03
Background
05
Scope of application
06
Capital and risk management
09
Credit risk
Credit risk management 10
Credit risk by IRB approach 14
Credit risk by standard approach 24
Credit risk – ABN AMRO 28
29
Counterparty credit risk
31
Securitisation
35
Market risk
38
Operational risk
40
Additional disclosures
Significant subsidiaries 40
Past due and impaired assets 43
Non-trading book exposures in equities 45 Interest rate risk in the banking book 46
This document contains certain forward-looking statements within the meaning of Section 27A of the US Securities Act of 1933 and Section 21E of the US Securities Exchange Act of 1934 with respect to the financial condition, results of operations and business of The Royal Bank of Scotland Group plc (‘the Group’). Generally, words such as ‘‘may’’, ‘‘could’’, ‘‘will’’, ‘‘expect’’, ‘‘intend’’, ‘‘estimate’’, ‘‘anticipate’’, ‘‘believe’’, ‘‘plan’’, ‘‘seek’’, ‘‘continue’’ or similar expressions identify forward-looking statements.
Any forward-looking statements set out herein represent the Group’s expectations or beliefs concerning future events and involve known and unknown risks and uncertainty that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. For example, certain of the market risk disclosures, some of which are only estimates and, therefore, could be
materially different from actual results, are dependent on key model characteristics and assumptions and are subject to various limitations. For further risks and uncertainties that may impact the Group and the statements set out in this document, please read its Annual Report and Accounts for the year ended 31 December 2008 and any other interim or update information published by the Group, including information furnished to the SEC on Form 6-K.
Any forward looking statements set out herein speak only as at the date of this document. Except as required by the FSA, the London Stock Exchange or other applicable law or regulation, the Group does not have any obligation to update or revise publicly any forward looking statement, whether as a result of new information, further events or otherwise, and expressly disclaims any obligation to do so.
Basis of disclosure
The Pillar 3 disclosures being made by the Group comply with the FSA Handbook (BIPRU 11). They should be read in conjunction with the 2008 Report and Accounts, published in March 2009.
There are important differences between the accounting and Basel disclosures, which can be summarised as follows:
•
The Basel II disclosures represent a regulatory, rather than an accounting consolidation. Various businesses (for example insurance) are included in the latter, but not in the former. Therefore, these disclosures may not be comparable to other external disclosures made by the Group.•
The definition of exposure differs between Basel II and accounting. The Basel II definition used in the Pillar 3 disclosures is exposure at default (EAD) rather than the balance sheet or drawn balance plus mark-to-market, as used in the 2008 Report and Accounts.•
Unlike accounting, it is not always possible to aggregate the disclosures across the different Basel II approaches to obtain a Group view. This is particularly important for the credit risk disclosures. The disclosures relate to the position through 2008, specifically the business as at 31 December 2008. The comments relate to the business structure, governance and risk management approach at that date. Comparatives have not been shown as the first year of Basel II adoption was 2008. In future disclosures comparative data will be shown where appropriate.The information has not been subject to external audit.
Whilst the Group has participated in discussions at the British Bankers Association and other trade bodies, it is likely that disclosures made by other banks, especially outside the UK, will not be directly comparable.
The Basel II framework was implemented in the European Union (EU) through the Capital Requirements Directive (CRD).
The framework is based around three Pillars:
•
Pillar 1 – Minimum capital requirements: defines rules for the calculation of credit, market and operational risk.•
Pillar 2 – Supervisory review process: requires banks to undertake an Individual Capital Adequacy Assessment Process (ICAAP) for other risks.•
Pillar 3 – Market discipline:requires expanded disclosures to allow investors and other market participants to understand the risk profiles of individual banks.The Group adopted Basel II on 1 January 2008, in line with the EU timescales.
Banks are required to disclose all their material risks as part of the Pillar 3 framework. Some of these requirements have already been satisfied within the Group’s 2008 Annual Report and
Accounts, also available on the Group's website. The 2008 Report and Accounts includes a range of Group and divisional risk factors and provides in-depth analysis on the specific risks to which the Group is exposed.
These Pillar 3 disclosures provide additional information over and above the Group’s 2008 Report and Accounts. Specifically, Pillar 3 provides additional information on the minimum capital requirements under Pillar 1. Liquidity risk, which does not form part of the minimum capital
requirements, is discussed on pages 103 to 107 of the Group’s 2008 Report and Accounts. Disclosures on credit market exposures are also published as part of the 2008 Report and Accounts on pages 122 to 144.
Application in the Group
For credit risk, the majority of the Group uses the Advanced Internal Ratings Based Approach (IRB) for calculating RWAs, making the Group one of the small number of banks whose risk systems and approaches have reached the required standards.
The Group manages market risk in the trading and non-trading (treasury) portfolios through the market risk management framework. The framework includes VaR limits, backtesting, stress testing, scenario analysis and position/sensitivity analysis.
For operational risk the Group uses The Standardised Approach (TSA) which calculates operational risk RWAs based on gross income. The Group is considering adopting the Advanced Measurements Approach (AMA) for all or part of the business.
Pillar 1 – Minimum capital requirements
Basel II requires risk -weighted assets (RWAs) to be calculated for credit, operational and market risk with various approaches available to banks, with differing levels of sophistication. Minimum capital requirements are calculated as 8% of RWAs.
Credit risk
Minimum capital requirements
Operational risk Market risk
Non-Retail - Standardised - Foundation IRB - Advanced IRB
Retail - Standardised - Retail-IRB
Counterparty Credit Risk - Mark to market - Internal models method - Standardised
Asset Securitisation - Rating based approach - Internal assessment approach
- Supervisory formula
Approaches : - Basic indicator - Standardised - Advanced measurement Enhancement to
1996 Market Risk Amendment
Pillar 2 – Supervisory review process
Pillar 2 focuses on risks either not adequately covered in, or excluded from, Pillar 1. The first part of Pillar 2 is the Group Board’s assessment of capital requirements, over the short and long term (ICAAP). The ICAAP is followed by in-depth discussions between the Group and regulators on the appropriate capital levels (this second stage is called the Supervisory Review and Evaluation Process or SREP).
For the Group, Pillar 2 currently focuses on pension fund and interest rate risk in the banking book (IRRBB), together with stress tests to assess the adequacy of capital across a range of economic scenarios and time periods. Whilst IRRBB forms part of these Pillar 3 disclosures, pension fund risk is discussed in the Group’s 2008 Report and Accounts on page 121.
Pillar 3 – Market discipline
The approach to disclosures, both internally and externally has been enhanced, with expanded Board level risk reporting providing greater focus on current and emerging issues. Externally, the Group’s discussion on risk and capital management has been expanded, to reflect feedback and satisfy good market practice, as articulated by accounting standards, the Financial Stability Forum and Committee of European Banking Supervisors (CEBS) proposals on bank transparency. The Board is committed to delivering best in class risk and capital disclosures, to ensure that stakeholders understand the risks inherent within the Group. The Pillar 3 disclosures, published as part of the Basel framework, represent a further enhancement of the Group’s disclosures which, in totality, are designed to encourage market transparency and stability.
Group Internal Audit undertook a review to assess the adequacy and effectiveness of the controls over the systems and processes to produce the Pillar 3 disclosures. The purpose of Group Internal Audit’s review was to provide management with assurance over the Pillar 3 disclosure process controls to satisfy regulatory requirements and to prevent material misstatement.
The Board intends to publish Pillar 3 on an annual basis, in line with the timescales required by the EU CRD.
The Group’s various subsidiaries in Europe will publish capital and risk weighted asset data externally through an appropriate mechanism (website, annual reporting statements etc), thereby satisfying the CEBS requirements for member state disclosures. Outside the EU, local subsidiaries may make additional disclosures under Pillar 3, as required by their local regulators.
The Group has participated in the British Bankers’ Association drive towards consistent Pillar 3 disclosures for UK banks wherever possible. Footnotes have been added to the data tables to ensure transparency of the approaches adopted in these disclosures. At the EU and global level, different definitions and assumptions will make direct comparison difficult.
ABN AMRO and Basel
ABN AMRO is fully consolidated in the financial results of the Group. For further details, see the 2008 Annual Report and Accounts.
With regard to Basel, ABN AMRO effectively remains on Basel I until the end of 2009. Each consortium member is currently working on their own implementation of the Basel II framework, in line with their chosen approach and philosophy. Unless explicitly stated, ABN AMRO is excluded from the data tables. Where it is disclosed, data is typically included on a Basel I basis unless otherwise stated.
As part of the ABN AMRO integration process some assets have migrated to Group portfolios and are therefore included in the Basel II disclosures.
The Royal Bank of Scotland Group plc is the parent undertaking for all authorised firms in the Group and is subject to consolidated supervision by the Financial Services Authority (FSA). The Pillar 3 disclosure has been prepared for the Group in accordance with BIPRU Chapter 11 of the FSA handbook. A summary of the structure of the Group for regulatory reporting purposes is as follows.
Regulatory and statutory consolidations
Control
Inclusion of an entity in the statutory consolidation is driven by the Group’s ability to exercise control over that entity. The regulatory consolidation applies the same test but is restricted to certain categories of entity – non-financial companies and insurers are excluded from the regulatory consolidation. In addition, certain special purpose entities are excluded from the regulatory consolidation in accordance with FSA rules.
Significant influence or joint control
Where the Group does not have control of an entity but has more that 20% of the votes or capital in that entity, then it must be included in the regulatory consolidation on a pro rata basis unless it falls into one of the excluded categories or the Group has agreed a different treatment with the FSA. Such entities will only be included in the statutory consolidation on a pro rata basis where the Group has joint control. Entities where the Group has significant influence will be equity accounted in the statutory
Solo-consolidation, impediments to the transfer of capital resources and aggregate capital deficiency
Individual firms within the Group apply the provisions laid down in BIPRU 2.1 (solo-consolidation waiver) in a limited number of cases only. At 31 December 2008, The Royal Bank of Scotland plc had four solo-consolidated subsidiaries whilst National Westminster Bank Plc had eleven solo-consolidated subsidiaries. The waiver is only used where the business is an extension of the parent bank’s activities undertaken through a subsidiary for commercial reasons and which requires solo-consolidation to ensure that there are no adverse consequences to the capital ratios.
The Group operates on an integrated basis with all Group companies being subject to policies, governance and controls that are set centrally. Aside from the need to ensure that regulated Group subsidiaries maintain adequate capital to meet their regulatory requirements, there are no current or foreseen material, practical or legal impediments to the transfer of capital or repayments of liabilities when due. The Royal Bank of Scotland Group plc
The Royal Bank of Scotland plc
The Royal Bank of Scotland plc Subsidiaries
Overseas Authorised Banks
Principal Entities:
• Citizens Financial Group Inc • The Royal Bank of Scotland • International Limited • Isle of Man Bank Limited National Westminster
Bank Plc
Ulster Bank Limited
Ulster Bank Limited Subsidiaries Adam & Company
PLC Subsidiaries Adam & Company
PLC
Coutts & Company National Westminster Bank Plc Subsidiaries Adam & Company
Group PLC
National Westminster Bank Plc Subsidiaries The Royal Bank of Scotland Group plc
Deconsolidated Subsidiaries
• RBS Insurance Group Limited • RBS Group Insurance Services Limited (excl. Lombard Direct Home Insurance
Services Limited) • RBS Life Holdings Limited
The Royal Bank of Scotland Group plc Subsidiaries
• RBSG Capital Corporation
ABN AMRO Bank and Subsidiaries
• ABN AMRO Bank NV
Overseas Authorised Banks
• First Active
• Ulster Bank Ireland Limited
Overseas Authorised Banks
• RBS Coutts Bank Limited
Governance
Risk and capital management strategy is owned and set by the Group’s Board of Directors, and implemented by executive management led by the Group Chief Executive. There are a number of committees and executives that support the execution of the business plan and strategy, as set out below:
Group Executive Management Committee
Executive Risk Forum
Group Audit Committee Group Board of Directors
Advances Committee
Group Credit Committee
Group Asset and Liability
Management Committee Group Risk Committee
The role and remit of these committees is as follows:
Committee Focus Membership
Group Audit Committee Financial reporting and the application of accounting Independent non-executive directors (GAC) policies as part of the internal control and risk
assessment process. GAC monitors the identification, evaluation and management of all significant risks throughout the Group.
Advances Committee Deals with transactions that exceed the Group Credit Members of GEMC (AC) Committee’s delegated authority and large exposures. Group Chief Credit Officer
Group Executive Ensures implementation of strategy consistent with risk Business and function heads, as determined by the
Management Committee appetite. Group Chief Executive/Board
(GEMC) (1)
Executive Risk Forum Acts on all strategic risk and control matters across Group Chief Executive (ERF) the Group including, but not limited to, credit risk, Group Finance Director
market risk, operational risk, compliance and regulatory Group Chief Risk Officer risk, enterprise risk, treasury and liquidity risk, Chairman, Regional Markets reputational risk, insurance risk and country risk. Chief Executive, RBS UK
Chief Executive, Global Banking & Markets Group Risk Committee Recommends limits and approves processes and Group Chief Risk Officer
(GRC) policies to ensure the effective management of all Group head of each risk type
material risks across the Group. Group Treasurer
Chief Executive and Chief Risk Officer from each division Group General Counsel and Group Secretary
Group Chief Economist
Group Credit Committee Approves credit proposals under the authority Members as determined by GEMC (GCC) delegated to the committee by the Board and/or the
Advances Committee.
Group Asset and Liability Identifies, manages and controls the Group balance Group Finance Director
Management Committee sheet risks. Chairman/Chief Executive from each division
Management responsibilities
All employees have a role to play in the day to day management of capital and risk which is set and managed by specialist staff in:
•
Risk management: credit, market, operational, regulatory, enterprise and insurance risk, together with risk analytics.•
Group Treasury: balance sheet, capital management, intra-group exposure, funding, liquidity and hedging policies.Independence underpins the approach to risk management, which is reinforced through the Group by appropriate reporting lines. Risk management and Group Treasury functions are independent of the revenue generating business. As part of the move toward greater functional independence, the divisional chief risk officers have a direct reporting line to the Group Chief Risk Officer.
Group Internal Audit supports the Group Audit Committee in providing an independent assessment of the design, adequacy and effectiveness of the internal controls.
Capital management
The Group aims to maintain appropriate levels of capital, in excess of regulatory requirements, that ensures the Group`s capital position remains appropriate given the economic and competitive environment.
Capital adequacy and risk management are closely aligned. The Group undertakes regular assessments of its internal capital requirement, based on a quantification of the material risks to which it is exposed. Capital allocation
As part of the annual planning and budgeting cycle, each division is allocated capital based on RWAs and associated regulatory deductions. The budgeting process considers risk appetite, available capital resources, stress testing results and business strategy. The Group’s capital budget is agreed by the Board and allocated to divisions to manage their allocated RWAs.
Group Treasury and the Group Asset and Liability Committee monitor actual utilisation of capital by tracking availability and utilisation by divisions. GALCO also makes the necessary decisions around re-allocation of budget and changes in RWA re-allocations.
Minimum capital and RWAs
Whilst disclosure of RWAs is not a requirement of Pillar 3, RWAs are included in the following table as they remain an important part of the internal management information used by the Group.
The following table analyses the Group’s total RWAs and minimum capital by risk type.
Minimum capital
RWAs requirement
31 December 2008 31 December 2008(1)
Risk type £m £m
Credit and counterparty risk 612,478 48,999
Market risk 46,461 3,717
Operational risk 36,851 2,948
695,790 55,664
Note:
The following table shows the Group’s capital resources under Pillar 3. This differs from Pillar 1 regulatory capital where innovative capital is shown under Tier 1 capital whereas under Pillar 3 it is part of Tier 2 capital.
31 December 2008
Composition of regulatory capital £m
Tier 1
Ordinary shareholders’ equity 45,525
Minority interests 21,619
Adjustments for:
Goodwill and other intangible assets – continuing (20,049)
Unrealised losses on available-for-sale debt securities 3,687
Reserves arising on revaluation of property and unrealised gains on available-for-sale equities (984)
Reallocation of preference shares and innovative securities (1,813)
Other regulatory adjustments (362)
Core Tier 1 capital 47,623
Preference shares 16,655
Tax on excess of expected losses over provisions 615
Material holdings (689)
Expected loss less provisions (1,078)
Securitisation positions (662)
Total Tier 1 capital 62,464
Tier 2
Innovative Tier 1 securities 7,383
Reserves arising on revaluation of property and unrealised gains on available-for-sale equities 984
Collective impairment allowances 666
Perpetual subordinated debt 9,829
Term subordinated debt 23,162
Minority and other interests in Tier 2 capital 11
Less deductions from Tier 2 capital (2,429)
Total Tier 2 capital 39,606
Tier 3 260
Supervisorydeductions
Unconsolidated investments (4,044)
Other deductions (111)
Total deductions other than from Tier 1 capital (4,155)
Total regulatory capital 98,175
The table below reconciles the Group’s Pillar 1 (as shown in the 2008 Report and Accounts) and Pillar 3, Tier 1 capital as at 31 December 2008: 31 December
2008 £m
Pillar 3 Tier 1 capital 62,464
Add: innovative tier 1 capital 7,383
Pillar 1 Tier 1 capital 69,847
Credit risk is the risk arising from the possibility that the Group will incur losses from the failure of customers to meet their financial obligations to the Group.
Objective
The objective of credit risk management is to enable the Group to achieve a sustainable risk profile by maintaining credit risk exposure within acceptable, pre-defined parameters.
The Group’s credit risk function analyses credit portfolios and individual facilities across all divisions and maintains minimum standards for credit risk management throughout the Group.
The application of the Group’s credit risk policy standards ensure that all credit risk managers have a clear and thorough understanding of the Group’s credit risk appetite and the minimum requirements that must be followed in the assessment, approval, monitoring and management of credit risk.
Principles
The key principles for credit risk management in the Group are as follows:
•
A credit risk assessment of the customer and credit facilities is undertaken prior to approval of credit exposure. Typically, this includes both quantitative and qualitative elements including, the purpose of the credit and sources of repayment; compliance with affordability tests; repayment history; ability to repay; sensitivity to economic and market developments; and risk-adjusted return based on credit risk measures appropriate to the customer and facility type.•
Credit risk authority is specifically granted in writing to individuals involved in the granting of credit approval, whether this is individually or collectively as part of a credit committee. In exercising credit authority, individuals are required to act independently of business considerations and must declare any conflicts of interest.•
Credit exposures, once approved, are monitored, managed and reviewed periodically against approved limits. Lower quality exposures are subject to more frequent analysis and assessment.•
Credit risk management works with business functions on the ongoing management of the credit portfolio, including decisions on mitigating actions taken against individual exposures or broader portfolios.•
Customers with emerging credit problems are identified early and classified accordingly. Remedial actions are implemented promptly and are intended to restore the customer to a satisfactory status and minimise any potential loss to the Group.•
Stress testing of portfolios is undertaken to assess the potential credit impact of non-systemic scenarios and wider macroeconomic events on the Group’s income and capital.Each division has established its own credit risk management framework consistent with that of the Group’s. Divisional credit departments are responsible for maintaining their credit risk
management framework and ensuring that asset quality is within agreed risk appetite. Divisional credit risk departments are independent of business management and have no direct responsibility or
accountability for revenue generation. This independence is supported by the divisional head of credit having dual reporting lines to both the divisional Chief Executive Officer (by the way of the divisional Chief Risk Officer) and to the Group Chief Credit Officer.
The Group Risk Committee and the Group Executive Management Committee reports on the Group’s portfolios on a monthly basis.
Structure and governance
As at 31 December 2008, the Group Risk Committee considers detailed reports of credit risk performance such as sector performance reports and monthly risk portfolio performance trend information. The committee also approves new credit risk policy standards which are material. The Group Credit Committee is responsible for approving material proposals to extend credit facilities in excess of those authorities delegated to divisional credit committees and will make
recommendations to the Advances Committee for approval of facilities in excess of its own delegated authority. As part of their decision the committee approves the credit grade and facility LGD estimates in each proposal.
Organisational changes will continue in 2009, to ensure a fully integrated approach to credit risk across the Group.
Credit risk management
Divisional Risk Management Committees focus on portfolio level decisions which drive credit quality, such as changes to policy and strategy, for example the setting of credit scorecard cut- offs, or divisional credit risk product policy standards. The divisional Risk Management Committees are also responsible for reviewing on going performance of the business and if necessary making or
recommending adjustments to risk appetite. Each divisional credit department manages its own credit portfolio and maintains its own base of detailed divisional credit policy standards. Divisional Heads of Credit delegate authorisation of credit undertakings to divisional credit officers according to each individual officer’s experience and capability.
Credit approval process
Different credit approval processes exist for each customer type which ensures that appropriate skills and resources are employed in credit assessment and approval:
•
specialist credit risk teams within the Group Credit Risk function and divisional credit risk functions oversee the credit processindependently, making credit decisions within their discretion, or recommending decisions to the appropriate credit committee. Assessments of borrower and transaction risk are undertaken using the application of credit risk models and/or credit analysis.
•
financial market counterparties are approved by a dedicated credit function which specialises in traded market product risk. Specialist credit grading models exist for certain bank and financial institutions. Wholesale businessesWholesale includes the following exposure classes; central governments and central banks, institutions, corporates, equities and securitisation positions.
Wholesale risk limits are aggregated at the counterparty level to determine the level of credit approval required and to facilitate consolidated credit risk management.
The credit approval process has two stages: assessment and decision. Credit applications for corporate customers are prepared by
relationship managers in the units originating the credit exposures or by the relationship management team with lead responsibility for a counterparty, where a customer has relationships with different divisions and business units across the Group. This includes the assignment of credit grades and LGD estimates using approved models.
For the more significant corporate exposures requiring credit committee approval, and where the obligor is graded using the large corporate grading model, the relationship managers are usually supported by specialist divisional counterparty analysis teams. The analysis functions are independent of the deal origination teams, and are responsible for providing a detailed financial report on the obligor group and assigning credit grades. They are staffed with accountants, ex-rating agency staff and highly experienced credit analysts.
Credit applications for banks and non bank financial institutions are prepared by the specialist teams with grading and LGD models. Credit applications are generally made in end to end credit systems. Following the approval of facilities, limits are marked approved in credit systems and, provided that conditions precedent are completed satisfactorily, the limits will be made available to front office systems.
Daily monitoring of individual counterparty limits is undertaken. For certain counterparties early warning indicators are also in place to detect deteriorating trends of concern in limit utilisation or account performance. A framework is also in place to monitor changes in credit quality at the portfolio level.
As a minimum, rerating is performed at annual review, as part of which the ongoing adequacy of security is assessed; and compliance with terms and conditions is examined. The credit grade and LGDs proposed as part of every credit application are reviewed by the credit department. This review considers explicitly whether the correct model has been used, whether the model inputs appear appropriate and whether the output adequately describes the risk.
Retail businesses
Retail includes the following exposure classes; retail secured by real estate collateral, qualifying revolving retail exposures and other retail exposures.
The retail business makes a large volume of small scale credit decisions, typically involving an application for a new product or a change in facilities on an existing product. The majority of these decisions are based upon automated strategies utilising best practice credit and behaviour scoring techniques. Scores and strategies are typically segmented by product, brand and other significant drivers of credit risk. These data driven strategies utilise a wide range of credit information relating to a customer including, where appropriate, information across a customer’s holdings.
A small number (by volume) of credit decisions are subject to additional manual underwriting, for example higher value more complex small business transactions and some residential mortgage applications. Divisional risk management committees focus on portfolio level decisions which drive credit quality, changes to policy and strategy, and the setting of credit scorecard cut-offs. The divisional risk management committees are also responsible for reviewing on-going performance of the business and, if necessary, making or recommending adjustments to risk appetite.
Definition of default
The definitions of default used by the Group are as follows:
•
wholesale businesses: the BIPRU unlikeliness to pay triggers and 90 days past due rule have been adopted within wholesale credit policy and modelling. Default is measured across all exposures to an obligor and in cases where a credit grade is cascaded to other obligor group members, the default grade will also serve to cross default those obligors. Where a cascaded grade has been applied it will serve to•
retail businesses: credit risk measurement policy defines default as 90 days past due or unlikeliness to pay in full. Whilst BIPRU rules permit 180 days for non small medium sized enterprise portfolios, retail portfolios adopt a uniform 90 days past due definition. This facilitates consistency, and is closely aligned with operational default and the Group’s impairment definition used in InternationalAccounting Standards. Default is measured at the account rather than obligor level. Cross product data is shared through the behaviour score, application score or the use of credit bureau data/scores.
Credit systems
The Group operates a centralised risk data warehouse and reporting system. Divisional credit risk and finance data is fed through to this data warehouse on a transactional basis for wholesale exposures and on a pooled basis for retail exposures. This centralised system is used to deliver regulatory reporting, external disclosures and internal
management reporting on credit risk. The scope of the data is primarily driven by RWAs, but is increasingly being enhanced to deliver additional risk management reporting on a consistent basis across the Group.
Credit risk models
Credit risk models are used throughout the Group to support the quantitative risk assessment part of the credit approval process, ongoing credit risk management, monitoring and reporting and portfolio analytics. Credit risk models used by the Group can be divided into three categories. Probability of default/customer credit grade (PD)
These models assess the probability that a customer will fail to make full and timely repayment of their obligations. The probability of a customer failing to do so is measured over a one year period through the economic cycle, although certain retail scorecards use longer periods for business management purposes.
•
wholesale businesses: each counterparty is assigned an internal credit grade which is in turn assigned to a default probability range. There are a number of different credit grading models in use across the Group, each of which considers risk characteristics particular to that type of customer. The credit grading models score a combination of quantitative inputs, such as recent financial performance and qualitative inputs, such as management performance or sector outlook. Scores are then mapped to grades within each model. Grades are calibrated centrally to default probabilities determined in accordance with the definition of default. Obligor grades can, under certain circumstances, be cascaded to other borrowing entities within the obligor group where there is sufficient dependence on the graded entity.Included in such models are grading models that cover customers or transactions categorised within BIPRU as specialised lending (e.g. certain categories of investment property and asset finance such as shipping and project finance).
The credit grades for sovereign and central bank entities are assigned by a specialist country risk analysis team using a sovereign grading model. This team is independent of the origination function and is comprised of economists.
Banking book equity transactions use the PD/LGD approach to capital calculation. Issuers are graded using the relevant corporate, financial institution or sovereign model. Where banking book equity issued by an existing borrowing customer is held, the customer’s credit grade is also used to grade the equity. LGDs are fixed by BIPRU.
•
retail businesses: each customer account is separately scored using models based on the most material drivers of default. In general, scorecards are statistically derived using customer data. Customers are assigned a score which in turn, is mapped to a probability of default. The probability of default is used for two main purposes. Firstly, within the credit approval process and ongoing credit risk management, monitoring and reporting. Secondly, customers are grouped into risk pools using the scored probability of default. Pools are then assigned a weighted average pool probability of default using regulatory default definitions. These weighted averages are used to determine regulatory capital requirements.Exposure at default (EAD)
These models estimate the expected level of utilisation of a credit facility at the time of a borrower’s default. For revolving and variable draw down type products the EAD will typically be higher than the current utilisation. The methodologies used in EAD modelling provide a conservative estimate of the potential exposure and recognise that customers may make more use of their existing credit facilities as they approach default. Unlike other credit risk models, the regulator has issued more direction to the industry in relation to acceptable EAD approaches for the IRB capital calculation. This includes rules that determine when exposures require an EAD, and when there is no exposure to report.
•
counterparty credit risk exposure measurement: These models calculate the market driven credit risk exposure for products where the exposure is not based simply upon principal and interest due. These models are most commonly used for derivative and other traded instruments where the amount of credit risk exposure may be dependent upon one or more underlying market variables such as interest or foreign exchange rates. These models drive internal credit risk activities such as limit and excess management. Some are used for regulatory reporting; where this is not the case regulatory exposure calculation rules are used.Loss given default (LGD)
These models estimate the economic loss that may be experienced by the Group on a credit facility in the event of default. The LGD represents the amount that cannot be recovered and is typically expressed as a percentage of the facility limit for wholesale portfolios, or as a percentage of the EAD for retail portfolios. The Group’s LGD models take into account both borrower and facility characteristics for unsecured or partially unsecured facilities, as well as the quality of any risk mitigation that may be in place for secured facilities, plus the cost of collections and a time discount factor for the delay in cash recovery. Secured LGD models cover, for example, guarantees, credit derivatives, and eligible collateral (both physical and financial).
Model validation
The performance and accuracy of credit models is critical, both in terms of effective risk management and also the calculation of risk parameters (PD, LGD and EAD) used by the Group to calculate RWAs. The models are subject to frequent validation internally and, if used as part of the IRB Basel II framework, have been reviewed and approved for use by the FSA.
Independent model validation is performed by the Group. This includes an evaluation of the model development and validation for the data set used, logic and assumptions, and performance of the model analysis. Where required, the Group has engaged external risk management consultants to undertake independent reviews and report their findings to the Wholesale or Retail Credit Model Committee. This provides a benchmark against industry practices.
The validation results are a key factor in deciding whether a model is recommended for ongoing use. The frequency, depth and extent of the valuation are consistent with the materiality and complexity of the risk being managed. The Group’s validation processes include:
•
Developmental evidence: to ensure that the credit risk model adequately discriminates between different levels of risk and delivers accurate risk estimates.•
Process verification:whether the methods used in the credit risk models are being used, monitored and updated in the way intended in the design of the model. Initial testing and validation is performed when the model is developed with the performance of models being assessed on an ongoing basis.Credit risk mitigation
The Group employs a number of structures and techniques to mitigate credit risk.
•
Netting of debtor and creditor balances is utilised under regulatory and internal policy and requires a formal agreement with the customer to net the balances and a legal right of set-off.•
Under market standard documentation net exposure on over the counter (OTC) derivative and secured financing transactions is further mitigated by the exchange of financial collateral.•
The Group enhances its position as a lender in a range of transactions, from retail mortgage lending to large wholesale financings bystructuring a security interest in a physical or financial asset.
•
Credit derivatives, including credit default swaps, credit linked debt instruments, and securitisation structures are used to mitigate the credit risk in its loan portfolio.•
Guarantees and similar instruments (e.g. credit insurance) from related and third parties are used in the management of credit portfolios typically to mitigate credit concentrations in relation to an individual obligor, a borrower group or a collection of related borrowers.Model review governance
The Group Risk Analytics Model Review Team is responsible for independent oversight of wholesale and retail models and approaches. Two committees, the Wholesale Credit Model Committee and the Retail Credit Model Committee, have been established to review and challenge high, medium and low materiality models before approval by the appropriate Risk Committee and to approve low materiality models.
These Committees comprise members of Group Risk and senior managers from within divisional credit risk. Models with high materiality are agreed by the Group Risk Committee and those of medium materiality are approved by the Group Models Committee, a sub committee of Group Risk Committee. The internal model process and governance arrangements are detailed below:
Group Risk Co
mm
ittee
Group Model Co
mm
ittee
Wholesale Credit Model
Co
mm
ittee
Retail Credit Model
Co
mm
ittee
Technical review of all models Approve low materiality models Approve high materiality models
Collateral valuation and management
The use and approach to credit risk mitigation varies by product type, customer, and business strategy and reflects the risk appetite of the Group. To ensure that credit risk mitigation is effective it must be in place prior to the drawdown of facilities and actively monitored and reported. Minimum standards cover:
•
general requirements including acceptable credit risk mitigation types and any conditions or restrictions applicable to those mitigants;•
the maximum loan to value percentages, minimum haircuts or other volatility adjustments applicable to each type of mitigant including, where appropriate, adjustments for currency mismatch, obsolescence and any time sensitivities on asset values;•
the means by which legal certainty is to be established, including required documentation and all necessary steps required to establish legal rights;•
acceptable methodologies for the initial and any subsequent valuations of collateral and the frequency with which they are to be re-valued (e.g. daily in the trading book);•
actions to be taken in the event the current value of mitigation falls below required levels;•
management of the risk of correlation between changes in the credit risk of the customer and the value of credit risk mitigation e.g. any situations where customer default materially impacts the value of a mitigant and applying a haircut or recovery value adjustment which reflects the potential correlation risk;•
management of concentration risks e.g. setting thresholds and controls on the acceptability of credit risk mitigants and in particular specialised businesses financing specific asset classes e.g. aircraft, shipping; and•
collateral management to ensure that credit risk mitigation is legally effective and enforceable.Primary types of collateral taken
The following table outlines how different risk mitigants are incorporated into IRB risk parameters across both wholesale and consumer
businesses.
Credit risk mitigants LGD PD EAD/E* Real estate (commercial and residential) √
Other physical collateral √
Third party guarantee √
Credit derivative √
Parental guarantee (connected parties) √
Financial collateral (trading book) √
Financial collateral (non-trading book) √
Netting (on and off balance sheet) √
Receivables √
Life policies √
Credit insurance √
•
Real estate: the most common form of security held with the consumer and wholesale businesses.•
Financial collateral:is taken to support credit exposures in the non-trading book. Financial collateral is also taken to support non-trading book exposures and is incorporated in E* (adjustment to the exposure value) calculations.•
Other physical collateral: the Group takes a wide range of other physical collateral including; business assets (stock and inventory, plant and machinery, equipment), project assets, intangible assets which provide a future cashflow and real value, commodities, vehicles, rail stock, aircraft, ships and receivables (not purchased).•
Guarantees: third party guarantees are taken from banks, government entities, export credit agencies, and corporate entities. The Group’s recovery value estimation methodology is sensitive to the variations in the credit quality of guarantors. Standby letters of credit are also given value in LGD models. Conditional guarantees are accepted, in accordance with internal requirements, and are included as appropriate in PD and LGD estimates (e.g. small firms loan guarantee schemes, completion guarantees). Personal guarantees are considered in the normal credit process where there is a change 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: all credit derivative activity is conducted through designated units to ensure consistency and appropriate control. Group policies are designed to ensure that the credit protection is appropriate to support offset for an underlying trading book asset or improvement to the LGD of a banking book asset. Within the banking book, credit derivatives are used as risk and capital management tools. The principal counterparties are banks, investment firms and other market participants, with the majority subject to collateralisation under a credit support annex. In accordance with internal policy, stress testing is conducted on the counterparty credit risk created by the purchase of credit protection.The following table analyses credit risk exposure and RWAs by approach.
31 December 2008 Minimum Credit RWAs capital post CRM(1) requirement
Credit risk approach £m £m
Advanced IRB 237,578 19,006
Standardised 107,596 8,609
Counterparty credit risk 61,087 4,887
406,261 32,502
ABN AMRO – Basel I 206,217 16,497
612,478 48,999 Note:
(1) Credit risk RWAs include both intra-group and non-customer assets.
A detailed analysis of the Advanced IRB, standardised and Basel I approaches follows. The counterparty credit risk is analysed on page 29. Exposure as shown in these credit disclosures is defined as exposure at default (EAD). This is an estimate of the expected level of utilisation of a credit facility at the time of default and will be equal to or greater than the drawn exposure.
Credit risk by IRB approach
The following table shows the Group’s RWAs and capital requirements by IRB exposure class. These balances include non-customer assets.
31 December 2008 Minimum Credit RWAs capital post CRM requirement
IRB exposure class and sub-class £m £m
Central governments and central banks 576 46
Institutions 3,717 297
Corporates 153,287 12,263
Retail 57,907 4,632
Retail SME 14,837 1,187
Retail secured by real estate collateral 18,930 1,514
Qualifying revolving retail exposures 11,822 946
Other retail exposures 12,318 985
Equities 7,951 636
Exchange traded exposures 4,170 334
Private equity exposures 2,064 165
Other exposures 1,717 137
Securitisation positions 8,921 714
Non-credit obligation assets 5,219 418
Gross IRB customer credit risk
The following tables detail the Group’s gross customer IRB credit risk by exposure class, geographic area, industry sector and residual maturity band. The gross customer exposure is shown as the exposure at default (EAD) before the application of credit risk mitigation (CRM), excluding products calculated under the counterparty credit risk approach.
IRB gross average exposure at default
31 December 2008
Average EAD EAD pre CRM(1, 2) pre CRM(3)
IRB exposure class £m £m
Central governments and central banks 16,019 16,170
Institutions 16,683 21,247
Corporates 365,900 348,882
Retail 172,212 172,179
Equities 5,425 5,564
Securitisation positions 64,010 46,850
Non-credit obligation assets (4) 3,670 2,151
643,919 613,043
Notes:
(1) EAD pre CRM is before the application of on-balance sheet netting.
(2) EAD excludes non-customer assets along with OTC and repo products which are shown separately in the counterparty credit risk disclosures. (3) Average is based on the last six months of 2008.
(4) Non-credit obligation assets above refers to residual value of leases only.
IRB gross exposure at default by geographic area
31 December 2008 (1, 2, 3) Western
North Europe Asia Latin CEE Middle East
UK America (excl. UK) Pacific America Central Asia & Africa Total
IRB exposure class £m £m £m £m £m £m £m £m
Central governments and central banks 8,227 605 5,458 1,435 — 13 281 16,019
Institutions 3,606 1,822 6,923 2,329 931 329 743 16,683
Corporates 175,870 46,151 99,444 18,875 11,742 3,429 10,389 365,900
Retail 145,408 185 25,964 312 114 67 162 172,212
Equities 1,074 263 108 3,927 53 — — 5,425
Securitisation positions 14,832 23,943 13,584 3,791 7,842 18 — 64,010
Non-credit obligation assets (4) 682 211 1,467 645 335 203 127 3,670
349,699 73,180 152,948 31,314 21,017 4,059 11,702 643,919
Notes:
(1) EAD pre CRM is before the application of on-balance sheet netting.
(2) EAD excludes non-customer assets along with OTC and repo products which are shown separately in the counterparty credit risk disclosures. (3) The geographic area is determined by the country of incorporation for companies and for individuals as the country of residence. (4) Non-credit obligation assets above refers to residual value of leases only.
IRB gross exposure at default by industry sector
31 December 2008(1, 2)
Central Non
governments credit
and central Securitisation obligation(4)
banks Institutions Corporates Retail Equities positions assets Total
Industry sector (3) £m £m £m £m £m £m £m £m
Agriculture and fisheries — — 2,340 1,655 — — — 3,995
Building and construction 63 — 20,243 1,539 39 — 153 22,037
Business services — — 11,447 — 20 408 8 11,883
Banks and building societies 2,986 16,589 1,152 1 3,967 86 91 24,872
Financial intermediaries 1,924 94 38,617 287 996 55,835 39 97,792
Manufacturing — — 38,311 808 29 1,537 53 40,738
Natural resources and nuclear 19 — 15,720 136 28 225 13 16,141
Personal — — 3,136 152,814 — — — 155,950
Power, water and waste — — 20,432 10 30 460 9 20,941
Property — — 101,408 5,477 39 1,512 18 108,454
Public sector and quasi government 10,674 — 11,213 2,230 37 — 93 24,247
Technology, media and telecommunications — — 20,692 20 119 735 110 21,676
Tourism and leisure 19 — 16,059 3,750 — 1,329 120 21,277
Transport and storage 53 — 36,883 352 3 565 2,612 40,468
Wholesale and retail trade 281 — 28,247 3,133 118 1,318 351 33,448
16,019 16,683 365,900 172,212 5,425 64,010 3,670 643,919
Notes:
(1) EAD pre CRM is before the application of on-balance sheet netting.
(2) EAD excludes non-customer assets along with OTC and repo products which are shown separately in the counterparty credit risk disclosures. (3) Industry sectors are determined using Standard Industrial Classification (SIC) codes of the counterparty.
(4) Non-credit obligation assets above refers to residual value of leases only.
IRB gross exposure at default by residual maturity
31 December 2008 (1, 2, 3) Within(5) After 1 but After
1 year within 5 years(5) 5 years Total
IRB exposure class £m £m £m £m
Central governments and central banks 7,089 5,192 3,738 16,019
Institutions 12,431 3,369 883 16,683
Corporates 78,967 190,800 96,133 365,900
Retail 40,045 12,535 119,632 172,212
Equities — — 5,425 5,425
Securitisation positions 34,198 11,171 18,641 64,010
Non-credit obligation assets(4) 366 740 2,564 3,670
173,096 223,807 247,016 643,919 Notes:
(1) EAD pre CRM is before the application of on-balance sheet netting.
(2) EAD excludes non-customer assets along with OTC and repo products which are shown separately in the counterparty credit risk disclosures. (3) The maturity bandings represent the residual contractual maturity.
(4) Non-credit obligation assets above refers to residual value of leases only. (5) Revolving facilities are included in the ‘within 1 year’ category.
PD Range Asset quality
Master grading scale Lower Upper 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%
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%
12 0.269% 0.381%
13 0.381% 0.538%
14 0.538% 0.761% AQ5
15 0.761% 1.076%
16 1.076% 1.522% AQ6
17 1.522% 2.153%
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%
24 17.222% 24.355%
25 24.355% 34.443% AQ9
26 34.443% 100%
27 100% 100% AQ10
Central governments and central banks by asset qualityband
31 December 2008
EAD Exposure Exposure Undrawn
post weighted weighted Undrawn weighted CRM(1) average(2) average(2)commitments(3) average(4)
Asset qualityband £m LGD risk-weight £m CCF
AQ1 69,984 6.3% 0.6% 14,636 17.5%
AQ2 49 38.0% 390.1% — —
AQ3 111 24.1% 95.2% 72 45.9%
AQ4 69 65.2% 83.8% 102 24.9%
AQ5 55 59.8% 101.0% 111 26.0%
AQ6 54 76.0% 215.4% 48 29.1%
AQ7 61 44.5% 137.3% 4 49.1%
AQ8 — — — — —
AQ9 — — — — —
AQ10/default — — — — —
70,383 6.5% 1.4% 14,973 17.7%
Notes:
(1) EAD post CRM is exposure at default after the application of on balance sheet netting and includes the IRB element of counterparty credit risk but excludes non-customer assets. Asset quality of IRB customer credit risk
The Group has adopted, as part of the move to Basel II, a new master grading scale for wholesale exposures which comprises 27 grades. These in turn map to ten asset quality (AQ) bands used for both wholesale and retail exposures. The relationship between these measures is shown below.
The following tables show the key parameters of the IRB RWA calculation for each of the exposure classes. They include over the counter derivatives and repo products which are also detailed in the counterparty credit risk disclosure, but exclude products where no PD
exists such as securitisation positions and non-customer assets. Grouping of internal grades into AQ bands is undertaken for external reporting purposes only.
Institutions by asset qualityband
31 December 2008
EAD Exposure Exposure Undrawn
post weighted weighted Undrawn weighted CRM(1) average(2) average(2)commitments(3) average(4)
Asset qualityband £m LGD risk-weight £m CCF
AQ1 84,777 33.8% 17.3% 29,243 7.5%
AQ2 1,820 45.1% 102.0% 937 17.1%
AQ3 1,483 63.8% 334.0% 584 21.9%
AQ4 544 44.8% 346.2% 361 13.9%
AQ5 268 55.4% 250.5% 194 12.0%
AQ6 25 56.3% 898.0% 69 6.5%
AQ7 129 54.2% 219.8% 20 4.2%
AQ8 28 52.0% 345.1% 14 4.0%
AQ9 13 76.8% 720.6% 28 21.5%
AQ10/default (5) 11 50.0% — — —
89,098 34.7% 27.7% 31,450 8.2%
Notes:
(1) EAD post CRM is exposure at default after the application of on balance sheet netting and includes the IRB element of counterparty credit risk but excludes non-customer assets. (2) Exposure weighted averages have been weighted by the sum of EAD within each of the PD bands.
(3) Undrawn commitments are defined as the difference between the drawn balance and the limit.
(4) Undrawn weighted average has been weighted by the sum of undrawn commitments within each of the PD bands.
(5) Low risk weight in AQ10 caused by Best Estimate of Expected Loss (BEEL) methodology on defaulted assets, based on downturn LGD. This may result in a nil RWA for defaulted assets as we take a capital deduction equal to the difference in expected loss and provisions.
(6) Conservatism added to institutional exposures to rebase RWAs, increasing exposure weighted average risk weights.
Corporates by asset qualityband
31 December 2008
EAD Exposure Exposure Undrawn
post weighted weighted Undrawn weighted CRM (1) average(2) average(2)commitments(3) average(4)
Asset qualityband £m LGD risk-weight £m CCF
AQ1 116,609 27.6% 10.7% 64,829 30.2%
AQ2 24,069 34.4% 14.4% 15,622 26.7%
AQ3 34,775 29.4% 19.3% 17,848 36.6%
AQ4 68,159 28.3% 31.9% 25,749 41.3%
AQ5 85,547 29.6% 62.1% 18,203 48.2%
AQ6 61,228 29.0% 78.3% 12,040 50.2%
AQ7 26,413 29.2% 87.6% 5,365 46.3%
AQ8 6,878 28.9% 129.2% 1,197 55.9%
AQ9 5,891 33.2% 178.5% 940 38.6%
AQ10/default (5) 9,922 31.9% 3.2% 982 27.4%
439,491 29.1% 42.9% 162,775 36.5%
Notes:
(1) EAD post CRM is exposure at default after the application of on balance sheet netting and includes the IRB element of counterparty credit risk but excludes non-customer assets. (2) Exposure weighted averages have been weighted by the sum of EAD within each of the PD bands.
(3) Undrawn commitments are defined as the difference between the drawn balance and the limit.
(4) Undrawn weighted average has been weighted by the sum of undrawn commitments within each of the PD bands. (5) The low risk weight in AQ10 is caused by the BEEL methodology.
Equities by asset qualityband
31 December 2008
EAD Exposure Exposure Undrawn
post weighted weighted Undrawn weighted CRM (1) average(2) average(2)commitments(3) average(4)
Asset qualityband £m LGD risk-weight £m CCF
AQ1 — — — — —
AQ2 — — — — —
AQ3 3,925 90.0% 106.0% — —
AQ4 16 90.0% 167.8% — —
AQ5 — — — — —
AQ6 349 90.0% 359.5% — —
AQ7 104 90.0% 325.3% — —
AQ8 — — — — —
AQ9 12 90.0% 555.4% — —
AQ10/default (5) 5 90.0% — — —
4,411 90.0% 132.5% — —
Equities calculated using simple risk weight approach
Private equity exposures 915 190.0% 285 100.0%
Other equity exposures 99 370.0% 67 100.0%
1,014 208.0% 352 100.0%
5,425 Notes:
(1) EAD post CRM is exposure at default after the application of on balance sheet netting and includes the IRB element of counterparty credit risk but excludes non-customer assets. (2) Exposure weighted averages have been weighted by the sum of EAD within each of the PD bands.
(3) Undrawn commitments are defined as the difference between the drawn balance and the limit.
(4) Undrawn weighted average has been weighted by the sum of undrawn commitments within each of the PD bands. (5) The low risk weight in AQ10 is caused by BEEL methodology.
Retail SME by asset qualityband
31 December 2008
EAD Exposure Exposure Undrawn
post weighted weighted Undrawn weighted CRM(1) average(2) average(2)commitments(3) average(4)
Asset qualityband £m LGD risk-weight £m CCF
AQ1 — — — — —
AQ2 — — — — —
AQ3 — — — — —
AQ4 1,144 75.8% 31.9% 926 100.0%
AQ5 1,120 59.2% 56.6% 557 100.0%
AQ6 7,942 42.6% 55.2% 955 100.0%
AQ7 4,669 39.6% 60.4% 131 100.0%
AQ8 4,945 40.2% 73.0% 213 100.0%
AQ9 2,058 40.4% 113.6% 42 100.0%
AQ10/default 1,189 59.6% 58.0% — —
23,067 44.6% 64.3% 2,824 100.0%
Notes:
(1) EAD post CRM is exposure at default after the application of on balance sheet netting and includes the IRB element of counterparty credit risk but excludes non-customer assets. (2) Exposure weighted averages have been weighted by the sum of EAD within each of the PD bands.
(3) Undrawn commitments are defined as the difference between the drawn balance and the limit.
Retail securedby real estate by asset qualityband
31 December 2008
EAD Exposure Exposure Undrawn
post weighted weighted Undrawn weighted CRM(1) average(2) average(2)commitments(3) average(4)
Asset qualityband £m LGD risk-weight £m CCF
AQ1 1,028 1.9% 0.2% 476 100%
AQ2 3,433 1.9% 0.2% 1,662 100%
AQ3 584 20.2% 3.2% — —
AQ4 47,084 13.3% 6.1% 1,625 98.5%
AQ5 31,054 11.8% 12.1% 1,868 92.8%
AQ6 13,318 19.3% 31.3% 1,656 84.6%
AQ7 5,723 15.6% 45.5% 176 100.0%
AQ8 2,332 16.2% 77.6% 9 100.0%
AQ9 1,633 17.7% 105.5% — —
AQ10/default 1,607 15.9% 123.3% 29 100.0%
107,796 13.5% 17.6% 7,501 94.5%
Notes:
(1) EAD post CRM is exposure at default after the application of on balance sheet netting and includes the IRB element of counterparty credit risk but excludes non-customer assets. (2) Exposure weighted averages have been weighted by the sum of EAD within each of the PD bands.
(3) Undrawn commitments are defined as the difference between the drawn balance and the limit.
(4) Undrawn weighted average has been weighted by the sum of undrawn commitments within each of the PD bands.
Qualifying revolving retail exposures by asset qualityband
31 December 2008
EAD Exposure Exposure Undrawn
post weighted weighted Undrawn weighted CRM(1) average(2) average(2)commitments(3) average(4)
Asset qualityband £m LGD risk-weight £m CCF
AQ1 133 20.2% 0.5% 3,578 3.7%
AQ2 1,608 79.1% 2.2% 1,065 100.0%
AQ3 6,227 76.0% 3.9% 4,639 100.0%
AQ4 2,133 72.2% 10.6% 9,058 16.2%
AQ5 6,255 73.2% 19.7% 14,623 29.8%
AQ6 2,931 70.6% 38.9% 4,077 35.7%
AQ7 3,507 73.2% 79.1% 1,839 70.7%
AQ8 3,005 77.0% 144.9% 605 80.9%
AQ9 654 81.2% 260.2% 56 100.0%
AQ10/default 1,022 76.1% 11.2% 299 0.5%
27,475 74.3% 43.0% 39,839 37.6%
Notes:
(1) EAD post CRM is exposure at default after the application of on balance sheet netting and includes the IRB element of counterparty credit risk but excludes non-customer assets. (2) Exposure weighted averages have been weighted by the sum of EAD within each of the PD bands.
(3) Undrawn commitments are defined as the difference between the drawn balance and the limit.
Other retail by asset qualityband
31 December 2008
EAD Exposure Exposure Undrawn
post weighted weighted Undrawn weighted CRM(1) average(2) average(2)commitments(3) average(4)
Asset qualityband £m LGD risk-weight £m CCF
AQ1 — — — — —
AQ2 — — — — —
AQ3 39 100.0% 19.2% 26 100.0%
AQ4 139 76.2% 43.3% 1 100.0%
AQ5 2,529 72.6% 67.9% 4 100.0%
AQ6 3,377 71.8% 90.9% 3 100.0%
AQ7 2,962 72.0% 111.8% 2 100.0%
AQ8 2,163 72.3% 129.3% — —
AQ9 620 70.6% 196.8% — —
AQ10/default 2,045 77.1% 6.7% — —
13,874 72.9% 88.8% 36 100.0%
Notes:
(1) EAD post CRM is exposure at default after the application of on balance sheet netting and includes the IRB element of counterparty credit risk but excludes non-customer assets. (2) Exposure weighted averages have been weighted by the sum of EAD within each of the PD bands.
(3) Undrawn commitments are defined as the difference between the drawn balance and the limit.
(4) Undrawn weighted average has been weighted by the sum of undrawn commitments within each of the PD bands.
IRB exposures coveredby guarantees and credit derivatives
The Group utilises a number of different types of collateral. The following table shows the total IRB exposure covered by guarantees and credit derivatives. However this only represents certain elements of collateral taken into consideration by the Group when calculating RWAs. For other types of collateral taken, refer to the credit risk section on page 13.
31 December 2008 (1,2)
IRB exposure class £m
Central governments and central banks 17
Institutions 103
Corporates 22,169
Non-credit obligation assets 92
22,381 Notes:
(1) Guarantees or credit derivatives represents the value of the guarantee or credit derivative applied in the LGD models. Guarantees disclosed do not include parental guarantees where the PD substitution approach is applied.
Expected loss and impairment
Expected loss is the forecast credit loss on a potential default over a one year period. The table shows the expected loss as at 31 December 2007 predicted by the Group models which incorporate LGDs and EADs that reflect downturn economic conditions and PDs calculated on a through-the-cycle basis.
The impairment charge for the year ended 31 December 2008 is also shown in the table. The impairment charge is a point in time estimate and reflects actual provision change and direct write-offs during the year to the income statement.
There are a number of significant differences between the methodology for calculating an expected loss under regulatory rules and raising
impairments under accounting standards. Accounting standards require observable data that provides evidence of events occurring to
recognise the loan losses while similar evidence is not necessarily required in the calculation of expected loss.
•
Expected loss is also calculated on a one year time horizon which is different to the provision charge that represents a point in time event.•
In addition, the impairment charge excludes £5.8 billion of trading asset write-downs. For further details see to page 37 of the 2008 Report and Accounts.Any comparison between these two numbers should not be made without taking into consideration these key differences.
Impairment Expected charge for loss as at year ended 31 December 31 December
2007 2008
IRB exposure class £m £m
Central governments and central banks 5 —
Institutions 40 81
Corporates 2,470 2,307
Retail SME 993 142
Retail secured by real estate collateral 158 55
Qualifying revolving retail exposures 1,227 590
Other retail exposures 2,717 473
Equities 14 —
7,624 3,648
The Group experienced a pronounced deterioration in impairments in the second half of 2008, as financial stress spread to a broad range of customers. Further details of the Group’s impairment charge are shown on page 37 of the 2008 Report and Accounts.
Probability of default
Wholesale credit grading models are hybrid models; the probabilities of default have been calibrated to each grade using sufficiently long historic data, and are expected to remain stable in their mapping to each grade over a cycle. However, the grade assignments to individual customers take into account current economic conditions and the customer’s credit quality. The customer grade is therefore expected to
change over a cycle, and as a result the models are regarded as being closer to point in time.
As an economic cycle deteriorates our portfolio credit quality is expected to be reflected in the grades assigned, resulting in an increase in capital (all other things being equal).
Retail PD models adopt a point in time methodology to facilitate pricing, setting of risk appetite and loss estimation. Models are regularly calibrated to produce robust estimates incorporating a degree of conservatism.
Actual Probability of defaults for default as at year ended 31 December 31 December
2007 2008
IRB exposure class % %
Central governments and central banks 0.83 —
Institutions 1.04 0.23
Corporates 1.72 2.70
Retail SME 3.78 4.37
Retail secured by real estate collateral 1.41 1.29
Qualifying revolving retail exposure 2.51 2.41
Other retail exposures 5.24 4.90
Equities 2.15 1.35
The actual default rate for corporates is higher than the predicted default rate. This was expected given the hybrid nature of the models, for which an economic downturn can result in actual defaults exceeding predicted defaults.
For retail, model observed PD rates are broadly in line with forecast with the exception of retail small and medium sized enterprises where observed PD slightly exceeds forecast. This reflects modest deterioration in this market which has now been incorporated in to revised estimates through the regular model calibration process. The following table shows the PD estimated at the end of 2007, together
with the actual defaults experienced in 2008. Neither is weighted by loss, limit or exposure at default.
Defaults include all cases which meet the Basel II definition of unlikeliness to pay or 90 days past due.
There are two exposure classes where the difference between the predicted and actual is most marked:
•
Corporates:the actual default experience diverges from that suggested by the average PD rates forecast at the end of December 2007.The Group’s corporate PD models utilise historical data based on a long run average of 25 years of default data. The market conditions witnessed in 2008 have resulted in a default experience which falls outside the range predicted by these historical data.
