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Abbey National plc
Annual Report and Accounts 2008
A copy of the above document has been submitted to the UK Listing Authority and will shortly be available for inspection at the UK Listing Authority's Document Viewing Facility, which is situated at:
Financial Services Authority
25 The North ColonnadeCanary WharfLondon
E14 5HS
In fulfilment of its obligations under the Disclosure and Transparency Rules, Abbey National plc hereby releases the unedited full text of its Annual Report & Accounts.
A printer-friendly PDF version of the accounts is now available on the Company's website:
www.aboutabbey.com
The full text of the accounts follows:
Business Review and Forward-looking Statements
Chief Executive's Review
Overview
2008 has been an excellent year for Abbey. In what has been a very difficult trading environment, we have delivered statutory profit growth of 20% underpinned by strong but prudent lending and substantial growth in retail and corporate deposits. Our lending volumes are significantly higher than 2007 and we have increased our share of lending in both the prime mortgage, and small and medium enterprise ('SME') markets. Together with robust contributions from each of our businesses this has allowed us to achieve double digit trading income growth. This is balanced against controlled costs, as we continue to invest in our Corporate Banking and Private Banking businesses, and means that we have double digit operating jaws for the fourth consecutive year and our cost to income ratio has reduced to the targeted 45%, which is now better than the sector average.
Business Performance
Abbey has continued to grow across all areas of its business in 2008 as the bank becomes a full-service commercial bank. We have been a consistent mortgage lender throughout the year offering a full range of competitive mortgage deals resulting in an estimated net lending mortgage share of 29% in 2008. We have continued to offer additional innovative value-for-money products, increased cross-sales and delivered a strong uplift in new business underpinned by the strong increase in the sale of current accounts, investment products and credit cards.
Our prudent approach to mortgage business has served us well and the quality of our lending continues to be based on affordability and robust risk management, benefiting from our decision to concentrate on lower loan-to-value (LTV) lending. Since September 2006, we have been carefully maintaining a balance between the margin of new business, prudent lending criteria and our market share aspirations.
Our lending growth has been largely funded by an increase in net deposits with over £11.1bn deposited by retail and SME customers. This clearly demonstrates that Abbey, as part of the Santander Group, continues to be seen as a safe haven for UK depositors. In addition, we have taken the opportunity to reduce assets in our Global Banking & Markets operations to fund our Retail Banking growth. This active funding allocation strategy has allowed us to maintain stable short-term funding requirements throughout the year.
The addition of Bradford & Bingley plc's savings business in September, which brought an additional £20bn of deposits and further £1.1bn net inflows since acquisition, has further strengthened this position, and has improved our commercial funding mix to over 70% from customer deposits.
Funding and Capital Strength
The recent market turmoil is unprecedented. Since August 2007, the global financial system has experienced difficult credit and liquidity conditions and disruptions leading to less liquidity, greater volatility and general widening of spreads. In September 2008, global financial markets deteriorated sharply following the bankruptcy filing by Lehman Brothers Holdings Inc.. In the days that followed, it became apparent that a number of other major financial institutions, including some of the largest global commercial banks, investment banks, mortgage lenders, mortgage guarantors and insurance companies, were experiencing significant difficulties.
The UK Government initiative announced in early October 2008, including the provision of liquidity and funding support and facilities to enable banks to raise new capital to strengthen their capital base, was welcomed by Abbey. Abbey has been managing its balance sheet prudently, having reduced assets in our Global Banking & Markets operations, almost doubling net deposit flows and achieving a lower level of short-term funding by the end of 2008 than at the start of the year. Abbey did not use the UK Government recapitalisation scheme, nor do we expect to in the future. In 2008, Santander's commitments to the UK Government and regulators to improve the combined Tier 1 ratio of Abbey and Alliance & Leicester plc were met using the additional £1bn of capital announced at the time of the acquisition of Alliance & Leicester plc, which was transferred into Abbey from Santander. This capital has, in turn, been transferred to Alliance & Leicester plc in late December as planned.
In 2009, with respect to liquidity and funding arrangements, rather than capital, we expect to remain flexible in our approach. We believe that the current arrangements with the Bank of England, European Central Bank and US Federal Reserve, as well as the UK Credit Guarantee Scheme that are available to the UK banking industry will help the banking sector to meet liquidity and funding needs.
Key Financial Highlights
Abbey has delivered profit growth of over 20% and successfully achieved its financial targets for 2008, with trading revenue growth in excess of the 5 - 10% target range and a further reduction in the trading cost:income ratio to below the sector average in the UK.
Summary Highlights
> Personal Financial Services trading profit before tax (management's preferred profit measure, described in the Business Review - Summary on page 11) increased by £197m to £1,301m compared to £1,104m in 2007, with strong underlying growth from all business divisions.
> Personal Financial Services trading income was 12.7% higher, exceeding the targeted range of between 5% and 10%, and was driven by a strong performance across all business divisions.
> Retail Banking income benefited from a 10% increase in both asset and deposit growth and better asset new business margins throughout 2008.
> Corporate Banking performance was ahead driven by a continued prudent lending approach whilst taking advantage of opportunities in the market to improve margins, such as investing in new people and using Abbey's strong funding and capital position to compete aggressively against our competitors who are in a weaker position.
> Private Banking was ahead reflecting growth in all business areas, in particular Cater Allen and Abbey International which were driven by increased customer deposits.
> Global Banking & Markets was also ahead reflecting global customer focus and the strength of its business model.
> Personal Financial Services trading expenses growth was in line with inflation before the impact of Bradford & Bingley plc's savings business, despite significant investment in customer facing operations and growth businesses such as Corporate Banking and Private Banking all of which contributed to robust income growth and the fourth consecutive year of double digit operating jaws. The 2008 targeted trading cost to income ratio, of 45% (2007: 50%), has been achieved and is now better than the sector average.
> Credit quality remained strong, with the average LTV on new business completions in Q4 reducing to 60% (Q3 08: 62%, Q4 07: 66%) and on stock increasing slightly to 51% (Q3 08: 50%, Q4 07: 46%) reflecting the fall in house prices offset by active management of new business LTVs and retention activities.
Looking Ahead to 2009
The acquisition of Bradford & Bingley plc's savings business in September and Santander's acquisition of Alliance & Leicester plc in October, now transferred to Abbey, were part of Santander's UK growth strategy. With the combination of the three businesses we have achieved our goal of being a significant player in the UK, and Abbey now has market shares above 10% in mortgages, savings, bank accounts and branches. This is a powerful platform from which we will grow our business further.
As part of this process, Abbey has given a full and unconditional guarantee in respect of the unsubordinated liabilities of Alliance & Leicester plc incurred prior to 31 July 2012 under a deed poll guarantee entered into by Abbey on 19 March 2009. Alliance & Leicester plc has given a reciprocal guarantee in respect of the unsubordinated liabilities of Abbey incurred prior to 31 July 2012 on the same date.
Our core business strategy will not change; we will continue to focus on delivering excellent customer service, drive efficiencies across the combined businesses and reinvest in innovative value-for-money products, which in turn will drive cross-sales to our 24 million UK customers, and increase customer loyalty.
We are committed to the branch network in the UK, which now numbers over 1,300 (including 141 agencies), supporting Santander's status as one of the world's leading retail banks.
In order to continue growing our business and enable further investment in frontline services and branches, we will be transferring Bradford & Bingley's savings operations and then Alliance & Leicester plc onto Santander's proprietary IT platform, Partenon, as well as removing duplicated back office and support functions across the businesses. Regrettably, this does mean we expect to reduce the combined UK workforce by approximately 1,900 in 2009, as announced in December.
The combination of Alliance & Leicester plc and Abbey accelerates our growth in the SME market by two to three years, with the addition of 20 corporate centres and around 100,000 SME customers. Over the next 12 months we plan to extend our product range to small and medium business customers and will look to recruit up to 100 additional small business advisers for the Abbey branch network.
Over time, we will make the full range of our value-for-money products and services available to Bradford & Bingley's customers, and as such, we have already added to its savings business by taking on Bradford & Bingley's 40 mortgage advisers in order to be able to offer the Abbey mortgage range through Bradford & Bingley branches.
Summary
2009 will undoubtedly be a very challenging year. Despite this, we are cautiously optimistic about our business prospects and are continuing to benefit from being part of the Santander Group, which means that our UK business is well-positioned for the challenges and opportunities ahead.
António Horta-Osório
Chief Executive
Abbey National plc (the 'Company') and its subsidiaries (together 'Abbey' or the 'Group') may from time to time make written or oral forward-looking statements. Examples of such forward-looking statements include, but are not limited to:
projections or expectations of revenues, costs, profit (or loss), earnings (or loss) per share, dividends, capital structure or other financial items or ratios;
statements of plans, objectives or goals of Abbey or its management, including those related to products or services;
statements of future economic performance; and
statements of assumptions underlying such statements.
Words such as 'believes', 'anticipates', 'expects', 'intends', 'aims', 'plans', 'targets' and similar expressions are intended to identify forward-looking statements but are not the exclusive means of identifying such statements.
By their very nature, forward-looking statements cannot be objectively verified, are speculative and involve inherent risks and uncertainties, both general and specific, and risks exist that the predictions, forecasts, projections and other forward-looking statements will not be achieved. Abbey cautions readers that a number of important factors could cause actual results to differ materially from the plans, objectives, expectations, estimates and intentions expressed in such forward-looking statements made by Abbey or on Abbey's behalf. Some of these factors are considered in detail in the Risk Management section on page 36 and the Risk Factors section on page 141 and may include:
inflation, interest rate, exchange rate, basis spread, market and monetary fluctuations;
lack of liquidity in funding markets and sources of funding in periods of economic and political crisis;
the effect of, and changes to, government supervision and regulation of financial services institutions;
extraordinary governmental actions as a result of current market turmoil, including nationalisation of financial services institutions;
the effects of market conditions and extent of economic activity in the UK and other geographical markets;
the length and severity of current market turmoil and its impact on credit quality, consumer confidence, market volatility, loan delinquencies and defaults;
the effects of counterparty defaults on the financial services industry;
the effects of competition in the geographic and business areas in which Abbey conducts operations;
changes in consumer spending, saving and borrowing habits in the UK;
illiquidity and downward price pressure in UK real estate markets;
the impact of lower than expected investment returns on the funding of private and public sector defined benefit pensions;
the effects of changes in laws, regulations, taxation or accounting standards or practices, or the effects of the interpretation of laws by the courts;
the ability to increase market share and control expenses;
the timely development and acceptance of new Abbey products and services and the perceived overall value of these products and services by customers;
acquisitions and disposals;
the ability to integrate recently acquired businesses and to realise anticipated saving and operational benefits from such integration;
technological changes;
the possibility of foreign exchange controls, expropriation, nationalisation or confiscation of assets in countries in which Abbey conducts operations;
consumer perception as to the continuing availability of credit and price competition; and
Abbey's success at managing the risks of the foregoing.
Abbey cautions that the foregoing list of important factors is not exhaustive. When relying on forward-looking statements to make decisions with respect to Abbey, investors and others should carefully consider the foregoing factors and other uncertainties and events. Such forward-looking statements speak only as of the date on which they are made and are based on the knowledge, information available and views taken on the date on which they are made; such knowledge, information and views may change at any time. Abbey does not undertake any obligation to update or revise any forward-looking statement, whether as a result of new information, future events or otherwise.
Written forward-looking statements may appear in documents filed with the US Securities and Exchange Commission, including this Annual Report and Accounts, reports to shareholders and other communications. The US Private Securities Litigation Reform Act of 1995 contains a safe harbour for forward-looking statements on which Abbey relies in making such disclosures.
Business and Financial Review
Business Overview
This Business and Financial Review contains forward-looking statements that involve inherent risks and uncertainties. Actual results may differ materially from those contained in such forward-looking statements. See "Forward-looking Statements" on page 4.
General
Abbey National plc (the 'Company') and its subsidiaries (together, 'Abbey' or the 'Group') operate primarily in the UK, under UK law and regulation and are part of Banco Santander, S.A. (together with its subsidiaries, 'Santander'). Abbey is a significant financial services provider in the UK, being the second largest residential mortgage lender and the third largest savings brand following the combinations with Alliance & Leicester plc and Bradford and Bingley plc's retail deposits, branch network and its related employees, operating across the full range of personal financial services.
The principal executive office and registered office of Abbey National plc and Abbey National Treasury Services plc is Abbey National House, 2 Triton Square, Regent's Place, London NW1 3AN. Abbey's telephone number is +44 (0) 870-607-6000. The designated agent for service of process on Abbey in the United States is CT Corporation System, 111 Eighth Avenue, New York, NY 10011. See "Business and Financial Review - Tangible fixed assets" for further information on Abbey's properties.
Summary history
The Abbey National Building Society ('the Society') was formed in 1944 with the merger of two long-standing building societies. In 1988, Abbey National plc was incorporated as a bank and in 1989 the Society transferred business to Abbey National plc as part of the conversion and listing on the London Stock Exchange. In 2003, the brand name was shortened to Abbey. A list of Abbey National plc's principal subsidiaries and their country of incorporation can be found on page 108.
On 12 November 2004, Banco Santander, S.A. completed the acquisition of the entire issued ordinary share capital of Abbey National plc, implemented by means of a scheme of arrangement under Section 425 of the Companies Act 1985, making Abbey National plc a wholly-owned subsidiary of Banco Santander, S.A.. Banco Santander, S.A. is one of the largest banks in the world by market capitalisation. Founded in 1857, Banco Santander, S.A. has more than 80 million customers, over 14,000 branches and a presence in over 40 countries.
In September 2008, following the announcement by HM Treasury to take Bradford & Bingley plc into public ownership, the retail deposits, branch network and its related employees transferred, under the provisions of the Banking (Special Provisions) Act 2008, to Abbey National plc. All of Bradford & Bingley plc's customer loans and treasury assets, including all its mortgage assets, were taken into public ownership. The transfer to the Company consisted of the £20bn retail deposit base with 2.7 million customers, as well as Bradford & Bingley plc's direct channels including 197 retail branches, 141 agencies (distribution outlets in third party premises) and related employees. The acquisition price was £612m, including the transfer of £208m of capital relating to offshore entities. The transfer of Bradford & Bingley plc's customers and their retail deposits further strengthened Abbey's retail customer deposit base and franchise.
In December 2008, following the acquisition by Banco Santander, S.A. of Alliance & Leicester plc, Abbey National plc injected £950m of capital into Alliance & Leicester plc through a subscription of: (i) 234,113,712 new Alliance & Leicester plc ordinary shares for cash at £2.99 per ordinary share; (ii) US$220m undated subordinated notes issued by Alliance & Leicester plc; and (iii) euro 115m undated subordinated notes issued by Alliance & Leicester plc. Previously, in October 2008, Abbey subscribed for US$100m undated floating rate subordinated notes issued by Alliance & Leicester plc. As a result of the subscription of ordinary shares, Abbey National plc held 35.6% of the issued ordinary share capital of Alliance & Leicester plc at 31 December 2008.
On 9 January 2009, in order to optimise the capital, liquidity funding and overall financial efficiency of the enlarged Santander group, Banco Santander, S.A. transferred all of its Alliance & Leicester plc shares to Abbey National plc in exchange for Abbey National plc newly issued ordinary shares. Accordingly, Abbey National plc is now the immediate parent company of Alliance & Leicester plc.
These business combinations will allow Abbey to deliver increased critical mass in the United Kingdom through greater distribution scale.
In 2008, Abbey National plc won Euromoney's 'Best UK Bank' award, and Banco Santander, S.A. won Euromoney's 'Best Global Bank' award.
Corporate purpose and strategy
Abbey's purpose is to maximise value for its shareholder, Banco Santander, S.A., by focusing on offering a full commercial banking service in the UK providing value-for-money products to customers. With the continuing support of Banco Santander, S.A., Abbey aims to be the best commercial bank in the UK.
Executive responsibility
Abbey's management structure is headed by António Horta-Osório, Chief Executive, and consists of a number of business and support divisions. The business divisions consist of:
> Retail Banking - offers residential mortgages, savings and banking and other personal financial products to customers throughout the United Kingdom. This division is headed by António Horta-Osório. Alison Brittain is responsible for the Retail Distribution channel as well as business banking, premium banking and e-commerce, while David Bennett is responsible for the Intermediary channel.
> Global Banking & Markets - provides financial markets sales, trading and risk management services, as well as manufacturing retail structured products. This division is headed by Jaime Astarloa.
> Corporate Banking - offers banking services principally to small and mid-sized UK companies. It also contains operations in run down. This division is headed by Miguel-Ángel Rodríguez-Sola. From 1 June 2009, and subject to UK Financial Services Authority approval, this division will be headed by Steve Pateman.
> Private Banking (formerly known as Wealth Management) - offers private banking services, self-invested personal pension plans, a WRAP service and other specialist banking services. This division is headed by António Lorenzo.
The support divisions consist of:
> Retail Products and Marketing - responsible for integrating and gaining the maximum value from Abbey's products, marketing and brand communications to serve Abbey's customers better. This division is headed by Nathan Bostock. On 25 February 2009, the Company announced that he would be leaving the Company on 1 June 2009. From 1 June 2009, and subject to UK Financial Services Authority approval, this division will be headed by Miguel-Ángel Rodríguez-Sola.
> Human Resources - responsible for delivering the human resources strategy and personnel support. It also includes the learning function. This division was formerly headed by Nathan Bostock and is now, as of 19 March 2009, headed by Karen Fortunato.
> Manufacturing - responsible for all information technology, cost control and operations activity, including service centres. This division is headed by Juan Olaizola.
> Risk - responsible for ensuring that the Board and senior management team of Abbey are provided with an appropriate risk policy and control framework, and to report any material risk issues to the Risk Committee and the Board. This division is headed by Juan Colombás.
> Internal Audit - responsible for supervising the compliance, effectiveness and efficiency of Abbey's internal control systems to manage its risks. This division is headed by Jorge de la Vega.
In addition there are a number of corporate units:
> Group Infrastructure - This unit includes Asset & Liability Management, Group Capital and Funding and reports to Nathan Bostock. The Asset & Liability Management unit will, from 1 June 2009 and subject to UK Financial Services Authority approval, be headed by António Lorenzo and report to the Chief Executive.
> Finance, Strategy, and Planning - This unit reports to António Lorenzo.
> Corporate Services - This unit includes Legal, Secretariat, Compliance and Regulatory Risk Management (a new unit created on 19 March 2009) and reports to Karen Fortunato.
> Service Quality - This unit reports to Miguel-Ángel Rodríguez-Sola.
> Communications - This unit formerly reported to Karen Fortunato and, with effect from 19 March 2009, is headed by Matthew Young as a stand-alone unit.
> Santander Universities in the UK - This unit formerly reported to Karen Fortunato and, with effect from 19 March 2009, is headed by Miguel-Ángel Rodríguez-Sola as a stand-alone unit.
Competition
Competitive environment, future trends and outlook
The economic environment in 2008 was very difficult, with falling house and share prices, rising unemployment, and difficulties facing banks, homeowners and savers. In the US, some financial institutions collapsed and others were bought out. The UK's retail banks also underwent significant changes, with Northern Rock plc and Bradford & Bingley plc taken into public ownership (with the exception of the retail deposits, branch network and related employees of Bradford & Bingley plc, which were transferred to the Company, as described above). The UK Government also subscribed for substantial holdings of shares in Royal Bank of Scotland Group plc and Lloyds Banking Group plc, and some other banks and building societies were bought out. The UK Government continues to support UK banks during the current market turmoil through the Special Liquidity Scheme, the Asset Protection Scheme, the Credit Guarantee Scheme and the UK Banking Act 2009.
Abbey's main competitors are other UK retail banks, building societies and other financial services providers such as insurance companies, supermarket chains and large retailers. The market has been highly competitive, driven largely by market incumbents. Management expects such competition to continue in response to competitor behaviour, consumer demand, technological changes, the impact of consolidation, regulatory actions and other factors.
2009 is expected to be a challenging year for the UK economy. The expectation is for continuing rising unemployment, falling house prices and a further deterioration in the UK economy that will present challenges to banks, homeowners and savers. Abbey continues to benefit from the strength of its parent company, Banco Santander, S.A., and as part of the Santander Group, management remains confident of Abbey's strength and potential to continue growing despite challenging conditions in some of its core personal financial services markets. A detailed description of management's basis for concluding that Abbey remains a going concern is set out in the Directors' Report - Going Concern on page 60.
Personal Financial Services ('PFS')
The overview below reflects the reporting structure in place during 2008 in accordance with which the segmental information in the Business and Financial Review has been presented. In this report, the Retail Banking, Global Banking & Markets, Corporate Banking, Private Banking and Group Infrastructure segments are referred to as the Personal Financial Services businesses.
Retail Banking
Retail Banking consists of residential mortgages, savings, banking and consumer credit, cahoot, general insurance, Abbey Business and an asset management business that was sold at the end of 2006.
Residential Mortgages
Following the transfer of Alliance & Leicester plc to Abbey National plc in January 2009, Abbey is now the second largest provider of residential mortgages in the UK measured by outstanding balances, providing mortgage loans for house purchases as well as home improvement loans to new and existing mortgage customers.
Mortgage loans are offered in two payment types. Repayment mortgages require both principal and interest to be repaid in monthly instalments over the life of the mortgage. Interest-only mortgages require monthly interest payments and the repayment of principal at the end of the mortgage term, which can be arranged via a number of investment products including Individual Savings Accounts and pension policies, or by the sale of the property.
Abbey's mortgage loans are usually secured by a first mortgage over property and are typically available over a 25-year term, with no minimum term. Variable rate products charge interest at variable rates, including trackers which track the Bank of England base rate, determined at the discretion of Abbey by reference to the general level of market interest rates and competitive forces in the UK mortgage market. Fixed rate products offer a predetermined interest rate, generally fixed for between two and five years, after which they bear interest at standard variable rates. The majority of new mortgage business is through fixed rate business, normally with an incentive period for the first two to five years. In line with the rest of the UK market, a significant proportion (although reduced compared with the previous period) of mortgages are repaid at the end of the fixed or incentive period, with the customer moving to a new incentive product, or staying on Abbey's standard variable rate.
Savings
Following the acquisition of Bradford & Bingley plc's savings business in September 2008 and the transfer of Alliance & Leicester plc to Abbey National plc in January 2009, Abbey is now the third largest deposit taker in the UK and provides a wide range of retail savings accounts in the UK, including on-demand, notice, and investment accounts, and Individual Savings Accounts, as well as capital guaranteed products. Interest rates on savings in the UK are primarily set with reference to the general level of market interest rates and the level of competition for such funds.
Banking and Consumer Credit
Abbey offers a range of personal banking services including current accounts, credit cards and unsecured personal loans. Credit scoring is used for initial lending decisions on these products and behavioural scoring is used for certain products for further lending. Abbey launched its own credit card range in the UK in the first half of 2007 through Banco Santander, S.A.'s global cards division. Previously, Abbey's principal credit card offering was delivered through a strategic alliance with MBNA Europe Bank Limited, which was responsible for taking the credit risk and managing the credit card base.
cahoot
cahoot is Abbey's separately branded, e-commerce retail banking and financial services provider.
General Insurance
The range of non-life insurance products distributed by Abbey includes property (buildings and contents) and payment protection. Residential home insurance remains the primary type of policy sold and is offered to customers through the branch network, Internet and over the telephone, as well as being sold by mortgage intermediaries, often at the time that a mortgage is being taken out.
Abbey Business
Abbey Business offers a range of banking services to small businesses in the UK.
Asset Management
On 31 December 2006, the Company sold 100% of its asset management businesses to Santander Asset Management UK Holdings Limited, an indirect subsidiary of Banco Santander, S.A., for a total cash consideration of £134m. The asset management companies sold were Abbey National Asset Managers Limited (now called Santander Asset Management UK Limited), Abbey National PEP & ISA Managers Limited, Abbey National Unit Trust Managers Limited (now called Santander Unit Trust Managers UK Limited) and Inscape Investments Limited (now called Santander Portfolio Management UK Limited). Retail Banking earns a commission on products sold through its agreement with Santander Asset Management UK Limited.
Global Banking & Markets
Global Banking & Markets is principally structured into two business areas: Rates and Equity. Rates cover sales and trading activity for fixed income derivatives. Equity comprises the Equity Derivatives, Property Derivatives, and Short Term Markets areas. Equity and residential property derivatives activities include the manufacture of structured products sold to retail customers both by Abbey and by other financial institutions. Short Term Markets runs the securities lending/borrowing and repurchase agreement ('repo') businesses and retains a US branch for funding purposes. In 2008, the decision was taken to close the US securities financing business. The closure was completed in the first half of 2008. Previously, Global Banking & Markets also operated a credit derivatives business, but given the lack of activity in the credit markets beginning in 2007, the business was closed and its activities consolidated in Spain with the equivalent Banco Santander, S.A. unit with effect from 1 January 2008.
Corporate Banking
Corporate Banking provides a range of banking services, including loans, deposits, trade finance and supplier payment solutions, principally to small and medium-sized UK companies in a variety of sectors including Real Estate, Social Housing, Education, Health and Communities. It provides funding and a range of treasury services via Global Banking & Markets. It is also developing a full service small and medium-size enterprise ('SME') operation, enabling it to compete in the UK's mid-corporate business banking segment. This business development has been accelerated as a result of the transfer of Alliance & Leicester plc to Abbey National plc by Banco Santander, S.A..
Corporate Banking is also responsible for managing the the run down of Motor Finance and Insurance Funding Solutions, and was also responsible for Porterbrook prior to its disposal. On 8 December 2008, the Group completed the disposal of Porterbrook, its rolling stock leasing business, by the sale of 100% of Porterbrook Leasing Company Limited and its subsidiaries to a consortium of investors including Antin Infrastructure Partners (the BNP Paribas sponsored infrastructure fund), Deutsche Bank and Lloyds TSB, for a cash consideration of approximately £1.6bn with Abbey continuing to provide £0.6bn medium term, senior loan funding to the acquisition vehicle.
Private Banking (formerly known as Wealth Management)
Private Banking consists of Abbey International and Abbey's majority interest in Santander Private Banking UK Limited. On 17 December 2007, Abbey sold 49% of its shareholding in Santander Private Banking UK Limited (consisting of James Hay, Cater Allen and Abbey Sharedealing) to Santander PB UK (Holdings) Limited, a direct subsidiary of Banco Santander, S.A., for a total cash consideration of £203m. The companies affected were Cater Allen Limited, Abbey Stockbrokers Limited, James Hay Holdings Limited, and their subsidiaries.
Abbey International
Abbey National International Limited uses the Abbey International brand. Its office is in Jersey, with a focus on attracting deposits by offering a range of savings accounts denominated in sterling, US dollars and euro.
James Hay
James Hay provides administration services for self-invested pension plans and the WRAP portfolio management product to end customers mainly via independent financial advisers and branded financial service providers.
Cater Allen
Cater Allen Limited, trading as Cater Allen Private Bank, provides products to assist with the finance requirements of individuals and businesses. The business attracts clients by marketing to introducers, including independent financial advisers.
Abbey Sharedealing
Abbey Stockbrokers Limited, trading as Abbey Sharedealing, provides a direct share trading service for customers. Customers buy and sell shares on their account with the help of the dealers at Abbey Sharedealing. No advice is provided and all trades are on an execution only basis.
Group Infrastructure
Group Infrastructure consists of Asset and Liability Management ('ALM'), which is also responsible for Group Capital and Funding. ALM is responsible for managing the Group's structural balance sheet shape and, in conjunction with Risk Division, tactical liquidity risk management. This includes short-term and medium-term funding, covered bond and securitisation programmes. ALM's responsibilities also include Retail Banking's product and structural exposure to interest rates and, in that role, is a link between Retail Banking and Global Banking & Markets. ALM recommends and helps to implement Board, Asset and Liability Management Committee and Risk Committee policies for all aspects of balance sheet management - formulating guidance for, and monitoring, the overall balance sheet shape, including maturity profile. Group Capital represents the return on the Group's capital, reserves, preference shares and subordinated debt. Funding represents the provision of funding, both to other businesses within the Group and to fellow subsidiaries of Banco Santander, S.A..
Abbey National plc and Abbey National Treasury Services plc had a shelf registration statement with the US Securities and Exchange Commission, which expired in December 2008. The Group is planning on filing a new shelf registration statement later in 2009. Additionally, as part of its prudent contingent funding arrangements, ALM ensures that Abbey has access to the central bank facilities made available by the Bank of England, the European Central Bank and the US Federal Reserve. Further information is set out in detail in the Balance Sheet Business Review - Sources of Liquidity on page 32.
Sold Life Businesses
In 2006, Abbey sold its entire life insurance business to Resolution plc for cash consideration of approximately £3.6bn. The principal life companies sold were Scottish Mutual Assurance plc, Scottish Provident Limited and Abbey National Life plc, as well as the two offshore life companies, Scottish Mutual International plc and Scottish Provident International Life Assurance Limited.
Business and Financial Review
Business Review - Summary
The results discussed below are not necessarily indicative of Abbey's results in future periods. The following information contains certain forward-looking statements. See "Forward-looking Statements" on page 4. The following discussion is based on and should be read in conjunction with the Consolidated Financial Statements elsewhere in this Annual Report and Accounts.
Executive Summary
Abbey has prepared this Business and Financial Review in a manner consistent with the way management views Abbey's business as a whole. As a result, Abbey presents the following key sections to the Business and Financial Review:
> Business Review Summary - this contains an explanation of the basis of Abbey's results and any potential changes to that basis in the future; a summary Income Statement with commentary; a summary of the nature of adjustments between Abbey's statutory basis of accounting (as described in the Accounting Policies section on pages 78 to 94) and Abbey's management basis of accounting (known as the "trading" basis); and a description of key performance indicators;
> Personal Financial Services - this contains a summary of the results, and commentary thereon, by Income Statement line item on a trading basis for each segment. Additional information is provided for the Retail Banking segment due to its significance to Abbey's results;
> Sold Life Businesses - this contains a commentary on the results of the life insurance businesses sold in 2006;
> Other Material Items - this contains information about the statutory to trading basis adjustments; and
> Balance Sheet Business Review - this contains an analysis of Abbey's balance sheet, including:
> Capital disclosures - this contains an analysis of Abbey's capital needs and availability;
> Off-Balance Sheet disclosures - this contains a summary of Abbey's off-balance sheet arrangements, their business purpose, and importance to Abbey; and
> Liquidity disclosures - this contains an analysis of Abbey's sources and uses of liquidity and cash flows.
Basis of results presentation
The Group's business is managed and reported on the basis of the following segments:
> Retail Banking;
> Global Banking & Markets;
> Corporate Banking;
> Private Banking;
> Group Infrastructure; and
> Sold Life Businesses.
In 2008, the Wealth Management business was renamed Private Banking. In addition, the results of the intermediary protection sales business that was terminated in 2007 have been reclassified from Retail Banking to Group Infrastructure. The segmental analysis of the Group's results for 2007 and 2006 has been amended to reflect this change. In this report, the Retail Banking, Global Banking & Markets, Corporate Banking, Private Banking and Group Infrastructure segments are referred to as the Personal Financial Services businesses.
Critical Factors Affecting Results
Critical accounting policies and areas of significant management judgement
The preparation of Abbey's Consolidated Financial Statements requires management to make estimates and judgements that affect the reported amount of assets and liabilities at the date of the Consolidated Financial Statements and the reported amount of income and expenses during the reporting period. Management evaluates its estimates and judgements on an ongoing basis. Management bases its estimates and judgements on historical experience and on other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. Estimates and judgements that are considered important to the portrayal of Abbey's financial condition including, where applicable, quantifications of the effects of reasonably possible ranges of such estimates and judgements are set out in the Accounting Policies in the Consolidated Financial Statements.
Impact of the current credit environment
Further information about the impact of the current credit environment is contained in the Risk Management Report on page 52, in addition to information relating to the valuation of financial instruments included in the Group's critical accounting policies disclosures referred to above.
Profit on disposal of Group undertakings
Profits / (losses) of £40m (2007: £7m, 2006: £(223)m) were made on the disposal of Group undertakings during the year. In addition, profits of nil (2007: £105m, 2006: nil) were made on the sale of non-controlling interests in subsidiary undertakings.
Significant acquisitions and disposals
The 2008 results were not materially affected by the acquisition of Bradford & Bingley plc's direct channels and retail deposits business, or the sale of the Porterbrook businesses, both as described in the Business Overview.
Current and future accounting developments under IFRS
Details can be found in the Accounting Policies on page 77 to the Consolidated Financial Statements.
Group Summary
Summarised consolidated statutory income statement and selected ratios
|
| 2008 £m | 2007 £m | 2006 £m |
| Net interest income | 1,772 | 1,499 | 1,228 |
| Non-interest income | 1,232 | 1,283 | 1,242 |
| Total operating income | 3,004 | 2,782 | 2,470 |
| Administrative expenses | (1,343) | (1,369) | (1,420) |
| Depreciation and amortisation | (202) | (205) | (215) |
| Total operating expenses excluding provisions and charges | (1,545) | (1,574) | (1,635) |
| Impairment losses on loans and advances | (348) | (344) | (344) |
| Provisions for other liabilities and charges | (17) | - | (63) |
| Total operating provisions and charges | (365) | (344) | (407) |
| Profit on continuing operations before tax | 1,094 | 864 | 428 |
| Tax on profit on continuing operations | (275) | (179) | (115) |
| Profit for the year from continuing operations | 819 | 685 | 313 |
| Loss for the year from discontinued operations | - | - | (245) |
| Profit for the year | 819 | 685 | 68 |
| Tier 1 capital ratio(1) (%) | 8.5% | 7.3% | 8.0% |
| Core Tier 1 capital ratio(1) (%) | 6.2% | 5.4% | 5.6% |
| Risk weighted assets(2) | 63,425 | 68,562 | 62,942 |
(1) From 1 January 2008, the Group has managed its capital requirements on a Basel II basis, as described in Note 47 to the Consolidated Financial Statements. 2007 and 2006 have been presented on a Basel I basis.
(2) In accordance with the requirements of the UK Financial Services Authority, this includes 35.6% of Alliance & Leicester plc's risk weighted assets at 31 December 2008, reflecting Abbey's ownership of that percentage of Alliance & Leicester plc's ordinary share capital on that date, as described in Business Overview - Summary History.
2008 compared to 2007
Profit on continuing operations before tax of £1,094m increased from £864m in 2007. Material movements by line include:
> Net interest income of £1,772m compared to £1,499m in 2007 increased by £273m, driven by a combination of asset growth and improved Commercial Banking spread up 4 basis points. Retail Banking income benefited from strong asset growth of 10% in challenging market conditions, and Abbey's continued focus on effective margin management for both mortgages and customer deposits. At the same time, Abbey maintained its focus on high quality prime residential lending at lower LTV and improved retention at attractive margins. Corporate Banking performance was ahead, driven by continued prudent growth in lending whilst taking advantage of opportunities in the market to improve margins. Private Banking also delivered an excellent performance reflecting growth in all business areas, in particular Cater Allen and Abbey International which were driven by increased customer deposits. Net interest income also benefited from higher earnings within Group Infrastructure on retained profits and the additional share capital injection of £1bn in October 2008, prior to its transfer into Alliance & Leicester plc in December 2008.
> Non-interest income of £1,232m compared to £1,283m in 2007 decreased by £51m. The decrease is largely due to the profit on sale received in 2007 from the part sale of PFS subsidiaries, not repeated in 2008. Despite difficult market conditions, Retail Banking continued to broaden its cross-selling activity, with increased commission from credit cards and investments. Growth in these areas was offset by lower mortgage redemption volumes, lower unsecured lending and continued pressure on current account charges. Corporate Banking increased as new business lending generated more in both fees and cross-selling of Global Banking & Markets' products. Private Banking was slightly ahead reflecting increased fees in James Hay offsetting lower income in Abbey International due to the one-off property sales in 2007. Global Banking & Markets finished the year with a strong performance, well ahead of last year, reflecting global customer focus and the strength of its business model.
> Administrative expenses of £1,343m (2007: £1,369m) decreased by £26m due to continuing cost reduction activity partially offset by costs relating to the Bradford & Bingley savings business and branch network.
> Depreciation and amortisation of £202m (2007: £205m) was in line with the previous year, as Porterbrook was only sold at the end of the year.
> Impairment losses on loans and advances were broadly unchanged at £348m (2007: £344m), as credit quality remained strong, with a continued reduction in the size of the unsecured personal lending book, offset by a further general deterioration in economic conditions affecting the mortgage portfolio provision.
> Provisions for other liabilities and charges of £17m compared to £nil in 2007, relating to the integration of the acquired Bradford & Bingley savings business and branch network, partially offset by a release of the misselling provision.
2007 compared to 2006
Profit on continuing operations before tax of £864m increased from £428m in 2006. Material movements by line include:
> Net interest income of £1,499m compared to £1,228m in 2006 increased by £271m. Retail Banking income benefited from robust asset growth of 8% in challenging market conditions, and Abbey's continued focus on effective margin management for both mortgages and customer deposits. Overall the Commercial Banking spread improved by 4 basis points. Net interest income also benefited from the full year impact of earnings from proceeds from the sale of the life insurance businesses in 2006.
> Non-interest income of £1,283m compared to £1,242m in 2006 increased by £41m. The increase related to the uplift in revenues within Global Banking & Markets despite difficult trading conditions in the second half of the year restricting transaction flow. In addition, 2007 benefited from the increase in the profit on part sale of PFS subsidiaries, partially offset by higher losses from hedging and other mark-to-market variances compared to 2006. Retail banking fee income declined slightly.
> Administrative expenses of £1,369m (2006: £1,420m) decreased by £51m driven by on-going cost reduction activity.
> Depreciation and amortisation of £205m (2006: £215m) decreased by £10m due to lower asset write-downs.
> Impairment losses on loans and advances were unchanged at £344m, with reduced exposure to unsecured lending, particularly internet-sourced lending, being offset by increases elsewhere reflecting the deterioration in market conditions. Credit quality overall remained sound.
> Provisions for other liabilities and charges net to £nil compared to £63m in 2006, principally due to the stay in complaints relating to unauthorised overdraft charges pending a decision on legal proceedings in the High Court of England and Wales to resolve legal uncertainties concerning the level, fairness and lawfulness of unauthorised overdraft charges, as described in Note 37 to the Consolidated Financial Statements
Loss for the year from discontinued operations of £245m in 2006 comprised the profit of the life insurance businesses of £19m and a loss on sale of £264m.
Adjustments between the statutory basis and the trading basis
Abbey's Board reviews discrete financial information for each of its segments that includes measures of operating results and assets. The segments are managed primarily on the basis of their results, which are measured on a 'trading' basis. The trading basis differs from the statutory basis as a result of the application of various adjustments, as presented below.
Management considers that the trading basis provides the most appropriate way of reviewing the performance of the business. The adjustments arise principally in the ongoing Personal Financial Services businesses.
The adjustments are:
> Reorganisation and other costs - Comprise implementation costs in relation to the strategic change cost reduction projects, as well as certain remediation administration expenses and credit provisions. Management needs to understand the underlying drivers of the cost base that will remain after these exercises are complete, and does not want this view to be clouded by these costs, which are managed independently.
> Depreciation of operating lease assets - The Porterbrook operating lease businesses sold in 2008 had been managed as financing businesses and, therefore, management needed to see the margin earned on the businesses. Residual value risk was separately managed. As a result, the depreciation was netted against the related income.
> Profit on part sale of PFS subsidiaries - These profits are excluded from the results to allow management to understand the underlying performance of the business. In 2008, the profit on the sale of the Porterbrook businesses was excluded. In 2007, the profit on the sale of 49% of James Hay, Cater Allen and Abbey Sharedealing, and small recoveries on certain other transactions were excluded. In 2006, the profit on the sale of the Asset Management businesses was similarly excluded.
> Hedging and certain other mark-to-market variances - The Balance Sheet and Income Statement are subject to mark-to-market volatility including that arising from the accounting for elements of derivatives deemed under IFRS rules to be ineffective as hedges. Volatility also arises on certain assets previously managed on a fair value basis, and hence classified as fair value through profit or loss under IFRS, that are now managed on an accruals basis. Where appropriate, such volatility is separately identified to enable management to view the underlying performance of the business.
> Capital and other charges - Principally comprise internal nominal charges for capital invested in the Group's businesses. Management implemented this charge to assess if capital is invested effectively.
For a detailed explanation of these items, see 'Other Material Items' in the Business and Financial Review.
Key performance indicators
Key performance indicators relevant to the Group during the years ended, and as at, 31 December 2008, 2007 and 2006 are set out below. This information describes the key measures used by management in assessing the success of the business against its strategies and objectives.
| Key performance indicator | Note | 2008 | 2007 | 2006 |
| PFS trading revenues | 1 | £2,947m | £2,615m | £2,452m |
| PFS trading cost:income ratio | 2 | 45% | 50% | 55% |
| Profit for the year | 3 | £819m | £685m | £68m |
| Commercial Banking spread | 4 | 1.44% | 1.40% | 1.36% |
| Total number of employees | 5 | 15,914 | 15,236 | 16,395 |
| Mortgage market share | 6 | 9.9% | 9.3% | 9.4% |
1. PFS trading revenues
PFS trading revenues comprise net interest income and non-interest income of the Personal Financial Services businesses. Discussion and analysis of this data is set out in the Business Review - Personal Financial Services on pages 16 and 17.
Management reviews PFS trading revenues in order to assess the Group's effectiveness in obtaining new customers and business. Management's target for PFS trading revenues is growth of between 5 and 10% per annum from 2006 to 2008. PFS trading revenue growth in 2008 was 12.7% (2007: 6.6%).
2. PFS trading cost:income ratio
The PFS trading cost:income ratio is defined as trading expenses divided by trading income of the Personal Financial Services businesses. Discussion and analysis of trading income and expenses is set out in the Business Review - Personal Financial Services on pages 16 to 19. Further information about the calculation of the PFS trading cost:income ratio is contained in Selected Financial Data on page 139.
Management reviews the PFS trading cost:income ratio in order to measure the operating efficiency of the Group. Management's target for the PFS trading cost:income ratio, set in 2005, was to achieve 45% by 2008.
3. Profit for the year
Profit for the year is the statutory consolidated profit after tax for the year. Discussion and analysis of this data is set out in the Group Summary in this Business Review - Summary section on pages 10 and 11.
Management reviews the profit for the year in order to monitor the effectiveness of the Group's strategy and decisions to maximise the value of the business, and increase the strength of its capital base and its capacity to pay dividends to its shareholder Banco Santander, S.A.. Management's target for the profit for the year is to achieve steady growth over the previous year.
4. Commercial Banking spread
Commercial Banking spread is defined as interest received (mortgages, unsecured personal loans, corporate loans and overdraft interest), less interest payable (retail and corporate deposits and in-credit bank accounts) divided by interest-earning customer loans. Discussion and analysis of this data is set out in the Business Review - Personal Financial Services on pages 13 to 19.
Management reviews the Commercial Banking spread in order to assess the economic sustainability of its commercial banking products and operations. Management's target for the Commercial Banking spread is to ensure that it is appropriate for the current market conditions and profit targets.
5. Total number of employees
Total number of employees is measured at the year-end and calculated on a full-time equivalent basis. 2008 data includes 1,556 employees who transferred to Abbey National plc in September 2008 as part of the acquisition of Bradford & Bingley plc's retail savings business and branch network. 2007 and 2006 data do not include such employees. As part of the planning process, headcount targets are set for each division and reviewed on a monthly basis. Further information about employees on a segmental basis is contained in Note 1 to the Consolidated Financial Statements.
Management reviews the total number of employees in order to support the continuing overall control of the Group's cost base. Management's targets for the total number of employees are to ensure that staffing levels are optimal for the nature and size of the Group's business.
6. Mortgage market share
Mortgage market share represents the value of the Group's mortgage asset as a percentage of the total value of mortgages in the UK market, and is measured at the year-end. Discussion and analysis of this data is set out in the Business Review - Personal Financial Services on pages 14 and 15.
Management reviews mortgage market share in order to assess the Group's effectiveness in obtaining new customers. Management's target for mortgage market share is to maintain the Group's historical market share of approximately 10%, subject to earning an appropriate margin.
Business and Financial Review
Business Review - Personal Financial Services
This section contains a summary of the results, and commentary thereon, by Income Statement line item on a trading basis for each segment within the Personal Financial Services businesses, together with reconciliations from the trading basis to the statutory basis. Additional information is provided on the adjustments between the trading basis and the statutory basis in the Business Review - Other Material Items.
Personal Financial Services profit before tax by segment
| 31 December 2008 | Retail Banking £m | Global Banking & Markets £m | Corporate Banking £m | Private Banking £m | Group Infrastructure £m | Total £m |
| Net interest income/(expense) | 1,827 | - | (13) | 85 | (127) | 1,772 |
| Non-interest income | 622 | 326 | 133 | 35 | 59 | 1,175 |
| Total trading income | 2,449 | 326 | 120 | 120 | (68) | 2,947 |
| Total trading expenses | (988) | (107) | (45) | (59) | (141) | (1,340) |
| Impairment losses on loans and advances | (309) | - | 6 | (3) | - | (306) |
| Trading profit/(loss) before tax | 1,152 | 219 | 81 | 58 | (209) | 1,301 |
| Adjust for: | ||||||
| - Reorganisation and other costs | (121) | - | - | - | (42) | (163) |
| - Profit on part sale of PFS subsidiaries | - | - | 40 | - | - | 40 |
| - Hedging and certain other mark-to-market variances | - | - | - | - | (84) | (84) |
| - Capital and other charges | (103) | - | (14) | 16 | 101 | - |
| Profit/(loss) from continuing operations before tax | 928 | 219 | 107 | 74 | (234) | 1,094 |
| 31 December 2007 | Retail Banking £m | Global Banking & Markets £m | Corporate Banking £m | Private Banking £m | Group Infrastructure £m | Total £m |
| Net interest income/(expense) | 1,623 | - | (31) | 70 | (163) | 1,499 |
| Non-interest income | 635 | 260 | 132 | 34 | 55 | 1,116 |
| Total trading income | 2,258 | 260 | 101 | 104 | (108) | 2,615 |
| Total trading expenses | (996) | (107) | (30) | (61) | (105) | (1,299) |
| Impairment losses on loans and advances | (239) | - | 29 | (2) | - | (212) |
| Trading profit/(loss) before tax | 1,023 | 153 | 100 | 41 | (213) | 1,104 |
| Adjust for: | ||||||
| - Reorganisation and other costs | (139) | (6) | - | (1) | (132) | (278) |
| - Profit on part sale of PFS subsidiaries | - | - | 5 | - | 105 | 110 |
| - Hedging and certain other mark-to-market variances | - | - | - | - | (72) | (72) |
| - Capital and other charges | (89) | - | (11) | 19 | 81 | - |
| Profit/(loss) from continuing operations before tax | 795 | 147 | 94 | 59 | (231) | 864 |
| 31 December 2006 | Retail Banking £m | Global Banking & Markets £m | Corporate Banking £m | Private Banking £m | Group Infrastructure £m | Total £m |
| Net interest income/(expense) | 1,466 | - | (46) | 62 | (146) | 1,336 |
| Non-interest income | 645 | 240 | 125 | 32 | 74 | 1,116 |
| Total trading income | 2,111 | 240 | 79 | 94 | (72) | 2,452 |
| Total trading expenses | (1,005) | (93) | (41) | (58) | (152) | (1,349) |
| Impairment losses on loans and advances | (273) | - | 27 | - | (5) | (251) |
| Provisions for other liabilities and charges | - | - | - | (2) | - | (2) |
| Trading profit/(loss) before tax | 833 | 147 | 65 | 34 | (229) | 850 |
| Adjust for: | ||||||
| - Reorganisation and other costs | (133) | (9) | - | (5) | (151) | (298) |
| - Profit on part sale of PFS subsidiaries | - | - | - | - | 41 | 41 |
| - Hedging and certain other mark-to-market variances | (8) | - | - | - | (37) | (45) |
| - Capital and other charges | (44) | - | (4) | 15 | (87) | (120) |
| Profit/(loss) from continuing operations before tax | 648 | 138 | 61 | 44 | (463) | 428 |
2008 compared to 2007
> Personal Financial Services trading profit before tax of £1,301m increased by £197m on the previous year (2007: £1,104m). Trading income was 12.7% higher driven by a strong performance across all four business divisions. This was balanced against controlled costs, up 3.2%, as we continued to invest in our Corporate Banking and Private Banking businesses, and additional costs relating to the Bradford & Bingley branch and savings operations acquired in September 2008. As a result, our trading cost:income ratio was further reduced to 45%, and is now better than the expected sector average.
> Retail Banking trading profit before tax increased by £129m to £1,152m (2007: £1,023m) which was driven by an 8.5% increase in trading income and lower expenses partly offset by higher credit provisions. Trading income benefited from a 10% growth in both assets and deposits and better mortgage new business margins throughout 2008. At the same time, we maintained our focus on high quality prime residential lending at lower LTV and improved retention at attractive margins. Trading provisions have increased largely reflecting an increase in mortgage arrears, driven by the change in economic conditions. The level of secured coverage remains strong at 25% and is expected to be well ahead of UK peers for 2008, and appropriately reflects the current economic conditions.
> Global Banking & Markets trading profit before tax increased by £66m to £219m (2007: £153m) reflecting strong performance in both Rates and Equity business, due to increased transactional flow arising from close co-operation with other parts of Abbey and the beneficial trading environment available from diverging spreads in an illiquid market.
> Corporate Banking trading profit before tax decreased by £19m to £81m (2007: £100m) reflecting lower provision releases from positions in run down partially offset by the net of higher trading income less expenses largely driven by investment in growing the business.
> Private Banking trading profit before tax increased by £17m to £58m (2007: £41m) reflecting growth in all business areas, in particular Cater Allen and Abbey International which were driven by increased customer deposits attracted by competitive rates.
> Group Infrastructure trading loss before tax decreased by £4m to £209m (2007: £213m) reflecting higher earnings on retained profits and earnings on the additional share capital injection of £1bn in October 2008, prior to its transfer into Alliance & Leicester plc in December 2008.
2007 compared to 2006
> Personal Financial Services trading profit before tax of £1,104m increased by £254m on the previous year (2006: £850m). Trading income was 6.6% higher and within the targeted range. There was a further reduction in trading expenses of 3.8% in 2007 with headcount 1,159 full time equivalents lower than 31 December 2006. Trading profit before tax benefited from positive trading income and cost trends and lower credit provisions.
> Retail Banking trading profit before tax increased by £190m to £1,023m (2006: £833m) driven by a 7% increase in trading income and lower expenses and credit provisions. Trading income benefited from robust asset growth of 8% in challenging market conditions, and Abbey's continued focus on effective margin management for both mortgages and customer deposits. Trading provisions have decreased due to the lower unsecured asset and are partially offset by a slight increase in mortgage provisions from historic low levels.
> Global Banking & Markets trading profit before tax increased by £6m to £153m (2006: £147m). Trading income has increased slightly with profits from the closeout of customer trades offsetting the effects of difficult market conditions in the second half of the year.
> Corporate Banking trading profit before tax increased by £35m to £100m (2006: £65m) reflecting lower trading costs from the run down of asset financing operations and a reduced net interest charge due to lower Porterbrook project and maintenance funding costs. In addition, new Corporate Banking business streams contributed positively.
> Private Banking trading profit before tax increased by £7m to £41m (2006: £34m) reflecting higher trading income and broadly stable costs. Trading income has improved as a result of higher deposits in Cater Allen and improved margins in both Cater Allen and Abbey International.
> Group Infrastructure trading loss before tax decreased by £16m to £213m (2006: £229m) reflecting a small decrease in net interest income due to base rate changes more than offset by a reduction in unallocated central costs.
Personal Financial Services business flows
Business flows relating to the Personal Financial Services businesses are set out below. These flows are used by management to assess the sales performance of Abbey, both absolutely and relative to its peers, and to inform management of product trends in the Personal Financial Services market.
| 2008 | 2007 | 2006 | |
| Mortgages: | |||
| Gross mortgage lending in the year | £31.8bn | £35.6bn | £32.6bn |
| Capital repayments in the year | £20.7bn | £26.9bn | £24.8bn |
| Net mortgage lending in the year | £11.1bn | £8.8bn | £7.8bn |
| Mortgage stock balance: | £121.6bn | £110.5bn | £101.7bn |
| - Abbey retail | £115.6bn | £105.0bn | £96.7bn |
| - Housing Association(1) | £6.0bn | £5.5bn | £5.0bn |
| Market share - gross mortgage lending(2) | 12.4% | 9.8% | 9.4% |
| Market share - capital repayments(2) | 9.5% | 10.5% | 10.5% |
| Market share - net mortgage lending(2) | 28.9% | 8.1% | 7.1% |
| Market share - mortgage stock(2) | 9.9% | 9.3% | 9.4% |
| Retail deposits: | |||
| Total net deposit flows(3) | £5.6bn | £3.2bn | £1.1bn |
| Deposit stock(4) | £94.4bn | £67.4bn | £63.8bn |
| Investment and pensions annual premium income | £2,247m | £1,669m | £1,224m |
| 2008 | 2007 | 2006 | |
| Banking: | |||
| Bank account openings (000's) | |||
| - Abbey retail | 548 | 400 | 425 |
| - Other | 24 | 30 | 28 |
| 572 | 430 | 453 | |
| Bank account liability balance: | |||
| - Abbey retail | £5.5bn | £5.5bn | £5.3bn |
| - Other | £4.7bn | £4.8bn | £4.5bn |
| £10.2bn | £10.3bn | £9.8bn | |
| Gross unsecured personal lending in the year: | |||
| - Abbey retail | £0.8bn | £0.9bn | £1.5bn |
| - Other, including cahoot | £0.1bn | £0.1bn | £0.8bn |
| £0.9bn | £1.0bn | £2.3bn | |
| Unsecured lending asset balance(5): | |||
| - Abbey retail | £2.3bn | £2.5bn | £2.7bn |
| - Other, including cahoot | £0.5bn | £0.8bn | £1.4bn |
| £2.8bn | £3.3bn | £4.1bn | |
| Credit card sales (000's) | 395 | 261 | 112 |
Housing Association mortgages are classified within the Corporate Banking segment. This excludes contingent liabilities and commitments. See Note 37 to the Consolidated Financial Statements.
Market shares are estimated internally, based on information from the Bank of England and The Council of Mortgage Lenders ("CML").
Includes Bradford & Bingley savings business net deposit flows in Q4.
Includes Bradford & Bingley deposits at acquisition and subsequent net inflows. 2007 and 2006 have been amended to include retail structured product flows.
Comprises unsecured personal loans, credit cards and overdrafts.
2008 compared to 2007
Mortgages
Gross mortgage lending was £31.8bn with an estimated market share of 12.4% compared to 9.8% in 2007. Abbey's mortgage performance has remained strong in a market that continues to contract, impacted by falling customer confidence, particularly in the purchase market. The strong performance has been driven by a competitive pricing strategy, targeting high quality lower LTV lending at good margins to optimise Abbey's position during challenging market conditions. The re-mortgage segment remains the strongest market segment, and it is here that Abbey has performed particularly well, both in volume and margins. Net mortgage lending of £11.1 billion, up 28%, was largely achieved in the first half of the year when Abbey increased gross lending, reflecting the strength of its franchise during challenging market conditions, and reduced capital repayments through excellent retention activity. This restored Abbey's stock position to its historical share of around 10%.
Retail Deposits and Investments
Retail net deposit flows were £5.6bn, up 80%, driven by Direct ISA, the Instant Access Saver account and eSaver Direct, together with the launch of innovative new products promoted through the branches and an excellent performance from Bradford & Bingley's branches since acquisition. Abbey has also seen a strong performance in bonds, driven by a contribution from both the Abbey and cahoot offerings. 2008 quarterly flows exceeded all comparative quarters in 2007, with Abbey doubling both the second and third quarter results and Bradford & Bingley's savings business contributing net flows of £1.1bn in the fourth quarter, compared to a trend of outflows prior to acquisition.
Investment sales were up 34%, despite the market being down 8%, reflecting Abbey's strength in offering capital guaranteed investment products as customers seek lower risk alternatives. The second half has also benefited from the continued expansion of the number of sales advisors and high levels of re-investment by customers. Abbey has seen significant growth in Corporate Banking flows resulting in £4.0bn inflows during the year, driven by a focus on relationship managers driving volumes from new business and existing clients, and attracting substantial deposits from corporate clients, further strengthening Abbey's balance sheet.
Banking
Abbey continued to increase its level of bank account openings, up 33%, achieving a record number of openings in the second half of the year and strong market share performance. This has been driven through effective development of the Internet and telephone channels and innovative new products and propositions such as the market leading 8% in credit rate offered on adult and youth accounts and the 0% overdraft offer.
Unsecured Personal Lending
Total gross UPL lending decreased 18% reflecting Abbey's continued cautious stance, with overall stock balances down 17% on last year. Abbey continues to focus the lending mix towards existing customers, which make up 94% of new lending, and through the branch channel. This has contributed to higher margins on UPL stock resulting in an increase of 149 basis points over last year.
Credit Card Sales
Credit card sales were up 51% benefiting from the launch of the Abbey Zero card and the improvement in cross-selling initiatives.
2007 compared to 2006
Mortgages
Gross mortgage lending of £35.6bn, 9% higher, with an estimated market share of 9.8% benefiting from a range of initiatives, including new affordability criteria to help first time buyers.
Retail Deposits and Investments
Total net customer deposit flows of £3.2bn were significantly higher than 2006 due to a stronger product range which includes a number of savings accounts linked to investment products. Performance also benefited from a continued focus on branch-based savings and changes in incentive schemes.
Investment sales were up 36% driven by a focus on retention and improved sales processes. Sales of structured growth products were up significantly as a result of the "Super Savings" propositions and tactical products which was recognised by the Moneyfacts award of 'Best Structured Products' provider.
Protection
Protection annual premium income sales were down in comparison to 2006, largely driven by the termination of the intermediary protection sales agreement with Resolution plc.
Banking
Abbey continued to attract adult and switcher customers with adult account openings increasing by 8% and we continued to be a net gainer of switcher accounts against other major UK retail banks. In total, bank account openings of 430,000 were slightly lower than 2006.
Unsecured Personal Lending
Total gross UPL lending decreased by 57% reflecting reduced unsecured personal lending through the Internet sales channel. Abbey took a cautious approach to lending with the objective to continue generating value whilst minimising risk. We continued to focus new lending mix towards existing customers and through the branch sales channel.
Credit Card Sales
During the second half of 2007, Banco Santander, S.A. also launched a new credit card business leveraging Abbey's branch distribution in the UK. Early performance was positive, with card openings up 134% benefiting from an attractive headline rate, promotional activity and sales focus through the branch channel.
Personal Financial Services trading net interest income by segment
| 2008 £m | 2007 £m | 2006 £m | |
| Retail Banking | 1,827 | 1,623 | 1,466 |
| Corporate Banking | (13) | (31) | (46) |
| Private Banking | 85 | 70 | 62 |
| Group Infrastructure | (127) | (163) | (146) |
| PFS trading net interest income | 1,772 | 1,499 | 1,336 |
| Adjust for: | |||
| - Capital and other charges | - | - | (108) |
| PFS net interest income | 1,772 | 1,499 | 1,228 |
2008 compared to 2007
Retail Banking net interest income increased by £204m to £1,827m (2007: £1,623m), reflecting a 10% growth in both assets and deposits and better mortgage new business margins throughout 2008. At the same time, Abbey has maintained its focus on high quality prime residential lending at lower LTV and improved retention at attractive margins.
Corporate Banking net interest income charge improved by £18m to £(13)m (2007: £(31)m) driven by a continued prudent growth in lending whilst taking advantage of opportunities in the market to improve margins. Furthermore Abbey has seen significant growth in deposits from corporate clients resulting in £4.0bn inflows during the year, further strengthening the Group's balance sheet. Overall, net interest income for 2006-2008 was a net charge as it included interest expense incurred by the Porterbrook businesses that were sold in December 2008, whereas its leasing income and depreciation were classified as non-interest income.
Private Banking net interest income increased by £15m to £85m (2007: £70m), reflecting growth in all business areas, in particular Cater Allen and Abbey International which were driven by increased customer deposits attracted by competitive rates.
Group Infrastructure net interest income charge decreased by £36m to £(127)m (2007: £(163)m) reflecting higher earnings on shareholder's funds.
2007 compared to 2006
Retail Banking net interest income increased by £157m to £1,623m (2006: £1,466m), due largely to growth in savings and banking balances combined with improved margins resulting from strong margin management given base rate increases. Retail Banking net interest income also benefited from robust asset growth of 8% in challenging market conditions, albeit offset by lower asset spreads. Competitive pressures impacted the mortgage spread albeit with improved new business margins in the latter part of the year. Growth in Abbey Business also contributed materially - both in terms of deposits and commercial mortgages.
Corporate Banking net interest income charge improved by £15m to £(31)m (2006: £(46)m) reflecting a reduced cost of funding in asset financing operations and growth in the Real Estate Finance and other new corporate business portfolios.
Private Banking net interest income increased by £8m to £70m (2006: £62m), reflecting higher liability balances in Cater Allen as a result of improved sales performance and higher cash balances under administration in James Hay. This was supported by improved margins in both Cater Allen and Abbey International.
Group Infrastructure net interest income charge decreased by £17m to £(163)m (2006: £(146)m) in part due to the increased spread between the base rate and LIBOR.
Personal Financial Services trading non-interest income by segment
| 2008 £m | 2007 £m | 2006 £m | |
| Retail Banking | 622 | 635 | 645 |
| Global Banking & Markets | 326 | 260 | 240 |
| Corporate Banking | 133 | 132 | 125 |
| Private Banking | 35 | 34 | 32 |
| Group Infrastructure | 59 | 55 | 74 |
| PFS trading non-interest income | 1,175 | 1,116 | 1,116 |
| Adjust for: | |||
| - Reorganisation and other costs | (16) | - | - |
| - Depreciation of operating lease assets | 117 | 129 | 130 |
| - Profit on part sale of PFS subsidiaries | 40 | 110 | 41 |
| - Hedging and certain other mark-to-market variances | (84) | (72) | (45) |
| PFS non-interest income | 1,232 | 1,283 | 1,242 |
2008 compared to 2007
Retail Banking trading non-interest income decreased by £13m to £622m (2007: £635m). Despite difficult market conditions, Retail Banking continued to broaden its cross-selling activity, with increased commission from credit cards and investments. Improvements in these areas were offset by lower mortgage redemption volumes, lower unsecured lending and continued pressure on current account charges.
Global Banking & Markets non-interest income increased by £66m to £326m (2007: £260m) which reflected strong performance in both Rates and Equity business, due to increased transactional flow arising from close co-operation with other parts of Abbey and the beneficial trading environment available from diverging spreads in an illiquid market.
Corporate Banking non-interest income was broadly in line with 2007 at £133m (2007: £132m) as new business lending generated increases in both fees and cross-selling of Global Banking & Markets products, which were offset by the cessation of operating lease rental income and depreciation as a result of the sale of the Porterbrook businesses in December 2008.
Private Banking non-interest income was broadly in line with 2007 at £35m (2007: £34m), reflecting increased fees in James Hay offsetting lower income in Abbey International due to one-off property sales in 2007.
Group Infrastructure non-interest income increased slightly to £59m (2007: £55m). This was due to an increase in income from short-term funding, partly offset by a decline in income caused by the termination of the protection business reported in this segment in 2007.
2007 compared to 2006
Retail Banking trading non-interest income decreased slightly to £635m (2006: £645m) due largely to lower current account charges and redemption fees offset by benefits from the contribution of new credit card sales and growth in both investments and protection.
Global Banking & Markets non-interest income was ahead of 2006 at £260m (2006: £240m) delivering robust growth in 2007, driven by the Rates and Equities businesses, despite difficult trading conditions.
Corporate Banking non-interest income increased by £7m to £132m (2006: £125m) as improved contributions from existing businesses more than offset the impact of those in run down.
Private Banking non-interest income was slightly ahead of 2006 at £34m (2006: £32m), due largely to the sale of two properties by Abbey International and higher fees in James Hay.
Group Infrastructure non-interest income decreased by £19m to £55m (2006: £74m), largely due to lower earnings from short-term funding.
Personal Financial Services total trading expenses by segment
| 2008 £m | 2007 £m | 2006 £m | |
| Retail Banking | 988 | 996 | 1,005 |
| Global Banking & Markets | 107 | 107 | 93 |
| Corporate Banking | 45 | 30 | 41 |
| Private Banking | 59 | 61 | 58 |
| Group Infrastructure | 141 | 105 | 152 |
| PFS total trading expenses | 1,340 | 1,299 | 1,349 |
| Adjust for: | |||
| - Reorganisation and other costs | 88 | 146 | 144 |
| - Depreciation of operating lease assets | 117 | 129 | 130 |
| - Capital and other charges | - | - | 12 |
| PFS expenses | 1,545 | 1,574 | 1,635 |
2008 compared to 2007
Trading expenses increased by £41m to £1,340m (2007: £1,299m) reflecting the impact of the acquisition of the Bradford & Bingley plc branch and savings operations in September, as well as investment in customer facing operations and growth businesses such as Corporate Banking and Private Banking which contributed to good income growth.
Retail Banking trading expenses of £988m decreased by £8m (2007: £996m) due to savings and efficiencies as a result of the strategic change cost reduction projects, partly offset by increased investment in customer facing operations.
Global Banking & Markets trading expenses of £107m were in line with 2007 (2007: £107m) reflecting strong cost management while increasing income.
Corporate Banking trading expenses of £45m were £15m higher than the previous year (2007: £30m), largely driven by investment in growing the business.
Private Banking trading expenses of £59m were slightly lower than the previous year (2007: £61m) driven by reduced employment costs in James Hay and Abbey Sharedealing due to operational efficiencies.
Group Infrastructure trading expenses of £141m were £36m higher than the previous year (2007: £105m) principally due to costs related to Bradford & Bingley's branches and savings business post acquisition.
2007 compared to 2006
During 2007 the cost reduction programme put in place at the time of acquisition of Abbey National plc by Banco Santander, S.A. made further progress and trading expenses of £1,299m in 2007 were 4% lower than the previous year (2006: £1,349m).
Retail Banking trading expenses of £996m showed a modest decrease of £9m (2006: £1,005m) where further benefits of the cost reduction programme marginally outweighed the inflationary effect on costs, and costs associated with an increased number of customer facing roles.
Global Banking & Markets trading expenses of £107m showed an increase compared to 2006 of £14m (2006: £93m), largely due to strategic growth of the business and higher performance related payments.
Corporate Banking trading expenses of £30m were £11m lower the previous year (2006: £41m), which was largely driven by the run down of the Motor Finance business.
Private Banking trading expenses of £61m, were slightly higher than the previous year (2006: £58m) driven by higher employment costs in James Hay reflecting growth plans.
Group Infrastructure trading expenses of £105m were £47m lower than the previous year (2006: £152m) due to lower central costs following on-going cost reduction activity and the non-recurrence of trading expenses indirectly related to the life insurance businesses and other entities sold during 2006.
Personal Financial Services trading impairment losses on loans and advances by segment
| 2008 £m | 2007 £m | 2006 £m | |
| Retail Banking | 309 | 239 | 273 |
| Corporate Banking | (6) | (29) | (27) |
| Private Banking | 3 | 2 | - |
| Group Infrastructure | - | - | 5 |
| PFS trading impairment losses on loans and advances | 306 | 212 | 251 |
| Adjust for: | |||
| - Reorganisation and other costs | 42 | 132 | 93 |
| PFS impairment losses on loans and advances | 348 | 344 | 344 |
2008 compared to 2007
Trading impairment losses on loans and advances increased by £94m to £306m (2007: £212m), largely driven by signs of a deterioration in the mortgage portfolio. The performance of the mortgage portfolio remains strong, and is expected to be better than Council of Mortgage Lenders ('CML') averages for 2008. In addition, the level of secured coverage appropriately reflects the current economic conditions and is expected to benchmark well ahead of UK peers for 2008. At the same time, there has been a reduction in the unsecured lending charge, driven by the tightening in lending policies in 2007 and the reduction in the unsecured loan portfolio.
Corporate Banking provision releases decreased by £23m to £6m (2007: £29m) reflecting an increased level of impairment on the new corporate portfolios more than offset by final provision releases from the successful run down of the legacy portfolios.
2007 compared to 2006
Trading impairment losses on loans and advances reduced by £39m to £212m (2006: £251m), driven by a lower provisions charge in Retail Banking as a result of reduced exposure to unsecured lending, particularly internet-sourced lending. The provisions on mortgages saw a slight increase from historic lows, reflecting economic conditions, although the credit quality of the mortgage portfolio remains strong.
Corporate Banking provision releases of £29m (2006: £27m) reflected the better than anticipated performance of the run-down portfolios, a trend also seen in 2006.
Personal Financial Services non-performing loans
| 2008 £m | 2007 £m | 2006 £m | |
| Total non-performing loans ('NPLs') | 1,505 | 892 | 826 |
| Total loans and advances to customers (excluding trading assets) | 136,352 | 118,399 | 109,035 |
| Total provisions (on a statutory basis) | 642 | 551 | 536 |
| NPLs as a % of loans and advances | 1.10% | 0.75% | 0.76% |
| Provisions as a % of NPLs | 42.66% | 61.77% | 64.89% |
In 2008, the value of non-performing loans increased to £1,505m (2007: £892m) and non-performing loans as a percentage of loans and advances increased to 1.10% (2007: 0.75%). The NPL ratio increased due to an increase in secured arrears given market deterioration. During the year, the coverage of non-performing loans was lower at 42.66% (2007: 61.77%) largely due to the change in mix of arrears, with an increase in secured arrears with lower coverage due to security held. Secured coverage is expected to benchmark ahead of the industry average for 2008 and unsecured coverage is also expected to be well above peer group for 2008.
In 2007, the value of non-performing loans increased to £892m (2006: £826m) and non-performing loans as a percentage of loans and advances decreased to 0.75% (2006: 0.76%). During the year, the coverage of non-performing loans was lower at 61.77% (2006: 64.89%), as the mix of non-performing asset changed, with more weighting towards mortgages where the coverage was lower due to the security held.
Personal Financial Services trading provisions for other liabilities and charges by segment
| 2008 £m | 2007 £m | 2006 £m | |
| Private Banking | - | - | 2 |
| PFS trading provisions for other liabilities and charges | - | - | 2 |
| Adjust for: | |||
| - Reorganisation and other costs | (17) | - | 61 |
| PFS provisions for other liabilities and charges | (17) | - | 63 |
In 2008 and 2007, there were no net trading provisions for other liabilities and charges. The charge of £2m in 2006 related to closure of the Isle of Man offices.
Business Review - Sold Life Businesses
In 2006, Abbey sold its entire life insurance business to Resolution for cash consideration of approximately £3.6bn. The principal life companies sold were Scottish Mutual Assurance plc, Scottish Provident Limited and Abbey National Life plc, as well as the two offshore life companies, Scottish Mutual International plc and Scottish Provident International Life Assurance Limited.
The life insurance business qualifies as discontinued operations. The results and loss on sale of the discontinued operations are set out in Note 11 to the Consolidated Financial Statements.
Trading income and operating expenses
There was no trading income, and there were no operating expenses, in 2008 and 2007 as the businesses were sold in 2006.
Impairment losses on intangible assets
There were no impairment losses on intangible assets in 2008 and 2007 as the businesses were sold in 2006. In 2006, an impairment charge of £69m on intangible assets was recognised as a result of the classification of the life insurance businesses as held for sale prior to their eventual sale.
Loss on sale of discontinued operations
The loss on sale of £245m in 2006 principally reflected the discount to embedded value that is normal in sales of life insurance businesses. The existence of a discount reflects a potential buyer's use of higher discount rates than an existing owner to reflect a buyer's inherent uncertainty over assumptions and the potential for adverse lapse experience after a change in ownership.
Business and Financial Review
Other Material Items
Adjustments between the statutory basis and the trading basis
The Company's Board reviews discrete financial information for each of its segments that includes measures of operating results and assets, which are measured on a 'trading' basis. The trading basis differs from the statutory basis as a result of the application of various adjustments, as presented below, and described in the Business Review - Summary. Management considers that the trading basis provides the most appropriate way of reviewing the performance of the business.
The adjustments arise principally in the ongoing Personal Financial Services businesses. Where similar costs were incurred in the Sold Life Businesses, management no longer adjusts their results for previous periods for these items, as those businesses have now been sold. However, due to the importance of the adjustments between the statutory basis and the trading basis, the consolidated amounts are presented below, together with an analysis of the total amount into the businesses in which they were incurred unless the entire amount arose in the continuing operations.
The trading adjustments consist of:
Reorganisation and other costs
| 2008 £m | 2007 £m | 2006 £m | |
| Cost reduction programme | (100) | (109) | (152) |
| Credit provisions | (42) | (132) | (93) |
| Misselling remediation administration costs | (21) | (37) | (61) |
| (163) | (278) | (306) |
These costs comprise implementation costs in relation to the strategic change and cost reduction process, certain credit provisions taken centrally, as well as remediation administration costs in respect of product misselling. Of the total reorganisation and other costs, £8m was adjusted in the Sold Life Businesses in 2006.
2008 compared to 2007
Total reorganisation and other costs of £163m decreased by £115m compared to the previous period (2007: £278m).
Cost reduction programme expenses of £100m decreased by £9m compared to the previous period (2007: £109m) reflecting the end of the cost reduction programme initiated in 2004 and reduced project reorganisation costs.
Non-trading credit provisions of £42m decreased £90m compared to the previous period (2007: £132m). In accordance with IFRS, the charge for credit provisions adjusts the balance sheet provisions to the level that management deems adequate to absorb actual and inherent losses in Abbey's loan portfolio from homogeneous portfolios of assets and individually identified loans, as described more fully in the Risk Management Report - Provisions on loans and advances to customers, and in the Accounting Policies in the Consolidated Financial Statements. The required charge is generally determined using statistical techniques developed on previous experience and on projections of current market conditions to the time the loss is expected to crystallise.
For management reporting purposes, the total charge is then split between the charge that would be required based on conditions that persist at the balance sheet date, and the adjustment to that charge in order to reflect the change in conditions when the loss is expected to crystallise. The charge that would be required based on conditions that persist at the balance sheet date is used in the day to day running of the business, and is therefore included in provisions on the trading basis. The adjustment is excluded from the results on a trading basis and is classified as non-trading. The reduction in 2008 compared to 2007 reflects the fact that the conditions at the balance sheet date are more closely aligned to the conditions that are expected to persist when the losses crystallise.
Misselling remediation administration costs decreased to £21m (2007: £37m) reflecting a reduction in complaints handling charges.
2007 compared to 2006
Total reorganisation and other costs of £278m decreased £28m compared to the previous period (2006: £306m).
Cost reduction programme related expenses of £109m decreased by £43m compared to the previous period (2006: £152m) reflecting the more advanced stage of the programme.
Non-trading credit provisions of £132m increased £39m compared to the previous period (2006: £93m). The charge in 2006 largely related to loan portfolios that are no longer open to new business.
Misselling remediation administration costs reduced to £37m (2006: £61m) reflecting lower levels of complaints activity in relation to endowments due to the continued effect of time barring and, in relation to unauthorised overdraft charges, due to the stay in complaints relating to unauthorised overdraft charges pending a decision on legal proceedings in the High Court of England and Wales to resolve legal uncertainties concerning the level, fairness and lawfulness of unauthorised overdraft charges, as described in Note 37 to the Consolidated Financial Statements.
Profit on part sale of PFS subsidiaries
| 2008 £m | 2007 £m | 2006 £m | |
| 40 | 110 | 41 |
These profits are excluded from the results to allow management to understand the underlying performance of the business. In 2008, this consisted of the profit on the sale of the Porterbrook businesses. In 2007, these consisted of the profit on the sale of 49% of James Hay, Cater Allen and Abbey Sharedealing, and small recoveries on certain other transactions. In 2006, the profit on the sale of the Asset Management businesses was similarly excluded.
Hedging and certain other mark-to-market variances
| 2008 £m | 2007 £m | 2006 £m | |
| (84) | (72) | (45) |
The Balance Sheet and Income Statement are subject to mark-to-market volatility including that arising from the accounting for elements of derivatives deemed under IFRS rules to be ineffective as hedges. Volatility also arises on certain assets previously managed on a fair value basis, and hence classified as fair value through profit or loss under IFRS, that are now managed on an accruals basis.
2008 compared to 2007
In 2008, there was substantial mark-to-market volatility which affected asset and liability positions and related derivatives. The impact of this volatility was a loss of £84m (2007: £72m), largely due to increasing asset credit spreads. Losses were incurred due to an increase in credit spreads on the Group's holdings of prime mortgage-backed securities (almost all of which are AAA rated), which are accounted for as fair value through profit or loss and ineligible for reclassification in accordance with IAS 39. However, this was partially offset by other mark-to-market volatility, principally arising on swaps which do not meet the IAS 39 requirements for hedge accounting.
2007 compared to 2006
In 2007, the impact of this volatility of £72m (2006: £45m) was due to decreasing asset credit spreads, with hedging variances representing an insignificant amount.
Capital and other charges
Capital charges principally comprise internal nominal charges for capital invested in the Group's businesses. Management implemented this charge to assess if capital is invested effectively. On a consolidated basis, the total of these internal reallocations is £nil. The change in allocation in Group Infrastructure compared to 2006 is due to the impact of the sale of the life insurance businesses in 2006.
Legal proceedings
Abbey is party to various legal proceedings in the ordinary course of business, the ultimate resolution of which is not expected to have a material adverse effect on the financial position or the results of operations of Abbey. In addition, Abbey is party to legal proceedings concerning unauthorised overdraft charges. See Note 37 to the Consolidated Financial Statements.
Material contracts
Abbey is party to various contracts in the ordinary course of business. For the three years ended 31 December 2008 there have been no material contracts entered into outside the ordinary course of business, except for the contracts described below.
On 9 January 2009, in order to optimise the capital, liquidity funding and overall financial efficiency of the enlarged group, Banco Santander, S.A. transferred all of its Alliance & Leicester plc shares to Abbey National plc in exchange for Abbey National plc newly issued ordinary shares.
On 19 March 2009, the Company gave a full and unconditional guarantee in respect of the unsubordinated liabilities of Alliance & Leicester plc incurred prior to 31 July 2012 under a deed poll guarantee entered into by the Company. A copy of this deed poll guarantee is included in the Shareholder Information section of this Annual Report and Accounts. Alliance & Leicester plc has given a reciprocal guarantee in respect of the unsubordinated liabilities of the Company incurred prior to 31 July 2012.
Audit fees
See Note 7 of the Consolidated Financial Statements.
Throughout this section, references to UK and non-UK refer to the location of the office where the transaction is recorded.
Securities
The following table sets out the book and market values of securities at 31 December 2008, 2007 and 2006. For further information, see the Notes to the Consolidated Financial Statements.
| 2008 | 2007 | 2006 | |
| £m | £m | £m | |
| Trading portfolio | |||
| Debt securities: | |||
| UK government | 191 | 1,168 | 48 |
| US treasury and other US government agencies and corporations | 574 | - | 13 |
| Other OECD governments | 2,374 | 2,554 | 2,402 |
| Bank and building society certificates of deposit | 8,032 | 9,679 | 10,839 |
| Other issuers: | |||
| Floating rate notes | 5,101 | 2,805 | 298 |
| Mortgage-backed securities | - | 2 | 75 |
| Other asset-backed securities | - | 2,368 | 1,584 |
| Other | 529 | 10,255 | 14,551 |
| Ordinary shares and similar securities | 708 | 1,494 | 2,754 |
| 17,509 | 30,325 | 32,564 | |
| Available for sale securities | |||
| Other issuers: | |||
| UK government | 739 | - | - |
| Other | 231 | 8 | 8 |
| Ordinary shares and similar securities | 35 | 32 | 15 |
| 1,005 | 40 | 23 | |
| Fair value through profit and loss | |||
| Debt securities: | |||
| Bank and building society certificates of deposit | - | 15 | 15 |
| Other issuers: | |||
| Mortgage-backed securities | 4,362 | 4,093 | 3,006 |
| Other asset-backed securities | - | 1,460 | - |
| Other | 265 | 514 | 302 |
| 4,627 | 6,082 | 3,323 | |
| Total | 23,141 | 36,447 | 35,910 |
UK government securities
The holdings of UK government securities represent Treasury Bills and UK government guaranteed issues by other UK banks.
US treasury and other US government agencies and corporations
The holdings of US treasury and other US government agencies and corporations securities represent US Treasury Bills, including cash management bills.
Other OECD governments
This category comprises issues by Organisation of Economic Co-operation and Development ('OECD') governments other than the US and UK governments.
Bank and building society certificates of deposit
Bank and building society certificates of deposit are fixed-rate securities with relatively short maturities. These are managed within the overall position for the relevant book.
Floating rate notes
Floating rate notes have regular interest rate profiles and are either managed within the overall position for the relevant book or are hedged into one of the main currencies.
Mortgage-backed securities
This category comprises highly rated, European residential mortgage-backed securities. The securities are of high quality, contain no sub-prime element and consist almost entirely of AAA-rated prime exposures. This category includes mortgage-backed securities issued by other Santander group companies.
Other asset-backed securities
This category comprises a range of mostly floating-rate asset-backed securities including home equity loans, commercial mortgages, car dealer, lease and credit card debtors and student loans. Some of the credit card debtors incorporate cap features.
Other securities
This category comprised mainly synthetic floating-rate notes (which are fixed-rate bonds packaged into floating-rate by means of swaps tailored to provide a match to the characteristics of the underlying bond), along with a number of structured transactions which were hedged, as appropriate, either on an individual basis or as part of the overall management of the books. The synthetic floating-rate notes comprised bonds issued by banks, financial institutions and corporations, the latter being largely guaranteed by banks and financial institutions.
The following table sets forth available for sale debt securities by contractual maturity at 31 December 2008. Contractual maturities of investments held for trading or classified as fair value through profit or loss are not presented.
| On demand £m | In not more than three months £m | In more than three months but not more than one year £m | In more than one year but not more than five years £m | In more than five years £m | Total £m | |
| UK government | - | - | 739 | - | - | 739 |
| Other | - | - | 231 | - | - | 231 |
| Weighted average yield for the year % | - | - | 5.19% | - | - | 5.19% |
Significant exposures
The following table sets forth the book and market values of securities of individual counterparties where the aggregate amount of those securities exceeded 10% of the Group's shareholders' funds at 31 December 2008 as set out in the Consolidated Balance Sheet on page 73.
| £m | |
| Hipototta No.3 plc | 1,387 |
| Barclays Bank plc | 1,214 |
| Hipototta No.2 plc | 1,047 |
| UK Government | 930 |
| Lloyds Banking Group plc | 750 |
| Government of Germany | 749 |
| Royal Bank of Scotland Group plc | 661 |
| US Government | 574 |
| Government of Austria | 567 |
| Kingdom of Spain | 504 |
| Credit Agricole S.A. | 473 |
Loans and advances to banks
Loans and advances to banks includes loans to banks and building societies and balances with central banks (excluding those central bank balances which can be withdrawn on demand). The geographical analysis of loans and advances presented in the following table are based on the location of the office from which the loans and advances are made, rather than the domicile of the borrower. The balances below include loans and advances to banks that are classified in the balance sheet as trading assets or financial assets designated at fair value.
| 2008 £m | 2007 £m | 2006 £m | 2005 £m | 2004 £m | |
| UK | 28,640 | 12,066 | 11,943 | 8,060 | 11,081 |
| Non-UK | 3,106 | 222 | 93 | 1,036 | 670 |
| 31,746 | 12,288 | 12,036 | 9,096 | 11,751 |
The balances above include loans and advances to other Santander companies from UK offices of £18,817m (2007: £1,640m, 2006: £1,514m).
The following table sets forth loans and advances to banks by maturity at 31 December 2008.
| On demand £m | In not more than three months £m | In more than three months but not more than one year £m | In more than one year but not more than five years £m | In more than five years £m | Total £m | |
| UK | 5,793 | 10,778 | 10,663 | 61 | 1,345 | 28,640 |
| Non-UK | 2,943 | 88 | - | - | 75 | 3,106 |
| 8,736 | 10,866 | 10,663 | 61 | 1,420 | 31,746 |
The following table sets forth loans and advances to banks by interest rate sensitivity at 31 December 2008.
| Fixed rate £m | Variable rate £m | Total £m | |
| Interest-bearing loans and advances to banks(1): | |||
| UK | 20,500 | 7,381 | 27,881 |
| Non-UK | 1,971 | 1,135 | 3,106 |
| 22,471 | 8,516 | 30,987 |
(1) Excludes non interest-bearing accounts
Loans and advances to customers
Abbey provides lending facilities primarily to personal customers in the form of mortgages secured on residential properties and a limited number of lending facilities to corporate customers. Purchase and resale agreements represent sale and repurchase activity with professional non-bank customers by the Global Banking & Markets short-term markets business. The geographical analysis of loans and advances presented in the following table is based on the location of the office from which the loans and advances are made. The balances below are stated before the deduction for loan loss allowances, and include loans and advances to customers that are classified in the balance sheet as trading assets or financial assets designated at fair value.
| 2008 £m | 2007 £m | 2006 £m | 2005 £m | 2004 £m | |
| UK | |||||
| Advances secured on residential properties | 122,162 | 110,857 | 102,096 | 94,330 | 91,164 |
| Purchase and resale agreements | 433 | 3,711 | 5,427 | 4,789 | 4,520 |
| Other secured advances | 4,150 | 2,960 | 2,305 | 1,882 | 1,793 |
| Corporate advances | 6,773 | 1,302 | 666 | 334 | 1,030 |
| Unsecured personal advances | 3,246 | 3,263 | 4,104 | 3,845 | 3,517 |
| Finance lease debtors | - | - | 1 | 3 | 1,108 |
| 136,764 | 122,093 | 114,599 | 105,183 | 103,132 | |
| Non-UK | |||||
| Advances secured on residential properties | 12 | 13 | 19 | 26 | 14 |
| Purchase and resale agreements | - | 13,544 | 14,375 | 13,152 | 6,737 |
| Other secured advances | 3 | 2 | - | - | - |
| Corporate advances | 103 | - | - | - | - |
| Unsecured personal advances | 2 | 2 | 35 | 31 | - |
| 120 | 13,561 | 14,429 | 13,209 | 6,751 | |
| Total | 136,884 | 135,654 | 129,028 | 118,392 | 109,883 |
The balances above include loans and advances to other Santander group companies of £2,652m (2007: £55m, 2006: £348m).
No single concentration of loans and advances, with the exception of advances secured on residential properties, as disclosed above, accounts for more than 10% of total loans and advances and no individual country, other than the UK and US, accounts for more than 5% of total loans and advances.
The following tables set forth loans and advances to customers by maturity and interest rate sensitivity at 31 December 2008. In the maturity analysis, overdrafts are included in the "on-demand" category. Advances secured by residential properties are included in the maturity analysis at their stated maturity; however, such advances may be repaid early.
|
| On demand £m | In not more than three months £m | In more than three months but not more than one year £m | In more than one year but not more than five years £m | In more than five years £m |
Total £m |
| UK | ||||||
| Advances secured on residential properties | 11 | 3,448 | 2,181 | 11,895 | 104,627 | 122,162 |
| Purchase and resale agreements | 433 | - | - | - | - | 433 |
| Other secured advances | 1 | 489 | 65 | 399 | 3,196 | 4,150 |
| Corporate advances | - | 4,494 | 267 | 1,782 | 230 | 6,773 |
| Unsecured personal advances | 524 | 278 | 480 | 1,332 | 632 | 3,246 |
| Total UK | 969 | 8,709 | 2,993 | 15,408 | 108,685 | 136,764 |
| Non-UK | ||||||
| Advances secured on residential properties | - | - | - | 1 | 11 | 12 |
| Other secured advances | - | - | - | - | 3 | 3 |
| Corporate advances | 99 | 4 | - | - | - | 103 |
| Unsecured personal advances | 2 | - | - | - | - | 2 |
| Total non-UK | 101 | 4 | - | 1 | 14 | 120 |
| Total | 1,070 | 8,713 | 2,993 | 15,409 | 108,699 | 136,884 |
The interest rate sensitivity table below analyses loans between fixed rate and variable rate as at 31 December 2008.
| Fixed rate £m | Variable rate £m | Total £m | |
| UK | 69,245 | 67,519 | 136,764 |
| Non-UK | 102 | 18 | 120 |
| 69,347 | 67,537 | 136,884 |
Abbey's policy is to hedge all fixed-rate loans and advances to customers using derivative instruments, or by matching with other on-balance sheet interest rate exposures.
Provisions on loans and advances to customers
Details of Abbey's provisioning policy, as well as an analysis of end-of-year provisions on loans and advances to customers, movements in provisions for bad and doubtful debts, and Group non-performing loans and advances are set out in the Risk Management Report on page 43.
Potential problem loans and advances
In Retail Banking, due to the homogenous nature of the loans, the assessment of impairment existing at the reporting date is undertaken on a collective basis through the use of statistical techniques. The collective assessment takes due consideration of the time in arrears, with longer periods in arrears indicating a higher probability of the loans going into possession. Individual assessments are only undertaken when the collateral on a secured residential loan is repossessed or on commercial loans, where the loan is overdue.
These techniques are equally used to establish the amount of provisions for bad and doubtful debts. In addition, Abbey's policy of initiating prompt contact with customers in arrears, together with the nature of the security held, which in the case of some advances secured on residential property may have increased in value over the life of the loans, means that some non-performing loans will not result in a loss.
The categories of non-performing loans and advances which are statistically most likely to result in losses are cases from 6 months to 12 months in arrears and 12 months or more in arrears. Losses on cases for which the property securing the loan has been taken into possession are evaluated individually with the amounts expected to be lost on realisation of the security being established with a high degree of certainty. The following table sets forth the values for each of these categories included in the non-performing loans and advances table above for each of the last five years.
| 2008 £m | 2007 £m | 2006 £m | 2005 £m | 2004 £m | |
| 6 months to 12 months in arrears | 336 | 163 | 155 | 172 | 105 |
| 12 months or more in arrears | 30 | 30 | 27 | 26 | 15 |
| Properties in possession | 113 | 64 | 42 | 44 | 18 |
Potential credit risk elements in loans and advances
Interest continues to be accrued on all loans and the element of interest that is not anticipated to be recovered is derecognised. Interest income recognised on impaired loans is set out in the Consolidated Financial Statements. The income adjustment in respect of interest that is not anticipated to be recovered was £21m (2007: £16m, 2006: £15m).
Country risk exposure
Despite the turbulent year for the global economy that has lead some countries, including Iceland, to experience severe difficulties, Abbey is not exposed to countries currently experiencing liquidity problems, other than a £4m trade finance exposure in Argentina to Banco Santander Rio (a fellow subsidiary of Banco Santander, S.A.), and a £24m exposure to Iceland which is covered by credit default swap protection.
Cross border outstandings
The operations of Abbey involve operations in non-local currencies. These cross border outstandings are controlled through a well-developed system of country limits, which are reviewed to avoid concentrations of transfer, economic or political risks. Cross border outstandings, which exclude finance provided within the Group, are based on the country of domicile of the borrower or guarantor of ultimate risk and comprise loans and advances to customers and banks, finance lease debtors, interest-bearing investments and other monetary assets denominated in currencies other than the borrower's local currency.
Cross border outstandings exceeding 1% of total assets
At 31 December 2008, Abbey had no cross border outstandings exceeding 1% of total assets.
| As % of total assets % | Total £m | Banks and other financial institutions £m | Governments and official institutions £m | Commercial, industrial and other private sector entities £m | |
| At 31 December 2007: | |||||
| United States | 1.19 | 2,369 | 2,369 | - | - |
| At 31 December 2006: | |||||
| United States | 1.25 | 2,395 | 2,395 | - | - |
Cross border outstandings between 0.75% and 1% of total assets
At 31 December 2008, 2007 and 2006, Abbey had no cross border outstandings between 0.75% and 1% of total assets.
Tangible fixed assets
| 2008 £m | 2007 £m | 2006 £m | |
| Capital expenditure incurred during the year | 241 | 407 | 230 |
Capital expenditure during each of the years ended 31 December 2008, 2007 and 2006 was principally incurred by Retail Banking (mostly consisting of computer infrastructure, computer software and furniture and fittings for branches) and by Corporate Banking (consisting of operating lease assets in the Porterbrook business which was sold in December 2008). Details of capital expenditure contracted but not provided for in respect of tangible fixed assets are set out in Note 23 to the Consolidated Financial Statements.
Abbey had 1,071 unique property interests at 31 December 2008, including the properties acquired from Bradford & Bingley plc in September 2008. The total consisted of 49 freeholds and 1,022 operating lease interests, occupying a total floor space of 436,057 square metres. The number of unique property interests owned by Abbey is more than the number of individual properties as Abbey has more than one interest in some properties. The majority of Abbey's property interests are retail branches. Included in the above total are 20 properties that were not occupied by Abbey as at 31 December 2008. Of Abbey's individual properties, 954 are located in the UK, 2 in Europe and 2 in the US. There are no material environmental issues associated with the use of the above properties.
Abbey has four principal sites consisting of Abbey's headquarters and Treasury operations; the banking back office and Human Resources functions; Private Banking and the telephone distribution operations; and Credit Cards, Debt Management, Finance, Compliance and Marketing. These properties are held under operating leases. The registered office of Abbey is located at Abbey National House, 2 Triton Square, Regent's Place, London NW1 3AN.
Management believes its existing properties and those under construction, in conjunction with the operating lease arrangements in place with Mapeley Columbus Limited, are adequate and suitable for its business as presently conducted and to meet future business needs. All properties are adequately maintained.
Deposits
The following tables set forth the average balances of deposits by location for each of the three years ended 31 December 2008. The balances below include deposits by banks that are classified in the balance sheet as trading liabilities.
| Average: year ended 31 December | |||
| 2008 £m | 2007 £m | 2006 £m | |
| Deposits by banks | |||
| UK | 29,125 | 34,120 | 29,713 |
| Non-UK | 2,403 | 2,454 | 1,981 |
| 31,528 | 36,574 | 31,694 | |
| Deposits by customers (all interest bearing) | |||
| UK | 76,198 | 64,676 | 62,452 |
| Non-UK | 3,367 | 3,401 | 4,226 |
| 79,565 | 68,077 | 66,678 | |
Deposits by customers
The following tables set forth the average balances of deposits by customers by type.
| Average: year ended 31 December | |||
| 2008 £m | 2007 £m | 2006 £m | |
| UK | |||
| Retail demand deposits | 50,298 | 56,563 | 54,529 |
| Retail time deposits | 23,095 | 6,033 | 6,089 |
| Wholesale deposits | 2,805 | 2,080 | 1,834 |
|
| 76,198 | 64,676 | 62,452 |
| Non-UK | |||
| Retail demand deposits | 1,482 | 1,811 | 1,490 |
| Retail time deposits | 1,885 | 1,532 | 1,144 |
| Wholesale deposits | - | 58 | 1,592 |
|
| 3,367 | 3,401 | 4,226 |
| 79,565 | 68,077 | 66,678 | |
Retail demand and time deposits are obtained either through the branch network, cahoot or remotely (such as postal accounts). Retail demand and time deposits are also obtained outside the UK, principally through Abbey International. They are all interest bearing and interest rates are varied from time to time in response to competitive conditions.
Demand deposits
Demand deposits consist of savings and current accounts. Savings products comprise Individual Savings Accounts, instant saver savings accounts, remote access accounts, such as those serviced by post, and a number of other accounts which allow the customer a limited number of notice-free withdrawals per year depending on the balance remaining in the account. These accounts are treated as demand deposits because the entire account balance may be withdrawn on demand without penalty as one of the notice-free withdrawals.
Time deposits
Time deposits consist of notice accounts, which require customers to give notice of an intention to make a withdrawal, and bond accounts, which have a minimum deposit requirement. In each of these accounts, early withdrawal incurs an interest penalty.
Wholesale deposits
Wholesale deposits are those which either are obtained through the money markets or for which interest rates are quoted on request rather than being publicly advertised. These deposits are of fixed maturity and bear interest rates that reflect the inter-bank money market rates.
Short-term borrowings
The following tables set forth information on short-term borrowings (deposits by banks, commercial paper and negotiable certificates of deposit) for each of the three years ended 31 December 2008. Deposits by banks are reported in the "Deposits" section above, but are also analysed under "Short-term borrowings" because of their importance as a source of funding.
Deposits by banks(1)
| 2008 £m | 2007 £m | 2006 £m | |
| Year-end balance (2) | 37,678 | 27,555 | 36,755 |
| Average balance(3) | 31,528 | 36,574 | 31,694 |
| Maximum balance | 37,678 | 48,278 | 37,485 |
(1) Abbey policy is to mark-to-market the majority of its deposits by banks balances including interest. Mark-to-market movements are recorded in net trading and other income rather than net interest income. As a result, it has not been possible to calculate average or year-end interest rates.
(2) The year-end deposits by banks balance includes non-interest bearing items in the course of transmission of £922m (2007: £786m, 2006: £363m).
(3) Average balances are based upon monthly data.
The balances above also include deposits by banks that are classified in the balance sheet as trading liabilities. At 31 December 2008, deposits by foreign banks amounted to £7,906m (2007: £7,922m, 2006: £15,040m).
Commercial paper
| 2008 £m | 2007 £m | 2006 £m | |
| Year-end balance | 4,862 | 7,283 | 6,705 |
| Year-end interest rate(1) | 1.66% | - | - |
| Average balance(2) | 4,482 | 6,610 | 6,344 |
| Average interest rate(1) (2) | 3.3% | - | - |
| Maximum balance | 5,797 | 8,784 | 7,308 |
(1) Prior to 2008, the majority of commercial paper balances including interest were marked-to-market rather than accounted for on an accruals basis. Mark-to-market movements were recorded in net trading and other income rather than net interest income. As a result, it was not possible to calculate average or a year-end interest rates for 2007 or 2006.
(2) Average balances are based upon monthly data.
Abbey issues commercial paper generally in denominations of not less than $50,000, with maturities of up to 365 days. Commercial paper is issued by Abbey National Treasury Services plc and Abbey National North America LLC.
Negotiable certificates of deposit
| 2008 £m | 2007 £m | 2006 £m | |
| Year-end balance | 9,638 | 11,326 | 10,832 |
| Year-end interest rate(1) | 4.17% | - | - |
| Average balance (2) | 12,729 | 13,037 | 7,644 |
| Average interest rate(1) (2) | 4.9% | - | - |
| Maximum balance | 15,807 | 14,821 | 10,832 |
(1) Prior to 2008, the majority of negotiable certificates of deposit balances including interest were marked-to-market rather than accounted for on an accruals basis. Mark-to-market movements were recorded in net trading and other income rather than net interest income. As a result, it was not possible to calculate average or year-end interest rates for 2007 or 2006.
(2) Average balances are based upon monthly data.
Certificates of deposit and certain time deposits
The following table sets forth the maturities of Abbey's certificates of deposit and other large wholesale time deposits from non-bank counterparties in excess of £50,000 (or the non-sterling equivalent of £50,000) at 31 December 2008. A proportion of Abbey's retail time deposits also exceeds £50,000 at any given date; however, the ease of access and other terms of these accounts means that they may not have been in excess of £50,000 throughout 2008.
Furthermore, the customers may withdraw their funds on demand upon payment of an interest penalty. For these reasons, no maturity analysis is presented for such deposits. See "Short-term borrowings" above for information on amounts of claims under issues of commercial paper.
| Not more than three months £m | In more than three months but not more than six months £m | In more than six months but not more than one year £m | In more than one year £m | Total £m | |
| Certificates of deposit: | |||||
| UK | 3,536 | 1,053 | 62 | 23 | 4,674 |
| Non-UK | 3,241 | 855 | 833 | 35 | 4,964 |
| Wholesale time deposits: | |||||
| UK | 3,275 | 455 | 496 | 652 | 4,878 |
| 10,052 | 2,363 | 1,391 | 710 | 14,516 |
At 31 December 2008, an additional £71m (2007: £1,819m) of wholesale deposits were repayable on demand.
Capital management and resources
Capital management and capital allocation
Abbey adopts a centralised capital management approach, based on an assessment of both regulatory requirements and the economic capital impacts of our businesses. Details of Abbey's objectives, policies and processes for managing capital, including the group capital table, can be found in Note 47 to the Consolidated Financial Statements.
Capital and risk management disclosures required by Pillar 3
Santander is supervised by the Banco de España on a consolidated basis. Abbey has applied Santander's approach to capital measurement and risk management in its implementation of Basel II. As a result, Abbey has been classified as a significant sub-group of Santander at 31 December 2008. The relevant Abbey Pillar 3 disclosure requirements are set out below. Further information on the Basel II risk measurement of Abbey's exposures is included in Santander's Pillar 3 report.
Scope of the Group's capital adequacy
Abbey National plc and its subsidiaries are a UK banking group regulated by the UK Financial Services Authority. The basis of consolidation for prudential purposes is the same as the basis of consolidation for financial statement purposes. Consequently, the results of significant subsidiaries regulated by the UK Financial Services Authority are included in the Group's capital adequacy disclosures.
Abbey and Santander recognise the additional security inherent in Tier 1 capital in the current commercial and regulatory environment. As a result, on 12 October 2008, Banco Santander, S.A. agreed to inject capital of £1bn into the combined businesses fulfilling its agreed commitment to the UK Government's banking support scheme announced on 8 October 2008. Consequently, on 12 October 2008, Abbey National plc issued ten billion Ordinary Shares of 10 pence each and these shares were issued at par to Banco Santander, S.A. on the same date. These ordinary shares qualified as Tier 1 capital for Abbey. This capital was, in turn, transferred to Alliance & Leicester plc in late December as planned.
At 31 December 2008, Abbey National plc held 35.6% of the issued ordinary share capital of Alliance & Leicester plc as described in Business Overview - Summary History. As a result, the Group's capital adequacy disclosures at 31 December 2008 include 35.6% of Alliance & Leicester plc's capital resources requirement on a proportional consolidation basis in accordance with the UK Financial Services Authority's rules. This amounted to £676m at 31 December 2008.
Capital transferability between the Group's subsidiaries is managed in accordance with the Group's corporate purpose and strategy, its risk and capital management policies and with regard to UK legal and regulatory requirements. There are no other current or foreseen material practical or legal impediments to the prompt transfer of capital resources or repayment of liabilities when due between Abbey National plc and its subsidiaries and associates, and between Alliance & Leicester plc and its subsidiaries and associates.
Capital ratios
The table below summarises the Group's capital ratios:
| Basel II 31 December 2008 £m | Basel I 31 December 2007 £m | |
| Core Tier 1 (after deductions) | 6.2% | 5.4% |
| Tier 1 | 8.5% | 7.3% |
| Total capital | 14.0% | 11.4% |
Ratios are calculated by taking the relevant capital resources as a percentage of risk weighted assets. Risk weighted assets at 31 December 2007 on a Basel I basis were £68,562m. The ratios improved compared to the prior year due to the lower capital requirement under Basel II.
Regulatory capital resources
The table below analyses the composition of the Group's regulatory capital resources at 31 December 2008. The table has been prepared in accordance with the requirements of Pillar 3 and therefore does not include comparatives.
| 31 December 2008 £m | |
| Core Tier 1 capital: | |
| Called up share capital | 1,148 |
| Share premium | 1,857 |
| Retained earnings and other reserves | 1,689 |
| 4,694 | |
| Deductions from Core Tier 1 capital: | |
| Intangible Assets | (508) |
| Securitisation positions | (21) |
| Expected Losses | (257) |
| Material Holdings | (6) |
| (792) | |
| Total Core Tier 1 capital after deductions | 3,902 |
| Non cumulative Preference Shares | 603 |
| Innovative Tier 1 instruments | 1,095 |
| Excess on limits for including innovative Tier 1 capital in total Tier 1 capital | (213) |
| Total Tier 1 Capital after deductions | 5,387 |
| Tier 2 capital: | |
| Subordinated debt | 4,543 |
| Excess innovative tier 1 capital | 213 |
| Other | 10 |
| 4,766 | |
| Deductions from Tier 2 capital: | |
| Securitisation positions | (21) |
| Expected Losses | (257) |
| Material Holdings | (6) |
| Total Tier 2 capital after deductions | 4,482 |
| Deductions from Tier 1 and 2 | (988) |
| Total Capital Resources | 8,881 |
The Group's core Tier 1 capital consists of shareholders' equity, share premium and audited profits for the years ended 31 December 2008 after adjustment to comply with the UK Financial Service Authority's rules.
Non cumulative preference shares and Innovative Tier 1 are shown separately in the above table. Details of the Innovative Tier 1 capital instruments are set out in Note 32 to the Consolidated Financial Statements. For capital management purposes and in accordance with the UK Financial Services Authority's rules, Innovative Tier 1 is treated as Tier 1 capital. The UK Financial Services Authority's capital gearing rules restrict the amount of Innovative Tier 1 capital included in Tier 1 capital to 15% of core Tier 1 capital after deductions. The excess is classified as Tier 2.
For details of the subordinated debt issues that meet the UK Financial Services Authority's definition of Tier 2 capital see Note 33 to the Consolidated Financial Statements. In accordance with the UK Financial Services Authority's rules, in the last five years to maturity, dated subordinated debt issues are amortised on a straight line basis.
The expected losses deduction represents the difference between expected loss calculated in accordance with the Group's Retail IRB and AIRB models, and the impairment provisions calculated in accordance with IFRS. Details of the Group's accounting policy for credit provisions are set out in the Accounting Policies in the Consolidated Financial Statements on pages 93 to 94. Expected losses are higher than the impairment provisions as the expected loss amount includes all losses that are anticipated to arise over the twelve months following the balance sheet date, not just those incurred at the balance sheet date.
Intangible assets represent goodwill arising on the purchase of the branch network and savings business of Bradford & Bingley plc, and certain capitalised computer software costs.
Material holdings deductions and other Tier 1 and Tier 2 deductions principally represent investments in and loans to other banks in the Santander group.
Capital resources requirement
The table below analyses the composition of the Group's regulatory capital requirements at 31 December 2008. The table has been prepared in accordance with the requirements of Pillar 3 and therefore does not include comparatives.
| 2008 £m | |
| Credit Risk - Standardised approach: | |
| Institutions | 34 |
| Corporates | 564 |
| Retail | 167 |
| Secured on real estate property | 187 |
| Past due items | 14 |
| Securitisation positions | 65 |
| Other items | 193 |
| 1,224 | |
| Credit Risk - IRB approach: | |
| Retail exposures secured by real estate collateral | 1,989 |
| Qualifying revolving retail | 169 |
| Other retail | 293 |
| Institutions | 124 |
| Corporates | 280 |
| Other | 21 |
| 2,876 | |
| Counterparty risk capital component | 215 |
| Operational risk - standardised approach: | 398 |
| Market Risk: | 361 |
| Total Pillar 1 capital requirement | 5,074 |
| Risk weighted assets (based on an 8% capital charge) | 63,425 |
From 1 January 2008, the Group applied Basel II to the calculation of its capital resources requirement. In addition, the Financial Services Authority approved the Group's application of the Retail IRB and AIRB approaches to the Group's credit portfolios with effect from 1 January 2008. Residential lending capital resources requirement include securitised residential mortgages.
There has been no significant net change in the capital requirement of Abbey during 2008. Although business volumes have increased, these increases have been offset by enhancement of Abbey's Retail IRB and AIRB models.
Off-Balance Sheet Arrangements
In the ordinary course of business, Abbey issues guarantees on behalf of customers. The significant types of guarantees are:
> It is normal in the UK to issue cheque guarantee cards to current account customers holding chequebooks, as retailers do not generally accept cheques without such form of guarantee. The guarantee is not automatic but depends on the retailer having sight of the cheque guarantee card at the time the purchase is made. The bank is liable to honour these cheques even where the customer doesn't have sufficient funds in his account. The bank's guarantee liability is in theory the number of cheques written and deposited with retailers multiplied by the amount guaranteed per cheque, which can be between £50 and £100. In practice most customers will only write cheques when they have funds in their account to meet the cheque, and cheques are frequently presented without the benefit of the cheque guarantee. On this basis management have assessed the risk with respect to this guarantee as highly remote and consider the risk of loss as part of the provisioning requirement on bank accounts.
> Standby letters of credit also represent the taking on of credit on behalf of customers when actual funding is not required, normally because a third party is not prepared to accept the credit risk of Abbey's customer. These are also included in the normal credit provisioning assessment alongside other forms of credit exposure.
> The Group, as is normal in such activity, gives representations, indemnities and warranties on the sale of subsidiaries and businesses. The maximum potential amount of any claims made against these is usually significantly higher than actual settlements. Appropriate provision is made with respect to management's best estimate of the likely outcome, either at the time of sale, or subsequently if additional information becomes available.
Further information regarding off-balance sheet arrangements can be found in the Risk Management Report - Impact of the Current Credit Environment on page 53. See Note 37 to the Consolidated Financial Statements for additional information regarding Abbey's guarantees, commitments and contingencies. In the ordinary course of business, Abbey also enters into securitisation transactions as described in Note 18 to the Consolidated Financial Statements. The Holmes securitisation companies are consolidated. The mortgage assets continue to be administered by Abbey. The Holmes securitisation companies provide Abbey with an important source of long-term funding.
Liquidity
Liquidity risk is the potential that, although remaining in operation, Abbey does not have sufficient liquid financial resources to enable it to meet its obligations as they fall due, or can secure them only at excessive cost.
The Board is responsible for the liquidity management and control framework at Abbey and has approved key liquidity limits in setting Abbey's liquidity risk appetite. Along with its internal Liquidity Risk Manual, which sets out the liquidity risk control framework and policy, Abbey abides by the "Sound Practices for Managing Liquidity in Banking Organisations" set out by the Basel Committee as its standard for liquidity risk management and control. Abbey also complies with the Financial Services Authority's liquidity requirements, and has appropriate liquidity controls in place.
See "Business and Financial Review - Risk Management" for more information.
Cash flows
| 2008 £m | 2007(1) £m | 2006(1) £m | |
| Net cash (outflow)/inflow from operating activities | (22,115) | (9,332) | 431 |
| Net cash inflow/(outflow)from investing activities | 17,705 | (196) | (597) |
| Net cash (outflow)/inflow from financing activities | (7,382) | 4,776 | 1,758 |
| (Decrease)/increase in cash and cash equivalents | (11,792) | (4,752) | 1,592 |
(1) In 2008, the Group changed its accounting policy for cash equivalents to exclude trading liabilities from its determination of cash equivalents. For more information, see the Accounting Policies on page 85. There was no impact on the income statements or balance sheets of any period or as at any date presented.
For the years ended 31 December 2008, 2007 and 2006, cash and cash equivalents decreased £11,792m and £4,752m, and increased £1,592m, respectively. The following discussion highlights the major activities and transactions that affected Abbey's cash flows during 2008, 2007 and 2006.
The net inflow from investing activities of £17,705m primarily arose as a result of the acquisition of Bradford & Bingley plc's savings business to strengthen Abbey's retail customer deposit base and franchise, which generated £18,001m of cash. This, plus additional inflows from customer deposits, has been invested in new lending.
The cash outflow from financing activities to repay loan capital reflected the maturity of some existing issues, which has not been offset by new issues of loan capital given current market conditions.
The reduction in cash and cash equivalents is a result of reducing assets, including those treated as cash and cash equivalents in the cash flow statement, in the Global Banking & Markets operations to fund our Retail Banking lending.
Cash Flows from Operating Activities
For the years ended 31 December 2008, 2007 and 2006, net cash used in operating activities was £22,115m, £9,332m and £(431)m, respectively. Abbey's operating assets and liabilities support the Group's lending activities, including the origination of mortgages and unsecured personal loans. During the two years ended 31 December 2008, net cash was used to fund the Group's core business of origination of mortgages in Retail Banking.
In addition to the movement related to the acquisition of Bradford & Bingley plc's savings business, other strong customer deposit inflows were partially offset by a reduction in deposits by banks. The remaining significant changes relate to the reduction of activity in Global Banking & Markets.
The amount and timing of cash flows related to the Group's operating activities may vary significantly in the normal course of business as a result of market conditions and trading strategies in Cater Allen International Limited.
Cash Flows from Investing Activities
The Group's investing activities primarily involve the acquisition and disposal of businesses, and the purchase of tangible and intangible assets.
For the year ended 31 December 2008, net cash of £17,705m was generated by investing activities, primarily as a result of the acquisition of Bradford & Bingley plc's savings business to strengthen Abbey's retail customer deposit base and franchise, which generated £18,001m of cash, and the sale of the Porterbrook operating lease business which generated £1,605m of cash. These sources of cash were partially offset by uses of cash of £708m to invest in associates, which represented Abbey's subscription for newly issued ordinary shares of Alliance & Leicester plc in December 2008 in order to support its capital position prior to its ultimate acquisition by Abbey in January 2009; £278m to fund purchases of tangible and intangible fixed assets; and £1,222m to invest in non-trading securities. Of the £278m invested in tangible and intangible fixed assets, £120m was invested in computer infrastructure and software, primarily reflecting investment in systems to support our expansion in lending to small and medium-sized enterprises, and further investment in elements of Partenon, the Santander Group's IT platform; £59m was invested in furniture and fittings for the Retail Banking branch network, mainly as a result of continuing branch refurbishments; and £88m was invested by the Porterbrook operating lease business in the construction of rail assets prior to its sale in December 2008. The £1,222m invested in non-trading securities represented the purchase of assets pledged related to the Group's obligations with respect to pensions funding.
For the year ended 31 December 2007, net cash of £196m was used in investing activities. £407m was invested in tangible fixed assets, principally consisting of the investment of £215m by Porterbrook in rolling stock; £103m in Partenon, reflecting the costs of migrating many of our core products onto the new platform; and £66m in refurbishments in the Retail Banking branch network. These uses of cash were partially offset by cash proceeds of £203m on the sale of 49% of Abbey's shareholding in Santander Private Banking UK Limited (consisting of James Hay, Cater Allen and Abbey Sharedealing) to Santander PB UK (Holdings) Limited, a direct subsidiary of Banco Santander, S.A., as part of a reorganisation of Santander's Private Banking businesses.
For the year ended 31 December 2006, net cash of £597m was used in investing activities, primarily attributable to £365m being absorbed by the sale of the life insurance business to Resolution plc, as a result of management's decision to focus on the commercial banking operations. In addition, £230m was invested in tangible fixed assets, principally consisting of the investment of £41m by Porterbrook in rolling stock; £103m in Partenon, reflecting the implementation of the single customer database and the commencement of the sales and service portals rollout; and £71m invested in refurbishments in the Retail Banking branch network.
Cash Flows from Financing Activities
The Group's financing activities reflect transactions involving the issuance and repayment of long-term debt, and the issuance of, and payment of dividends on, the Company's shares.
In 2008, net cash outflow from financing activities was £7,382m, principally due to repayment of loan capital. There were no external issuances of long-term debt in 2008, reflecting the difficult conditions in the credit markets. The net cash used was partially offset by the issuance of £1bn of ordinary share capital. In addition, cash dividends on ordinary shares of £595m were paid.
In 2007, net cash provided by financing activities was £4,776m principally due to new issuances of mortgage-backed securities under Abbey's securitisation programme classified as long-term debt. The effect was partially offset by redemption of securities issued by the securitisation companies. For further information on Abbey's securitisation programme, see Note 18 to the Consolidated Financial Statements. No cash dividends were paid on ordinary shares.
In 2006, net cash provided by financing activities was £1,758m due to new issuances of mortgage-backed securities under Abbey's securitisation programme. The net cash provided was offset partially by the payment of cash dividends on ordinary shares of £207m.
Sources of liquidity
Abbey is primarily funded by its Commercial Bank franchise, including retail and corporate deposits, attracted through a variety of entities. Around three quarters of Commercial Bank customer lending is financed by Commercial Bank customer deposits. The retail sources primarily originate from the Retail Banking savings business. Although primarily callable, these funds provide a stable and predictable core of liquidity due to the nature of the retail accounts and the breadth of personal customer relationships.
Additionally, Abbey has a strong wholesale funding base, which is diversified across funding types and geography. Through the wholesale markets, Abbey has active relationships with more than 500 counterparties across a range of sectors, including banks, central banks, other financial institutions, corporates and investment funds. Other sources of funding include collateralised borrowings, mortgage securitisations and long-term debt issuance. While there is no certainty regarding money market lines of credit extended to Abbey, they are actively managed as part of the ongoing business. No guaranteed lines of credit have been purchased as such arrangements are not common practice in the European banking industry.
Short-term funding is accessed through money market instruments, including time deposits, certificates of deposit and commercial paper. Medium to long-term funding is accessed primarily through the stand-alone bond markets. In addition, Abbey utilises its euro medium-term note programme. The major debt issuance programmes are managed by Abbey National Treasury Services plc on its own behalf, except for the US commercial paper programme, which is managed for Abbey National North America LLC, a guaranteed subsidiary of Abbey, are set forth below:
| Programme | Outstanding at 31 December 2008 | Markets issued in |
| $15bn medium-term notes | $8.8bn | Europe |
| $4bn commercial paper | $0.9bn | Europe |
| $20bn commercial paper | $6.1bn | United States |
| Euro 2bn structured notes | Euro 0.5bn | Europe |
| Euro 25bn covered bond | Euro 17.5bn | Europe |
The ability to sell assets quickly is also an important source of liquidity for Abbey. Abbey holds marketable investment securities, such as central bank, eligible government and other debt securities, which could be disposed of, either by entering into sale and repurchase agreements, or by being sold to provide additional funding should the need arise. Abbey also makes use of asset securitisation arrangements to provide alternative funding sources.
Along with other major UK banks and building societies, Abbey participated in the Bank of England's Special Liquidity Scheme whereby it swapped self-subscribed-for asset-backed security issuances for highly liquid Treasury Bills. This facility was provided to all UK banks and building societies, without stigma, as part of the measures designed to improve the liquidity position of the UK banking system in general. 2008 saw an unprecedented and prolonged stress within the wholesale funding markets. Abbey was able to raise wholesale funds in the short-term market and also from the debt capital markets. However, in light of market conditions, the Group also used alternatives to wholesale funding arrangements to manage its liquidity needs.
Securitisation of assets
The Group has provided prime retail mortgage-backed securitised products to a diverse investor base through its mortgage backed funding programmes. Funding has historically been raised via mortgage-backed notes, both issued to third parties and retained (the latter being central bank eligible collateral, both via the Bank of England's Special Liquidity Scheme facility and for contingent funding purposes in other Bank of England, European Central Bank and US Federal Reserve facilities). It is expected that issues to third parties and retained issuances will together represent a similar proportion of the Group's overall funding in 2009 and 2010. During 2008, as a result of market conditions, the main means of raising funding was through retained issuances. If and when credit conditions improve, our intention is to resume third party issuances.
UK Government 2008 Credit Guarantee Scheme
On 8 October 2008, the UK Government announced measures intended to ensure the stability of the financial system and to protect ordinary savers, depositors, businesses and borrowers. On 13 October 2008 the UK Government announced the details of its 2008 Credit Guarantee Scheme for UK incorporated banks and building societies debt issuance (the 'Scheme'). The Scheme forms part of the UK Government's measures intended to ensure the stability of the financial system.
The Scheme provides for HM Treasury to guarantee specific debt instruments issued by eligible institutions during the six-month period ending on 13 April 2009 and with a maturity not exceeding three years. Eligible institutions (which must be either authorised UK deposit-takers or building societies) seeking to utilise the Scheme must submit applications to HM Treasury and a fee will be payable by the relevant issuer for each guarantee granted. The Company is the eligible institution for the Group.
In 2009, with respect to funding, rather than capital, we expect to remain flexible in our approach to liquidity and funding arrangements, and we believe that the current arrangements with the Bank of England, European Central Bank and US Federal Reserve, as well as the Scheme will assist us in meeting our liquidity and funding needs.
Uses of liquidity
The principal uses of liquidity for Abbey are the funding of Retail Banking lending and investment securities, payment of interest expense, dividends paid to shareholders, and the repayment of debt. Abbey's ability to pay dividends depends on a number of factors, including Abbey's regulatory capital requirements, distributable reserves and financial performance.
For further information on liquidity, including liquidity risk management and developments during the year, see Risk Management - Liquidity Risk on page 54 and Risk Management - Impact of the Current Credit Environment on page 52.
Contractual obligations
The amounts and maturities of contractual obligations in respect of guarantees are described in Note 37 to the Consolidated Financial Statements. Other contractual obligations are:
| Payments due by period | |||||
| Total £m | Less than 1 year £m | 1-3 years £m | 3-5 years £m | Over 5 years £m | |
| Deposits by banks(1) | 37,678 | 37,490 | 78 | 110 | - |
| Deposits by customers(1) | 103,868 | 97,237 | 2,513 | 2,011 | 2,107 |
| Debt securities in issue(2) | 47,147 | 18,774 | 2,870 | 1,208 | 24,295 |
| Other borrowed funds | 2,076 | - | - | - | 2,076 |
| Subordinated liabilities | 5,826 | 515 | 515 | - | 4,796 |
| Retirement benefit obligations | 796 | 129 | 132 | 153 | 382 |
| Operating lease obligations | 1,097 | 104 | 311 | 85 | 597 |
| Purchase obligations | 170 | 86 | 84 | - | - |
| Total | 198,658 | 154,335 | 6,503 | 3,567 | 34,523 |
(1) Includes deposits by banks and deposits by customers that are classified in the balance sheet as trading liabilities.
(2) Includes debt securities in issue that are classified in the balance sheet as trading liabilities and financial liabilities designated at fair value.
As the above table is based on contractual maturities, no account is taken of call features related to subordinated liabilities. The repayment terms of the debt securities may be accelerated in line with the covenants contained within the individual loan agreements. Details of deposits by banks and deposits by customers can be found in Notes 27 and 28 of the Consolidated Financial Statements.
Abbey has entered into outsourcing contracts where, in some circumstances, there is no minimum specified spending requirement. In these cases, anticipated spending volumes have been included within purchase obligations.
Under current conditions, Abbey's working capital is expected to be sufficient for its present requirements and to pursue its planned business strategies.
Interest rate sensitivity
Interest rate sensitivity refers to the relationship between interest rates and net interest income resulting from the periodic repricing of assets and liabilities. The largest administered rate items in the Group's balance sheet are residential mortgages and retail deposits, the majority of which bear interest at variable rates. Abbey is able to mitigate the impact of interest rate movements on net interest income in Retail Banking by repricing separately the variable rate mortgages and variable rate retail deposits, subject to competitive pressures.
Abbey also offers fixed-rate mortgages and savings products on which the interest rate paid by or to the customer is fixed for an agreed period of time at the start of the contract. Abbey manages the margin on fixed-rate products by the use of derivatives matching the fixed-rate profiles. The risk of prepayment is reduced by imposing early termination charges if the customers terminate their contracts early.
Abbey seeks to manage the risks associated with movements in interest rates as part of its management of the overall non-trading position. This is done within limits as described in the Risk Management Report elsewhere in this Annual Report and Accounts.
Changes in net interest income - volume and rate analysis
The following table allocates changes in interest income, interest expense and net interest income between changes in volume and changes in rate for the Group, including the Sold Life Businesses, for the years ended 31 December 2008, 2007 and 2006. Volume and rate variances have been calculated on the movement in the average balances and the change in the interest rates on average interest-earning assets and average interest-bearing liabilities. The variance caused by changes in both volume and rate has been allocated to rate changes.
| 2008/2007 | 2007/2006 | |||||
|
| Total change | Changes due to increase/(decrease) in | Total change | Changes due to increase/(decrease) in | ||
|
|
£m | Volume £m | Rate £m |
£m | Volume £m | Rate £m |
| Interest income | ||||||
| Loans and advances to banks | ||||||
| UK | 198 | 538 | (340) | 69 | 85 | (16) |
| Non-UK | 24 | 17 | 7 | (1) | (1) | - |
| Loans and advances to customers | ||||||
| UK | 650 | 881 | (231) | 1,280 | 390 | 890 |
| Non-UK | - | - | - | (2) | (1) | (1) |
| Total interest income | ||||||
| UK | 848 | 1,419 | (571) | 1,349 | 475 | 874 |
| Non-UK | 24 | 17 | 7 | (3) | (2) | (1) |
| 872 | 1,436 | (564) | 1,346 | 473 | 873 | |
| Interest expense | ||||||
| Deposits by banks | ||||||
| UK | 19 | (25) | 44 | 105 | 157 | (52) |
| Deposits by customers - retail demand deposits | ||||||
| UK | 4 | (261) | 265 | 429 | 72 | 357 |
| Non-UK | (48) | (18) | (30) | 58 | 8 | 50 |
| Deposits by customers - retail time deposits | ||||||
| UK | 208 | 959 | (751) | (2) | (3) | 1 |
| Non-UK | 30 | 15 | 15 | (2) | 22 | (24) |
| Deposits by customers - wholesale deposits | ||||||
| UK | 31 | 25 | 6 | (7) | 10 | (17) |
| Non-UK | (3) | - | (3) | (63) | (64) | 1 |
| Bonds and medium-term notes | ||||||
| UK | 282 | 816 | (534) | 668 | 285 | 383 |
| Non-UK | 48 | 152 | (104) | 15 | (13) | 28 |
| Dated and undated loan capital and other subordinated liabilities | ||||||
| UK | 12 | 15 | (3) | (60) | (21) | (39) |
| Non-UK | 17 | 4 | 13 | (1) | (8) | 7 |
| Other interest-bearing liabilities UK | (1) | 3 | (4) | (3) | (10) | 7 |
| Total interest expense | ||||||
| UK | 555 | 1,532 | (977) | 1,130 | 490 | 640 |
| Non-UK | 44 | 153 | (109) | 7 | (55) | 62 |
| 599 | 1,685 | (1,086) | 1,137 | 435 | 702 | |
| Net interest income | 273 | (249) | 522 | 209 | 38 | 171 |
Average balance sheet (1) (2)
| 2008 | 2007 | 2006 | |||||||
| Average balance £m |
Interest £m | Average rate % | Average balance £m |
Interest £m | Average rate % | Average balance £m |
Interest £m | Average rate % | |
| Assets |
| ||||||||
| Loans and advances to banks |
| ||||||||
| UK | 12,620 | 424 | 3.36 | 3,731 | 226 | 6.06 | 2,416 | 157 | 6.50 |
| Non-UK | 454 | 24 | 5.29 | 30 | 1 | 3.99 | 53 | 2 | 3.77 |
| Loans and advances to customers(3) |
|
|
| ||||||
| UK | 121,639 | 7,465 | 6.14 | 107,709 | 6,815 | 6.33 | 100,627 | 5,536 | 5.50 |
| Non-UK | 18 | 1 | 5.56 | 22 | 1 | 4.55 | 51 | 2 | 3.92 |
| Debt securities |
|
|
| ||||||
| UK | 13 | 1 | 3.93 | 8 | - | 7.60 | 1 | - | 0.00 |
| Total average interest-earning assets, | 134,744 | 7,915 | 5.87 | 111,500 | 7,043 | 6.32 | 103,148 | 5,697 | 5.52 |
| interest income | |||||||||
| Provision for loan losses | (562) | - | - | (458) | - | - | (431) | - | - |
| Trading business | 34,747 | - | - | 68,612 | - | - | 60,780 | - | - |
| Assets designated at fair value through profit and loss | 12,755 | - | - | 9,152 | - | - | 18,336 | - | - |
| Non-interest-earning assets: |
|
|
| ||||||
| Other | 22,585 | - | - | 15,162 | - | - | 17,815 | - | - |
| Total average assets | 204,269 | 203,968 | 199,648 |
|
| ||||
| Non-UK assets as a % of total | 0.23% | 0.03% | 0.05% |
|
| ||||
| Liabilities |
|
|
| ||||||
| Deposits by banks |
|
|
| ||||||
| UK | (4,509) | (218) | 4.83 | (5,169) | (199) | 3.85 | (1,938) | (94) | 4.85 |
| Deposits by customers: retail demand(4) |
|
|
| ||||||
| UK | (50,298) | (2,363) | 4.70 | (56,563) | (2,359) | 4.17 | (54,529) | (1,930) | 3.54 |
| Non-UK | (1,482) | (49) | 3.31 | (1,811) | (97) | 5.36 | (1,490) | (39) | 2.62 |
| Deposits by customers: retail time(4) |
|
|
| ||||||
| UK | (23,095) | (547) | 2.37 | (6,033) | (339) | 5.62 | (6,089) | (341) | 5.60 |
| Non-UK | (1,885) | (92) | 4.87 | (1,532) | (62) | 4.05 | (1,144) | (64) | 5.59 |
| Deposits by customers: wholesale(4) |
|
|
| ||||||
| UK | (2,805) | (102) | 3.64 | (2,080) | (71) | 3.41 | (1,834) | (78) | 4.25 |
| Non-UK | - | - | - | (58) | (3) | 5.17 | (1,592) | (66) | 4.15 |
| Bonds and medium-term notes |
|
|
| ||||||
| UK | (41,309) | (1,957) | 4.74 | (27,776) | (1,675) | 6.03 | (21,649) | (1,007) | 4.65 |
| Non-UK | (8,202) | (325) | 3.96 | (5,293) | (277) | 5.23 | (5,579) | (262) | 4.70 |
| Dated and undated loan capital and other subordinated liabilities |
|
|
| ||||||
| UK | (6,002) | (400) | 6.66 | (5,778) | (388) | 6.72 | (6,067) | (448) | 7.38 |
| Non-UK | (560) | (62) | 11.07 | (511) | (45) | 8.81 | (613) | (46) | 7.50 |
| Other interest-bearing liabilities UK | (917) | (28) | 3.05 | (825) | (29) | 3.52 | (1,179) | (32) | 2.70 |
| Total average interest-bearing liabilities, interest expense | (141,064) | (6,143) | 4.35 | (113,429) | (5,544) | 4.89 | (103,703) | (4,407) | 4.25 |
| Trading business | (41,196) | - | - | (64,342) | - | - | (56,062) | - | - |
| Liabilities designated at fair value through profit and loss | - | - | - | (7,847) | - | - | (8,500) | - | - |
| Non-interest-bearing liabilities: |
| ||||||||
| Other | (18,434) | - | - | (15,248) | - | - | (28,292) | - | - |
| Shareholders' funds | (3,575) | - | - | (3,102) | - | - | (3,091) | - | - |
| Total average liabilities and shareholders' funds | (204,269) | (203,968) | (199,648) |
|
| ||||
| Non-UK liabilities as a % of total | 5.94% | 4.51% | 5.22% |
|
|
| Interest income as a percentage of average interest-earning assets | - | - | 5.87 | - | - | 6.32 | - | - | 5.52 |
| Interest expense as a percentage of average interest-bearing liabilities | - | - | 4.35 | - | - | 4.89 | - | - | 4.25 |
| Interest spread | - | - | 1.52 | - | - | 1.43 | - | - | 1.27 |
| Net interest margin | - | - | 1.31 | - | - | 1.34 | - | - | 1.25 |
(1) Average balances are based upon monthly data.
(2) The ratio of average interest-earning assets to interest-bearing liabilities for the year ended 31 December 2008 was 95.52% (2007: 98.30%, 2006: 99.46%).
(3) Loans and advances to customers includes non-performing loans. See "Analysis of end-of-year provisions on loans and advances to customers" in the Risk Management Report elsewhere in this Annual Report and Accounts.
(4) Demand deposits, time deposits and wholesale deposits are defined under "Deposits" above.
Business and Financial Review
Risk Management
The Risk Management report contains audited financial information except principally for the discussion of Operational Risk on page 39 that, in accordance with the guidance in paragraph BC65 of IFRS 7, is unaudited.
Summary
This Risk Management report describes the Risk Governance Framework of Abbey National plc (the 'Company', and together with its subsidiaries, the 'Group'), and includes more detail on the Group's key risks, on a segmental basis or aggregated where relevant. It is divided into the following sections:
Introduction - A description of the Group's Risk Governance Framework, including the three tiers of the Risk Governance structure. This can be found on page 37.
Financial Risks and Risk Management - Group-wide disclosures about specific risks which do not originate in any single operating segment, such as operational risk and pension obligation risk, as well as Group-wide disclosures about market risk and concentrations of credit risk are described on pages 38 to 40.
Discussion of Key Risks by Operating Segment- Detailed discussions about risk exposures, measurement information and management policies presented by operating segment can be found on pages 41 to 51:
Risks in Retail Banking- The risks in this segment are described on pages 41 to 45, including:
> Credit risk, including its management, an analysis of types and credit quality of retail lending, and disclosures relating to provisioning, arrears and recoveries.
> Market risk, including its management.
Risks in Corporate Banking - The risk in this segment is described on pages 45 to 46, comprising:
> Credit risk, including its management, mitigation, and the disclosure of exposure by rating of counterparty.
> Market risk, including its management.
Risks in Global Banking & Markets - The risks in this segment are described on pages 47 to 49, including:
> Credit risk, including its management, mitigation, and the disclosure of exposure by rating of counterparty.
> Market risk, including its management, and disclosures on short-term market risk and structural market risk.
> Trading risk, including details of segmental exposures and trading derivatives.
Risks in Private Banking - The risks in this segment are described on page 49, including a description of credit risk and market risk in the entities which this segment incorporates.
Risks in Group Infrastructure - The risks in this segment are described on pages 50 to 51, including:
> Credit risk, including its management, an analysis of types and credit quality of lending, and disclosures relating to provisioning, arrears and recoveries.
> Market risk, including its management, and disclosure of Net Interest Margin Sensitivity and the Market Value of Equity sensitivity.
> A description of the types of derivative contracts used to hedge risks in these segments.
The Impact of the Current Credit Environment - Detailed disclosures can be found on pages 52 to 53, including a description of the Group's exposures to certain classes of financial assets and off-balance sheet entities.
Liquidity Risk - A description of the liquidity risks the Group faces, along with their management and activity in 2008 and 2007, can be found on pages 54 to 56.
Introduction
The Group accepts that risk arises from its full range of activities, and actively manages and controls it. The management of risk is an integral part of the Group's activities. Risk is defined as the uncertainty around the Group's ability to achieve its business objectives and execute its strategy effectively. Risk constitutes the Group's exposure to uncertainty and the consequent variability of return. Specifically, risk equates to the adverse impacts on profitability arising from different sources of uncertainty including Credit Risk (Retail), Credit Risk (Wholesale), Market Risk, Operational Risk, Securitisation Risk, Concentration Risk, Liquidity Risk, Reputational Risk, Strategic Risk, Pension Obligation Risk, Group Risk and Regulatory Risk. Risk measurement is used to capture the source of the uncertainty and the magnitude of its potential effect on the profitability and solvency of the Group. Effective risk management and control is therefore of fundamental importance to the Group's long-term success.
Understanding and controlling risk is critical for the effective management of the business. The Company's Risk Framework aims to ensure that risk is managed and controlled on behalf of shareholders, customers, depositors, employees and the firm's regulators. Effective and efficient risk governance and oversight provide management with assurance that the Group's business activities will not be adversely impacted by risks that could have been reasonably foreseen. This in turn reduces the uncertainty of achieving the Group's strategic objectives.
Authority for Risk Management flows from the Abbey National plc Board of Directors (the 'Board') to the Chief Executive and from him to specific individuals. Formal standing committees are maintained for effective management or oversight. Their authority is derived from the person they are intended to assist.
Risk Governance Framework
The diagram below shows the Risk Governance Framework in operation in respect of risk management and oversight.
The Risk Division at Banco Santander, S.A. reports to the President of the Comisión Delegada de Riesgos (Delegated Risk Committee or 'CDR').
The main elements of risk governance within the Group are as follows:
First tier of risk governance
Risk management is provided by the Board. It approves the Group's Risk Appetite in consultation with Banco Santander, S.A. as appropriate, approves the strategy for managing risk and is responsible for the Group's system of internal control. The Board is supported by the Chief Executive and Executive Management, who have primary responsibility for understanding, identifying, and owning the risks generated by their lines of business and establishing a framework for managing those risks within the Board-approved Risk Appetite of the Group. In addition, understanding, identifying, and owning the risks generated by the Group's operations are the responsibility of the Divisional Heads and central functions. These functions provide technical support and advice to assist in the management and control of risk. Within this tier, there is a process for transaction review and approval within certain thresholds, discharged by the Credit Approval Committee. Transactions reviewed which exceed the threshold limits set are subject to prior review by Banco Santander, S.A.'s Risk Division before final approval by the Credit Approval Committee.
Risk Committee
The Risk Committee is a management committee, established under the authority of and chaired by the Chief Executive. The Risk Committee reviews risk issues, gives advice and recommendations to the Chief Executive, the Executive Committee, or other parties as appropriate as well as makes decisions on risk issues within its sphere of responsibility.
Second tier of risk governance
Risk control is provided by the Board independently supported by the Risk Division. The roles of the Chief Risk Officer, the Head of Wholesale Risk, and the Risk Division include development of risk measurement methodologies, risk approval, risk monitoring, risk reporting and escalation of risk issues in line with the relevant risk policy for all risks across all lines of Retail Banking, Global Banking & Markets, Corporate Banking and Private Banking business.
Dedicated Business Risk Oversight Fora (ROFs) advise and support the Chief Risk Officer in fulfilling his risk control responsibilities and help to ensure that risks are suitably understood, managed and controlled.
The Risk Division provides independent challenge to all business areas in respect of risk management and compliance with policies and advises the business when they are approaching the limits of the Group's Risk Appetite.
The Board, as supported by the Risk Division, is responsible for ensuring compliance with Group policies and limits imposed by Banco Santander, S.A. including:
> Group-wide risk policies;
> Group-wide risk limits/parameters;
> Approval processes relating to transactions that exceed local risk limits;
> The systematic review of exposures to large clients, sectors, geographical areas and different risk types; and
> Reporting to Banco Santander, S.A..
Third tier of risk governance
Risk assurance provides independent objective assurance on the effectiveness of the management and control of risk across the Group. This is provided through the Non-Executive Directors, Internal Audit function and the Audit and Risk Committee.
Non-Executive Directors
The Non-Executive Directors are members of the Board who have a particular responsibility for constructively challenging and contributing to the development of strategy, scrutinising the performance of management in meeting agreed goals and objectives and monitoring reporting performance, and assuring themselves that the financial controls and systems of risk management are robust and defensible.
Internal Audit
The Internal Audit function supports the Audit and Risk Committee by providing independent and objective opinions on the effectiveness and integrity of the Group's risk governance arrangements. It does this via a systematic programme of risk-based audits of the controls established and operated by the "first tier" risk management functions and those exercised by the "second tier" risk control functions.
The audit opinions and underlying rationale of findings and recommendations form the basis upon which the Audit and Risk Committee can take reasonable (but not absolute) assurance that the risk governance arrangements are fit for purpose and working properly. The Audit and Risk Committee also receive reports from management, the risk control functions and the external auditors to help them to discharge their risk governance oversight responsibilities.
Audit and Risk Committee
The Audit and Risk Committee is made up of Non-Executive Directors, and is a committee of the Board. The Committee has responsibility for:
> The oversight of the risk governance framework;
> Review of the effectiveness of the Group's internal and external audit process;
> Review of control policies and procedures including regulatory compliance and financial reporting;
> The identification, assessment and reporting of risks; and
> The risk governance structure and associated compliance with risk control policies and procedures.
Financial Risks and Risk Management
The financial risks affecting the Group are discussed below. Risks are generally managed through tailored management policies within the business division or operating segment in which they are originated.
Group-wide disclosures including about specific risks which do not originate in any single operating segment, are described separately at the beginning of this section, apart from liquidity risk which is discussed at the end of the section, following the detailed disclosures about the impact of the current credit environment.
Following the Group-wide disclosures are detailed discussions about risk exposures, measurement information and management policies presented by operating segment, being Retail Banking, Corporate Banking, Global Banking & Markets, Private Banking, and Group Infrastructure (which includes Asset and Liability Management ('ALM')).
The risk exposure and management information relating to the Company principally arise in Retail Banking and Group Infrastructure. Following the outsourcing of key IT and operations processes to group companies, risk governance of these entities is crucial. The use of service level agreements and key metrics support this governance.
Financial Instruments
The Group uses financial instruments to manage the structural balance sheet exposures that arise from its banking activities, in accordance with Risk policies and the Asset and Liability Management Committee's direction. The Group also trades in financial instruments where it takes positions in traded and over the counter instruments, including derivatives, to take advantage of short-term market movements in the equity and bond markets and in currency and interest rates.
Operational Risk - Group-wide (unaudited)
Operational risk is the risk of loss to the Group, resulting from inadequate or failed internal processes, people and systems, or from external events. Such risks can materialise as frauds, process failures, system downtime or damage to assets due to fire, floods etc. When such risks materialise they have not only immediate financial consequences for the Group but also an effect on its business objectives, customer service, regulatory responsibilities and reputation. Operational risk exposures arise across the Group's business divisions and operating segments, and are managed on a consistent basis.
Managing operational risk (unaudited)
The Group undertakes extensive activity to minimise the impacts operational risks may have on business areas. An independent central operational risk function (Enterprise and Operational Risk) has responsibility for establishing the framework within which these risks are managed and is aligned to operational risk professionals within business areas to ensure consistent approaches are applied across the Group. The primary purpose of the framework, which is approved by the Risk Committee, is to define and articulate the Group-wide policy, processes, roles and responsibilities. The framework incorporates industry practice and regulatory requirements, particularly those emanating from the Basel Committee, European Union Directives and the UK Financial Services Authority.
The day-to-day management of operational risk is the responsibility of business managers who identify, assess and monitor the risks, in line with the processes described in the framework. The operational risk function ensures that all key risks are regularly reported to Risk Fora, the Risk Committee and Board.
Key operational risk activity in 2008 (unaudited)
During 2008, the Group has continued to respond to the developing operational risk environment with coordinated responses. The Group continues to perform detailed control reviews in response to major industry events.
Following many high profile customer data security lapses experienced by other organisations in the UK, the Group has taken proactive steps to minimise similar risks. A corporate information security programme has been established which involves the strengthening of controls for the management of sensitive data and includes the implementation of encryption standards across the Group. A review of trading controls was carried out in response to the incident at Société Générale and the opportunity was taken to further enhance trading controls even though it was confirmed that existing controls were robust in this area. To highlight awareness of such issues, Operational Risk training has been made available to management and staff involved in control functions throughout the Group. In line with UK Financial Services Authority guidance and industry practice, the Group has crisis management and disaster recovery arrangements to ensure that critical business processes are maintained in the event of an unforeseen interruption. Insurance policies are also purchased to provide cover for a range of potential operational risk losses. In response to the increased threats of terrorism, flooding, and pandemic disasters, contingency strategies continue to be refined and key progress has included the development of dispersed contingency sites and automated system switch over facilities.
The Group continues to strengthen its point of sale compliance and control procedures to minimise risk and serve its customers. To this end, work continues to progress in implementing new systems which are already successfully operating in Banco Santander, S.A.. The increased use of data analytics and modelling for fraud prevention continues to have an impact in reducing exposure to third party fraud activity.
Credit Risk - Group-wide
Significant concentrations of credit risk
During 2008, the Group's most significant exposures to credit risk derived from the residential mortgage portfolio and unsecured personal lending businesses in Retail Banking, unsecured lending and derivatives exposure to banks and non-banking financial institutions in Global Banking & Markets, and secured lending and derivatives exposures to real estate entities and social housing associations in Corporate Banking.
The residential mortgage portfolio comprises loans to private individuals secured against residential properties in the UK. This is a prime portfolio with total exposure of £115.5bn at 31 December 2008. The Unsecured Personal Loan portfolio comprises unsecured loans to private individuals issued in the UK. Total exposure stood at £3.25bn at 31 December 2008. The real estate and social housing portfolios in Corporate Banking comprise loans and associated derivatives secured on UK property. The total committed facilities exposure to these portfolios was £10.9bn at 31 December 2008.
Although Global Banking & Markets' operations are based mainly in the UK, it has built up exposures to various entities around the world and is therefore exposed to concentrations of risk related to geographic area. At 31 December 2008, 9% of Global Banking & Markets' credit exposures were to counterparties from the United States, and 47% were to counterparties from the UK. 1% of Global Banking & Markets' exposures were to countries that are not members of the Organisation for Economic Co-operation and Development ('OECD'). The remaining exposures were mainly to European counterparties. Geographical exposures are governed by country limits set by Santander centrally and determined according to the classification of the country (whether it is a developed OECD country or not), the rating of the country and its gross domestic product. The Group is further constrained in its country risk exposure, within the group limits, and by its capital base. The Corporate Banking operations may include the development of niche portfolios.
Maximum exposure to credit risk
The following table presents the amount that best represents the Group's estimated maximum exposure to credit risk at the reporting date without taking account of any collateral held or other credit enhancements:
|
| 2008 £m | 2007 £m |
| Trading assets | 24,230 | 32,378 |
| Purchase and resale agreements | 9,936 | 24,049 |
| Derivatives | 32,281 | 9,951 |
| Financial assets designated at fair value | 11,314 | 11,783 |
| Loans and advances to customers | 129,023 | 112,147 |
| Loans and advances to banks | 15,621 | 3,441 |
| Other | 3,664 | 3,241 |
| Third party exposures(1) | 226,069 | 196,990 |
(1) In addition, the Group is exposed to credit risk in respect of guarantees granted, loan commitments and stock borrowing and lending agreements. The estimated maximum exposure to credit risk is described in Note 37 to the Consolidated Financial Statements on page 121.
In managing the gross exposures, the Group uses the policies and processes described in the credit risk sections below. Collateral, when received, can be held in the form of security over the mortgaged property, full debentures over a company's assets and through market standard collateral agreements in its treasury business.
Basel II (unaudited)
From 1 January 2008, the Group applied the retail internal ratings-based (IRB) approach for credit risk to its key retail portfolios. The advanced internal ratings-based (AIRB) approach has been employed for the principal wholesale portfolios from the same date. For the remaining credit exposures, currently on the Basel II standardised approach, a rolling programme of transition to the appropriate IRB approach is underway. From 1 January 2008, the standardised approach was adopted for Operational Risk, and the Group applied Basel II to its Internal Capital Adequacy Assessment Process (ICAAP) and to the risk and capital disclosures made to the market. The Group has applied Santander's approach to risk management in its application of Basel II. Further information on the Group's capital position under Basel II is included in Note 47 in the Consolidated Financial Statements. Further information on the Basel II risk measurement of the Group's exposures will be included in Santander's Pillar 3 report. The Group's Pillar 3 disclosures are set out in the Balance Sheet Business Review on pages 28 to 30.
Market risk - Group-wide
Market risk is the potential for loss of income or decrease in the value of net assets caused by movements in the levels and prices of financial instruments including interest rate and foreign currency risks. The Group accepts that market risk arises from its full range of activities. The Group aims to actively manage and control market risk by limiting the adverse impact of market movements whilst seeking to enhance earnings within clearly defined parameters. The Market Risk Manual, which is reviewed and approved by the Head of Wholesale Risk on an annual basis, sets the framework under which market risks are managed and controlled. Business area policies, risk limits and mandates are established within the context of the Market Risk Manual. Executive directors are responsible for ensuring that they have sufficient expertise to manage the risks originated and retained with their business divisions. The business areas are responsible for ensuring that they have sufficient expertise to manage the risks associated with their operations. The independent Risk function, under the direction of the Head of Wholesale Risk, aims to ensure that risk-taking and risk control occur within the framework prescribed by the Market Risk Manual. The Risk function also provides oversight of all risk-taking activities through a process of reviews. The Group aims to ensure that exposure to market risks is measured and reported on an accurate and timely basis to senior management. In addition to the regular reporting for the purposes of active risk management, the Board also receives reporting of all significant market risk exposures on a monthly basis where actual exposure levels are measured against limits. Senior management recognise that different risk measures are required to best reflect the risks faced in different types of business activities. In measuring exposure to market risk, the Group uses a range of complementary measures, covering both value and income as appropriate.
Pension obligation risk - Group-wide
The Group has statutory funding obligations as the sponsoring employer for a number of defined benefit staff pension schemes. The schemes are managed by independent trustees in accordance with legislation and trust deeds and rules, for the benefit of members. The Group accepts that it is exposed to pension obligation risk that could give rise to an unexpected increase in the Group's obligations to fund the schemes, either because of a loss of net asset value or because of changes in legislation or regulatory action. The principal risks to the net asset value of the schemes are an increase in the value of the liabilities arising from adverse changes in the longevity, inflation, and scheme assets being adversely affected by market movements. Further information on pensions can be found in "Critical Accounting Policies" within the Accounting Policies on page 79 and in Note 36 to the Consolidated Financial Statements.
Risk management
The Chief Financial Officer is responsible for managing the Group's exposure to pension obligation risk, in conjunction with the trustees. Further details of the funding arrangements for the pension schemes can be found on page 119.
Risk Management in Retail Banking
Credit risk in Retail Banking
Credit risk is the risk that counterparties will not meet their financial obligations, which may result in the Retail Banking losing the principal amount lent, the interest accrued and any unrealised gains (less any security held). Credit risk occurs mainly in Retail Banking's loan and investment assets (including residential mortgages and secured lending, personal and business banking). Retail Banking actively manages and controls credit risk.
Residential Mortgages and secured lending
Retail Banking lends on many types of property but only after a credit risk assessment of the borrower and an assessment of the property is undertaken. The systems used to manage and monitor the quality of the mortgage assets are reviewed in accordance with policy to ensure they perform as expected. Residential lending is subject to lending policy and lending authority levels, which are used to structure lending decisions to the same high standard across the retail network, a process further improved by mortgage credit scoring, underwriter accreditation and regular compliance reviews.
Details concerning the prospective borrower and the mortgage are subject to a criteria-based decision-making process. Criteria for assessment include credit references, loan-to-value ratio, borrower status and the mortgage credit score.
The majority of loans provided by Retail Banking are secured on UK properties. All properties must be permanent in construction; mobile homes are not generally acceptable. The Group can provide a mortgage for the purchase of properties outside the UK where the property is a second home and the loan is secured on the main property located in the UK.
Prior to granting any first mortgage loan on a property, the Group has the property valued by an approved and qualified surveyor, who may be a Group employee. The valuation is based on set Group guidelines, which build upon the Royal Institute of Chartered Surveyors guidance on valuation methods. In the case of re-mortgages, where the loan-to-value ('LTV') is 75% or lower, and the risk judged by the size of the advance requested and the credit score of the applicant is considered medium or low, and an accurate, reputable automated valuation is available, this may substitute for a surveyor's valuation.
For additional lending where a first-charge mortgage is already held with the Group and the loan-to-value is less than 90%, the original property value used to be subject to indexation and no further survey carried out. During 2008, this practice was phased-out, with all additional loans requiring an automated valuation or surveyor's valuation. The use of an automated valuation depends upon the availability of a reliable automated valuation, and the level of credit risk posed by the proposed loan.
Progressively stricter lending criteria are applied to mortgages above a loan-to-value of 75%. Only 1% of new secured loan advances in 2008 were made with a loan-to-value of more than 90%. Loans with higher loan-to-value ratios carry a higher risk due to the increased likelihood that liquidation of the collateral will not yield sufficient funds to cover the loan advanced and costs of liquidation. These loans generally attract higher margins as a result.
Mortgage credit quality(1)
|
| 2008 | 2007 | 2006 |
| Loan-to-value analysis: |
|
|
|
| New business |
|
|
|
| > 90% | 2% | 3% | 4% |
| 75% - 90% | 35% | 45% | 33% |
| < 75% | 63% | 52% | 63% |
| Average (at inception) | 64% | 64% | 61% |
| Average loan-to-value of stock (indexed) | 51% | 46% | 44% |
| New business profile: |
| ||
| First-time buyers | 9% | 13% | 11% |
| Home movers | 23% | 37% | 38% |
| Remortgagers | 68% | 50% | 51% |
| Average earnings multiple | 3.0 | 3.0 | 2.9 |
(1) For main advances only. Does not include further advances. Excludes any fees added to the loan, and only includes the drawn loan amount, not drawdown limits.
The residential mortgage portfolio has started to show an increasing trend of payment arrears with the deterioration in economic conditions. Credit quality remains strong, with the LTV on new business completions gradually reducing through the year, with the 4th quarter at 60% (Q3 08: 62%, Q4 07: 66%). The indexed stock LTV increased to 51% (Q3 08: 50%, Q4 07: 46%) as a result of declining house prices, mitigated by the reduction in new business LTVs. Credit criteria have been progressively tightened in response to the changing market environment. As a result, the LTV profile of new lending has improved significantly.
> Arrears more than 90 days past due have increased from 0.60% in December 2007 to 0.95% at the end of 2008. In the same period, industry arrears more than 90 days past due are forecast by the UK Council of Mortgage Lenders to have increased from 1.10% to 2.03%.
> Monthly mortgage completions in excess of 75% LTV fell from 47% in December 2007 to 13% in December 2008.
Mortgage arrears and repossessions
Collections & Recoveries Department is responsible for all debt management initiatives on the secured portfolio for Retail Banking. Debt management strategies, which include negotiating repayment arrangements and concessions and debt counselling, can start as early as the day after a repayment is past due and will continue until legal action. Different collection strategies are applied to different segments of the portfolio subject to the perceived levels of risk for example, loan-to-value, collections score and account characteristics.
If the agreed repayment arrangement is not maintained, legal proceedings may be taken and may result in the property being taken into possession. The Group sells the repossessed property at market price and uses the sale proceeds, net of costs, to pay off the outstanding value of the mortgage. The stock of repossessed properties held by the Group varies according to the number of new possessions and the buoyancy of the housing market.
The following tables set forth information on UK residential mortgage arrears, and properties in possession, at 31 December 2008, 2007 and 2006 for Retail Banking compared to the industry average as provided by the Council of Mortgage Lenders ('CML'), as well as the carrying amount of assets obtained as collateral.
| Group(1)(2) | |
| Mortgage arrears | (Percentage of total mortgage loans by number) |
| 31 to 60 days in arrears |
|
| 31 December 2006 | 1.19 |
| 31 December 2007 | 1.48 |
| 31 December 2008 | 1.35 |
| 61 to 90 days in arrears |
|
| 31 December 2006 | 0.50 |
| 31 December 2007 | 0.59 |
| 31 December 2008 | 0.76 |
| Group | CML(2) (unaudited) | |
|
| (Percentage of total mortgage loans by number) | |
| 3 to 5 months in arrears |
|
|
| 31 December 2006 | 0.42 | 0.57 |
| 31 December 2007 | 0.49 | 0.62 |
| 31 December 2008 | 0.67 | 1.01 |
| 6 to 11 months in arrears |
|
|
| 31 December 2006 | 0.17 | 0.31 |
| 31 December 2007 | 0.17 | 0.35 |
| 31 December 2008 | 0.26 | 0.62 |
| 12 months or more in arrears |
|
|
| 31 December 2006 | 0.03 | 0.14 |
| 31 December 2007 | 0.03 | 0.13 |
| 31 December 2008 | 0.02 | 0.25 |
(1) Group data is not readily available for arrears less than 31 days
(2) Council of Mortgage Lenders data is not available for arrears less than 3 months
| Group | CML (unaudited) | |
| Properties in possession | (Percentage of total mortgage loans by number) | |
| 31 December 2006 | 0.04 | 0.08 |
| 31 December 2007 | 0.05 | 0.10 |
| 31 December 2008 | 0.07 | 0.21 |
| Carrying amount of assets obtained as collateral | £m |
| 31 December 2006 | 43 |
| 31 December 2007 | 64 |
| 31 December 2008 | 113 |
Restructured loans
Loans have been restructured or renegotiated by capitalising the arrears where customers in arrears have maintained an agreed monthly repayment for a period of five months. The value of capitalised arrears on loans that would have been impaired if the terms had not been renegotiated at 31 December 2008 were £17m (2007: £12m).
Banking and Consumer Credit. Retail Banking uses systems and processes to manage the risks involved in providing unsecured personal loans and overdraft lending or in granting bank account facilities. These include the use of application and behavioural scoring systems to assist in the granting of credit facilities as well as regular monitoring of scorecard performance and the quality of the unsecured lending portfolios. Behavioural scoring examines the lending relationships that a customer has with Retail Banking and how the customer uses their bank account. This information generates a score that is used to assist in deciding the level of risk (in terms of overdraft facility amount, card facilities granted and preferred unsecured personal loan value) for each customer that the Group is willing to accept. Individual customer scores are normally updated on a monthly basis. Retail Banking has successfully extended the use of behavioural scoring into other areas of the business, including the refinement of debt management strategies and bank account transaction processing.
Personal Financial Services banking and unsecured personal loan arrears
|
| 2008 £m | 2007 £m | 2006 £m |
| Total banking and unsecured personal loan arrears(1,2) | 158 | 134 | 167 |
| Total banking and unsecured personal loan asset | 2,691 | 3,119 | 3,936 |
| Banking and unsecured personal loan arrears as a % of asset | 5.87% | 4.30% | 4.25% |
(1) In 2008, banking arrears was defined as customers that had been in arrears for greater than 90 days. In prior years, it was defined as customers whose borrowings exceed their overdraft by over £100. If the prior year definition were applied to 2008 data, the total arrears would increase by £53m.
(2) Unsecured personal loan and credit card arrears are defined as the balances of accounts that are three or more months in arrears (> 4 instalments).
Provisions on loans and advances to customers
The charge for provisions on loans and advances to customers adjusts the balance sheet provisions to the level that management deems adequate to absorb actual and inherent losses in Retail Banking's loan portfolio from homogeneous portfolios of assets and individually identified loans. A proportion of Retail Banking's provisions on loans and advances to customers relate to loans and advances secured either by a first charge on residential property in the UK, or by other appropriate security depending on the nature of the loan.
The Group's provisioning policy is as follows. Further information is set out in the Accounting Policies in the Consolidated Financial Statements:
> Observed provision - an observed provision is established for all past due loans after a specified period of repayment default where it is likely that some of the capital will not be repaid or recovered through enforcement of any applicable security. The length of the default period depends on the nature of the advance and is generally no more than three months. Once a loan misses a payment (breach of contractual terms) an assessment of the likelihood of collecting the principal and overdue payments is made. This assessment is generally made using statistical techniques developed on previous experience and on projections of current market conditions to the time the loss is expected to crystallise. These techniques estimate the propensity of loans to go to write off and as a separate exercise, the loss incurred on written off debt is monitored. For advances secured on residential property, the propensity of loans to reach repossession is determined with repossessed properties assessed on an individual basis through the use of an external valuation, anticipated disposal costs and the current exposure.
> Incurred but not yet observed provision - an incurred but not yet observed provision is made against loans, which have not missed a payment but are known from past experience to have deteriorated since the initial decision to lend was made. Based on historical evidence, the number of accounts likely to default in the future as a result of events present at the balance sheet date are identified through use of statistical techniques.
From 1 January 2005, these statistical techniques were expanded and enhanced. In particular, further detailed examination is now performed on the losses that emerge over a defined period of time after the reporting date called the emergence period. This period is determined to ensure that only those accounts which have credit deterioration at the reporting date are captured and excludes accounts which will suffer credit deterioration after the reporting period. The emergence period is two to three months for unsecured lending and twelve months for secured lending. The provision methodology outlined for observed provisions is then applied to accounts identified as impaired in the performing portfolios.
> Amounts written off - Unsecured loans are written off when all internal avenues of collecting the debt have failed and the debt is passed onto external collection agencies. On secured loans, the write off takes place on ultimate realisation of collateral value, or from claiming on any mortgage indemnity guarantee or other insurance. All write offs are on a case by case basis, taking account of the exposure at the date of write off, after accounting for the value from any collateral or insurance held against the loan. The write-off policy is regularly reviewed.
Security is realised in accordance with Retail Banking's internal debt management programme. Contact is made with customers with the aim to achieve a realistic and sustainable repayment arrangement. Litigation and/or enforcement of security is usually carried out only when the steps described above have been undertaken without success. As a result of the write-off policy, the provisions will be made a significant time in advance of the related write-off on all products. The exception to this rule is the discovery of fraud, where the exposure is written off once full investigations have been completed and the probability of recovery is minimal. The time span between the discovery and write off will be a short period and may not result in a provision being raised.
Analysis of provisions on loans and advances to customers
|
| 2008 £m | 2007 £m | 2006 £m | 2005 £m | 2004 £m |
| Observed provision |
|
|
|
| |
| Advances secured on residential properties - UK | 174 | 73 | 45 | 21 | 9 |
| Other secured advances - UK | 37 | 34 | 75 | 126 | 148 |
| Unsecured personal advances - UK | 227 | 249 | 242 | 158 | 133 |
| Corporate advances - UK | 13 | - | - | - | 67 |
| Total observed provisions | 451 | 356 | 362 | 305 | 357 |
| Incurred but not yet observed provision |
|
| |||
| Advances secured on residential properties - UK | 123 | 102 | 60 | 35 | 58 |
| Other secured advances - UK | 11 | 8 | 3 | - | 3 |
| Unsecured personal advances - UK | 44 | 85 | 111 | 54 | 35 |
| Corporate advances - UK | 13 | - | - | - | 14 |
| Total incurred but not yet observed provisions | 191 | 195 | 174 | 89 | 110 |
| Total provisions | 642 | 551 | 536 | 394 | 467 |
Movements in provisions for impairment losses on loans and advances
|
| 2008 £m | 2007 £m | 2006 £m | 2005 £m | 2004 £m |
| Provisions at 31 December | 551 | 536 | 394 | 467 | - |
| IFRS reclassifications | - | - | - | (40) | - |
| Provisions at 1 January | 551 | 536 | 394 | 427 | 865 |
| Disposal of subsidiary undertakings | - | - | - | - | (70) |
| 551 | 536 | 394 | 427 | 795 | |
| Amounts written off |
|
|
| ||
| Advances secured on residential properties - UK | (32) | (9) | (11) | (5) | (2) |
| Other secured advances - UK | (9) | (25) | (27) | (36) | (39) |
| Unsecured personal advances - UK | (262) | (339) | (205) | (247) | (136) |
| Corporate advances - UK | - | - | - | - | (144) |
| (303) | (373) | (243) | (288) | (321) | |
| Advances secured on residential properties - non-UK | - | - | - | - | (2) |
| Other secured advances - non-UK | - | - | - | - | (2) |
| Total amounts written off | (303) | (373) | (243) | (288) | (325) |
| Observed provisions charged against profit |
|
| |||
| Advances secured on residential properties - UK | 132 | 38 | 35 | 12 | 3 |
| Other secured advances - UK | 14 | (17) | (25) | 11 | 155 |
| Unsecured personal advances - UK | 239 | 346 | 289 | 221 | 98 |
| Corporate advances - UK | 13 | - | - | - | 71 |
| 398 | 367 | 299 | 244 | 327 | |
| Advances secured on residential properties - non-UK | - | - | - | (3) | (1) |
| Unsecured personal advances - non-UK | - | - | - | - | 1 |
| Total observed provisions charged against profit | 398 | 367 | 299 | 241 | 327 |
| Incurred but not yet observed provisions charged against profit | (4) | 21 | 86 | 14 | (330) |
| Total provisions charged against profit (including discontinued operations) | 394 | 388 | 385 | 255 | (3) |
| Provisions at the end of the year | 642 | 551 | 536 | 394 | 467 |
IFRS reclassifications related primarily to provisions on certain corporate loans in businesses and portfolios that were inconsistent with the Group's strategy, and were sold during 2005 or transferred to Corporate Banking.
Recoveries
|
| 2008 £m | 2007 £m | 2006 £m | 2005 £m | 2004 £m |
| Advances secured on residential properties - UK | 1 | 2 | 2 | 3 | 16 |
| Other secured advances - UK | 12 | 6 | 7 | 7 | 8 |
| Unsecured personal advances - UK | 33 | 36 | 32 | 27 | 28 |
| Total amount recovered | 46 | 44 | 41 | 37 | 52 |
Group non-performing loans and advances(1)
|
| 2008 £m | 2007 £m | 2006 £m | 2005 £m | 2004 £m |
| Group non-performing loans and advances that are impaired | 614 | 296 | 375 | 314 | 297 |
| Group non-performing loans and advances that are not impaired | 891 | 596 | 451 | 568 | 844 |
| Total non-performing loans and advances(2) | 1,505 | 892 | 826 | 882 | 1,141 |
|
| % | % | % | % | % |
| Non-performing loans and advances as a % of loans and advances to customers(3) | 1.10 | 0.66 | 0.64 | 0.74 | 1.04 |
| Provision as a percentage of total non-performing loans and advances | 42.66 | 61.77 | 64.89 | 44.67 | 40.93 |
(1) Loans and advances are classified as non-performing typically when the counterparty fails to make payments when contractually due for three months or longer
(2) All non-performing loans are UK
(3) Loans and advances to customers includes trading assets and excludes finance leases
In 2008, non-performing loans and advances as a percentage of loans and advances to customers (including trading assets and excluding finance leases) increased from 0.66% to 1.10%. This primarily reflects the impact of the deteriorating market environment on the performance of the residential mortgage portfolio. This has also increased the proportion of non-performing loans secured against residential property in the non-performing loan balance, which has in turn further reduced the average provision coverage required in respect of the eventual credit losses that are expected to emerge from these loans.
In 2007, non-performing loans and advances as a percentage of loans and advances to customers (including trading assets and excluding finance leases) increased from 0.64% to 0.66%. This is a reflection of the mortgage performance normalising from historic lows. This has also changed the proportions of mortgages and unsecured loans in the non-performing loan balance, with a greater proportion representing mortgages (which have a lower provision as a percentage of the asset), driving down the overall ratio from 64.89% to 61.77%.
In 2006, non-performing loans and advances as a percentage of loans and advances to customers (including trading assets and excluding finance leases) decreased from 0.74% to 0.64%. This reflected the continuing strength of the credit quality of the Group's loans, particularly on the secured mortgages. Provisions as a percentage of total non-performing loans and advances increased from 44.67% to 64.89% in 2006, which reflected the change in macro-economic factors such as interest rate rises.
In 2005, non-performing loans and advances as a percentage of loans and advances to customers (including trading assets and excluding finance leases) decreased from 1.04% to 0.74%. This was due to the sale of the majority of the wholesale lending book and to the run down of the Motor Finance and Litigation businesses. Provisions as a percentage of total non-performing loans and advances have increased from 40.93% to 44.67% in 2005. This movement is attributable to the sale of the majority of the wholesale lending book.
Interest income recognised on impaired loans amounted to £51m (2007: £36m, 2006: £32m).
Abbey Business
Business Banking provides a range of products to assist with the finance requirements of small businesses, including overdrafts. Risk management policies are specific to and reflect the risks inherent in each product set. Approval processes for credit risk include the use of judgement, assisted by the use of probability of default and loss given default data, and the use of credit scoring. Business Banking operates within policies and authority levels approved by the Chief Risk Officer. Business Banking has a dedicated risk team, reflecting the desire for risk control to be close to the business needs and risks. Commercial Property Finance provides mortgages to borrowers on a range of mainly non-residential property. Agreed credit assessment criteria include serviceability ratios, loan-to-value ratios, and quality of tenants, with stress testing against interest rate movements. Concentration limits per borrower and business sector are also employed to ensure a balanced loan portfolio. The management of defaulting accounts and the repossession and sale of properties is handled by a dedicated function within the risk operation.
The strategic plan to extend the customer proposition into the SME market is being supported by a workstream to manage all risks within this market and throughout the risk cycle. The development of the risk framework is overseen by the Chief Risk Officer.
Market risk in Retail Banking
Market risk is not taken within Retail Banking. Market risks arising in the Retail Banking division are transferred from the originating business to the Asset and Liability Management ('ALM') operation within Group Infrastructure, where they can be managed in conjunction with exposures arising from the funding, liquidity or capital management activities of ALM. Funds received with respect to deposits taken are lent on to Group Infrastructure on matching terms as regards interest rate repricing and maturity. Similarly, loans are funded through matching borrowings from Group Infrastructure.
Risk Management in Corporate Banking
Credit risk in Corporate Banking
Credit risk is the risk that counterparties will not meet their financial obligations resulting in Corporate Banking losing the monies lent, including any interest accrued, or having to close out transactions prematurely, which may incur losses after realising collateral held. Credit risk arises by Corporate Banking making loans, investing in debt securities or other financial instruments or entering into financing transactions or derivative contracts.
Managing credit risk
The Board has approved a set of risk appetite limits to cover different types of risk, including credit risk, arising in Corporate Banking. The Group's credit risk appetite is measured and controlled by a maximum Economic Capital value, which is defined as the maximum level of unexpected loss that the Group is willing to sustain over a one-year period. Within these limits, credit mandates and policies are approved to cover detailed industry, sector and product limits. All transactions falling within these mandates and policies are accommodated under credit limits approved by the appropriate credit authority. Specific approval is usually required by the Credit Approval Committee (a specific committee established under the authority of the Chief Executive) for any transaction that falls outside the mandates.
Analysis of credit exposures and credit risk trends are provided each month to the Corporate Banking Risk Oversight Forum, with key issues escalated to the Risk Committee as required. Large Exposures (as defined by the UK Financial Services Authority) are reported quarterly to the Risk Committee and the UK Financial Services Authority.
Credit risk on derivative instruments is calculated using the potential future mark-to-market exposure of the instruments at a 97.5% statistical confidence level and adding this value to the current value. The resulting "loan equivalent" or credit risk is then included against credit limits, along with other non-derivative exposures. In addition, there is a policy framework to enable the collateralisation of derivative instruments including swaps. If collateral is deemed necessary to reduce credit risk, any unsecured risk threshold, and the nature of any collateral to be accepted, is determined by management's credit evaluation of the counterparty.
Corporate Banking has been targeted as an area where the Group aims to achieve controlled growth, mainly in the area of structured lending to the Real Estate, Education and Health sectors. The Group intends to achieve more modest growth in terms of lending to corporate counterparties in broadly the £500m to £2bn turnover range as well as the initial development of an offering to smaller corporate entities. Focus is being given to the control of credit risks within this expansion with, amongst other things, the development and implementation of robust Credit Policy Mandates and models covering both risk appetite and ratings.
Corporate Banking committed facilities net exposure by credit rating of the issuer or counterparty(1)
|
2008 | Social Housing £m | Other £m | Total £m |
| AAA | - | 124 | 124 |
| AA | 1,008 | 100 | 1,108 |
| A | 5,222 | 450 | 5,672 |
| BBB | 1,821 | 3,016 | 4,837 |
| BB | 100 | 825 | 925 |
| B | 10 | 41 | 51 |
| D | - | 22 | 22 |
| Total | 8,161 | 4,578 | 12,739 |
| 2007 | Social Housing £m | Other £m | Total £m |
| AAA | - | 110 | 110 |
| AA | 1,915 | 18 | 1,933 |
| A | 5,646 | 227 | 5,873 |
| BBB | 2,827 | 703 | 3,530 |
| BB | 383 | 636 | 1,019 |
| B | 86 | 2 | 88 |
| Total | 10,857 | 1,696 | 12,553 |
(1) Internal ratings are applied to all exposures.
The reduction in Social Housing exposures of £2,696m in 2008 is due to the termination of a transaction involving the Group writing credit protection on a pool of Social Housing exposures, partially offset by new business. The increase in Other Lending reflects the planned expansion of the Corporate Banking business.
Corporate Banking non-performing loans and advances(1)
|
| 2008 £m | 2007 £m |
| Non-performing loans and advances that are impaired | 54 | - |
| Non-performing loans and advances that are not impaired | - | - |
| Total non-performing loans and advances(2) | 54 | - |
|
| ||
| Non-performing loans and advances as a percentage of loans and advances to customers(3) | 1.25% | - |
| Provision as a percentage of total non-performing loans and advances | 48% | - |
(1) Amounts are only presented for 2008 and 2007 as this business only became operational in early 2007.
(2) Loans and advances are classified as non-performing typically when the counterparty fails to make payments when contractually due for three months or longer.
(3) All non-performing loans are UK loans.
In 2008, non-performing loans and advances as a percentage of loans and advances to customers (including trading assets and excluding finance leases) increased to 1.25%. This reflects the impact of the deteriorating market environment on the performance of the corporate and real estate portfolios.
Interest income recognised on impaired loans amounted to £2m. In 2007, there were no impaired loans.
Credit risk mitigation
Collateralisation
The Social Housing portfolio is secured on residential real estate owned and let by UK Housing Associations. In the Other category, the real estate portfolio collateral is in the form of commercial real estate assets, the corporate portfolio is largely unsecured but holds cross-guarantee agreements or contractual and financial governance. There are also a small number of PFI transactions where collateral is held in the form of a charge over the underlying concession contract.
Restructured loans
Loans may be restructured or renegotiated by capitalising the arrears where customers in arrears have maintained an agreed monthly repayment for a period of five months. In 2008 there were no deals made where interest was capitalised to avoid the loan becoming impaired.
Market risk in Corporate Banking
Market risk is not taken within Corporate Banking. Market risks arising in the Corporate & Corporate Banking division are transferred from the originating business to ALM within Group Infrastructure, where they can be managed in conjunction with exposures arising from the funding, liquidity or capital management activities of ALM. Funds received with respect to deposits taken are lent on to Group Infrastructure on matching terms as regards interest rate repricing and maturity. Similarly, loans are funded though matching borrowings from Group Infrastructure.
Risk Management in Global Banking & Markets
Credit risk in Global Banking & Markets
Credit risk is the risk that counterparties will not meet their financial obligations resulting in Global Banking & Markets losing the monies lent, including any interest accrued, or having to close out transactions prematurely, which may incur losses after realising collateral held. Credit risk arises by Global Banking & Markets making loans, investing in debt securities or other financial instruments or entering into financing transactions or derivative contracts.
Managing credit risk
The Board has approved a set of risk appetite limits to cover different types of risk, including credit risk, arising in Global Banking & Markets. The Group's credit risk appetite is measured and controlled by a maximum Economic Capital value, which is defined as the maximum level of unexpected loss that the Group is willing to sustain over a one-year period. Within these limits, credit mandates and policies are approved to cover detailed industry, sector and product limits.
All transactions falling within these mandates and policies are accommodated under credit limits approved by the appropriate credit authority. Specific approval is usually required by the Credit Approval Committee (a specific committee established under the authority of the Chief Executive) for any transaction that falls outside the mandates.
Analysis of credit exposures and credit risk trends are provided each month to either the Santander Global Banking & Markets Risk Oversight Forum with key issues escalated to the Risk Committee as required. Large Exposures (as defined by the UK Financial Services Authority) are reported quarterly to the Risk Committee and the UK Financial Services Authority.
Credit risk on derivative instruments is calculated using the potential future mark-to-market exposure of the instruments at a 97.5% statistical confidence level and adding this value to the current value. The resulting "loan equivalent" or credit risk is then included against credit limits, along with other non-derivative exposures.
In addition, there is a policy framework to enable the collateralisation of derivative instruments including swaps. If collateral is deemed necessary to reduce credit risk, any unsecured risk threshold, and the nature of any collateral to be accepted, is determined by management's credit evaluation of the counterparty.
Credit risk mitigation
(i) Netting arrangements
The Group restricts its credit risk by entering into transactions under industry standard agreements which facilitate netting of transactions in the jurisdictions where netting agreements are recognised and have legal force. The netting arrangements do not generally result in an offset of balance sheet assets and liabilities for accounting purposes, as transactions are usually settled on a gross basis. However, there is scope for the credit risk associated with favourable contracts to be reduced by netting arrangements embodied in the agreements to the extent that if an event of default occurs, all amounts with the counterparty under the specific agreement can be terminated and settled on a net basis. Derivatives, repurchase and reverse repurchase transactions, stock borrowing/lending transactions and securities financing transactions are governed by industry standard agreements that facilitate netting.
(ii) Collateralisation
The Group also mitigates its credit risk to counterparties with which it primarily transacts financial instruments through collateralisation, using industry standard collateral agreements. Under these agreements, net exposures with counterparties are collateralised with cash, securities or equities. Exposures and collateral are generally revalued daily and collateral is adjusted accordingly to reflect deficits/surpluses. Collateral taken must comply with Global Banking & Markets collateral parameters policy. This policy is designed to control the quality and concentration risk of collateral taken such that collateral held can be liquidated when a counterparty defaults. Cash collateral in respect of derivatives held at the year-end was £2.8bn, not all derivative arrangements being subject to collateral agreements. Collateral obtained during the year in respect of purchase and resale agreements (including securities financing) is equal to at least 100% of the amount of the exposure.
Global Banking & Markets net exposure by credit rating of the issuer or counterparty(1)
|
| 2008 £m | 2007 £m |
| AAA | 10,625 | 4,687 |
| AA | 10,865 | 16,552 |
| A | 3,007 | 4,396 |
| BBB | 251 | 445 |
| BB | 91 | 38 |
| B | 1 | 5 |
| Total | 24,840 | 26,123 |
(1) In accordance with the requirements of Basel II, internal ratings are applied to all exposures.
In the securities financing businesses, credit risk arises on both assets and liabilities and on both on and off-balance sheet transactions. Consequently, the above credit risk exposure arises not only from the on balance sheet assets, but also from securities financing trades classified as liabilities and off-balance sheet assets.
Market risk in Global Banking & Markets
Market risk-taking is performed within the framework established by the Market Risk Manual. A major portion of the market risk arises from exposures to changes in the levels of interest rates, equity markets and credit spreads. Interest rate exposure is generated from trading activities. Exposure to equity markets is generated by the creation and risk management of structured products by Global Banking & Markets for the Personal Financial Services market and trading activities. Credit spread exposure arises from credit risk management and trading activities within Global Banking & Markets.
Managing market risk in Global Banking & Markets
Risks are managed within limits approved by the Head of Wholesale Risk or Banco Santander, S.A.'s Board Risk Committee and within the risk control framework defined by the Market Risk Manual. For trading activities the primary risk exposures for Global Banking & Markets are interest rate, equity, credit spread and residual exposure to property indices. Interest rate risks are managed via interest rate swaps, futures and options (caps, floors and swaptions). Equity risks are managed via equity stock, index futures, options and structured equity derivatives. Credit-spread risks are managed via credit derivatives (credit default swaps, total return swaps). Property index risk is managed via insurance contracts and property derivatives.
To facilitate understanding and communication of different risks, risk categories have been defined. Exposure to all market risk factors is assigned to one of these categories. The Group considers two categories:
Short-term liquid market risk covers activities where exposures are subject to frequent change and could be closed out over a short-time horizon. Most of the exposure is generated by Global Banking & Markets.
Structural market risk includes exposures arising as a result of the structure of portfolios of assets and liabilities, or where the liquidity of the market is such that the exposure could not be closed out over a short time horizon. The risk exposure is generated by features inherent in either a product or portfolio and normally presented over the life of the portfolio or product. Such exposures are a result of the decision to undertake specific business activities, can take a number of different forms, and are generally managed over a longer time horizon.
Global Banking & Markets operates within a market risk framework designed to ensure that it has the capability to manage risk in a well-controlled manner. A comprehensive set of policies, procedures and processes have been developed and implemented to identify, measure, report, monitor and control risk across Global Banking & Markets.
For trading activities the standardised risk measure adopted is Value at Risk calculated at a 95% confidence level over a one-day time horizon. On a daily basis, market risk factor sensitivities, Value at Risk measures and stress tests are produced, reported and monitored against limits for each major activity and at the aggregate Global Banking & Markets level. These limits are used to align risk appetite with the business's risk-taking activities and are reviewed on a regular basis.
Measurement of risks can involve the use of complex quantitative methods and mathematical principles to model and predict the changes in instruments and portfolio valuation. These methods are essential tools to understand the risk exposures.
Trading Risk in Global Banking & Markets
Trading risk exposure arises only in the Abbey National Treasury Services plc group. Exposures are managed on a continuous basis, and are marked to market on a daily basis.
The following table shows the Value at Risk-based consolidated exposures for the major risk classes as at 31 December 2008, together with the highest, lowest and average exposures for the year. Exposures within each risk class reflect a range of exposures associated with movements in that financial market. For example, interest rate risks include the impact of absolute rate movements, movements between interest rate bases and movements in implied volatility on interest rate options. The range of possible statistical modelling techniques and assumptions mean these measures are not precise indicators of expected future losses, but are estimates of the potential change in the value of the portfolio over a specified time horizon and within a given confidence interval. Historical simulation models are used with appropriate add-ons to reflect unobservable inputs.
From time to time, losses may exceed the amounts stated where the movements in market rates fall outside the statistical confidence interval used in the calculation of the value at risk analysis. The 95% confidence interval, used as a standard across the Group, means that the theoretical loss at a risk factor level is likely to be exceeded in one period in twenty. The Group address this risk by monitoring stress-testing measures across the different business areas. For trading instruments the actual, average, highest and lowest value at risk exposures shown below are all calculated to a 95% level of confidence using a simulation of actual one day market movements over a one-year period. The effect of historic correlations between risk factors is additionally shown below. The use of a one-day time horizon for all risks associated with trading instruments reflects the horizon over which market movements will affect the measured profit and loss of these activities.
The amounts below represent the potential change in market values of trading instruments. Since trading instruments are recorded at market value, these amounts also represent the potential effect on income.
| Actual Exposure at 31 December | |||
|
Group trading instruments | 2008 £m | 2007 £m | 2006 £m |
| Interest rate risks | 5.3 | 3.0 | 1.7 |
| Equity risks | 1.2 | 2.2 | 2.9 |
| Spread risks | 1.9 | 1.9 | 0.7 |
| Property risks | 6.8 | 3.4 | 1.2 |
| Other risks(1) | 0.9 | 0.3 | 0.5 |
| Correlation offsets(2) | (2.5) | (2.3) | (1.6) |
| Total correlated one-day Value at Risk | 13.6 | 8.5 | 5.4 |
|
| Exposure for the year ended 31 December | ||||||||
|
| Average exposure | Highest exposure | Lowest exposure | ||||||
| Group trading instruments | 2008 £m | 2007 £m | 2006 £m | 2008 £m | 2007 £m | 2006 £m | 2008 £m | 2007 £m | 2006 £m |
| Interest rate risks | 3.6 | 1.7 | 1.8 | 5.6 | 3.7 | 2.7 | 2.5 | 0.9 | 1.2 |
| Equity risks | 2.0 | 2.4 | 2.7 | 3.5 | 3.7 | 3.9 | 1.0 | 1.6 | 2.0 |
| Spread risks | 1.3 | 0.9 | 1.6 | 2.8 | 2.0 | 2.3 | 0.5 | 0.4 | 0.7 |
| Property risks | 4.7 | 2.3 | 1.5 | 7.4 | 3.5 | 2.0 | 3.2 | 1.0 | 1.2 |
| Other risks(1) | 0.6 | 0.3 | 0.4 | 1.0 | 1.2 | 0.7 | 0.2 | 0.1 | 0.1 |
| Correlation offsets(2) | (2.2) | (1.6) | (1.7) | - | - | - | - | - | - |
| Total correlated one-day Value at Risk | 10.0 | 6.0 | 6.3 | 14.5 | 8.8 | 7.4 | 8.0 | 4.1 | 5.1 |
(1) Other risks include foreign exchange risk.
(2) The highest and lowest exposure figures reported for each risk type did not necessarily occur on the same day as the highest and lowest total correlated one-day Value-at-Risk. A corresponding correlation offset effect cannot be calculated and is therefore omitted from the above table.
Property risks have increased over the last two years and in particular 2008. The largest factor in the Value at Risk increase is from an equity release business funded by the Group, as total equity advances increased over the three-year period. A secondary factor is the significant fall in interest rates in the same period. The present value of all the cashflows has increased significantly as a result of the lower discount rates, increasing sensitivity and hence Value at Risk.
Derivatives held for Trading Purposes
Global Banking & Markets is the only area of the Group actively trading derivative products and is additionally responsible for implementing most Group derivative hedging with the external market. For trading activities, Global Banking & Markets objectives are to gain value by marketing derivatives to end users and hedging the resulting exposures efficiently; and the management of trading exposure reflected on the Group's balance sheet. Trading derivatives include interest rate, cross currency, equity, residential property and other index related swaps, forwards, caps, floors, swaptions, as well as credit default and total return swaps, equity index contracts and exchange traded interest rate futures and equity index options.
Credit Derivatives
Previously, Global Banking & Markets also operated a credit derivatives business. The business traded in single-name credit derivatives, credit derivative indices and a limited number of portfolio credit derivative transactions. The credit derivatives trading function operated within the same framework as other trading functions. Risk limits were established and monitored. Given the lack of activity in the credit markets in 2007 and early 2008, the business was closed and its activities consolidated in Spain with the equivalent Banco Santander, S.A. business area with effect from 1 January 2008. Any residual positions have been hedged with Banco Santander, S.A..
Risk Management in Private Banking
Credit risk in Private Banking
Cater Allen
Cater Allen provides a limited range of products to assist with the finance requirements of individuals and businesses. Risk management policies are specific to and reflect the risks inherent in each product set. Approval processes for credit risk include the use of judgement, assisted by the use of credit scoring and credit ratings. In 2008, Cater Allen operated within policies and authority levels approved by the Chief Risk Officer; in 2009 this is due to change to the Head of Wholesale Risk. Cater Allen has a dedicated risk team, reflecting the desire for risk control to be close to the business needs and risks.
The following table presents the amount that best represents Cater Allen's estimated maximum exposure to credit risk at the reporting date without taking account of any collateral held or other credit enhancements:
|
| 2008 £m | 2007 £m |
| Loans and advances to customers | 3.8 | 3.7 |
| Other | 0.2 | 0.3 |
| Third party exposures | 4.0 | 4.0 |
Abbey International
Abbey International's office is in Jersey, with a focus on attracting deposits by offering a range of savings accounts denominated in sterling, US dollars and euros. There is no credit risk associated in taking deposits.
James Hay
James Hay provides and offers administration services for self-invested personal pension schemes and the WRAP portfolio management product. Its services are provided to end customers mainly via independent financial advisers and branded financial service providers. With the exception of fees receivable, there is no credit risk associated with this type of service.
Abbey Sharedealing
Abbey Sharedealing provides a direct share dealing service to customers and provides a share-trading platform for cahoot. Customers buy and sell shares on their account with the help of the dealers at Abbey Sharedealing. No advice is provided and all trades are on an execution only basis, account customers are required to provide funds before settlement. As such there is no credit risk associated with this type of activity.
Market risk in Private Banking
Market risk arises from exposures to changes in the levels of interest rates, foreign exchange rates and equity markets. Market risk arises through the provision of retail and other banking products and services, as well as structural exposures arising in the balance sheet of the entities in Private Banking.
Managing market risk
Market risks in Private Banking arising from exposure to changes in the levels of interest rates and foreign exchanges rates are substantially transferred from the original business to ALM. Market risks arising from structured products, including exposure to changes in the levels of equity markets, are hedged with Global Banking & Markets. Risks not transferred are managed within a series of market risk mandates, which set triggers for reporting on the extent of market risk that may be retained. These limits are defined in terms of nominal amounts, sensitivity, earnings-at-risk or value-at-risk. Retained market risk exposure is minimal.
Risk Management in Group Infrastructure
Group Infrastructure consists of ALM, which is also responsible for Group Capital and Funding. ALM is responsible for managing the Group's structural balance sheet shape and, in conjunction with Risk Division, tactical liquidity risk management. This includes short-term and medium-term funding, covered bond and securitisation programmes. ALM's responsibilities also include Retail Banking's product and structural exposure to interest rates and, in that role, is a link between the Retail Banking and Global Banking & Markets. ALM recommends and helps to implement Board, Asset and Liability Management Committee and Risk Committee policies for all aspects of balance sheet management - formulating guidance for, and monitoring, the overall balance sheet shape, including maturity profile. Group Capital represents the return on the Group's capital, reserves, preference shares and subordinated debt. Funding represents the provision of funding, both to other businesses within the Group and to fellow subsidiaries of Banco Santander, S.A..
Credit risk in Group Infrastructure
Credit risk is the risk that counterparties will not meet their financial obligations resulting in Group Infrastructure losing the monies lent, including any interest accrued, or having to close out transactions prematurely, which may incur losses after realising collateral held. Credit risk arises by Group Infrastructure making loans, investing in debt securities or other financial instruments or entering into financing transactions or derivative contracts.
Managing credit risk
Credit risk arises in Group Infrastructure with respect to the division's holdings of Santander and Group-issued externally rated, European asset-backed securities and residential mortgage-backed securities principally issued by Santander Group entities, other assets held for liquidity purposes, and lending to fellow subsidiaries of the Santander Group.
All credit risk meets the criteria approved by the Board in respect to Risk Appetite parameters and all exposure, including intra-group, is captured on the global risk management systems and falls within limits approved by Santander Risk Division. The exposure is managed by the Group´s Wholesale Risk Team.
Group Infrastructure net exposure by credit rating of the issuer or counterparty(1)
|
| 2008 £m | 2007 £m |
| AAA | 9,464 | 7,254 |
| AA | 3,193 | 643 |
| A | 4,982 | 637 |
| BBB+ | 1,174 | 43 |
| D | 10 | 5 |
| Total | 18,823 | 8,582 |
(1) In accordance with the requirements of Basel II, internal ratings are applied to all exposures.
Market risk in Group Infrastructure
Most market risks arising from the Retail Banking, Corporate Banking, and Private Banking divisions are transferred from the originating business to the ALM function within Group Infrastructure, where they can be managed in conjunction with exposures arising from the funding, liquidity or capital management activities of ALM. As a consequence, non-trading risk exposures are substantially transferred to Group Infrastructure. Market risks mainly arise through the provision of banking products and services to personal and corporate/business customers, as well as structural exposures arising in the Group's balance sheet. These risks impact the Group's current earnings and economic value.
The most significant market risks in Group Infrastructure are interest rate and credit spread risks. Yield curve risk arises from the timing mismatch in the repricing of fixed and variable rate assets, liabilities and off-balance sheet instruments, as well as the investment of non-interest-bearing liabilities in interest-bearing assets. Credit spread risk arises principally on Group Infrastructure's holdings of mortgage-backed securities. Basis risk arises, to the extent that the volume of administered variable rate assets and liabilities are not precisely matched, which exposes the balance sheet to changes in the relationship between administered rates and market rates.
The Group is also exposed to risks arising from features in retail products that give customers the right to alter the expected cash flows of a financial contract. This creates prepayment risk, for example where customers may prepay loans before their contractual maturity. In addition, the Group is exposed to product launch risk, for example where the customers may not take up the expected volume of new fixed rate mortgages or other loans.
Managing market risks in Group Infrastructure
The Asset and Liability Management Committee is responsible for managing the Group's overall balance sheet position. Natural offsets are used as far as possible to mitigate yield curve exposures but the overall balance sheet position is generally managed using derivatives that are transacted through Global Banking & Markets. The Treasurer is responsible for managing risks in accordance with the Asset and Liability Management Committee's direction.
Risks are managed within limits approved either by the Head of Wholesale Risk or Banco Santander, S.A.'s Board Risk Committee, and within the risk control framework defined by the Market Risk Manual. The key risk limits relate to yield curve risk. They are:
> Net Interest Margin sensitivity: the sensitivity of annual net interest margin to an instantaneous and unexpected adverse 100 basis point parallel shock to the yield curve.
> Market Value of Equity sensitivity: the sensitivity of the net present value of interest rate sensitive positions to an instantaneous and unexpected adverse 100 basis point parallel shock to the yield curve.
These two measures provide complementary views of potential losses from interest rate movements. Market Value of Equity sensitivity provides a long-term view covering the present value of all future cash flows, whereas Net Interest Margin sensitivity considers only the impact on net interest margin over the next 12 months. Calculation of these two measures requires modelling of expected customer and other behaviours. These models are regularly reviewed and updated.
The following table shows the results of these measures as at 31 December 2008 and 2007:
|
| 2008 £m | 2007 £m |
| Net interest margin sensitivity (100 basis points adverse parallel shock) | (64) | (7) |
| Market value of equity sensitivity (100 basis points adverse parallel shock) | (153) | (197) |
Market risk on the Group's Santander-issued mortgage-backed securities portfolio is managed against credit spread triggers approved by the Head of Wholesale Risk and sensitivity analysis is disclosed in 'Critical accounting policies and areas of significant management judgement' within the Accounting Policies.
Derivatives
Derivative financial instruments ('derivatives') are contracts or agreements whose value is derived from one or more underlying indices or asset values inherent in the contract or agreement, which require no or little initial net investment and are settled at a future date. They include interest rate, cross-currency and equity related swaps, forward rate agreements, caps, floors, options and swaptions (see below). In Group Infrastructure, derivatives are used for economic hedging.
All derivatives are classified as held at fair value through profit or loss. For accounting purposes, the Group chooses to designate certain derivatives as in a hedging relationship if they meet specific criteria. The main hedging derivatives are interest rate and cross-currency swaps, which are used to hedge fixed-rate lending and structured savings products and medium-term note issuances, capital issuances and other capital markets funding.
Derivative products that are combinations of more basic derivatives (such as swaps with embedded option features), or that have leverage features, may be used in circumstances where the underlying position being hedged contains the same risk features. In such cases the derivative used will be structured to match the risks of the underlying asset or liability. Exposure to market risk on such contracts is therefore economically hedged.
The following table summarises the activities undertaken within Group Infrastructure, the related risks associated with such activities and the types of hedging derivatives used in managing such risks. These risks may also be managed using on-balance sheet instruments as part of an integrated approach to risk management. Further information is contained in Note 14 of the Consolidated Financial Statements.
| Activity | Risk | Type of hedge |
| Management of the return on variable rate assets financed by shareholders' funds and net non-interest-bearing liabilities. | Reduced profitability due to falls in interest rates. | Receive fixed interest rate swaps. |
| Management of the basis between administered rate assets and liabilities and wholesale market rates. | Reduced profitability due to adverse changes in the basis spread. | Basis swaps. |
| Management of repricing profile of wholesale funding. | Reduced profitability due to adverse movement in wholesale interest rates when large volumes of wholesale funding are repriced. | Forward rate agreements. |
| Fixed rate lending and investments. | Sensitivity to increases in interest rates. | Pay fixed interest rate swaps. |
| Fixed rate retail and wholesale funding. | Sensitivity to falls in interest rates. | Receive fixed interest rate swaps. |
| Equity-linked retail funding. | Sensitivity to increases in equity market indices. | Receive equity swaps. |
| Management of other net interest income on retail activities. | Sensitivity of income to changes in interest rates. | Interest rate swaps. |
| Issuance of products with embedded equity options. | Sensitivity to changes in underlying index and index volatility causing option exercise. | Interest rate swaps combined with equity options. |
| Lending and issuance of products with embedded interest rate options. | Sensitivity to changes in underlying rate and rate volatility causing option exercise. | Interest rate swaps plus caps/floors. |
| Investment in, and issuance of, bonds with put/call features. | Sensitivity to changes in rates causing option exercise. | Interest rate swaps combined with swaptions(1) and other matched options. |
(1) A swaption is an option on a swap that gives the holder the right but not the obligation to buy or sell a swap.
Impact of the Current Credit Environment
The Group aims to actively manage its exposure to financial institutions and non-bank financial institutions such as pension and investment funds, monoline insurers and general insurers. This exposure arises from investment in floating rate notes, short term money market placements, derivative transactions and margin posting on securities borrowing transactions. Investments in structured assets are concentrated in residential mortgage-backed securities issued by Santander entities in Spain and Portugal, with seasoned portfolios that are performing in line with expectations on the basis of strong credit ratings.
The Group had limited exposure to Lehman Brothers Group arising from derivative contracts. The total claim lodged with the Administrators was £9m and was fully provided for at the year end. The Group had no exposure to Washington Mutual and only a £24m exposure to Iceland which is covered by credit default swap protection. At 31 December 2008, the Group also had indirect exposure of euro 3m to Madoff funds through a structured note. This note was closed out with no loss in February 2009.
Details of the Group's investing and lending arrangements with respect to floating rate notes ('FRNs'), asset-backed securities, Collateralised Debt and Loan Obligations ('CDOs' and 'CLOs'), Structured Investment Vehicles ('SIVs'), monoline Insurers, off-balance sheet entities, other holdings for liquidity purposes, and lending activities are set out below.
Floating Rate Notes
| Nominal value | Fair value movement | Provisions and write-offs | Fair value | Value as % of nominal value | |||
| Income statement | Reserves | ||||||
|
Country | 2008 £m | 2008 % | 2008 £m | 2008 £m | 2008 £m | 2008 £m | 2008 % |
| UK | 2,153 | 42 | (4) | - | - | 2,194 | 102 |
| Italy | 215 | 4 | (1) | - | - | 215 | 100 |
| Spain | 522 | 10 | (2) | - | - | 523 | 100 |
| Rest of Europe | 1,722 | 34 | (15) | - | - | 1,676 | 97 |
| US | 108 | 2 | - | - | - | 109 | 101 |
| Rest of World | 384 | 8 | (3) | - | - | 384 | 100 |
| 5,104 | 100 | (25) | - | - | 5,101 | 100 | |
| Nominal value | Fair value movement | Provisions and write-offs | Fair value | Value as % of nominal value | |||
| Income statement | Reserves | ||||||
|
Credit rating | 2008 £m | 2008 % | 2008 £m | 2008 £m | 2008 £m | 2008 £m | 2008 % |
| AA and above | 4,085 | 80 | (17) | - | - | 4,062 | 99 |
| A | 1,019 | 20 | (8) | - | - | 1,039 | 102 |
| 5,104 | 100 | (25) | - | - | 5,101 | 100 | |
The FRNs held are principally issued by banks and other financial institutions. On average, the FRNs have 7 months to maturity.
The above table excludes US$100m undated floating rate subordinated notes issued by Alliance & Leicester plc in October 2008, and US$220m and euro 115m undated subordinated notes issued by Alliance & Leicester plc in December 2008 all of which were subscribed for by the Company. As set out in Note 45, the Company is now the immediate parent company of Alliance & Leicester plc.
Asset-Backed Securities
The Group has acquired highly rated, European asset-backed securities ('ABS') and residential mortgage-backed securities with a total value of £4,087m (2007: £5,515m). The Group's portfolios of ABS and MBS are of high quality, containing no sub-prime element and consist almost entirely of AAA rated prime exposures.
| Nominal value | Fair value movement | Provisions and write-offs | Fair value | Value as % of nominal value | |||
| Income statement | Reserves | ||||||
|
Country | 2008 £m | 2008 % | 2008 £m | 2008 £m | 2008 £m | 2008 £m | 2008 % |
| Europe (excluding UK) | |||||||
| ABS | 363 | 8 | (23) | - | - | 336 | 92 |
| MBS | 4,155 | 92 | (305) | - | - | 3,751 | 90 |
| 4,518 | 100 | (328) | - | - | 4,087 | 90 | |
| Nominal value | Fair value movement | Provisions and write-offs | Fair value | Value as % of nominal value | |||
| Income statement | Reserves | ||||||
|
Credit rating | 2008 £m | 2008 % | 2008 £m | 2008 £m | 2008 £m | 2008 £m | 2008 % |
| AAA | |||||||
| ABS | 352 | 8 | (23) | - | - | 325 | 92 |
| MBS | 3,855 | 85 | (266) | - | - | 3,496 | 91 |
| 4,207 | 93 | (289) | - | - | 3,821 | 91 | |
| Aa1 | |||||||
| ABS | 11 | - | (1) | - | - | 10 | 91 |
| MBS | 300 | 7 | (38) | - | - | 256 | 85 |
| 311 | 7 | (39) | - | - | 266 | 85 | |
| 4,518 | 100 | (328) | - | - | 4,087 | 90 | |
The fair value movements above exclude the effects of changes in foreign exchange rates.
Collateralised Debt and Loan Obligations
The Group has no investments in Collateralised Debt Obligations or Collateralised Loan Obligations.
However, in the ordinary course of business, the Group entered into long-term interest rate hedging contracts with five investment vehicles whose underlying assets comprise debt securities, bank loans and energy and infrastructure financings. Although the vehicles themselves are not externally rated, the counterparty exposure ranks super-senior to the most senior notes issued by the vehicles and these notes are rated AAA or AA. The total mark-to-market exposure at 31 December 2008 was £186m.
Structured Investment Vehicles
The Group has insignificant holdings in SIVs, with a nominal value of £17m (2007: £40m) against which provisions of £12m (2007: £10m) are held, giving a book value of £5m (2007: £30m).
Monoline Insurers
The Group has a £41m exposure to a corporate bond which is wrapped by a monoline insurer. In this instance, principal risk exposure is recorded against the corporate bond, with the monoline wrap being viewed as contingent exposure.
Exposure to Off-Balance Sheet Entities sponsored by the Group
The only Special Purpose Entities ('SPEs') sponsored but not consolidated by the Group are SPEs which issue shares that back retail structured products. The Group's arrangements with these entities comprise the provision of equity derivatives and a secondary market making service to those retail customers who wish to exit early from these products. The total value of products issued by the SPEs is £3,213m (2007: £2,455m), and the total value of repurchases held by the Group is £254m (2007: £322m).
Credit Derivatives
As noted above, previously, Global Banking & Markets operated a credit derivatives business. The business traded in single-name credit derivatives, credit derivative indices and a limited number of portfolio credit derivative transactions. The credit derivatives trading function operated within the same framework as other trading functions. Risk limits were established and monitored. There is a limited number of remaining credit derivative transactions with a nominal value of £1.1bn where the Group faces external counterparties and the risk has been hedged with Banco Santander, S.A. in Spain.
Lending Activities
The Group is principally a retail prime lender and has no appetite or product offering for any type of sub-prime business. The Group's credit policy explicitly prohibits such lending and is specifically designed to ensure that any business written is responsible, affordable (both initially and an on-going basis) and of a good credit quality. The Group's principal lending activities arise in the Retail Banking division. For further information, see Risk Management in Retail Banking and Group Infrastructure.
Liquidity
In addition to funding customer loans and advances, the Group also holds available liquid assets, in the form of cash and short term deposits, to manage the day-to-day requirements of the business. The Group holds a significantly higher level of liquid assets than in 2007, in recognition of the current market conditions.
Liquidity risk
Liquidity risk is the potential that the Group has insufficient financial resources to meet its payment obligations as they fall due, or can do so only at excessive cost. Liquidity risks arise throughout the Group's businesses. Its primary business activity is commercial banking and, as such, it engages in maturity transformation, whereby it raises funds that may be withdrawn at short notice and lends them to customers at longer terms.
Following Banco Santander, S.A.'s acquisition of Alliance & Leicester plc in October 2008, the liquidity risks of the Group and Alliance & Leicester plc have been managed on a combined basis. In 2008, Santander's commitments to the UK Government and regulators to improve the Tier 1 ratio of the combined UK businesses were met using the additional £1bn of capital announced at the time of the acquisition of Alliance & Leicester plc, which was transferred into Abbey from Santander. This capital was in turn transferred to Alliance & Leicester plc in late December as planned.
The majority of funding is raised from retail deposits with the balance raised in wholesale markets. The traditional sources of wholesale funding were:
> Secured and unsecured money-market funding (including unsecured cash, repo, CD and CP issuance);
> Senior debt issuance (including discrete bond issues and MTNs);
> Mortgage-backed funding (including securitisation and covered bond issuance);
> Subordinated debt and capital issuance (although the primary purpose is not funding).
As a result of current market conditions, the mortgage-backed funding markets, which have traditionally been important sources of funding, were effectively closed to new external issuances, except for private placements with a small number of investors. However, the Group benefitted both from the conservative proportion of retail assets that are funded in wholesale markets, as well as having entered the period of market stress in a strong liquidity position. All internal and external liquidity ratios were maintained during this period.
The Group has access to the Bank of England's and the US Federal Reserve's lending facilities. In addition, the Group has the ability to access indirectly the European Central Bank's repo facilities. The key on-going liquidity risks to the Group are therefore:
> Loss of customer deposits;
> Loss of access to wholesale funding markets (including foreign exchange swaps) or counterparties;
> Intra-day payments systems dislocation; and
> Contingent liabilities arising from mortgage-backed or other funding, such as collateral calls or early amortisation.
Liquidity risk management
The Board is responsible for the liquidity management and control framework and defines the liquidity risk appetite. Liquidity risk management is the responsibility of the Chief Financial Officer who delegates day-to-day responsibility to the Treasurer. The Group has a centralised liquidity risk management approach whereby all liquidity/funding is managed centrally by the Treasurer, under the direction of the Asset & Liability Management Committee and within the framework of the Liquidity Risk Manual. The Asset and Liability Management Committee and the Risk Committee monitor Abbey's liquidity position on a monthly basis. The Board also receives a monthly update on key liquidity issues and Abbey's liquidity position is reported to the Financial Services Authority on a weekly basis.
Abbey views the essential elements of liquidity management as controlling potential cash outflows, maintaining prudent levels of highly liquid assets and ensuring that access to funding is available from a diversity of sources. A management and monitoring process, and a series of liquidity limits within which liquidity is managed, underpin these elements. For example, an excessive concentration in either liquid assets or contractual liabilities contributes to potential liquidity risk, and so appropriate limits have been defined under the Liquidity Risk Appetite. Management also monitors Abbey's compliance with limits set by the Financial Services Authority. In addition to such limits, liquidity ratios have trigger-review levels that require the Treasurer, Head of Asset and Liability Management, and Head of Wholesale Risk to initiate appropriate reviews of current exposure when such levels are exceeded.
In line with the policy of Banco Santander, S.A., the Group manages its funding and maintains adequate liquidity on a stand-alone basis.
While the Group's liquidity risk is consolidated and centrally controlled, liquidity risk is also measured, monitored and controlled within the specific business area or the subsidiary where it arises.
The key elements of the Group's liquidity risk management are:
Short-term, tactical liquidity management:
> Liquid assets - a buffer of liquid assets is held to cover unexpected cashflows in extreme but plausible stress scenarios. In the Group's case, the largest stress event is likely to include large and unexpected deposit withdrawals by retail customers.
> Intra-day collateral management - to ensure that adequate collateral is available to support payments in each payment or settlement system in which the Group participates, as they fall due.
Strategic liquidity management:
> Structural balance sheet shape - to manage the extent of maturity transformation (investment of shorter term funding in longer term assets), the funding of non-marketable assets with wholesale funding and the extent to which non-marketable assets can be used to generate liquidity.
> Wholesale funding strategy - to avoid over-reliance on any individual counterparty, currency, market or product, or group of counterparties, currencies, markets or products that may become highly correlated in a stress scenario; and to avoid excessive concentrations in the maturity of wholesale funding.
> Wholesale funding capacity - to maintain and promote counterparty relationships, monitor line availability and ensure funding capacity is maintained through ongoing use of lines and markets.
The Liquidity Contingency Plan becomes operational when the demand for cash, whether from demands for repayment, from wholesale funding or from retail deposits, exceeds the normal liquidity management process capacity. The circumstances that cause this to happen will tend to be sudden, unexpected events that trigger demands for cash that cannot be managed within the procedures, limits and controls defined in the Liquidity Risk Manual.
To be effective, the management of liquidity in a crisis must be timely, proactive and flexible enough to respond to a variety of different circumstances. The management structure for the Liquidity Contingency Plan, which is structured around a small team of individuals with the authority to agree, co-ordinate and implement actions that will control a volatile, dynamic situation, has two key elements:
> the Treasurer and Head of Asset and Liability Management is responsible for the rapid assessment of the implications of a sudden, unexpected event on the day-to-day liquidity of the Group, and for the decision to activate the Liquidity Contingency Plan; and
> the liquidity crisis management team, under the chairmanship of the Chief Financial Officer, is the decision-making authority in the event of a liquidity crisis, and is responsible for implementing the Liquidity Contingency Plan.
Risk limits or triggers are set for the key tactical and strategic liquidity risk drivers. These are monitored by the Treasurer and Risk Division and reported monthly to the Asset & Liability Management Committee, Risk Committee and the Board.
Current market conditions
During 2008, liquidity in the wholesale funding markets came under unprecedented and prolonged stress. From the Group's perspective, short-term unsecured money-market funding has been continuously available. However, investor demand for unsecured and mortgage-backed issuance has been much reduced since 2007 and at significantly wider spreads. These markets have traditionally been important sources of funding. Funding issues also came to the fore in the banking sector more generally, resulting in the introduction of government-backed funding initiatives, including the UK Government Credit Guarantee Scheme.
During this time, the Group kept its main stress scenarios under review and updated the extreme stress scenario, upon which the Board's risk appetite is based, in light of market developments. At all times, the Group sought to maintain a buffer of securities that are eligible for discount in open market operations with the central banks to which the Group has access. This buffer was at least sufficient to survive either an acute Group-specific stress during stressed market conditions, or a prolonged loss of unsecured wholesale funding during stressed market conditions. The underlying analysis of customer deposit behaviour under stressed conditions is aligned with the assumptions made in operational contingency planning.
In addition, the acquisition in September 2008 of the retail deposits of Bradford & Bingley plc significantly increased the proportion of the balance sheet that was funded by retail, rather than wholesale, liabilities.
The UK Government initiative announced in early October 2008, including the provision of liquidity and funding support and facilities to enable banks to raise new capital to strengthen their capital base, was welcomed by the Group. The Group did not use the UK Government recapitalisation scheme, nor does it expect to in the future. In 2009, with respect to liquidity and funding arrangements, rather than capital, we expect to remain flexible in our approach. We believe that the current arrangements with the Bank of England, European Central Bank and US Federal Reserve, as well as the UK Credit Guarantee Scheme that are available to the UK banking industry will help the banking sector to meet liquidity and funding needs.
During 2008, all key liquidity limits were maintained.
Maturities of financial liabilities
The table below analyses the maturities of the undiscounted cashflows relating to financial liabilities of the Group based on the remaining period to the contractual maturity date at the balance sheet date. Deposits by customers are largely made up of Retail Deposits. In particular the 'Demand' grouping includes current accounts and other variable rate savings products. The 'Up to 3 months' grouping largely constitutes wholesale funding of wholesale assets of a similar maturity. This table is not intended to show the liquidity of the Group.
|
| Group | |||||
| At 31 December 2008
|
Demand £m | Up to 3 months £m | 3-12 months £m | 1-5 years £m | Over 5 years £m | Total £m |
| Deposits by banks | 1,096 | 1,994 | 147 | 117 | - | 3,354 |
| Deposits by customers | 73,735 | 8,116 | 14,144 | 3,405 | 743 | 100,143 |
| Derivative financial instruments | 1,377 | 1,294 | 2,581 | 8,657 | 24,408 | 38,317 |
| Trading liabilities | 5,071 | 31,253 | 1,817 | 1,667 | 1,554 | 41,362 |
| Financial liabilities designated at fair value | - | 1,495 | 994 | 1,832 | 1,160 | 5,481 |
| Debt securities in issue | - | 11,122 | 5,635 | 7,357 | 42,768 | 66,882 |
| Other borrowed funds | - | 60 | 93 | 493 | 4,110 | 4,756 |
| Subordinated liabilities | - | 216 | 242 | 2,069 | 5,788 | 8,315 |
| Total financial liabilities | 81,279 | 55,550 | 25,653 | 25,597 | 80,531 | 268,610 |
|
| Company | |||||
| At 31 December 2008
|
Demand £m | Up to 3 months £m | 3-12 months £m | 1-5 years £m | Over 5 years £m | Total £m |
| Deposits by banks | 2,907 | 18,354 | 19,638 | 58,758 | 36,477 | 136,134 |
| Deposits by customers | 64,514 | 18,286 | 14,516 | 14,001 | 59,490 | 170,807 |
| Derivative financial instruments | 176 | - | - | 2,067 | 5,258 | 7,501 |
| Trading liabilities | 4 | 22 | 748 | - | - | 774 |
| Debt securities in issue | - | - | - | - | - | - |
| Other borrowed funds | - | 45 | 46 | 245 | 1,247 | 1,583 |
| Subordinated liabilities | - | 232 | 288 | 2,316 | 8,651 | 11,487 |
| Total financial liabilities | 67,601 | 36,939 | 35,236 | 77,387 | 111,123 | 328,286 |
|
| Group | |||||
| At 31 December 2007
| Demand £m | Up to 3 months £m | 3-12 months £m | 1-5 years £m | Over 5 years £m | Total £m |
| Deposits by banks | 416 | 7,318 | 257 | - | - | 7,991 |
| Deposits by customers | 55,766 | 8,541 | 3,668 | 1,920 | 166 | 70,061 |
| Derivative financial instruments | 3 | 502 | 731 | 4,855 | 10,891 | 16,982 |
| Trading liabilities | 21,069 | 28,973 | 2,931 | 1,409 | 1,515 | 55,897 |
| Financial liabilities designated at fair value | - | 1,598 | 2,111 | 3,647 | 1,800 | 9,156 |
| Debt securities in issue | - | 8,696 | 2,437 | 8,433 | 47,619 | 67,185 |
| Other borrowed funds | - | 56 | 80 | 424 | 3,394 | 3,954 |
| Subordinated liabilities | - | 194 | 223 | 1,820 | 5,456 | 7,693 |
| Total financial liabilities | 77,254 | 55,878 | 12,438 | 22,508 | 70,841 | 238,919 |
| Company | ||||||
| At 31 December 2007
| Demand £m | Up to 3 months £m | 3-12 months £m | 1-5 years £m | Over 5 years £m | Total £m |
| Deposits by banks | 2,060 | 14,635 | 8,897 | 36,497 | 6,444 | 68,533 |
| Deposits by customers | 52,806 | 7,332 | 4,090 | 10,088 | 33,978 | 108,294 |
| Derivative financial instruments | - | - | - | 94 | 2,658 | 2,752 |
| Debt securities in issue | - | 4 | - | - | - | 4 |
| Other borrowed funds | - | 45 | 46 | 245 | 1,280 | 1,616 |
| Subordinated liabilities | - | 205 | 257 | 1,999 | 7,570 | 10,031 |
| Total financial liabilities | 54,866 | 22,221 | 13,290 | 48,923 | 51,930 | 191,230 |
The growth in the Company balance sheet is due to the increased use of inter-company loans and deposits rather than inter-company swaps to match the interest rate profile of customer balances.
Report of the Directors
Directors
Board of Directors
As at 31 December 2008
Chairman
Lord Burns
Lord Burns (age 65) was appointed Joint Deputy Chairman on 1 December 2001 and Chairman on 1 February 2002. He is also Chairman of Alliance & Leicester plc and Glas Cymru Cyfyngedig (Welsh Water) and a Non-Executive Director of Pearson plc and Banco Santander, S.A.. His current professional roles include President of the Society of Business Economists, Fellow of the London Business School, Companion of the Institute of Management, President of the National Institute of Economic and Social Research and Vice President of the Royal Economic Society. He was formerly Permanent Secretary to the Treasury and chaired the Parliamentary Financial Services and Markets Bill Joint Committee. He was a Non-Executive Director of British Land plc (2000-2005) and Legal & General Group plc (1991-2001). He was also Chairman of the National Lottery Commission (2000-2001) and Marks and Spencer Group plc (2006-2008).
Executive Directors
António Horta-Osório
Chief Executive
António Horta-Osório (age 45) was appointed Chief Executive on 21 August 2006. He was a Non-Executive Director of Abbey National plc from 1 December 2004 until his appointment as Chief Executive. He joined Abbey National plc from Banco Santander Totta in Portugal where he was Chief Executive Officer. He is also Chief Executive of Alliance & Leicester plc, Executive Vice President of Banco Santander, S.A. and a member of its management committee as well as Non-Executive Chairman of Banco Santander Totta. He was previously Chief Executive Officer of Banco Santander Brasil. António started his career at Citibank Portugal, where he was head of Capital Markets and at the same time was an assistant professor at the Universidade Católica Portuguesa. He then worked for Goldman Sachs in New York and London, focusing on corporate finance activities in Portugal and, in 1993, joined the Santander group as Chief Executive Officer of Banco Santander de Negócios Portugal. He is a graduate in Management and Business Administration at Universidade Católica Portuguesa, has an MBA from INSEAD, where he was awarded the Henry Ford II Prize, and an AMP from Harvard Business School.
David Bennett
Executive Director, Integration Advisor and Intermediaries
David Bennett (age 46) was appointed Executive Director, Integration Advisor and Intermediaries on 21 October 2008 following the acquisition of Alliance & Leicester plc by Banco Santander, S.A.. He is also an Executive Director of Alliance & Leicester plc and a Non-Executive Director of EasyJet plc. He has many years of experience in the financial sector as Finance Director of Cheltenham & Gloucester plc and Executive Director of the National Bank of New Zealand Ltd.
Nathan Bostock
Chief Financial Officer and Executive Director, Retail Products & Marketing, Human Resources, Credit Cards and Insurance
Nathan Bostock (age 48) was appointed as an Executive Director on 22 February 2005. This followed his appointment to Abbey National plc's Executive Committee in November 2004. Nathan is currently Chief Financial Officer and his responsibilities include Group Infrastructure, (comprising Asset & Liability Management, Group Capital and Funding), Retail Products and Marketing, Human Resources, Credit Cards and Insurance. Nathan joined Abbey National plc in November 2001 as Chief Operating Officer, Abbey National Treasury Services plc, with responsibility for finance, market risk and operations. Prior to joining Abbey National plc, Nathan spent nine years (1992-2001) with The Royal Bank of Scotland plc where his roles included Director, Group Risk Management and Chief Operating Officer, Treasury and Capital Markets. Prior to joining The Royal Bank of Scotland plc, Nathan was Head of Risk Analysis and Finance, Treasury and Interest Rate Derivatives (Europe) for Chase Manhattan Bank (1988-1992). He joined Chase Manhattan Bank in 1986 having previously worked for Coopers and Lybrand. He is also an Executive Director of Alliance & Leicester plc.
Alison Brittain
Executive Director, Retail Distribution
Alison Brittain (age 44) was appointed Executive Director, Retail Distribution on 2 January 2008. She is responsible for Branch Distribution, Telephone Distribution, e-commerce, Business Banking, Premium Banking and Commercial Mortgages. She was previously Managing Director of the Barclays and Woolwich Retail Network divisions and the Small Business Banking division of Barclays Bank plc. She is also an Executive Director of Alliance & Leicester plc.
Non-Executive Directors
Juan Rodríguez Inciarte
Deputy Chairman
Juan Inciarte (age 56) was appointed Non-Executive Director on 1 December 2004. He joined Banco Santander, S.A. in 1985. After holding various positions, he was appointed to the Board of Directors in 1991, holding this office until 1999. He is currently Chief Executive of Santander Consumer Finance, S.A., Executive Vice President of Banco Santander, S.A. and a Non-Executive Director of Alliance & Leicester plc. In addition, he is a director of Compañia Española de Petróleos, NIBC Bank N.V., Banco Banif S.A., Vista Capital de Expansion S.A. and director and member of the Executive Committee of Sovereign Bancorp in the U.S. For several years he served on the Board of Directors of First Union Corporation (presently Wachovia) in the US, the Board of Directors and Executive Committee of San Paolo - IMI in Italy and the Boards of the Royal Bank of Scotland plc and National Westminster Bank plc (from 1998 - 2004). He is a member of the US-Spain Council and Fellow of The Chartered Institute of Bankers in Scotland.
Jane Barker
Jane Barker (age 59) was appointed Non-Executive Director on 21 October 2008. She is Chief Executive Officer of Equitas Limited, the company set up to re-insure and run-off the 1992 and prior years' non-life liabilities of Lloyd's of London syndicates and a Non-Executive Director of Alliance & Leicester plc. She is Deputy Chairman of the Royal College of Music and was previously a member of the council and chair of the Audit Committee of the Open University. Her previous roles have included being Finance Director of the London Stock Exchange.
Roy Brown
Roy Brown (age 62) was appointed Non-Executive Director on 21 October 2008. He is a Chartered Engineer and is Chairman of GKN plc, Senior Independent Director of HMV Group plc and a Non-Executive Director of Alliance & Leicester plc. Formerly, he was an Executive Director of Unilever plc and NV, a Non-Executive Director of Brambles Industries plc, the British United Provident Association Ltd (BUPA) and the Franchise Board of Lloyd's of London.
José María Carballo
José María Carballo (age 64) was appointed Non-Executive Director on 1 December 2004. He is a Non-Executive Director of Alliance & Leicester plc, Chairman of La Unión Resinera Española, Chairman of Vista Desarrollo, Director of Vista Capital Expansion S.A. S.G.E.C.R. and Director of Teleférico Pico del Teide S.A. He is also Vice President and Honorary Treasurer of the Iberoamerican Benevolent Society (UK). He was Executive Vice President of Banco Santander, S.A. from 1989-2001 and Chief Executive Officer of Banco Santander de Negocios from 1989 to 1993. Until 1989 he was Executive Vice President responsible for Europe at Banco Bilbao Vizcaya. He was also Executive Vice President of Banco de Bilbao in New York until 1983.
José María Fuster
José María Fuster (age 50) was appointed Non-Executive Director on 1 December 2004. He is Executive Vice President of Operations and Technology, and Chief Information Officer of Banco Santander, S.A., Non-Executive Director of Banesto and Non-Executive Director of Alliance & Leicester plc. He joined Banesto in 1998 and was appointed as Chief Information Officer of Banco Santander, S.A. in 2003. He started his professional career with International Business Machines, S.A. and Arthur Andersen as a consultant. He has also worked for Citibank España, S.A. and National Westminster Bank plc.
Rosemary Thorne
Rosemary Thorne (age 57) was appointed Non-Executive Director on 1 July 2006. She is also a Non-Executive Director on the board of Smurfitt Kappa Group plc and a Non-Executive Director of Alliance & Leicester plc. She was Group Finance Director of Ladbrokes plc until April 2007, Non-Executive Director of Cadbury Schweppes plc until September 2007 and Senior Independent Director on the board of Virgin Radio Holdings Limited until June 2008. Previously, she was Group Financial Controller of Grand Metropolitan Public Limited Company (prior to its merger with Guinness plc to become Diageo plc) and spent almost eight years as the Group Finance Director of J Sainsbury plc. She joined the board of Bradford & Bingley plc in 1999 as Group Finance Director, initially working on its demutualisation and flotation, resulting in a place in the FTSE 100 in December 2000. She remained in this role for a further five years. She was a member of the Financial Reporting Council and Financial Reporting Review Panel for nine years and a member of The Hundred Group of Finance Directors Main Committee for 15 years. She also sits on the Council of the Royal College of Art.
Keith Woodley
Keith Woodley (age 69) was appointed Non-Executive Director on 5 August 1996. He was made Senior Independent Non-Executive Director in April 1999 and was Deputy Chairman from 6 April 1999 until November 2004. He is a Non-Executive Director of Alliance & Leicester plc, former Non-Executive Director of National and Provincial Building Society and a former partner of Deloitte Haskins & Sells. A past President of the Institute of Chartered Accountants in England and Wales, he is Complaints Commissioner for the London Stock Exchange and a Council Member and Pro-Chancellor of the University of Bath.
Report of the Directors
Directors' Report
Corporate Structure
Abbey National plc (the 'Company') is a wholly owned subsidiary of Banco Santander, S.A.. The ordinary shares of the Company are not traded on the London Stock Exchange. Banco Santander, S.A. is incorporated in Spain and has its registered office at Paseo de Pereda 9-12, Santander, Spain. Note 20 to the Consolidated Financial Statements provides a list of the principal subsidiaries of the Company and the nature of each subsidiary's business as well as details of branches.
The Company is subject to the Listing Rules and the Disclosure & Transparency Rules of the UK Financial Services Authority, because it has preference shares listed on the London Stock Exchange. As it does not have listed ordinary shares, the Company is exempt from the requirement to make certain disclosures that are normally part of the continuing obligations of listed companies in the UK. This exemption applies, among other things, to corporate governance and certain Directors' remuneration disclosures.
Principal Activities and Business Review
The principal activity of the Company and its subsidiaries (together 'Abbey' or the 'Group') continues to be the provision of an extensive range of personal financial services. The Company is authorised and regulated by the UK Financial Services Authority.
The Company is required to set out in this report a fair review of the development and performance of the business of the Group during the year ended 31 December 2008 and of the position of the Group at the end of the year. The information that fulfils this requirement can be found in the Chief Executive's Review on pages 2 and 3. The Chief Executive's Review also contains a description of the likely future developments for the Group. When reading the Chief Executive's Review, reference should be made to the Forward-looking Statements section on page 4.
Further information on the development and performance of the business of the Group, both at a consolidated level and analysed by division can be found in the following sections:
> An analysis of the Group's development and performance during the year is contained in the Business Review - Summary on pages 9 to 12.
> A further detailed analysis of the Personal Financial Services businesses is contained in the Business Review - Personal Financial Services on pages 13 to 19.
> Further analyses of the Sold Life Businesses is contained in the Business Review - Sold Life Businesses on page 19.
Further information on the position of the Group at the end of the year can be found in the following sections:
> An analysis of the Personal Financial Services business flows is contained in the Business Review - Personal Financial Services on pages 14 to 16.
> The Balance Sheet Business Review can be found on pages 22 to 35, including a review of capital management and resources on page 28, details of capital expenditure on page 26, off-balance sheet arrangements on page 30, liquidity on pages 31 to 33, and contractual obligations on page 33.
> The Group's key performance indicators are described in the Business Review - Summary on page 12.
The Company is also required to describe the principal risks and uncertainties facing the Group. Financial risks are described in the Risk Management Report for each segment of the business by type of risk on pages 36 to 56, and material risk factors are described in the Risk Factors section on pages 141 to 144.
Results and Dividends
The results of the Group are discussed in the Principal Activities and Business Review above. The Directors do not recommend the payment of a final dividend (2007: £nil). An interim dividend of up to £225m was declared on 22 July 2008 on the Company's ordinary shares in issue. This dividend of £225m was paid on 22 December 2008. A further interim dividend of up to £225m was declared on 16 December 2008 on the Company's ordinary shares in issue and this will be paid during the first half of 2009. Interim dividends of £200m and £170m were declared in 2007 and paid in 2008.
Recent Developments
In September 2008, following the announcement by UK HM Treasury to take Bradford & Bingley plc into public ownership, the retail deposits, branch network and its related employees transferred, under the provisions of the UK Banking (Special Provisions) Act 2008, to the Company. All of Bradford & Bingley plc's customer loans and treasury assets, including all its mortgage assets, were taken into public ownership.
On 10 October 2008, Banco Santander, S.A. acquired Alliance & Leicester plc. On 17 December 2008, the Company injected £950m of capital into Alliance & Leicester plc through a subscription of: (i) 234,113,712 Alliance & Leicester plc ordinary shares for cash at £2.99 per share; (ii) US$220m undated subordinated notes issued by Alliance & Leicester plc; and (iii) euro 115m undated subordinated notes issued by Alliance & Leicester plc. Previously, in October 2008, the Company subscribed for US$100m undated floating rate subordinated notes issued by Alliance & Leicester plc. As a result of the subscription of ordinary shares, the Company held 35.6% of the issued ordinary share capital of Alliance & Leicester plc at 31 December 2008.
Post Balance Sheet Events
On 9 January 2009, in order to optimise the capital, liquidity funding and overall financial efficiency of the enlarged group, Banco Santander, S.A. transferred all of its Alliance & Leicester plc shares to the Company in exchange for Abbey National plc newly issued ordinary shares of £0.10 per share. Accordingly, the Company is now the immediate parent company of Alliance & Leicester plc.
Going Concern
The Directors confirm that they are satisfied that the Group has adequate resources to continue in business for the foreseeable future. For this reason, they continue to adopt a going concern basis in preparing the financial statements.
As outlined above, the Group's business activities, together with the factors likely to affect its future development, performance and position are set out in the Chief Executive's Review on pages 2 and 3 and in the Business Review on pages 9 to 21. The financial position of the Group, its cash flows, liquidity position and borrowing facilities are described in the Balance Sheet Business Review on pages 22 to 35. In addition, Note 47 to the Consolidated Financial Statements includes the Group's objectives, policies and processes for managing its capital; its financial risk management objectives; details of its financial instruments and hedging activities; and its exposures to credit risk and liquidity risk. As also outlined above, in respect of the principal risks and uncertainties facing the Group, financial risks are described in the Risk Management Report on pages 36 to 56, and material risk factors are described in the Risk Factors section on page 141 to 144.
In assessing going concern, the Directors take account of all information of which they are aware about the future, which is at least, but is not limited to, twelve months from the date that the balance sheet is signed. This information includes the Group's results forecasts and projections, estimated capital, funding and liquidity requirements as well as contingent liabilities, and possible economic, market and product developments, taking account of reasonably possible changes in trading performance.
> Budgets and forecasts
Since the acquisition of the Company by Banco Santander, S.A., the Group has a history of profitable operations. Management prepares a 3-year plan (the '3-Year Plan') that forecasts balance sheet, income and margin, by product, with a particular focus on the forthcoming year.
> Review and reforecast
The 3-Year Plan, its assumptions, forecast results and key sensitivities are reviewed by senior management and presented by the Group Financial Controller to the Executive Committee, the Board of Directors and to senior executives of Banco Santander, S.A.. The budget is reforecast on a monthly basis and reviewed by the Executive Committee and the Board of Directors. As part of the budgets and planning process, a particular emphasis is placed on ensuring the sustainability of earnings, and achieving and maintaining a high level of operating efficiency in the Group (measured by the PFS trading cost:income ratio) to enable competitive products to be developed for customers.
> Stress testing
To assess the Group's ability to adapt to various market challenges, the budgets are "stress tested" as part of the Group's internal capital adequacy assessment process ('ICAAP') under Basel II. Several scenarios are modelled, including a severe scenario, and senior management makes an assessment of how this would affect the Group's profit and funding plans.
> Borrowing requirements and Liability management
The Group's financial plans are constructed to ensure that they allow the Group to meet its financial obligations as they fall due, both with respect to maturing existing liabilities and future borrowing requirements.
Abbey's funding requirements are met from a variety of sources, with the vast majority being sourced from retail customer deposits. The balance is sourced from the wholesale markets with reference to prevailing and expected market conditions and the desired balance sheet structure. The Board considers it appropriate to balance cost effective short-term financing with medium and long term funds, which have less refinancing risk, all within the context of not placing over-reliance on a single source of wholesale funds.
Asset and Liability Management produces strategic and tactical funding plans as part of the Group's planning process. These funding plans are approved by the Board and the Asset & Liability Management Committee and are controlled on a day-to-day basis by the Group Treasurer and within the framework of the Liquidity Risk Manual. These plans are stressed to ensure adverse conditions can be accommodated via a range of management levers, including adjustment to Retail Banking's and Corporate Banking's plans.
Liquidity risk management is the responsibility of the Chief Financial Officer who delegates day-to-day responsibility to the Group Treasurer. Liquidity risk control and oversight are provided by the Chief Risk Officer, supported by the Risk Division. See the "Risk Management" section for further details on Liquidity Risk Management.
> Contingent liabilities
The Directors, via the Audit & Risk Committee, also consider the Group's exposure to contingent liabilities. This consideration addresses contingent liabilities experienced by the Group in the past, such as legal proceedings, guarantees, operating lease commitments and product misselling liabilities, but also considers whether there are any new contingencies such as those arising in respect of the UK Financial Services Compensation Scheme.
Contingent liabilities are captured on a timely basis for purposes of disclosure in the Annual Report and Accounts, and the interim financial statements for the half year. Information about guarantees to third parties, tax contingencies and other contingencies are gathered and disclosed. Data about the Group's operating lease commitments are also captured.
Potential obligations that are not included in the day-to-day trading systems are captured in a separate register, which is updated on a quarterly basis by the heads of various departments within the Group. Non-trading guarantees require the approval of the Chief Executive or the Chief Financial Officer or, in their absence, any two Company Executive Directors or one Company Executive Director and the Company Secretary. This provision forms part of the Company's Corporate Governance Framework (other Financial Delegated Authorities).
> Products and markets
The Directors review information about the major aspects of the economic environment within which the Group operates at monthly Board meetings. This information includes an economic update which contains data on key economic and market trends. In addition, the Group's Economic Analysis team monitors and provides information to the Board on current and prospective economic and market developments. Retail financial markets, such as the housing market, are a major focus for analysing current trends and potential developments.
The Directors also receive regular briefings on market share for the Group's major products and six-monthly competitor analyses.
Wholesale market conditions are reviewed daily by the Group Treasurer and Head of Short Term Financing and presented monthly to the Asset & Liability Management Committee by way of an update. The tactical and strategic funding plans are updated, if necessary, with reference to current and expected market conditions.
> Financial risk management
The Group's risk management focuses on major areas of risk, namely credit risk, market risk, liquidity risk, and operational risk. The Risk Management Report contained in the Annual Report and Accounts sets out in detail how the Group manages these risks.
> Financial adaptability
The Directors also consider the ability of the Group to take effective action to alter the amounts and timing of cash flows so that it can respond to unexpected needs or opportunities. Such financial adaptability mitigates the areas of financial risk above in considering the appropriateness of the going concern presumption in relation to the Group. In determining the financial adaptability of the Group, the Directors have considered the ability of the Group to:
> Obtain new sources of finance
Abbey minimises refinancing risk by sourcing funds from a variety of markets as appropriate and subject to consideration of the appropriate leverage ratio and funding mix for the Group, and in particular customer deposit levels and medium-term financing. Abbey actively manages its relationships with existing providers of funding and considers new sources of funds as and when they arise.
Day-to-day sources of finance consist primarily of retail deposits. To the extent that wholesale funding is required, a variety of sources are usually available from a range of markets, including:
- money markets: both unsecured (including interbank and customer deposits, and issuances of certificates of deposit and commercial paper) and secured (including repos in open market operations);
- debt capital markets (including discrete bond issues and medium term notes);
- mortgage-backed funding (including securitisation and covered bond issuances); and
- capital instrument issuance (although primarily issued to maintain capital ratios).
In addition to day-to-day funding sources, Abbey has access to contingent sources from Central Banks, including the Bank of England, the US Federal Reserve and indirectly the European Central Bank. Abbey ensures that it has access to these contingent facilities as part of its prudent liquidity risk management. See the "Risk Management" section of the Annual Report and Accounts for further details on Liquidity Risk Management.
Abbey minimises reliance on any one market by maintaining a diverse funding base, and avoiding concentrations by maturity, currency and institutional type. It is expected that the next year will see a continuation of the systemic dislocation in the wholesale markets that was seen in 2008. However, Abbey is well positioned for the coming year given the acquisition of Bradford and Bingley plc's deposits and the rationalisation of the balance sheet in the first half of 2008, leading to a reduction in short-term wholesale funding requirements. This is expected to continue as the balance sheet is further rationalised following the acquisition of Alliance and Leicester plc.
> Obtain financial support from other group companies
For liquidity purposes, Abbey operates on a stand-alone basis. However, in case of stress conditions, Abbey would consult with its parent company, Banco Santander, S.A., about financial support.
> Continue business by making limited reductions in the level of operations or by making use of alternative resources
Abbey maintains and regularly updates a Contingency Funding Plan to cover potential extreme scenarios. In addition, the 3-Year Plan is stressed, as part of the ICAAP process, to ensure Abbey can accommodate extreme scenarios and the impact this would have on the Plan and profits. In accommodating these extreme scenarios, various management levers would be utilised, including the encashment of certain liquid assets and a reduction in new business in Retail Banking and Corporate Banking.
After making enquiries, the Directors have a reasonable expectation that the Company and the Group have adequate resources to continue in operational existence for the foreseeable future. Accordingly, they continue to adopt the going concern basis in preparing the Annual Report and Accounts.
Directors
The members of the Company's board (the 'Board') at 31 December 2008 are named on pages 57 to 58. For each Director, the date of appointment is shown. As at 31 December 2008, the Board comprised a Chairman, four Executive Directors including the Chief Executive, and seven Non-Executive Directors. At the date of publication of this report, the Board comprises a Chairman, four Executive Directors, including the Chief Executive, and seven Non-Executive Directors. The roles of Chairman and Chief Executive are separated and clearly defined. The Chairman is primarily responsible for the working of the Board and the Chief Executive for the running of the business and implementation of Board strategy and policy. The following Non-Executive Directors resigned on 21 October 2008: Miguel Bragança, Andrew Longhurst and Jorge Morán. In addition, on 25 February 2009 the Company announced that Executive Director, Nathan Bostock, would be leaving the Company on 1 June 2009.
Non-Executive Directors have been appointed for an indefinite term (other than Jane Barker, Roy Brown, Rosemary Thorne and Keith Woodley, who have been appointed for a three-year term, after which their appointments may be extended upon mutual agreement). In accordance with the Company's Articles of Association, all of the Directors shall retire from office and face re-election at every Annual General Meeting.
When they were appointed, the appointments of António Horta-Osório, Juan Rodríguez Inciarte, José María Fuster and José María Carballo were all proposed by Banco Santander, S.A.. The Company may pay an Executive Director instead of allowing them to work during their notice period. One Executive Director's service contract provides for specific benefits on termination of employment.
Committees of the Board
The Board maintains one standing committee, which operates within written terms of reference.
Audit and Risk Committee
Membership of the Audit and Risk Committee is restricted to Non-Executive Directors. The Audit and Risk Committee's primary tasks are to review the scope of external and internal audit, to receive reports from the external auditors (currently Deloitte LLP) and the Chief Internal Auditor, and to review the preliminary results, interim information, annual financial statements and any other significant financial reports before they are presented to the Board, focusing in particular on accounting policies, compliance and areas of management judgement and estimates. The Audit and Risk Committee's scope also includes risk management and oversight and the review of the procedures in place for employees to raise concerns about possible wrongdoing in financial reporting and other matters. For a further discussion of the risk-control responsibilities of the Audit and Risk Committee, see the Risk Management section on page 36.
The Audit and Risk Committee more generally acts as a forum for discussion of internal control issues and contributes to the Board's review of the effectiveness of the Group's internal control and risk management systems and processes. The Audit and Risk Committee also conducts a review of the remit and reports of the Abbey and Banco Santander, S.A. internal audit functions, as well as their effectiveness, authority, resources and standing within Abbey and management's response to their findings and recommendations. Abbey's relationship with the external auditors and the experience and qualifications of the external auditors are monitored by the Audit and Risk Committee and external auditor's audit plans and audit findings are reviewed by the Audit and Risk Committee. A framework for ensuring auditor independence has been adopted, which defines unacceptable non-audit assignments, pre-approval of acceptable non-audit assignments and procedures for approval of other non-audit assignments.
The Audit and Risk Committee may make any recommendations to the Board as it sees fit and the Chairperson of the Audit and Risk Committee reports formally to the Board after each meeting. The Chairperson, Rosemary Thorne, has over 15 years of experience as Finance Director of FTSE 100 companies and was a member of the Financial Reporting Council, The Financial Reporting Review Panel and The Hundred Group of Finance Directors Main Committee. The Board has determined that Rosemary Thorne has the necessary qualifications and experience to qualify as an audit committee financial expert as defined for the purposes of the US Sarbanes-Oxley Act of 2002 and the Board considers that she is independent in accordance with Section 303A.02 of the New York Stock Exchange Corporate Governance Rules.
The other members of the Audit and Risk Committee are Juan Rodríguez Inciarte, José María Carballo, Keith Woodley, Roy Brown and Jane Barker. Pursuant to SEC Rule 10A-3(c)(2), which provides a general exemption from the requirement to have an audit committee for subsidiaries that are listed on a national securities exchange or market where the parent satisfies the requirement of SEC Rule 10A-3, the Company is exempt from the requirements of SEC Rule 10A-3. According to SEC Rule 10A-3(c)(2), additional listings of an issuer's securities are exempt from the audit committee requirements if the issuer is already subject to them as a result of listing any class of securities on any market subject to SEC Rule 10A-3. This exemption extends to listings of non-equity securities by a direct or indirect subsidiary that is consolidated or at least 50% beneficially owned by a parent company, if the parent is subject to the requirements as a result of the listing of a class of its equity securities. Consequently, as applied to the current shareholding structure of the Company, (as the wholly-owned subsidiary of Banco Santander, S.A.), the Company is exempt from the audit committee requirements of SEC Rule 10A-3 since: (i) the Company is a wholly-owned subsidiary of Banco Santander, S.A., (ii) Banco Santander, S.A., has equity securities listed on the New York Stock Exchange and is therefore subject to SEC Rule 10A-3, and (iii) the Company does not have any equity securities listed on the New York Stock Exchange or any other national securities exchange in the United States of America.
Remuneration Committee
The Remuneration Committee was formally dissolved in 2007 following a review of its role within Abbey. Prior to this date, the Remuneration Committee was responsible for oversight of the remuneration of senior management within Abbey and its aim was to ensure that these arrangements supported Abbey's business objectives. These responsibilities are now discharged by the Banco Santander, S.A. Appointments and Remuneration Committee.
Directors' Remuneration (audited)
The aggregate remuneration received by the Directors of the Company in 2008 was:
| £ | |
| Salaries and fees | 2,946,081 |
| Performance-related payments | 5,672,908 |
| Other taxable benefits | - |
| Total remuneration excluding pension contributions | 8,618,989 |
| Pension contributions | 141,486 |
| Compensation for loss of office | - |
These totals exclude emoluments received by Directors in respect of their primary duties as Directors or Officers of Banco Santander, S.A. and Alliance & Leicester plc in respect of which no apportionment has been made.
Medium-Term Incentive Plan (audited)
Under the Medium-Term Incentive Plan granted on 20 October 2005, certain Executive Directors, Other Key Management Personnel and other nominated individuals were granted a conditional award of shares in Banco Santander, S.A.. Key Management Personnel are defined as the Executive Committee of the Company and the Board and Executive Committee of its parent company, Banco Santander, S.A. who served during the year.
The amount of shares participants would receive at the end of the three-year period depended on the performance of Abbey in this period. The performance conditions were linked to Abbey's three-year plan. Performance was measured in two ways, half of the award depended on Abbey achieving an attributable profit target for the 2007 financial year, and the remainder depended on the achievement of a revenue target for the 2007 financial year. Both performance conditions were achieved, resulting in a full award of shares to participants in March 2008.
Long-Term Incentive Plan (audited)
In 2008, two Executive Directors (2007: three) were granted conditional awards of shares in Banco Santander, S.A. under the Santander Long-Term Incentive Plan for a total fair value of £702,952 (2007: £1,444,058) based on the closing share price on 20 June 2008 of Euro 11.96 (2007: Euro 14.79). Under the Santander Long-Term Incentive Plans granted on 21 June 2008 and 31 December 2007, certain Executive Directors, Key Management Personnel (as defined in Note 44 to the Consolidated Financial Statements) and other nominated individuals were granted conditional awards of shares in Banco Santander, S.A.. The amount of shares participants will receive throughout a three-year period (2007: a three-year period) depends on the performance of Banco Santander, S.A. during this period. All awards under the Santander Long-Term Incentive Plan will depend on Santander's Total Shareholder Return and Earnings Per Share performance against a competitor benchmark group. Provided the performance conditions are met, 100% of the 2008 conditional award of shares will vest in 2011. 40% of the 2007 conditional award of shares will vest in July 2009 with the remaining 60% vesting in July 2010.
Remuneration of Highest Paid Director (audited)
In 2008, the remuneration, excluding pension contributions, of the highest paid Director was £3,563,784 (2007: £3,292,207) of which £2,742,908 (2007: £2,496,331) was performance related. There was no accrued pension benefit for the highest paid Director (2007: nil), other than that accrued by, or treated to be accrued by a Spanish subsidiary of Banco Santander, S.A.. A conditional award of shares was made to the highest paid Director under the Long-Term Incentive Plan during the year.
Retirement Benefits (audited)
Defined benefit pension plans are provided to certain of Abbey's employees. See Note 36 to the Consolidated Financial Statements for a description of the plans and the related costs and obligations. Retirement benefits are accruing for one director under a defined benefit scheme (2007: one) in respect of their qualifying services to Abbey.
In July 2008, as part of the Group's periodic review of its pension schemes, updated funding arrangements were agreed with the pension scheme Trustees of four schemes.
Non-Executive Directors (audited)
Fees were paid to Non-Executive Directors in 2008 totalling £390,710 (2007: £310,000); this amount is included above in the table of Directors' remuneration and excludes emoluments received by Jane Barker and Roy Brown, which are shown aggregated in the Annual Report and Accounts of Alliance & Leicester plc.
Directors' Interests and Related Party Transactions
In 2008, loans were made to two members of Abbey's Key Management Personnel, with a principal amount of £647,199 outstanding at 31 December 2008. No Directors had any loans in 2008. See Notes 43 and 44 to the Consolidated Financial Statements included elsewhere in this Annual Report and Accounts for disclosures of deposits and investments made and insurance policies entered into by the Directors, Key Management Personnel and their connected persons with Abbey at 31 December 2008. Note 44 to the Consolidated Financial Statements also includes details of other related party transactions.
In 2008, there were no other transactions, arrangements or agreements with the Group in which Directors or Key Management Personnel or persons connected with them had a material interest. No Director had a material interest in any contract of significance other than a service contract with Abbey at any time during the year.
No Director held any interest in the shares of any company within the Group at any time during the year and no Director exercised or was granted any rights to subscribe for shares in any company within the Group. During 2008, one Director exercised share options over shares in Banco Santander, S.A., the parent company of the Company (2007: none).
Third Party Indemnities
Since 2005, the Company has issued enhanced indemnities to its Directors and to directors of its subsidiaries and certain other companies against liabilities and associated costs which they could incur in the course of their duties for Abbey and those other companies. All of the indemnities remain in force as at the date of this Annual Report and Accounts. A copy of each of the indemnities is kept at the address shown on page 146.
Financial Risk Management Objectives
The financial risk management objectives and policies of the Group; the policy for hedging each major type of forecasted transaction for which hedge accounting is used; and the exposure of the Group to price risk, credit risk, liquidity risk and cash-flow risk are outlined in the Risk Management Report on pages 36 to 56.
Pension Funds
The assets of the pension schemes are held separately from those of Abbey and are under the control of trustees.
Three of the Abbey pension schemes have a common corporate trustee which, at 31 December 2008, had eight directors, comprising five Abbey appointed directors and three member-elected directors. The National and Provincial Pension Fund has a different corporate trustee, the Board of which at 31 December 2008 comprised three Abbey appointed directors, and three member-elected directors. The above four pension schemes were, as at 31 December 2008, invested in a Common Investment Fund which has a corporate trustee, comprising four Abbey appointed directors and two scheme trustee appointed directors.
As at 31 December 2008 the Scottish Mutual Assurance plc Staff Pension Scheme had six trustees, of whom four are selected by Abbey (two of whom are members) and two are elected by eligible members. In the case of the Scottish Provident Institution Staff Pension Fund, as at 31 December 2008 there were eight trustees, of whom five (one of whom is a member) are selected by Abbey and the remaining three are elected by eligible members.
Asset management of the schemes is delegated to a number of fund managers and the trustees receive independent professional advice on the performance of the managers.
Legal advice to the trustees of the various schemes is provided by external firms of solicitors. The audits of the pension schemes are separate from that of Abbey. The audits of the Amalgamated, Associated Bodies, Group and the National and Provincial Pension schemes are undertaken by Grant Thornton UK LLP. The audits of the Scottish Mutual Assurance plc Staff Pension Scheme and the Scottish Provident Institution Staff Pension Fund are undertaken by KPMG LLP.
In July 2008, as part of the Group's periodic review of its pension schemes, updated funding arrangements were agreed with the pension scheme trustees of four schemes. Further information is provided in Note 36 to the Consolidated Financial Statements.
Market Value of Land and Buildings
On the basis of a periodic review process, the estimated aggregate market value of the Group's land and buildings was not significantly different from the fixed asset net book value of £93m, as disclosed in Note 23 to the Consolidated Financial Statements. It is considered that, except where specific provisions have been made, the land and buildings have a value in use to the Group that exceeds the estimated market value, and the net book value is not impaired.
Disability
Abbey is committed to equality of access and quality of service for disabled people and embraces the spirit of the UK Disability Discrimination Act 1995 and 2005 throughout its business operations. Abbey has processes in place to help recruit, train, develop, retain and promote employees with disabilities and is committed to giving full and fair consideration to applications for employment made by disabled persons, and for continuing the employment of, and arranging appropriate training for, existing employees who have become disabled.
Employee Involvement
Employee share ownership
In recognition of the Banco Santander, S.A. acquisition of the Company, all employees were given 100 free shares in Banco Santander, S.A. on 15 February 2005. These shares were granted using a UK HM Revenue & Customs approved Share Incentive Plan ('SIP'). The free shares will be held in trust on the employees' behalf for a minimum of three years.
In January 2006, Abbey introduced a Partnership Shares scheme, which also operates under the SIP umbrella. Employees are able to invest up to a maximum of £1,500 of pre-tax salary in Banco Santander, S.A. shares per tax year. These shares will be held in trust on the employees' behalf.
In recognition of the Banco Santander, S.A. 150th anniversary, all Abbey and Banco Santander, S.A. employees were given 100 free shares in Banco Santander, S.A. on 6 August 2007. These shares were granted under an existing SIP for Abbey employees and a new SIP was set up for UK-based Banco Santander, S.A. employees.
In response to employee feedback, and in support of the Human Resources strategy, Abbey introduced its first Sharesave Scheme under Banco Santander, S.A. ownership. The HM Revenue and Customs approved Sharesave Scheme was launched in September 2008. Employees were given the option of saving between £5 and £250 per month for a three or five-year savings period. The option price was set at a 20% discount on the average middle market quotation of Banco Santander, S.A. shares over the first three dealing days of September 2008.
Communication
Abbey wants to involve and inform employees on matters that affect them. Abbey publishes a magazine every quarter for employees, and almost all employees have access to the Company intranet. Abbey also uses face-to-face communication, such as team meetings, regional roadshows and an annual staff convention. All these channels are designed to keep employees fully informed of news and developments which may have an impact on them, and also to keep them up to date on financial, economic and other factors which affect Abbey's performance. Abbey considers employees' opinions and asks for their views on a range of issues through regular company-wide surveys.
Consultation
Abbey has over 30 years of trade union recognition through a partnership agreement with Advance, the independent trade union that it recognises to act as the voice of Abbey employees. Advance is affiliated to the Trade Union Congress and operates from its own offices in Hertfordshire. Advance is involved in major Abbey initiatives, and the Company consults it on significant proposals within the business. Consultation takes place at both national and local levels. Abbey holds regular Joint Consultative and Negotiating Committee meetings to enable collaborative working and ensure that communication is open and two-way.
On 29 September 2008, the Company acquired the retail deposits, branch network and related employees of Bradford & Bingley plc. Bradford & Bingley plc recognised the union UBAC (an independent trade union in accordance with the UK Trade Union and Labour Relations Act 1974) and UBAC's recognition arrangements automatically transferred to the Company. The Company has worked closely with both UBAC and Advance since the acquisition, and agreement has been reached on pension provision, changes to redundancy terms and the contractual working hours for transferred employees. UBAC is currently progressing a Transfer of Engagement to Advance. This is effectively a merger of UBAC and Advance, which is subject to the endorsement by ballot of UBAC's membership and certain other formalities required by the Certification Officer who oversees such mergers. The transfer is expected to complete by 30 June 2009.
Donations
The Abbey National Charitable Trust Limited (the 'Trust') supports disadvantaged people throughout the UK. In 2008, Abbey made total cash donations through the Trust of £2,528,747 (2007: £2,701,959) to a wide range of charities, which predominantly support projects addressing education, finance and regeneration issues.
Political Contributions
No contributions were made for political purposes and no political expenditure was incurred.
Suppliers
Abbey has cost management and procurement policies that explicitly promote competitive tendering and dealing with suppliers in a fair and open manner. Abbey does not operate a single payment policy in respect of all classes of suppliers. Payment terms vary depending on the supplier and the type of spend, and the supplier is made aware of these before engagement.
Policy and Practice on Payment of Creditors
It is Abbey's policy to ensure payments are made in accordance with the terms and conditions agreed, except where the supplier fails to comply with those terms and conditions. Abbey's practice on payment of creditors has been quantified under the terms of the UK Companies Act 1985 (Directors' Report) (Statement of Payment Practice) Regulations 1997. Based on the ratio of the aggregate amounts owed to trade creditors at the end of the year to the aggregate amounts invoiced by suppliers during the year at 31 December 2008, trade creditor days for Abbey were 27 days (2007: 29 days).
Code of Ethics
Abbey is committed to maintaining high ethical standards - adhering to laws and regulations, conducting business in a responsible way and treating all stakeholders with honesty and integrity. Abbey's policies in this regard are set out in 'How we do business'. This document, which was established in 1999, and reviewed and updated by the Board in 2003, was the subject of a review in 2008 to separate the component parts into two dedicated sets of policies for the Company's external and internal stakeholders. This has resulted in the creation of a dedicated Code of Conduct for employees, consistent with Banco Santander, S.A.'s General Code of Conduct. It is anticipated that the new policies will be launched during 2009, as part of the harmonisation of Human Resources policies across the Abbey businesses.
The principles of the policies have not changed: staff are required to act at all times with the highest standards of business conduct in order to protect Abbey's reputation and ensure a company culture which is free from any risk of corruption, compromise or conflicts of interest. The Core Principles outlined in the Code of Conduct state that employees must:
> Abide by all relevant laws and regulations.
> Act with integrity in all their business actions on Abbey's behalf.
> Not use their authority or office for personal gain.
> Conduct business relationships in a transparent manner.
> Reject all improper practices or dealings they may be exposed to.
> Be individually responsible for keeping to the Code of Conduct.
Abbey's ethical policies include ethical investment guidelines, which are an integral part of the risk management processes for investment decision making. Procedures are also in place for employees to follow if they feel that there has been a breach of our ethical policies. "How we do business" can be read in full on the Company's website at www.aboutabbey.com>about>Our policies>How We Do Business.
Abbey also complies with the applicable code of ethics regulations of the United States Securities and Exchange Commission arising from the US Sarbanes-Oxley Act of 2002. Amongst other things, the US Sarbanes-Oxley Act aims to protect investors by improving the accuracy and reliability of information that companies disclose. It requires companies to disclose whether they have a code of ethics that applies to the Chief Executive and senior financial officers that promotes honest and ethical conduct; full, fair, accurate, timely and understandable disclosures; compliance with applicable governmental laws, rules and regulations; prompt internal reporting of violations; and accountability for adherence to such a code of ethics. Abbey meets these requirements through the Code of Conduct, Abbey's whistleblowing policy, the UK Financial Services Authority's Principles for Businesses, and the UK Financial Services Authority's Principles and Code of Practice for Approved Persons (together, the 'Code of Ethics'), with which the Chief Executive and senior financial officers must comply. These include requirements to manage conflicts of interest appropriately and to disclose any information the Financial Services Authority may want to know about. Abbey provides a copy of its "How we do business" policy to anyone, free of charge, on application to the address on page 146.
Disclosure Controls and Procedures (US Sarbanes-Oxley Act 2002)
Abbey evaluated with the participation of Abbey's Chief Executive and Chief Financial Officer, the effectiveness of Abbey's disclosure controls and procedures as of 31 December 2008. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives. Based upon Abbey's evaluation, the Chief Executive and the Chief Financial Officer concluded that, as of 31 December 2008, Abbey's disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed by Abbey in the reports that Abbey files and submits under the US Securities Exchange Act of 1934 is recorded, processed, summarised and reported within the time periods specified in the applicable rules and forms, and that it is accumulated and communicated to Abbey's management, including Abbey's Chief Executive and Chief Financial Officer, as appropriate, to allow timely decisions regarding disclosure. There has been no change in Abbey's internal control over financial reporting during Abbey's 2008 fiscal year that has materially affected, or is reasonably likely to materially affect Abbey's internal controls over financial reporting.
Management's Report on Internal Control over Financial Reporting
Internal control over financial reporting is a component of an overall system of internal control. The Group's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting, the preparation and fair presentation of financial statements for external purposes in accordance with International Financial Reporting Standards ('IFRS') as issued by the International Accounting Standards Board, and as endorsed by the European Union. The Group's internal control over financial reporting includes:
> Policies and procedures that relate to the maintenance of records that fairly and accurately reflect the transactions and disposition of assets.
> Controls providing reasonable assurance that transactions are recorded as necessary to permit the preparation of financial statements in accordance with IFRS, and that receipts and expenditures are being made only as authorised by management.
> Controls providing reasonable assurance regarding prevention or timely detection of unauthorised acquisition, use or disposition of assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. In addition, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or because the degree of compliance with policies or procedures may deteriorate.
Management is responsible for establishing and maintaining adequate internal control over the financial reporting of the Group. Management assessed the effectiveness of the Group's internal control over financial reporting as of 31 December 2008 based on the criteria established in the Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, Management believes that, as of 31 December 2008, the Group's internal control over financial reporting is effective.
Management excluded from its assessment the internal controls over financial reporting of Bradford & Bingley plc's retail deposits, and branch network which were acquired in September 2008. At 31 December 2008, this business represented 1% and 10% of the Group's total assets and total liabilities, respectively.
This Annual Report and Accounts does not include an attestation report of the Company's registered public accounting firm regarding internal control over financial reporting. The Company's internal controls over financial reporting were not subject to attestation by the Company's registered public accounting firm pursuant to temporary rules of the US Securities and Exchange Commission that permit the Company to provide only management's report in this Annual Report and Accounts.
Relevant Audit Information
Each of the Directors as at the date of approval of this report confirms that:
> so far as the Director is aware, there is no relevant audit information of which Abbey's auditors are unaware; and
> the Director has taken all steps that he/she ought to have taken as a Director to make himself/herself aware of any relevant audit information and to establish that Abbey's auditors are aware of that information.
This confirmation is given and should be interpreted in accordance with the provisions of Section 234ZA of the UK Companies Act 1985.
Statement of Directors' Responsibilities
The Directors are responsible for preparing the Annual Report and Accounts including the financial statements in accordance with applicable law and regulations.
Company law requires the Directors to prepare financial statements for each financial year. The Directors are required by the International Accounting Standards ('IAS') Regulation to prepare the group financial statements under IFRS, as adopted by the European Union, and have also elected to prepare the parent company financial statements in accordance with IFRS, as adopted by the European Union. The financial statements are also required by law to be properly prepared in accordance with the UK Companies Act 1985 and Article 4 of the IAS Regulation. In addition, in order to meet certain US requirements, the Directors are required to prepare the Group financial statements in accordance with IFRS, as issued by the International Accounting Standards Board.
The Directors acknowledge their responsibility to ensure the financial statements give a true and fair view of the assets, liabilities, financial position and profit or loss presented and that the management report, which is incorporated into this report, includes a fair review of the development and performance of the business and the position presented in these financial statements, together with a description of the principal risks and uncertainties they face.
International Accounting Standard 1 requires that financial statements present fairly for each financial year the Company's financial position, financial performance and cash flows. This requires the faithful representation of the effects of transactions, other events and conditions in accordance with the definitions and recognition criteria for assets, liabilities, income and expenses set out in the International Accounting Standards Board's 'Framework for the preparation and presentation of financial statements'. In virtually all circumstances, a fair presentation will be achieved by compliance with all applicable IFRS. However, the Directors are also required to:
> properly select and apply accounting policies;
> present information, including accounting policies, in a manner that provides relevant, reliable, comparable and understandable information;
> provide additional disclosures when compliance with the specific requirements in IFRS are insufficient to enable users to understand the impact of particular transactions, other events and conditions on the entity's financial position and financial performance; and
> make an assessment of the company's ability to continue as a going concern.
The Directors are responsible for keeping proper accounting records that disclose with reasonable accuracy at any time the financial position of the Company and enable them to ensure that the financial statements comply with the UK Companies Act 1985. They are also responsible for safeguarding the assets of the Company and hence for taking reasonable steps for the prevention and detection of fraud and other irregularities.
The Directors are responsible for the maintenance and integrity of the corporate and financial information included on the Company's website. Legislation in the United Kingdom governing the preparation and dissemination of financial statements may differ from legislation in other jurisdictions.
Auditors
Deloitte LLP have expressed their willingness to continue in office as auditors and a resolution to reappoint them will be proposed at the Company's forthcoming Annual General Meeting.
By order of the Board
Karen M. Fortunato
Company Secretary and Head of Legal
19 March 2009
Abbey National House, 2 Triton Square, Regent's Place, London NW1 3AN
Report of the Directors
Supervision and Regulation
As a firm authorised by the UK Financial Services Authority, the Company is subject to UK financial services laws and regulations, which are discussed below. Recent significant regulatory developments which will affect Abbey are also highlighted below.
UK
In the UK, the Financial Services Authority is the single independent regulator for the regulation of deposit taking, investment business, mortgages and insurance. The UK Financial Services Authority was set up by the government and exercises statutory powers under the UK Financial Services and Markets Act 2000 ('FSMA'). The Company, together with several of its subsidiaries, is authorised by the UK Financial Services Authority to carry on a range of regulated activities in the UK, which include mortgages, banking, insurance and investment business. The UK Financial Services Authority must adhere to four regulatory objectives, as prescribed in FSMA, which set out the parameters of regulation: market confidence; public awareness; the protection of consumers; and the reduction of financial crime. Based on these regulatory objectives, the UK Financial Services Authority has formulated an extensive handbook of rules and guidance to which authorised firms are subject.
Banks, insurance companies and other financial institutions in the UK are subject to the UK Financial Services Compensation Scheme (the 'FSCS'). The FSCS covers claims made against authorised firms (or any participating EEA firms) where they are unable, or likely to be unable, to pay claims against them. In relation to deposits, the FSCS provides cover for 100% of the first £50,000 of a claim, with £50,000 being the maximum amount payable per customer. In relation to investments, 100% of the first £30,000 can be claimed plus 90% of the next £20,000, with £48,000 being the maximum amount payable per customer. In relation to mortgage advice and arranging, the FSCS will pay 100% of the first £30,000 and 90% of the next £20,000, with £48,000 being the maximum amount payable per customer. The FSCS also extends (up to various amounts) to certain long term and general insurance contracts, including general insurance advice and arranging.
European Union
Abbey is directly affected by laws emanating from the European Union, primarily through directives that must be implemented by the UK as a Member State of the European Union.
Basel II
The new Basel II Accord replaces the 1988 Basel Capital Accord. The supervisory objective of the Basel II Accord is to promote safety and soundness in the financial system and require banks to maintain appropriate levels of capital to cover the risks inherent in their business model. Basel II is a supervisory framework for the risk and capital management of banks and is structured around three pillars. Pillar 1 specifies minimum capital requirements for banks and new methodologies for calculating risk weighted assets. Pillar 2 describes the supervisory review process and outlines the internal capital adequacy assessment process ('ICAAP') required by banks applying Pillar 1 methodologies. Pillar 3 requires disclosure of risk and capital information. Abbey's capital and risk management disclosures are set out in Note 47 to the Consolidated Financial Statements on page 134.
In the European Union, Basel II was implemented by the Capital Requirements Directive ('CRD') with effect from 1 January 2007. In the UK, the Financial Services Authority implemented the CRD by including it in UK Financial Services Authority rules. These new UK Financial Services Authority rules took effect from 1 January 2007. Transitional provisions meant that banks could continue to apply the Basel I calculations of risk weighted assets until 1 January 2008. From 1 January 2007 Abbey applied the Basel II regime to its capital resources and relied on the transitional provisions. From 1 January 2008, Abbey applied Basel II to its capital requirement calculations, its ICAAP and to the risk and capital disclosures made to the market. In addition, the UK Financial Services Authority approved Abbey's application of the Retail Internal Ratings Based ('Retail IRB') and Advanced Internal Ratings Based ('AIRB') approaches to most of Abbey's credit portfolios with effect from 1 January 2008.
Other Changes to Capital Adequacy and Liquidity Arrangements
On 8 October 2008, the UK Government announced a UK banking support scheme that addressed both capital and liquidity requirements of the UK banking industry. To fulfil its agreed commitment to this scheme, Banco Santander, S.A. subscribed for £1bn of Abbey National plc's Core Tier 1 capital issued on 12 October 2008. This capital was, in turn, transferred to Alliance & Leicester plc in December 2008 as planned. As part of the UK Government's banking support scheme, Abbey has participated in the UK Special Liquidity Scheme.
Other Regulatory Developments
There are a number of other regulatory developments going through a consultation and implementation process which may have some effect on Abbey's business. These include the FSCS arrangements, consumer credit regulations, financial stability, and conduct of business arrangements such as those resulting from the Payment Services Directive, Retail Distribution review, the UK Financial Services Authority reviews of deposit-taking regulation and Treating Customers Fairly.
Following recent turmoil in money markets and credit markets, regulatory capital and liquidity supervisory arrangements and requirements are being reviewed by financial services supervisors and policy makers at a number of international and national forums. These reviews are expected to result in changes to the regulation of capital adequacy, the measurement of regulatory capital requirements and liquidity risk management and reporting. These changes may have some direct or indirect effect on Abbey's business.
Financial Statements
Report of Independent Registered Public Accounting Firm
We have audited the group and parent company financial statements (the ''financial statements'') of Abbey National plc for the year ended 31 December 2008 which comprise the Consolidated Income Statement, the Consolidated and Company Balance Sheets, the Consolidated and Company Statements of Recognised Income and Expense, the Consolidated and Company Cash Flow Statements, the Accounting Policies and the related notes 1 to 48. These financial statements have been prepared under the accounting policies set out therein.
This report is made solely to the company's members, as a body, in accordance with section 235 of the Companies Act 1985. Our audit work has been undertaken so that we might state to the company's members those matters we are required to state to them in an auditors' report and for no other purpose. To the fullest extent permitted by law, we do not accept or assume responsibility to anyone other than the company and the company's members as a body, for our audit work, for this report, or for the opinions we have formed.
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 (IFRSs) 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 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. The information given in the Directors' Report includes specific information presented in the Business and Financial Review that is cross referred from the Principal Activities and Business Review section of the Directors' Report.
In addition we report to you if, in our opinion, the company has not kept proper accounting records, if 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 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 further information outside the Annual Report.
Basis of audit opinion
We conducted our audit in accordance with International Standards on Auditing (UK and Ireland) issued by the Auditing Practices Board. 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 judgments made by the directors in the preparation of the financial statements, and of whether the accounting policies are appropriate to the group's and company's circumstances, 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.
Opinion
In our opinion:
the group financial statements give a true and fair view, in accordance with IFRSs as adopted by the European Union, of the state of the group's affairs as at 31 December 2008 and of its profit for the year then ended;
the parent company financial statements give a true and fair view, in accordance with IFRSs as adopted by the European Union as applied in accordance with the provisions of the Companies Act 1985, of the state of the parent company's affairs 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 IFRSs
As explained in the Accounting Policies section of the group financial statements, the group in addition to complying with its legal obligation to comply with IFRSs as adopted by the European Union, has also complied with the IFRSs as issued by the International Accounting Standards Board.
In our opinion, the group financial statements give a true and fair view, in accordance with IFRSs, of the state of the group's affairs as at 31 December 2008 and of its profit for the year then ended.
Deloitte LLPChartered Accountants and Registered Auditors
London, United Kingdom 19 March 2009