Edgar Filing: ROYAL BANK OF SCOTLAND GROUP PLC

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 6-K

Report of Foreign Private Issuer

Pursuant to Rule 13a-16 or 15d-16 of
the Securities Exchange Act of 1934

28 May 2009

The Royal Bank of Scotland Group plc

Gogarburn
PO Box 1000
Edinburgh EH12 1HQ
Scotland
United Kingdom

(Address of principal executive offices)

Indicate by check mark whether the registrant files or will file annual reports under cover of Form 20-F or Form 40-F.

Form 20-F X

Form 40-F___

Indicate by check mark if the registrant is submitting the Form 6-K in paper as permitted by Regulation S-T Rule 101(b)(1):___

Indicate by check mark if the registrant is submitting the Form 6-K in paper as permitted by Regulation S-T Rule 101(b)(7):___

Indicate by check mark whether the registrant by furnishing the information contained in this Form is also thereby furnishing the information to the Commission pursuant to Rule 12g3-2(b) under the Securities Exchange Act of 1934.

Yes

No X

If “Yes” is marked, indicate below the file number assigned to
the registrant in connection with Rule 12g3-2(b): 82-___

THE ROYAL BANK OF SCOTLAND plc

CONTENTS		Page

Explanatory note		2

Presentation of information		2

Forward-looking statements		3

Selected financial data		4

Description of business		6

Risk factors		7

Risk, capital and liquidity management		15

Financial statements
	Independent auditors' report	56
	Consolidated income statement	57
	Balance sheets	58
	Statements of recognised income and expense	59
	Cash flow statements	60
	Accounting policies	61
	Notes on the accounts	71

Signature		137

THE ROYAL BANK OF SCOTLAND plc

Explanatory note

The Royal Bank of Scotland Group plc is filing this report in order for its wholly-owned subsidiary, The Royal Bank of Scotland plc (hereafter “the Royal Bank”, the “Bank” or “Company”), to meet the requirements of item 1115 of Regulation AB issued by the Securities and Exchange Commission. This report contains selected financial data (on pages 4 - 5) and audited financial statements (on pages 56 - 135) as required by Item 3.A. and Item 17 of Form 20-F respectively and other related information.

Presentation of information

For the purpose of this report, the term 'Group' mean the Bank and its subsidiary and associated undertakings and the term 'RBS Group' means The Royal Bank of Scotland Group plc and its subsidiary and associated undertakings. The term 'the holding company' means The Royal Bank of Scotland Group plc.

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

The results, assets and liabilities of individual business units are classified as trading or non-trading based on their predominant activity. Although this method may result in some non-trading activity being classified as trading, and vice versa, the Group believes that any resulting misclassification is not material.

International Financial Reporting Standards

As required by the Companies Act 1985 and Article 4 of the European Union IAS Regulation, the consolidated financial statements of the Group are prepared in accordance with International Financial Reporting Standards issued by the International Accounting Standards Board (IASB) and interpretations issued by the International Financial Reporting Interpretations Committee of the IASB (together ‘IFRS’) as adopted by the European Union. It also complies with IFRS as issued by the IASB. On implementation of IFRS on 1 January 2005, the Group took advantage of the option in IFRS 1 ‘First-time Adoption of International Financial Reporting Standards’ to implement IAS 39 ‘Financial Instruments: Recognition and Measurement’ and IAS 32 ‘Financial Instruments: Disclosure and Presentation’ from 1 January 2005 without restating its 2004 income statement and balance sheet. The date of transition to IFRS for the Group and the date of its opening IFRS balance sheet is 1 January 2004.

The Group is no longer required to include reconciliations of shareholders' equity and net income under IFRS and US GAAP in its filings with the Securities and Exchange Commission in the US.

THE ROYAL BANK OF SCOTLAND plc

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’, ‘could’, ‘intend’, ‘plan’, ‘probability’, ‘risk’, ‘Value-at-Risk (“VaR”)’, ‘target’, ‘goal’, ‘objective’, ‘may’, ‘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: the extent and nature of future developments in the credit markets, including the sub-prime market, and their impact on the financial industry in general and the Group in particular; 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 fluctuations in interest rates, foreign currency exchange rates, commodity prices and equity prices; changes in UK and foreign laws, regulations and taxes; changes in competition and pricing environments; natural and other disasters; the inability to hedge certain risks economically; the adequacy of loss reserves; acquisitions or restructurings; technological changes; changes in consumer spending and saving habits; and the success of the Group in managing the risks involved in the foregoing.

The forward-looking statements contained in this report speak only as of the date of this report, and 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 on certain risks faced by the Group, see Risk Factors on page 7.

THE ROYAL BANK OF SCOTLAND plc

SELECTED FINANCIAL DATA

The Group’s accounts are prepared in accordance with IFRS as issued by the IASB. Selected data under IFRS for each of the five years ended 31 December 2008 are presented on pages 4 and 5.

The dollar financial information included below has been translated for convenience at the of £1.00 to US$1.4619, the Noon Buying Rate on 31 December 2008.

Amounts in accordance with IFRS

Summary consolidated income statement — IFRS	2008 $m		2008 £m		2007 £m	2006 £m	2005 £m	2004 £m
Net interest income	19,749		13,509		11,116	10,392	9,711	8,790
Non-interest income	3,432		2,348		11,191	11,176	9,963	8,441
Total income	23,181		15,857		22,307	21,568	19,674	17,231
Operating expenses (1)	29,527		20,198		11,287	11,341	10,672	9,225
(Loss)/profit before impairment	(6,346	)	(4,341	)	11,020	10,227	9,002	8,006
Impairment	6,880		4,706		1,865	1,873	1,709	1,485
Operating (loss)/profit before tax	(13,226	)	(9,047	)	9,155	8,354	7,293	6,521
Tax	(738	)	(505	)	1,903	2,433	2,267	1,751
(Loss)/profit from continuing operations	(12,488	)	(8,542	)	7,252	5,921	5,026	4,770
Profit from discontinued operations, net of tax	—		—		—	—	—	258
(Loss)/profit for the year	(12,488	)	(8,542	)	7,252	5,921	5,026	5,028

(Loss)/profit attributable to:
Minority interests	304		208		53	45	27	53
Other owners	933		638		331	252	154	315
Ordinary shareholders	(13,725	)	(9,388	)	6,868	5,624	4,845	4,660

Note:

(1) Includes integration and restructuring expenditure of £647 million (2007 - £92 million, 2006 - £120 million, 2005 - £349 million, 2004 - £499 million).

Summary consolidated balance sheet — IFRS	2008 $m	2008 £m	2007 £m	2006 £m	2005 £m	2004 £m
Loans and advances	1,021,707	698,890	647,795	547,042	485,488	405,512
Debt securities and equity shares	263,810	180,457	169,941	126,621	120,351	91,356
Derivatives and settlement balances (1)	1,386,361	948,328	211,301	109,548	89,479	15,297
Other assets	73,468	50,255	42,701	50,416	49,806	50,436
Total assets	2,745,346	1,877,930	1,071,738	833,627	745,124	562,601

Shareholders’ equity	67,186	45,958	47,683	37,936	34,510	34,320
Minority interests	1,889	1,292	152	396	104	679
Subordinated liabilities	58,404	39,951	27,796	27,786	28,422	21,262
Deposits	928,469	635,111	594,490	516,462	452,729	383,669
Derivatives, settlement balances and short positions(1)	1,396,205	955,062	256,921	152,989	128,295	43,812
Other liabilities	293,193	200,556	144,696	98,058	101,064	78,859
Total liabilities and equity	2,745,346	1,877,930	1,071,738	833,627	745,124	562,601

Note:

(1) Derivative balances in 2007 to 2004 have been restated for the netting of certain balances with the London Clearing House.

THE ROYAL BANK OF SCOTLAND plc

SELECTED FINANCIAL DATA (continued)

Other financial data

Based upon IFRS	2008		2007	2006	2005	2004
Return on average total assets(1)	(0.64%	)	0.72%	0.71%	0.74%	0.93%
Return on average ordinary shareholders' equity(2)	(22.7%	)	19.9%	18.4%	16.9%	17.6%
Average shareholders' equity as a percentage of total assets	3.4%		4.2%	4.4%	4.4%	6.2%
Risk asset ratio
- Tier 1	8.5%		7.9%	6.7%	6.8%	N/A(4)
- Total	14.2%		12.8%	12.1%	12.3%	N/A(4)
Ratio of earnings to fixed charges and preference dividends(3)
- including interest on deposits	0.48		1.50	1.57	1.62	1.83
- excluding interest on deposits	(2.94	)	5.68	6.30	6.77	6.79
Ratio of earnings to fixed charges only(3)
- including interest on deposits	0.50		1.53	1.59	1.64	1.91
- excluding interest on deposits	(3.97	)	6.89	7.54	7.73	9.37

Notes:

(1)	Return on average total assets represents profit attributable to ordinary shareholders as a percentage of average total assets.

(2)	Return on average ordinary shareholders' equity represents profit attributable to ordinary shareholders expressed as a percentage of average ordinary shareholders' equity.

(3)

For this purpose, earnings consist of income before taxes and minority interests, plus fixed charges less the unremitted income of associated undertakings (share of profits less dividends received). Fixed charges consist of total interest expense, including or excluding interest on deposits and debt securities in issue, as appropriate, and the proportion of rental expense deemed representative of the interest factor (one third of total rental expenses).

(4)

Upon 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 filers. The Risk Asset Ratios as at 31 December 2008, 2007, 2006 and 2005 have been presented in compliance with these revised FSA requirements.

Description of business

Introduction

The Royal Bank of Scotland plc (“the Royal Bank” or “the Bank”) is a wholly-owned subsidiary of The Royal Bank of Scotland Group plc (“the holding company”), a large banking and financial services group. The “Group” comprises the Bank and its subsidiary and associated undertakings. 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. “RBS Group” comprises the holding company and its subsidiary and associated undertakings.

Following a placing and open offer in December 2008, Her Majesty's Treasury in the United Kingdom (HM Treasury) owned approximately 58% of the enlarged ordinary share capital of the holding company and £5 billion of non-cumulative sterling preference shares. In April 2009, the holding company issued new ordinary shares by way of a second placing and open offer, the proceeds from which were used in full to fund the redemption of the preference shares held by HM Treasury at 101% of their issue price together with the accrued dividend and the commissions payable to HM Treasury under the second placing and open offer agreement. The second placing and open offer was underwritten by HM Treasury and as a result, HM Treasury currently owns approximately 70% of the enlarged ordinary share capital of the holding company.

Organisational structure and business overview

The Group’s activities are organised in the following business divisions: Global Markets (comprising Global Banking & Markets and Global Transaction Services), Regional Markets (comprising UK Retail & Commercial Banking, US Retail & Commercial Banking, Europe & Middle East Retail & Commercial Banking and Asia Retail & Commercial Banking), Group Manufacturing and the Centre. A description of each of the divisions is given below.

The RBS Group has undertaken a strategic review to re-focus the RBS Group on those businesses with clear competitive advantages and attractive marketing positions, primarily in stable, low-to-medium risk sectors.

Global Banking & Markets is a leading banking partner to major corporations and financial institutions around the world, providing an extensive range of debt and equity financing, risk management and investment services to its customers. In 2008 the division was organised along four principal business lines: rates, currencies, and commodities, including RBS Sempra Commodities LLP (the commodities-marketing joint venture between RBS and Sempra Energy which was formed on 1 April 2008); equities; credit markets; and asset and portfolio management.

Following the RBS Group’s strategic review, GBM is planning to re-focus its business around its core corporate and institutional clients, concentrating its activities in major financial centres and scaling back its presence elsewhere. It will exit illiquid proprietary trading and balance sheet-heavy niche products segments.

Globally, the intention is for GBM to move increasingly towards a “hub-and- spoke” model. Risk will be managed from regional hubs. It is intended that distribution and coverage will be delivered from a mix of hub countries and a scaled-back presence in some local offices. The aim, over time, will be to reduce much of the on-shore trading activity outside the key financial centres.

Assets, products and geographies that fit GBM’s new client-focused proposition will be defined as “core” and will remain within the division. Assets, business lines and some geographies that are non-core will be transferred to the new Non-Core Bank. These non-core activities accounted for approximately £205 billion of third party assets at end 2008.

Global Transaction Services ranks among the top five global transaction services providers, offering global payments, cash and liquidity management, as well as trade finance, United Kingdom and international merchant acquiring and commercial card products and services. It includes the Group’s corporate money transmission activities in the United Kingdom and the United States.

Following the RBS Group’s strategic review, Global Transaction Services intends to reduce its international network while retaining the capability to serve multinational clients globally.

The business also plans to increase efficiency through development of a lower cost front and back-office operating model and explore joint ventures for growth and selective disposals.

UK Retail & Commercial Banking (RBS UK) comprises retail, corporate and commercial banking and wealth management services. It operates through a range of channels including on-line and fixed and mobile telephony, and through two of the largest networks of branches and ATMs in the UK.

UK Retail Banking offers a full range of banking products and related financial services to the personal market. It serves customers through two of the largest networks of branches and ATMs in the United Kingdom, and also through telephone and internet channels and, according to Gfk NOP, is the second largest provider of personal current accounts. The division also issues credit and charge cards, including through other brands such as MINT.

UK Business & Commercial Banking is the largest provider of banking, finance, and risk management services to the SME sector in the United Kingdom. It offers a full range of banking products and related financial services through a nationwide network of relationship managers, and also through telephone and internet channels. The product range includes asset finance, in which, according to the Finance Lease Association, it has a strong market presence through the Lombard brand.

According to Ph. Group, UK Corporate Banking holds the largest market share in the United Kingdom of relationships with larger companies, offering a full range of banking, finance, and risk management services.

US Retail & Commercial Banking provides financial services primarily through the Citizens and Charter One brands. Citizens is engaged in retail and corporate banking activities through its branch network in 12 states in the United States and through non-branch offices in other states.

Following the RBS Group’s strategic review, Citizens intends to invest in its core business through increased marketing activity and targeted technology investments while reducing activity in its out-of-footprint national businesses in consumer and commercial finance.

This strategy will allow Citizens to become fully funded from its own customer deposits over time, and will support a low risk profile.

Europe & Middle East Retail & Commercial Banking comprises Ulster Bank and the Group’s combined retail and commercial businesses in Europe and the Middle East.

Ulster Bank, including First Active, provides a comprehensive range of financial services across the island of Ireland. Its retail banking arm has a network of branches and operates in the personal, commercial and wealth management sectors, while its corporate markets operations provide services in the corporate and institutional markets.

The retail and commercial businesses in Europe and the Middle East have smaller activities in Romania, Kazakhstan and the United Arab Emirates. Following the Group’s strategic review, the Group has decided to exit sub-scale retail and commercial activities outside its core markets in the United Kingdom, Europe and the United States.

Asia Retail & Commercial Banking is present in markets including India, Pakistan, China, Taiwan, Hong Kong, Indonesia, Malaysia and Singapore. It provides financial services across four segments: affluent banking, cards and consumer finance, business banking and international wealth management, which offers private banking and investment services to clients in selected markets through the RBS Coutts brand.

Following the RBS Group’s strategic review, the Group has decided to exit sub-scale retail and commercial activities outside its core markets in the United Kingdom, Europe and the United States.

Group Manufacturing comprises the Group’s worldwide manufacturing operations. It supports the customer-facing businesses and provides operational technology, customer support in telephony, account management, lending and money transmission, global purchasing, property and other services. Manufacturing drives efficiencies and supports income growth across multiple brands and channels by using a single, scalable platform and common processes wherever possible. It also leverages the Group’s purchasing power and has become the centre of excellence for managing large-scale and complex change.

The Centre comprises group and corporate functions, such as capital raising, finance, risk management, legal, communications and human resources. The Centre manages the Group’s capital requirement and Group-wide regulatory projects and provides services to the operating divisions.

Non-core division

The Group intends to create during the second quarter of 2009 a non-core division to manage separately approximately £240 billion of third party assets, £145 billion of derivative balances and £155 billion of risk weighted assets that it intends to run off or dispose of over the next three to five years. The division will contain primarily assets from the GBM division linked to proprietary trading portfolios, excess risk concentrations and other illiquid portfolios. It will also include excess risk concentrations from other divisions as well as a number of small Regional Markets businesses that the Group has concluded are no longer strategic.

Recent developments

Asset Protection Scheme

On 26 February 2009, the RBS Group confirmed its intended participation in HM Treasury’s Asset Protection Scheme (APS). The arrangements between the RBS Group and HM Treasury will, if completed, allow the RBS Group to secure asset protection in respect of some of its riskiest assets that enhances its financial strength and provides improved stability for customers and depositors, and also enhances the RBS Group’s ability to lend into the UK market.

The proposed entry by the RBS Group into the APS is subject to the approval of independent shareholders of the RBS Group.

Litigation Update

Note 29 of the Notes on the Accounts provides disclosure regarding, among other things, litigation claims in the United Kingdom. With respect to the claims regarding unarranged overdraft charges, the House of Lords has granted the RBS Group and other banks leave to appeal the Court of Appeal’s decision. That further appeal is scheduled to take place on 23 June 2009.

Debt Tender and Exchange Offer

On 26 March 2009, RBS Financing Limited ("RBSF"), a subsidiary of the RBS Group, launched a cash tender offer in the United States (the “RBSF US Tender Offer”) for any and all of the outstanding securities of ten different series previously issued by the Group and certain of its affiliates. Concurrently therewith, RBSF also launched a cash tender offer outside of the United States (the “RBSF Non-US Tender Offer”) for five different series of securities previously issued by The Royal Bank and certain of its affiliates and an offer outside of the United States to exchange (the “RBSF Exchange Offer”) any or all of the outstanding securities of fourteen different series previously issued by The Royal Bank and certain of its affiliates for new senior unsecured notes of The Royal Bank.

The RBSF Tender Offers and the RBSF Exchange Offer expired on 22 April 2009. In the RBSF US Tender Offer, an aggregate of approximately US $4.1 billion principal amount of securities were validly tendered, resulting in an aggregate purchase consideration paid for the tendered securities of approximately US $1.7 billion.

In the RBSF Non-US Tender Offer, an aggregate of approximately €2.3 billion principal amount of Euro-denominated securities and approximately US $264 million principal amount of Dollar-denominated securities were validly tendered, resulting in aggregate purchase consideration paid for the tendered securities of approximately €1.1 billion and US $100 million, respectively.

In the RBSF Exchange Offer, an aggregate of approximately £3.5 billion principal amount of securities were validly offered for exchange and exchanged for new senior unsecured notes of The Royal Bank in an aggregate principal amount of approximately £1.8 billion.

Competition

The Group faces strong competition in all the markets it serves. However, the global banking crisis has reduced the capacity of many institutions to lend and has resulted in the withdrawal or disappearance of a number of market participants and significant consolidation of competitors, particularly in the US and UK. Competition for retail deposits has intensified significantly reflecting the difficulties in the wholesale money markets.

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

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

In the personal banking segment, the Group competes with UK banks, building societies and major retailers. In the mortgage market, the Group competes with UK banks and building societies. A number of competitors have either left or scaled back their lending in the mortgage and unsecured markets.

In the UK credit card market, large retailers and specialist card issuers, including major US operators, are active in addition to the UK banks. In addition to physical distribution channels, providers compete through direct marketing activity and the internet.

In Europe, Asia and the Middle East, the Group competes in retail banking with local and international banks. In a number of these markets there are regulatory barriers to entry or expansion, and the state ownership of banks. Competition is generally intensifying as more players enter markets that are perceived to be de-regulating and offer significant growth potential.

In Wealth Management, The Royal Bank of Scotland International competes with other UK and international banks to offer offshore banking services. Coutts and Adam & Company compete as private banks with UK clearing and private banks, and with international private banks. Competition in wealth management remains strong as banks maintain their focus on competing for affluent and high net worth customers.

In Ireland, Ulster Bank and First Active compete in retail and commercial banking with the major Irish banks and building societies, and with other UK and international banks and building societies active in the market.

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

Risk factors

The Royal Bank of Scotland plc is a principal subsidiary of The Royal Bank of Scotland Group plc. Consequently, the risk factors facing RBS Group also apply to the Royal Bank and are therefore discussed in this section. References in this section to ‘RBS’ refer to The Royal Bank of Scotland Group plc.

Set out below are certain risk factors which could affect the RBS Group’s future results and cause them to be materially different from expected results. The RBS 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.

RBS may face the risk of full nationalisation and under such circumstances shareholders may lose the full value of their shares.

Under the provisions of the Banking Act, substantial powers have been granted to HM Treasury, the Bank of England and the Financial Services Authority (FSA) as part of the Special Resolution Regime to stabilise banks that are in financial difficulties. The Special Resolution Regime gives the authorities three stabilisation options: private sector transfer, of all or part of the business of a UK-incorporated institution with permission to accept deposits (a “relevant entity”); transfer of all or part of the business of the relevant entity to a “bridge bank” established by the Bank of England; and temporary public ownership (nationalisation) of the relevant entity or its UK-incorporated holding company.

The purpose of the stabilising options is to address the situation where all or part of the business of the relevant entity has encountered, or is likely to encounter, financial difficulties. Accordingly, the stabilisation options may only be exercised if the FSA is satisfied that a relevant entity such as the RBS Group’s banking subsidiaries, including the Royal Bank, (i) is failing, or is likely to fail, to satisfy the threshold conditions set out in Schedule 6 to the Financial Services and Markets Act 2000 (the “FSMA”) and (ii) having regard to timing and other relevant circumstances it is not reasonably likely that action will be taken that will enable the relevant entity to satisfy those threshold conditions. The threshold conditions are conditions which an FSA-authorised institution must satisfy in order to retain its FSA authorisation. They are relatively wide-ranging and deal with most aspects of a relevant entity’s business, including, but not limited to, minimum capital resource requirements. It is therefore possible that the FSA may exercise one of the stabilisation options before a relevant entity is in severe difficulties and before an application for insolvency or an administration order could be made.

The stabilisation options may be exercised by means of powers to transfer property, rights or liabilities of a relevant entity and shares and other securities issued by a relevant entity. HM Treasury may also take the parent company of a relevant entity (such as RBS) into temporary public ownership provided that certain conditions set out in Section 82 of the Banking Act are met. Temporary public ownership is effected by way of a share transfer order.

If HM Treasury makes the decision to take the holding company of a relevant entity into temporary public ownership, it may take various actions in relation to securities issued by the holding company, including:

·	to transfer securities free from any contractual or legislative restrictions on transfer;

·	to transfer securities free from any trust, liability, or encumbrance;

·	to extinguish rights to acquire securities;

·	to delist securities; or

·	to convert securities into another form or class.

Where HM Treasury has made a share transfer order in respect of securities issued by the holding company of a relevant entity, HM Treasury may make an order providing for the property, rights or liabilities of the holding company or of any relevant entity in the holding company group to be transferred.

Shareholders may have a claim for compensation under one of the compensation schemes provided for in the Banking Act. For the purposes of determining an amount of compensation, an independent valuer must disregard actual or potential financial assistance provided by the Bank of England or HM Treasury.

There can be no assurance that Shareholders would thereby recover compensation promptly and/or equal to any loss actually incurred.

If the RBS Group were made subject to the Special Resolution Regime and a partial transfer of the RBS Group’s business was effected, the nature and mix of the assets and liabilities not transferred may adversely affect its financial condition and increase the risk that the RBS Group may eventually become subject to administration or insolvency proceedings.

Over the last six months, the UK Government has taken action under the Banking (Special Provisions) Act 2008 in respect of a number of UK financial institutions including, in extreme circumstances, full and part nationalisation. There have been concerns in the market in recent months regarding the risks of such nationalisation in relation to RBS and other UK banks. If economic conditions in the UK or globally continue to deteriorate, or the events described in the following risk factors occur to such an extent that they have a materially adverse impact on the financial condition, perceived or actual credit quality, results of operations or business of any of the relevant entities in the RBS Group, the UK Government may decide to take similar action in relation to RBS. Given the extent of HM Treasury’s and the Bank of England’s powers under the Banking Act, it is difficult to predict what effect such actions might have on RBS and any securities issued by it. However, potential impacts may include full nationalisation of RBS and the total loss of value in RBS shares.

If RBS is unable to participate in the APS, or the operation of the APS fails to have the desired effect on RBS’s financial and capital position, RBS may face the increased risk of full nationalisation. If the costs of participation outweigh the benefits, this could have a negative impact on RBS’s business, earnings and financial prospects and its Share price may suffer.

On 26 February 2009, RBS announced its intention to participate in the APS. However, its ability to participate in the APS is subject to the satisfaction of a number of conditions which may not be satisfied, including, among others, the completion of due diligence by (and to the satisfaction of) HM Treasury, the receipt of certain regulatory approvals (including European Commission State Aid clearance), the approval of a majority of RBS’s Independent Shareholders, finalisation of the terms of the APS and RBS’s participation therein and the satisfaction by RBS of certain specified application criteria. The failure to satisfy these conditions could result in RBS being unable to participate in the APS and therefore failing to obtain protection against stressed losses through the economic cycle as well as failing to improve its capital ratios at the RBS consolidated Group level. The result of this may mean intervention by the UK Government, which could include full nationalisation, under which circumstances any compensation payable to Shareholders would be subject to the provisions of the Banking Act, and Shareholders may lose the full value of their Shares.

Furthermore, even if RBS is able to participate in the APS, there can be no assurance that such participation will enable RBS to achieve all of the stated goals of the APS. While the APS is expected to limit losses associated with assets to be covered by the APS, RBS would remain fully exposed in respect of a specified “first loss” amount and exposed to 10 per cent. of losses exceeding that “first loss” amount. In addition, RBS would continue to be exposed to the risk of losses, impairments and write-downs with respect to assets not covered by the APS. Although RBS would have the option to obtain an additional £6 billion in capital from HM Treasury (in the form of a subscription for further B Shares) there can be no assurance that such additional capital, together with RBS’s strengthened capital position as a result of the Placing and Open Offer, and the capital resulting from the proposed issue of the £6.5 billion and £13 billion of B Shares, will be sufficient to maintain the RBS Group’s capital ratios in the event of further losses, which could cause RBS’s business, results of operation and financial condition to suffer, its credit rating to drop, its ability to lend and access funding to be further limited, its cost of funding to increase and its Share price to decline, any of which would increase the risk of the full nationalisation of RBS.

In addition, there can be no assurance that the costs to RBS of its participation in the APS will not outweigh any benefits received. For example, RBS has agreed in principle that if it accedes to the APS, it will give up the right to certain tax losses and allowances which may affect the after-tax returns of the RBS Group in future years. As a result of RBS’s agreement to give up such UK tax losses and allowances it is likely that RBS will pay UK corporation tax in earlier accounting periods than it would otherwise have done.

The RBS Group’s businesses, earnings and financial condition have been and will continue to be affected by the continued deterioration in the global economy, as well as ongoing instability in the global financial markets.

The performance of the RBS Group has been and will continue to be influenced by the economic conditions of the countries in which it operates, particularly the United Kingdom, the United States and other countries throughout Europe and Asia. Recessionary conditions are present in many of these countries, including the United Kingdom and the United States, and such conditions are expected to continue or worsen over the near to medium term. In addition, the global financial system is continuing to experience the difficulties which first manifested themselves in August 2007, and the financial markets have deteriorated significantly since the bankruptcy filing by Lehman Brothers in September 2008. These conditions have led to severe and continuing dislocation of financial markets around the world and unprecedented levels of illiquidity, resulting in the development of significant problems at a number of the world’s largest corporate institutions operating across a wide range of industry sectors, many of whom are the RBS Group’s customers and counterparties in the ordinary course of its business. In response to this economic instability and illiquidity in the market, a number of governments, including the UK Government, the governments of the other EU member states and the US Government, have intervened in order to inject liquidity and capital into the financial system, and, in some cases, to prevent the failure of these institutions.

Despite such measures, the volatility and disruption of the capital and credit markets have continued at unprecedented levels, and global recessionary conditions are expected to continue. These conditions have produced and will continue to produce downward pressure on stock prices and on availability and cost of credit for financial institutions, including the RBS Group, and will continue to impact on the credit quality of the RBS Group’s customers and counterparties. Such conditions, alone or in combination with regulatory changes or actions of other market participants, may cause the RBS Group to experience further reductions in business activity, increased funding costs and funding pressures, lower share prices, decreased asset values, additional write downs and impairment charges and lower profitability or to incur losses.

In addition, the RBS Group will continue to be exposed to the risk of loss if major corporate borrowers or counterparty financial institutions fail or are otherwise unable to meet their obligations. The RBS Group’s performance may also be affected by future recovery rates on assets and the historical assumptions underlying asset recovery rates, which may no longer be accurate given the unprecedented market disruption and general economic instability. The precise nature of all the risks and uncertainties the RBS Group faces as a result of current economic conditions cannot be predicted and many of these risks are outside the RBS Group’s control.

Any conversion of the B Shares would significantly increase HM Treasury’s ownership interest in RBS, have a corresponding dilutive effect on other RBS Shareholders and could result in the delisting of RBS’s securities.

At the same time as RBS announced its proposed participation in the APS, RBS announced that, if it participated in the APS, it would issue £6.5 billion of B Shares to HM Treasury. RBS also announced that it would issue a further £13 billion of B Shares to HM Treasury on or after implementation of the APS, and HM Treasury would grant RBS the option to require HM Treasury to purchase a further £6 billion of B Shares from it. The B Shares, if issued, will rank pari passu with the Ordinary Shares on a winding-up. The B Shares would be convertible, at the option of the holder at any time, into Ordinary Shares at an initial conversion price of £0.50 per Ordinary Share. HM Treasury would agree not to convert any B Shares it holds if, as a result of such conversion, it would hold 75 per cent. or more of the Ordinary Shares, unless the price of the Ordinary Shares is equal to or exceeds £0.65 for a specified period in which case conversion is mandatory in any event. In addition, HM Treasury will not be entitled to vote in respect of Ordinary Shares acquired by it as a result of the conversion of B Shares into Ordinary Shares to the extent, but only to the extent, that votes cast on such Ordinary Shares, together with any other votes which HM Treasury is entitled to cast in respect of any other Ordinary Shares held by or on behalf of HM Treasury would exceed 75 per cent. of the total votes eligible to be cast on a resolution presented at a general meeting of RBS. If all £25.5 billion of B Shares are issued, such conversion of the B Shares would significantly increase HM Treasury’s ownership interest in RBS up to approximately 84.4 per cent. of the RBS’s issued share capital, and have a corresponding dilutive effect on other RBS Shareholders (as would the issue of the B Shares themselves in the event of a winding-up) although any such conversion would have no impact on the RBS Group’s Tier 1 capital position. Furthermore, a mandatory conversion of the B Shares by HM Treasury would put RBS in breach of the Listing Rules requirement that 25 per cent. of its issued share capital must be in public hands. Although RBS may apply to the UKLA for a waiver in such circumstances, there is no guarantee that such a waiver would be granted, the result of which could be the delisting of RBS from the Official List and potentially other exchanges where its securities are currently listed and traded.

Lack of liquidity is a risk to the RBS Group’s business and its ability to access sources of liquidity has been, and will continue to be, constrained.

Liquidity risk is the risk that a bank will be unable to meet its obligations, including funding commitments, as they fall due. This risk is inherent in banking operations and can be heightened by a number of enterprise specific factors, including an over-reliance on a particular source of funding (including, for example, short term and overnight funding), changes in credit ratings or market-wide phenomena such as market dislocation and major disasters. Credit markets worldwide have experienced and continue to experience a severe reduction in liquidity and term-funding in the aftermath of events in the US sub-prime residential mortgage market and the current severe market dislocation. Perception of counterparty risk between banks has also increased significantly following the bankruptcy filing by Lehman Brothers. This increase in perceived counterparty risk has led to further reductions in inter-bank lending, and hence, in common with many other banks, the RBS Group’s access to traditional sources of liquidity has been, and may continue to be, restricted.

The RBS Group’s liquidity management focuses on maintaining a diverse and appropriate funding strategy for its operations, controlling the mismatch of maturities and carefully monitoring its undrawn commitments and contingent liabilities. However, the RBS Group’s ability to access sources of liquidity (for example, through the issue or sale of financial and other instruments or through the use of term loans) during the recent period of liquidity stress has been constrained to the point where it, like other banks, has had to rely on shorter term and overnight funding with a consequent reduction in overall liquidity, and to increase its recourse to liquidity schemes provided by central banks.

In addition, there is also a risk that corporate and institutional counterparties with credit exposures may look to reduce all credit exposures to banks, given current risk aversion trends. It is possible that credit market dislocation becomes so severe that overnight funding from non-government sources ceases to be available.

Furthermore, like many banks, the RBS Group relies on customer deposits to meet a considerable portion of its funding requirements and such deposits are subject to fluctuation due to certain factors outside the RBS Group’s control, such as a loss of confidence, competitive pressures or the encouraged or mandated repatriation of deposits by foreign wholesale or central bank depositors which could result in a significant outflow of deposits within a short period of time. Any material decrease in the RBS Group’s deposits could, particularly if accompanied by one of the other factors described above, have a negative impact on the RBS Group’s liquidity unless corresponding actions were taken to improve the liquidity profile of other deposits or to reduce assets.

The governments of some of the countries in which the RBS Group operates have taken steps to guarantee the liabilities of the banks and branches operating in their respective jurisdiction. Whilst in some instances the operations of the RBS Group are covered by government guarantees alongside other local banks, in other countries this may not necessarily always be the case. This may place subsidiaries operating in those countries, such as Ulster Bank Ireland Ltd, which did not participate in such government guarantee schemes, at a competitive disadvantage to the other local banks and therefore may require the RBS Group to provide additional funding and liquidity support to these operations.

There can be no assurance that these measures, alongside other available measures, will succeed in improving the funding and liquidity in the markets in which the RBS Group operates, or that these measures, combined with any increased cost of any funding currently available in the market, will not lead to a further increase in the RBS Group’s overall cost of funding, which could have an adverse impact on the RBS Group’s financial condition and results of operations or result in a loss of value in RBS shares.

Governmental support schemes are subject to cancellation, change or withdrawal (on a general or individual basis), which may have a negative impact on the availability of funding in the markets in which the RBS Group operates.

Governmental support schemes are subject to cancellation, change or withdrawal (on a general or individual basis) subject to contract, based on changing economic and political conditions in the jurisdiction of the relevant scheme. Furthermore, certain schemes which have been recently announced have in fact not been fully implemented, or their terms have not yet been finalised. To the extent government support schemes are cancelled, changed or withdrawn in a manner which diminishes their effectiveness, or to the extent such schemes fail to generate additional liquidity or other support in the relevant markets in which such schemes operate, the RBS Group, in common with other banks, may continue to face limited access to, have insufficient access to, or incur higher costs associated with, funding alternatives, which could have a material adverse impact on the RBS Group’s business, financial condition, results of operations and prospects and result in a loss of value in RBS shares.

The financial performance of the RBS Group has been and will be affected by borrower credit quality.

Risks arising from changes in credit quality and the recoverability of loans and amounts due from counterparties are inherent in a wide range of the RBS Group’s businesses. The outlook for the global economy over the near to medium term has continued to deteriorate, particularly in the UK, the United States and other European economies. For example, there is an expectation of further reductions in residential and commercial property prices, higher unemployment rates and reduced profitability of corporate borrowers. As a result, the RBS Group has seen and expects to continue to see adverse changes in the credit quality of its borrowers and counterparties, with increasing delinquencies, defaults and insolvencies across a range of sectors. This trend has led and may lead to further impairment charges, higher costs, additional write downs and losses for the RBS Group or result in a loss of value in RBS shares.

The actual or perceived failure or worsening credit of the RBS Group’s counterparties has adversely affected and could continue to adversely affect the RBS Group.

The RBS Group’s ability to engage in routine funding transactions has been and will continue to be adversely affected by the actual or perceived failure or worsening credit of its counterparties, including other financial institutions and corporate borrowers. The RBS Group has exposure to many different industries and counterparties and routinely executes transactions with counterparties in the financial industry, including brokers and dealers, commercial banks, investment banks, mutual and hedge funds and other institutional clients. As a result, defaults by, or even the perceived creditworthiness of or concerns about, one or more corporate borrowers, financial services institutions, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by the RBS Group or by other institutions. Many of these transactions expose the RBS Group to credit risk in the event of default of the RBS Group’s counterparty or client. In addition, the RBS Group’s credit risk is exacerbated when the collateral it holds cannot be realised or is liquidated at prices not sufficient to recover the full amount of the loan or derivative exposure that is due to the RBS Group, which is most likely to occur during periods of illiquidity and depressed asset valuations, such as those currently experienced. Any such losses could have a material adverse effect on the RBS Group’s results of operations and financial condition or result in a loss of value in RBS shares.

The RBS Group’s earnings and financial condition have been, and its future earnings and financial condition are likely to continue to be, affected by depressed asset valuations resulting from poor market conditions.

Financial markets are currently subject to significant stress conditions, where steep falls in perceived or actual asset values have been accompanied by a severe reduction in market liquidity, as exemplified by recent events affecting asset backed collateralised debt obligations (CDOs), the US subprime residential mortgage market and the leveraged loan market. In dislocated markets, hedging and other risk management strategies have proven not to be as effective as they are in normal market conditions due in part to the decreasing credit quality of hedge counterparties, including monoline and other insurance companies and credit derivative product companies. Severe market events have resulted in the RBS Group recording large write-downs on its credit market exposures in 2007 and 2008. The RBS Group expects that the deterioration in economic and financial market conditions will lead to further impairment charges and write-downs during the current financial year. Moreover, recent market volatility and illiquidity has made it difficult to value certain of the RBS Group’s exposures. Valuations in future periods, reflecting, among other things, then-prevailing market conditions and changes in the credit ratings of certain of the RBS Group’s assets, may result in significant changes in the fair values of the RBS Group’s exposures, even in respect of exposures, such as credit market exposures, for which the RBS Group has previously recorded write-downs. In addition, the value ultimately realised by the RBS Group may be materially different from the current or estimated fair value. Any of these factors could require the Group to recognise further significant write-downs or realise increased impairment charges, any of which may adversely affect its capital position, its financial condition and its results of operations or result in a loss of value in RBS shares.

The value or effectiveness of any credit protection that the RBS Group has purchased from monoline and other insurers and other market counterparties (including credit derivative product companies) depends on the value of the underlying assets and the financial condition of the insurers and such counterparties.

The RBS Group has credit exposure arising from over-the-counter derivative contracts, mainly credit default swaps (CDSs), which are carried at fair value. The fair value of these CDSs, as well as the RBS Group’s exposure to the risk of default by the underlying counterparties, depends on the valuation and the perceived credit risk of the instrument against which protection has been bought. Since 2007, monoline and other insurers and other market counterparties (including credit derivative product companies) have been adversely affected by their exposure to residential mortgage linked and corporate credit products. As a result, their actual and perceived credit worthiness deteriorated significantly in 2008 and may continue to be so impacted in 2009. If the financial condition of these counterparties or their actual and perceived credit worthiness deteriorates further, the RBS Group may record further credit valuation adjustments on the CDSs bought from these counterparties in addition to those already recorded.

Changes in interest rates, foreign exchange rates, bond, equity and commodity prices, and other market factors have significantly affected and will continue to affect the RBS Group’s business.

Some of the most significant market risks the RBS Group faces are interest rate, foreign exchange, bond, equity and commodity price risks. Changes in interest rate levels, yield curves and spreads may affect the interest rate margin realised between lending and borrowing costs, the effect of which may be heightened during periods of liquidity stress, such as those experienced in recent months. Changes in currency rates, particularly in the sterling-US dollar and sterling-euro exchange rates, affect the value of assets, liabilities, income and expenses denominated in foreign currencies and the reported earnings of the RBS Group’s non-UK subsidiaries (principally ABN AMRO, Citizens and RBS Greenwich Capital) and may affect income from foreign exchange dealing. The performance of financial markets may affect bond, equity and commodity prices and, therefore, cause changes in the value of the RBS Group’s investment and trading portfolios. This has been the case during the period since August 2007, with market disruptions and volatility resulting in significant reductions in the value of such portfolios. While the RBS Group has implemented risk management methods to mitigate and control these and other market risks to which it is exposed, it is difficult, particularly in the current environment, to predict with accuracy changes in economic or market conditions and to anticipate the effects that such changes could have on the RBS Group’s financial performance and business operations or result in a loss of value in RBS shares.

The RBS Group’s borrowing costs and its access to the debt capital markets depend significantly on its credit ratings.

On 19 January 2009, S&P affirmed the long-term and short-term counterparty credit ratings for the Royal Bank at A+ and A-1 respectively. The outlook for all entities of the RBS Group was confirmed as stable, reflecting S&P’s view that the RBS Group is of systemic importance to the UK banking system and that S&P now explicitly factor four notches of uplift into their long-term counterparty credit rating on the RBS Group. At the same time S&P lowered its ratings on the RBS Group’s hybrid capital issues to BB from BBB, additionally the BB rating was placed under CreditWatch with negative implications. On the same date, Fitch affirmed the RBS Group and the Royal Bank’s Long-term and Short-term Issuer Default Ratings at AA- and F1+ respectively and downgraded the RBS Group and the Royal Bank’s individual ratings to E from B/C. The outlook for the Issuer Default Ratings remains stable reflecting Fitch’s expectation of continued strong government support for the RBS Group. The RBS Group’s support rating was upgraded from 1 to 5 and its support floor revised to AA- from No Floor. Fitch also downgraded the RBS Group and the Royal Bank’s Tier 1 preference shares to BB- from A+, and upper tier 2 hybrid capital instruments issued by RBS Group companies to BB from A+ and placed all of these securities on Rating Watch Negative. Moody’s on 20 January 2009 downgraded the senior unsecured rating of the Royal Bank to Aa3 from Aa1 with a negative outlook. The RBS Group’s senior debt rating was downgraded to A1 from Aa2 again with a negative outlook. The Bank Financial Strength Rating was lowered to C- from B and remains under review for further possible downgrade. The short term P-1 ratings of both the RBS Group and the Royal Bank were affirmed. The outlook for all RBS Group entities incorporates Moody’s view on the long-term credit profile of the RBS Group beyond the current government support phase as well as their view of the very high probability of on-going support from the Aaa-rated UK Government. Any future reductions in the long-term credit ratings of the RBS Group or one of its principal subsidiaries (particularly the Royal Bank) could further increase its borrowing costs. Any further reductions may also limit the RBS Group’s access to the capital markets and trigger additional collateral requirements in derivative contracts and other secured funding arrangements. Credit ratings of the RBS Group and the Royal Bank are also important to the RBS Group when competing in certain markets, such as over-the-counter derivatives. As a result, any further reductions in the RBS Group’s or the Royal Bank’s credit ratings could adversely affect its access to liquidity and competitive position, increase its funding costs and have a negative impact on the RBS Group’s earnings and financial condition or result in a loss of value in RBS shares.

The RBS Group’s business performance could be adversely affected if its capital is not managed effectively.

Effective management of the RBS Group’s capital is critical to its ability to operate its businesses, to grow organically and to pursue its strategy. The RBS Group is required by regulators in the United Kingdom, the United States, the Netherlands and in other jurisdictions in which it undertakes regulated activities, to maintain adequate capital. The maintenance of adequate capital is also necessary to enhance the RBS Group’s financial flexibility in the face of continuing turbulence and uncertainty in the global economy. Accordingly, the purpose of the First Placing and Open Offer and the issue of the Preference Shares was to allow RBS to strengthen its capital position. As at 31 December 2008 the RBS Group’s Tier 1 and Core Tier 1 capital ratios were 10.0 per cent. and 6.8 per cent. respectively, using the Basel II methodology. Although the net proceeds of the First Placing and Open Offer and the Preference Share Issue strengthened the RBS Group’s capital base significantly, and the net proceeds of the Second Placing and Open Offer were used to redeem the existing £5 billion of Preference Shares and which thereby improved the quality of the RBS Group’s capital by increasing the RBS Group’s Core Tier 1 capital ratio, any change that limits the RBS Group’s ability effectively to manage its balance sheet and capital resources going forward (including, for example, reductions in profits and retained earnings as a result of write-downs or otherwise, increases in risk-weighted assets, delays in the disposal of certain assets or the inability to syndicate loans as a result of market conditions or otherwise) or to access funding sources, could have a material adverse impact on its financial condition and regulatory capital position or result in a loss of value in RBS shares.

The value of certain financial instruments recorded at fair value is determined using financial models incorporating assumptions, judgements and estimates that may change over time or may ultimately not turn out to be accurate.

Under IFRS, the RBS Group recognises at fair value: (i) financial instruments classified as ‘held-for-trading’ or ‘designated as at fair value through profit or loss’; (ii) financial assets classified as ‘available-for-sale’; and (iii) derivatives, each as further described in ‘Accounting Policies’ on page 64 of the financial statements. Generally, to establish the fair value of these instruments, the RBS Group relies on quoted market prices or, where the market for a financial instrument is not sufficiently active, internal valuation models that utilise observable market data. In certain circumstances, the data for individual financial instruments or classes of financial instruments utilised by such valuation models may not be available or may become unavailable due to changes in market conditions, as has been the case during the current financial crisis. In such circumstances, the RBS Group’s internal valuation models require the RBS Group to make assumptions, judgements and estimates to establish fair value. In common with other financial institutions, these internal valuation models are complex, and the assumptions, judgements and estimates the RBS Group is required to make often relate to matters that are inherently uncertain, such as expected cash flows, the ability of borrowers to service debt, residential and commercial property price appreciation and depreciation, and relative levels of defaults and deficiencies. Such assumptions, judgements and estimates may need to be updated to reflect changing facts, trends and market conditions. The resulting change in the fair values of the financial instruments has had and could continue to have a material adverse effect on the RBS Group’s earnings and financial condition. Also, recent market volatility and illiquidity has challenged the factual bases of certain underlying assumptions and has made it difficult to value certain of the RBS Group’s financial instruments. Valuations in future periods, reflecting prevailing market conditions, may result in further significant changes in the fair values of these instruments, which could have a negative effect on the RBS Group’s results of operations and financial condition or result in a loss of value in RBS shares.

The RBS Group’s future earnings and financial condition in part depend on the success of the RBS Group’s strategic refocus on core strengths and its disposal programme.

In light of the recently changed global economic outlook, the RBS Group has embarked on a restructuring which focused on achieving appropriate risk adjusted returns under these changed circumstances, reducing reliance on wholesale funding and lowering exposure to capital intensive businesses. The RBS Group will also continue with its disposal programme and continue to review its portfolio to identify further disposals of certain non-core assets. Although the proceeds of the Second Placing and Open Offer improved the quality of the RBS Group's capital by replacing the existing £5 billion of Preference Shares with £5 billion of Core Tier 1 capital, the global credit markets remain challenging and the RBS Group’s execution of its current and future strategic plans may not be successful. In connection with the implementation of these plans, the RBS Group may incur restructuring charges, which may be material. Furthermore, if the RBS Group’s plans, including any planned disposals, are not successful or fail to achieve the results expected, the RBS Group’s business, capital position financial condition, results of operations and future prospects may be negatively impacted or this could result in a loss of value in RBS shares.

The RBS Group operates in markets that are highly competitive and consolidating. If the RBS Group is unable to perform effectively, its business and results of operations will be adversely affected.

Recent consolidation among banking institutions in the United Kingdom, the United States and throughout Europe is changing the competitive landscape for banks and other financial institutions. This consolidation, in combination with the introduction of new entrants into the US and UK markets from other European and Asian countries, could increase competitive pressures on the RBS Group. Moreover, if financial markets continue to be volatile, more banks may be forced to consolidate.

In addition to the effects of consolidation, increased government ownership of, and involvement in, banks generally may have an impact on the competitive landscape in the major markets in which the RBS Group operates. Although, at present, it is difficult to predict what the effects of this increased government ownership and involvement will be or how it will differ from jurisdiction to jurisdiction, such involvement may cause the RBS Group to experience stronger competition for corporate, institutional and retail clients and greater pressure on profit margins. Since the markets in which the RBS Group operates are expected to remain highly competitive in all areas, these and other changes to the competitive landscape could adversely affect the RBS Group’s business, margins, profitability and financial condition or result in a loss of value in RBS shares.

The RBS Group has agreed to certain undertakings in relation to the operation of its business in the First Placing and Open Offer Agreement, the Second Placing and Open Offer Agreement and in connection with the proposed APS, which may serve to limit the RBS Group’s operations.

Under the terms of the First Placing and Open Offer Agreement, the RBS Group provided certain undertakings aimed at ensuring that the subscription by HM Treasury for the relevant Ordinary Shares and the Preference Shares and the RBS Group’s potential participation in the guarantee scheme promoted by HM Treasury as part of its support for the UK banking industry are compatible with the common market under EU law. These undertakings include (i) supporting certain initiatives in relation to mortgage lending and lending to SMEs until 2011, (ii) regulating management remuneration and (iii) regulating the rate of growth of the RBS Group’s balance sheet. Under the terms of the Second Placing and Open Offer Agreement, the RBS Group’s undertakings in relation to mortgage lending and lending to SMEs were extended to larger commercial and industrial companies in the United Kingdom. These undertakings may serve to limit the RBS Group’s operations. In addition, pursuant to the Lending Commitments Letter, the RBS Group is subject to further undertakings, which supersede the lending commitments made to HM Treasury in October 2008 and January 2009 by agreeing to lend £16 billion above the amount the RBS Group had budgeted to lend to UK businesses and £9 billion above the amount the RBS Group had budgeted to lend to UK homeowners in the year commencing 1 March 2009, with a commitment to lend at similar levels in the year commencing 1 March 2010.

The RBS Group could fail to attract or retain senior management or other key employees.

The RBS Group’s ability to implement its strategy depends on the ability and experience of its senior management and other key employees. The loss of the services of certain key employees, particularly to competitors, could have a negative impact on the RBS Group’s business. The RBS Group’s future success will also depend on its ability to attract, retain and remunerate highly skilled and qualified personnel competitively with its peers. This cannot be guaranteed, particularly in light of heightened regulatory oversight of banks and heightened scrutiny of, and (in some cases) restrictions placed upon, management compensation arrangements, in particular those in receipt of Government funding (such as the RBS Group). The RBS Group recently announced changes to its compensation structure which included significant reductions in bonuses to be paid in respect of 2008, and limitations on pay rises in 2009. In addition to the effects of such measures on the RBS Group’s ability to retain senior management and other key employees, the marketplace for skilled personnel is becoming more competitive, which means the cost of hiring, training and retaining skilled personnel may continue to increase. The failure to attract or retain a sufficient number of appropriately skilled personnel could prevent the RBS Group from successfully implementing its strategy, which could have a material adverse effect on the RBS Group’s financial condition and results of, operations or result in a loss of value in RBS shares.

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

The RBS Group is subject to financial services laws, regulations, administrative actions and policies in each location in which it operates. All of these are subject to change, particularly in the current market environment, where there have been unprecedented levels of government intervention and changes to the regulations governing financial institutions, including recent nationalisations in the United Kingdom, the United States and other European countries. As a result of these and other ongoing and possible future changes in the financial services regulatory landscape (including requirements imposed by virtue of the RBS Group’s participation in any government or regulator-led initiatives), the RBS Group expects to face greater regulation in the United Kingdom, the United States, the Netherlands and other countries in which it operates, including throughout the rest of Europe.

Compliance with such regulations may increase the RBS Group’s capital requirements and costs and have an adverse impact on its business, the products and services it offers and the value of its assets or result in a loss of value in RBS shares. Other areas where governmental policies and regulatory changes could have an adverse impact include, but are not limited to:

·	the monetary, interest rate, capital adequacy and other policies of central banks and regulatory authorities;

·	general changes in government or regulatory policy or changes in regulatory regimes that may significantly influence investor decisions in particular markets in which the RBS Group operates or may increase the costs of doing business in those markets;

·	changes to financial reporting standards;

other general changes in the regulatory requirements, such as prudential rules relating to the capital adequacy framework and the imposition of onerous compliance obligations, restrictions on business growth or pricing and requirements to operate in a way that prioritises objectives other than shareholder value creation;

·	changes in competition and pricing environments;

·	further developments in the financial reporting environment;

differentiation amongst financial institutions by governments with respect to the extension of guarantees to bank customer deposits and the terms attaching to such guarantees, including requirements for the entire RBS Group to accept exposure to the risk of any individual member of the RBS Group, or even third party participants in guarantee schemes, failing;

·	implementation of, or costs related to, local customer or depositor compensation or reimbursement schemes;

·	transferability and convertibility of currency risk;

·	expropriation, nationalisation and confiscation of assets;

·	changes in legislation relating to foreign ownership; and

·	other unfavourable political, military or diplomatic developments producing social instability or legal uncertainty which, in turn, may affect demand for the RBS Group’s products and services.

The RBS Group’s results have been and could be further adversely affected in the event of goodwill impairment.

The RBS Group capitalises goodwill, which is calculated as the excess of the cost of an acquisition over the net fair value of the identifiable assets, liabilities and contingent liabilities acquired. Acquired goodwill is recognised initially at cost and subsequently at cost less any accumulated impairment losses. As required by IFRS, the RBS Group tests goodwill for impairment annually or more frequently, at external reporting dates, when events or circumstances indicate that it might be impaired. An impairment test involves comparing the recoverable amount (the higher of value in use and fair value less cost to sell) of an individual cash generating unit with its carrying value. The value in use and fair value of the RBS Group’s cash generating units are affected by market conditions and the performance of the economies in which the RBS Group operates. Where the RBS Group is required to recognise a goodwill impairment, it is recorded in the RBS Group’s income statement, although it has no effect on the RBS Group’s regulatory capital position. For the year ended 31 December 2008, the Group recorded a £8.1 billion accounting write-down of goodwill and other intangibles relating to prior year acquisitions.

The RBS Group may be required to make further contributions to its pension schemes if the value of pension fund assets is not sufficient to cover potential obligations.

The RBS Group maintains a number of defined benefit pension schemes for past and current employees. Pensions risk is the risk that the liabilities of the RBS Group’s various defined benefit pension schemes which are long term in nature will exceed the schemes’ assets, as a result of which the RBS Group is required or chooses to make additional contributions to the schemes. The schemes’ assets comprise investment portfolios that are held to meet projected liabilities to the scheme members. Risk arises from the schemes because the value of these asset portfolios and returns from them may be less than expected and because there may be greater than expected increases in the estimated value of the schemes’ liabilities. In these circumstances, the RBS Group could be obliged, or may choose, to make additional contributions to the schemes, and during recent periods, the RBS Group has voluntarily made such contributions. Given the current economic and financial market difficulties and the prospects for them to continue over the near and medium term, the RBS Group may be required or elect to make further contributions to the pension schemes and such contributions could be significant and have a negative impact on the RBS Group’s capital position results of operations or financial condition or result in a loss of value in RBS shares.

The RBS Group is and may be subject to litigation and regulatory investigations that may impact its business.

The Group’s operations are diverse and complex and it operates in legal and regulatory environments that expose it to potentially significant litigation, regulatory investigation and other regulatory risk. As a result, the Group is, and may in the future be, involved in various disputes, legal proceedings and regulatory investigations in the United Kingdom, the United States and other jurisdictions, including class-action litigation. Furthermore, the RBS Group, like many other financial institutions, has come under greater regulatory scrutiny over the last year and expects that environment to continue for the foreseeable future, particularly as it relates to compliance with new and existing corporate governance, employee compensation, conduct of business, anti-money laundering and anti-terrorism laws and regulations, as well as the provisions of applicable sanctions programmes. Disputes, legal proceedings and regulatory investigations are subject to many uncertainties, and their outcomes are often difficult to predict, particularly in the earlier stages of a case or investigation. Adverse regulatory action or adverse judgements in litigation could result in restrictions or limitations on the Group’s operations or result in a material adverse effect on the RBS Group’s reputation or results of operations or result in a loss of value in RBS shares. For details about certain litigation and regulatory investigations in which the Group is involved, see Note 29 on the financial statements.

Operational risks are inherent in the RBS Group’s operations.

The RBS Group’s operations are dependent on the ability to process a very large number of transactions efficiently and accurately while complying with applicable laws and regulations where it does business. The RBS Group has complex and geographically diverse operations and operational risk and losses can result from internal or external fraud, errors by employees or third-parties, failure to document transactions properly or to obtain proper authorisation, failure to comply with applicable regulatory requirements and conduct of business rules (including those arising out of anti-money laundering and anti-terrorism legislation, as well as the provisions of applicable sanctions programmes), equipment failures, natural disasters or the inadequacy or failure of systems and controls, including those of the RBS Group’s suppliers or counterparties. Although the RBS Group has implemented risk controls and loss mitigation actions, and substantial resources are devoted to developing efficient procedures, to identifying and rectifying weaknesses in existing procedures and to training staff, it is not possible to be certain that such actions have been or will be effective in controlling each of the operational risks faced by the RBS Group. Any weakness in these systems or controls, or any breaches or alleged breaches of applicable laws or regulations could have a materially negative impact on the RBS Group’s business, reputation, results of operations and share price. Notwithstanding anything contained in this risk factor, it should not be taken as implying that either RBS or the RBS Group will be unable to comply with its obligations as a company with securities admitted to the Official List or as a supervised firm regulated by the FSA.

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

The RBS 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 RBS’s profitability. Revisions to tax legislation or to its interpretation might also affect the RBS Group’s results in the future.

The acquisition of a majority shareholding in the RBS Group by HM Treasury in December 2008 could lead to certain adverse tax consequences for the RBS Group.

The acquisition by HM Treasury of a majority shareholding in the RBS Group in consequence of the First Placing and Open Offer could, in certain circumstances, have adverse tax consequences which could affect the post-tax profitability of the RBS Group. However, if the RBS Group enters into the APS it has agreed, in principle, to give up the right to certain UK tax losses and allowances and this may limit the adverse tax consequences of the acquisition by HM Treasury of a majority shareholding in the RBS Group.

The RBS Group’s operations have inherent reputational risk.

Reputational risk, meaning the risk to earnings and capital from negative public opinion, is inherent in the RBS Group’s business. Negative public opinion can result from the actual or perceived manner in which the RBS Group conducts its business activities or from actual or perceived practices in the banking and financial industry. Negative public opinion may adversely affect the RBS Group’s ability to keep and attract customers and, in particular, corporate and retail depositors. The RBS Group cannot ensure that it will be successful in avoiding damage to its business from reputational risk.

In the United Kingdom and in other jurisdictions, the RBS Group is responsible for contributing to compensation schemes in respect of banks and other authorised financial services firms that are unable to meet their obligations to customers.

In the United Kingdom, the Financial Services Compensation Scheme (the “Scheme”) was established under the FSMA and is the UK’s statutory fund of last resort for customers of authorised financial services firms. The Scheme can pay compensation to customers if a firm is unable, or likely to be unable, to pay claims against it and, if the Banking Bill is enacted in its current form, may be required to make payments either in connection with the exercise of a stabilisation power or in exercise of the bank insolvency procedures under that Bill. The Scheme is funded by levies on firms authorised by the FSA, including the RBS Group. In the event that the Scheme raises funds from the authorised firms, raises those funds more frequently or significantly increases the levies to be paid by such firms, the associated costs to the RBS Group may have a material impact on its results of operations and financial condition. During the financial year ended 31 December 2008, the RBS Group made a provision of £150 million related to a levy by the Scheme.

In addition, to the extent that other jurisdictions where the RBS Group operates have introduced or plan to introduce similar compensation, contributory or reimbursement schemes (such as in the United States with the Federal Deposit Insurance Corporation), the RBS Group may make further provisions and may incur additional costs and liabilities, which may negatively impact its financial condition and results of operations or result in a loss of value in RBS shares.

The RBS Group’s business and earnings may be affected by geopolitical conditions.

The performance of the RBS Group is significantly influenced by the geopolitical and economic conditions prevailing at any given time in the countries in which it operates, particularly the United Kingdom, the United States and other countries in Europe and Asia. For example, the RBS Group has a presence in countries where businesses could be exposed to the risk of business interruption and economic slowdown following the outbreak of a pandemic, or the risk of sovereign default following the assumption by governments of the obligations of private sector institutions. Similarly the RBS Group faces the heightened risk of trade barriers, exchange controls and other measures taken by sovereign governments which may impact a borrower’s ability to repay. Terrorist acts and threats and the response to them of governments in any of these countries could also adversely affect levels of economic activity and have an adverse effect upon the RBS Group's business.

The restructuring proposals for ABN AMRO are complex and may not realise the anticipated benefits for the RBS Group.

The restructuring plan in place for the integration and separation of ABN AMRO into and among the businesses and operations of the consortium members is complex, involving substantial reorganisation of ABN AMRO’s operations and legal structure. In addition, the plan contemplates activities taking place simultaneously in a number of businesses and jurisdictions. Although integration efforts are well underway and are being advanced on a number of fronts, the implementation of the reorganisation and the realisation of the forecast benefits within the planned timescales, particularly given current market and economic conditions, remains challenging, although the RBS Group remains confident that such goals will be achieved. Execution of the restructuring requires management resources previously devoted to the RBS Group businesses and the retention of appropriately skilled ABN AMRO staff. The RBS Group may not realise the benefits of the acquisition or the restructuring when expected or to the extent projected. The occurrence of any of these events, including as a result of staff losses or performance issues, may have a negative impact on the RBS Group’s financial condition and results of operations. It is not expected that the Dutch State’s acquisition of Fortis Bank Nederland’s shares in RFS Holdings, which was effected in December 2008, will materially affect the integration benefits envisaged by the RBS Group.

The recoverability of certain deferred tax assets recognised by the RBS Group depend on the RBS Group's ability to generate sufficient future taxable profits and there being no adverse changes to tax legislation.

In accordance with IFRS, the RBS Group has recognised deferred tax assets on losses available to relieve future profits from tax only to the extent that it is probable that they will be recovered. The losses are quantified on the basis of current tax legislation and are subject to change in respect of the rate of tax or the rules for computing taxable profits and allowable losses. Failure to generate sufficient future taxable profits or changes in tax legislation may reduce the recoverable amount of the recognised deferred tax assets.

RBS’s ability to pay dividends on or make other distributions in respect of the Ordinary Shares will depend on the availability of distributable reserves and may be limited by the terms of the B Shares.

RBS’s ability to pay dividends is limited under UK company law, which limits a company to only paying cash dividends to the extent that it has distributable reserves and cash available for this purpose. As a holding company, RBS’s ability to pay dividends in the future is affected by a number of factors, principally its ability to receive sufficient dividends from subsidiaries. The payment of dividends to RBS by its subsidiaries is, in turn, subject to restrictions, including certain regulatory requirements and the existence of sufficient distributable reserves and cash in RBS’s subsidiaries. The ability of these subsidiaries to pay dividends and RBS’s ability to receive distributions from its investments in other entities are subject to applicable local laws and regulatory requirements and other restrictions, including, but not limited to, applicable tax laws and covenants in some of RBS’s debt facilities. These laws and restrictions could limit the payment of future dividends and distributions to RBS by its subsidiaries, which could restrict RBS’s ability to fund other operations or to pay, in due course, a dividend to holders of the Existing Shares or the New Shares.

In addition, if the B Shares are issued, no cash dividend may be paid on the Ordinary Shares unless the cash dividend payable in respect of the same period on the B Shares is paid in full, and no scrip dividend may be paid on the Ordinary Shares unless the cash or scrip dividend payable in respect of the same period on the B Shares is paid in full.

Risk, capital and liquidity management

Risk, capital and liquidity management is conducted on an overall basis within the RBS Group. Therefore the discussion on risk, capital and liquidity management (pages 15 to 55) refers principally to policies and procedures in the RBS Group. Data is also provided for the Bank and its subsidiaries (‘the Group’) and the Bank.

On pages 15 to 55 certain information has been audited and is labelled as such.

Risk governance (unaudited)

Risk and capital management strategy is owned and set by the RBS Group’s Board of Directors, and implemented by executive management led by the Group Chief Executive. There are a number of committees and executives that support the execution of the business plan and strategy.

The role and remit of these committees is as follows:

•	Group Audit Committee (GAC): Financial reporting and the application of accounting policies as part of the internal control and risk assessment process. GAC monitors the identification, evaluation and management of all significant risks throughout the RBS Group.

•	Advances Committee (AC): Deals with transactions that exceed the Group Credit Committee’s delegated authority and large exposures.

•	Group Executive Management Committee (GEMC): Ensures implementation of strategy consistent with risk appetite.

•

Executive Risk Forum (ERF): Acts on all strategic risk and control matters across the RBS Group including, but not limited to, credit risk, market risk, operational risk, compliance and regulatory risk, enterprise risk, treasury and liquidity risk, reputational risk, insurance risk and country risk.

•	Group Risk Committee (GRC): Recommends limits and approves processes and policies to ensure the effective management of all material risks across the RBS Group.

•	Group Credit Committee (GCC): Approves credit proposals under the authority delegated to the committee by the Board and/or the Advances Committee.

•	Group Asset and Liability Management Committee (GALCO): Identifies, manages and controls the RBS Group balance sheet risks.

•	Group Chief Executive’s Advisory Group (GCEAG): Acts as a forum for the provision of information and advice to the Group Chief Executive. Forms part of the control process of the RBS Group.

Risk and capital (unaudited)

It is the RBS Group’s policy to optimise return to shareholders while maintaining a strong capital base and credit rating to support business growth and meet regulatory capital requirements at all times.

Risk appetite is measured as the maximum level of retained risk the RBS Group will accept to deliver its business objectives. Risk appetite is generally defined through both quantitative and qualitative techniques including stress testing, risk concentration, value-at-risk and risk underwriting criteria, ensuring that appropriate principles, policies and procedures are in place and applied.

Risk appetite (unaudited)

Risk and capital management across the RBS Group is based on the risk appetite set by the Board, which is established through setting strategic direction, contributing to, and ultimately approving annual plans for each division and regularly reviewing and monitoring the RBS Group’s performance in relation to risk through monthly Board reports.

Risk appetite is defined in both quantitative and qualitative terms as follows:

•	Quantitative: encompassing stress testing, risk concentration, value- at-risk, liquidity and credit related metrics.

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

Different techniques are used to ensure that the RBS Group’s risk appetite is achieved.

The GEMC is responsible for ensuring that the implementation of strategy and operations are in line with the risk appetite determined by the Board. This is reinforced through a policy framework ensuring that all staff within the RBS Group make appropriate risk and reward trade- offs within pre-agreed boundaries.

The main risks facing the RBS Group are as follows:

•	Credit risk: the risk arising from the possibility that the RBS Group will incur losses from the failure of customers to meet financial obligations to the RBS Group.

•	Funding and liquidity risk: the risk that the RBS Group is unable to meet obligations as they fall due.

•	Market risk: the risk that the value of an asset or liability may change as a result of a change in market rates.

•	Operational risk: the risk of financial loss or reputational impact resulting from fraud; human error; ineffective or inadequately designed processes or systems; improper behaviour; legal events; or from external events.

•	Regulatory risk: the risks arising from regulatory changes/enforcement.

•	Other risk: the risks arising from reputation and pension fund risk.

Credit risk

Principles for credit risk management (audited)

The key principles for credit risk management in the RBS Group are as follows:

•

A credit risk assessment of the customer and credit facilities is undertaken prior to approval of credit exposure. Typically, this includes both quantitative and qualitative elements including, the purpose of the credit and sources of repayment; compliance with affordability tests; repayment history; ability to repay; sensitivity to economic and market developments; and risk-adjusted return based on credit risk measures appropriate to the customer and facility type.

•

Credit risk authority is specifically granted in writing to individuals involved in the granting of credit approval, whether this is individually or collectively as part of a credit committee. In exercising credit authority, individuals are required to act independently of business considerations and must declare any conflicts of interest.

•	Credit exposures, once approved, are monitored, managed and reviewed periodically against approved limits. Lower quality exposures are subject to more frequent analysis and assessment.

•	Credit risk management works with business functions on the ongoing management of the credit portfolio, including decisions on mitigating actions taken against individual exposures or broader portfolios.

•	Customers with emerging credit problems are identified early and classified accordingly. Remedial actions are implemented promptly and are intended to restore the customer to a satisfactory status and minimise any potential loss to the RBS Group.

•	Stress testing of portfolios is undertaken to assess the potential credit impact of non-systemic scenarios and wider macroeconomic events on the RBS Group’s income and capital.

Specialist credit risk teams oversee the credit process independently, making credit decisions within their discretion, or recommending decisions to the appropriate credit committee. Assessments of corporate borrower and transaction risk are undertaken using fundamental credit analysis and the application of general corporate and certain specialist counterparty credit risk models.

Financial markets counterparties are approved by a dedicated credit function which specialises in traded market product risk. Specialist credit grading models exist for certain bank and non-bank financial institutions.

Different approaches are used for the management of wholesale and retail businesses:

•

Wholesale businesses: exposures are aggregated to determine the appropriate level of credit approval required and to facilitate consolidated credit risk management. Credit applications for corporate customers are prepared by relationship managers (RMs) in the units originating the credit exposures, or by the RM team with lead responsibility for a counterparty where a customer has relationships with different divisions and business units across the RBS Group. This includes the assignment of counterparty credit grades and LGD estimates using approved models, which are also independently checked by the credit team.

•

Retail businesses: the retail business makes a large volume of small value credit decisions. Credit decisions will typically involve an application for a new or additional product or a change in facilities on an existing product. The majority of these decisions are based upon automated strategies utilising industry standard credit and behaviour scoring techniques.

Credit risk models (audited)

Credit risk models are used throughout the RBS Group to support the analytical elements of the credit risk management framework, in particular the risk assessment part of the credit approval process, ongoing monitoring as well as portfolio analysis and reporting. Credit risk models used by the RBS Group can be broadly grouped into three categories.

•

Probability of default (PD): models estimate the likelihood that a customer will fail to make full and timely repayment of credit obligations over a one year time horizon. Customers are assigned an internal credit grade which corresponds to probability of default. Every customer credit grade across all grading scales in the RBS Group can be mapped to a RBS Group level credit grade.

•

Exposure at default (EAD): models estimate the expected level of utilisation of a credit facility at the time of a borrower’s default. The EAD may be assumed to be higher than the current utilisation (e.g. in the case where further drawings are made on a revolving credit facility prior to default) but will not typically exceed the total facility limit.

•	Loss given default (LGD): models estimate the economic loss that may occur in the event of default and represents, the debt that cannot be recovered. The RBS Group’s LGD models take into account the type of borrower, facility and any risk mitigation such as security or collateral held.

Model validation (audited)

The performance and accuracy of credit models is critical, both in terms of effective risk management and also the calculation of risk parameters (PD, LGD and EAD) used by the RBS Group to calculate RWAs. The models are subject to frequent validation internally and, if used as part of the AIRB Basel II framework, have been reviewed and approved for use by the FSA.

Independent model validation is performed by the RBS Group. This includes an evaluation of the model development and validation for the data set used, logic and assumptions, and performance of the model analysis. Where required, the RBS Group has engaged external risk management consultants to undertake independent reviews and report their findings to the Wholesale or Retail Credit Model Committee. This provides a benchmark against industry practices.

The validation results are a key factor in deciding whether a model is recommended for ongoing use.

The frequency, depth and extent of the validation are consistent with the materiality and complexity of the risk being managed. The RBS Group’s validation processes include:

•	Developmental evidence: to ensure that the credit risk model adequately discriminates between different levels of risk and delivers accurate risk estimates.

•	Process verification: whether the methods used in the credit risk models are being used, monitored and updated in the way intended in the design of the model. Initial testing and validation is performed when the model is developed with the performance of models being assessed on an ongoing basis.

Credit risk mitigation (audited)

The RBS Group takes a number of steps to mitigate credit risk. The key risk mitigants are as follows:

•	Real estate: the most common form of security held is real estate within the consumer and wholesale businesses.

•	Financial collateral: is taken to support credit exposures in the non- trading book. Financial collateral is also taken in Global Markets and Regional Markets to support trading book exposures and is incorporated in E* (adjustment to the exposure value) calculations.

•

Other physical collateral: the RBS Group takes a wide range of other physical collateral including business assets (stock and inventory, plant and machinery, equipment), project assets, intangible assets which provide a future cashflow and real value, commodities, vehicles, rail stock, aircraft, ships and receivables (not purchased).

•

Guarantees: third party guarantees are taken from banks, government entities, export credit agencies, and corporate entities. The RBS Group’s recovery value estimation methodology is sensitive to the variations in the credit quality of guarantors. Standby letters of credit are also given value in LGD models. Conditional guarantees are accepted, in accordance with internal requirements, and are included as appropriate in PD and LGD estimates (e.g. small firms loan guarantee schemes, completion guarantees). Personal guarantees are considered in the normal credit process where there is a charge over specific assets. While personal guarantees may be called for and are always accepted, no value is given to unsupported personal guarantees in any credit models.

•

Credit derivatives: credit derivative activity is conducted through designated units within GBM to ensure consistency and appropriate control. RBS Group policies are designed to ensure that the credit protection is appropriate to support offset for an underlying trading book asset or improvement to the LGD of a banking book asset. Within the banking book, credit derivatives are used as risk and capital management tools. The principal counterparties are banks, investment firms and other market participants, with the majority subject to collateralisation under a credit support annex. In accordance with internal policy, stress testing is conducted on the counterparty credit risk created by the purchase of credit protection.

•	Minimum standards (for example loan to value, legal certainty) are ensured through the policy framework.

Credit risk assets (audited)

Credit risk assets consist of loans and advances (including overdraft facilities), instalment credit, finance lease receivables and other traded instruments across all customer types. The RBS Group uses a series of models to measure the size of its exposure to credit risk and to calculate expected EAD in both its trading and banking books. In so doing, the RBS Group recognises the effects of credit risk mitigation that reduces potential loss.

Credit concentration risk (including country risk) (audited)

The RBS Group defines three key areas of concentration in credit risk that are monitored, reported and managed at RBS Group and divisional levels. These are single name concentration, industry/sector and country risk. The RBS Group has a series of quantitative and qualitative controls in place to limit the amount of concentration risk in credit portfolios. A threshold is set on the aggregate LGD to a single customer group above which approval is required from the RBS Group’s most senior credit committee, the Advances Committee.

During the year work progressed on an enhancement of the frameworks for managing single name and sector concentrations. These enhancements are planned to be fully implemented in 2009 to improve the identification and management of concentrations in the portfolio through the introduction of additional parameters and increased scrutiny of concentration limit excesses.

A stress testing framework, Correlated Exposure Loss Testing, assesses the impact on the RBS Group’s impairment charge of non-systemic events that affect groups of inter-related sectors in order to limit the impact of these scenarios to within defined tolerances.

Country risk arises from sovereign events (e.g. default or restructuring); economic events (e.g. contagion of sovereign default to other parts of the economy, cyclical economic shock); political events (e.g. convertibility restrictions and expropriation or nationalisation) and natural disaster or conflict. Losses are broadly defined and include credit, market, liquidity, operational and franchise risk related losses. It is the RBS Group’s policy to monitor and control country risk exposures and to avoid excessive concentrations.

The RBS Group’s appetite is expressed by a matrix of limits by country risk grade and is approved by GEMC. The RBS Group’s exposure is managed and measured within this appetite by the Group Country Risk Management Committee (GCRMC), that has delegated authority from the GRC to manage country risk and agree related policy. Membership of GCRMC comprises the Group Chief Credit Officer, Heads of Credit and business representatives from those divisions with material country risk exposures. GCRMC sets limits for each country based on a risk assessment taking into account the RBS Group’s franchise and business mix in that country. Additional limitations – on product types with higher loss potential and longer tenor transactions, for example – may be established depending on the country outlook and business strategy. A country watch list framework is in place to proactively monitor emerging issues and facilitates the development of mitigation strategies.

Global Restructuring Group (GRG) (audited)

GRG was formed in 2008, tasked with managing the RBS Group’s problem and potential problem exposures to help rejuvenate and restore customers to profitable business. This may include assisting with the restructuring of their businesses and/or renegotiation.

GRG brings together previously disparate functions across the RBS Group. Its primary function is to work closely with the RBS Group’s customer facing businesses to support the proactive management of any problem lending. This is based on a clear process (watch listing) which requires the transfer of problem credits to GRG. GRG reports to the Group Chief Risk Officer.

Given the current economic outlook, it is particularly important that potential problems are identified early and referred to GRG as the RBS Group’s past experience has shown that the sooner specialists in restructuring are engaged, the greater the likelihood of a successful outcome. Early identification of potential problems therefore has a benefit to the borrower as well as to the RBS Group.

GRG is structured with specialist teams focused on: large corporate cases (higher value, multiple lenders); small/mid size business cases (lower value, bilateral relationships); and recovery/litigations. Given the negative trends in the portfolio in 2008, the size of GRG has grown substantially and further investment in staffing is expected in 2009.

Originating business units liaise with GRG upon the emergence of a potentially negative event or trend that may impact a borrowers’ ability to service its debt. This may be a significant deterioration in some aspect of the borrowers’ activity, such as trading, where a breach of covenant is likely or where a borrower has missed or is expected to miss a material contractual payment to the RBS Group or another creditor.

On transfer of a relationship to GRG a strategy is devised to:

•	Work with the borrower to facilitate changes that will maximise the potential for turnaround of their situation and return them to profitability.

•	Define the RBS Group’s role in the turnaround situation and assess the risk/return dimension of the RBS Group’s participation.

•	Return customers to the originating business unit in a sound and stable condition or, if such recovery can not be achieved, avoid additional losses and maximise recoveries.

•	Ensure key lessons learned are fed back into origination policies and procedures.

Retail collections and recoveries (audited)

There are collections and recoveries functions in each of the four regional markets. Their role is to provide support and assistance to customers who are currently experiencing difficulties meeting their financial obligations.

Where possible, the aim of collections and recoveries teams is to return the customer to a satisfactory position, by working with them to restructure their finances and/or business. If this is not possible, the team has the objective of reducing the loss to the RBS Group.

There have been material increases in staffing levels in all collections functions to manage the increase in the number of customers in financial difficulty. In the UK and Ireland, there is a common collection and recovery operational model managed by Group Manufacturing. During 2008, there was significant investment in systems development and staff training to make collections activity more efficient and effective.

In the UK there have been several initiatives to ensure fair and appropriate treatment of customers experiencing difficulties. For mortgage customers the RBS Group will not initiate repossession proceedings for at least six months after arrears are evident.

Preventative measures have also been a key focus throughout 2008, and as a result, the RBS Group has announced the introduction of over 1,000 dedicated Money Sense advisers in its branch network who will provide free financial counselling to both customers and non-customers. The RBS Group has also implemented a programme to proactively contact customers who exhibit early signs of financial stress but are not yet in Collections to offer them assistance in managing their finances more effectively.

Credit risk asset quality (audited)

Internal reporting and oversight of risk assets is principally differentiated by credit grades. Customers are assigned credit grades, based on various credit grading models that reflect the key drivers of default for the customer type. All credit grades across the RBS Group map to both a RBS Group level asset quality scale, used for external financial reporting, and a master grading scale for wholesale exposures used for internal management reporting across disparate portfolios. Accordingly, measurement of risk is easily aggregated and can be reported at increasing levels of granularity depending on audience and business need.

The RBS Group has adopted, as part of the move to Basel II, a new master grading scale for wholesale exposures which comprises 27 grades. These in turn map to ten asset quality (AQ) bands used for both wholesale and retail exposures. This replaced the less granular AQ1-5 bands used prior to 2008.

The relationship between these measures is shown below (unaudited).

	PD Range		New AQ1-	Old AQ1-5
Master grading scale	Lower	Upper	10 bands	bands
1	0%	0.006%
2	0.006%	0.012%
3	0.012%	0.017%	AQ1
4	0.017%	0.024%
5	0.024%	0.034%		AQ1
6	0.034%	0.048%	AQ2
7	0.048%	0.067%	AQ3
8	0.067%	0.095%
9	0.095%	0.135%
10	0.135%	0.190%	AQ4
11	0.190%	0.269%	AQ4
11	0.190%	0.269%
12	0.269%	0.381%		AQ2
13	0.381%	0.538%
14	0.538%	0.761%	AQ5
15	0.761%	1.076%		AQ3
16	1.076%	1.522%	AQ6
17	1.522%	2.153%		AQ4
18	2.153%	3.044%		AQ4
18	2.153%	3.044%
19	3.044%	4.305%	AQ7
20	4.305%	6.089%
21	6.089%	8.611%
22	8.611%	12.177%	AQ8
23	12.177%	17.222%		AQ5
24	17.222%	24.355%
25	24.355%	34.443%	AQ9
26	34.443%	100%
27	100%	100%	AQ10

Asset grades (unaudited)

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

	Annual probability of default
Asset quality grade	Minimum	Midpoint	Maximum
Asset quality grade	%	%	%
AQ1	0.00	0.10	0.20
AQ2	0.21	0.40	0.60
AQ3	0.61	1.05	1.50
AQ4	1.51	3.25	5.00
AQ5	5.01	52.50	100.00

The following table provides an analysis of the credit quality of financial assets by the RBS Group’s internal credit ratings (audited).

									Group
											Balances
											with Group		Accruing		Non-		Impairment
	AQ1		AQ2		AQ3		AQ4		AQ5		companies		past due		accrual		provision			Total
2008		£m		£m		£m		£m		£m		£m		£m		£m		£m			£m
Cash and balances
at central banks		6,806		—		—		—		—		—		—		—		—			6,806
Loans and advances
to banks (1)		68,885		91		77		28		230		7,297		—		83		(83	)		76,608
Loans and advances
to customers		231,688		108,005		144,408		74,314		36,736		4,484		12,797		13,643		(6,572	)		619,503
Debt securities		171,685		847		263		3,736		1,220		—		—		33		(18	)		177,766
Settlement balances		5,651		516		290		129		256		—		4,029		—		—			10,871
Derivatives		812,895		33,632		24,984		4,077		5,434		56,424		11		—		—			937,457
Other financial instruments		32		—		—		—		—		—		—		—		—			32
		1,297,642		143,091		170,022		82,284		43,876		68,205		16,837		13,759		(6,673	)		1,829,043
Commitments		173,350		44,710		43,765		20,983		18,278		51		—		—		—			301,137
Contingent liabilities		20,946		5,976		2,989		2,519		487		—		—		—		—			32,917
Total off-balance sheet		194,296		50,686		46,754		23,502		18,765		51		—		—		—			334,054


2007
Cash and balances at
central banks		5,559		—		—		—		—		—		—		—		—			5,559
Loans and advances
to banks (1)		89,357		1,772		426		94		2		1,966		—		2		(2	)		93,617
Loans and advances
to customers		191,451		109,460		163,792		46,293		19,850		9,088		9,083		6,665		(4,233	)		551,449
Debt securities		153,391		8,026		1,383		466		1,165		—		—		1		—			164,432
Settlement balances		3,228		98		344		21		68		—		1,567		—		—			5,326
Derivatives		175,770		21,166		4,801		894		394		2,950		—		—		—			205,975
Other financial instruments		19		—		—		—		—		—		—		—		—			19
		618,775		140,522		170,746		47,768		21,479		14,004		10,650		6,668		(4,235	)		1,026,377
Commitments		95,664		73,221		60,895		19,797		12,177		—		—		—		—			261,754
Contingent liabilities		7,658		7,915		4,989		1,214		1,100		—		—		—		—			22,876
Total off-balance sheet		103,322		81,136		65,884		21,011		13,277		—		—		—		—			284,630

Note:

(1) Excluding items in the course of collection of £2,779 million (2007 – £2,729 million).

									Bank
											Balances
											with Group		Accruing		Non-		Impairment
	AQ1		AQ2		AQ3		AQ4		AQ5		companies		past due		accrual		provision			Total
2008		£m		£m		£m		£m		£m		£m		£m		£m		£m			£m
Cash and balances at
central banks		3,714		—		—		—		—		—		—		—		—			3,714
Loans and advances
to banks(1)		54,403		66		50		8		225		36,481		—		81		(81	)		91,233
Loans and advances
to customers		127,883		50,267		60,255		28,830		9,727		44,368		2,482		5,622		(2,394	)		327,040
Debt securities		153,490		804		206		3,396		1,079		708		—		17		(2	)		159,698
Settlement balances		4,051		120		129		—		25		—		1,010		—		—			5,335
Derivatives		807,283		31,173		23,224		3,367		4,587		68,860		11		—		—			938,505
		1,150,824		82,430		83,864		35,601		15,643		150,417		3,503		5,720		(2,477	)		1,525,525
Commitments		131,942		23,847		17,102		6,659		7,511		346		—		—		—			187,407
Contingent liabilities		16,804		3,093		1,155		1,081		182		—		—		—		—			22,315
Total off-balance sheet		148,746		26,940		18,257		7,740		7,693		346		—		—		—			209,722


2007
Cash and balances
at central banks		3,333		—		—		—		—		—		—		—		—			3,333
Loans and advances
to banks(1)		66,418		574		275		70		—		24,115		—		—		—			91,452
Loans and advances
to customers		97,715		59,825		75,432		12,645		5,874		74,340		2,501		2,088		(1,273	)		329,147
Debt securities		98,303		5,699		1,254		338		1,044		612		—		—		—			107,250
Settlement balances		1,273		89		130		—		39		—		515		—		—			2,046
Derivatives		174,288		20,879		4,575		795		367		7,009		—		—		—			207,913
		441,330		87,066		81,666		13,848		7,324		106,076		3,016		2,088		(1,273	)		741,141
Commitments		61,866		39,825		31,604		6,478		5,784		258		—		—		—			145,815
Contingent liabilities		5,876		5,187		2,962		278		703		—		—		—		—			15,006
Total off-balance sheet		67,742		45,012		34,566		6,756		6,487		258		—		—		—			160,821

Note:

(1) Excluding items in the course of collection of £484 million (2007 – £530 million).

Industry risk – geographical analysis (audited)

			Group
	Loans and advances to banks and customers		Debt securities and equity shares		Derivatives		Other(1)		Total		Netting offset(2)
2008	£m		£m		£m		£m		£m		£m
UK
Central and local government		6,033		34,942		3,998		1		44,974		1,636
Manufacturing		23,640		263		5,929		56		29,888		3,812
Construction		13,346		33		744		—		14,123		1,485
Finance		140,951		64,174		494,667		3,454		703,246		426,522
Service industry and business activities		82,006		4,980		13,229		586		100,801		7,710
Agriculture, forestry and fishing		3,118		—		34		1		3,153		87
Property		73,632		1,662		5,073		2		80,369		1,026
Individuals:
Home mortgages		80,941		—		14		—		80,955		52
Other		26,182		248		36		—		26,466		5
Finance leases and instalment credit		17,363		3		25		—		17,391		—
Interest accruals		2,690		774		—		—		3,464		—
Total UK		469,902		107,079		523,749		4,100		1,104,830		442,335
US
Central and local government		352		24,784		45		33		25,214		—
Manufacturing		10,569		102		1,809		128		12,608		217
Construction		885		63		122		6		1,076		—
Finance		25,517		36,408		364,544		5,445		431,914		323,910
Service industry and business activities		25,291		1,133		8,535		907		35,866		2,346
Agriculture, forestry and fishing		30		—		3		1		34		—
Property		6,475		7		97		—		6,579		—
Individuals:
Home mortgages		34,235		—		—		—		34,235		—
Other		14,368		—		—		—		14,368		—
Finance leases and instalment credit		3,066		—		—		—		3,066		—
Interest accruals		488		466		—		—		954		—
Total US		121,276		62,963		375,155		6,520		565,914		326,473
Europe
Central and local government		742		1,335		8		5		2,090		—
Manufacturing		11,174		1		31		—		11,206		—
Construction		4,380		—		57		—		4,437		—
Finance		6,145		455		212		110		6,922		7
Service industry and business activities		20,116		48		136		1		20,301		—
Agriculture, forestry and fishing		1,095		1		1		—		1,097		—
Property		18,618		1		299		—		18,918		—
Individuals:
Home mortgages		23,132		—		—		—		23,132		—
Other		3,933		—		19		—		3,952		—
Finance leases and instalment credit		1,793		—		—		—		1,793		—
Interest accruals		337		1		—		—		338		—
Total Europe		91,465		1,842		763		116		94,186		7
Rest of the World
Central and local government		534		5,164		268		142		6,108		—
Manufacturing		1,032		155		94		—		1,281		—
Construction		421		—		2		—		423		—
Finance		10,928		2,657		37,035		25		50,645		31,262
Service industry and business activities		6,001		337		328		—		6,666		—
Agriculture, forestry and fishing		15		—		10		—		25		—
Property		1,951		402		53		—		2,406		—
Individuals:
Home mortgages		439		—		—		—		439		—
Other		1,466		—		—		—		1,466		—
Finance leases and instalment credit		24		—		—		—		24		—
Interest accruals		91		—		—		—		91		—
Total Rest of the World		22,902		8,715		37,790		167		69,574		31,262

					Group
	Loans and advances to banks and customers		Debt securities and equity shares		Derivatives		Other(1)		Total		Netting offset (2)
2008		£m		£m		£m		£m		£m		£m
Total
Central and local government		7,661		66,225		4,319		181		78,386		1,636
Manufacturing		46,415		521		7,863		184		54,983		4,029
Construction		19,032		96		925		6		20,059		1,485
Finance		183,541		103,694		896,458		9,034		1,192,727		781,701
Service industry and business activities		133,414		6,498		22,228		1,494		163,634		10,056
Agriculture, forestry and fishing		4,258		1		48		2		4,309		87
Property		100,676		2,072		5,522		2		108,272		1,026
Individuals:
Home mortgages		138,747		—		14		—		138,761		52
Other		45,949		248		55		—		46,252		5
Finance leases and instalment credit		22,246		3		25		—		22,274		—
Interest accruals		3,606		1,241		—		—		4,847		—
		705,545		180,599		937,457		10,903		1,834,504		800,077

Notes:

(1)	Includes settlement balances of £10,871 million.

(2)

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

					Group
	Loans and advances to banks and customers		Debt securities and equity shares		Derivatives		Other(1)		Total		Netting offset(2)
2007		£m		£m		£m		£m		£m		£m
UK
Central and local government		4,722		15,280		1,157		—		21,159		1,531
Manufacturing		19,574		211		1,517		—		21,302		4,031
Construction		12,249		3		741		—		12,993		1,684
Finance		173,741		74,137		186,041		1,678		435,597		190,316
Service industry and business activities		69,011		5,125		4,412		—		78,548		6,690
Agriculture, forestry and fishing		2,564		1		58		—		2,623		104
Property		59,821		603		969		7		61,400		2,033
Individuals:
Home mortgages		72,726		—		5		—		72,731		—
Other		27,408		260		15		—		27,683		7
Finance leases and instalment credit		15,632		131		27		—		15,790		—
Interest accruals		2,202		857		—		—		3,059		—
Total UK		459,650		96,608		194,942		1,685		752,885		206,396
US
Central and local government		347		22,982		—		212		23,541		—
Manufacturing		5,412		236		—		—		5,648		—
Construction		793		96		—		—		889		—
Finance		26,722		36,843		9,470		2,800		75,835		7,417
Service industry and business activities		14,254		1,388		233		—		15,875		1
Agriculture, forestry and fishing		20		—		—		—		20		—
Property		6,339		—		—		—		6,339		—
Individuals:
Home mortgages		27,882		—		—		—		27,882		—
Other		10,879		—		—		—		10,879		—
Finance leases and instalment credit		2,228		—		—		—		2,228		—
Interest accruals		619		379		—		—		998		2
Total US		95,495		61,924		9,703		3,012		170,134		7,420

Industry risk – geographical analysis (audited) continued

					Group
	Loans and advances to banks and customers		Debt securities and equity shares		Derivatives		Other(1)		Total		Netting offset(2)
2007		£m	£m		£m		£m		£m		£m
Europe
Central and local government		551		960		10		—		1,521		—
Manufacturing		5,868		—		—		—		5,868		—
Construction		3,519		—		—		—		3,519		—
Finance		10,984		790		1,011		28		12,813		—
Service industry and business activities		13,391		19		7		—		13,417		16
Agriculture, forestry and fishing		588		—		—		—		588		—
Property		12,971		67		—		—		13,038		—
Individuals:
Home mortgages		16,276		18		—		—		16,294		—
Other		5,111		—		—		—		5,111		—
Finance leases and instalment credit		1,620		—		—		—		1,620		—
Interest accruals		277		1		—		—		278		—
Total Europe		71,156		1,855		1,028		28		74,067		16
Rest of the World
Central and local government		239		1,054		—		—		1,293		—
Manufacturing		214		—		—		—		214		—
Construction		463		4		—		—		467		1
Finance		18,176		8,477		38		575		27,266		69
Service industry and business activities		3,103		1		9		—		3,113		2
Agriculture, forestry and fishing		11		—		—		—		11		—
Property		1,751		52		1		—		1,804		—
Individuals:
Home mortgages		477		—		—		—		477		—
Other		1,149		—		—		—		1,149		—
Finance leases and instalment credit		18		—		254		45		317		—
Interest accruals		128		11		—		—		139		—
Total Rest of the World		25,729		9,599		302		620		36,250		72
Total
Central and local government		5,859		40,276		1,167		212		47,514		1,531
Manufacturing		31,068		447		1,517		—		33,032		4,031
Construction		17,024		103		741		—		17,868		1,685
Finance		229,623		120,247		196,560		5,081		551,511		197,802
Service industry and business activities		99,759		6,533		4,661		—		110,953		6,709
Agriculture, forestry and fishing		3,183		1		58		—		3,242		104
Property		80,882		722		970		7		82,581		2,033
Individuals:
Home mortgages		117,361		18		5		—		117,384		—
Other		44,547		260		15		—		44,822		7
Finance leases and instalment credit		19,498		131		281		45		19,955		—
Interest accruals		3,226		1,248		—		—		4,474		2
		652,030		169,986		205,975		5,345		1,033,336		213,904

Notes:

(1)	Includes settlement balances of £5,326 million.

(2)

			Bank
	Loans and advances to banks and customers	Debt securities and equity shares		Derivatives	Settlement balances	Total	Netting offset(1)
2008	£m	£m		£m	£m	£m	£m
UK
Central and local government	3,559	33,099		4,003	1	40,662	352
Manufacturing	16,047	263		5,516	15	21,841	1,904
Construction	6,614	33		687	—	7,334	405
Finance	167,225	101,653		502,642	3,462	774,982	426,102
Service industry and business activities	57,456	4,787		11,935	478	74,656	2,290
Agriculture, forestry and fishing	836	—		21	1	858	71
Property	44,390	2,296		4,509	2	51,197	433
Individuals:
Home mortgages	39,409	—		5	—	39,414	52
Other	7,857	—		6	—	7,863	—
Finance leases and instalment credit	652	—		25	—	677	—
Interest accruals	2,453	761		—	—	3,214	—
Total UK	346,498	142,892		529,349	3,959	1,022,698	431,609
US
Central and local government	75	319		45	3	442	—
Manufacturing	3,769	44		1,308	5	5,126	—
Construction	203	3		123	—	329	—
Finance	7,937	11,611		365,575	1,314	386,437	320,460
Service industry and business activities	12,305	330		3,838	54	16,527	151
Agriculture, forestry and fishing	—	—		2	—	2	—
Property	1,057	—		97	—	1,154	—
Individuals:
Home mortgages	—	—		—	—	—	—
Other	—	—		—	—	—	—
Finance leases and instalment credit	120	—		—	—	120	—
Interest accruals	74	61		—	—	135	—
Total US	25,540	12,368		370,988	1,376	410,272	320,611
Europe
Central and local government	598	—		8	—	606	—
Manufacturing	8,862	—		—	—	8,862	—
Construction	1,031	—		—	—	1,031	—
Finance	1,765	59		—	—	1,824	7
Service industry and business activities	10,986	—		—	—	10,986	—
Agriculture, forestry and fishing	2	—		—	—	2	—
Property	5,893	—		—	—	5,893	—
Individuals:
Home mortgages	4	—		—	—	4	—
Other	1	—		—	—	1	—
Finance leases and instalment credit	90	—		—	—	90	—
Interest accruals	149	1		—	—	150	—
Total Europe	29,381	60		8	—	29,449	7
Rest of the World
Central and local government	534	1,622		268	—	2,424	—
Manufacturing	1,032	155		94	—	1,281	—
Construction	421	—		2	—	423	—
Finance	9,227	2,934		37,405	—	49,566	31,262
Service industry and business activities	5,979	336		328	—	6,643	—
Agriculture, forestry and fishing	15	—		10	—	25	—
Property	1,930	397		53	—	2,380	—
Individuals:
Home mortgages	439	—		—	—	439	—
Other	3	—		—	—	3	—
Finance leases and instalment credit	147	—		—	—	147	—
Interest accruals	86	—		—	—	86	—
Total Rest of the World	19,813	5,444		38,160	—	63,417	31,262

					Bank
	Loans and advances to banks and customers		Debt securities and equity shares		Derivatives		Settlement balances		Total		Netting offset(1)
2008	£m		£m		£m		£m		£m		£m
Total
Central and local government		4,766		35,040		4,324		4		44,134		352
Manufacturing		29,710		462		6,918		20		37,110		1,904
Construction		8,269		36		812		—		9,117		405
Finance		186,154		116,257		905,622		4,776		1,212,809		777,831
Service industry and business activities		86,726		5,453		16,101		532		108,812		2,441
Agriculture, forestry and fishing		853		—		33		1		887		71
Property		53,270		2,693		4,659		2		60,624		433
Individuals:
Home mortgages		39,852		—		5		—		39,857		52
Other		7,861		—		6		—		7,867		—
Finance leases and instalment credit		1,009		—		25		—		1,034		—
Interest accruals		2,762		823		—		—		3,585		—
		421,232		160,764		938,505		5,335		1,525,836		783,489

Note:

(1)

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

					Bank
	Loans and		Debt
	advances to banks		securities and				Settlement				Netting
	and customers		equity shares		Derivatives		balances		Total		offset(1)
2007		£m		£m		£m		£m		£m		£m
UK
Central and local government		2,396		13,379		1,158		—		16,933		387
Manufacturing		11,470		209		1,416		—		13,095		1,775
Construction		5,834		3		716		—		6,553		768
Finance		178,673		73,290		188,740		1,673		442,376		189,948
Service industry and business activities		42,694		5,710		4,228		—		52,632		2,143
Agriculture, forestry and fishing		800		—		56		—		856		87
Property		33,741		545		866		7		35,159		588
Individuals:
Home mortgages		35,710		—		1		—		35,711		—
Other		8,213		—		6		—		8,219		—
Finance leases and instalment credit		708		128		27		—		863		—
Interest accruals		1,554		854		—		—		2,408		—
Total UK		321,793		94,118		197,214		1,680		614,805		195,696
US
Central and local government		73		1,892		—		—		1,965		—
Manufacturing		2,307		124		—		—		2,431		—
Construction		217		48		—		—		265		—
Finance		31,867		10,799		10,400		321		53,387		4,932
Service industry and business activities		6,640		558		—		—		7,198		—
Property		724		—		—		—		724		—
Finance leases and instalment credit		36		—		—		—		36		—
Interest accruals		67		83		—		—		150		—
Total US		41,931		13,504		10,400		321		66,156		4,932

					Bank
	Loans and		Debt
	advances to banks		securities and				Settlement				Netting
	and customers		equity shares		Derivatives		balances		Total		offset(1)
2007		£m		£m		£m		£m		£m		£m
Europe
Central and local government		389		—		10		—		399		—
Manufacturing		3,910		—		—		—		3,910		—
Construction		630		—		—		—		630		—
Finance		18,964		37		—		—		19,001		—
Service industry and business activities		6,897		—		—		—		6,897		—
Property		4,938		—		—		—		4,938		—
Individuals:
Home mortgages		3		—		—		—		3		—
Other		1		—		—		—		1		—
Finance leases and instalment credit		113		—		—		—		113		—
Interest accruals		100		1		—		—		101		—
Total Europe		35,945		38		10		—		35,993		—
Rest of the World
Central and local government		239		1,053		—		—		1,292		—
Manufacturing		214		—		—		—		214		—
Construction		443		—		—		—		443		1
Finance		6,211		2,530		24		—		8,765		69
Service industry and business activities		13,497		—		10		—		13,507		2
Agriculture, forestry and fishing		11		—		—		—		11		—
Property		1,751		26		1		—		1,778		—
Individuals:
Home mortgages		280		—		—		—		280		—
Other		3		—		—		—		3		—
Finance leases and instalment credit		18		—		254		45		317		—
Interest accruals		66		—		—		—		66		—
Total Rest of the World		22,733		3,609		289		45		26,676		72
Total
Central and local government		3,097		16,324		1,168		—		20,589		387
Manufacturing		17,901		333		1,416		—		19,650		1,775
Construction		7,124		51		716		—		7,891		769
Finance		235,715		86,656		199,164		1,994		523,529		194,949
Service industry and business activities		69,728		6,268		4,238		—		80,234		2,145
Agriculture, forestry and fishing		811		—		56		—		867		87
Property		41,154		571		867		7		42,599		588
Individuals:
Home mortgages		35,993		—		1		—		35,994		—
Other		8,217		—		6		—		8,223		—
Finance leases and instalment credit		875		128		281		45		1,329		—
Interest accruals		1,787		938		—		—		2,725		—
		422,402		111,269		207,913		2,046		743,630		200,700

Note:

(1)

Impairment (audited)

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

Both REIL and PPL are reported gross of the value of any security held, which could reduce the eventual loss should it occur, and gross of any provision marked. Therefore impaired assets which are highly collateralised, such as mortgages, will have a low coverage ratio of provisions held against reported impaired balance. The analyses of risk elements and impairment charges as discussed below form a key part of the data provided to senior management on the credit performance of the Group’s portfolios.

The table below sets out loans that are classified as REIL and PPL.

	Group
	2008			2007
	£m			£m
Non-accrual loans (1)		13,726			6,667
Accrual loans past due 90 days (2)		1,669			256
Total REIL		15,395			6,923
PPL (3)		226			64
Total REIL and PPL		15,621			6,987
REIL and PPL as % of customer loans and advances – gross (4)		2.60	%		1.47	%

The sub-categories of REIL and PPL are calculated as described in notes 1 to 4 below.

Notes:

(1)	All loans against which an impairment provision is held are reported in the non-accrual category.

(2)	Loans where an impairment event has taken place but no impairment recognised. This category is used for fully collateralised non-revolving credit facilities.

(3)	Loans for which an impairment event has occurred but no impairment provision is necessary. This category is used for fully collateralised advances and revolving credit facilities where identification as 90 days overdue is not feasible.

(4)	Gross of provisions and excluding reverse repurchase agreements.

Impairment loss provision methodology (audited)

Provisions for impairment losses are assessed under three categories:

• Individually assessed provisions: provisions required for individually significant impaired assets which are assessed on a case by case basis, taking into account the financial condition of the counterparty and any guarantor and collateral held after being stressed for downside risk. This incorporates an estimate of the discounted value of any recoveries and realisation of security or collateral. The asset continues to be assessed on an individual basis until it is repaid in full, transferred to the performing portfolio or written-off.

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

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

Provision analysis (audited)

The RBS Group’s consumer portfolios, which consist of high volume, small value credits, have highly efficient largely automated processes for identifying problem credits and very short timescales, typically three months, before resolution or adoption of various recovery methods. Corporate portfolios consist of higher value, lower volume credits, which tend to be structured to meet individual customer requirements. Provisions are assessed on a case by case basis by experienced specialists with input from professional valuers and accountants. The RBS Group operates a clear provisions governance framework which sets thresholds whereby suitable oversight and challenge is undertaken and significant cases will be presented to a committee chaired by the Group Chief Executive or the Group Finance Director.

Impairment charge (audited)

The following table shows total impairment losses charged to the income statement.

	Group
	2008			2007
		£m			£m
New impairment losses		4,917			2,110
less: recoveries of amounts previously written-off		(211	)		(245	)
Charge to income statement		4,706			1,865
Comprising:
Loan impairment losses		4,555			1,843
Impairment losses on available-for-sale securities		151			22
Charge to income statement		4,706			1,865

Analysis of loan impairment charge (audited)

	Group
	2008			2007
	£m			£m
Latent loss impairment charge		582			2
Collectively assessed impairment charge		2,183			1,644
Individually assessed impairment charge (1)		1,709			197
Charge to income statement		4,474			1,843
Charge as a % of customer loans and advances – gross (2)		0.75	%		0.39	%

Notes:

(1)	Excludes loan impairment charge against loans and advances to banks of £81 million (2007 – nil).

(2)	Gross of provisions and excluding reverse repurchase agreements.

Analysis of loan impairment provisions (audited)

	Group
	2008			2007
		£m			£m
Latent loss provisions		1,328			600
Collectively assessed provisions		3,380			2,996
Individually assessed provisions		1,864			637
Total provisions (1)		6,572			4,233

Total provision as a % of customer loans and advances – gross (2)		1.10	%		0.89	%

Notes:
(1) Excludes provisions against loans and advances to banks of £83 million (2007 – £2 million).
(2) Gross of provisions and excluding reverse repurchase agreements.

Provisions coverage (audited)

The provision coverage ratios are shown in the table below.

	Group
	2008			2007
		£m			£m
Total provision expressed as a:
% of REIL		43	%		61	%
% of REIL and PPL		43	%		61	%

The coverage ratio of closing provisions to REIL and PPL decreased from 61% to 43% during 2008. The lower coverage ratio reflects amounts written- off and the changing mix from unsecured to secured exposures.

Movement in loan impairment provisions (audited)

The following table shows the movement in the provision for impairment losses for loans and advances.

	Group
	Individually			Collectively						Total
	assessed			assessed			Latent			2008			2007
		£m			£m			£m			£m			£m
At 1 January		639			2,996			600			4,235			3,929
Currency translation and other adjustments		164			113			176			453			30
(Disposals)/acquisitions		—			(148	)		(30	)		(178	)		6
Amounts written-off		(636	)		(1,811	)		—			(2,447	)		(1,652	)
Recoveries of amounts previously written-off		23			188			—			211			245
Charged to the income statement		1,790			2,183			582			4,555			1,843
Unwind of discount		(33	)		(141	)		—			(174	)		(166	)
At 31 December (1)		1,947			3,380			1,328			6,655			4,235

Note:

(1) The provision for impairment losses at 31 December 2008 includes £83 million relating to loans and advances to banks (2007 – £2 million).

Liquidity risk (audited)

The RBS Group’s liquidity policy is designed to ensure that it can at all times meet its obligations as they fall due.

Liquidity management within the RBS Group addresses the overall balance sheet structure and the control, within prudent limits, of risk arising from the mismatch of maturities across the balance sheet and from exposure to undrawn commitments and other contingent obligations. The management of liquidity risk within the RBS Group is undertaken within a formal governance structure. The Group Board of Directors oversees the liquidity risk appetite and strategy of the RBS Group; the Group Executive Management Committee reviews the key liquidity metrics and trends in the context of the RBS Group’s overall risk profile; the Group Asset and Liability Management Committee (GALCO), chaired by the Group Finance Director and including the chief executives of the business divisions as well as the Group Treasurer, Group Chief Risk Officer and heads of other relevant Group functions, sets explicit metrics across a number of asset and liability targets and these are cascaded to the business and monitored by the Group Treasury and risk functions.

Group Treasury has overall responsibility for the daily monitoring and control of the RBS Group’s liquidity and funding positions. The Liquidity Managers’ Forum is chaired and directed by the Group Treasurer with membership including the Head of Short Term Markets and Financing, GBM. The forum typically meets weekly with more frequent, ad hoc, meetings as necessary. There are Regional and Country ALCOs that oversee RBS Group policy in our business in Europe, Asia and the Americas. The RBS Group is divided into Liquidity Reporting Units each of which is required to have its own liquidity limits and contingency funding plan. In addition, all subsidiaries and branches outside the UK are required to comply with local regulatory liquidity requirements and are subject to Group Treasury oversight.

Management of term structure

The RBS Group evaluates on a regular basis its structural liquidity risk and applies a variety of balance sheet management and term funding strategies to maintain this risk within its normal policy parameters. The degree of maturity mismatch within the overall long-term structure of the RBS Group’s assets and liabilities is managed within internal policy guidelines, aimed at ensuring term asset commitments may be funded on an economic basis over their life. In managing its overall term structure, the RBS Group analyses and takes into account the effect of retail and corporate customer behaviour on actual asset and liability maturities where they differ materially from the underlying contractual maturities.

Daily management

The primary focus of the daily management activity is to ensure access to sufficient liquidity to meet cash flow obligations within key time horizons, in particular out to one month ahead. The short-term maturity structure of the RBS Group’s liabilities and assets is managed daily to ensure that all material or potential cash flow obligations, arising from undrawn commitments and other contingent obligations can be met. Potential sources include cash inflows from maturing assets, new borrowings or the sale of various debt securities held (after allowing for appropriate haircuts). Short-term liquidity risk is generally managed on a consolidated basis with liquidity mismatch limits in place for subsidiaries and non-UK branches which have material local treasury activities, thereby assuring that the daily maintenance of the RBS Group’s overall liquidity risk position is not compromised. Citizens Financial Group manages liquidity locally, given different regulatory regimes, subject to review by Group Treasury.

Stress testing

The RBS Group performs stress tests to simulate how events may impact its funding and liquidity capabilities. Such tests inform the overall balance sheet structure and help define suitable limits for control of the risk arising from the mismatch of maturities across the balance sheet and from undrawn commitments and other contingent obligations. The form and content of stress tests are updated where required as market conditions evolve.

Contingency planning

Contingency funding plans have been developed to anticipate and respond to approaching or actual material deterioration in market conditions. The RBS Group reviews its contingency plans in the light of evolving market conditions. The contingency funding plan covers: the available sources of contingent funding to supplement cash flow shortages; the lead times to obtain such funding; the roles and responsibilities of those involved in the contingency plans, including the communication lines for escalation of events which give rise to liquidity stress; assumptions, including the expected change impact of market conditions; and the ability and circumstances within which the RBS Group accesses central bank liquidity.

Liquidity management in 2008 (audited)

The amount of unsecured wholesale funding of the Group represented by bank funding and debt securities increased from £206 billion in December 2007 to £298 billion in December 2008. The gap between customer loans and customer deposits increased over this period from £109 billion to £199 billion. The market disruption during 2008 had a marked effect on the Group’s liquidity and funding which was at its most acute in the autumn of 2008 following the collapse of Lehman Brothers. During that period, the Group’s credit ratings were downgraded constraining both access to and tenor of wholesale funding and there was an outflow of customer deposits. The effective closure of the term funding markets and sharp reduction in the quantity and maturity of short term bank funding had profound consequences for the Group.

Whilst the Group’s customer funding sources remain well diversified and its retail franchise proved resilient, the availability of longer term funding diminished. The Group therefore increased its shorter term wholesale funding exposure, increased its access to central bank funding and issued government guaranteed debt to fund the balance sheet. The government schemes have enabled the mitigation of the financial crisis as the Group rebalances its asset and liability structure.

An analysis of the Group’s funding is set out below.

	Group
	2008		2007
Sources of funding	£m	%	£m	%
Customer accounts (excluding repos)
Repayable on demand	248,978	27	226,451	27
Time deposits	150,056	16	141,502	17
Total customer accounts (excluding repos)	399,034	43	367,953	44
Debt securities in issue over one year
remaining maturity	57,447	6	50,580	6
Subordinated liabilities	39,951	4	27,796	3
Owners’ equity	45,958	5	47,683	5
Total customer accounts and long term funds	542,390	58	494,012	58
Repo agreements with customers	54,095	6	75,029	9
Repo agreements with banks	66,006	7	75,154	9
Total customer accounts, long term funds
and collateralised borrowing	662,491	71	644,195	76
Debt securities in issue up to one year
remaining maturity	122,495	13	79,552	9
Deposits by banks (excluding repos)	115,976	12	76,354	9
Short positions	37,172	4	47,058	6
Total	938,134	100	847,159	100

Customer accounts – the principal source of funds for the Group is its core customer deposits gathered by its retail banking, private client, corporate and SME franchises. The underlying strength of the franchise is demonstrated by the performance of the Group in these markets as customer deposits increased from £368 billion in December 2007 to £399 billion at the end of December 2008. There was a fluctuation in balances at the height of the market disruption in October 2008 but this was recovered by the year end. The Group’s multi-brand offering and strong client focus is a key part of the funding strategy and continues to benefit the Group’s funding position.

Repo agreements are borrowings collateralised by a range of debt securities and other assets undertaken with a range of corporate and institutional customers and banks. These reduced in the course of 2008 as the Group took strategic actions and wholesale markets retrenched.

Short positions in various securities are held primarily by GBM including RBS Greenwich Capital in the US.

Debt securities in issue over one year, subordinated liabilities and equity – during 2008, the debt markets saw reduced activity, in both the term and the securitisation markets; as a result the maturity profile of the Group’s wholesale funding has become shorter in duration over the course of the year. This was partly offset by issues of government guaranteed debt in the latter part of 2008. The maturity profile of debt securities is predominantly concentrated under one year and this is a source of refinancing risk in the coming twelve months.

Short term debt and bank deposits – the Group saw considerable pressure and risk aversion in the short term debt and bank deposit markets. In order to relieve funding shortages in the market, central banks across the world allowed banks to pledge assets to access funding. The Group has used central bank schemes to support its funding and pledged assets into several of these schemes in a number of countries in which it operates. The Group has set up a series of initiatives to improve the liquidity value of its assets to assist in relieving funding pressures.

Undrawn commitments – the Group provides undrawn commitments to both its corporate and personal customers in the form of products such as overdrafts and credit card facilities. The commitments portfolio is well diversified in terms of customers, geography and business type. The total amount of the Group’s undrawn commitments at the end of 2008 was £294 billion.

Conduits – the Group’s most significant multi-seller conduits have thus far continued to fund the vast majority of their assets solely through asset backed commercial paper (ABCP) issuance. There were significant disruptions to the liquidity of the financial markets during the year following the bankruptcy filing of Lehman Brothers in September 2008 and this required a small amount of the assets held in certain conduits to be funded by the Group rather than through ABCP issuance. By the end of 2008 there had been an improvement in market conditions, supported by central bank initiatives, which enabled normal ABCP funding to replace this Group funding of the conduits.

The average maturity of ABCP issued by the Group’s conduits as at 31 December 2008 was 72.4 days (2007– 60.4 days).

The Group values the funding flexibility and liquidity provided by the ABCP market to fund client and Group-originated assets. Whilst there are plans to decrease the multi-seller conduit business in line with the Group’s balance sheet, the Group is reviewing the potential for new own-asset conduit structures to add funding diversity.

Balance sheet (audited)

The following tables show the contractual undiscounted cash flows receivable and payable up to a period of 20 years including future payments of interest.

On balance sheet assets by contractual maturity

	Group
	0-3 months		3-12 months		1-3 years		3-5 years		5-10 years		10-20 years
2008		£m		£m		£m		£m		£m		£m
Cash and balances at central banks		6,804		—		—		—		2		—
Loans and advances to banks		14,356		3,037		650		343		156		1
Loans and advances to customers		112,181		63,785		117,538		106,942		137,546		129,999
Debt securities		21,104		4,785		14,647		7,983		16,509		23,742
Derivatives held for hedging		5		734		1,842		911		876		268
Settlement balances		10,869		—		—		—		2		—
Other financial assets		2		—		—		10		20		—
		165,321		72,341		134,677		116,189		155,111		154,010

On balance sheet liabilities by contractual maturity

	Group
	0-3 months		3-12 months		1-3 years		3-5 years		5-10 years		10-20 years
2008		£m		£m		£m		£m		£m		£m
Deposits by banks		83,879		5,938		3,114		1,758		662		34
Customer accounts		368,115		18,634		2,313		2,811		4,105		2,718
Debt securities in issue		110,728		30,213		22,461		3,581		5,600		4,038
Derivatives held for hedging		67		755		1,926		674		597		317
Subordinated liabilities		972		2,659		5,113		5,583		17,213		13,287
Settlement balances and other liabilities		10,407		5		7		4		7		6
		574,168		58,204		34,934		14,411		28,184		20,400

Other contractual cash obligations
Other contractual obligations are summarised by payment date in the tables below

	Group
	0-3 months		3-12 months		1-3 years		3-5 years		5-10 years		10-20 years
2008		£m		£m		£m		£m		£m		£m
Operating leases		103		304		743		611		1,174		1,836
Contractual obligations to purchase goods or services		176		696		262		22		—		1
		279		1,000		1,005		633		1,174		1,837

2007
Operating leases		89		261		638		555		1,073		1,937
Contractual obligations to purchase goods or services		371		815		526		194		3		2
		460		1,076		1,164		749		1,076		1,939

		Bank
	0-3 months		3-12 months		1-3 years		3-5 years		5-10 years		10-20 years
2008		£m		£m		£m		£m		£m		£m
Operating leases		41		118		299		287		599		1,209
Contractual obligations to purchase goods or services		65		170		162		22		—		—
		106		288		461		309		599		1,209

2007
Operating leases		35		106		269		256		582		1,176
Contractual obligations to purchase goods or services		100		249		199		34		2		—
		135		355		468		290		584		1,176

Undrawn formal facilities, credit lines and other commitments to lend were £294,349 million (2007 – £259,263 million) for the Group and £187,041 million (2007 – £144,185 million) for the Bank. While the Bank and its subsidiaries have given commitments to provide these funds, some facilities may be subject to certain conditions being met by the counterparty. Not all facilities are expected to be drawn, and some may lapse before drawdown.

The tables above show the timing of cash inflows and outflows to settle financial assets and liabilities. They have been prepared on the following basis:

Financial assets have been reflected in the time band of the latest date on which they could be repaid unless earlier repayment can be demanded by the reporting entity; financial liabilities are included at the earliest date on which the counterparty can require repayment regardless of whether or not such early repayment results in a penalty. If the repayment of a financial asset or liability is triggered by, or is subject to, specific criteria such as market price hurdles being reached, the asset is included in the latest date on which it can repay regardless of early repayment whereas the liability is included at the earliest possible date that the conditions could be fulfilled without considering the probability of the conditions being met. For example, if a structured note is automatically prepaid when an equity index exceeds a certain level, the cash outflow will be included in the less than three months period whatever the level of the index at the year end. The settlement date of debt securities in issue issued by certain securitisation vehicles consolidated by the Group depends on when cash flows are received from the securitised assets. Where these assets are prepayable, the timing of the cash outflow relating to securities assumes that each asset will be prepaid at the earliest possible date. As the repayment of assets and liabilities are linked, the repayment of assets in securitisations are shown on the earliest date that the asset can be prepaid as this is the basis used for liabilities.

Assets and liabilities with a contractual maturity of greater than 20 years – the principal amounts of financial assets and liabilities that are repayable after 20 years or where the counterparty has no right to repayment of the principal are excluded from the table as are interest payments after 20 years.

Held-for-trading assets and liabilities – held-for-trading assets and liabilities amounting to £1,148.7 billion (assets) and £1,091.7 billion (liabilities) have been excluded from the table in view of their short term nature.

This contractual analysis highlights the maturity transformation of the balance sheet that is fundamental to the structure of banking. In practice, this is not a reflection of the actual behaviour of assets or liabilities. In particular the customer funding of the balance sheet exhibits much greater stability and maturity than the tables indicate. This is because the funding franchise of the Group is diversified across an extensive retail network.

Regulatory environment (audited)

The RBS Group is subject to the FSA’s liquidity regime, whilst overseas subsidiaries and branches are subject to local regimes.

Sterling liquidity

The FSA requires the RBS Group, on a consolidated basis, to maintain daily a minimum ratio of 100% between:

•	a stock of qualifying high quality liquid assets (primarily UK and EU government securities, treasury bills and cash held in branches); and

•

the sum of: sterling wholesale net outflows contractually due within five working days (offset up to a limit of 50%, by 85% of sterling certificates of deposit held which mature beyond five working days); and 5% of retail deposits with a residual contractual maturity of five working days or less. The FSA also sets an absolute minimum level for the stock of qualifying liquid assets that the RBS Group is required to maintain each day.

Given the developments in 2008 the FSA has published new proposals for liquidity management (CP08/22) to replace the current regulatory framework. The FSA is proposing a major overhaul of liquidity risk regulation that will include:

•	Improved systems and controls including governance standards, pricing, intra day systems and collateral management.

•	Individual liquid assessments that will include mandatory scenarios and an analysis of principal liquidity exposure factors.

•	Reporting standards improved both in scope and frequency by enhanced mismatch reporting.

Market risk (audited)

Market risk arises from changes in interest rates, foreign currency, credit spread, equity prices and risk related factors such as market volatilities. Market risk is actively managed and aligned with the RBS Group’s risk appetite. Market conditions were difficult throughout 2008 with significant volatility and write-downs across markets and portfolios. The RBS Group manages market risk in the trading and non-trading (treasury) portfolios using the market risk management framework. The framework includes value-at-risk (VaR) limits, backtesting, stress testing, scenario analysis, position/sensitivity analysis and model validation. The focus through 2008 has been on overhauling and reviewing the market risk limits for trading book activities, reflecting market performance and events.

Measurement (audited)

A number of techniques are used to calculate the RBS Group’s exposure to market risk, including VaR, sensitivity analysis and stress testing. VaR is a technique that produces estimates of the potential change in the market value of a portfolio over a specified time horizon at given confidence levels. For internal risk management purposes, the RBS Group’s VaR assumes a time horizon of one trading day and a confidence level of 95%. The trading book market risk is calculated using VaR at a confidence level of 99% and a time horizon of ten trading days. From 2009, the RBS Group is adopting 99% confidence limits, in line with industry practice.

The RBS Group calculates VaR using historical simulation models but does not make any assumption about the nature or type of underlying loss distribution. The methodology uses the previous 500 trading days of market data and calculates both general market risk (i.e. the risk due to movement in general market benchmarks) and idiosyncratic market risk (i.e. the risk due to movements in the value of securities by reference to specific issuers). All VaR models have limitations, which include:

•	Historical data may not provide the best estimate of the joint distribution of risk factor changes in the future and may fail to capture the risk of possible extreme adverse market movements which have not occurred in the historical window used in the calculations.

•	VaR using a one-day time horizon does not fully capture the market risk of positions that cannot be liquidated or hedged within one day.

•	VaR using a 95% confidence level does not reflect the extent of potential losses beyond that percentile.

Traded portfolios (audited)

The primary focus of the RBS Group’s trading activities is client facilitation. The Group also undertakes:

•	Market making – quoting firm bid (buy) and offer (sell) prices with the intention of profiting from the spread between the quotes.

•	Arbitrage – entering into offsetting positions in different but closely related markets in order to profit from market imperfections.

•	Proprietary activity – taking positions in financial instruments as principal in order to take advantage of anticipated market conditions.

Financial instruments held in the RBS Group’s trading portfolios include, but are not limited to: debt securities, loans, deposits, equities, securities sale and repurchase agreements and derivative financial instruments (futures, forwards, swaps and options).

The RBS Group participates in exchange traded and over-the-counter (OTC) derivatives markets. The RBS Group buys and sells financial instruments that are traded or cleared on an exchange, including interest rate swaps, futures and options. Holders of exchange traded instruments provide margin daily with cash or other security at the exchange, to which the holders look for ultimate settlement. The RBS Group also buys and sells financial instruments that are traded OTC, rather than on a recognised exchange. These instruments range from commoditised transactions in derivative markets, to trades where the specific terms are tailored to the requirements of the RBS Group’s customers. In many cases, industry standard documentation is used, most commonly in the form of a master agreement, with individual transaction confirmations. The RBS Group calculates the VaR of trading portfolios at the close of business and positions may change substantially during the course of a trading day. Further controls are in place to limit the RBS Group’s intra-day exposure, such as the calculation of the VaR for selected portfolios. The RBS Group cannot guarantee that losses will not exceed the VaR amounts indicated due to the limitations and nature of VaR measurements.

Assets and liabilities in the trading book are measured at their fair value. Fair value is the amount at which the instrument could be exchanged in a current transaction between willing parties. The fair values are determined following IAS 39 guidance which requires banks to use quoted market prices or valuation techniques (models) that make the maximum use of observable inputs. When marking to market using a model, the valuation methodologies are reviewed and approved either by the market risk function in the business or at RBS Group level. Group Risk provides an independent evaluation of the model for transactions deemed by the Model Product Review Committee (MPRC) to be large, complex and/or innovative. Any profits or losses on the revaluation of positions are recognised in the daily profit and loss.

The VaR for the trading portfolios segregated by type of market risk exposure, including idiosyncratic risk, is presented in the table below.

	Group
	2008									2007
	Average		Period end			Maximum		Minimum		Average		Period end			Maximum		Minimum
		£m		£m			£m		£m		£m		£m			£m		£m
Interest rate		18.9		25.8			38.8		9.2		11.7		9.6			17.6		7.6
Credit spread		35.0		40.4			51.3		19.4		17.7		37.9			44.0		12.6
Currency		3.9		7.0			10.8		2.1		2.6		2.6			6.9		1.1
Equity		3.4		2.4			11.0		1.5		2.4		1.9			6.8		1.4
Commodity		6.3		5.7			17.4		—		0.2		0.1			1.6		—
Diversification				(31.0	)								(12.4	)
Total trading VaR		42.3		50.3			63.9		24.8		20.3		39.7			45.5		13.2

The average total VaR utilisation increased in 2008 compared with 2007 as a result of increased market volatility. This increase was offset by a reduction in trading book exposure throughout the period, due to a reduction in the size of the inventory held on the balance sheet as a result of sales, reclassification of assets to the non-trading book and write-downs.

The 2008 data in the table above excludes exposures to super-senior tranches of asset backed CDOs, as VaR no longer produces an appropriate measure of risk for these exposures due to the illiquidity and opaqueness of the pricing of these instruments over an extended period. For these exposures, the maximum potential loss is equal to the aggregate net exposure, which was £734 million as at 31 December 2008. For more information, please refer to the discussion of Credit market and related exposures – Super senior CDOs on page 46 and Financial statements: Note 10, Financial instruments – Valuation – level 3 portfolios – collateralised debt obligations on pages 87 and 88. RBS Sempra Commodities LLP, the commodities-marketing joint venture between RBS and Sempra Energy, was formed on 1 April 2008, and its trading risks were included in the disclosed VaR from that date.

Backtesting, stress testing and sensitivity analysis (audited)

The RBS Group undertakes a programme of daily backtesting, which compares the actual profit or loss realised in trading activity to the VaR estimation. The results of the backtesting process are one of the methods by which the RBS Group monitors the ongoing suitability of its VaR model.

A ‘Risks not in VaR’ framework has been developed to address those market risks not adequately captured by the market standard VaR methodology. Where risks are not included in the model various non-VaR controls (e.g. position monitoring, sensitivity limits, triggers or stress limits) are in place.

The RBS Group undertakes daily stress testing to identify the potential losses in excess of VaR. Stress testing is used to calculate a range of trading book exposures which result from exceptional but plausible market events. Stress testing measures the impact of abnormal changes in market rates and prices on the fair value of the RBS Group’s trading portfolios. GEMC approves the high-level market stress test limit for the RBS Group. The RBS Group calculates historical stress tests and hypothetical stress tests.

Historical stress tests calculate the loss that would be generated if the market movements that occurred during historical market events were repeated. Hypothetical stress tests calculate the loss that would be generated if a specific set of adverse market movements were to occur.

Stress testing is also undertaken at key trading strategy level, for those strategies where the associated market risks are not adequately captured by VaR. Stress test exposures are discussed with senior management and are reported to GRC, GEMC and the Board. Breaches in the RBS Group’s market risk stress testing limits are monitored and reported.

In addition to VaR and stress testing, the RBS Group calculates a wide range of sensitivity and position risk measures, for example interest rate ladders or option revaluation matrices. These measures provide valuable additional controls, often at individual desk or strategy level.

Model validation governance (audited)

Pricing models are developed and owned by the front office. Where pricing models are used as the basis of books and records valuations, they are all subject to independent review and sign-off. Models are assessed by MPRC as having either immaterial or material model risk (valuation uncertainty arising from choice of modelling assumptions), the assessment being made on the basis of expert judgement.

Those models assessed as having material model risk are prioritised for independent quantitative review. Independent quantitative review aims to quantify model risk by comparing model outputs against alternative independently developed models. The results of independent quantitative review are used by Market Risk to inform risk limits and by Finance to inform reserves. Governance over this process is provided by MPRC, a forum which brings together front office quants, market risk, finance and QuaRC (Quantitative Research Centre, Group Risk’s independent quantitative model review function). Risk (market risk, incremental default risk, counterparty credit risk) models are developed both within business units and by Group functions. Risk models are also subject to independent review and sign-off. Meetings are held with the FSA every quarter to discuss the traded market risk, including changes in models, management, back testing results, other risks not included in the VaR framework and other model performance statistics.

Risk control (audited)

All divisions that are exposed to market risk in the course of their business are required to comply with the requirements of the RBS Group’s Market Risk Policy Standards (MRPS). The main risk management tools are delegated authorities, specifically hard limits and discussion triggers, independent model valuation, a robust and efficient risk system and timely and accurate management information.

Limits form part of the dealing authorities and constitute one of the cornerstones of the market risk management framework. Upon notification of a limit breach, the appropriate body must take one of the following actions:

•	Instructions can be given to reduce positions so as to bring the RBS Group within the agreed limits.

•	A temporary increase in the limit (for instance, in order to allow orderly unwinding of positions) can be granted.

•	A permanent increase in the limit can be granted.

Non-traded portfolios (audited)

Risks in non-traded portfolios mainly arise in retail and commercial banking assets and liabilities and financial investments designated as available-for-sale and held-to-maturity.

Group Treasury is responsible for setting and monitoring the adequacy and effectiveness of management, using a framework that identifies, measures, monitors and controls the underlying risk. GALCO approves the RBS Group’s non-traded market risk appetite, expressed as statistical and non-statistical risk limits, which are delegated to the businesses responsible.

Various banking regulators review non-trading market risk as part of their regulatory oversight. As home regulator, the FSA has responsibility for reviewing non-trading market risk at a RBS Group consolidated level.

The RBS Group is exposed to the following non-traded risks:

Interest Rate Risk in the Banking Book (IRRBB) represents exposures to instruments whose values vary with the level or volatility of interest rates. These instruments include, but are not limited to, loans, debt securities, equity shares, deposits, certificates of deposits, and other debt securities issued, loan capital and derivatives. Hedging instruments used to mitigate these risks include related derivatives such as options, futures, forwards and swaps. Interest rate risk arises from the RBS Group’s non-trading activities in four principal forms:

•	Repricing risk – arises from differences in the repricing terms of the RBS Group’s assets and liabilities.

•	Optionality – arises where a customer has an option to exit a deal early.

•	Basis risk – arises, for example, where one month LIBOR is used to fund base rate assets.

•	Yield curve risk – arises as a result of non-parallel changes in the yield curve.

From an economic perspective, it is the RBS Group’s policy to minimise the sensitivity to changes in interest rates in its retail and commercial businesses and, where interest rate risk is retained, to ensure that appropriate resources, measures and limits are applied.

Non-trading interest rate risk is calculated in each business on the basis of establishing the repricing behaviour of each asset, liability and off- balance sheet product. For many retail and commercial products, the actual interest rate repricing characteristics differ from the contractual repricing. In most cases, the repricing maturity is determined by the market interest rate that most closely fits the historical behaviour of the product interest rate. For non-interest bearing current accounts, the repricing maturity is determined by the stability of the portfolio. The repricing maturities used are approved by Group Treasury and divisional asset and liability committees at least annually. Key conventions are reviewed annually by GALCO.

A static maturity gap report is produced as at the month-end for each business, in each functional currency based on the behavioural repricing for each product. It is RBS Group policy to include in the gap report, non-financial assets and liabilities, mainly property, plant and equipment and the RBS Group’s capital and reserves, spread over medium and longer term maturities. The report includes hedge transactions, principally derivatives.

Any residual non-trading interest rate exposures are controlled by limiting repricing mismatches in the individual business balance sheets. Potential exposures to interest rate movements in the medium to long- term are measured and controlled using a version of the same VaR methodology that is used for the RBS Group’s trading portfolios. Net accrual income exposures are measured and controlled in terms of sensitivity over time to movements in interest rates.

Risk is managed within VaR limits approved by GALCO, through the execution of cash and derivative instruments. Execution of the hedging is carried out by the relevant division through the RBS Group’s treasury functions. The residual risk position is reported to divisional asset and liability committees, GALCO and the Board.

Foreign Exchange Risk in the Banking Book (FXRBB) represents exposures to changes in the values of current holdings and future cashflows denominated in other currencies. Hedging instruments used to mitigate these risks include foreign currency options, currency swaps, futures, forwards and deposits. Foreign exchange risk results from the RBS Group’s investments in overseas subsidiaries, associates and branches in three principal forms:

(i)	Structural foreign currency exposures that arise from net investment in overseas subsidiaries, associates and branches;

(ii)	Transactional/commercial foreign currency exposures that arise from mismatches in the currency balance sheet; and

(iii)

Foreign currency profit streams.

Equity Risk in the Banking Book (ERBB) is defined as the potential variation in the RBS Group’s non-trading income and reserves arising from changes in equity prices/income. This risk may crystallise during the course of normal business activities or in stressed market conditions.

Equity positions in the RBS Group’s banking book are retained to achieve strategic objectives, support venture capital transactions or in respect of restructuring arrangements. From an economic perspective, it is the RBS Group’s policy to ensure that equity exposures in the banking book are identified, monitored and controlled, with the aim of maximising their potential strategic or business value.

The types, nature and amounts of exchange-traded exposures, private equity exposures, and other exposures vary significantly. Such exposures may take the form of listed and unlisted equity shares, linked equity fund investments, private equity and venture capital investments, preference shares classified as equity and Federal Home Loan Stock.

The commercial decision to invest in equity holdings is taken by GEMC, GCC or an appropriate sub-committee within delegated authority. Investments of a strategic nature are referred to GEMC for approval; those involving the purchase or sale by the Group or subsidiary companies also require Board approval, after consideration by GEMC.

Treasury (audited)

The RBS Group’s treasury activities include its money market business and the management of internal funds flow within the RBS Group’s businesses. In addition, this includes GBM trading portfolio assets that have been reclassified to available-for-sale. Money market portfolios include cash instruments (principally debt securities, loans and deposits) and related hedging derivatives.

Non-trading interest rate VaR (audited)

Non-trading interest rate VaR for the Group’s treasury and retail and commercial banking activities was £117.8 million at 31 December 2008 (2007 – £65.1 million) with the major exposure being to changes in longer term US dollar interest rates. During 2008, the maximum VaR was £171.7 million (2007 – £71.8 million), the minimum was £75.9 million (2007 – £51.5 million) and the average was £109.6 million (2007 – £62.9 million).

Citizens Financial Group (CFG) was the main contributor to overall non-trading interest rate VaR. CFG manages non-trading interest rate risk with the objective of minimising accrual accounted earnings volatility.

To do so it uses a variety of income simulation and valuation risk measures that more effectively capture the risk to earnings due to mortgage prepayment and competitive deposit pricing behaviour than a VaR based methodology would. This balance sheet management approach is common for US retail banks. Interest rate risk in the banking book is managed by a professional treasury function which optimises the yield, whilst staying within approved limits on interest rate risk, liquidity and capitalisation.

Mortgages, home equity loans and mortgage-backed securities (MBS) comprise a large portion of CFG’s assets. In the US, mortgage and home equity customers may prepay loans without penalty. However, under the requirements of FAS 133, the risk that they may do so cannot be hedged in a cost effective manner and must be born by the lender. Prepayment risk is a primary component of interest rate risk in the banking book at CFG.

	2008				2007
			Carrying				Carrying
	Principal(1)		amount		Principal(1)		amount
	US$m		US$m		US$m		US$m
Total MBS and mortgages		63,542		63,165		69,948		69,672
MBS – total
– high grade (AA or AAA rated)		26,268		25,893		26,848		26,572
– rated C to A		602		600		—		—
MBS – commercial
– high grade (AA or AAA rated)		2,253		2,089		2,205		2,211
MBS – retail
– high grade (AA or AAA rated)		24,015		23,804		24,643		24,361
– rated C to A		602		600		—		—
Residential mortgage and home equity loans (non-securitised, fixed rate and ARM, prepayable)		36,672		36,672		43,100		43,100

Note:

(1)	The principal on MBS is the redemption amount on maturity or, in the case of an amortising instrument, the sum of future redemption amounts through the residual life of the security.

In addition to VaR, the following measures are reported to CFG ALCO, Group Treasury, GALCO and the Board:

•	The sensitivity of net accrual earnings to a variety of parallel and non-parallel movements in interest rates.

•	Economic value of equity (EVE) sensitivity to a series of parallel movements in interest rates. EVE is only used within CFG and to meet the FSA prescribed standard shock test of +/- 200bp parallel shock.

	Percent increase/ decrease in CFG EVE(1)
				2% parallel
				downward
	2% parallel			movement in
	upward			US interest
	movement in			rates (No
	US interest			negative rates
(Unaudited)	rates			allowed)
Period end		(0.7	)		(19.0	)
Maximum		(18.2	)		(20.8	)
Minimum		(0.7	)		(4.4	)
Average		(12.2	)		(12.6	)

Note:

(1)

Economic value of equity is the net present value of assets and liabilities calculated by discounting expected cash flows of each instrument over its expected life. Risk to EVE is quantified by calculating the impact of interest rate changes on the net present value of equity and is expressed as a percentage of CFG regulatory capital.

Currency risk (audited)

The RBS 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 RBS 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 RBS Group’s or the subsidiary’s regulatory capital ratios to currency movements. The policy requires structural foreign exchange positions to be reviewed regularly by GALCO. Foreign exchange differences arising on the translation of foreign operations are recognised directly in equity together with the effective portion of foreign exchange differences arising on hedging instruments.

Equity classification of foreign currency denominated preference share issuances requires that these shares be held on the balance sheet at historic cost. Consequently, these share issuances have the effect of increasing the RBS Group’s structural foreign currency position.

The table below sets out the Group’s structural foreign currency exposures.

	2008							2007
	Net investments in foreign operations		Net investment hedges			Structural foreign currency exposures		Net investments in foreign operations		Net investment hedges			Structural foreign currency exposures
		£m		£m			£m		£m		£m			£m
US dollar		16,710		(4,302	)		12,408		13,919		(2,437	)		11,482
Euro		4,571		(617	)		3,954		3,483		—			3,483
Swiss franc		912		(912	)		—		563		(561	)		2
Other non-sterling		877		(844	)		33		185		(153	)		32
		23,070		(6,675	)		16,395		18,150		(3,151	)		14,999

Retranslation gains and losses on the Group’s net investments in operations together with those on instruments hedging these investments are recognised directly in equity. Changes in foreign currency exchange rates will affect equity in proportion to the structural foreign currency exposure. A five percent strengthening in foreign currencies would result in a gain of £820 million (2007 – £750 million) recognised in equity, while a five per cent weakening in foreign currencies would result in a loss of £780 million (2007 – £715 million) recognised in equity. These movements in equity would offset retranslation effects on the Group's foreign currency denominated risk weighted assets, reducing the sensitivity of the Group's Tier 1 capital ratio to movements in foreign currency exchange rates.

Equity risk (audited)
Equity positions are measured at fair value. Fair value calculations are based on available market prices wherever possible. In the event that market prices are not available, fair value is based on appropriate valuation techniques or management estimates.

Credit market and related exposures (unaudited)

These disclosures provide information on certain of the Group’s business activities affected by the unprecedented market events of 2008, the majority of which arose within Global Banking & Markets (‘GBM’), and are focussed around GBM’s credit markets activities, including the conduit business, which have been particularly affected by the widespread market disruptions, as well as similar exposures in US Retail & Commercial (’Citizens’).

Market background (unaudited)

Overall, 2008 has been characterised by rapid dislocation in financial markets. In many cases, the dramatic liquidity squeeze and rise in funding costs for financial institutions has resulted in reluctance or inability of market participants to transact, and has adversely affected the performance of most financial institutions globally, including the Group. Stock markets have experienced extraordinary falls, and levels of volatility have been at record highs. Commodity prices have reduced sharply in the second half of the year, and credit spreads continued to widen. Market perception of counterparty risk increased and the failure of major credit protection providers caused fair value losses for the Group and other market participants and further increased the costs of mitigating credit exposure. Sustained falls globally in both residential and commercial real estate prices, fund valuations and worsening loan performance combined with a sustained lack of liquidity in the market, resulted in a greater amount of assets being valued at significantly lower prices.

The first quarter of 2008 saw a continuation of credit and liquidity shortages experienced during 2007, culminating in the collapse of Bear Stearns in March. The centre of the credit issues remained the ABS market with worsening US economic data supporting higher levels of default expectation in the property market. However, these default expectations started to go beyond the sub-prime market with Alt A and other non-conforming classes of loans particularly seeing significant price deterioration. In addition, wider economic concerns led to heavy fair value losses in the commercial mortgage backed securities market, in corporate debt and in leveraged loan exposures. Following this tightening of conditions, the Group incurred significant losses in March and the holding company took steps in April to materially strengthen its capital base through a £12 billion rights issue which was completed in June.

During the second quarter ABS prices initially rallied and steadied, however towards the end of the quarter a negative house price trend in the UK became clear, and in the US, market reaction to sub-prime mortgages extended to prime and near prime lending. Corporate credit spreads followed a similar pattern reacting to rising oil prices, inflationary pressures and continuing high LIBOR despite base rate cuts to 5% in April 2008.

Credit spreads continued to widen across the market through the third quarter and liquidity levels reduced further, resulting in pressure on banks and economies worldwide. This culminated in the demise of Lehman Brothers in September and further market consolidation and global state intervention to provide support to the banking sector.

During the fourth quarter there was a continued lack of confidence in the inter-bank market, with demand for stable investments resulting in US treasuries reaching negative spreads. Corporate and ABS prices fell further particularly in the last two months of the year increasing pressure on banks’ capital positions. The year concluded with S&P downgrading the credit ratings of eleven global banks, including the Group.

Asset-backed exposures (audited)

Significant risk concentrations

The Group’s credit markets activities gives rise to risk concentrations that have been particularly affected by the market turmoil experienced since the second half of 2007. The Group structures, originates, distributes and trades debt in the form of loan, bond and derivative instruments in all major currencies and debt capital markets in North America, Western Europe, Asia and major emerging markets.

During 2008, certain assets identified as being high risk were also transferred to a centrally managed asset unit, set up to provide specific management of this portfolio of higher risk assets. Transferred assets are predominantly ABS and associated protection purchased from monoline insurers and other counterparties.

The table below summarises, for the Group, the net exposures and balance sheet carrying values of these securities by measurement classification.

	Held-for-trading				Available-for-sale				Loans and receivables				Designated at fair value				All ABS
	2008		2007		2008		2007		2008		2007		2008		2007		2008		2007
Net exposure		£m		£m		£m		£m		£m		£m		£m		£m		£m		£m
RMBS		20,932		30,616		26,039		12,495		2,248		—		1		—		49,220		43,111
CMBS		908		2,870		917		409		1,151		500		—		—		2,976		3,779
CDOs/CLOs		1,790		4,722		2,225		20		1,141		—		—		16		5,156		4,758
Other ABS		195		2,996		3,208		679		3,375		—		—		186		6,778		3,861
Total		23,825		41,204		32,389		13,603		7,915		500		1		202		64,130		55,509


Carrying value
RMBS		24,304		32,794		26,381		12,501		2,248		—		1		—		52,934		45,295
CMBS		2,431		2,969		938		409		1,151		500		—		—		4,520		3,878
CDOs/CLOs		7,531		9,568		5,525		20		1,141		—		—		17		14,197		9,605
Other ABS		1,505		5,275		3,208		679		3,375		—		—		186		8,088		6,140
Total		35,771		50,606		36,052		13,609		7,915		500		1		203		79,739		64,918

Notes:

(1)

Net exposure is carrying value after taking account of hedge protection purchased from monolines and other counterparties but excludes the effect of counterparty credit valuation adjustment. The protection provides credit protection against the notional and interest cash flows due to the holders of debt instruments in the event of default by the debt security counterparty. The value of the protection is based on the underlying instrument being protected.

(2)	Carrying value is the amount recorded on the balance sheet.

(3)	Certain instruments have been reclassified from the held-for-trading category to loans and receivables or available-for-sale categories, as permitted by the amendment to IAS 39 issued in October 2008, therefore affecting comparability by measurement classification.

Asset backed securities are securities that represent an interest in an underlying pool of referenced assets. The referenced pool can comprise any assets which attract a set of associated cash flows but are commonly pools of residential or commercial mortgages and, in the case of collateralised debt obligations (‘CDOs’), the referenced pool may be ABS or other classes of assets. The process by which the risks and rewards of the pool are passed on to investors via the issuance of securities with varying seniority is commonly referred to as securitisation.

During 2008, as the problems in the sub-prime sector spread to other asset classes on a global basis and credit spreads widened due to concerns over creditworthiness of underlying assets, securitisation volumes continued to be thin. Over the preceding years Global Banking & Markets (‘GBM’) had established itself as an active arranger of third- party securitisations and a secondary dealer in these securities, and GBM had therefore accumulated assets that became difficult to sell given market conditions.

The Group has exposures to ABS which are predominantly debt securities but can be held in derivative form. These positions had been acquired primarily through the Group’s activities in the US leveraged finance market which were expanded during 2007. These include residential mortgage backed securities (‘RMBS’), commercial mortgage backed securities (‘CMBS’), ABS CDOs, collateralised loan obligations (‘CLOs’) and other ABS. In many cases the risk on these assets is hedged via credit derivative protection purchased over the specific asset or relevant ABS indices. The counterparty to some of these hedge transactions are monoline insurers.

The net exposure of the Group’s holdings of ABS increased from £55.5 billion at 31 December 2007 to £64.1 billion by 31 December 2008, where underlying reductions have been more than offset by the effect of exchange rates. The net exposure incorporates hedge protection but excludes counterparty credit valuation adjustments. All hedge protection referred to in the credit market and related exposures section relates to economic hedges that do not qualify for hedge accounting.

Through a sustained de-risking exercise, the Group made reductions to the overall risk through a combination of direct asset sales and switching to lower risk assets through trading activities. As a large proportion of the ABS are denominated in US dollars, these reductions in exposure were partially offset due to the movement in the exchange rate against sterling. The majority of the Group’s RMBS portfolio at 31 December 2008, in terms of net exposure, was AAA rated guaranteed or effectively guaranteed securities of £33.5 billion of US agency securities.

The table below analyses, for the Group, carrying values of these debt securities by measurement classification and rating.

	RMBS
					Prime
	Sub-prime		Non conforming		Guaranteed		Other		CMBS		CDOs/CLOs		Other ABS		Total
2008		£m		£m		£m		£m		£m		£m		£m		£m
Held-for-trading		1,578		352		18,586		3,788		2,431		7,531		1,505		35,771
Available-for-sale		899		2,184		14,898		8,400		938		5,525		3,208		36,052
Loans and receivables		282		1,482		—		484		1,151		1,141		3,375		7,915
Designated at fair value		—		—		—		1		—		—		—		1
Total		2,759		4,018		33,484		12,673		4,520		14,197		8,088		79,739

Of which:
AAA rated (1)	1,132	3,532	33,475	11,174	2,928	9,192	3,189	64,622
BBB and above rated (1)	878	338	—	1,391	1,552	2,810	3,422	10,391
Non-investment grade (1)	749	146	—	106	39	1,512	241	2,793
Not publicly rated	—	2	9	2	1	683	1,236	1,933
	2,759	4,018	33,484	12,673	4,520	14,197	8,088	79,739

2007
Held-for-trading	4,246	2,884	15,627	10,037	2,969	9,568	5,275	50,606
Available-for-sale	7	640	10,533	1,321	409	20	679	13,609
Loans and receivables	—	—	—	—	500	—	—	500
Designated at fair value	—	—	—	—	—	17	186	203
Total	4,253	3,524	26,160	11,358	3,878	9,605	6,140	64,918

Of which:
AAA rated (1)	1,191	2,733	26,034	10,643	2,820	7,186	3,324	53,931
BBB and above rated (1)	2,384	526	—	557	1,010	1,352	1,179	7,008
Non-investment grade (1)	589	146	—	27	35	248	104	1,149
Not publicly rated	89	119	126	131	13	819	1,533	2,830
	4,253	3,524	26,160	11,358	3,878	9,605	6,140	64,918

Note:

(1) Credit ratings are based on those from rating agencies Standard & Poor’s (S&P), Moody’s and Fitch and have been mapped onto S&P scale.

Residential mortgage-backed securities (audited)

Residential mortgage backed securities (RMBS) are securities that represent an interest in a portfolio of residential mortgages. Repayments made on the underlying mortgages are used to make payments to holders of the RMBS. The risk of the RMBS will vary primarily depending on the quality and geographic region of the underlying mortgage assets and the credit enhancement of the securitisation structure.

Several tranches of notes are issued, each secured against the same portfolio of mortgages, but providing differing levels of seniority to match the risk appetite of investors. The most junior (or equity) notes will suffer early capital and interest losses experienced by the referenced mortgage collateral, with each more senior note benefiting from the protection provided by the subordinated notes below. Additional credit enhancements may be provided to the holder of senior RMBS notes, including guarantees over the value of the exposures, often provided by monoline insurers.

The main categories of mortgages that serve as collateral to RMBS held by the Group are described below. As can be seen from the tables below, the Group’s RMBS portfolio covers a range of geographic locations and there different categories used to classify the exposures depending on the geographical region of the underlying mortgage.

The categories are described below. The US market has more established definitions of differing underlying mortgage quality and these are used as the basis for the Group’s RMBS categorisation.

Sub-prime mortgages: are loans to sub-prime borrowers typically having weakened credit histories that include payment delinquencies, and potentially more severe problems such as court judgements and bankruptcies. They may also display reduced repayment capacity as measured by credit scores, high debt-to-income ratios, or other criteria indicating heightened risk of default.

Non-conforming mortgages (or ‘Alt-A’ used for US exposures) have a higher credit quality than sub-prime mortgages, but lower than those prime borrowers. Within the US mortgage industry, non-conforming mortgages are those that do not meet the lending criteria for US agency mortgages (described below). For non-US mortgages, judgement is applied in identifying loans with similar characteristics to US nonconforming loans and also include self-certified loans. Alt-A describes a category of mortgages in which lenders consider the risk to be greater than prime mortgages though less than sub-prime. The offered interest rate is usually representative of the associated risk level.

Guaranteed mortgages are mortgages that form part of a mortgaged backed security issuance by a government agency, or in the US, an entity that benefits from a guarantee (direct or indirect) provided by the US government. For US RMBS, this category includes, amongst others, RMBS issued by Freddie Mac, Fannie Mae and Ginnie Mae.

Other prime mortgages are those of a higher credit quality than nonconforming and sub-prime mortgages, and exclude guaranteed mortgages.

The table below shows, for the Group, RMBS net exposures and carrying values by underlying asset type, geographical location of the property that the mortgage is secured against and the year in which the underlying mortgage was originated.

	2008										2007
					Prime										Prime
	Sub-prime		Non conforming		Guaranteed(3)		Other		Total		Sub-prime		Non Conforming		Guaranteed(3)		Other		Total
Net exposure (1)		£m		£m		£m		£m		£m		£m		£m		£m		£m		£m
United States		358		1,106		33,458		5,548		40,470		2,662		2,800		26,005		2,643		34,110
United Kingdom		390		2,906		26		2,998		6,320		9		724		149		2,185		3,067
European Union		136		—		—		1,784		1,920		—		—		—		5,787		5,787
Rest of the World		300		—		—		210		510		5		—		—		142		147
		1,184		4,012		33,484		10,540		49,220		2,676		3,524		26,154		10,757		43,111

Carrying values (2)
United States	1,822	1,112	33,458	5,623	42,015	3,986	2,800	26,005	2,643	35,434
United Kingdom	419	2,906	26	4,084	7,435	9	724	155	2,514	3,402
European Union	155	—	—	2,725	2,880	3	—	—	6,059	6,062
Rest of the World	363	—	—	241	604	255	—	—	142	397
	2,759	4,018	33,484	12,673	52,934	4,253	3,524	26,160	11,358	45,295

Of which originated in:
- 2004 and earlier	646	122	5,537	1,647	7,952	922	176	2,548	1,819	5,465
- 2005	348	1,372	6,014	4,306	12,040	1,113	437	3,209	2,185	6,944
- 2006	1,214	872	1,698	4,023	7,807	1,721	1,188	5,570	4,787	13,266
- 2007 and later	551	1,652	20,235	2,697	25,135	497	1,723	14,833	2,567	19,620
	2,759	4,018	33,484	12,673	52,934	4,253	3,524	26,160	11,358	45,295

Notes:

(1)	Net exposures reflect the effect of hedge protection purchased from monolines and other counterparties but excludes the effect of counterparty credit valuation adjustment.

(2)	Carrying values are amounts recorded on the balance sheet.

(3)	Prime guaranteed exposures and carrying values include:

(a)

£5.7 billion (2007 – £5.0 billion) guaranteed by US government via Ginnie Mae of which £0.5 billion (2007 – £0.3 billion) are held-for-trading.

(b)

£27.8 billion (2007 – £21.0 billion) effectively guaranteed by the US government via its support for Freddie Mac and Fannie Mae of which £17.9 billion (2007 – £15.1 billion) are held-for-trading.

The Group’s largest concentration of RMBS assets relate to a portfolio of US agency asset backed securities comprising mainly of current year vintage positions of £33.5 billion at 31 December 2008 (2007 – £26.2 billion). Due to the US government backing implicit in these securities, the counterparty credit risk exposure is low. Financial markets and economic conditions have been extremely difficult in the US throughout 2008, particularly in the last quarter. Credit conditions have deteriorated and financial markets have experienced widespread illiquidity and elevated levels of volatility due to forced de-leveraging. Transaction activity in the securities portfolio has been reduced due to general market illiquidity. Residential mortgages have been affected by the stress that consumers experienced from depreciating house prices, rising unemployment and tighter credit conditions, resulting in higher levels of delinquencies and foreclosures. In particular, the deteriorating economy and financial markets have negatively impacted the valuation, liquidity, and credit quality of private-label securities.

Citizens maintains an available-for-sale investment securities portfolio to provide high-quality collateral to provide a liquidity buffer and to enhance earnings. The size of the portfolio has been relatively stable through 2008, but both the absolute and relative size (% of earning assets) declined in 2006-2007. The portfolio comprises high credit quality mortgage-backed securities, to ensure both pledgeability and liquidity. The US Government guarantees on MBS, whether explicit or implicit, put most of the portfolio in a secure credit position. The non- agency MBS holdings derive credit support in two ways. Firstly, there is senior and subordinated structuring, and Citizens hold only the most senior tranches. Secondly, there is high quality supporting loan collateral. The collateral quality is evidenced (a) by the vintages, with 82% issued in 2005 and earlier, (b) by the borrower’s weighted loan to value (LTV) ratio of 65%, and (c) by the borrower’s weighted-average FICO score of 734.

The Group has other portfolios of RMBS from secondary trading activities, warehoused positions previously acquired with the intention of further securitisation and a portfolio of assets from the unwinding of a securities arbitrage conduit. This conduit was established to benefit from the margin between the assets purchased and the notes issued. The majority of these held–for–trading RMBS have been grouped together for management purposes.

Some of these assets (£6.7 billion) were reclassified from held-for- trading category to the loans and receivables (£1.5 billion) and available-for-sale (£5.2 billion) categories during the year.

Overall, the Group has recognised significant fair value losses on RMBS assets during the year due to reduced market liquidity and deteriorating credit ratings of these assets. The Group has reduced its exposure to RMBS predominantly through fair value hedges and asset sales during the year. These decreases in were partially offset by the weakening of sterling relative to the US dollar and the euro.

Commercial mortgage-backed securities (audited)

Commercial mortgages backed securities (‘CMBS’) are securities that are secured by mortgage loans on commercial land and buildings. The securities are structured in the same way as an RMBS but typically the underlying assets referenced will be of greater individual value. The performance of the securities are highly dependent upon the sector of commercial property referenced and the geographical region.

The Group accumulated CMBS for the purpose of securitisation and secondary trading. The largest holding of CMBS arose as a result of the Group’s purchase of senior tranches in mezzanine and high grade CMBS structures from third parties. These securities are predominantly hedged with monoline insurers. As a result, the Group’s risk is limited to the counterparty credit risk exposure to the hedge. The Group also holds CMBS arising from securitisations of European commercial mortgages originated by the Group.

Asset-backed collateralised debt and loan obligations (audited)

Collateralised debt obligations (CDOs) are securities whose performance is dependant on a portfolio of referenced underlying securitised assets. The referenced assets generally consist of ABS, but may also include other classes of assets. Collateralised loan obligations represent securities in special purpose entities, the assets of which are primarily cash flows from underlying leveraged loans.

The Group’s ABS CDO and CLO net exposures comprised super senior CDOs and other CDOs and CLOs. The Group’s CDO exposures were structured by the Group from 2003 to 2007 that were unable to be sold to third parties due to prevailing illiquid markets as well as exposures purchased from third parties some of which are fully hedged through CDS with other banks or monoline insurers.

Super senior CDOs

Super senior CDOs represent the most senior positions in a CDO, having subordination instruments (usually represented by a combination of equity, mezzanine and senior notes) which absorb losses before the super senior note is affected. Losses will only be suffered by the super senior note holders after a certain threshold of defaults of the underlying reference assets has been reached. The threshold is usually referred to in percentage terms of defaults of the remaining pool, and known as the ‘attachment point’. These super senior instruments carry an AAA rating at point of origination or are senior to other AAA rated notes in the same structure. The level of defaults occurring on recent vintage sub-prime mortgages and other asset classes has been higher than originally expected. This has meant that the subordinate positions have diminished significantly in value, credit quality and rating and, as a result, the super senior tranches of the CDOs have a higher probability of suffering losses than at origination. The ratings of the majority of the underlying collateral are now below investment grade.

Depending on the quality of the underlying reference assets at issuance, the super senior tranches will be either classified as high grade or mezzanine. The majority of the Group’s total exposure relates to high grade super senior tranches of ABS CDOs. The table below summarises, for the Group, the carrying amounts and net exposures after hedge protection of the super senior CDOs as at 31 December 2008. The collateral rating is determined with reference to S&P ratings where available. Where S&P ratings are not available the lower of Moody’s and Fitch ratings have been used.

				2008(1)									2007
	High grade			Mezzanine			Total			High grade			Mezzanine			Total
		£m			£m			£m			£m			£m			£m
Gross exposure		4,210			3,720			7,930			3,396			3,040			6,436
Hedges and protection		(2,525	)		(691	)		(3,216	)		(2,150	)		(1,250	)		(3,400	)
		1,685			3,029			4,714			1,246			1,790			3,036
Write-downs on net open position		(1,095	)		(2,885	)		(3,980	)		(147	)		(537	)		(684	)
Net exposure after hedges		590			144			734			1,099			1,253			2,352

	%			%			%			%			%			%
Average price		35			6			18			90			70			78
Underlying RMBS sub-prime assets (origination)		58			91			79			58			91			79
Of which originated in:
2005 and earlier		53			23			34			53			23			34
2006		41			69			59			41			69			59
2007		6			8			7			6			8			7
Collateral by rating at reporting date: (2)
AAA		19			—			7			36			—			9
BBB- and above		40			5			17			62			31			32
Non-investment grade		41			95			76			2			69			59
Attachment point (3)		29			46			40			30			46			40
Attachment point post write down		75			97			89			40			62			54

Notes

(1)	The above table includes data for two trades liquidated in the last quarter of 2008, to provide consistency with comparatives.

(2)	Credit ratings are based on those from rating agencies Standard & Poor’s (S&P), Moody’s and Fitch and have been mapped onto S&P scale.

(3)

Attachment point is the minimum level of losses in a portfolio which a tranche is exposed to, as a percentage, of the total notional size of the portfolio. For example, a 5 – 10% tranche has an attachment point of 5% and a detachment point of 10%. When the accumulated loss of the reference pool is less than 5% of the total initial notional of the pool, the tranche will not be affected. However, when the loss has exceeded 5%, any further losses will be deducted from the tranche’s notional principal until detachment point, 10%, is reached.

The change in net exposure during the year is analysed below.

	High grade			Mezzanine			Total
		£m			£m			£m
Net exposure at 1 January 2008		1,099			1,253			2,352
Net income statement		(723	)		(1,140	)		(1,863	)
Foreign exchange and other movements		214			31			245
Net exposure at 31 December 2008		590			144			734

The fair value of these assets has fallen significantly during the period, representing the decline in performance in the underlying reference assets and the lack of an active market for the securities. Some of the Group’s holdings have been hedged with monoline counterparties.

The majority of the Group’s high grade super senior exposures represent securities retained in CDO structures originated by the Group. At origination, the reference assets of the high grade structures predominantly comprised investment grade tranches of sub-prime residential mortgage securitisations along with other senior tranches of some combination of other ABS assets, including prime and Alt-A RMBS, CMBS, trust preferred ABS, student loan backed ABS and CDO assets. The underlying assets referenced by these super senior securities are primarily more recent vintages (the year the underlying loan was originated), with 6% being 2007. Generally, loans with more recent vintages carry greater discounts, reflecting the market expectation of greater default levels than on earlier loan vintages.

The mezzanine super senior tranches of CDOs have suffered a greater level of price decline than high grade tranches, due to the relative credit quality of the underlying assets. The majority of the Group’s mezzanine super senior exposures represent securities retained in CDO structures originated by the Group.

Other CDOs and CLOs

The Group’s net exposure to other CDOs and CLOs was £4.4 billion (2007 – £2.4 billion) after hedge protection with bank or monoline counterparties and include transfers from ABN AMRO in 2008. The unhedged exposures comprise CDOs representing positions with various types of underlying collateral, rating and vintage characteristics.

The positions hedged with derivative protection from banks include a number of positions referencing early vintages of RMBS and other ABS assets against which it purchased protection from bank counterparties through CDS. The Group therefore has no net exposure to these certain CDOs before credit valuation adjustment. Due to the early vintage, the assets underlying these structures have not deteriorated to the same degree as the more recently issued securities. The protection purchased is from banks as opposed to monoline insurers and the credit valuation adjustment on banks is less than on monoline insurers.

Additionally, the Group has one exposure that, while not structured as a super senior security, incorporates similar risk characteristics. The exposure results from options sold to a third-party conduit structure on a portfolio of ABS. The Group assumes the risk of these securities only after the first loss protection has been eroded. The Group also has protection purchased against the remainder of this exposure through a CDS purchased from a monoline insurer. The Group holds other subordinated note positions in CDO vehicles which have experienced significant reductions in value since inception. The majority of these positions are junior notes that have been fully written down by the Group with no ongoing exposure remaining at the balance sheet date.

Collateralised loan obligations represent securities in special purpose entities the assets of which are primarily cash flows from underlying leveraged loans. The Group has CLO exposures resulting from a number of trading activities. They consist of exposures retained by the Group and from notes purchased from third-party structures. The Group holds super senior securities in two CLO structures which were originated by the Group in 2005 and 2007. The underlying collateral of these structures predominantly references leveraged loans.

£5.5 billion of these assets were reclassified from the held-for-trading category to the loans and receivables (£0.9 billion) and available-for- sale (£4.6 billion) categories during the year.

Other asset backed securities

Other assets backed securities are securities issued from securitisation vehicles, similar to those in RMBS and CMBS structures, which reference cash flow generating assets other than mortgages. The Group has accumulated these assets from a range of trading and funding activities.

Counterparty valuation adjustments (audited)

Credit valuation adjustments

Credit valuation adjustments (‘CVAs’) represent an estimate of the adjustment to fair value that a market participant would make to incorporate the credit risk inherent in counterparty derivative exposures. During 2008, as credit spreads have widened, there has been a significant increase in the Group’s CVA as set out in the table below.

	2008		2007
		£m		£m
Monoline insurers		3,289		452
CDPCs		746		—
Other counterparties		1,089		128
Total CVA adjustments		5,124		580

The widening of credit spreads of corporate and financial institution counterparties during the year contributed to a significant increase in the level of CVA adjustments recorded across all counterparties, particularly monoline insurers and credit derivative product companies (‘CDPCs’).

The monoline insurer CVA is calculated on a trade-by-trade basis, and is derived using market observable monoline credit spreads. The majority of the monoline CVA is taken against credit derivatives hedging exposures to ABS. The CDPC CVA is calculated using a similar approach. However, in the absence of market observable credit spreads, the cost of hedging the counterparty risk is estimated by analysing the underlying trades and the cost of hedging expected default losses in excess of the capital available in each vehicle.

The CVA for all other counterparties, including in respect of derivatives with banks, is calculated either on a trade-by-trade basis, reflecting the estimated cost of hedging the risk through credit derivatives, or on a portfolio basis reflecting an estimate of the amount a third party would charge to assume the risk.

Monoline insurers

The Group has purchased protection from monoline insurers, mainly against specific ABS, CDOs and CLOs. Monoline insurers are entities which specialise in providing credit protection against the notional and interest cash flows due to the holders of debt instruments in the event of default by the debt security counterparty. This protection is typically held in the form of derivatives such as credit default swaps (‘CDS’) referencing the underlying exposures held by the Group.

During the year the market value of securities protected by monoline insurers continued to decline as markets deteriorated. As the fair value of the protected assets declined, the fair value of the CDS protection from monoline insurers increased. As the monoline insurers had concentrated their exposures to credit market risks, their perceived credit quality deteriorated as concerns increased regarding their ability to meet their contractual obligations. This resulted in increased levels of CVA being recorded on the purchased protection.

The change in the Group’s exposure to monoline insurers during the year has been driven by the increased value of purchased derivative protection and the strengthening of the US$ against sterling as significantly all of the exposures are US$ denominated. The combination of greater exposure and widening credit spreads has increased the level of CVA required. Towards the end of the year the Group reached settlement on a group of contracts with one monoline counterparty, thereby reducing the overall exposure.

The tables below analyse, for the Group, holdings of CDS with monoline counterparties.

	2008			2007
		£m			£m
Gross exposure to monolines		6,531			2,275
Hedges with bank counterparties		(518	)		—
Credit valuation adjustment		(3,289	)		(452	)
Net exposure to monolines		2,724			1,823


The change in CVA is analysed in the table below:
					£m
At 1 January 2008					452
CVA realised in 2008					(662	)
Net benefit on counterparty hedges					189
Foreign currency movements					748
Net benefit on reclassified debt securities					741
Net income statement effect					1,821
At 31 December 2008					3,289

			2008								2007
	Notional								Notional
	amount		Fair value				Credit		amount		Fair value				Credit
	protected		protected		Gross		valuation		protected		protected		Gross		valuation
	assets		assets		exposure		adjustment		assets		assets		exposure		adjustment
		£m		£m		£m		£m		£m		£m		£m		£m
AAA/AA rated
CDO of RMBS		—		—		—		—		3,475		1,799		1,676		76
RMBS		3		2		1		—		73		73		—		—
CMBS		96		70		26		12		493		475		18		2
CLOs		3,742		2,780		962		435		6,135		5,993		142		13
Other ABS		91		41		50		24		1,105		1,052		53		1
Other		267		167		100		47		295		269		26		—
		4,199		3,060		1,139		518		11,576		9,661		1,915		92
A/BBB rated
CDO of RMBS		4,250		964		3,286		1,549		—		—		—		—
RMBS		90		63		27		10		—		—		—		—
CMBS		566		251		315		182		—		—		—		—
CLOs		4,000		2,951		1,049		565		—		—		—		—
Other ABS		493		221		272		140		—		—		—		—
		9,399		4,450		4,949		2,446		—		—		—		—
Sub-investment grade
CDO of RMBS		161		—		161		121		464		167		297		297
CLOs		350		268		82		60		—		—		—		—
Other ABS		1,208		1,037		171		123		—		—		—		—
Other		155		126		29		21		63		—		63		63
		1,874		1,431		443		325		527		167		360		360
Total
CDO of RMBS		4,411		964		3,447		1,670		3,939		1,966		1,973		373
RMBS		93		65		28		10		73		73		—		—
CMBS		662		321		341		194		493		475		18		2
CLOs		8,092		5,999		2,093		1,060		6,135		5,993		142		13
Other ABS		1,792		1,299		493		287		1,105		1,052		53		1
Other		422		293		129		68		358		269		89		63
		15,472		8,941		6,531		3,289		12,103		9,828		2,275		452

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

Credit derivative product companies

A credit derivative product company (CDPC) is a company that sells protection on credit derivatives. CDPCs are similar to monoline insurers. However, unlike monoline insurers, they are not regulated as insurers.

The Group has £2.6 billion of gross exposures with CDPCs which predominantly relates to tranched credit derivatives. Tranched credit derivatives have exposure to certain default losses that arise in reference portfolio of assets. The Group has bought protection on tranched credit derivatives from CDPCs. The reference portfolios of assets are predominantly investment grade loans and bonds. CDS spreads have widened and credit protection has become more valuable and the gross exposure to CDPC counterparties has increased. At the same time, the credit quality of CDPC counterparties has declined, reflecting the negative impact of their concentrated credit risk in a declining market. As a result CVA adjustments taken against exposures to these counterparties have increased significantly as described above.

The tables below present a comparison of the protected assets and the fair value and CVA of the CDPC protection for the Group.

	2008		2007
	£m		£m
Gross exposure to CDPCs	2,638		90
Credit valuation adjustment	(746	)	—
Net exposure to CDPCs	1,892		90

	2008				2007
	Notional amount protected assets	Fair value protected assets	Gross exposure	Credit valuation adjustment	Notional amount protected assets	Fair value protected assets	Gross exposure	Credit valuation adjustment
	£m	£m	£m	£m	£m	£m	£m	£m
AAA/AA rated	12,835	10,435	2,400	663	1,557	1,467	90	—
A/BBB rated	1,707	1,469	238	83	—	—	—	—
	14,542	11,904	2,638	746	1,557	1,467	90	—

The movement in the year in CDPC CVA is analysed below:

	£m
At 1 January 2008	—
Novations from ABN AMRO	621
Net effect of counterparty hedges	(38	)
Foreign currency movement	20
Net income statement effect	143
At 31 December 2008	746

Leveraged finance (audited)

Leveraged finance is commonly employed to facilitate corporate finance transactions, such as acquisitions or buy-outs. A bank acting as a lead manager will typically underwrite the loan, alone or with others, and then syndicate the loan to other participants. The Group’s syndicated loan book represent amounts retained from underwriting positions where the Group was lead manager or underwriter, in excess of the Group’s intended long term participation.

Since the beginning of the credit market dislocation in the second half of 2007, investor appetite for leveraged loans and similar risky assets has fallen dramatically, with secondary prices falling due to selling pressure and margins increasing, thus also affecting the primary market.

There were a small number of deals executed in the first half of 2008 which were much less significant in overall quantum and leverage and which were priced at less than mid-2007 levels. Concerted efforts to sell positions during the first half of 2008 were only partially successful due to the rapid change in market conditions since origination of the loans. Most of the leveraged finance loans were reclassified from the held-for- trading category to loans and receivables category in the second half of 2008.

The table below shows the carrying value of leveraged finance exposures by industry and geography for the Group.

					2008										2007
	Americas		UK		Europe		ROW		Total		Americas		UK		Europe			ROW		Total
		£m		£m		£m		£m		£m		£m		£m		£m			£m		£m
TMT		1,472		628		265		3		2,368		6,824		424		138			—		7,386
Retail		166		550		201		10		927		542		1,318		157			38		2,055
Industrial		280		391		164		—		835		225		1,613		231			—		2,069
Other		—		552		15		35		602		16		339		163			13		531
		1,918		2,121		645		48		4,732		7,607		3,694		689			51		12,041
Of which:
Held-for-trading		31		31		41		—		103		7,607		3,694		689			51		12,041
Loans and receivables		1,887		2,090		604		48		4,629		—		—		—			—		—
		1,918		2,121		645		48		4,732		7,607		3,694		689			51		12,041
Of which:
Drawn		1,887		2,090		634		48		4,659		2,116		3,662		687			51		6,516
Undrawn		31		31		11		—		73		5,491		32		2			—		5,525
		1,918		2,121		645		48		4,732		7,607		3,694		689			51		12,041

The table below analyses the movement in the amounts reported above.
															Held-for trading			Loans and receivables		Total
																£m			£m		£m
At 1 January 2008																12,041			—		12,041
Reclassifications																(3,602	)		3,602		—
Reclassifications – income effect																216			16		232
Additions																1,853			—		1,853
Sales																(5,708	)		—		(5,708	)
Realised losses on sale																(298	)		—		(298	)
Lapsed/collapsed deals																(4,153	)		—		(4,153	)
Changes in fair value																(618	)		—		(618	)
Exchange and other movements																372			1,011		1,383
At 31 December 2008																103			4,629		4,732

In addition to the leveraged finance syndicated portfolio discussed above, the Group has £6.1 billion of portfolio positions, mostly to European companies, that have been classified as loans and receivables since origination.

SPEs and conduits (audited)

SPEs

The Group arranges securitisations to facilitate client transactions and undertakes securitisations to sell financial assets or to fund specific portfolios of assets. The Group also acts as an underwriter and depositor in securitisation transactions involving both client and proprietary transactions. In a securitisation, assets, or interests in a pool of assets, are transferred generally to a special purpose entity (SPE) which then issues liabilities to third party investors. SPEs are vehicles established for a specific, limited purpose, usually do not carry out a business or trade and typically have no employees. They take a variety of legal forms – trusts, partnerships and companies – and fulfil many different functions. As well as being a key element of securitisations, SPEs are also used in fund management activities to segregate custodial duties from the fund management advice provided by the Group. It is primarily the extent of risks and rewards assumed that determines whether these entities are consolidated in the Group’s financial statements. The following section aims to address the significant exposures which arise from the Group’s activities through specific types of SPEs.

The Group sponsors and arranges own-asset securitisations, whereby the sale of assets or interests in a pool of assets into an SPE is financed by the issuance of securities to investors. The pool of assets held by the SPE may be originated by the Group, or (in the case of whole loan programmes) purchased from third parties, and may be of varying credit quality. Investors in the debt securities issued by the SPE are rewarded through credit-linked returns, according to the credit rating of their securities. The majority of securitisations are supported through liquidity facilities, other credit enhancements and derivative hedges extended by financial institutions, some of which offer protection against initial defaults in the pool of assets. Thereafter, losses are absorbed by investors in the lowest ranking notes in the priority of payments. Investors in the most senior ranking debt securities are typically shielded from loss, since any subsequent losses may trigger repayment of their initial principal. The Group also employs synthetic structures, where assets are not sold to the SPE, but credit derivatives are used to transfer the credit risk of the assets to an SPE. Securities may then be issued by the SPE to investors, on the back of the credit protection sold to the Group by the SPE. In general residential and commercial mortgages and credit card receivables form the types of assets generally included in cash securitisations, while corporate loans and commercial mortgages typically serve as reference obligations in synthetic securitisations.

The Group sponsors own-asset securitisations as a way of diversifying funding sources, managing specific risk concentrations, and achieving capital efficiency. The Group purchases the securities issued in own- asset securitisations set up for funding purposes. During 2008, the Group was able to pledge AAA-rated asset-backed securities as collateral for repurchase agreements with major central banks under schemes such as the Bank of England’s Special Liquidity Scheme, launched in April 2008, which allowed banks to temporarily swap high- quality mortgage-backed and other securities for liquid UK Treasury Bills. This practice has contributed to the Group’s sources of funding during 2008 in the face of the contraction in the UK market for inter- bank lending and the investor base for securitisations.

Conduits

The Group sponsors and administers a number of ABCP conduits. A conduit is an SPE that issues commercial paper and uses the proceeds to purchase or fund a pool of assets. The commercial paper is secured on the assets and is redeemed either by further commercial paper issuance, repayment of assets or liquidity drawings. Commercial paper is typically short-dated – the length of time from issuance to maturity of the paper is typically up to three months.

The Group’s conduits are multi-seller conduits. In line with market practice, the Group consolidates a conduit where it is exposed to the majority of risks and rewards of ownership of these entities. The Group also extends liquidity commitments to multi-seller conduits sponsored by other banks, but typically does not consolidate these entities as it is not exposed to the majority of the risks and rewards.

The multi-seller conduits were established by the Group for the purpose of providing its clients with access to diversified and flexible funding sources. A multi-seller conduit typically purchases or funds assets originated by the banks’ clients. The multi-seller conduits form the vast majority of the Group’s conduit business. The Group sponsors six multi- seller conduits, four of which were transferred from ABN AMRO in 2008, that finance assets from Europe, North America and Asia-Pacific. The Group’s most significant multi-seller conduits have thus far continued to fund the vast majority of their assets solely through ABCP issuance. There were significant disruptions to the liquidity of the financial markets during the year following the bankruptcy filing of Lehman Brothers in September 2008 and this required a small amount of the assets held in certain conduits to be funded by the Group rather than through ABCP issuance. By the end of 2008 there had been an improvement in market conditions, supported by central bank initiatives, which enabled normal ABCP funding to replace this Group funding of the conduits. The average maturity of ABCP issued by the Group’s conduits as at 31 December 2008 was 72.4 days (2007 – 60.4 days).

The total assets held by the Group’s sponsored conduits are £31.5 billion (2007 – £10.7 billion). Since these liquidity facilities are sanctioned on the basis of total conduit purchase commitments, the liquidity facility commitments will exceed the level of assets held, with the difference representing undrawn commitments. Assets purchased or financed by the multi-seller conduits include auto loans, credit card receivables, residential mortgages, consumer loans and trade receivables. Most of the assets held by the conduits are recorded on the Group’s balance sheet as loans and receivables.

The third-party assets financed by the conduits are structured with a significant degree of first-loss credit enhancement provided by the originators of the assets. This credit enhancement, which is specific to each transaction, can take the form of over-collateralisation, excess spread or subordinated loan, and typically ensures the conduit asset has a rating equivalent to at least a single-A credit. In addition and in line with general market practice, the Group provides a small second- loss layer of programme-wide protection to the multi-seller conduits. Given the nature and investment grade equivalent quality of the first loss enhancement provided to the structures, the Group has only a minimal risk of loss on its program wide exposure. The issued ABCP is rated P-1 / A1 by Moody’s and Standard & Poor’s.

The Group provides liquidity back-up facilities to the conduits it sponsors. These facilities can be drawn upon by the conduits in the event of a disruption in the ABCP market, or when certain trigger events occur such that ABCP cannot be issued. For a very small number of transactions within two of the multi-seller conduits sponsored by the Group these liquidity facilities have been provided by third-party banks. This typically occurs on transactions where the third-party bank does not use, or have, its own conduit vehicles. Conduit commercial paper issuance is managed such that the spread of maturity dates of the issued ABCP mitigates the short-term contingent liquidity risk of providing back-up facilities. Group limits sanctioned for such facilities as at 31 December 2008 totalled approximately £40.9 billion (2007 – £15.8 billion). The Group’s maximum exposure to loss on its multi-seller conduits is £38.8 billion (2007 – £15.3 billion), being the total amount of the Group’s liquidity commitments plus the extent of programme-wide credit enhancements which relate to conduit assets for whom liquidity facilities were provided by third parties.

Exposure from both its consolidated conduits and its involvement with third-party conduits for the Group are set out below.

			2008						2007
	Consolidated						Consolidated
	conduits		Third party		Total		conduits		Third party		Total
		£m		£m		£m		£m		£m		£m
Total assets held by the conduits		31,473						10,733
Commercial paper issued		30,833						10,733
Liquidity and credit enhancements:
deal specific drawn liquidity
– drawn		640		3,078		3,718		—		2,280		2,280
– undrawn		38,201		198		38,399		15,272		490		15,762
programme-wide credit enhancements		2,072		—		2,072		552		—		552
		40,913		3,276		44,189		15,824		2,770		18,594
Maximum exposure to loss (1)		38,841		3,276		42,117		15,272		2,770		18,042

Note:

(1)	Maximum exposure to loss is determined as the Group’s total liquidity commitments to the conduits and additionally programme-wide credit support which would absorb first loss on transactions where liquidity support is provided by a third party.

Collateral analysis, geographic, profile, credit ratings and weighted average lives of the assets in the assets relating to the consolidated conduits and related undrawn commitments of the Group are set out in the tables below.

					2008															2007
			Funded assets													Funded assets
			Funded assets						Liquidity from third							Funded assets						Liquidity from third
									Liquidity from third			Total										Liquidity from third			Total
	Loans		Securities		Total		Undrawn		parties			exposure		Loans		Securities		Total		Undrawn		parties			exposure
		£m		£m		£m		£m		£m			£m		£m		£m		£m		£m		£m			£m
Auto loans		9,670		383		10,053		1,871		—			11,924		3,119		—		3,119		1,281		(102	)		4,298
Credit card receivables		5,632		—		5,632		918		—			6,550		2,123		—		2,123		501		—			2,624
Trade receivables		2,706		—		2,706		1,432		(71	)		4,067		223		—		223		15		—			238
Student loans		2,555		—		2,555		478		(132	)		2,901		329		—		329		545		(132	)		742
Consumer loans		2,371		—		2,371		409		—			2,780		562		—		562		207		—			769
Corporate loans		430		—		430		31		—			461		—		—		—		—		—			—
Mortgages
Prime		1,822		—		1,822		456		—			2,278		1,663		—		1,663		153		—			1,816
Non-conforming		2,181		—		2,181		727		—			2,908		1,289		—		1,289		633		—			1,922
Commercial		1,069		507		1,576		61		(23	)		1,614		525		503		1,028		65		(23	)		1,070
Other		1,664		483		2,147		985		—			3,132		397		—		397		1,138		—			1,535
		30,100		1,373		31,473		7,368		(226	)		38,615		10,230		503		10,733		4,538		(257	)		15,014

									CP funded assets
	Geographic distribution												Credit ratings (S&P equivalent)
											Weighted							BBB and
	UK		Europe		US		ROW		Total		average		AAA		AA		A	below		Total
2008		£m		£m		£m		£m		£m	life			£m		£m	£m		£m		£m
Auto loans		801		1,706		7,402		144		10,053		1.7		6,075		868	3,110		—		10,053
Credit card receivables		633		—		4,999		—		5,632		0.7		3,465		62	1,959		146		5,632
Trade receivables		68		922		1,371		345		2,706		0.8		120		1,025	1,561		—		2,706
Student loans		144		—		2,411		—		2,555		0.3		2,296		144	115		—		2,555
Consumer loans		708		1,195		468		—		2,371		1.7		387		993	923		68		2,371
Corporate loans		320		110		—		—		430		1.7		—		—	430		—		430
Mortgages
Prime		—		—		—		1,822		1,822		3.7		17		1,806	—		—		1,823
Non-conforming		960		1,221		—		—		2,181		4.6		351		368	475		987		2,181
Commercial		713		453		74		336		1,576		12.1		274		518	315		469		1,576
Other		166		1,198		684		99		2,147		2.1		3		601	1,309		233		2,146
		4,513		6,805		17,409		2,746		31,473		2.0		12,988		6,385	10,197		1,903		31,473

2007
Auto loans		2,071		324		724		—		3,119		1.6		30		1,755	1,334		—		3,119
Credit card receivables		629		—		1,494		—		2,123		0.4		443		—	1,680		—		2,123
Trade receivables		175		—		48		—		223		0.8		—		—	223		—		223
Student loans		140		—		189		—		329		2.4		184		140	5		—		329
Consumer loans		528		—		34		—		562		—		—		229	333				562
Mortgages
Prime		—		—		—		1,663		1,663		4.4		26		1,638	—		—		1,664
Non-conforming		1,133		156		—		—		1,289		5.8		93		610	586		—		1,289
Commercial		729		—		28		271		1,028		16.4		271		507	250		—		1,028
Other		122		179		—		96		397		2.7		96		—	300		—		396
		5,527		659		2,517		2,030		10,733		3.7		1,143		4,879	4,711		—		10,733

Structured investment vehicles (unaudited)

The Group does not sponsor any structured investment vehicles.

Investment funds set up and managed by the Group (unaudited)

The Group’s investment funds are managed by RBS Asset Management (RBSAM), which is an integrated asset management business, which manages investments on behalf of third-party institutional and high net worth investors, as well as for the Group. RBSAM is active in most traditional asset classes and employs both fund of funds structures and multi-manager strategies. Its offering includes money market funds, long only funds and alternative investment funds.

Money market funds

The Group has established and manages a number of money market funds for its customers. When a new fund is launched, RBSAM as fund manager typically provides a limited amount of seed capital to the funds. RBSAM does not have investments in these funds greater than £25 million. As RBSAM does not have holdings in these funds of significant size and as the risks and rewards of ownership are not with the Group, these funds are not consolidated by the Group.

The funds have been authorised by the Irish Financial Services Regulatory Authority as UCITS pursuant to the UCITS Regulations (UCITS Regulations refer to the European Communities’ Undertakings for Collective Investment in Transferable Securities Regulations) and are therefore restricted in the types of investments and borrowings they can make. The structure of the assets within the funds is designed to meet the liabilities of the funds to their investors who have no recourse other than to the assets of the funds. The risks to the Group as a result are restricted to reputational damage if the funds were unable to meet withdrawals when requested on a timely basis or in full.

Money market funds had total assets of £13.6 billion at 31 December 2008 (2007 – £11.2 billion). The sub categories of money market funds are:

•	£8.0 billion (2007 – £5.1 billion) in Money Funds denominated in sterling, US dollars and euro, which invest in short-dated, highly rated money market securities with the objective of providing security, performance and liquidity.

•	£4.9 billion (2007 – £5.5 billion) in multi-manager money market funds denominated in sterling, US dollars and euro, which invest in short dated, highly rated securities.

•	£0.7 billion (2007 – £0.6 billion) in Money Funds Plus denominated in sterling, US dollars and euro, which invest in longer-dated, highly rated securities with the objective of providing security, enhanced performance and liquidity.

Non-money market funds

RBSAM has also established a number of non-money market funds to enable investors to invest in a range of assets including bonds, equities, hedge funds, private equity and real estate. The Group does not have investments in these funds greater than £200 million. As RBSAM does not have holdings in these funds of significant size and as the risks and rewards of ownership are not with the Group, these funds are not consolidated by the Group.

The non-money market funds had total assets of £18.7 billion at 31 December 2008 (31 December 2007 – £19.4 billion). The sub categories of non-money market funds are:

•	£16.0 billion (2007 – £17.0 billion) in multi-manager funds, which offer fund of funds products across bond, equity, hedge fund, private equity and real estate asset classes.

•	£1.6 billion (2007 – £1.3 billion) in committed capital to private equity investments, which invests primarily in equity and debt securities of private companies.

•	£1.1 billion (2007 – £1.1 billion) in credit investments, which invests in various financial instruments.

The structure of the assets within the funds is designed to meet the liabilities of the funds to their investors who have no recourse other than to the assets of the funds. The risks to the Group as a result are restricted to reputational damage if the funds were unable to meet withdrawals when requested on a timely basis or in full, and the Group’s own investment in the funds.

The Group’s maximum exposure to non-money market funds is represented by the investment in the shares of each fund and was £200 million at 31 December 2008 (2007 – £171 million).

Independent auditors’ report to the members of The Royal Bank of Scotland plc

We have audited the financial statements of The Royal Bank of Scotland plc (“the Bank”) and its subsidiaries (together “the Group”) for the year ended 31 December 2008 which comprise the accounting policies, the balance sheets as at 31 December 2008 and 2007, the consolidated income statements, the cash flow statements, the statements of recognised income and expense for each of the three years in the period ended 31 December 2008, the related Notes 1 to 40 and the information identified as ‘audited’ in the Risk, capital and liquidity management section of the Financial review. These financial statements have been prepared under the accounting policies set out therein.

Respective responsibilities of directors and auditors

The directors’ responsibilities for preparing the annual report and the financial statements in accordance with applicable law and International Financial Reporting Standards (IFRS) as adopted by the European Union are set out in the statement of directors’ responsibilities.

Our responsibility is to audit the financial statements in accordance with relevant legal and regulatory requirements and International Standards on Auditing (UK and Ireland).

We report to you our opinion as to whether the financial statements give a true and fair view and whether the financial statements have been properly prepared in accordance with the Companies Act 1985 and as regards the Group’s consolidated financial statements, Article 4 of the IAS Regulation. We also report to you whether in our opinion, the information given in the directors’ report is consistent with the financial statements.

In addition we report to you if, in our opinion, the Bank has not kept proper accounting records, we have not received all the information and explanations we require for our audit, or if information specified by law regarding directors’ remuneration and other transactions is not disclosed.

We read the other information contained in the Annual Report and Accounts 2008 as described in the contents section and consider whether it is consistent with the audited financial statements. We consider the implications for our report if we become aware of any apparent misstatements or material inconsistencies with the financial statements. Our responsibilities do not extend to any other information outside the Annual Report and Accounts 2008.

Basis of audit opinion

We conducted our audit in accordance with International Standards on Auditing (UK and Ireland) issued by the Auditing Practices Board and with the standards of the Public Company Accounting Oversight Board (United States). An audit includes examination, on a test basis, of evidence relevant to the amounts and disclosures in the financial statements. It also includes an assessment of the significant estimates and judgements made by the directors in the preparation of the financial statements and of whether the accounting policies are appropriate to the circumstances of the Bank and the Group, consistently applied and adequately disclosed.

We planned and performed our audit so as to obtain all the information and explanations which we considered necessary in order to provide us with sufficient evidence to give reasonable assurance that the financial statements are free from material misstatement, whether caused by fraud or other irregularity or error. In forming our opinion, we also evaluated the overall adequacy of the presentation of information in the financial statements.

The Group is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Group’s internal control over financial reporting. Accordingly, we express no such opinion.

UK opinion

In our opinion:

•	the Group financial statements give a true and fair view, in accordance with IFRS as adopted by the European Union, of the state of the Group’s affairs as at 31 December 2008 and of its loss and cash flows for the year then ended;

•	the Bank financial statements give a true and fair view, in accordance with IFRS as adopted by the European Union as applied in accordance with the provisions of the Companies Act 1985, of the state of affairs of the Bank as at 31 December 2008;

•	the financial statements have been properly prepared in accordance with the Companies Act 1985 and, as regards the Group financial statements, Article 4 of the IAS Regulation; and

•	the information given in the directors’ report is consistent with the financial statements.

Separate opinion in relation to IFRS

As explained in the accounting policies, the Group, in addition to complying with its legal obligation to comply with IFRS as adopted by the European Union, has also complied with IFRS as issued by the International Accounting Standards Board (IASB).

In our opinion the financial statements give a true and fair view, in accordance with IFRS, of the state of the Group’s affairs as at 31 December 2008 and of its loss and cash flows for the year then ended.

US opinion

In our opinion, the financial statements present fairly, in all material respects, the financial position of the Group as at 31 December 2008 and 2007 and the results of its operations and its cash flows for each of the three years in the period ended 31 December 2008, in accordance with IFRS as adopted for use in the European Union and IFRS as issued by the IASB.

The financial statements for the year ended 31 December 2007 were restated for the matters disclosed in Note 1 of the Accounting policies.

Deloitte LLP

Chartered Accountants and Registered Auditors

Edinburgh, United Kingdom

25 March 2009

Consolidated income statement for the year ended 31 December 2008

			2008			2007			2006
	Note		£m			£m			£m
Interest receivable		1		31,413			28,310			24,319
Interest payable		1		(17,904	)		(17,194	)		(13,927	)
Net interest income		1		13,509			11,116			10,392
Fees and commissions receivable		2		7,483			7,519			7,060
Fees and commissions payable		2		(1,733	)		(1,496	)		(1,426	)
(Loss)/income from trading activities		2		(5,583	)		1,142			2,543
Other operating income		2		2,181			4,026			2,999
Non-interest income				2,348			11,191			11,176
Total income				15,857			22,307			21,568
Staff costs		3		5,973			6,181			6,280
Premises and equipment		3		1,760			1,521			1,405
Other administrative expenses		3		2,759			2,147			2,241
Depreciation and amortisation		3		1,562			1,438			1,415
Write-down of goodwill and other assets		3		8,144			—			—
Operating expenses		3		20,198			11,287			11,341
(Loss)/profit before impairment				(4,341	)		11,020			10,227
Impairment		11		4,706			1,865			1,873
Operating (loss)/profit before tax				(9,047	)		9,155			8,354
Tax		6		(505	)		1,903			2,433
(Loss)/profit for the year				(8,542	)		7,252			5,921

(Loss)/profit attributable to:
Minority interests				208			53			45
Preference shareholders		7		638			331			252
Ordinary shareholders				(9,388	)		6,868			5,624
				(8,542	)		7,252			5,921

The accompanying notes on pages 71 to 135, the accounting policies on pages 61 to 70 and the audited sections of the Financial review: Risk, capital and liquidity management on pages 15 to 55 form an integral part of these financial statements.

Balance sheets at 31 December 2008

			Group				Bank
					Restated				Restated
			2008		2007		2008		2007
	Note			£m		£m		£m		£m
Assets
Cash and balances at central banks		10		6,806		5,559		3,714		3,333
Loans and advances to banks		10		79,387		96,346		91,717		91,982
Loans and advances to customers		10		619,503		551,449		327,040		329,147
Debt securities subject to repurchase agreements		27		75,660		75,001		70,206		30,633
Other debt securities				102,106		89,431		89,492		76,617
Debt securities		13		177,766		164,432		159,698		107,250
Equity shares		14		2,691		5,509		1,020		4,019
Investments in Group undertakings		15		—		—		26,814		22,210
Settlement balances				10,871		5,326		5,335		2,046
Derivatives		12		937,457		205,975		938,505		207,913
Intangible assets		16		12,591		17,761		136		295
Property, plant and equipment		17		16,628		13,025		2,368		2,116
Deferred taxation		21		2,833		240		1,323		319
Prepayments, accrued income and other assets		18		11,397		6,116		5,930		1,680
Total assets				1,877,930		1,071,738		1,563,600		772,310

Liabilities
Deposits by banks		10		181,982		151,508		201,266		196,968
Customer accounts		10		453,129		442,982		229,266		197,926
Debt securities in issue		10		179,942		130,132		115,149		79,877
Settlement balances and short positions		19		45,957		53,849		29,361		33,677
Derivatives		12		909,105		203,072		911,174		204,234
Accruals, deferred income and other liabilities		20		16,685		12,167		9,618		5,783
Retirement benefit liabilities		4		1,446		334		23		11
Deferred taxation		21		2,483		2,063		—		—
Subordinated liabilities		22		39,951		27,796		33,698		22,745
Total liabilities				1,830,680		1,023,903		1,529,555		741,221

Equity
Minority interests		23		1,292		152		—		—
Equity owners		25		45,958		47,683		34,045		31,089
Total equity				47,250		47,835		34,045		31,089


Total liabilities and equity				1,877,930		1,071,738		1,563,600		772,310

The accounts were approved by the Board of directors on 25 March 2009 and signed on its behalf by:

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

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

	Group									Bank
	2008			2007			2006			2008			2007			2006
		£m			£m			£m			£m			£m			£m
Available-for-sale investments
Net valuation (losses)/gains taken direct to equity		(2,585	)		511			340			(2,592	)		249			122
Net (profit)/loss taken to income on sales		(11	)		(465	)		(196	)		49			(231	)		(71	)

Cash flow hedges
Net (losses)/gains taken direct to equity		(461	)		(408	)		(108	)		1,292			60			(138	)
Net losses/(gains) taken to earnings		185			(141	)		(143	)		(54	)		25			2

Exchange differences on translation of foreign operations		4,968			9			(1,347	)		(331	)		5			1
Actuarial (losses)/gains on defined benefit plans		(1,716	)		2,153			1,776			(2	)		2			2
Income/(expense) before tax on items recognised direct in equity		380			1,659			322			(1,638	)		110			(82	)
Tax on items recognised direct in equity		1,627			(449	)		(512	)		372			(34	)		13
Net income/(expense) recognised direct in equity		2,007			1,210			(190	)		(1,266	)		76			(69	)
(Loss)/profit for the year		(8,542	)		7,252			5,921			(1,140	)		7,255			3,519
Total recognised income and expense for the year		(6,535	)		8,462			5,731			(2,406	)		7,331			3,450

Attributable to:
Equity shareholders		(7,087	)		8,420			5,756			(2,406	)		7,331			3,450
Minority interests		552			42			(25	)		—			—			—
		(6,535	)		8,462			5,731			(2,406	)		7,331			3,450

Cash flow statements for the year ended 31 December 2008

			Group									Bank
			2008			2007			2006			2008			2007			2006
	Note			£m			£m			£m			£m			£m			£m
Operating activities
Operating (loss)/profit before tax				(9,047	)		9,155			8,354			(2,204	)		7,759			4,039

Adjustments for:
Depreciation and amortisation				1,562			1,438			1,415			483			485			390
Write-down of goodwill and other assets				8,144			—			—			215			—			—
Interest on subordinated liabilities				1,694			1,452			1,161			1,487			1,200			878
Charge for defined benefit pension schemes				351			479			578			8			5			8
Cash contribution to defined benefit pension schemes				(491	)		(536	)		(533	)		(8	)		(16	)		(1	)
Elimination of foreign exchange differences				(20,997	)		(2,137	)		4,515			(16,892	)		(2,034	)		1,345
Other non-cash items				4,905			(833	)		(1,134	)		4,835			(575	)		218
Net cash (outflow)/inflow from trading activities				(13,879	)		9,018			14,356			(12,076	)		6,824			6,877
Changes in operating assets and liabilities				2,845			6,869			3,292			41,418			8,578			16,815
Net cash flows from operating activities before tax				(11,034	)		15,887			17,648			29,342			15,402			23,692
Income taxes (paid)/received				(886	)		(1,802	)		(2,122	)		83			(526	)		(298	)
Net cash flows from operating activities		30		(11,920	)		14,085			15,526			29,425			14,876			23,394

Investing activities
Sale and maturity of securities				37,877			23,775			25,810			30,455			17,268			15,240
Purchase of securities				(50,360	)		(26,160	)		(17,803	)		(80,693	)		(20,726	)		(10,609	)
Sale of property, plant and equipment				2,363			5,596			2,926			90			857			180
Purchase of property, plant and equipment				(5,153	)		(3,886	)		(3,938	)		(719	)		(449	)		(509	)
Net investment in business interests and intangible assets				(908	)		(430	)		(19	)		(3,264	)		(590	)		(445	)
Net cash flows from investing activities		31		(16,181	)		(1,105	)		6,976			(54,131	)		(3,640	)		3,857

Financing activities
Issue of ordinary shares				10,000			—			—			10,000			—			—
Issue of equity preference shares				—			3,650			1,092			—			3,650			1,092
Issue of subordinated liabilities				5,055			1,018			3,027			5,055			968			2,936
Proceeds of minority interests issued				812			—			427			—			—			—
Redemption of minority interests				(140	)		(247	)		(81	)		—			—			—
Repayment of subordinated liabilities				(1,035	)		(1,708	)		(1,318	)		(1,035	)		(1,288	)		(672	)
Dividends paid				(4,722	)		(2,362	)		(3,531	)		(4,638	)		(2,331	)		(3,502	)
Interest on subordinated liabilities				(1,511	)		(1,431	)		(1,181	)		(1,325	)		(1,173	)		(890	)
Net cash flows from financing activities				8,459			(1,080	)		(1,565	)		8,057			(174	)		(1,036	)
Effects of exchange rate changes on cash and cash equivalents				15,295			2,714			(3,475	)		12,849			2,601			(2,036	)

Net (decrease)/increase in cash and cash equivalents				(4,347	)		14,614			17,462			(3,800	)		13,663			24,179
Cash and cash equivalents 1 January				84,761			70,147			52,685			77,249			63,586			39,407
Cash and cash equivalents 31 December				80,414			84,761			70,147			73,449			77,249			63,586

Accounting policies

1. Presentation of accounts

The accounts, which should be read in conjunction with the Directors’ report, are prepared on a going concern basis and in accordance with International Financial Reporting Standards issued by the International Accounting Standards Board (IASB), and interpretations issued by the International Financial Reporting Interpretations Committee of the IASB (together “IFRS”) as adopted by the European Union (EU). The EU has not adopted the complete text of IAS 39 'Financial Instruments: Recognition and Measurement'; it has relaxed some of the standard's hedging requirements. The Group has not taken advantage of this relaxation and has adopted IAS 39 as issued by the IASB: the Group’s financial statements are prepared in accordance with IFRS as issued by the IASB. The date of transition to IFRS for the Group and the Bank and the date of their opening IFRS balance sheets was 1 January 2004.

The Group adopted IFRS 8 ‘Operating Segments’ with effect from 1 January 2008. Early adoption of IFRS 8 has not materially affected segmental disclosures.

In October 2008, the IASB issued, and the European Union endorsed, amendments to IAS 39 ‘Financial Instruments: Recognition and Measurement’ to permit the reclassification of financial assets out of the held-for-trading (HFT) and available-for-sale (AFS) categories subject to certain restrictions. Transfers must be made at fair value and this fair value becomes the instruments’ new cost or amortised cost. The amendments are effective from 1 July 2008. Reclassifications made before 1 November 2008 were backdated to 1 July 2008; subsequent reclassifications were effective from the date the reclassification was made.

The Group has reclassified certain loans and debt securities out of the held-for-trading and available-for-sale categories into the loans and receivables category. It has also reclassified certain debt securities out of the held-for-trading category into the available-for-sale category. The balance sheet values of these assets, the effect of the reclassification on the income statement and the impairment losses relating to these assets are shown in Note 10 Financial instruments on pages 91 and 92.

The 2007 comparative amounts have been restated for the netting of certain derivative asset and derivative liability balances with the London Clearing House, as described in Note 12.

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

The Bank accounts are presented in accordance with the Companies Act 1985.

2. Basis of consolidation

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

The results of subsidiaries acquired are included in the consolidated income statement from the date control passes until the Group ceases to control them through sale or significant change in circumstances.

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

3. Revenue recognition

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

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

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

Accounting policies continued

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

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

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

•

Interchange received: as issuer, the Group receives a fee (interchange) each time a cardholder purchases goods and services. The Group also receives interchange fees from other card issuers for providing cash advances through its branch and Automated Teller Machine networks. These fees are accrued once the transaction has taken place.

•	An annual fee payable by a credit card holder is deferred and taken to profit or loss over the period of the service i.e. 12 months.

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

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

4. Pensions and other post-retirement benefits

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

For defined benefit schemes, scheme liabilities are measured on an actuarial basis using the projected unit credit method and discounted at a rate that reflects the current rate of return on a high quality corporate bond of equivalent term and currency to the scheme liabilities. Scheme assets are measured at their fair value. Any surplus or deficit of scheme assets over liabilities is recognised in the balance sheet as an asset (surplus) or liability (deficit). The current service cost and any past service costs together with the expected return on scheme assets less the unwinding of the discount on the scheme liabilities is charged to operating expenses. Actuarial gains and losses are recognised in full in the period in which they occur outside profit or loss and presented in the statement of recognised income and expense.

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

5. Intangible assets and goodwill

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

Core deposit intangibles	6 to 10 years

Other acquired intangibles	5 to 10 years

Computer software	3 to 5 years

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

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

On implementation of IFRS, the Group did not restate business combinations that occurred before January 2004. Under previous GAAP, goodwill arising on acquisitions after 1 October 1998 was capitalised and amortised over its estimated useful economic life. Goodwill arising on acquisitions before 1 October 1998 was deducted from equity. The carrying amount of goodwill in the Group’s opening IFRS balance sheet (1 January 2004) was £12,342 million, its carrying value under previous GAAP.

6. Property, plant and equipment

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

Depreciation is charged to profit or loss on a straight-line basis so as to write-off the depreciable amount of property, plant and equipment (including assets owned and let on operating leases (except investment property – see accounting policy 8)) over their estimated useful lives. The depreciable amount is the cost of an asset less its residual value. Land is not depreciated. Estimated useful lives are as follows:

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

Under previous GAAP, the Group’s freehold and long leasehold property occupied for its own use was recorded at valuation on the basis of existing use value. The Group elected to use this valuation as at 31 December 2003 as deemed cost for its opening IFRS balance sheet (1 January 2004).

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

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

8. Investment property

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

9. Foreign currencies

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

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

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

10. Leases

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

Finance lease receivables are stated in the balance sheet at the amount of the net investment in the lease being the minimum lease payments and any unguaranteed residual value discounted at the interest rate implicit in the lease. Finance lease income is allocated to accounting periods so as to give a constant periodic rate of return before tax on the net investment. Unguaranteed residual values are subject to regular review to identify

Accounting policies continued

potential impairment. If there has been a reduction in the estimated unguaranteed residual value, the income allocation is revised and any reduction in respect of amounts accrued is recognised immediately.

Rental income from operating leases is credited to the income statement on a receivable basis over the term of the lease. Operating lease assets are included within Property, plant and equipment and depreciated over their useful lives (see accounting policy 6).

11. Provisions

The Group recognises a provision for a present obligation resulting from a past event when it is more likely than not that it will be required to transfer economic benefits to settle the obligation and the amount of the obligation can be estimated reliably.

Provision is made for restructuring costs, including the costs of redundancy, when the Group has a constructive obligation to restructure. An obligation exists when the Group has a detailed formal plan for the restructuring and has raised a valid expectation in those affected by starting to implement the plan or announcing its main features.

If the Group has a contract that is onerous, it recognises the present obligation under the contract as a provision. An onerous contract is one where the unavoidable costs of meeting the obligations under it exceed the expected economic benefits. When the Group vacates a leasehold property, a provision is recognised for the costs under the lease less any expected economic benefits (such as rental income).

Contingent liabilities are possible obligations arising from past events whose existence will be confirmed only by uncertain future events or present obligations arising from past events that are not recognised because either an outflow of economic benefits is not probable or the amount of the obligation cannot be reliably measured. Contingent liabilities are not recognised but information about them is disclosed unless the possibility of any outflow of economic benefits in settlement is remote.

12. Taxation

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

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

13. Financial assets

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

Held-to-maturity investments – a financial asset may be classified as a held-to-maturity investment only if it has fixed or determinable payments, a fixed maturity and the Group has the positive intention and ability to hold to maturity. Held-to-maturity investments are initially recognised at fair value plus directly related transaction costs. They are subsequently measured at amortised cost using the effective interest method (see accounting policy 3) less any impairment losses.

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

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

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

The Group has designated financial assets as at fair value through profit or loss principally: (a) where the assets are economically hedged by derivatives and fair value designation eliminates the measurement inconsistency that would arise if the assets were carried at amortised cost or classified as available-for-sale and (b) financial assets held in the Group’s venture capital portfolio managed on a fair value basis.

Loans and receivables – non-derivative financial assets with fixed or determinable repayments that are not quoted in an active market are classified as loans and receivables except those that are classified as available-for-sale or as held-for-trading, or designated as at fair value through profit or loss. Loans and receivables are initially recognised at fair value plus directly related transaction costs. They are subsequently measured at amortised cost using the effective interest method (see accounting policy 3) less any impairment losses.

Available-for-sale – financial assets that are not classified as held-to- maturity; held-for-trading; designated as at fair value through profit or loss; or loans and receivables are classified as available-for-sale. Financial assets can be designated as available-for-sale on initial recognition. Available-for-sale financial assets are initially recognised at fair value plus directly related transaction costs. They are subsequently measured at fair value. Unquoted equity investments whose fair value cannot be measured reliably are carried at cost and classified as available-for-sale financial assets. Impairment losses and exchange differences resulting from retranslating the amortised cost of foreign currency monetary available-for-sale financial assets are recognised in profit or loss together with interest calculated using the effective interest method (see accounting policy 3). Other changes in the fair value of available-for-sale financial assets are reported in a separate component of shareholders’ equity until disposal, when the cumulative gain or loss is recognised in profit or loss.

Reclassifications – held-for-trading and available-for-sale financial assets that meet the definition of loans and receivables (non-derivative financial assets with fixed or determinable payments that are not quoted in an active market) may be reclassified to loans and receivables if the Group has the intention and ability to hold the financial asset for the foreseeable future or until maturity. The Group typically regards the foreseeable future as twelve months from the date of reclassification. Additionally, held-for- trading financial assets that do not meet the definition of loans and receivables may, in rare circumstances, be transferred to available-for- sale financial assets or to held-to-maturity investments.

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

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

14. Impairment of financial assets

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

Financial assets carried at amortised cost – if there is objective evidence that an impairment loss on a financial asset or group of financial assets classified as loans and receivables or as held-to- maturity investments has been incurred, the Group measures the amount of the loss as the difference between the carrying amount of the asset or group of assets and the present value of estimated future cash flows from the asset or group of assets discounted at the effective interest rate of the instrument at initial recognition.

Impairment losses are assessed individually for financial assets that are individually significant and individually or collectively for assets that are not individually significant. In making collective assessment of impairment, financial assets are grouped into portfolios on the basis of similar risk characteristics. Future cash flows from these portfolios are estimated on the basis of the contractual cash flows and historical loss experience for assets with similar credit risk characteristics. Historical loss experience is adjusted, on the basis of current observable data, to reflect the effects of current conditions not affecting the period of historical experience.

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

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

15. Financial liabilities

On initial recognition financial liabilities are classified into held-for-trading, designated as at fair value through profit or loss, or amortised cost.

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

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

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

Accounting policies continued

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

All other financial liabilities are measured at amortised cost using the effective interest method (see accounting policy 3).

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

16. Loan commitments

Provision is made for loan commitments, other than those classified as held-for-trading, if it is probable that the facility will be drawn and the resulting loan will be recognised at a value less than the cash advanced. Syndicated loan commitments in excess of the level of lending under the commitment approved for retention by the Group are classified as held-for-trading and measured at fair value.

17. Derecognition

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

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

18. Sale and repurchase transactions

Securities subject to a sale and repurchase agreement under which substantially all the risks and rewards of ownership are retained by the Group continue to be shown on the balance sheet and the sale proceeds recorded as a deposit. Securities acquired in a reverse sale and repurchase transaction under which the Group is not exposed to substantially all the risks and rewards of ownership are not recognised on the balance sheet and the consideration is recorded in Loans and advances to banks or Loans and advances to customers as appropriate.

Securities borrowing and lending transactions are usually secured by cash or securities advanced by the borrower. Borrowed securities are not recognised on the balance sheet or lent securities derecognised. Cash collateral received or given is treated as a loan or deposit; collateral in the form of securities is not recognised. However, where securities borrowed are transferred to third parties, a liability for the obligation to return the securities to the stock lending counterparty is recorded.

19. Netting

Financial assets and financial liabilities are offset and the net amount presented in the balance sheet when, and only when, the Group currently has a legally enforceable right to set off the recognised amounts; and it intends either to settle on a net basis, or to realise the asset and settle the liability simultaneously. The Group is party to a number of arrangements, including master netting agreements, that give it the right to offset financial assets and financial liabilities but where it does not intend to settle the amounts net or simultaneously and therefore the assets and liabilities concerned are presented gross.

20. Capital instruments

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

21. Derivatives and hedging

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

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

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

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

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

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

Hedge of net investment in a foreign operation – in the hedge of a net investment in a foreign operation, the portion of foreign exchange differences arising on the hedging instrument determined to be an effective hedge is recognised directly in equity. Any ineffective portion is recognised in profit or loss. Non-derivative financial liabilities as well as derivatives may be the hedging instrument in a net investment hedge.

22. Share-based payments

The Group grants options over shares in The Royal Bank of Scotland Group plc under various share option schemes. The Group has applied IFRS 2 ‘Share-based Payment’ to grants under these schemes after 7 November 2002 that had not vested on 1 January 2005. The expense for these transactions is measured based on the fair value on the date the options are granted. The fair value is estimated using valuation techniques which take into account the option’s exercise price, its term, the risk free interest rate and the expected volatility of the market price of The Royal Bank of Scotland Group plc’s shares. Vesting conditions are not taken into account when measuring fair value, but are reflected by adjusting the number of options included in the measurement of the transaction such that the amount recognised reflects the number that actually vest. The fair value is expensed on a straight-line basis over the vesting period.

23. Cash and cash equivalents

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

24. Shares in Group entities

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

Critical accounting policies and key sources of estimation uncertainty

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

Loan impairment provisions

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

Accounting policies continued

At 31 December 2008, gross loans and advances to customers totalled £626,075 million (2007 – £555,682 million) and customer loan impairment provisions amounted to £6,572 million (2007 – £4,233 million).

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

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

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

Pensions

The Group operates a number of defined benefit pension schemes as described in Note 4 on the accounts. The assets of the schemes are measured at their fair value at the balance sheet date. Scheme liabilities are measured using the projected unit method, which takes account of projected earnings increases, using actuarial assumptions that give the best estimate of the future cash flows that will arise under the scheme liabilities. These cash flows are discounted at the interest rate applicable to high-quality corporate bonds of the same currency and term as the liabilities. Any recognisable surplus or deficit of scheme assets over liabilities is recognised in the balance sheet as an asset (surplus) or liability (deficit). In determining the value of scheme liabilities, assumptions are made as to price inflation, dividend growth, pension increases, earnings growth and employees. There is a range of assumptions that could be adopted in valuing the schemes’ liabilities. Different assumptions could significantly alter the amount of the surplus or deficit recognised in the balance sheet and the pension cost charged to the income statement. The assumptions adopted for the Group’s pension schemes are set out in Note 4 on the accounts. A pension asset of £4 million and a liability of £1,446 million were recognised in the balance sheet at 31 December 2008 (2007 – asset £566 million; liability – £334 million).

Fair value- financial instruments

Financial instruments classified as held-for-trading or designated as at fair value through profit or loss and financial assets classified as available-for-sale are recognised in the financial statements at fair value. All derivatives are measured at fair value. Gains or losses arising from changes in the fair value of financial instruments classified as held-for-trading or designated as at fair value through profit or loss are included in the income statement. Unrealised gains and losses on available-for-sale financial assets are recognised directly in equity unless an impairment loss is recognised.

Financial instruments measured at fair value include:

Loans and advances (held-for-trading and designated as at fair value though profit or loss) – principally comprise reverse repurchase agreements (reverse repos) and syndicated loans. In repurchase agreements one party agrees to sell securities to another and simultaneously agrees to repurchase the securities at a future date for a specified price. The repurchase price is fixed at the outset, usually being the original sale price plus an amount representing interest for the period from the sale to the repurchase. Syndicated loans measured at fair value are amounts retained, from syndications where the Group was lead manager or underwriter, in excess of the Group’s intended long term participation.

Debt securities (held-for-trading, designated as at fair value though profit or loss and available-for-sale) – debt securities include those issued by governments, municipal bodies, mortgage agencies and financial institutions as well as corporate bonds, debentures and residual interests in securitisations.

Equity securities (held-for-trading, designated as at fair value though profit or loss and available-for-sale) – comprise equity shares of companies or corporations both listed and unlisted.

Deposits by banks and customer accounts (held-for-trading and designated as at fair value though profit or loss) – deposits measured at fair value principally include repurchase agreements (repos) discussed above.

Debt securities in issue (held-for-trading and designated as at fair value though profit or loss) – measured at fair value and principally comprise medium term notes.

Short positions (held-for-trading) – arise in dealing and market making activities where debt securities and equity shares are sold which the Group does not currently possess.

Derivatives – these include swaps, forwards, futures and options. They may be traded on an organised exchange (exchange-traded) or over-the-counter (OTC). Holders of exchange traded derivatives are generally required to provide margin daily in the form of cash or other collateral.

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

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

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

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

Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. Fair values are determined from quoted prices in active markets for identical financial assets or financial liabilities where these are available. Fair value for a net open position in a financial asset or financial liability in an active market is the current bid or offer price times the number of units of the instrument held. Where a trading portfolio contains both financial assets and financial liabilities which are derivatives of the same underlying instrument, fair value is determined by valuing the gross long and short positions at current mid market prices, with an adjustment at portfolio level to the net open long or short position to amend the valuation to bid or offer as appropriate. Where the market for a financial instrument is not active, fair value is established using a valuation technique. These valuation techniques involve a degree of estimation, the extent of which depends on the instrument’s complexity and the availability of market-based data. The sensitivity to reasonably possible alternative assumptions of the fair value of financial instruments valued using techniques where at least one significant input is unobservable is given in Note 10 on pages 85 and 86.

Goodwill

The Group capitalises goodwill arising on the acquisition of businesses, as disclosed in accounting policy 5. The carrying value of goodwill as at 31 December 2008 was £11,832 million (2007 – £16,783 million).

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

For the purposes of impairment testing, goodwill acquired in a business combination is allocated to each of the Group’s cash-generating units or groups of cash-generating units expected to benefit from the combination. Goodwill impairment testing involves the comparison of the carrying value of a cash-generating unit or group of cash generating units with its recoverable amount. The recoverable amount is the higher of the unit's fair value and its value in use. Value in use is the present value of expected future cash flows from the cash-generating unit or group of cash-generating units. Fair value is the amount obtainable for the sale of the cash-generating unit in an arm’s length transaction between knowledgeable, willing parties. Impairment testing inherently involves a number of judgmental areas: the preparation of cash flow forecasts for periods that are beyond the normal requirements of management reporting; the assessment of the discount rate appropriate to the business; estimation of the fair value of cash- generating units; and the valuation of the separable assets of each business whose goodwill is being reviewed. Sensitivity to changes in assumptions is discussed in Note 16 on page 107.

Deferred tax

The Group makes provision for deferred tax on short-term and other temporary differences where tax recognition occurs at a different time from accounting recognition.

The Group has recognised deferred tax assets in respect of losses, principally in the UK, and short-term timing differences. Tax relief is given for operating losses by offset when future profits arise and therefore the recoverability of deferred tax assets is a matter of judgement.

Accounting policies continued

Accounting developments

International Financial Reporting Standards

The International Accounting Standards Board issued a revised IAS 23 ‘Borrowing Costs’ in March 2007. Entities are required to capitalise borrowing costs attributable to the development or construction of intangible assets or property plant or equipment. The standard is effective for accounting periods beginning on or after 1 January 2009 and is not expected to have a material effect on the Group or the Bank.

The IASB issued a revised IAS 1 ‘Presentation of Financial Statements’ in September 2007 effective for accounting periods beginning on or after 1 January 2009. The amendments to the presentation requirements for financial statements are not expected to have a material effect on the Group or the Bank.

The IASB published a revised IFRS 3 ‘Business Combinations’ and related revisions to IAS 27 ‘Consolidated and Separate Financial Statements’ following the completion in January 2008 of its project on the acquisition and disposal of subsidiaries. The standards improve convergence with US GAAP and provide new guidance on accounting for changes in interests in subsidiaries. The cost of an acquisition will comprise only consideration paid to vendors for equity; other costs will be expensed immediately. Groups will only account for goodwill on acquisition of a subsidiary; subsequent changes in interest will be recognised in equity and only on a loss of control will there be a profit or loss on disposal to be recognised in income. The changes are effective for accounting periods beginning on or after 1 July 2009 but both standards may be adopted together for accounting periods beginning on or after 1 July 2007. These changes will affect the Group's accounting for future acquisitions and disposals of subsidiaries.

The IASB published revisions to IAS 32 ‘Financial Instruments: Presentation’ and consequential revisions to other standards in February 2008 to improve the accounting for and disclosure of puttable financial instruments. The revisions are effective for accounting periods beginning on or after 1 January 2009 but together they may be adopted earlier. They are not expected to have a material affect on the Group or the Bank.

The IASB issued an amendment, 'Vesting Conditions and Cancellations’, to IFRS 2 'Share-based Payment' in January 2008 that will change the accounting for share awards that have non-vesting conditions. The fair value of these awards does not currently take account of the effect of non-vesting conditions and where such conditions are not subsequently met, costs recognised up to the date of cancellation are reversed. The amendment requires costs not recognised up to the date of cancellation to be recognised immediately. The amendment is effective for accounting periods beginning on or after 1 January 2009. The Group estimates that adoption will cause a restatement of 2008 results, reducing profit by £110 million with no material affect on earlier periods. There is not expected to be a material effect on the Bank.

The IASB issued amendments to a number of standards in May 2008 as part of its annual improvements project. The amendments are effective for accounting periods beginning on or after 1 January 2009 and are not expected to have a material effect on the Group or Bank.

Also in May 2008, the IASB issued amendments to IFRS 1 'First-time Adoption of International Financial Reporting Standards' and IAS 27 'Consolidated and Separate Financial Statements' that change the investor's accounting for the cost of an investment in a subsidiary, jointly controlled entity or associate. It does not affect the consolidated accounts but may prospectively affect the Bank’s accounting and presentation of receipts of dividends from such entities.

The IASB issued an amendment to IAS 39 in July 2008 to clarify the IFRS stance on eligible hedged items. The amendment is effective for accounting periods beginning on or after 1 January 2009 and is not expected to have a material effect on the Group or the Bank.

The International Financial Reporting Interpretations Committee (IFRIC) issued interpretation IFRIC 15 'Agreements for the Construction of Real Estate' in July 2008. This interpretation clarifies the accounting for construction profits. It is applicable for accounting periods beginning on or after 1 January 2009 and is not expected to have a material effect on the Group or the Bank.

The IFRIC issued interpretation IFRIC 16 'Hedges of a Net Investment in a Foreign Operation' in July 2008. The interpretation addressed the nature of the hedged risk and the amount of the hedged item; where in a group the hedging item could be held; and what amounts should be reclassified from equity on the disposal of a foreign operation that had been subject to hedging. The interpretation is effective for accounting periods beginning on or after 1 October 2008 and is not expected to have a material effect on the Group or the Bank.

The IFRIC issued interpretation IFRIC 17 ‘Distributions of Non-Cash Assets to Owners’ and the IASB made consequential amendments to IFRS 5 'Non-Current Assets Held for Sale and Discontinued Operations' in December 2008. The interpretation requires distributions to be presented at fair value with any surplus or deficit to be recognised in income. The amendment to IFRS 5 extends the definition of disposal groups and discontinued operations to disposals by way of distribution. The interpretation is effective for accounting periods beginning on or after 1 July 2009, to be adopted at the same time as IFRS 3 (revised 2008), and is not expected to have a material effect on the Group or the Bank.

The IFRIC issued interpretation IFRIC 18 ‘Transfers of Assets from Customers’ in January 2009. The interpretation addresses the accounting by suppliers that receive assets from customers, requiring measurement at fair value. The interpretation is effective for assets from customers received on or after 1 July 2009 and is not expected to have a material effect on the Group or the Bank.

In March 2009, the IASB improved IFRS 7 ‘Financial Instruments: Disclosure’ by enhancing the disclosure requirements for fair value measurements and liquidity risk. The changes are effective for accounting periods beginning on or after 1 January 2009, although comparative information is not needed in the first year of application, and will be adopted by the Group and the Bank for 2009 reporting.

Notes on the accounts

1 Net interest income

				Group
	2008			2007			2006
		£m			£m			£m
Loans and advances to customers		28,240			25,886			22,145
Loans and advances to banks		1,302			1,126			688
Debt securities		1,871			1,298			1,486
Interest receivable		31,413			28,310			24,319
Customer accounts: demand deposits		2,970			3,680			3,095
Customer accounts: savings deposits		2,348			2,266			1,437
Customer accounts: other time deposits		5,408			5,848			4,642
Deposits by banks		3,147			2,802			2,625
Debt securities in issue		5,446			4,325			3,068
Subordinated liabilities		1,694			1,452			1,161
Internal funding of trading business		(3,109	)		(3,179	)		(2,101	)
Interest payable		17,904			17,194			13,927
Net interest income		13,509			11,116			10,392

2 Non-interest income

				Group
	2008			2007			2006
		£m			£m			£m
Fees and commissions receivable		7,483			7,519			7,060
Fees and commissions payable		(1,733	)		(1,496	)		(1,426	)
(Loss)/income from trading activities:
Foreign exchange (1)		707			798			612
Interest rate (2)		561			1,796			967
Credit (3)		(7,691	)		(1,620	)		841
Equities and commodities (4)		840			168			123
		(5,583	)		1,142			2,543
Other operating income:
Operating lease and other rental income		1,232			1,187			1,288
Changes in the fair value of own debt		665			152			—
Changes in the fair value of securities and other financial assets and liabilities		(325	)		846			430
Changes in the fair value of investment properties		(86	)		288			486
Profit on sale of securities		174			496			252
Profit on sale of property, plant and equipment		177			672			215
Profit on sale of subsidiaries and associates		417			67			41
Dividend income		50			70			67
Share of profits less losses of associated entities		(19	)		2			36
Other income		(104	)		246			184
		2,181			4,026			2,999

The analysis of trading income is based on how the business is organised and the underlying risks managed.

Notes:

Trading income comprises gains and losses on financial instruments held for trading, both realised and unrealised, interest income and dividends and the related funding costs. The types of instruments include:

(1)	Foreign exchange: spot foreign exchange contracts, currency swaps and options, emerging markets and related hedges and funding.

(2)	Interest rate: interest rate swaps, forward foreign exchange contracts, forward rate agreements, interest rate options, interest rate futures and related hedges and funding.

(3)	Credit: asset-backed securities, corporate bonds, credit derivatives and related hedges and funding.

(4)	Equities and commodities: equities, commodities, equity derivatives, commodity contracts and related hedges and funding.

Notes on the accounts continued

3 Operating expenses

			Group
	2008		2007		2006
		£m		£m		£m
Wages, salaries and other staff costs		5,234		5,249		5,285
Social security costs		365		357		342
Shared-based compensation		—		65		65
Pension costs
– defined benefit schemes (Note 4)		351		479		578
– defined contribution schemes		23		31		10
Staff costs		5,973		6,181		6,280
Premises and equipment		1,760		1,521		1,405
Other administrative expenses		2,759		2,147		2,241
Property, plant and equipment (see Note 17)		1,221		1,021		1,055
Intangible assets (see Note 16)		341		417		360
Depreciation and amortisation		1,562		1,438		1,415
Write-down of goodwill and other assets		8,144		—		—
		20,198		11,287		11,341

Integration costs included in operating expenses comprise expenditure incurred in respect of cost reduction and revenue enhancement programmes set in connection with the various acquisitions made by the Group.

			Group
	2008		2007		2006
		£m		£m		£m
Staff costs		246		18		76
Premises and equipment		25		4		10
Other administrative expenses		194		10		18
Depreciation and amortisation		22		60		16
		487		92		120
Restructuring costs included in operating expenses comprise:
					2008
						£m
Staff costs						111
Premises and equipment						15
Other administrative expenses						34
						160

No restructuring costs were incurred in 2007 and 2006.

The average number of persons employed by the Group during the year, excluding temporary staff, was 123,000 (2007 – 123,500; 2006 – 122,600). The number of persons employed by the Group at 31 December, excluding temporary staff, was as follows:

			Group
	2008		2007		2006
Global Banking & Markets		10,100		9,300		8,100
Global Transaction Services		2,900		2,700		2,500
UK Retail & Commercial Banking		45,800		45,500		46,000
US Retail & Commercial Banking		18,700		19,000		19,800
Europe & Middle East Retail & Commercial Banking		5,600		6,400		5,700
Asia Retail & Commercial Banking		4,200		5,200		3,800
Group Manufacturing		32,300		33,500		34,100
Centre		3,200		3,000		2,700
Total		122,800		124,600		122,700
UK		86,600		88,600		88,300
US		26,000		25,600		26,200
Europe		6,600		7,600		6,900
Rest of the World		3,600		2,800		1,300
Total		122,800		124,600		122,700

			Bank
	2008		2007		2006
		£m		£m		£m
Wages, salaries and other staff costs		2,499		2,910		2,847
Social security costs		192		203		193
Share-based compensation		—		65		65
Pension costs
– defined benefit schemes		8		5		8
– defined contribution schemes		298		310		295
Staff costs		2,997		3,493		3,408

The average number of persons employed by the Bank during the year, excluding temporary staff, was 63,500 (2007 – 63,700; 2006 – 60,900). The number of persons employed by the Bank at 31 December, excluding temporary staff, was as follows:

			Bank
	2008		2007		2006
Global Banking & Markets		8,500		8,200		6,600
Global Transaction Services		1,200		1,100		900
UK Retail & Commercial Banking		22,600		24,000		22,600
Group Manufacturing		27,500		29,200		28,700
Centre		3,100		2,900		2,500
Total		62,900		65,400		61,300
UK		58,100		61,700		60,100
US		1,100		400		—
Europe		1,000		1,300		1,100
Rest of the World		2,700		2,000		100
Total		62,900		65,400		61,300

Notes on the accounts continued

4 Pension costs

Members of the Group sponsor a number of pension schemes in the UK and overseas, defined benefit schemes, whose assets are independent of the Group’s finances. Defined benefit pensions generally provide a pension of one-sixtieth of final pensionable salary for each year of service prior to retirement up to a maximum of 40 years. Employees do not make contributions for basic pensions but may make voluntary contributions to secure additional benefits on a money-purchase basis. Since October 2006 the defined benefit section of The Royal Bank of Scotland Group Pension Fund (‘Main scheme’) has been closed to new entrants.

The Group also provides post-retirement benefits other than pensions, principally through subscriptions to private healthcare schemes in the UK and the US and unfunded post-retirement benefit plans. Provision for the costs of these benefits is charged to the income statement over the average remaining future service lives of the eligible employees. The amounts are not material.

There is no contractual agreement or policy on the way that the cost of The Royal Bank of Scotland Group defined benefit pension schemes and healthcare plans are allocated to the Bank. The Bank therefore accounts for the charges it incurs as payments to a defined contribution scheme.

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

Principal actuarial assumptions at 31 December (weighted average)	2008			2007			2006
Discount rate		6.3	%		6.0	%		5.3	%
Expected return on plan assets		7.1	%		6.9	%		6.9	%
Rate of increase in salaries*		3.8	%		4.4	%		4.1	%
Rate of increase in pensions in payment		2.5	%		3.1	%		2.8	%
Inflation assumption		2.6	%		3.2	%		2.9	%

* Rate of increase in salaries in the Main scheme assumed to be 2.0% over the next two years.

Major classes of plan assets as a percentage of total plan assets	2008			2007			2006
Equities		58.2	%		61.3	%		60.7	%
Index-linked bonds		16.7	%		16.9	%		16.1	%
Government fixed interest bonds		2.9	%		2.3	%		3.3	%
Corporate and other bonds		17.9	%		14.8	%		13.9	%
Property		4.1	%		4.0	%		4.5	%
Cash and other assets		0.2	%		0.7	%		1.5	%

Ordinary shares of the holding company with a fair value of £15 million (2007 – £69 million; 2006 – £89 million) are held by the Group’s pension schemes together with holdings of other financial instruments issued by the Group with a value of £421 million (2007 – £606 million; 2006 – £258 million).

The expected return on plan assets at 31 December 2008 is based upon the weighted average of the following assumed returns on the major classes of plan assets:

	2008			2007			2006
Equities		8.5	%		8.1	%		8.1	%
Index-linked bonds		3.9	%		4.5	%		4.5	%
Government fixed interest bonds		4.4	%		4.6	%		4.5	%
Corporate and other bonds		6.1	%		5.5	%		5.3	%
Property		6.0	%		6.3	%		6.3	%
Cash and other assets		3.4	%		4.3	%		4.4	%

Post-retirement mortality assumptions (Main scheme)	2008		2007		2006
Longevity at age 60 for current pensioners (years)
Males		26.1		26.0		26.0
Females		26.9		26.8		28.9
Longevity at age 60 for future pensioners (years)
Males		28.1		28.1		26.8
Females		28.2		28.2		29.7

	Fair value of plan assets		Present value of defined benefit obligations		Net pension deficit/ (surplus)
Changes in value of net pension deficit/(surplus)	£m		£m		£m
At 1 January 2007	18,894		20,865		1,971
Currency translation and other adjustments	38		45		7
Income statement:
Expected return	1,297		—		(1,297	)
Interest cost	—		1,105		1,105
Current service cost	—		649		649
Past service cost	—		22		22
	1,297		1,776		479
Statement of recognised income and expense:
Actuarial gains and losses	140		(2,013	)	(2,153	)
Contributions by employer	536		—		(536	)
Contributions by plan participants	4		4		—
Benefits paid	(605	)	(605	)	—
Expenses included in service cost	(40	)	(40	)	—
At 1 January 2008	20,264		20,032		(232	)
Currency translation and other adjustments	522		623		101
Income statement:
Expected return	1,401		—		(1,401	)
Interest cost	—		1,196		1,196
Current service cost	—		528		528
Past service cost	—		28		28
	1,401		1,752		351
Statement of recognised income and expense:
Actuarial gains and losses	(5,318	)	(3,602	)	1,716
Disposal of subsidiaries	—		(3	)	(3	)
Contributions by employer	491		—		(491	)
Contributions by plan participants	6		6		—
Benefits paid	(689	)	(689	)	—
Expenses included in service cost	(26	)	(26	)	—
At 31 December 2008	16,651		18,093		1,442

Notes on the accounts continued

4 Pension costs (continued)

Net pension liability comprises:	£m
Net assets of schemes in surplus (included in Prepayments, accrued income and other assets, Note 18)	(4	)
Net liabilities of schemes in deficit	1,446
	1,442

The Group expects to contribute £488 million to its defined benefit pension schemes in 2009. Of the net liabilities of schemes in deficit, £118 million (2007 – £94 million) relates to unfunded schemes.

Cumulative net actuarial losses of £180 million (2007 – £1,536 million gains; 2006 – £617 million losses) have been recognised in the statement of recognised income and expense.

	2008			2007			2006			2005			2004
History of defined benefits schemes		£m			£m			£m			£m			£m
Fair value of plan assets		16,651			20,264			18,894			17,331			14,752
Present value of defined benefit obligations		18,093			20,032			20,865			21,040			17,674
Net (deficit)/surplus		(1,442	)		232			(1,971	)		(3,709	)		(2,922	)
Experience losses on plan liabilities		(91	)		(204	)		(20	)		(68	)		(631	)
Experience (losses)/gains on plan assets		(5,318	)		140			585			1,654			408
Actual return on pension schemes assets		(3,917	)		1,437			1,654			2,667			1,327

The table below sets out the sensitivities of the pension cost for the year and the present value of defined benefit obligations at the balance sheet dates to a change in the principal actuarial assumptions:

	Increase/(decrease)						Increase/(decrease)
	in pension cost for the year						in obligation at 31 December
	2008			2007			2008			2007
		£m			£m			£m			£m
25 bps increase in the discount rate		(44	)		(47	)		(786	)		(963	)
25 bps increase in inflation		86			91			696			872
25 bps additional rate of increase in pensions in payment		46			47			423			503
25 bps additional rate of increase in deferred pensions		9			6			103			121
25 bps additional rate of increase in salaries		33			39			199			246
Longevity increase of 1 year		34			33			337			419

5 Auditors’ remuneration

Amounts paid to the Bank’s auditors for statutory audit and other services were as follows:	Group
	2008		2007
		£m		£m
Fees payable for the audit of the Group’s annual accounts		4.3		3.7
Fees payable to the auditors and their associates for other services to the Group:
– The audit of the Bank’s subsidiaries pursuant to legislation		7.9		5.3
Total audit fees		12.2		9.0

Fees payable to the auditors for non-audit services are disclosed in the consolidated financial statements of The Royal Bank of Scotland Group plc.

6 Tax

				Group
	2008			2007			2006
		£m			£m			£m
Current taxation:
Charge for the year		646			2,373			2,355
Over provision in respect of prior periods		(257	)		(25	)		(167	)
Relief for overseas taxation		(34	)		(198	)		(147	)
		355			2,150			2,041
Deferred taxation:
(Credit)/charge for the year		(849	)		89			365
(Under)/over provision in respect of prior periods		(11	)		(336	)		27
Tax (credit)/charge for the year		(505	)		1,903			2,433

The actual tax charge differs from the expected tax charge computed by applying the standard rate of UK corporation tax of 28.5% (2007 – 30%, 2006 – 30%) as follows:

	2008			2007			2006
		£m			£m			£m
Expected tax (credit)/charge		(2,578	)		2,747			2,506
Non-deductible goodwill impairment		1,949			12			—
Unrecognised timing differences		274			29			—
Other non-deductible items		245			218			280
Non-taxable items		(305	)		(568	)		(252	)
Taxable foreign exchange movements		161			4			(33	)
Foreign profits taxed at other rates		4			(13	)		61
Increase/(decrease) in deferred tax liability following change in the rate of UK corporation tax		1			(156	)		—
Unutilised losses brought forward and carried forward		12			(9	)		11
Adjustments in respect of prior periods		(268	)		(361	)		(140	)
Actual tax (credit)/charge		(505	)		1,903			2,433

The effective tax rate for the year was 5.6% (2007 – 20.8%; 2006 – 29.1%).

7 Profit attributable to preference shareholders

			Group
	2008		2007		2006
Dividends paid to equity preference shareholders		£m		£m		£m
Non-cumulative preference shares of US$0.01		350		210		160
Non-cumulative preference shares of €0.01		205		110		92
Non-cumulative preference shares of £1		83		11		—
Total		638		331		252

Notes:

(1)	In accordance with IAS 32, several of the Group’s preference share issues are included in subordinated liabilities and the related finance cost in interest payable.

(2)	Between 1 January 2009 and the date of approval of these accounts, dividends amounting to US$194 million have been declared in respect of equity preference shareholders for payment on 31 March 2009.

Notes on the accounts continued

8 Ordinary dividends

	2008		2007		2006
		£m		£m		£m
Ordinary dividend paid to holding company		4,000		2,000		3,250

9 Profit dealt with in the accounts of the Bank

As permitted by section 230(3) of the Companies Act 1985, no income statement for the Bank has been presented as a primary financial statement. Of the loss attributable to ordinary shareholders, £1,778 million (2007 – £6,924 million profit; 2006 – £3,267 million profit) has been dealt with in the accounts of the Bank.

10 Financial instruments

Classification

The following tables analyse the Group’s financial assets and financial liabilities in accordance with the categories of financial instruments in IAS 39. Assets and liabilities outside the scope of IAS 39 are shown separately.

									Group
			Designated
			as at fair												Non
			value								Other				financial
	Held-for-		through		Hedging		Available-		Loans and		(amortised		Finance		assets/
	trading		profit or loss		derivatives		for-sale		receivables		cost)		leases		liabilities		Total
2008		£m		£m		£m		£m		£m		£m		£m		£m		£m
Assets
Cash and balances at central banks		—		—				—		6,806				—				6,806
Loans and advances to banks (1)		60,957		—				—		18,430				—				79,387
Loans and advances to customers (2, 3)		52,173		1,767				—		551,110				14,453				619,503
Debt securities (4)		101,773		2,599				61,638		11,756				—				177,766
Equity shares		577		275				1,839		—				—				2,691
Settlement balances		—		—				—		10,871				—				10,871
Derivatives		933,203		—		4,254		—		—				—				937,457
Intangible assets																12,591		12,591
Property, plant and equipment																16,628		16,628
Deferred taxation																2,833		2,833
Prepayments, accrued income and other assets		—		—				—		32				—		11,365		11,397
		1,148,683		4,641		4,254		63,477		599,005				14,453		43,417		1,877,930
Liabilities
Deposits by banks (5)		86,938		—								95,044		—				181,982
Customer accounts (6, 7)		57,817		2,707								392,605		—				453,129
Debt securities in issue (8, 9)		3,991		12,164								163,787		—				179,942
Settlement balances and short positions		37,172		—								8,785		—				45,957
Derivatives		905,546		—		3,559						—		—				909,105
Accruals, deferred income and other liabilities		260		—								1,619		22		14,784		16,685
Retirement benefit liabilities																1,446		1,446
Deferred taxation																2,483		2,483
Subordinated liabilities (10)		—		708								39,243		—		—		39,951
		1,091,724		15,579		3,559						701,083		22		18,713		1,830,680
Equity																		47,250
																		1,877,930

									Group
			Designated
			as at fair												Non
			value								Other				financial
	Held-for-		through		Hedging		Available-		Loans and		(amortised		Finance		assets/
	trading		profit or loss		derivatives		for-sale		receivables		cost)		leases		liabilities		Total
2007		£m		£m		£m		£m		£m		£m		£m		£m		£m
Assets
Cash and balances at central banks		—		—				—		5,559				—				5,559
Loans and advances to banks (1)		72,697		—				—		23,649				—				96,346
Loans and advances to customers (2, 3)		105,420		2,622				—		430,837				12,570				551,449
Debt securities (4)		136,785		2,854				24,293		500				—				164,432
Equity shares		3,786		156				1,567		—				—				5,509
Settlement balances		—		—				—		5,326				—				5,326
Derivatives		205,056		—		919		—		—				—				205,975
Intangible assets																17,761		17,761
Property, plant and equipment																13,025		13,025
Deferred taxation								—		—				—		240		240
Prepayments, accrued income
and other assets		—		—				—		19				—		6,097		6,116
		523,744		5,632		919		25,860		465,890				12,570		37,123		1,071,738
Liabilities
Deposits by banks (5)		71,714		—								79,794		—				151,508
Customer accounts (6, 7)		61,990		1,920								379,072		—				442,982
Debt securities in issue (8, 9)		9,455		9,021								111,656		—				130,132

Settlement balances and short positions		47,058		—		1,270						6,791		—				53,849
Derivatives		201,802		—								—		—				203,072
Accruals, deferred income
and other liabilities		210		—								1,545		19		10,393		12,167
Retirement benefit liabilities																334		334
Deferred taxation																2,063		2,063
Subordinated liabilities (10)		—		358								27,438				—		27,796
		392,229		11,299		1,270						606,296		19		12,790		1,023,903
Equity																		47,835
																		1,071,738

Notes:

(1)	Includes reverse repurchase agreements of £31,436 million (2007 – £67,619 million), items in the course of collection from other banks of £2,779 million (2007 – £2,729 million) and amounts due from fellow subsidiaries of £7,297 million (2007 – £1,966 million).

(2)	Includes reverse repurchase agreements of £27,972 million (2007 – £79,056 million), amounts due from holding company of £1,828 million (2007 – £5,572 million) and amounts due from fellow subsidiaries of £2,656 million (2007 – £3,516 million).

(3)	The change in the fair value of loans and advances to customers designated as at fair value through profit and loss attributable to changes in credit risk was £301 million for the year and £408 million cumulatively. The amounts for 2007 were not material.

(4)	Includes treasury bills and similar securities of £23,797 million (2007 – £14,604 million) and other eligible bills of £54 million (2007 – £1,914 million).

(5)	Includes repurchase agreements of £66,006 million (2007 – £75,154 million) and items in the course of transmission to other banks of £542 million (2007 – £372 million).

(6)	Includes repurchase agreements of £54,095 million (2007 – £75,029 million), amounts due to holding company of £15,801 million (2007 – £1,012 million) and amounts due to fellow subsidiaries of £2,488 million (2007 – £2,105 million).

(7)

The carrying amount of other customer accounts designated as at fair value through profit or loss is £44 million lower (2007 – £77 million, greater) than the principal amount. No amounts have been recognised in profit or loss for changes in credit risk associated with these liabilities as the changes are immaterial measured as the change in fair value from movements in the period in the credit risk premium payable.

(8)	Comprises bonds and medium term notes of £70,153 million (2007 – £40,945 million) and certificates of deposit and other commercial paper of £109,789 million (2007 – £89,187 million).

(9)

£665 million (2007 – £152 million) has been recognised in profit or loss for changes in credit risk associated with these liabilities measured as the change in fair value from movements in the period in the credit risk premium payable by the Group. The carrying amount is £1,145 million (2007 – £317 million) lower than the principal amount.

(10)	Includes amounts due to holding company of £11,572 million (2007 – £6,113 million).

(11)	During 2008 the Group reclassified financial assets from the held-for-trading and available-for-sale categories into loans and receivables category and from held-for-trading category into the available-for-sale category (see page 91).

Notes on the accounts continued

10 Financial instruments (continued)

The following tables analyse the Bank’s financial assets and financial liabilities in accordance with the categories of financial instruments in IAS 39. Assets and liabilities outside the scope of IAS 39 are shown separately.

							Bank
			Designated
			as at fair										Non
			value								Other		financial
	Held-for-		through		Hedging		Available-		Loans and		(amortised		assets/
	trading		profit or loss		derivatives		for-sale		receivables		cost)		liabilities		Total
2008		£m		£m		£m		£m		£m		£m		£m		£m
Assets
Cash and balances at central banks		—		—				—		3,714						3,714
Loans and advances to banks (1)		56,089		—				—		35,628						91,717
Loans and advances to customers (2)		59,146		1,160				—		266,734						327,040
Debt securities (3)		67,911		906				41,898		48,983						159,698
Equity shares		463		28				529		—						1,020
Investments in Group undertakings		—		—				—		—				26,814		26,814
Settlement balances		—		—				—		5,335						5,335
Derivatives		934,709		—		3,796		—		—						938,505
Intangible assets														136		136
Property, plant and equipment														2,368		2,368
Deferred taxation														1,323		1,323
Prepayments, accrued income and other assets		—		—				—		—				5,930		5,930
		1,118,318		2,094		3,796		42,427		360,394				36,571		1,563,600
Liabilities
Deposits by banks (4)		85,126		—								116,140				201,266
Customer accounts (5, 6)		46,178		170								182,918				229,266
Debt securities in issue (7, 8)		3,993		12,099								99,057				115,149
Settlement balances and short positions		23,827		—								5,534				29,361
Derivatives		910,188		—		986						—				911,174
Accruals, deferred income and other liabilities		260		—								1,087		8,271		9,618
Retirement benefit liabilities														23		23
Subordinated liabilities		—		708								32,990		—		33,698
		1,069,572		12,977		986						437,726		8,294		1,529,555
Equity																34,045
																1,563,600

							Bank
			Designated
			as at fair										Non
			value								Other		financial
	Held-for-		through		Hedging		Available-		Loans and		(amortised		assets/
	trading		profit or loss		derivatives		for-sale		receivables		cost)		liabilities		Total
2007		£m		£m		£m		£m		£m		£m		£m		£m
Assets
Cash and balances at central banks		—		—				—		3,333						3,333
Loans and advances to banks (1)		60,640		—				—		31,342						91,982
Loans and advances to customers (2)		109,992		791				—		218,364						329,147
Debt securities (3)		97,455		996				8,799		—						107,250
Equity shares		3,634		10				375		—						4,019
Investments in Group undertakings		—		—				—		—				22,210		22,210
Settlement balances		—		—				—		2,046						2,046
Derivatives		207,266		—		647		—		—						207,913
Intangible assets														295		295
Property, plant and equipment														2,116		2,116
Deferred taxation														319		319
Prepayments, accrued income and other assets		—		—				—		—				1,680		1,680
		478,987		1,797		647		9,174		255,085				26,620		772,310
Liabilities
Deposits by banks (4)		71,261		—								125,707				196,968
Customer accounts (5, 6)		57,823		54								140,049				197,926
Debt securities in issue (7, 8)		9,455		8,895								61,527				79,877
Settlement balances and short positions		30,567		—								3,110		—		33,677
Derivatives		203,733		—		501						—		—		204,234
Accruals, deferred income and other liabilities		210		—								1,080		4,493		5,783
Retirement benefit liabilities														11		11
Subordinated liabilities		—		358								22,387		—		22,745
		373,049		9,307		501						353,860		4,504		741,221
Equity																31,089
																772,310

Notes:

(1)

Includes reverse repurchase agreements of £19,263 million (2007 – £52,128 million), items in the course of collection from other banks of £484 million (2007 – £530 million), amounts due from subsidiaries of £29,619 million (2007 – £22,367 million) and amounts due from fellow subsidiaries of £6,862 million (2007 – £1,748 million).

(2)

Includes reverse repurchase agreements of £22,564 million (2007 – £58,785 million), amounts due from subsidiaries of £39,908 million (2007 – £66,102 million), amounts due from fellow subsidiaries of £2,632 million (2007 – £2,666 million) and amounts due from holding company of £1,828 million (2007 – £5,572 million).

(3)	Includes treasury bills and similar securities of £23,415 million (2007 – £14,200 million).

(4)

Includes repurchase agreements of £52,290 million (2007 – £59,955 million), items in the course of transmission to other banks of £312 million (2007 – £68 million), amounts due to subsidiaries of £63,198 million (2007 – £74,006 million) and amounts due to fellow subsidiaries of £5,715 million (2007 – £8,473 million).

(5)

Includes repurchase agreements of £24,041 million (2007 – £30,177 million), amounts due to fellow subsidiaries of £1,940 million (2007 – £123 million), amounts due to holding company of £15,800 million (2007 – £1,013 million) and amounts due to subsidiaries of £68,282 million (2007 – £53,565 million).

(6)

The carrying amount of other customer accounts designated as at fair value through profit or loss is £2 million (2007 – £15 million) lower than the principal amount. No amounts have been recognised in profit or loss for changes in credit risk associated with these liabilities as the changes are immaterial measured as the change in fair value from movements in the period in the credit risk premium payable.

(7)	Comprises bonds and medium term notes of £40,595 million (2007 – £17,274 million) and certificates of deposit and other commercial paper of £74,553 million (2007 – £62,603 million).

(8)

£665 million (2007 – £152 million) has been recognised in profit or loss for changes in credit risk associated with these liabilities measured as the change in fair value from movements in the period in the credit risk premium payable by the Group. The carrying amount is £1,055 million (2007 – £252 million) lower than the principal amount.

(9)	During 2008 the Group reclassified financial assets from the held-for-trading and available-for-sale categories into loans and receivables category and from held-for-trading category into the available-for-sale category (see page 92).

Notes on the accounts continued

10 Financial instruments (continued)

Valuation of financial instruments

Control environment

The Group’s control environment for the determination of the fair value of financial instruments has been designed to ensure there are formalised review protocols for independent review and validation of fair values separate from those businesses entering into the transactions. This includes specific controls to ensure consistent pricing policies and procedures, incorporating disciplined price verification for both proprietary and counterparty risk trades. The Group ensures special attention is given to bespoke transactions, structured products, illiquid products, and other assets which are difficult to price.

The business entering into the transaction is responsible for the initial determination and recording of the fair value of the transaction. There are daily controls over the profit or loss recorded by trading and treasury front office traders.

A key element of the control environment, segregated from the recording of the transaction’s valuation, is the independent price verification (IPV) process. Valuations are first calculated by the business which entered into the transaction. Such valuations may be direct prices, or may be derived using a model and variable model inputs. These valuations are reviewed, and if necessary amended, by the IPV process. This process involves a team, independent of those trading the financial instruments, reviewing valuations in the light of available pricing evidence. IPV is performed at a frequency to match the availability of independent data, and the size of the Group’s exposure. For liquid instruments the process is performed daily. The minimum frequency of review in GBM is monthly for regulatory trading book positions, and six monthly for regulatory banking book positions. The IPV control includes formalised reporting and escalation of any valuation differences in breach of defined thresholds. In addition, within GBM, there is a dedicated team (the Global Pricing Unit) which determines IPV policy, monitors adherence to policy, and performs additional independent review on highly subjective valuation issues.

In GBM, when models are used to value products, those models are subject to a review process which requires different levels of model documentation, testing and review, depending on the complexity of the model and the size of the Group’s exposure. A key element of the control environment over model use in GBM is a review committee which comprises of valuations experts from several functions within GBM. The committee sets the policy for model documentation, testing and review, and prioritises models with significant exposure for review by the Group’s quantitative research centre. This centre, which is independent of the trading businesses, assesses the appropriateness of the application of the model to the product, the mathematical robustness of the model, and (where appropriate), considers alternative modelling approaches.

GBM also maintains a valuation control committee that meets formally on a monthly basis to discuss and review escalated items and to consider highly complex and subjective valuation matters. The committee includes valuation specialists representing several independent review functions (including market risk, quantitative research and finance) and senior members of the Group’s front office trading businesses.

Certain financial instruments have become more difficult and subjective to value and have therefore been transferred to a centrally managed asset unit, to separate them from business as usual activities and to allow dedicated focus on the management and valuation of the exposures. The unit has a valuation committee comprising senior representatives of the trading function, risk management and GBM Global Pricing Unit which meets regularly and is responsible for monitoring, assessing and enhancing the adequacy of the valuation techniques being adopted for these instruments.

Valuation techniques

The Group uses a number of methodologies to determine the fair values of financial instruments for which observable prices in active markets for identical instruments are not available. These techniques include: relative value methodologies based on observable prices for similar instruments; present value approaches where future cash flows from the asset or liability are estimated and then discounted using a risk-adjusted interest rate; option pricing models (such as Black-Scholes or binomial option pricing models) and simulation models such as Monte-Carlo.

The principal inputs to these valuation techniques are listed below. Values between and beyond available data points are obtained by interpolation and extrapolation. When utilising valuation techniques, the fair value can be significantly affected by the choice of valuation model and underlying assumptions made concerning factors such as the amounts and timing of cash flows, discount rates and credit risk.

•	Bond prices – quoted prices are generally available for government bonds, certain corporate securities and some mortgage-related products.

•	Credit spreads – where available, these are derived from prices of CDS or other credit based instruments, such as debt securities. For others, credit spreads are obtained from pricing services.

•	Interest rates – these are principally benchmark interest rates such as the London Inter-Bank Offered Rate (LIBOR) and quoted interest rates in the swap, bond and futures markets.

•	Foreign currency exchange rates – there are observable markets both for spot and forward contracts and futures in the world’s major currencies.

•	Equity and equity index prices – quoted prices are generally readily available for equity shares listed on the world’s major stock exchanges and for major indices on such shares.

•	Commodity prices – many commodities are actively traded in spot and forward contracts and futures on exchanges in London, New York and other commercial centres.

•

Price volatilities and correlations – volatility is a measure of the tendency of a price to change with time. Correlation measures the degree to which two or more prices or other variables are observed to move together. If they move in the same direction there is positive correlation; if they move in opposite directions there is negative correlation. Volatility is a key input in valuing options and the valuation of certain products such as derivatives with more than one underlying variable that are correlation-dependent. Volatility and correlation values are obtained from broker quotations, pricing services or derived from option prices.

•	Prepayment rates – the fair value of a financial instrument that can be prepaid by the issuer or borrower differs from that of an instrument that cannot be prepaid. In valuing prepayable instruments that are not quoted in active markets, the Group considers the value of the prepayment option.

•	Counterparty credit spreads – adjustments are made to market prices (or parameters) when the creditworthiness of the counterparty differs from that of the assumed counterparty in the market price (or parameters).

•	Recovery rates/loss given default – these are used as an input to valuation models and reserves for ABS and other credit products as an indicator of severity of losses on default. Recovery rates are primarily sourced from market data providers or inferred from observable credit spreads.

In order to determine a reliable fair value, where appropriate, the Group applies valuation adjustments to the pricing information derived from the above sources. These adjustments reflect the Group’s assessment of factors that market participants would consider in setting a price, to the extent that these factors have not already been included in the information from the above sources. Furthermore, on an ongoing basis, the Group assesses the appropriateness of any model used. To the extent that the price provided by internal models does not represent the fair value of the instrument, for instance in highly stressed market conditions, the Group makes adjustments to the model valuation to calibrate to other available pricing sources. Where unobservable inputs are used, the Group may determine a range of possible valuations based upon differing and stress scenarios to determine the sensitivity associated with the valuation. When establishing the fair value of a financial instrument using a valuation technique, the Group considers certain adjustments to the modelled price which market participants would make when pricing that instrument. Such adjustments include the credit quality of the counterparty and adjustments to correct model valuations for any known limitations. In addition, the Group makes adjustments to defer income for financial instruments valued at inception where the valuation of that financial instrument materially depends on one or more unobservable model inputs.

The Group refines and modifies its valuation techniques as markets and products develop and as the pricing for individual products becomes more or less readily available. While the Group believes its valuation techniques are appropriate and consistent with other market participants, the use of different methodologies or assumptions could result in different estimates of fair value at the balance sheet date.

Notes on the accounts continued

10 Financial instruments (continued)

Valuation hierarchy

The table below shows the financial instruments carried at fair value by valuation method.

			2008								2007
	Level 1(1)		Level 2 (2)		Level 3 (3)		Total		Level 1(1)		Level 2 (2)		Level 3(3)		Total
	£bn		£bn		£bn		£bn		£bn		£bn		£bn		£bn
Assets
Fair value through profit or loss:
Loans and advances to banks		—		61.0		—		61.0		—		72.6		0.1		72.7
Loans and advances to customers		—		50.8		3.1		53.9		—		94.9		13.1		108.0
Debt securities		50.1		50.5		3.8		104.4		59.0		70.2		10.4		139.6
Equity shares		0.5		—		0.4		0.9		3.7		—		0.2		3.9
Derivatives		1.4		929.7		6.3		937.4		1.0		201.9		3.1		206.0
		52.0		1,092.0		13.6		1,157.6		63.7		439.6		26.9		530.2
Available-for-sale:
Debt securities		16.2		43.1		2.3		61.6		2.2		21.8		0.3		24.3
Equity shares		0.1		1.6		0.1		1.8		0.1		1.0		0.5		1.6
		16.3		44.7		2.4		63.4		2.3		22.8		0.8		25.9
		68.3		1,136.7		16.0		1,221.0		66.0		462.4		27.7		556.1
Liabilities
Deposits by banks and customers		—		147.1		0.3		147.4		—		134.1		1.5		135.6
Debt securities in issue		—		15.4		0.8		16.2		—		13.3		5.2		18.5
Short positions		32.0		5.2		—		37.2		43.3		3.7		—		47.0
Derivatives		0.7		905.6		2.8		909.1		1.3		199.5		2.3		203.1
Other financial liabilities (4)		—		0.7		0.3		1.0		—		0.4		0.2		0.6
		32.7		1,074.0		4.2		1,110.9		44.6		351.0		9.2		404.8

Notes:

(1)	Valued using unadjusted quoted prices in active markets for identical financial instruments. This category includes listed equity shares, certain exchange-traded derivatives, G10 government securities and certain US agency securities.

(2)	Valued using techniques based significantly on observable market data. Instruments in this category are valued using:

(a)

quoted prices for similar instruments or identical instruments in markets which are not considered to be active; or

(b)

valuation techniques where all the inputs that have a significant effect on the valuation are directly or indirectly based on observable market data.

The type of instruments that trade in markets that are not considered to be active, but are based on quoted market prices, broker dealer quotations, or alternative pricing sources with reasonable levels of price transparency and those instruments valued using techniques include most government agency securities, investment-grade corporate bonds, certain mortgage products, certain bank and bridge loans, repos and reverse repos, less liquid listed equities, state and municipal obligations, most physical commodities, and certain money market securities and loan commitments and most OTC derivatives.

(3)

Instruments in this category have been valued using a valuation technique where at least one input (which could have a significant effect on the instrument’s valuation) is not based on observable market data. Where inputs can be observed from market data without undue cost and effort, the observed input is used. Otherwise, the Group determines a reasonable level for the input.

Financial instruments included within level 3 of the fair value hierarchy primarily consist of cash instruments which trade infrequently, certain syndicated and commercial mortgage loans, unlisted equity shares, certain residual interests in securitisations, super senior tranches of high grade and mezzanine collateralised debt obligations (CDOs), and other mortgage-based products and less liquid debt securities, certain structured debt securities in issue and OTC derivatives where valuation depends upon unobservable inputs such as certain credit and exotic derivatives. No gain or loss is recognised on the initial recognition of a financial instrument valued using a technique incorporating significant unobservable data.

(4)	Other financial liabilities comprise subordinated liabilities and write downs relating to undrawn syndicated loan facilities.

Level 3 portfolios

Level 3 loans and advances decreased by £10 billion, primarily reflecting reclassification of certain loans (leveraged finance and other corporate loans) to loans and receivables (LAR) and fair value adjustments on the remaining portfolio at the end of the year.

Debt securities categorised as level 3 at the end of the year include £4.4 billion of asset-backed securities and £1.7 billion of corporate and other debt securities. The decrease during the year reflects termination of a deal in early 2008, reclassification of illiquid mortgage-backed securities (MBS) to loans and receivables, fair value changes, and the transfer of certain previous illiquid MBS, primarily sub-prime from level 3 to level 2.

Level 3 derivative assets at 31 December 2008 include credit derivative trades with credit derivative product companies (CDPCs) with a fair value of £2.8 billion (2007 – £90 million) after credit valuation adjustments of £0.7 billion (2007 – nil). Other level 3 derivative assets at 31 December 2008 include illiquid credit default swaps (CDSs), other credit derivatives, commodity derivatives and illiquid interest rate derivatives.

Debt securities in issue, categorised as level 3, were structured medium term notes and the decrease in the year primarily reflects the termination of a deal in the first half of 2008.

The tables below presents the Level 3 financial instruments carried at fair value as at the balance sheet date, valuation basis, main assumptions used in the valuation of these instruments and reasonably possible increases or decreases in fair value based on reasonably possible alternative assumptions:

					Reasonably possible
					alternative assumptions
			Carrying		Increase in		Decrease in
Valuation basis/		Main	value		fair value		fair value
Assets	technique	assumptions	£bn			£m		£m
Loans and advances	Proprietary model	Credit spreads, indices		3.1		70		50
Debt securities:
– RMBS (1)	Industry standard model	Prepayment rates, probability of default, loss severity and yield		0.5		40		90
– CMBS (2)	Industry standard model	Prepayment rates, probability of default, loss severity and yield		0.5		20		20
– CDOs	Proprietary model	Implied collateral valuation, defaults rates, housing prices, correlation		1.1		230		230
– CLOs (3)	Industry standard simulation model	Credit spreads, recovery rates, correlation		1.0		40		40
– Other	Proprietary model	Credit spreads		3.0		50		50
Derivatives
– credit	Proprietary CVA model, industry option models, correlation model	Counterparty credit risk, correlation, volatility		4.4		580		560
– interest rate and commodity	Proprietary model	Volatility, correlation		1.9		130		130
Equity shares – private equity	Valuation statements	Fund valuations		0.5		70		140
2008				16.0		1,230		1,310
2007				27.7		510		600

Notes:
(1)	Residential mortgage-backed securities.
(2)	Commercial mortgage-backed securities.
(3)	Collateralised loan obligations.

Notes on the accounts continued

10 Financial instruments (continued)

					Reasonably possible alternative assumptions
Liabilities	Valuation basis/ technique	Main assumptions	Carrying amount £bn		Increase fair value £m		Decrease fair value £m
Debt securities in issue	Proprietary model	Credit spreads		0.8		20		20
Derivatives:
Credit derivatives	Proprietary CVA model,	Counterparty credit risk,		1.6		100		100
	industry option models, correlation model	correlation, volatility
Other derivatives	Proprietary model	Volatility, correlation		1.2		90		90
Other portfolios	Proprietary model	Credit spreads, correlation		0.6		40		60
2008				4.2		250		270
2007				9.2		25		25

For each of the portfolio categories shown in the above table, set out below is a description of the types of products that comprise the portfolio and the valuation techniques that are applied in determining fair value, including a description of valuation techniques used, including for those in level 2, and inputs to those models and techniques. Where reasonably possible alternative assumptions of unobservable inputs used in models would change the fair value of the portfolio significantly, the alternative inputs are indicated along with the impact this would have on the fair value. Where there have been significant changes to valuation techniques during the year a discussion of the reasons for this are also included.

Loans and advances to customers

Loans in level 3 primarily comprise US commercial mortgages and syndicated loans.

Commercial mortgages

These senior and mezzanine commercial mortgages are loans secured on commercial land and buildings that were originated or acquired by GBM for securitisation. Senior commercial mortgages carry a variable interest rate and mezzanine or more junior commercial mortgages may carry a fixed or variable interest rate. Factors affecting the value of these loans may include, but are not limited to, loan type, underlying property type and geographic location, loan interest rate, loan to value ratios, debt service coverage ratios, prepayment rates, cumulative loan loss information, yields, investor demand, market volatility since the last securitisation, and credit enhancement. Where observable market prices for a particular loan are not available, the fair value will typically be determined with reference to observable market transactions in other loans or credit related products including debt securities and credit derivatives. Assumptions are made about the relationship between the loan and the available benchmark data. Using reasonably possible alternative assumptions for credit spreads (taking into account all other applicable factors) would reduce the fair value of these mortgages of £1.1 billion by up to £18 million or increase the fair value by up to £25 million.

Syndicated lending

The Group’s syndicated lending activities are conducted by the syndicate business in conjunction with the various product lines covering corporate, leveraged, real estate and project finance activities. When a commitment to lend is entered into, the Group estimates the proportion of the loan that is intended to be held for trading on draw down, and the proportion it anticipates to retain on its balance sheet as a loan and receivable. Where the commitment is intended to be syndicated, the commitment to lend is fair valued through profit or loss. On drawdown, the portion of the loan expected to be syndicated is recorded at fair value as a held-for-trading asset, and the expected hold portion is measured at amortised cost less, where appropriate, impairment.

The Group values the portion of the loan expected to be syndicated held at fair value by using market observable syndication prices in the same or similar assets. Where these prices are not available, a discounted cash flow model is used. The model incorporates observable assumptions such as current interest rates and yield curves, the notional and tender amount of the loan, and counterparty credit quality where it is derived from credit default swap spreads using market indices. The model also incorporates unobservable assumptions, including expected refinancing periods, and counterparty credit quality where it is derived from the Group’s internal risk assessments. Derivatives arising from commitments to lend are measured using the same model, based on proxy notional amounts.

Using reasonably possible alternative assumptions for expected cash flows to value these assets of £2.0 billion would reduce the fair value by up to £32 million or increase the fair value by up to £45 million. The assumptions to determine these amounts were based on restructuring scenarios and expected margins.

Debt securities

Residential mortgage backed securities (RMBS)

RMBS where the underlying assets are US agency-backed mortgages and there is regular trading are generally classified as level 2 in the fair value hierarchy. RMBS are also classified as level 2 when regular trading is not prevalent in the market, but similar executed trades or third-party data including indices, broker quotes and pricing services can be used to substantiate the fair value. RMBS are classified as level 3 when trading activity is not available and a model is utilised which uses significant unobservable data.

In determining whether an instrument is similar to that being valued, the Group considers a range of factors, principally: the lending standards of the brokers and underwriters that originated the mortgages, the lead manager of the security, the issue date of the respective securities, the underlying asset composition (including origination date, loan to value ratios, historic loss information and geographic location of the mortgages), the credit rating of the instrument, and any credit protection that the instrument may benefit from, such as insurance wraps or subordinated tranches. Where there are instances of market observable data for several similar RMBS tranches, the Group considers the extent of similar characteristics shared with the instrument being valued, together with the frequency,

tenor and nature of the trades that have been observed. This method is most frequently used for US and UK RMBS. The RMBS of Dutch and Spanish originated mortgages guaranteed by those governments are valued using the credit spreads of the respective government debt and certain assumptions made by the Group, or based on observable prices from Bloomberg or consensus pricing services.

Where there is an absence of trading activity, models are used. The Group primarily uses an industry standard model to project the expected future cash flows to be received from the underlying mortgages and to forecast how these cash flows will be distributed to the various holders of the RMBS. This model utilises data provided by the servicer of the underlying mortgage portfolio, layering on assumptions for mortgage prepayments, probability of default, expected losses, and yield. The Group uses data from third-party sources to calibrate its assumptions, including pricing information from third party pricing services, independent research, broker quotes, and other independent sources. An assessment is made of third-party data source to determine its applicability and reliability. The Group adjusts the model price with a liquidity premium to reflect the price that the instrument could be traded at in the market and may also make adjustments for model deficiencies.

The weighted average of the key significant inputs utilised in valuing US level 3 RMBS positions are shown in the table below.

	Weighted–average inputs
2008	Non-agency prime RMBS			Alt-A RMBS
Yield		11.02	%		20.69	%
Probability of default	3.00 CDR(1)			40.00 CDR(1)
Loss severity		45.00	%(2)		52.25	%(2)
Prepayment	12.67 CPR			10.65 CPR

Notes:

(1) Constant default rate or probability of default.

(2) Constant prepayment rate.

The fair value of securities within each class of asset changes on a broadly consistent basis in response to changes in given market factors. However, the extent of the change, and therefore the range of reasonably possible alternative assumptions, may be either more or less pronounced, depending on the particular terms and circumstances of the individual security. Through most of 2008, while default rates on sub-prime mortgages were on the rise, there was less transparency and historical data to predict future defaults on both Alt-A and prime securities. As such, the Group felt that probability of default was the least transparent input into Alt-A and prime RMBS modelled valuations throughout 2008 (and most sensitive to variations). The Group believes that a range of 500 basis points greater than and 500 basis points less than the weighted average constant default rate, and a range of 200 basis points greater than and 200 basis points less than the weighted average constant default rate represents a reasonably possible set of acceptable pricing alternatives for Alt-A and prime RMBS, respectively. These assumptions consider the inherently risky nature of Alt-A over prime securities, as well as declining economic condition leading to an increased likelihood of default at year-end. While other key inputs may possess characteristics of unobservability in both Alt-A and prime modelled valuations, the effect of utilising reasonably possible alternatives for these respective inputs would have an immaterial effect on the overall valuation. Using these reasonably possible alternative assumptions the fair value of RMBS of £0.5 billion would be £90 million lower or £40 million higher.

Commercial mortgage backed securities

CMBS is valued using an industry standard model and the inputs, where possible, are corroborated using observable market data.

For senior CMBS and subordinated tranches, the Group determined that the most sensitive input to reasonably possible alternatives valuation is probability of default and yield respectively. Using reasonably possible alternative assumptions for these inputs, the fair value of CMBS of £0.5 billion would be £20 million lower or £20 million higher.

Collateralised debt obligations

CDOs purchased from third parties are valued using independent, third- party quotes or independent lead manager indicative prices. For super senior CDOs which have been originated by the Group no specific third- party information is available. The valuation of these super senior CDOs therefore takes into consideration outputs from a proprietary model, market data and appropriate valuation adjustments.

The Group’s proprietary model calculates the expected cashflows from the underlying mortgages using assumptions, derived from publicly available data on future macroeconomic conditions (including house price appreciation and depreciation) and on defaults and delinquencies on these underlying mortgages. The model used by the Group comprises an econometric loan-level model which provides the input to an industry standard ABS model, the output of which feeds a proprietary model generating expected cashflows which are discounted using a risk adjusted rate.

Notes on the accounts continued

10 Financial instruments (continued)

Due to the subjectivity of the inputs to the pricing model, alternative valuation points are constructed to benchmark the output of the model. These valuation points include determining an ABS index implied collateral valuation, which provides a market calibrated valuation data point. A collateral net asset value methodology is also considered which uses dealer buy side marks to determine an upper bound for super senior CDO valuations. Both the ABS index implied valuation and the collateral net asset value methodology apply an assumed immediate liquidation approach.

The Group, using all pricing points available, may make necessary and appropriate valuation adjustments to the pricing information derived from the proprietary model. These adjustments reflect the Group’s assessment of factors that market participants would consider in setting a price, to the extent that these factors that have not already been included in the model and may include adjustments made for liquidity discounts.

In order to provide disclosures of the valuation of super senior CDOs using reasonably possible alternative assumptions, the Group has considered macroeconomic conditions, including house price appreciation and depreciation, and the effect of regional variations. The output from using these alternative assumptions has been compared with inferred pricing from other published data. The Group believes that reasonably possible alternative assumptions could reduce or increase valuations by up to 4%. Using these alternative assumptions would reduce the fair value of level 3 CDOs of £1.1 billion by up to £230 million (super senior CDOs: £190 million) and increase the fair value by up to £230 million (super senior CDOs: £190 million).

Collateralised loan obligations

To determine the fair value of CLOs purchased from third parties, the Group use third-party broker or lead manager quotes as the primary pricing source. These quotes are benchmarked to consensus pricing sources where they are available.

For CLOs originated and still held by the Group, the fair value is determined using a correlation model based on a Monte Carlo simulation framework. The main model inputs are credit spreads and recovery rates of the underlying assets and their correlation. A credit curve is assigned to each underlying asset based on prices, from third- party dealer quotes, and cash flow profiles, sourced from an industry standard model. Losses are calculated taking into account the attachment and detachment point of the exposure. As the correlation inputs to this model are not observable CLOs are deemed to be level 3. Using reasonably possible alternative assumptions the fair value of CLOs of £1.0 billion would be £40 million lower or £40 million higher.

Other debt securities

Other level 3 debt securities comprise £1.3 billion of other ABS of £1.7 billion of other debt securities. Where observable market prices for a particular debt security are not available, the fair value will typically be determined with reference to observable market transactions in other related products, such as similar debt securities or credit derivatives. Assumptions are made about the relationship between the individual debt security and the available benchmark data. Where significant management judgement has been applied in identifying the most relevant related product, or in determining the relationship between the related product and the instrument itself, the valuation is shown in level 3. Using differing assumptions about this relationship would result in different fair values for these assets. The main assumption made is that of relative creditworthiness. Using reasonably possible alternative assumption credit assumptions, taking into account the underlying currency, tenor, and rating of the debt securities within each portfolio, would reduce the fair value of the debt securities of £3.0 billion by up to £50 million or increase the fair value by up to £50 million.

Derivatives

Level 3 derivative assets comprised credit derivatives of £4.4 billion and interest rate, foreign exchange rate and commodity derivative contracts of £1.9 billion. Derivative liabilities comprise credit derivatives of £1.6 billion and interest rate, foreign exchange rate and commodity derivatives contracts of £1.2 billion.

Derivatives are priced using quoted prices for the same or similar instruments where these are available. However, the majority of derivatives are valued using pricing models. Inputs for these models are usually observed directly in the market, or derived from observed prices. However, it is not always possible to observe or corroborate all model inputs. Unobservable inputs used are based on estimates taking into account a range of available information including historic analysis, historic traded levels, market practice, comparison to other relevant benchmark observable data and consensus pricing data.

Credit derivatives

The Group’s credit derivatives include vanilla and bespoke portfolio tranches, gap risk products and certain other unique trades. The bespoke portfolio tranches are synthetic tranches referenced to a bespoke portfolio of corporate names on which the Group purchases credit protection. Bespoke portfolio tranches are valued using Gaussian Copula, a standard method which uses observable market inputs (credit spreads, index tranche prices and recovery rates) to generate an output price for the tranche via a mapping methodology. In essence this method takes the expected loss of the tranche expressed as a fraction of the expected loss of the whole underlying portfolio and calculates which detachment point on the liquid index, and hence which correlation level, coincides with this expected loss fraction. Where the inputs into this valuation technique are observable in the market, bespoke tranches are considered to be level 2 assets. Where inputs are not observable, bespoke tranches are considered to be level 3 assets. However, all transactions executed with a CDPC counterparty are considered level 3 as the counterparty credit risk assessment is a significant component of these valuations.

Gap risk products are leveraged trades, with the counterparty’s potential loss capped at the amount of the initial principal invested. Gap risk is the probability that the market will move discontinuously too quickly to exit a portfolio and return the principal to the counterparty without incurring losses, should an unwind event be triggered. This optionality is embedded within these portfolio structures and is very rarely traded outright in the market. Gap risk is not observable in the markets and, as such, these structures are deemed to be level 3 instruments.

Other unique trades are valued using a specialised model for each instrument and the same market data inputs as all other trades where applicable. By their nature, the valuation is also driven by a variety of other model inputs, many of which are unobservable in the market.

Where these instruments have embedded optionality it is valued using a variation of the Black-Scholes option pricing formula, and where they have correlation exposure it is valued using a variant of the Gaussian Copula model. The volatility or unique correlation inputs required to value these products are generally unobservable and the instruments are therefore deemed to be level 3 instruments.

Other derivatives

Exotic equity, interest rate and commodity options provide a payout (or series of payouts) linked to the performance of one or more underlying, including equities, interest rates, foreign exchange rates and commodities. Included in commodities derivatives are energy contracts entered into by RBS Sempra Commodities. Most of these contracts are valued using models that incorporate observable data. A small number are more complex, structured derivatives which incorporate in their valuation assumptions regarding power price volatilities and correlation between inputs, which are not market observable. These include certain tolling agreements, where power is purchased in return for a given quantity of fuel, and load deals, where a seller agrees to deliver a fixed proportion of power used by a client’s utility customers.

Exotic options do not trade in active markets except in a small number of cases. Consequently, the Group uses models to determine fair value using valuation techniques typical for the industry. These techniques can be divided, firstly, into modelling approaches and, secondly, into methods of assessing appropriate levels for model inputs. The Group uses a variety of proprietary models for valuing exotic trades. Exotic valuation inputs include correlation between equities, interest rates, foreign exchange rates and commodity prices. Correlations for more liquid equity and rate pairs are valued using independently sourced consensus pricing levels. Where a consensus pricing benchmark is unavailable, these instruments are categorised as level 3.

Reasonably possible alternative assumptions

In determining the effect of reasonably possible alternative assumptions for unobservable inputs, the Group has considered credit derivative trades with CDPCs separately from all other level 3 derivatives due to the significant element of subjectivity in determining the counterparty credit risk.

The fair value of credit derivative trades with CDPCs as at 31 December 2008 was £2.6 billion before applying a CVA of £0.7 billion. The Group’s credit derivative exposures to CDPCs are valued using pricing models with inputs observed directly in the market. An adjustment is made to the model valuation as the creditworthiness of CDPC counterparties differs from that of the credit risk assumptions used in the model. The adjustment reflects the estimated cost of hedging the counterparty risk arising from each trade. In the absence of market observable credit spreads of CDPCs, the cost of hedging the counterparty risk is estimated from an analysis of the underlying trades and the cost of hedging expected default losses in excess of the capital available in each vehicle. A reasonably possible alternative approach would be to estimate the cost of hedging the counterparty risk from market observable credit spreads of entities considered similar to CDPCs (for example monoline insurers with similar business or similarly rated entities). These reasonably possible alternative approaches would reduce the fair value credit derivatives with CDPCs by up to £390 million or increase the fair value by up to £400 million.

For all other level 3 derivatives, unobservable inputs are principally comprised of correlations and volatilities. Where a derivative valuation relies significantly on an unobservable input, the valuation is shown in level 3. It is usual for such derivative valuations to depend on several observable, and one or few unobservable model inputs. In determining reasonably possible alternative assumptions, the relative impact of unobservable inputs as compared to those which may be observed was considered. Using reasonably possible alternative assumptions the fair value of all other level 3 derivative assets (excluding CDPCs) would be reduced by up to £300 million or increased by up to £310 million and derivative liabilities would be reduced by up to £190 million or increased by up to £190 million.

Equity shares – private equity

Private equity investments include unit holdings and limited partnership interests primarily in corporate private equity funds, debt funds and fund of hedges funds. Externally managed funds are valued using recent prices where available. Where not available, the fair value of investments in externally managed funds is generally determined using statements or other information provided by the fund managers.

Although such valuations are provided from third parties, the Group recognises that such valuations may rely significantly on the judgements and estimates made by those fund managers, particularly in assessing private equity components. Following the decline in liquidity in world markets, the Group believes that there is sufficient subjectivity in such valuations to report them in level 3.

Reasonably possible alternative valuations have been determined based on the historic trends in valuations received, and by considering the possible impact of market movements towards the end of the reporting period, which may not be fully reflected in valuations received. Using these reasonably possible alternate assumptions would reduce the fair value of externally managed funds of £0.5 billion by up to £140 million or increase the fair value by up to £70 million.

Other financial instruments

Other than the portfolios discussed above, there are other financial instruments which are held at fair value determined from data which are not market observable, or incorporating material adjustments to market observed data. Using reasonably possible alternate assumptions appropriate to the liability in question, such as credit spreads, derivative inputs and equity correlations, would reduce the fair value of other financial instruments held at fair value of £1.4 billion, mainly debt securities in issue of £0.8 billion, by up to £80 million or increase the fair value by up to £60 million.

Notes on the accounts continued

10 Financial instruments (continued)

Own credit

When valuing financial liabilities recorded at fair value, the Group takes into account the effect of its own credit standing. The categories of financial liabilities on which own credit spread adjustments are made are issued debt, including issued structured notes, and derivatives. An own credit adjustment is applied to positions where it is believed that counterparties would consider the Group’s creditworthiness when pricing trades.

For issued debt and structured notes, this adjustment is based on independent quotes from market participants for the debt issuance spreads above average inter-bank rates (at a range of tenors) which the market would demand when purchasing new senior or sub-debt issuances from the Group. Where necessary, these quotes are interpolated using a curve shape derived from CDS prices.

The fair value of the Group’s derivative financial liabilities reflects the Group’s own credit risk. The adjustment takes into account collateral posted by the Group and the effects of master netting agreements. No adjustments were made for own credit risk in relation to derivative liabilities in prior periods as it was not a significant factor in the pricing of derivative transactions by market participants. The change in methodology reflects market turbulence in 2008 which led to participants focussing increased attention on counterparty credit quality.

The table below shows the own credit spread adjustments on liabilities recorded in the income statement during the year.

	Debt securities in issue
	Held-for- trading £m		Designated at fair value through profit and loss £m		Total £m		Derivatives £m		Total £m
At 1 January 2008		123		152		275		—		275
Effect of changes to credit spreads		396		373		769		360		1,129
Benefit of foreign exchange hedges		208		195		403		—		403
New issues		78		97		175		—		175
At 31 December 2008		805		817		1,622		360		1,982

Reclassification of financial instruments

As discussed in accounting policies on page 61, during 2008 the Group reclassified financial assets from the held-for-trading (HFT) and available-for- sale categories (AFS) into the loans and receivables (LAR) category (as permitted by paragraph 50D of IAS 39 as amended) and from the held-for-trading category into the available-for-sale category (as permitted by paragraph 50B of IAS 39 as amended).

The turbulence in the financial markets during the second half of 2008 was regarded by management as rare circumstances in the context of paragraph 50B of IAS 39 as amended.

The balance sheet values of these assets, the effect of the reclassification on the income statement for the period from the date of reclassification to 31 December 2008 and the gains and losses relating to these assets recorded in the income statement for the years ended 31 December 2008, 2007 and 2006 were as follows:

	Group
											2008														2007			2006
	2008 – on reclassification						31 December 2008							After reclassification
	Carrying value		Effective interest rate		Expected cash flows		Carrying value		Fair value		Gains/(losses) up to the date of reclassi- fication			Income		Impairment losses			Gains/ (losses) in AFS reserves			Amount that would have been recognised			Gains/(losses) recognised in the income statement in prior periods
		£m	%			£m		£m		£m		£m			£m		£m			£m			£m			£m			£m
Reclassified from HFT to LAR:
Loans:
Leveraged finance		3,602		10.15		6,083		4,304		2,523		(457	)		454		—						(1,206	)		(155	)		—
Corporate loans		5,040		6.19		7,582		5,827		4,940		(76	)		198		—						(681	)		(50	)		3
		8,642				13,665		10,131		7,463		(533	)		652		—						(1,887	)		(205	)		3
Debt securities:
CDO of RMBS		215		4.92		259		236		221		4			5		—						(11	)		5			6
RMBS		1,534		6.05		1,815		1,695		1,311		(108	)		157		—						(227	)		(12	)		—
CMBS		1		11.11		4		1		1		1			—		—						—			—			—
CLOs		744		6.65		1,040		827		598		(21	)		104		—						(125	)		(14	)		(2	)
Other ABS		1,649		5.24		2,547		1,757		1,382		(61	)		116		—						(259	)		3			(1	)
Other		2,538		2.62		2,764		2,602		2,388		72			3		—						(166	)		94			476
		6,681				8,429		7,118		5,901		(113	)		385		—						(788	)		76			479
Total		15,323				22,094		17,249		13,364		(646	)		1,037		—						(2,675	)		(129	)		482
Reclassified from HFT to AFS:
Debt securities:
CDO of RMBS		3,382		4.65		4,178		3,077		3,077		(438	)		1,281		(43	)		(441	)		798			(119	)		—
RMBS		5,205		8.03		8,890		5,171		5,171		(530	)		24		—			(162	)		(122	)		(4	)		73
CMBS		32		6.81		85		31		31		(5	)		5		—			(3	)		2			(4	)		—
CLOs		1,207		4.88		1,477		1,063		1,063		(128	)		435		—			(267	)		168			(34	)		1
Other ABS		786		4.47		1,262		761		761		(67	)		64		—			(42	)		22			(8	)		72
Other		210		20.23		610		175		175		7			4		—			(58	)		(41	)		—			—
		10,822				16,502		10,278		10,278		(1,161	)		1,813		(43	)		(973	)		827			(169	)		146
Reclassified from AFS to LAR:
Debt securities		704		1.38		772		1,028		968		(12	)(1)		6		—			—			(37	) (1)		—			—
Total		26,849				39,368		28,555		24,610		(1,819	)		2,856		(43	)		(973	)		(1,885	)		(298	)		628

Note:

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

Notes on the accounts continued

10 Financial instruments (continued)

	Bank
											After
	2008 – on reclassification						31 December 2008				reclassification
											Gains/
			Effective		Expected						(losses)
	Carrying		interest		cash		Carrying		Fair		in AFS
	value		rate		flows		value		value		reserves
2008		£m	%			£m		£m		£m		£m
Reclassified from HFT to LAR:
Loans:
Leveraged finance		3,602		10.15		6,083		4,304		2,523		—
Corporate loans		4,874		6.10		6,960		5,625		4,738		—
		8,476				13,043		9,929		7,261		—
Debt securities:
CDO of RMBS		215		4.92		259		236		221		—
RMBS		1,533		6.05		1,815		1,695		1,311		—
CMBS		1		11.11		4		1		1		—
CLOs		744		6.65		1,040		827		598		—
Other ABS		1,649		5.24		2,547		1,757		1,382		—
Other		2,538		2.62		2,765		2,602		2,387		—
		6,680				8,430		7,118		5,900		—
Total		15,156				21,473		17,047		13,161		—
Reclassified from HFT to AFS:
Debt securities:
CDO of RMBS		3,382		4.65		4,177		3,077		3,077		(441	)
RMBS		5,205		8.03		8,890		5,171		5,171		(162	)
CMBS		32		6.81		85		31		31		(3	)
CLOs		1,207		4.88		1,477		1,063		1,063		(267	)
Other ABS		786		4.47		1,262		761		761		(42	)
Other		210		20.23		610		175		175		(58	)
		10,822				16,501		10,278		10,278		(973	)
Reclassified from AFS to LAR:
Debt securities (1)		704		1.38		772		1,028		968		—
Total		26,682				38,746		28,353		24,407		(973	)

Note:

(1) The available-for-sale reserve was £12 million loss to the date of reclassification and would have increased by a further £37 million loss if reclassification had not occurred.

Amounts included in the income statement:			Group
	2008		2007		2006
		£m		£m		£m
Gains on financial assets/liabilities designated as at fair value through profit or loss		198		721		344
Gains on disposal or settlement of loans and receivables		4		10		21

On the initial recognition of financial assets and liabilities valued using valuation techniques incorporating information other than observable market data, any difference between the transaction price and that derived from the valuation technique is deferred. Such amounts are recognised in profit or loss over the life of the transaction; when market data become observable; or when the transaction matures or is closed out as appropriate. At 31 December 2008, net gains of £42 million (2007 – £62 million) were carried forward in the balance sheet. During the year net gains of £25 million (2007 – £57 million) were deferred and £47 million (2007 – £10 million) released to profit or loss.

Fair value of financial instruments not carried at fair value.

The following table shows the carrying values and the fair values of financial instruments on the balance sheets carried at amortised cost.

	Group								Bank
	2008		2008		2007		2007		2008		2008		2007		2007
	Carrying		Fair		Carrying		Fair		Carrying		Fair		Carrying		Fair
	value		value		value		value		value		value		value		value
		£m		£m		£m		£m		£m		£m		£m		£m
Financial assets
Cash and balances at central banks		6,806		6,806		5,559		5,559		3,714		3,714		3,333		3,333
Loans and advances to banks
Loans and receivables		18,430		18,441		23,649		23,644		35,628		35,663		31,342		31,343
Loans and advances to customers
Loans and receivables		551,110		507,219		430,837		433,655		266,734		238,345		218,364		218,490
Finance leases		14,453		14,527		12,570		12,376		—		—		—		—
Debt securities
Loans and receivables		11,756		10,479		500		500		48,983		47,706		—		—
Settlement balances		10,871		10,871		5,326		5,326		5,335		5,335		2,046		2,046

Financial liabilities
Deposits by banks		95,044		94,414		79,794		79,614		116,140		115,993		125,707		125,697
Customer accounts		392,605		392,106		379,072		378,793		182,918		182,426		140,049		139,985
Debt securities in issue		163,787		158,707		111,656		111,676		99,057		98,700		61,527		61,530
Settlement balances and short positions		8,785		8,785		6,791		6,791		5,534		5,534		3,110		3,110
Subordinated liabilities		39,243		36,084		27,438		26,206		32,990		30,528		22,387		21,137

Notes:

(1)	Financial assets and financial liabilities for which carrying amount approximates to fair value because they are of short maturity.

(2)	Fair values are estimated by discounting expected future cash flows; using current interest rates and making adjustments for credit.

(3)

The fair value of deposits repayable on demand is equal to their carrying value. The fair value of other deposits by banks and customer accounts is estimated by discounting expected future cash flows at current rates and adjusting, where appropriate, for the Group’s own credit spread. The fair value of many of these instruments approximates to their carrying value because they are of short maturity or reprice frequently.

(4)	The fair value of short-term debt securities in issue is close to their carrying value. The fair value of other debt securities in issue is based on quoted prices; where these are unavailable fair value is estimated using other valuation techniques.

(5)	The fair value of subordinated liabilities in issue is based on quoted prices; where these are unavailable fair value is estimated using other valuation techniques.

Notes on the accounts continued

10 Financial instruments (continued)

Remaining maturity

The following tables show the residual maturity of financial instruments, based on contract date of maturity.

	Group
	2008						2007
	Less than		More than				Less than		More than
	12 months		12 months		Total		12 months		12 months		Total
		£m		£m		£m		£m		£m		£m
Assets
Cash and balances at central banks		6,804		2		6,806		5,559		—		5,559
Loans and advances to banks		77,874		1,513		79,387		91,951		4,395		96,346
Loans and advances to customers		245,607		373,896		619,503		251,553		299,896		551,449
Debt securities		54,909		122,857		177,766		34,593		129,839		164,432
Equity shares		—		2,691		2,691		—		5,509		5,509
Settlement balances		10,869		2		10,871		5,298		28		5,326
Derivatives		175,147		762,310		937,457		41,432		164,543		205,975

Liabilities
Deposits by banks		176,319		5,663		181,982		143,919		7,589		151,508
Customer accounts		438,114		15,015		453,129		430,297		12,685		442,982
Debt securities in issue		122,495		57,447		179,942		79,552		50,580		130,132
Settlement balances and short positions		18,090		27,867		45,957		30,597		23,252		53,849
Derivatives		166,208		742,897		909,105		45,362		157,710		203,072
Subordinated liabilities		1,859		38,092		39,951		811		26,985		27,796

	Bank
	2008						2007
	Less than		More than				Less than		More than
	12 months		12 months		Total		12 months		12 months		Total
		£m		£m		£m		£m		£m		£m
Assets
Cash and balances at central banks		3,714		—		3,714		3,333		—		3,333
Loans and advances to banks		84,230		7,487		91,717		85,920		6,062		91,982
Loans and advances to customers		179,790		147,250		327,040		185,992		143,155		329,147
Debt securities		48,458		111,240		159,698		27,045		80,205		107,250
Equity shares		—		1,020		1,020		—		4,019		4,019
Settlement balances		5,334		1		5,335		2,018		28		2,046
Derivatives		172,539		765,966		938,505		41,750		166,163		207,913

Liabilities
Deposits by banks		194,512		6,754		201,266		190,825		6,143		196,968
Customer accounts		200,767		28,499		229,266		183,887		14,039		197,926
Debt securities in issue		83,500		31,649		115,149		58,420		21,457		79,877
Settlement balances and short positions		13,277		16,084		29,361		26,100		7,577		33,677
Derivatives		163,500		747,674		911,174		45,367		158,867		204,234
Subordinated liabilities		850		32,848		33,698		603		22,142		22,745

Balance sheet

The following tables show the contractual undiscounted cash flows payable up to a period of 20 years including future payments of interest.

	Group
	0-3 months		3-12 months		1-3 years		3-5 years		5-10 years		10-20 years
2008		£m		£m		£m		£m		£m		£m
Deposits by banks		83,879		5,938		3,114		1,758		662		34
Customer accounts		368,115		18,634		2,313		2,811		4,105		2,718
Debt securities in issue		110,728		30,213		22,461		3,581		5,600		4,038
Derivatives held for hedging		67		755		1,926		674		597		317
Subordinated liabilities		972		2,659		5,113		5,583		17,213		13,287
Settlement balances and other liabilities		10,407		5		7		4		7		6
		574,168		58,204		34,934		14,411		28,184		20,400
2007
Deposits by banks		71,944		4,739		1,539		2,344		39		48
Customer accounts		367,881		6,043		1,833		1,697		4,732		2,488
Debt securities in issue		73,927		20,638		15,256		7,789		4,884		2,200
Derivatives held for hedging		38		357		531		227		210		97
Subordinated liabilities		402		1,909		4,686		3,305		15,770		9,540
Settlement balances and other liabilities		7,242		5		14		6		12		7
		521,434		33,691		23,859		15,368		25,647		14,380

	Bank
	0-3 months		3-12 months		1-3 years		3-5 years		5-10 years		10-20 years
2008		£m		£m		£m		£m		£m		£m
Deposits by banks		102,525		9,033		2,990		1,840		778		47
Customer accounts		156,050		16,035		1,216		4,353		4,241		2,801
Debt securities in issue		59,229		25,623		18,247		2,299		4,752		2,178
Derivatives held for hedging		24		195		349		154		206		152
Subordinated liabilities		718		1,541		3,210		4,832		16,647		10,819
Settlement balances and other liabilities		6,621		—		—		—		—		—
		325,167		52,427		26,012		13,478		26,624		15,997
2007
Deposits by banks		115,262		6,782		2,170		1,859		901		58
Customer accounts		125,043		4,170		3,978		3,197		4,840		2,673
Debt securities in issue		39,694		17,282		8,155		1,801		2,478		2,123
Derivatives held for hedging		36		143		157		101		110		31
Subordinated liabilities		328		1,172		2,994		2,681		14,536		7,889
Settlement balances and other liabilities		3,093		1		8		4		8		—
		283,456		29,550		17,462		9,643		22,873		12,774

The tables above show the timing of cash outflows to settle financial liabilities. They have been prepared on the following basis:

Financial liabilities are included at the earliest date on which the counterparty can require repayment regardless of whether or not such early repayment results in a penalty. If repayment is triggered by, or is subject to, specific criteria such as market price hurdles being reached, the liability is included at the earliest possible date that the conditions could be fulfilled without considering the probability of the conditions being met. For example, if a structured note is automatically prepaid when an equity index exceeds a certain level, the cash outflow will be included in the less than three months period whatever the level of the index at the year end. The settlement date of debt securities in issue issued by certain securitisation vehicles consolidated by the Group depends on when cash flows are received from the securitised assets. Where these assets are prepayable, the timing of the cash outflow relating to securities assumes that each asset will be prepaid at the earliest possible date.

Liabilities with a contractual maturity of greater than 20 years – the principal amounts of financial liabilities that are repayable after 20 years or where the counterparty has no right to repayment of the principal are excluded from the table as are interest payments after 20 years.

Held-for-trading liabilities – held-for-trading liabilities amounting to £1,091.7 billion (2007 – £392.2 billion) and £1,069.6 billion (2007 – £373.0 billion) for the Bank have been excluded from the table in view of their short term nature.

Notes on the accounts continued

11 Past due and impaired financial assets

The following tables show the movement in the provision for impairment losses for loans and advances.

	Group
	Individually			Collectively						Total
	assessed			assessed			Latent			2008			2007			2006
		£m			£m			£m			£m			£m			£m
At 1 January		639			2,996			600			4,235			3,929			3,886
Currency translation and other adjustments		164			113			176			453			30			(62	)
(Disposals)/acquisitions		—			(148	)		(30	)		(178	)		6			—
Amounts written-off		(636	)		(1,811	)		—			(2,447	)		(1,652	)		(1,841	)
Recoveries of amounts previously written-off		23			188			—			211			245			215
Charged to the income statement		1,790			2,183			582			4,555			1,843			1,873
Unwind of discount		(33	)		(141	)		—			(174	)		(166	)		(142	)
At 31 December (1)		1,947			3,380			1,328			6,655			4,235			3,929

Note:

(1) The provision for impairment losses at 31 December 2008 includes £83 million relating to loans and advances to banks (2007 – £2 million; 2006 – £2 million).

	Bank
	Individually			Collectively					Total
	assessed			assessed			Latent		2008			2007			2006
		£m			£m			£m		£m			£m			£m
At 1 January		277			814			182		1,273			1,353			1,219
Currency translation and other adjustments		91			1			—		92			(9	)		76
Amounts written-off		(358	)		(436	)		—		(794	)		(553	)		(634	)
Recoveries of amounts previously written-off		6			51			—		57			76			63
Charged to the income statement		1,212			519			177		1,908			471			692
Unwind of discount		(9	)		(52	)		—		(61	)		(65	)		(63	)
At 31 December		1,219			897			359		2,475			1,273			1,353

Note:

(1)	The provision for impairment losses at 31 December 2008 includes £81 million relating to loans and advances to banks (2007 and 2006 - nil).

	Group
	2008		2007		2006
		£m		£m		£m
Impairment charged to the income statement
Loans and advances to customers		4,474		1,843		1,873
Loans and advances to banks		81		—		—
		4,555		1,843		1,873
Debt securities		71		20		—
Equity shares		80		2		—
		151		22		—
		4,706		1,865		1,873
	Group
	2008		2007		2006
		£m		£m		£m
Gross income not recognised but which would have been recognised under the original terms of non-accrual and restructured loans
Domestic		384		390		370
Foreign		229		64		77
		613		454		447
Interest on non-accrual and restructured loans included in net interest income
Domestic		150		165		142
Foreign		24		16		15
		174		181		157

The following tables show analyses of impaired financial assets.

	2008						2007
					Net book						Net book
	Cost		Provision		value		Cost		Provision		value
Group		£m		£m		£m		£m		£m		£m
Impaired financial assets
Loans and advances to banks (1)		83		83		—		2		2		—
Loans and advances to customers (2)		13,643		5,244		8,399		6,665		3,633		3,032
Debt securities (1)		33		18		15		1		—		1
Equity shares (1)		164		124		40		54		45		9
		13,923		5,469		8,454		6,722		3,680		3,042

		2008					2007
					Net book						Net book
	Cost		Provision		value		Cost		Provision		value
Bank		£m		£m		£m		£m		£m		£m
Impaired financial assets
Loans and advances to banks (1)		81		81		—		—		—		—
Loans and advances to customers (3)		5,622		2,035		3,587		2,088		1,091		997
Debt securities (1)		17		2		15		—		—		—
Equity securities (1)		75		44		31		—		—		—
		5,795		2,162		3,633		2,088		1,091		997

Notes:
(1)	Impairment provisions individually assessed.
(2)	Impairment provisions individually assessed on balances of £6,864 million (2007 – £1,226 million).
(3)	Impairment provisions individually assessed on balances of £3,761 million (2007 – £518 million).

The Group and Bank hold collateral in respect of certain loans and advances to banks and to customers that are past due or impaired. Such collateral includes mortgages over property (both personal and commercial); charges over business assets such as plant, inventories and trade debtors; and guarantees of lending from parties other than the borrower.

The following table shows financial and non-financial assets, recognised on the Group's balance sheet, obtained during the year by taking possession of collateral or calling on other credit enhancements.

	Group
	2008		2007
		£m		£m
Residential property		41		31
Cash		59		18
Other assets		30		4
		130		53


	Bank
	2008		2007
		£m		£m
Cash		30		15

In general, the Group seeks to dispose of property and other assets obtained by taking possession of collateral that are not readily convertible into cash as rapidly as the market for the individual asset permits.

Notes on the accounts continued

11 Past due and impaired financial assets (continued)

The following loans and advances to customers were past due at the balance sheet date but not considered impaired:

	Group														Bank
							Past due										Past due
	Past due		Past due		Past due		90 days				Past due		Past due		Past due		90 days
	1-29 days		30-59 days		60-89 days		or more		Total		1-29 days		30-59 days		60-89 days		or more		Total
		£m		£m		£m		£m		£m		£m		£m		£m		£m		£m
2008		7,851		2,138		1,139		1,669		12,797		1,201		415		221		645		2,482

2007		6,233		1,613		981		256		9,083		1,703		440		190		168		2,501

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

Loans that have been renegotiated in the past 12 months that would otherwise have been past due or impaired amounted to £2,637 million (Bank – £2,141 million) as at 31 December 2008 (2007: Group – £577 million; Bank – £259 million).

12 Derivatives

Companies in the Group transact derivatives as principal either as a trading activity or to manage balance sheet foreign exchange, interest rate and credit risk.

The Group enters into fair value hedges, cash flow hedges and hedges of net investments in foreign operations. The majority of the Group’s interest rate hedges relate to the management of the Group’s non- trading interest rate risk. The Group manages this risk to Value-at-Risk limits. The risk is assessed using gap reports that show maturity mismatches. To the extent that such mismatches exceed predetermined limits they are closed by executing derivatives principally interest rate swaps. Suitable larger ticket financial instruments are fair value hedged; the remaining exposure, where possible, is hedged by derivatives documented as cash flow hedges and qualifying for hedge accounting. The majority of the Group’s fair value hedges involve interest rate swaps hedging the interest rate risk in recognised financial assets and financial liabilities. Cash flow hedges relate to exposure to variability in future interest payments and receipts on forecast transactions and on recognised financial assets and financial liabilities. The Group hedges its net investments in foreign operations with currency borrowings and forward exchange contracts.

For cash flow hedge relationships of interest rate risk, the hedged items are actual and forecast variable interest rate cash flows arising from financial assets and financial liabilities with interest rates linked to LIBOR, EURIBOR or the Bank of England Official Bank Rate. The financial assets are customer loans and the financial liabilities are customer deposits and LIBOR linked medium-term notes and other issued securities. As at 31 December 2008, variable rate financial assets of £24.0 billion for the Group and £21.3 billion for the Bank, and variable rate financial liabilities of £27.4 billion for the Group and £5.7 billion for the Bank were hedged in such cash flow hedge relationships.

For cash flow hedging relationships, the initial and ongoing prospective effectiveness is assessed by comparing movements in the fair value of the expected highly probable forecast interest cash flows with movements in the fair value of the expected changes in cash flows from the hedging interest rate swap or by comparing the respective changes in the price value of a basis point. Prospective effectiveness is measured on a cumulative basis i.e. over the entire life of the hedge relationship. The method of calculating hedge ineffectiveness is the hypothetical derivative method. Retrospective effectiveness is assessed by comparing the actual movements in the fair value of the cash flows and actual movements in the fair value of the hedged cash flows from the interest rate swap over the life to date of the hedging relationship.

For fair value hedge relationships of interest rate risk, the hedged items are typically large corporate fixed rate loans, fixed rate finance leases, fixed rate medium-term notes or preference shares classified as debt. As at 31 December 2008, fixed rate financial assets of £13.9 billion for the Group and £4.8 billion for the Bank, and fixed rate financial liabilities of £26.5 billion for the Group and £20.1 billion for the Bank were hedged by interest rate swaps in fair value hedge relationships.

The initial and ongoing prospective effectiveness of fair value hedge relationships is assessed on a cumulative basis by comparing movements in the fair value of the hedged item attributable to the hedged risk with changes in the fair value of the hedging interest rate swap. Retrospective effectiveness is assessed by comparing the actual movements in the fair value of the hedged items attributable to the hedged risk with actual movements in the fair value of the hedging derivative over the life to date of the hedging relationship.

	Group
	2008								2007
	Notional						Notional
	amounts		Assets		Liabilities		amounts		Assets		Liabilities
	£bn			£m		£m	£bn			£m		£m
Exchange rate contracts
Spot, forwards and futures		2,230		84,165		82,395		1,669		16,486		18,091
Currency swaps		848		41,004		44,241		359		8,231		7,628
Options purchased		656		39,025		—		450		11,943		—
Options written		702		—		37,024		469		—		11,317

Interest rate contracts
Interest rate swaps		36,701		517,731		502,408		20,479		115,928		114,799
Options purchased		5,774		99,924		—		3,886		27,609		—
Options written		3,887		—		97,842		3,424		—		27,553
Futures and forwards		9,049		8,530		7,273		2,805		708		876

Credit derivatives		2,111		131,680		122,198		1,112		21,234		18,537

Equity and commodity contracts		534		15,398		15,724		110		3,836		4,271
				937,457		909,105				205,975		203,072

Certain derivative asset and liability balances with the London Clearing House, which meet the offset criteria in IAS 32 ‘Financial Instruments: Presentation,’ are now shown net. Comparative figures have been restated, reducing derivative assets and liabilities at 31 December 2007 by £43,930 million for the Group and the Bank.

Included in the above are derivatives held for hedging purposes as follows:

	Group
	2008				2007
	Assets		Liabilities		Assets		Liabilities
		£m		£m		£m		£m
Fair value hedging:
Interest rate swaps		2,047		1,290		546		379

Cash flow hedging:
Exchange rate contracts		—		77		4		24
Interest rate swaps		2,168		2,178		369		777
Commodity contracts		39		14		—		—

Net investment hedging:
Exchange rate contracts		—		—		—		90

Amounts above include:
Due from/to holding company		361		1,168		179		173
Due from/to fellow subsidiaries		56,063		53,222		2,771		2,740

Notes on the accounts continued

12 Derivatives (continued)

Hedge ineffectiveness recognised in other operating income comprised:

	Group
	2008			2007			2006
		£m			£m			£m
Fair value hedging:
Gains on the hedged items attributable to the hedged risk		(949	)		66			219
Losses on the hedging instruments		905			(72	)		(215	)
Fair value ineffectiveness		(44	)		(6	)		4
Cash flow hedging ineffectiveness		(16	)		9			4
		(60	)		3			8

The following tables show for interest rate swaps in cash flow hedges for the Group, when the hedged cash flows are expected to occur and when they will affect profit or loss.

	2008
Hedged forecast cash flows		0-1			1-2			2-3			3-4			4-5			5-10			10-20		Over 20
Hedged forecast cash flows	years			years			years			years			years			years			years			years			Total
expected to occur		£m			£m			£m			£m			£m			£m			£m			£m			£m
Forecast receivable cash flows		648			641			568			459			329			869			240			41			3,795
Forecast payable cash flows		(417	)		(357	)		(273	)		(232	)		(197	)		(527	)		(307	)		(47	)		(2,357	)

	2008
Hedged forecast cash flows		0-1			1-2			2-3			3-4			4-5			5-10			10-20		Over 20
Hedged forecast cash flows	years			years			years			years			years			years			years			years			Total
affect profit or loss		£m			£m			£m			£m			£m			£m			£m			£m			£m
Forecast receivable cash flows		649			639			561			453			327			835			237			36			3,737
Forecast payable cash flows		(413	)		(355	)		(268	)		(229	)		(192	)		(513	)		(305	)		(47	)		(2,322	)

	Bank
	2008						2007
	Notional							Notional
	amounts		Assets		Liabilities			amounts		Assets		Liabilities
	£bn			£m		£m		£bn			£m		£m
Exchange rate contracts
Spot, forwards and futures		2,260		85,353		83,417			1,683		16,877		18,061
Currency swaps		863		41,783		48,100			363		8,896		7,927
Options purchased		659		39,133		—			452		12,022		—
Options written		706		—		37,134			471		—		11,400

Interest rate contracts
Interest rate swaps		36,786		522,729		504,692			20,544		116,633		115,141
Options purchased		5,750		99,648		—			3,816		27,549		—
Options written		3,873		—		97,812			3,364		—		27,545
Futures and forwards		8,991		8,524		7,270			2,781		707		876

Credit derivatives		2,358		132,531		123,555			1,124		21,539		18,998

Equity and commodity contracts		374		8,804		9,194			109		3,690		4,286
				938,505		911,174					207,913		204,234

100

Included in the above are derivatives held for hedging purposes as follows:

	Bank
	2008				2007
	Assets		Liabilities		Assets		Liabilities
		£m		£m		£m		£m
Fair value hedging:
Interest rate swaps		1,850		411		372		241

Cash flow hedging:
Exchange rate contracts		—		77		4		24
Interest rate swaps		1,907		498		271		236
Commodity contracts		39		—		—		—

Amounts above include:
Due from/to holding company		361		1,168		179		173
Due from/to fellow subsidiaries		56,054		52,954		2,771		2,740
Due from/to subsidiaries		12,445		11,141		4,059		2,443

The following tables show for interest rate swaps in cash flow hedges for the Bank, when the hedged cash flows are expected to occur and when they will affect profit or loss.

	2008
Hedged forecast cash flows		0-1			1-2			2-3			3-4			4-5			5-10			10-20		Over 20
Hedged forecast cash flows	years			years			years			years			years			years			years			years			Total
expected to occur		£m			£m			£m			£m			£m			£m			£m			£m			£m
Forecast receivable cash flows		594			587			521			418			300			771			177			41			3,409
Forecast payable cash flows		(137	)		(107	)		(66	)		(54	)		(49	)		(182	)		(175	)		(47	)		(817	)

	2008
Hedged forecast cash flows		0-1			1-2			2-3			3-4			4-5			5-10			10-20		Over 20
Hedged forecast cash flows	years			years			years			years			years			years			years			years			Total
affect profit or loss		£m			£m			£m			£m			£m			£m			£m			£m			£m
Forecast receivable cash flows		595			585			514			412			298			737			174			36			3,351
Forecast payable cash flows		(135	)		(107	)		(64	)		(54	)		(49	)		(180	)		(175	)		(47	)		(811	)

101

Notes on the accounts continued

13 Debt securities

	Group
												Mortgage
	UK central		US central			Other central			Bank and			and other
	and local		and local			and local			building			asset backed
	government		government			government			society			securities(1)			Corporate			Other(2)			Total
2008		£m		£m			£m			£m			£m			£m			£m			£m
Held-for-trading		5,363		9,842			33,223			1,590			35,771			15,275			709			101,773
Designated as at fair value through profit or loss		1,994		510			—			—			1			88			6			2,599
Available-for-sale		10,915		1,008			2,796			8,625			36,052			2,218			24			61,638
Loans and receivables		—		—			—			102			7,915			3,738			1			11,756
		18,272		11,360			36,019			10,317			79,739			21,319			740			177,766

Available-for-sale
Gross unrealised gains		16		30			25			13			308			1			1			394
Gross unrealised losses		—		(5	)		(95	)		(86	)		(2,763	)		(136	)		(1	)		(3,086	)

2007
Held-for-trading		8,952		14,405			36,410			1,016			50,606			25,026			370			136,785
Designated as at fair value through profit or loss		1,881		397			6			123			203			140			104			2,854
Available-for-sale		605		562			1,545			5,816			13,609			1,415			741			24,293
Loans and receivables		—		—			—			—			500			—			—			500
		11,438		15,364			37,961			6,955			64,918			26,581			1,215			164,432

Available-for-sale
Gross unrealised gains		23		13			7			4			14			8			1			70
Gross unrealised losses		—		(35	)		(2	)		(29	)		(125	)		(5	)		—			(196	)

Notes:

(1)	Includes securities issued by US federal agencies and government sponsored entities.

(2)	Includes non asset-backed securities issued by US federal agencies and government sponsored entities.

(3)	During 2008 the Group reclassified financial assets from the held-for-trading and available-for-sale categories into the loans and receivables category and from the held-for-trading category into the available-for-sale category (see page 91).

Gross gains of £64 million (2007 – £56 million) and gross losses of £72 million (2007 – £5 million) were realised by the Group on the sale of available- for-sale securities.

	Bank
											Mortgage
	UK central		US central		Other central			Bank and			and other
	and local		and local		and local			building			asset backed
	government		government		government			society			securities(1)			Corporate			Other(2)		Total
2008		£m		£m		£m			£m			£m			£m			£m		£m
Held-for-trading		5,363		1,960		29,693			1,595			15,433			13,200			667		67,911
Designated as at fair value through profit or loss		—		296		—			—			—			610			—		906
Available-for-sale		10,915		—		1,452			7,912			18,506			3,113			—		41,898
Loans and receivables		—		—		—			290			44,954			3,738			1		48,983
		16,278		2,256		31,145			9,797			78,893			20,661			668		159,698

Available-for-sale
Gross unrealised gains		16		—		1			12			16			1			—		46
Gross unrealised losses		—		—		(95	)		(62	)		(2,173	)		(204	)		—		(2,534	)

2007
Held-for-trading		8,952		3,306		28,598			1,016			30,329			24,320			934		97,455
Designated as at fair value through profit or loss		—		241		—			—			202			553			—		996
Available-for-sale		605		3		606			4,740			682			2,016			147		8,799
		9,557		3,550		29,204			5,756			31,213			26,889			1,081		107,250

Available-for-sale
Gross unrealised gains		23		—		7			4			7			22			—		63
Gross unrealised losses		—		—		—			(3	)		(1	)		(3	)		—		(7	)

Notes:

(1)	Includes securities issued by US federal agencies and government sponsored entities.

(2)	Includes non asset-backed securities issued by US federal agencies and government sponsored entities.

(3)	During 2008 the Bank reclassified financial assets from the held-for-trading and available-for-sale categories into the loans and receivables category and from the held-for-trading category into the available-for-sale category (see page 92).

102

Impairment losses on available-for-sale debt securities are recognised when there is objective evidence of impairment. The Group reviews its portfolios of available-for-sale financial assets for such evidence which includes: default or delinquency in interest or principal payments; significant financial difficulty of the issuer or obligor; and it becoming probable that the issuer will enter bankruptcy or other financial reorganisation. However, the disappearance of an active market because an entity’s financial instruments are no longer publicly traded is not evidence of impairment. Furthermore, a downgrade of an entity’s credit rating is not, of itself, evidence of impairment, although it may be evidence of impairment when considered with other available information. A decline in the fair value of a financial asset below its cost or amortised cost is not necessarily evidence of impairment. Determining whether objective evidence of impairment exists requires the exercise of management judgment. The unrecognised losses on the Group’s available-for-sale debt securities are concentrated in its portfolios of mortgage-backed securities. The losses reflect the widening of credit spreads as a result of the reduced market liquidity in these securities and the current uncertain macro-economic outlook in US and Europe. The underlying securities remain unimpaired.

14 Equity shares

	Group
	2008									2007
	Listed			Unlisted			Total			Listed			Unlisted			Total
		£m			£m			£m			£m			£m			£m
Held-for-trading		438			139			577			3,617			169			3,786
Designated as at fair value through profit or loss		24			251			275			32			124			156
Available-for-sale		57			1,782			1,839			76			1,491			1,567
		519			2,172			2,691			3,725			1,784			5,509

Available-for-sale
Gross unrealised gains		4			142			146			27			108			135
Gross unrealised losses		(95	)		(59	)		(154	)		(3	)		(7	)		(10	)
		(91	)		83			(8	)		24			101			125

Gross gains of £188 million (2007 – £445 million) and gross losses of £6 million (2007 – £0.2 million) were realised by the Group on the sale of available-for-sale equity shares.

Dividend income from available-for-sale equity shares was £50 million (2007 – £70 million; 2006 – £67 million).

Unquoted equity investments whose fair value cannot be reliably measured are carried at cost and classified as available-for-sale financial assets. They include the Group’s investments in the Federal Home Loan Bank and Federal Reserve Bank that are redeemable at cost of £0.9 billion (2007 – £0.5 billion), together with a number of individually small shareholdings. Disposals in the year generated no gains or losses (2007 – £0.5 million gain; 2006 – £56 million gain).

	Bank
	2008									2007
	Listed			Unlisted			Total			Listed		Unlisted		Total
		£m			£m			£m			£m		£m		£m
Held-for-trading		431			32			463			3,605		29		3,634
Designated as at fair value through profit or loss		—			28			28			—		10		10
Available-for-sale		17			512			529			5		370		375
		448			572			1,020			3,610		409		4,019

Available-for-sale
Gross unrealised gains		1			45			46			4		53		57
Gross unrealised losses		(46	)		(19	)		(65	)		—		—		—
		(45	)		26			(19	)		4		53		57

Disposals in the year of unquoted equity instruments classified as available-for-sale financial assets generated no gains or losses (2007 – £0.1 million loss; 2006 – £21 million gain).

103

Notes on the accounts continued

15 Investments in Group undertakings

Investments in Group undertakings are carried at cost less impairment. Movements during the year were as follows:

	Bank
	2008			2007
		£m			£m
At 1 January		22,210			21,918
Currency translation and other adjustments		898			23
Additions		3,943			137
Additional investments in Group undertakings		212			424
Repayment of investments		(349	)		(281	)
Increase in provisions		(100	)		(11	)
At 31 December		26,814			22,210

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

		Country of incorporation
	Nature of	and principal area
	business	of operation
National Westminster Bank Plc (1)	Banking	Great Britain
Citizens Financial Group, Inc.	Banking	US
Coutts & Co (2)	Private Banking	Great Britain
Greenwich Capital Markets Inc (3)	Broker dealer	US
Ulster Bank Limited (3, 4)	Banking	Northern Ireland

Notes:

(1)	The Bank does not hold any of the NatWest preference shares in issue.

(2)	Coutts & Co is incorporated with unlimited liability. Its registered office is 440 Strand, London WC2R 0QS.

(3)	Shares are not directly held by the Bank.

(4)	Ulster Bank Limited and its subsidiaries also operate in the Republic of Ireland.

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

104

16 Intangible assets

	Group
				Core			Other			Internally
				deposit			purchased			generated
	Goodwill			intangibles			intangibles			software			Total
2008		£m			£m			£m			£m			£m
Cost:
At 1 January 2008		16,783			275			278			2,883			20,219
Currency translation and other adjustments		2,689			130			80			9			2,908
Acquisition of subsidiaries		211			—			—			—			211
Additions		—			—			23			340			363
Disposal of subsidiaries		(47	)		—			—			—			(47	)
Disposals and write-off of fully amortised assets		—			(4	)		(1	)		(16	)		(21	)
At 31 December 2008		19,636			401			380			3,216			23,633

Accumulated amortisation and impairment:
At 1 January 2008		—			176			131			2,151			2,458
Currency translation and other adjustments		—			81			54			1			136
Disposals and write-off of fully amortised assets		—			(3	)		(1	)		(14	)		(18	)
Charge for the year		—			55			45			241			341
Write down of goodwill and other intangible assets		7,804			—			21			300			8,125
At 31 December 2008		7,804			309			250			2,679			11,042
Net book value at 31 December 2008		11,832			92			130			537			12,591

2007
Cost:
At 1 January 2007		16,834			265			275			2,518			19,892
Currency translation and other adjustments		(77	)		(2	)		—			4			(75	)
Acquisitions of subsidiaries		66			12			—			—			78
Additions		—			—			6			445			451
Goodwill written off		(40	)		—			—			—			(40	)
Disposals and write-off of fully amortised assets		—			—			(3	)		(84	)		(87	)
At 31 December 2007		16,783			275			278			2,883			20,219

Accumulated amortisation:
At 1 January 2007		—			127			97			1,897			2,121
Currency translation and other adjustments		—			—			—			1			1
Disposals and write-off of fully amortised assets		—			—			(1	)		(80	)		(81	)
Charge for the year		—			49			35			333			417
At 31 December 2007		—			176			131			2,151			2,458
Net book value at 31 December 2007		16,783			99			147			732			17,761

105

Notes on the accounts continued

16 Intangible assets (continued)

	Bank
			Internally
			generated
	Goodwill		software			Total
2008		£m		£m			£m
Cost:
At 1 January 2008		11		844			855
Currency translations and other adjustments		3		2			5
Acquisitions of subsidiaries		9		—			9
Additions		—		179			179
Disposals and write-off of fully amortised assets		—		(14	)		(14	)
At 31 December 2008		23		1,011			1,034

Accumulated amortisation and impairment:
At 1 January 2008		—		560			560
Disposals and write-off of fully amortised assets		—		(12	)		(12	)
Charge for the year		—		142			142
Write-down of goodwill and other intangible assets		12		196			208
At 31 December 2008		12		886			898

Net book value at 31 December 2008		11		125			136

2007
Cost:
At 1 January 2007		10		617			627
Currency translations and other adjustments		1		—			1
Additions		—		307			307
Disposals and write-off of fully amortised assets		—		(80	)		(80	)
At 31 December 2007		11		844			855

Accumulated amortisation:
At 1 January 2007		—		455			455
Disposals and write-off of fully amortised assets		—		(79	)		(79	)
Charge for the year		—		184			184
At 31 December 2007		—		560			560

Net book value at 31 December 2007		11		284			295

Impairment review

The Group’s goodwill acquired in business combinations is reviewed annually at 30 September for impairment by comparing the recoverable amount of each cash generating unit (CGU) to which goodwill has been allocated with its carrying value. In light of the unprecedented market conditions the review has been updated to reflect the latest position as at 31 December 2008.

Following the reorganisation of the Group reporting structure, NatWest and Citizens goodwill was reallocated to the appropriate CGUs.

The CGUs where the goodwill arising is significant, principally on the acquisition of NatWest and Charter One are as follows:

		Goodwill
	Recoverable	prior to					Goodwill at
	amount	write down		Write down			31 December
2008	based on		£m		£m			£m
Global Banking & Markets	Value in use		2,225		(2,225	)		—
Global Transaction Services	Value in use		1,919		—			1,919
UK Retail & Commercial Banking	Value in use		6,009		—			6,009
US Retail & Commercial Banking	Value in use		7,405		(4,382	)		3,023
Europe & Middle East Retail & Commercial Banking	Value in use		1,036		(1,036	)		—
Asia Retail & Commercial Banking	Value in use		180		(70	)		110

106

	Recoverable	Goodwill at
	amount	30 September
2007	based on		£m
Global Banking & Markets	Fair value less cost to sell		2,346
UK Corporate Banking	Fair value less cost to sell		1,630
Retail	Fair value less cost to sell		4,278
Wealth Management	Fair value less cost to sell		1,100
Citizens – Retail Banking	Value in use		2,067
Citizens – Retail and Commercial Banking	Value in use		2,274
Citizens – Consumer Financial Services	Value in use		1,701

In 2007, the recoverable amounts for all CGUs, except Citizens, were based on fair value less costs to sell. Fair value was based upon a price- earnings methodology using current earnings for each unit. Approximate price earnings multiples, validated against independent analyst information, were applied to each CGU. The multiples used were in the range 9.5 – 13.0 times earnings after charging manufacturing costs. The goodwill allocated to Global Banking & Markets, UK Corporate Banking, Retail and Wealth Management principally arose from the acquisition of NatWest in 2000. The recoverable amount of these cash generating units exceeded their carrying value by over £15 billion. The multiples or earnings would have to be less than one third of those used to cause the value in use of the units to equal their carrying value.

In light of the unprecedented market turmoil, fair value was increasingly hard to appraise and consequently the Group has generally adopted value in use tests for CGUs in 2008, based upon management’s latest five year forecasts. The long-term growth rates have been based on respective country GDP rates adjusted for inflation. The risk discount rates are based on observable market long-term government bond yields and average industry betas adjusted for an appropriate risk premium based on independent analysis.

Goodwill in respect of Global Banking & Markets principally arose from the acquisition of Natwest in 2000. The failure of a number of banks and severe weakness in the global economy during the second half of 2008 resulted in a fundamental reappraisal of business forecasts, leading to the conclusion that the Global Banking & Markets business at 31 December 2008 could support no goodwill. In addition, impairments were recognised in respect of capitalised software of £0.3 billion. The value in use was based on a 3% terminal growth rate and pre-tax discount rate of 19.5%. The result was insensitive to reasonably possible changes in key assumptions.

The recoverable amount of the Global Transaction Services business based on a 3% terminal growth rate and 15.7% pre tax risk discount rate exceeded its carrying value by more than 100% and was insensitive to a reasonably possible change in key assumptions. The goodwill arises principally from the cash management and corporate money transmission businesses previously in Citizens and Regional businesses.

UK Retail & Commercial Banking was formed at the beginning of 2008 when the Group brought together the businesses that use its UK branch network. It primarily comprised the UK Retail and Corporate banks but excluded their transaction services business. The recoverable amount was equal to the carrying amount including goodwill arising from the NatWest acquisition. This is based on a 4% terminal growth rate and 15.9% pre tax risk discount rate. A 1% change in discount rate or the terminal growth rate would change the recoverable amount by over £2 billion and £1 billion respectively. In addition, a 5% change in forecast pre-tax earnings would change the recoverable amount by approximately £1 billion.

The goodwill in Europe & Middle East Retail & Commercial Banking arose from the Group’s interests in Ulster Bank Group principally arising out of the acquisitions of NatWest and First Active. The Irish economy stalled in 2008, with the Government providing rescue packages to local banks, and forecasts within the Eurozone economies have reduced accordingly. The impairment review, based on a 3% terminal growth rate and 14.1% pre-tax risk discount rate, showed all goodwill associated with the business was impaired. The result was insensitive to reasonably possible changes in key assumptions.

The Asia Retail & Commercial Banking business comprises much of the Group’s Wealth management business and retail operations in Asia. The outlook in the Asian economies has deteriorated and falling investment values have reduced the yield from managed portfolios. The allocated goodwill principally arising on the acquisition of Natwest was impaired by £70 million based on a 5% terminal growth rate and 14% pre-tax risk discount rate. A 1% change in the discount rate or similar change in the terminal growth rate would change the recoverable amount by approximately £200 million and £100 million respectively. In addition, a 5% change in forecast pre-tax earnings would change the recoverable amount by approximately £50 million.

Further developments in the Group’s US businesses have led to the separation of the transaction services business, with the retail and commercial business being managed as a single unit. The 2007 impairment review indicated the recoverable amount of Citizens exceeded its carrying value by over £2.5 billion ($5 billion) using a terminal growth rate of 5% and a pre tax discount rate of 16.5%. In 2008, rates of 5% and 18% were used respectively and the recoverable amount indicated an impairment of £4.4 billion ($6.4 billion). A 1% change in discount rate or the terminal growth rate would change the recoverable amount and hence goodwill impairment by over £1 billion ($2 billion) and £0.7 billion ($1 billion) respectively. In addition, a 5% change in forecast pre-tax earnings would change the recoverable amount by approximately £0.5 billion ($0.8 billion).

107

Notes on the accounts continued

17 Property, plant and equipment
										Group
							Long			Short			Computers			Operating
	Investment			Freehold			leasehold			leasehold			and other			lease
	properties			premises			premises			premises			equipment			assets			Total
2008		£m			£m			£m			£m			£m			£m			£m
Cost or valuation:
At 1 January 2008		3,431			2,225			214			1,445			3,387			6,385			17,087
Currency translation and other adjustments		320			162			5			131			414			1,183			2,215
Acquisition of subsidiaries		—			—			—			30			31			—			61
Disposal of subsidiaries		—			—			—			(2	)		(52	)		—			(54	)
Reclassifications		—			(196	)		—			197			(1	)		—			—
Additions		417			458			22			26			663			3,448			5,034
Expenditure on investment properties		8			—			—			—			—			—			8
Change in fair value of investment properties		(86	)		—			—			—			—			—			(86	)
Transfers to disposal groups		—			(15	)		(18	)		—			—			(27	)		(60	)
Disposals and write-off of fully depreciated assets		(222	)		(21	)		—			(56	)		(599	)		(2,007	)		(2,905	)
At 31 December 2008		3,868			2,613			223			1,771			3,843			8,982			21,300
Accumulated impairment, depreciation and amortisation:
At 1 January 2008		—			376			74			438			1,888			1,286			4,062
Transfers to disposal groups		—			—			—			—			—			(1	)		(1	)
Currency translation and other adjustments		—			10			1			49			203			176			439
Disposal of subsidiaries		—			—			—			(1	)		(35	)		—			(36	)
Reclassifications		—			(1	)		(2	)		1			2			—			—
Write down of property, plant and equipment		—			19			—			—			—			—			19
Disposals and write-off of fully depreciated assets		—			(1	)		—			(12	)		(531	)		(488	)		(1,032	)
Charge for the year		—			63			6			108			455			589			1,221
At 31 December 2008		—			466			79			583			1,982			1,562			4,672
Net book value at 31 December 2008		3,868			2,147			144			1,188			1,861			7,420			16,628

2007
Cost or valuation:
At 1 January 2007		4,884			2,420			276			1,254			2,959			7,151			18,944
Currency translation and other adjustments		96			5			1			3			5			(63	)		47
Acquisition of subsidiaries		—			14			6			—			1			—			21
Reclassifications		3			(4	)		(2	)		1			2			—			—
Additions		449			276			35			231			569			2,328			3,888
Expenditure on investment properties		41			—			—			—			—			—			41
Change in fair value of investment properties		288			—			—			—			—			—			288
Transfers to disposal groups		—			(4	)		(13	)		—			—			(422	)		(439	)
Disposals and write-off of fully depreciated assets		(2,330	)		(482	)		(89	)		(44	)		(149	)		(2,609	)		(5,703	)
At 31 December 2007		3,431			2,225			214			1,445			3,387			6,385			17,087
Accumulated depreciation and amortisation:
At 1 January 2007		—			435			95			374			1,630			1,360			3,894
Currency translation and other adjustments		—			1			—			1			5			(4	)		3
Acquisition of subsidiaries		—			—			2			—			—			—			2
Transfers to disposal groups		—			—			—			—			—			(52	)		(52	)
Disposals and write-off of fully depreciated assets		—			(124	)		(30	)		(25	)		(109	)		(518	)		(806	)
Charge for the year		—			64			7			88			362			500			1,021
At 31 December 2007		—			376			74			438			1,888			1,286			4,062
Net book value at 31 December 2007		3,431			1,849			140			1,007			1,499			5,099			13,025

																						2008				2007
																							£m				£m

Contracts for future capital expenditure not provided for in the accounts
at the year end (excluding investment properties and operating lease assets)	97	108
Contractual obligations to purchase, construct or develop investment
properties or to repair, maintain or enhance investment property	7	9

108

Investment properties are valued to reflect fair value, that is, the market value of the Group’s interest at the reporting date excluding any special terms or circumstances relating to the use or financing of the property and transaction costs that would be incurred in making a sale. Observed market data such as rental yield, replacement cost and useful life, reflect relatively few transactions involving property that, necessarily, is not identical to property owned by the Group.

Valuations are carried out by management with the support of qualified surveyors who are members of the Royal Institution of Chartered Surveyors, or an equivalent overseas body. The valuation as at 31 December 2008 for a significant majority of the Group’s investment properties was undertaken by external valuers.

The fair value of investment properties includes £172 million (2007 – £234 million) of appreciation since purchase.

Rental income from investment properties was £237 million (2007 – £291 million; 2006 – £270 million). Direct operating expenses of investment properties were £2 million (2007 – £49 million; 2006 – £54 million).

Property, plant and equipment, excluding investment properties, include £1,132 million (2007 – £382 million) assets in the course of construction.

Freehold and long leasehold properties with a net book value of nil (2007 – £374 million; 2006 – £161 million) were sold subject to operating leases.

							Bank
				Long			Short			Computers			Operating
	Freehold			leasehold			leasehold			and other			lease
	premises			premises			premises			equipment			assets			Total
2008		£m			£m			£m			£m			£m			£m
Cost or valuation:
At 1 January 2008		860			52			628			2,083			126			3,749
Currency translation and other adjustments		2			—			17			19			—			38
Additions		207			1			28			406			7			649
Transfer from fellow subsidiary		—			—			8			6			—			14
Disposals and write-off of fully depreciated assets		(4	)		—			(48	)		(523	)		(23	)		(598	)
At 31 December 2008		1,065			53			633			1,991			110			3,852
Accumulated impairment, depreciation and amortisation:
At 1 January 2008		122			22			167			1,221			101			1,633
Currency translation and other adjustments		—			—			5			7			—			12
Transfer from fellow subsidiary		—			—			1			2			—			3
Write down of property, plant and equipment		7			—			—			—			—			7
Disposals and write-off of fully depreciated assets		—			—			(7	)		(482	)		(23	)		(512	)
Charge for the year		30			2			37			260			12			341
At 31 December 2008		159			24			203			1,008			90			1,484
Net book value at 31 December 2008		906			29			430			983			20			2,368

2007
Cost or valuation:
At 1 January 2007		1,017			55			509			1,786			124			3,491
Currency translation and other adjustments		—			—			—			2			—			2
Additions		15			8			140			369			7			539
Disposals and write-off of fully depreciated assets		(172	)		(11	)		(21	)		(74	)		(5	)		(283	)
At 31 December 2007		860			52			628			2,083			126			3,749
Accumulated depreciation and amortisation:
At 1 January 2007		164			23			144			1,044			94			1,469
Disposals and write-off of fully depreciated assets		(72	)		(3	)		(10	)		(46	)		(6	)		(137	)
Charge for the year		30			2			33			223			13			301
At 31 December 2007		122			22			167			1,221			101			1,633
Net book value at 31 December 2007		738			30			461			862			25			2,116

	2008		2007
		£m		£m
Contracts for future capital expenditure not provided for in the accounts
at the year end (excluding investment properties and operating lease assets)		39		22

109

Notes on the accounts continued

18 Prepayments, accrued income and other assets
	Group				Bank
	2008		2007		2008		2007
		£m		£m		£m		£m
Prepayments		768		730		301		270
Accrued income		1,189		962		858		685
Deferred expenses		289		47		252		30
Pension schemes in net surplus		4		566		4		—
Other assets		9,147		3,811		4,515		695
		11,397		6,116		5,930		1,680

19 Settlement balances and short positions
	Group				Bank
	2008		2007		2008		2007
		£m		£m		£m		£m
Settlement balances (amortised cost)		8,785		6,791		5,534		3,110
Short positions (held-for-trading):
Debt securities – Government		31,899		41,048		19,930		26,685
– Other issues		4,521		5,561		3,145		3,433
Equity shares		752		449		752		449
		45,957		53,849		29,361		33,677

20 Accruals, deferred income and other liabilities
	Group				Bank
	2008		2007		2008		2007
		£m		£m		£m		£m
Notes in circulation		1,619		1,545		1,087		1,080
Current taxation		201		1,017		47		159
Accruals		5,870		4,155		3,826		2,807
Deferred income		1,564		601		1,143		143
Other liabilities (1)		7,431		4,849		3,515		1,594
		16,685		12,167		9,618		5,783

Note:

(1) Other liabilities include £1 million (2007 – £9 million) in respect of share-based compensation.

Included in other liabilities are provisions for liabilities and charges as follows:

	Group			Bank
		£m			£m
At 1 January 2008		143			76
Currency translation and other movements		3			2
Charge to income statement		99			36
Releases to income statement		(41	)		(19	)
Provisions utilised		(24	)		(14	)
At 31 December 2008		180			81

Note:

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

110

21 Deferred taxation
Provision for deferred taxation has been made as follows:
	Group						Bank
	2008			2007			2008			2007
		£m			£m			£m			£m
Deferred tax liability		2,483			2,063			—			—
Deferred tax asset		(2,833	)		(240	)		(1,323	)		(319	)
Net deferred tax		(350	)		1,823			(1,323	)		(319	)

																Group
																Fair			Available-
				Accelerated												value of			for-sale									Losses
				capital						Deferred			IAS			financial			financial			Cash flow						carried
	Pension			allowances			Provisions			gains			transition			instruments			assets			Intangibles			hedging			forward			Other			Total
		£m			£m			£m			£m			£m			£m			£m			£m			£m			£m			£m			£m
At 1 January 2007		(624	)		3,224			(278	)		266			(664	)		(143	)		—			210			(94	)		—			(135	)		1,762
Charge/(credit)
to income statement		33			(130	)		(29	)		(141	)		45			65			—			16			(57	)		—			(49	)		(247	)
Charge/(credit)
to equity directly		661			—			—			(17	)		—			30			—			—			(108	)		—			57			623
Acquisitions/(disposals)
of subsidiaries		—			(284	)		—			(3	)		—			—			—			—			—			—			—			(287	)
Other		(4	)		(12	)		2			—			4			1			—			(4	)		—			—			(15	)		(28	)
At 1 January 2008		66			2,798			(305	)		105			(615	)		(47	)		—			222			(259	)		—			(142	)		1,823
Charge/(credit) to income statement		66			16			(372	)		21			203			(125	)		(24	)		(291	)		260			(805	)		191			(860	)
(Credit)/charge to equity directly		(464	)		—			—			(6	)		—			3			7			—			(78	)		(709	)		6			(1,241	)
Acquisitions/(disposals)
of subsidiaries		—			—			—			—			5			2			(2	)		—			—			—			(11	)		(6	)
Other		(20	)		267			(203	)		7			(2	)		(2	)		(27	)		90			(102	)		(39	)		(35	)		(66	)
At 31 December 2008		(352	)		3,081			(880	)		127			(409	)		(169	)		(46	)		21			(179	)		(1,553	)		9			(350	)

																Bank
																Fair			Available-
				Accelerated												value of			for-sale								Losses
				capital						Deferred			IAS			financial			financial			Cash flow					carried
	Pension			allowances			Provisions			gains			transition			instruments			assets			Intangibles		hedging			forward			Other			Total
		£m			£m			£m			£m			£m			£m			£m			£m		£m			£m			£m			£m
At 1 January 2007		(67	)		48			(117	)		56			(257	)		(1	)		—			—		(136	)		—			(75	)		(549	)
Charge/(credit)
to income statement		57			20			36			(26	)		42			—			—			—		—			—			8			137
Charge to equity directly		—			—			—			—			—			—			—			—		36			—			57			93
At 1 January 2008		(10	)		68			(81	)		30			(215	)		(1	)		—			—		(100	)		—			(10	)		(319	)
Charge/(credit) to income statement		4			(17	)		33			1			34			—			—			—		1			(699	)		1			(642	)
Charge/(credit) to equity directly		(3	)		—			—			—			—			—			(3	)		—		344			(709	)		6			(365	)
Other		—			—			—			—			—			1			(1	)		—		2			—			1			3
At 31 December 2008		(9	)		51			(48	)		31			(181	)		—			(4	)		—		247			(1,408	)		(2	)		(1,323	)

Notes:

(1)

Deferred tax assets are recognised, as set out above, that depend on the availability of future taxable profits in excess of profits arising from the reversal of other temporary differences. Business projections prepared for impairment reviews indicate it is probable that sufficient future taxable income will be available against which to offset these recognised tax assets within 8 years. UK losses do not expire. In jurisdictions where doubt exists over the availability of future taxable profits, deferred tax assets of £29 million (2007 – £34 million) have not been recognised in respect of tax losses carried forward of £108 million (2007 – £110 million). These losses have no expiry date.

(2)

Deferred tax liabilities of £844 million (2007 – £972 million) have not been recognised in respect of retained earnings of overseas subsidiaries and held-over gains on the incorporation of overseas branches. Retained earnings of overseas subsidiaries are expected to be reinvested indefinitely or remitted to the UK free from further taxation. No taxation is expected to arise in the foreseeable future in respect of held-over gains.

111

Notes on the accounts continued

22 Subordinated liabilities
	Group				Bank
	2008		2007		2008		2007
		£m		£m		£m		£m
Dated loan capital		20,594		14,605		17,135		11,892
Undated loan capital		15,208		10,240		12,774		8,206
Preference shares		4,149		2,951		3,789		2,647
		39,951		27,796		33,698		22,745

Certain preference shares are classified as liabilities; these securities remain subject to the capital maintenance rules of the Companies Act 1985.

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

						Group
2008 – final redemption	2009		2010		2011-2013		2014-2018	Thereafter		Perpetual		Total
2008 – final redemption		£m		£m	£m		£m		£m		£m		£m
Sterling		186		—	167		736		370		7,911		9,370
US dollar		1,268		342	1,125		5,362		86		7,237		15,420
Euro		379		590	1,991		4,891		1,454		3,271		12,576
Other		26		—	—		1,882		—		677		2,585
		1,859		932	3,283		12,871		1,910		19,096		39,951

							Group
2008 – call date	Currently		2009		2010			2011–2013	2014–2018	Thereafter		Perpetual		Total
2008 – call date		£m		£m		£m		£m	£m		£m		£m		£m
Sterling		—		186		737		1,030	3,507		3,740		170		9,370
US dollar		1,833		3,207		1,537		5,668	1,597		1,578		—		15,420
Euro		—		857		877		4,246	6,098		447		51		12,576
Other		—		497		405		553	914		216		—		2,585
		1,833		4,747		3,556		11,497	12,116		5,981		221		39,951

						Group
2007 – final redemption	2008		2009		2010-2012		2013-2017	Thereafter		Perpetual		Total
2007 – final redemption		£m		£m	£m		£m		£m		£m		£m
Sterling		186		—	—		771		389		5,942		7,288
US dollar		183		747	620		4,003		233		3,987		9,773
Euro		417		220	815		3,731		937		2,567		8,687
Other		25		—	—		1,560		—		463		2,048
		811		967	1,435		10,065		1,559		12,959		27,796

							Group
2007 – call date	Currently		2008		2009			2010–2012	2013–2017	Thereafter		Perpetual		Total
2007 – call date		£m		£m		£m		£m	£m		£m		£m		£m
Sterling		—		186		—		1,463	1,822		3,652		165		7,288
US dollar		1,348		543		1,795		3,235	1,681		1,171		—		9,773
Euro		—		1,265		591		2,495	4,075		222		39		8,687
Other		—		25		431		837	652		103		—		2,048
		1,348		2,019		2,817		8,030	8,230		5,148		204		27,796

112

						Bank
2008 – final redemption	2009		2010		2011-2013		2014-2018	Thereafter		Perpetual		Total
2008 – final redemption		£m		£m	£m		£m		£m		£m		£m
Sterling		132		—	167		298		—		6,935		7,532
US dollar		371		—	840		5,362		86		5,999		12,658
Euro		326		—	1,515		4,891		1,454		2,742		10,928
Other		21		—	—		1,882		—		677		2,580
		850		—	2,522		12,433		1,540		16,353		33,698

							Bank
2008 – call date	Currently		2009		2010			2011-2013	2014-2018	Thereafter		Total
2008 – call date		£m		£m		£m		£m	£m		£m		£m
Sterling		—		132		397		964	3,135		2,904		7,532
US dollar		582		2,323		1,195		5,383	1,597		1,578		12,658
Euro		—		326		287		3,770	6,098		447		10,928
Other		—		492		405		553	914		216		2,580
		582		3,273		2,284		10,670	11,744		5,145		33,698

						Bank
2007 – final redemption	2008		2009		2010-2012		2013-2017	Thereafter		Perpetual		Total
2007 – final redemption		£m		£m	£m		£m		£m		£m		£m
Sterling		132		—	—		429		—		4,973		5,534
US dollar		75		199	159		4,004		233		3,077		7,747
Euro		376		220	—		3,731		937		2,157		7,421
Other		20		—	—		1,560		—		463		2,043
		603		419	159		9,724		1,170		10,670		22,745

							Bank
2007 – call date	Currently		2008		2009			2010-2012	2013-2017	Thereafter		Total
2007 – call date		£m		£m		£m		£m	£m		£m		£m
Sterling		—		132		—		1,129	1,415		2,858		5,534
US dollar		425		449		1,247		2,774	1,681		1,171		7,747
Euro		—		1,224		220		1,680	4,075		222		7,421
Other		—		20		431		837	652		103		2,043
		425		1,825		1,898		6,420	7,823		4,354		22,745

113

Notes on the accounts continued

22 Subordinated liabilities (continued)

	2008		2007
Dated loan capital		£m		£m
The Bank
€255 million 5.25% subordinated notes 2008 (redeemed July 2008)		—		192
€300 million 4.875% subordinated notes 2009		298		228
€1,000 million floating rate subordinated notes 2013 (redeemed October 2008)		—		744
US$50 million floating rate subordinated notes 2013		36		26
€1,000 million 6.0% subordinated notes 2013		1,083		790
€500 million 6.0% subordinated notes 2013		487		374
£150 million 10.5% subordinated bonds 2013(2)		180		169
US$1,250 million floating rate subordinated notes 2014 (callable July 2009)		862		630
AUD590 million 6.0% subordinated notes 2014 (callable October 2009)		281		254
AUD410 million floating rate subordinated notes 2014 (callable October 2009)		195		182
CAD700 million 4.25% subordinated notes 2015 (callable March 2010)		409		358
£250 million 9.625% subordinated bonds 2015		311		286
US$750 million floating rate subordinated notes 2015 (callable September 2010)		513		374
€750 million floating rate subordinated notes 2015		783		564
CHF400 million 2.375% subordinated notes 2015		257		166
CHF100 million 2.375% subordinated notes 2015		72		41
CHF200 million 2.375% subordinated notes 2015		125		86
US$500 million floating rate subordinated notes 2016 (callable October 2011)		346		252
US$1,500 million floating rate subordinated notes 2016 (callable April 2011)		1,038		757
€500 million 4.5% subordinated notes 2016 (callable January 2011)		511		379
CHF200 million 2.75% subordinated notes 2017 (callable December 2012)		129		89
€100 million floating rate subordinated notes 2017		97		73
€500 million floating rate subordinated notes 2017 (callable June 2012)		482		371
€750 million 4.35% subordinated notes 2017 (callable October 2017)		770		548
AUD450 million 6.5% subordinated notes 2017 (callable February 2012)		217		202
AUD450 million floating rate subordinated notes 2017 (callable February 2012)		214		199
US$1,500 million floating rate subordinated callable step-up notes 2017 (callable August 2012)		1,029		752
€2,000 million 6.93% subordinated notes 2018 (issued April 2008)		2,136		—
US$125.6 million floating rate subordinated notes 2020		87		64
€1,000 million 4.625% subordinated notes 2021 (callable September 2016)		1,019		724
€300 million CMS linked floating rate subordinated notes 2022		303		228
€144 million floating rate subordinated notes 2022 (issued June 2008)		152		—

Due to the holding company
US$400 million 6.4% subordinated notes 2009 (1)		278		202
US$300 million 6.375% subordinated notes 2011 (1)		231		163
US$750 million 5% subordinated notes 2013 (1)		581		384
US$750 million 5% subordinated notes 2014 (1)		617		386
US$250 million 5% subordinated notes 2014 (1)		168		123
US$675 million 5.05% subordinated notes 2015 (1)		551		358
US$350 million 4.7% subordinated notes 2018 (1)		287		174
		17,135		11,892
National Westminster Bank Plc
US$1,000 million 7.375% subordinated notes 2009		697		507
€600 million 6.0% subordinated notes 2010		623		474
€500 million 5.125% subordinated notes 2011		488		376
£300 million 7.875% subordinated notes 2015		379		349
£300 million 6.5% subordinated notes 2021		376		330

Charter One Financial, Inc.
US$400 million 6.375% subordinated notes 2012		287		212

Greenwich Capital Holdings, Inc.
US$100 million 5.575% senior subordinated revolving credit 2009		69		50
US$170 million subordinated loan capital floating rate notes 2009		116		85
US$500 million subordinated loan capital floating rate notes 2010 (callable on any interest payment date)		342		249

First Active plc
£60 million 6.375% subordinated bonds 2018 (callable April 2013)		66		65

Other minority interest subordinated issues		16		16
		20,594		14,605

Notes:

(1)	On-lent to The Royal Bank of Scotland Group plc on a subordinated basis.

(2)	Unconditionally guaranteed by The Royal Bank of Scotland Group plc.

(3)	In the event of certain changes in tax laws, dated loan capital issues may be redeemed in whole, but not in part, at the option of the issuer, at the principal amount thereof plus accrued interest, subject to prior regulatory approval.

(4)	Except as stated above, claims in respect of the Group’s dated loan capital are subordinated to the claims of other creditors. None of the Group’s dated loan capital is secured.

(5)	Interest on all floating rate subordinated notes is calculated by reference to market rates.

114

	2008		2007
Undated loan capital		£m		£m
The Bank
£150 million 5.625% undated subordinated notes (callable June 2032)		144		144
£175 million 7.375% undated subordinated notes (callable August 2010)		190		183
€152 million 5.875% undated subordinated notes (redeemed October 2008)		—		114
£350 million 6.25% undated subordinated notes (callable December 2012)		380		354
£500 million 6.0% undated subordinated notes (callable September 2014)		565		517
€500 million 5.125% undated subordinated notes (callable July 2014)		516		371
€1,000 million floating rate subordinated notes (callable July 2014)		966		742
£500 million 5.125% undated subordinated notes (callable March 2016)		556		499
£200 million 5.625% undated subordinated upper tier 2 notes (callable September 2026)		210		210
£600 million 5.5% undated subordinated notes (callable December 2019)		677		595
£500 million 6.2% undated subordinated notes (callable March 2022)		614		543
£200 million 9.5% undated subordinated bonds (callable August 2018) (3)		253		228
£400 million 5.625% undated subordinated upper tier 2 notes (callable September 2026)		397		397
£300 million 5.625% undated subordinated notes (callable September 2026)		431		318
£350 million 5.625% undated subordinated notes (callable June 2032)		364		363
£400 million 5% undated subordinated notes (callable March 2011)		424		402
JPY25 billion 2.605% undated subordinated notes (callable November 2034)		217		103
CAD700 million 5.37% fixed rate undated subordinated notes (callable May 2016)		464		363

Due to the holding company
US$350 million undated floating rate primary capital notes (callable on any interest payment date) (1)		240		175
€1,250 million 6.467% perpetual regulatory tier one securities (callable June 2012) (1)		1,325		979
US$1,200 million 7.648% perpetual regulatory tier one securities (callable September 2031) (1, 2)		831		606
£1,500 million floating rate perpetual subordinated notes (issued March 2008)		1,500		—
$600 million floating rate perpetual subordinated notes (issued March 2008)		412		—
$1,600 million floating rate perpetual subordinated notes (issued March 2008)		1,098		—
		12,774		8,206
National Westminster Bank Plc
US$500 million primary capital floating rate notes, Series A (callable on any interest payment date)		343		251
US$500 million primary capital floating rate notes, Series B (callable on any interest payment date)		347		256
US$500 million primary capital floating rate notes, Series C (callable on any interest payment date)		346		255
€400 million 6.625% fixed/floating rate undated subordinated notes (callable October 2009)		388		303
€100 million floating rate undated step-up notes (callable October 2009)		97		74
£325 million 7.625% undated subordinated step-up notes (callable January 2010)		363		357
£200 million 7.125% undated subordinated step-up notes (callable October 2022)		201		205
£200 million 11.5% undated subordinated notes (callable December 2022) (4)		269		269

First Active plc
£20 million 11.75% perpetual tier two capital		26		23
€38 million 11.375% perpetual tier two capital		52		39
£1.3 million floating rate perpetual tier two capital		2		2
		15,208		10,240

Notes:

(1)	On lent to The Royal Bank of Scotland Group plc on a subordinated basis.

(2)	The company can satisfy interest payment obligations by issuing ordinary shares to appointed Trustees sufficient to enable them, on selling those shares, to settle the interest payment.

(3)	Guaranteed by the company.

(4)	Exchangeable at the option of the issuer into 200 million 8.392% (gross) non-cumulative preference shares of £1 each of National Westminster Bank Plc at any time.

(5)	Except as stated above, claims in respect of the Group's undated loan capital are subordinated to the claims of other creditors. None of the Group's undated loan capital is secured.

(6)	In the event of certain changes in tax laws, undated loan capital issues may be redeemed in whole, but not in part, at the option of the Group, at the principal amount thereof plus accrued interest, subject to prior regulatory approval.

(7)	Interest on all floating rate subordinated notes is calculated by reference to market rates.

115

Notes on the accounts continued

22 Subordinated liabilities (continued)

	2008	2007
Preference shares	£m	£m
The Bank
Non-cumulative preference shares of US$0.01 (1)
Series F US$200 million 7.65% (redeemable at option of issuer)	137	100
Series H US$300 million 7.25% (redeemable at option of issuer)	205	150
Series L US$750 million 6.8% (callable March 2009)	514	374
Series M US$850 million 4.709% (callable July 2013)	640	421
Series N US$650 million 6.425% (redeemable January 2034)	677	344
Series R US$850 million 5.75% (callable September 2009)	582	424
Series 1 US$1,000 million 9.118% (callable March 2010)	698	508

Non-cumulative preference shares of £1
Series 1 £200 million 7.387% (callable December 2010) (1)	211	201
£125 million 7.25%	125	125
	3,789	2,647
National Westminster Bank Plc
Non-cumulative preference shares of £1
Series A £140 million 9% (non-redeemable)	145	143

Non-cumulative preference shares of US$25
Series C US$300 million 7.7628% (2)	215	161
	4,149	2,951

Notes:

(1)	Issued by the Bank to the holding company on terms which, in general, mirror the original issues by the holding company.

(2)	Series C preference shares each carry a gross dividend of 8.625% inclusive of associated tax credit. Redeemable at the option of the issuer at US$25 per share.

116

23 Minority interests

	Group
	2008			2007
		£m			£m
At 1 January		152			396
Currency translation adjustments and other movements		344			(11	)
Profit attributable to minority interests		208			53
Dividends paid		(84	)		(31	)
Equity raised		812			—
Equity withdrawn and disposals		(140	)		(255	)
At 31 December		1,292			152

24 Share capital

	Allotted, called up and fully paid				Authorised
	2008		2007		2008		2007
	£m		£m		£m		£m
Ordinary shares of £1		6,481		5,481		£7,980		£7,980
Non-cumulative preference shares of US$0.01		2		2		$5		$3
Non-cumulative preference shares of €0.01		—		—		—		—
Perpetual zero coupon preference shares of £1		—		—		£100		£100
Non-cumulative preference shares of £1		126		126		£2,200		£2,200

	Allotted, called up and fully paid				Authorised
Number of shares – millions	2008		2007		2008		2007
Ordinary shares of £1		6,481		5,481		7,980		7,980
Non-cumulative preference shares of US$0.01		313		313		549		349
Non-cumulative preference shares of €0.01		3		3		66		66
Perpetual zero coupon preference shares of £1		—		—		100		100
Non-cumulative preference shares of £1		126		126		2,200		2,200

Ordinary shares

In June 2008, the Bank issued 1 billion new ordinary shares of £1 each to the holding company at £10 per share.

Preference shares

The non-cumulative preference shares have been issued by the Bank to the holding company on terms which, in general, mirror the original issues by the holding company.

Under IFRS, certain of the Group’s preference shares are classified as debt and are included in subordinated liabilities on the balance sheet.

117

Notes on the accounts continued

25 Shareholders’ equity

	Group									Bank
	2008			2007			2006			2008			2007			2006
		£m			£m			£m			£m			£m			£m
Called-up share capital
At 1 January		5,483			5,482			5,481			5,483			5,482			5,481
Shares issued during the year		1,000			1			1			1,000			1			1
At 31 December		6,483			5,483			5,482			6,483			5,483			5,482

Share premium account
At 1 January		16,175			12,526			11,435			16,175			12,526			11,435
Shares issued during the year		9,000			3,649			1,091			9,000			3,649			1,091
At 31 December		25,175			16,175			12,526			25,175			16,175			12,526

Merger reserve
At 1 January and 31 December		10,881			10,881			10,881			—			—			—

Available-for-sale reserve
At 1 January		(35	)		(65	)		(198	)		72			52			12
Unrealised (losses)/gains in the year		(2,585	)		511			365			(2,592	)		249			123
Realised (gains)/losses in the year		(11	)		(465	)		(196	)		49			(231	)		(71	)
Taxation		738			(16	)		(36	)		716			2			(12	)
At 31 December		(1,893	)		(35	)		(65	)		(1,755	)		72			52

Cash flow hedging reserve
At 1 January		(511	)		(142	)		68			(211	)		(260	)		(150	)
Amount recognised in equity during the year		(461	)		(408	)		(108	)		1,292			60			(138	)
Amount transferred from equity to earnings in the year (1)		185			(141	)		(143	)		(54	)		25			2
Tax		64			180			41			(344	)		(36	)		26
At 31 December		(723	)		(511	)		(142	)		683			(211	)		(260	)

Foreign exchange reserve
At 1 January		(782	)		(833	)		469			3			(2	)		(2	)
Retranslation of net assets		7,254			287			(2,117	)		(331	)		5			—
Foreign currency (losses)/gains on hedges of net assets		(2,630	)		(267	)		815			—			—			—
Tax		361			31			—			—			—			—
At 31 December		4,203			(782	)		(833	)		(328	)		3			(2	)

Retained earnings
At 1 January		16,472			10,087			6,374			9,567			4,633			4,535
(Loss)/profit attributable to ordinary and equity preference shareholders		(8,750	)		7,199			5,876			(1,140	)		7,255			3,519
Ordinary dividends paid		(4,000	)		(2,000	)		(3,250	)		(4,000	)		(2,000	)		(3,250	)
Equity preference dividends paid		(638	)		(331	)		(252	)		(638	)		(331	)		(252	)
Actuarial (losses)/gains recognised in retirement benefit schemes net of tax		(1,252	)		1,509			1,259			(2	)		2			1
Share-based payments, net of tax		—			8			80			—			8			80
At 31 December		1,832			16,472			10,087			3,787			9,567			4,633

Shareholders’ equity at 31 December		45,958			47,683			37,936			34,045			31,089			22,431

Note:

(1) The amounts transferred to earnings are included in net interest income.

The merger reserve comprises the premium on shares issued to acquire NatWest less goodwill amortisation charged under previous GAAP. No share premium was recorded in the Bank financial statements through the operation of the merger relief provisions of the Companies Act 1985.

UK law prescribes that only reserves of the Bank are taken into account for the purpose of making distributions and the permissible applications of the share premium account.

The Group optimises capital efficiency by maintaining reserves in subsidiaries, including regulated entities. Certain preference shares and subordinated debt are also included within regulatory capital. The remittance of reserves to the parent or the redemption of shares or subordinated capital by regulated entities may be subject to maintaining the capital resources required by the relevant regulator.

118

26 Leases

Minimum amounts receivable and payable under non-cancellable leases.

	2008												2007
	Year in which receipt or payment will occur												Year in which receipt or payment will occur
				After 1 year												After 1 year
	Within 1			but within			After 5						Within 1			but within			After 5
	year			5 years			years			Total			year			5 years			years			Total
Group		£m			£m			£m			£m			£m			£m			£m			£m
Finance lease assets:
Amounts receivable		1,485			6,112			12,567			20,164			1,297			4,968			11,648			17,913
Present value adjustment		(613	)		(2,004	)		(3,094	)		(5,711	)		(390	)		(1,766	)		(3,187	)		(5,343	)
Other movements		(24	)		(128	)		(341	)		(493	)		(23	)		(144	)		(288	)		(455	)
Present value amounts receivable		848			3,980			9,132			13,960			884			3,058			8,173			12,115

Operating lease assets:
Future minimum lease receivables		897			2,307			1,058			4,262			670			1,612			682			2,964

Operating lease obligations:
Future minimum lease payables:
Premises		395			1,342			3,010			4,747			341			1,179			3,010			4,530
Equipment		12			12			—			24			9			14			—			23
		407			1,354			3,010			4,771			350			1,193			3,010			4,553

Amounts above include:
Obligations to fellow subsidiaries – Premises		7			28			49			84			7			28			56			91

2008

2007

Year in which receipt or payment will occur

After 1 year

Within 1

but within

After 5

Within 1

but within

After 5

year

5 years

years

Total

year

5 years

years

Total

Bank

£m

Operating lease obligations:

Future minimum lease payables:

Premises

159

586

1,808

2,553

141

525

1,758

2,424

Amounts above include:

Obligations to fellow subsidiaries – Premises

119

Notes on the accounts continued

26 Leases (continued)

	2008			2007
Group		£m			£m
Nature of operating lease assets in balance sheet
Transportation		5,883			3,502
Cars and light commercial vehicles		1,199			1,282
Other		338			315
		7,420			5,099
Amounts recognised as income and expense
Finance lease receivables – contingent rental income		(37	)		(23	)
Operating lease payables – minimum payments		380			305

Contracts for future capital expenditure not provided for at the year end
Operating leases		237			78

Finance lease receivables
Unearned finance income		5,711			5,343
Accumulated allowance for uncollectable minimum lease receivables		96			63

Bank
Amounts recognised as expense
Operating lease payables – minimum payments		164			116

Residual value exposures

The table below gives details of the unguaranteed residual values included in the carrying value of finance lease receivables (see above) and operating lease assets (see Note 17).

	Group
	Year in which residual value will be recovered
			After 1 year		After 2 years
	Within 1		but within		but within		After 5
	year		2 years		5 years		years		Total
2008		£m		£m		£m		£m		£m
Operating leases
Transportation		794		130		1,701		2,103		4,728
Cars and light commercial vehicles		577		195		182		8		962
Other		112		35		48		7		202
Finance leases		24		29		99		341		493
		1,507		389		2,030		2,459		6,385

2007
Operating leases
Transportation		259		207		758		1,535		2,759
Cars and light commercial vehicles		331		467		118		—		916
Other		26		47		64		18		155
Finance leases		23		29		115		288		455
		639		750		1,055		1,841		4,285

The Group provides asset finance to its customers through acting as a lessor. It purchases plant, equipment and intellectual property; renting them to customers under lease arrangements that, depending on their terms, qualify as either operating or finance leases.

120

27 Collateral and securitisations

Securities repurchase agreements and lending transactions

The Group enters into securities repurchase agreements and securities lending transactions under which it receives or transfers collateral in accordance with normal market practice. Generally, the agreements require additional collateral to be provided if the value of the securities falls below a predetermined level.

Under standard terms for repurchase transactions in the UK and US markets, the recipient of collateral has an unrestricted right to sell or repledge it, subject to returning equivalent securities on settlement of the transaction.

The fair value (and carrying value) of securities transferred under repurchase transactions included within debt securities on the balance sheet were £75,660 million (2007 – £75,001 million) for the Group and £70,206 million (2007 – £30,633 million) for the Bank. All of these securities could be sold or repledged by the holder. Securities received as collateral under reverse repurchase agreements amounted to £54.9 billion (2007 – £159.8 billion), of which £49.1 billion (2007 – £128.4 billion) had been resold or repledged as collateral for the Group’s own transactions.

Other collateral given

	Group				Bank
	2008		2007		2008		2007
Group assets charged as security for liabilities		£m		£m		£m		£m
Loans and advances to customers		107,409		55,227		16,480		5,411
Debt securities		15,108		8,911		4,872		—
Loans and advances to banks		13		—		—		—
Other		8		—		—		—
		122,538		64,138		21,352		5,411

	Group		Bank
	2008	2007	2008	2007
Liabilities secured by charges on Group assets	£m	£m	£m	£m
Deposits by banks	11,322	6,171	—	—
Customer accounts	11,050	6,670	4,867	5,398
Debt securities in issue	52,755	34,090	343	—
	75,127	46,931	5,210	5,398

Of the assets above, £84.2 billion (2007 – £36.4 billion) relate to securitisations. In securitisations, debt securities are issued that are secured on assets of the Group; the rights to the cash flows from those assets are transferred to special purpose vehicles which issue debt securities. The remaining balances primarily relate to assets charged as security against deposits from federal banks and other public sector bodies.

Securitisations and other asset transfers

Continuing recognition

The table below sets out the asset categories together with the carrying amounts of the assets and associated liabilities for those securitisations and other asset transfers where substantially all of the risks and rewards of the asset have been retained by the Group.

	Group
	2008				2007
Asset type	Assets £m		Liabilities £m		Assets £m		Liabilities £m
Residential mortgages		46,998		18,613		19,657		19,441
Credit card receivables		3,004		3,197		2,948		2,664
Other loans		1,679		1,071		1,703		1,149
Commercial paper conduits		31,473		30,833		11,043		11,092
Finance lease receivables		1,077		857		1,038		823
		84,231		54,571		36,389		35,169

Continuing involvement

At 31 December 2008, securitised assets were £1.1 billion (2007 – £17.6 billion); retained interest £50 million (2007 – £888 million) subordinated assets £9 million (2007 – £314 million) and related liabilities £9 million (2007 – £314 million).

121

Notes on the accounts continued

28 Capital resources

The Group’s regulatory capital resources at 31 December in accordance with Financial Services Authority (FSA) definitions were as follows:

	Basel II			Basel I
Composition of regulatory capital	2008			2007
Composition of regulatory capital		£m			£m
Tier 1:
Ordinary shareholders' equity		36,711			38,436
Minority interests		1,292			152
Adjustment for:
– Goodwill and other intangible assets		(12,591	)		(17,761	)
– Unrealised losses on available-for-sale debt securities		1,855			110
– Reserves arising on revaluation of property and unrealised gains on available-for-sale equities		(154	)		(281	)
– Other regulatory adjustments		(56	)		423
Core Tier 1 capital		27,057			21,079

Preference shares		10,896			10,126
Innovative Tier 1 securities		4,177			3,538
Tax on the excess of expected losses over provisions		615			—
Tier 1 deductions		(1,725	)		—
Total Tier 1 capital		41,020			34,743

Tier 2:
Reserves arising on revaluation of property and unrealised gains on available-for-sale equities		154			281
Collective impairment allowances		666			2,582
Perpetual subordinated debt		12,085			8,291
Term subordinated debt		16,488			12,605
Minority and other interests in Tier 2 capital		11			109
Tier 2 deductions		(1,725	)		—
Total Tier 2 capital		27,679			23,868

Supervisory deductions:
Unconsolidated investments		(119	)		(130	)
Other deductions		(111	)		(2,324	)
Total deductions other than from Tier 1 capital		(230	)		(2,454	)
Total regulatory capital		68,469			56,157

In the management of capital resources, the Group is governed by the RBS Group’s policy which is to maintain a strong capital base, to expand it as appropriate and to utilise it efficiently throughout its activities to optimise the return to shareholders while maintaining a prudent relationship between the capital base and the underlying risks of the business. In carrying out this policy, 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 risk-weighted assets (the assets and off-balance sheet exposures are ‘weighted’ to reflect the inherent credit and other risks); by international agreement, the RAR should be not less than 8% with a tier 1 component of not less than 4%. The Group has complied with the FSA’s capital requirements throughout the year.

A number of subsidiaries and sub-groups within the Group, principally banking entities, are subject to various individual regulatory capital requirements in the UK and overseas.

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29 Memorandum items

Contingent liabilities and commitments

The amounts shown in the table below are intended only to provide an indication of the volume of business outstanding at 31 December. Although the Group is exposed to credit risk in the event of non-performance of the obligations undertaken by customers, the amounts shown do not, and are not intended to, provide any indication of the Group’s expectation of future losses.

	Group				Bank
	2008		2007		2008		2007
		£m		£m		£m		£m
Contingent liabilities:
Guarantees and assets pledged as collateral security		15,075		11,661		7,248		6,838
Other contingent liabilities		17,842		11,215		15,067		8,168
		32,917		22,876		22,315		15,006
Commitments:
Undrawn formal standby facilities, credit lines and other commitments to lend
– less than one year		156,290		153,348		75,800		61,582
– one year and over		138,059		105,915		111,241		82,603
Other commitments		6,788		2,491		366		1,630
		301,137		261,754		187,407		145,815

Notes:

(1)	In the normal course of business, the Bank guarantees specified third party liabilities of certain subsidiaries; it also gives undertakings that individual subsidiaries will fulfil their obligations to third parties under contractual or other arrangements.

(2)	Includes commitments for £5,705 million (2007 – £805 million) in respect of the construction of aircraft.

Banking commitments and contingent obligations, which have been entered into on behalf of customers and for which there are corresponding obligations from customers, are not included in assets and liabilities. The Group’s maximum exposure to credit loss, in the event of non-performance by the other party and where all counterclaims, collateral or security proves valueless, is represented by the contractual nominal amount of these instruments included in the table above. These commitments and contingent obligations are subject to the Group’s normal credit approval processes.

Contingent liabilities

Guarantees – the Group gives guarantees on behalf of customers. A financial guarantee represents an irrevocable undertaking that the Group will meet a customer’s obligations to third parties if the customer fails to do so. The maximum amount that the Group could be required to pay under a guarantee is its principal amount as disclosed in the table above. The Group expects most guarantees it provides to expire unused.

Other contingent liabilities – these include standby letters of credit, supporting customer debt issues and contingent liabilities relating to customer trading activities such as those arising from performance and customs bonds, warranties and indemnities.

Commitments

Commitments to lend – under a loan commitment the Group agrees to make funds available to a customer in the future. Loan commitments, which are usually for a specified term may be unconditionally cancellable or may persist, provided all conditions in the loan facility are satisfied or waived. Commitments to lend include commercial standby facilities and credit lines, liquidity facilities to commercial paper conduits and unutilised overdraft facilities.

Other commitments – these include forward asset purchases, forward deposits placed and undrawn note issuance and revolving underwriting facilities, documentary credits and other short-term related transactions.

Trustee and other fiduciary activities

In its capacity as trustee or other fiduciary role, the Group may hold or place assets on behalf of individuals, trusts, companies, pension schemes and others. The assets and their income are not included in the Group’s financial statements. The Group earned fee income of £476 million (2007 – £507 million; 2006 – £472 million) from these activities. The Bank earned fee income of £45 million (2007 – £49 million; 2006 – £42 million).

The Financial Services Compensation Scheme

The Financial Services Compensation Scheme (FSCS), the UK's statutory fund of last resort for customers of authorised financial services firms, pays compensation if a firm is unable to meet its obligations. The FSCS funds compensation for customers by raising management expenses levies and compensation levies on the industry. In relation to protected deposits, each deposit-taking institution contributes towards these levies in proportion to their share of total protected deposits on 31 December of the year preceding the scheme year (which runs from 1 April to 31 March), subject to annual maxima set by the Financial Services Authority (FSA). In addition, the FSCS has the power to raise levies (‘exit levies’) on firms who have ceased to participate in the scheme and are in the process of ceasing to be authorised for the amount that the firm would otherwise have been asked to pay during the relevant levy year. The FSCS also has the power to raise exit levies on such firms which look at their potential liability to pay levies in future years.

FSCS has borrowed from HM Treasury to fund the compensation costs associated with Bradford & Bingley, Heritable Bank, Kaupthing Singer & Friedlander, Landsbanki ‘Icesave’ and London Scottish Bank plc. These borrowings are on an interest-only basis until September 2011. The annual limit on the FSCS management expenses levy for the three years from September 2008 in relation to these institutions has been capped at £1 billion per annum.

123

Notes on the accounts continued

29 Memorandum items (continued)

The FSCS will receive funds from asset sales, surplus cash flow, or other recoveries in relation to these institutions which will be used to reduce the principal amount of the FSCS's borrowings. Only after the interest only period, which is expected to end in September 2011, will a schedule for repayment of any remaining principal outstanding (after recoveries) on the borrowings be agreed between the FSCS and HM Treasury. It is expected that, from that point, the FSCS will begin to raise compensation levies (principal repayments). No provision has been made for these levies as the amount is not yet known and is unlikely to be determined before 2011.

The Group has accrued £150 million for its share of FSCS management expenses levies for the 2008/9 and 2009/10 scheme years.

Investigations

The Group’s businesses and financial condition can be affected by the fiscal or other policies and other actions of various governmental and regulatory authorities in the United Kingdom, the European Union, the United States and elsewhere.

The Group has engaged, and will continue to engage, in discussions with relevant regulators, including in the United Kingdom and the United States, on an ongoing and regular basis informing them of operational, systems and control evaluations and issues as deemed appropriate or required and it is possible that any matters discussed or identified may result in investigatory actions by the regulators, increased costs being incurred by the Group, remediation of systems and controls, public or private censure or fines. Any of these events or circumstances could have a material adverse impact on the Group its business, reputation, results of operations or RBS share price.

There is continuing political and regulatory scrutiny of the operation of the retail banking and consumer credit industries in the United Kingdom and elsewhere. The nature and impact of future changes in policies and regulatory action are not predictable and are beyond the Group’s control but could have an adverse impact on the Group’s businesses and earnings.

European Union

In the European Union, regulatory actions included an inquiry into retail banking in all of the then 25 member states by the European Commission’s Directorate General for Competition. The inquiry examined retail banking in Europe generally. On 31 January 2007, the European Commission announced that barriers to competition in certain areas of retail banking, payment cards and payment systems in the European Union had been identified. The European Commission indicated that it will consider using its powers to address these barriers and will encourage national competition authorities to enforce European and national competition laws where appropriate.

In 2007, the European Commission issued a decision that, while interchange is not illegal per se, MasterCard’s current multilateral interchange fee (MIF) arrangement for cross border payment card transactions with MasterCard and Maestro-branded consumer credit and debit cards in the European Union are in breach of competition law. MasterCard was required by the decision to withdraw the relevant cross border MIFs by 21 June 2008. MasterCard lodged an appeal against the decision with the European Court of First Instance on 1 March 2008, and on 12 June 2008 it announced that it would be temporarily withdrawing its cross border MIF, pending the outcome of the appeal. The Group has been granted leave to intervene in the appeal proceedings. Visa’s MIFs were exempted in 2002 by the European Commission for a period of five years up to 31 December 2007 subject to certain conditions. On 26 March 2008, the European Commission opened a formal inquiry into Visa’s current MIF arrangements for cross border payment card transactions with Visa-branded debit and consumer credit cards in the European Union. There is no deadline for the closure of the inquiry.

United Kingdom

In the United Kingdom, in September 2005, the Office of Fair Trading (OFT) received a super-complaint from the Citizens Advice Bureau relating to payment protection insurance (PPI). As a result, the OFT commenced a market study on PPI in April 2006. In October 2006, the OFT announced the outcome of the market study and, on 7 February 2007, following a period of consultation, the OFT referred the PPI market to the Competition Commission (CC) for an in-depth inquiry. The CC published its final report on 29 January 2009. It found a lack of competition in the PPI market as a result of various factors, including a lack of transparency and barriers to entry for standalone providers. The CC will therefore impose by Order a range of remedies, including a prohibition on actively selling PPI at point of sale of the credit product (and for 7 days thereafter), a ban on single premium policies and other measures to increase transparency (in order to improve customers’ ability to search and improve price competition). The deadline for implementation will be 2010.

The FSA has been conducting a broad industry thematic review of PPI sales practices and in September 2008 announced that it intends to escalate its level of regulatory intervention. The FSA is expected to publish a further update in 2009. Substantial numbers of customer complaints alleging the mis-selling of PPI policies have been made to banks and to the Financial Ombudsman Service (FOS) and many of these are being upheld by the FOS against the banks. Discussions continue between the FSA, the FOS and industry bodies on how best to handle these complaints. Separately, discussions are ongoing between the FSA and the Group in respect of concerns expressed by the FSA over certain categories of historic PPI sales.

The OFT has carried out investigations into Visa and MasterCard domestic credit card interchange rates. The decision by the OFT in the MasterCard interchange case was set aside by the Competition Appeals Tribunal in June 2006. The OFT’s investigations in the Visa

124

interchange case and a second MasterCard interchange case are ongoing. The outcome is not known, but these investigations may have an impact on the consumer credit industry in general and, therefore, on the Group’s business in this sector. On 9 February 2007, the OFT announced that it was expanding its investigation into domestic interchange rates to include debit cards.

On 29 March 2007, the OFT announced that, following an initial review into bank current account charges, it had decided to conduct a market study into personal current accounts in the United Kingdom and a formal investigation into the fairness of bank current account charges.

On 16 July 2008, the OFT published the results of its market study into personal current accounts in the United Kingdom. The OFT found evidence of competition and several positive features in the personal current account market but believes that the market as a whole is not working well for consumers and that the ability of the market to function well has become distorted. The OFT is currently consulting with the banking industry, consumer groups and interested parties on its report. After this consultation the OFT will decide on next steps, which could include further discussions or agreed remedies with the industry, or possibly a reference of the market to the CC.

The OFT’s investigation into the fairness of bank current account charges is ongoing. On 12 August 2008, the OFT indicated to the Group and other banks that, although it had not concluded its investigation and had reached no final view, it had serious concerns that contractual terms relating to Relevant Charges in personal current account agreements were unfair under the Regulations. The OFT is currently consulting with the Group and other banks on this issue. Given the stage of the investigation, the Group cannot reliably estimate the impact of any adverse outcome of the OFT’s market study or investigation upon it, if any. However, the Group is co-operating fully with the OFT to achieve resolution of the matters under investigation.

On 26 January 2007, the FSA issued a Statement of Good Practice relating to Mortgage Exit Administration Fees. On 1 March 2007, the Group adopted a policy of charging all customers the fee applicable at the time the customers took out the mortgage or, if later, varied their mortgage. The Group believes that it is currently in compliance with the Statement of Good Practice and will continue to monitor its performance against those standards.

United States

The New York State Attorney General has issued subpoenas to a wide array of participants in the sub-prime mortgage industry, including mortgage originators, appraisers, due diligence firms, investment banks and rating agencies, focusing on the information underwriters obtained as part of the due diligence process from the independent due diligence firms and whether that information is adequately disclosed to investors. RBS Greenwich Capital has produced documents requested by the New York State Attorney General principally related to sub-prime loans that were pooled into one securitisation transaction.

In addition to the above, certain RBS Group’s subsidiaries have received requests for information from various US governmental agencies and self-regulatory organisations including in connection with sub-prime mortgages and securitisations, collateralised debt obligations and synthetic products related to sub-prime mortgages. In particular, during March 2008, the RBS Group was advised by the SEC that it had commenced a non-public, formal investigation relating to the RBS Group’s US sub-prime securities exposures and US residential mortgage exposures. The RBS Group and its subsidiaries are co-operating with these various requests for information and investigations.

Litigation

United Kingdom

In common with other banks in the United Kingdom, The Royal Bank of Scotland plc (“the Royal Bank”) and National Westminster Bank Plc (“NatWest”) have received claims and complaints from a large number of customers challenging unarranged overdraft charges (the ‘Charges’) as contravening the Unfair Terms in Consumer Contracts Regulations 1999 (the ‘Regulations’) or being unenforceable penalties (or both).

On 27 July 2007, the OFT issued proceedings in a test case against the banks which was intended to determine certain preliminary issues concerning the legal status and enforceability of contractual terms relating to the Charges. Because of the test case, most existing and new claims in the County Courts are currently stayed, the FSA temporarily waived the customer complaints-handling process and there is a standstill of Financial Ombudsman Service decisions.

A High Court judgment in April 2008 addressed preliminary issues in respect of the banks’ contractual terms relating to the Charges in force in early 2008 (the ‘Current Terms’). The judgment held that the Current Terms used by the Royal Bank and NatWest (i) are not unenforceable as penalties, but (ii) are not exempt from assessment for fairness under the Regulations.

The RBS Group (in common with the other banks) has accepted that the ruling in the April judgment that the Current Terms are not exempt from assessment for fairness applies also to a sample of the Royal Bank and NatWest contractual terms relating to the Charges in force between 2001 and 2007 (the ‘Historic Terms’). The High Court made an order to this effect in October 2008.

The RBS Group and the other banks have appealed against the rulings in April 2008 and October 2008 that the Current Terms and Historic Terms are not exempt from assessment for fairness under the Regulations. The hearing of the appeal in relation to Current Terms took place before the Court of Appeal in October and November 2008. The Court of Appeal delivered its judgment on 26 February 2009 and rejected the appeals. The RBS Group and the other banks intend to seek leave from the House of Lords to appeal the Court of Appeal’s decision. The appeal in relation to the Historic Terms is stayed pending the resolution of the appeal in relation to the Current Terms.

High Court judgments on further preliminary issues were handed down in October 2008 and January 2009. These judgments primarily addressed the question of whether certain Historic Terms were capable of being unenforceable penalties. The Judge decided that all of the Royal Bank’s and most of NatWest’s Historic Terms were not penalties, but that a term contained in a set of NatWest 2001 terms and conditions was a contractual prohibition against using a card to obtain an unarranged overdraft. The Judge did not decide whether any charge payable upon a breach of this prohibition was a penalty. The RBS Group has not appealed that decision.

125

Notes on the accounts continued

29 Memorandum items (continued)

The issues relating to the legal status and enforceability of the Charges are complex. The RBS Group maintains that its Charges are fair and enforceable and believes that it has a number of substantive and credible defences. The RBS Group cannot at this stage predict with any certainty the final outcome of the customer claims and complaints, the appeals referred to above and any further stages of the test case. It is unable reliably to estimate the liability, if any, that may arise as a result of or in connection with these matters or its effect on the Group’s consolidated net assets, operating results or cash flows in any particular period.

United States

Proceedings, including consolidated class actions on behalf of former Enron securities holders, have been brought in the United States against a large number of defendants, including the Group, following the collapse of Enron. The claims against the Group could be significant; the class plaintiff’s position is that each defendant is responsible for an entire aggregate damage amount less settlements – they have not quantified claimed damages against the Group in particular. The Group considers that it has substantial and credible legal and factual defences to these claims and will continue to defend them vigorously. Recent decisions by the US Supreme Court and the US Federal Court for the Fifth Circuit provide further support for the Group’s position. The Group is unable reliably to estimate the liability, if any, that might arise or its effect on the Group’s consolidated net assets, operating results or cash flows in any particular period.

RBS Group companies have been named as defendants in a number of purported class action and other lawsuits in the United States that relate to the sub-prime mortgage business. In general, the cases involve the issuance of sub-prime-related securities or the issuance of shares in companies with sub-prime-related exposure, where the plaintiffs have brought actions against the issuers and underwriters (including RBS Group companies) of such securities claiming that certain disclosures made in connection with the relevant offerings of such securities were false or misleading. The RBS Group considers that it has substantial and credible legal and factual defences to these claims and will continue to defend them vigorously. The RBS Group does not currently expect that these lawsuits, individually or in the aggregate, will have a material impact on its consolidated net assets, operating results or cash flows in any particular period.

The holding company and a number of its subsidiaries and certain individual officers and directors have been named as defendants in a number of class action complaints filed in the United States District Court for the Southern District of New York. The complaints allege that public filings in connection with the issuance of RBS Group Non- cumulative Dollar Preference Shares, ADS, including Series Q, Series R, Series S and Series T, together with the much broader class of RBS Group publicly traded securities between 26 June 2007 and 19 January 2009, contained false and misleading statements, and variously assert claims under Sections 11, 12 and 15 of the Securities Act 1933, Section 10 of the Securities Exchange Act 1934 and SEC Rule 10b-5. Plaintiffs seek unquantified damages on behalf of purchasers of these shares. The proceedings are in their initial stages. The RBS Group considers that it has substantial and credible legal and factual defences to these claims and will defend them vigorously. The RBS Group is unable reliably to estimate the liability, if any, that might arise or its effect on the Group’s consolidated net assets, operating results or cash flows in any particular period.

Summary of other disputes, legal proceedings and litigation

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

126

30 Net cash flow from operating activities

	Group									Bank
	2008			2007			2006			2008			2007			2006
		£m			£m			£m			£m			£m			£m
Operating (loss)/profit before tax		(9,047	)		9,155			8,354			(2,204	)		7,759			4,039
(Increase)/decrease in prepayments and accrued income		(513	)		(411	)		55			(426	)		(221	)		76
Interest on subordinated liabilities		1,694			1,452			1,161			1,487			1,200			878
Increase/(decrease) in accruals and deferred income		2,497			(248	)		701			2,089			220			682
Provisions for impairment losses		4,706			1,865			1,873			2,007			473			692
Loans and advances written-off net of recoveries		(2,236	)		(1,407	)		(1,626	)		(737	)		(477	)		(571	)
Unwind of discount on impairment losses		(174	)		(166	)		(142	)		(61	)		(65	)		(63	)
Profit on sale of property, plant and equipment		(177	)		(672	)		(215	)		(4	)		(740	)		(1	)
(Profit)/loss on sale of subsidiaries and associates		(417	)		(67	)		(41	)		(617	)		8			(2	)
Profit on sale of securities		(174	)		(496	)		(252	)		(94	)		(231	)		(92	)
Charge for defined benefit pension schemes		351			479			578			8			5			8
Cash contribution to defined benefit pension schemes		(491	)		(536	)		(533	)		(8	)		(16	)		(1	)
Other provisions utilised		(24	)		(200	)		(40	)		(14	)		(65	)		(11	)
Depreciation and amortisation		1,562			1,438			1,415			483			485			390
Write-down of goodwill and other assets		8,144			—			—			215			—			—
Elimination of foreign exchange differences		(20,997	)		(2,137	)		4,515			(16,892	)		(2,034	)		1,345
Other non-cash items		1,417			969			(1,447	)		2,692			523			(492	)
Net cash (outflow)/inflow from trading activities		(13,879	)		9,018			14,356			(12,076	)		6,824			6,877
Increase in loans and advances to banks and customers		(69,339	)		(92,494	)		(46,036	)		(10,544	)		(88,570	)		(24,025	)
Decrease/(increase) in securities		19,719			(25,033	)		(16,632	)		14,127			(16,069	)		(13,136	)
(Increase)/decrease in other assets		(4,494	)		(5,122	)		404			(3,920	)		(3,003	)		(1,068	)
Increase in derivative assets		(724,306	)		(103,852	)		(18,649	)		(730,592	)		(105,426	)		(19,044	)
Changes in operating assets		(778,420	)		(226,501	)		(80,913	)		(730,929	)		(213,068	)		(57,273	)
Increase in deposits by banks and customers		42,367			79,408			63,733			35,638			72,435			76,496
Increase/(decrease) in debt securities in issue		49,810			47,526			(3,616	)		35,272			38,056			(22,990	)
(Decrease)/increase in other liabilities		(3,650	)		405			814			2,102			325			532
Increase in derivative liabilities		706,052			99,559			19,206			706,940			100,577			19,016
(Decrease)/increase in settlement balances and short positions		(13,314	)		6,472			4,068			(7,605	)		10,253			1,034
Changes in operating liabilities		781,265			233,370			84,205			772,347			221,646			74,088
Total income taxes paid		(886	)		(1,802	)		(2,122	)		83			(526	)		(298	)
Net cash (outflow)/inflow from operating activities		(11,920	)		14,085			15,526			29,425			14,876			23,394

31 Analysis of the net investment in business interests and intangible assets

	Group									Bank
	2008			2007			2006			2008			2007			2006
		£m			£m			£m			£m			£m			£m
Fair value given for businesses acquired		(1,491	)		(147	)		(21	)		(47	)		(6	)		(236	)
Additional investments in Group undertakings		—			5			—			(4,155	)		(560	)		(449	)
Net outflow of cash in respect of purchases		(1,491	)		(142	)		(21	)		(4,202	)		(566	)		(685	)
Cash and cash equivalents in businesses sold		—			21			229			—			—			—
Other assets sold		552			16			41			146			—			—
Repayment of investments		—			—			—			349			281			340
Non-cash consideration		(35	)		(2	)		(3	)		—			—			—
Profit/(loss) on disposal		417			67			41			617			(8	)		2
Net inflow of cash in respect of disposals		934			102			308			1,112			273			342
Dividends received from joint ventures		9			9			29			3			2			3
Cash expenditure on intangible assets		(360	)		(399	)		(335	)		(177	)		(299	)		(105	)
Net outflow of cash		(908	)		(430	)		(19	)		(3,264	)		(590	)		(445	)

127

Notes on the accounts continued

32 Interest received and paid

	Group									Bank
	2008			2007			2006			2008			2007			2006
		£m			£m			£m			£m			£m			£m
Interest received		30,876			27,641			25,284			16,169			12,897			12,669
Interest paid		(17,581	)		(15,482	)		(15,189	)		(11,576	)		(10,071	)		(9,534	)
		13,295			12,159			10,095			4,593			2,826			3,135

33 Analysis of changes in financing during the year

	Group										Bank
	Share capital, share premium				Subordinated						Share capital and				Subordinated
	and merger reserve				liabilities						share premium				liabilities
	2008		2007		2008			2007			2008		2007		2008			2007
		£m		£m		£m			£m			£m		£m		£m			£m
At 1 January		32,539		28,889		27,796			27,786			21,658		18,008		22,745			22,403
Issue of ordinary shares		10,000		—								10,000		—
Issue of equity preference shares		—		3,650								—		3,650
Net proceeds from issue of subordinated liabilities						5,055			1,018							5,055			968
Repayment of subordinated liabilities						(1,035	)		(1,708	)						(1,035	)		(1,288	)
Net cash inflow/(outflow) from financing		10,000		3,650		4,020			(690	)		10,000		3,650		4,020			(320	)
Currency translation and other adjustments		—		—		8,135			700			—		—		6,933			662
At 31 December		42,539		32,539		39,951			27,796			31,658		21,658		33,698			22,745

34 Analysis of cash and cash equivalents

	Group							Bank
	2008			2007		2006		2008			2007		2006
		£m			£m		£m		£m			£m		£m
At 1 January
– cash		27,289			28,175		25,333		16,591			16,025		9,629
– cash equivalents		57,472			41,972		27,352		60,658			47,561		29,778
		84,761			70,147		52,685		77,249			63,586		39,407
Net cash (outflow)/inflow		(4,347	)		14,614		17,462		(3,800	)		13,663		24,179
At 31 December		80,414			84,761		70,147		73,449			77,249		63,586

Comprising:
Cash and balances at central banks		6,442			5,121		5,752		3,432			3,003		3,424
Treasury bills and debt securities		14,006			6,818		1,596		14,006			6,521		1,595
Loans and advances to banks		59,966			72,822		62,799		56,011			67,725		58,567
Cash and cash equivalents		80,414			84,761		70,147		73,449			77,249		63,586

The Bank and certain subsidiaries are required to maintain balances with the Bank of England which, at 31 December 2008, amounted to £282 million (2007 – £330 million). Certain subsidiary undertakings are required by law to maintain reserve balances with the Federal Reserve Bank in the US. Such reserve balances were nil at 31 December 2008 (2007 – US$1 million).

128

35 Segmental analysis

(a) Divisions

The directors manage the Group primarily by class of business and present the segmental analysis on that basis. The Group’s activities are organised as follows:

Global Markets is focused on the provision of debt and equity financing, risk management and transaction banking services to large businesses and financial institutions in the United Kingdom and around the world. Its activities have been organised into two divisions; Global Banking & Markets (GBM) and Global Transaction Services (GTS), in order best to serve the Group’s customers whose financial needs are global.

GBM is a leading banking partner to major corporations and financial institutions around the world, providing an extensive range of debt and equity financing, risk management and investment services to its customers.

GTS ranks among the top five global transaction services providers, offering global payments, cash and liquidity management, as well as trade finance, UK and international merchant acquiring and commercial card products and services. It includes the Group’s corporate money transmission activities in the United Kingdom and the United States.

Regional Markets is organised around the provision of retail and commercial banking to customers in four regions; the United Kingdom, the United States, Europe and the Middle East and Asia. This includes the provision of wealth management services both in the United Kingdom and internationally.

UK Retail & Commercial Banking comprises retail, commercial and corporate banking, and wealth management services in the United Kingdom. It supplies financial services through both the RBS and NatWest brands.

US Retail & Commercial Banking comprises Citizens which is engaged in retail and corporate banking activities through its branch network in 12 states in the United States and through non-branch offices in other states. Citizens Financial Group provides financial services through the Citizens and Charter One brands.

Europe & Middle East Retail & Commercial Banking comprises Ulster Bank and the Group’s combined retail and commercial businesses in Europe and the Middle East.

Asia Retail & Commercial Banking holds prominent market positions in India, Pakistan, China and Taiwan, as well as presences in Hong Kong, Indonesia, Malaysia and Singapore . It provides financial services across four segments: affluent banking, cards and consumer finance, business banking and international wealth management, which offers private banking and investment services to clients in selected markets through the RBS Coutts brand.

Group Manufacturing comprises the Group’s worldwide manufacturing operations. It supports the Group’s customer-facing businesses and provides operational technology, customer support in telephony, account management, lending and money transmission, global purchasing, property and other services.

The Centre comprises group and corporate functions, such as capital raising, finance, risk management, legal, communications and human resources. The Centre manages the Group’s capital resources and Group- wide regulatory projects and provides services to the operating divisions.

Segments charge market prices for services rendered to other parts of the Group with the exception of Group Manufacturing and central items. The expenditure incurred by Manufacturing relates to costs principally in respect of the Group’s banking and insurance operations in the UK and Ireland. These costs reflect activities that are shared between the various customer-facing divisions. These shared costs and related assets and liabilities are not allocated to divisions in the day-to-day management of the businesses and the results below reflect this. Funding charges between segments are determined by Group Treasury, having regard to commercial demands. The results of each division before amortisation of purchased intangible assets, integration and restructuring and write down of goodwill costs (Contribution) are shown in the following tables.

129

Notes on the accounts continued

35 Segmental analysis (continued)

	Group
	Revenue								Total Income
																					Depreciation
			Inter									Inter						Operating			and			Impairment
	External		segment			Total			External			segment			Total			expenses			amortisation			losses			Contribution
2008		£m		£m			£m			£m			£m			£m			£m			£m			£m			£m
Global Markets
– Global Banking & Markets		5,361		12,325			17,686			1,249			(2,258	)		(1,009	)		(1,946	)		(286	)		(1,255	)		(4,496	)
– Global Transaction Services		2,253		81			2,334			1,743			(28	)		1,715			(430	)		(9	)		(29	)		1,247
Regional Markets
– UK Retail & Commercial Banking		18,424		3,605			22,029			12,069			(1,462	)		10,607			(2,554	)		(413	)		(1,964	)		5,676
– US Retail & Commercial Banking		5,031		—			5,031			3,049			(39	)		3,010			(942	)		(144	)		(1,041	)		883
– Europe & Middle East Retail
& Commercial Banking		3,626		584			4,210			2,030			(677	)		1,353			(480	)		—			(410	)		463
– Asia Retail & Commercial Banking		353		346			699			15			282			297			(199	)		(8	)		(5	)		85
Group Manufacturing		33		—			33			(204	)		(9	)		(213	)		(3,055	)		(577	)		—			(3,845	)
Central items		413		11,328			11,741			(4,094	)		4,191			97			(261	)		(3	)		(2	)		(169	)
Eliminations		—		(28,269	)		(28,269	)		—			—			—			—			—			—			—
		35,494		—			35,494			15,857			—			15,857			(9,867	)		(1,440	)		(4,706	)		(156	)
Amortisation of purchased intangible assets		—		—			—			—			—			—			—			(100	)		—			(100	)
Integration and restructuring costs		—		—			—			—			—			—			(625	)		(22	)		—			(647	)
Goodwill and other asset write-downs		—		—			—			—			—			—			(8,144	)		—			—			(8,144	)
		35,494		—			35,494			15,857			—			15,857			(18,636	)		(1,562	)		(4,706	)		(9,047	)


2007
Global Markets
– Global Banking & Markets		11,585		9,501			21,086			7,711			(1,634	)		6,077			(2,156	)		(247	)		(36	)		3,638
– Global Transaction Services		2,502		77			2,579			1,983			(356	)		1,627			(394	)		(6	)		(15	)		1,212
Regional Markets
– UK Retail & Commercial Banking		17,460		3,642			21,102			11,187			(865	)		10,322			(2,499	)		(337	)		(1,368	)		6,118
– US Retail & Commercial Banking		5,184		—			5,184			2,837			(56	)		2,781			(844	)		(118	)		(340	)		1,479
– Europe & Middle East Retail
& Commercial Banking		2,841		197			3,038			1,794			(477	)		1,317			(435	)		(6	)		(104	)		772
– Asia Retail & Commercial Banking		281		330			611			(22	)		272			250			(170	)		(5	)		—			75
Group Manufacturing		44		1			45			(192	)		(4	)		(196	)		(2,569	)		(593	)		—			(3,358	)
Central items		1,100		8,906			10,006			(2,991	)		3,120			129			(710	)		18			(2	)		(565	)
Eliminations		—		(22,654	)		(22,654	)		—			—			—			—			—			—			—
		40,997		—			40,997			22,307			—			22,307			(9,777	)		(1,294	)		(1,865	)		9,371
Amortisation of purchased intangible assets		—		—			—			—			—			—			(40	)		(84	)		—			(124	)
Integration costs		—		—			—			—			—			—			(32	)		(60	)		—			(92	)
		40,997		—			40,997			22,307			—			22,307			(9,849	)		(1,438	)		(1,865	)		9,155

130

	Group
	Revenue								Total Income
																					Depreciation
			Inter									Inter						Operating			and			Impairment
	External		segment			Total			External			segment			Total			expenses			amortisation			losses			Contribution
2006		£m		£m			£m			£m			£m			£m			£m			£m			£m			£m
Global Markets
– Global Banking & Markets		10,824		7,627			18,451			8,015			(1,607	)		6,408			(2,313	)		(248	)		(85	)		3,762
– Global Transaction Services		2,073		4			2,077			1,527			2			1,529			(334	)		(6	)		(4	)		1,185
Regional Markets
– UK Retail & Commercial Banking		15,438		2,725			18,163			10,852			(1,002	)		9,850			(2,357	)		(345	)		(1,497	)		5,651
– US Retail & Commercial Banking		5,456		2			5,458			3,072			(82	)		2,990			(910	)		(156	)		(180	)		1,744
– Europe & Middle East Retail
& Commercial Banking		2,361		196			2,557			1,296			(153	)		1,143			(360	)		(5	)		(104	)		674
– Asia Retail & Commercial Banking		218		252			470			2			210			212			(141	)		(5	)		1			67
Group Manufacturing		52		5			57			(210	)		(21	)		(231	)		(2,520	)		(557	)		2			(3,306	)
Central items		499		6,900			7,399			(2,986	)		2,653			(333	)		(887	)		17			(6	)		(1,209	)
Eliminations		—		(17,711	)		(17,711	)		—			—			—			—			—			—			—
		36,921		—			36,921			21,568			—			21,568			(9,822	)		(1,305	)		(1,873	)		8,568
Amortisation of purchased intangible assets		—		—			—			—			—			—			—			(94	)		—			(94	)
Integration costs		—		—			—			—			—			—			(104	)		(16	)		—			(120	)
		36,921		—			36,921			21,568			—			21,568			(9,926	)		(1,415	)		(1,873	)		8,354

Notes:

(1) Revenue represents total income included in the income statement grossed-up for interest payable and commissions payable.

(2) Segmental results for 2007 and 2006 have been restated to reflect transfers of businesses between segments in 2008.

	Group
	2008						2007
	Assets		Liabilities		Cost to acquire fixed assets and intangible assets		Assets		Liabilities		Cost to acquire fixed assets and intangible assets
		£m		£m		£m		£m		£m		£m
Global Markets
– Global Banking & Markets		1,421,892		1,361,207		2,755		678,122		612,712		1,645
– Global Transaction Services		11,603		36,971		4		13,629		36,421		15
Regional Markets
– UK Retail & Commercial Banking		245,315		189,856		1,447		227,816		192,277		1,497
– US Retail & Commercial Banking		104,026		94,026		204		78,979		68,458		171
– Europe & Middle East Retail & Commercial Banking		68,454		51,708		2		56,316		45,185		35
– Asia Retail & Commercial Banking		5,283		9,077		18		4,338		7,549		14
Group Manufacturing		5,820		2,166		966		5,528		2,065		1,001
Central items		15,537		85,669		9		7,010		59,236		2
Group		1,877,930		1,830,680		5,405		1,071,738		1,023,903		4,380

Note:

(1) Segmental results for 2007 have been restated to reflect transfer of businesses between segments in 2008.

Segmental analysis of goodwill is as follows:

	Global Banking & Markets			Global Transaction Services			UK Retail & Commercial Banking			US Retail & Commercial Banking			Europe & Middle East Retail & Commercial Banking			Asia Retail & Commercial Banking			Central items		Total
		£m			£m			£m			£m			£m			£m			£m		£m
At 1 January 2007		2,279			1,742			6,158			5,429			904			298			24		16,834
Currency translation and other adjustments		(4	)		(18	)		—			(103	)		41			7			—		(77	)
Acquisitions		—			—			—			66			—			—			—		66
Goodwill written off		—			(40	)		—			—			—			—			—		(40	)
At 1 January 2008		2,275			1,684			6,158			5,392			945			305			24		16,783
Currency translation and other adjustments		56			425			—			2,013			138			57			—		2,689
Acquisitions		211			—			—			—			—			—			—		211
Disposals		—			—			—			—			(47	)		—			—		(47	)
Write down of goodwill		(2,225	)		(44	)		(47	)		(4,382	)		(1,036	)		(70	)		—		(7,804	)
At 31 December 2008		317			2,065			6,111			3,023			—			292			24		11,832

131

Notes on the accounts continued

35 Segmental analysis (continued)

(b) Geographical segments

The geographical analyses in the tables below have been compiled on the basis of location of office where the transactions are recorded.

							Group
										Rest of
	UK			US			Europe			the World			Total
2008		£m			£m			£m			£m			£m
Total revenue		20,755			6,744			5,542			2,453			35,494
Net interest income		9,917			2,576			802			214			13,509
Net fees and commissions		3,982			1,341			333			94			5,750
(Loss)/income from trading activities		(3,835	)		(1,657	)		(302	)		211			(5,583	)
Other operating income		1,556			158			489			(22	)		2,181
Total income		11,620			2,418			1,322			497			15,857
Operating (loss)/profit before tax		(2,772	)		(5,514	)		(764	)		3			(9,047	)
Total assets		1,131,765			583,149			102,318			60,698			1,877,930
Total liabilities		1,104,026			568,344			98,126			60,184			1,830,680
Net assets attributable to equity shareholders and minority interests		27,739			14,805			4,192			514			47,250
Contingent liabilities and commitments		178,411			106,921			36,886			11,836			334,054
Cost to acquire property, plant and equipment and intangible assets		3,167			444			1,687			107			5,405

2007
Total revenue		27,057			7,488			4,658			1,794			40,997
Net interest income		8,150			2,098			756			112			11,116
Net fees and commissions		4,299			1,140			435			149			6,023
Income/(loss) from trading activities		1,582			(567	)		73			54			1,142
Other operating income		3,167			241			562			56			4,026
Total income		17,198			2,912			1,826			371			22,307
Operating profit before tax		7,533			721			797			104			9,155
Total assets		705,372			251,514			78,419			36,433			1,071,738
Total liabilities		674,989			238,345			74,363			36,206			1,023,903
Net assets attributable to equity shareholders and minority interests		30,383			13,169			4,056			227			47,835
Contingent liabilities and commitments		170,361			66,283			40,135			7,851			284,630
Cost to acquire property, plant and equipment and intangible assets		2,864			238			1,255			23			4,380

132

					Group
							Rest of
	UK		US		Europe		the World		Total
2006		£m		£m		£m		£m		£m
Total revenue		22,644		9,001		4,249		1,027		36,921
Net interest income		7,418		2,212		697		65		10,392
Net fees and commissions		3,883		1,245		412		94		5,634
Income from trading activities		1,453		939		108		43		2,543
Other operating income		2,186		295		506		12		2,999
Total income		14,940		4,691		1,723		214		21,568
Operating profit before tax		5,299		2,267		762		26		8,354
Total assets		562,689		197,421		59,784		13,733		833,627
Total liabilities		542,422		183,432		55,797		13,644		795,295
Net assets attributable to equity shareholders and minority interests		20,267		13,989		3,987		89		38,332
Contingent liabilities and commitments		186,827		57,873		13,244		7,159		265,103
Cost to acquire property, plant and equipment and intangible assets		2,708		254		1,346		19		4,327

36 Directors’ and key management remuneration

The directors of the Bank are also directors of the holding company and are remunerated for their services to the RBS Group as a whole. The remuneration of the directors is disclosed in the Report and Accounts of the RBS Group.

Compensation of key management

The aggregate remuneration of directors and other members of key management during the year, borne by the RBS Group, was as follows:

	2008		2007
		£000		£000
Short-term benefits		16,813		37,763
Post-employment benefits		13,174		10,051
Other long-term benefits		496		708
Termination benefits		345		—
Share-based payments		2,078		5,165
		32,906		53,687

37 Transactions with directors, officers and others

(a) At 31 December 2008, the amounts outstanding in relation to transactions, arrangements and agreements entered into by authorised institutions in the Group, as defined in UK legislation, were £117,847 in respect of loans to 27 persons who were directors of the Bank (or persons connected with them) at any time during the financial period and £4,196,374 to 16 people who were officers of the Bank at any time during the financial period.

(b) For the purposes of IAS 24 ‘Related Party Disclosures’, key management comprise directors of the Bank and members of RBS Group’s Group Executive Management Committee. The captions in the Group’s primary financial statements include the following amounts attributable, in aggregate, to key management:

	2008		2007
		£000		£000
Loans and advances to customers		4,217		2,023
Customer accounts		9,572		13,309

Key management have banking relationships with Group entities which are entered into in the normal course of business and on substantially the same terms, including interest rates and security, as for comparable transactions with other persons of a similar standing or, where applicable, with other employees. These transactions did not involve more than the normal risk of repayment or present other unfavourable features.

Key management had no reportable transactions or balances with the holding company except for dividends.

133

Notes on the accounts continued

38 Related parties

(a) Group companies and the Bank provide development and other types of capital support to businesses in their roles as providers of finance. These investments are made in the normal course of business and on arm’s-length terms. In some instances, the investment may extend to ownership or control over 20% or more of the voting rights of the investee company. However, these investments are not considered to give rise to transactions of a materiality requiring disclosure under IAS 24.

(b) The Group recharges The Royal Bank of Scotland Group Pension Fund with the cost of administration services incurred by it. The amounts involved are not material to the Group.

(c) In accordance with IAS 24, transactions or balances between Group entities that have been eliminated on consolidation are not reported.

(d) The captions in the primary financial statements of the Bank include amounts attributable to subsidiaries. These amounts have been disclosed in aggregate in the relevant notes to the financial statements. The table below discloses items included in income and operating expenses on transactions between the Group and fellow subsidiaries of the RBS Group.

	2008		2007
		£m		£m
Income
Interest receivable		569		175
Interest payable		885		498
Fees and commissions receivable		237		200
Fees and commissions payable		14		4

Expenses
Premises and equipment		7		7

(e)

On 1 December 2008, the UK Government through HM Treasury became the ultimate controlling party of The Royal Bank of Scotland Group plc. The UK Government’s shareholding is managed by UK Financial Investments Limited, a company wholly owned by the UK Government. As a result, the UK Government and UK Government controlled bodies became related parties of the Group. The Group enters into transactions with many of these bodies on an arms’ length basis. The volume and diversity of such transactions are such that disclosure of their amounts in the period 1 December 2008 to 31 December 2008 is impractical.

As at 31 December 2008, balances with the UK Government and UK Government controlled bodies were:

			Group
	Central government (including the Bank of England)		Local government		Banks, financial corporations and public corporations		2008 Total
		£m		£m		£m		£m
Assets
Balances at central banks		282						282
Loans and advances to banks		—				1,053		1,053
Loans and advances to customers		1		575		431		1,007
Debt securities		19,732		—		—		19,732
Derivatives		1,286		60		10		1,356
Other		249		—		—		249

Liabilities
Deposits by banks		26,541				605		27,146
Customer accounts		222		1,436		149		1,807
Derivatives		276		69		18		365
Other		176		—		—		176

134

	Bank
	Central government (including the Bank of England)		Local government		Banks, financial corporations and public corporations		2008 Total
		£m		£m		£m		£m
Assets
Balances at central banks		282						282
Loans and advances to banks		—				1,053		1,053
Loans and advances to customers		—		399		14		413
Debt securities		19,111		—		—		19,111
Derivatives		1,286		60		10		1,356
Other		249		—		—		249

Liabilities
Deposits by banks		26,541				605		27,146
Customer accounts		222		1,436		149		1,807
Derivatives		276		69		18		363
Other		176		—		—		176

Notes:

(1)

In addition to the UK Government’s shareholding in the Group, the UK Government and UK Government controlled bodies may hold debt securities, subordinated liabilities and other liabilities or shares issued by the Group in the normal course of their business. It is not practicable to ascertain and disclose these amounts.

(2)	Certain of the liability balances are secured.

No impairment losses were recognised by the Group in 2008 in respect of balances with UK Government and UK Government controlled bodies.

The Group participates in a number of schemes operated by the Bank of England and the UK Government and made available to eligible banks and building societies.

Bank of England facilities include:

•

Open market operations – these provide market participants with funding at market rates on a tender basis in the form of short and long-term repos on a wide range of collateral and outright purchases of high-quality bonds to enable them to meet the reserves that they must hold at the Bank of England.

•	US dollar repo operations – these commenced in September 2008 taking the form of an auction. Eligible collateral consists of securities routinely eligible in the Bank's short-term repo open market operations together with conventional US Treasuries.

•	The special liquidity scheme – this was launched in April 2008 to allow financial institutions to swap temporarily illiquid assets for treasury bills, with fees charged based on the spread between 3-month LIBOR and the 3-month gilt repo rate.

As at 31 December 2008, the Group’s utilisation of these facilities amounted to £41.8 billion.

Government credit guarantee scheme – this was announced in October 2008. The Government, in return for a fee (50 basis points plus the bank’s median five-year credit default spread during the twelve months to 7 October 2008), guarantees new unsecured borrowing.

As at 31 December 2008, the Group had obtained funding from the Bank of England and issued debt guaranteed by the government totalling £32.2 billion.

39 Ultimate holding company

The Group’s ultimate holding company is The Royal Bank of Scotland Group plc which is incorporated in Great Britain and registered in Scotland. As at 31 December 2008, The Royal Bank of Scotland Group plc heads the largest group in which the Group is consolidated. Copies of the consolidated accounts may be obtained from The Secretary, The Royal Bank of Scotland Group plc, Gogarburn, PO Box 1000, Edinburgh EH12 1HQ.

Following a placing and open offer by The Royal Bank of Scotland Group plc in December 2008, the UK Government, through HM Treasury, currently holds 57.9% of the issued ordinary share capital of the holding company and is therefore the Group’s ultimate controlling party.

40 Post balance sheet events

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

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Additional information

Amounts in accordance with IFRS	2008			2007		2006		2005		2004
Summary consolidated income statement – IFRS		£m			£m		£m		£m		£m
Net interest income		13,509			11,116		10,392		9,711		8,790
Non-interest income		2,348			11,191		11,176		9,963		8,441
Total income		15,857			22,307		21,568		19,674		17,231
Operating expenses (1)		20,198			11,287		11,341		10,672		9,225
Profit before impairment		(4,341	)		11,020		10,227		9,002		8,006
Impairment		4,706			1,865		1,873		1,709		1,485
Operating profit before tax		(9,047	)		9,155		8,354		7,293		6,521
Tax		(505	)		1,903		2,433		2,267		1,751
(Loss)/profit from continuing operations		(8,542	)		7,252		5,921		5,026		4,770
Profit from discontinued operations, net of tax		—			—		—		—		258
(Loss)/profit for the year		(8,542	)		7,252		5,921		5,026		5,028

(Loss)/profit attributable to:
Minority interests		208			53		45		27		53
Other owners		638			331		252		154		315
Ordinary shareholders		(9,388	)		6,868		5,624		4,845		4,660

Note:

(1) Includes integration and restructuring expenditure of £661 million (2007 – £92 million, 2006 – £120 million, 2005 – £349 million, 2004 – £499 million).

	2008		2007		2006		2005		2004
Summary consolidated balance sheet – IFRS		£m		£m		£m		£m		£m
Loans and advances		698,890		647,795		547,042		485,488		405,512
Debt securities and equity shares		180,457		169,941		126,621		120,351		91,356
Derivatives and settlement balances (1)		948,328		211,301		109,548		89,479		15,297
Other assets		50,255		42,701		50,416		49,806		50,436
Total assets		1,877,930		1,071,738		833,627		745,124		562,601
Shareholders’ equity		45,958		47,683		37,936		34,510		34,320
Minority interests		1,292		152		396		104		679
Subordinated liabilities		39,951		27,796		27,786		28,422		21,262
Deposits		635,111		594,490		516,462		452,729		383,669
Derivatives, settlement balances and short positions (1)		955,062		256,921		152,989		128,295		43,812
Other liabilities		200,556		144,696		98,058		101,064		78,859
Total liabilities and equity		1,877,930		1,071,738		833,627		745,124		562,601

Note:

(1) Derivative balances in 2007 to 2004 have been restated for the netting of certain balances with the London Clearing House.

136

SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorised.

Date: 28 May 2009

The Royal Bank of Scotland Group plc Registrant

/s/ Guy Robert Whittaker

Guy Robert Whittaker
Group Finance Director

137