processes conducted by experienced staff, to ensure that claims are handled in a timely and accurate manner. Detailed policies and procedures exist to ensure that all claims are handled appropriately, with each member of staff having a specified handling authority. The processes include controls to avoid claims staff handling or paying claims beyond their authorities, as well as controls to avoid paying invalid claims. Loss adjustors are used to handle certain claims to conclusion.

Reinsurance risk

Reinsurance is used to protect the insurance results against the impact of major catastrophic events or unforeseen volumes of, or adverse trends in, large individual claims and to transfer risk that is outside the Group’s current risk appetite.

The following types of reinsurance are used where appropriate:

  • Excess of loss ‘per individual risk’ reinsurance to protect against significantly large individual losses.

  • Excess of loss catastrophe ‘event’ reinsurance to protect against major events, for example, windstorms or floods.

  • Quota share reinsurance to protect against unforeseen adverse trends, where the reinsurer takes an agreed percentage of premiums and claims.

  • Other forms of reinsurance may be utilised according to need, subject to approval by senior management or the board as appropriate.

Reinsurance is only effective when the counterparty is financially secure. Before entering a contract with a new reinsurer, it must satisfy the Credit Risk Approval process that uses information derived internally and from security ratings agencies. Acceptable reinsurers are rated at A- or better unless specifically authorised by the RBS Insurance Group Board.

Reserving risk

Reserving risk relates to both premiums and claims. It is the risk that reserves are assessed incorrectly such that insufficient funds have been retained to pay or handle claims as the amounts fall due, both in relation to those claims which have already occurred (in relation to the claims reserves, including claims handling expense reserves) or will occur in future periods of insurance (in relation to the premium reserves).

a) Premium reserves

In respect of premium reserves, it is the Group’s policy to ensure that the net unearned premium reserves and deferred acquisition costs are adequate to meet the expected cost of claims and associated expenses in relation to the exposure after the balance sheet date. To the extent that the unearned premium reserves and deferred acquisition costs are inadequate, a liability adequacy provision will be held which will initially write down any deferred acquisition asset held. Once any deferred acquisition asset has been exhausted, an additional liability adequacy provision will be established.

b) Claims reserves

It is the Group’s policy to hold undiscounted claims reserves (including reserves to cover claims which have occurred but not been reported (IBNR reserves)) for all classes at a sufficient level to meet all liabilities as they fall due, having regard to actuarial estimates and the volatility observed and expected in the claims in each class.

The Group’s policy is to hold provisions for the major classes of business in excess of the actuarial best estimate. The percentage margin in excess of this estimate is assessed by senior management, with particular reference to the volatility observed and expected in the claims in each class.

The Group’s focus is on high volume and relatively straightforward products, for example home and motor. This facilitates the generation of comprehensive underwriting and claims data, which is used to monitor and accurately price the risks accepted. This attention to data analysis is reinforced by tight controls on costs and claims handling procedures.

Frequency and severity of specific risks and sources of uncertainty

Most general insurance contracts written by the Group are issued on an annual basis, which means that the Group’s liability extends for a 12 month period, after which the Group is entitled to decline or renew or can impose renewal terms by amending the premium or excess or both.

The following paragraphs explain the frequency and severity of claims and the sources of uncertainty for the key classes that the Group is exposed to:

a) Motor insurance contracts (private and commercial)

Claims experience is quite variable, due to a wide number of factors, but the principal ones of these are age of driver, type of vehicle and use.

There are many sources of uncertainty that will impact the Group's experience under motor insurance, including operational risk, reserving risk, premium rates not matching claims inflation rates, the social, economic and legislative environment and reinsurance failure risks.

b) Property insurance contracts (residential and commercial)

The major causes of claims for property insurance are theft, flood, escape of water, fire, storm, subsidence and various types of accidental damage.

The major source of uncertainty in the Group’s property accounts is the volatility of weather. Weather in the UK can affect most of the above perils. Over a longer period, the strength of the economy is also a factor. There are many other sources of uncertainty which include operational, reserving and reinsurance issues.

56






c) Commercial other insurance contracts

Other commercial claims come mainly from business interruption and loss arising from the negligence of the insured (liability insurance). Business interruption losses come from the loss of income, revenue and/or profit as a result of property damage claims. Liability insurance can be broken down between employers liability and public/products liability. The first is to indemnify employees for injury caused as a result of the insured’s negligence. Public/products liability is to indemnify a third party for injury and/or damage as a result of an act of the Insured’s negligence. As liability insurance is written on an occurrence basis, these covers are still subject to claims that manifest over a substantial period of time, but where loss was in existence during the life of the policy.

Fluctuations in the social, economic and legislative climate are a source of uncertainty in the Group’s general liability account, and in particular court judgements and legislation (for example periodic payments under the Courts Act, a review of the Ogden tables used by the courts when setting personal injury claim values), significant events (for example terrorist attacks) and any emerging new heads of damage, types of claim that are not envisaged when the policy is written.

d) Creditor insurance

Creditor insurance contracts are designed to cover payments on secured or unsecured lending. These contracts are for a maximum term of 5 years. The causes of creditor insurance claims are loss of income through accident, sickness or unemployment or, in some circumstances, loss of life.

The main source of uncertainty affecting the Group's creditor accounts is the economic environment. A recession could lead to an increased number and cost of unemployment, accident and sickness claims. Other sources of uncertainty include operational and reserving issues.

Life business

The three regulated life companies of RBSG, NatWest Life Assurance Limited, Royal Scottish Assurance plc and Direct Line Life Limited, are required to meet minimum capital requirements at all times under the Financial Service Authority’s Prudential Sourcebook. The capital resources covering the regulatory requirement are not transferable to other areas of the Group. To ensure that the capital requirement is satisfied at all times, each company holds an additional voluntary buffer above the absolute minimum. Sufficient capital resources are held to ensure that the capital requirements are covered over a two year projection period. Life insurance results are inherently uncertain, due to actual experience being different to modelled assumptions. Such differences affect regulatory capital resources, as do varying levels of new business. Therefore, projections are formally reviewed twice a year. Where there is a shortfall of capital, various options are available to provide new capital.

The Group is not exposed to price, currency, credit, or interest risk on unit linked life contracts but it is exposed to variation in management fees. A decrease of 10% in the value of the assets would reduce the asset management fees by £5 million per annum (2004 – £5 million). The Group also writes insurance contracts with minimum guaranteed death benefits that expose it to the risk that declines in the value of underlying investments may increase the Group’s net exposure to death risk.

Frequency and severity of claims – for contracts where death is the insured risk, the most significant factors that could increase the overall frequency of claims are epidemics or wide spread changes in lifestyle, resulting in earlier or more claims than expected.

For contracts where survival is the insured risk, the most significant factor is continued improvement in medical science and social conditions that would increase longevity.

For contracts with fixed and guaranteed benefits and fixed future premiums, there are no mitigating terms and conditions that reduce the insurance risk accepted. Participating contracts can result in a significant portion of the insurance risk being shared with the insured party.

Sources of uncertainty in the estimation of future benefit payments and premium receipts – the Group uses base tables of standard mortality appropriate to the type of contract being written and the territory in which the insured person resides. These are adjusted to reflect the Group’s experience, mortality improvements and voluntary termination behaviour.

Purchased insurance

The Insurance Sourcing Department is responsible to GEMC for the Group-wide purchase of insurance as a means of reducing other risk exposures.

Enterprise risk

In order to adequately identify and manage the full range of Enterprise risk, the Group has separately defined operational and external risk:

Operational risk is defined as the risk arising within the organisation from:

  • People – risks arising from an inappropriate level of staff, inadequately skilled or managed.

  • Process – risk caused by inadequate or failed internal processes.

  • Systems – risks of inadequately designed or maintained systems.

  • Assets – risk of damage, misappropriation or theft of the Group’s physical, logical and intangible assets.

 

57




Operating and financial review continued

External risk is defined as the risk arising outside of the organisation in three main areas:

  • Business – risks arising from product performance, competitor activity, supplier unreliability or customer activity.

  • Political – risks caused by political unrest or uncertainty, activity by public interest groups or extremists, and non-compliance with, or changes to, current legislation.

  • Environment – risks arising due to demographic, macroeconomic, technical, cultural or environmental change.

Enterprise risk also includes the potential or actual impact on corporate reputation arising from any of the Group’s activities.

Enterprise risk management is achieved through monitoring the Group’s exposure to direct or indirect loss using a range of policies, procedures, data, analytical tools and reporting techniques. In particular, Group-wide risk management processes ensure that enterprise risk issues are quickly escalated and resolved, that the risks inherent in new products are fully evaluated, and that emerging external risks are actively monitored.

Operational risk exposures and loss events for each division are captured through monthly Risk and Control returns, which provide details on the change of risk exposures for each risk category in the light of trends and the risk profile of each division.

Regulatory risk

Regulatory risk is the risk arising from failing to meet the requirements of our regulators. To mitigate this risk, the Group is active in various regulatory developments affecting risk, capital and liquidity management. This includes working with domestic and international trade associations, being active with various regulators, especially the FSA and the main regulatory groups, including the Basel Committee (see page 208), the Committee of European Banking Supervisors, the EU Commission and US regulators.

58




Governance

Contents
60   Board of directors
    and secretary
62   Report of the directors
67   Corporate governance
73   Directors’ remuneration report
82   Directors’ interests in shares
83   Statement of directors’
    responsibilities

59






Board of directors and secretary*


*Not pictured: Johnny Cameron, Mark Fisher and Bill Friedrich (each appointed in March 2006)

60






Chairman
Sir George Mathewson (age 65)
CBE, DUniv, LLD, FRSE, FCIBS
C (Chairman), N (Chairman)

Appointed to the Board in September 1987 and as Chairman in April 2001, Sir George Mathewson has a wide background in finance, technology and management and spent some of his career in the United States. He became Group Chief Executive in January 1992 and, in March 2000, he was appointed Executive Deputy Chairman. He is a director of The Scottish Investment Trust PLC and the Institute of International Finance, Inc. He is also president of the International Monetary Conference, a member of the Advisory Committee of Bridgepoint Capital Limited and a member of the Financial Reporting Council. He was chief executive of the Scottish Development Agency from 1981 to 1987 and is a former president of the British Bankers’ Association.

Deputy Chairman and
Chairman-designate
Sir Tom McKillop* (age 62)
C, N

Appointed to the Board as Deputy Chairman in September 2005, Sir Tom is a non-executive director of BP p.l.c., and was formerly chief executive of AstraZeneca plc. He was formerly president of the European Federation of Pharmaceutical Industries and Associations and chairman of the British Pharma Group. He is Pro-Chancellor of the University of Leicester and a trustee of the Council for Industry and Higher Education.

Executive directors
Sir Fred Goodwin (age 47)
DUniv, FCIBS, FCIB, LLD
Group Chief Executive
C

Appointed to the Board in August 1998, Sir Fred Goodwin is a Chartered Accountant. He was formerly chief executive and director, Clydesdale Bank PLC and Yorkshire Bank PLC. He is chairman of The Prince’s Trust, a non-executive director of Bank of China Limited and a former president of the Chartered Institute of Bankers in Scotland.

Lawrence Fish (age 61)
Chairman and Chief Executive
Officer of Citizens Financial
Group, Inc.

Appointed to the Board in January 1993, Lawrence Fish is an American national. He is a career banker and was a director of the Federal Reserve Bank of Boston. He is a trustee of The Brookings Institution and a director of the Financial Services Roundtable, Textron Inc., and numerous community organisations in the USA.

Gordon Pell (age 56)
FCIBS, FCIB
Chief Executive,
Retail Markets

Appointed to the Board in March 2000, Gordon Pell was formerly group director of Lloyds TSB UK Retail Banking before joining National Westminster Bank Plc as a director in February 2000 and then becoming chief executive, Retail Banking. He is also a director of Race for Opportunity and a member of the National Employment Panel and the FSA Practitioner Panel.

Guy Whittaker (age 49)
Group Finance Director
C

Appointed to the Board in February 2006, Guy Whittaker was formerly group treasurer at Citigroup Inc., based in New York, having previously held a number of management positions within the financial markets business at Citigroup. He was elected a Lady Beaufort Fellow of Christ's College Cambridge in 2004.

Johnny Cameron (age 51)
FCIBS
Chief Executive, Corporate Markets

Appointed to the Board in March 2006, Johnny Cameron has held a number of senior positions in financial institutions including County NatWest, Dresdner Kleinwort Benson and RBS. He was appointed Managing Director, Corporate and Institutional Banking in 1998, before being promoted to Deputy Chief Executive, Corporate Banking and Financial Markets (renamed Corporate Markets in January 2006) in 2000, and Chief Executive in 2001.

Mark Fisher (age 46)
FCIBS
Chief Executive, Manufacturing

Appointed to the Board in March 2006, Mark Fisher is a career banker, having joined the Group in 1981 as a graduate trainee. Mark has held a number of senior management positions in NatWest Retail Bank, including Finance Director and latterly Chief Operating Officer. He was responsible for overseeing the successful integration of NatWest on to the RBS operational platform following the acquisition in 2001, and has since then completed the integration of Churchill Insurance. Mark is also Chairman of The Association for Payment Clearing Services (APACS).

Non-executive directors
Colin Buchan* (age 51)
A, C, R

Appointed to the Board in June 2002, Colin Buchan was educated in South Africa and spent the early part of his career in South Africa and the Far East. He has considerable international investment banking experience, as well as experience in very large risk management in the equities business. He was formerly a member of the group management board of UBS AG and head of equities of UBS Warburg. He is chairman of UBS Securities Canada Inc. and vice-chairman of Standard Life Investments Limited. He is also a director of Merrill Lynch World Mining Trust Plc, Merrill Lynch Gold Limited, Royal Scottish National Orchestra Society Limited and World Mining Investment Company Limited.

Jim Currie* (age 64)
D.Litt
R

Appointed to the Board in November 2001, Jim Currie is a highly experienced senior international civil servant who spent many years working in Brussels and Washington. He was formerly director general at the European Commission with responsibility for the EU’s environmental policy and director general for Customs and Excise and Indirect Taxation. He is also a director of Total Holdings UK Limited, an international advisor to Eversheds and a consultant to Butera & Andrews UK Limited.

Bill Friedrich* (age 56)

Appointed to the Board in March 2006, Bill Friedrich was appointed to the Board of BG Group plc as an Executive Director, Deputy Chief Executive and General Counsel in October 2000. Since 2005, he has had primary responsibility for the Group’s overall strategy function and portfolio development activities as well as oversight of the Group’s organisational and human resource matters. Prior to that he was responsible for BG’s operations in North and South America and various Group-wide staff functions. He joined British Gas plc in December 1995 as General Counsel after a 20-year career with Shearman & Sterling, based in New York, where he became a partner in 1983.

Archie Hunter* (age 62)
A (Chairman), C

Appointed to the Board in September 2004, Archie Hunter is a Chartered Accountant. He was Scottish senior partner of KPMG between 1992 and 1999 and President of The Institute of Chartered Accountants of Scotland in 1997/1998. He has extensive professional experience in the UK and North and South America. He is currently chairman of Macfarlane Group plc, a director of Edinburgh US Tracker Trust plc, Convenor of Court at the University of Strathclyde and a governor of the Beatson Cancer Research Institute.

Charles ‘Bud’ Koch (age 59)

Appointed to the Board in September 2004, Bud Koch is an American national. He has extensive professional experience in the USA and is currently chairman of the board of the Federal Home Loan Bank of Cincinnati, chairman of the board of John Carroll University and a trustee of Case Western Reserve University. He was chairman, president and chief executive officer of Charter One Financial, Inc. and its wholly owned subsidiary, Charter One Bank, N.A between 1973 and 2004. He is also a director of Assurant, Inc.

Janis Kong* (age 55)
OBE, DUniv

Appointed to the Board in January 2006, Janis Kong is currently executive chairman of Heathrow Airport Limited, chairman of Heathrow Express Limited and a director of BAA plc and Portmeirion Group plc. She is also a member of the board of Visit Britain and previously served as a member of the board of the South East England Regional Development Agency.

Joe MacHale* (age 54)
A

Appointed to the Board in September 2004, Joe MacHale is currently a non-executive director and chairman of the audit committee of Morgan Crucible plc, a non-executive director of Brit Insurance Holdings plc, and a trustee of MacMillan Cancer Relief. He held a number of senior executive positions with J P Morgan between 1979 and 2001 and was latterly chief executive of J P Morgan Europe, Middle East and Africa Region.

Sir Steve Robson* (age 62)
A

Appointed to the Board in July 2001, Sir Steve Robson is a former senior UK civil servant, who had responsibility for a wide variety of Treasury matters. His early career included the post of private secretary to the Chancellor of the Exchequer and secondment to ICFC (now 3i). He was also a second permanent secretary of HM Treasury, where he was managing director of the Finance and Regulation Directorate. He is a non-executive director of JP Morgan Cazenove Holdings, Xstrata Plc and Partnerships UK plc, and a member of the Chairman’s Advisory Committee of KPMG.

Bob Scott* (age 64)
CBE, FCIBS
C, N, R (Chairman)

Appointed to the Board in January 2001, Bob Scott is an Australian national. He is the senior independent director. He has many years experience in the international insurance business and played a leading role in the consolidation of the UK insurance industry. He is a former group chief executive of CGNU plc and chairman of the board of the Association of British Insurers. He is chairman of Yell Group plc and a non-executive director of Swiss Reinsurance Company (Zurich), Jardine Lloyd Thompson Group plc and Focus DIY Group Limited. He is also a trustee of the Crimestoppers Trust and an adviser to Duke Street Capital.

Peter Sutherland* (age 59)
KCMG
C, N

Appointed to the Board in January 2001, Peter Sutherland is an Irish national. He is a former attorney general of Ireland and from 1985 to 1989 was the European Commissioner responsible for competition policy. He is chairman of BP p.l.c. and Goldman Sachs International and honorary president and member of the Advisory Council for the European Movement – Ireland. He was formerly chairman of Allied Irish Bank and a director general of GATT and the World Trade Organisation.

Group Secretary and
General Counsel
Miller McLean (age 56)
FCIBS
C

Miller McLean was appointed Group Secretary in August 1994. He is a trustee of the Industry and Parliament Trust, a non-executive chairman of The Whitehall and Industry Group and a director of The Scottish Parliament and Business Exchange.

A member of the Audit Committee
C member of the Chairman’s Advisory Group
N member of the Nominations Committee
R member of the Remuneration Committee
* independent non-executive director

61






Report of the directors

The directors have pleasure in presenting their report together with the audited accounts for the year ended 31 December 2005.

Profit and dividends

The profit attributable to the ordinary shareholders of the company for the year ended 31 December 2005 amounted to £5,392 million compared with £4,856 million for the year ended 31 December 2004, as set out in the consolidated income statement on page 97.

An interim dividend of 19.4p per ordinary share was paid on 7 October 2005 totalling £619 million (2004 – £529 million). The directors now recommend that a final dividend of 53.1p per ordinary share totalling £1,700 million (2004 – £1,308 million) be paid on 9 June 2006 to members on the register at the close of business on 10 March 2006. Subject to approval of the dividend at the Annual General Meeting, shareholders will be offered the opportunity to participate in a dividend reinvestment plan, which will replace the current scrip dividend scheme.

Activities and business review

The company is a holding company owning the entire issued ordinary share capital of the Royal Bank, the principal direct operating subsidiary undertaking of the company. The “Group” comprises the company and all its subsidiary and associated undertakings, including the Royal Bank and NatWest. The Group is engaged principally in providing a wide range of banking, insurance and other financial services. The financial risk management objectives and policies of the Group and information on the Group’s exposure to price, credit, liquidity and cash flow risk are contained in Note 34 on the financial statements. Details of the principal subsidiary undertakings of the company are shown in Note 15. A review of the business for the year to 31 December 2005, of recent events and of likely future developments is contained in the Operating and financial review.

Business developments

In August 2005, the Group announced a strategic partnership with Bank of China (BoC). Subsequently, a Group-led consortium acquired a 10% shareholding in BoC through a majority-owned subsidiary for US$3.1 billion (£1.7 billion). The Group’s share of the investment (US$1.6 billion) was financed through the disposal of its 2.2% holding in the issued share capital of Banco Santander Central Hispano, S.A. Following receipt of all required regulatory approvals, the investment was completed in December 2005. The two banks will co-operate across a range of business activities in China including credit cards, wealth management, corporate banking and personal lines insurance. They will also closely co-operate in key operational areas including financial controls, risk management, human resources and corporate governance.

Going concern

The directors are satisfied that the Group has adequate resources to continue in business for the foreseeable future. For this reason, they continue to adopt the ‘going concern’ basis for preparing the accounts.

Ordinary share capital

During the year ended 31 December 2005, the ordinary share capital was increased by the following issues:

(a)      13.5 million ordinary shares allotted as a result of the exercise of options under the company’s executive, sharesave and option 2000 schemes and a further 0.7 million ordinary shares allotted in respect of the exercise of options under the NatWest executive and sharesave schemes which had been exchanged for options over the company’s shares following the acquisition of NatWest in 2000;
   
(b)      7.4 million ordinary shares allotted in lieu of cash dividends; and
   
(c)      2.3 million ordinary shares allotted under the company’s employee share ownership plan.

Details of the authorised and issued ordinary share capital at 31 December 2005 are shown in Note 30.

Preference share capital

Details of issues of preference shares during the year and the authorised and issued share capital at 31 December 2005 are shown in Note 30.

Authority to repurchase shares

At the Annual General Meeting in 2005, shareholders renewed the authority for the company to make market purchases of up to 317,495,924 ordinary shares. The directors have not exercised this authority to date. The Group has however announced its intention to repurchase up to £1 billion of ordinary shares over the course of the next 12 months, and shareholders will be asked to renew this authority at the Annual General Meeting in April.

62






Shareholdings

As at 27 February 2006, the company had been notified of the following interests in its shares, in accordance with section 198 of the Companies Act 1985:

    Number of shares   % held       Number of shares   % held











Ordinary shares:           5½% cumulative preference shares:        
       Legal & General Group plc   98,761,695   3.40          Commercial Union Assurance plc   91,429   22.86
       Barclays PLC   126,816,644   3.97          Mr P. S. and Mrs J. Allen   86,999   21.75
       The Capital Group of Companies, Inc   95,578,555   3.01          Bassett-Patrick Securities Limited*   46,255   11.56
11% cumulative preference shares:                  E M Behrens Charitable Trust   20,000   5.00
       Guardian Royal Exchange                  Mrs Gina Wild   19,800   4.95
       Assurance plc   129,830   25.97          Trustees of The Stephen Cockburn        
       Windsor Life Assurance                          Limited Pension Scheme   19,879   4.97
       Company Limited   51,510   10.30          Miss Elizabeth Hill   16,124   4.03
       Mr S. J. and Mrs J. A. Cockburn   30,810   6.16          Mr W. T. Hardison Jr.   13,532   3.38
       Cleaning Tokens Limited   25,500   5.10          Ms C. L. Allen   13,200   3.30
                   Ms J. C. Allen   12,750   3.18












* Notification has been received on behalf of Mr A. W. R. Medlock and Mrs H. M. Medlock that they each have an interest in the holding of 51/2 % cumulative preference shares registered in the name of Bassett-Patrick Securities Limited noted above and that there are further holdings of 5,300 and 5,000 shares, respectively, of that class registered in each of their names.

Directors

The names and brief biographical details of the directors are shown on page 61. All directors, except:

  • Sir Angus Grossart, Lord Vallance and Iain Robertson, who retired from the Board on 20 April 2005, and Eileen Mackay, who retired from the Board on 31 December 2005,

  • Sir Tom McKillop, who was appointed to the Board on 1 September 2005, Janis Kong, who was appointed to the Board on 1 January 2006, and Guy Whittaker, who was appointed to the Board on 1 February 2006, and

  • Fred Watt, who resigned from the Board on 31 January 2006,

served throughout the year and to the date of signing of the financial statements.

Sir Tom McKillop, Colin Buchan, Janis Kong, Bob Scott, Peter Sutherland and Guy Whittaker will retire and offer themselves for election or re-election at the company’s Annual General Meeting. Bill Friedrich, Johnny Cameron and Mark Fisher have been appointed as directors with effect from 1 March 2006 and will also offer themselves for election at the company’s Annual General Meeting.

Details of the service agreement for Guy Whittaker are set out on page 77. Johnny Cameron has a service agreement with The Royal Bank of Scotland plc dated 29 March 1998 which may be terminated by Mr Cameron giving six months notice to the Royal Bank and by the Royal Bank giving 12 months notice to Mr Cameron. Mark Fisher has a service agreement with The Royal Bank of Scotland plc dated 3 May 2000 which may be terminated by either party giving six months notice to the other. No other director seeking election or re-election has a service agreement.

Sir George Mathewson will retire as Chairman of the Board with effect from the conclusion of the Annual General Meeting on 28 April 2006. The Group has secured his continued employment to serve in an advisory role to the Group. Sir Tom McKillop will succeed Sir George as Chairman.

Directors’ interests

The interests of the directors in the shares of the company at 31 December 2005 are shown on page 82. None of the directors held an interest in the loan capital of the company or in the shares and loan capital of any of the subsidiary undertakings of the company, during the period from 1 January 2005 to 27 February 2006.

Employee proposition

The Group recognises that staff performance is central to the successful delivery of its overall business strategy. Accordingly, the Group focuses on maintaining an employee proposition that attracts, engages and retains the best available talent.

Employee recruitment

Utilising a wide range of recruitment channels, including an open internal jobs market, talent forums and detailed succession planning, the Group ensures that the recruitment and development of employees is closely aligned to organisational requirements. A strong standing as an employer of choice prompts applications from hundreds of thousands of potential candidates each year. Similarly, all vacancies are displayed internally and RBS employees can apply for any role.

The Group retains a high profile as a graduate recruiter, providing a wide range of development programmes. In 2005, more than 14,000 graduates applied for over 230 places with the Group. The Group also received the Association of Graduate Recruiters Award for delivering the ‘Best Integrated Marketing Recruitment Campaign’ targeted at graduates.

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Report of the directors continued

Group-wide co-ordination and access to recruitment and interview skills training ensures recruitment complies with internal and regulatory requirements. In addition, the Group continues to ensure all appointees are appropriately referenced and screened prior to joining the organisation.

Employee reward

The Group acknowledges that its continuing success is closely linked to the performance, skills and individual commitment of its employees. Significant focus is therefore given to offering an exceptional reward proposition to all RBS Group employees in order to attract, motivate and retain the best available talent at every level.

In 2005, employee costs of £5,992 million, including National Insurance and pension costs of £864 million, made up over a third of total expenditure.

The Group’s remuneration and benefits package, Total Reward, (consisting of salary, bonus, share scheme and competitive pension benefits) is acknowledged as one of the most comprehensive and flexible packages in the financial services sector. Salary awards within the Group reflect individual performance, offering greater increases for high performers, as well as acknowledging market competitor movements.

RBSelect, the Group’s benefits choice programme, forms part of the Total Reward package. It provides for UK staff in the Group a flexible way of tailoring their reward to reflect their own individual lifestyle needs. Options range from subsidised childcare vouchers and discounted personal insurance products to environmentally friendly bicycle purchases.

Employees can also participate in bonus incentive plans specific to their business and share in the Group’s ongoing success through profit sharing, Buy As You Earn and Sharesave schemes, which align their interests with those of shareholders. UK employees participate in profit sharing that is directly related to the annual performance of the Group. For the last seven years this has amounted to a further 10 percent of basic salary.

To enable employees to get the most from Total Reward, a wide range of information about reward and benefits has been introduced through RBSpeople.com, an internet site offering 24 hour access from home or work.

The RBS group Charity Lottery was launched during 2005. Employees contributing to the prize fund through a small monthly entry fee have the chance to win up to 50% of the total funds collected each month. The remainder, after payment of a small lottery-operating fee, is donated to charity.

The Group continues to offer membership of its final pension scheme, with the entire cost being met by the Group. The largest scheme is the Royal Bank of Scotland Group Pension Fund, with 80,000 employee members in the UK.

Employee learning and development

The Group actively encourages learning and development and is committed to creating and providing opportunities both inside and outside the workplace. These experiences are provided through a variety of developmental initiatives, technological innovations and learning networks and forums. Creating and maintaining a talented network of people across the Group ensures not only a strong leadership capability, but also a high performing workforce.

In 2005 a new Group-wide approach to leadership development was launched. Called the “Leadership Journey”, it defines success at different leadership levels and the key developmental challenges that employees face as they progress within the Group. A suite of development programmes has been designed and implemented to ensure appropriate leadership development, supporting the challenges that individual leaders face whilst completing different stages of the Leadership Journey.

A core component of this ongoing activity is the Group’s Executive Leadership Programme (developed in conjunction with the Harvard Business School) and the establishment of an on-site business school at the Group Headquarters at Gogarburn, Edinburgh, which opened in January 2006. The Business School is central to the Group’s commitment to developing its leaders, and equipping them with the skills and confidence necessary to lead in complex and challenging environments.

Employee communication

Employee engagement is encouraged through a variety of means including a corporate intranet, Group and divisional magazines, team meetings led by line managers, briefings held by senior managers and regular dialogue with employees and employee representatives.

During 2005, the high quality of the Group’s internal communications was reflected by success in a number of prestigious external awards schemes. Awards were attained at both Group and divisional level and included a Gold Award for hub magazine, the Manufacturing division’s internal publication, at the UK Communicators in Business Awards, and a Gold Award for the Group Communications team in the Regular Communications category at the International Visual Communication Association Awards

The Group Chief Executive and other senior Group executives regularly communicate with employees through ‘Question Time’ style programmes, broadcast on the Group’s internal television network. An ‘Open Air’ debate chaired by the Group Chief Executive on Diversity and Inclusion, seeking to ensure equality of opportunity for employees and customers, typifies this approach.

64






Employee consultation

The Group’s confidential global Employee Opinion Survey is externally designed, undertaken and analysed annually on behalf of the Group by International Survey Research (“ISR”).

The survey enables employees to maximise their contribution to the Group by expressing their views and opinions on a range of key issues.

The results from the 2005 survey, which 86% of Group employees completed, demonstrated significant improvements for the fifth successive year. This year, for the very first time, the Group scored above the ISR Global Financial Services Norm in every single category.

The survey results are presented at Board, divisional and team levels. Action plans are developed to address any issues identified. With continuing year-on-year improvement, strong divisional results and improvements in all leading indicators, it is believed that results are sustainable, particularly given the Group’s focus on continuous improvement.

In addition to direct communication and consultation with employees, the Group recognises the trade union Amicus in the UK, and the Irish Bank Officials Association and the Services, Industrial, Professional and Technical Union in Ireland. These formal relationships are complemented by works council arrangements in many of the Group’s mainland Europe-based operations.

The Group has an European Employee Communication Council that provides elected employee representatives with an opportunity to better understand market conditions and strategic decisions with transnational impact on our European operations.

Diversity

The Group’s “Managing Diversity” policy sets a framework and a minimum standard within which all employees can develop to their full potential irrespective of race, gender, marital status, age, disability, religious belief, political opinion or sexual orientation. Each division has developed and delivered an action plan incorporating both Group and division-specific priorities to promote diversity across all areas of the employee lifecycle.

The success of this approach culminated in the Group receiving a Gold Standard Award in the Race for Opportunity Benchmarking Survey, having previously attained a Bronze in 2004. The Group maintains its involvement in and support of the UK Employers’ Forum on Age, Employers’ Forum on Disability, Employers’ Forum on Belief, Stonewall and of the Government’s Age Positive campaign.

The Group is also committed to ensuring that all prospective applicants for employment are treated fairly and equitably throughout the recruitment process. Its comprehensive resourcing standards cover the attraction and retention of individuals with disabilities. Reasonable adjustments are provided to support applicants in the recruitment process where these are required. The Group provides reasonable workplace adjustments for new entrants into the Group and for existing employees who become disabled during their employment.

Health, safety, wellbeing and security

The health, safety, wellbeing and security of RBS staff and customers continue to be a priority for the Group. Regular reviews are undertaken of both policies and processes to ensure compliance with current legislation and best practice. The Group focus is on ensuring that these policies are closely linked to the operational needs of the business.

Corporate responsibility

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

The Board regularly considers corporate responsibility issues and receives a formal report twice each year. Further details of the Group’s corporate responsibility policies will be contained in the 2005 Corporate Responsibility Report.

Code of ethics

The Group has adopted a code of ethics that is applicable to all of the Group’s employees and a copy is available upon request.

Charitable contributions

In 2005 the contribution to the Group’s Community Investment programmes increased to £56.2 million (2004 – £45.8 million). The total amount given for charitable purposes by the company and its subsidiary undertakings during the year ended 31 December 2005 was £24.3 million (2004 – £20.1 million).

Corporate governance

The company is committed to high standards of Corporate governance. Details are given on pages 67 to 72.

Political donations

No political donations were made during the year.

At the Annual General Meeting in 2002, shareholders gave authority for the company and certain of its subsidiaries to make political donations and incur political expenditure up to a maximum aggregate sum of £675,000 as a precautionary measure in light of the wide definitions in The Political Parties, Elections and Referendums Act 2000, for a period of four years. These authorities have not been used and it is not proposed that the Group’s longstanding policy of not making contributions to any political party be changed. A resolution to renew a general Group authority will be proposed at the Annual General Meeting on 28 April 2006.

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Report of the directors continued

Policy and practice on payment of creditors

The Group is committed to maintaining a sound commercial relationship with its suppliers. Consequently, it is the Group’s policy to negotiate and agree terms and conditions with its suppliers, which includes the giving of an undertaking to pay suppliers within 30 days of receipt of a correctly prepared invoice submitted in accordance with the terms of the contract or such other payment period as may be agreed.

At 31 December 2005, the Group’s trade creditors represented 27 days (2004 – 27 days) of amounts invoiced by suppliers. The company does not have any trade creditors.

Directors' indemnities

In terms of section 309C of The Companies Act 1985 (as amended), the directors of the company, members of the Group Executive Management Committee and Approved Persons of the Group (under the Financial Services and Markets Act 2000) have been granted Qualifying Third Party Indemnity Provisions by the company.

Auditors

The auditors, Deloitte & Touche LLP, have indicated their willingness to continue in office. A resolution to re-appoint Deloitte & Touche LLP as the company’s auditor will be proposed at the forthcoming Annual General Meeting.

By order of the Board.

 
Miller McLean
Secretary
27 February 2006
 
 
The Royal Bank of Scotland Group plc
is registered in Scotland No. 45551.

66






Corporate governance

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

Throughout the year ended 31 December 2005, the company has complied with all of the provisions set out in the revised Combined Code issued by the Financial Reporting Council in July 2003 (the “Code”) except in relation to the authority reserved to the Board to make the final determination of the remuneration of the executive directors, which is explained below in the paragraph headed ‘Remuneration Committee’.

The company has also complied with the Smith Guidance on Audit Committees in all material respects.

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

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 by the Board. Responsibility for the development of policy and strategy and operational management is delegated to the Group Chief Executive and other executive directors.

All directors participate in discussing strategy, performance and the financial and risk management of the company. Meetings of the Board are structured to allow open discussion.

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 at meetings of the Board.

Board balance and independence

The Board currently comprises the Chairman, six executive directors and eleven non-executive directors. The Board functions effectively and efficiently, and is considered to be of an appropriate size in view of the scale of the company and the diversity of its businesses. The directors provide the Group with the knowledge, mix of skills, experience and networks of contacts required. The Board Committees contain directors with a variety of relevant skills and experience so that no undue reliance is placed on any individual.

The non-executive directors combine broad business and commercial experience with independent and objective judgement. The balance between non-executive and executive directors enables the Board to provide clear and effective leadership and maintain the highest standards of integrity across the company’s business activities. The names and biographies of all Board members are set out on page 61.

The composition of the Board is subject to continuing review and the provisions of the Code will be taken into account in respect of the balance of the Board. The Code requires the Board to determine whether its non-executive members are independent.

The Board currently comprises ten independent and seven non-independent directors (including executive directors), in addition to the Chairman. Sir Tom McKillop is Chairman-designate and Bob Scott has been nominated as the senior independent director.

The Board considers that all non-executive directors are independent for the purposes of the Code, with the exception of Bud Koch who was formerly Chairman, President and Chief Executive Officer of Charter One Financial, Inc. which was acquired by Citizens Financial Group, Inc. in 2004.

Re-election of directors

At each Annual General Meeting, one third of the directors retire and offer themselves for re-election and each director must stand for re-election at least once every three years. Any non-executive directors who have served for more than nine years will also stand for annual re-election and the Board may consider their independence at that time. The proposed reelection of directors is subject to prior review by the Board.

The names of directors standing for re-election at the 2006 Annual General Meeting are contained on page 63 and further information will be given in the Chairman’s letter to shareholders in relation to the company’s Annual General Meeting.

Information, induction and professional development

All directors receive accurate, timely and clear information on all relevant matters. Any requests for further information or clarification are dealt with or co-ordinated by the Group Secretary.

The Group Secretary is responsible for advising the Board, through the Chairman, on all governance matters. All directors have access to the advice and services of the Group Secretary who is responsible to the Board for ensuring that Board procedures are followed and that applicable rules and regulations are complied with. In addition, all directors are able, if necessary, to obtain independent professional advice at the company’s expense.

Each new director receives a formal induction, including visits to all the Group’s major businesses and meetings with senior management. The induction is tailored to the director’s specific requirements. Existing directors undertake such professional development as they consider necessary in assisting them to carry out their duties as directors.

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Corporate governance continued

Performance evaluation

The annual performance evaluation of the Board and its Committees was undertaken in the autumn of 2005. The evaluation, which covered the operation and effectiveness of the Board, the Remuneration Committee and the Nominations Committee, was conducted by the Group Secretary using a detailed questionnaire and meetings with each director. Amongst the areas reviewed were the composition of the Board, Board processes and performance against objectives.

In addition, each director discussed his or her own performance with the Chairman and the senior independent director met individually with the executive directors and with the non-executive directors as a group without the Chairman present, to consider the Chairman’s performance. The report on the Board evaluation, which was designed to assist the Board in further improving its performance, was considered and discussed by the Board as a whole and specific actions are currently being implemented.

A review of the effectiveness of the Audit Committee was undertaken during the year by PricewaterhouseCoopers and was the subject of a separate report to the Board. Amongst the areas reviewed were the composition and performance of the Committee and the Committee’s role in relation to internal and external audit, risk management and financial reporting.

Board Committees

In order to provide effective oversight and leadership, the Board has established a number of Board Committees with particular responsibilities. The Committee chairmanship and membership are reviewed on a regular basis. The names and biographies of all Board Committee members are set out on page 61.

The terms of reference of the Audit, Remuneration and Nominations committees and the standard terms and conditions of the appointment of non-executive directors are available on the Group's website (www.rbs.com) and copies are available on request.

Audit Committee

All members of the Audit Committee are independent non-executive directors. The Audit Committee holds at least five meetings each year. The Audit Committee’s report is contained on pages 71 and 72.

Remuneration Committee

All members of the Remuneration Committee are independent non-executive directors. The Remuneration Committee holds at least three meetings each year.

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. The Directors’ Remuneration Report is contained on pages 73 to 81.

Responsibility for determining the remuneration of executive directors has not been delegated to the Remuneration Committee, and in that sense the provisions of the Code have not been complied with. The Board as a whole reserves the authority to make the final determination of the remuneration of directors as it considers that this two stage process allows greater consideration and evaluation and is consistent with the unitary nature of the Board. No director is 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 meets as required.

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 to, and the 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 Nominations Committee takes into account the knowledge, mix of skills, experience and networks of contacts which are anticipated to be needed on the Board in the future. The Chairman, Group Chief Executive and non-executive directors meet to consider executive succession planning. No director is involved in decisions regarding his or her own succession.

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.

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Meetings

The number of meetings of the Board and the Audit, Remuneration and Nominations Committees and individual attendance by members is shown below.

    Board   Audit   Remuneration   Nominations









Total number of meetings                
in 2005        9   9   5   5









Number of meetings                
attended in 2005                









Sir George Mathewson        9       5









Sir Tom McKillop*        2       2









Lord Vallance**        4      









Sir Angus Grossart**        4      









Sir Fred Goodwin        9      









Mr Buchan        9   8   5  









Dr Currie        9     5  









Mr Fish        6      









Mr Hunter        9   9    









Mr Koch        9      









Mr MacHale        9   9    









Miss Mackay        9   9   5  









Mr Pell        9      









Mr Robertson**        3      









Sir Steve Robson        9   9    









Mr Scott        9     5   4









Mr Sutherland        8       4









Mr Watt        9      









* Sir Tom McKillop was appointed to the Board on 1 September 2005.

** Lord Vallance, Sir Angus Grossart and Iain Robertson retired from the Board on 20 April 2005.

Relations with shareholders

The company communicates with shareholders through the annual report and by providing information in advance of the Annual General Meeting. Individual shareholders can raise matters relating to their shareholdings and the business of the Group at any time throughout the year. Shareholders are given the opportunity to ask questions at the Annual General Meeting or submit written questions in advance. The chairmen of the Audit, Remuneration and Nominations Committees are available to answer questions at the Annual General Meeting.

Communication with the company’s largest institutional shareholders is undertaken as part of the company’s investor relations programme. During the year, the directors received copies of analysts’ reports and a monthly report from the Group’s investor relations department which includes an analysis of share price movements, the Group’s performance against the sector, and key broker comments. In addition, information on major investor relations activities and changes to external ratings are provided. In 2005, the senior independent director attended results presentations to enhance his understanding of the views of major shareholders and would be available to shareholders if concerns could not be addressed through the normal channels. The arrangements used to ensure that directors develop an understanding of the views of major shareholders are considered as part of the annual Board performance evaluation.

The Chairman, Group Chief Executive, Group Finance Director and, if appropriate, the senior independent director communicate shareholder views to the Board as a whole.

In 2005, a survey of investor perceptions was undertaken on behalf of the Board by independent advisers, and the findings were considered by the Board.

Internal control

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

The Board has established a process for the identification, evaluation and management of the significant risks faced by the Group, which operated throughout the year ended 31 December 2005 and to 27 February 2006, the date the directors approved the Report and Accounts. This process is regularly reviewed by the Board and meets the requirements of the guidance ‘Internal Control: Guidance for Directors on the Combined Code’ issued by the Institute of Chartered Accountants in England and Wales in 1999.

The effectiveness of the Group’s internal control system is reviewed regularly by the Board and the Audit Committee. Executive management committees or boards of directors in each of the Group’s businesses receive quarterly reports on significant risks facing their business and how they are being controlled. These reports are combined and submitted to the Board as quarterly risk and control assessments. Additional details of the Group’s approach to risk management are given in the ‘Risk management’ section of the ‘Operating and financial review’ on pages 38 to 58. The Audit Committee also receives regular reports from Group Risk Management and Group Internal Audit. In addition, the Group’s independent auditors present to the Audit Committee reports that include details of any significant internal control matters which they have identified. The system of internal controls of the authorised institutions and other regulated entities in the Group is also subject to regulatory oversight in the UK and overseas. Additional details of the Group’s regulatory oversight are given in the Supervision and Regulation section on pages 205 to 208.

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Corporate governance continued

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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Audit Committee Report

The members of the Audit Committee are Archie Hunter (Chairman), Colin Buchan, Joe MacHale, Eileen Mackay, until her retirement on 31 December 2005, and Sir Steve Robson. All members of the Audit Committee are independent non-executive directors. The Audit Committee holds at least five meetings each year, two of which are held immediately prior to submission of the interim and annual financial statements to the Group Board. This core agenda is supplemented by additional meetings as required, four being added in 2005. Audit Committee meetings are attended by relevant executive directors, the internal and external auditors and risk management executives. At least twice per annum the Committee meets privately with the external auditors. The Audit Committee also visits business divisions and certain Group functions under a programme set at the beginning of each year.

The Board is satisfied that all the Audit Committee members have recent and relevant financial experience. Although the Board has determined that each Member of the Audit Committee is an ‘Audit Committee Financial Expert’ and is independent, each as defined in the SEC rules under the US Securities Exchange Act of 1934 and related guidance, the members of the Audit Committee are selected with a view to the expertise and experience of the Audit Committee as a whole, and the Audit Committee reports to the Board as a single entity. The designation of a director or directors as an ‘Audit Committee Financial Expert’ does not impose on any such director any duties, obligations or liability that are greater than the duties, obligations and liability imposed on such director as a member of the Audit Committee and Board in the absence of such a designation. Nor does the designation of a director as an ‘Audit Committee Financial Expert’ affect the duties, obligations or liability of any other member of the Board.

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.

Full details of the responsibilities of the Audit Committee are available at www.rbs.com/content/corporate_responsibility/corporate_governance/downloads/group_audit.pdf.

The Audit Committee has adopted a policy on the engagement of the external auditors to supply audit and non-audit services, which takes into account relevant legislation regarding the provision of such services by an external audit firm. The Audit Committee reviews the policy annually and prospectively approves the provision of audit services and certain non-audit services by the external auditors.

Annual audit services include all services detailed in the annual engagement letter including the annual audit and interim reviews (including US reporting requirements), periodic profit verifications and reports to regulators including skilled persons reports commissioned by the Financial Services Authority (e.g. Reporting Accountants Reports).

Annual audit services also include statutory or non-statutory audits required by any Group companies that are not incorporated in the United Kingdom. Terms of engagement for these audits are agreed separately with management, and are consistent with those set out in the audit engagement letter, as local regulations permit.

The prospectively approved non-audit services include the following classes of service:

  • capital raising, including consents, comfort letters and relevant reviews of registration statements;

  • provision of accounting opinions relating to the financial statements of the Group;

  • provision of reports that, according to law or regulation, must be rendered by the external auditors;

  • tax compliance services;

  • corporate finance services relative to companies that will remain outside the Group; and

  • insolvency work relating to the Group’s customers.

The Audit Committee approves all other permitted non-audit services on a case by case basis. The relevant submissions by management outline the service required and confirm that the external auditor’s independence will not be compromised. In addition, the Audit Committee reviews and monitors the independence and objectivity of the external auditors when it approves non-audit work to be carried out by them, taking into consideration relevant legislation and ethical guidance.

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

The Audit Committee 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.

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Corporate governance continued

In 2004 KPMG conducted a review of the effectiveness of Group Internal Audit. It is intended that there will be an external review of the effectiveness of Group Internal Audit every three years, with internal reviews continuing in the intervening years. In 2005 the Audit Committee conducted a review of Group Internal Audit that involved cross Group participation and the external auditors.

During 2005 PricewaterhouseCoopers conducted an external review of the effectiveness of the Audit Committee. It is intended that there will be an external review of the effectiveness of the Audit Committee every three years, with internal reviews by the Board continuing in the intervening years.

In 2005 the Audit Committee reviewed the audit committee structure throughout the Group and as a result proposed to the Board a reorganisation and strengthening of the structure to ensure that audit committees would cover each separate Group business appropriately. That recommendation was accepted by the Board and is now being implemented.

 

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Directors’ remuneration report

The Remuneration Committee

The members of the Remuneration Committee are Bob Scott (Chairman), Colin Buchan, Jim Currie and Eileen Mackay, until her retirement on 31 December 2005. All members of the Remuneration Committee are independent non-executive directors.

During the accounting period, the Remuneration Committee received advice from Watson Wyatt, Mercer Human Resource Consulting and Ernst & Young LLP on matters relating to directors’ remuneration in the UK (Watson Wyatt and Ernst & Young) and US (Mercer). In addition, the Remuneration Committee has taken account of the views of the Chairman of the Board and the Group Chief Executive on performance assessment of the executive directors.

In addition to advising the Remuneration Committee, Watson Wyatt provided professional services in the ordinary course of business, including actuarial advice and benefits administration services to subsidiaries of the Group and investment consulting advice to The Royal Bank of Scotland Pension Trustees Limited. Mercer Human Resource Consulting provided advice and support in connection with a range of benefits, pension actuarial and investment matters. Ernst & Young provided professional services in the ordinary course of business, including actuarial and corporate recovery advice.

Remuneration policy

The executive remuneration policy was approved by shareholders at the company’s Annual General Meeting in 2005. At the beginning of 2005, the Remuneration Committee decided to conduct a comprehensive review of all aspects of the executive remuneration package. A review of this depth had not been undertaken since 2000/2001. Its terms of reference were to examine all aspects of the executive remuneration strategy, policy and practice in light of the changing business make up and strategy of the Group and the evolution of best practice on executive remuneration. Following this review, the Remuneration Committee made no change to the overall executive remuneration policy, which is set out below. However, as a result of this review, the Group is making a number of changes to executive director remuneration practice which are described below.

The objective of the executive remuneration policy is to provide, in the context of the company’s business strategy, remuneration in form and amount which will attract, motivate and retain high calibre executives. In order to achieve this objective, the policy is framed around the following core principles:

  • Total rewards will be set at levels that are competitive within the relevant market, taking each executive director’s remuneration package as a whole.

  • Total potential rewards will be earned through achievement of demanding performance targets based on measures consistent with shareholder interests over the short, medium and longer-term.

  • Remuneration arrangements will strike an appropriate balance between fixed and performance-related rewards. Performance- related elements will comprise the major part of executive remuneration packages. See illustrative charts below.

  • Incentive plans and performance metrics will be structured to be robust through the business cycle.

  • Remuneration arrangements will be designed to support the company’s business strategy, to promote appropriate teamwork and to conform to best practice standards.

The above diagram has been prepared to illustrate the use of performance metrics in the total compensation package. For the Group Chief Executive 22% of the package is fixed and 78% is performance related. For the other executive directors, 28% is fixed and 72% is performance related. Values are entered on the basis of on target performance; long term incentives are shown at the approximate expected value at grant. Pension and other benefits have been excluded. Financial metrics include profit growth, cost control and ROE.

The non-executive directors’ fees are reviewed annually by the Board, on the recommendation of its Chairman. The level of remuneration reflects the responsibility and time commitment of directors and the level of fees paid to non-executive directors of comparable major UK companies. Non-executive directors do not participate in any incentive or performance plan.

The Remuneration Committee approves the remuneration arrangements of senior executives below Board level who are members of the Group Executive Management Committee, on the recommendation of the Group Chief Executive, and reviews all long-term incentive arrangements which are operated by the Group.

Components of executive remuneration
UK based directors
Salary

Salaries are reviewed annually as part of total remuneration, having regard to remuneration packages received by executives of comparable companies. The Remuneration Committee uses a range of survey data from remuneration consultants and reaches individual salary decisions taking account of the remuneration environment and the performance and responsibilities of the individual director.

Benefits

UK-based executive directors are eligible to participate in The Royal Bank of Scotland Group Pension Fund (“the RBS Fund”).

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Directors’ remuneration report continued

The RBS Fund is a non-contributory defined benefit fund which provides pensions and other benefits within Inland Revenue limits. Certain directors receive additional pension and life assurance benefits in excess of Inland Revenue limits. Details of pension arrangements of directors are shown on page 81.

From April 2006, new tax legislation will apply to UK pensions; in particular any pension in excess of the Lifetime Allowance will be subject to additional taxation. The Group will allow directors and employees whose benefits do, or are likely to exceed the Lifetime Allowance to opt-out of future tax-approved pension provision. In such cases the Group will pay the individual a salary supplement in lieu of pension provision. The Group will not meet the cost of any additional tax that individuals may incur as a result of their benefits exceeding the new Lifetime or Annual Allowances.

Executive directors are eligible to receive a choice of various employee benefits or a cash equivalent, on a similar basis to other employees. In addition, as employees, executive directors are eligible also to participate in Sharesave, Buy As You Earn and the Group profit sharing scheme, which currently pays up to 10 per cent of salaries, depending on the Group’s performance. These schemes are not subject to performance conditions since they are operated on an all-employee basis. Executive directors also receive death-in-service benefits.

Short-term annual incentives

As part of the overall review of the executive remuneration package referred to above, short term incentive levels were considered and the Remuneration Committee agreed to increase annual incentive potentials to reflect market practice and the setting of stretching new targets. As a result, from 2006 individual UK-based executive directors will normally have a maximum annual incentive potential of between 160% and 200% of salary. These will typically focus from year to year on the delivery of a combination of appropriate Group and individual financial and operational targets approved by the Remuneration Committee.

For the Group Chief Executive, the annual incentive is primarily based on specific Group financial performance measures such as operating profit, earnings per share growth and return on equity. The remainder of the Group Chief Executive’s annual incentive is based on a range of non-financial measures which may include measures relating to shareholders, customers and staff.

For the other executive directors a proportion of the annual incentive is based on Group financial performance and a proportion on division financial performance. The remainder of each individual’s annual incentive opportunity is dependent on achievement of a range of non-financial measures, specific objectives and key result areas. Divisional performance includes measures such as operating income, costs, bad debts or operating profit. Non-financial measures include customer measures (e.g. customer numbers, customer satisfaction), staff measures (e.g. employee engagement) and efficiency and change objectives.

For exceptional performance, as measured by the achievement of significant objectives, executive directors may be awarded incentive payments of up to 200% of salary, or 250% of salary, in the case of the Group Chief Executive. This discretion to pay additional bonuses for exceptional performance was last used in 2002 to recognise the successful integration of Natwest.

Long-term incentives

The company provides long-term incentives in the form of share options and share or share equivalent awards. Their objective is to encourage the creation of value over the long-term and to align the rewards of the executive directors with the returns to shareholders.

The Group’s polic