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Santander UK plc

Risk Management Report

This Risk Management Report contains information that has been reviewed by Deloitte LLP and forms an integral part of the Condensed Consolidated Interim Financial Statements, except as marked on pages 78 and 83 and the Operational Risk and Other Risks sections on pages 115 to 122.

SUMMARY

This Risk Management Report describes the Risk Governance Framework of Santander UK plc (the 'Company', and together with its subsidiaries, 'Santander UK' or 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:

EXECUTIVE SUMMARY

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. Specifically, risk equates to the adverse impacts on profitability arising from different sources of uncertainty. The key risks Santander UK is exposed to are credit (including residual credit and concentration), market (including trading and non-traded), funding and liquidity, operational and other risks (including business/strategic, reputational, pension obligation and residual value). 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 oversight 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 Group's risk management framework aims to ensure that risk is managed and controlled on behalf of shareholders, customers, depositors, employees and the Group's regulators. Effective and efficient risk governance together with oversight provide management 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.

PRINCIPLES OF RISK MANAGEMENT

Risk management at Santander UK is based on the following principles:

Phases of risk management

The risk management and control process at Santander UK is structured into the following phases:

Key techniques and tools

For many years, Santander UK has managed risk using a number of techniques and tools which are described in detail in this Risk Management Report. The key techniques and tools used are as follows:

 RISK GOVERNANCE FRAMEWORK

The Group's risk governance framework is structured to ensure that there is segregation of duties between those who have responsibilities for:

The framework is based on the following five principles:

Enhanced Risk Management Framework

Following a review of Santander UK's risk governance in 2011 an enhanced Risk Management Framework ("Framework") was approved by the Santander UK Board (the "Board") in November 2011 and, following further refinement, was formally adopted in April 2012. The Framework, which takes into account the increasing size and capacity of the Group and recent changes to regulation and best practice, will further strengthen the Group's risk management controls. The new Framework:

The Group is now in a period of transition to the new Framework and a number of changes have been made to the risk committee governance structure. The focus is now on continuing to implement and embed the new Framework across the Group during the remainder of 2012 and ensuring that all employees are aware of their role in risk management and control.

Risk Governance

The overall risk appetite and Framework are approved by the Board, which also approves the strategy for managing risk and is responsible for the Group's system of internal control. Responsibility for identifying, monitoring and managing risk and ensuring adherence to the risk appetite is delegated by the Board to the Chief Executive Officer and from her to specific individuals. Formal committees are maintained to assist the responsible individual in their effective management or oversight.

The Chief Risk Officer has overall accountability for risk management under authority delegated by the Chief Executive Officer. He provides oversight and challenge to the business and central functions to ensure that they are compliant with the risk policies and limits set by the Board and he provides assurance that all material risks are correctly identified, measured and controlled. The Chief Risk Officer also proposes the Framework for adoption by the Board (through the Board Risk Committee) and advises on any matters relating to risk management.

The principal responsibilities of the committees and functions that comprise the Group's risk governance structure are as follows:

Board Risk Committee

The Board Risk Committee comprises independent Non-Executive Directors and is a formally constituted committee of the Board. Its responsibilities include oversight and advice to the Board on the overall risk appetite, tolerance and risk strategy of the Group; monitoring the effectiveness of the Group's risk management and risk controls; oversight and advice to the Board on current risk exposures and future risk strategy, including the strategy for capital and liquidity management; advising the Remuneration Oversight Committee on the risk weightings applied in executive remuneration; and the oversight and challenge of the design and execution of stress and scenario testing.

Board Audit Committee

The Board Audit Committee comprises independent Non-Executive Directors and is a committee formally constituted by the Board. It provides advice to the Board Risk Committee on matters within its remit which impact on the Group's risk management including the effectiveness of the Internal Audit function in the context of the overall risk management system.

Internal Audit Function

The Internal Audit function supports the Board Risk Committee by providing independent and objective opinions on the effectiveness and integrity of the Group's risk management arrangements. It does this via a systematic programme of risk-based audits of the controls established and operated by operational management and support functions and also those exercised by the risk oversight function.

The audit opinions and underlying rationale of findings and recommendations form the basis upon which the Board Risk Committee can take reasonable (but not absolute) assurance that the risk management arrangements are fit for purpose and are working properly.

The Board Risk Committee also receives reports from management, the Board Audit Committee, the risk function and other business functions to help them to discharge their risk oversight responsibilities.

Executive Risk Committee

The Executive Risk Committee is the most senior risk committee within the Group at the executive level. It monitors the control and management of all key risks in the Group ensuring they are managed within the Board approved Framework, appetite and associated policies. It also ensures that the Board risk management policy decisions are appropriately implemented and that effective procedures are in place to monitor risk exposures and deal effectively with any breach of limits. The Executive Risk Committee is also responsible for approving material wholesale, corporate and commercial banking credit and market risk transactions above the level delegated to the Credit Approvals Committee (see below). Responsibility has been delegated for certain aspects of risk within defined thresholds to four new sub-committees: the Risk Management Committee; the Internal Control Committee; the Capital Committee; and the Credit Approvals Committee.

(i) Risk Management Committee

The Risk Management Committee ensures the effective management and control of all material financial risks within the Group. Its responsibilities include reviewing and monitoring financial risk management information and ensuring that adequate and effective risk control processes and reporting systems are in place so that all material financial risks are correctly identified and addressed. It also ensures that there is clear allocation and accountability for risk management and mitigation. The Risk Management Committee reports on its activities to the Executive Risk Committee and will escalate significant matters, as appropriate.

(ii) Internal Control Committee

The Internal Control Committee ensures effective management and control of material non-financial risks within the Group. These include, but are not limited to, Operational Risk (which can include financial crime risk, cyber security risk, human resources risk, customer and conduct risk, and regulatory, legal and compliance risk); Business/Strategic Risk; and Reputational Risk. The Internal Control Committee reviews and monitors non-financial risk management information and ensures that adequate and effective control processes and reporting systems are in place so that all material non-financial risks are correctly identified and addressed and there is clear allocation and accountability for risk management and mitigation. The Internal Control Committee reports on its activities to the Executive Risk Committee and will escalate significant matters, as appropriate.

(iii) Capital Committee

The Capital Committee ensures the effective management and control of capital within Board approved parameters. Its responsibilities include monitoring capital risk and ensuring that adequate and effective risk control processes are in place to manage and address capital risks. It also proposes and reviews actions and plans to optimise capital consumption and considers the effectiveness of capital measurement processes. In addition, the Capital Committee oversees the implementation of the Basel II and Basel III programmes. Any key issues will be escalated to the Executive Risk Committee, as appropriate.

(iv) Credit Approvals Committee ('CAC')

CAC is responsible for reviewing and approving wholesale, corporate and commercial banking transactions within certain defined limits over and above individual authority limits. Transactions which exceed the threshold limits set are referred for final approval to Banco Santander, S.A.'s Risk Division and the Executive Risk Committee, following agreement by CAC.

Risk Oversight Committee

The Risk Oversight Committee assists the Chief Risk Officer in the effective oversight of the control and management of all key financial and non-financial risks within the Group. Its remit includes the review and challenge of the risk appetite statements and associated business plan, the risk profile and stress testing results, in addition to providing assurance that the Group is operating within the defined risk management framework limits approved by the Board.

ECONOMIC CAPITAL

Economic capital is an internal measure of the minimum equity and preference capital required for the Group to maintain its credit rating based upon its risk profile. The concept of economic capital differs from that of regulatory capital, the latter being the capital required by capital adequacy regulations. Economic capital is calculated using the Banco Santander, S.A. economic capital model.

The economic capital model enables the Group to quantify the consolidated risk profile taking into account the significant risks of the business, as well as the diversification effect inherent in a multi-business group such as Santander UK. The Group uses this model to prepare the economic capital forecasts as part of its internal capital adequacy assessment report in accordance with the UK Financial Services Authority regulations within the framework of Pillar 2 of Basel II. Santander UK monitors the economic capital utilisation and its sufficiency on a monthly basis at the Executive Risk Committee.

The concept of diversification is fundamental to the proper measurement of the risk profile of a multi-business group. Diversification can be explained in terms of the imperfect correlation between the various risks, which means that the largest loss events do not occur simultaneously in all portfolios or for all types of risk. Consequently, the sum of the economic capital of the various portfolios and types of risk, taken separately, is higher than the Group's total economic capital. In other words, the risk borne by Santander UK as a whole is less than the risk arising from the sum of its various components considered separately.

The economic capital model also considers the concentration risk for corporate and markets portfolios, in terms of both the size of their exposure and their sector or geographic concentration. Product concentration in retail portfolios is captured through the application of an appropriate correlation model.

RISK APPETITE

The risk appetite is principally set by defining the economic capital limits by risk types. The Board agrees on high level limits for each principal risk type. The authority for managing and monitoring the risk appetite then flows to the Chief Executive Officer and from her to specific individuals. The Chief Risk Officer is responsible for setting other limits to support the monitoring of Board-approved limits, which is in turn supported by the Risk Division and the Risk Oversight function.

The risk appetite statement is recommended by the Chief Executive Officer and approved by the Board, under advice from the Board Risk Committee. The risk appetite statement is reviewed by the Board at least annually or more frequently if necessary (e.g. in the case of significant methodological change). This ensures that the risk appetite continues to be consistent with Santander UK's current and planned business activities. The Chief Executive Officer under advice from the Executive Risk Committee approves the detailed allocation of risk appetite to different businesses or portfolios. The Chief Risk Officer, supported by the Risk Division, is responsible for the ongoing maintenance of the risk appetite statement.

RECOVERY AND RESOLUTION PLAN ('RRP')

The FSA's draft rules and guidance on RRPs are part of an international initiative to make the financial system safer. The Company was one of the banks involved in the pilot phase of RRP planning. It has had a number of discussions in relation to its draft RRP with both the FSA and the Bank of England but no part has been formally approved. Santander UK plc filed the current version of its RRP with the FSA by the 30 June 2012 deadline which applied to the pilot banks.

The Board is ultimately responsible for reviewing and approving the recovery section of the RRP and for approving the processes for the preparation of resolution information. The Executive Committee is responsible for the review and challenge of the recovery section of the RRP and for recommending it to the Board, and is also responsible for ensuring that the resolution information is complete and accurate.

RETURN ON RISK-ADJUSTED CAPITAL AND VALUE CREATION

Santander UK uses the RORAC methodology in its credit risk management, with the following activities and objectives:

The RORAC methodology facilitates the comparison, on a consistent basis, of the performance of transactions, customers, portfolios and businesses. It also identifies those which achieve a risk-adjusted return higher than the Group's cost of capital, thus aligning risk management and business management with the aim of maximising value creation.

PRINCIPAL RISKS AND RISK MANAGEMENT

The principal 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. Within Santander UK, these risks are divided into two populations:

All risks are classified as population 1 risks except for Funding and Liquidity risk and Reputational risk which are classified as population 2 risks.

PRINCIPAL RISKS

The principal risks are:

CREDIT RISK

Definition

Credit risk is the risk of financial loss arising from the default of a customer or counterparty to which the Group has directly provided credit, or for which the Group has assumed a financial obligation, after realising collateral held. Credit risk includes residual credit risk, which arises when credit risk measurement and mitigation techniques prove less effective than expected. In addition, concentration risk which is part of credit risk, includes large (connected) individual exposures, and significant exposures to groups of counterparties whose likelihood of default is driven by common underlying factors, e.g. sector, economy, geographical location or instrument type.

Treatment of credit risk

The specialisation of Santander UK's Risk Division is based on the type of customer and, accordingly, a distinction is made between non-standardised customers and standardised customers in the risk management process:

TOTAL CREDIT RISK EXPOSURES

The Group's exposures to credit risk arise in the following businesses:

Maximum exposure to credit risk

The following table presents the Group's estimated maximum exposure to credit risk at 30 June 2012 and 31 December 2011 without taking account of any collateral held or other credit enhancements:

(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 27 of the Condensed Consolidated Interim Financial Statements.

MEASURES AND MEASUREMENT TOOLS

Rating tools

The Group uses proprietary internal rating models to measure the credit quality of a given customer or transaction. Each rating relates to a certain probability of default or non-payment, determined on the basis of the Company's historical experience, with the exception of certain portfolios classified as "low default portfolios", where the probability is assigned using external sources, as described below.

Banco Santander, S.A. global rating tools are applied to the sovereign, financial institution and large corporates segments. Management of the rating tools for these segments is centralised at Banco Santander, S.A. group level, with rating calculation and risk monitoring devolved to the Group under Banco Santander, S.A. group supervision. These tools assign a rating to each customer, which is obtained from a quantitative or automatic module, based on balance sheet ratios or macroeconomic variables, supplemented by the analyst's expert judgement. The ratings are reviewed at least annually or more frequently in the case of watchlist counterparties.

For non-standardised corporates and financial institutions, Banco Santander, S.A. has defined a single methodology for the construction of a rating in each country, based on an automatic module which includes an initial participation of the analyst that can be supplemented subsequently if required. The automatic module determines the rating in two phases, a quantitative phase and a qualitative phase. The latter is based on a corrective questionnaire which enables the analyst to modify the automatic score up or down in a controlled manner. The quantitative rating is determined by analysing the credit performance of a sample of customers and the correlation with their financial statements. Ratings assigned to customers are reviewed at least annually to include any new financial information available and the Group's experience in its banking relationship with the customer. The frequency of the reviews is increased when customers reach certain levels in the automatic warning systems or are classified as requiring special monitoring. The rating tools are also reviewed in order to progressively fine-tune the ratings they provide.

For standardised customers, both legal entities and individuals, the Group has scoring tools that automatically assign a score to the proposed transactions. The ratings are reviewed and updated periodically, depending on performance.

Credit risk parameters

The assessment of customers or transactions using rating or scoring systems constitutes a judgement of their credit quality, which is quantified through the probability of default ('PD'), in accordance with Basel II terminology. In addition to PD, the quantification of credit risk requires the estimation of other parameters, such as exposure at default ('EAD') and the percentage of EAD that will not be recovered (loss given default or 'LGD'). In estimating the risk involved in transactions, other factors such as any off-balance sheet exposure and collateral valuations are also taken into account.

The combination of these risk parameters (i.e. PD, LGD and EAD) enables calculation of the probable loss or expected loss ('EL'). The risk parameters also make it possible to calculate the Basel II regulatory capital.

For portfolios with limited internal default experience (e.g. banks) parameter estimates are based on alternative sources, such as market prices or studies conducted by external agencies gathering the shared experience of a sufficient number of entities. These portfolios are known as "low default portfolios".

For other portfolios, parameter estimates are based on internal risk models. The PD is calculated by observing the cases of new defaults in relation to the final rating assigned to customers or to the scoring assigned to the related transactions. The LGD is calculated by observing the recoveries of defaulted loans, taking into account not only the income and expenses associated with the recovery process, but also the timing thereof and the indirect costs arising from the recovery process. EAD is calculated by comparing the use of committed facilities at the time of default and their use under normal (i.e. performing) circumstances, so as to estimate the eventual extent of use of the facilities in the event of default.

The parameters estimated for global portfolios (e.g. banks) are the same throughout the Banco Santander, S.A. group. Therefore, a financial institution will have the same PD for a specific rating, regardless of the Banco Santander, S.A. group entity in which the exposure is booked. By contrast, local portfolios (e.g. residential mortgages) have specific score and rating systems. PDs are assessed specifically for each local portfolio.

Master scale of global ratings

The following tables are used to calculate regulatory capital. They assign a PD on the basis of the internal rating, with a minimum value of 0.03%. These PDs are applied uniformly throughout the Santander group in accordance with the global management of these portfolios. As can be seen, the PD assigned to the internal rating is not exactly equal for the same rating in each portfolio, although it is very similar in the tranches where most of the exposure is concentrated (i.e. in tranches with a rating of more than six).

Probability of default

Credit risk cycle

The risk management process consists of identifying, measuring, analysing, controlling, negotiating and deciding on, as appropriate, the risks incurred in the Group's operations. The parties involved in this process are the risk-taking areas, senior management and the risk units.

The process begins at senior management level, through the Board of Directors, the Executive Committee and the Executive Risk Committee, which establishes the risk policies and procedures, and the limits and delegations of authorities, and approves and supervises the scope of action of the risk function.

The risk cycle comprises three different phases:

Risk limit planning and setting

Risk limit planning and setting is the first of the pre-sale risk management procedures and is a dynamic process that identifies the Group's risk appetite through the discussion of business proposals and the attitude to risk. This process is defined in the global risk limit plan, a comprehensive document for the integrated management of the balance sheet and its inherent risks, which establishes risk appetite on the basis of the various factors involved. The risk limits are founded on two basic structures: customers/segments and products.

For non-standardised risks, a top-level risk limit is approved if the quantum of risk required to support the customer is material when compared to its overall financing needs. This limit covers a variety of products (such as lending, trade finance or derivatives) enabling the Group to define a total risk appetite with that customer based on its current and expected financial needs. For global corporate groups, a pre-classification model based on an economic capital measurement and monitoring system is used. For the large corporate customers, a simplified pre-classification model is applied for customers meeting certain requirements.

For standardised risks, the risk limits are planned and set using the credit management programme, a document agreed upon by the business areas and the Risk Division and approved by the Executive Risk Committee, which contains the expected results of transactions in terms of risk and return, as well as the limits applicable to the activity and the related risk management.

Risk analysis and credit rating process

Risk analysis is another key pre-sale procedure and is a pre-requisite for the approval of credit to customers by the Group. This analysis consists of examining the customer's ability to meet its contractual obligations to the Group, which involves analysing the customer's credit quality, its risk transactions, its solvency and the return to be obtained in view of the risk assumed.

The risk analysis is conducted when a new customer or transaction arises or with a pre-established frequency, depending on the segment involved. Additionally, the credit rating is examined and reviewed whenever a warning is triggered or an event affecting the credit risk of the customer or transaction occurs.

Transaction decision-making

The purpose of the transaction decision-making process is to analyse transactions and then make a decision about whether or not to approve the transaction, taking into account the risk appetite and any transaction elements that are important in achieving a balance between risk and return. The Group uses, among others, the RORAC methodology for risk analysis and pricing in the decision-making process on transactions and deals.

Risk monitoring and control

In order to ensure adequate credit quality control in addition to the tasks performed by the Internal Audit function, the Risk Division has a specific risk monitoring function that covers all non-standardised portfolios and to which specific resources and persons in charge have been assigned.

This monitoring function is based on an ongoing process of observation to enable early detection of any incidents that might arise in the evolution of the risk, the transactions, the customers and their environment, with a view to adopting mitigating actions. The risk monitoring function is specialised by customer segment.

For this purpose a system called "companies under special watch" (FEVE, using the Spanish acronym) has been designed that distinguishes four categories, three of which are considered as 'proactive' (extinguish, secure and reduce) and one of which is considered 'enhanced monitoring' (monitor). The inclusion of a customer in the FEVE system does not mean that there has been a default, but rather that it is deemed advisable to adopt a specific policy for this customer, to place a person in charge of the execution of this strategy and to set the implementation period. Customers classified as FEVE are reviewed monthly and the assigned rating is reviewed at least every six months, or every three months for those classified in the proactive categories. A customer can be classified as FEVE as a result of the monitoring process itself, a review performed by the Internal Audit function, a decision made by the sales manager responsible for that customer or the triggering of the automatic warning system.

For exposures to standardised customers, the key indicators are monitored in order to detect any variance in the performance of the loan portfolio compared to the forecasts contained in the credit management programmes.

Analysis of the mortgage portfolio

With regard to standardised exposures, the mortgage loan portfolio is particularly noteworthy because of its significance with respect to the Group's total loans and receivables. Disclosures relating to the mortgage portfolio are set out in the section entitled Credit Risk - Retail Banking.

Risk control function

Supplementing the management process, the risk control function obtains a global view of the Group's loan portfolio, through the various phases of the risk cycle, with a sufficient level of detail to permit the assessment of the current risk position and any changes therein. Changes in the Group's risk position are controlled on an ongoing and systematic basis against budgets, limits and benchmarks, and the impacts of these changes in future situations, both of an external nature and those arising from strategic decisions, are assessed in order to establish measures that place the profile and amount of the loan portfolio within the parameters set by the Group.

The risk control function assesses risks from various complementary perspectives, including geographical location, business area, management model and product and process, thus facilitating the detection of specific areas requiring management actions to control the risk profile of the group.

Within the corporate framework established in the wider Banco Santander, S.A. group for compliance with the US Sarbanes-Oxley Act of 2002, a corporate tool is used for the documentation and certification of all the sub-processes, operational risks and related mitigating controls. The Risk Division assesses annually the efficiency of the internal control of its activities.

Scenario analysis

As part of the ongoing risk management and oversight process, the Group performs simulations of the portfolio performance in different adverse and stress scenarios ('stress testing') which enable it to assess the Group's capital adequacy in certain future situations. These simulations cover the Group's main portfolios and are conducted systematically using a corporate methodology which:

The simulation models used by the Group use data of a full business cycle to calibrate the performance of risk factors, given certain movements in macroeconomic variables. In the corporate banking area, since low-default portfolios are involved, there is insufficient historical default data available to perform the calibration and, therefore, expert judgement is used.

The main macroeconomic variables contained in the Group's scenarios are as follows:

The scenario analysis enables management to better understand the expected performance of the portfolio given certain changing market conditions and situations. The analyses performed, both in benchmark and in stressed scenarios, with a time horizon of five years, show the strength of the balance sheet against the macroeconomic situations simulated.

Recovery management

Recovery management is defined as a strategic, integrated business activity. Banco Santander, S.A. has a global model which is applied and implemented locally by the Group, considering the specific features of the business in each area of activity.

The objectives of the recovery process are as follows:

CREDIT RISK: CONCENTRATION AND MITIGATION

Certain areas and/or specific views of credit risk deserve specialist attention, complementary to global risk management.

Significant concentrations of credit risk

The management of risk concentration is a key part of risk management. The Group tracks the degree of concentration of its credit risk portfolios using various criteria, including geographic areas and countries, economic sectors, products and groups of customers.

During 2012, the Group's most significant exposures to credit risk derived from:

In Retail Banking, the business consists of a relatively large number of homogenous loans where a problem with one customer will have a relatively small impact. In Corporate Banking, the business consists of a relatively small number of high value balances where a problem with one customer may cause a relatively large impact.

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 £163.2bn at 30 June 2012 (31 December 2011: £166.2bn). The Unsecured Personal Loan portfolio comprises unsecured loans to private individuals in the UK. Total exposure stood at £2.6bn at 30 June 2012 (31 December 2011: £2.9bn).

In Corporate Banking the Mid-corporate and SME portfolios are largely unsecured, and the real estate portfolio comprise loans and associated derivatives secured on UK property. The total committed facilities exposure to these portfolios was £34.5bn at 30 June 2012 (31 December 2011: £37.2bn).

The derivatives exposures in Markets are mitigated by collateralisation as described in the section on Markets - Derivatives.

The holdings in the Treasury Asset Portfolio benefit from senior positions in the creditor cascade or are covered by derivatives with well rated market counterparties with additional protection given by daily collateralisation under market standard documentation.

Although the operations of Corporate Banking, Markets and Corporate Centre are based mainly in the UK, they have built up exposures to various entities around the world and are therefore exposed to concentrations of risk related to geographic area. These exposures are classified by the country of domicile of the counterparty and are further analysed below:

(1) Derivative counterparty exposures are managed and reported on a group basis

Geographical exposures are governed by country limits set by Banco Santander, S.A. centrally and determined according to the classification of the country (whether it is a developed Organisation for Economic Co-operation and Development ('OECD') country or not), the rating of the country, its gross domestic product and the type of business activities and products the Banco Santander, S.A. group wishes to engage in within that country. The Group is constrained in its country risk exposure, within the Banco Santander, S.A. group limits, and by its capital base.

Credit risk mitigation

In managing its 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 mortgaged property, debentures over a company's assets and through market-standard collateral agreements (cash or highly liquid securities).

LOANS AND ADVANCES

The following tables categorise the Group's loans and advances into three categories as: neither past due nor impaired, past due but not individually impaired, or individually impaired. For certain homogeneous portfolios of loans and advances, impairment is assessed on a collective basis and each loan is not individually assessed for impairment. Loans in this category are classified as neither past due nor impaired, or past due but not individually impaired, depending upon their arrears status. The impairment loss allowances include allowances against financial assets that have been individually assessed for impairment and those that are subject to collective assessment for impairment.

Credit quality of loans and advances that are neither past due nor individually impaired

The credit quality of loans and advances that are neither past due nor individually impaired is as follows:

Internal measures of credit quality have been used in the table analysing credit quality, above. Different measures are applied to retail and corporate lending, as follows:

(1) Unsecured consists of other unsecured advances to individuals.

(2) Secured consists of advances to individuals secured on residential property.

(3) Or a loan-to-value ('LTV') ratio of less than 75%.

Summarised descriptions of credit quality used in the financial statements relating to retail and corporate lending are as follows:

Maturity analysis of loans and advances that are past due but not individually impaired

A maturity analysis of loans and advances that are past due but not individually impaired is set out below.

In the retail loan portfolio, a loan or advance is considered past due when any contractual payments have been missed and for secured loans, when they are more than 30 days in arrears. The amounts disclosed in the table are the total financial asset of the account, not just the past due payments. All retail accounts are classified as non-impaired as impairment loss allowances are raised collectively with the exception of properties in possession, where an impairment loss allowance is raised on a case by case basis and hence are not included in the table below.

In the corporate loan portfolio, a loan or advance is considered past due when it is 90 days or more in arrears, and also when the Group has reason to believe that full repayment of the loan is in doubt.

Renegotiated loans and advances to customers

The following tables provides a breakdown of the population of loans and advances to customers which have been subject to renegotiation or forbearance programmes and are included in the previous tables. For further detail regarding these programmes refer to pages 80 and 92.

Impairment loss allowances on loans and advances to customers

The Group's impairment loss allowances policy is set out in Note 1 of the Group's 2011 Annual Report.

Period/Year-end impairment loss allowances on loans and advances to customers

An analysis of the Group's impairment loss allowances on loans and advances to customers is presented below. The geographical analysis presented in the tables below is based on the location of the office from which the loans and advances to customers are made, rather than the domicile of the borrower. Further geographical analysis, showing the country of domicile of the borrower rather than the office of lending is contained within the "Country Risk Exposure" tables on pages 28 to 29.

Movements in impairment loss allowances on loans and advances to customers

An analysis of movements in the Group's impairment loss allowances on loans and advances is presented below.

Recoveries

An analysis of the Group's recoveries is presented below.

Group non-performing loans and advances(1,3)

An analysis of the Group's non-performing loans and advances is presented below.

(1) Loans and advances are classified as non-performing typically when the counterparty fails to make payments when contractually due for three months or in the case of individually significant corporate loans where it is assessed as being unlikely to pay.

(2) All non-performing loans continue accruing interest.

(3) Accrued interest is excluded for purposes of these analyses.

(4) Loans and advances to customers include social housing loans and finance leases, and exclude trading assets.

(5) Impairment loan loss allowances as a percentage of non-performing loans and advances.

In the six months ended 30 June 2012, the value of non-performing loans increased to £4,135m (31 December 2011: £3,976m) and non-performing loans as a percentage of loans and advances to customers increased to 2.04% (31 December 2011: 1.93%). Non-performing loans increased as a result of changes to the residential mortgage collections policy which has resulted in more cases remaining in NPLs for longer and further stress in the legacy portfolios including shipping, structured finance and real estate, as well as other legacy commercial real estate exposures written pre 2009.

The overall coverage ratio has remained flat at 39% as reserves have been increased in line with the increase in non-performing loans. Equally, mortgage coverage remained stable at 20%.

Further analyses on the Group non-performing loans and advances are set out in the Retail Banking, Corporate Banking and Corporate Centre credit risk discussions below.

Group loan collections, including forbearance

The Collections and Recoveries Department ('Collections & Recoveries') is responsible for debt management initiatives by Retail Banking. The Workouts and Collections Department ('Workouts & Collections') is responsible for debt management activities on the other portfolios. Debt management strategies, which include affordability assessment, use of collection tools, negotiation of appropriate repayment arrangements and debt counselling, can start prior to actual payment default or as early as the day after a repayment is past due and can continue until legal action. Different collection strategies are applied to different segments of the portfolio subject to the perceived levels of risk.

Forbearance

To support customers that encounter actual or apparent financial difficulties, the Group may grant a concession whether temporary or permanent to amend contractual amounts or timings where a customer's financial distress indicates the potential that satisfactory repayment may not be made within the original terms and conditions of the contract.These arrangements are known as forbearance.

A range of forbearance strategies are employed in order to improve the management of customer relationships, maximise opportunities for positive customer outcomes in collections, and, if possible, avoid foreclosure or repossession. The Group's policies and practices are based on criteria which, in the judgement of management, indicate that repayment is likely to continue.

The Group also aims to ensure that after the initial period of financial difficulties the customer can revert to the previous terms, with appropriate support where necessary. These agreements may be initiated by the customer, the Group or by a third party.

Other support for customers

Group restructured loans

At 30 June 2012, the carrying amount of financial assets that would otherwise be past due or impaired whose terms have been renegotiated was £2,366m (31 December 2011: £1,914m).

CREDIT RISK - RETAIL BANKING

Definition

Credit risk is the risk of financial loss arising from the default of a customer or counterparty to which the Group has directly provided credit, or for which the Group has assumed a financial obligation, after realising collateral held. Credit risk arises principally in connection with Retail Banking's loan and investment assets (including residential mortgages, unsecured lending, and finance leases and credit cards).

MANAGING CREDIT RISK

Retail Banking aims to actively manage and control credit risk. 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 on an on-going basis) and of a good credit quality.

The Board has approved a set of risk appetite limits to cover credit risk arising in Retail Banking. Within these limits, credit mandates and policies are approved with respect to products sold by the Group.

RETAIL BANKING CUSTOMER ASSETS

Retail Banking offers a comprehensive range of banking products and related financial services to customers throughout the UK, including residential mortgages, other banking and consumer credit products such as current account facilities and overdrafts, and provides unsecured personal loans, credit cards, finance leases and other secured loans.

An analysis of Retail Banking customer assets is presented below.

(1) Excludes loans to UK Social Housing Associations, which are managed within Corporate Banking and Corporate Centre, accrued interest and other items.

(2) Overdrafts, UPLs and other loans relating to cards and consumer are disclosed within unsecured loans and other loans.

(3) Includes cahoot UPLs of £0.1bn (31 December 2011: £0.1bn).

(4) Additional finance leases of £1.0bn (31 December 2011: £1.1bn) are managed and classified within Corporate Banking.

Further discussion and analysis is set out below on the main products and services offered by Retail Banking, consisting of residential mortgages, and banking and consumer credit, including current account facilities, unsecured personal loans, finance lease arrangements and credit cards.

RESIDENTIAL MORTGAGES

Retail Banking grants mortgage loans for house purchases as well as home improvement loans to new and existing mortgage customers.

Residential mortgage lending(1)

An analysis of movements in Retail Banking mortgage balances is presented below.

(1) Excludes loans to UK Social Housing Associations, which are managed within Corporate Banking and Corporate Centre, accrued interest and other items.

Managing Credit Risk

Retail Banking lends on many types of property but only after a credit risk assessment of the borrower, including affordability modelling (i.e. an assessment of the customer's capacity to repay) and an assessment of the property is undertaken. The quality of the mortgage assets are monitored to ensure that they are within agreed portfolio limits. Residential lending is subject to lending policy and lending authority levels, which are used to structure lending decisions to the same 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 ('LTV') ratio, borrower status and the mortgage credit score.

All mortgages provided by Retail Banking are secured on UK or Isle of Man properties. All properties must be permanent in construction; mobile homes are not acceptable. The Group can provide a loan 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.

Collateralisation  

Prior to granting any first mortgage loan on a property, the Group has the property valued by an approved and qualified surveyor. The valuation is based on Group guidelines, which build upon the Royal Institution of Chartered Surveyors ('RICS') guidance on valuation methods. In the case of re-mortgages, where the LTV is 75% or lower, the risk judged by the size of the advance requested is medium to low, the credit score of the applicant is considered medium or high, and an accurate, reputable automated valuation is available, this may substitute for a surveyor's valuation.

For existing mortgages, the current values of the properties on which individual mortgages are secured are estimated quarterly. For each individual property, details such as address, type of property and number of bedrooms are supplied to an independent agency that estimates current property valuations using information from recent property transactions and valuations in that local area. All additional loans require 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.

(1) The collateral held excludes the impact of over-collateralisation - where the collateral held is of a higher value than the loan balance held. The carrying value of loans where the LTV is greater than 100% (i.e. negative equity) is £8,259m (2011: £7,867m), the total which is therefore effectively uncollateralized is £1,115m (2011: £995m).

Higher risk loans  

The Group is principally a retail prime lender and does not originate second charge mortgages. Certain mortgage products may be considered higher risk. Operating as a prime lender in the UK mortgage market, the Group does not have any material sub-portfolio demonstrating very poor performance. The portfolio's arrears performance has continued to be relatively stable and favourable to industry benchmarks. Arrears rates and loss rates continued to be very low. Nonetheless, there are some mortgage types that present higher risks than others. These products consist of:

a) Interest-only loans  

Interest-only mortgages require monthly interest payments and the repayment of principal at maturity. This can be arranged via investment products including Individual Savings Accounts and pension policies, or by the sale of the property. It is the customer's responsibility to ensure that they have sufficient funds to repay the principal in full at maturity.

Interest-only mortgages are well-established and common in the UK market. Lending policies to mitigate the risks inherent in this repayment structure are in place and mature. While the risks are higher than capital repayment mortgages, they are only modestly so. The performance of this significant sub-portfolio has been in line with expectations and stable.

b) Flexible loans  

Flexible mortgages allow customers to vary their monthly payment, or take payment holidays, within predetermined criteria and/or up to an agreed credit limit. Customers are also permitted to draw down additional funds at any time up to the limit or redraw amounts that have been previously overpaid.

c) Loans with original loan-to-value >100%  

Progressively stricter lending criteria have been applied to mortgages above a loan-to-value (LTV) of 75% with less than 0.1% of new secured loan advances having an LTV of more than 90%. Loans with higher LTV 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, arrears and the costs of liquidation. However, the recently implemented government "New Buy" scheme whereby LTV's of up to 95% are allowed will mean there will be a small proportion of >90% LTV lending in 2012. The extra risk associated with these higher LTV mortgages is offset as the companies who build the new homes as part of this scheme must offer an indemnity guarantee to the mortgage lender to cover any shortfall in collateral should the home become repossessed.

d) Sub-prime lending  

The Group has no appetite or product offering for sub-prime business. The Group's credit policy explicitly prohibits such lending and is designed to ensure that any business written is responsible, affordable (both initially and on an on-going basis) and of a good credit quality.

Mortgage credit quality and credit risk mitigation - loan-to-value analysis(1)  

(1) Excludes any fees added to the loan, and only includes the drawn loan amount, not drawdown limits.

During the first half of 2012, the average LTV on new business completions increased slightly from 64% to 65%, due to the continuing competition between lenders to write low LTV mortgages. At 30 June 2012, the retail mortgage portfolio with an LTV over 100% remained at 5% and the portfolio with an LTV of 90-100% remained at 7%.

At 30 June 2012, the indexed LTV of the book had increased to 53% from 52% at 31 December 2011. This was due to three factors: a small fall in the house price index, new business lending during 2012 having a slightly higher LTV than the current stock average and the average LTV of redemptions being slightly lower than the current stock average. The average LTV of impaired loans is higher than that of unimpaired loans due to higher LTV business being inherently riskier and hence more likely to go into arrears.

Mortgage credit quality and credit risk mitigation - borrower profile(1)

(1) Excludes any fees added to the loan, and only includes the drawn loan amount, not drawdown limits.

(2) Where a loan exhibits more than one of the higher risk criteria, it is included in all the applicable categories

During the first half of 2012, the proportion of new business for first-time buyers and home movers increased while the proportion of re-mortgages decreased. This was mainly due to a continued stagnation in the re-mortgage market brought about by prolonged low interest rates. A lower percentage of new interest-only loans was written in 2012 compared with 2011 due to no longer accepting interest-only applications with an LTV greater than 50%. The percentage of flexible loans written increased during the first half of 2012.

Average earnings multiple (at inception)

The average earnings multiple (at inception) remained static during the first half of 2012.

Mortgages - Non-performing loans and advances

(1) Mortgages are classified as non-performing when the counterparty fails to make a payment when contractually due for typically three months.

(2) Excludes accrued interest. 

(3) Impairment loan loss allowances as a percentage of non-performing loans and advances.

During the first half of 2012, mortgage non-performing loans as a percentage of mortgage loans and advances to customers increased to 1.57% (31 December 2011: 1.46%). The overall increase was due to a change in collections policy implemented in late 2011 that holds more accounts in NPL for longer, in addition to which the asset reduced. The ratio remained considerably below the UK industry average based on Council of Mortgage Lenders ('CML') published data. After considering the impact of the change in collections policy, the underlying performance remained broadly stable reflecting the high quality of the mortgage book, a lower than anticipated increase in unemployment and prolonged low interest rates.

Impairment loss allowances increased to £502m (31 December 2011: £478m) due to the increase in non-performing loans. The coverage ratio was broadly unchanged at 20% (31 December 2011: 20%).

Mortgages - non-performing loans and advances by higher risk loan type(1)

(1) Where a loan exhibits more than one of the higher risk criteria, it is included in all the applicable categories.

Mortgages - Arrears

The following table analyses the residential mortgage arrears status at 30 June 2012 and 31 December 2011 for Retail Banking by volume and value.

(1) Excludes accrued interest.

(2) Early arrears refer to mortgages that are between 31 days and 90 days in arrears.

(3) Late arrears refer to mortgages that are typically over 90 days in arrears, past maturity and sole deceased.

In the first half of 2012, arrears and repossession levels remained significantly better than UK industry benchmarks from the Council of Mortgage Lenders. Mortgage arrears increased due to a change in collections policy implemented in late 2011 that holds more accounts in NPL for longer. The underlying performance remained stable supported by continued low interest rates and a high quality book. Properties in possession increased slightly but remained stable at 0.06% of the total mortgage book by volume. Properties in possession by value increased slightly during the period and the ratio of properties in possession to the total mortgage book was considerably better than the industry average. This was due to stable sales performance of repossessed assets.

The following table set forth information on UK residential mortgage arrears by volume of accounts (separately for higher risk loans and the remaining loan portfolio) at 30 June 2012 and 31 December 2011for Retail Banking compared to the industry average as provided by the Council of Mortgage Lenders ('CML').

(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 three months.

(3) Where a loan exhibits more than one of the higher risk criteria, it is included in all the applicable categories. As a result, the total of the mortgage arrears for higher risk loans and remaining loan portfolio will not agree to the total mortgage arrears percentages.

Arrears rates increased slightly during the first half of 2012, mainly in the 6 to 12 months arrears category but generally not in the higher risk areas. This increase was mainly due to process changes made within Collections & Recoveries to meet evolving regulatory requirements. Overall, the arrears rate remained well below the industry average as provided by the Council of Mortgage Lenders.

Arrears rates at 30 June 2012 also included loans that had a capital balance outstanding 90 days after the contractual maturity date of the loan even if they were not in payment arrears.

Mortgages - arrears management

When a mortgage is in arrears, the account is considered due and classified in the Collections category. Collections & Recoveries is responsible for all debt management initiatives on the secured loan portfolio for Retail Banking. Debt management strategies, which include affordability assessment, negotiating appropriate 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. Policies and processes are designed to ensure that collections staff tailor repayment arrangements to suit the individual circumstances and financial situation of the customer.

Collections & Recoveries' activities exist to ensure customers who have failed to make their contractual or required minimum payments or have exceeded their agreed credit limits are encouraged, subject to assessment of circumstances and affordability, to enter into appropriate arrangements to pay back the required amounts, and in the event they are unable to do so to pursue recovery of the debt in order to maximise the net recovered balance. The overall aim is to minimise losses by helping customers repay their debts in a timely but affordable and sustainable manner whilst not adversely affecting brand, customer loyalty, fee income, or compliance with relevant legal and regulatory standards.

Collections & Recoveries activity is performed within either:

The Collections & Recoveries department follows the Collections & Recoveries policies and makes use of various collection and rehabilitation tools with the aim to bring the customer account up to date as soon as possible. The policies comply with the UK Financial Services Authority Treating Customers Fairly ('TCF') and Mortgage: Conduct of Business ('MCOB') rules and principles. The MCOB rules govern the relationship between mortgage lenders and borrowers in the UK, and are designed to improve the information available to consumers and increase their ability to make informed choices in the mortgage market.

General principles of collections

The general principles of the Group's collections consist of:

Effective collections and recoveries activity is dependent on:

If the agreed repayment arrangement is not maintained, and all other appropriate solutions or options have been exhausted, legal proceedings may be undertaken and may result in the property being taken into possession. The Group sells the repossessed property in a reasonable time frame for the best possible price based on fair market value 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.

Collection tools 

The Group uses the following collection tools to recover mortgage arrears: